| SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES | 2. SUMMARY
OF SIGNIFICANT ACCOUNTING POLICIES Basis
of Presentation The
Company’s condensed consolidated financial statements have been prepared in conformity with U.S. generally accepted accounting principles
(“GAAP”) as determined by the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification
(“ASC”). The Business Combination was
accounted for as a reverse recapitalization in accordance with GAAP. Legacy Spectral was determined as the accounting acquirer and the
Company as the acquired company for financial reporting purposes. Legacy
Spectral was determined to be the accounting acquiror based on evaluation of the following facts and circumstances:
(i) Legacy Spectral’s former shareholders have a majority of the voting
power of Spectral AI;
(ii) Legacy Spectral’s senior
management comprises all of the senior management of Spectral AI;
(iii) Legacy Spectral selected five
of the six directors for the Board of Directors of Spectral AI;
(iv) Legacy Spectral’s relative size of assets and operations compared
to Rosecliff; and
(v) Legacy Spectral’s operations
comprise the ongoing operations of Spectral AI. All
historical financial information presented in the unaudited condensed consolidated financial statements represents the accounts of Legacy
Spectral at their historical values as if Legacy Spectral is the predecessor to the Company. The unaudited condensed consolidated financial
statements following the Closing reflect the results of the combined entity’s operations. All
issued and outstanding shares of Legacy Spectral Common Stock and warrants, stock options, restricted stock units (“RSUs”)
and restricted stock awards (“RSAs”) of Legacy Spectral and the per share amounts contained in the unaudited condensed consolidated
financial statements for the periods presented prior to the Closing have been retroactively restated to reflect the Exchange Ratio (as
defined in Note 3). Unaudited
Interim Condensed Financial Statements The
accompanying condensed consolidated balance sheet as of September 30, 2023, the condensed consolidated statements of operations and stockholders’
equity for the three and nine months ended September 30, 2023 and 2022, and the condensed consolidated statements of cash flows for the
nine months ended September 30, 2023 and 2022 are unaudited. The interim condensed consolidated financial statements have been prepared
on the same basis as the audited annual consolidated financial statements and, in management’s opinion, include all adjustments
consisting of normal recurring adjustments necessary for the fair statement of the Company’s financial position as of September
30, 2023 and its results of operations and cash flows for the three and nine months ended September 30, 2023 and 2022. The results of
operations for the three and nine months ended September 30, 2023 and 2022 are not necessarily indicative of the results to be expected
for the full fiscal year or any other period. These interim condensed consolidated
financial statements should be read in conjunction with Legacy Spectral’s annual consolidated financial statements for the year
ended December 31, 2022 included in the Company’s Form S-4/A filed with the Securities and Exchange Commission (“SEC”)
on August 11, 2023. Principles
of Consolidation The
condensed consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries, Spectral MD Holdings
LLC, Spectral MD Inc. and Spectral MD UK Ltd. (“Spectral MD UK”). Significant inter-company transactions and balances have
been eliminated in consolidation. Use of
Estimates The
preparation of these condensed consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions
that affect the amounts reported in the condensed consolidated financial statements and accompanying notes. The Company bases its estimates
and judgments on historical experience and on various other assumptions that it believes are reasonable under the circumstances. The amounts
of assets and liabilities reported in the Company’s balance sheets and the amounts of expenses reported for each of the periods
presented are affected by estimates and assumptions, which are used for, but not limited to, revenue recognition, warrant liabilities,
stock-based compensation expense, stock issued for transaction costs, the net realizable value of inventory, right-of-use assets and income
tax valuation allowances. Actual results could differ from these estimates. Cash The
Company considers all highly liquid investments with an original maturity of three months or less when purchased to be cash equivalents.
All cash is held in US financial institutions. Accounts
Receivable, Net and Unbilled Revenue Accounts
receivable represent amounts due from US government agencies pursuant to research and development contracts associated with the Company’s
DeepView® Wound Imaging System. The
Company evaluates the collectability of its receivables based on a variety of factors, including the length of time the receivables are
past due, the financial health of its customers and historical experience. Based upon the review of these factors, the Company recorded
no allowance for doubtful accounts as of September 30, 2023 and December 31, 2022. The
Company records unbilled revenue when revenue is recognized prior to billing customers. Concentrations
of Credit Risk Financial
instruments which potentially subject the Company to credit risk consist principally of cash and accounts receivable. Primarily all cash
is held in US financial institutions which, at times, exceed federally insured limits. The Company has not recognized any losses from
credit risks on such accounts. The Company believes it is not exposed to significant credit risk on cash. Additional
credit risk is related to the Company’s concentration of receivables. As of September 30, 2023 and December 31, 2022, receivables
were concentrated from one customer (which is a US. government agency) representing 87% and 96% of total net receivables, respectively. No allowance
for doubtful accounts were recorded as of September 30, 2023 and December 31, 2022. One
customer (which is a U.S. government agency) accounted for 89% and 94% for the three and nine months ended September 30, 2023,
respectively, and 98% for each of the three and nine months ended September 30, 2022 of the recognized research and development revenue. Inventory Inventory
is comprised of finished goods, purchased from a third-party manufacturer, and is stated at the lower of cost (average cost) or net realizable
value. For the three and nine months ended September 30, 2023, the Company did not have write-downs for obsolete inventory. Fair
Value Fair
value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal
or most advantageous market for the asset or liability in an orderly transaction between market participants at the measurement date.
Assets and liabilities that are measured at fair value are reported using a three-level fair value hierarchy that prioritizes the inputs
used to measure fair value. This hierarchy maximizes the use of observable inputs and minimizes the use of unobservable inputs. The three
levels of inputs used to measure fair value are as follows:
Level 1 - Unadjusted quoted prices in active markets that are assessable at the measurement date for identical, unrestricted assets or liabilities.
Level 2 - Quoted prices in markets that are not active, or inputs that are observable, either directly or indirectly, for substantially the full term of the asset or liability; and
Level 3 - Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (supported by little or no market activity). Foreign
Currency The
reporting currency for the condensed consolidated financial statements of the Company is the US dollar. The functional currency of the
Company and its wholly owned subsidiaries Spectral MD Holdings LLC and Spectral MD, Inc. is the US dollar. The functional currency of
Spectral MD UK is its local currency, the British pound. The assets and liabilities of Spectral MD UK are translated into US. dollars
at exchange rates in effect at the end of each reporting period, and the revenues and expenses are translated at average exchange rates
in effect during the applicable period. Translation adjustments are included in accumulated other comprehensive income as a component
of stockholders’ equity. As of September 30, 2023 and December 31, 2022, the Company’s translation adjustments are not material. Monetary
assets and liabilities denominated in currencies other than the functional currency are translated at exchange rates in effect at the
balance sheet date. Resulting unrealized gains and losses are included in other income (expense), net in the condensed consolidated statements
of operations. For the three and nine months ended September 30, 2023 the Company recorded approximately $24,000 and $11,000, respectively,
of net foreign exchange transaction losses. For the three and nine months ended September 30, 2022, the Company recorded approximately
$0.1 million and $0.3 million, respectively, of net foreign exchange transaction losses primarily related to the Company’s
bank account denominated in British Pounds and accounts payable denominated in British Pounds. Leases The
Company accounts for its leases under ASC 842, Leases. Under this guidance, arrangements meeting the definition of a lease are classified
as operating or financing leases. Operating leases are recorded in the condensed consolidated balance sheets as both a right-of-use asset
and a lease liability, calculated by discounting fixed lease payments at the rate implicit in the lease or the Company’s incremental
borrowing rate factoring the term of the lease. The incremental borrowing rate used by the Company is an estimate of the interest rate
the Company would incur to borrow an amount equal to the lease payments on a collateralized basis over the term of the lease. Because
the Company does not generally borrow on a collateralized basis, it uses the interest rate it pays on its noncollateralized borrowings
as an input to deriving an appropriate incremental borrowing rate, adjusted for the amount of lease payments, the lease term and the effect
on that rate of designating specific collateral with a value equal to the unpaid lease payments for that lease. Lease liabilities are
increased by interest and reduced by payments each period, and the right-of-use asset is amortized over the lease term. For operating
leases, interest on the lease liability and the amortization of the right-of-use asset results in straight-line rent expense over the
lease term. Variable lease expenses are recorded when incurred. In calculating the right-of-use assets and lease liabilities, the Company
has elected to combine lease and non-lease components. The Company excludes short-term leases having initial terms of 12 months or less
from the requirement to capitalize right-of-use assets and liabilities as an accounting policy election. During
the three and nine months ended September 30, 2023 and 2022, the Company did not have any financing leases. Warrant
Liabilities On
September 11, 2023, in conjunction with the Business Combination, the Company assumed the Public Warrants which have an exercise price
of $11.50 per share, are exercisable 30 days after the Business Combination and expire five years after the Business Combination or upon
redemption. The Company may redeem the Public Warrants if the Company’s common stock equals or exceeds $18.00 per share for 20 trading
days within a 30-trading day period ending on the third trading day prior to the date on which the Company sends the notice of redemption
to the holders of Public Warrants. As of September 30, 2023, there are 8,433,333 Public Warrants Outstanding. In
September 2021, Legacy Spectral issued 73,978 warrants, with a strike price of $7.60 and a five-year life, to SP Angel Corporate
Finance LLP (“SP Angel”), who acted as nominated adviser and broker to the Company for the purposes of the AIM Rules (“Angel
Warrants”). In conjunction with the Business Combination, the Angel Warrants were converted into warrants to purchase Company Common
Stock based on the Exchange Ratio. As of September 30, 2023, there are 73,978 warrants to purchase Company Common Stock outstanding. The
Company accounts for its Public Warrants and the Angel Warrants as derivative liabilities in accordance with ASC 815, Derivatives and
Hedging (“ASC 815”). Accordingly, the Company recognizes the instruments as liabilities at fair value, determined using the
closing price of the observable market quote in an active market (the NASDAQ) for the Public Warrants and the Black-Scholes option-pricing
model for the Angel Warrants, and adjusts the instruments to fair value at the end of each reporting period. The liabilities are subject
to re-measurement at each balance sheet date until exercised, redeemed or expired, and any change in fair value is recognized in the Company’s
condensed consolidated statements of operations within other income (expense). Research
and Development Revenue The
Company recognizes revenue when the Company’s customers obtain control of promised goods or services, in an amount that reflects
the consideration which the Company expects to receive in exchange for those goods or services by analyzing the following five steps:
(1) identify the contract with a customer(s); (2) identify the performance obligations in the contract; (3) determine the transaction
price; (4) allocate the transaction price to the performance obligations in the contract; and (5) recognize revenue when (or as) the Company
satisfies a performance obligation. The
Company generates research and development revenue, primarily from the contracts with BARDA and MTEC. Each contract for BARDA and MTEC
has a single performance obligation. The
contracts with BARDA are cost-plus-fee contracts associated with development of certain product candidates. Revenues from these reimbursable
contracts are recognized as costs are incurred, generally based on allowable costs incurred during the period, plus any recognizable earned
fee. The
MTEC Agreement provides for installment payments after the completion of milestone events. The installment payments are considered variable
consideration as the entitlement depends on successful completion of research, however, the payments are not constrained from inclusion
in the transaction price as it not probable that a significant reversal of cumulative revenue will be reversed when the underlying uncertainty
is resolved. Revenue for the MTEC Agreement is recognized over time based upon the cost-to-cost measure of progress, using this input
method to measure progress as the customer has the benefit of access to the development research under these projects and therefore benefits
from the Company’s performance incrementally as research and development activities occur under each project. The Company measures
progress of performance by comparing the actual costs incurred to-date to the total estimated cost of the project. The Company will adjust
the measure of progress at the end of each reporting period and reflect any changes to the estimated cost of the project on a prospective
basis. The
Company elected the practical expedient not to adjust the transaction price for the effects of a significant financing component as the
period between performance (satisfaction of a performance obligation) and payment is one year or less. Payments from customers are generally
received within 30 days of when the invoice is sent. The
Company records deferred revenue when the customers have been billed prior to recognizing revenue. Research
and Development Expense The
Company expenses research and development costs as incurred. These expenses include salaries for research and development personnel, consulting
fees, product development, pre-clinical studies, clinical trial costs, and other fees and costs related to the development of the technology.
For the three months ended September 30, 2023 and 2022, research and development expense was $3.6 million and $4.3 million,
respectively, of which $2.0 million and $3.8 million, respectively, is related to the BARDA and MTEC contracts and included
in cost of revenue and $1.6 million and $0.5 million, respectively, is included in general and administrative expenses. For
the nine months ended September 30, 2023 and 2022, research and development expense was $11.3 million and $12.2 million, respectively,
of which $7.3 million and $10.9 million, respectively, is related to the BARDA and MTEC contracts and included in cost of revenue
and $4.0 million and $1.3 million, respectively, is included in general and administrative expenses. Stock-Based
Compensation The
Company accounts for all stock-based payments to employees and non-employees, including grants of stock options, RSUs, RSAs and stock
options with non-market performance conditions (“PSOs”) based on their respective grant date fair values. The Company estimates
the fair value of stock option grants and PSOs using the Black-Scholes option pricing model. The RSUs and RSAs are valued based on the
fair value of the Company’s common stock on the date of grant. The assumptions used in calculating the fair value of the Company’s
stock and stock-based awards represent management’s best estimates and involve inherent uncertainties and the application of management’s
judgment. The Company expenses stock-based compensation related to stock options, RSUs and RSAs over the requisite service period. As
the PSOs have performance conditions, compensation expense is recognized for each award if and when the Company’s management deems
it probable that the performance conditions will be satisfied. Forfeitures are recorded as they occur. Compensation previously recorded
for unvested equity awards that are forfeited is reversed upon forfeiture. The Company expenses stock-based compensation to employees
over the requisite service period, on a straight-line basis, based on the estimated grant-date fair value of the awards. Income
Taxes Income
taxes are recorded in accordance with ASC 740, Income Taxes (“ASC 740”), which provides for deferred taxes using an asset
and liability approach. The Company recognizes deferred tax assets and liabilities for the expected future tax consequences of events
that have been included in the condensed consolidated financial statements or tax returns. Deferred tax assets and liabilities are determined
based on the difference between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect for
the year in which the differences are expected to reverse. Valuation allowances are provided, if based upon the weight of available evidence,
it is more likely than not that some or all of the deferred tax assets will not be realized. The
Company accounts for uncertain tax positions in accordance with the provisions of ASC 740. When uncertain tax positions exist, the Company
recognizes the tax benefit of tax positions to the extent that the benefit would more likely than not be realized assuming examination
by the taxing authority. The determination as to whether the tax benefit will more likely than not be realized is based upon the technical
merits of the tax position as well as consideration of the available facts and circumstances. The Company has no uncertain tax positions
as of September 30, 2023 and December 31, 2022 that qualify for either recognition or disclosure in the condensed consolidated financial
statements under this guidance. The
Company’s policy is to classify assessments, if any, for tax related interest as interest expense and penalties as general and
administrative expenses in the condensed consolidated statements of operations. The Company did not have any interest and penalties during
the three and nine months ended September 30, 2023 and 2022 and did not have any interest or penalties accrued as of September 30, 2023. Comprehensive
Loss Comprehensive
loss is equal to net loss as presented in the condensed consolidated statements of operations, as the Company did not have any material
other comprehensive income or loss for the periods presented. Net Loss
per Share of Common Stock Basic
net loss share of common stock is computed by dividing the net loss attributable to common stockholders by the weighted-average number
of shares of common stock outstanding during the period. Diluted net loss per share of common stock adjusts basic earnings per share for
the potentially dilutive impact of unvested restricted stock, stock options and warrants. Securities having an anti-dilutive effect on
diluted net earnings per share are excluded from the calculation. The dilutive effect of the unvested restricted stock and stock options
is calculated using the treasury stock method. For warrants that are liability-classified, during periods when the impact is dilutive,
the Company assumes share settlement of the instruments as of the beginning of the reporting period and adjusts the numerator to remove
the change in fair value of the warrant liability and adjusts the denominator to include the dilutive shares calculated using the treasury
stock method. Recently
Adopted Accounting Standards In
September 2016, the FASB issued Accounting Standards Update (“ASU”) No. 2016-13, Financial Instruments - Credit Losses, which
was subsequently amended by ASU 2018-19 and ASU 2019-10. This standard requires the measurement of expected credit losses for financial
instruments carried at amortized cost held at the reporting date based on historical experience, current conditions and reasonable forecasts.
The updated guidance also amends the current other-than-temporary impairment model for available-for-sale debt securities by requiring
the recognition of impairments relating to credit losses through an allowance account and limits the amount of credit loss to the difference
between a security’s amortized cost basis and its fair value. In addition, the length of time a security has been in an unrealized
loss position will no longer impact the determination of whether a credit loss exists. The main objective of this ASU is to provide financial
statement users with more decision-useful information about the expected credit losses on financial instruments and other commitments
to extend credit held by a reporting entity at each reporting date. The Company adopted this standard on January 1, 2023, with no impact
on its condensed consolidated financial statements and related disclosures. In
September 2022, the FASB issued ASU 2022-03, ASC Subtopic 820, Fair Value Measurement of Equity Securities Subject to Contractual Sale
Restrictions. The FASB is issuing this update (1) to clarify the guidance in Topic 820, Fair Value Measurement, when measuring the fair
value of an equity security subject to contractual restrictions that prohibit the sale of an equity security, (2) to amend a related illustrative
example, and (3) to introduce new disclosure requirements for equity securities subject to contractual sale restrictions that are measured
at fair value in accordance with Topic 820. The amendments in this update are effective for the Company on January 1, 2025. Early adoption
is permitted for both interim and annual financial statements that have not yet been issued or made available for issuance. The Company
is still evaluating the impact of this pronouncement on the condensed consolidated financial statements. |
