BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of presentation

The condensed consolidated financial statements (“financial statements”) include the accounts of the Company and its subsidiary Energy Focus Europe, Ltd. located in the United Kingdom, which is not active. The results of operations and financial position of EFLS, CLL, and the pool products business are included in the condensed consolidated financial statements as discontinued operations and previously reported financial information for the current and prior year have been adjusted. Unless indicated otherwise, the information in the Notes to the condensed consolidated financial statements relates to our continuing operations.

We have prepared the accompanying financial data for the three and six months ended June 30, 2016 and 2015 pursuant to the rules and regulations of the United States Securities and Exchange Commission (“SEC”). Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States (“U.S. GAAP”) have been condensed or omitted pursuant to such rules and regulations. The accompanying financial data and information should be read in conjunction with our Annual Report on Form 10-K for the year ended December 31, 2015, as amended ("2015 Annual Report").

In the opinion of management, the accompanying financial statements contain all normal and recurring adjustments necessary to present fairly our Condensed Consolidated Balance Sheets as of June 30, 2016 and December 31, 2015, Condensed Consolidated Statements of Operations for the three and six months ended June 30, 2016 and 2015, Condensed Consolidated Statements of Comprehensive (Loss) Income for the three and six months ended June 30, 2016 and 2015, Condensed Consolidated Statements of Changes in Stockholders’ Equity for the six months ended June 30, 2016, and Condensed Consolidated Statements of Cash Flows for the six months ended June 30, 2016 and 2015.

During the quarter ended June 30, 2016, we recorded an adjustment to reduce revenue by $814 thousand to reflect the return of products and related discounts on sales of products sold during the fourth quarter of 2015 and the first quarter of 2016. We determined that certain shipments did not comply with our process to assemble finished products with the applicable standard for those orders. This operational error did not relate to the safety or quality of the products, but instead to conformity with the manufacturing standard represented with respect to the product. This adjustment was recorded in the results for the quarter ended June 30, 2016. We also recorded an adjustment to inventory to write-down the value of this product remaining in inventory at June 30, 2016. These adjustments also increased accounts payable by $814 thousand, increased net inventories by $221 thousand, reduced cost of sales by $221 thousand, and increased the net loss by $593 thousand. We have arranged for returns and credits for the impacted customers and have evaluated and are implementing improvements to our sales, supply chain, and manufacturing processes. We have also enhanced our communications with our customers regarding their purchasing requirements and implemented internal processes to ensure that our inventory fulfillment is in line with those needs. We have estimated an amount of the potential credits for the remaining affected customers and determined that the impact is likely to be not material to the condensed consolidated financial statements.

Use of estimates

The preparation of financial statements in accordance with accounting principles generally accepted in the United States ("U.S. GAAP") requires management to make estimates and assumptions that affect the amounts reported in our financial statements and accompanying notes. Management bases its estimates on historical experience and various other assumptions believed to be reasonable. Although these estimates are based on management’s best knowledge of current events and actions that may impact us in the future, actual results may vary from the estimates. Estimates include, but are not limited to, the establishment of reserves for accounts receivable, sales returns, inventory obsolescence and warranty claims; the useful lives of property and equipment; valuation allowance for net deferred taxes; and stock-based compensation. In addition, estimates and assumptions associated with the determination of the fair value of financial instruments and evaluation of long-lived assets for impairment requires considerable judgment. Actual results could differ from those estimates and such differences could be material.

Certain risks and concentrations

We have certain customers whose net sales individually represented 10 percent or more of our total net sales, or whose net trade accounts receivable balance individually represented 10 percent or more of our total net trade accounts receivable, as follows:

For the three months ended June 30, 2016, Atlantic Diving Supply, Inc. ("ADS"), a distributor for the U.S. Navy, accounted for approximately 36 percent of net sales. During the three months ended June 30, 2016, we amended our exclusive distributor agreement with ADS to extend it until March 31, 2017 and reduce the minimum commitment requirements for certain products. In addition, one of the largest global healthcare systems located in Northeast Ohio accounted for approximately 11 percent of net sales for the three months ended June 30, 2016. For the three months ended June 30, 2015, LED Lighting Solutions Global, LLC (an affiliate of Energy Management Products, LLC) ("LLS"), who was our former distributor for the U.S. Navy, accounted for approximately 79 percent of net sales and nearly all of the sales of products for the U.S. Navy.

For the six months ended June 30, 2016, DFAS Columbus accounted for approximately 11 percent of net sales and ADS accounted for approximately 27 percent of net sales, and together they comprised sales of products for the U.S. Navy totaling approximately 38 percent of net sales. In addition, one of the largest global healthcare systems located in Northeast Ohio accounted for approximately 11 percent of net sales for the six months ended June 30, 2016. For the six months ended June 30, 2015, LLS accounted for approximately 82 percent of net sales and nearly all of the sales of products for the U.S. Navy.

The indefinite duration, indefinite quantity ("IDIQ") U.S. Navy supply contract that we were awarded in 2011 terminates on August 1, 2016. This contract accounted for approximately $3.2 million in sales in 2015 and $1.6 million in sales for the six months ended June 30, 2016. The remainder of our sales for the U.S. Navy during these periods occurred through ship-level procurement, which purchasing is not impacted by the termination of this agreement.

At June 30, 2016, ADS accounted for approximately 64 percent of net trade accounts receivable. At December 31, 2015, ADS accounted for approximately 62 percent of net trade accounts receivable.

Recent accounting pronouncements

In June 2016, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") No. 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, which significantly changes the accounting for credit losses on instruments within its scope. The new guidance introduces an approach based on expected losses to estimate credit losses on certain financial instruments, including trade receivables, and requires an entity to recognize an allowance based on its estimate of expected credit losses rather than incurred losses. This standard will be effective for interim and annual periods beginning after December 15, 2019. We are in the process of evaluating the impact of the standard.

In May 2016, the FASB issued ASU No. 2016-12, Revenue from Contracts with Customers (Topic 606): Narrow Scope Improvements and Practical Expedients, which was intended to address implementation issues raised by stakeholders regarding collectability, non-cash consideration, presentation of sales tax, and transition. The amendments clarify the requirement to assess the collectability of contract consideration, specify that non-cash consideration should be measured at contract inception, allow entities to present sales net of sales taxes collected from customers, and provide a practical expedients related to completed contracts and contracts modified prior to adopting the new standard. These amendments are to be adopted concurrently with ASU No. 2014-09. We are in the process of evaluating the impact of the standard.

In March 2016, the FASB issued ASU No. 2016-09, Compensation–Stock Compensation: Improvements to Employee Share-Based Payment Accounting, which changes the accounting for employee share-based payments. This standard addresses several aspects of the accounting for share-based payment award transactions, including: (a) income tax consequences; (b) classification of awards as either equity or liabilities; and (c) classification on the statement of cash flows. This standard will be effective for interim and annual periods beginning after December 15, 2016, and early adoption is permitted. We are in the process of evaluating the impact of the standard.

In March 2016, the FASB issued ASU No. 2016-08, Revenue from Contracts with Customers (Topic 606): Principal versus Agent Considerations (Reporting Revenue Gross versus Net), which amends the guidance in ASU No. 2014-09 on assessing whether an entity is a principal or an agent in a revenue transaction (i.e., whether an entity reports revenue on a gross or net basis). This amendment retains the guidance that the principal in an arrangement controls a good or service before it is transferred to a customer and clarifies the indicators for principal versus agent assessment in an arrangement. This amendment is to be adopted concurrently with ASU No. 2014-09. We are in the process of evaluating the impact of the standard.

In February 2016, the FASB issued ASU No. 2016-02, Leases, which impacts the accounting for leasing transactions. This standard requires a lessee to record on the balance sheet the assets and liabilities for the rights and obligations created by leases with lease terms of more than 12 months. For lessors, the guidance modifies the classification criteria and the accounting for sales-type and direct financing leases. In addition, this standard requires both lessees and lessors to disclose certain key information about lease transactions. This standard will be effective for interim and annual periods beginning after December 15, 2018. We are in the process of evaluating the impact of the standard.

In January 2016, the FASB issued ASU No. 2016-01, Recognition and Measurement of Financial Assets and Financial Liabilities, which amends certain aspects of the recognition, measurement, presentation and disclosure of financial instruments. This amendment requires all equity investments to be measured at fair value with changes in the fair value recognized through net income (other than those accounted for under the equity method of accounting or those that result in the consolidation of the investee). This standard will be effective for interim and annual periods beginning after December 15, 2017. We are in the process of evaluating the impact of the standard.

In November 2015, the FASB issued ASU No. 2015-17, Income Taxes (Topic 740): Balance Sheet Classification of Deferred Taxes, which requires entities to present deferred tax assets ("DTAs") and deferred tax liabilities ("DTLs") as noncurrent in a classified balance sheet. This presentation simplifies the current guidance, which requires entities to separately present DTAs and DTLs as current or noncurrent in a classified balance sheet. The netting of DTAs and DTLs by tax jurisdiction is still required under the new guidance. The standard is effective for interim and annual periods beginning after December 15, 2016, and early adoption is permitted. We expect to adopt this ASU on January 1, 2017, as required. The adoption of this ASU is not expected to have a material impact on our disclosures as a result of the full valuation allowance we have recorded against our DTAs.

In August 2015, the FASB issued ASU No. 2015-14, Revenue from Contracts with Customer (Topic 606): Deferral of the Effective Date. This ASU defers the effective date of ASU 2014-09, Revenue from Contracts with Customer (Topic 606) for all entities by one year. As a result, all entities will be required to apply the provisions of ASU 2014-09 to annual reporting periods beginning after December 15, 2017, including interim reporting periods within that reporting period. Early adoption is permitted only as of annual reporting periods beginning after December 15, 2016, including interim reporting periods within that reporting period. We are currently assessing the adoption date and impact the guidance in this ASU will have, if any, on our consolidated results of operations, cash flows, or financial position.

In July 2015, the FASB issued ASU No. 2015-11, Inventory (Topic 330), which requires entities to measure most inventory at the lower of cost and net realizable value. This measure simplifies the current guidance, which requires entities to measure inventory at the lower of cost or market, where market is defined as one of three different measures, including net realizable value. The ASU does not apply to inventories measured by using either the last-in, first-out method or the retail inventory method. The ASU is effective prospectively for interim and annual periods beginning after December 15, 2016, and early adoption is permitted. We expect to adopt the new standard on January 1, 2017, as required, and do not expect the adoption of this ASU to have a material impact on our consolidated results of operations, cash flows, or financial position.

Update to significant accounting policies

There have been no material changes to our significant accounting policies, as compared to those described in our 2015 Annual Report.

Net (loss) income per share

Basic (loss) earnings per share is computed by dividing net (loss) income available to common stockholders by the weighted average number of common shares outstanding during the period, excluding the effects of any potentially dilutive securities. Diluted (loss) earnings per share gives effect to all dilutive potential common shares outstanding during the period. Dilutive potential common shares consist of incremental shares upon the exercise or release of stock options, restricted stock units, and warrants, unless the effect would be anti-dilutive.

The following is a reconciliation of the numerator and denominator of the basic and diluted net (loss) income per share computations for the periods presented below (in thousands):



	Three months ended June 30,						Six months ended June 30,
	2016			2015			2016			2015
Numerator:
(Loss) income from continuing operations	$	(3,916	)	$	2,192		$	(5,893	)	$	3,416
Loss from discontinued operations	—			(81		)	(12		)	(176		)
Net (loss) income	$	(3,916	)	$	2,111		$	(5,905	)	$	3,240

Denominator:
Basic weighted average common shares outstanding	11,657			10,019			11,653			9,846
Potential common shares from equity awards and warrants	—			119			—			212
Diluted weighted average shares	11,657			10,138			11,653			10,058

As a result of the net loss we incurred for the three and six months ended June 30, 2016, approximately 146 thousand and 183 thousand options, restricted stock units, and warrants, respectively, were excluded from the net loss per share calculation, as their inclusion would have been anti-dilutive. Therefore, for the three and six months ended June 30, 2016, the basic weighted average shares outstanding were used in calculating diluted loss per share.

Product warranties

Through March 31, 2016, we warranted finished goods against defects in material and workmanship under normal use and service for periods generally between one and five years. Beginning April 1, 2016, we warrant commercial LED tubes, LED dock lights, globes, and retrofit kits for a period of ten years. Settlement costs consist of actual amounts expensed for warranty, which are largely a result of the cost of replacement products. A liability for the estimated future costs under product warranties is maintained for products and services outstanding under warranty. Extending the warranty did not have a material impact to our condensed consolidated financial statements for the three and six months ended June 30, 2016. The following table summarizes warranty activity for the periods presented (in thousands):



	Three months ended June 30,						Six months ended June 30,
	2016			2015			2016			2015
Balance at beginning of period	$	327		$	410		$	314		$	81
Accruals for warranties issued	30			49			46			381
Adjustments to existing warranties	(52		)	(56		)	(52		)	(56		)
Settlements made during the period (in cash or in kind)	(7		)	(12		)	(10		)	(15		)
Accrued warranty reserve	$	298		$	391		$	298		$	391

Debt

During the three and six months ended June 30, 2015, we incurred interest expense of approximately $26 thousand and $49 thousand, respectively, in connection with our former revolving credit facility that was terminated in December 2015. For a full description of our debt financing, please refer to Note 7, "Debt," included under Item 8 of our 2015 Annual Report.

Geographic information

Approximately 99 percent of our long-lived fixed assets are located in the United States, with the remainder located in Taiwan. Net sales attributable to customers outside the United States accounted for less than one percent and approximately three percent of our total net sales for the three and six months ended June 30, 2016, respectively. Net sales attributable to customers outside the United States accounted for less than one percent of our total net sales for the three and six months ended June 30, 2015. The geographic location of our net sales is derived from the destination to which we ship the product.

Related Party Transactions

On February 27, 2012, we entered into an Asian Business Development/Collaboration Agreement with Communal International Ltd. ("Communal"), a British Virgin Islands company that is 50 percent owned by James Tu, our Executive Chairman and Chief Executive Officer and 50 percent owned by Yeh-Mei Cheng, the mother of Simon Cheng, a current member of our Board of Directors and an employee of the Company. On December 23, 2015, we terminated this agreement. For the three and six months ended June 30, 2015, nothing was paid under this agreement and we recorded expense of $56 thousand and $113 thousand, respectively. For a full discussion of our related parties and the Communal agreement, please refer to Note 14, "Related Party Transactions," included under Item 8. of our 2015Annual Report.