U.S. SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended ~~September 30, 2017~~March 31, 2019

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.

For the transition period from __________ to __________.

Commission file number 001-31972

TELKONET, INC.

(Exact name of Registrant as specified in its charter)

Utah	87-0627421
(State or Other Jurisdiction of Incorporation or Organization)	(I.R.S. Employer Identification No.)

20800 Swenson Drive, Suite 175, Waukesha, WI	53186
(Address of Principal Executive Offices)	(Zip Code)

(414) 302-2299

(Registrant’s Telephone Number, Including Area Code)

Securities registered pursuant to Section 12(b) of the Act:

Title of each class	Trading Symbol(s)	Name of each exchange on which registered
None	None	None

Securities registered pursuant to Section 12(g) of the Act: Common Stock, $0.001 par value

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 ~~days.~~days Yesx No¨

Indicate by check mark whether the registrant has submitted electronically, ~~and posted on its corporate Web site, if any,~~ every Interactive Data File required to be submitted ~~and posted~~ pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit ~~and post~~ such files). Yesx No¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

Large accelerated filero	Accelerated filero
Non-accelerated filero~~(Do not check if a smaller reporting company)~~x	Smaller reporting companyx
Emerging growth companyo

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.o

Indicate by check mark whether the registrant is a shell company as defined in Rule 12b-2 of the Exchange Act. Yes o Nox

The number of shares outstanding of the registrant’s common stock, par value $0.001 per share, as of ~~October 31, 2017~~April 30, 2019 is ~~133,440,111.~~135,085,519.

TELKONET, INC.

FORM 10-Q for the ~~Nine~~Three Months Ended ~~September 30, 2017~~March 31, 2019

Index

	Page

PART I. FINANCIAL INFORMATION	3

Item 1. Financial Statements	3

Condensed Consolidated Balance Sheets (Unaudited): ~~September 30, 2017~~	3
March 31, 2019 and December 31, ~~2016~~ 2018	3

Condensed Consolidated ~~Statements~~Statement of Operations (Unaudited):	4
Three ~~and Nine~~ Months Ended ~~September 30, 2017~~March 31, 2019 and ~~2016~~ 2018	4

Condensed Consolidated Statement of Stockholders’ Equity (Unaudited):	5
January 1, ~~2017~~2019 through ~~September 30, 2017~~March 31, 2019	5

Condensed Consolidated Statements of Cash Flows (Unaudited): ~~Nine~~	7
Three Months Ended ~~September 30, 2017~~March 31, 2019 and ~~2016~~ 2018	6

Notes to Condensed Consolidated Financial Statements (Unaudited)	89

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations	2322

Item 4. Controls and Procedures	3228

PART II. OTHER INFORMATION	3330

Item 1. Legal Proceedings	3330

Item 1A. Risk Factors	3330

Item 6. Exhibits	3330

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

TELKONET, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(UNAUDITED)

	September 30, 2017			December 31, 2016			March 31, 2019			December 31, 2018
ASSETS
Current assets:
Cash and cash equivalents	$	8,959,229		$	791,858		$	3,745,998		$	4,678,891
Restricted cash on deposit		800,000			–
Accounts receivable, net		1,769,221			1,403,772			2,546,293			1,081,291
Inventories		1,082,289			777,202			1,613,960			1,790,919
Prepaid expenses and other current assets		260,269			205,328
Current assets of discontinued operations		–			7,149,971
Contract assets								446,662			314,749
Prepaid expenses								562,366			577,386
Income taxes receivable								25,334			19,695
Total current assets		12,871,008			10,328,131			8,940,613			8,462,931

Property and equipment, net		318,767			143,907			232,659			247,289

Other assets:
Deposits		17,130			–			17,130			17,130
Operating lease right of use assets								1,005,587			–
Total other assets		17,130			–			1,022,717			17,130

Total Assets	$	13,206,905		$	10,472,038		$	10,195,989		$	8,727,350

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	1,137,632		$	765,617		$	870,650		$	408,045
Accrued liabilities and expenses		1,094,054			925,581
Related party payable		–			97,127
Accrued liabilities								843,738			656,611
Line of credit		79,953			1,062,129			907,241			121,474
Deferred revenues - current		444,110			184,793
Deferred lease liability – current		–			3,942
Customer deposits		215,576			165,830
Income taxes payable		85,884			–
Deferred income taxes		–			933,433
Current liabilities of discontinued operations		–			869,604
Contract liabilities – current								908,743			1,070,502
Operating lease liabilities – current								220,037			–
Total current liabilities		3,057,209			5,008,056			3,750,409			2,256,632

Long-term liabilities:
Deferred revenue - long term		190,896			120,421
Deferred lease liability - long term		40,508			23,761
Contract liabilities – long term								154,533			162,121
Operating lease liabilities – long term								862,114			–
Deferred lease liability – long term								–			71,877
Total long-term liabilities		231,404			144,182			1,016,647			233,998
Total liabilities							$	4,767,056		$	2,490,630

Commitments and contingencies

Stockholders’ Equity
Series A, par value $.001 per share; 215 shares issued, 185 shares outstanding at September 30, 2017 and December 31, 2016, preference in liquidation of $1,507,481 and $1,452,114 as of September 30, 2017 and December 31, 2016, respectively		1,340,566			1,340,566
Series B, par value $.001 per share; 538 shares issued, 52 shares outstanding at September 30, 2017 and December 31, 2016, preference in liquidation of $409,009 and $393,435 as of September 30, 2017 and December 31, 2016, respectively		362,059			362,059
Common stock, par value $.001 per share; 190,000,000 shares authorized; 133,440,111 and 132,774,475 shares issued and outstanding at September 30, 2017 and December 31, 2016 , respectively		133,440			132,774
Series A, par value $.001 per share; 215 shares issued, 185 shares outstanding at March 31, 2019 and December 31, 2018, preference in liquidation of $1,618,421 and $1,600,168 as of March 31, 2019 and December 31, 2018, respectively								1,340,566			1,340,566
Series B, par value $.001 per share; 538 shares issued, 52 shares outstanding at March 31, 2019 and December 31, 2018, preference in liquidation of $440,216 and $435,081 as of March 31, 2019 and December 31, 2018, respectively								362,059			362,059
Common stock, par value $.001 per share; 190,000,000 shares authorized; 135,085,519 and 134,793,211 shares issued and outstanding at March 31, 2019 and December 31, 2018, respectively								135,086			134,792
Additional paid-in-capital		127,383,314			126,955,435			127,608,232			127,570,709
Accumulated deficit		(119,301,087	)		(123,471,034	)		(124,017,010	)		(123,171,406	)
Total stockholders’ equity		9,918,292			5,319,800			5,428,933			6,236,720

Total Liabilities and Stockholders’ Equity	$	13,206,905		$	10,472,038		$	10,195,989		$	8,727,350

See accompanying notes to the unaudited condensed consolidated financial statements

TELKONET, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(UNAUDITED)

													For the Three Months Ended
	Three Months Ended September 30,						Nine Months Ended September 30,						March 31,
	2017			2016			2017			2016			2019			2018
Revenues, net:
Product	$	1,904,571		$	1,360,887		$	5,728,878		$	6,356,437		$	2,586,669		$	1,503,658
Recurring		131,665			143,028			344,708			340,412			176,533			101,538
Total Net Revenue		2,036,236			1,503,915			6,073,586			6,696,849			2,763,202			1,605,196

Cost of Sales:
Product		1,160,019			770,830			3,233,978			3,194,094			1,690,598			994,237
Recurring		55,702			36,618			118,347			92,324			86,042			59,997
Total Cost of Sales		1,215,721			807,448			3,352,325			3,286,418			1,776,640			1,054,234

Gross Profit		820,515			696,467			2,721,261			3,410,431			986,562			550,962

Operating Expenses:
Research and development		500,656			429,622			1,323,669			1,321,007			486,626			438,780
Selling, general and administrative		1,188,905			1,432,489			4,396,667			5,012,249			1,323,049			1,276,903
Depreciation and amortization		14,616			8,382			34,405			24,366			16,931			16,915
Total Operating Expenses		1,704,177			1,870,493			5,754,741			6,357,622			1,826,606			1,732,598

Operating Loss		(883,662	)		(1,174,026	)		(3,033,480	)		(2,947,191	)		(840,044	)		(1,181,636	)

Other Income (Expenses):
Interest income (expense), net		8,722			(15,482	)		2,797			(45,308	)
Total Other Income (Expense)		8,722			(15,482	)		2,797			(45,308	)
Other (Expenses) Income:
Interest (expense), net														(5,560	)		(2,530	)
Total Other (Expenses)														(5,560	)		(2,530	)

Loss from Continuing Operations before Provision (Benefit) for Income Taxes		(874,940	)		(1,189,508	)		(3,030,683	)		(2,992,499	)
Loss before Provision (Benefit) for Income Taxes														(845,604	)		(1,184,166	)

Provision (Benefit) for Income Taxes		(3,600	)		2,575			4,301			3,200			–			–
Net loss from continuing operations		(871,340	)		(1,192,083	)		(3,034,984	)		(2,995,699	)
Discontinued Operations:
Gain from sale of discontinued operations (net of tax)		218,000			–			6,602,871			–
Income from discontinued operations (net of tax)		11,403			798,887			602,060			2,050,998
Net income (loss) attributable to common stockholders	$	(641,937	)	$	(393,196	)	$	4,169,947		$	(944,701	)
Net loss attributable to common stockholders													$	(845,604	)	$	(1,184,166	)

Net income (loss) per common share:
Basic - continuing operations	$	(0.01	)	$	(0.01	)	$	(0.02	)	$	(0.02	)
Basic - discontinued operations	$	0.00		$	0.01		$	0.05		$	0.02
Basic – net income (loss) attributable to common stockholders	$	(0.01	)	$	(0.00	)	$	0.03		$	(0.00	)
Net loss per common share:
Basic – net loss attributable to common stockholders													$	(0.01	)	$	(0.01	)

Diluted - continuing operations	$	(0.01	)	$	(0.01	)	$	(0.02	)	$	(0.02	)
Diluted - discontinued operations	$	0.00		$	0.01		$	0.05		$	0.02
Diluted – net income (loss) attributable to common stockholders	$	(0.01	)	$	(0.00	)	$	0.03		$	(0.00	)
Diluted – net loss attributable to common stockholders													$	(0.01	)	$	(0.01	)

Weighted Average Common Shares Outstanding – basic		133,231,367			132,314,049			133,007,830			130,399,390			134,793,211			133,695,111
Weighted Average Common Shares Outstanding –diluted		133,231,367			132,314,049			133,405,096			130,399,390
Weighted Average Common Shares Outstanding – diluted														134,793,211			133,695,111

See accompanying notes to the unaudited condensed consolidated financial statements

TELKONET, INC.

CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY (UNAUDITED)

~~NINE~~THREE MONTHS FROM JANUARY 1, ~~2017~~2018 THROUGH ~~SEPTEMBER 30, 2017~~MARCH 31, 2018

Series A Preferred Stock Series A Preferred Stock Series B
Preferred
Stock Series B
Preferred
Stock Common Common
Stock Additional
Paid-in Accumulated Total
Stockholders’
Shares Amount Shares Amount Shares Amount Capital Deficit Equity
Balance at January 1, 2017 185 $ 1,340,566 52 $ 362,059 132,774,475 $ 132,774 $ 126,955,435 $ (123,471,034 ) $ 5,319,800

Shares issued to directors – – – – 665,636 666 107,334 – 108,000

Stock-based compensation expense related to employee stock options – – – – – – 320,545 – 320,545

Net income – – – – – – – 4,169,947 4,169,947

Balance at September 30, 2017 185 $ 1,340,566 52 $ 362,059 133,440,111 $ 133,440 $ 127,383,314 $ (119,301,087 ) $ 9,918,292
~~See accompanying notes to the unaudited condensed consolidated financial statements~~
Series A Preferred Stock Series A Preferred Stock Series B
Preferred
Stock Series B
Preferred
Stock Common Common
Stock Additional
Paid-in Accumulated Total
Stockholders’
Shares Amount Shares Amount Shares Amount Capital Deficit Equity
Balance at December 31, 2017 185 $ 1,340,566 52 $ 362,059 133,695,111 $ 133,695 $ 127,421,402 $ (119,724,656 ) $ 9,533,066

January 1, 2018, Cumulative effect of a change in accounting principle related to ASC 606, net of tax – – – – – – – (430,000 ) (430,000 )

Shares issued to directors – – – – 294,808 294 35,706 – 36,000

Stock-based compensation expense related to employee stock options – – – – – – 1,531 – 1,531

Net loss – – – – – – – (1,184,166 ) (1,184,166 )

Balance at March 31, 2018 185 $ 1,340,566 52 $ 362,059 133,989,919 $ 133,989 $ 127,458,639 $ (121,338,822 ) $ 7,956,431

5

TELKONET, INC.
CONDENSED CONSOLIDATED ~~STATEMENTS~~STATEMENT OF ~~CASH FLOWS~~STOCKHOLDERS’ EQUITY (UNAUDITED)
~~(UNAUDITED)~~THREE MONTHS FROM JANUARY 1, 2019 THROUGH MARCH 31, 2019

For the Nine Months Ended
September 30,
2017 2016
Cash Flows from Operating Activities:
Net income (loss) $ 4,169,947 $ (944,701 )
Less: Net income from discontinued operations (602,060 ) (2,050,998 )
Gain on sale of discontinued operations (6,602,871 ) –
Net loss from continuing operations (3,034,984 ) (2,995,699 )

Adjustments to reconcile net loss from continuing operations to cash used in operating activities of continuing operations:

Stock-based compensation expense 320,545 10,204
Stock issued to directors as compensation 108,000 36,000
Amortization of deferred financing costs – 14,210
Depreciation 34,405 24,366
Provision for doubtful accounts, net of recoveries 15,013 7,047
Related party payable – 161,075

Changes in operating assets and liabilities:
Accounts receivable (380,462 ) 468,589
Inventories (305,087 ) (410,202 )
Prepaid expenses and other current assets (54,941 ) 60,271
Deposits and other long term assets (17,130 ) 23,871
Accounts payable 305,322 (535,016 )
Accrued liabilities and expenses 168,473 299,919
Deferred revenue 329,792 56,825
Related party payable (97,127 ) (15,928 )
Customer deposits 49,746 27,985
Income taxes payable 85,884 –
Deferred lease liability 12,805 (1,818 )
Net Cash Used In Operating Activities of Continuing Operations (2,459,746 ) (2,768,301 )
Net Cash Provided By Operating Activities of Discontinued Operations 517,242 2,023,820
Net Cash Used In Operating Activities (1,942,504 ) (744,481 )

Cash Flows From Investing Activities:
Purchase of property and equipment (142,572 ) (33,629 )
Net proceeds from sale of subsidiary 12,034,623 –
Change in restricted cash (800,000 ) 31,277
Net Cash Provided By (Used In) Investing Activities of Continuing Operations 11,092,051 (2,352 )

Cash Flows From Financing Activities:
Payments on notes payable – (79,864 )
Proceeds from exercise of warrants – 677,501
Proceeds from line of credit 3,572,500 4,327,068
Payments on line of credit (4,554,676 ) (4,217,068 )
Net Cash (Used In) Provided By Financing Activities of Continuing Operations (982,176 ) 707,637

Net increase (decrease) in cash and cash equivalents 8,167,371 (39,196 )
Cash and cash equivalents at the beginning of the period 791,858 951,249
Cash and cash equivalents at the end of the period $ 8,959,229 $ 912,053
Series A Preferred Stock Series A Preferred Stock Series B
Preferred
Stock Series B
Preferred
Stock Common Common
Stock Additional
Paid-in Accumulated Total
Stockholders’
Shares Amount Shares Amount Shares Amount Capital Deficit Equity
Balance at December 31, 2018 185 $ 1,340,566 52 $ 362,059 134,793,211 $ 134,792 $ 127,570,709 $ (123,171,406 ) $ 6,236,720

Shares issued to directors – – – – 292,308 294 35,708 – 36,002

Stock-based compensation expense related to employee stock options – – – – – – 1,815 – 1,815

Net loss attributable to common stockholders – – – – – – – (845,604 ) (845,604 )

Balance at March 31, 2019 185 $ 1,340,566 52 $ 362,059 135,085,519 $ 135,086 $ 127,608,232 $ (124,017,010 ) $ 5,428,933

See accompanying notes to the unaudited condensed consolidated financial statements

6
TELKONET, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
For the Three Months Ended March 31,
2019 2018
Cash Flows from Operating Activities:
Net loss $ (845,604 ) $ (1,184,166 )

Adjustments to reconcile net loss to cash used in operating activities:
Stock-based compensation expense 1,815 1,531
Stock issued to directors as compensation 36,002 36,000
Depreciation and amortization 16,931 16,915
Provision for doubtful accounts, net of recoveries (26,317 ) (3,356 )
Reserve for inventory obsolescence 171,901 54,100
Noncash operating lease expense 59,476 –

Changes in operating assets and liabilities:
Accounts receivable (1,438,685 ) 329,367
Inventories 5,061 361,948
Prepaid expenses and other current assets 15,020 (219,316 )
Accounts payable 462,605 (283,485 )
Accrued liabilities and expenses 187,127 (67,554 )
Contract liability (169,347 ) 255,170
Contract assets (131,913 ) (295,479 )
Operating lease liability (54,788 ) –
Income taxes receivable (5,641 ) –
Deferred lease liability – 6,441
Net Cash Used In Operating Activities (1,716,357 ) (991,884 )

Cash Flows From Investing Activities:
Purchase of property and equipment (2,302 ) (7,493 )
Net proceeds from sale of subsidiary – –
Net Cash Used In By Investing Activities (2,302 ) (7,493 )

Cash Flows From Financing Activities:
Proceeds from line of credit 2,339,000 220,610
Payments on line of credit (1,553,234 ) (279,969 )
Net Cash (Used In) Provided By Financing Activities 785,766 (59,359 )

Net decrease in cash and cash equivalents (932,893 ) (1,058,736 )
Cash, cash equivalents and restricted cash at the beginning of the period 4,678,891 9,195,595
Cash, cash equivalents and restricted cash at the end of the period $ 3,745,998 $ 8,136,859

Reconciliation of cash, cash equivalents, and restricted cash to the consolidated balance sheets:
Cash and cash equivalents $ 3,745,998 $ 8,126,859
Restricted cash – 10,000
Total cash, cash equivalents, and restricted cash $ 3,745,998 $ 8,136,859
See accompanying notes to the unaudited condensed consolidated financial statements

67

TELKONET, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)
(UNAUDITED)

Nine Months Ended
September 30,

Three Months Ended
March 31,

2017 2016 2019 2018
Supplemental Disclosures of Cash Flow Information:

Cash transactions:
Cash paid during the period for interest $ 11,485 $ 30,980 $ 10,937 $ 12,228
Cash paid during the period for income taxes, net of refunds 58,551 –

Schedule of Non-Cash Investing Activities:
Unpaid purchases of property and equipment included in accounts payable $ 66,693 –

See accompanying notes to the unaudited condensed consolidated financial statements

78

TELKONET, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
~~SEPTEMBER 30, 2017~~MARCH 31, 2019
(UNAUDITED)

NOTE A – BASIS OF PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES

A summary of the significant accounting policies applied in the preparation of the accompanying condensed consolidated financial statements follows.

General

The accompanying unaudited condensed consolidated financial statements of Telkonet, Inc. (the “Company”, “Telkonet”) have been prepared in accordance with Rule S-X of the Securities and Exchange Commission (the “SEC”) and with the instructions to Form 10-Q. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements.

In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. However, the results from operations for the ~~nine~~three months ended ~~September 30, 2017,~~March 31, 2019, are not necessarily indicative of the results that may be expected for the year ending December 31, ~~2017.~~2019. The unaudited condensed consolidated financial statements should be read in conjunction with the consolidated December 31, ~~2016~~2018 financial statements and footnotes thereto included in the Company's Form 10-K filed with the SEC.

Business and Basis of Presentation

Telkonet, Inc. (the “Company”, “Telkonet”), formed in 1999 and incorporated under the laws of the state of Utah, is the creator of the EcoSmart Platform of intelligent automation solutions designed to optimize energy efficiency, comfort and analytics in support of the emerging Internet of Things (“IoT”).

In 2007, the Company acquired substantially all of the assets of Smart Systems International (“SSI”), which was a provider of energy management products and solutions to customers in the United States and Canada and the precursor to the Company’s EcoSmart platform. The EcoSmart platform provides comprehensive savings, management reporting, analytics and virtual engineering of a customer’s portfolio and/or property’s room-by-room energy consumption. Telkonet has deployed more than a half million intelligent devices worldwide in properties within the hospitality, military, educational, healthcare and other commercial markets. The EcoSmart platform is ~~rapidly being~~ recognized as a ~~leading~~ solution for reducing energy consumption, operational costs and carbon footprints, and eliminating the need for new energy generation in these marketplaces – all ~~while~~whilst improving occupant comfort and convenience.
On March 28, 2017, the Company, and the Company’s wholly-owned subsidiary, EthoStream LLC, a Wisconsin limited liability company (“EthoStream”), entered into an Asset Purchase Agreement (the “Purchase Agreement”) with DCI-Design Communications LLC (“DCI”), a Delaware limited liability company, whereby DCI would acquire all of the assets and certain liabilities of EthoStream for a base purchase price of $12,750,000. The Purchase Agreement provided that proceeds of $900,000 were to be withheld from the $12,750,000 base purchase price and placed into an escrow account to support potential indemnification obligations of up to $800,000 and net working capital adjustments of up to $100,000. Another $93,000 is classified in other current assets as a net working capital receivable. The escrow amount, net of potential claims, will be fully released after an escrow period not to exceed 12 months after closing. The assets included, among other items, certain inventory, contracts and intellectual property. DCI acquired only the liabilities provided for in the Purchase Agreement. On March 29, 2017, pursuant to the terms and the conditions of the Purchase Agreement, the Company closed on the sale. The income from discontinued operations (net of tax) represents the activity of EthoStream from January 1, 2017 through the date of the sale on March 28, 2017. The gain from sale of discontinued operations (net of tax) represents the gain recognized from the EthoStream selling price that was in excess of the assets sold to DCI and liabilities assumed by DCI on March 28, 2017. On September 27, 2017, the Company reached a final settlement with DCI on net working capital as set forth in the Purchase Agreement. On September 29, 2017, the Company received $100,000 from the escrow account for the portion of the escrow account set aside for net working capital adjustments and cash proceeds of $311,000 from DCI in the settlement of net working capital adjustments. The net working capital receivable of $93,000 in other current assets was applied against the cash proceeds of $311,000 received on September 29, 2017 resulting in a gain from sale of discontinued operations of $218,000 recognized during the three months ended September 30, 2017.
8
~~TELKONET, INC.~~
~~NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS~~
~~SEPTEMBER 30, 2017~~
~~(UNAUDITED~~)

The condensed consolidated financial statements include the accounts of the Company and its wholly-owned ~~subsidiaries,~~subsidiary, Telkonet Communications, Inc., and EthoStream. The current and prior period accounts of Ethostream have been classified as discontinued operations on the condensed consolidated balance sheet, the condensed consolidated statement of operations and the condensed consolidated statement of cash flows. All significant intercompany balances and transactions have been eliminated We currently operate in ~~consolidation.~~
~~Unless otherwise noted, all financial information in the consolidated financial statement footnotes reflect the Company’s results from continuing operations.~~
~~Liquidity and Financial Condition~~
~~The Company reported~~ a net loss of $3,034,984 from continuing operations for the nine months ended September 30, 2017, had cash used in operating activities from continuing operations of $2,459,746 and had an accumulated deficit of $119,301,087. Since inception, the Company’s primary sources of ongoing liquidity for operations have come through private and public offerings of equity securities, and the issuance of various debt instruments, asset-based lending and the sale of assets.
On March 29, 2017, an amendment to the revolving credit facility with Heritage Bank of Commerce, a California state chartered bank (“Heritage Bank”), was executed to amend certain terms of the Loan and Security Agreement (the “Heritage Bank Loan Agreement”) following the sale of certain assets of the Company’s wholly-owned subsidiary, EthoStream. Heritage Bank amended the EBITDA compliance measurement.
On October 23, 2017, an amendment to the revolving credit facility with Heritage Bank was executed to amend certain terms of the Heritage Bank Loan Agreement. Among the terms of the amendment was that if the Company deviates from its projected EBITDA for the quarters ended September 30, 2017 or December 31, 2017, the Company will be deemed to be in compliance as of the measurement date if the Company’s unrestricted cash maintained at Heritage Bank is in excess of $5,000,000. The amendment also extends the revolving credit facility’s maturity date by one year to September 30, 2019.
The outstanding balance of the revolving credit facility was $79,953 as of September 30, 2017 and the remaining available borrowing capacity was approximately $1,304,000. As of September 30, 2017, the Company was in compliance with all financial covenants.
On March 28, 2017, the Company and EthoStream, entered into the Purchase Agreement with DCI whereby DCI acquired all of the assets and certain liabilities of EthoStream for a base purchase price of $12,750,000, subject to an adjustment based on the net working capital of EthoStream on the closing date of the sale transaction. The Company’s liquidity for the remainder of 2017 remains strong due to the net proceeds received from the sale of EthoStream.
~~Restricted Cash on Deposit~~
The restricted cash on deposit of $800,000 as of September 30, 2017 reflects amounts placed into an escrow account to support potential indemnification obligations associated with the sale of the Company’s wholly-owned subsidiary, EthoStream. The escrow amount, net of potential claims, would be fully released after an escrow period not to exceed 12 months from the transaction closing on March 29, 2017. On September 29, 2017, the Company received $100,000 from the escrow account for the portion of the escrow account set aside for net working capital adjustments.single reportable business segment.

9

~~TELKONET, INC.~~Going Concern and Management’s Plan
~~NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS~~
~~SEPTEMBER 30, 2017~~The accompanying financial statements have been prepared on a going concern basis which assumes the Company will be able to realize its assets and discharge its liabilities in the normal course of business for the foreseeable future and, thus, do not include any adjustments relating to the recoverability and classification of assets and liabilities that may be necessary if the Company is unable to continue as a going concern.
~~(UNAUDITED~~)
Since inception through March 31, 2019, we have incurred cumulative losses of $124,017,010 and have never generated enough funds through operations to support our business. For the three-month period ended March 31, 2019, we had an operating cash flow deficit of $1,716,357 from operations. The Company’s ability to continue as a going concern is dependent upon generating profitable operations in the future and obtaining the necessary financing to meet its obligations and repay its liabilities arising from normal business operations when they come due. There can be no assurance that the Company will be able to secure such financing at commercially reasonable terms, if at all. If cash resources become insufficient to meet the Company’s ongoing obligations, the Company will be required to scale back or discontinue portions of its operations or discontinue operations entirely, whereby, the Company’s shareholders may lose some or all of their investment.
We have not identified, and cannot be certain we will be able to identify, a course of action that guarantees the achievement of profitable operations in the foreseeable future. In June 2018, the Company’s Board engaged an investment bank to identify strategic alternatives to maximize shareholder value, including but not limited to, a sale of the Company, an investment in the Company, a merger or other business combination, a sale of all or substantially all assets or a strategic joint venture. At May 15, 2019, no definitive alternatives had been identified.
At March 31, 2019, the Company had $3,745,998 of cash and approximately $1,043,000 of availability on its credit facility. The Company currently expects to draw on these cash reserves and utilize the credit facility to finance its near term working capital needs. It expects to continue to incur operating losses and negative operating cash flows for one year beyond the date of these financial statements. Accordingly, and in light of the Company’s historic and continuing losses, there is substantial doubt about the Company’s ability to continue as a going concern.

Income (Loss) per Common Share

The Company computes earnings per share under ASC 260-10, “Earnings Per Share”. Basic net income (loss) per common share is computed using the weighted average shares outstanding. Diluted net income (loss) per common share is computed using the treasury stock method, which assumes that the proceeds to be received on exercise of outstanding stock options and warrants are used to repurchase shares of the Company at the average market price of the common shares for the year. Dilutive common stock equivalents consist of shares issuable upon the exercise of the Company's outstanding stock options and warrants. For the ~~nine~~three months ended ~~September 30, 2017~~March 31, 2019 and ~~2016,~~2018, there were ~~5,621,800~~3,559,793 and ~~2,240,225~~3,557,399 shares of common stock underlying options and warrants excluded due to these instruments being anti-dilutive, respectively.

Use of Estimates

The preparation of financial statements in conformity with United States of America (U.S.) generally accepted accounting principles (“GAAP”) requires management to make certain estimates, judgments and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Estimates are used when accounting for items and matters such as revenue recognition and allowances for uncollectible accounts receivable, inventory obsolescence, depreciation and amortization, long-lived assets, taxes, ~~and~~ related valuation allowance and income tax provisions, stock-based compensation, and contingencies. The Company believes that the estimates, judgments and assumptions are reasonable, based on information available at the time they are made. Actual results may differ from those estimates.
10

Income Taxes

The Company accounts for income taxes in accordance with ASC 740-10 “Income Taxes.” Under this method, deferred income taxes (when required) are provided based on the difference between the financial reporting and income tax bases of assets and liabilities and net operating losses at the statutory rates enacted for future periods. The Company has a policy of establishing a valuation allowance when it is more likely than not that the Company will not realize the benefits of its deferred income tax assets in the future.

The Company adopted ASC 740-10-25, which prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. ASC 740-10-25 also provides guidance on ~~derecognition,~~de-recognition, classification, treatment of interest and penalties, and disclosure of such positions. The Securities and Exchange Commission issued Staff Accounting Bulletin 118 to address uncertainty regarding the application of ASC 740 to the income tax effects of the Tax Cuts and Jobs Act, signed into law on December 22, 2017. The bulletin provides a measurement period (not to exceed one year from the Tax Act enactment date) for companies to complete the accounting under ASC 740. To the extent that a company’s accounting for certain income tax effects is incomplete, but is able to determine a reasonable estimate, it must record a provisional estimate in the financial statements. If a company cannot determine a provisional estimate in the financial statements, it should continue to apply ASC 740 on the basis of the provisions of the tax laws that were in effect immediately before the enactment of the Tax Act. The company was able to make reasonable estimates of certain effects and, therefore, recorded non-material provisional adjustments.

Revenue ~~Recognition~~from Contracts with Customers

~~For revenue~~Accounting Standards Codification Topic 606, Revenue from ~~product sales,~~Contracts with Customers (“ASC 606, the Company recognizes revenue in accordance with ASC 605-10, “Revenue Recognition” and ASC 605-10-S99 guidelines that require that four basic criteria must be met before revenue can be recognized: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred; (3) the selling price is fixed and determinable; and (4) collectability is reasonably assured. Determination of criteria (3) and (4) are based on management’s judgments regarding the fixed nature of the selling prices of the products delivered and the collectability of those amounts. AssumingStandard”) supersedes nearly all ~~conditions for~~legacy revenue recognition ~~have been satisfied, product~~guidance. ASC 606, the Standard outlines a comprehensive five-step revenue is recognized when products are shipped and installation revenue is recognized when the services are completed. Provisions for discounts and rebates to customers, estimated returns and allowances, and other adjustments are provided for in the same period the related sales are recorded. The guidelines also address the accounting for arrangements that may involve the delivery or performance of multiple products, services and/or rights to use assets.
10
~~TELKONET, INC.~~
~~NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS~~
~~SEPTEMBER 30, 2017~~
~~(UNAUDITED~~)
~~Multiple-Element Arrangements (“MEAs”):~~ The Company accounts for contracts that have both product and installation under the MEAs guidance in ASC 605-25. Arrangements under such contracts may include multiple deliverables consisting of a combination of equipment and services.  The deliverables included in the MEAs are separated into more than one unit of accounting when (i) the delivered equipment has value to the customer on a stand-alone basis, and (ii) delivery of the undelivered service element(s) is probable and substantially in the Company’s control.  Arrangement consideration is then allocated to each unit, delivered or undelivered,recognition model based on the relative selling price of each unit of accounting based first on vendor-specific objective evidence (“VSOE”) if it exists, second on third-party evidence (“TPE”) if it exists and on estimated selling price (“ESP”) if neither VSOE or TPE exist.
~~VSOE – In most instances, products are sold separately in stand-alone arrangements. Services are also sold separately through renewals of contracts with varying periods. The Company determines VSOE~~principle that an entity should recognize revenue based on ~~pricing and discounting practices for~~when it satisfies its performance obligations by transferring control of promised goods or services in an amount that reflects the specific product or service when sold separately, considering geographical, customer, and other economic or marketing variables, as well as renewal rates or stand-alone prices for the service element(s).
TPE – If the Company cannot establish VSOE of selling price for a specific product or service included in a multiple-element arrangement, the Company uses third-party evidence of selling price. The Company determines TPE based on sales of a comparable amount of similar product or service offered by multiple third parties considering the degree of customization and similarity of product or service sold.
~~ESP – The estimated selling price represents the price at~~consideration to which the ~~Company would sell a product~~entity expects to be entitled in exchange for said goods or service if it were sold on a stand-alone basis. When neither VSOE nor TPE exists for all elements, the Company determines ESP for the arrangement element based on sales, cost and margin analysis, as well as other inputs based on the Company’s pricing practices. Adjustments for other market and Company-specific factors are made as deemed necessary in determining ESP.
Under the estimated selling price method, revenue is recognized in MEAs based on estimated selling prices for all of the elements in the arrangement, assuming all other conditions for revenue recognition have been satisfied. To determine the estimated selling price, the Company establishes the selling price for its products and installation services using the Company’s established pricing guidelines, and the proceeds are allocated between the elements and the arrangement.services.

~~When MEAs include an element of~~Identify the customer training, the Company determined it is not essential to the functionality, efficiency or effectiveness of the MEA due to its perfunctory nature in relation to the entire arrangement. Therefore the Company has concluded that this obligation is inconsequential and perfunctory. As such, for MEAs that include training, customer acceptance of said training is not deemed necessary in order to record the related revenue, but is recorded when the installation deliverable is fulfilled. Historically, training revenues have not been significant.contracts

The Company ~~provides call center support services to properties installed~~accounts for a customer contract under ASC 606 when the contract is legally enforceable. A contract is legally enforceable when all of the following criteria are met: (1) the contract has been approved by the ~~Company.~~ Company and the customer and both parties are committed to perform their respective obligations, (2) the Company can identify each party’s rights regarding goods or services transferred, (3) the Company can identify payment terms for goods or services transferred, (4) the contract has commercial substance, and (5) collectability of all the consideration to which the Company is entitled in exchange for the goods or services transferred is probable.
A contract does not exist if each party to the contract has the unilateral right to terminate a wholly unperformed contract without compensating the other party (or parties). Nearly all of the Company’s contracts do not contain such mutual termination rights for convenience. All contracts are in written form.
Identify the performance obligations
The Company ~~receives monthly service fees from such properties for its services. The Company recognizes~~will enter into product only contracts that contain a single performance obligation related to the ~~service fee ratably over the term~~transfer of the contract. The prices for these services are fixed and determinable prior to delivery of the service. The fair value of these services is known due to objective and reliable evidence from standalone executed contracts.  The Company reports such revenues as recurring revenues. Deferred revenue includes deferrals for the monthly support service fees. Long-term deferred revenue represents support service fees to be earned or provided beginning after September 30, 2018. Revenue recognized that has not yet been billedEcoSmart products to a customer results in an asset as of the end of the period. As of September 30, 2017 and December 31, 2016, there was $68,855 and $193,400 recorded within accounts receivable, respectively, related to revenue recognized that has not yet been billed.customer.

11

The Company will also enter into certain customer contracts that encompass product and installation services, referred to as “turnkey” solutions. These contracts ultimately provide the customer with a solution that enhances the functionality of the customer’s existing equipment. For this reason, the Company has determined that the product and installation services are not separately identifiable performance obligations, but in essence represent one, combined performance obligation (“turnkey”).
~~TELKONET, INC.~~
~~NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS~~The Company also offers technical phone support services to customers. This service is considered a separate performance obligation.
~~SEPTEMBER 30, 2017~~
Determine the transaction price
The Company generally enters into contracts containing fixed prices. It is not customary for the Company to include contract terms that would result in variable consideration. In the rare situation that a contract does include this type of provision, it is not expected to result in a material adjustment to the transaction price. The Company regularly extends pricing discounts; however, they are negotiated up front and adjust the fixed transaction price set out in the contract.
Customer contracts will typically contain upfront deposits that will be applied against future invoices, as well as customer retainage. The intent of any required deposit or retainage is to ensure that the obligations of either party are honored and follow customary industry practices. In addition, the Company will typically be paid in advance at the beginning of any support contracts, consistent with industry practices. None of these payment provisions are intended to represent significant implicit financing. The Company’s standard payment terms are thirty days from invoice date. Products are fully refundable when returned in their original packaging without damage or defacing less a restocking fee. Historical returns have shown to be immaterial. The Company offers a standard one-year assurance warranty. However customers can purchase an extended warranty. Under the new standard, extended warranties are accounted for as a service warranty, requiring the revenue to be recognized over the extended service periods. Contracts involving an extended warranty are immaterial and will continue to be combined with technical phone support services revenue and recognized on a straight-line basis over the term of the contract.
Allocate the transaction price to the performance obligations
Revenues from customer contracts are allocated to the separate performance obligations based on their relative stand-alone selling price (“SSP”) at contract inception. The SSP is the price at which the Company would sell a promised good or service separately. The best evidence of an SSP is the observable price of a good or service when the entity sells that good or service separately in similar circumstances and to similar customers. However, turnkey solutions are sold for a broad range of amounts resulting from, but not limited to, tiered discounting for value added resellers (“VAR”) based upon committed volumes and other economic factors. Due to the high variability of our pricing, the Company cannot establish a reliable SSP using observable data. Accordingly, the Company uses the residual approach to allocate the transaction price to performance obligations related to its turnkey solutions. When support services are not included within the turnkey solution, the residual method is not utilized and no allocation of the transaction price to the performance obligation is necessary.
All support service agreements, whether single or multi-year terms, automatically renew for one-year terms at a suggested retail price (“SRP”). Support service renewals are consistently priced and therefore would support the use of SRP as the best estimate of an SSP for such performance obligations.
Revenue Recognition
The Company recognizes revenues from product only sales at a point in time, when control over the product has transferred to the customer. As the Company’s principal terms of sale are FOB shipping point, the Company primarily transfers control and records revenue for product only sales upon shipment.
A typical turnkey project involves the installation and integration of 200-300 rooms in a customer-controlled facility and usually takes sixty days to complete. Since control over goods and services transfers to a customer once a room is installed, the Company recognizes revenue for turnkey solutions over time. The Company uses an outputs measure based on the number of rooms installed to recognize revenues from turnkey solutions.
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Revenues from support services are recognized over time, in even daily increments over the term of the contract, and are presented as “Recurring Revenue” in the Statement of Operations.
Contract liabilities include deferrals for the monthly support service fees. Long-term contract liabilities represent support service fees that will be recognized as revenue after March 31, 2020.
~~(UNAUDITED~~Contract Fulfillment Cost)
The Company recognizes related costs of the contract over time in relation to the revenue recognition. Costs included within the projects relate to the cost of the material, direct labor and costs of outside services utilized to complete projects. These are represented as “Contract assets” in the condensed consolidated balance sheets.

Guarantees and Product Warranties

The Company records a liability for potential warranty claims in cost of sales at the time of sale. The amount of the liability is based on the trend in the historical ratio of claims to sales, the historical length of time between the sale and resulting warranty claim, new product introductions and other factors. The products sold are generally covered by a warranty for a period of one year. In the event the Company determines that its current or future product repair and replacement costs exceed its estimates, an adjustment to these reserves would be charged to earnings in the period such determination is made. For the ~~nine~~three months ended ~~September 30, 2017~~March 31, 2019 and the year ended December 31, ~~2016,~~2018, the Company experienced returns of approximately ~~1.0%~~1% to ~~2.5%~~2% of materials included in the cost of sales. As of ~~September 30, 2017~~March 31, 2019 and December 31, ~~2016,~~2018, the Company recorded warranty liabilities in the amount of ~~$77,810~~$39,736 and ~~$95,540,~~$46,103, respectively, using this experience factor range.

Product warranties for the ~~nine~~three months ended ~~September 30, 2017~~March 31, 2019 and the year ended December 31, ~~2016~~2018 are as follows:

September 30,
2017 December 31,
2016
Beginning balance $ 95,540 $ 66,555
Warranty claims incurred (48,767 ) (115,120 )
Provision charged to expense 31,037 144,105
Ending balance $ 77,810 $ 95,540
~~Reclassifications~~
Certain amounts on the condensed consolidated balance sheets as of December 31, 2016 and statements of cash flows have been reclassified to conform to the current year presentation. The Company reclassified $106,743 from current assets of discontinued operations to cash and cash equivalents for certain EthoStream assets not sold to DCI on March 28, 2017. The Company reclassified $150,936 from current liabilities of discontinued operations to accrued liabilities and expenses for certain EthoStream liabilities not assumed by DCI on March 28, 2017. The reclassifications were not material and had no effect on the Company’s total current assets, current liabilities or stockholders’ equity as of December 31, 2016.
March 31,
2019 December 31,
2018
Beginning balance $ 46,103 $ 59,982
Warranty claims incurred (11,194 ) (28,000 )
Provision charged to expense 4,826 14,211
Ending balance $ 39,736 $ 46,103

NOTE B – NEW ACCOUNTING PRONOUNCEMENTS

In May 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2014-09, Revenue from Contracts with Customers (ASU 2014-09), which supersedes nearly all existing revenue recognition guidance under U.S. GAAP. The core principle of ASU 2014-09 is to recognize revenues when promised goods or services are transferred to customers in an amount that reflects the consideration to which an entity expects to be entitled for those goods or services. ASU 2014-09 defines a five step process to achieve this core principle and, in doing so, more judgment and estimates may be required within the revenue recognition process than are required under existing U.S. GAAP. The guidance for this standard was initially effective for annual reporting periods beginning after December 15, 2016, including interim periods within that reporting period, however in August 2015 the FASB delayed the effective date of the standard for one full year. Companies will adopt the standard using either of the following transition methods: (i) a full retrospective approach reflecting the application of the standard in each prior reporting period with the option to elect certain practical expedients, or (ii) a modified retrospective approach with the cumulative effect of initially adopting ASU 2014-09 recognized at the date of adoption (which includes additional footnote disclosures). The Company expects to adopt ASU 2014-09 as of January 1, 2018 with a cumulative effect adjustment to opening retained earnings, if necessary, under the modified retrospective approach. The Company has developed a project plan for the implementation of the new standard including a review of all revenue streams to identify any differences in the performance obligations, timing, measurement or presentation of revenue recognition. The Company’s implementation of this ASU includes the evaluation of its customer agreements to identify terms or conditions that could be considered a performance obligation such that, if material to the terms of the contract, consideration would be allocated to the performance obligation and could accelerate or defer the timing of recognizing revenue. The Company also continues to evaluate the presentation of its principal versus agent arrangements. The Company’s evaluation of its revenue streams and the treatment under the new guidance on the timing of revenue recognition and the allocation of revenue to the Company’s goods and services is in process and any effect cannot be determined at this time.
12
~~TELKONET, INC.~~
~~NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS~~
~~SEPTEMBER 30, 2017~~
~~(UNAUDITED~~)
~~In February~~June 2016, the FASB issued ASU No. ~~2016-02, Leases (“~~2016-13, Financial Instruments—Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. ASU 2016-02”). The new standard establishes a right-of-use (ROU) model that requires a lessee to record a ROU asset and a lease liability on the balance sheet for all leases with terms longer than 12 months. Leases will be classified as either finance or operating, with classification affecting the pattern of expense recognition in the statement of operations. ASU 2016-02 is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. A modified retrospective transition approach is required for lessees for capital and operating leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements, with certain practical expedients available. The Company is currently evaluating the impact of its pending adoption of ASU 2016-02 on its consolidated financial statements. Upon adoption, the Company expects that the ROU asset and lease liability will be recognized in the balance sheets in amounts that will be material.
~~In August 2016, the FASB issued ASU No. 2016-15, Classification of Certain Cash Receipts and Cash Payments (“ASU 2016-15”). The new standard~~2016-13 provides guidance for estimating credit losses on ~~the classification of~~ certain transactions in the statement of cash flows, such as contingent consideration payments made in connection with a business combination and debt prepayment or extinguishment costs. ASU 2016-15 is effective for fiscal years beginning after December 15, 2017, including interim periods within that fiscal year. When adopted, the new guidance will be applied retrospectively. The Company is currently evaluating the impact of its pending adoption of ASU 2016-15 on its consolidated financial statements.
~~In May 2017, the FASB issued ASU 2017-09, Compensation — Stock Compensation — Scope of Modification Accounting (“ASU 2017-09”), which provides guidance about the~~ types of ~~changes~~financial instruments, including trade receivables, by introducing an approach based on expected losses. The expected loss approach will require entities to ~~terms or conditions~~incorporate considerations of ~~a share-based payment award that would require an entity to apply modification accounting.~~historical information, current information and reasonable and supportable forecasts. ASU 2016-13 also amends the accounting for credit losses on available-for-sale debt securities and purchased financial assets with credit deterioration. The ~~new~~ guidance is effective for fiscal years beginning after December 15, ~~2017,~~2019, including interim periods within those fiscal years. ~~Early~~The guidance requires a modified retrospective transition method and early adoption is permitted. The ~~amendments in this update should be applied prospectively to an award modified on or after~~Company does not expect the adoption ~~date.~~
~~NOTE C– ACCOUNTS RECEIVABLE~~of ASU 2016-13 to have a material impact on its consolidated financial statements.

~~Components~~Management has evaluated other recently issued accounting pronouncements and does not believe that any of ~~accounts receivable as of September 30, 2017~~these pronouncements will have a significant impact on our consolidated financial statements and ~~December 31, 2016 are as follows:~~
September 30,
2017 December 31,
2016
Accounts receivable $ 1,781,394 $ 1,438,345
Allowance for doubtful accounts (12,173 ) (34,573 )
Accounts receivable, net $ 1,769,221 $ 1,403,772
~~NOTE D – ACCRUED LIABILITIES AND EXPENSES~~
~~Accrued liabilities and expenses at September 30, 2017 and December 31, 2016 are as follows~~:
September 30,
2017 December 31,
2016
Accrued liabilities and expenses $ 589,288 $ 223,011
Accrued payroll and payroll taxes 354,293 331,908
Accrued sales taxes, penalties, and interest 72,331 274,869
Accrued interest 332 253
Product warranties 77,810 95,540
Total accrued liabilities and expenses $ 1,094,054 $ 925,581
related disclosures.

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Accounting Standards Recently Adopted
~~TELKONET, INC.~~
~~NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS~~Effective January 1, 2019, the Company has adopted ASU 2016-02, Leases (“ASU 2016-02”), subsequently amended in 2018 by ASU 2018-10, ASU 2018-11 and ASU 2018-20 and codified in ASC 842, Leases (“ASC 842”). ASC 842 is effective for annual periods beginning after December 15, 2018 and interim periods thereafter. Earlier application was permitted, however the Company did not elect to do so. ASC 842 supersedes current lease guidance in ASC 840 and requires a lessee to recognize a right-of-use asset and a corresponding lease liability for substantially all leases. The lease liability will be equal to the present value of the remaining lease payments while the right-of-use asset will be similarly calculated and then adjusted for initial direct costs. In addition, ASC 842 expands the disclosure requirements to increase the transparency and comparability of the amount, timing and uncertainty of cash flows arising from leases.
~~SEPTEMBER 30, 2017~~
We chose to elect available practical expedients permitted under the guidance, which among other items, allowed the Company to carry forward its historical lease classification to not reassess leases for the definition of lease under the new standard, and to not reassess initial direct costs for existing leases. Refer below for practical expedient package adopted:
· Whether expired or existing contracts contain leases under the new definition of the lease;
· Lease classification for expired or existing leases; and
· Whether previously capitalized initial direct costs would qualify for capitalization under ASC 842.
Upon the adoption of ASC 842, we have elected to not recognize a right-of-use asset and related lease liability for leases with an initial term of 12 months or less as an accounting policy choice and elected to account for lease and non-lease components as a single lease component.
The Company elected to utilize the new alternative transition approach introduced by ASU 2018-11, under which the standard is adopted and measured from the first date of the fiscal year under adoption, in this case January 1, 2019. Comparative periods are presented in accordance with Topic 840 and do not include any retrospective adjustments to comparative periods to reflect the adoption of Topic 842.
As of March 31, 2019, $1.01 million was included in total other assets, $0.22 million in total current liabilities, and $0.86 million in total long-term liabilities. There was no impact on our Condensed Consolidated Statements of Operations. Refer to Note K for further discussion.
NOTE C – REVENUE
The following table presents the Company’s product and recurring revenues disaggregated by industry for the three months ended March 31, 2019.
Hospitality Education Multiple Dwelling Units Government Total
Product $ 1,694,649 $ 255,736 $ 200,426 $ 435,858 $ 2,586,669
Recurring 156,272 19,445 816 – 176,533
$ 1,850,921 $ 275,181 $ 201,242 $ 435,858 $ 2,763,202
Sales taxes and other usage-based taxes are excluded from revenues.
~~(UNAUDITED~~Remaining performance obligations)
As of March 31, 2019, the aggregate amount of the transaction price allocated to remaining performance obligations was approximately $1.2 million. Except for support services, the Company expects to recognize 100% of the remaining performance obligations over the next six months.
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Contract assets and liabilities
March 31,
2019 December 31,
2018 Variance
Contract assets $ 446,662 $ 314,749 $ 131,913
Contract liabilities 1,063,276 1,232,623 (169,347 )
Net contract liabilities $ 616,614 $ 917,874 $ (301,260 )
Contracts are billed in accordance with the terms and conditions, either at periodic intervals or upon substantial completion. This can result in billings occurring subsequent to revenue recognition, resulting in contract assets. Contract assets are presented as current assets in the Condensed Consolidated Balance Sheet. There were $0.40 million of costs incurred to fulfill contracts in the closing balance of contract assets.
Often, the Company will require customers to pay a deposit upon contract signing that will be applied against work performed or products shipped. In addition, the Company will often invoice the full term of support at the start of the support period. Billings that occur prior to revenue recognition result in contract liabilities. The change in the contract liability balance during the three-month period ended March 31, 2019 is the result of cash payments received and billing in advance of satisfying performance obligations.
NOTE D – ACCOUNTS RECEIVABLE
Components of accounts receivable as of March 31, 2019 and December 31, 2018 are as follows:
March 31,
2019 December 31,
2018
Accounts receivable $ 2,566,692 $ 1,146,832
Allowance for doubtful accounts (20,399 ) (65,541 )
Accounts receivable, net $ 2,546,293 $ 1,081,291

NOTE E – ~~DEBT~~ACCRUED LIABILITIES

~~Kross Promissory Note~~
On August 4, 2016, the Board of Directors authorized the Company to reimburse Peter T. Kross (“Mr. Kross”) $161,075 for expenses incurred related to his successful contested proxy. Effective June 27, 2016, Mr. Kross became a director of the Company and is considered a related party. On August 30, 2016, Mr. Kross accepted an unsecured promissory note (“Kross Note”) for $161,075 from the Company. The outstanding principal balance bore interestAccrued liabilities at the annual rate of 3.00%. Payment of interest and principal began on September 1, 2016 and continued monthly on the first day of each month thereafter through and including June 1, 2017. The Company was required to pay equal monthly installments of $16,330 which included all remaining principal and accrued interest owed by the Company to Mr. Kross under the Kross Note. The Company could prepay in advance any unpaid principal or interest due under the Kross Note without premium or penalty. The principal balance of the Kross Note as of September 30, 2017March 31, 2019 and December 31, ~~2016 was zero and $97,127, respectively.~~2018 are as follows:
March 31,
2019 December 31,
2018
Accrued payroll and payroll taxes $ 343,426 $ 241,253
Accrued expenses 330,467 239,793
Accrued professional 70,924 86,062
Accrued sales taxes, penalties, and interest 59,185 43,400
Product warranties 39,736 46,103
Total accrued liabilities $ 843,738 $ 656,611
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NOTE F – DEBT

Revolving Credit Facility

~~On September 30, 2014, the~~The Company ~~and its wholly-owned subsidiary, EthoStream, as co-borrowers (collectively, the “Borrowers”), entered into~~is a party to a loan and security agreement (the “Heritage Bank Loan Agreement”), with Heritage Bank of Commerce, a California state chartered bank (“Heritage Bank”), governing a new revolving credit facility in a principal amount not to exceed $2,000,000 (the “Credit Facility”). Availability of borrowings under the Credit Facility ~~from time to time~~ is subject to a borrowing base calculation based on the Company’s eligible accounts receivable and eligible inventory each multiplied by an applicable advance rate, with an overall limitation tied to the Company’s eligible accounts receivable. The Heritage Bank Loan Agreement is available for working capital and other general business purposes. The outstanding principal balance of the Credit Facility bears interest at the Prime Rate plus 3.00%, which was ~~7.25%~~8.50% at ~~September 30, 2017~~March 31, 2019 and ~~6.75%~~8.50% at December 31, ~~2016.~~2018. On October 9, 2014, as part of the Heritage Bank Loan Agreement, Heritage Bank was granted a warrant to purchase 250,000 shares of Telkonet common ~~stock.~~stock, for further information on the accounting for warrants, refer to Note I. The warrant has an exercise price of $0.20 and expires October 9, 2021. On February ~~17, 2016, an~~13, 2019, the tenth amendment to the Credit Facility was executed extending the maturity date to September 30, ~~2018,~~2020, unless earlier accelerated under the terms of the Heritage Bank Loan Agreement.

The Heritage Bank Loan Agreement also contains financial covenants that place restrictions on, among other things, the incurrence of debt, granting of liens and sale of assets. The Heritage Bank Loan Agreement ~~and amendments~~ also ~~contain~~contains financial covenants, ~~that require the Borrowers to maintain~~including a ~~minimum~~maximum EBITDA ~~level,~~loss covenant, measured quarterly, a minimum asset coverage ratio, measured monthly, and a minimum unrestricted cash ~~account balances.~~balance of $2 million. During the quarter ended March 31, 2019 and the year ended December 31, 2018, the Company and Heritage Bank entered into several amendments to the Credit Facility to adjust these covenant levels. As long as the Company maintains the minimum unrestricted cash balance of $2 million, a violation of the minimum EBITDA level will not trigger an event of default. A violation of any of these covenants could result in an event of default under the Heritage Bank Loan Agreement. Upon the occurrence of such an event of default or certain other customary events of defaults, payment of any outstanding amounts under the Credit Facility may be accelerated and Heritage Bank’s commitment to extend credit under the Heritage Bank Loan Agreement may be terminated. The Heritage Bank Loan Agreement contains other representations and warranties, covenants, and other provisions customary to transactions of this nature.
The outstanding balance on the Credit Facility was $907,241 and $121,474 at March 31, 2019 and December 31, 2018 and the remaining available borrowing capacity was approximately $1,043,000 and $499,000, respectively. As of ~~September 30, 2017,~~March 31, 2019, the Company was in compliance with all financial covenants. The outstanding balance on the Credit Facility was $79,953 and $1,062,129 at September 30, 2017 and December 31, 2016, respectively. The remaining available borrowing capacity was approximately $1,304,000 and $107,000 at September 30, 2017 and December 31, 2016, respectively.

On March 28, 2017, the Company and the Company’s wholly-owned subsidiary, EthoStream, entered into an Asset Purchase Agreement with DCI-Design Communications LLC (“DCI”), whereby DCI would acquire all of the assets and certain liabilities of EthoStream. Heritage Bank had provided the Company with its consent to the sale transaction. Upon closing of the sale transaction on March 29, 2017, the entire balance outstanding on the Credit Facility was repaid. On March 29, 2017~~an amendment to the Credit Facility was executedamending the quarterly and year to date EBITDA compliance measurements for 2017.~~
14
~~TELKONET, INC.~~
~~NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS~~
~~SEPTEMBER 30, 2017~~
~~(UNAUDITED~~)
On August 29, 2017, an amendment to the Credit Facility with Heritage Bank was executed to amend certain terms of the Heritage Bank Loan Agreement allowing for the issuance of corporate credit cards providing credit not to exceed $100,000. The Borrower may request credit advances in an aggregate outstanding amount not to exceed the borrowing limits set forth in the amendment.
On October 23, 2017, an amendment to the revolving credit facility with Heritage Bank was executed to amend certain terms of the Heritage Bank Loan Agreement. Among the terms of the amendment was that if the Company deviates from its projected EBITDA for the quarters ended September 30, 2017 or December 31, 2017, the Company will be deemed to be in compliance as of the measurement date if the Company’s unrestricted cash maintained at Heritage Bank is in excess of $5,000,000. The amendment also extends the revolving credit facility’s maturity date by one year to September 30, 2019.
NOTE FG – REDEEMABLE PREFERRED STOCK
~~Series A~~
The Company has designated 215 shares of preferred stock as Series A Preferred Stock (“Series A”). Each share of Series A is convertible, at the option of the holder thereof, at any time, into shares of the Company’s common stock at a conversion price of $0.363 per share. On November 16, 2009, the Company sold 215 shares of Series A with attached warrants to purchase an aggregate of 1,628,800 shares of the Company’s common stock at $0.33 per share. The Series A shares were sold at a price per share of $5,000 and each Series A share is convertible into approximately 13,774 shares of common stock at a conversion price of $0.363 per share. The Company received $1,075,000 from the sale of the Series A shares. In prior years, 30 of the preferred shares issued on November 16, 2009 were converted to shares of the Company’s common stock. In a prior year, the redemption feature available to the Series A holders expired.
~~Series B~~
The Company has designated 538 shares of preferred stock as Series B Preferred Stock (“Series B”). Each share of Series B is convertible, at the option of the holder thereof, at any time, into shares of the Company’s common stock at a conversion price of $0.13 per share. On August 4, 2010, the Company sold 267 shares of Series B with attached warrants to purchase an aggregate of 5,134,626 shares of the Company’s common stock at $0.13 per share. The Series B shares were sold at a price per share of $5,000 and each Series B share was convertible into approximately 38,461 shares of common stock at a conversion price of $0.13 per share. The Company received $1,335,000 from the sale of the Series B shares on August 4, 2010.  On April 8, 2011, the Company sold 271 additional shares of Series B with attached warrants to purchase an aggregate of 5,211,542 shares of the Company’s common stock at $0.13 per share. The Series B shares were sold at a price per share of $5,000 and each Series B share was convertible into approximately 38,461 shares of common stock at a conversion price of $0.13 per share. The Company received $1,355,000 from the sale of the Series B shares on April 8, 2011. In prior years, 486 of the preferred shares issued on August 4, 2010 and April 8, 2011 were converted to shares of the Company’s common stock. In a prior year, the redemption feature available to the Series B holders expired.

Preferred stock carries certain preference rights as detailed in the Company’s Amended and Restated Articles of Incorporation related to both the payment of dividends and as to payments upon liquidation in preference to any other class or series of capital stock of the Company. As of ~~September 30, 2017,~~March 31, 2019, the liquidation preference of the preferred stock is based on the following order: first, Series B with a preference value of ~~$409,009,~~$440,216, which includes cumulative accrued unpaid dividends of ~~$149,009,~~$180,216, and second, Series A with a preference value of ~~$1,507,481,~~$1,618,421, which includes cumulative accrued unpaid dividends of ~~$582,481.~~$693,421. As of December 31, ~~2016,~~2018, the liquidation preference of the preferred stock is based on the following order: first, Series B with a preference value of ~~$393,435,~~$435,081, which includes cumulative accrued unpaid dividends of ~~$133,435,~~$175,081, and second, Series A with a preference value of ~~$1,452,114,~~$1,600,168, which includes cumulative accrued unpaid dividends of ~~$527,114.~~
15
~~TELKONET, INC.~~
~~NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS~~
~~SEPTEMBER 30, 2017~~
~~(UNAUDITED~~)$675,168.

NOTE GH – CAPITAL STOCK

The Company has authorized 15,000,000 shares of preferred stock (designated and undesignated), with a par value of $.001 per share. The Company has designated 215 shares as Series A preferred stock and 538 shares as Series B preferred stock. ~~As of September 30, 2017~~At March 31, 2019 and December 31, ~~2016,~~2018, there were 185 shares of Series A and 52 shares of Series B outstanding.

The Company has authorized 190,000,000 shares of common stock with a par value of $.001 per share. As of ~~September 30, 2017~~March 31, 2019 and December 31, ~~2016~~2018 the Company had ~~133,440,111~~135,085,519 and ~~132,774,475~~134,793,211 common shares issued and ~~outstanding.~~outstanding, respectively.

During the nine months ended September 30, 2016, 5,211,542 warrants were exercised for an aggregate of 5,211,542 shares of the Company’s common stock at $0.13 per share. These warrants were originally granted to shareholders of the April 8, 2011 Series B preferred stock issuance.

~~During the nine months ended September 30, 2016, 3 shares of Series B preferred stock were converted to, in aggregate, 115,385 shares of common stock.~~
16

NOTE HI – STOCK OPTIONS AND WARRANTS

Employee Stock Options

The Company maintains an equity incentive plan, (the “Plan”). The Plan was established in 2010 as an incentive plan for officers, employees, non-employee directors, prospective employees and other key persons. It is anticipated that providing such persons with a direct stake in the Company’s welfare will assure a better alignment of their interests with those of the Company and its stockholders.

The following table summarizes the changes in options outstanding and the related prices for the shares of the Company’s common stock issued to employees of the Company under the Plan as of ~~September 30, 2017.~~March 31, 2019.

Options Outstanding Options Exercisable
Exercise Prices Number
Outstanding Weighted Average
Remaining
Contractual Life
(Years) Weighted Average
Exercise Price Number
Exercisable Weighted Average
Exercise Price
$ 0.01 - $0.15 3,075,000 6.19 $ 0.14 3,075,000 $ 0.14
$ 0.16 - $0.99 2,476,800 3.44 0.18 2,246,800 0.18
5,551,800 4.97 $ 0.16 5,321,800 $ 0.16
16
~~TELKONET, INC.~~
~~NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS~~
~~SEPTEMBER 30, 2017~~
~~(UNAUDITED~~)
Options Outstanding Options Exercisable
Exercise Prices
Number
Outstanding

Weighted Average
Remaining
Contractual Life
(Years)

Weighted Average
Exercise Price

Number
Exercisable

Weighted Average
Exercise Price

$ 0.01 - $0.15 2,000,000 7.76 $ 0.14 2,000,000 $ 0.14
$ 0.16 - $0.99 1,349,793 4.60 0.18 1,153,118 0.18
3,349,793 6.49 $ 0.16 3,153,118 $ 0.16

Transactions involving stock options issued to employees are summarized as follows:

Number of
Shares Weighted Average
Price Per Share Number of
Shares Weighted Average
Price Per Share
Outstanding at January 1, 2016 1,825,225 $ 0.28
Outstanding at January 1, 2018 4,376,474 $ 0.18
Granted 1,300,000 0.17 67,394 0.14
Exercised – – – –
Cancelled or expired (292,500 ) 0.69 (1,094,075 ) 0.17
Outstanding at December 31, 2016 2,832,725 $ 0.18
Outstanding at December 31, 2018 3,349,793 $ 0.16
Granted 3,000,000 0.14 – –
Exercised – – – –
Cancelled or expired (280,925 ) 0.17 – –
Outstanding at September 30, 2017 5,551,800 $ 0.16
Outstanding at March 31, 2019 3,349,793 $ 0.16

The expected life of awards granted represents the period of time that they are expected to be outstanding. The Company determines the expected life based on historical experience with similar awards, giving consideration to the contractual terms, vesting schedules, exercise patterns and pre-vesting and post-vesting forfeitures. The Company estimates the volatility of the Company’s common stock based on the calculated historical volatility of the Company’s own common stock using the trailing 24 months of share price data prior to the date of the award. The Company bases the risk-free interest rate used in the Black-Scholes option valuation model on the implied yield currently available on U.S. Treasury zero-coupon issues with an equivalent remaining term equal to the expected life of the award. The Company has not paid any cash dividends on the Company’s common stock and does not anticipate paying any cash dividends in the foreseeable future. Consequently, the Company uses an expected dividend yield of zero in the Black-Scholes option valuation model. The Company uses historical data to estimate pre-vesting option forfeitures and record share-based compensation for those awards that are expected to vest. In accordance with ASC 718-10, the Company adjusts share-based compensation for changes to the estimate of expected equity award forfeitures based on actual forfeiture experience.
~~There~~No options were ~~3,000,000 and zero options~~ granted and ~~zero~~no options were exercised during the ~~nine~~three months ended ~~September 30, 2017~~March 31, 2019 and ~~2016,~~2018. There were zero and 1,094,075 options cancelled or expired during the three months ended March 31, 2019 and 2018, respectively. Total stock-based compensation expense in connection with options granted to employees recognized in the condensed consolidated statements of operations for the three ~~and nine~~ months ended ~~September 30, 2017~~March 31, 2019 and ~~2016~~2018 was ~~$2,343~~$1,815 and ~~$2,703, respectively, and $320,545 and $10,204,~~$1,531, respectively.

17
Warrants

The following table summarizes the changes in warrants outstanding and the related exercise prices for the ~~shares of the Company’s common stock~~warrants issued to ~~non-employees of~~ the ~~Company.~~debt holder in relation to the revolving credit facility see Note G.

Warrants Outstanding Warrants Exercisable Warrants Outstanding Warrants Exercisable
Exercise Prices Exercise Prices
Number
Outstanding

Weighted Average
Remaining
Contractual Life
(Years)

Weighted Average
Exercise Price

Number
Exercisable

Weighted Average
Exercise Price
Exercise Prices
Number
Outstanding

Weighted Average
Remaining
Contractual Life
(Years)

Weighted Average
Exercise Price

Number
Exercisable

Weighted Average
Exercise Price

$ 0.18 50,000 0.16 $ 0.18 50,000 $ 0.18 0.20 250,000 3.52 $ 0.20 250,000 $ 0.20
0.20 250,000 4.02 0.20 250,000 0.20
300,000 3.38 $ 0.20 300,000 $ 0.20

17
~~TELKONET, INC.~~
~~NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS~~
~~SEPTEMBER 30, 2017~~
~~(UNAUDITED~~)

Transactions involving warrants are summarized as follows:

Number of
Shares Weighted Average
Price Per Share Number of
Shares Weighted Average
Price Per Share
Outstanding at January 1, 2016 5,638,410 $ 0.20
Outstanding at January 1, 2018 250,000 $ 0.20
Issued – – – –
Exercised (5,211,542 ) 0.13 – –
Cancelled or expired (126,868 ) 3.00 – –
Outstanding at December 31, 2016 300,000 0.20
Outstanding at December 31, 2018 250,000 0.20
Issued – – – –
Exercised – – – –
Cancelled or expired – – – –
Outstanding at September 30, 2017 300,000 $ 0.20
Outstanding at March 31, 2019 250,000 $ 0.20

There were no warrants granted, exercised, cancelled or forfeited during the ~~nine~~three months ended ~~September 30, 2017~~March 31, 2019 and ~~no warrants granted, 5,211,542 warrants exercised and 126,868 cancelled or forfeited during the nine months ended September 30, 2016,~~2018, respectively.

NOTE IJ – RELATED PARTY TRANSACTIONS

~~On August 4, 2016,~~During the ~~Board of Directors authorized~~three months ended March 31, 2019 and during the year ended December 31, 2018, the Company agreed to reimburse Peter T. Kross (“Mr. Kross”) $161,075 for expenses incurred related to his successful contested proxy. Effective June 27, 2016, Mr. Kross became a director of the Company and is considered a related party. On August 30, 2016, Mr. Kross accepted an unsecured promissory note (“Kross Note”) for $161,075 from the Company. The outstanding principal balance bore interest at the annual rate of 3.00%. Payment of interest and principal began on September 1, 2016 and continued monthly on the first day of each month thereafter through and including June 1, 2017. The Company was required to pay equal monthly installments of $16,330 which included all remaining principal and accrued interest owed by the Company to Mr. Kross under the Kross Note. The Company could prepay in advance any unpaid principal or interest due under the Kross Note without premium or penalty. The principal balance of the Kross Note as of September 30, 2017 and December 31, 2016 was zero and $97,127, respectively.
~~During the nine months ended September 30, 2017, the Company issued~~issue common stock in the amount of ~~$108,000~~$36,002 and $144,000, respectively, to the Company’s non-employee directors as compensation for their attendance and participation in the Company’s Board of Director and committee meetings.

On July 1, 2016, each newly elected Board of Director member, Mr. Kross, Mr. Blatt and Mr. Byrnes were granted 100,000 stock options pursuant to the Company’s Board of Director compensation plan. These options have an expiration period of ten years, vest quarterly over five years and have an exercise price of $0.19.
Upon execution of their employment agreements during the nine months ended September 30, 2017, each of Messrs. Tienor, Sobieski and Koch, were granted 1,000,000 stock options at fair market value and all were scheduled to vest over a three year period. However, pursuant to the terms of the employment agreements, the stock options vested immediately upon the sale of the Company’s subsidiary, EthoStream, in March 2017.
~~During the nine months ended September 30, 2017, Messrs. Tienor, Sobieski and Koch, earned a bonus of $29,250 contingent on the sale and sale price amount of Ethostream.~~
From time to time the Company may receive advances from certain of its officers in the form of salary deferment or cash advances to meet short term working capital needs. These advances may not have formal repayment terms or arrangements. As of September 30, 2017 and December 31, 2016, there were no such arrangements.

18

~~TELKONET, INC.~~
~~NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS~~
~~SEPTEMBER 30, 2017~~
~~(UNAUDITED~~)
NOTE JK – COMMITMENTS AND CONTINGENCIES

~~Office Lease Obligations~~Leases

~~In October 2013,~~
On January 1, 2019 the Company ~~entered into~~adopted ASC Topic 842 “Leases” (“ASC 842”), which supersedes ASC Topic 840 “Leases” (“ASC 840”), using the alternative transition method of adoption. Under this method of adoption, the Company have recognized and measured all leases that exist as at January 1, 2019 (the effective date) using a modified retrospective transition approach. Comparative periods are presented in accordance with Topic 840 and do not include any retrospective adjustments to comparative periods to reflect the adoption of Topic 842. Any cumulative-effect adjustments to retained earnings is recognized as of January 1, 2019. Upon adoption, we recognized our leases with greater than one year in duration on the balance sheet as right-of-use assets and lease liabilities. For income statement purposes, the FASB retained a dual model, requiring leases to be classified as either operating or finance. Classification is based on criteria that are largely similar to those applied in prior lease accounting, but without explicit lines. We have made certain assumptions in judgments when applying ASC 842. Those judgments of most significance are as follows:
· We elected the package of practical expedients available for transition which allow us to not reassess the following:
o Whether expired or existing contracts contain leases under the new definition of the lease;
o Lease classification for expired or existing leases; and
o Whether previously capitalized initial direct costs would qualify for capitalization under ASC 842.
· We did not elect to use hindsight for transition when considering judgments and estimates such as assessments of lessee options to extend or terminate a lease or purchase the underlying asset.
· For all asset classes, we elected to not recognize a right-of-use asset and lease liability for leases with a term of 12 months or less.
· For all asset classes, we elected to not separate non-lease components from lease components to which they relate and have accounted for the combined lease and non-lease components as a single lease component.
We determine if an arrangement is a lease ~~agreement~~at inception. Operating leases are included in our consolidated balance sheet as right-of-use assets, operating lease liabilities - current and operating lease liabilities – long term. Upon adoption, the Company determined there were no financing leases. Our current operating leases are for ~~6,362 square feet~~facilities and office equipment. Our leases may contain renewal options; however, we do not recognize right-of-use assets or lease liabilities for renewal periods unless it is determined that we are reasonably certain of ~~commercial office~~renewing the lease at inception or when a triggering event occurs. Some of our lease agreements may contain rent escalation clauses, rent holidays, capital improvement funding, or other lease concessions. We recognize our minimum rental expense on a straight-line basis based on the fixed components of a lease arrangement. Payments are set on a pre-determined schedule within each lease agreement. We amortize this expense over the term of the lease beginning with the date of the standard adoption for current leases and beginning with the date of initial possession, which is the date we enter the leased space and begin to make improvements in ~~Waukesha, Wisconsin~~the preparation for its ~~corporate headquarters.~~ intended use, for future leases. Variable lease components represent amounts that are not fixed in nature and are not tied to an index or rate, and are recognized as incurred. Variable lease components consist primarily of common area maintenance, taxes and insurance.
The ~~Waukesha lease would have expired~~Company does not, upon adoption of ASC 842, control a specific space or underlying asset used in ~~April 2021, but was subsequently amended and extended through April 2026. On April 7, 2017~~providing a service by a third-party service provider, under any third party service agreements. There are no such arrangements that meet the Company executed an amendment to its’ existing lease in Waukesha, Wisconsin to expand another 3,982 square feet, bringing the total leased space to 10,344 square feet. In addition, the lease term was extended from May 1, 2021 to April 30, 2026. The commencement date for this amendment was July 15, 2017.definition under ASC 842.

In ~~January 2016,~~determining our right-of-use assets and lease liabilities, we apply a discount rate to the ~~Company entered into~~minimum lease payments within each lease agreement. ASC 842 requires us to use the rate of interest that a ~~lease agreement for 2,237 square feet of commercial office space in Germantown, Maryland for its Maryland employees. The Germantown lease was set~~lessee would have to ~~expire at the end of January 2017. In December 2016, the Company entered into~~pay to borrow on a ~~first amendment~~collateralized basis over a similar term, an amount equal to the lease ~~agreement extending~~payments in a similar economic environment. When we cannot readily determine the discount rate implicit in the lease ~~through the end~~agreement, we utilize our current borrowing rate on our outstanding line of ~~January 2018.~~credit. The Company’s line of credit utilizes market rates to assess an interest rate. Refer to Note F for further discussion.

~~In May 2017, the Company entered into a lease agreement for 5,838 square feet of floor space in Waukesha, Wisconsin for its inventory warehousing operations. The Waukesha lease expires in May 2027.~~

~~Commitments for~~
19
We lease certain property under non-cancelable operating leases, primarily facilities. The impact of the adoption of ASC 842 at January 1, 2019 created a right-of-use asset of $1,042,004, lease liability of $1,095,761 and unwound the $71,877 balance of the deferred lease liability account.
The components of lease expense were as follows:
Operating lease expense:
Operating lease cost - fixed $ 59,476
Variable lease cost 30,050
Total operating lease cost $ 89,526
Other information related to leases as of March 31, 2019 was as follows:
Operating lease liability - current $ 220,037
Operating lease liability - long-term $ 862,114
Operating cash flows from operating leases $ 54,788

Weighted-average remaining lease term of operating leases 6.3 years
Weighted-average discount rate of operating leases 8.5%
Future annual minimum ~~rentals~~operating lease payments as of March 31, 2019 were as follows:
2019 (excluding the three months ended March 31, 2019) $ 165,008
2020 223,835
2021 242,299
2022 195,176
2023 193,169
2024 and thereafter 384,119
Total minimum lease payments $ 1,403,606
Less imputed interest (321,455 )
Total $ 1,082,151
Future annual minimum lease payments under non-cancelable leases as of ~~September 30, 2017~~December 31, 2018 prior to our adoption of ASU 2016-02, Leases (Topic 842) are as follows:

2017 (remainder of) $ 43,738
2018 153,063
2019 154,496
2020 164,903
2021 182,512
2022 and thereafter 764,024
Total $ 1,462,736
2019 $ 211,448
2020 223,417
2021 242,785
2022 195,176
2023 193,169
2024 and thereafter 380,715
Total $ 1,446,708
20

Rental expenses charged to ~~continuing~~ operations for the three ~~and nine~~ months ended ~~September 30, 2017~~March 31, 2019 and ~~2016~~2018 was ~~$86,649~~$89,526 and ~~$42,271 and $200,816 and $127,537,~~$83,882, respectively.

Litigation

The Company is subject to legal proceedings and claims which arise in the ordinary course of its business. Although occasional adverse decisions or settlements may occur, the Company believes that the final disposition of such matters should not have a material adverse effect on its financial position, results of operations or liquidity.

Sales Tax

During 2012, the Company engaged a sales tax consultant to assist in determining the extent of its potential sales tax exposure. Based upon this analysis, management determined the Company had probable exposure for certain unpaid obligations, including interest and penalty, of approximately $1,100,000 including and prior to the year ended December 31, 2011. The Company has approximately $72,000 and $275,000 accrued as of September 30, 2017 and December 31, 2016, respectively.
During the year ended December 31, 2016, the State of Wisconsin performed a sales and use tax audit covering the period from January 1, 2012 through December 31, 2015. The audit resulted in approximately $120,000 in additional use tax and interest. As of September 30, 2017, the Company paid in full the additional use tax liability and interest associated with the sales and use tax audit.
19
~~TELKONET, INC.~~
~~NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS~~
~~SEPTEMBER 30, 2017~~
~~(UNAUDITED~~)
~~Prior to 2017, the Company successfully executed and paid in full VDAs in thirty six states totaling approximately $765,000 and is current with the subsequent filing requirements.~~
The following table sets forth the change in the sales tax accrual as of ~~September 30, 2017~~March 31, 2019 and December 31, ~~2016:~~2018:

September 30,
2017
December 31, 2016 March 31,
2019 December 31, 2018
Balance, beginning of year $ 274,869 $ 229,768 $ 43,400 $ 83,282
Sales tax collected 235,091 452,016 56,314 101,145
Provisions (reversals) (52,000 ) 151,000
Provisions (7,706 ) 30,465
Interest and penalties - (3,017 ) – –
Payments (385,629 ) (554,898 ) (32,823 ) (171,492 )
Balance, end of period $ 72,331 $ 274,869 $ 59,185 $ 43,400

NOTE KL – BUSINESS CONCENTRATION

For the ~~nine~~three months ended ~~September 30, 2017 and 2016, no single customer~~March 31, 2019, two customers represented ~~10% or more~~approximately 31% of total net revenues. For the three months ended March 31, 2018, one customer represented approximately 14% of total net revenues.
As of ~~September 30, 2017, one customer~~March 31, 2019, three customers accounted for approximately ~~10%~~51% of the Company’s net accounts receivable. As of December 31, ~~2016, two~~2018, three customers accounted for approximately ~~24%~~47% of the Company’s net accounts receivable.

Purchases from one supplier approximated ~~$2,122,000,~~$775,000, or ~~86%~~76%, of inventory purchases for the three months ended March 31, 2019 and $760,000, or 82%, of purchases for the ~~nine~~three months ended ~~September 30, 2017 and $1,907,000, or 77%,~~March 31, 2018. Deposits paid to this vendor were in excess of ~~purchases for the nine months ended September 30, 2016. Total~~total accounts payable due to this supplier ~~net~~in the amount of ~~deposits, was approximately $525,858~~$697,405 as of ~~September 30, 2017,~~March 31, 2019, and ~~$45,037~~$320,352 as of December 31, ~~2016.~~
~~NOTE L – DISCONTINUED OPERATIONS~~
In October of 2016, the Company, under the direction and authority of the Board of Directors, committed to a plan to offer for sale EthoStream, the Company’s wholly–owned High-Speed Internet Access (“HSIA”) subsidiary. As a result of this decision to sell EthoStream, the operating results of EthoStream as of and for the year ended December 31, 2016 were reclassified as discontinued operations and as assets and liabilities held for sale in the consolidated financial statements as detailed in the table below. During the nine months ended September 30, 2017, the Company, and EthoStream, entered into an Asset Purchase Agreement (the “Purchase Agreement”) with DCI-Design Communications LLC (“DCI”), a Delaware limited liability company, whereby DCI acquired all of the assets and certain liabilities of EthoStream for a base purchase price of $12,750,000. The Purchase Agreement includes that proceeds of $900,000 are to be withheld from the $12,750,000 base purchase price and placed into an escrow account to support potential indemnification obligations of up to $800,000 and net working capital adjustments of up to $100,000. The escrow amount, net of potential claims, would be fully released after an escrow period not to exceed 12 months after closing. Another $93,000 is classified in other current assets as a net working capital receivable. The assets included, among other items, certain inventory, contracts and intellectual property. DCI acquired only the liabilities provided for in the Purchase Agreement. On March 29, 2017, pursuant to the terms and the conditions of the Purchase Agreement, the Company closed on the sale.
On September 27, 2017, the Company reached a final settlement with DCI on net working capital as set forth in the Purchase Agreement. On September 29, 2017, the Company received $100,000 from the escrow account for the portion of the escrow account set aside for net working capital adjustments and cash proceeds of $311,000 from DCI in the settlement of net working capital adjustments. The net working capital receivable of $93,000 in other current assets was applied against the cash proceeds of $311,000 received on September 29, 2017 resulting in a gain from sale of discontinued operations of $218,000 recognized during the three months ended September 30, 2017.
20
~~TELKONET, INC.~~
~~NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS~~
~~SEPTEMBER 30, 2017~~
~~(UNAUDITED~~)
~~The following table summarizes the balance sheet information for discontinued operations.~~
September 30, December 31,
2017 2016

Accounts receivable, net $ – $ 456,478
Inventories – 350,506
Other current assets – 12,980
Other asset – goodwill – 5,796,430
Other  asset – intangible asset, net – 533,577
Current assets of discontinued operations – 7,149,971

Accounts payable – 465,346
Accrued liabilities and expenses – 90,187
Deferred revenues – 37,509
Customer deposits – 200,466
Deferred lease liability – 76,096
Current liabilities of discontinued operations – 869,604

Net assets of discontinued operations $ – $ 6,280,367
~~The following table summarizes the statements of operations information for discontinued operations.~~

Three Months Ended
September 30,

Nine Months Ended
September 30,

2017 2016 2017 2016
Revenues, net:
Product $ – $ 995,425 $ 653,839 $ 2,749,001
Recurring – 1,038,585 925,837 2,985,550
Total Net Revenue – 2,034,010 1,579,676 5,734,551

Cost of Sales:
Product (11,600 ) 565,276 403,004 1,753,994
Recurring – 242,678 209,868 697,541
Total Cost of Sales (11,600 ) 807,954 612,872 2,451,535

Gross Profit 11,600 1,226,056 966,804 3,283,016

Operating Expenses:
Selling, general and administrative 197 315,437 252,307 896,385
Depreciation and amortization – 60,420 60,420 181,697
Total Operating Expenses 197 375,857 312,727 1,078,082

Income from Discontinued Operations before Provision for Income Taxes 11,403 850,199 654,077 2,204,934

Provision for Income Taxes – 51,312 52,017 153,936
Income from Discontinued Operations (net of tax) $ 11,403 $ 798,887 $ 602,060 $ 2,050,998
2018.

21

~~TELKONET, INC.~~
~~NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS~~
~~SEPTEMBER 30, 2017~~
~~(UNAUDITED~~)
The consolidated statements of cash flows do not present the cash flows from discontinued operations for investing activities or financing activities because there were no investing or financing activities associated with the discontinued operations in three and nine months ended September 30, 2017 and 2016.
~~NOTE M - SUBSEQUENT EVENT~~
On October 24, 2017, the Company announced a share repurchase program authorized by its Board of Directors. The share repurchase program does not obligate the Company to acquire any specific number of shares, but authorizes the Company to repurchase up to ten million shares of the Company’s common stock. Under the program, shares may be repurchased in privately negotiated and/or open market transactions. The program does not have a specific expiration date and may be suspended or discontinued at any time. As of the date of this filing, no shares have been repurchased under the program.
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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis of the Company’s financial condition and results of operations should be read in conjunction with the accompanying condensed consolidated financial statements and related notes thereto for the three ~~and nine~~ months ended ~~September 30, 2017,~~March 31, 2019, as well as the Company’s consolidated financial statements and related notes thereto and management’s discussion and analysis of financial condition and results of operations in the Company’s Form 10-K for the year ended December 31, ~~2016,~~2018, filed with the ~~U.S.~~US. Securities and Exchange Commission (the “SEC”) on April ~~3, 2017.~~1, 2019.

Business

Telkonet, Inc. (the “Company”, “Telkonet”~~, “we”, “our”~~), formed in 1999 and incorporated under the laws of the state of Utah, is the creator of the EcoSmart Platform of intelligent automation solutions designed to optimize energy efficiency, comfort and analytics in support of the emerging Internet of Things (“IoT”).
~~In October of 2016, the Company, under the direction and authority of the Board of Directors, committed to~~ We currently operate in a plan to offer for sale EthoStream LLC (“EthoStream”), its wholly-owned High-Speed Internet Access (“HSIA”) subsidiary. The sale will enable the Company to focus on its higher growth potential EcoSmart Platform line. As a result of this decision to sell EthoStream, the operating results of EthoStream for the three and nine months ended September 30, 2017 and 2016 have been reclassified as discontinued operations in the condensed consolidated statement of operations and as assets and liabilities of discontinued operations in the condensed consolidated balance sheet for the year ended December 31, 2016. The transaction closed on March 29, 2017.single reportable business segment.

The Company’s direct sales effort targets the hospitality, education, commercial, utility and government/military markets. Taking advantage of legislation, including the Energy Independence and Security Act of 2007, or EISA, the Energy Policy Act of 2005, and the American Recovery and Reinvestment Act the Company is focusing its sales efforts in areas with available public funding and incentives, such as rebate programs offered by utilities for efficiency upgrades. Through the Company’s proprietary platform, technology and partnerships with energy efficiency providers, the Company’s management intends to position the Company as a leading provider of energy management solutions.

Forward-Looking Statements

In accordance with the Private Securities Litigation Reform Act of 1995, the Company can obtain a “safe-harbor” for forward-looking statements by identifying those statements and by accompanying those statements with cautionary statements which identify factors that could cause actual results to differ materially from those in the forward-looking statements. Accordingly, the following “Management’s Discussion and Analysis of Financial Condition and Results of Operations” may contain certain forward-looking statements regarding strategic growth initiatives, growth opportunities and management’s expectations regarding orders and financial results for the remainder of ~~2017~~2019 and future periods. These forward-looking statements are based on current expectations and current assumptions which management believes are reasonable. However, these statements involve risks and uncertainties that could cause actual results to differ materially from any future results encompassed within the forward-looking statements.  Factors that could cause or contribute to such differences include those risks affecting the Company’s business as described in the Company’s filings with the SEC, including the current reports on Form 8-K, which factors are incorporated herein by reference. The Company expressly disclaims a duty to provide updates to forward-looking statements, whether as a result of new information, future events or other occurrences.

Critical Accounting Policies and Estimates
~~The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires the Company to make estimates~~ and assumptions that affect the amounts reported in the condensed consolidated financial statements and accompanying notes.  On an ongoing basis, the Company evaluates significant estimates used in preparing its condensed consolidated financial statements including those related to revenue recognition and allowances for uncollectible accounts receivable, inventory obsolescence, depreciation and amortization, long-lived asset valuations, impairment assessments, taxes and related valuation allowance, income tax provisions, stock-based compensation, and contingencies. The Company bases its estimates on historical experience, underlying run rates and various other assumptions that the Company believes to be reasonable, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Actual results could differ from these estimates. The following are critical judgments, assumptions, and estimates used in the preparation of the condensed consolidated financial statements.
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~~Revenue Recognition~~
For revenue from product sales, the Company recognizes revenue in accordance with ASC 605-10, “Revenue Recognition” and ASC 605-10-S99 guidelines that require that four basic criteria must be met before revenue can be recognized: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred; (3) the selling price is fixed and determinable; and (4) collectability is reasonably assured. Determination of criteria (3) and (4) are based on management’s judgments regarding the fixed nature of the selling prices of the products delivered and the collectability of those amounts. Assuming all conditions for revenue recognition have been satisfied, product revenue is recognized when products are shipped and installation revenue is recognized when the services are completed. Provisions for discounts and rebates to customers, estimated returns and allowances, and other adjustments are provided for in the same period the related sales are recorded. The guidelines also address the accounting for arrangements that may involve the delivery or performance of multiple products, services and/or rights to use assets.
~~Multiple-Element Arrangements (“MEAs”):~~ The Company accounts for contracts that have both product and installation under the MEAs guidance in ASC 605-25. Arrangements under such contracts may include multiple deliverables consisting of a combination of equipment and services.  The deliverables included in the MEAs are separated into more than one unit of accounting when (i) the delivered equipment has value to the customer on a stand-alone basis, and (ii) delivery of the undelivered service element(s) is probable and substantially in the Company’s control. Arrangement consideration is then allocated to each unit, delivered or undelivered, based on the relative selling price of each unit of accounting based first on vendor-specific objective evidence (“VSOE”) if it exists, second on third-party evidence (“TPE”) if it exists and on estimated selling price (“ESP”) if neither VSOE or TPE exist.
VSOE – In most instances, products are sold separately in stand-alone arrangements. Services are also sold separately through renewals of contracts with varying periods. The Company determines VSOE based on pricing and discounting practices for the specific product or service when sold separately, considering geographical, customer, and other economic or marketing variables, as well as renewal rates or stand-alone prices for the service element(s).
TPE – If the Company cannot establish VSOE of selling price for a specific product or service included in a multiple-element arrangement, the Company uses third-party evidence of selling price. The Company determines TPE based on sales of a comparable amount of similar product or service offered by multiple third parties considering the degree of customization and similarity of product or service sold.
ESP – The estimated selling price represents the price at which the Company would sell a product or service if it were sold on a stand-alone basis. When neither VSOE nor TPE exists for all elements, the Company determines ESP for the arrangement element based on sales, cost and margin analysis, as well as other inputs based on the Company’s pricing practices. Adjustments for other market and Company-specific factors are made as deemed necessary in determining ESP.
Under the estimated selling price method, revenue is recognized in MEAs based on estimated selling prices for all of the elements in the arrangement, assuming all other conditions for revenue recognition have been satisfied. To determine the estimated selling price, the Company establishes the selling price for its products and installation services using the Company’s established pricing guidelines, and the proceeds are allocated between the elements and the arrangement.
When MEAs include an element of customer training, the Company determined it is not essential to the functionality, efficiency or effectiveness of the MEA due to its perfunctory nature in relation to the entire arrangement. Therefore the Company has concluded that this obligation is inconsequential and perfunctory. As such, for MEAs that include training, customer acceptance of said training is not deemed necessary in order to record the related revenue, but is recorded when the installation deliverable is fulfilled. Historically, training revenues have not been significant.
24
The Company provides call center support services to properties installed by the Company. The Company receives monthly service fees from such properties for its services. The Company recognizes the service fee ratably over the term of the contract. The prices for these services are fixed and determinable prior to delivery of the service. The fair value of these services is known due to objective and reliable evidence from standalone executed contracts.  The Company reports such revenues as recurring revenues. Deferred revenue includes deferrals for the monthly support service fees. Long-term deferred revenue represents support service fees to be earned or provided beginning after September 30, 2018. Revenue recognized that has not yet been billed to a customer results in an asset as of the end of the period. As of September 30, 2017 and December 31, 2016, there was $68,855 and $193,400 recorded within accounts receivable, respectively, related to revenue recognized that has not yet been billed.
New Accounting Pronouncements

Please refer to the Company’s Form 10-K filed April 1, 2019 for critical accounting policies and estimates. For information regarding recent accounting pronouncements and their effect on the Company, see “New Accounting Pronouncements” in Note B of the Notes to Unaudited Condensed Consolidated Financial Statements contained herein.

Revenues

The table below outlines product versus recurring revenues for comparable periods:

Three Months Ended
September 30, 2017 September 30, 2016 Variance

Product $ 1,904,571 94% $ 1,360,887 90% $ 543,684 40%
Recurring 131,665 6% 143,028 10% (11,363 ) -8%
Total $ 2,036,326 100% $ 1,503,915 100% $ 532,321 35%
Three Months Ended
March 31, 2019 March 31, 2019 Variance

Product $ 2,586,669 94% $ 1,503,658 94% $ 1,083,011 72%
Recurring 176,533 6% 101,538 6% 74,995 74%
Total $ 2,763,202 100% $ 1,605,196 100% $ 1,158,006 72%

Nine Months Ended

September 30, 2017 September 30, 2016 Variance

Product $ 5,728,878 94% $ 6,356,437 95% $ (627,559 ) -10%
Recurring 344,708 6% 340,412 5% 4,296 1%
Total $ 6,073,586 100% $ 6,696,849 100% $ (623,263 ) -9%
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Product Revenue

Product revenue principally arises from the sale and installation of the EcoSmart energy management platform. The EcoSmart Suite of products consists of thermostats, sensors, controllers, wireless networking products, switches, outlets and a control platform.

For the three months ended ~~September 30, 2017,~~March 31, 2019, product revenue increased by ~~40%~~72% or ~~$0.5~~$1.08 million ~~and for~~when compared to the ~~nine months ended September 30, 2017, product revenue decreased 10% or $0.6~~prior year period as a result of the Company beginning the quarter with a backlog of approximately $4.00 million, along with continued growth in channel sales. As a result of continued sales growth, the Company also finished the quarter with a backlog of approximately $4.00 million. ~~For the three months ended September 30, 2017, the~~The hospitality market ~~comprised $1.3 million of product~~ sales for the three months ended ~~September 30, 2017, a $0.1~~March 31, 2019 increased $0.49 million ~~decrease~~ from the prior year ~~period. The~~period to $1.69 million, largely driven by international sales in the hospitality market due to contract for a modular home project sold through an OEM partner. In addition, the government market increased $0.43 million to $0.44 million and the Multiple Dwelling Unit (“MDU”) market increased $0.18 million to $0.20 million. This was partially offset by a decrease in the education market sales for the three months ended ~~September 30, 2017 increased $0.3~~March 31, 2019 of $0.03 million ~~to $0.4 million~~ from $0.1 million for the prior year period. The Multiple Dwelling Unit (“MDU”) market increased $0.2 million from $0.0 million during the three months ended September 30, 2016. The hospitality market sales for the nine months ended September 30, 2017 decreased $0.7 million to $4.2 million from $4.9 million for the prior year period. The education market sales for the nine months ended September 30, 2017 increased $0.1 million to $1.0 million from $0.9 million for the prior year period ~~and the Commercial and MDU market sales for the nine months ended September 30, 2017 remained at $0.5 million for the nine months ended September 30, 2017 and 2016.~~to $0.26 million. The Company’s commitment to access distribution channels through resellers and value added distribution partners ~~decreased~~continued to grow. Product revenue derived from ~~$3.1~~channel partners increased $0.86 million to $2.13 million for the ~~nine~~three months ended ~~September 30, 2016~~March 31, 2019 compared to ~~$2.8 million at September 30, 2017.~~the prior year period.
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Recurring Revenue
Recurring revenue is attributed to our call center support services. The Company recognizes revenue ratably over the service month for monthly support revenues and defers revenue for annual support services over the term of the service period. Recurring revenue consists of Telkonet’s EcoCare service and support program.

For the three ~~and nine~~ months ended ~~September 30, 2017,~~March 31, 2019, recurring revenue ~~decreased by 8% and~~ increased by ~~1%, respectively,~~74% when compared to the prior year period. New sales outpaced non-renewals.

Cost of Sales

Three Months Ended
September 30, 2017 September 30, 2016 Variance

Product $ 1,160,019 61% $ 770,830 57% $ 389,189 50%
Recurring 55,702 42% 36,618 26% 19,084 52%
Total $ 1,215,721 60% $ 807,448 54% $ 408,273 51%
Nine Months Ended
September 30, 2017 September 30, 2016 Variance

Product $ 3,233,978 56% $ 3,194,094 50% $ 39,884 1%
Recurring 118,347 34% 92,324 27% 26,023 28%
Total $ 3,352,325 55% $ 3,286,418 49% $ 65,907 2%
Three Months Ended
March 31, 2019 March 31, 2018 Variance

Product $ 1,690,598 65% $ 994,237 66% $ 696,361 70%
Recurring 86,042 49% 59,997 59% 26,045 43%
Total $ 1,776,640 64% $ 1,054,234 66% $ 722,406 69%

Costs of Product ~~Revenue~~Sales
Costs of product revenue include equipment and installation labor related to EcoSmart technology. For the three ~~and nine~~ months ended ~~September 30, 2017,~~March 31, 2019, total product costs increased by ~~50% and 1%, respectively,~~70% compared to the prior year. Cost of materials increased by 82% or $0.42 million compared to the prior year ~~periods. For the three month comparison, the materials costs~~period, primarily as a ~~percentage~~result of ~~product sales increased 2% to 45% for~~ the ~~three month ended September 30, 2017 from 43% for the three months ended September 30, 2016.~~increase in sales. The ~~cost~~impact of ~~materials increased $0.15~~tariffs resulted in a $0.25 million increase in freight ~~and warranty expense increased $0.04 million and inventory adjustments increased $0.08 million. For the three months ended September 30, 2017, the~~expense. The Company’s ~~increased~~ use of outside contractors for installations ~~resulted~~increased, resulting in a ~~$0.19~~$0.12 million ~~variance~~increase in contractor services ~~costs, consequently, salary, benefits and travel costs related to installations decreased~~costs. These increases were partially offset by ~~$0.07 million.~~
~~For the nine month comparison, the use of outside contractors for installations resulted in~~ a ~~$0.20~~$0.10 million decrease in ~~salary, wages and travel expense. These decreases were offset by a $0.16 million adjustment in~~ inventory ~~costs, a $0.03 million increase in freight costs, a $0.03 million increase in outside services and a $0.02 million increase in parts and supplies and warranty expense.~~adjustments.
Costs of Recurring Revenue
Recurring costs are comprised of labor and telecommunication services for our customer service department. For the three ~~and nine~~ months ended ~~September 30, 2017,~~March 31, 2019, recurring costs increased by ~~52% and 28%, respectively, when~~43% compared to the prior year ~~periods. The three and nine month variances are the result of a $0.02~~period. This $0.03 million ~~and a $0.03 million~~variance was due to an increase in salary, benefits and ~~benefit costs for the period ended September 30, 2017. The Company added a support services supervisor.~~temporary staffing.

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Gross Profit

Three Months Ended
September 30, 2017 September 30, 2016 Variance

Product $ 744,552 39% $ 590,057 43% $ 154,495 26%
Recurring 75,963 58% 106,410 74% (30,447 ) -29%
Total $ 820,515 40% $ 696,467 46% $ 124,048 18%
Three Months Ended
March 31, 2019 March 31, 2018 Variance

Product $ 896,071 35% $ 509,421 34% $ 386,650 76%
Recurring 90,491 51% 41,541 41% 48,950 118%
Total $ 986,562 36% $ 550,962 34% $ 435,600 79%

Nine Months Ended
September 30, 2017 September 30, 2016 Variance

Product $ 2,494,900 44% $ 3,162,343 50% $ (667,443 ) -21%
Recurring 226,361 66% 248,088 73% (21,727 ) -9%
Total $ 2,721,261 45% $ 3,410,431 51% $ (689,170 ) -20%
Gross Profit on Product Revenue

Gross profit for the three ~~and nine~~ months ended ~~September 30, 2017~~March 31, 2019 increased by 26% and decreased by 21%, respectively, when compared to the prior year periods. For the three months ended September 30, 2017, the actual gross profit percentage declined to 39% from 43%. The majority of the variance was due to an approximate increase of 20% for outside services. For the nine months ended September 30, 2017, the actual gross profit percentage declined to 44% from 50%. Material costs as a percentage of sales increased 3% for the nine months ended September 30, 201776% when compared to the prior year period. The ~~inventory valuation adjustment variance of $0.16 million during~~actual gross profit percentage increased from 34% for the ~~nine~~three months ended ~~September 30, 2017 when compared~~March 31, 2018 to 35% for the three months ended March 31, 2019. Contributing to the ~~prior year period also contributed to gross profit decline.~~increase in margin were lower discounts utilized offsetting the increases in costs of product sales discussed above.

Gross Profit on Recurring Revenue
The gross profit associated with recurring revenue ~~decreased~~increased by ~~29% and 9%, respectively,~~118% for the three ~~and nine~~ months ended ~~September 30, 2017~~March 31, 2019 when compared to the prior year ~~periods. For the three months ended September 30, 2017, the actual gross profit percentage decreased 16% compared~~period. The increase was related to ~~the prior year period, from 74% to 58%. The primary reason was a manager was added to the Company’s~~increased unit sales with call center support ~~department, increasing wages and benefits. For the nine months ended September 30, 2017, the actual gross profit percentage decreased 7% compared to the prior year period, from 73% to 66%.~~services included.

Operating Expenses

Three Months Ended September 30,
2017 2016 Variance

Total $ 1,704,177 $ 1,870,493 $ (166,316 ) -9%
Nine Months Ended September 30,
2017 2016 Variance

Total $ 5,754,741 $ 6,357,622 $ (602,881 ) -9%
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Three Months Ended March 31,
2019 2018 Variance

Total $ 1,826,607 $ 1,732,598 $ 94,009 5%

During the three ~~and nine~~ months ended ~~September 30, 2017,~~March 31, 2019, operating expenses ~~decreased~~increased by 9%5% when compared to the prior year ~~periods~~period as outlined below.

Research and Development
Three Months Ended September 30
2017 2016 Variance

Total $ 500,656 $ 429,622 $ 71,034 17%
Nine Months Ended September 30,
2017 2016 Variance

Total $ 1,323,669 $ 1,321,007 $ 2,662 0%
Three Months Ended March 31,
2019 2018 Variance

Total $ 486,626 $ 438,780 $ 47,846 11%

Research and development costs are related to both present and future products and are expensed in the period incurred. Current research and development costs are associated with product development and integration. During the three ~~and nine~~ months ended ~~September 30, 2017,~~March 31, 2019, research and development costs increased ~~by 17% and 0%, respectively,~~11% when compared to the prior year ~~periods. For the three month comparison, the~~period. The variance is due to an approximate ~~$0.04~~$0.05 million increase in expenditures for consulting, a $0.01 increase in personnel recruiting and an increase of $0.02 million for salary and benefits. For the nine month comparison, overall expense remained unchanged however there were changes within the research and development category. For the nine months ended September 30, 2017, a $0.06 million decrease was the result of retooling charges related to new product development for the prior year period. This was offset by a $0.04 million increase in consulting and a $0.02 million increase for new product certification expenses for the nine months ended September 30, 2017.consulting.
24

Selling, General and Administrative Expenses
Three Months Ended September 30,
2017 2016 Variance

Total $ 1,188,905 $ 1,432,489 $ (243,584) -17%
Nine Months Ended September 30,
2017 2016 Variance

Total $ 4,396,667 $ 5,012,249 $ (615,582) -12%
Three Months Ended March 31,
2019 2018 Variance

Total $ 1,323,049 $ 1,276,903 $ 46,146 4%

During the three ~~and nine~~ months ended ~~September 30, 2017,~~March 31, 2019, selling, general and administrative expenses ~~decreased~~increased over the prior year ~~periods~~period by ~~17% and 12%, respectively.~~4%. For the three month comparison, ~~due to~~ the sale of EthoStream, the Company was able to decrease executive, accounting and sales salaries, wages and benefits by $0.20 million. A $0.07 million decrease was a result of a refund received from a utility. The Company had a $0.09 million decrease in sales and use tax, the result of a $0.10 million State of Wisconsin audit assessment during 2016 as well as a $0.06 million decrease in bad debt expense, the result of a collection previously reserved. These decreases were offset by increases for legal expense of $0.03 million, hardware/software expenses of $0.06 million, marketing and trade show expense of $0.05 million, rent expense of $0.04 million and commissions of $0.02 million.
~~For the nine month comparison, $0.29 million~~majority of the variance is attributed to the ~~costs associated with the contested 2016 proxy contest as discussed~~increase in ~~detail~~accounting and legal services, leading to an increase in $0.06 million. Additionally, there were increased commissions in the ~~June 30, 2017 Form 10-Q as well as an additional $0.10 million in public company fees in 2016. Due to the sale~~amount of EthoStream, the Company was able to decrease temporary staffing, executive, accounting and sales salaries, wages and benefits of $0.61 million, $0.11 million for sales and use tax, related to the State of Wisconsin audit discussed above, a utility refund of $0.07 million, $0.03 million for director fees, $0.04 ~~million for insurance expense.~~million. These ~~reductions in expense~~costs were offset by ~~an increase~~a decrease in ~~stock option expense~~salaries of ~~$0.31 million, marketing and trade show expenses of $0.14 million, rent expense of $0.07 million, commissions of $0.02~~$0.03 million and ~~hardware/software costs of $0.05 million.~~
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~~Income from Discontinued Operations, Net of Tax~~
Three Months Ended September 30,
2017 2016 Variance

Total $ 11,403 $ 798,887 $ (787,484) -99%

Nine Months Ended September 30,

2017 2016 Variance

Total $ 602,060 $ 2,050,998 $ (1,448,938) -71%
Income from discontinued operations decreased $0.79 million or 99% and $1.45 million or 71% for the three and nine months ended September 30, 2017 over the prior year periods. On March 29, 2017, pursuant to the terms and the conditions of the Purchase Agreement, the Company closed on the sale of EthoStream. The income from discontinued operations (net of tax) represents the activity of EthoStream from January 1, 2017 through the date of the sale on March 28, 2017. After March 28, 2017, certain liabilities retained by the Company will be adjusteda $0.02 change in ~~future periods as these liability balances are paid.~~bad debt expense.

EBITDA from ~~Continuing~~ Operations

Management believes that certain non-GAAP financial measures may be useful to investors in certain instances to provide additional meaningful comparisons between current results and results in prior operating periods. Adjusted earnings before interest, taxes, depreciation and amortization (“Adjusted EBITDA”) is a metric used by management and frequently used by the financial community. Adjusted EBITDA provides insight into an organization’s operating trends and facilitates comparisons between peer companies, since interest, taxes, depreciation and amortization can differ greatly between organizations as a result of differing capital structures and tax strategies. Adjusted EBITDA is one of the measures used for determining our debt covenant compliance. Adjusted EBITDA excludes certain items that are unusual in nature or not comparable from period to period. While management believes that non-GAAP measurements are useful supplemental information, such adjusted results are not intended to replace our GAAP financial results. Adjusted EBITDA is not, and should not be considered, an alternative to net income (loss), income (loss) from operations, or any other measure for determining operating performance of liquidity, as determined under accounting principles generally accepted in the United States (GAAP). In assessing the overall health of its business for the three ~~and nine~~ months ended ~~September 30, 2017~~March 31, 2019 and ~~2016,~~2018, the Company excluded items in the following general category described below:

· Stock-based compensation: The Company believes that because of the variety of equity awards used by companies, varying methodologies for determining stock-based compensation and the assumptions and estimates involved in those determinations, the exclusion of non-cash stock-based compensation expense related to employee stock options enhances the ability of management and investors to understand the impact of non-cash stock-based compensation on our operating results. Further, the Company believes that excluding stock-based compensation expense related to employee stock options allows for a more transparent comparison of its financial results to the previous period.
· Bonuses paid to executives upon sale of discontinued operations: The Company does not consider the bonuses of $87,750 associated with the sale of EthoStream to be indicative of current or future operating performance. Therefore, the Company does not consider the inclusion of these costs helpful in assessing its current financial performance compared to the previous year.
RECONCILIATION OF NET LOSS FROM
OPERATIONS TO ADJUSTED EBITDA
FOR THE THREE MONTHS ENDED MARCH 31,
2019 2018
Net loss $ (845,604 ) $ (1,184,166 )
Interest expense, net 5,561 2,530
Depreciation and amortization 16,931 16,915
EBITDA (823,112 ) (1,164,721 )
Adjustments:
Stock-based compensation 1,815 1,531
Adjusted EBITDA $ (821,297 ) $ (1,163,190 )

2925

~~RECONCILIATION OF NET LOSS FROM~~
~~CONTINUING OPERATIONS TO ADJUSTED EBITDA~~
~~(Unaudited)~~

Three Months Ended
September 30,

Nine Months Ended
September 30,

2017 2016 2017 2016

Net loss from continuing operations $ (871,340 ) $ (1,192,083 ) $ (3,034,984 ) $ (2,995,699 )
Interest (income) expense, net (8,722 ) 15,482 (2,797 ) 45,308
Provision (benefit) for income taxes (3,600 ) 2,575 4,301 3,200
Depreciation and amortization 14,616 8,382 34,405 24,366
EBITDA – continuing operations (869,046 ) (1,165,644 ) (2,999,075 ) (2,922,825 )
Adjustments:
Stock-based compensation 2,343 2,703 320,545 10,204
Bonuses paid to executives upon sale of discontinued operations – – 87,750 –
Adjusted EBITDA $ (866,703 ) $ (1,162,941 ) $ (2,590,780 ) $ (2,912,621 )

Liquidity and Capital Resources

For the three-month period ended March 31, 2019, the Company reported a net loss of $845,604 and had cash used in operating activities of $1,716,357 and ended the period with an accumulated deficit of $124,017,010 and total current assets in excess of current liabilities of 5,190,204. At March 31, 2019, the Company had $3,745,998 of cash and approximately $1,043,000 of availability on its credit facility. The credit facility is a $2,000,000 line of credit, which is subject to a borrowing base calculation based on the Company’s eligible accounts receivable and eligible inventory each multiplied by an applicable advance rate, with an overall limitation tied to the Company’s eligible accounts receivable. As of March 31, 2019, we had borrowing capacity of $2,000,000 and an outstanding balance of approximately $907,000, resulting in the approximate availability of $1,043,000 on the credit facility.
Since inception, the Company has incurred operating losses and has reported negative cash flows from operating activities. Since 2012, the Company has made significant investments in the engineering, development and marketing of an intelligent automation platform, including but not limited to, hardware and software enhancements, support services and applications. The funding for these development efforts has contributed to the ongoing operating losses and use of cash. Operating losses have been financed by debt and equity transactions, credit facility capacity, the sale of a wholly-owned subsidiary and management of working capital levels. The report from our independent registered public accounting firm on our consolidated financial statements for the year ended December 31, 2018 stated there is substantial doubt about our ability to continue as a going concern.
The Company’s ability to continue as a going concern is dependent upon generating profitable operations in the future and/or securing the necessary financing to meet its obligations and repay its liabilities arising from normal business operations when they come due. There can be no assurance that the Company will be able to secure such financing at commercially reasonable terms, if at all. If cash resources become insufficient to meet the Company’s ongoing obligations, the Company will be required to scale back or discontinue portions of its operations or discontinue operations entirely, whereby, the Company’s shareholders may lose some or all of their investment.
We have not identified, and cannot be certain we will be able to identify, a course of action that guarantees the achievement of profitable operations in the foreseeable future. In June 2018, the Company’s Board engaged an investment bank to identify strategic alternatives to maximize shareholder value, including but not limited to, a sale of the Company, an investment in the Company, a merger or other business combination, a sale of all or substantially all assets or a strategic joint venture. At May 15, 2019, no definitive alternatives had been identified.
The Company ~~has financed~~expects to draw on its’ cash reserves and utilize the credit facility to the extent availability exists to finance its ~~operations since inception primarily through private~~near term working capital needs. We expect to continue to incur operating losses and ~~public offerings~~negative operating cash flows for one year beyond the date of these financial statements. Accordingly, and in light of the Company’s ~~equity securities,~~historic and continuing losses, there is substantial doubt about the ~~issuance of various debt instruments and asset based lending, and the sale of assets.~~Company’s ability to continue as a going concern.

Working Capital

Working capital (current assets in excess of current liabilities) from ~~continuing~~ operations ~~increased~~decreased by ~~$9,840,658~~$1,016,095 during the ~~nine~~three months ended ~~September 30, 2017~~March 31, 2019 from working capital ~~deficit~~ of ~~$26,859~~$6,206,299 at December 31, ~~2016~~2018 to a working capital of ~~$9,813,799~~$5,190,204 at ~~September 30, 2017.~~March 31, 2019.

~~Kross Promissory Note~~

On August 4, 2016, the Board of Directors authorized the Company to reimburse Peter T. Kross (“Mr. Kross”) $161,075 for expenses incurred related to his successful contested proxy. Effective June 27, 2016, Mr. Kross became a director of the Company and is considered a related party. On August 30, 2016, Mr. Kross accepted an unsecured promissory note (“Kross Note”) for $161,075 from the Company. The outstanding principal balance bore interest at the annual rate of 3.00%. Payment of interest and principal began on September 1, 2016 and continued monthly on the first day of each month thereafter through and including June 1, 2017. The Company was required to pay equal monthly installments of $16,330 which included all remaining principal and accrued interest owed by the Company to Mr. Kross under the Kross Note. The Company could prepay in advance any unpaid principal or interest due under the Kross Note without premium or penalty. The principal balance of the Kross Note as of September 30, 2017 and December 31, 2016 was zero and $97,127, respectively.
26
Revolving Credit Facility

~~On September 30, 2014, the~~The Company ~~and its wholly-owned subsidiary, EthoStream, as co-borrowers (collectively, the “Borrowers”), entered into~~is a party to a loan and security agreement (the “Heritage Bank Loan Agreement”), with Heritage Bank of Commerce, a California state chartered bank (“Heritage Bank”), governing a new revolving credit facility in a principal amount not to exceed $2,000,000 (the “Credit Facility”). Availability of borrowings under the Credit Facility ~~from time to time~~ is subject to a borrowing base calculation based on the Company’s eligible accounts receivable and eligible inventory each multiplied by an applicable advance rate, with an overall limitation tied to the Company’s eligible accounts receivable. The Heritage Bank Loan Agreement is available for working capital and other general business purposes. The outstanding principal balance of the Credit Facility bears interest at the Prime Rate plus 3.00%, which was ~~7.25%~~8.50% at ~~September 30, 2017~~March 31, 2019 and ~~6.75% at~~ December 31, ~~2016.~~2018. On October 9, 2014, as part of the Heritage Bank Loan Agreement, Heritage Bank was granted a warrant to purchase 250,000 shares of Telkonet common stock. The warrant has an exercise price of $0.20 and expires October 9, 2021. On February ~~17, 2016, an~~13, 2019, the tenth amendment to the Credit Facility was executed extending the maturity date to September 30, ~~2018,~~2020, unless earlier accelerated under the terms of the Heritage Bank Loan Agreement.
30

The Heritage Bank Loan Agreement also contains financial covenants that place restrictions on, among other things, the incurrence of debt, granting of liens and sale of assets. The Heritage Bank Loan Agreement also contains financial covenants, ~~that require the Borrowers to maintain~~including a ~~minimum~~maximum EBITDA ~~level,~~loss covenant, measured quarterly, ~~and~~ a minimum asset coverage ratio, measured ~~monthly.~~monthly, and a minimum unrestricted cash balance of $2 million. During the period ended March 31, 2019 and the year ended December 31, 2018, the Company and Heritage Bank entered into several amendments to the Credit Facility to adjust these covenant levels. As long as the Company maintains the minimum unrestricted cash balance of $2 million, a violation of the minimum EBITDA level will not trigger an event of default. A violation of any of these covenants could result in an event of default under the Heritage Bank Loan Agreement. Upon the occurrence of such an event of default or certain other customary events of defaults, payment of any outstanding amounts under the Credit Facility may be accelerated and Heritage Bank’s commitment to extend credit under the Heritage Bank Loan Agreement may be terminated. The Heritage Bank Loan Agreement contains other representations and warranties, covenants, and other provisions customary to transactions of this nature.
The outstanding balance ofon the ~~revolving credit facility~~Credit Facility was ~~$79,953 as of September 30, 2017~~$907,241 and $121,474 at March 31, 2019 and December 31, 2018 and the remaining available borrowing capacity was approximately ~~$1,304,000.~~$1,043,000 and $499,000, respectively. As of ~~September 30, 2017,~~March 31, 2019, the Company was in compliance with all financial covenants.
On March 28, 2017, the Company and the Company’s wholly-owned subsidiary, EthoStream, entered into an Asset Purchase Agreement with DCI-Design Communications LLC (“DCI”), whereby DCI acquired all of the assets and certain liabilities of EthoStream. Heritage Bank provided the Company with its consent to the sale transaction. Upon closing of the sale transaction on March 29, 2017, the entire balance outstanding on the Credit Facility was repaid. On March 29, 2017~~an amendment to the Credit Facility was executedamending the quarterly and year to date EBITDA compliance measurements for 2017.~~
On August 29, 2017, an amendment to the Credit Facility with Heritage Bank was executed to amend certain terms of the Heritage Bank Loan Agreement allowing for the issuance of corporate credit cards providing credit not to exceed $100,000. The Borrower may request credit advances in an aggregate outstanding amount not to exceed the borrowing limits set forth in the amendment.
On October 23, 2017, an amendment to the revolving credit facility with Heritage Bank was executed to amend certain terms of the Heritage Bank Loan Agreement. Among the terms of the amendment was that if the Company deviates from its projected EBITDA for the quarters ended September 30, 2017 or December 31, 2017, the Company will be deemed to be in compliance as of the measurement date if the Company’s unrestricted cash maintained at Heritage Bank is in excess of $5,000,000. The amendment also extends the revolving credit facility’s maturity date by one year to September 30, 2019.

Cash Flow Analysis

Cash used in ~~continuing~~ operations was ~~$2,459,746~~$1,716,357 and ~~$2,768,301~~$991,884 during the ~~nine~~three months ended ~~September 30, 2017~~March 31, 2019 and ~~2016,~~2018, respectively. As of ~~September 30, 2017,~~March 31, 2019, our primary capital needs included costs incurred to increase energy management sales, inventory procurement and managing current liabilities. The working capital changes during the ~~nine~~three months ended ~~September 30, 2017~~March 31, 2019 were primarily a result of increased working capital needs based on revenue growth, with an approximate $1,439,000 increase in accounts receivable, a $463,000 increase in accounts payable, a $187,000 increase in accrued expenses, a $172,000 increase in the reserve for inventory obsolescence, a $169,000 decrease in contract liabilities, and a $132,000 increase in contract assets. The working capital changes during the three months ended March 31, 2018 were primarily related to an approximate $380,500 increase in accounts receivable, a $305,000 increase in inventory, a $305,000 increase in accounts payable, a $330,000 increase in deferred revenue and a $168,000 increase in accrued liabilities and expenses. The working capital changes during the nine months ended September 30, 2016 were primarily related to an approximately $469,000$329,000 decrease in accounts receivable, a ~~$410,000 increase~~$362,000 decrease in inventory, a ~~$535,000~~$283,000 decrease in accounts payable, a $295,000 increase in customer asset, a $124,000 decrease in customer deposits and a ~~$300,000~~$273,000 decrease in deferred revenue that were both reclassified to contract liabilities which increased $653,000 and a $219,000 increase in ~~accrued liabilities and~~prepaid expenses. Accounts receivable ~~fluctuates~~balances fluctuate based on the negotiated billing terms with customers and collections. We purchase inventory based on forecasts and orders, and when those forecasts and orders change, the amount of inventory may also fluctuate. Accounts payable ~~fluctuates~~balances fluctuate with changes in inventory levels, volume of inventory purchases, and negotiated supplier and vendor terms.

Cash provided by investing activities was $11,092,051 during the nine months ended September 30, 2017 and cash used in investing activities was $2,352 during the nine months ended September 30, 2016, respectively. During the nine months ended September 30, 2017, the cash provided by investing activities reflects the proceeds less adjustments associated with the sale of the assets and certain liabilities assumed of the Company’s wholly-owned subsidiary, EthoStream and a decrease of $142,572 associated with the purchase of computer equipment and furniture, fixtures and equipment. Due to the sale of EthoStream, the Company extended the Waukesha lease, as discussed in Note J, and refurbished the corporate office to accommodate employee’s previously working at the Milwaukee operations office. During the nine months ended September 30, 2016, the Company purchased $33,629 of computer equipment and had $31,277 of restricted cash related to a bonding requirement released.

3127

Cash used in ~~financing~~investing activities was $982,176 and cash provided by financing activities was $707,637 during the nine months ended September 30, 2017 and 2016, respectively. The Heritage Bank Loan Agreement for the Company’s line of credit includedthe Company and EthoStream as co borrowers. Upon closing the EthoStream sale transaction on March 29, 2017, the entire balance outstanding on the Credit Facility, $1,062,129, was repaid and a net balance of $79,953 was subsequently borrowed$2,302 during the three months ended ~~September 30, 2017.~~March 31, 2019. Cash used in investing activities was $7,493 during the three months ended March 31, 2018. During the ~~nine~~three months ended ~~September 30, 2016, 5,211,542 warrants were exercised for an aggregate~~March 31, 2019 and March 31, 2018, the Company purchased approximately $2,302 and $7,493, respectively, of 5,211,542 shares of the Company’s common stock at $0.13 per share. These warrants were originally granted to shareholders of the April 8, 2011 Series B preferred stock issuance. Total proceeds received were $677,501. computer equipment.
Cash used in financing activities ~~to repay indebtedness~~ was ~~$79,864~~$785,766 and ~~net~~$59,359 during the three months ended March 31, 2019 and 2018, respectively. Proceeds borrowed from the line of credit were $2,339,000 and cash ~~paid~~used for payments on the line of credit ~~was $110,000~~were $1,553,234 during the ~~nine~~three months ended ~~September 30, 2016.~~March 31, 2019. Proceeds borrowed from the line of credit were $220,610 and cash used for payments on the line of credit were $279,969 during the three months ended March 31, 2018.

We are working to manage our current liabilities while we continue to make changes in operations to improve our cash flow and liquidity position.

Management expects that global economic conditions, in particular the decreasing price of energy, along with the impact of tariffs and competition will continue to present a challenging operating environment through ~~2017;~~2019; therefore working capital management will continue to be a high priority for ~~2017.~~2019. The Company’s estimated cash requirements for our operations for the next 12 months is not anticipated to differ significantly from our present cash requirements for our operations.

Off-Balance Sheet Arrangements

The Company has no material off-balance sheet arrangements.

Acquisition or Disposition of Property and Equipment

The Company does not anticipate significant purchases of property or equipment during the next twelve months. The ~~amended and expanded~~ Waukesha, Wisconsin lease ~~requires~~may require additional furniture, shelving, computer equipment and peripherals to be used in the Company’s day-to-day operations.

Item 4. Controls and Procedures.

~~As of September 30, 2017, the Company performed an evaluation, under the supervision~~Our management is responsible for establishing and with the participation of management, including the Chief Executive Officer and the Chief Financial Officer, of the effectiveness of the design and operation of its disclosure controls and procedures. Management has identified control deficiencies regarding the lack of segregation of duties due to the limited size of the Company’s accounting department, a failure to implementmaintaining adequate internal control over financial reporting, ~~including~~as defined in Rule 13a-15(f) under the Exchange Act. The Company’s internal control over financial reporting is designed to provide reasonable assurances regarding the reliability of financial reporting and the preparation of the financial statements of the Company in accordance with U.S. generally accepted accounting principles, or GAAP. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree or compliance with the policies or procedures may deteriorate.
With the participation of our ~~IT general~~Chief Executive Officer, our management conducted an evaluation of the effectiveness of our internal control over financial reporting as of December 31, 2018 based on the framework in Internal Control—Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission ("COSO"). Based on our evaluation and the material weaknesses described below, management concluded that the Company did not maintain effective internal control over financial reporting as of December 31, 2018 based on the COSO framework criteria.
Management did not properly design or maintain effective controls over the control environment and ~~the need for~~monitoring components of COSO. We did not have a ~~stronger internal control environment particularly in our financial reporting and close process. We lack~~ sufficient ~~personnel resources and technical~~complement of accounting and ~~reporting expertise~~financial personnel with an appropriate level of knowledge to ~~appropriately~~ address ~~certain~~technical accounting and financial reporting matters in accordance with generally accepted accounting ~~principles.~~principles and the Company’s overall financial reporting requirements. We also lack sufficient information technology resources to address our IT general control environment requirements. The failures within the control environment and monitoring components contributed to the following control activity level material weaknesses:
28
· Revenues – We did not properly design or maintain effective controls over the recording of revenue recognition for contracts whose performance obligations are fulfilled over time.
· Financial Statement Close and Reporting – We did not properly design or maintain effective controls over the period end financial close and reporting process. Specifically, we lacked control over the review of account reconciliations, journal entries, identification of related party transactions, and reporting of our financial results and disclosures.
· Information Technology – We did not properly design or maintain effective controls to prevent unauthorized access to certain systems, programs and data, and provide for periodic review and monitoring of access and changes in programs, including review of security logs and analysis of segregation of duties conflicts.
· Segregation of Duties – We did not maintain adequate segregation of duties within the Company’s business processes, financial applications, and IT systems. Specifically, we did not have ~~an adequate process or~~ appropriate controls in place to adequately assess the segregation of job responsibilities and system user access for initiating, authorizing, and recording transactions.
These control deficiencies could result in ~~place~~a misstatement of account balances resulting in a more than remote likelihood that a material misstatement to ~~support the accurate reporting of~~ our financial ~~results~~statements may not be prevented or detected on a timely basis. Accordingly, we have determined that these control deficiencies as described above constitute material weaknesses.
We are reviewing actions to remediate the identified material weaknesses. As we continue to evaluate and ~~disclosures on~~work to improve our ~~Form 10-Q. Management of~~internal controls over financial reporting, our senior management may determine to take additional measures to address deficiencies or modify the remediation efforts. Until the remediation efforts that our senior management identifies as necessary, are completed, tested and determined effective, the material weaknesses described above will continue to exist. At present, the Company ~~believes that~~does not expect to hire additional personnel to remediate these control deficiencies in the near future.
In light of these material weaknesses, ~~are due~~we performed additional analyses and procedures in order to the small size of the Company’s accounting staff. The small size of the Company’s accounting staff may prevent adequate controls in the future, such as segregation of duties, due to the cost/benefit of such remediation. The Chief Executive Officer and Chief Financial Officer concludedconclude that our ~~disclosure controls and procedures were ineffective~~consolidated financial statements as of and for the ~~end of~~year ended December 31, 2018 and 2017 included in this Annual Report on Form 10-K were fairly stated in accordance with GAAP. Accordingly, management believes that despite our material weaknesses, our financial statements for the ~~period covered by this report.~~years ended December 31, 2018 and 2017 are fairly stated, in all material respects, in accordance with GAAP.

~~During~~Under applicable Securities Law, the ~~nine months~~Company is not required to obtain an attestation report from the Company's independent registered public accounting firm regarding internal control over financial reporting, and accordingly, such an attestation has not been obtained or included in this Annual Report.
Changes in Internal Controls
Other than the material weaknesses discussed above, during the quarter ended ~~September 30, 2017,~~March 31, 2019, there ~~were~~have been no changes in ~~the Company’s~~our internal control over financial reporting that have materially affected or are reasonably likely to materially affect ~~the Company’s~~our internal ~~control~~controls over financial reporting.

3229

PART II. OTHER INFORMATION

Item 1. Legal Proceedings.

The Company is subject to legal proceedings and claims which arise in the ordinary course of its business.  Although occasional adverse decisions or settlements may occur, the Company believes that the final disposition of such matters should not have a material adverse effect on its financial position, results of operations or liquidity.

Item 1A. Risk Factors.

There ~~have been~~were no material changes during the quarter to ~~risk factors previously~~the Risk Factors disclosed in Item 1A – “Risk Factors” in our annual report on Form 10-K for the year ended December 31, ~~2016 in response to Item 1A of Form 10-K.~~2018.

Item 6. Exhibits.

Exhibit Number Description Of Document
31.1 Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 of Jason L. Tienor
31.2 Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 of Richard E. Mushrush
32.1 Certification of Jason L. Tienor pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2 Certification of Richard E. Mushrush pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
101.INS XBRL Instance Document
101.SCH XBRL Schema Document
101.CAL XBRL Calculation Linkbase Document
101.DEF XBRL Definition Linkbase Document
101.LAB XBRL Label Linkbase Document
101.PRE XBRL Presentation Linkbase Document

3330

SIGNATURES

Pursuant to the requirements of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

Telkonet, Inc.
Registrant

Date: ~~November 14, 2017~~May 15, 2019 By: /s/ Jason L. Tienor

Jason L. Tienor
Chief Executive Officer
(principal executive officer)

Date: ~~November 14, 2017~~May 15, 2019 By: /s/ Richard E. Mushrush

Richard E. Mushrush
Chief Financial Officer
(principal financial officer)

3431

	Series A Preferred Stock		Series A Preferred Stock		Series B Preferred Stock		Series B Preferred Stock		Common		Common Stock		Additional Paid-in		Accumulated			Total Stockholders’
	Shares		Amount		Shares		Amount		Shares		Amount		Capital		Deficit			Equity
Balance at January 1, 2017		185	$	1,340,566		52	$	362,059		132,774,475	$	132,774	$	126,955,435	$	(123,471,034	)	$	5,319,800

Shares issued to directors		–		–		–		–		665,636		666		107,334		–			108,000

Stock-based compensation expense related to employee stock options		–		–		–		–		–		–		320,545		–			320,545

Net income		–		–		–		–		–		–		–		4,169,947			4,169,947

Balance at September 30, 2017		185	$	1,340,566		52	$	362,059		133,440,111	$	133,440	$	127,383,314	$	(119,301,087	)	$	9,918,292

	For the Nine Months Ended
	September 30,
	2017			2016
Cash Flows from Operating Activities:
Net income (loss)	$	4,169,947		$	(944,701	)
Less: Net income from discontinued operations		(602,060	)		(2,050,998	)
Gain on sale of discontinued operations		(6,602,871	)		–
Net loss from continuing operations		(3,034,984	)		(2,995,699	)

Adjustments to reconcile net loss from continuing operations to cash used in operating activities of continuing operations:
Stock-based compensation expense		320,545			10,204
Stock issued to directors as compensation		108,000			36,000
Amortization of deferred financing costs		–			14,210
Depreciation		34,405			24,366
Provision for doubtful accounts, net of recoveries		15,013			7,047
Related party payable		–			161,075

Changes in operating assets and liabilities:
Accounts receivable		(380,462	)		468,589
Inventories		(305,087	)		(410,202	)
Prepaid expenses and other current assets		(54,941	)		60,271
Deposits and other long term assets		(17,130	)		23,871
Accounts payable		305,322			(535,016	)
Accrued liabilities and expenses		168,473			299,919
Deferred revenue		329,792			56,825
Related party payable		(97,127	)		(15,928	)
Customer deposits		49,746			27,985
Income taxes payable		85,884			–
Deferred lease liability		12,805			(1,818	)
Net Cash Used In Operating Activities of Continuing Operations		(2,459,746	)		(2,768,301	)
Net Cash Provided By Operating Activities of Discontinued Operations		517,242			2,023,820
Net Cash Used In Operating Activities		(1,942,504	)		(744,481	)

Cash Flows From Investing Activities:
Purchase of property and equipment		(142,572	)		(33,629	)
Net proceeds from sale of subsidiary		12,034,623			–
Change in restricted cash		(800,000	)		31,277
Net Cash Provided By (Used In) Investing Activities of Continuing Operations		11,092,051			(2,352	)

Cash Flows From Financing Activities:
Payments on notes payable		–			(79,864	)
Proceeds from exercise of warrants		–			677,501
Proceeds from line of credit		3,572,500			4,327,068
Payments on line of credit		(4,554,676	)		(4,217,068	)
Net Cash (Used In) Provided By Financing Activities of Continuing Operations		(982,176	)		707,637

Net increase (decrease) in cash and cash equivalents		8,167,371			(39,196	)
Cash and cash equivalents at the beginning of the period		791,858			951,249
Cash and cash equivalents at the end of the period	$	8,959,229		$	912,053

	For the Three Months Ended March 31,
	2019			2018
Cash Flows from Operating Activities:
Net loss	$	(845,604	)	$	(1,184,166	)

Adjustments to reconcile net loss to cash used in operating activities:
Stock-based compensation expense		1,815			1,531
Stock issued to directors as compensation		36,002			36,000
Depreciation and amortization		16,931			16,915
Provision for doubtful accounts, net of recoveries		(26,317	)		(3,356	)
Reserve for inventory obsolescence		171,901			54,100
Noncash operating lease expense		59,476			–

Changes in operating assets and liabilities:
Accounts receivable		(1,438,685	)		329,367
Inventories		5,061			361,948
Prepaid expenses and other current assets		15,020			(219,316	)
Accounts payable		462,605			(283,485	)
Accrued liabilities and expenses		187,127			(67,554	)
Contract liability		(169,347	)		255,170
Contract assets		(131,913	)		(295,479	)
Operating lease liability		(54,788	)		–
Income taxes receivable		(5,641	)		–
Deferred lease liability		–			6,441
Net Cash Used In Operating Activities		(1,716,357	)		(991,884	)

Cash Flows From Investing Activities:
Purchase of property and equipment		(2,302	)		(7,493	)
Net proceeds from sale of subsidiary		–			–
Net Cash Used In By Investing Activities		(2,302	)		(7,493	)

Cash Flows From Financing Activities:
Proceeds from line of credit		2,339,000			220,610
Payments on line of credit		(1,553,234	)		(279,969	)
Net Cash (Used In) Provided By Financing Activities		785,766			(59,359	)

Net decrease in cash and cash equivalents		(932,893	)		(1,058,736	)
Cash, cash equivalents and restricted cash at the beginning of the period		4,678,891			9,195,595
Cash, cash equivalents and restricted cash at the end of the period	$	3,745,998		$	8,136,859

Reconciliation of cash, cash equivalents, and restricted cash to the consolidated balance sheets:
Cash and cash equivalents	$	3,745,998		$	8,126,859
Restricted cash		–			10,000
Total cash, cash equivalents, and restricted cash	$	3,745,998		$	8,136,859

	Nine Months Ended September 30,				Three Months Ended March 31,
	2017		2016		2019		2018
Supplemental Disclosures of Cash Flow Information:

Cash transactions:
Cash paid during the period for interest	$	11,485	$	30,980	$	10,937	$	12,228
Cash paid during the period for income taxes, net of refunds		58,551		–

Schedule of Non-Cash Investing Activities:
Unpaid purchases of property and equipment included in accounts payable	$	66,693		–

	September 30, 2017			December 31, 2016
Beginning balance	$	95,540		$	66,555
Warranty claims incurred		(48,767	)		(115,120	)
Provision charged to expense		31,037			144,105
Ending balance	$	77,810		$	95,540

	Hospitality		Education		Multiple Dwelling Units		Government		Total
Product	$	1,694,649	$	255,736	$	200,426	$	435,858	$	2,586,669
Recurring		156,272		19,445		816		–		176,533
	$	1,850,921	$	275,181	$	201,242	$	435,858	$	2,763,202

	March 31, 2019		December 31, 2018		Variance
Contract assets	$	446,662	$	314,749	$	131,913
Contract liabilities		1,063,276		1,232,623		(169,347	)
Net contract liabilities	$	616,614	$	917,874	$	(301,260	)

	March 31, 2019		December 31, 2018
Accrued payroll and payroll taxes	$	343,426	$	241,253
Accrued expenses		330,467		239,793
Accrued professional		70,924		86,062
Accrued sales taxes, penalties, and interest		59,185		43,400
Product warranties		39,736		46,103
Total accrued liabilities	$	843,738	$	656,611

Options Outstanding								Options Exercisable
Exercise Prices		Number Outstanding		Weighted Average Remaining Contractual Life (Years)		Weighted Average Exercise Price		Number Exercisable		Weighted Average Exercise Price
$	0.01 - $0.15		3,075,000		6.19	$	0.14		3,075,000	$	0.14
$	0.16 - $0.99		2,476,800		3.44		0.18		2,246,800		0.18
			5,551,800		4.97	$	0.16		5,321,800	$	0.16

	Number of Shares			Weighted Average Price Per Share		Number of Shares			Weighted Average Price Per Share
Outstanding at January 1, 2016		1,825,225		$	0.28
Outstanding at January 1, 2018							4,376,474		$	0.18
Granted		1,300,000			0.17		67,394			0.14
Exercised		–			–		–			–
Cancelled or expired		(292,500	)		0.69		(1,094,075	)		0.17
Outstanding at December 31, 2016		2,832,725		$	0.18
Outstanding at December 31, 2018							3,349,793		$	0.16
Granted		3,000,000			0.14		–			–
Exercised		–			–		–			–
Cancelled or expired		(280,925	)		0.17		–			–
Outstanding at September 30, 2017		5,551,800		$	0.16
Outstanding at March 31, 2019							3,349,793		$	0.16

		Warrants Outstanding						Warrants Exercisable					Warrants Outstanding						Warrants Exercisable
Exercise Prices	Exercise Prices	Number Outstanding		Weighted Average Remaining Contractual Life (Years)		Weighted Average Exercise Price		Number Exercisable		Weighted Average Exercise Price		Exercise Prices	Number Outstanding		Weighted Average Remaining Contractual Life (Years)		Weighted Average Exercise Price		Number Exercisable		Weighted Average Exercise Price
$	0.18		50,000		0.16	$	0.18		50,000	$	0.18	0.20		250,000		3.52	$	0.20		250,000	$	0.20
	0.20		250,000		4.02		0.20		250,000		0.20
			300,000		3.38	$	0.20		300,000	$	0.20

Operating lease expense:
Operating lease cost - fixed	$	59,476
Variable lease cost		30,050
Total operating lease cost	$	89,526

Operating lease liability - current	$	220,037
Operating lease liability - long-term	$	862,114
Operating cash flows from operating leases	$	54,788

Weighted-average remaining lease term of operating leases		6.3 years
Weighted-average discount rate of operating leases		8.5%

2019 (excluding the three months ended March 31, 2019)	$	165,008
2020		223,835
2021		242,299
2022		195,176
2023		193,169
2024 and thereafter		384,119
Total minimum lease payments	$	1,403,606
Less imputed interest		(321,455	)
Total	$	1,082,151

2017 (remainder of)	$	43,738
2018		153,063
2019		154,496
2020		164,903
2021		182,512
2022 and thereafter		764,024
Total	$	1,462,736

2019	$	211,448
2020		223,417
2021		242,785
2022		195,176
2023		193,169
2024 and thereafter		380,715
Total	$	1,446,708

	September 30, 2017			December 31, 2016			March 31, 2019			December 31, 2018
Balance, beginning of year	$	274,869		$	229,768		$	43,400		$	83,282
Sales tax collected		235,091			452,016			56,314			101,145
Provisions (reversals)		(52,000	)		151,000
Provisions								(7,706	)		30,465
Interest and penalties		-			(3,017	)		–			–
Payments		(385,629	)		(554,898	)		(32,823	)		(171,492	)
Balance, end of period	$	72,331		$	274,869		$	59,185		$	43,400

	September 30,		December 31,
	2017		2016

Accounts receivable, net	$	–	$	456,478
Inventories		–		350,506
Other current assets		–		12,980
Other asset – goodwill		–		5,796,430
Other asset – intangible asset, net		–		533,577
Current assets of discontinued operations		–		7,149,971


Accounts payable		–		465,346
Accrued liabilities and expenses		–		90,187
Deferred revenues		–		37,509
Customer deposits		–		200,466
Deferred lease liability		–		76,096
Current liabilities of discontinued operations		–		869,604

Net assets of discontinued operations	$	–	$	6,280,367

	Three Months Ended
	September 30, 2017			September 30, 2016			Variance

Product	$	1,904,571	94%	$	1,360,887	90%	$	543,684		40%
Recurring		131,665	6%		143,028	10%		(11,363	)	-8%
Total	$	2,036,326	100%	$	1,503,915	100%	$	532,321		35%

	Three Months Ended
	March 31, 2019			March 31, 2019			Variance

Product	$	2,586,669	94%	$	1,503,658	94%	$	1,083,011	72%
Recurring		176,533	6%		101,538	6%		74,995	74%
Total	$	2,763,202	100%	$	1,605,196	100%	$	1,158,006	72%

	Nine Months Ended
	September 30, 2017			September 30, 2016			Variance

Product	$	5,728,878	94%	$	6,356,437	95%	$	(627,559	)	-10%
Recurring		344,708	6%		340,412	5%		4,296		1%
Total	$	6,073,586	100%	$	6,696,849	100%	$	(623,263	)	-9%

	Three Months Ended
	March 31, 2019			March 31, 2018			Variance

Product	$	1,690,598	65%	$	994,237	66%	$	696,361	70%
Recurring		86,042	49%		59,997	59%		26,045	43%
Total	$	1,776,640	64%	$	1,054,234	66%	$	722,406	69%

	Three Months Ended September 30,
	2017		2016		Variance

Total	$	1,704,177	$	1,870,493	$	(166,316	)	-9%

	Nine Months Ended September 30,
	2017		2016		Variance

Total	$	5,754,741	$	6,357,622	$	(602,881	)	-9%

	Three Months Ended March 31,
	2019		2018		Variance

Total	$	1,826,607	$	1,732,598	$	94,009	5%

	Three Months Ended September 30
	2017		2016		Variance

Total	$	500,656	$	429,622	$	71,034	17%

	·	Revenues – We did not properly design or maintain effective controls over the recording of revenue recognition for contracts whose performance obligations are fulfilled over time.

	·	Financial Statement Close and Reporting – We did not properly design or maintain effective controls over the period end financial close and reporting process. Specifically, we lacked control over the review of account reconciliations, journal entries, identification of related party transactions, and reporting of our financial results and disclosures.

	·	Information Technology – We did not properly design or maintain effective controls to prevent unauthorized access to certain systems, programs and data, and provide for periodic review and monitoring of access and changes in programs, including review of security logs and analysis of segregation of duties conflicts.

	·	Segregation of Duties – We did not maintain adequate segregation of duties within the Company’s business processes, financial applications, and IT systems. Specifically, we did not have ~~an adequate process or~~ appropriate controls in place to adequately assess the segregation of job responsibilities and system user access for initiating, authorizing, and recording transactions.

Exhibit Number		Description Of Document
31.1		Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 of Jason L. Tienor
31.2		Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 of Richard E. Mushrush
32.1		Certification of Jason L. Tienor pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2		Certification of Richard E. Mushrush pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
101.INS		XBRL Instance Document
101.SCH		XBRL Schema Document
101.CAL		XBRL Calculation Linkbase Document
101.DEF		XBRL Definition Linkbase Document
101.LAB		XBRL Label Linkbase Document
101.PRE		XBRL Presentation Linkbase Document

	Telkonet, Inc. Registrant

Date: ~~November 14, 2017~~May 15, 2019	By:	/s/ Jason L. Tienor
		Jason L. Tienor Chief Executive Officer (principal executive officer)