Notes to Condensed Consolidated Financial Statements (Unaudited)

March 31, 2019

1. Organization

Great Elm Capital Group, Inc. (the Company ) is a holding company incorporated in Delaware.  The Company currently has four operating segments: durable medical equipment, investment management, real estate and general corporate.  The Company is pursuing business development opportunities in durable medical equipment, investment management, real estate and other industries.

On September 7, 2018, the Company, through its majority-owned subsidiary, Great Elm DME Holdings, Inc. ( DME Holdings ), acquired an 80.1% equity interest in Great Elm DME, Inc. ( DME Inc. ) an entity formed to acquire and combine two companies Valley Healthcare Holding, LLC ( Valley ) and Northwest Medical, Inc. ( Northwest ), which both specialize in the distribution of respiratory care equipment, including primarily positive air pressure equipment and supplies, ventilators and oxygen equipment and operate in Arizona, Nebraska Oregon, Washington and Alaska.

The accompanying condensed consolidated financial statements include the accounts of the Company and its wholly-owned and majority-owned subsidiaries.  Wholly-owned subsidiaries include Great Elm Capital Management, Inc. ( GECM ), Great Elm Opportunities GP, Inc., Great Elm FM Acquisition, Inc., DME Holdings and Great Elm DME Manager, LLC.  Majority-owned subsidiaries include GECC GP Corp., Great Elm FM Holdings, Inc., CRIC IT Fort Myers, LLC and DME Inc. and its seven wholly-owned subsidiaries.

2. Summary of Significant Accounting Policies

Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with the instructions for Form 10-Q and, therefore, do not include all information and footnotes which are normally included in the Company’s Form 10-K.  These financial statements reflect all adjustments (consisting of normal recurring items or items discussed herein) that management believes are necessary to fairly state results for the interim periods presented.  Results of operations for interim periods are not necessarily indicative of annual results of operations.  The condensed consolidated balance sheet as of June 30, 2018, presented herein, has been derived from the Company’s audited consolidated financial statements as of and for the year-ended June 30, 2018.

Use of Estimates

The preparation of these financial statements in accordance with accounting principles generally accepted in the United States of America ( US GAAP ) requires the Company to make estimates and assumptions that affect the reported amounts in the financial statements and disclosures of contingent assets and liabilities.  On an on-going basis, the Company evaluates all of these estimates and assumptions.  The most important of these estimates and assumptions relate to revenue recognition, recognition of rental income, estimates for contractual allowances, estimates for allowance for doubtful accounts, the valuation of excess and obsolete inventories, depreciable lives of equipment, impairment of long lived tangible and intangible assets, valuation allowance for deferred tax assets, fair value measurements including stock-based compensation and contingent consideration, estimates associated with the application of acquisition accounting, and the value of lease liabilities and corresponding right to use assets.  Although these and other estimates and assumptions are based on the best available information, actual results could be different from these estimates.

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Principles of Consolidation

The Company consolidates the assets, liabilities, and operating results of its wholly-owned subsidiaries; majority-owned subsidiaries; and subsidiaries in which we hold a controlling financial interest as of the financial statement date. In most cases, a controlling financial interest reflects ownership of a majority of the voting interests. We consolidate a variable interest entity ( VIE ) when we possess both the power to direct the activities of the VIE that most significantly impact its economic performance and we are either obligated to absorb the losses that could potentially be significant to the VIE or we hold the right to receive benefits from the VIE that could potentially be significant to the VIE.

All intercompany accounts and transactions have been eliminated in consolidation.

Non-controlling interests in the Company’s subsidiaries are reported as a component of liabilities for mandatorily redeemable interests, temporary equity for contingently redeemable interests or permanent equity, separate from the Company’s equity.  See Note 13 – Non-Controlling Interests and Preferred Stock of Subsidiary.  Results of operations attributable to the non-controlling interests are included in the Company’s condensed consolidated statements of operations.

Segments

The Company has four operating segments: durable medical equipment, investment management, real estate and general corporate.  The Company regularly reviews each segment for purposes of allocating resources and assessing performance.

Cash, Cash Equivalents, and Restricted Cash

Cash and cash equivalents are comprised of cash and highly liquid investments with original maturities of 90 days or less at the date of purchase.  Cash equivalents consist primarily of money market funds.  The Company is exposed to credit risk in the event of default by the financial institutions or the issuers of these investments to the extent the amounts on deposit or invested are in excess of amounts that are insured.

The Company’s restricted cash consists of real estate rental income received in advance and a portion of prior period rental income that is reserved for capital and certain operating expenses in connection with the Company’s real estate assets.

Accounts receivable

Accounts receivable are customer obligations due under normal sales and rental terms and represent the amount estimated to be collected from the customers and, if applicable, the third-party private insurance provider or government program (collectively, Payors ), based on the contractual agreements.  Substantially all of the accounts receivable balance relates to the durable medical equipment business.  The Company does not require collateral in connection with its customer transactions.  Revenue and accounts receivable have been constrained to the extent that billed amounts exceed the amounts estimated to be collected.  The constrained transaction price relates primarily to contractual allowances where the gross charge is greater than the contractual rate with the Payors.  Management’s evaluation of variable consideration takes into account such factors as past experience, contractual rates with Payors and information about specific receivables and Payors.  In addition, co-payments, co-insurance and deductible amounts billed to patient customers are initially constrained until paid.  See Note 3 – Revenue.

The assessment of variable consideration to be constrained is based on estimates, and ultimate losses may vary from current estimates. As adjustments to these estimates become necessary, they are reported in earnings in the periods in which they become known.  There were no material adjustments to revenues made in the three and nine months ended March 31, 2019 relating to prior periods.  Changes in constraints on variable consideration are recorded as a component of net revenues.

The Company generally does not allow returns from providers for reasons not covered under the manufacturer’s standard warranty. Therefore, there is no provision for sales return reserves.  The Company does not have significant bad debt experience with Payors, and therefore does not maintain an allowance for doubtful accounts.

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As of March 31, 2019, the Company had unbilled receivables of approximately $0.7 million that relate to transac tions where the Company has the ultimate right to invoice a Payor under the terms of the arrangement, but are not currently billable and are therefore contract assets.  Such contract assets are included in accounts receivable in the consolidated balance sh eets.

Investments and Restricted Investments

Investments and restricted investments consist of shares in Great Elm Capital Corp. ( GECC ), which is carried at fair value.  The Company’s restricted investment represents a portion of its investment in GECC, which has been contributed as part of the capitalization of DME Holdings, as required under the terms of the DME Holdings preferred stock.  Under the terms of the preferred stock issued by DME Holdings (See Note 13 – Non-Controlling Interests and Preferred Stock of Subsidiary), the Company is required to maintain capitalization of DME Holdings at a specified level with qualifying assets.  Therefore these assets are restricted and not available for use to fund the Company’s operations.  If at any month end the value of the qualifying assets falls below the required threshold, the Company shall, as promptly as practicable, contribute additional assets to meet the capitalization requirements.  Similarly, if at any month end the value of the qualifying assets exceeds the required threshold, the Company may remove the excess assets.  The Company has provided DME Holdings with shares of GECC in the amount of $4.4 million as of March 31, 2019, as capitalization for the preferred stock in DME Holdings.

Fair Value Measurements

Certain assets and liabilities are carried at fair value under US GAAP.  See Note 8 – Fair Value Measurements.

Property, Equipment, Real Estate Assets and Rental Equipment

The Company records property and equipment acquired at cost.  The costs of property acquired from asset acquisitions or business combinations is recorded at fair value at the date of acquisition based on its estimated replacement costs.

The Company capitalizes the cost of the equipment predominantly leased out as part of the durable medical equipment business as such assets are acquired within equipment held for rental, net.  These purchases are classified as cash outflows from investing activities when they are paid.  The Company capitalizes the cost of equipment predominantly sold as part of the durable medical equipment business as such assets are acquired within inventories.  These purchases are classified as cash outflows from operating activities when they are paid.  A portion of equipment recorded within equipment held for rental, net, could ultimately be sold.  A portion of equipment recorded within inventories could ultimately be leased.  Management is not able to accurately track the ultimate use of equipment and has therefore adopted the above stated policy.

Management has estimated the useful lives of equipment leased to customers where title ultimately transfers to customers (e.g., capped rentals, typically 13 months with title transfer) based upon an analysis of ultimate disposition of rental equipment, some of which is returned to the Company and either re-leased or sold.

The Company recognizes depreciation in amounts sufficient to match the cost of depreciable assets to operations over their estimated service lives, which considers the term of lease for any leased assets.  The Company capitalizes expenditures for improvements that significantly extend the useful life of an asset.  The Company charges expenditures for maintenance and repairs to operations in the periods incurred.  When assets are sold, the asset and accumulated depreciation are eliminated and a gain or loss is recognized in operating income.

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Depreciation is recognized using the straight-line method over their estimated useful lives as follows:

Inventories

Inventories, which principally consist of durable medical equipment and related supplies that are predominantly held for sale, are stated at the lower of cost or net realizable value, with cost determined on a first-in, first-out basis.  The Company reduces the carrying value of inventories for items that are potentially excess, obsolete, or slow-moving based on changes in customer demand, technology developments or other economic factors.  The Company bases its provisions for excess, expired and obsolete inventory primarily on our estimates of forecasted net sales.  A significant change in the timing or level of demand for our products as compared with forecasted amounts may result in recording additional provisions for excess, expired and obsolete inventory in the future.  As the Company purchases all of its inventories, all inventories are categorized as finished goods.  There were no significant write-offs during the nine months ended March 31, 2019.

Goodwill and Other Identifiable Intangible Assets

Goodwill represents the excess of fair value over identifiable tangible and intangible net assets acquired in business combinations.  Goodwill is not amortized. Instead goodwill is reviewed for impairment at least annually, or on an interim basis between annual tests when events or circumstances indicate that it is more likely than not that the fair value of a reporting unit is less than its carrying value.  We perform our annual impairment test on the first day of the fiscal fourth quarter.

The Company amortizes its identifiable intangible assets over their estimated useful lives using applicable discounted cash flow attribution and straight-line methods.  The Company amortizes its identifiable intangible assets over periods ranging from five to fifteen years.

Long-Lived Assets

Long-lived assets include real estate assets, property and equipment, intangible assets and the right of use assets.  These assets are evaluated for potential impairment whenever events or changes in circumstances indicate that their carrying value may not be recoverable based on undiscounted cash flows.  If an impairment is indicated, the Company records the impaired asset at fair value, and records a charge to operations.  No such impairment triggering events were identified in the current period.

Leases and Right of Use Assets

We determine if an arrangement is a lease at inception.  As of March 31, 2019, all of our leases are operating leases.  Operating leases are included in operating lease right of use assets ( ROU ), current portion of lease liabilities and lease liabilities net of current portion in the condensed consolidated balance sheets.

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ROU assets represent our right to use an underlying asset for the lease term and lease liabilities represent our obligation to make lease payments arising from the lease.  ROU assets and liabilities are recognized at commencement date based on the present value of lease payments over the lease term.  As most of our leases do not provide an implicit rate, we use our incremental borrowing rate based on the information available at commencement date in determining the present value of lease payments.  We use the implicit rate when readily determinable.  The ROU assets also includes any lease payments made and adjustments recorded in acquisition accountin g.  Our lease terms may include options to extend or terminate the lease when it is reasonably certain that we will exercise that option.  Lease expense for operating leases is recognized on a straight-line basis over the lease term.

We have lease agreements with lease and non-lease components, which are accounted for together as a single lease component.

At March 31, 2019, the majority of our lease liabilities and ROU assets were acquired with the durable medical equipment businesses as discussed in Note 4 – Acquisition and the amounts disclosed on the condensed consolidated balance sheet represent preliminary valuations.

Cost of Durable Medical Equipment Sold and Services

Cost of durable medical equipment sold and services includes costs included in inventory for medical equipment sold and direct costs associated with providing sleep study services, including staff to perform the studies and supplies used in the studies.

Cost of Durable Medical Equipment Rentals

Cost of rentals includes depreciation on medical equipment held for lease and related maintenance expenses.

Durable Medical Equipment Other Operating Expenses

The Company classifies direct expenses of its durable medical equipment segment, including payroll, facilities and equipment costs, professional fees and other administrative costs, in durable medical equipment other operating expenses in the accompanying condensed consolidated statements of operations.

Investment Management Expenses

The Company classifies direct expenses of its investment management segment including: payroll, stock-compensation, and related taxes and benefits; facilities costs; and professional fees; in investment management expenses in the accompanying condensed consolidated statements of operations.  GECM has a three-year contractual consulting arrangement through November 2019 with a third party to provide services in exchange for 26% of the fees earned from the management of GECC, excluding incentive fees.

Real Estate Expenses

The Company classifies direct expenses of its real estate segment, including: real estate taxes, insurance, property management fees and other operating expenses in real estate expenses in the accompanying condensed consolidated statements of operations.  Under the terms of the lease, the Company may recover from the tenant certain expenses including: real estate taxes, insurance and other operating expenses; the recovery of these expenses is recognized in rental income in the accompanying consolidated statements of operations, in the same periods as the expense are incurred.

Depreciation and Amortization

The Company has separately presented depreciation and amortization expense, except for depreciation expense which is included in cost of durable medical equipment rentals as described above, which is based on its estimate of useful lives of the assets.

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Business combinations  

Business combinations are accounted for at fair value. Acquisition costs are expensed as incurred and recorded in selling, general and administrative expenses; previously held equity interests are valued at fair value upon the acquisition of a controlling interest; restructuring costs associated with a business combination are expensed subsequent to the acquisition date; and changes in deferred tax asset valuation allowances and income tax uncertainties after the acquisition date affect income tax expense. Measurement period adjustments are made in the period in which the amounts are determined and the current period income effect of such adjustments will be calculated as if the adjustments had been completed as of the acquisition date. All changes that do not qualify as measurement period adjustments are also included in current period earnings. The accounting for business combinations requires estimates and judgment as to expectations for future cash flows of the acquired business, and the allocation of those cash flows to identifiable intangible assets, in determining the estimated fair value for assets acquired and liabilities assumed. The fair values assigned to tangible and intangible assets acquired and liabilities assumed, including contingent consideration, are based on management’s estimates and assumptions, as well as other information compiled by management, including valuations that utilize customary valuation procedures and techniques. If the actual results differ from the estimates and judgments used in these estimates, the amounts recorded in the financial statements could result in a possible impairment of the intangible assets and goodwill, require acceleration of the amortization expense of finite-lived intangible assets, or the recognition of additional consideration which would be expensed. The fair value of contingent consideration is remeasured each period based on relevant information and changes to the fair value are included in the operating results for the period.

Net Income (Loss) per Share

Basic net income or loss per share is computed by dividing the net income or loss by the weighted-average number of common shares outstanding for the period.  Diluted net income or loss per share is computed by dividing the diluted net income or loss by the weighted-average number of common shares, including potential dilutive common shares assuming the dilutive effect of outstanding stock options, unvested restricted common shares and common stock warrants, as determined using the treasury stock method.  For periods in which the Company has reported net losses from continuing operations, diluted net loss per share is the same as basic net loss per share, since dilutive common shares are not assumed to have been issued if their effect is anti-dilutive.

As of March 31, 2019, the Company had 3,459,602 potential shares of Company common stock issuable upon exercise of the stock options that are not included in the diluted net loss per share calculations for the nine months ended March 31, 2019 because to do so would be antidilutive.  In calculating diluted income per share for the three months ended March 31, 2019, we adjusted the denominator by 12,365 incremental shares under the treasury stock method, however, we excluded the effects of 1,530,156 potential shares of the Company common stock issuable upon exercise of the stock options as inclusion of these potential shares would be antidilutive.

As of March 31, 2018, the company had 3,876,259 potential shares of Company common stock issuable upon exercise of the stock options that are not included in the diluted net loss per share calculations for the three and nine months ended March 31, 2018 because to do so would be antidilutive.

Restrictions on Subsidiary Dividends

In the GP Corp. Note Agreement, GECC GP Corp. agreed not to declare any dividends until the GP Corp. Note is satisfied.  In the Senior Note and Subordinated Note, CRIC IT Fort Myers, LLC is restricted from paying any dividends until the Notes are satisfied.  The ability of DME Inc. to pay dividends is subject to compliance with the restricted payment covenants under the Corbel Facility and DME Revolver.

Concentration of Risk

The Company’s net investment revenue and receivables for the periods presented were attributable to the management of one investment vehicle, GECC, which is also a related party.  See Note 5 – Related Party Transactions.

The Company’s real estate rental revenue from continuing operations is derived from one tenant.

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The Company’s durable medical equipment revenue and related accounts receivable are concentrated with third-party Payors.  For the three and nine months ended March 31, 2019, one government program payor constituted approximately 25 % and 27%, respectively, of consolidated revenues.  As of March 31, 2019, receivables from that government program payor constituted 23% of our ending accounts receivable.  An additional government program payor constituted another 11% and 10% of consolida ted revenues for the three and nine months ended March 31, 2019, respectively.  

Recently Adopted Accounting Standards

Revenue Recognition    In May 2014, the Financial Accounting Standards Board ( FASB ) issued the New Revenue Standard, which replaced Accounting Standards Codification ( ASC ) Topic 605, Revenue Recognition ( Topic 605 ), including industry-specific requirements, and provided companies with a single principles-based revenue recognition model for recognizing revenue from contracts with customers.  The core principle of the New Revenue Standard is that a company should recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers.

On July 1, 2018, the Company adopted ASU 2014-09, Revenue from Contracts with Customers (Topic 606) , ( Topic 606 ) and related amendments, under the modified retrospective transition method.  Accordingly, the periods prior to adoption are presented under our prior accounting policies and we applied the new guidance to all open contracts with customers as of the implementation date.

The new guidance outlines a single revenue recognition model for all contracts with customers and provides a framework for addressing revenue recognition issues on a comprehensive basis.  The framework includes five steps:

The adoption of Topic 606 impacted the Company’s revenue recognition policy for incentive fee revenue associated with our investment management agreements.  The Company’s revenue recognition policy for rental revenue for its real estate segment did not change since the revenue recognition for such arrangements is outside the scope of Topic 606.

Under Topic 606, variable consideration such as incentive fees must be constrained (not recognized) if it is not probable that there would not be a significant reversal of recognized revenue.  There was no impact on the Company’s revenue recognition policy for management and administrative revenues as these amounts are not subject to constraint.  The Company fully constrained its performance-based incentive fee revenue in contrast to recognizing revenue based on a hypothetical liquidation of net assets on the reporting date and the distribution of the net proceeds in accordance with the respective investment management agreements under its prior policies.  Under the modified retrospective method, the cumulative effect of adopting Topic 606 was recognized as an adjustment to eliminate incentive fees receivable and increase accumulated deficit of $2.9 million and after such adjustment there were no incentive fees receivable.

The following table reflects the impact of the cumulative effect of the accounting changes upon the adoption of Topic 606 on the condensed consolidated balance sheet as of the beginning of the period:

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The following table shows the effect of the change in accounting on the condensed consolidated statement of operations:

Fair Value Measurements In August 2018, the FASB issued ASU 2018-13, Fair Value Measurement (Topic 820): Disclosure Framework – Changes to the Disclosure Requirements for Fair Value Measurement , resulting in various disclosures related to fair value measurements being eliminated, modified or supplemented.  ASU 2018-13 is effective for interim and annual periods beginning after December 15, 2019, with an option to early adopt any eliminated or modified disclosures, and to delay adoption of the additional disclosures, until the effective date.  The Company early adopted the eliminated and modified disclosures of ASU 2018-13 during the three months ended September 30, 2018 and, as a result, updated its financial statement disclosures accordingly. A modified narrative description of measurement uncertainty for level 3 fair value measurements was applied prospectively, with all other amendments applied retrospectively.

Lessor Lease Accounting   In December 2018, the FASB issued ASU 2018-20, Leases (Topic 842): Narrow-Scope Improvements for Lessors ( ASU 2018-20 ).  The new guidance permits lessors, as an accounting policy election, to not evaluate whether certain sales taxes and other similar taxes are lessor costs or lessee costs, and instead, account for those costs as lessee costs.  Additionally, the guidance updates revenue recognition related to variable payments by (1) requiring lessors to exclude from variable payments lessor costs paid directly to third parties by lessees; and (2) requiring lessors to allocate certain variable payments to lease and nonlease components when there are changes in facts and circumstances on which the variable payment is based.  When an allocation of variable payments between lease and nonlease components is made, the variable payment allocated to the lease component will be recognized as revenue in accordance with Topic 842, whereas the variable payment allocated to the nonlease component will be recognized in accordance with other applicable topics, such as Topic 606.  On January 1, 2019, the Company adopted ASU 2018-20 on a prospective basis and did not make the accounting policy election to account for certain taxes as lessee costs.  Sales and use taxes incurred and reimbursed by lessees related to our Real Estate business are recorded gross within real estate rental income and real estate expenses.  In addition, the adoption resulted in a reduction of real estate rental income and real estate expenses related to lessor costs paid directly to third parties by lessees of approximately $0.2 million during the quarter ended March 31, 2019.

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Recently Issued Accounting Standards

Share-Based Compensation   In June 2018, the FASB issued amended guidance expanding the scope of Topic 718 to include share-based payment transactions for acquiring goods and services from nonemployees, ASU 2018-07 Compensation – Stock Compensation (Topic 718): Improvements to Nonemployee Share-Based Payment .  The new standard will include share-based payment transactions for acquiring goods and services from nonemployees, whereby share-based payments to nonemployees will be measured and recorded at the fair value of the equity instruments that an entity is obligated to issue on the grant date. The standard should be applied for annual reporting periods beginning after December 15, 2018, including interim periods within that reporting period using a modified retrospective approach with a cumulative adjustment to opening retained earnings in the year of adoption for the remeasurement of liability-classified awards that have not been settled by the date of adoption and equity-classified awards for which a measurement date has not been established.  Early application is permitted.  We are currently evaluating the impact of this guidance on the Company’s financial statements.

3. Revenue

The revenues from each major source of revenue are summarized in the following table: