See accompanying notes to the unaudited condensed consolidated financial statements

TELKONET, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)

(UNAUDITED)

See accompanying notes to the unaudited condensed consolidated financial statements

TELKONET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2017MARCH 31, 2020

(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 ninethree months ended September 30, 2017,March 31, 2020, are not necessarily indicative of the results that may be expected for the year ending December 31, 2017.2020. The unaudited condensed consolidated financial statements should be read in conjunction with the consolidated December 31, 20162019 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 whilewhilst improving occupant comfort and convenience.

On March 28, 2017,The condensed consolidated financial statements include the accounts of the Company and the Company’sits wholly-owned subsidiary, EthoStream LLC,Telkonet Communications, Inc. We currently operate in a Wisconsin limited liability company (“EthoStream”), entered into an Asset Purchase Agreement (the “Purchase Agreement”) with DCI-Design Communications LLC (“DCI”),single reportable business segment.

Going Concern and Management’s Plan

The accompanying financial statements have been prepared on a Delaware limited liability company, whereby DCI would acquire all ofgoing concern basis which assumes the Company will be able to realize its assets and certaindischarge its liabilities in the normal course of EthoStreambusiness for a base purchase pricethe foreseeable future and, thus, do not include any adjustments relating to the recoverability and classification of $12,750,000. The Purchase Agreement providedassets and liabilities that proceeds of $900,000 weremay be necessary if the Company is unable 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 assetscontinue 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.going concern.

TELKONET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2017

(UNAUDITED)Since inception through March 31, 2020, we have incurred cumulative losses of $125,758,040 and have never generated enough cash through operations to support our business. For the three-month period ended March 31, 2020, we had a cash flow deficit from operations of $109,888. 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 previous independent registered public accounting firm on our consolidated financial statements for the year ended December 31, 2019 stated there is substantial doubt about our ability to continue as a going concern.

The condensed consolidated financial statements includeCompany’s ability to continue as a going concern is dependent upon generating profitable operations in the accounts offuture 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 and its wholly-owned subsidiaries, 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 ofwill be able to secure such financing at commercially reasonable terms, if at all. If cash flows. All significant intercompany balances and transactions have been eliminated in consolidation.

Unless otherwise noted, all financial information in the consolidated financial statement footnotes reflectresources become insufficient to meet the Company’s results from continuing operations.

Liquidity and Financial Conditionongoing 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.

The Company’s operations and financial results have also been impacted by the COVID-19 pandemic. On January 30, 2020 the World Health Organization (“WHO”) announced a global health emergency because of a new strain of a novel coronavirus in Wuhan, China (the “COVID-19 outbreak”) and the risks to the international community as the virus spreads globally. In March 2020, the WHO classified the COVID-19 outbreak a pandemic, based on the rapid increase in exposure globally. The spread of the COVID-19 outbreak has caused significant volatility and uncertainty in U.S. and international markets.

The Company’s sales have been disrupted as a result of its customers furloughing and laying off their employees and/or suspending projects. Despite these challenges, quoting remains active and the aggregate pipeline has not contracted significantly. Thus far, the impact has been delays as opposed to cancellations. Due to travel restrictions, social distancing and shelter at home edicts, the hospitality industry, our largest market that generally contributes more than 50% of our revenue, has suffered as much as any. At this time, the disruption is expected to be temporary; however, the length or severity of this pandemic is unknown. Depending on the length and severity, the demand for our products, our customers’ ability to meet payment obligations to the Company, reportedour supply chain and production capabilities, and our workforces’ ability to deliver our products and services could be impacted. Management is actively monitoring the impact of the global situation on its financial condition, liquidity, operations, suppliers, industry, and workforce. While we expect this disruption to have a net lossmaterial adverse impact our results of $3,034,984 from continuing operations, financial condition and cash flows for the nine months ended September 30, 2017, had cash used in operating activities from continuing operations of $2,459,746year 2020, the Company is unable to reasonably determine the impact at this time.

In response to the COVID-19 pandemic and had an accumulated deficit of $119,301,087. Since inception,its effects (and potential further effects) on the Company’s primary sourcesoperations and financial results, the Company has taken and is continuing to take a number of ongoing liquidity for operations have come through privateactions to preserve cash. These actions include suspending the use of engineering consultants, and public offerings of equity securities,cancelling all travel and the issuanceCompany’s attendance at tradeshows (implemented prior to applicable government stay-at-home orders being put in place). In addition, in early April of various debt instruments, asset-based lending2020, management made the decision to furlough certain employees, instituted pay cuts for certain other employees and suspended the saleCompany’s 401(k) match through the end of assets.2020. With the receipt of the PPP Loan (discussed below), the Company was able to bring back the furloughed employees, restore payroll to prior levels and delay suspension of the 401(k) match. The actions taken in response to the COVID-19 pandemic are in addition to the cost elimination and liquidity management actions that the Company began implementing in the second half of 2019, including reviewing opportunities to decrease spend with third party consultants and providers, strategically reviewing whether or not to fill employee positions in the event of vacancies, and implementing sales campaigns to sell slow-moving inventory and reducing existing inventory volumes. There is no guarantee, however, that these actions, nor any other actions identified, will yield profitable operations in the foreseeable future.

On March 29, 2017,In addition, on April 21, 2020, the Company entered into an amendment to unsecured promissory note, dated as of April 17, 2020 (“the revolving credit facilityPPP Loan”), with Heritage Bank of Commerce for a California state chartered bank$913,063 loan under the Paycheck Protection Program (“Heritage Bank”PPP”), SBA 7(a) loan. The PPP SBA 7(a) loan program is being administered by the United States Small Business Administration (“SBA”) and was executed to amend certain termsauthorized by the Keeping American Workers Employed and Paid Act, which is part of the Coronavirus Aid, Relief, and Economic Security (“CARES”) Act that was signed into law on March 27, 2020. The principal amount of the Loan is $913,063, bears interest of 1.0% per annum and Security Agreement (the “Heritage Bank Loan Agreement”) following the salehas a maturity date of certain assetsApril 21, 2022. See Note N – Subsequent Event for a summary 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.PPP Loan.

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.

TELKONET, INC.At March 31, 2020, the Company had $3,084,828 of cash and approximately $153,000 of availability on its credit facility. However, the credit facility requires that the Company maintain an unrestricted cash balance of $2,000,000, limiting the ability of the Company to use its cash reserves to fund its operations. As of March 31, 2020, the outstanding balance on the credit facility was $518,463. On average, during the twelve-month period between April 1, 2019 and March 31, 2020, the Company’s cash balance decreased $55,000 per month.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2017The Company is using the proceeds of the PPP Loan to support its ongoing operations and currently expects to also draw on its 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. The Credit Facility provides us with needed liquidity to assist in meeting our obligations or pursuing strategic objectives. Continued operating losses will deplete these cash reserves and could result in a violation of the financial covenants. Consequently, repayment of amounts borrowed 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 occurrence of any of these events could have a material adverse effect on our business and results of operations.

(UNAUDITED)

The Company’s Board also continues to consider 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. However, these actions are not solely within the control of the Company. At May 15, 2020, no definitive alternatives had been identified.

Accordingly, and in light of the Company’s historic 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 both the ninethree months ended September 30, 2017March 31, 2020 and 2016,2019, there were 5,621,800 and 2,240,2253,599,793 shares of common stock underlying options and warrants excluded due to these instruments being anti-dilutive, respectively.anti-dilutive.

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, 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.

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 adoptedfollows 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.

Revenue Recognitionfrom Contracts with Customers

For revenueAccounting 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 forlegacy revenue recognition have been satisfied, productguidance. 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.

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.

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 ofIdentify 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 centeraccounts 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 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 will enter into product only contracts that contain a single performance obligation related to the transfer of EcoSmart products to a customer.

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”).

The Company also offers technical phone support services to properties installed by the Company. The Company receives monthlycustomers. This 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 toconsidered 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.separate performance obligation.

Determine the transaction price

TELKONET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTSThe 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.

SEPTEMBER 30, 2017

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.

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.

Contracts are billed in accordance with the terms and conditions, either at periodic intervals or upon substantial completion. This can result in billing occurring subsequent to revenue recognition, resulting in contract assets. Contract assets are presented as current assets in the Condensed Consolidated Balance Sheet.

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, 2021.

Contract Completion 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 material, direct labor and costs of outside services utilized to complete projects. These are presented as “Contract assets” in the consolidated balance sheets.

(UNAUDITEDSales Taxes)

Unless provided with a resale or tax exemption certificate, the Company assesses and collects sales tax on sales transactions and records the amount as a liability. It is recognized as a liability until remitted to the applicable state. Total revenues do not include sales tax as the Company is considered a pass through conduit for collecting and remitting sales taxes.

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 ninethree months ended September 30, 2017March 31, 2020 and the year ended December 31, 2016,2019, the Company experienced returns of approximately 1.0%1% to 2.5%3% of materials included in the cost of sales. As of September 30, 2017March 31, 2020 and December 31, 2016,2019, the Company recorded warranty liabilities in the amount of $77,810$61,742 and $95,540,$58,791, respectively, using this experience factor range.

Product warranties for the ninethree months ended September 30, 2017March 31, 2020 and the year ended December 31, 20162019 are as follows:

ReclassificationsAdvertising

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 assetsfollows the policy of discontinued operationscharging the costs of advertising to cash and cash equivalents for certain EthoStream assets not sold to DCI on March 28, 2017.expenses as incurred. The Company reclassified $150,936 from current liabilities of discontinued operations to accrued liabilitiesincurred $5,893 and expenses for certain EthoStream liabilities not assumed by DCI on$10,805 in advertising costs during the three months ended March 28, 2017. The reclassifications were not material31, 2020 and had no effect on the Company’s total current assets, current liabilities or stockholders’ equity as of December 31, 2016.2019, respectively.

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.

TELKONET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2017

(UNAUDITED)

In February 2016, the FASB issued ASU No. 2016-02, Leases (“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 provides guidance 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 to terms or conditions of a share-based payment award that would require an entity to apply modification accounting. The new guidance is effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. Early adoption is permitted. The amendments in this update should be applied prospectively to an award modified on or after the adoption date.

NOTE C– ACCOUNTS RECEIVABLE

Components of accounts receivable as of September 30, 2017 and December 31, 2016 are as follows:

NOTE D – ACCRUED LIABILITIES AND EXPENSES

Accrued liabilities and expenses at September 30, 2017 and December 31, 2016 are as follows:

Research and Development

TELKONET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTSThe Company accounts for research and development costs in accordance with the ASC 730-10, “Research and Development”. Under ASC 730-10, all research and development costs must be charged to expense as incurred. Accordingly, internal research and development costs are expensed as incurred. Third-party research and development costs are expensed when the contracted work has been performed or as milestone results have been achieved. Company-sponsored research and development costs related to both present and future products are expensed in the period incurred. Total expenditures on research and product development for the three months ended March 31, 2020 and 2019 were $369,243 and $486,626, respectively.

SEPTEMBER 30, 2017

(UNAUDITEDStock-Based Compensation

The Company accounts for stock-based awards in accordance with ASC 718-10, “Share-Based Compensation”, which requires a fair value measurement and recognition of compensation expense for all share-based payment awards made to the Company’s employees and directors, including employee stock options and restricted stock awards. The Company estimates the fair value of stock options granted using the Black-Scholes valuation model. This model requires the Company to make estimates and assumptions including, among other things, estimates regarding the length of time an employee will hold vested stock options before exercising them, the estimated volatility of the Company’s common stock price and the number of options that will be forfeited prior to vesting. The fair value is then amortized on a straight-line basis over the requisite service periods of the awards, which is generally the vesting period. Changes in these estimates and assumptions can materially affect the determination of the fair value of stock-based compensation and consequently, the related amount recognized in the Company’s consolidated statements of operations.

The expected term of the options represents the estimated period of time until exercise and is based on historical experience of similar awards, giving consideration to the contractual terms, vesting schedules and expectations of future employee behavior. For 2019 and prior years, expected stock price volatility is based on the historical volatility of the Company’s stock for the related expected term.

Stock-based compensation expense in connection with options granted to employees for both the three months ended March 31, 2020 and 2019 was $1,815.

NOTE B – NEW ACCOUNTING PRONOUNCEMENTS

In June 2016, the FASB issued ASU No. 2016-13, Financial Instruments—Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. ASU 2016-13 provides guidance for estimating credit losses on certain types of financial instruments, including trade receivables, by introducing an approach based on expected losses. The expected loss approach will require entities to incorporate considerations of 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 guidance requires a modified retrospective transition method and early adoption is permitted. In November 2019, FASB issued ASU No. 2019-10, Financial Instruments – Credit Losses, Derivatives and Hedging, and Leases (“ASU 2019-10”), which defers the adoption of ASU 2016-13 for smaller reporting companies until January 1, 2023. The Company will continue to evaluate the impact of ASU 2016-13 on its consolidated financial statements.

In August 2018, the FASB issued ASU 2018-13, Fair Value Measurement (Topic 820): Disclosure Framework - Changes to the Disclosure Requirements for Fair Value Measurement. This guidance modifies, removes, and adds certain disclosure requirements on fair value measurements. This ASU is effective for annual periods beginning after December 15, 2019, including interim periods therein. The adoption of this guidance did not have a material impact on the Company’s consolidated financial statements.

Management has evaluated other recently issued accounting pronouncements and does not believe any will have a significant impact on our consolidated financial statements and related disclosures.

NOTE C – REVENUE

The following table presents the Company’s product and recurring revenues disaggregated by industry for the three months ended March 31, 2020.

The following table presents the Company’s product and recurring revenues disaggregated by industry for the three months ended March 31, 2019.

Sales taxes and other usage-based taxes are excluded from revenues.

Remaining performance obligations

As of March 31, 2020, the aggregate amount of the transaction price allocated to remaining performance obligations was approximately $0.29 million. Except for support services, the Company expects to recognize 100% of the remaining performance obligations over the next six months.

Contract assets and liabilities

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.

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, 2020 is the result of cash payments received and billing in advance of satisfying performance obligations.

Contract costs

Costs to complete a turnkey contract primarily relate to the materials cost and direct labor and are recognized proportionately as the performance obligation is satisfied. The Company will defer costs to complete a contract when materials have shipped (and control over the materials has transferred to the customer), but an insignificant amount of rooms have been installed. The Company will recognize any deferred costs in proportion to revenues recognized from the related turnkey contract. The Company does not expect deferred contract costs to be long-lived since a typical turnkey project takes sixty days to complete. Deferred contract costs are generally presented as other current assets in the condensed consolidated balance sheets.

The Company incurs incremental costs to obtain a contract in the form of sales commissions. These costs, whether related to performance obligations that extend beyond twelve months or not, are immaterial and will continue to be recognized in the period incurred within selling, general and administrative expenses.

NOTE D – ACCOUNTS RECEIVABLE

Components of accounts receivable as of March 31, 2020 and December 31, 2019 are as follows:

NOTE E – DEBTINVENTORIES

Kross Promissory Note

On August 4, 2016, the BoardComponents 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 Noteinventories as of September 30, 2017March 31, 2020 and December 31, 2016 was zero2019 are as follows:

NOTE F – ACCRUED LIABILITIES AND EXPENSES

Accrued liabilities at March 31, 2020 and $97,127, respectively.December 31, 2019 are as follows:

NOTE G – DEBT

Revolving Credit Facility

On September 30, 2014, the Company and its wholly-owned subsidiary, EthoStream, as co-borrowers (collectively, the “Borrowers”), entered into 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%6.25% at September 30, 2017March 31, 2020 and 6.75% at7.75% December 31, 2016.2019. 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 J. The warrant has an exercise price of $0.20 and expires October 9, 2021. On February 17, 2016, anNovember 6, 2019, the eleventh amendment to the Credit Facility was executed extendingto extend the maturity date to September 30, 2018,2021, unless earlier accelerated under the terms of the Heritage Bank Loan Agreement.Agreement, and eliminate the maximum EBITDA loss covenant.  The eleventh amendment was effective as of September 30, 2019.

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 containcontains financial covenants. As discussed above, the EBITDA loss covenant was eliminated in the eleventh amendment to the Credit Facility. The sole financial covenants that require the Borrowers to maintain a minimum EBITDA level, measured quarterly,are a minimum asset coverage ratio and a minimum unrestricted cash balance of $2 million, both of which are measured monthly and minimum cash account balances.at the end of each month. 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 $518,463 and $624,347 at March 31, 2020 and December 31, 2019 and the remaining available borrowing capacity was approximately $153,000 and $424,000, respectively. As of September 30, 2017,March 31, 2020, 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, 2017an amendment to the Credit Facility was executedamending the quarterly and year to date EBITDA compliance measurements for 2017.

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 FH – PREFERRED STOCK

Series A

The Company has designatedauthorized 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 538authorized 567 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 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, 2020, the liquidation preference of the preferred stock is based on the following order: first, Series B with a preference value of $409,009,$461,094, which includes cumulative accrued unpaid dividends of $149,009,$201,094, and second, Series A with a preference value of $1,507,481,$1,692,649, which includes cumulative accrued unpaid dividends of $582,481.$767,649. As of December 31, 2016,2019, the liquidation preference of the preferred stock is based on the following order: first, Series B with a preference value of $393,435,$455,904, which includes cumulative accrued unpaid dividends of $133,435,$195,904, and second, Series A with a preference value of $1,452,114,$1,674,195, which includes cumulative accrued unpaid dividends of $527,114.

TELKONET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2017

(UNAUDITED)$749,195.

NOTE GI – 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 designatedauthorized 215 shares as Series A preferred stock and 538567 shares as Series B preferred stock. As of September 30, 2017At March 31, 2020 and December 31, 2016,2019, there were 185 shares of Series A and 52 shares of Series B outstanding.outstanding, respectively.

The Company has authorized 190,000,000 shares of common stock with a par value of $.001 per share. As of September 30, 2017March 31, 2020 and December 31, 20162019, the Company had 133,440,111136,311,335 and 132,774,475135,990,491 common shares issued and outstanding.outstanding, respectively.

During the ninethree months ended September 30, 2016, 5,211,542March 31, 2020 and 2019, the Company issued 320,844 and 292,308 shares of common stock, respectively to directors for services performed during the three months ended March 31, 2020 and 2019. These shares were valued at $18,000 and $36,002, respectively, which approximated the fair value of the shares when they were issued.

During the three months ended March 31, 2020 and 2019, no warrants were exercised for an aggregate of 5,211,542 shares of the Company’s common stock at $0.13 per share.exercised. These warrants were originally granted to shareholders of the April 8, 2011 Series B preferred stock issuance.

During the ninethree months ended September 30, 2016, 3March 31, 2020 and 2019, no shares of Series A or B preferred stock were converted to in aggregate, 115,385 shares of common stock.

NOTE HJ – 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. The Plan is administered by the Board of Directors or the compensation committee, which is comprised of not less than two non-employee directors who are independent. A total of 10,000,000 shares of stock were reserved and available for issuance under the Plan. The exercise price per share for the stock covered by a stock option granted shall be determined by the administrator at the time of grant but shall not be less than 100 percent of the fair market value on the date of grant. The term of each stock option shall be fixed by the administrator, but no stock option shall be exercisable more than ten years after the date the stock option is granted. As of March 31, 2020, there were approximately 85,425 shares remaining for issuance in the Plan.

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, 2020.

TELKONET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2017

(UNAUDITED)

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

The expected life of awardsNo options were 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 were 3,000,000 and zero options granted and zero options exercised, cancelled or expired during the ninethree months ended September 30, 2017 and 2016, respectively.March 31, 2020 or 2019. Total stock-based compensation expense in connection with options granted to employees recognized in the condensed consolidated statements of operations for both the three and nine months ended September 30, 2017March 31, 2020 and 20162019 was $2,343 and $2,703, respectively, and $320,545 and $10,204, respectively.$1,815.

Warrants

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

TELKONET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2017

(UNAUDITED)

Transactions involving warrants are summarized as follows:

ThereNo warrants were no warrants granted, exercised, cancelled or forfeited during the ninethree months ended September 30, 2017 and no warrants granted, 5,211,542 warrants exercised and 126,868 cancelledMarch 31, 2020 or forfeited during the nine months ended September 30, 2016, respectively.2019.

NOTE IK – RELATED PARTY TRANSACTIONS

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.STOCK ISSUANCE TO NON-EMPLOYEE DIRECTORS

During the ninethree months ended September 30, 2017,March 31, 2020 and during the year ended December 31, 2019, the Company issued common stock in the amount of $108,000$18,000 and $132,000 and paid cash consideration of $24,000 and $20,000, 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.

TELKONET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2017

(UNAUDITED)

NOTE JL – COMMITMENTS AND CONTINGENCIES

Office LeaseLeases Obligations

In October 2013, the Company entered into a lease agreement for 6,362 square feet of commercial office space in Waukesha, Wisconsin for its corporate headquarters. The Waukesha lease would have expired in April 2021, but was subsequently amended and extended through April 2026. On April 7, 2017 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.

In January 2016, the Company entered into a lease agreement for 2,237 square feet of commercial office space in Germantown, Maryland for its Maryland employees. The Germantown lease, as amended, was set to expire at the end of January 2017.2018. In December 2016,November 2017, the Company entered into a firstsecond amendment to the lease agreement extending the lease through the end of January 2018.2019. In November 2018, the Company entered into a third amendment to the lease agreement extending the lease through the end of January 2022.

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 2027.2024.

CommitmentsThe Company determines if an arrangement is a lease at inception. This determination generally depends on whether the arrangement conveys to the Company the right to control the use of an explicitly or implicitly identified fixed asset for a period of time in exchange for consideration. Control of an underlying asset is conveyed to the Company if the Company obtains the rights to direct the use of and to obtain substantially all of the economic benefits from using the underlying asset. The Company does not separate non-lease components from lease components to which they relate and accounts for the combined lease and non-lease components as a single lease component.

Operating leases are included in our condensed consolidated balance sheet as right-of-use assets, operating lease liabilities – current and operating lease liabilities – long-term. We do not recognize a right-of-use asset and lease liability for leases with a term of 12 months or less. Our current operating leases are for facilities. 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 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.

In determining our right-of-use assets and lease liabilities, we apply a discount rate to the minimum rentalslease payments within each lease agreement. ASC 842 requires us to use the rate of interest that a lessee would have to pay to borrow on a collateralized basis over a similar term, an amount equal to the lease payments in a similar economic environment. When we cannot readily determine the discount rate implicit in the lease agreement, we utilize our current borrowing rate on our outstanding line of credit. The Company’s line of credit utilizes market rates to assess an interest rate. Refer to Note G for further discussion.

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 the preparation for its 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 the Company's proportionate share of common area maintenance, utilities, taxes and insurance and are presented as operating expenses in the Company’s statements of operations in the same line item as expense arising from fixed lease payments.

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 for the three months ended March 31, 2020 were as follows:

Other information related to leases as of September 30, 2017 areMarch 31, 2020 was as follows:

Future annual minimum operating lease payments as of March 31, 2020 were as follows:

Rental expenses charged to continuing operations for the three and nine months ended September 30, 2017March 31, 2020 and 20162019 was $86,649$97,511 and $42,271 and $200,816 and $127,537,

$89,526, 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,Unless provided with a resale or tax exemption certificate, the Company engaged aassesses and collects sales tax consultanton sales transactions and records the amount as a liability. It is recognized as a liability until remitted to assist in determining the extent of its potentialapplicable state. Total revenues do not include sales tax exposure. Based upon this analysis, management determinedas the Company had probable exposureis considered a pass through conduit for certain unpaid obligations, including interestcollecting 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 aremitting 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.

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.taxes.

The following table sets forth the change in the sales tax accrual as of September 30, 2017March 31, 2020 and December 31, 2016:2019:

NOTE K – BUSINESS CONCENTRATION

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

Purchases from one supplier approximated $2,122,000, or 86%, of purchases for the nine months ended September 30, 2017 and $1,907,000, or 77%, of purchases for the nine months ended September 30, 2016. Total due to this supplier, net of deposits, was approximately $525,858 as of September 30, 2017, and $45,037 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.

TELKONET, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2017

(UNAUDITED)

The following table summarizes the balance sheet information for discontinued operations.

The following table summarizes the statements of operations information for discontinued operations.