NOTE 1.

Summary of Significant Accounting Policies and Significant Judgments and Estimates

Basis of Presentation. The accompanying condensed consolidated financial statements include the accounts of the Company and its wholly-owned subsidiary. All significant intercompany accounts and transactions have been eliminated in consolidation.

The discussion and analysis of our financial condition and results of operations are based on our condensed consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of these condensed consolidated financial statements requires management to make estimates and judgments that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported revenues and expenses during the reporting periods.

On an ongoing basis, management evaluates its estimates and judgments, including but not limited to those related to revenue recognition, inventory reserves, receivable reserves, marketable securities, income taxes, fair value of financial instruments and share-based compensation. Management bases its estimates on historical experience and on various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. By their nature estimates are subject to an inherent degree of uncertainty. Actual results may differ from these estimates under different assumptions or conditions.

The accounting policies that management believes are most critical to aid in fully understanding and evaluating our reported financial results include the following:

Revenue Recognition

Product revenue is recognized when there is persuasive evidence of an arrangement, the fee is fixed or determinable, delivery of the product to the customer has occurred and we have determined that collection of the fee is probable. Title to the product generally passes upon shipment of the product, as the products are shipped FOB shipping point, except for certain foreign shipments for which title passes upon entry of the product into the first port in the buyer’s country. If the product requires installation to be performed by TCC, all revenue related to the product is deferred and recognized upon completion of the installation. We provide for a warranty reserve at the time the product revenue is recognized.

We perform funded research and development and technology development for commercial companies and government agencies under both cost reimbursement and fixed-price contracts. Cost reimbursement contracts provide for the reimbursement of allowable costs and, in some situations, the payment of a fee. These contracts may contain incentive clauses providing for increases or decreases in the fee depending on how actual costs compare with a budget. Revenue from cost reimbursement contracts is recognized as services are performed. On fixed-price contracts that are expected to exceed one year in duration, revenue is recognized pursuant to the proportional performance method based upon the proportion of actual costs incurred to date to the total estimated costs for the contract. In each type of contract, we receive periodic progress payments or payments upon reaching interim milestones, and we retain the rights to the intellectual property developed in government contracts. All payments to TCC for work performed on contracts with agencies of the U.S. government are subject to audit and adjustment by the Defense Contract Audit Agency. Adjustments are recognized in the period made. When current estimates of total contract revenue and contract costs for a product development contract indicate a loss, a provision for the entire loss on the contract is recorded. Any losses incurred in performing funded research and development projects are recognized as funded research and development expenses.

Cost of product revenue includes material, labor and overhead. Costs incurred in connection with funded research and development are included in cost of sales. Product development costs are charged to billable engineering services, bid and proposal efforts or support of business development activities, as appropriate. Product development costs charged to billable projects are recorded as cost of sales; engineering costs charged to bid and proposal efforts are recorded as selling expenses; and product development costs charged to business development activities are recorded as marketing expenses. Product development costs consist primarily of personnel costs, outside contractor and engineering services, supplies and materials.

Inventory

We value our inventory at the lower of actual cost (based on first-in, first-out (FIFO)) to purchase and/or manufacture or the current estimated market value (based on the estimated selling prices, less the cost to sell) of the inventory. We periodically review inventory quantities on hand and record a provision for excess and/or obsolete inventory based primarily on our estimated forecast of product demand, as well as historical usage. Due to the custom and specific nature of certain of our products, demand and usage for products and materials can fluctuate significantly. A significant decrease in demand for our products could result in a short-term increase in the cost of inventory purchases and an increase in excess inventory quantities on hand. In addition, our industry is characterized by rapid technological change, frequent new product development and rapid product obsolescence, any of which could result in an increase in the amount of obsolete inventory quantities on hand. Therefore, although we make every effort to ensure the accuracy of our forecasts of future product demand, any significant unanticipated changes in demand or technological developments could have a significant negative impact on the value of our inventory and would reduce our reported operating results.

Accounts Receivable

Accounts receivable are reduced by an allowance for amounts that may become uncollectible in the future. The estimated allowance for uncollectible amounts is based primarily on a specific analysis of accounts in the receivable portfolio and historical write-off experience. While management believes the allowance to be adequate, if the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required, which would reduce net income. The allowance recorded for accounts receivable at March 29, 2014 and September 28, 2013 was $25,000.

Marketable Securities

The Company accounts for marketable securities in accordance with FASB ASC 320, Investments—Debt and Equity Securities. All marketable securities must be classified as one of the following: held to maturity, available for sale, or trading. The Company holds certain marketable securities classified as available for sale or held to maturity. The available for sale investments are valued at fair value, with unrealized holding gains and losses reported in stockholders’ equity as a separate component of accumulated other comprehensive income (loss). The cost of securities sold is determined based on the specific identification method. Realized gains and losses, and declines in value judged to be other than temporary, are included in investment income. The Company’s held to maturity securities, comprised of investments in municipal bonds, are valued at amortized cost. The purchase discount or premium is amortized to income or expense, respectively, over the life of the securities.

Accounting for Income Taxes

The preparation of our condensed consolidated financial statements requires us to estimate our income taxes in each of the jurisdictions in which we operate, including those outside the United States, which may subject the Company to certain risks that ordinarily would not be expected in the United States. The income tax accounting process involves estimating our actual current exposure together with assessing temporary differences resulting from differing treatments of items, such as deferred revenue, reserves on accounts receivable and inventory, as well as depreciation differences for tax and accounting purposes. These differences result in the recognition of deferred tax assets and liabilities. We must then record a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized.

Significant management judgment is required in determining our provision for income taxes, our deferred tax assets and liabilities, and any valuation allowance recorded against deferred tax assets. We have recorded a valuation allowance against our deferred tax assets of approximately $2.1 million as of March 29, 2014 due to uncertainties related to our ability to utilize these assets. The valuation allowance is based on our estimates of taxable income by jurisdiction and the period over which our deferred tax assets will be recoverable. In the event that actual results differ from these estimates or we adjust these estimates in future periods, we may need to adjust our valuation allowance, which could materially impact our financial position and results of operation.

Due to the nature of our current operations in foreign countries (selling products into these countries with the assistance of local representatives), the Company has not been subject to any foreign taxes in recent years, and it is not anticipated that we will be subject to foreign taxes in the near future.

Fair Value of Financial Instruments

In determining the fair value of financial instruments, the Company follows the provisions of FASB ASC 820, Fair Value Measurements and Disclosures. FASB ASC 820 defines fair value, establishes a framework for measuring fair value under GAAP and enhances disclosures about fair value measurements. The topic provides a consistent definition of fair value which focuses on an exit price, which is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The topic also prioritizes, within the measurement of fair value, the use of market-based information over entity specific information and establishes a three-level hierarchy for fair value measurements based on the nature of inputs used in the valuation of an asset or liability as of the measurement date. The three level hierarchy is as follows:


Level 1 -		Pricing inputs are quoted prices available in active markets for identical investments as of the reporting date.

Level 2 -		Pricing inputs are quoted prices for similar investments, or inputs that are observable, either directly or indirectly, for substantially the full term through corroboration with observable market data.

Level 3 -		Pricing inputs are unobservable for the investment, that is, inputs that reflect the reporting entity’s own assumptions about the assumptions market participants would use in pricing the asset or liability.

In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, an investment’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement. The Company’s assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment, and considers factors specific to the investment.

The Company holds certain marketable securities classified as available for sale. These available for sale securities are comprised of certificates of deposit in U.S. banks and money market funds held in a brokerage account. The fair value of these investments is based on quoted prices from recognized pricing services (e.g. Standard & Poor’s, Bloomberg, etc.), or in the case of mutual funds, at their closing net asset value.

The Company assesses the levels of the investments at each measurement date, and transfers between levels are recognized on the actual date of the event or change in circumstances that caused the transfer in accordance with the Company’s accounting policy regarding the recognition of transfers between levels of the fair value hierarchy. During the three and six month periods ended March 29, 2014, there were no transfers between levels.

The following table sets forth by level, within the fair value hierarchy, the financial instruments carried at fair value as of March 29, 2014 and September 28, 2013, in accordance with the fair value hierarchy as defined above. As of March 29, 2014 and September 28, 2013, the Company did not hold any assets classified as Level 3.


	Total		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)
March 29, 2014 (Unaudited)

Certificates of deposits:
Certificates of deposit	$	2,577,833	$	—	$	2,577,833

Total debt instruments		2,577,833		—		2,577,833


Mutual funds:
Money market funds		589,781		589,781		—

Total mutual funds		589,781		589,781		—


Total investments	$	3,167,614	$	589,781	$	2,577,833


September 28, 2013

Certificates of deposits:
Certificates of deposit	$	1,247,384	$	—	$	1,247,384

Total debt instruments		1,247,384		—		1,247,384


Mutual funds:
Money market funds		880,230		880,230		—

Total mutual funds		880,230		880,230		—


Total investments	$	2,127,614	$	880,230	$	1,247,384

Assets and liabilities measured at fair value on a nonrecurring basis are recognized at fair value subsequent to initial recognition when they are deemed to be impaired. As of March 29, 2014 and September 28, 2013, the Company’s assets and liabilities subject to measurement at fair value on a nonrecurring basis are equipment and leasehold improvements. Neither was deemed to be impaired or measured at fair value on a nonrecurring basis.

Share-Based Compensation

Share-based compensation cost is measured at the grant date based on the calculated fair value of the award. The expense is recognized over the participant’s requisite service period, generally the vesting period of the award. The related excess tax benefit received upon the exercise of stock options, if any, is reflected in the Company’s statement of cash flows as a financing activity. There were no excess tax benefits recorded during the three and six month periods ended March 29, 2014 and March 30, 2013.

The Company selected the Black-Scholes option pricing model as the method for determining the estimated fair value of its stock awards. The Black-Scholes method of valuation requires several assumptions: (1) the expected term of the stock award, (2) the expected future stock price volatility over the expected term, (3) a risk-free interest rate and (4) the expected dividend rate. The expected term represents the expected period of time the Company believes the options will be outstanding based on historical information. Estimates of expected future stock price volatility are based on the historic volatility of the Company’s common stock and the risk free interest rate is based on the U.S. Treasury Note rate. The Company utilizes a forfeiture rate based on an analysis of its actual experience. The forfeiture rate is not material to the calculation of share-based compensation.

The fair value of options at date of grant was estimated with the following assumptions (unaudited):


	Three and Six Months Ended
	March 29, 2014			March 30, 2013

Option term		6.5 years			6.5 years
Risk-free interest rate		1.33% to 1.53	%		0.71% to 0.79	%
Stock price volatility		60% to 65	%		66	%
Dividend yield		—			—

There were 14,200 options granted during the six months ended March 29, 2014, and 16,500 options granted during the six months ended March 30, 2013. The weighted average grant date fair value for the options granted during the six month periods ended March 29, 2014 and March 30, 2013 was $4.53 and $2.89, respectively.

The following table summarizes share-based compensation costs included in the Company’s condensed consolidated income statements for the three and six month periods ended March 29, 2014 and March 30, 2013 (unaudited):


	March 29, 2014				March 30, 2013
	3 months		6 months		3 months		6 months
Cost of sales	$	4,079	$	8,158	$	4,074	$	8,148
Selling, general and administrative expenses		75,360		87,290		51,810		63,777
Product development expenses		21,165		43,430		25,739		54,613

Total share-based compensation expense before taxes	$	100,604	$	138,878	$	81,623	$	126,538

As of March 29, 2014 and September 28, 2013, there was $210,558 and $289,838, respectively, of unrecognized compensation cost related to options granted. The unrecognized compensation cost will be recognized over the remaining requisite service period. As of March 29, 2014, the weighted average period over which the compensation cost is expected to be recognized is 1.7 years.

The Company had the following stock option plans outstanding as of March 29, 2014: the Technical Communications Corporation 2001 Stock Option Plan, the 2005 Non-Statutory Stock Option Plan and the 2010 Equity Incentive Plan. There were an aggregate 750,000 shares authorized for issuance under these plans, of which options to purchase 268,185 shares were outstanding at March 29, 2014. Vesting periods for options are at the discretion of the Board of Directors and typically range between zero and five years. Options under these plans are granted with an exercise price equal to fair market value at time of grant and have a term of ten years from the date of grant.

As of March 29, 2014, there were no shares available for new option grants under the 2001 Stock Option Plan, there were 19,723 shares available for grant under the 2005 Non-Statutory Stock Option Plan and there were 56,903 shares available for grant under the 2010 Equity Incentive Plan.

The following table summarizes stock option activity during the first six months of fiscal 2014 (unaudited):


	Options Outstanding
	Number of Shares									Weighted Average		Weighted Average
	Unvested			Vested			Total			Exercise Price		Contractual Life

Outstanding, September 28, 2013		60,488			197,094			257,582		$	8.83		6.21 years
Grants		200			—			200			7.65
Vested		(1,600	)		1,600			—			8.02
Cancellations/forfeitures		—			—			—			—


Outstanding, December 28, 2013		59,088			198,694			257,782		$	8.83		5.96 years


Grants		—			14,000			14,000			7.65
Vested		(900	)		900			—			6.55
Exercises		—			(900	)		(900	)		5.00
Cancellations/forfeitures		(1,079	)		(1,618	)		(2,697	)		11.51


Outstanding, March 29, 2014		57,109			211,076			268,185		$	8.75		5.93 years

Information related to the stock options vested and expected to vest as of March 29, 2014 is as follows (unaudited):


Range of Exercise Prices		Number of Shares		Weighted-Average Remaining Contractual Life (years)		Weighted Average Exercise Price		Exercisable Number of Shares		Exercisable Weighted- Average Exercise Price

$	2.01 - $ 3.00		15,288		1.44	$	3.00		15,288	$	3.00
$	3.01 - $ 4.00		16,600		2.33	$	3.66		16,600	$	3.66
$	4.01 - $ 5.00		28,000		7.05	$	4.78		26,700	$	4.78
$	5.01 - $10.00		68,600		6.20	$	7.48		65,080	$	7.45
$	10.01 - $15.00		139,697		6.50	$	11.41		87,408	$	11.36


			268,185		5.93	$	8.75		211,076	$	8.11

The aggregate intrinsic value of the Company’s “in-the-money” outstanding and exercisable options as of March 29, 2014 and September 28, 2013 was $138,632 and $159,521, respectively. Unvested common stock options are subject to the risk of forfeiture until the fulfillment of specified conditions.