CMHC SYSTEMS, INC.
Notes to Consolidated Financial Statements
March 31, 2005 and 2004
among other factors. If any of these factors change, the Company may also change its original estimates, which could impact the level of its future allowance for doubtful accounts. Account balances are charged off against the allowance after all means of collection have been exhausted and the potential for recovery is considered remote. The Company does not have any off-balance sheet credit exposure related to its customers. Unbilled receivables of $296,923 and $235,567 are included in current accounts receivable at March 31, 2005 and 2004, respectively, and represent amounts recognized in revenue in advance of invoicing.
The Company derives revenues by selling perpetual software licenses and hardware. The Company also derives revenues from annual maintenance and support services for its software. Revenue from perpetual software licenses is recognized when the following four criteria are met: (1) persuasive evidence of an arrangement exists, (2) delivery has occurred, (3) the related fee is fixed and determinable, and (4) collectibility is probable. Software license fees and hardware are not recognized upfront unless the Company has established vendor-specific objective evidence (VSOE) of the undelivered element of the arrangement. In the event the Company has not established VSOE, revenue from software licenses is recognized over the maintenance period. Maintenance revenue is recognized ratably over the applicable maintenance period and services revenue is recognized as the services are delivered.
Deferred revenues primarily represent support contracts or services that have been billed in advance of the support or services being provided.
The Company records reimbursements received for out-of-pocket expenses as revenues in the accompanying consolidated financial statements, with the related expense recorded as cost of revenue.
Income taxes for CMHC Systems, Inc. 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. The Partnership is not subject to state or federal taxes as those amounts are included in the tax returns of the partners. Consequently, and as the Company does not have an equity ownership in the Partnership, no deferred taxes have been provided for the Partnership.
CMHC SYSTEMS, INC.
Notes to Consolidated Financial Statements
March 31, 2005 and 2004
The Company applies the intrinsic value-based method of accounting prescribed by Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations including FASB Interpretation No. 44, Accounting for Certain Transactions involving Stock Compensation, an interpretation of APB Opinion No. 25, to account for its fixed plan stock options. Under this method, compensation expense is recorded on the date of grant and amortized on a straight-line basis over the period of service only if the current market price of the underlying stock exceeds the exercise price. SFAS No. 123, Accounting for Stock-Based Compensation, established accounting and disclosure requirements using a fair value-based method of accounting for stock-based employee compensation plans. As allowed by SFAS No. 123, the Company has elected to continue to apply the intrinsic value-based method of accounting described above, and has adopted the disclosure requirements of SFAS No. 123.
The Company accounts for equity instruments granted to non-employees in accordance with the provisions of SFAS No. 123 and Emerging Issues Task Force Issue No. 96-18, Accounting for Equity Instruments that are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods, or Services. All transactions in which goods or services are the consideration received for the issuance of equity instruments are accounted for based on the fair value of the consideration received or the equity instrument issued, whichever is more reliably measurable. The measurement date of the fair value of the equity instrument issued is the earlier of the date on which the counterparty’s performance is complete or the date on which it is probable that performance will occur.
On April 1, 2003, CMHC issued 800 options to purchase common stock to four directors along with a put provision contained in a Buy-Sell Agreement with these same directors. The accounting treatment for these options requires variable accounting as prescribed by Financial Interpretation (FIN) No. 28, Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans. The Company will recognize compensation cost for the increases and decreases in the intrinsic value of the shares until the date the option is exercised.
CMHC SYSTEMS, INC.
Notes to Consolidated Financial Statements
March 31, 2005 and 2004
The following table illustrates the effect on net income (loss) if the Company had applied the fair value recognition provisions of SFAS No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation using the Black-Scholes option-pricing model with straight-line recognition of compensation cost over the related vesting periods for fixed awards.
| | | 2005 | | 2004 (Restated) | |
| Net income (loss) | | $ | (1,129,359 | ) | | 414,141 | |
| Add: | | | | | | | |
Stock-based employee compensation expense included in reported net loss | | | 9,600 | | | — | |
| Deduct: | | | | | | | |
Total stock-based employee compensation expense determined under fair value based method for all awards | | | (11,962 | ) | | (19,217 | ) |
| Pro forma net income (loss) | | $ | (1,131,721 | ) | | 394,924 | |
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates 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. Actual results could differ from those estimates. Significant estimates include revenue recognition, allowance for doubtful accounts, deferred tax valuation allowance, impairment of long lived estimates and fair value estimates.
| (m) | Impairment of Long-Lived Assets and Long-Lived Assets to Be Disposed Of |
The Company’s long-lived assets and certain identifiable intangibles are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future net cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets. Assets to be disposed of are reported at the lower of the carrying amount or fair value less costs to sell.
Certain 2004 amounts have been reclassified to conform to the 2005 presentation.
CMHC SYSTEMS, INC.
Notes to Consolidated Financial Statements
March 31, 2005 and 2004
In August of 2005, the Company identified that the accounting for the Partnership equity and earnings was not proper. The previously issued financial statements for the year ended March 31, 2004 have been restated to correct for these errors.
The Partnership equity and the earnings of the Partnership were included in the operating results and equity of the Company, respectively, when they should have been reported as a minority interest in the statement of operations and balance sheet.
The Company has reclassified the Partnership equity and earnings. The effect of these changes on the Company’s financial statements is as follows:
| | | Consolidated Balance Sheet as of March 31, 2004 | |
| | | As Previously | | | | | |
| | | Reported | | Adjustments | | As Restated | |
Minority interest - Partnership | | $ | — | | | 57,043 | | | 57,043 | |
| Total stockholders’ deficit | | | (1,359,748 | ) | | (57,043 | ) | | (1,416,791 | ) |
| | | Consolidated Statement of Operations for the Year ended March 31, 2004 | |
| | | As Previously | | | | | |
| | | Reported | | Adjustments | | As Restated | |
Minority interest - Partnership | | $ | — | | | (141,967 | ) | | (141,967 | ) |
| Income before taxes | | | 757,083 | | | (141,967 | ) | | 615,116 | |
| Net income | | | 556,108 | | | (141,967 | ) | | 414,141 | |
The restatement did not impact net cash provided by operating activities or net cash used by investing and financing activities.
The Partnership equity of $48,076 as of March 31, 2003 has been recorded as an adjustment to the balance of total stockholders’ deficit as of March 31, 2003.
The Partnership is not subject to state or Federal income taxes as those amounts are included in the tax returns of the partners. As a result, the restatement has had no effect on income tax expense.
CMHC SYSTEMS, INC.
Notes to Consolidated Financial Statements
March 31, 2005 and 2004
| (4) | Property and Equipment |
Property and equipment at March 31, 2005 and 2004 are summarized as follows:
| | | 2005 | | 2004 | |
| Building, parking lot, and building improvements | | $ | 2,626,427 | | | 2,626,427 | |
| Computer equipment | | | 2,405,846 | | | 2,203,737 | |
| Furniture and fixtures | | | 1,058,802 | | | 1,057,484 | |
| Software | | | 164,926 | | | 45,161 | |
| Total | | | 6,256,001 | | | 5,932,809 | |
| Less accumulated depreciation and amortization | | | (3,766,606 | ) | | (3,498,543 | ) |
| Property and equipment, net | | $ | 2,489,395 | | | 2,434,266 | |
Included in fixed assets is $37,180 of equipment recorded under capital lease agreements at March 31, 2005 and 2004. Accumulated amortization related to this equipment was approximately $12,394 and $0 as of March 31, 2005 and 2004, respectively.
In November 2001, the Company obtained a line of credit from Silicon Valley Bank. The line of credit was renewed effective April 29, 2005, until April 30, 2006. The line of credit has a credit limit of $1,750,000 or 80% of the amount of the Company’s eligible receivables, plus $500,000 whichever is lower. The line of credit is secured by the Company’s inventory, receivables, equipment and general intangibles, and all of the Company’s deposit accounts. The Company is required to maintain its primary banking relationship with Silicon Valley Bank. The line bears an interest rate of 8% or prime plus 3%, whichever is greater. The Agreement requires a monthly minimum interest amount of $1,000 per month along with a collateral monitoring fee of $700 per month. The company believes it is in compliance with the minimum tangible net worth and minimum net income (loss) financial covenants as of March 31, 2005. In the event of noncompliance with the financial covenants, Silicon Valley Bank has the right to cease making loans under the line of credit, immediately request payment of all outstanding loans and take possession of the collateral for the loans. As of March 31, 2005 and 2004, the Company had no borrowings outstanding and approximately $1.7 million available as of March 31, 2005.
CMHC SYSTEMS, INC.
Notes to Consolidated Financial Statements
March 31, 2005 and 2004
The approximate aggregate maturities of long-term debt for each of the five years subsequent to March 31, 2005 are as follows: 2006, $94,716; 2007, $99,203; 2008, $75,783; 2009, $371,142; 2010, $51,935; and thereafter, $1,339,831. During 2005, the Partnership refinanced all of the existing debt on the land and building occupied by CMHC Systems. A twenty year mortgage was obtained in the amount of $1,600,000 and a second mortgage was obtained with a five year term for $430,000. The interest rate on the first mortgage is 4.875%, subject to adjustment as defined, and the second mortgage is the Prime Rate plus 3.00%.
In connection with the subordinated loan, in 1998 the Company issued warrants to purchase a total of 58,750 shares of common stock at a purchase price of $0.001 per share. The warrants, which were immediately exercisable, expired on May 31, 2004. The Company determined the value of the warrants to be $528,000 at the date of grant using the Black-Scholes valuation model. The $528,000 was recorded as a debt discount and was amortized as interest expense through the original maturity date of April 28, 2004.
The warrants have a put feature whereby the holders of the warrants can require the Company to repurchase the warrants at fair market value. The put feature was exercisable until May 31, 2004. As a result of the loan amendment in April 2004, the subordinate lender and the Company agreed to extend the put and the expiration of the warrants until November 30, 2004. The warrants were exercised on November 18, 2004 at the exercise price of $.01 per share.
The Company has several operating leases for office space and equipment, and capital leases for fixed assets. The Company leases office space from the Partnership whose general partner is the Chairman of the Board of Directors and majority stockholder of the Company. The lease was renewed during fiscal year 2003 for two consecutive five year periods expiring on December 31, 2013. The lease calls for monthly rentals of $31,431. These monthly rentals are adjusted annually to accommodate adjustments for both inflation and mortgage amortization of the Partnership. Rentals for the renewal periods are mutually agreed-upon between the Partnership and the Company. The Company is responsible for all real estate taxes on the facility during the term of the lease. The Company is a guarantor of the second mortgage of this affiliated partnership for $430,000. These intercompany transactions have been eliminated in consolidation.
CMHC SYSTEMS, INC.
Notes to Consolidated Financial Statements
March 31, 2005 and 2004
The Company has certain other operating leases for office equipment and other office space. Future minimum lease payments under non-cancelable operating leases (with initial or remaining lease terms in excess of one year) and future minimum capital lease payments as of March 31, 2005 are:
| | | Capital lease | | Operating leases | |
| Year ending March 31: | | | | | | | |
| 2006 | | $ | 14,689 | | | 362,311 | |
| 2007 | | | 13,464 | | | 147,460 | |
| 2008 | | | — | | | 27,082 | |
| 2009 | | | — | | | 12,720 | |
| 2010 | | | — | | | 9,540 | |
| Total minimum lease payments | | | 28,153 | | $ | 559,113 | |
| Less amount representing interest | | | 2,970 | | | | |
| Present value of minimum lease payments | | | 25,183 | | | | |
| Less current installments of obligations under capital lease | | | 12,866 | | | | |
Obligations under capital lease, excluding current installments | | $ | 12,317 | | | | |
Total rent expense was $399,281 and $406,193 for 2005 and 2004, respectively.
Income tax expense (benefit) consists of:
| | | 2005 | |
| | | Current | | Deferred | | Total | |
| Federal | | $ | 30,792 | | | (280,453 | ) | | (249,661 | ) |
| State and local | | | 41,439 | | | (46,688 | ) | | (5,249 | ) |
| Total income tax | | $ | 72,231 | | | (327,141 | ) | | (254,910 | ) |
| | | 2004 | |
| | | Current | | Deferred | | Total | |
| Federal | | $ | — | | | 104,101 | | | 104,101 | |
| State and local | | | 73,910 | | | 22,964 | | | 96,874 | |
| Total income tax | | $ | 73,910 | | | 127,065 | | | 200,975 | |
CMHC SYSTEMS, INC.
Notes to Consolidated Financial Statements
March 31, 2005 and 2004
In 2005 and 2004, the income tax expense from continuing operations varies from the statutory rate due primarily to state and local income taxes, the change in the valuation allowance and, non-deductible amortization.
The tax effects of temporary differences that give rise to the deferred tax assets and liabilities for the years ended March 31, 2005 and 2004 are:
| | | 2005 | | 2004 | |
| Deferred tax assets: | | | | | | | |
| Allowance for doubtful receivables | | $ | 43,205 | | | 43,751 | |
| Accrued compensation | | | 246,707 | | | 251,539 | |
| Property and equipment and purchased software | | | 131,018 | | | 167,523 | |
| Deferred revenue | | | 105,844 | | | — | |
| Other | | | 31,118 | | | — | |
| Net operating loss carryforwards | | | 1,855,988 | | | 1,468,496 | |
| | | | 2,413,880 | | | 1,931,309 | |
| Less valuation allowance | | | (848,475 | ) | | (675,958 | ) |
| | | | 1,565,405 | | | 1,255,351 | |
| Deferred tax liabilities: | | | | | | | |
| Capitalized software development costs | | | 118,212 | | | 135,299 | |
| Net deferred tax assets | | $ | 1,447,193 | | | 1,120,052 | |
The Company has remaining net operating loss carryforwards totaling approximately $4,400,000 as of March 31, 2005, which expire in 2017 through 2024. Changes in the Company’s ownership may cause annual limitations on the amount of loss carryforwards that can be utilized to offset income in the future.
As of March 31, 2005, the Company had recorded a valuation allowance against a portion of its net deferred tax assets. The Company believes that the probability of generating sufficient taxable income in future years to realize the deferred tax assets is uncertain for a portion of the net operating loss carryforward. As a result, in 2005, the Company recorded an income tax expense in the amount of $172,517 from the increase in the valuation allowance.
The Company has a defined contribution profit sharing and salary deferral plan under Section 401(k) of the Internal Revenue Code. Under this plan, eligible employees may elect to defer a portion of their salary until retirement by making periodic contributions to a nontaxable trust. The Company contributes a matching contribution of up to 6% of qualified deferred salaries (as defined) and an annual contribution determined each year by the board of directors. The Company’s aggregate contributions were $269,497 and $251,288 for the years ended March 31, 2005 and 2004, respectively.
CMHC SYSTEMS, INC.
Notes to Consolidated Financial Statements
March 31, 2005 and 2004
| (10) | Redeemable Preferred Stock |
The Company has authorized 1,150,000 shares of common stock and 15,000 shares of preferred stock.
During the year ended March 31, 2000, the Company entered into an agreement to sell shares of Convertible Redeemable Preferred Stock (preferred stock) to an unrelated investor for an amount up to $2,500,000. An initial sale occurred in April 1999, representing 5,917 shares for a total purchase price of $1,000,000. The investor did not exercise the option to purchase additional shares.
The shares of preferred stock could be converted into shares of common stock on a 1:10 ratio either upon a qualified initial public offering (as defined in the agreement) by the Company or upon the seventh anniversary of the most recent purchase of preferred shares by the investor. If no public offering had occurred by the fifth anniversary of the initial sale of preferred stock, the investor could require the Company to re-purchase the preferred stock between the fifth and seventh anniversary. Dividends accrued on the preferred stock at a rate of 7% per annum beginning in the fiscal year ended March 31, 2001. Any dividends not paid were cumulative and compounded at 7% per year. As of March 31, 2004, the Company had cumulative unpaid dividends of $316,750 ($53.53 per share). The holder of the preferred stock exercised the put on January 29, 2005. The redemption price including dividends and interest was $1,392,253. The company paid $700,000 of the redemption balance in cash, with the remaining $692,253 converted into a promissory note bearing a 14% interest rate due on April 29, 2005.
During the fiscal year ended March 31, 1999, the Company adopted a stock option plan under which a committee of the board of directors may grant to employees, directors and consultants incentive stock options and nonqualified stock options with or without appreciation rights, restricted stock (as defined in the plan) and performance awards. The options may be exercised at such times as determined by the committee and expire ten years from the date of the grant (five years in the case of a participant who is a 10% stockholder). The options vest 33 1/3% after one year, 66 2/3% after two years and 100% after 3 years. The committee has sole discretion to determine the employees to whom shares of restricted stock and performance awards shall be granted along with all related terms and conditions of the grants or awards.
The Company made available 124,610 shares of common stock for issuance under this plan.
During the fiscal year ended March 31, 2003, the Company amended the Buy-Sell agreement for Directors, of which two were also common stockholders, to include a put option, exercisable upon the occurrence of certain events. This put option requires variable accounting for the Directors’ stock options. During fiscal year 2003, 800 options were granted to four Directors at a fair market value of $5.00. The Company will recognize compensation cost for the increases and decreases in the intrinsic value of the shares until the final measurement date. On March 31, 2005, the intrinsic value of the options increased from $5 to $17 per share, generating additional non-cash compensation expense of $9,600.
