NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE A—SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Torotel specializes in the custom design and manufacture of a wide variety of precision magnetic components, consisting of transformers, inductors, reactors, chokes and toroidal coils. Approximately 95% of Torotel’s sales during fiscal 2007 were derived from domestic customers. The following summarizes the significant accounting policies consistently applied in the preparation of the accompanying consolidated financial statements.

Principles of Consolidation

The consolidated financial statements include the accounts of Torotel, Inc. and its wholly owned subsidiaries, Torotel Products, Inc. and Electronika, Inc. and Subsidiary. All significant inter-company accounts and transactions have been eliminated in consolidation.

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 certain reported amounts and disclosures. Significant estimates used in preparing these consolidated financial statements include those assumed in computing the carrying value of equipment, allowance for doubtful accounts receivable, reserve for obsolete and excess inventory, the valuation allowance on deferred tax assets and the reserve for warranty costs. Accordingly, actual results could differ from those estimates. Any changes in estimates are recorded in the period in which they become known.

Credit Risk

Financial instruments that potentially subject Torotel to concentrations of credit risk consist principally of cash and accounts receivable. Torotel grants unsecured credit to substantially all of its customers. Management does not believe that it is exposed to any extraordinary credit risk as a result of this policy.

Torotel deposits all monies at the Bank of Blue Valley. These accounts are secured up to $100,000 by the Federal Deposit Insurance Corporation. At various times and at April 30, 2007, these cash balances exceed federally insured limits. Torotel has not experienced any losses in such accounts. Management does not believe Torotel is exposed to any significant credit risk with respect to its cash and cash equivalents.

Fair Value of Financial Instruments

Cost approximates market for all financial instruments as of April 30, 2007 and 2006.

Treasury Stock

Torotel utilizes the weighted average cost method in accounting for its treasury stock transactions.

Revenue Recognition

Revenue is recognized on contracts and orders on the date the product is shipped to the customer (unit-of-delivery method). Torotel’s annual consolidated sales arising from contracts having deliveries scheduled over a period of more than one year for fiscal years 2007 and 2006 were approximately 23% and 20%, respectively, because of the contracts for the potted coil assembly.

26

---

Allowance for Doubtful Accounts

Gross trade accounts receivable are offset with an allowance for doubtful accounts. The allowance for doubtful accounts is management’s best estimate of the amount of probable credit losses in Torotel’s existing accounts receivable. Management reviews the allowance for doubtful accounts on a regular basis, and all past due balances are reviewed individually for collectibility. Account balances are charged against the allowance when placed for collection. Recoveries of receivables previously written off are recorded when received. The majority of the customer accounts are considered past due after the invoice becomes older than the customer’s credit terms. Interest is not charged on past due accounts.

Inventories

Inventories are stated at the lower of cost or market. Cost is determined using a moving average cost method of valuation that currently and historically approximates the first-in, first-out method. Torotel’s industry is characterized by short-term customer commitments and changes in demand, as well as other market considerations. Provisions for estimated obsolete and excess inventory are based on reviews of inventory usage, quantities on hand and latest product demand information from customers. Inventories are reviewed in detail utilizing a 12-month time horizon. Individual part numbers that have not had any usage in a 12-month time period are categorized as obsolete; individual part numbers having more than a 12-month supply based on the current year’s usage are categorized as excess. The reserve balance is analyzed for adequacy along with the inventory review each quarter.

Property, Plant and Equipment

Property, plant and equipment are carried at cost. Depreciation and amortization are provided in amounts sufficient to relate the costs of depreciable assets to operations primarily using the straight-line method over estimated useful lives of three to five years for property and equipment, and ten to twenty years for buildings and improvements.

Cash Flows

For purposes of the statements of cash flows, Torotel considers all short-term investments purchased with original maturity dates of three months or less to be cash equivalents.

Intangible Assets

The intangible assets acquired in the purchase of Electronika are accounted for under Statement of Financial Accounting Standards No. 142 (“SFAS 142”), Goodwill and Other Intangible Assets . SFAS 142 requires that intangible assets be amortized over their useful life and tested for impairment annually (see Note M of Notes to Consolidated Financial Statements).

Equity Investment in Apex

Torotel has a 12.88% interest in Apex. The investment in Apex has no carrying value on the consolidated balance sheet of Torotel, and in the opinion of Torotel management, it is not likely that any of the investment will be recovered because of Apex’s continued financial losses. If Apex were to eventually be sold, any cash recovered would be recognized as a gain upon receipt of the proceeds.

Advertising Costs

Advertising costs are expensed as incurred. For the years ended April 30, 2007 and 2006, advertising costs were $23,000 and $4,000, respectively.

27

---

Warranty Costs

Torotel has a reserve for estimated warranty costs associated with products returned from customers. A limited warranty is provided for a period of one year which requires Torotel to repair or replace defective products at no cost to the customer. The warranty reserve is based on historical experience and reflects management’s best estimate of probable liability under the product warranties.

Share-Based Compensation

Effective May 1, 2006, Torotel adopted the fair value recognition provisions of Statement of Financial Accounting Standards No. 123 (revised 2004) (“SFAS 123(R)”), Share-Based Payment, using the modified prospective method of adoption under the provisions of SFAS No. 148, Accounting for Stock-Based Compensation—Transition and Disclosure . In accordance with the modified prospective method, results for prior periods have not been restated. Prior to May 1, 2006, Torotel accounted for all stock option grants under the provisions of APB Opinion 25, Accounting for Stock Issued to Employees and related interpretations; and accounted for all grants involving stock appreciation rights (“SARs”) under the provisions of SFAS 123 using the intrinsic value measurement guidelines of APB Opinion 25. The adoption of SFAS 123(R) on existing stock option grants did not have any impact on Torotel’s financial condition or results of operations for the year ended April 30, 2007; the adoption of SFAS 123(R) for the SARs resulted in a cumulative effect reduction in stock compensation costs of $8,000 for the year ended April 30, 2007.

Adjustment to Accumulated Deficit

In September 2006, the SEC staff issued Staff Accounting Bulletin No. 108 (“SAB 108”), Financial Statements—Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements. This Bulletin provides guidance on how prior year misstatements should be taken into consideration when quantifying misstatements in current year financial statements for purposes of determining whether the current year’s financial statements are materially misstated and should be restated. SAB 108 became effective for fiscal years ending after November 15, 2006. Historically, Torotel evaluated unrecorded differences using the “roll-over” method, which focused primarily on the impact of unrecorded differences, including the reversal of prior-year unrecorded differences, on the current year consolidated statement of operations. As required by SAB 108, Torotel must now evaluate misstatements under a “dual approach” method, which requires quantification under both the “roll-over” and the “iron curtain” methods. The “iron curtain” method quantifies misstatements based on the effects of correcting the period-end consolidated balance sheet. In accordance with the transition provisions of SAB 108, Torotel recorded an aggregate adjustment of $15,000 that increased the beginning accumulated deficit as of May 1, 2006. These adjustments were considered to be immaterial to our consolidated statements of operations in prior years, under the “roll-over” method. The components of the adjustment are detailed in the tables below:

Changes to the
Consolidated Statements of Operations
Year Ended April 30,

		2006			2005 and prior years					SAB 108 Cumulative Effect
Cost of goods sold(a)		$	14,000			$	13,000				$	27,000
Selling, general and administrative expenses(b)		—				(12,000		)			(12,000		)
Total		$	14,000			$	1,000				$	15,000

---

The following footnotes refer to the table above.

28

---

(a)            To increase accrued liabilities for estimated warranty costs

(b)           To reduce allowance for doubtful accounts and increase accounts receivable, net

New Accounting Pronouncements

In July 2006, the FASB issued Interpretation No. 48 (“FIN 48”), Accounting for Uncertainty in Income Taxes—An Interpretation of FASB Statement No. 109, which prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. In particular, this interpretation requires uncertain tax positions to be recognized only if they are, more likely than not, to be upheld based on their technical merits. Additionally, the measurement of the tax position will be based on the largest amount that is determined to have greater than a 50% likelihood of realization upon ultimate settlement. Any resulting cumulative effect of applying the provisions of FIN 48 upon adoption would be reported as an adjustment to the beginning balance of retained earnings and an adjustment to tax liabilities in the period of adoption. FIN 48 will be effective beginning May 1, 2007. Torotel does not believe the adoption of FIN 48 will have a material effect on its results of operations, financial condition and cash flows.

In September 2006, the FASB issued Statement of Financial Accounting Standard No. 157 (“SFAS 157”), Fair Value Measurements . SFAS 157 defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. SFAS 157 applies to other accounting pronouncements that require or permit fair value measurements, but does not require any new fair value measurements. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those years. Torotel is currently evaluating the effect of the guidance contained in SFAS 157 and does not expect the implementation to have a material effect on its results of operations, financial condition and cash flows.

In October 2006, the FASB issued FSP No. FAS 123(R)-6, Technical Corrections of FASB Statement No. 123(R) , which amends various provisions of SFAS No. 123(R). FSP No. FAS 123(R)-6 (1) exempts non-public entities from disclosing the aggregate intrinsic value of outstanding fully vested share options (or share units) and share options expected to vest, (2) revises the computation of the minimum compensation cost that must be recognized to comply with paragraph 42 of SFAS No. 123(R), (3) amends paragraph A170 of Illustration 13(e) to indicate that at the date that the illustrative awards were no longer probable of vesting, any previously recognized compensation cost should have been reversed, and (4) amends the definition of “short-term inducement” to exclude an offer to settle an award. The provisions of FSP No. FAS 123(R)-6 became effective in the first reporting period beginning after October 20, 2006. Retrospective application is required if an entity had been applying Statement 123(R) inconsistent with the guidance in FSP No. FAS 123(R)-6. The adoption of FSP No. FAS 123(R)-6 did not have a material impact on Torotel’s results of operations, financial condition and cash flows for the year ended April 30, 2007.

In February 2007, the FASB issued Statement of Financial Accounting Standard No. 159 (“SFAS 159”), The Fair Value Option for Financial Assets and Financial Liabilities—Including an amendment of FASB Statement No. 115 . SFAS 159 permits entities to choose to measure many financial instruments and certain other items at fair value. The objective is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. SFAS 159 is expected to expand the use of fair value measurement, which is consistent with the FASB’s long-term measurement objectives for accounting for financial instruments. SFAS 159 applies to all entities, including not-for-profit organizations. Most of the provisions of this Statement apply only to entities that elect the fair value option. However, the amendment to FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, applies to all entities with available-for-sale and

29

---

trading securities. SFAS 159 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those years. Torotel is currently evaluating the effect of the guidance contained in SFAS 159 and does not expect the implementation to have a material effect on its results of operations, financial condition and cash flows.

NOTE B—INVENTORIES

The following table summarizes the components of inventories:

Raw materials		$	604,000
Work in process		135,000
Finished goods		76,000
		815,000
Less: reserve for obsolete and excess inventories		380,000
		$	435,000

 

During the fourth quarter ended April 30, 2007, Torotel installed a software update to its computer system. This update featured a new report, which in management’s opinion, provides better information for evaluating obsolete and excess inventory. As a result of using this new report, Torotel decreased its reserve for obsolete and excess inventory by $100,000. This change in estimate is included in the cost of goods sold in the accompanying consolidated statement of operations.

NOTE C—FINANCING AGREEMENTS

On June 25, 2006, Torotel Products refinanced its mortgage debt with the Bank of Blue Valley. Under the terms of the new financing, the outstanding balance bears interest at a fixed rate of 8.0% per annum. The note requires monthly principal and interest payments of $9,947. The note, which continues to be guaranteed by Torotel, Inc. and Electronika, Inc., has a maturity date of June 25, 2011, may be prepaid without penalty and is collateralized by substantially all assets of Torotel. Proceeds of the original loan were used to purchase and make improvements to the land and buildings in Olathe, Kansas, and to payoff a $325,000 balance on a first mortgage loan on the Grandview property held by United Trust Bank. As of April 30, 2007, the outstanding balance was $769,000.

On September 30, 2006, Torotel Products renewed its $200,000 revolving credit agreement with Bank of Blue Valley. Advances under the credit line are limited to 75% of eligible billed receivables. The revolving line is collateralized by the land and buildings in Olathe, Kansas. Under the terms of the agreement, the outstanding balance of the revolving line bears interest at 1.25% over the bank’s corporate base rate and has a maturity date of September 30, 2007. As of April 30, 2007, the effective borrowing rate was 9.50% and the entire credit line was available.

Information concerning Torotel’s long-term indebtedness is as follows:

 

30

---

The amount of long-term debt maturing in each of the next five years is as follows:

Year Ending April 30,				Amount
2008				$	58,000
2009				64,000
2010				69,000
2011				75,000
2012				503,000
				$	769,000

 

NOTE D—INCOME TAXES

The provision for income taxes reflected in the consolidated statements of operations differs from the amounts computed at the federal statutory tax rates. The principal differences between the statutory income tax expense and the effective provision for income taxes are summarized as follows:

		2007			2006
Computed tax expense (benefit) at statutory rates		$	(66,000	)	$	159,000
Addition to (utilization of) net operating loss carryforwards		66,000			(159,000		)
Decrease (increase) in deferred tax assets		(37,000		)	13,000
Increase (decrease) in valuation allowance		37,000			(13,000		)
		$	—		$	—

 

Torotel has available as benefits to reduce future income taxes, subject to applicable limitations, the following estimated net operating loss (“NOL”) carryforwards:

Year of Expiration				NOL Carryforwards
2009					$	13,000
2010					694,000
2011					319,000
2012					355,000
2013					801,000
2019					2,960,000
2020					8,000
2021					2,000
2022					57,000
2023					1,000
2024					77,000
2025					212,000
					$	5,499,000

 

 

31

The difference between the financial and tax bases of assets and liabilities are determined quarterly. Deferred income taxes and liabilities are computed for those differences that have future tax consequences using the currently enacted tax laws and rates that apply to the periods in which they are expected to affect taxable income. Valuation allowances are established, if necessary, to reduce the deferred tax asset to the amount that will, more likely than not, be realized. Income tax expense is the current tax payable or refundable for the period plus or minus the net change in the deferred tax assets or liabilities. The following table summarizes the components of the net deferred tax asset:

Net operating loss carryforwards		$	1,730,000
Inventory valuation reserve		118,000
Amortization and impairment of intangibles		402,000
Loss on equity and impairment in investee		349,000
Tax credit carryforwards		19,000
Other		49,000
		2,667,000
Less: valuation allowance		2,667,000
		$	—

 

NOTE E—COMMITMENTS AND CONTINGENCIES

Torotel is a party to four operating leases, which include a digital copier and fax, a digital color copier, and two automobiles. All four leases are non-cancelable. As of April 30, 2007, there were no capital lease obligations. Future minimum lease payments are as follows:

Year Ending April 30,				Operating Leases
2008					$	31,000
2009					14,000
2010					5,000
					$	50,000

 

Total rent expense for all operating leases for the years ended April 30, 2007 and 2006, was $48,000 for each year.

NOTE F—EMPLOYEE INCENTIVE PLANS

Short-term Cash Incentive Plan

The Short-term Cash Incentive Plan (“STIP”) becomes effective for fiscal year 2008. The purpose of the STIP is to promote the long-term financial performance of Torotel by providing all key employees with the opportunity to earn cash awards for accomplishing annual goals for Return on Capital Employed (“ROCE”) as defined in the Plan, which is filed as Exhibit 10.8 of this Form 10-KSB and herein incorporated by reference.

Long-term Incentive Plans

The Long-term Incentive Plans (“LTIPs”), which consist of a Stock Award Plan and a Long-term Cash Incentive Plan, also become effective for fiscal year 2008. The purpose of the LTIPs is to provide incentives that will attract and retain highly competent persons as key employees to promote the long-term financial performance of Torotel by providing key employees an opportunity to earn stock and cash awards for accomplishing long-range goals for sales growth, earnings growth, ROCE and debt to equity, as defined

32

---

and measured in the Stock Award Plan and the Long-term Cash Incentive Plan, which are filed as Exhibits 10.9 and 10.10 of this Form 10-KSB, respectively.

Stock Award Plan

The Stock Award Plan (“SAP”) provides key employees the opportunity to acquire common stock of Torotel pursuant to awards earned for accomplishing goals that promote the long-term financial performance of Torotel. Under the terms of the SAP, stock awards are in the form of restricted stock having a five (5) year restriction period, which shall lapse based on certain conditions as outlined in the SAP. All stock awards are represented by a Restricted Stock Agreement, which afford the grantees all of the rights of a stockholder with respect to the award shares, including the right to vote such shares and to receive dividends and other distributions payable with respect to such shares since the Date of Award.

Long-term Cash Incentive Plan

The Long-term Cash Incentive Plan (“LTCIP”) provides key employees with the opportunity to earn cash awards for accomplishing annual goals based on predetermined targets for average annual sales and earnings growth, ROCE and debt to equity. Under the terms of the LTCIP, awards will not be paid if Torotel’s performance on any LTCIP metric is less than the threshold level of performance defined for that LTCIP metric.

Incentive Compensation Plan

Torotel’s shareholders approved the Incentive Compensation Plan (“ICP”) in 1994. The ICP has been terminated as of April 30, 2007. The ICP provided for participants to receive incentive payments in cash and/or Torotel common stock based on targeted pretax earnings, as defined in the ICP. There were no awards for the year ended April 30, 2007. Incentive awards of $73,000 were incurred under ICP for the year ended April 30, 2006.

Employee Stock Option Plans

In accordance with the Incentive Compensation Plan approved on September 19, 1994, Torotel reserved 400,000 common shares for issuance to key employees pursuant to the exercise of incentive and non-qualified stock options granted prior to June 20, 2004. The options were accounted for under APB Opinion 25, Accounting for Stock Issued to Employees , and related interpretations in accounting for this Plan. The incentive stock options had a term of five years when issued and vested 50% per year during the first two years. The non-qualified stock options had a term of ten years when issued and vested 25% per year during the first four years.

33

---

The fair values of the options granted were estimated on the date of grant using the Black-Scholes options-pricing model. The fair value of the incentive stock options was determined using the following weighted average assumptions: no dividend payments over the life of the options; expected volatility of 551.0%; risk-free interest rate of 3.50%; and expected life of five years. Stock option transactions under this Plan for each period are summarized as follows:

		2007							2006
				Weighted							Weighted
		Shares		Average					Shares		Average
		Under		Exercise					Under		Exercise
		Option		Price					Option		Price
Outstanding at beginning of year		40,000			$	.37			40,000			$	.37
Granted		—			—				—			—
Exercised		(40,000	)		.37				—			—
Forfeited		—			—				—			—
Outstanding at end of year		—			$	—			40,000			$	.37
Options exercisable at end of period		—			$	—			40,000			$	.37
Weighted average fair value of options granted during the year					—							—

 

The total aggregate intrinsic value of the 40,000 shares exercised was $2,400. These 40,000 shares were released from treasury at the time of exercise. The following information applies to options outstanding for each period through April 30:

		2007				2006
Number outstanding			—			40,000
Range of exercise prices			—			$	.37
Weighted average exercise price			—			$	.37
Weighted average remaining contractual life			—			.50 yr.

 

401(k) Retirement Plan

Torotel has a 401(k) Retirement Plan for Torotel Products’ employees. Employer contributions to the Plan are at the discretion of the Board of Directors. Employer contributions to the Plan were $6,000 and $5,000 for the years ended April 30, 2007 and 2006, respectively.

NOTE G—RESTRICTED STOCK AGREEMENTS

Restricted Stock Agreements are authorized by the Compensation and Nominating Committee (“Committee”) and the Board of Directors of Torotel. The Committee and the Board have determined that the interests of Torotel and its stockholders will be promoted by hiring talented individuals and, to induce such individuals to accept employment with Torotel, the Committee and the Board believe a key component of such individuals’ compensation should be granting equity ownership opportunities based upon the acceptance of employment and the continuing employment of such individual, subject to certain conditions and restrictions.

Effective July 31, 2006, a Restricted Stock Agreement was entered into between Torotel and Benjamin E. Ames, Jr., as part of Mr. Ames’ employment as Executive Vice President of Torotel Products, Inc., with primary responsibilities being new business development. The amount of the restricted stock award was 200,000 shares of common stock, $.01 par value per share. Based upon Mr. Ames attaining mutually agreed upon written annual goals, the restricted shares shall be released from the restrictions on transfer and risk of forfeiture in the amount of 40,000 shares per year for five years beginning July 31, 2007, and each anniversary thereof. Based on the market price of $.30 for Torotel’s

34

---

common stock as of July 31, 2006, the fair value of the restricted stock at the date of award was $60,000. Of this amount, $2,000 was credited to common stock at par value and the excess of $58,000 was credited to additional paid - in capital. The restricted shares are treated as non-vested stock pursuant to SFAS 123(R). Accordingly, an offset amount, classified as unearned stock compensation, is included in the accompanying consolidated balance sheet under stockholders’ equity. Stock compensation cost of $3,000 per quarter will be recorded during the aggregate five-year vesting period provided the mutually agreed upon goals are achieved.

A Restricted Stock Agreement having a measurement date of February 12, 2007, was entered into between Torotel and E. Mark Flynn, as part of Mr. Flynn’s employment as Vice President of Torotel Products, Inc., with primary responsibilities being supply chain management and development. The amount of the restricted stock award was 25,000 shares of common stock, $.01 par value per share. Based upon Mr. Flynn attaining mutually agreed upon written annual goals, the restricted shares shall be released from the restrictions on transfer and risk of forfeiture in the amount of 5,000 shares per year for five years beginning February 12, 2008, and each anniversary thereof. Based on the market price of $.45 for Torotel’s common stock as of February 12, 2007, the fair value of the restricted stock at the date of award was $11,250. Of this amount, $250 was credited to common stock at par value and the excess of $11,000 was credited to additional paid-in capital. The restricted shares are treated as non-vested stock pursuant to SFAS 123(R). Accordingly, an offset amount, classified as unearned stock compensation, is included in the consolidated balance sheet under stockholders’ equity. Stock compensation cost of $562.50 per quarter will be recorded during the aggregate five-year vesting period provided the mutually agreed upon goals are achieved.

Under the terms of both agreements, the non-vested shares are restricted as to disposition and subject to forfeiture under certain circumstances. The agreements provide Messrs. Ames and Flynn with all voting rights with respect to the restricted shares. The agreements further provide that if, prior to all of the restricted shares having been released, Torotel undergoes a change in control, then all of the restricted shares shall be released and no longer subject to restrictions under the agreements.

Restricted stock activity for the year ended April 30 is summarized as follows:

		2007
		Weighted		Weighted
		Shares		Average
		Under		Grant Date
		Option		Value
Outstanding at beginning of period		—			—
Granted		225,000			$	.317
Vested		—			—
Forfeited		—			—
Outstanding at end of period		225,000			$	.317

 

NOTE H—STOCKHOLDERS’ EQUITY

The components of stockholders’ equity are summarized as follows:

Common stock, at par value		$	54,000
Capital in excess of par value		12,331,000
Unearned stock compensation		(61,000		)
Accumulated deficit		(10,941,000		)
		1,383,000
Less treasury stock, at cost, 31,205 shares		90,000
		$	1,293,000

 

35

---

Torotel has 6,000,000 shares of common stock, $.01 par value, authorized and 5,376,590 shares issued and outstanding. The changes in shares of common stock outstanding are summarized as follows:

Balance, May 1, 2006		5,111,590
Issuance of restricted stock		225,000
Issuance of treasury stock		40,000
Balance, April 30, 2007		5,376,590

 

NOTE I—EARNINGS PER SHARE

SFAS 128, Earnings per Share , requires dual presentation of basic and diluted EPS on the face of the statement of operations. It also requires a reconciliation of the numerator and denominator used in computing basic and diluted EPS. Basic EPS excludes dilution and is computed by dividing earnings available to common stockholders by the weighted average number of common shares outstanding for the period. Diluted EPS is computed similarly to fully diluted EPS pursuant to APB Opinion 15. Diluted EPS reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the entity. The 225,000 shares issued pursuant to the Restricted Stock Agreement (see Note G of Notes to Consolidated Financial Statements) meet the definition of contingently issuable shares as outlined in SFAS No. 128; as a result, these shares will not be included in the basic EPS calculation until the performance measurements have been satisfied. The restricted shares will be treated as a common stock equivalent for the diluted EPS calculation.

Pursuant to SFAS 128, the basic and diluted earnings per common share were computed as follows:

		2007			2006
Earnings (loss) before cumulative effect		$	(135,000	)	$	463,000
Cumulative effect		8,000			—
Net earnings (loss)		$	(127,000	)	$	463,000
Weighted average common shares outstanding for basic EPS		5,133,837			5,111,590
Incremental shares for effect of restricted stock and options		—			8,891
Weighted average common shares outstanding for dilutive EPS		5,133,837			5,120,481
Basic and diluted earnings (loss) per share:
Before cumulative effect		$	(.02	)	$	.09
Cumulative effect		—			—
		$	(.02	)	$	.09

 

No incremental shares are included in the 2007 EPS calculations for the 40,000 shares under option exercised during the year or the 225,000 shares of restricted common stock since the effect would be anti-dilutive.

36

---

NOTE J—ACCRUED LIABILITIES

Accrued liabilities consist of the following:

Employee related expenses:
Accrued payroll		$	94,000
Deferred compensation		24,000
Other		19,000
		137,000
Other, including interest:
Warranty reserve		$	31,000
Real estate taxes		25,000
Other		9,000
		65,000
		$	202,000

 

NOTE K—GAIN ON SETTLEMENT OF DEBT

Other income as presented in the accompanying consolidated statements of operations for the year ended April 30, 2006, includes a net gain of $35,000 resulting from the settlement of an old liability at an amount lower than originally recorded.

NOTE L—INFORMATION ABOUT MAJOR CUSTOMERS

For the year ended April 30, 2007, sales to two major customers accounted for 28% and 12% of consolidated net sales. For the year ended April 30, 2006, sales to two major customers accounted for 25% and 15% of consolidated net sales.

NOTE M—AMORTIZATION OF INTANGIBLE ASSETS

Since the acquisition of Electronika in 2002 primarily involved the purchase of certain technology-based intangible assets, annual reviews were performed to determine the amount of any impairment. The selling shareholders of Electronika (“the Caloyeras family”) contractually guaranteed that the aggregate sales from Electronika’s existing ballast designs over the first five (5) full fiscal years, specifically fiscal years 2003-2007, would be at least $2,500,000, which based on the terms of the Manufacturing Agreement with Magnetika, Inc., would result in an aggregate gross profit of $1,500,000 before any operating expenses. Actual aggregate sales during this five-year period were $1,404,000, resulting in an aggregate gross profit of $842,000. The gross profit shortfall resulted in an amount recoverable from the Caloyeras family of $658,000. Per an offset agreement with the Caloyeras family, filed as Exhibit 10.2 on Form 8-K on April 20, 2007, the recoverable amount was offset against a $750,000 note payable to the Caloyeras family having an extended maturity date of April 30, 2007, with the net balance of $92,000 being paid in cash by Torotel. For purposes of such offset agreement, the Caloyeras family agreed to extend the maturity date of the note payable in return for a loan extension fee of $11,525, which is included in selling, general and administrative expenses in the accompanying consolidated statement of operations.

37

The following table provides the adjusted gross carrying value and accumulated amortization for each major class of intangible asset based on Torotel’s reassessment of previously recognized intangible assets in accordance with the adoption of SFAS 142, Goodwill and Other Intangible Assets :

						2007								2006
		Average				Gross								Gross
		Amortizable				Carrying			Accumulated					Carrying			Accumulated
		Life				Amount			Amortization					Amount			Amortization
Aircraft—ballasts			3			$	490,000			$	490,000			$	1,148,000			$	457,000

 

The total intangible amortization expense for the years ended April 30, 2007 and 2006 was $33,000 and $79,000, respectively. No further amortization expense will be incurred for these intangible assets.

NOTE N—EQUITY INVESTMENT

On March 29, 2002, Torotel acquired a 17.8% equity interest in Apex. The total investment of $1,035,000 consisted of $35,000 in acquisition costs and a stock purchase of 4,000,000 common shares for $1,000,000, of which $250,000 came from available cash and the remaining $750,000 from loan proceeds from the Caloyeras Family Partnership (see Note M of Notes to Consolidated Financial Statements). The Caloyeras Family Partnership and a Caloyeras Trust also acquired 4,000,000 shares of Apex on the same terms as Torotel. On May 23, 2003, Torotel purchased an additional 355,637common shares of Apex stock for $89,000 at 25 cents per share. As of April 30, 2006, Torotel now owns a 12.88% equity interest in Apex. The investment in Apex has no carrying value on the consolidated balance sheet of Torotel, and in the opinion of Torotel management, it is not likely that any of the investment will be recovered because of Apex’s continued financial losses. If Apex were to eventually be sold, any cash recovered would be recognized as a gain upon receipt of any proceeds.

NOTE O—STOCK APPRECIATION RIGHTS (SARs)

On September 10, 2004, the board of directors of Torotel approved the Directors Stock Appreciation Rights Plan (the “Plan”) for non-employee directors. Each SAR is equal to one share of common stock of Torotel, and the aggregate number of SARs that may be granted under the Plan shall not exceed 500,000. The effective date of the Plan is October 1, 2004. The SARs are now accounted for under SFAS No. 123(R), Accounting for Stock-Based Compensation.

Pursuant to the Plan, 20,000 SARs were granted on the effective date to each of the three current non-employee directors. The initial price at which each SAR was granted was $.35, which equaled the market price of Torotel’s common stock on the date of grant. Accordingly, no compensation cost was recognized at the time of grant in accordance with APB Opinion 25, prior to the adoption of SFAS No. 123(R) on May 1, 2006, as discussed in Note A of Notes to Consolidated Financial Statements.

SARs shall automatically be granted in the future as follows: (1) each person who is elected as a director, who was not a director on the effective date of the Plan, shall be granted 10,000 SARs on the date such person is elected a director; and (2) on each May 1 following the effective date during the term of the Plan, each person serving as a director on such date shall be granted 10,000 SARs. After the initial grant, the price at which each SAR is granted shall be the average of the closing price of Torotel’s common stock for the ten consecutive days immediately preceding the date of grant. Upon exercise of a SAR, Torotel will pay the grantee an amount (the “Spread”) equal to the excess of the Exercise Price over the SAR grant price multiplied by the number of shares being exercised. The Exercise Price shall be the average of the closing price of Torotel’s common stock for the ten consecutive days immediately preceding the notice of exercise. For any payments that exceed $10,000, Torotel has the option to make quarterly payments over three years with interest payable quarterly at the prime rate of Torotel’s primary bank.

38

---

Each SAR granted hereunder may be exercised to the extent that the Grantee is vested in such SAR. The SARs will vest according to the following schedule:

Number of Years the Grantee has remained a director of the Company following  the Date of Grant				Shares represented by a SAR in which a Grantee is Vested
Under one					0	%
At least one but less than two					33	%
At least two but less than three					67	%
Three or more					100	%

 

A Grantee shall become fully (100%) vested in each of his or her SARs under the following circumstances: (i) upon termination of the Grantee’s service as a director of Torotel for reasons of death, disability or retirement; (ii) if the Compensation and Nominating Committee (the “Committee”), in its sole discretion, determines that acceleration of the SAR vesting schedule would be desirable for Torotel; or (iii) if Torotel shall, pursuant to action by its Board of Directors, at any time propose to merge into, consolidate with, or sell or otherwise transfer all or substantially all of its assets to another corporation, and provision is not made pursuant to the terms of such transaction for the assumption by the surviving, resulting or acquiring corporation of outstanding SARs or for substitution of new SARs therefore, the Committee shall cause written notice of the proposed transaction to be given to each Grantee not less than twenty days prior to the anticipated effective date of the proposed transaction, and his or her SARs shall become fully (100%) vested and, prior to a date specified in such notice, which shall be not more than ten days prior to the anticipated effective date of the proposed transaction, each Grantee shall have the right to exercise his or her SARs.

In accordance with SFAS 123(R), compensation expense is recognized over the vesting period based upon the estimated fair value of the SARs pursuant to the terms of the Plan using the Black-Scholes options-pricing model as of the end of each financial reporting period. As of April 30, 2007, the fair value of the SARs was determined using the following assumptions: no dividend payments over the life of the SARs since Torotel has not issued any form of dividend since 1985; an expected volatility of 174.8% based on Torotel’s historical volatility using the weekly closing price over the past 4.25 years; a risk-free interest rate of 4.50%; and an expected life of 4.25 years based on the length of service estimated to be served. Based on these assumptions, the fair value prices per share of the outstanding SARs are summarized as follows:

				SARs																Aggregate					Aggregate
				Under		Exercise					Fair Value					%				Vested					Intrinsic
Grant Date				Option		Price					Price					Vested				Fair Value					Value
October 1, 2004				60,000			$	.350				$	.473				67	%			$	19,000				$	9,000
May 1, 2005				30,000			$	.302				$	.475				33	%			$	5,000				$	6,000
May 1, 2006				30,000			$	.695				$	.462				0	%			$	—				$	—

 

The vested portion represents 50,100 SARs. As of April 30, 2007, the total aggregate intrinsic value of these exercisable SARs was $8,000.

39

---

SARs transactions for each period though April 30 are summarized as follows:

		2007							2006
				Weight							Weighted
		SARs		Average					SARs		Average
		Under		Grant					Under		Grant
		Option		Price					Option		Price
Outstanding at beginning of period		90,000			$	.334			60,000			$	.350
Granted		30,000			$	.695			30,000			$	.302
Exercised		—			—				—			—
Forfeited		—			—				—			—
Outstanding at end of period		120,000			$	.424			90,000			$	.334
SARs exercisable at end of period		50,100			$	.341			20,000			$	.350
Weighted average fair value of
SARs granted during the period					$	.462						$	.686

 

The following information applies to SARs outstanding for each period through April 30:

		2007			2006
Number outstanding		120,000			90,000
Range of grant prices		$	.302 - $.695		$	.302 - $.350
Weighted average grant price		$.424			$.334
Weighted average remaining contractual life		7.96 yrs.			8.61 yrs.

 

Total compensation expense for the outstanding SARs for the year ended April 30, 2007, was a reduction of $9,000, which included an $8,000 reduction for the cumulative effect of adopting SFAS No. 123(R). Total compensation expense for the outstanding SARs for the year ended April 30, 2006, was $29,000. As of April 30, 2007, there was $33,000 of total unrecognized compensation expense related to non-vested SARs granted under the Plan. That cost is expected to be recognized over a weighted average period of .96 years. The liability for SARs on the consolidated balance sheet as of April 30, 2007, was $24,000.

The following table summarizes the pro forma effect if compensation cost for the Plan had been determined applying the fair value based method to all outstanding SARs in the period presented:

		2006
Net earnings		$	463,000
Add: Stock-based compensation expense included in reported net earnings		29,000
Deduct: Stock-based compensation expense determined under fair value based method		14,000
Pro forma net earnings		$	478,000
Basic and diluted earnings per share:
as reported		$	.09
pro forma		$	.09

 

NOTE P—AGREEMENTS WITH RELATED PARTY

Electronika’s requirements for the ballast transformers are outsourced pursuant to a Manufacturing Agreement with Magnetika, a corporation owned by the Caloyeras family. Under the terms of the agreement, Magnetika provides all necessary raw material, labor, testing, packaging and related services required to complete the manufacture, delivery and sale of the ballast transformers, and Electronika is

40

---

obligated to order all of its ballast transformer requirements exclusively from Magnetika. Electronika retains ownership of all designs, drawings, specifications and intellectual property rights associated with the ballast transformers. In exchange for the services provided to Electronika under the Manufacturing Agreement, Magnetika receives 40 percent of the net sales price of all ballast transformers sold by Electronika, plus a $2,500 per month management fee for processing all quotations and orders. Per the Manufacturing Agreement, the monthly management fee will no longer be incurred because of Electronika’s lower sales volume. The Manufacturing Agreement continues in effect until April 1, 2012. In the fiscal year ended April 30, 2007, Electronika incurred costs of $78,000 for goods and services purchased on trade terms of net 20 days pursuant to the Manufacturing Agreement. Of the amount purchased, $38,000 was due and payable as of April 30, 2007.

Pursuant to a purchase option settlement agreement, filed as Exhibit 10.1 on Form 8-K on April 20, 2007, the Caloyeras family granted to Torotel, until July 31, 2007, the option for Torotel to purchase all, but not less than all, of the 2,537,505 shares of Torotel common stock owned by the Caloyeras family, at seventy cents ($.70) per share for a total cash purchase price of $1,776,000, subject to the provisions of the agreement. As part of the agreement, Basil P. Caloyeras dismissed without prejudice the action captioned Basil Caloyeras v. Torotel, Inc. , No. 06-2485-KHV (United States District Court, District of Kansas), agreed to obtain mutual releases of all claims in the event the shares are purchased pursuant to this option, and made a covenant not to sue prior to July 31, 2007, in consideration for Torotel agreeing that neither it, nor any subsidiary or affiliate controlled by it will, prior to July 31, 2007: (i) issue any shares, restricted or otherwise, of capital stock of Torotel; (ii) grant any options to purchase any shares of capital stock of Torotel; (iii) enter in any new employment agreements to which Torotel will be a party; (iv) modify, amend or alter any employment agreements to which Torotel is a party; or (v) effect a merger, recapitalization, reorganization or other corporate transaction which would have the effect of diluting the percentage interest of the Caloyeras Family Partnership and the Caloyeras Shareholders in Torotel. Torotel’s Board of Directors is seeking a 60-day extension of the option. In the event that an extension is not granted, Torotel intends to let the option expire. In the event the option does expire, it is possible that the Caloyeras family will re-file the litigation.

NOTE Q—GRANDVIEW, MISSOURI REAL ESTATE

Prior to moving to Olathe, Kansas in March 2004, Torotel previously occupied a two-building complex with approximately 29,000 square feet located in Grandview, Missouri. This property was split into two parcels, one consisting of a 24,000 square foot building on a 1.72-acre lot (“Lot No. 1”), and the other consisting of a 5,000 square foot building on an .88-acre lot (“Lot No. 2”). On July 20, 2005, Torotel closed on the sale of Lot No. 2 at a contract price of $225,000. The sale resulted in net proceeds of $205,000 and a net gain of $105,000, which is presented in other income in the accompanying consolidated statements of operations for the fiscal year ended April 30, 2006.

Torotel had entered into a real estate contract to sell Lot No. 1 at a gross selling price of $175,000. Upon completion of the 50-day inspection period, the buyer rescinded his original offer of $175,000 and countered at a price of $125,000, which Torotel accepted in order to eliminate the costs for real estate taxes, property and casualty insurance, and utilities. In doing so, Torotel recorded an impairment charge of $36,000, which is presented in other expense in the accompanying consolidated statements of operations for the fiscal year ended April 30, 2006. Closing on the sale took place on September 16, 2005, with Torotel receiving net proceeds from the sale of $112,000. The sale resulted in a net gain of $5,000, which is presented in other income in the accompanying consolidated statements of operations for the fiscal year ended April 30, 2006.

41