GSB Globalscape Inc

Notes to Condensed Consolidated Financial Statements

As of September 30, 2016 and For the Three and Nine Months Then Ended

(Unaudited)

1.

Nature of Business

We develop and sell computer software that provides secure information exchange, file transfer and file sharing capabilities for enterprises and consumers. Our primary business is selling and supporting managed file transfer, or MFT, software for enterprises. The brand name of our MFT product platform is Enhanced File Transfer, or EFT. We also sell other products that are synergistic to EFT including Mail Express, scConnect, WAFS, and CuteFTP.

We earn most of our revenue from the sale of EFT and products that are part of our EFT platform. We earn revenue from the sale of perpetual software licenses, providing products under software-as-a-service, or SaaS, subscriptions, providing maintenance and support services, or M&S, and offering professional services for product customization and integration.

Throughout these notes unless otherwise noted, our references to the 2016 quarter and the 2015 quarter refer to the three months ended September 30, 2016 and 2015, respectively.  Our references to the 2016 nine months and the 2015 nine months refer to the nine months ended September 30, 2016 and 2015, respectively.

2.

Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with Rule 10-01 of Regulation S-X, “Interim Financial Statements”, as prescribed by the Securities and Exchange Commission, or SEC. Accordingly, they do not include all information and footnotes required under generally accepted accounting principles in the United States, or GAAP, for complete financial statements. In the opinion of management, all accounting entries necessary for a fair presentation of our financial position and results of operations have been made. The results of operations for any interim period are not necessarily indicative of the results to be expected for the full year. The information included in this Form 10-Q should be read in conjunction with the financial statements and the notes thereto included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2015, which we refer to as the 2015 Form 10-K, as well as Management’s Discussion and Analysis of Financial Condition and Results of Operations also included in our 2015 Form 10-K and in this report.

We follow accounting standards set by the Financial Accounting Standards Board. This board sets GAAP that we follow in preparing financial statements that report our financial position, results of operations, and sources and uses of cash. We also follow the reporting regulations of the United States Securities and Exchange Commission, or SEC.

 

The preparation of financial statements in accordance with GAAP requires the use of estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities known to exist as of the date the financial statements are published, and the reported amounts of revenues and expenses during the reporting period. Uncertainties with respect to such estimates and assumptions are inherent in the preparation of our financial statements. It is possible the actual results could differ from these estimates and assumptions and could have a material effect on the reported amounts of our financial position and results of operations.

3.

Significant Accounting Policies

Principles of Consolidation

The accompanying consolidated financial statements of GlobalSCAPE, Inc. and its wholly-owned subsidiary (collectively referred to as the “Company” or “we”) are prepared in conformity with GAAP.  All intercompany accounts and transactions have been eliminated.

Revenue Recognition

We develop, market and sell software products. We recognize revenue from a sale transaction when the following conditions are met:

·            Persuasive evidence of an arrangement exists.

·            Delivery has occurred or services have been rendered.

·            The amount of the sale is fixed or determinable.

·            Collection of the sale amount is reasonably assured.

For a sale transaction not meeting any one of these four criteria, we defer recognition of revenue related to that transaction until all the criteria are met.

We earn the majority of our software license revenue from software products sold under perpetual software license agreements. At the time our customers purchase these products, they typically also purchase a product maintenance and support, or M&S, agreement. These transactions are multiple element software sales for which we assess the presence of vendor specific objective evidence (“VSOE”) of the fair value of the undelivered elements to determine the portion of these sales to recognize as revenue upon delivery of the software product and the portion of these sales to record as deferred revenue at the time the product is delivered. We amortize the deferred revenue component to revenue in future periods as we deliver the related future services to the customer. For transactions, if any, for which we cannot establish VSOE of the fair value of the undelivered elements, we initially record the entire transaction as deferred revenue and amortize that amount to revenue in future periods as we deliver the related future services to the customer.

 

Our deferred revenue consists primarily of revenue to be earned in the future as we deliver services under M&S agreements. We bill our customers in advance for M&S services and record accounts receivable and deferred revenue in the same amount at the time we issue an invoice. We commence recognition of the deferred revenue as revenue only after the M&S period begins.

 

For our products licensed and delivered under a SaaS transaction on a monthly or other periodic subscription basis, we recognize subscription revenue, including initial setup fees, on a monthly basis over the contractual term of the customer contract as we deliver our products and services. Amounts invoiced or paid prior to this revenue recognition are presented as deferred revenue until earned.

 

We provide professional services to our customers consisting primarily of software installation support, operations support and training. We recognize revenue from these services as they are completed and accepted by our customers.

 

We collect sales tax on many of our sales. We do not include sales tax collected in our revenue. We record it as a liability payable to taxing authorities.

Reclassification of Expenses

In preparing our financial statements for the year ended December 31, 2015, we revised the manner in which we present cost of revenues and other elements of our statement of operations in response to the changing nature of our business and the resulting differences in the scope and nature of certain expenses we incur.

Cost of Revenue

Cost of revenue was expanded from one line to three lines to correspond with the associated revenue classifications.  Amortization of capitalized software development costs was moved from depreciation and amortization and included in the cost of license revenue.  Other costs included in cost of license revenue are royalties we pay to use technology in our products that is developed by others and fees paid to third party service providers who support our cloud based and SaaS solutions.  Cost of M&S revenue and cost of professional services revenue consist primarily of salaries and related personnel costs of our employees who deliver the related service to our clients.  These costs were previously included in the general and administrative classification.  Also included in the cost of professional services revenue are the fees of third party service providers.

Selling, General and Administrative

We separated selling, general and administrative expenses into two line items – sales and marketing and general and administrative.

Depreciation and Amortization

After reclassifying amortization of capitalized software development costs to cost of license revenue, the remaining depreciation and amortization costs were included in general and administrative expense and the depreciation and amortization line on our statement of operations was removed.

Effect of the reclassifications

The reclassifications were between cost of revenues and operating expenses and had no effect on revenue, income from operations, net income or earnings per share.  The following tables illustrate the effects of these reclassifications on previously reported amounts for the quarter and the nine months ended September 30, 2015 ($ in thousands):

 

		Quarter Ended September 30, 2015
						Reclassification of Previously Reported Amounts
		As Previously Reported				Cost of Revenues				Capitalized Software Cost Amortization				Personnel Costs				Depreciation				Selling, General & Administrative				As Now Reported
Operating Revenues:
Software licenses		$	2,852																							$	2,852
Maintenance and support			4,142																								4,142
Professional services			653																								653
Total revenues			7,647																								7,647
Cost of Revenues:
Software licenses							195				367																562
Maintenance and support															341												341
Professional services							263								342												605
Total cost of revenues			-																								1,508
Gross profit			-																								6,139
Operating Expenses
Sales and marketing			-																				2,289				2,289
General and administrative			-																				1,449				1,449
Cost of Revenues			458				(458	)																			-
Selling, general and administrative			4,355												(683	)			66				(3,738	)			-
Research and development			646																								646
Depreciation and amortization			433								(367	)							(66	)							-
Total operating expenses			5,892																								4,384
Income from operations			1,755																								1,755
Other income (expense), net			17																								17
Income before income taxes			1,772																								1,772
Income tax expense			542																								542
Net income		$	1,230																							$	1,230
Comprehensive income		$	1,230																							$	1,230
Net income per common share -
Basic		$	0.06																							$	0.06
Diluted		$	0.06																							$	0.06

		Nine Months Ended September 30, 2015
						Reclassification of Previously Reported Amounts
		As Previously Reported				Cost of Revenues				Capitalized Software Cost Amortization				Personnel Costs				Depreciation				Selling, General & Administrative				As Now Reported
Operating Revenues:
Software licenses		$	8,590																							$	8,590
Maintenance and support			12,269																								12,269
Professional services			1,531																								1,531
Total revenues			22,390																								22,390
Cost of Revenues:
Software licenses							739				912																1,651
Maintenance and support															1,057												1,057
Professional services							327								930												1,257
Total cost of revenues			-																								3,965
Gross profit			-																								18,425
Operating Expenses
Sales and marketing			-																				7,060				7,060
General and administrative			-																				4,629				4,629
Cost of Revenues			1,066				(1,066	)																			-
Selling, general and administrative			13,472												(1,987	)			204				(11,689	)			-
Research and development			1,832																								1,832
Depreciation and amortization			1,116								(912	)							(204	)							-
Total operating expenses			17,486																								13,521
Income from operations			4,904																								4,904
Other income (expense), net			51																								51
Income before income taxes			4,955																								4,955
Income tax expense			1,585																								1,585
Net income		$	3,370																							$	3,370
Comprehensive income		$	3,370																							$	3,370
Net income per common share -
Basic		$	0.16																							$	0.16
Diluted		$	0.16																							$	0.16

Cash and cash equivalents

Cash and cash equivalents includes all cash and highly liquid investments with original maturities of three months or less.

Short Term Investments

Short-term investments consist of certificates of deposit held with financial institutions with contractual maturity dates less than one year from the balance sheet date.  The Company has the intent and ability to hold these investments until their maturity dates and therefore accounts for them as held-to-maturity. These certificates of deposit are stated at amortized cost, which approximates the fair value of these investments.

 

Goodwill

Goodwill is not amortized. On at least an annual basis, we test goodwill for impairment at the reporting unit level. We operate as a single reporting unit.

 

When testing goodwill, we first assess qualitative factors to determine whether it is more likely than not (that is, a likelihood of more than 50 percent) that the fair value of our reporting unit is less than its carrying amount, including goodwill. In performing this qualitative assessment, we assess events and circumstances relevant to us including, but not limited to:

•	Macroeconomic conditions.

•	Industry and market considerations.

•	Cost factors and trends for labor and other expenses of operating our business.

•	Our overall financial performance and outlook for the future.

•	Trends in the quoted market value and trading of our common stock.

 

In considering these and other factors, we consider the extent to which any adverse events and circumstances identified could affect the comparison of our reporting unit’s fair value with its carrying amount. We place more weight on events and circumstances that most affect our reporting unit’s fair value or the carrying amount of our net assets. We consider positive and mitigating events and circumstances that may affect our determination of whether it is more likely than not that the fair value of our reporting unit is less than its carrying amount. We evaluate, on the basis of the weight of the evidence, the significance of all identified events and circumstances in the context of determining whether it is more likely than not that the fair value of our reporting unit is less than its carrying amount.

 

If, after assessing the totality of these qualitative events and circumstances, we determine it is not more likely than not that the fair value of our reporting unit is less than its carrying amount, we conclude there is no impairment of goodwill and perform no further testing in accordance with GAAP. If we conclude otherwise, we proceed with performing the first step, and if necessary, the second step, of the two-step goodwill impairment test prescribed by GAAP.

As of December 31, 2015, after assessing the totality of the relevant events and circumstances, we determined it not more likely than not that the fair value of our reporting unit was less than its carrying amount. Accordingly, we concluded there was no impairment of goodwill as of that date. There have been no material events or changes in circumstances since that time indicating that the carrying amount of goodwill may exceed its fair market value and that interim testing needed to be performed.

Capitalized Software Development Costs

 

When we complete research and development for a software product and have in place a detail program design or a working model of that software product, we capitalize production costs incurred for that software product from that point forward until it is ready for general release to the public. Thereafter, we amortize capitalized software production costs to expense using the straight-line method over the estimated useful life of that product, which is generally three years. We periodically assess the carrying value of capitalized software development costs relative to our estimates of realizability through sales of products in the marketplace.

Research and Development

 

We expense research and development costs as incurred.

Share-Based Compensation

We measure the cost of share-based payment transactions at the grant date based on the calculated fair value of the award. We recognize this cost as an expense ratably over the recipient’s requisite service period during which that award vests or becomes unrestricted.

For stock option awards, we estimate their fair value at the grant date using the Black-Scholes option-pricing model considering the following factors:

•	We estimate expected volatility based on historical volatility of our common stock.

•

We use primarily the simplified method to derive an expected term which represents an estimate of the time options are expected to remain outstanding. We use this method because our options are plain-vanilla options, and we believe our historical option exercise experience is not adequately indicative of our future expectations.

•	We base the risk-free rate for periods within the contractual life of the option on the U.S. treasury yield curve in effect at the time of grant.

•	We estimate a dividend yield based on our historical and expected future dividend payments.

For restricted stock awards, we use the quoted price of our common stock on the grant date as the fair value of the award.

Income Taxes

We account for income taxes using the asset and liability method.  We record deferred tax assets and liabilities based on the difference between the tax bases of assets and liabilities and their carrying amount for financial reporting purposes, as measured by the enacted tax rates and laws that will be in effect when the differences are expected to reverse. Deferred tax assets and liabilities are carried on the balance sheet with the presumption that they will be realizable in future periods in which we generate taxable income.

We assess the likelihood that deferred tax assets will be realized from future taxable income. Based on this assessment, we provide any necessary valuation allowance on our balance sheet with a corresponding increase in the tax provision on our statement of operations.   Any valuation allowances we establish are determined based upon a number of assumptions, judgments, and estimates, including forecasted earnings, future taxable income, and the relative proportions of revenue and income before taxes in the various domestic jurisdictions in which we operate.

We account for uncertainty in income taxes using a two-step process to determine the amount of tax benefit to be recognized. First, we evaluate the tax position to determine the likelihood that it will be sustained upon external examination. If the tax position is deemed “more-likely-than-not” to be sustained, we assess the tax position to determine the amount of benefit to recognize in the financial statements. The amount of the benefit we recognize is the largest amount that we believe has a greater than 50% likelihood of being realized upon ultimate settlement. Unrecognized tax benefits represent tax positions for which reserves have been established.

Earnings Per Share

We compute basic earnings per share using the weighted-average number of common shares outstanding during the periods.  We compute diluted earnings per share using the weighted-average number of common shares outstanding plus the number of common shares that would be issued assuming conversion of all potentially dilutive common shares outstanding.

Awards of non-vested restricted stock and options are considered potentially dilutive common shares for the purpose of computing earnings per common share.  We apply the treasury stock method to non-vested options under which the assumed proceeds include the amount the employee must pay to exercise the option plus the amount of unrecognized cost attributable to future periods less any expected tax benefits.

Recent accounting pronouncements

In June 2016, the Financial Accounting Standards Board, or FASB, issued Accounting Standard Update (ASU) 2016-15, Statement of Cash Flows – Classification of Certain Cash Receipts and Cash Payments. This pronouncement provides guidance as to the treatment of transactions in a statement of cash flows with respect to eight specific cash flow issues. During 2015 and 2016, we had no transactions of the type cited in the statement and do not anticipate having any such transactions in the foreseeable future. Accordingly we do not expect this pronouncement to have a material effect on how we present items in our statement of cash flows.

In June 2016, the FASB issued ASU 2016-13, Financial Instruments – Credit Losses . Among its provisions is a requirement that assets measured at amortized cost, which includes trade accounts receivable, be presented at the net amount expected to be collected. This pronouncement requires that an entity reflect all of its expected credit losses based on current estimates which will replace the current standard requiring that an entity need consider only past events and current conditions in measuring an incurred loss. We are subject to this guidance effective with financial statements we issue for the year ending December 31, 2020, and the quarterly periods during that year. We do not expect the amounts we report as accounts receivable in those future periods under this guidance to be materially affected relative to current guidance.

In March 2016, the FASB issued ASU 2016-09, Improvements to Employee Share-Based Payment Accounting . When implemented, this standard will discontinue the recording in equity of tax benefits or tax deficiencies that arise from differences between share-based payment compensation expense recorded for financial statement purposes and that expense deductible for tax purposes. This new standard requires that the tax effect of all such differences be recorded and reported in the statement of operations. This standard also requires that tax-related cash flows resulting from share-based payments be reported as operating activities in the statement of cash flows which is a change from the current requirement to present such tax-related items as an inflow from financing activities and an outflow from operating activities. In accordance with this standard, we will implement it beginning with our interim and annual financial statements for 2017. The extent of the effect of this standard on our financial statements for 2017 and later depends upon the level of stock option exercise activity we experience in 2017 and later. The amounts involved in accounting for tax benefits or deficiencies from share-based compensation that are the subject of ASU 2016-09 are presented in our 2016 and earlier consolidated statements of cash flows and consolidated statements of stockholders’ equity on lines that are captioned tax benefit or tax deficiency from share-based compensation.

In February 2016, the FASB issued ASU 2016-02, Leases . The main difference between existing GAAP and this ASU 2016-02 is the presentation by lessees on their financial statements of lease assets and lease liabilities arising from operating leases. Since this new standard retains the distinction between finance and operating leases, the effect of leases in the statement of operations and the statement of cash flows will be largely unchanged from existing GAAP. Our only lease of significance is our operating lease for our corporate office space for which we will present a right-to-use asset and a lease liability on our balance sheet when we implement this standard. We are in the process of determining those amounts. In accordance with this standard, we will implement it beginning with our interim and annual financial statements for 2019. The extent of the effect of this standard on our financial statements for 2019 and later will depend upon the leases, if any, that we have in effect at that date.

In November 2015, the FASB, issued ASU No. 2015-17, Income Tax: Balance Sheet Classification of Deferred Taxes . ASU 2015-07 requires that all deferred tax assets and liabilities for a tax jurisdiction, along with any related valuation allowance, be classified as noncurrent on the balance sheet. We have implemented this ASU in the accompanying financial statements in the manner described in the Note 6 below.

In May 2014, FASB issued ASU No. 2014-09 entitled Revenue from Contracts with Customers (Topic 606) . The core principle of this guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects consideration to which the entity expects to be entitled in exchange for those goods or services. We are subject to this guidance effective with financial statements we issue for the year ending December 31, 2018, and the quarterly periods during that year. We do not expect the amounts or timing of revenue we report in those future periods under this guidance to be materially affected relative to current guidance.

Use of Estimates

The preparation of consolidated financial statements in accordance with GAAP requires the use of estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities known to exist as of the date the financial statements are published, and the reported amounts of revenues and expenses during the reporting period. Uncertainties with respect to such estimates and assumptions are inherent in the preparation of the Company’s financial statements. It is possible that the actual results could differ from these estimates and assumptions, which could have a material effect on the reported amounts of the Company’s financial position and results of operation.

4.

Capitalized Software Development Costs

Our capitalized software development costs profile was as follows: ($ in thousands):

 

 

The future amortization expense of the gross capitalized software development costs related to unreleased products will be determinable at a future date when those products are ready for general release to the public.

5.

Stock Options, Restricted Stock and Share-Based Compensation

We have stock-based compensation plans under which we have granted, and may grant in the future, incentive stock options, non-qualified stock options, and restricted stock to employees and non-employee members of the Board of Directors. Our share-based compensation expense was as follows ($ in thousands):

		Three Months Ended September 30,								Nine Months Ended September 30,
		2016				2015				2016				2015
Share-based compensation expense		$	221			$	167			$	721			$	482

Stock Options

 

The GlobalSCAPE, Inc. 2010 Employee Long-Term Equity Incentive Plan is our current stock-based incentive plan for our employees.  Provisions and characteristics of this plan include the following:

·	It authorizes the issuance of up to three million shares of common stock for stock-based incentives including stock options and restricted stock awards.

·	The exercise price, term and other conditions applicable to each stock option or stock award granted are determined by the Compensation Committee of the Board of Directors.

·	The exercise price of stock options is set on the grant date and may not be less than the fair market value per share of our stock at market close on that date.

·	Stock options we issue generally become exercisable ratably over a three-year period and expire ten years from the date of grant.

·	We issued no restricted stock awards under this plan during the 2016 or 2015 periods.

·	As of September 30, 2016, stock-based incentives for up to 167,335 shares remained available for issuance in the future under this plan.

Our stock option activity has been as follows:

 

Additional information about our stock options is as follows:

 

We used the following assumptions to determine compensation expense for our stock options using the Black-Scholes option-pricing model:

Based upon our dividend payment activity in recent years, beginning with the first quarter of 2015, we added an expected annual dividend yield to these assumptions.

Restricted Stock Awards

 

In May 2015, we adopted the 2015 Non-Employee Directors Long Term Incentive Plan (“2015 Directors Plan”). This plan provides for the issuance of either stock options or restricted stock awards for up to 500,000 shares of our common stock. Provisions and characteristics of this plan include the following:

·	The exercise price, term and other conditions applicable to each stock option or stock award granted are determined by the Compensation Committee of the Board of Directors.

·	Restricted stock awards are initially issued with a legend restricting transferability of the shares until the recipient satisfies the vesting provision of the award, which is generally continuing service for one year subsequent to the date of the award.

·	As of September 30, 2016, stock based incentives for up to 340,000 shares remained available for issuance in the future under this plan.

Our restricted stock awards activity has been as follows:

 

 

 

6.

Income Taxes

The components of our income tax expense (benefit) are as follows ($ in thousands):

 

 

Current taxes per our federal income tax return are presented in these financial statements as follows ($ in thousands):

 

 

Deferred income taxes on our balance sheet reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes.  Significant components of our deferred tax assets and liabilities are as follows ($ in thousands):

As of September 30, 2016, we had federal income tax net operating loss carryforwards of $312,000 available to offset future federal taxable income, if any. These carryforwards became available through our acquisition of TappIn, Inc. in 2011.  These carryforwards expire in 2030 and 2031.

As of September 30, 2016, we had federal income tax capital loss carryforwards of $1,100,000 (tax effected) which resulted from the reduction of our investments in and notes receivable from CoreTrace Corporation in 2012.  We can realize capital loss carryforwards to the extent we have capital gains in future periods against which this capital loss can be deducted.  We believe it uncertain that we will have sufficient capital gains in the future to support this deduction and accordingly have not reflected this item as a deferred tax asset in the schedule above.  This carryforward expires in 2017.

In assessing the realizability of deferred tax assets, we consider whether it is more-likely-than-not that a deferred tax asset will not be realized.  Our assessment of the likelihood of having sufficient taxable income in the future to support deduction or utilization of the items giving rise to our deferred tax assets indicates it is more-likely-than-not that we will realize the deferred tax assets listed in the table above.

We claim research and experimentation tax credits, or R&D tax credits, on certain of our tax returns and have included the effect of those credits in our provision for income taxes. Because our 2008, 2009 and 2010 tax returns were under routine examination by the Internal Revenue Service and because we believed it more-likely-than-not the examination could result in $125,000 of such credits we claimed not being allowed by the Internal Revenue Service, we recorded a reserve for an uncertain tax position in the amount of $125,000 in 2012 related to this item.  The Internal Revenue Service completed its routine examination of our 2008, 2009 and 2010 income tax returns in 2015 and those results have been included in our provision for income taxes in 2015. We continue to maintain a reserve for an uncertain tax position in the amount of $110,000 for our 2011 through 2016 tax returns related to the R&D tax credit.

The aggregate changes in the balance of our gross unrecognized tax benefits were as follows ($ in thousands):

To the extent they arise, we record interest and penalty expenses related to income taxes as components of other expense in our statement of operations.  We incurred no such expenses in 2016, 2015 or 2014.

We file state tax returns in various states.  The taxes resulting from these filings are included in income tax expense.

Our income tax expense (benefit) reconciles to an income tax expense resulting from applying an assumed statutory federal income rate of 34% to income before income taxes as follows ($ in thousands):

In November 2015, the FASB issued Accounting Standards Update (ASU) No. 2015-17, Income Tax: Balance Sheet Classification of Deferred Taxes . ASU 2015-07 requires that all deferred tax assets and liabilities for a tax jurisdiction, along with any related valuation allowance, be classified as noncurrent on the balance sheet. We have implemented this ASU in the accompanying financial statements. This implementation resulted in the previously reported current deferred tax asset of $313,000 as of September 30, 2015, being reclassified and combined with the previously reported non-current deferred asset of $699,000 as of that date to yield a non-current deferred tax asset balance of $1,012,000 being reported as of September 30, 2015, in the accompanying financial statements.

7.

Earnings per Common Share

Earnings per share for the periods indicated were as follows ($ in thousands, except per share amounts):