PRESENTATION OF INTERIM INFORMATION | NOTE 1 – PRESENTATION OF INTERIM INFORMATION The November 30, 2019 consolidated balance sheet, the consolidated statements of operations and comprehensive income for the three months ended November 30, 2019 and 2018, the consolidated statements of shareholders’ equity for the three months ended November 30, 2019 and 2018, and the consolidated statements of cash flows for the three months ended November 30, 2019 and 2018 have been prepared by Pure Cycle Corporation (the “Company”) and have not been audited. The unaudited consolidated financial statements include all adjustments that are, in the opinion of management, necessary to present fairly the financial position, results of operations and cash flows at November 30, 2019, and for all periods presented. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) have been condensed or omitted. It is suggested that these consolidated financial statements be read in conjunction with the financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended August 31, 2019 (the “2019 Annual Report”) filed with the Securities and Exchange Commission (the “SEC”) on November 12, 2019. The results of operations for interim periods presented are not necessarily indicative of the operating results for the full fiscal year. The August 31, 2019 balance sheet was derived from the Company’s audited consolidated financial statements. Use of Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America (“GAAP”) 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. Estimates are used to account for certain items such as revenue recognition, reimbursable costs and expenses, costs of revenue for lot sales, share-based compensation, deferred tax asset valuation, and the recoverability of long lived assets. Actual results could differ from those estimates. Cash and Cash Equivalents Cash and cash equivalents include all highly liquid debt instruments with original maturities of three months or less. The Company’s cash equivalents are comprised entirely of money market funds maintained at a reputable financial institution and U.S. Treasury debt securities. At various times during the three months ended November 30, 2019, the Company’s main operating account exceeded federally insured limits. To date, the Company has not suffered a loss due to such excess balance. Land Development Inventories Inventories primarily include land held for development and sale. Inventories are stated at cost. Capitalized lot development costs at Sky Ranch are costs incurred to construct lots at Sky Ranch that meet the Company’s capitalization criteria for improvements to a lot and are capitalized as incurred. The Company capitalizes certain legal, engineering, design, permitting, land acquisition, and construction costs related to the development of lots at Sky Ranch. The Company accumulates land development costs and allocates costs to each lot to determine the cost basis for each lot sale. The Company records all land cost of sales over time based on inputs of costs incurred to date to total estimated costs to complete. In accordance with Accounting Standards Codification (“ASC”) Topic 360, Property, Plant and Equipment Fair Value Measurements Contract Asset Contract receivables are recorded at the invoiced amount and do not bear interest. Credit is extended based on the evaluation of a customer’s financial condition and collateral is not required. is revenue which has been earned but not yet invoiced. The contract assets are transferred to the receivables when the Company has the right to bill such amounts and they are invoiced. Investments Management determines the appropriate classification of its investments in U.S. Treasury debt securities at the time of purchase and re-evaluates such determinations each reporting period. Securities that the Company does not have the positive intent or ability to hold to maturity, including U.S. Treasury debt securities, are reported at their fair value. Changes in value of such securities are recorded as a component of Accumulated other comprehensive income (loss). Concentration of Credit Risk and Fair Value Financial instruments that potentially subject the Company to concentrations of credit risk consist primarily of cash, cash equivalents and investments. From time to time, the Company places its cash in money market instruments, certificates of deposit and U.S. Treasury obligations. To date, the Company has not experienced significant losses on any of these investments. The following methods and assumptions were used to estimate the fair value of each class of financial instrument for which it is practicable to estimate that value. Cash and Cash Equivalents – Trade Accounts Receivable – Investments – Fair Value Measurements. Accounts Payable – Long-Term Financial Liabilities – Water and Land Assets Water and Land Assets Long-Term Obligations and Operating Lease – Participating Interests in Export Water Supply Notes Receivable – Related Parties – Notes receivable – related parties Off-Balance Sheet Instruments – Long-Term Obligations and Operating Lease – Participating Interests in Export Water Supply Revenue Recognition The Company disaggregates revenue by major product line as reported on the consolidated statements of operations and comprehensive income. Wholesale Water and Wastewater Fees The Company generates revenues through two lines of business. Revenues are derived through its wholesale water and wastewater business and through the sale of developed land primarily for residential lots, both of which businesses are described below. The Company generates revenues through its wholesale water and wastewater business predominantly from three sources: (i) monthly wholesale water usage fees and wastewater service fees, (ii) one-time water and wastewater tap fees and construction fees/Special Facility funding, and (iii) consulting fees. Because these items are separately delivered and distinct, the Company accounts for each of the items separately, as described below. (i) Monthly water usage and wastewater treatment fees – Water and Land Assets In addition to providing domestic water, the Company provides raw water for hydraulic fracturing to industrial customers in the oil and gas industry that are located in and adjacent to its service areas. Frack water revenues are recognized at a point in time upon delivering water to a customer. The Company delivered 748,000 and 114.5 million gallons of water to customers during the three months ended November 30, 2019 and 2018, respectively, of which 6% and 86% was used for oil and gas exploration. The Company recognizes wastewater treatment revenues monthly based on a flat monthly fee and actual usage charges. The monthly wastewater treatment fees are shown net of amounts retained by the Rangeview District. Costs of delivering water and providing wastewater service to customers are recognized as incurred. (ii) Water and wastewater tap fees/Special Facility funding Long-Term Obligations and Operating Lease Participating Interests in Export Water Supply The Company recognizes construction fees, including fees received to construct “Special Facilities,” over time as the construction is completed because the customer is generally able to use the property improvement to enhance the value of other assets during the construction period. Special Facilities are facilities that enable water to be delivered to a single customer and are not otherwise classified as a typical wholesale facility or retail facility. Temporary infrastructure required prior to construction of permanent water and wastewater systems or transmission pipelines to transfer water from one location to another are examples of Special Facilities. Management has determined that Special Facilities are separate and distinct performance obligations because these projects are contracted to construct a specific water and wastewater system or transmission pipeline and typically do not include multiple performance obligations in a contract with a customer. No Special Facilities revenue has been recognized during the three months ended November 30, 2019 or 2018. (iii) Consulting fees Land Development Activities The Company generates revenues through the sale of finished lots at its Sky Ranch development primarily from several sources of revenues: (i) the sale of finished lots, (ii) construction support activities, (iii) project management services, and (iv) reimbursable expenses incurred to develop certain public improvements. (i) Land development through the sale of finished lots The Company sells lots at Sky Ranch pursuant to distinct agreements with each builder. These agreements follow one of two formats. One format is the sale of a finished lot, whereby the purchaser pays for a ready-to-build finished lot and payment is a lump-sum payment upon completion of the finished lot that is permit ready. The Company will recognize revenues at the point in time of the closing of the sale of a finished lot in which control transfers to the builder as the transaction cycle will be complete and the Company will have no further obligations for the lot. During the three months ended November 30, 2019, the Company received payment and recognized revenue of $1,430,600 from one home builder in exchange for the delivery of 21 finished lots. No revenue was recognized for lot sales at a point in time for the three months ended November 30, 2018. The Company’s second format is the sale of finished lots pursuant to a development agreement with builders, whereby the Company receives payments in stages that include (i) payment upon the delivery of platted lots (which requires the Company to deliver deeded title to individual lots), (ii) a second payment upon the completion of certain infrastructure milestones, and (iii) final payment upon the delivery of the finished lot. Ownership and control of the platted lots pass to the builders once the Company closes the sale of the platted lots. Because the builder (i.e., the customer) takes control of the lot at the first closing and subsequent improvements made by the Company improve the builder’s lot as construction progresses, the Company accounts for revenue over time with progress measured based upon costs incurred to date compared to total expected costs. Any revenue in excess of amounts entitled to be billed is reflected on the balance sheet as a contract asset, and amounts received in excess of revenue recognized are recorded as deferred revenue. As of November 30, 2019, the Company had received cumulative payments of approximately $18 million under development agreements relating to 293 lots from two home builders, of which approximately $17.0 million of revenue was recognized over time based on the costs incurred to date compared to total expected costs for full completion of the 293 lots. For the three months ended November 30, 2019 and 2018, the Company recognized $7,111,000 and $1,381,200 of lot sales over time, respectively. The Company had deferred revenue related to lot sales of $1,143,800 as of November 30, 2019. The Company had a contract asset of $1,020,100 as of November 30, 2018. (ii) Construction support activities Inventories Land development construction costs Related Party Transactions Reimbursable Costs for Public Improvements Inventories (iii) Project management services Inventories (iv) Reimbursable Costs for Public Improvements Related Party Transactions The Company and the CAB have agreed that no payment is required with respect to advances made by the Company or expenses incurred related to construction of public improvements unless and until the CAB and/or the Sky Ranch Districts issue bonds in an amount sufficient to reimburse the Company for all or a portion of the advances made and expenses incurred. Due to this contingency, the reimbursable costs for the construction of public improvements, including reimbursable costs for construction support activities, are included in Inventories Land development construction costs Inventories All amounts owed under the 2018 FFAA (as defined in Note 6 – Related Party Transactions Interest Income On November 19, 2019, the CAB sold tax-exempt, fixed rate senior bonds in the aggregate principal amount of approximately $11,435,000 and tax-exempt, fixed-rate subordinate bonds in the aggregate principal amount of approximately $1,765,000 (collectively, the “Bonds”). Upon the sale of the Bonds approximately $10.5 million of the net proceeds from the Bonds were used to partially reimburse the Company for advances it made to the CAB pursuant to the 2018 FFAA to fund the construction of public improvements to the Sky Ranch property. Approximately $2.7 million of the bond proceeds were retained by the CAB in cash in order to repay debt service through 2021, when the CAB expects to generate enough revenue through mill levies, to repay bond holders. The Company applied approximately $4.2 million of the net proceeds to partially reduce the remaining capitalized expenses in Inventories Income from reimbursement of construction costs (related party) The Company records all reimbursable costs to Inventories Land development construction costs As of November 30, 2019 Costs incurred to date Payments repaid by CAB Net costs incurred to date Construction support activities $ 533,500 $ — $ 533,500 Project management services 869,900 — 869,900 Public Improvements 22,966,400 10,505,000 12,461,400 Accrued interest 1,031,700 — 1,031,700 Total reimbursable costs $ 25,401,500 $ 10,505,000 $ 14,896,500 The Company expects to incur approximately an additional $6.0 million of construction costs related to public improvements and expects to be reimbursed approximately an additional $18.5 million. The Company evaluated disaggregation of revenue and has determined that no additional disaggregation of revenue is necessary. Contract asset by segment is as follows: The Company did not have a contract asset at November 30, 2019 or August 30, 2019. The contract asset at November 30, 2018, related solely to the Company’s land development activities. Changes in contract asset were as follows: November 30, 2019 August 31, 2019 Balance, beginning of period $ — $ — Recognition of revenue contract asset — 1,020,146 Contract asset invoiced — (1,020,146 ) Balance, end of period $ — $ — Deferred revenue by segment is as follows: November 30, 2019 August 31, 2019 Land development activities $ 1,143,771 $ 3,991,535 Oil and gas leases and water sales payment 1,861,496 1,067,348 Balance, end of period $ 3,005,267 $ 5,058,883 The current portion of deferred revenue for oil and gas leases and water sales payment as of November 30, 2019 and August 31, 2019, is $1,548,063 and $706,464, respectively. There were no water segment deferred revenues as of November 30, 2019 and August 31, 2019. Changes in deferred revenue were as follows: November 30, 2019 August 31, 2019 Balance, beginning of period $ 5,058,883 $ 1,846,630 Deferral of revenue 8,469,154 12,700,065 Recognition of unearned revenue (10,522,770 ) (9,487,812 ) Balance, end of period $ 3,005,267 $ 5,058,883 The recognition of unearned revenue was $8,541,643 and $5,920,319 from land development activities and $1,981,127 and $3,567,493 from oil and gas leases and water sales payments for the three months ended November 30, 2019 and August 31, 2019, respectively. Revenue allocated to remaining performance obligations represents contracted revenue that has not yet been recognized (“contracted not recognized revenue”), which includes unearned revenue and amounts that will be invoiced and recognized as revenue in future periods. At November 30, 2019, the Company had outstanding open contracts for $13,739,100, which primarily related to the sale of 506 lots at Sky Ranch. The Company expects to recognize approximately 84% of such revenue over the next 12 months. Inventories Inventories primarily include land held for development and sale, which the Company has begun developing and are stated at cost. Capitalized lot development costs at Sky Ranch are costs incurred to construct finished lots at Sky Ranch that meet the Company’s capitalization criteria for improvements to a lot and are capitalized as incurred. The Company capitalizes certain legal, engineering, design, permitting, land acquisition, and construction costs related to the development of lots at Sky Ranch. The Company uses the specific identification method for purposes of accumulating land development costs and allocates costs to each lot to determine the cost basis for each lot sale. The Company records all land cost of sales when a lot is completed and sold on a lot-by-lot basis. Costs included in Inventories Inventories In accordance with ASC 360, the Company measures land held for sale at the lower of the carrying value or net realizable value. In determining net realizable value, the Company primarily relies upon the most recent negotiated price. If a negotiated price is not available, the Company will consider several factors, including, but not limited to, current market conditions, recent comparable sales transactions and market analysis studies. If the net realizable value is lower than the current carrying value, the land is written down to its net realizable value. Royalty and Other Obligations Revenues from the sale of Export Water are shown gross of royalties payable to the Land Board. Revenues from the sale of water on the Lowry Range are invoiced directly by the Rangeview District, and a percentage of such collections are then paid to the Company by the Rangeview District. Water revenue from such sales are shown net of royalties paid to the Land Board and amounts retained by the Rangeview District. Oil and Gas Lease Payments As described in Note 2 – Summary of Significant Accounting Policies Other income Deferred Revenue In July 2019, the Company received an up-front payment of $573,700 from an Agreement on Locations of Oil and Gas Operations for a pad site covering approximately 16 acres with the operator of the Sky Ranch O&G Lease (the “OGOA”), which will be recognized as income on a straight-line basis over three years. If after three years the operator has not spud at least one well on the OGOA, the operator may extend the right to the OGOA one additional year by paying $75,000 to the Company. The operator may only extend the OGOA for two additional years for a total of five years. The Company recognizes the up-front payments on a straight-line basis over the terms of the respective agreements. During the three months ended November 30, 2019, the Company recognized $47,800 of income related to the up-front payments received pursuant to the OGOA. No revenue was recognized for the three months ended November 30, 2018 related to the up-front payments received pursuant to the OGOA. As of November 30, 2019, and August 31, 2019 the Company had deferred revenue of $499,700 and $547,500, respectively, related to the OGOA. In September 2017, the Company entered into a Paid-Up Oil and Gas Lease with Bison Oil and Gas, LLP (the “Bison Lease”). Pursuant to the Bison Lease, the Company received an up-front payment of $167,200 in October 2017, which will be recognized as income on a straight-line basis over the three year term of the lease. The Company recognized lease income of $13,900 during the three months ended November 30, 2019 and 2018 related to the up-front payment received pursuant to the Bison Lease. As of November 30, 2019, and August 31, 2019, the Company had deferred revenue of $46,500 and $60,400, respectively, related to the Bison Lease that will be recognized as income ratably through September 2020. The Company also received a payment of $425,800 in fiscal 2019 from one of its industrial water customers and $822,500 in the quarter ended November 30, 2019, to reserve first priority water for its oil and gas fracking needs for defined periods during 2020. As the Customer uses the forecasted volumes each month, the Company will recognize revenue based on the volumes used. The Customer may take such volumes up to one year from invoice date. If the Customer does not take the forecasted volumes in the anticipated period, such volumes are forfeited by the Customer. At that time, any payments received for unused volumes will be recognized as revenue. As of November 30, 2019, the Company had deferred revenue of $1.2 million as a result of these advanced water purchase payments. Long-Lived Assets The Company reviews its long-lived assets 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 undiscounted net cash flows expected to be generated by the eventual use of 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. Capitalized Costs of Water and Wastewater Systems and Depletion and Depreciation of Water Assets Costs to construct water and wastewater systems that meet the Company’s capitalization criteria are capitalized as incurred, including any interest, and depreciated on a straight-line basis over their estimated useful lives of up to 30 years. The Company capitalizes design and construction costs related to construction activities, and it capitalizes certain legal, engineering and permitting costs relating to the adjudication and improvement of its water assets. The Company depletes its groundwater assets that are being utilized on the basis of units produced (i.e., thousands of gallons sold) divided by the total volume of water adjudicated in the water decrees. Share-Based Compensation The Company maintains a stock option plan for the benefit of its employees and non-employee directors. The Company records share-based compensation costs as expense over the applicable vesting period of the stock award using the straight-line method. The compensation costs to be expensed are measured at the grant date based on the fair value of the award. The Company has adopted the alternative transition method for calculating the tax effects of share-based compensation, which allows for a simplified method of calculating the tax effects of employee share-based compensation. The impact on the income tax provision for the granting and exercise of stock options during the three months ended November 30, 2019 was a tax expense of approximately $26,000. Because the Company had a full valuation allowance on its deferred tax assets as of November 30, 2018 there was no effect on the tax provision during the period. The Company recognized $105,400 and $103,500 of share-based compensation expense during the three months ended November 30, 2019 and 2018, respectively. Income Taxes The Company uses a “more-likely-than-not” threshold for the recognition and de-recognition of tax positions, including any potential interest and penalties relating to tax positions taken by the Company. The Company did not have any significant unrecognized tax benefits as of November 30, 2019. As a result of H.R.1, commonly known as the Tax Cuts and Jobs Act (the “Tax Act”), signed into law on December 22, 2017, the Company has a $282,000 alternative minimum tax (“AMT”) deferred tax asset for which it did not have a valuation allowance as of November 30, 2019 and August 31, 2019. The Company expects to receive the AMT as a refund in future years. Most, if not all, of this credit will be refundable starting with the filing of the 2018 (fiscal year ending 2019) through 2021 (fiscal year ending 2022) tax returns, subject to limitations of Internal Revenue Code Section 382 (arises with ownership changes) and the sequestration limitation of the Balanced Budget Act of 1997. The Company’s effective tax rate was 24.7% for the three months ended November 30, 2019. The effective tax rate was 0% for the three months ended November 30, 2018 due to the valuation allowance the Company maintained on its net deferred tax asset. The Company records deferred tax assets and liabilities for the estimated future tax effects of temporary differences between the tax bases of assets and liabilities and amounts reported in the accompanying consolidated balance sheets, as well as operating loss and tax credit carry-forwards. The Company measures deferred tax assets and liabilities using enacted tax rates expected to be applied to taxable income in the years in which those temporary differences are expected to be recovered or settled. The Company maintained a valuation allowance on the net deferred tax asset other than AMT credits as of November 30, 2018, as the Company had determined it was more likely than not that the Company would not realize its deferred tax assets as of November 30, 2018. Such assets primarily consisted of operating loss carryforwards. The Company assessed the realizability of its deferred tax asset using all available evidence. In particular, the Company considered both historical results and projections of profitability for the reasonably foreseeable future periods. The Company is required to reassess its conclusions regarding the realization of its deferred tax assets at each financial reporting date. As a result of the evaluation, the Company concluded that all of the valuation allowance was no longer necessary as of August 31, 2019 and released the valuation allowance. The Company files income tax returns with the Internal Revenue Service and the State of Colorado. The tax years that remain subject to examination are fiscal year 2015 through fiscal year 2018. The Company’s policy is to recognize interest and penalties accrued on any unrecognized tax benefits as a component of income tax expense. At November 30, 2019, the Company did not have any accrued interest or penalties associated with any unrecognized tax benefits, nor was any interest expense recognized during the three months ended November 30, 2019 or 2018. Income per Common Share Income per common share is computed by dividing net income by the weighted average number of shares outstanding during each period. Common stock options of 224,097 and 223,962 common share equivalents as of the three months ended November 30, 2019 and 2018, respectively, were included in the calculation of income per common share as dilutive common stock equivalents using the treasury stock method. Common stock options aggregating 50,000 common share equivalents as of the three months ended November 30, 2018, have been excluded from the calculation of income per common share as their effect is anti-dilutive. Recently Issued Accounting Pronouncements The Company continually assesses any new accounting pronouncements to determine their applicability. When it is determined that a new accounting pronouncement affects the Company’s financial reporting, the Company undertakes a study to determine the consequence of the change to its consolidated financial statements and to ensure that there are proper controls in place to ascertain that the Company’s consolidated financial statements properly reflect the change. New pronouncements assessed by the Company recently are discussed below: In February 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2016-02, Leases (Topic 842). In June 2016, the FASB issued ASU No. 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments In February 2018, the FASB issued ASU 2018-02, Income Statement — Reporting Comprehensive Income (Topic 220); Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income. The amendments in ASU 2018-02 allow a reclassification from accumulated other comprehensive income to retained earnings for stranded tax effects resulting from the Tax Act. Consequently, the amendments eliminate the stranded tax effects resulting from the Tax Act and will improve the usefulness of information reported to financial statement users. The amendments are effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Early adoption is permitted in any interim period after issuance of the standard. The Company believes the impact of this standard on its condensed consolidated financial statements is immaterial. In June 2018, the FASB issued ASU 2018-07, Compensation — Stock Compensation (Topic 718): Improvements to Nonemployee Share-Based Payment Accounting. ASU 2018-07 is intended to reduce cost and complexity and to improve financial reporting for share-based payments issued to nonemployees. This standard expands the scope of ASC Topic 718, Compensation — Stock Compensation Equity — Equity-Based Payments to Non-Employees |