NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

For The Three Months Periods Ended March 31, 2019 and 2018

NOTE 1 – THE COMPANY AND BASIS OF PRESENTATION

Nature of Operations

One Stop Systems, Inc. (“we,” “our,” “OSS,” or the “Company”) was originally incorporated as a California corporation in 1999 after initially being formed as a California limited liability company in 1998. On December 14, 2017, the Company was reincorporated as a Delaware corporation in connection with its initial public offering.  The Company designs, manufactures and markets industrial grade computer systems and components that are based on industry standard computer architectures. The Company markets its products to manufacturers of automated equipment used for telecommunications, industrial and military applications.      

During the year ended December 31, 2015, the Company formed a new wholly-owned subsidiary in Germany (“OSS GmbH”).  During July 2016, the Company acquired Mission Technologies Group, Inc. (“Magma”) and its operations (Note 3).

In April 2017, the Company and a related entity formed a joint venture named SkyScale, LLC in the State of California (“SkyScale”).  In accordance with the Contribution Agreement, each member contributed $750,000 and received a 50% interest in the joint venture.  The purpose of SkyScale is to engage in the business of providing high performance computing capabilities as cloud services.

On December 31, 2018, as a result of changes in the competitive landscape and downward pressure on pricing from large competitors, the members to the SkyScale joint venture agreement agreed to dissolve SkyScale.  As a result, it became necessary for OSS to write-off the outstanding balances of accounts and notes receivable and interest in the amount of $648,411, which write-off was offset by receipt of equipment valued at $160,000 and allocation of income from disposition of assets and liabilities of $71,502.  These amounts have been included as an administrative expense in the accompanying consolidated statements of operations.  Additional reserves for future expenses to be incurred in the process of closing SkyScale were recorded in the amount of $288,400 and are included in administrative expenses.  As a result of the above, total charges related to the dissolution of SkyScale were $705,309 during the year ended December 31, 2018.  

In May 2017, the Company entered into a Technology and Software License Agreement with Western Digital (“WDT”) for their Ion flash storage software.  The agreement provides the Company with the Ion source code and rights to develop and market derivative products.  The Company intends to develop and sell Ion flash storage software with its high-density storage arrays, as well as service existing WDT software users (Note 3).

Also, in July 2017, the Company entered in to a Service Agreement with WDT to service its existing customer base that utilizes Ion flash storage software.  The Company also purchased certain equipment from WDT and hired selected employees to assist in the servicing of these existing customers.  Management has determined that the activities and assets acquired from WDT comprise a business as defined in ASC 805-10-55-4 through 55.  Consideration paid by the Company to WDT pursuant to the arrangements described above was $67,000.  In addition, the Company is required to pay prospective royalties to WDT of $2,500 or $5,000 for each sale of the Company’s products that include licensed software.  WDT is obligated to pay the Company for services rendered to support existing WDT software users the amount of $1,400,000 in defined declining quarterly amounts over a three year period.  Management does not believe this business acquisition meets the significance definition provided in Regulation S-X, Rule 210.1-02(w).

On August 31, 2018, the Company acquired Concept Development Inc. (CDI) located in Irvine, California for cash of $646,759, and common stock valued at $4,194,673 (Note 3).  CDI specializes in the design and manufacture of custom high-performance computing systems for airborne in-flight entertainment systems.

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On October 31, 2018, the Company’s wholly-owned German subsidiary, OSS GmbH, acquired 100% of the outstanding stock of Bressner Technology GmbH, a Germany limited liability company located near Munich, Germany, from its principal owners for cash considerat ion of €4,725,000 (US$5,374,582) and stock consideration of 106,463 newly-issued restricted shares of the Company’s common stock.

Going Concern Considerations

On February 1, 2018, the Company completed its initial public offering through the initial sale of 3,800,000 shares of common stock at a price to the public of $5.00 per share (see Note 8).  Proceeds from the sale were used to retire outstanding debt obligations, complete complimentary business acquisitions, and provide the Company with working capital.

The combination of continued revenue and gross profit growth, has resulted in growth of the organization as a whole, along with acquisitions of two companies, but has been offset by increased spending in all areas of operating expenses:  general & administrative, marketing & selling, along with research & development.  The Company is developing plans for cost containment, as well as debt and/or equity financing to ensure that liquidity will be sufficient to meet our cash requirements for current operations through at least a period of the next twelve months. As of March 20, 2019, the Company received funding commitments in the amount of $4,000,000 from members of the Board of Directors, of which $1,500,000 has been borrowed from multiple parties subsequent to March 31, 2019.

As a result, management believes that the Company has sufficient liquidity to satisfy its anticipated cash requirements for at least the next twelve months. However, there can be no assurance that our operations will become profitable or that external sources of financing, including the issuance of debt and/or equity securities, will be available at times and on terms acceptable to us, or at all.  The Company’s management prepares budgets and monitors the financial results of the Company as a tool to align liquidity needs to the recurring business requirements.     

Basis of Presentation

The accompanying financial statements have been prepared on an accrual basis of accounting in accordance with United States Generally Accepted Accounting Principles (“U.S. GAAP”), as set forth in the Financial Accounting Standards Board’s (“FASB”) Accounting Standards Codification (“ASC”).  

The unaudited consolidated financial statements herein have been prepared by the Company pursuant to the rules and regulations of the United States Securities Exchange Commission (“SEC”).  The accompanying interim unaudited financial statements have been prepared under the presumption that users of the interim financial information have either read or have access to the audited consolidated financial statements for the latest year ended December 31, 2018.  Accordingly, note disclosures which would substantially duplicate the disclosures contained in the December 31, 2018 audited consolidated financial statements have been omitted from these interim unaudited consolidated financial statements.  The Company evaluated all subsequent events and transactions through the date of filing this report.

Certain information and note disclosures normally included in financial statements prepared in accordance with U.S. GAAP have been condensed or omitted pursuant to such rules and regulations.  In the opinion of management, all adjustments considered necessary for a fair presentation have been included.  Operating results for the three months ended March 31, 2019, are not necessarily indicative of the results that may be expected for the year ending December 31, 2019.  For further information, refer to the audited consolidated financial statements and notes for the year ended December 31, 2018 included in the Company’s Annual Report on Form 10-K filed with the SEC on March 21, 2019.

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Principles of Consolidation

The accompanying unaudited consolidated financial statements include the accounts of OSS, which include the results from the Magma acquisition, Ion business combination, and acquisition of Concept Development Inc., since their respective dates of acquisition, its wholly-owned subsidiary, OSS GmbH, which includes the acquisition of Bressner Technology GmbH on October 31, 2018 and the accounts of the joint venture, SkyScale LLC (collectively referred to as the “Company”).  Intercompany balances and transactions have been eliminated in consolidation.

On April 6, 2017, the Company and Jacoma Investments, LLC, an entity owned by our board member Jack Harrison, formed a joint venture, SkyScale, LLC (“SkyScale”), to engage in the business of providing high performance computing capabilities as cloud services.  In accordance with the terms of the contribution agreement, Jacoma Investments, LLC agreed to contribute $750,000 in capital and the Company agreed to contribute $750,000 in the form of credits to purchase equipment, personnel or support services from the Company.  Each party received a 50% membership interest in the joint venture.  Management determined that SkyScale is a variable interest entity primarily because it is thinly capitalized and may require additional capital to finance its activities.  

Management determined that the Company is the primary beneficiary of SkyScale based primarily on the related party nature of SkyScale’s decision-makers and daily business operators.  In May 2018, the Company loaned SkyScale $300,000 for operations at an interest rate of 12%, per annum.  On August 30, 2018, an additional one-year working capital loan of $300,000 was authorized on similar terms of which SkyScale utilized $150,000.  

On December 31, 2018, as a result of changes in the competitive landscape and downward pressure on pricing from large competitors, the members to the SkyScale joint venture agreement agreed to dissolve SkyScale.  As a result, it became necessary for the Company to write-off the outstanding balances due from SkyScale of notes receivable and interest in the amount of $478,599.  The Company also had unpaid invoices for services rendered to SkyScale in the amount of $169,812.  These amounts have been charged to administrative expenses and are included in the accompanying consolidated financial statements as an operating expense.  As partial consideration for unpaid balances, SkyScale transferred computer equipment to the Company at an estimated market value of $160,000, which is held-for-sale and included in prepaid expenses and other current assets in the accompanying consolidated balance sheet.  The Company also received allocated income from disposition of SkyScale assets and liabilities of $71,502.  Additionally, accruals for future expenses to be incurred in the process of closing SkyScale were recorded in the amount of $288,400.   As a result of the above, total charges related to the dissolution of SkyScale were $705,309 during the year ended December 31, 2018.  

The assets and liabilities of SkyScale are as follows:

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Operating results for SkyScale are as follows:

The non-controlling interest attributable to SkyScale is shown as a component of equity on the consolidated balance sheets and the share of the loss attributable to the non-controlling interest is shown as a component of income (loss) in the accompanying consolidated statements of operations.  Management determined that the dissolution of SkyScale did not represent a strategic shift that has a major effect on the Company’s operations and financial results.  Accordingly, it has not been reported as discontinued operations.

NOTE 2 – SIGNIFICANT ACCOUNTING POLICIES

Use of Estimates

The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and disclosures of contingent assets, liabilities, and expenses at the date of the consolidated financial statements during the reporting period.  

Significant estimates made by management include, among others, the fair value of acquired net assets of CDI in August 2018, and Bressner Technology GmbH in October 2018, dissolution expenses for SkyScale, the allowance for doubtful accounts, fair value of stock options, recoverability of inventories and long-lived assets, and realizability of deferred tax assets.  Actual results could differ from those estimates.

Concentration Risks

At times, deposits held with financial institutions may exceed the amount of insurance provided by the Federal Deposit Insurance Corporation (“FDIC”), which provides basic deposit coverage with limits up to $250,000 per owner.  As of March 31, 2019, the Company had $65,446 in excess of the insurance limits.  The Company has not experienced any such losses in these accounts.  In Germany, the deposit insurance is €100,000 per bank, per customer.  As of March 31, 2019, Bressner has no funds on deposit with banks in excess of the insurance limits.

In the three month periods ended March 31, 2019 and 2018, our top three customers represent approximately 36%, and 54% of sales, respectively. As of March 31, 2019 and 2018, three customers accounted for 53% and   64% of net trade accounts receivables, respectively.

The Company made purchases from three suppliers which represented approximately 21% and 48% of purchases for the three month periods ended March 31, 2019 and 2018, respectively.

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Cash and Cash Equivalents

Cash and cash equivalents consist of cash on deposit and money market accounts.  The Company considers all highly liquid temporary cash investments with an initial maturity of three months or less when acquired to be cash equivalents.  Management believes that the carrying amounts of cash equivalents approximate their fair value because of the short maturity period.

Accounts Receivable

Accounts receivable are presented at net realizable value.  This value includes an appropriate allowance for estimated uncollectible accounts to reflect any loss anticipated on the trade accounts receivable and unbilled receivables.   Unbilled receivables include costs and gross profit earned in excess of billings.  The allowance for doubtful accounts is an estimate to cover the losses resulting from the inability of customers to make payments on their outstanding balances and unbilled receivables.  In estimating the required allowance, management considers the overall quality and aging of the accounts receivable, specific customer circumstances, current economic trends, and historical experience with collections.  At March 31, 2019 and December 31, 2018, the allowance for doubtful accounts was $13,210 and $ 13,403, respectively.

Revenues earned in excess of related billings are recorded as an asset on the balance sheet as unbilled receivables.  Unbilled receivables as of March 31, 2019 and December 31, 2018, were $6,663 and $65,157, respectively.

Inventories

Inventories are valued at the lower of cost or net realizable value determined on a first-in, first-out basis.  The Company uses the average cost method for purposes of determining cost, which approximates the first-in, first-out method.

The Company establishes reserves on its inventories to write-down the carrying value of its estimated obsolete or excess inventories to estimated net realizable value based upon observations of historical usage and assumptions about future demand and market conditions.  In addition, the Company considers changes in the market value of components in determining the net realizable value of its inventory.  Inventory reserves are not typically reversed until the specific inventories are sold or otherwise disposed.

Actual demand, product mix and alternative usage may be lower than those that we project and this difference could have a material adverse effect on our gross margin if inventory write-downs beyond those initially recorded become necessary.  Alternatively, if actual demand, product mix and alternative usage are more favorable than those we estimated at the time of such a write-down, our gross margin could be favorably impacted in future periods.

Property and Equipment

Property and equipment, other than leasehold improvements, are recorded at cost and depreciated using the straight-line method over the estimated useful lives of the assets, generally from three to five years. Leasehold improvements are recorded at cost and are amortized using the straight-line method over the shorter of the remaining lease term or the estimated useful life of the related asset.  Tooling and test equipment includes capitalized labor costs associated with the development of the related tooling and test equipment.  Costs incurred for maintenance and repairs are expensed as incurred, and expenditures for major replacements and improvements are capitalized. Upon retirement or sale, the cost and related accumulated depreciation and amortization of disposed assets are removed from the accounts and any resulting gain or loss is included in other expense, net.

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Goodwill

Goodwill represents the excess of the purchase price paid over the fair value of the net assets acquired in business combinations. Goodwill is not amortized but is tested for impairment at least annually or when we deem that a triggering event has occurred.  The Company reviews goodwill for impairment annually on December 31 ^st .  The Company completed its annual assessment for goodwill impairment and determined that goodwill is not impaired as of December 31, 2018 and no adjustment was required.  For the three month period ended March 31, 2019, the Company did a review for impairment of goodwill and no adjustment was required.  During the year ended December 31, 2018, the Company recognized goodwill related to two business acquisitions as described in Note 3.  

Intangible Assets and Long-lived Assets

We evaluate our intangible and long-lived assets for impairment when events or circumstances arise that indicate our intangible and long-lived assets may be impaired. Indicators of impairment include, but are not limited to, a significant deterioration in overall economic conditions, a decline in our market capitalization, the loss of significant business, significant decreases in funding for our contracts, or other significant adverse changes in industry or market conditions. The Company completed its qualitative assessment for impairment in December 2018 and determined that there was no impairment as of December 31, 2018.  There were no events or circumstances that arose during the three month period ended March 31, 2019, that gave an indication of impairment. There can be no assurance, however, that market conditions will not change or demand for the Company’s products will continue, which could result in an impairment of intangible and long-lived assets in the future.

Revenue Recognition

On January 1, 2019, the Company adopted the new accounting standard update ASC 606, Revenue from Contracts with Customers, which superseded nearly all existing revenue recognition guidance under GAAP, to all contracts using the modified retrospective method. The comparative information has not been restated and continues to be reported under the accounting standards in effect for those periods.  

The Company’s performance obligations are satisfied over time as work is performed or at a point in time. The majority of the Company’s revenue is recognized at a point in time when products ship and control is transferred to the customer. The Company determines revenue recognition through the following steps: (1) identification of the contract with a customer; (2) identification of the performance obligations in the contract; (3) determination of the transaction price; (4) allocation of the transaction price to the performance obligations in the contract; and (5) recognition of revenue when, or as, a performance obligation is satisfied.

The Company’s contracts are executed through a combination of written agreements along with purchase orders with all customers including certain general terms and conditions. Generally, purchase orders entail products, quantities and prices, which define the performance obligations of each party and are approved and accepted by the Company. The Company’s contracts with customers do not include extended payment terms. Payment terms vary by contract type and type of customer and generally range from 30 to 60 days from invoice. Additionally, taxes assessed by a governmental authority that are both imposed on and concurrent with a specific revenue-producing transaction, that are collected by the Company from a customer and deposited with the relevant government authority, are excluded from revenue.

The transaction price is determined based on the consideration to which the Company will be entitled in exchange for transferring goods or services to the customer adjusted for estimated variable consideration.  Variable consideration may include discounts, rights of return, refunds, and other similar obligations. The Company allocates the transaction price to each distinct product and service based on its relative standalone selling price. The standalone selling price for products primarily involves the cost to produce the deliverable plus the anticipated margin and for services is estimated based on the Company’s approved list price.

In the normal course of business, the Company does not accept product returns unless the items are defective as manufactured. The Company establishes provisions for estimated returns and warranties. In addition, the Company does not typically provide customers with the right to a refund and does not transact for noncash consideration.

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Customer agreements include one vendor managed invent ory program. T he Company recognizes revenue under this arrangement when (i) risks of ownership have passed to the customer; (ii) the customer's commitment to purchase the goods is fixed ; (iii) there is a fixed schedule for delivery of the goods that is rea sonable and consistent with the customer ' s business purpose ; (iv) the Company does not have any specific performance obligations such that the earning process is not complete; (v) the ordered goods have been segregated from the Company ' s inventory and are not subject to being used to fill other orders; and (vi) the product is complete and ready for shipment. Also , such arrangement must be requested by the customer and the customer has explained a substantial business purpose for the arrangement. Management also considers whether the customer ' s custodial risks are insured and whether modifications to the Company ' s normal billing and credit terms were required.

The Company recorded revenue from product sales that are held in vendor managed inventory under these agreements of $1,494,078 and $990,401, for the three month periods ended March 31, 2019 and 2018, respectively.

Revenues on certain fixed-price contracts where we provide engineering services, prototypes and completed products are recognized over the contract term based on the percentage of completion or based upon milestones delivered that are provided during the period and compared to the total estimated development and milestone goals to be provided over the entire contract. These services require that we perform significant, extensive and complex design, development, modification or implementation of our customers’ systems. Performance will often extend over long periods of time, and our right to receive future payment depends on our future performance in accordance with the agreement. Recognized revenue using the percentage of completion accounting method was $34,480 and $0 during the three month periods ended March 31, 2019 and 2018, respectively.

The percentage-of-completion methodology involves recognizing probable and reasonably estimable revenue using the percentage of services completed, on a current cumulative cost to estimate total cost basis, using a reasonably consistent profit margin over the period. Due to the long-term nature of these projects, developing the estimates of costs often requires significant judgment. Factors that must be considered in estimating the progress of work completed and ultimate cost of the projects include, but are not limited to, the availability of labor and labor productivity, the nature and complexity of the work to be performed and the impact of delayed performance. If changes occur in delivery, productivity or other factors used in developing the estimates of costs or revenues, we revise our cost and revenue estimates, which may result in increases or decreases in revenues and costs, and such revisions are reflected in earnings in the period in which the revision becomes known.

Related billings that are in excess of revenue earned are deferred and recorded as a liability on the balance sheet until the related services are provided. Deferred revenue was $1,123,896 and $175,000 for the three month periods ended March 31, 2019 and 2018, respectively. The Company recognizes revenues for non-refundable, upfront implementation fees on a straight-line basis over the period beginning with initiation of ongoing services through the end of the contract term.

The Company’s operating segment revenues disaggregated by primary geographic market, which is determined based on a customer’s geographic location, for the three month period ended March 31, 2019 is as follows:

Warranty Reserve

The Company offers product warranties that extend for one year from the date of sale. Such warranties require the Company to repair or replace defective product returned to the Company during the warranty period at no cost to the customer. The Company records an estimate for warranty‑related costs at the time of sale based on its historical and estimated future product return rates and expected repair or replacement costs (Note 7).  

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While such costs have historically been within management’s expectations and the provisions established, unexpected changes in failure rates could have a material adverse impact on the Company, requiring additional warranty reserves and could adversely affect the Company’ s gross profit and gross margins.

The Company offers customers extended warranties beyond the standard one-year warranty on the product.  The customer can purchase extended warranties from one to five years, in the bronze, silver or gold categories.  This entails hardware repair or replacement, shipping methods on how the warranties will be returned / delivered, response times and hours of operations to receive support.  The amount of warranties sold for the three months period ended March 31, 2019 and 2018 was $80,123 and $16,184.

The revenue that was recognized for the warranties sold for the three months ended March 31, 2019 and 2018 was $106,698 and $27,447, respectively.  The Company does have recourse with some of its suppliers that offer more than a one-year guarantee on parts, but this is not standard.  The few that offer greater than a year warranty, the Company may be able to cover the cost of the part from the manufacturer for the failed part.  The amount of these costs vary in a wide range, but are not material, due to the infrequency of failure.  The amount of liability on the Company’s books for revenue not recognized as of March 31, 2019 and December 31, 2018 were $382,759 and $409,334, respectively.  

Shipping and Handling Costs

The Company's shipping and handling costs are included in cost of goods sold for all periods presented.

Foreign Currency

We operate primarily in the United States.  Foreign sales of products and services are primarily denominated in U.S. dollars.  We also conduct limited business outside the United States through our foreign subsidiary in Germany, where business is largely transacted in non-U.S. dollar currencies, particularly the Euro, which is subject to fluctuations due to changes in foreign currency exchange rates.   Accordingly, we are subject to exposure from changes in the exchange rates of local currencies. Foreign currency transaction gains and losses are recorded in other income (expense), net in the consolidated statements of operations .

OSS GmbH operates as an extension of OSS’s domestic operations.  The functional currency of OSS GmbH is the Euro. Transactions denominated in currencies other than the functional currency are remeasured to the functional currency at the average exchange rate in effect during the period.  At the end of each reporting period, monetary assets and liabilities are remeasured using exchange rates in effect at the balance sheet date. Non-monetary assets and liabilities are remeasured at historical exchange rates. Consequently, changes in the exchange rates of the currencies may impact the translation of the foreign subsidiaries’ statements of operations into U.S. dollars, which may in turn affect our consolidated statement of operations. The resulting foreign currency translation adjustments are recorded as a separate component of accumulated other comprehensive income in the consolidated balance sheet.

Derivative Financial Instruments

We employ derivatives to manage certain market risks through the use of foreign exchange forward contracts. We do not use derivatives for trading or speculative purposes. Our derivatives are designated as a hedge of a forecasted transaction or of the variability of cash flows to be received or paid related to a recognized asset or liability (cash flow hedge). We hedge a portion of the exchange risk involved in anticipation of highly probable foreign currency-denominated transactions. In anticipation of these transactions, we enter into foreign exchange contracts to provide currency at a fixed rate. As of March 31, 2019, the Company had no foreign exchange contracts outstanding.  

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Unrealized gains on derivatives designated as cash flow hedges are recorded a t fair value as assets, and unrealized losses on derivatives designated as cash flow hedges are recorded at fair value as liabilities. For derivative instruments designated as cash flow hedges, the effective portion is reported as a component of accumulate d other comprehensive income until reclassified into interest expense in the same period the hedged transaction affects earnings. The gain or loss on the ineffective portion is recognized as “Other income (expense) – net” in the consolidated statements of income in each period.

Stock-Based Compensation

The Company accounts for employee and director share-based compensation in accordance with the provisions of ASC Topic 718 “Compensation – Stock Compensation” .  Under ASC 718, share-based compensation cost is measured at the grant date, based on the calculated fair value of the award, and is recognized as an expense over the employee’s requisite service period (generally the vesting period of the equity grant).

All transactions in which goods or services are the consideration received for the issuance of equity instruments to non-employees are accounted for based on the fair value of the consideration received or the fair value of the equity instrument issued, whichever is more reliably measurable.  The measurement date used to determine the estimated fair value of the equity instrument issued is the earlier of the date on which the third-party performance is complete or the date on which it is probable that performance will occur.

Employee and director stock-based compensation expense recognized during the period is based on the value of the portion of stock-based payment awards that is ultimately expected to vest during the period.  Given that stock-based compensation expense recognized in the accompanying consolidated statements of operations is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. The Company’s estimated average forfeiture rates are based on historical forfeiture experience and estimated future forfeitures.

Compensation cost for stock awards, which include restricted stock units (“RSUs”), is measured at the fair value on the grant date and recognized as expense, net of estimated forfeitures, over the related service period. The fair value of stock awards is based on the quoted price of our common stock on the grant date.

The estimated fair value of common stock option awards is calculated using the Black-Scholes option pricing model. The Black-Scholes model requires subjective assumptions regarding future stock price volatility and expected time to exercise, along with assumptions about the risk-free interest rate and expected dividends, all of which affect the estimated fair values of the Company’s common stock option awards.  The expected term of options granted is calculated using the simplified method, which is the weighted average vesting period and the contractual lives of the options.  

This calculation is based on a method acceptable in instances where the vesting and exercise terms of options granted meet certain conditions and where limited historical exercise data is available.  The expected volatility is based on the historical volatility of the common stock of comparable public companies that operate in similar industries as the Company.

The risk-free rate selected to value any particular grant is based on the U.S. Treasury rate that corresponds to the expected term of the grant effective as of the date of the grant. The expected dividend assumption is based on the Company’s history and management’s expectation regarding dividend payouts. Compensation expense for common stock option awards with graded vesting schedules is recognized on a straight-line basis over the requisite service period for the last separately vesting portion of the award, provided that the accumulated cost recognized as of any date at least equals the value of the vested portion of the award.

If there are any modifications or cancellations of the underlying vested or unvested stock-based awards, the Company may be required to accelerate, increase or cancel any remaining unearned stock-based compensation expense, or record additional expense for vested stock-based awards. Future stock-based compensation expense and unearned stock- based compensation may increase to the extent that the Company grants additional common stock options or other stock-based awards.

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Business Combinations

We utilize the acquisition method of accounting for business combinations and allocate the purchase price of an acquisition to the various tangible and intangible assets acquired and liabilities assumed based on their estimated fair values. We primarily establish fair value using the income approach based upon a discounted cash flow model. The income approach requires the use of many assumptions and estimates including future revenues and expenses, as well as discount factors and income tax rates. Other estimates include:

While we use our best estimates and assumptions as part of the purchase price allocation process to accurately value assets acquired and liabilities assumed at the business acquisition date, our estimates and assumptions are inherently uncertain and subject to refinement. As a result, during the purchase price allocation period, which is generally one year from the business acquisition date, we record adjustments to the assets acquired and liabilities assumed, with the corresponding offset to goodwill.

For changes in the valuation of intangible assets between preliminary and final purchase price allocation, the related amortization is adjusted in the period it occurs. Subsequent to the purchase price allocation period any adjustment to assets acquired or liabilities assumed is included in operating results in the period in which the adjustment is determined.  Should we issue shares of our common stock in an acquisition, we will be required to estimate the fair value of the shares issued.

Advertising Costs

Advertising costs are expensed as incurred and included in marketing and selling expense in the accompanying consolidated statements of operations.  Advertising costs for the three month periods ended March 31, 2019 and 2018 were $130,922 and $17,626, respectively.

Research and Development Expenses

Research and development expenditures are expensed in the period incurred.  Research and development expenses primarily consist of salaries, benefits and stock-based compensation, as well as consulting expenses and allocated facilities and other overhead costs. Research and development activities include the development of new technologies, features and functionality in support of the Company’s products and customer needs.

Income Taxes

The Company utilizes the asset and liability method of accounting for income taxes. Under this method, deferred tax assets and liabilities are determined based on the difference between the consolidated 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 affect taxable income. Valuation allowances are established when necessary to reduce deferred tax assets to the amounts expected to be realized.

Under ASC Topic 740, the impact of an uncertain income tax position on the income tax return must be recognized at the largest amount that is more-likely-than-not to be sustained upon audit by the relevant taxing authority.  An uncertain income tax position will not be recognized if it has less than a 50% likelihood of being sustained.  Additionally, ASC Topic 740 provides requirements for derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition.  The Company’s policy is to recognize interest and/or penalties related to income tax matters in income tax expense.  

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The Company files income tax returns in the U.S. federal jurisdiction, California and Germany.   On December 22, 2017, the U.S. government enacted comprehensive tax legislation commonly r eferred to as the Tax Cuts and Jobs Act (the “Tax Act”).  The Tax Act reduces the corporate tax rate to 21%, effective January 1, 2018.  Consequently, the Company has recorded a decrease related to deferred tax assets and deferred tax liabilities as of Dec ember 31, 2017.   Except for this adjustment, the Company does not foresee material changes to its gross liability of uncertain tax positions within the next twelve months .

Interest Expense

Interest expense consists primarily of interest associated with the Company’s issued debt including the amortization of debt discounts.  The Company recognizes the amortization of debt discounts and the amortization of interest costs using a straight-line method which approximates the effective interest method.

Net (Loss) Income Per Share

Basic net (loss) income per share is calculated by dividing net (loss) income by the weighted-average common shares outstanding during the period.  Diluted net (loss) income per share is calculated by dividing the net (loss) income by the weighted-average shares and dilutive potential common shares outstanding during the period. Dilutive potential shares consist of dilutive shares issuable and the exercise or vesting of outstanding stock options and warrants, respectively, computed using the treasury stock method. During a period where a net loss is incurred, dilutive potential shares are excluded from the computation of dilutive net loss per share, as inclusion is anti-dilutive.  

On February 1, 2018, in connection with the Company’s initial public offering, the Company’s outstanding Series A, Series B, and Series C, Preferred Stock was automatically converted to common stock, par value $0.0001.

Recent Accounting Pronouncements

In February 2016, the FASB issued ASU No. 2016-02, Leases (“ASU 2016-02”).  Under ASU 2016-02, lessees will be required to recognize the following for all leases (with the exception of short-term leases) at the commencement date: a lease liability, which is a lessee’s obligation to make lease payments arising from a lease, measured on a discounted basis; and a right-of-use asset, which is an asset that represents the lessee’s right to use, or control the use of, a specified asset for the lease term.  ASU 2016-02 is effective for the Company for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years.  Early application is permitted.  Lessees must apply a modified retrospective transition approach for leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements.  The modified retrospective approach would not require any transition accounting for leases that expired before the earliest comparative period presented.  Lessees may not apply a full retrospective transition approach.  The Company is currently evaluating the impact of adopting ASU 2016-02 on its consolidated financial statements and disclosures, but preliminary expects its assets and liabilities to increase significantly.

In August 2016, the FASB issued ASU No. 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments (“ASU 2016-15”), which is intended to reduce the existing diversity in practice in how certain cash receipts and cash payments are classified in the statement of cash flows. ASU 2016-15 is effective for fiscal years beginning after December 15, 2018, with early adoption permitted, provided that all of the amendments are adopted in the same period. The Company is currently evaluating the impact of adopting ASU 2016-15 on its consolidated financial statements.

In January 2017, the FASB issued ASU No. 2017-01, Business Combinations (Topic 805): Clarifying the Definition of a Business (“ASU 2017-01”). The amendments in this update clarify the definition of a business with the objective of adding guidance to assist entities with evaluating whether transactions should be accounted for as acquisitions or disposals of assets or businesses. ASU 2017-01 will be effective for the Company for the year ending December 31, 2019 and interim reporting periods within 2020. Early adoption is permitted for transactions that have not been reported in financial statements that have been issued or made available for issuance. The Company is currently evaluating the effect of the adoption of this guidance on the Company’s consolidated financial statements.

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In June 2018, the FASB issued ASU No. 2018-07, Stock-based Compensation: Improvements to Nonemployee Share-based Payment Accounting , which amends the existing accounting standards for share-based payments to nonemployees. This ASU aligns much of the guidance on measuring and classifying nonemployee awards with that of awards to employees. Under the new guidance, the measurement of nonemployee equity awards is fixed on the grant date. This ASU becomes effective for the year ending December 31, 2020 and early adoption is permitted but no earlier than an entity’s adoption date of Topic 606. Entities will apply the ASU by recognizing a cumulative-effect adjustment to retained earnings as of the beginning of the annual period of adoption. We are currently evaluating the impact that ASU 2018-07 will have on our condensed consolidated financial statements.

Recently implemented accounting pronouncements

In May 2014, the FASB issued Accounting Standards Update (“ASU”) No. 2014-09, Revenue from Contracts with Customers (“ASU 2014-09”). ASU 2014-09 supersedes the revenue recognition requirements in FASB Topic 605, Revenue Recognition . ASU 2014-09 implements a five-step process for customer contract revenue recognition that focuses on transfer of control, as opposed to transfer of risk and rewards.  This guidance provides a single, comprehensive accounting model for revenue arising from contracts with customers. This guidance supersedes most of the existing revenue recognition guidance, including industry-specific guidance. Under this model, revenue is recognized at an amount that a company expects to be entitled to upon transferring control of goods or services to a customer, as opposed to when risks and rewards transfer to a customer. The new guidance also requires additional disclosures about the nature, timing and uncertainty of revenue and cash flow arising from customer contracts, including significant judgments and changes in judgments. We adopted this standard beginning January 1, 2019 and used the modified retrospective method of adoption. Under the new guidance, based on the nature of our contracts, we continued to recognize revenue in a similar manner as with the former guidance. Additionally, we expect the unit of accounting, that is, the identification of performance obligations, will be consistent with current revenue guidance. Accordingly, the adoption of this standard did not significantly impact our revenues.  

In January 2017, the FASB issued ASU No. 2017-04, Intangibles - Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment (“ASU 2017-04”). ASU 2017-04 simplifies the subsequent measurement of goodwill by eliminating Step 2 from the goodwill impairment testing. An entity will no longer determine goodwill impairment by calculating the implied fair value of goodwill by assigning the fair value of a reporting unit to all of its assets and liabilities as if that reporting unit had been acquired in a business combination. Instead, an entity should perform its annual, or interim, goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount and recognize an impairment charge for the amount by which the carrying amount exceeds the reporting unit’s fair value. The loss recognized should not exceed the total amount of goodwill allocated to that reporting unit. An entity still has the option to perform the qualitative assessment for a reporting unit to determine if the quantitative impairment test is necessary.  The Company adopted early ASU 2017-04 in 2018.  The Company’s early adoption of this guideline did not have a material effect on the Company’s consolidated financial statements.

NOTE 3 – ACQUISITIONS

Concept Development Inc.

On August 31, 2018, the Company acquired 100% of the outstanding common stock of Concept Development Inc. (“CDI”) from CDI’s former stockholder (“CDI Stockholder”) pursuant to an Agreement and Plan of Merger and Reorganization (the “Merger Agreement”).  CDI specializes in the design and manufacturing of custom high-performance computing systems for airborne in-flight entertainment systems.  CDI is located in Southern California. The acquisition is expected to increase the Company’s access to the in-flight entertainment market and gain technical expertise in the design and manufacturing of airborne equipment.  

The Company paid cash of $646,759 and issued 1,266,364 shares of the Company’s common stock to the CDI Stockholder for 100% of CDI outstanding common stock. The fair value assigned to the shares of common stock was $4,194,673, which was based upon the closing price of OSS’s stock on August 31, 2018 of $3.63 less a discount of 8.75% for lack of marketability for a one year period.

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This transaction was accounted for using the acquisition method purs uant to ASC Topic 805, Business Combinations . Accordingly, goodwill has been measured as the excess of the total consideration over the amounts assigned to the identifiable assets acquired and liabilities assumed.

The preliminary allocation of the total consideration to the acquired net assets as of the acquisition date for CDI is as follows:

The determination of fair value for the identifiable net assets acquired in the acquisition was determined by management and considered the results of a third-party appraisal of the fair value of equipment purchased. Management estimates that any residual value from the intangible assets listed above will not be significant. On the acquisition date, goodwill of $3,100,361 and other intangible assets of $1,770,000 were recorded. The business combination is considered a tax-free reorganization under Section 368(a) under the Internal Revenue Code.

As of the date of this report, management is still in the process of determining the final accounting related to the CDI transaction.  Because management’s analysis has not yet been completed, the Company’s determination of the purchase price and the resulting purchase price allocation is preliminary.  The Company incurred $245,028 in accounting and legal fees related to the acquisition of CDI.

Bressner Technology GmbH

On October 31, 2018, the Company’s wholly-owned German subsidiary, OSS GmbH, acquired 100% of the outstanding stock of Bressner Technology GmbH, a Germany limited liability company located near Munich, Germany, from its principal owners for cash consideration of €4,725,000 (US$5,374,582) and stock consideration of 106,463 newly-issued restricted shares of the Company’s common stock. The fair value assigned to the shares of common stock was $228,779, which was based upon the closing price of OSS’s stock on October 31, 2018 of $2.47 less a discount of 13.0% for lack of marketability for a two year period.

This transaction was accounted for using the acquisition method pursuant to ASC Topic 805, Business Combinations . Accordingly, goodwill has been measured as the excess of the total consideration over the amounts assigned to the identifiable assets acquired and liabilities assumed.

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The preliminary allocation of the total consideration to the acquired net assets as o f the acquisition date for Bressner Technology GmbH is as follows:

The determination of fair value for the identifiable net assets acquired in the acquisition was determined by management and considered the results of a third-party appraisal of the fair value of equipment purchased. Management estimates that any residual value from the intangible assets listed above will not be significant. On the acquisition date, goodwill of $1,489,722 and other intangible assets of $1,777,110 were recorded. The business combination is considered a tax-free reorganization under Section 368(a) under the Internal Revenue Code.

As of the date of this report, management is still in the process of determining the final accounting related to the Bressner transaction.  Because management’s analysis has not yet been completed, the Company’s determination of the purchase price and the resulting purchase price allocation is preliminary.  The Company incurred $419,305 in accounting and legal fees related to the acquisition of Bressner.

Definite lived intangible assets related to acquisitions are as follows, as of March 31, 2019:

Definite lived intangibles assets related to acquisitions are as follows, as of December 31, 2018:

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The amortization expense of the definite lived intangible assets for the years remaining is as follows:

Amortization expense recognized during the three month period ended March 31, 2019 and 2018 was $359,616 and $98,660, respectively.

The amount of revenue and net loss of CDI included in the Company’s consolidated statements of operations for the three month periods ended March 31, 2019 was $299,454 and $363,529, respectively.  The amount of revenue and net loss of Bressner included in the Company’s consolidated statements of operations for the three month periods ended March 31, 2019 was $4,535,604 and $149,159, respectively.  The following unaudited consolidated pro forma information presents the results of operations for the three month periods ended March 31, 2019 and 2018 as if these two acquisitions occurred on January 1, 2018.

Unbilled receivable includes amounts associated with percentage-of-completion accounting, which includes cost and gross profit earned in excess of billing, not currently billable due to contractual provisions.  The provision for bad debt expense related to accounts receivable was $(88) and $91,127 for the three month periods ended March 31, 2019 and 2018, respectively .

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During the three month periods ended March 31, 2019 and 2018, the Company incurred $105,111 and $155,097 of depreciation and amortization expense related to property and equipment, respectively.

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NOTE 8 – DEBT

Bank Lines of Credit

In May 2015, the Company entered into a credit agreement (“Credit Agreement”) with a financial institution which provides for a revolving line of credit and a term note payable. Borrowings under the Credit Agreement were collateralized by substantially all of the Company's assets and the personal guarantee of the Company’s Chief Executive Officer (“CEO”).  Under the terms of the revolving line of credit, as amended on October 5, 2017, the line of credit was extended through August 31, 2018, and the unrestricted borrowing capacity was increased from $3,000,000 to $3,500,000.

Borrowings under the revolving line of credit bear interest at a LIBOR-based rate, as defined in the Credit Agreement, plus 2.5% (totaling 3.93% at December 31, 2017), and interest is payable monthly. On February 5, 2018, the Company paid down the remaining outstanding balance on the line of credit.  On March 2, 2018, the Company cancelled its line of credit with the Bank of West and the personal guarantee of the Company’s CEO was released as a result.   

Bressner Technology GmbH has five revolving lines of credit with German institutions totaling €3,820,000 (US$4,286,307).  Borrowing under the lines of credit bear interest at variable rates of Euribor plus a stated rate.  Current rates are between 3.75% and 7.99%.  The lines of credit were guaranteed by the managing director through March 31, 2019. Total outstanding balance as of March 31, 2019 was €493,698 (US $553,965).

Notes Payable

In May 2015, the Company issued a note payable in connection with the Credit Agreement totaling $1,250,000 (“May 2015 Note”).  Under the terms of the note agreement, interest accrued on the outstanding balance at 3.60% per annum.  The May 2015 Note required the Company to make monthly principal and interest payments totaling $36,750 through the maturity date.

In July 2016, the Company refinanced the Magma note payable (Note 2) and the May 2015 Note into a new $1,600,000 note payable (“Refinanced Note”).  Under the terms of the Refinanced Note, interest accrued on the outstanding balance at 3.80% per annum.  The Refinanced Note required the Company to make monthly principal and interest payments totaling $47,219 through the maturity date of July 31, 2019.  The note was paid in full on February 23, 2018.

In July 2016, the Company issued a note payable totaling $250,000 (“July 2016 Note”) to a third party.  Under the terms of the note agreement, interest accrued on the outstanding balance at 11% per annum.  The July 2016 Note requires the Company to make monthly principal and interest payments totaling $9,570 with a maturity date on January 15, 2019.  The note is unsecured and guaranteed by the Company’s CEO and is subordinated to borrowings under the Credit Agreement. The note was paid in full on February 15, 2018.  

In connection with July 2016 Note, the Company issued to the noteholder warrants to purchase shares of the Company’s common stock equal to 20% of the original principal at a price per share equal to $1.78 per share. Accordingly, the Company issued to the noteholder warrants to purchase 28,090 shares of the Company’s common stock at an exercise price of $1.78 per share in July 2016. The relative fair value of the warrants was $24,830.  The relative fair value of warrants was estimated using Black-Scholes with the following weighted-average assumptions: fair value of the Company’s common stock at issuance of $1.78 per share; seven year contractual term; 54% volatility; 0% dividend rate; and a risk-free interest rate of 1.42%.  

Bressner Technology GmbH has three term loans outstanding with a total balance outstanding of €386,458 (US$433,634) as follows:

Bressner entered into an unsecured note payable for working capital in August 2015, in the amount of €250,000 (US$280,518) which bears interest at 2.125% which matures on August 12, 2019.  Quarterly payments of €15,600 (US$17,504) are due at the beginning of each calendar quarter with remaining balance due at maturity.  The balance outstanding as of March 31, 2019 is €33,058 (US$37,094).

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Bressner entered into a note payable in August 2016, in the amount of €250,000 (US$280,518) which bears interest at 2.125% which matures on September 30, 2020.  The loan is guaranteed by the managing director of Bressner th rough March 31, 2019.  Quarterly payments of €15,600 (US$17,504) are due at the end of each calendar quarter with remaining balance due at maturity.  The balance outstanding as of March 31, 201 9 is € 78,400 (US$ 87,970 ).

Bressner entered into a note payable in September 2017, in the amount of €400,000 (US$448,828) which bears interest at 2.125% which matures on April 30, 2020.  The loan was guaranteed by the managing director of Bressner through March 31, 2019.  Quarterly payments of €25,000 (US$28,052) are due in January, April, July and November with remaining balance due at maturity.  The balance outstanding as of March 31, 2019 is €275,000 (US$308,570).

Related-Party Notes Payable

In July 2016, the Company issued notes payable totaling $350,000 (“July 2016 Related Party Notes”) to two stockholders.  Under the terms of the note agreements, interest accrues on the outstanding balance at 11% per annum.  The July 2016 Related Party Notes require the Company to make total monthly principal and interest payments of $13,397 with maturity dates on January 15, 2019.  The notes are unsecured and guaranteed by the Company’s CEO and are subordinated to borrowings under the Credit Agreement. The notes were paid in full on February 15, 2018.  

In connection with July 2016 Related Party Notes, the Company issued to the noteholders warrants to purchase shares of the Company’s common stock equal to 20% of the original principal at a price per share equal to $1.78 per share. Accordingly, the Company issued to the noteholders warrants to purchase 39,326 shares of the Company’s common stock at an exercise price of $1.78 per share in July 2016.

The relative fair value of the warrants was $34,763. The relative fair value of warrants was estimated using Black-Scholes with the following weighted-average assumptions: fair value of the Company’s common stock at issuance of $1.78 per share; seven year contractual term; 54% volatility; 0% dividend rate; and a risk-free interest rate of 1.42%.  

A summary of notes payable as described above as of March 31, 2019 is as follows:

NOTE 9 – STOCKHOLDERS’ EQUITY

The Company’s amended and restated certificate of incorporation filed on December 14, 2017, authorizes the Company to issue 10,000,000 shares of preferred stock and 50,000,000 shares of common stock. On February 1, 2018, in connection with the Company’s initial public offering, each share of the Company’s outstanding Series A, Series B, and Series C, Preferred Stock was automatically converted into a share of the Company’s common stock, par value $0.0001 on a one-for-one basis.  

Common Stock

The voting, dividend and liquidation rights of the holders of the common stock are subject to rights of preferred stockholders, if any, as designated by the Board of Directors.  Common stockholders have voting rights at all meetings of stockholders and are entitled to one vote for each share held subject to certain limitations otherwise required by law.  Dividends may be declared and paid on the common stock as and when determined by the Board of Directors subject to any preferential dividend or other rights of preferred stockholders.  The Company does not anticipate declaring any dividends in the foreseeable future.  Upon the dissolution or liquidation of the Company, common stockholders are entitled to receive all assets of the Company, subject to any preferential or other rights of preferred stockholders.

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Initial Public Offering

On December 18, 2017, the Company announced the commencement of an underwritten public offering of its common stock, par value $0.0001 per share. The offering became effective on January 31, 2018 and trading began on February 1, 2018.  On February 5, 2018, the Company closed the initial public offering selling an aggregate of 3,800,000 shares of common stock at a price to the public of $5.00 for total gross proceeds of $19,000,000, which resulted in net proceeds of $17,485,000, after deducting underwriting discounts and commissions of $1,330,000 and underwriter offering-related transaction costs of $185,000. Additionally, the Company incurred costs associated with the transaction for accounting, legal and other fees and costs of $1,148,352 and a warrant expense of $699,408 for warrants issued to the underwriter pursuant to the underwriter agreement.  Such stock issuance costs have been deducted from the proceeds received from the underwriter and disclosed as net proceeds in the consolidated statement of stockholders’ equity.

On February 9, 2018, the underwriters exercised their over-allotment option to purchase an additional 200,000 shares of common stock at the public offering price of $5.00 per share, of which 100,000 shares of newly issued common stock were purchased from the Company and 100,000 shares were sold by the Company’s CEO’s family trust.  The Company received gross proceeds of $500,000, which resulted in net proceeds to the Company of $465,000, after deducting underwriting discounts and commissions of $35,000.

Warrants

In conjunction with the Company’s initial public offering, on February 1, 2018, the Company issued warrants to the underwriter to purchase 380,000 shares of common stock at a price of $6.00 pursuant to the Underwriting and Warrant Agreements dated February 1, 2018.

The fair value of the warrants was $699,408. The fair value of warrants was estimated using Black-Scholes with the following weighted-average assumptions: fair value of the Company’s common stock at issuance of $5.00 per share; five year contractual term; 42.7% volatility; 0% dividend rate; and a risk-free interest rate of 2.72%.  The warrant expense was treated as a stock issuance cost and was deducted from the gross proceeds received in the offering in the current period.  A corresponding increase in additional paid in capital was recognized in relation to this transaction.

Exercise of Stock Options and Warrants

During the three month periods ended March 31, 2019, the Company issued 54,098 shares of common stock for proceeds of $14,201 in cash related to the exercise of stock options and warrants.  Of the total shares issued, 17,598 shares of common stock were issued as a cashless exercise of stock options. 

Preferred Stock

Preferred Stock may be issued from time to time in one or more series, each of these series to have such terms as stated or expressed in resolutions providing for the issue of such series adopted by the Board of Directors.  Since February 1, 2018, there has been no outstanding preferred stock.

Regarding unissued preferred stock, the Board of Directors is authorized to determine or alter any or all of the rights, preferences, privileges and restrictions granted to or imposed upon wholly unissued series of preferred stock, and to fix or alter the number of shares comprising any such series and the designation thereof, or any of them, and to provide for rights and terms of redemption or conversion of the shares of any such series.

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The following table presents details of the assumptions used to calculate the weighted-average grant date fair value of common stock options granted by the Company:

As of March 31, 2019, the amount of unearned stock-based compensation estimated to be expensed from 2019 through 2022 related to unvested common stock options is $319,285, net of estimated forfeitures. The weighted-average period over which the unearned stock-based compensation is expected to be recognized is 2.04 years.

If there are any modifications or cancellations of the underlying unvested awards, the Company may be required to accelerate, increase or cancel any remaining unearned stock-based compensation expense or calculate and record additional expense.  Future stock-based compensation expense and unearned stock-based compensation will increase to the extent that the Company grants additional common stock options or other stock-based awards.

Restricted Stock Units

Restricted stock units may be granted at the discretion of the compensation committee of the Board of Directors under the 2017 Plan in connection with the hiring and retention of personnel and are subject to certain conditions.  Restricted stock units generally vest quarterly over a period of three years and are typically forfeited if employment is terminated before the restricted stock unit vest.  The compensation expense related to the restricted stock units is calculated as the fair value of the common stock on the grant date and is amortized to expense over the vesting period and is adjusted for estimated forfeitures.

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The Company’s restricted stock unit activity for the three month period ended March 31, 201 9 is as follows: