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 nine months ended September 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 September 30, 2016 and December 31, 2015, Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2016 and 2015, Condensed Consolidated Statements of Comprehensive (Loss) Income for the three and nine months ended September 30, 2016 and 2015, Condensed Consolidated Statements of Changes in Stockholders’ Equity for the nine months ended September 30, 2016, and Condensed Consolidated Statements of Cash Flows for the nine months ended September 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, as 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 products. This adjustment was recorded in the results for the quarter ended June 30, 2016, and is included in the results for the nine months ended September 30, 2016. We also recorded an adjustment to inventory to write-down the value of the products remaining in inventory at June 30, 2016. These adjustments also increased accounts payable by $814 thousand and increased net inventories by $221 thousand at June 30, 2016, and reduced cost of sales by $221 thousand, and increased the net loss by $593 thousand for the three months ended June 30, 2016 and the nine months ended September 30, 2016. We have received the returned products and provided credits for the impacted customers and have evaluated and are continuing to implement improvements to our sales, supply chain, and manufacturing processes. We have also enhanced our communications with our customers to fully understand their purchasing requirements and implemented internal processes to ensure that our inventory fulfillment processing and procedures are in line with those needs.

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 September 30, 2016, Atlantic Diving Supply, Inc. (“ADS”), a distributor for the U.S. Navy, accounted for approximately 40 percent of net sales, and total sales of products for the U.S. Navy were approximately 46 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 reduced the minimum purchase commitment requirements through December 31, 2016 for certain products. In addition, LED Lighting Solutions Global, LLC (an affiliate of Energy Management Products, LLC) (“LLS”), accounted for approximately 12 percent of net sales for the three months ended September 30, 2016. For the three months ended September 30, 2015, LLS, who was a former distributor for the U.S. Navy, accounted for approximately 74 percent of net sales, and total sales of products for the U.S. Navy were approximately 82 percent of net sales.

For the nine months ended September 30, 2016, ADS accounted for approximately 32 percent of net sales, and total sales of products for the U.S. Navy were approximately 40 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 nine months ended September 30, 2016. For the nine months ended September 30, 2015, LLS accounted for approximately 79 percent of net sales, and total sales of products for the U.S. Navy were approximately 85 percent of net sales.

The indefinite duration, indefinite quantity (“IDIQ”) U.S. Navy supply contract that we were awarded in 2011 expired on August 1, 2016. This contract accounted for approximately $3.2 million in sales in 2015 and $2.1 million in sales for the nine months ended September 30, 2016. The remainder of our sales for the U.S. Navy during these periods occurred through ship-level procurement, which is not impacted by the expiration of this agreement.

At September 30, 2016, ADS accounted for approximately 65 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 August 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2016-15, Statement of Cash Flows (Topic 230) Classification of Certain Cash Receipts and Cash Payments, which is intended to reduce diversity in practice by making eight targeted changes to how cash receipts and cash payments are presented and classified in the statement of cash flows. This ASU is effective for fiscal years beginning after December 15, 2017, and will require adoption on a retrospective basis. We are in the process of evaluating the impact of the standard.

In June 2016, the FASB issued 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, and will generally require adoption on a modified retrospective basis. 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, which will be required to be adopted on a modified retrospective basis, 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, and will require adoption on a modified retrospective basis. 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, and will require adoption on a prospective basis with a cumulative-effect adjustment to the beginning balance sheet. 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 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.

In May 2014, the FASB issued No. ASU 2014-09, Revenue from Contracts with Customers (Topic 606), which supersedes previous revenue recognition guidance. This standard requires an entity to recognize revenue when it transfers promised goods or services to customers in amounts that reflect the consideration the entity expects for receive in exchange for those goods or services. Entities will need to use more judgments and estimates than under the current guidance, including estimated the amount of variable revenue to recognize for each performance obligation. Additional disclosures regarding the nature, amount, and timing of revenues and cash flows from contracts will also be required. In August 2015, the FASB issued ASU No. 2015-14, Revenue from Contracts with Customers (Topic 606): Deferral of the Effective Date. This ASU defers the effective date of ASU No. 2014-09 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, using either a full retrospective or a modified retrospective approach. 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.

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 September 30,						Nine months ended September 30,
	2016			2015			2016			2015
Numerator:
(Loss) income from continuing operations	$	(3,177	)	$	4,398		$	(9,070	)	$	7,814
Loss from discontinued operations	—			(142		)	(12		)	(318		)
Net (loss) income	$	(3,177	)	$	4,256		$	(9,082	)	$	7,496

Denominator:
Basic weighted average common shares outstanding	11,690			10,310			11,666			10,002
Potential common shares from equity awards and warrants	—			355			—			340
Diluted weighted average shares	11,690			10,665			11,666			10,342

As a result of the net loss we incurred for the three and nine months ended September 30, 2016, approximately 74 thousand and 150 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 nine months ended September 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 our commercial LED tubes, globes, and troffer luminaires for a period of ten years. Warranty settlement costs consist of actual amounts expensed for warranty, which are largely a result of the cost of replacement products provided to our customers. A liability for the estimated future costs under product warranties is maintained for products outstanding under warranty based on estimated of claims incurred to date and the nature, frequency, and costs of future claims. These estimates are inherently uncertain and changes to our historical or projected experience may cause material changes to our warranty reserves in the future. We continuously review the assumptions related to the adequacy of our warranty reserve, including product failure rates, and make adjustments to the existing warranty liability when there are changes to these estimates or the underlying replacement product costs, or the warranty period expires. Extending the warranty did not have a material impact to our condensed consolidated financial statements for the three and nine months ended September 30, 2016. The following table summarizes warranty activity for the periods presented (in thousands):



	Three months ended September 30,						Nine months ended September 30,
	2016			2015			2016			2015
Balance at beginning of period	$	298		$	391		$	314		$	81
Accruals for warranties issued	65			—			111			381
Adjustments to existing warranties	(60		)	—			(112		)	(56		)
Settlements made during the period (in kind)	(8		)	(2		)	(18		)	(17		)
Accrued warranty reserve	$	295		$	389		$	295		$	389

As part of the quarterly review of the warranty reserve, we became aware of failures experienced by a limited number of end-users of our commercial Intellitube® product. The commercial Intellitube® product failures, which are not related to any health or safety concerns, occur when the product is installed in a certain manner or with certain ballasts. We have conducted an analysis of the failed product and have determined a course of action under our standard warranty policy to address the issue for these customers, which is reflected in the accrued warranty reserve at September 30, 2016.

Debt

During the three and nine months ended September 30, 2015, we incurred interest expense of approximately $22 thousand and $71 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 our product development office in Taiwan. Net sales attributable to customers outside the United States accounted for less than one percent and approximately two percent of our total net sales for the three and nine months ended September 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 nine months ended September 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 President 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 nine months ended September 30, 2015, nothing was paid under this agreement and we recorded expense of $56 thousand and $169 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.