PRECISION OPTICS CORPORATION, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

FOR THE THREE AND SIX MONTHS ENDED

December 31, 2019 AND 2018

(UNAUDITED)

The accompanying notes are an integral part of these consolidated interim financial statements.

PRECISION OPTICS CORPORATION, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

FOR THE SIX MONTHS ENDED

December31, 20172019 AND 20162018

(UNAUDITED)

The accompanying notes are an integral part of these consolidated interim financial statements.

PRECISION OPTICS CORPORATION, INC.

NOTES TO CONSOLIDATED INTERIM FINANCIAL STATEMENTS (UNAUDITED)

Principles of Consolidation and Operations

The accompanying consolidated financial statements include the accounts of Precision Optics Corporation, Inc. and its wholly-owned subsidiaries (the “Company”). All significant intercompany accounts and transactions have been eliminated in consolidation.

These consolidated financial statements have been prepared by the Company, without audit, and reflect normal recurring adjustments which, in the opinion of management, are necessary for a fair statement of the results of the second quarter and six months of the Company’s fiscal year 2018.2020. These consolidated financial statements do not include all disclosures associated with annual consolidated financial statements and, accordingly, should be read in conjunction with footnotes contained in the Company’s consolidated financial statements for the year ended June 30, 2017,2019, together with the Report of Independent Registered Public Accounting Firm filed under cover of the Company’s 20172019 Annual Report on Form 10-K, filed with the Securities and Exchange Commission on September 28, 2017.26, 2019.

Use of Estimates

The preparation of these consolidated financial statements requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

Income (Loss) Per Share

Basic income (loss) per share is computed by dividing net income or net loss by the weighted average number of shares of common stock outstanding during the period. Diluted income (loss) per share is computed by dividing net income or net loss by the weighted average number of shares of common stock outstanding during the period, plus the number of potentially dilutive securities outstanding during the period such as stock options and warrants. For the three and six months ended December 31, 20172019 and 2016,2018, the effect of such securities was antidilutive and not included in the diluted calculation because of the net loss generated in these periods.

The following is the calculation of loss per share for the three and six months ended December 31, 20172019 and 2016:2018:

The number of shares issuable upon the exercise of outstanding stock options and warrants that were excluded from the computation as their effect was antidilutive was approximately 1,708,8672,047,800 and 5,113,2241,493,200 for the three months ended December 31, 2017 and 2016, respectively, and approximately 4,739,960 and 5,113,224 for the six months ended December 31, 20172019 and 2016,2018, respectively.

Income Taxes

Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.

In assessing the likelihood of utilization of existing deferred tax assets, management has considered historical results of operations and the current operating environment. Based on this evaluation, a full valuation reserve has been provided for the deferred tax assets.

Recently Issued Accounting PronouncementsGoodwill and Patents

In May 2014,Long-lived assets such as goodwill and patents are capitalized when acquired and reviewed for impairment whenever events or changes in circumstances indicate that the Financial book value of the asset may not be recoverable. Impairment of the carrying value of long-lived assets such as goodwill and patents would be indicated if the best estimate of future undiscounted cash flows expected to be generated by the asset grouping is less than its carrying value. If an impairment is indicated, any loss is measured as the difference between estimated fair value and carrying value and is recognized in operating income or loss. Assets to be disposed of are reported at the lower of the carrying amount or fair value less costs to sell. No such impairments of goodwill or patents have been estimated by management as of December 31, 2019.

Accounting Standards Board (FASB) issuedPronouncements Recently Adopted

On July 1, 2018, the Company adopted ASU No. 2014-09, Revenue from Contracts with Customers which requires an entityCustomers. Refer to recognize the amount of revenue to which it expects to be entitledNote 5 for the transfer of promised goods or services to customers. The ASU guidance requires an entity to recognize revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration to which an entity expects to be entitled in exchange for those goods or services. The guidance also requires expanded disclosures relating to the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. Additionally, qualitative and quantitative disclosures are required regarding customer contracts, significant judgments and changes in judgments, and assets recognized from the costs to obtain or fulfill a contract. The standard will be effective forfurther information.

On July 1, 2019, the Company adopted ASU 2016-02, Topic 842 – Leases. Refer to Note 3 for annual reporting periods beginning after December 15, 2017, including interim reporting periods within that reporting period. The Company is reviewing the financial statement effect, if any, of implementing ASU No. 2014-09, that will go into effect on July 1, 2018.further information.

Inventories are stated at the lower of cost (first-in, first-out) or market and consisted of the following:

The Company entered into a five-year capital lease obligation in January 2016 for the acquisition of manufacturing equipment totaling $51,252.

In February 2016, FASB issued ASU 2016-02, “Leases” (Topic 842). ASU 2016-02 requires the recognition of lease asset and lease liabilities by lessees for those leases currently classified as operating leases with terms greater than twelve months and make certain changes to the accounting for lease expenses. The Company adopted this standard effective July 1, 2019 and has reflected its impact upon the El Paso, Texas facility operating lease entered into on July 1, 2019 in connection with the Ross Optical acquisition. The facility lease is a three-year operating lease obligation with total remaining minimum lease payments of $154,981 at December 31, 2019. Total rent expense including base rent and common area expenses were $15,190 and $30,381 during the three and six months ended December 31, 2019, respectively. Included in the accompanying balance sheet at December 31, 2019 is a right-of-use asset of $145,428 and current and long-term right-of-use operating lease liabilities of $55,247 and $90,181, respectively.

At December 31, 2017,2019, future minimum lease payments under the capital lease obligationand operating lease obligations are as follows:

The following table summarizes stock-based compensation expense for the three and six months ended December 31, 20172019 and 2016:2018:

No compensation has been capitalized because such amounts would have been immaterial.

The following tables summarize stock option activity for the six months ended December 31, 2017:2019:

Information related to the stock options outstanding as of December 31, 20172019 is as follows:

The aggregate intrinsic value of the Company’s “in-the-money” outstanding and exercisable options as of December 31, 20172019 was $5,750$1,770,050 and $5,650,$1,493,050, respectively.

Common Stock Award

On August 2, 2018, the Company awarded its Chief Executive Officer 300,000 shares of common stock for services performed through June 30, 2018. As of December 31, 2019, 200,000 shares have been issued. The fair market value of the 300,000 shares on the award date equal to $210,000 has been recorded as general and administrative stock-based compensation expense in the three months ended September 30, 2018.

As of September 30, 2017, there were warrants outstanding for the issuance of an aggregate of 666,667 shares of common stock, $0.01 par value, at a purchase price of $0.01 per share. All warrants for 666,667 shares were exercised on or before October 16, 2017, by payment to the Company for the aggregate purchase price of $6,667. There are no warrants for the purchase of the Company’s stock outstanding as of December 31, 2017.

On August 22, 2017,July 1, 2018, the Company entered into agreementsadopted ASU 2014-09 Revenue from Contracts with accredited investorsCustomers (ASC 606) using the modified retrospective method for contracts that were not completed as of July 1, 2018, whereby revenues are recognized as the performance obligations to deliver products or services are satisfied and are recorded based on the amount of consideration the Company expects to receive in exchange for satisfying the performance obligations. Most of the Company’s products and services are marketed to medical device companies almost exclusively in the United States. Products and services are primarily transferred to customers at a point in time based upon when services are performed or product is shipped.

Revenues represent the amount of consideration the Company expects to receive from customers in exchange for transferring products and services. Other selling costs to obtain and fulfill contracts are expensed as incurred due to the short-term nature of a majority of its revenues. The Company extends terms of payment to its customers based on commercially reasonable terms for the sale and purchase of 466,668 unregistered sharesmarkets of its common stock, $0.01 par value at a purchase price of $0.45 per share. The Company received $210,001customers, while also considering their credit quality. Shipping and handling costs charged to customers are included in gross proceeds from the offering. The Company is using the net proceeds from this placement for general working capital purposes.revenues.

Concurrently withThe Company disaggregates revenues by product and service types as it believes it best depicts how the placement,nature, amount, timing and uncertainty of revenues and cash flows are affected by economic factors. Revenues are comprised of the Company entered into an agreement with an investorfollowing for the salethree and six months ended December 31, 2019 and 2018:

Contract Assets and Liabilities

The nature of 88,888 unregistered sharesthe Company’s products and services does not generally give rise to contract assets as it typically does not incur costs to fulfill a contract before a product or service is provided to a customer. The Company’s costs to obtain contracts are typically in the form of its common stocksales commissions paid to employees. The Company has elected to expense sales commissions associated with obtaining a contract as incurred as the amortization period is generally less than one year. These costs have been recorded in selling, general and administrative expenses. As of December 31, 2019, there were no contract assets recorded in the Company’s Consolidated Balance Sheets.

The Company’s contract liabilities arise as a result of unearned revenue received from customers at inception of contracts or where the timing of billing for services provided toprecedes satisfaction of our performance obligations. The Company generally satisfies performance obligations within one year from the Company at a price of $0.45 per share.contract inception date.

In connection with the placement, the Company also entered into a registration rights agreement with the investors, whereby the Company was obligated to file a registration statement with the Securities Exchange Commission on or before 90 calendar days after August 22, 2017 to register the resale by the investors of 555,556 shares of our common stock purchasedContract liabilities, which were recorded as customer advances in the placement. The registration statement was filed withCompany’s Consolidated Balance Sheets, and unearned revenue are comprised of the Securities and Exchange Commission on November 20, 2017 and became effective on December 13, 2017.following:

On July 1, 2019 the Company acquired the operating assets of Ross Optical Industries, Inc. of El Paso, Texas, a supplier of custom and catalogue optical components sourced through an extensive network of worldwide specialized vendors and sold for industrial, military and medical applications. The acquisition had an effective date of June 1, 2019. All of Ross’ results of operations are included in our financial statements for the three and six month periods ended December 22, 2017, the Tax Cuts and Jobs Act was signed into law. The Tax Cuts and Jobs Act will significantly change the taxation of U.S.-based multinational corporations, by, among other things, reducing the U.S. corporate income tax rate, adopting elements of a territorial tax system, affecting the deductibility of capital expenditures, assessing a one-time transition tax on earnings of certain foreign subsidiaries that were previously tax deferred, continuing the moratorium on Medical Device Excise Tax, and the creation of new taxes on certain foreign-sourced earnings. The legislation is unclear in some respects and will require interpretations and implementing regulations by the Internal Revenue Service, as well as state tax authorities, and the legislation could be subject to potential amendments and technical corrections, any of which could lessen or increase certain adverse impacts of the legislation. The Company is in the process of determining what, if any, effect those provisions will have on its financial results.31, 2019.

Consolidated unaudited actual and pro forma results of operations for the Company are presented below assuming that the acquisition of the Ross Optical division had occurred on July 1, 2018. Pro forma operating results include net adjustments resulting from the acquisition transaction.

Pro forma financial information is not necessarily indicative of the Company’s actual results of operations if the acquisition had been completed at the date indicated, nor is it necessarily an indication of future operating results. Amounts do not include any operating efficiencies or cost saving that the Company believes may become achievable over time.

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

The following discussion of our financial condition and results of operations should be read in conjunction with the unaudited condensed consolidated financial statements and notes to those statements included elsewhere in this Quarterly Report on Form 10-Q for the quarter and six months ended December 31, 20172019 and with our audited consolidated financial statements for the year ended June 30, 20172019 included in our Annual Report on Form 10-K, filed with the Securities and Exchange Commission on September 28, 2017.26, 2019.

This Quarterly Report on Form 10-Q contains forward-looking statements. When used in this report, the words “anticipate,” “suggest,” “estimate,” “plan,” “project,” “continue,” “ongoing,” “potential,” “expect,” “predict,” “believe,” “intend,” “may,” “will,” “should,” “could,” “would” and similar expressions are intended to identify forward-looking statements. You should not place undue reliance on these forward-looking statements. Our actual results could differ materially from those anticipated in the forward-looking statements for many reasons, including the risks described in this report, the risks described in our Annual Report on Form 10-K for the year ended June 30, 20172019 and other reports we file with the Securities and Exchange Commission. Although we believe the expectations reflected in the forward-looking statements are reasonable, they relate only to events as of the date on which the statements are made. We do not intend to update any of the forward-looking statements after the date of this report to conform these statements to actual results or to changes in our expectations, except as required by law.

Overview

We have been developinga developer and manufacturingmanufacturer of advanced optical instruments since 1982. Today, the vast majority of our business is the design and manufacture of high-quality medical devices and less than 10% of our business is the design and manufacture of military and industrial products. Our medical instrumentation line includes traditional endoscopes and endocouplers as well as other custom imaging and illumination products for use in minimally invasive surgical procedures. Much of our recent development efforts have been targeted at the development of next generation endoscopes. OverFor the last ten years, we have funded internal research and development programs to develop next generation capabilities for designing and manufacturing 3D endoscopes and very small Microprecision™ lenses, anticipating future requirements as the surgical community continues to demand smaller and more enhanced imaging systems for minimally invasive surgery.

Effective June 1, 2019 we acquired the operating assets of Ross Optical Industries, Inc. of El Paso, Texas, which we began operating as a division of our Company beginning on that date. The accompanying financial statements include the results of operations of the Ross Optical division for the entire six and three-month periods ended December 31, 2019 and the assets and liabilities of the division as of June 30, 2019 and December 31, 2019. The acquisition of the assets of Ross Optical Industries effective June 1, 2019 expands our optics components and assemblies business. All products supplied by Ross Optical include a custom or catalog optic, which is sourced through Ross Optical’s extensive domestic and worldwide network of optical fabrication companies. Most systems make use of optical lenses, prisms, mirrors and windows and range from individual optical components to complex mechano-optical assemblies. Products often include thin film optical coatings that are applied using the in-house coating department. Approximately 76% of Ross Optical revenues are from customers in the United States, 8% from Western Europe and 5% from Canada during the six months ended December 31, 2019. Ross Optical’s sales are mostly resale of specialized optical components with the remainder being assemblies. Ross Optical does not perform revenue generating engineering services or internal research and development. The majority of Ross Optical sales are for industrial applications with the remainder split between military and medical device products.

The Management Discussion and Analysis which follows is based on the financial condition and results of operations of our Company including the operating results for the six and three month periods ended December 31, 2019 and the balance sheet as of June 30, 2019 and December 31, 2019 of our new division Ross Optical.

Our unique proprietary technologybusiness is the design and manufacture of high-quality medical devices. Approximately 12% of our revenue in the areassix months ended December 31, 2019 is from the design, manufacture and resale of micro optical lensesproducts for military and prisms, micro medical fiber and CMOS based cameras, and custom design of medical grade instruments, combined with recent developments in the areas of 3D displays, has allowed us to begin commercialization of related product and service offerings to a widening group of customers addressing various medical device, defense and aerospace applications. Thus, a portion of our revenues are now derived29% is from engineeringother industrial, non-medical products. Our medical instrumentation line and unique design services we performedand manufacturing capabilities include traditional endoscopes and endocouplers as well as other custom imaging and illumination products for our customersuse in minimally invasive surgical procedures. We design and manufacture 3D endoscopes and very small Microprecision™ lenses, assemblies and complete medical devices to incorporate our technologiesmeet the surgical community’s continuing demand for smaller, disposable, and capabilities into their medical device products. We believe that new products based on these technologies providemore enhanced imaging systems for existing surgical procedures and can enable development of many new medical device products and related medical procedures.minimally invasive surgery. 

We are registered to the ISO 9001:20082015 and ISO 13485:20032016 Quality Standards and comply with the FDA Good Manufacturing Practices and the European Union Medical Device Directive for CE marking of our medical products. Our internet website is www.poci.com. Information on our website is not intended to be integrated into this report.

The markets in which we do business are highly competitive and include both foreign and domestic competitors. Many of our competitors are larger and have substantially greater resources than we do. Furthermore, other domestic or foreign companies, some with greater financial resources than we have, may seek to produce products or services that compete with ours. We routinely outsource specialized production efforts as required to obtain the most cost effective production.

We believe that competition for sales Over the years and through the acquisition of our medical products and services, whichthe Ross Optical division in June 2019, we have been principally sold to original equipment manufacturers, or OEM, customers, is based on our ability to design and produce technical features, performance, engineering service and production scheduling, on-time delivery, quality control and product reliability, and competitive pricing.developed extensive experience collaborating with other optical specialists worldwide.

We believe that our future success depends to a large degree on our ability to develop new optical products and services to enhance the performance characteristics and methods of manufacture of existing products. Accordingly, we expect to continue to seek and obtain product-related design and development contracts with customers and to selectively invest our own funds on research and development, particularly in the areas of Microprecision™ optics, micro medical cameras, illumination, and 3D endoscopes.

The Ross Optical division sales are primarily optical components and assemblies for industrial applications in addition to medical and military uses. By combining the unique capabilities of our Company with the Ross Optical division we believe there are opportunities for expanded sales of each division products and services throughout the combined customer base. Additionally, we believe Ross’ expanded worldwide vendor relationships will benefit our traditional efforts to source materials at competitive prices for our development projects and manufacturing activities.

For the six months ended December 31, 2017,2019, approximately 75%24% of our sales were made to seven customers. Ofour three largest customers and no customer, including these four were medium to large, international,three, made up more than 10% of our total sales. Our three largest customers during the quarter ended December 31, 2019 are in the defense and medical device industries. One represents engineering service revenue for an established defense contractor, and the other two represent production revenue for companies commercializing a cardiovascular endoscope and one was a large defense contractor.an ENT scanning device. Each of these three products incorporates our Microprecision™ technologies as enabling design features. In addition to the three largest customers, has been our customer for numerous years. Thewe made sales to two hundred thirty-eight other two customers were early-stage companies developing endoscopic products that incorporate our unique design capabilities. Sales to these seven customers included both products we developed over five years ago and products we are currently developing which rely heavily on our unique, proprietary Microprecision™ lens technology and optical visualization system expertise.during the six month period ended December 31, 2019. 

Current sales and marketing activities are intended to broaden awareness of the benefits of our new technology platforms which we believe are ready for generaland our successful application of these new technologies to medical device projects requiring surgery-grade visualization from sub-millimeter sized devices and 3D endoscopy.endoscopy, including disposable products and assemblies. We market directly to established medical device companies primarily in the United States that we believe could benefit from our advanced endoscopy visualization systems. Through this direct marketing, referrals, attendance at trade shows including Medical Design and Manufacturing West and MD&M East, and periodically a presence in online professional association websites, we have expanded our on-going pipeline of projects to significant medical device companies as well as well-funded emerging technology companies. We expect our customer pipeline to continue to expand as development projects transition to production orders and new customer projects enter the development phase. Our Ross Optical division markets through existing customers and trade shows, in addition to proactive online marketing strategies executed primarily through its website. We believe there are opportunities to expand the reach of sales activities of our business and that of our new division, Ross Optical, through the gradual integration of some of the sales and marketing resources of the two operations.

General

This management’s discussion and analysis of financial condition and results of operations is based upon our unaudited consolidated financial statements, which have been prepared without audit, pursuant to the rules and regulations of the Securities and Exchange Commission. The preparation of these consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

There have been no significant changes in our critical accounting policies as disclosed in the Notes to our Financial Statements contained in our Annual Report on Form 10-K for the year ended June 30, 20172019 filed with the Securities and Exchange Commission on September 28, 2017.26, 2019.

Results of Operations

Our total revenues for the quarter ended December 31, 2017,2019, were $812,773,$2,796,762, as compared to $601,590$1,477,851 for the same period in the prior year, an increase of $211,183,$1,318,911, or 35.1%89.2%. Revenues increased during the quarter ended December 31, 20172019 compared to the same quarter of the prior year inprimarily due to the engineering services and production categories by 75% and 16%, respectively. The majorityrevenues of ourthe Ross Optical division, which were $1,150,844 for the quarter ended December 31, 2019. Our non-Ross revenues are derived from engineering design and manufacturing services related to products marketed or under development by our OEM customers. Therefore, our revenues are subject to fluctuations on a product by product basis from period to period. The increase in production revenueincreased $168,067 during the quarter ended December 31, 2017 when compared to2019 from their levels in the same quarterperiod of the prior year resulted primarily from an increase inyear. The mix of engineering service, production and component sales were consistent between the quarters and changes were considered the result of a traditional product to a long-standing customer. Engineering service revenuecustomary fluctuations within and between the various products during the quarter ended December 31, 2017, when compared to the same quarter of the prior year included a similar number of projects, but increases in revenue from two specific customers, one of which is now transitioning from the engineering to production phase. We believe most engineering design projects have the potential to generate production revenues when our customers achieve commercialization of the products under design.quarters.

Our total revenues for the six months ended December 31, 20172019 were $1,841,519,$5,311,746, as compared to $1,451,138$3,037,309 for the same period in the prior year, an increase of $390,381,$2,274,437, or 26.9%74.9%. The increase in revenues forRevenues increased during the six month periodmonths ended December 31, 20172019 compared to the same period of the prior year resulted from increases in engineering and productionprimarily due to the revenues of 41% and 18%, respectively. The engineering revenue increase during the quarterRoss Optical division, which were $2,241,688 for the six months ended December 31, 2017 compared to2019. Our non-Ross revenues increased $32,769 during the six months ended December 31, 2019 from their levels in the same period of the prior year resulted primarily from two large customer projects, oneyear. The mix of which is now transitioning to production. These increasesengineering service, production and component sales were partially offset byconsistent between the previously mentioned lossquarters and changes were considered the result of a customer’s Microprecision™ technology product in fiscal 2017. Production revenues increasedcustomary fluctuations within and between the various products during the quarter ended December 31, 2017 compared to the same period of the prior year due to the addition of an optical component project and a cyclical increase in traditional laryngoscopes.quarters.

Gross profit for the quarter ended December 31, 20172019 was $300,222,$917,939, compared to $148,407$355,722 for the same period in the prior year, reflecting an increase of $151,815,$562,217, or 102.3%158%. Gross profit for the quarter ended December 31, 20172019 as a percentage of our revenues was 36.9%32.8%, an increase from the gross profit percentage of 24.7%24.1% for the same period in the prior year. Gross profit for the six months ended December 31, 20172019 was $686,964,$1,892,056, as compared to $315,458$818,229 for the same period in the prior year, which reflects an increase of $371,506$1,073,827 or 117.8%131.2%. Gross profit for the six months ended December 31, 20172019 as a percentage of our revenues was 37.3%35.6%, an increase from the gross profit percentage of 21.7%26.9% for the same period in the prior year. Quarterly gross profit and gross profit percentage depend on a number of factors, including overall sales volume, facility utilization, product sales mix, and the costs of engineering services, and initial production start-up costs and challenges in connection with new products.

The improvementincrease in our gross profit performancedollars and gross profit percentage during the quarter and six month periodsperiod ended December 31, 2017 resulted from increased revenues absorbing a higher percentage of fixed manufacturing costs, and lower fixed compensation expense during the quarter. Management expects compensation costs to increase since new hires for these or similar positions are planned. Additionally, targeted or better margins were realized on most engineering and production projects during the quarter ended December 31, 2017, including the larger revenue projects in each category, due to experienced related efficiencies in producing traditional products and engineering development activities associated with Microprecision™ technologies.

Research and development expenses were $90,031 for the quarter ended December 31, 2017, compared to $119,215 for the same period in the prior year, a decrease of $29,184, or 24.5%. Research and development expenses were $208,458 for the six months ended December 31, 2017, compared to $236,207 for the same period in the prior year, a decrease of $27,749, or 11.7%. The decrease in research and development expenses during the quarter and six months ended December 31, 2017,2019 compared to the same periods of the prior year is primarily due to the inclusion of the Ross Optical division revenue at a higher gross margin percentage than we realize on non-Ross revenues. Ross Optical division revenues generated a gross margin percentage of 48-50% while non-Ross revenue margin was 26.4% for the six months ended December 31, 2019. The non-Ross gross margin is dependent on a number of factors and is expected to fluctuate from quarter to quarter based on the nature and status of engineering projects. Specifically, periodic margins are impacted by revenue volume, facility utilization, product sales mix, and unanticipated cost over-runs associated with engineering projects and start-up production activities of new products. During the quarter ended December 31, 2019 two non-Ross engineering service projects experienced cost over-runs that negatively impacted gross margins during the period. The two projects collectively represented 18% of total revenue and negatively impacted the gross margin percentage by 6.5% during the quarter ended December 31, 2019. The cost over-runs in each of these cases resulted from design challenges and issues we are addressing and that we believe will only cause a temporary reductiondecrease in total realized gross margins. The remainder of our production and engineering department staffingjobs resulted in margins within our targeted range with reasonably expected fluctuations.

Research and a higher percentage of available engineering resources being consumed in revenue generating engagements with our customersdevelopment expenses were $228,576 for the quarter ended December 31, 2019, compared to $125,413 for the same period in the prior year, an increase of $103,163, or 82%. Research and development expenses were $380,730 for the six months ended December 31, 2019, compared to $226,211 for the same period in the prior year, an increase of their products.$154,519, or 68%. In-house research and development and certain internal functions not directly related to customer engagements are classified as research and development expenses.expenses with the majority of our engineering, research and development activities being consumed in revenue generating engagements with our customers for the development of their products. During the quarter ended December 31, 2019 we had a larger staff of engineering personnel and a greater amount of our engineering personnel time was consumed in internal research and development activities; the product of which we believe will benefit various engineering design projects involving specialized fixturing and illumination features.

Selling, general and administrative expenses were $270,035$2,148,806 for the quartersix months ended December 31, 2017,2019, compared to $342,487$1,016,405 for the same period in the prior year, an increase of $1,132,401, or 111%. The increase in the six months ended December 31, 2019, compared to the same quarter of the prior fiscal year was primarily due to the addition of $598,078 of selling, general and administrative expenses incurred by our Ross Optical division. Non-Ross selling, general and administrative expenses reflect a decrease$42,999 increase in stock-based compensation and service fees in the six months ended December 31, 2019 compared to the same period of $72,452, or 21.2%. the prior year, and a $491,322 increase in compensation to existing and newly hired employees.

Selling, general and administrative expenses were $566,619$1,240,961 for the six monthsquarter ended December 31, 2017,2019, compared to $686,269$355,916 for the same period in the prior year, a decreasean increase of $119,650,$885,045, or 17.4%.The decrease249%. The increase in the quarter and six months ended December 31, 2017,2019, compared to the same periods inquarter of the prior fiscal year was primarily due to reduced stock based compensation expense relating to stock optionsthe addition of $325,987 of selling, general and stock accrued for consulting services, plus reduced wages resulting from the retirement ofadministrative expenses incurred by our Ross Optical division. Non-Ross selling, general and administrative expenses reflect a sales person in January 2017 and a temporarily vacated administrative position which has since been filled. The expense reductions were partially offset by a $25,000$264,478 increase in the reserve for doubtful accounts receivable relating to one specific customerstock-based compensation and increased sales commissions for a lesser amount.

No income tax provision was recordedservice fees in the quarter and six month periods ended December 2017 and 2016 because31, 2019 compared to the same period of the losses generatedprior year, and a $294,581 increase in those periods.compensation to existing and newly hired employees.

Liquidity and Capital Resources

We have sustained recurring net losses for several years. During the quarteryear ended June 30, 2019 and the six month periodsmonths ended December 31, 2017,2019 we incurred net losses of $60,326$614,871 and $89,111, respectively. We also incurred net losses of $1,006,457 and $1,034,765 during the fiscal years ended June 30, 2017 and 2016, respectively, and used cash in operating activities of $667,434 and $876,298 during the same fiscal periods,$636,935, respectively. As a result of our acquisition of the Ross Optical division, our revenue, gross margin and components of our working capital have increased. At December 31, 2017,2019 cash and cash equivalentswas $347,858, accounts receivables were $381,752, accounts receivable were $753,152,$2,000,048 and current liabilities were $1,529,694. Our working capital was $671,433$2,021,535, including $388,506 of customer advances received for future order deliveries.

Although our financial performance has improved during the last few fiscal quarters, our operating expenses have also increased and $479,604 at December 31, 2017we continue to experience pricing pressure from our customers and June 30, 2017, respectively.challenges in engineering projects and production orders that result in cost over-runs and depressed gross margins. Consequently, critical to our ability to maintain our financial condition is achieving and maintaining a level of quarterly revenues that generate break even or better financial performance as well as timely collection of accounts receivable from our customers. We believe profitable operating results can be achieved through a combination of revenue levels, realized gross margins and controlling operating expense increases, all of which are subject to periodic fluctuations resulting from sales mix and the stage of completion of varying engineering service projects as they progress towards and into production level revenues.

We have traditionally funded working capital needs through product sales, management of working capital components of our business, and by cash received from public and private offerings of our common stock, warrants to purchase shares of our common stock or convertible notes. We have incurred quarter to quarter operating losses duringnotes, and by customer advances paid against purchase orders and recorded in the current liabilities section of the accompanying financial statements. Our management believes that the opportunities represented by our efforts to develop current products includingproduction projects and engineering pipeline of Microprecision™ optical elements, micro medical camera assemblies and 3D endoscopes. Our management believes that the opportunities represented by these productsendoscope projects have the potential to generate sales increases to achieve sustained breakevenincreasing revenues and profitable results. However, our current financial condition may raise doubt regarding our ability to continue as a going concern, as referenced by the Report of our Independent Registered Public Accounting Firm on our financial statements for the year ended June 30, 2017, included in our Annual Report on Form 10-K.

We recognize that the working capital described above and our cash and accounts receivable as of December 31, 2017 is low considering the level of cash historically used in our operations at our current sales levels. Our accounts receivable and cash balances are subject to significant fluctuations based on the timing and amount of customer billings and accounts receivable collections as well as the terms of vendor payment obligations. If quarterly sales revenues do not increase and maintain near or above cash breakeven levels in the next six to nine months, we may be required to obtain cash for operations from non-working capital sources, which may not be available, in which case we would have to significantly decrease or cease operations.

The sale of additional equity or convertible debt securities would result in additional dilution to our stockholders, and debt financing, if available, may involve restrictive covenants that could restrict our operations or finances. Financing, if necessary, may not be available in amounts or on terms acceptable to us, if at all. If we cannot raise funds on acceptable terms or achieve positive cash flow, we may not be able to continue to conduct operations, develop new products, grow market share, take advantage of future opportunities or respond to competitive pressures or unanticipated requirements, any of which would negatively impact our business, operating results and financial condition.results.

Capital equipment expenditures and additional patent application related expenditurescosts during the six months ended December 31, 20172019 and 20162018 were $17,189$56,914 and $31,691,$76,184, respectively. Future capital equipment and patent application expenditures will be dependent upon the type and amount of future sales revenue and successthe needs of on-going research and development efforts.

We have contractual cash commitments related to open purchase orders as of December 31, 20172019 of approximately $338,000, including$976,440, plus a $27,828$9,835 commitment remaining under a five-year capital lease obligation for the acquisition of equipment and $145,428 commitment remaining under a three-year facility lease relating the Ross Optical division in El Paso, Texas (see Note 3. Capital Lease Obligation)Obligations). We have no other contractual cash commitments since leased facilities are currently on a month-to-month basis.

Off-Balance Sheet Arrangements

We currently have no off-balance sheet arrangements that have, or are reasonably likely to have, a current or future material effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.

Item 3. Quantitative and Qualitative Disclosures About Market Risk.

As a smaller reporting company, as defined by Rule 12b-2 of the Exchange Act and in Item 10(f)(1) of Regulation S-K, we are electing scaled disclosure reporting obligations and therefore are not required to provide the information requested by this Item.

Item 4. Controls and Procedures.

Management’s Evaluation of Disclosure Controls and Procedures

Our Chief Executive Officer and our Chief Financial Officer evaluated the effectiveness of our disclosure controls and procedures as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on this evaluation, our Chief Executive Officer and our Chief Financial Officer have concluded that our disclosure controls and procedures, including internal control over financial reporting, were not effective as of December 31, 2017,13, 2019, to ensure the information we are required to disclose in reports that we file or submit under the Securities Exchange Act of 1934, as amended (i) is recorded, processed, summarized, and reported within the time periods specified in Securities and Exchange Commission rules and forms, and (ii) is accumulated and communicated to our management, including our Chief Executive Officer and our Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. Our disclosure controls and procedures are intended to be designed to provide reasonable assurance that such information is accumulated and communicated to our management. Based on this evaluation, our management concluded that our internal control over financial reporting was not effective as of December 31, 2017.2019.

The following is a description of two material weaknesses in our internal control over financial reporting:

Segregation of Duties: As previously disclosed in our Annual Reports on Form 10-K for the fiscal years ended June 30, 2008-2017,2008-2019, our management identified a control deficiency during the 2008 fiscal year because we lacked sufficient staff to segregate accounting duties. We believe the control deficiency resulted primarily because we have the equivalent of one and one-half persons performing all accounting-related on-site duties. As a result, we did not maintain adequate segregation of duties within our critical financial reporting applications, the related modules and financial reporting processes. This control deficiency could result in a misstatement of balance sheet and income statement accounts in our interim or annual consolidated financial statements that would not be detected. Accordingly, management has determined that this control deficiency constitutes a material weakness. During the period beginning with fiscal year 2008 through June 30, 2017,2019, no audit adjustments resulting from this condition were required.

To address and remediate the material weakness in internal control over financial reporting described above, beginning with the quarter ended September 30, 2008, we instituted a procedure whereby our Chief Executive Officer, our Chief Financial Officer and other members of our Board of Directors perform a higher level review of the quarterly and annual reports on Form 10-Q and Form 10-K prior to filing.

We believe that the step outlined above strengthens our internal control over financial reporting and mitigates the material weakness described above. As part of our assessment of internal control over financial reporting for the fiscal year ended June 30, 2017,2019, our management has evaluated this additional control and has determined that it is operating effectively.

Inventory Valuation: As previously disclosed in our Annual Report on Form 10-K for the fiscal year ended June 30, 2017,2019, we reported a material weakness with respect to the valuation of our inventories. Specifically, the amounts used to value our inventory at June 30, 2009 with respect to overhead rates and purchased items were often inconsistent with the supporting documentation, due to year-to-year changes in overhead rates and costs of purchased items that were not properly reflected in inventory valuation. Accordingly, management had determined that this control deficiency constituted a material weakness as of June 30, 2009. AuditPeriodic fiscal year end audit adjustments of approximately $58,000 and $41,000 to our audited financial statements as of June 30, 2011 and June 30, 2017, respectively, were$50,000 have been necessary as a result of this condition.

Changes in Internal Control over Financial Reporting

There was no change in our internal control over financial reporting that occurred during the firstsecond quarter of our fiscal year covered by this Quarterly Report on Form 10-Q that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

To address and remediate the material weakness in internal control over financial reporting described above, beginning in the quarter ended September 30, 2009 and continuing through the quarter ended December 31, 2017,2019, we implemented processes to improve our inventory controls and documentation surrounding inventory valuation for overhead rates, and performed procedures to ensure that the pricing of inventory items was consistent with the supporting documentation. We believe that the step outlined above strengthens our internal control over financial reporting and mitigates the material weakness described above.

We intend to continue to remediate material weaknesses and enhance our internal controls but cannot guarantee that our efforts will result in remediation of our material weaknesses or that new issues will not be exposed in this process.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings.

Our Company, on occasion, may be involved in legal matters arising in the ordinary course of our business. While management believes that such matters are currently insignificant, matters arising in the ordinary course of business for which we are or could become involved in litigation may have a material adverse effect on our business, financial condition or results of operations. We are not aware of any pending or threatened litigation against us or our officers and directors in their capacity as such that could have a material impact on our operations or finances.

Item 1A. Risk Factors.

Other than as described below, there have been no material changes from the risk factors previously disclosed in our annual report on Form 10-K for the fiscal year ended June 30, 2017,2019, as filed with the Securities and Exchange Commission on September 28, 2017; and our quarterly report for the quarter ended September 30, 2017, as filed with the Securities and Exchange Commission on November 14, 2017.26, 2019.

AsWe depend on the availability of December 31, 2017,certain key supplies and services that are available from only a few sources and we may not have sufficient cashexperience difficulty with certain suppliers due to continue operations for the next six to nine months.

As of December 31, 2017, we had $381,752recent coronavirus outbreak in cashChina and cash equivalents, $753,152 in accounts receivable, and $1,529,694 in current liabilities. We incurred net losses of $89,111 and $1,006,457 during the six months ended December 31, 2017 and the fiscal year ended June 30, 2017, respectively. If quarterly sales revenues do not increase and maintain near or above cash breakeven levels in the next six to nine months, we may be required to obtain cash for operations from non-working capitalhave difficulty finding alternative sources which may not be available, in which case we would have to significantly decreaseof these supplies or cease operations. The sale of additional equity or convertible debt securities would result in additional dilution to our stockholders, and debt financing, if available, may involve restrictive covenants that could restrict our operations or finances. Financing, if necessary, may not be available in amounts or on terms acceptable to us, if at all. If we cannot raise funds on acceptable terms or achieve positive cash flow, we may not be able to continue to conduct operations, develop new products, grow market share, take advantage of future opportunities or respond to competitive pressures or unanticipated requirements, any of which would negatively impact our business, operating results and financial condition.

The newly enacted Tax Cuts and Jobs Act may affect our financial results, including our net deferred tax asset, and we are in the process of evaluating its effects.services.

OnWe source certain key supplies to develop and manufacture our products, particularly our precision grade optical glass, which is available from only a few sources, in China. Due to the recent coronavirus outbreak in China in December 22, 2017, the Tax Cuts2019, we may experience difficulties with certain suppliers. Our business could be affected if we become unable to procure these essential materials and Jobs Act was signed into law. The Tax Cutsservices in adequate quantities and Jobs Act will significantly change the taxation of U.S.-based multinational corporations, by, among other things, reducing the U.S. corporate income tax rate, adopting elements ofat acceptable prices. We are always evaluating our suppliers and alternative sources. If we experience a territorial tax system, affecting the deductibility of capital expenditures, assessing a one-time transition tax on earningsshortage of certain foreign subsidiaries that were previously tax deferred, continuing the moratorium on Medical Device Excise Tax,supplies and the creationare unable to find an alternative source, our financial condition and results of new taxes on certain foreign-sourced earnings. The legislation is unclear in some respects and will require interpretations and implementing regulations by the Internal Revenue Service, as well as state tax authorities, and the legislationoperations could be subject to potential amendments and technical corrections, any of which could lessen or increase certain adverse impacts of the legislation. We are in the process of determining what, if any, effect those provisions will have on our financial results, and there can be no assurance of whether such additional effects will be positive or negative.adversely affected.   

The Tax Cuts and Jobs Act also reduces the federal corporate income tax rate from 35% to 21% effective January 1, 2018, which we expect will positively impact our future effective tax rate and after-tax earnings in the United States. As a result of the reduction in the corporate income tax rate, we are required to revalue our net deferred tax asset to account for the future impact of lower corporate tax rates on this deferred amount and record any change in the value of such asset as a one-time non-cash charge on our income statement.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.

We did not issue any unregistered equity securities during the quarter ended December 31, 2017.2019.

Item 3. Defaults Upon Senior Securities.

Not applicable.

Item 4. Mine Safety Disclosures.

Not applicable.

Item 5. Other Information.

None.

Item 6. Exhibits.

Copies of above exhibits not contained herein are available to any stockholder, upon written request to: Chief Financial Officer, Precision Optics Corporation, Inc., 22 East Broadway, Gardner, MA 01440.