Notes to Interim Condensed Consolidated Financial Statements

1. NATURE OF OPERATIONS AND BASIS OF PRESENTATION

e.Digital Corporation is a holding company incorporated under the laws of Delaware that operates through a wholly-owned California subsidiary of the same name. The Company is developing and marketing an intellectual property portfolio consisting of context and interpersonal awareness systems (“Nunchi®” technology), advanced data security technologies (“microSignet™” technology), secure communication technologies (“Synap™” technology) and other technologies.

Unaudited Interim Financial Statements

These unaudited condensed consolidated financial statements have been prepared by management in accordance with accounting principles generally accepted in the United States and with the instructions to Form 10-Q and Article 10 of Regulation S-X. These interim condensed consolidated financial statements do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, the unaudited consolidated financial statements reflect all adjustments considered necessary for a fair statement of the Company's financial position at September 30, 2016, and the results of its operations and cash flows for the periods presented, consisting only of normal and recurring adjustments. All significant intercompany transactions have been eliminated in consolidation. Operating results for the six months ended September 30, 2016 are not necessarily indicative of the results that may be expected for the fiscal year ending March 31, 2017. For further information, refer to the Company's consolidated financial statements and footnotes thereto for the year ended March 31, 2016 filed on Form 10-K.

Going Concern/ Liquidity

The Company has incurred significant losses and negative cash flow from operations and has an accumulated deficit of $83,195,725 at September 30, 2016. Other than cash on hand, the Company has no other sources of financing currently available as of September 30, 2016. The Company may incur additional losses in the future until licensing or other revenues are sufficient to sustain continued profitability. Until the Company can demonstrate sustained profitability, its ability to continue as a going concern is in doubt and may be dependent upon obtaining additional financing in the future. There is no assurance that the Company will be successful in generating or raising funds, if necessary, to sustain its operations for twelve months or beyond. Should the Company be unable to generate funds or obtain required financing, it may have to curtail operations, which may have a material adverse effect on its financial position and results of operations. Uncertainty as to the outcome of these factors raises substantial doubt about the Company’s ability to continue as a going concern. These consolidated financial statements do not give effect to any adjustments that would be necessary should the Company be unable to continue as a going concern and therefore be required to realize its assets and discharge its liabilities in other than the normal course of business and at amounts different from those reflected in the accompanying consolidated financial statements.

The Company has not identified any trends or any known demands, commitments, events or uncertainties that will result in or that are reasonably likely to result in a material increase or decrease in liquidity. The termination of eVU operations in the second quarter of fiscal 2016 and the loss of eVU revenues did not have a material impact on liquidity, results of operations or financial condition of the Company.

Estimates

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

2. RECENT ACCOUNTING PRONOUNCEMENTS

In May 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2014-09, Revenue from Contracts with Customers , which requires entities to recognize revenue in a way that depicts the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled to in exchange for those goods or services. The new guidance also requires additional disclosure about the nature, amount, timing and uncertainty of revenue and cash flows arising from customer contracts, including significant judgments and changes in judgments and assets recognized from costs incurred to obtain or fulfill a contract. The amendment is effective for annual reporting periods beginning after December 15, 2017 and interim periods within those annual periods. The Company is currently evaluating the new guidance to determine the impact it will have on its consolidated financial statements.

In August 2014, the FASB issued ASU 2014-15, Presentation of Financial Statements Going Concern (Subtopic 205-40) - Disclosure of Uncertainties about an Entity's Ability to Continue as a Going Concern. This ASU requires management to assess an entity's ability to continue as a going concern by incorporating and expanding upon certain principles that are currently in U.S. auditing standards. Specifically, the ASU (1) provides a definition of the term substantial doubt, (2) requires an evaluation every reporting period including interim periods, (3) provides principles for considering the mitigating effect of management's plans, (4) requires certain disclosures when substantial doubt is alleviated as a result of consideration of management's plans, (5) requires an express statement and other disclosures when substantial doubt is not alleviated, and (6) requires an assessment for a period of one year after the date that the financial statements are issued (or available to be issued). This standard is effective for the fiscal years ending after December 15, 2016, and for annual periods and interim periods thereafter. Early application is permitted. The Company is currently evaluating the new guidance to determine the impact it will have on its consolidated financial statements.

In November 2015, the FASB issued ASU 2015-17, Balance Sheet Classification of Deferred Taxes . This new guidance requires all deferred tax assets and liabilities, along with any related valuation allowance, be classified as non-current on the balance sheet. ASU 2015-17 is effective for fiscal periods beginning after December 15, 2016 and may be adopted either prospectively or retrospectively. Early adoption is permitted. The Company has not yet selected a transition method and is currently evaluating the impact that ASU 2015-17 will have on its consolidated financial statements.

In February 2016, the FASB issued ASU 2016-02, Leases , which changes the accounting for leases and requires expanded disclosures about leasing activities. This new guidance will require lessees to recognize a right of use asset and a lease liability at the commencement date for all leases with terms greater than twelve months. Accounting by lessors is largely unchanged. ASU 2016-02 is effective for fiscal periods beginning after December 15, 2018 and must be adopted using a modified retrospective approach. Early adoption is permitted. The Company is currently evaluating the impact that ASU 2016-02 will have on its consolidated financial statements.

In March 2016, the FASB issued ASU No. 2016-09, Compensation — Stock Compensation , which amends ASC Topic 718, Compensation — Stock Compensation. The new standard identifies areas for simplification involving several aspects of accounting for share-based payment transactions, including the income tax consequences, classification of awards as either equity or liabilities, an option to recognize gross stock compensation expense with actual forfeitures recognized as they occur, as well as certain classifications on the statement of cash flows. The amendments are effective for annual periods beginning after December 15, 2016, and interim periods within those annual periods. Early adoption is permitted. An entity that elects early adoption must adopt all of the amendments in the same period. The Company is currently evaluating the potential impact that ASU 2016-09 may have on the Company’s financial position or results of operations.

In August 2016, the FASB issued ASU 2016-15, Statement of Cash Flows: Clarification of Certain Cash Receipts and Cash Payments (“ASU 2016-15”), which eliminates the diversity in practice related to the classification of certain cash receipts and payments in the statement of cash flows, by adding or clarifying guidance on eight specific cash flow issues. ASU 2016-15 is effective for annual and interim reporting periods beginning after December 15, 2017 and early adoption is permitted. ASU 2016-15 provides for retrospective application for all periods presented. The Company is currently evaluating the impact that ASU 2016-15 will have on its consolidated financial statements.

Other Accounting Standards Updates not effective until after September 30, 2016 are not expected to have a material effect on the Company’s financial position or results of operations.

3. LOSS PER SHARE

Basic loss per common share is computed by dividing net loss for the period by the weighted-average number of shares of common stock outstanding during the period. Diluted loss per common share is computed by dividing net loss by the weighted-average number of shares of common stock outstanding during the period increased to include the number of additional shares of common stock that would have been outstanding if the potentially dilutive securities had been issued. Potentially dilutive securities consist of stock options. The dilutive effect of potentially dilutive securities is reflected in diluted earnings per share by application of the treasury stock method. Under the treasury stock method, an increase in the fair market value of the Company’s common stock can result in a greater dilutive effect from potentially dilutive securities. At September 30, 2016 and 2015, stock options exercisable into 4,750,000 and 5,598,578 shares of common stock were outstanding, respectively. These securities were not included in the computation of diluted loss per share because they had no effect or were antidilutive, but they could potentially dilute earnings per share in future periods. There was no difference in basic and diluted loss per share or basic and diluted weighted average shares outstanding for the periods presented.

4. STOCK-BASED COMPENSATION COSTS

The Company accounts for stock-based compensation under the provisions of ASC 718, Share-Based Payment and ASC 505-50, Equity-Based Payments to Non-Employees. ASC 718 requires measurement of all employee stock-based awards using a fair-value method and recording of related compensation expense in the consolidated financial statements over the requisite service period. Further, as required under ASC 718, the Company estimates forfeitures for stock-based awards that are not expected to vest. The Company recorded stock-based compensation in its consolidated statements of operations for the relevant periods as follows:

As of September 30, 2016 total estimated compensation cost of stock options granted but not yet vested was $8,879 and is expected to be recognized over the weighted average period of 1.5 years.

The following table sets forth the weighted-average key assumptions and fair value results for stock options granted during the six-month period ended September 30, 2016 (annualized percentages). No options were granted during the six months ended September 30, 2015.

The dividend yield of zero is based on the fact that the Company has never paid cash dividends and has no present intention to pay cash dividends. Expected volatility is based on the historical volatility of the common stock over the period commensurate with the expected life of the options. The Company has a small number of option grants and limited exercise history and accordingly has for all new option grants applied the simplified method prescribed by SEC Staff Accounting Bulletin 110, Share-Based Payment: Certain Assumptions Used in Valuation Methods - Expected Term , to estimate expected life (computed as vesting term plus contractual term divided by two). The expected forfeiture rate is estimated based on historical experience and is assumed at 0.0% for nonemployees/directors and certain long-term employees and 5.0% for other employees. Additional expense is recorded when the actual forfeiture rates are lower than estimated and a recovery of prior expense will be recorded if the actual forfeitures are higher than estimated.

See Note 5 for further information on outstanding stock options.

Since the Company has a net operating loss carryforward as of September 30, 2016, no excess tax benefit for the tax deductions related to stock-based awards was recognized for the six months ended September 30, 2016.

6. FAIR VALUE MEASUREMENTS

Cash and cash equivalents are measured at fair value in the Company’s consolidated financial statements. Accounts receivable are financial assets with carrying values that approximate fair value due to the short-term nature of these assets. Accounts payable, and accrued and other liabilities are financial liabilities with carrying values that approximate fair value due to the short-term nature of these liabilities. Effective April 1, 2008 the Company adopted and follows ASC 820, Fair Value Measurements and Disclosures (“ASC 820”) which established a fair value hierarchy that requires the Company to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. A financial instruments categorization within the hierarchy is based on the lowest level of input that is significant to the fair value measurement.

The Company’s cash and cash equivalents are valued using unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 inputs under ASC 820).

7. SEGMENT INFORMATION

Through September 30, 2015, the Company had two operating segments: (1) patent licensing and (2) products and services. Patent licensing consists of intellectual property revenues from the Company’s patent portfolio. Products and services consisted of sales of the Company’s eVU products and related services. The Company ceased providing eVU services at September 30, 2015, effectively ending this segment’s operations.

Reportable segment information for the three and six months ended September 30, 2016 and 2015 is as follows:

The Company did not have significant assets employed in the product and services segment during the periods and does not track capital expenditures or assets by reportable segment. Consequently it is not practicable to show this information.

Revenue by geographic region is determined based on the location of the Company’s direct customers or distributors for product sales and services. Patent license revenue is considered United States revenue as payments are for licenses for United States operations irrespective of the location of the licensee’s home domicile.

Revenues from two licensees comprised 84% and 15% of revenue for the six months ended September 30, 2016, with no other licensee or customer accounting for more than 10% of revenues. Revenues from three licensees comprised 25%, 21% and 14% of revenue for the six months ended September 30, 2015, with no other licensee accounting for more than 10% of revenues. There were no accounts receivable at September 30, 2016. Accounts receivable from one licensee comprised 100% of net accounts receivable at September 30, 2015.

8. COMMITMENTS AND CONTINGENCIES

Legal Matters

Intellectual Property Litigation

As of September 30, 2015, the Company had settled or dismissed all complaints with respect to its Flash-R patent portfolio.

The Company commenced legal action with regards to its Nunchi portfolio of patents in July 2014 and currently has three active complaints in the U.S. District Court for the Northern District of California and four in the U.S. District Court for the Southern District of California.

The Company did not enter into any new license agreements during the second quarter of fiscal 2017. During the first quarter of fiscal 2017, the Company entered into two new Nunchi license agreements covering three defendants, and received a royalty payment related to a royalty-based agreement executed in the prior fiscal year.

Commitment Related to Intellectual Property Legal Services

In September 2012, the Company engaged Handal and Associates (“Handal”) to provide IP legal services in connection with licensing and prosecuting claims of infringement of the Company’s patent portfolio. From September 2012 through August 2016, pursuant to a partial contingent fee arrangement, the Company paid a monthly retainer fee of $30,000 to Handal creditable against future contingency recoveries and a fee ranging from 33% to 40% of license fees. A new agreement, which supersedes and replaces all previous agreements, was executed effective September 1, 2016, reducing the monthly retainer fee to $22,500 so long as Handal is simultaneously litigating ten or fewer cases. Parties agreed to meet and discuss an increase in the amount of the monthly retainer should the number of cases exceed ten. Monthly retainers paid are creditable against future contingency recoveries. The Company has agreed to reimburse Handal for pre-approved expenditures advanced on behalf of the Company and to pay Handal a fee of 40% of any net license fee or settlement.

Commitment Related to Intellectual Property Royalties

The Company is obligated for inventor royalties of 4% of net Nunchi license revenues for the term of related patents, currently 2030.

Facility Lease

In January 2012, the Company entered into a sixty-two month facility lease for its corporate office location, commencing May 1, 2012, for approximately 3,253 square feet at 16870 West Bernardo Drive, Suite 120, San Diego, California. The aggregate monthly payment is $7,157 excluding utilities and costs. Future lease commitments at September 30, 2016 total $64,409. The Company recognizes rent expense by the straight-line method over the lease term. As of September 30, 2016, deferred rent totaled $10,978.

Concentration of Credit Risk and Sources of Supply

Financial instruments that potentially subject the Company to concentration of credit risk consist principally of cash and cash equivalents and trade receivables. The Company maintains cash and cash equivalent accounts with Federal Deposit Insurance Corporation (“FDIC”) insured financial institutions. Certain of the Company’s accounts are each insured up to $250,000 by the FDIC. The Company’s exposure for amounts in excess of FDIC insured limits at September 30, 2016 was approximately $270,000. The Company has not experienced any losses in such accounts. The Company does not believe that it is subject to any unusual financial risk beyond the normal risk associated with commercial banking relationships. The Company performs periodic evaluations of the relative credit standing of these financial institutions. The Company has not experienced any significant losses on its cash equivalents.

Concentrations of credit risk with respect to trade accounts receivable are limited due to the number and nature of customers comprising the Company’s customer base and their geographic dispersion. The Company has not incurred any significant credit related losses.

Guarantees and Indemnifications

The Company enters into standard indemnification agreements in the ordinary course of business. Some of the Company’s product sales and services agreements include a limited indemnification provision for claims from third parties relating to the Company’s intellectual property. Such indemnification provisions are accounted for in accordance with ASC 450, Contingencies . The indemnification is generally limited to the amount paid by the customer. To date, there have been no claims under such indemnification provisions.

Employee Benefit – 401K Plan

In September 2012, the Company adopted a defined contribution plan (401(k)) covering its employees. Matching contributions are made on behalf of all participants, according to the Safe Harbor provision. The Company matches 100% (dollar for dollar) on deferrals of up to 4% of employee compensation deferred. During the six months ended September 30, 2016, the Company made matching contributions totaling $4,908.

9. INCOME TAXES

There is no provision for income taxes for the six months ended September 30, 2016 and 2015 as the Company currently estimates its effective tax rate to be zero due to uncertainty of income in future interim quarters of the current year and due to net operating loss carryforwards.

At September 30, 2016 and 2015, the Company had deferred tax assets associated with federal net operating losses (“NOLs”), related state NOLs, foreign tax credits and certain Federal and California research and development tax credits, but recorded a corresponding full valuation allowance as it is more likely than not that some portion or all of the deferred tax assets will not be realized.

The Company records a liability for uncertain tax positions when it is probable that a loss has been incurred and the amount can be reasonably estimated.  At September 30, 2016, the Company has no liabilities for uncertain tax positions.