NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

NOTE 1 — BASIS OF PRESENTATION

The consolidated condensed balance sheet as of July 31,  2018, which has been derived from the audited financial statements of Torotel, Inc. ("Torotel" or the “Company”), is accompanied by the unaudited interim consolidated condensed financial statements, which reflect the normal recurring adjustments that in the opinion of management are necessary to present fairly Torotel’s consolidated financial position at July 31,  2018, and the consolidated results of operations and cash flows for the three months ended July 31,  2018, and 2017, respectively. 

The unaudited interim consolidated condensed financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission ("SEC").  Certain information and note disclosures normally included in the annual financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to those rules and regulations, although management believes the disclosures made are adequate to make the information not misleading. The financial statements contained herein should be read in conjunction with Torotel’s consolidated financial statements and related notes filed on Torotel's Form 10-K/A for the year ended April 30, 2018 as filed with the SEC on July 12, 2018.

In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842) , in order to increase transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet for those leases classified as operating leases under previous GAAP. ASU 2016-02 requires that a lessee should recognize a liability to make lease payments (the lease liability) and a right-of-use asset representing its right to use the underlying asset for the lease term on the balance sheet. ASU 2016-02 requires expanded disclosures about the nature and terms of lease agreements and is effective for annual reporting periods beginning after December 15, 2018, including interim periods within that reporting period. Early adoption is permitted. Torotel is currently evaluating the potential impact of this standard on its consolidated financial statements. Torotel anticipates the impact will be material to the consolidated financial statements for reporting periods beginning after December 15, 2018, due to the amendment to the lease for Torotel’s manufacturing facility that was executed on October 31, 2016. The status of the implementation effort is in the preliminary stage. No significant implementation matters have been identified as needing to be addressed.

In May 2014, the FASB issued ASU No. 2014-09,  Revenue from Contracts with Customers (Topic 606) (ASC 606) . ASU 2014-09 supersedes the revenue recognition requirements in  Revenue Recognition (Topic 605) , and 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 in exchange for those goods or services. The new revenue recognition standard also requires disclosures that sufficiently describe the nature, amount, timing and uncertainty of revenue and cash flows arising from customer contracts. This ASU was amended by ASU No. 2015-14, issued in August 2015, which deferred the original effective date by one year; the effective date of this ASU is for fiscal years, and interim reporting periods within those years, beginning after December 15, 2017, using one of two retrospective application methods. In addition, the FASB issued other amendments during 2016 to ASC 606, which include implementation guidance to principal versus agent considerations, guidance to identifying performance obligations and licensing guidance and other narrow scope improvements. The Company adopted this new guidance on May 1, 2018 using the modified retrospective application method. As part of the Company's implementation plan for this new standard, the Company assessed the impact of these new standards on its business processes, business and accounting systems, and consolidated financial statements and related disclosures by evaluating the terms and conditions of samples of both standard and non-standard contracts across the Company's in-scope business segments in light of the new standards. Specifically, the Company recognized the cumulative effect of initially applying the new revenue standard as an adjustment to the opening balance of retained earnings of $102,000 as of May 1, 2018. The comparative information has not been restated and continues to be reported under the accounting standards in effect for those periods. We expect the impact of the adoption of the new standard to be material to our results of operations on an ongoing basis.

Torotel has two primary product revenue streams. Over 90% of our revenue is derived from product revenue in the aerospace and defense industries. Under this revenue stream, control is transferred as products are completed and closed to finished goods.  Torotel’s industrial and commercial product revenue makes up less than 7% of total revenue. Under this revenue stream, control is transferred as the products are shipped. The remainder of Torotel revenue consists of product fees and engineering and design services. With product fees, control transfer is determined by the revenue stream of the associated product. Percentage-of-completion revenue recognition is utilized when revenue recognized exceeds the amount billed to the customer for any project-related services, utilizing labor as the input method.  Torotel recognizes revenue when control has been transferred to the customer. Under the previous revenue recognition accounting standard, Torotel product revenue was recognized upon shipment or delivery of goods. Over 90% of Torotel revenue is derived from contracts with performance obligations satisfied over time.  Performance obligations under long-term agreements are considered to be under contract at the time that authorization to ship has been obtained from the customer. Performance obligations under standalone purchase orders are considered to be under contract at the time that the purchase order is received. Parts manufactured for customers in our aerospace and defense product revenue stream must be built to certain specifications that are then qualified by the customer. Due to the proprietary nature of our custom-built products designed for a specific use by our aerospace and defense customers, control is considered to be with the customer as the products are finalized and placed into finished goods.  For our commercial customers, control of the underlying product design is retained by Torotel, therefore the products are considered in our control until the moment of shipment. Torotel’s warranty obligations fall under Topic 460, and are not considered to be within the scope of Topic 606.

The following table summarizes the cumulative effect of the changes to our consolidated condensed balance sheet as of May 1, 2018 from the adoption of ASC 606:

In accordance with the new revenue recognition requirements relative to the revenue recognition requirements under ASC 605, the disclosure of the impact of adoption on our consolidated condensed balance sheet, consolidated condensed statement of operations, and consolidated condensed statement of cash flows as of and for the three months ended July 31, 2018 was as follows:

NOTE 2 — NATURE OF OPERATIONS

Torotel conducts business primarily through its wholly owned subsidiary, Torotel Products, Inc. (“Torotel Products”). Torotel Products specializes in the custom design and manufacture of a wide variety of precision magnetic components, consisting of transformers, inductors, reactors, chokes, toroidal coils, high voltage transformers, dry-type transformers and electro-mechanical assemblies, for use in commercial, industrial and military electronics.

NOTE 3—INVENTORIES

The following table summarizes the components of inventories:

NOTE 4—FINANCING AGREEMENTS

Torotel Products has a financing agreement (the “financing agreement”) with Commerce Bank, N.A. (the “Bank”).  The financing agreement provides for a revolving line of credit, a guidance line of credit, and a real estate term loan. Torotel serves as the guarantor to all promissory notes described below. A summary of the notes outstanding under the financing agreement is provided below:

Under the financing agreement, prepayment of the mortgage note up to $100,000 per year is allowed without penalty so long as the funds used for any repayment are generated through internal cash flow and not borrowed from a separate financial institution. The mortgage note is cross collateralized and cross defaulted with all other credit facilities of Torotel Products and is secured by a first real estate mortgage on the property located at 620 North Lindenwood Drive in Olathe, Kansas.

The working capital revolving line of credit is renewable annually. The associated interest rate is equal to the greater of the floating Commerce Bank Prime Rate (currently 5.00%) or a floor of 4% (as listed above).  Monthly repayments of interest only are required under the working capital revolving line of credit promissory note with the principal due at maturity.  This working capital revolving line of credit is cross collateralized and cross defaulted with all other credit facilities and arrangements of Torotel Products with the Bank and is secured by a first lien on all business

assets of Torotel Products. This working capital revolving line of credit is scheduled to mature on October 20, 2018, and Torotel Products expects to negotiate an extension of that maturity date.

On March 31, 2017, Torotel Products entered into a $500,000 building revolving line of credit, which is available for working capital purposes and is renewable annually. The associated interest rate is equal to the greater of the floating Commerce Bank Prime Rate (currently 5.00%) or a floor of 4% (as listed above). Monthly repayments of interest only are required with the principal due at maturity. The maximum borrowing of this building line of credit is $500,000. This facility is cross collateralized and cross defaulted with all other facilities and is secured by a first lien on the building located at 620 North Lindenwood Drive in Olathe, Kansas. This building revolving line of credit is scheduled to mature on October 20, 2018, and Torotel Products expects to negotiate an extension of that maturity date.

The equipment note is a guidance line of credit to be used for equipment purchases. Monthly repayments consisting of both interest and principal are required. This note is cross collateralized and cross defaulted with all other facilities of Torotel Products and is secured by a purchase money security interest in the assets purchased as well as a first lien on all business assets of Torotel Products.  The maximum borrowing of this line of credit is $500,000.

Torotel Products is required to comply with specified financial covenants of the financing agreement with Commerce Bank. As of July 31,  2018, Torotel Products was not in compliance with the covenants in such financing agreement that require (1) a ratio of EBITDA (as defined in the financing agreement) to fixed charge coverage (as defined in the financing agreement) in excess of 1.100 to 1.000,  and (2) that Torotel maintain a minimum Tangible Net Worth (as defined in the financing agreement) of $4,500,000.  A waiver for non-compliance with these covenants was received from Commerce Bank for the period ending July 31, 2018.

Irrevocable Standby Letter of Credit

Under the terms of a lease amendment for its manufacturing facility located in Olathe, Kansas (see Note 11), Torotel provided the landlord an irrevocable standby letter of credit in the original amount of $350,000 as additional security. The balance under the letter of credit will automatically reduce in accordance with the below schedule if not drawn upon:

NOTE 5—INCOME TAXES

As of July 31,  2018, the federal tax returns for the fiscal years ended 2016 through 2018 are open to audit until the statute of limitations closes for the years in which our net operating losses are utilized. We would recognize interest and penalties accrued on unrecognized tax benefits as well as interest received from favorable tax settlements within income tax expense. As of July 31, 2018, we recorded no accrued interest or penalties related to uncertain tax positions. We expect no significant change in the amount of unrecognized tax benefit, accrued interest or penalties within the next twelve months.

NOTE 6—RESTRICTED STOCK AGREEMENTS

Restricted Stock Agreements, and stock awards thereunder, are authorized by the Compensation and Nominating Committee (the "Committee") and the Board of Directors of Torotel (the "Board"). The terms of the Restricted Stock Agreements afford the grantees all of the rights of a stockholder with respect to the award shares, including the right to vote such shares and to receive dividends and other distributions payable with respect to such shares since the date of

award. Under the terms of each agreement, the non-vested shares are restricted as to disposition and subject to forfeiture under certain circumstances. The Restricted Stock Agreements further provide, subject to certain conditions, that if prior to all of the restricted shares having vested, we undergo a change in control, then all of the restricted shares shall be vested and no longer subject to restrictions under the Restricted Stock Agreements. The restricted shares are treated as non-vested stock; accordingly, the fair value of the restricted stock at the date of award is offset against capital in excess of par value in the accompanying consolidated balance sheets under stockholders' equity.

Restricted Stock Grants

  On September 21, 2016, we entered into Restricted Stock Agreements (“2016 Agreements”) with three key employees for the grant of an aggregate total of 730,000 restricted shares of the Company's common stock (the “Shares”).  The Shares were granted, and the 2016 Agreements were entered into, pursuant to the Company’s Stock Award Plan (the “Plan”).  The award of the Shares was authorized by both the Committee and the Board as a whole on September 19, 2016.   Except for the number of shares granted to each recipient, the terms of each of the 2016 Agreements are identical.

The Shares were granted subject to restrictions that prohibit them from being sold, assigned, pledged or otherwise disposed of until the restrictions lapse.  The restrictions will lapse on the fifth anniversary of the date of grant if during the five year restriction period, (1) the Company's cumulative annual growth in revenue is at least 10%, and (2) the average economic value added as a percentage of revenue is at least 2%. The economic value added, which attempts to capture the true economic profit, will be calculated as the operating profit less the cost of capital with adjustments made for taxes. The restrictions will also lapse, if prior to the fifth anniversary of the date of grant, (1) the grantee's employment with the Company is terminated by reason of disability, (2) the grantee dies, or (3) the Committee, in its sole discretion, terminates the restrictions.  If the restrictions on the Shares have not lapsed by the fifth anniversary of the date of grant, the Shares will be forfeited to the Company.

Stock Compensation Costs and Restricted Stock Activity

Total stock compensation cost for the three months ended July 31, 2018 and 2017 was $27,000 and $27,000, respectively.

Restricted stock activity for each three month period through July 31 is summarized as follows:

NOTE 7—STOCKHOLDERS' EQUITY

The shares of common stock outstanding as of July 31 of each year are summarized as follows:

NOTE 8—EARNINGS PER SHARE

Basic and diluted earnings per share are computed using the two-class method. The two-class method is an earnings allocation formula that determines net income per share for each class of common stock and participating security according to dividends declared and participation rights in undistributed earnings. Per share amounts are computed by dividing net income attributable to common shareholders by the weighted average shares outstanding during each period.

The basic earnings per common share were computed as follows:

ASC 260, Earnings per Share, provides that unvested share-based payment awards that contain non-forfeitable rights to dividends are considered to be participating securities and must be considered in the computation of earnings per share pursuant to the two-class method.  Diluted earnings per share is not presented as we do not have any shares considered incremental and dilutive.

NOTE 9— CONTRACT ASSETS AND LIABILITIES

For each of our contracts, the timing of revenue recognition, customer billings, and cash collections results in a net contract asset or liability at the end of each reporting period. Contract assets consist of unbilled receivables typically resulting from revenue recognition under contracts when either control has passed to the customer but the product has not yet shipped or the percentage-of-completion of revenue recognition is utilized when revenue recognized exceeds the amount billed to the customer for any project-related services, utilizing labor as the input method.  Contract liabilities (formerly referred to on the balance sheet as customer deposits) include advance payments and billings in excess of revenue recognized.  Contract assets and contract liabilities were as follows:

Contract assets increased $233,000 between April 30, 2018 and July 31, 2018 due to the adoption of the new revenue standard, and relates to the recognition of revenue related to the satisfaction or partial satisfaction of performance obligations for which we have not yet billed.

Contract liabilities decreased $163,000 between April 30, 2018 and July 31, 2018 due to the recognition of revenue on advance payments exceeding additional advance payment receipts.

NOTE 10 — CONCENTRATIONS OF CREDIT RISK

Financial instruments that potentially subject us to concentrations of credit risk consist principally of cash and accounts receivable.  We grant unsecured credit to most of our customers.  We do not believe that we are exposed to any extraordinary credit risk as a result of this policy.  At various times cash balances exceeded federally insured

limits. However, we have incurred no losses in the cash accounts and we do not believe we are exposed to any significant credit risk with respect to our cash.

NOTE 11 —  COMMITMENTS AND CONTINGENCIES

Torotel is obligated under several capital leases for the lease of various information technology and production equipment that expire at various dates during the next three years.  All of these leases are non-cancellable and are presented in the accompanying consolidated financial statements as long-term debt.  At July 31, 2018 and April 30, 2018, the gross amount of equipment under capital lease was $225,000.  Related accumulated depreciation recorded under capital lease were $48,000 and $0, respectively.

Amortization of assets held under capital lease is included with depreciation expense.

On August 30, 2017, Torotel entered into a Third Amendment (“Amendment”) to the lease for its manufacturing facility located in Olathe, Kansas. The Amendment reconfigured the Suite 520 entry design, and granted Torotel a $37,500 lump sum net base rent abatement, to be applied at $18,750 per month from September 1, 2017 through October 31, 2017.  The Amendment also reduced the current letter of credit requirement from $350,000 to $300,000.  The Amendment did not change the term of the lease, which continues through December 31, 2026 (subject to early termination options and two separate options to extend the lease term for additional five year periods).

Future minimum lease payments on the amended operating lease and future minimum capital lease payments as of July 31, 2018 are as follows:

Forward-Looking Information

This report, as well as our other reports filed with or furnished to the Securities and Exchange Commission (the “SEC”), contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). The words “believe,” “estimate,” “anticipate,” “project,” “intend,” “expect,” “plan,” “outlook,” “forecast,” “may,” “should,” “predict,” and similar expressions are intended to identify forward-looking statements. Statements regarding expectations, including performance assumptions and estimates relating to capital requirements, as well as other statements that are not historical facts, are forward-looking statements. This report contains forward-looking statements regarding, among other topics, our expected financial position, results of operations, cash flows, strategy, budgets and management's plans and objectives. Accordingly, these forward-looking statements are based on management’s judgments based on currently available information and assumptions about a number of important factors. While we believe that our assumptions about such factors are reasonable, such factors involve risks and uncertainties that could cause actual results to differ materially from those in the forward-looking statements. These factors include,without limitation:

In light of these risks and uncertainties, there can be no assurance that the forward-looking information contained in this report will prove accurate, and actual results may differ materially from these forward-looking statements. We assume no obligation to update any forward-looking statements made herein.