| Nature of Business and Summary of Significant Accounting Policies | NOTE 1. NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT
ACCOUNTING POLICIES Nature of Business: Digital Ally, Inc.
and subsidiaries (collectively, “Digital Ally,” “Digital,” the “Company,” “we,”
“ours” and “us”) produces digital video imaging and storage products for use in law enforcement, security
and commercial applications. Its current products are an in-car digital video/audio recorder contained in a rear-view mirror for
use in law enforcement and commercial fleets, a system that provides our law enforcement customers with audio/video surveillance
from multiple vantage points and hands-free automatic activation of body-worn cameras and in-car video systems; a miniature digital
video system designed to be worn on an individual’s body; and cloud storage solutions including cloud-based fleet management
and driver monitoring/training applications. The Company has active research and development programs to adapt our technologies
to other applications. It can integrate electronic, radio, computer, mechanical, and multi-media technologies to create unique
solutions to address needs in a variety of other industries and markets, including mass transit, school bus, taxi cab and the military.
The Company sells its products to law enforcement agencies and other security organizations, and consumer and commercial fleet
operators through direct sales domestically and third-party distributors internationally. The Company has several new and derivative
products in research and development that it anticipates will begin commercial production during 2018. The Company was
originally incorporated in Nevada on December 13, 2000 as Vegas Petra, Inc. and had no operations until 2004. On November 30, 2004,
Vegas Petra, Inc. entered into a Plan of Merger with Digital Ally, Inc., at which time the merged entity was renamed Digital Ally,
Inc. Accounting
Changes: Except for the
changes discussed below, the Company has consistently applied the accounting policies to all periods presented in these unaudited
consolidated financial statements. Effective January1,
2018 the Company adopted FASB ASC Topic 606, Revenue from Contracts with Customers Revenue
Recognition
Amounts without the
As Reported Adjustments Adoption of ASC 606
Revenue 2,472 — 2,472
Operating Expenses 4,445 7 4,438
Operating Profit (Loss) (1,973 ) (7 ) (1,966 ) The impact of the
adoption of ASC 606 on net (loss) for the Company was not material and the impact of the adoption of ASC 606 on the unaudited consolidated
financial statements at March 31, 2018 and the unaudited consolidated statements of operations, equity/(deficit) and cash flows
for the three months ended March 31, 2018 was not material. Upon adoption of
ASC 606, the Company changed our accounting policy for the capitalization of costs to obtain contracts. Prior to the adoption of
ASC 606, all commissions paid to the salesforce was recognized as commission expense including any commissions earned for future
revenues. Under ASC 606, the Company is required to capitalize commissions paid to the salesforce for future revenues and recognize
as commission expense as the respective revenues are earned. This change was the principal adjustment to the Company’s reported
revenue and operating expenses included in the above table. Management’s Liquidity
Plan The Company incurred
substantial operating losses in the three months ended March 31, 2018 and for the year ended December 31, 2017 primarily due to
reduced revenues and gross margins caused by specific product quality issues resulting in significant delays in customer orders
and product rework expenditures and introduction by competitors of newer products with more features than those of the Company.
In addition, the Company’s revenues and gross margins have been significantly and negatively impacted by its competitors’
willful infringement of the Company’s patents, specifically the auto-activation of body-worn and in-car video systems, and
its competitors’ significant price cutting of their products. The Company has incurred net losses of approximately $2.6 million
during the three months ended March 31, 2018 and $12.3 million in the year ended December 31, 2017 and it had an accumulated deficit
of $64.4 million as of March 31, 2018. In recent years the Company has accessed the public and private capital markets to raise
funding through the issuance of debt and equity. In that regard, the Company raised funding in the form of subordinated and secured
debt totaling $1,608,500 and the issuance of common stock and warrants totaling $2,776,332 during the year ended December 31, 2017.
During 2016, the Company raised $4.0 million of funding in the form of convertible debentures and common stock purchase warrants.
These debt and equity raises were utilized to fund its operations and management expects to continue this pattern until it achieves
positive cash flows from operations, although it can offer no assurance in this regard. The Company had
outstanding $1,008,500 principal amount of subordinated and secured notes payable which were to mature prior to or on March 31,
2018. Additionally, the $3,250,000 million principal amount of 8% Secured Convertible Debentures (the “Debentures”)
matured on March 30, 2018. The notes and Debentures represent current liabilities as of March 31, 2018 and required the Company
to negotiate extensions and/or raise substantial funds through the issuance of new debt and/or equity to liquidate such notes and
Debentures. As part of the Company’s overall strategic alternatives process which commenced in November 2017, the Board of
Directors approved a private placement (the “Private Placement”) of $6.05 million principal amount of 8% Senior Secured
Convertible Notes (the “Notes”) and 806,667 warrants (the “Warrants”) exercisable to purchase 806,667 shares
of common stock of the Company. This Private Placement closed on April 3, 2018 and is described in Subsequent Events Footnote 14.
A portion of the proceeds were used to repay in full the Debentures and approximately $1,008,500 principal amount and accrued interest
on the subordinated and secured notes that were due to mature. The balance of the net proceeds will be used for working capital
and general corporate purposes. The Company believes that this financing has addressed its near-term liquidity needs. The Company is
also negotiating with the Web.com golf tournament officials to terminate its sponsorship fee commitment of $500,000 annually for
2018 and 2019 tournaments. There can be no assurance that it will be successful in negotiating the termination of this sponsorship
agreement or that if successful in such negotiation on terms acceptable or favorable to the Company. The Company will
have to restore positive operating cash flows and profitability over the next twelve months and/or raise additional capital to
fund its operational plans, meet its customary payment obligations and otherwise execute its business plan. There can be no assurance
that it will be successful in restoring positive cash flows and profitability, or that it can raise additional financing if and
when needed, and obtain it on terms acceptable or favorable to the Company. The Company has
implemented an enhanced quality control program to detect and correct product issues before they result in significant rework expenditures
affecting the Company’s gross margins and has seen progress in that regard. In addition, the Company has undertaken a number
of cost reduction initiatives, including a reduction of its workforce by approximately 40%, restructuring its direct sales force
and cutting other selling, general and administrative costs. In 2017 the Company introduced a new full high definition in-car video
system (DVM-800 HD), which is intended to help it regain market share and improve revenues in its law enforcement division. In
late 2017 the Company entered into a three-year supply and distribution agreement with a competitor (“VieVu”) that
includes minimum purchase requirements of $2.5 million in 2018 and $3.0 million in 2019 to maintain its exclusive status. The Company
has increased its addressable market to non-law enforcement customers and obtained new non-law enforcement contracts in 2017 and
early 2018, which contracts include recurring revenue over the 2018 to 2020 period. The Company believes that its quality control,
headcount reduction and cost cutting initiatives, introduction of the DVM-800 HD for law enforcement and expansion to non-law enforcement
sales channels will restore positive operating cash flows and profitability during the next year, although it can offer no assurances
in this regard. In addition to
the initiatives described above, the Board of Directors is conducting a review of a full range of strategic alternatives to best
position the Company for the future including, but not limited to, monetizing its patent portfolio and related patent infringement
litigation against Axon Enterprise, Inc. (“Axon” formerly Taser International, Inc.) and Enforcement Video, LLC d/b/a
WatchGuard Video (“WatchGuard”), the sale of all or certain assets, properties or groups of properties or individual
businesses or merger or combination with another company. The result of this review may also include the continued implementation
of the Company’s business plan. The Company has retained Roth Capital Partners (“Roth”) to assist in this process.
The Private Placement completed on April 3, 2018 was a part of this strategic alternatives review. While the Private Placement
addressed the Company’s near-term liquidity needs, it continues to consider strategic alternatives to address longer-term
liquidity needs and operational issues. There can be no assurance that any additional transactions or financings will result from
this process. Based on the uncertainties
described above, the Company believes its business plan does not alleviate the existence of substantial doubt about its ability
to continue as a going concern within one year after the date of the consolidated condensed financial statements in this Report. The following is a summary of the Company’s Significant
Accounting Policies: Basis of Consolidation: The accompanying
financial statements include the consolidated accounts of Digital Ally and its wholly-owned subsidiaries, Digital Ally International,
Inc., MP Ally, LLC, Medical Devices Ally, LLC and Digitaldeck, LLC. All intercompany balances and transactions have been eliminated
during consolidation. The Company formed
Digital Ally International, Inc. during August 2009 to facilitate the export sales of its products. In addition, it formed Medical
Devices Ally, LLC in July 2014, MP Ally, LLC in July 2015, and Digitaldeck, LLC in June 2017, all of which have been inactive since
formation. Fair Value of Financial Instruments: The carrying amounts
of financial instruments, including cash and cash equivalents, accounts receivable, accounts payable and subordinated notes payable
approximate fair value because of the short-term nature of these items. The Company accounts for its derivative liabilities and
its secured convertible debentures on a fair value basis. Revenue Recognition: The Company applies
the provisions of Accounting Standards Codification (ASC) 606-10, Revenue from Contracts with Customers The Company considers
customer purchase orders, which in some cases are governed by master sales agreements, to be the contracts with the customer. In
situation where sales are to a distributor, the Company had concluded its contracts are with the distributor as the Company holds
a contract bearing enforceable rights and obligations only with the distributor. As part of part of its consideration for the contract,
the Company evaluates certain factors including the customers’ ability to pay (or credit risk). For each contract, the Company
considers the promise to transfer products, each of which is distinct, to be the identified performance obligations. In determining
the transaction price the Company evaluates whether the price is subject to refund or adjustment to determine the net consideration
to which the Company expects to be entitled. As the Company’s standard payment terms are less than one year, the Company
has elected the practical expedient under ASC 606-10-32-18 to not assess whether a contract has a significant financing component.
The Company allocates the transaction price to each distinct product based on their relative standalone selling price. The product
price as specified on the purchase order is considered the standalone selling price as it is an observable input which depicts
the price as if sold to a similar customer in similar circumstances. Revenue is recognized when control of the product is transferred
to the customer (i.e. when the Company’s performance obligations is satisfied), which typically occurs at shipment. Further
in determining whether control has been transferred, the Company considers if there is a present right to payment and legal title,
along with risks and rewards of ownership having transferred to the customer. Customers do not have a right to return the product
other than for warranty reasons for which they would only receive repair services or replacement product. The Company has also
elected the practical expedient under ASC 340-40-25-4 to expense commissions when incurred as the amortization period of the commission
asset the Company would have otherwise recognized is less than one year. The Company sells
its products and services to law enforcement and commercial customers in the following manner:
● Sales to domestic customers are made direct to the end customer (typically a law enforcement agency or a commercial customer) through its sales force, which is composed of its employees. Revenue is recorded when the product is shipped to the end customer.
● Sales to international customers are made through independent distributors who purchase products from the Company at a wholesale price and sell to the end user (typically law enforcement agencies or a commercial customer) at a retail price. The distributor retains the margin as its compensation for its role in the transaction. The distributor generally maintains product inventory, customer receivables and all related risks and rewards of ownership. Accordingly, upon application of steps one through five above, revenue is recorded when the product is shipped to the distributor consistent with the terms of the distribution agreement.
● Repair parts and services for domestic and international customers are generally handled by its inside customer service employees. Revenue is recognized upon shipment of the repair parts and acceptance of the service or materials by the end customer. Sales taxes collected
on products sold are excluded from revenues and are reported as an accrued expense in the accompanying balance sheets until payments
are remitted. Service and other
revenue is comprised of revenues from extended warranties, repair services, cloud revenue and software revenue. Revenue is recognized
upon shipment of the product and acceptance of the service or materials by the end customer for repair services. Revenue for extended
warranty, cloud service or other software-based products is over the term of the contract warranty or service period. A time-elapsed
method is used to measure progress because the Company transfers control evenly over the contractual period. Accordingly, the fixed
consideration related to these revenues is generally recognized on a straight-line basis over the contract term, as long as the
other revenue recognition criteria have been met. Contracts with
some of the Company’s customers contain multiple performance obligations that are distinct and accounted for separately.
The transaction price is allocated to the separate performance obligations on a relative standalone selling price (“SSP”).
The Company determined SSP for all of the performance obligations using observable inputs, such as standalone sales and historical
pricing. SSP is consistent with the Company’s overall pricing objectives, taking into consideration the type of service being
provided. SSP also reflects the amount the Company would charge for the performance obligation if it were sold separately in a
standalone sale. Multiple performance obligations consist of product, software, cloud subscriptions and extended warranties. The Company’s
multiple performance obligations may include future in-car or body-worn camera devices to be delivered at defined points within
a multi-year contract, and in those arrangements, the Company allocates total arrangement consideration over the life of the multi-year
contract to future deliverables using management’s best estimate of selling price. Contract liabilities
consist of deferred revenue and include payments received in advance of performance under the contract. Such amounts are generally
recognized as revenue over the contractual period. Sales returns and
allowances aggregated $20,019 and $(41,321) for the three months ended March 31, 2018 and 2017, respectively. Obligations for estimated
sales returns and allowances are recognized at the time of sales on an accrual basis. The accrual is determined based upon historical
return rates adjusted for known changes in key variables affecting these return rates. A customer paid under a sales transaction
in March 2017 that had been accrued to be returned at December 31, 2016, which the caused the negative sales returns for the three
months ended March 31, 2017. Revenues for first quarter 2018 and
first quarter 2017 were derived from the following sources:
Three months ended March 31,
2018 2017
DVM-800 $ 1,082,146 $ 2,403,364
DVM-250 Plus 180,306 714,916
FirstVu HD 266,364 681,089
DVM-100 & DVM-400 48,043 110,811
DVM-750 63,970 106,740
VuLink 39,636 88,856
Repair and service 299,952 382,677
Cloud service revenue 145,322 49,548
Other service revenue 35,127 112,980
Laser Ally 15,050 17,150
Accessories and other revenues 295,597 561,729
$ 2,471,513 $ 5,229,860 Use of Estimates: The preparation of
the consolidated 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 amount of revenues and expenses during
the reporting period. Actual results could differ from those estimates. Cash and cash equivalents: Cash and cash equivalents
include funds on hand, in bank and short-term investments with original maturities of ninety (90) days or less. Cash and cash equivalents
that are restricted as to withdrawal or use under the terms of the secured convertible debentures are presented as restricted cash
separate from cash and cash equivalents on the accompanying balance sheet. Accounts Receivable: Accounts receivable
are carried at original invoice amount less an estimate made for doubtful receivables based on a review of all outstanding amounts
on a weekly basis. The Company determines the allowance for doubtful accounts by regularly evaluating individual customer receivables
and considering a customer’s financial condition, credit history, and current economic conditions. Trade receivables are
written off when deemed uncollectible. Recoveries of trade receivables previously written off are recorded when received. A trade receivable
is considered to be past due if any portion of the receivable balance is outstanding for more than thirty (30) days beyond terms.
No interest is charged on overdue trade receivables. Inventories: Inventories consist
of electronic parts, circuitry boards, camera parts and ancillary parts (collectively, “components”), work-in-process
and finished goods, and are carried at the lower of cost (First-in, First-out Method) or market value. The Company determines the
estimate for the reserve for slow moving or obsolete inventories by regularly evaluating individual inventory levels, projected
sales and current economic conditions. Furniture, fixtures and equipment: Furniture, fixtures
and equipment is stated at cost net of accumulated depreciation. Additions and improvements are capitalized while ordinary maintenance
and repair expenditures are charged to expense as incurred. Depreciation is recorded by the straight-line method over the estimated
useful life of the asset, which ranges from three to ten years. Amortization expense on capitalized leases is included with depreciation
expense. Intangible assets: Intangible assets
include deferred patent costs and license agreements. Legal expenses incurred in preparation of patent application have been deferred
and will be amortized over the useful life of granted patents. Costs incurred in preparation of applications that are not granted
will be charged to expense at that time. The Company has entered into several sublicense agreements under which it has been assigned
the exclusive rights to certain licensed materials used in its products. These sublicense agreements generally require upfront
payments to obtain the exclusive rights to such material. The Company capitalizes the upfront payments as intangible assets and
amortizes such costs over their estimated useful life on a straight-line method. Secured convertible debentures: The Company has
elected to record its Debentures at their fair value. Accordingly, the Debentures will be marked-to-market at each reporting date
with the change in fair value reported as a gain (loss) in the Condensed Consolidated Statement of Operations. All issuance costs
related to the Debentures were expensed as incurred in the statement of operations. Long-Lived Assets: Long-lived assets
such as property, plant and equipment and purchased intangible assets subject to amortization are reviewed for impairment whenever
events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. If circumstances require
a long-lived asset or asset group be tested for possible impairment, the Company first compares undiscounted cash flows expected
to be generated by that asset or asset group to its carrying value. If the carrying value of the long-lived asset or asset group
is not recoverable on an undiscounted cash flow basis, an impairment is recognized to the extent that the carrying value exceeds
its fair value. Fair value is determined through various valuation techniques, including discounted cash flow models, quoted market
values and third-party appraisals, as considered necessary. Warranties: The Company’s
products carry explicit product warranties that extend up to two years from the date of shipment. The Company records a provision
for estimated warranty costs based upon historical warranty loss experience and periodically adjusts these provisions to reflect
actual experience. Accrued warranty costs are included in accrued expenses. Extended warranties are offered on selected products
and when a customer purchases an extended warranty the associated proceeds are treated as deferred revenue and recognized over
the term of the extended warranty. Shipping and Handling Costs: Shipping and handling
costs for outbound sales orders totaled $13,967 and $20,430 for the three months ended March 31, 2018 and 2017, respectively. Such
costs are included in selling, general and administrative expenses in the Condensed Consolidated Statements of Operations. Advertising Costs: Advertising expense
includes costs related to trade shows and conventions, promotional material and supplies, and media costs. Advertising costs are
expensed in the period in which they are incurred. The Company incurred total advertising expense of approximately $79,569 and
$127,276 for the three months ended March 31, 2018 and 2017, respectively. Such costs are included in selling, general and administrative
expenses in the Condensed Consolidated Statements of Operations. Income Taxes: Deferred taxes
are provided for by the liability method in which deferred tax assets are recognized for deductible temporary differences and operating
loss and tax credit carryforwards and deferred tax liabilities are recognized for taxable temporary differences. Temporary differences
are the differences between the reported amounts of assets and liabilities and their tax basis. Deferred tax assets are reduced
by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all the deferred tax
assets will not be realized. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates
on the date of enactment. The Company applies
the provisions of the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”)
No. 740 - Income Taxes that provides a framework for accounting for uncertainty in income taxes and provided a comprehensive model
to recognize, measure, present, and disclose in its financial statements uncertain tax positions taken or expected to be taken
on a tax return. It initially recognizes tax positions in the financial statements when it is more likely than not the position
will be sustained upon examination by the tax authorities. Such tax positions are initially and subsequently measured as the largest
amount of tax benefit that is greater than 50% likely of being realized upon ultimate settlement with the tax authority assuming
full knowledge of the position and all relevant facts. Application requires numerous estimates based on available information.
The Company considers many factors when evaluating and estimating its tax positions and tax benefits, and it recognized tax positions
and tax benefits may not accurately anticipate actual outcomes. As it obtains additional information, the Company may need to periodically
adjust its recognized tax positions and tax benefits. These periodic adjustments may have a material impact on its Consolidated
Statements of Operations. The Company’s
policy is to record estimated interest and penalties related to the underpayment of income taxes as income tax expense in the consolidated
statements of operations. There was no interest expense related to the underpayment of estimated taxes during the three months
ended March 31, 2018 and 2017. There have been no penalties in the three months ended March 31, 2018 and 2017. The Company is
subject to taxation in the United States and various states. As of March 31, 2018, the Company’s tax returns filed for 2014,
2015, and 2016 and to be filed for 2017 are subject to examination by the relevant taxing authorities. With few exceptions, as
of March 31, 2018, the Company is no longer subject to Federal, state, or local examinations by tax authorities for years before
2014. Research and Development Expenses: The
Company expenses all research and development costs as incurred. Development costs of computer software to be sold, leased, or
otherwise marketed are subject to capitalization beginning when a product’s technological feasibility has been established
and ending when a product is available for general release to customers. In most instances, the Company’s products are released
soon after technological feasibility has been established. Costs incurred subsequent to achievement of technological feasibility
were not significant, and software development costs were expensed as incurred during the three months ended March 31, 2018 and
2017. Common Stock Purchase Warrants: The
Company has common stock purchase warrants that are accounted for as liabilities under the caption of derivative liabilities on
the consolidated balance sheet and recorded at fair value due to the warrant agreements containing anti-dilution provisions. The
change in fair value is being recorded in the Condensed Consolidated Statement of Operations. The
Company has common stock purchase warrants that are accounted for as equity based on their relative fair value and are not subject
to re-measurement. Stock-Based Compensation: The Company grants
stock-based compensation to its employees, board of directors and certain third party contractors. Share-based compensation arrangements
may include the issuance of options to purchase common stock in the future or the issuance of restricted stock, which generally
are subject to vesting requirements. The Company records stock-based compensation expense for all stock-based compensation granted
based on the grant-date fair value. The Company recognizes these compensation costs on a straight-line basis over the requisite
service period of the award. The Company estimates
the grant-date fair value of stock-based compensation using the Black-Scholes valuation model. Assumptions used to estimate compensation
expense are determined as follows:
● Expected term is determined using the contractual term and vesting period of the award;
● Expected volatility of award grants made in the Company’s plan is measured using the weighted average of historical daily changes in the market price of the Company’s common stock over the period equal to the expected term of the award;
● Expected dividend rate is determined based on expected dividends to be declared;
● Risk-free interest rate is equivalent to the implied yield on zero-coupon U.S. Treasury bonds with a maturity equal to the expected term of the awards; and
● Forfeitures are accounted for as they occur. Segments of Business: Management has
determined that its operations are comprised of one reportable segment: the sale of digital audio and video recording and speed
detection devices. For the three months ended March 31, 2018 and 2017, sales by geographic area were as follows:
Three months ended March 31,
2018 2017
Sales by geographic area:
United States of America $ 2,438,788 $ 5,200,054
Foreign 32,725 29,806
$ 2,471,513 $ 5,229,860 Sales to customers
outside of the United States are denominated in U.S. dollars. All Company assets are physically located within the United States. Adoption of New Accounting Pronouncement: In August 2016,
the FASB issued ASU 2016-15, Clarification on Classification of Certain Cash Receipts and Cash Payments on the Statement of
Cash Flows In November 2016,
the FASB issued ASU 2016-18, Statement of Cash Flows - Restricted Cash (Topic 230), In May 2017, the
FASB issued ASU 2017-09, Stock Compensation (Topic 718)-Scope of Modification Accounting |
