| 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,” “Company,”) produces digital video imaging
and storage products for use in law enforcement, security and commercial applications. Its 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 its 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 its 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 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 January 1, 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 8,913 — 8,913
Operating Expenses 9,225 21 9,204
Operating Profit (Loss) (5,320 ) (21 ) (5,299 ) The impact of the adoption
of ASC 606 as of January 1, 2018 for the Company was not material and the impact of the adoption of ASC 606 on the unaudited consolidated
financial statements at September 30, 2018 and the unaudited consolidated statements of operations, equity (deficit) and cash flows
for the nine months ended September 30, 2018 was not material. Upon adoption of ASC 606,
the Company changed its 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 nine months ended September 30, 2018 primarily due to reduced revenues and gross margins caused by competitors’
willful infringement of its patents, specifically the auto-activation of body-worn and in-car video systems, and by competitors’
introduction of newer products with more features than those of the Company and significant price cutting of their products. The
Company incurred net losses of approximately $10.1 million during the nine months ended September 30, 2018 and $12.3 million in
the year ended December 31, 2017 and it had an accumulated deficit of $72.1 million as of September 30, 2018. In recent years and
including 2018, 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 debt, secured debt and proceeds investment agreements
totaling $16,500,000, and net proceeds of $7,324,900 from an underwritten public offering of common stock during the nine months
ended September 30, 2018. The Company issued common stock and detachable common stock purchase warrants totaling $2,776,332 and
raised funding from subordinated and secured debt totaling $1,608,500 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 retired all
interest-bearing debt outstanding during the nine months ended September 30, 2018. The only long-term obligations outstanding as
of September 30, 2018 are associated with the proceeds investment agreement that the Company entered into during July 2018, as
more fully described in Note 6. The Company is also negotiating
with 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,
the termination will be 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 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. The
Company has increased its addressable market to non-law enforcement customers and obtained new non-law enforcement contracts in
the first nine months of 2018, which contracts include recurring revenue during the period 2018 to 2020. 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 capital raises/fundings
completed on April 3, 2018, August 21, 2018, and September 28, 2018, as discussed in Notes 6 and 13, were part of this strategic
alternatives review. While such funding 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 from the date of the issuance of these consolidated condensed interim financial
statements. 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.
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. 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, its
secured convertible debentures and proceeds investment agreement 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 it expects to be entitled. As the Company’s standard payment terms are less than one year, it 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 its 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 accrued expenses 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 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 $72,127 and $12,390 for the three months ended September 30, 2018 and 2017, respectively, and $126,373 and $(15,195)
for the nine months ended September 30, 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 then caused the negative sales returns for the nine months ended September 30,
2017. Revenues for the nine months ended September
30, 2018 and 2017 were derived from the following sources:
Nine months ended September 30,
2018 2017
DVM-800 $ 3,956,816 $ 5,597,673
DVM-250 Plus 617,705 1,188,283
FirstVu HD 1,070,245 1,379,625
DVM-100 & DVM-400 69,496 195,223
DVM-750 378,660 406,314
VuLink 146,896 210,398
Repair and service 1,093,141 1,176,144
Cloud service revenue 500,305 259,961
Laser Ally 79,155 35,793
Accessories and other revenues 1,000,703 1,250,525
$ 8,913,122 $ 11,699,939 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. Proceeds investment agreement: The Company has elected
to record its proceeds investment agreement at its fair value. Accordingly, the proceeds investment agreement 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 proceeds investment agreement 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 $12,378 and $11,858 for the three months ended September 30, 2018 and 2017, respectively,
and $46,662 and $51,949 for the nine months ended September 30, 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 $104,395 and $346,935
for the three months ended September 30, 2018 and 2017, respectively, and $295,641 and $617,264 for the nine months ended September
30, 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 nine months ended
September 30, 2018 and 2017. There have been no penalties in the nine months ended September 30, 2018 and 2017. The Company is subject
to taxation in the United States and various states. As of September 30, 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 September 30, 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 nine months ended September 30, 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 condensed 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 and nine months ended September 30, 2018 and 2017, sales by geographic area were as follows:
Three Months Ended September 30, Nine Months Ended September 30,
2018 2017 2018 2017
Sales by geographic area:
United States of America $ 2,787,618 $ 2,747,053 $ 8,612,552 $ 11,373,569
Foreign 90,441 236,524 300,570 326,370
$ 2,878,059 $ 2,983,577 $ 8,913,122 $ 11,699,939 Sales to customers outside of the United States
are denominated in U.S. dollars. All Company assets are physically located within the United States. New Accounting Pronouncement: In February 2016, the
FASB issued ASU 2016-2, Leases (Topic 842) Adoption of Accounting Pronouncements: 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 |
