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. Unless indicated otherwise, the information in the accompanying financial statements and 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, 2017 and 2016 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, 2016 (“2016 Annual Report”). The Condensed Consolidated Balance Sheet as of December 31, 2016 has been derived from the audited consolidated financial statements at that date, but does not include all of the information and footnotes required by U.S. GAAP for complete financial statements.

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, 2017 and December 31, 2016, Condensed Consolidated Statements of Operations for the three and six months ended June 30, 2017 and 2016, Condensed Consolidated Statements of Comprehensive Loss for the three and six months ended June 30, 2017 and 2016, Condensed Consolidated Statements of Changes in Stockholders’ Equity for the six months ended June 30, 2017, and Condensed Consolidated Statements of Cash Flows for the six months ended June 30, 2017 and 2016.

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 the sales of products sold during the fourth quarter of 2015 and the first quarter of 2016. This adjustment also reduced cost of sales by $221 thousand and increased the net loss by $593 thousand.

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.

Reclassifications

Certain amounts related to purchase price and manufacturing variances capitalized in inventories in 2016 were reclassified to conform to current period reporting presentation with no impact on financial position, loss from operations, or cash used in operations.

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, 2017, one of the largest global healthcare systems located in Northeast Ohio accounted for approximately 11 percent of net sales. While the last contractually required stocking commitment under our exclusive distributor agreement with Atlantic Diving Supply, Inc. (“ADS”), a distributor for the U.S. Navy, was fulfilled in December 2016, sales to ADS accounted for approximately 11 percent of net sales, and when combined with non-exclusive sales to other distributors, sales of products for the U.S. Navy comprised approximately 12 percent of net sales for the three months ended June 30, 2017. For the three months ended June 30, 2016, ADS accounted for approximately 36 percent of net sales and the healthcare system located in Northeast Ohio accounted for approximately 11 percent of net sales.

For the six months ended June 30, 2017, the healthcare system located in Northeast Ohio accounted for approximately 15 percent of net sales. While the last contractually required stocking commitment under our exclusive distributor agreement with ADS was fulfilled in December 2016, sales to ADS accounted for approximately 12 percent of net sales, and when combined with non-exclusive sales to other distributors, sales of products for the U.S. Navy comprised approximately 17 percent of net sales for the six months ended June 30, 2017. For the six months ended June 30, 2016, sales directly to the U.S. Department of Defense accounted for approximately 11 percent of net sales and sales to ADS accounted for approximately 27 percent of net sales, representing sales of products for the U.S. Navy of approximately 38 percent of net sales. In addition, the healthcare system located in Northeast Ohio accounted for approximately 11 percent of net sales for the six months ended June 30, 2016.

Our exclusive distributor agreement with ADS ended on March 31, 2017 and we are currently evaluating all sales channels within the military maritime market to broaden our sales opportunities.

Due to the nature and timing of end user retrofit projects, two energy services contracting companies accounted for approximately 17 percent and approximately 12 percent of net trade accounts receivable, respectively, at June 30, 2017. At December 31, 2016, ADS and one of the largest global healthcare systems located in Northeast Ohio accounted for approximately 63 percent and approximately 10 percent of net trade accounts receivable, respectively.

Recent accounting pronouncements

In May 2017, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2017-09, Compensation—Stock Compensation: Scope of Modification Accounting, which provides guidance about which changes to the terms or conditions of a share-based payment award would require an entity to apply modification accounting. This standard is effective for fiscal years beginning after December 15, 2017. We are in the process of evaluating the impact of the standard.

In November, 2016, the FASB issued ASU No. 2016-18, Restricted Cash, which requires entities to show the changes in the total of cash, cash equivalents, restricted cash, and restricted cash equivalents in the statement of cash flow. This standard is effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. Early adoption is permitted, including adoption in an interim period. The new standard must be adopted retrospectively. We are in the process of evaluating the impact of the standard.

In August 2016, the FASB issued 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 February 2016, the FASB issued ASU No. 2016-02, Leases, which supersedes the current lease accounting requirements. 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. In addition, this standard requires lessees to disclose certain key information about lease transactions. Upon implementation, an entity’s lease payment obligations will be recognized at their estimated present value along with a corresponding right-of-use asset. Lease expense recognition will be generally consistent with current practice. 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 May 2014, the FASB issued No. ASU 2014-09, Revenue from Contracts with Customers (Topic 606), as amended by ASU 2015-14, 2016-08, 2016-10, 2016-12, and 2016-20, which is a comprehensive revenue recognition standard which supersedes nearly all of the existing revenue recognition guidance under U.S. GAAP. 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 estimating 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. This ASU is effective for 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. We will adopt the standard on January 1, 2018, as required. We continue to evaluate the transition method we will use and the impact the guidance in this ASU will have on our disclosures. At this time, we do not expect the guidance to have a significant impact on our consolidated results of operations, cash flows, or financial position, as our revenue arrangements generally consist of a single performance obligation to transfer promised goods.

Update to significant accounting policies

There have been no material changes to our significant accounting policies, as compared to those described in our 2016 Annual Report.

Net loss per share

Basic (loss) earnings per share is computed by dividing net loss 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.

As a result of the net loss we incurred for the three and six months ended June 30, 2017, approximately 64 thousand and 99 thousand potentially dilutive equity awards, respectively, were excluded from the net loss per share calculation, as their inclusion would have been anti-dilutive. 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 potentially dilutive equity awards, 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, 2017 and 2016, the basic weighted average shares outstanding were used in calculating diluted loss per share.

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



	Three months ended June 30,						Six months ended June 30,
	2017			2016			2017			2016
Numerator:
Loss from continuing operations	$	(3,114	)	$	(3,916	)	$	(7,636	)	$	(5,893	)
Loss from discontinued operations	—			—			—			(12		)
Net loss	$	(3,114	)	$	(3,916	)	$	(7,636	)	$	(5,905	)

Denominator:
Basic weighted average common shares outstanding	11,791			11,657			11,755			11,653
Potential common shares from equity awards and warrants	—			—			—			—
Diluted weighted average shares	11,791			11,657			11,755			11,653

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 the actual claims incurred to date and the estimated 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 on our condensed consolidated financial statements in 2016 or for the three and six months ended June 30, 2017. The following table summarizes warranty activity for the periods presented (in thousands):



	Three months ended June 30,						Six months ended June 30,
	2017			2016			2017			2016
Balance at beginning of period	$	258		$	327		$	331		$	314
Accruals for warranties issued	17			30			44			46
Adjustments to existing warranties	(17		)	(52		)	(66		)	(52		)
Settlements made during the period (in kind)	(79		)	(7		)	(130		)	(10		)
Accrued warranty reserve	$	179		$	298		$	179		$	298

Geographic information

Approximately 98 percent of our long-lived fixed assets are located in the United States, with the remainder located in our product development center in Taiwan. Net sales attributable to customers outside the United States accounted for approximately one percent of our total net sales for each of the three months ended June 30, 2017 and 2016. Net sales attributable to customers outside the United States accounted for approximately one percent and three percent of our total net sales for the six months ended June 30, 2017 and 2016, respectively. The geographic location of our net sales is derived from the destination to which we ship the product.