AWARE INC /MA/ - Annual Report: 2015 (Form 10-K)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

Annual Report Pursuant to Section 13 or 15(d) of The

Securities Exchange Act of 1934

For the fiscal year ended December 31, 2015

Commission file number 000-21129

(Exact Name of Registrant as Specified in Its Charter)

(Address of Principal Executive Offices)

(Zip Code)

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Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x

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As of June 30, 2015 the aggregate market value of the registrant’s common stock held by non-affiliates of the registrant, based on the closing sale price as reported on the Nasdaq Global Market, was approximately $58,926,193.

The number of shares outstanding of the registrant’s common stock as of February 5, 2016 was 22,993,139.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the registrant’s definitive Proxy Statement to be delivered to shareholders in connection with the registrant’s Annual Meeting of Shareholders to be held on May 25, 2016 are incorporated by reference into Part III of this Annual Report on Form 10-K.

AWARE, INC.

FORM 10-K

FOR THE YEAR ENDED DECEMBER 31, 2015

TABLE OF CONTENTS

PART I

FORWARD LOOKING STATEMENTS

Matters discussed in this Annual Report on Form 10-K relating to future events or our future performance, including any discussion, express or implied, of our anticipated growth, operating results, future earnings per share, market opportunity, plans and objectives, are “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. These statements are often identified by the words “may,” “will,” “expect,” “believe,” “anticipate,” “intend,” “could,” “estimate,” or “continue,” and similar expressions or variations. Such forward-looking statements are subject to risks, uncertainties and other factors that could cause actual results and the timing of certain events to differ materially from future results expressed or implied by such forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in the section titled “Risk Factors,” set forth in Item 1A of this Annual Report on Form 10-K and elsewhere in this Report. The forward-looking statements in this Annual Report on Form 10-K represent our views as of the date of this Annual Report on Form 10-K. We anticipate that subsequent events and developments will cause our views to change. However, while we may elect to update these forward-looking statements at some point in the future, we have no current intention of doing so except to the extent required by applicable law. You should, therefore, not rely on these forward-looking statements as representing our views as of any date subsequent to the date of this Annual Report on Form 10-K.

ITEM 1. BUSINESS

Company Overview

Aware, Inc. (“Aware”, “we”, “us”, “our”, or the “Company”) is a leading provider of software and services to the biometrics industry. We have been engaged in this business since 1993. Our software products are used in government and commercial biometrics systems to identify or authenticate people. Principal government applications of biometrics systems include border control, visitor screening, law enforcement, national defense, intelligence, secure credentialing, access control, and background checks. Principal commercial applications include: i) user authentication for login to mobile devices, computers, networks, and software programs; ii) user authentication for financial transactions and purchases (online and in-person); iii) physical access control to buildings, and iv) screening and background checks of prospective employees and customers.

Our products provide interoperable, standards-compliant, field-proven biometric functionality and are used to capture, verify, format, compress and decompress biometric images as well as aggregate, analyze, process, match and transport those images within biometric systems. We sell a broad range of software products for fingerprint, facial, and iris modalities. We also offer a variety of software engineering services, including: i) project planning and management; ii) system design; iii) software design, development, customization, configuration, and testing; and iv) software integration and installation. We sell our biometrics software products and services globally through systems integrators and OEMs, and directly to end user customers.

Aware was incorporated in Massachusetts in 1986. We are headquartered at 40 Middlesex Turnpike in Bedford, Massachusetts, and our telephone number at this address is (781) 276-4000. Our website address is www.aware.com. The information on our website is not part of this Form 10-K, unless expressly noted. Our stock is traded on the Nasdaq Global Market under the symbol AWRE.

Industry Background

Biometrics is the measurement of unique, individual physiological characteristics, such as fingerprints, faces, irises, and voices that can be used to determine or verify an individual’s identity. The biometrics industry offers technology that digitally captures and encodes biometric characteristics and then compares those characteristics against previously encoded biometric data to determine or verify an individual’s identity. Biometrics addresses the limitations inherent in traditional identification and authentication processes, such as paper credentials, passwords, PIN codes, and magnetic access cards.

The biometrics industry provides solutions for a broad range of government and commercial applications. Principal government biometrics applications include border control, visitor screening, law enforcement, national defense, intelligence, secure credentialing, access control and background checks. Principal commercial applications include: i) user authentication for login to mobile devices, computers, networks, and software programs; ii) user authentication for financial transactions and purchases (online and in-person); iii) physical access control to buildings; and iv) screening and background checks of prospective employees and customers.

We believe that government and commercial entities will continue to adopt and expand the use of biometrics-enabled solutions to address the limitations and vulnerabilities of traditional identification and authentication processes. We believe the following factors, among others, will contribute to the growth of biometrics solutions: i) government-mandated implementation of identification for employees, citizens, and foreign nationals to enhance national security; ii) military implementations for the identification of terrorists and other hostile persons; iii) increasing threats to personal security encountered in areas such as transportation; iv) government and commercial efforts to detect and reduce fraud and cybercrime; v) adoption of biometrics on mobile devices; and vi) the emergence and adoption of international biometrics standards.

The biometrics industry may be segmented into government and commercial sub-markets. While these markets are similar in many respects and share similar characteristics and technology, certain aspects of the markets are different. We believe that this market-based distinction is important to an understanding of Aware’s business as the vast majority of our revenue is currently derived from government customers.

Government market

Governments throughout the world were early adopters of biometrics technology and continue to be the largest consumers of the technology. Biometrics technology is used by local, state, and national governments.

At the local and state level, biometrics technology is used in the following applications:

At the national level, biometrics technology is used in the following applications:

National governments throughout the world have mandated increased spending on security measures, implemented new regulations and placed greater emphasis on technology to address growing security concerns. Immigration and border control agencies have taken steps to improve security in response to heightened concerns over public safety from the threat of terrorism. They use biometrics to help establish the identity of visitors upon application for a visa or upon arrival at border checkpoints. For example, the U.S. Office of Biometric Identity Management currently requires foreign visitors entering the United States to have their ten fingers scanned and a facial photograph taken to determine if they are present on a watch list. The European Union now mandates that e-passports include fingerprint data in addition to a digital photograph.

Within military organizations, key applications of biometrics include: i) background checks of military personnel and contractors; ii) access control to physical and digital assets; and iii) identification of unknown and potentially hostile persons by a comparison of their biometric sample against a watch list.

Law enforcement agencies perform background checks that use biometrics to help confirm the identity of individuals who might be present in a biometric database. Background checks might also be provided as a service to other agencies within the government.

Governments also use biometrics for physical access control by storing biometric data on a digital ID card and performing a match to verify that the holder of the card is the same person issued the card. Biometrics are also used for securing access to digital assets, where a biometric match might be required in addition to a password to gain access to a computer system.

Government biometrics systems typically operate on client/server-based computer networks. Enrollment workstations with peripheral capture devices are used to enroll individuals into biometrics systems. Enrollment involves the capture, processing, and formatting of “biometric samples.” A “biometric sample” is biometric data which may include: i) images of fingerprints, faces, or irises; ii) digital voice signals; or iii) some other electronic representation of a biometric characteristic. Examples of capture peripherals include: i) scanners for fingerprint images, ii) cameras for iris and facial images, iii) handheld devices for mobile capture of fingerprint, iris, and facial images, or iv) mobile phones for voice signals.

After biometric samples are captured, they are then transported in digital form to centralized matching systems for identification. Equipment used to perform these functions includes: i) servers to process and transport biometric samples; and ii) mainframe computers and servers to store and match those samples. In addition, military applications may employ handheld devices that are capable of capturing samples and matching those samples against sample databases that reside on the devices.

Due to the nature of government applications, particularly those involving security and defense, government biometrics systems must be capable of accurately and rapidly searching and matching biometric samples against large databases of stored samples. The ability to accurately and rapidly match samples against databases of millions of samples is critical because incorrect or delayed results could have severe adverse consequences. These requirements are an important distinguishing characteristic of the government market as compared to the commercial market.

Another characteristic that defines government markets can be seen in the difference between biometric identification and biometric verification. Biometric identification involves a one-to-many search of thousands or even millions of records to determine which, if any, record belongs to the individual in question. Government applications tend to involve biometric identification.

Biometric verification involves a one-to-one biometric comparison that serves to verify that both biometric samples belong to the same individual. One-to-one matches tend to require less algorithmic accuracy, speed, sensor fidelity, and computer processing power than “one-to-many” searches performed on large databases of stored biometric records. Commercial applications tend to involve biometric verification.

Commercial market

Biometrics-based solutions compete with more traditional security methods including keys, cards, personal identification numbers and security personnel in commercial markets. The adoption of biometrics by leading vendors of smartphones and other popular consumer products has increased users’ confidence and comfort with biometrics as a convenient and secure means of authentication. Biometrics solutions are also being considered in commercial markets as a means of increasing security and reducing fraud as part of “know-your-customer” and “know-your-employee” efforts. “Know-your-customer” initiatives are designed to verify the identity of customers before providing products or services. “Know-your-employee” initiatives are designed to verify the identity of employment candidates upon application for employment.

Notwithstanding these positive developments, commercial markets for biometrics technology are in the process of developing and evolving. The rate of adoption of biometrics in commercial markets depends upon a number of factors, including: i) the performance and reliability of biometric solutions; ii) costs involved in adopting and integrating biometric solutions; iii) public concerns regarding privacy; iv) potential privacy legislation; and v) standardization efforts by various industry consortia and standards bodies.

Principal biometrics applications in commercial markets involve the authentication and/or identification of individuals. The types of users that may need to be authenticated or identified in commercial applications include customers, employees, suppliers, visitors, patients, or other parties wishing to gain access to information, systems, bank accounts, credit card accounts, events, devices, buildings, or organizations.

Examples of commercial market applications include:

We believe that the commercial biometrics market may be further segmented into: i) a consumer mass market segment; and ii) an enterprise segment. While we believe this delineation serves a useful purpose in describing the current state of the market, it has its limitations because the two segments overlap.

Consumer mass market segment – This segment is dominated by biometrics-enabled smartphones. Many smartphones now contain fingerprint sensors and software that can: i) enroll and encode a fingerprint sample; ii) store the sample in a secure area on the phone; and iii) collect a live fingerprint and match it to the stored fingerprint sample. Once a biometric match is achieved, the subsequent software functions are analogous to password authentication. This type of biometric authentication is sometimes referred to as a “one-to-one” match and it requires a less complex and robust biometric match capability than that used in large client-server based biometrics systems.

Mobile biometrics authentication applications are largely controlled by smartphone manufacturers as this functionality is executed by smartphone operating systems and sensor hardware, as opposed to third-party applications running on the phone. Third party applications on smartphones are currently granted access to biometric authentication results, but may not necessarily have access to raw biometric samples, hardware, relevant security functions, or other smartphone capabilities. In contrast, authentication using facial or voice biometric modalities may be implemented in applications running on the phone, because these applications can make use of the camera and microphone on the device, which are generally granted broader access to third party developers.

User authentication and payment features enabled by smartphones continue to evolve, and we expect to see further changes in smartphone security features and functionality.

Enterprise segment – Enterprise biometrics systems are similar to government systems in that they typically operate in a client/server environment that: i) captures biometrics samples on a client PC; ii) stores those samples in a database on a server, and then, when queried; iii) matches live samples against stored samples. Mobile devices are likely to be used in conjunction with enterprise systems as we have seen a desire by customers to use smartphones as enrollment and access devices.

Opportunities and customer demand are beginning to emerge in the enterprise segment of the commercial market, but it remains a nascent and evolving market. We are beginning to see three potential types of opportunities, including:

Biometrics service providers have begun to offer pay-per-transaction biometrics service offerings in commercial markets. These services allow organizations to biometrically identify or verify employees, customers, or other individuals relevant to their business. A pay-per-transaction model may be potentially more financially attractive for some organizations as compared to the cost of purchasing, installing and maintaining internal biometrics systems.

Biometrics industry participants

There are a large number of vendors that serve government and commercial biometrics markets. In order to provide an understanding of the biometrics industry and our role in it, we have categorized industry participants into categories that have been defined by us. While we believe our categorization is a reasonable representation of the industry, we acknowledge that: i) knowledgeable industry participants may define categories differently or classify vendors differently; and ii) not all companies involved in the industry were included. Accordingly, the classification that follows represents our perspective on the industry.

We believe that biometrics industry participants may be classified into the following categories:

Category descriptions and companies that offer products and services in each category are provided below. It should be noted that some companies appear in multiple categories.

Core biometrics technology includes hardware and software products that enable: i) traditional biometrics systems used by government and commercial customers; ii) new biometric service offerings; and iii) biometrically-enabled functionality embedded in other products and solutions. Core biometrics technology includes three types of products: i) sensor products, ii) biometric capture devices, and iii) software products.

Sensor products

Biometrics sensors are primarily silicon-based devices that capture biometrics samples, such as fingerprints. Sensors are typically embedded in other devices, such as smartphones or biometric capture devices.

Examples of companies that offer biometric sensor products include: 1) Qualcomm Technologies, Inc. through its acquisition of UltraScan Corporation; 2) Sonavation, Inc.; 3) Synaptics, Inc.; 4) Fingerprint Cards AB; 5) Integrated Biometrics, LLC; and 6) Next Biometrics AS.

Biometric capture devices

Biometric capture devices are designed to capture and process biometric samples as their primary function. These products may be strictly hardware products or hardware products that also incorporate biometrics software.

Examples of companies that offer biometric capture devices include: 1) Cross Match Technologies, Inc.; 2) Suprema, Inc.; 3) HID Global Corporation through its 2014 acquisition of Lumidigm, Inc. (“HID”); 4) Iris ID Systems, Inc (“Iris ID”); 5) Precise Biometrics AB (“Precise Biometrics”); 6) Credence ID, LLC; 7) SecuGen Corporation; 8) IrisGuard, Inc. (“IrisGuard”); 9) Aurora Biometrics, Inc. (“Aurora Biometrics”); 10) EyeLock LLC (“EyeLock”); and 11) Tascent, Inc. through its 2015 acquisition of Aoptix Technology Identity Solutions’ business unit.

Software products

Biometrics software products provide functionality that captures, formats, stores, processes, or matches samples of fingerprints, faces, iris, voices and other modalities. Biometrics software is capable of operating on variety of equipment platforms, including personal computers, smartphones, biometric capture devices, hand-held devices, servers, and mainframe computers.

Examples of companies that offer biometrics software products include: 1) Aware, Inc.; 2) MorphoTrak and MorphoTrust, divisions of the Safran Group Company (“Safran Morpho”); 3) 3M Cogent Inc. (“3M Cogent”); 4) NEC Corporation (“NEC”); 5) Cognitec Systems GmbH (“Cognitec”); 6) Neurotechnology; 7) Iritech, Inc. (“Iritech”); 8) Innovatrics s.r.o. (“Innovatrics”); 9) M2Sys Technology (“M2Sys”); 10) SpeechPro, Inc.; 11) Agnitio S.L.; 12) Precise Biometrics; 13) Facebanx, a subsidiary of OhHi, Ltd; 14) VoiceTrust GmbH.; 15) Eyelock; 16) BIO-key International, Inc.; 17) VoiceVault Inc.; 18) EyeVerify, Inc.; 19) Iris ID; 20) IrisGuard; 21) Aurora Biometrics; 22) NexID Biometrics LLC.; and 23) Daon Trusted Identity Services (“Daon”).

System integrators purchase hardware and software technology from core biometrics technology vendors and incorporate those components into customized biometrics systems that they deliver to end-user customers. Historically those end-user customers have been governments, but in recent years system integrators have begun to serve commercial enterprise customers as well. System integrators include large multinationals with a broad range of expertise and the capacity to execute very large projects, as well as smaller system integrators that have more focused expertise on a particular market sector, technology, or geography. Some system integrators have developed their own biometric technologies that they deliver as part of their solutions.

Examples of companies that offer systems integration services include: 1) Northrop Grumman Corporation; 2) Lockheed Martin Corporation; 3) Science Applications International Corporation; 4) Hewlett-Packard Enterprise Services; 5) International Business Machines Corporation; 6) Fujitsu Limited; 7) Accenture plc; 8) Unisys Corporation; 9) Leidos, Inc.; and 10) ManTech International Corporation.

Fully integrated solutions suppliers are similar to systems integrators in that they deliver customized biometrics systems to government and commercial enterprise end-user customers. They differ from system integrators in that they use core hardware and software technologies that they developed in-house or acquired from others. Vendors in this category may purchase some third party software, but we believe such purchases represent a minor component of the overall systems they deliver.

There are three large global suppliers of fully integrated solutions, including: 1) Safran Morpho; 2) 3M Cogent; and iii) NEC. We believe these companies supply a large percentage of the biometric systems that are delivered to government customers around the world.

In addition to these three large suppliers, we would categorize Dermalog Identification Systems GmbH as a fully integrated solution provider, but one that operates on a smaller scale. Aware also has a product portfolio and services capability that enables us to deliver fully integrated solutions. We have acted in this capacity on a limited basis in the past and an element of our strategy is to grow this part of our business in the future.

Biometrics service providers have begun to offer a pay-per-transaction biometrics service offering. This service allows organizations to biometrically identify or verify employees, customers, or other individuals relevant to their business. A pay-per-transaction model may be potentially more financially attractive for some organizations as compared to the cost of purchasing, installing and maintaining internal biometrics systems.

Examples of companies offering biometrics services include: 1) Certibio Identidade Biometrica, a wholly-owned subsidiary of Certisign Certificadora Digital S.A. (“Certisign”); 2) Safran Morpho; and 3) Daon.

Vendors of biometrically-enabled solutions provide products that are not principally marketed as biometrics products, but include biometric functionality. Biometrics capability is a feature, but not the chief function of these products. Such vendors represent a potential opportunity for core biometrics technology providers as some of them do not own core biometrics technology.

Examples of companies that offer biometrically-enabled smartphone products include: 1) Apple, Inc.; 2) Samsung Electronics Co., Ltd.; and 3) Google, Inc.

Examples of companies that offer secure identification/access solutions that incorporate biometrically-enabled components include: 1) Gemalto NV; 2) HID; 3) Entrust Datacard Corporation; and 4) Oberthur Technologies.

Examples of companies that offer physical access control solutions that may incorporate biometrics include: 1) Honeywell International, Inc.; 2) Tyco International Ltd.; 3) Lenel Systems International Inc.; and 4) Stanley Security Limited.

Products and Services

Software products

We sell a broad range of biometrics software products for fingerprint, facial, and iris modalities. Our software products enable important functions in biometrics systems, including:

Our biometrics software products range from discrete software blocks that customers can use to develop their own solutions to more complete applications that customers can use to reduce or eliminate their development times. We classify our biometrics software products into five product groups, including, i) Software Development Kits; ii) Enrollment Controls and Applets; iii) Applications; iv) Middleware/Workflow Server; and v) Cluster Computing Platform. Each of these product groups is described below.

SDK Group 1: Enrollment SDKs. Our suite of enrollment SDKs performs a variety of functions that are critical to biometric enrollment, including image capture, image quality assurance, image formatting, and image compression. Our enrollment SDK products include:

SDK Group 2: Biometric Search and Match SDKs. Our Nexa™ line of biometric search and matching products for fingerprint, face and iris includes our Nexa|Fingerprint™, Nexa|Face™, and Nexa|Iris™ products. These products contain algorithms that convert images into biometric templates. A biometric template is a mathematical representation of a biometric image. Templates can then be compared to templates stored in databases to find matches. Our Nexa products also compare and match templates.

Each Nexa SDK can be deployed on a workstation or a server, either as a standalone biometric search/match API, or in combination with our other SDKs, applications, and BioSP product. Our SequenceCheck, PreFace, and IrisCheck SDKs may be used in concert with Nexa libraries to perform optional quality assurance and preprocessing for enhanced fingerprint, face, and iris search and match functionality.

Our biometric search and match SDKs also include our AwareXM™ product which extracts and matches MINEX-compliant fingerprint templates.

SDK Group 3: Text Search and Identity Analytics SDKs. We have two products in this SDK group, including: i) Inquire|Search™ and ii) Inquire|Resolve™. These products contain algorithms for text-based filtering, searching, matching, and linking functions to discover useful information in identity data. Product capabilities include: i) integrating and resolving identity-centric data across multiple data stores; ii) assessing data quality and detecting anomalies; iii) performing link analysis and relationship discovery; and iv) performing text-based pre- and post-filtering of biometric searches.

Key BioSP features and functionality include:

Imaging products

In addition to our biometrics software products, we also sell products used in applications involving medical and advanced imaging. Our principal imaging product is Aware JPEG 2000, which is based on the JPEG2000 standard. The JPEG2000 standard is an image compression standard and coding system that was created by the Joint Photographic Experts Group committee in 2000. Our JPEG2000 product is used to compress, store, and display images. Those images are typically medical images.

Software maintenance

We also sell software maintenance contracts to many of our customers who purchase software licenses. These contracts typically have a one year term during which customers have the right to receive technical support and software updates, if and when they become available. Customers tend to renew maintenance contracts during the period of time that our software is being used in their biometrics systems.

Services

We offer a variety of software engineering services, including: i) project planning and management; ii) system design; iii) software design, development, customization, configuration, and testing; and iv) software integration and installation. Services are typically, but not always, sold in conjunction with software licenses.

Service engagement deliverables may include: i) custom-designed software products; ii) custom-configured versions of existing software products; iii) one or more subsystems comprised of software products that are integrated within a larger system; or iv) complete software solutions. In some cases, the software resulting from service engagements may form the basis for new or improved Aware software products.

Our customers for services include: i) government agencies; ii) large multinational systems integrators; iii) smaller systems integrators with a particular market, technology or geographic focus; and iv) commercial providers of products, solutions, and services. We provide services directly to end-users or indirectly to end-users through systems integrators. When we provide services to systems integrators, they are often engaged with the end-user as a prime contractor and are responsible for delivery of a complete solution, in which case we typically serve as a subcontractor assigned a subset of the total scope of work.

The scope of our services projects varies. A small project might involve configuration and testing of a single software product, taking a small team one month or less. A large project might involve delivery of a more complex solution comprised of multiple products and subsystems, requiring a larger team to conduct project management, system design, software customization and integration, and taking up to one year or more. Some projects are followed by subsequent projects that serve to change or extend the features and functionality of the initial system.

Hardware products

We developed a biometrics software system for a U.S. government customer under a Small Business Innovation Research (“SBIR”) contract that began in 2008 and ended in early 2013. When the software development project ended in early 2013, we entered into a separate contract to supply hardware products incorporating the developed software. Hardware products sold to this customer integrate the developed software with: i) hardware purchased from third parties; ii) software purchased from third parties; and iii) some of our biometrics software products. While other customers could theoretically purchase the hardware products developed for this customer, we believe that it is unlikely that they will do so, because of the highly customized nature of the products.

Sales and Marketing

As of December 31, 2015, we had a total of 11 employees in our sales and marketing organization. In addition to our employee sales staff, we also engage third party sales agents to sell our products and services in foreign countries.

We sell our products and services through three principal channels of distribution:

All of our revenue in 2015, 2014, and 2013 was derived from unaffiliated customers. Revenue from Certisign Certificadora Digital S.A. represented 10%, 2%, and 0% of revenue during 2015, 2014, and 2013, respectively. Revenue from the U.S. Navy represented 9%, 24%, and 21% of total revenue during 2015, 2014, and 2013, respectively. Revenue from the U.S. Marine Corps represented 3%, 10%, and 3% of total revenue during 2015, 2014, and 2013, respectively. No other customer represented 10% or more of total revenue in any of those years.

Competition

The markets for our products and services are competitive and uncertain. We compete against: i) other companies that provide biometric software solutions; and ii) fully diversified companies that provide biometric software solutions and also act as systems integrators. We can give no assurance that: i) our products and services will succeed in the market; ii) that we will be able to compete effectively; or iii) that competitive pressures will not seriously harm our business.

Many of our competitors are larger than us and have significantly greater financial, technological, marketing and personnel resources than we do. At the other end of the competitive spectrum, we have seen increasing competition from smaller biometrics companies in foreign countries. These smaller foreign competitors have demonstrated a willingness to sell their biometrics software products at low prices.

We can give no assurance that our customers will continue to purchase products from us or that we will be able to compete effectively in obtaining new customers to maintain or grow our business.

Aware’s Strategy

Our strategy is to capitalize on our strong brand and reputation to sell biometrics software products and services into government and commercial markets. We intend to offer a broad portfolio of high quality products that are coupled with expert technical support and services. We expect to continue to employ a three-pronged distribution strategy using systems integrators, OEMs, and direct sales.

Our strategy for growing our biometrics business may include one or more of the following elements:

Our strategy to offer complete solutions involves:

We believe the evolution of commercial markets over the past few years may present opportunities for us. While it is unlikely that we will pursue opportunities in the consumer mass market segment of the market, we are beginning to see opportunities in the enterprise segment. The requirements of the enterprise segment appear to be well suited to our technology, products, and expertise.

As we attempt to grow our biometrics business, we may make investments in growth initiatives, such as those described above, that may cause our profitability to decline in the near term.

Our strategy does not include growing biometrics hardware revenue. Hardware revenue in 2015, 2014 and 2013 represents an accommodation to an important customer. Other than a $0.3 million order in backlog as of December 31, 2015, it is unlikely that we will have meaningful sales of hardware in future periods as this customer appears to have completed the bulk of its purchasing.

Backlog

We had $6.6 million of backlog on December 31, 2015. We define backlog as revenue items in deferred revenue and undelivered orders in our backlog report. Total backlog of $6.6 million included: i) $3.7 million of software licenses that will be recognized over the first ten months of 2016; ii) $2.3 million of software maintenance revenue of which approximately $2.2 million will be recognized during 2016; iii) $0.3 million of services that we anticipate will be delivered in the first quarter of 2016; and iv) $0.3 million of hardware that we anticipate will be delivered in the first quarter of 2016.

Research and Development

Our research and development activities are focused on enhancing our existing products and developing new products. Our engineering organization is based in Bedford, Massachusetts. As of December 31, 2015, we had an engineering staff of 47 employees, representing 68% of our total employee staff.

During the years ended December 31, 2015, 2014, and 2013, research and development expenses totaled $5.8 million, $5.5 million, and $4.1 million, respectively. We expect that we will continue to invest substantial funds in research and development activities.

Patents and Intellectual Property

We rely on a combination of nondisclosure agreements and other contractual provisions, as well as patent, trademark, trade secret and copyright law to protect our proprietary rights. We have an active program to protect our proprietary technology through the filing of patents. As of December 31, 2015, we had approximately 38 U.S. and foreign patents and approximately 31 pending patent applications. Our patents and patent applications pertain primarily to biometrics and imaging compression.

Although we have patented certain aspects of our technology, we rely primarily on trade secrets to protect our intellectual property. We attempt to protect our trade secrets and other proprietary information through agreements with our customers, suppliers, employees and consultants, and through security measures. Each of our employees is required to sign a non-disclosure and non-competition agreement. Although we intend to protect our rights vigorously, we cannot assure you that these measures will be successful. In addition, effective intellectual property protection may be unavailable or limited in certain foreign countries.

Third parties may assert exclusive patent, copyright and other intellectual property rights to technologies that are important to us. From time to time, we receive claims from third parties suggesting that we may be obligated to license such intellectual property rights. If we were found to have infringed any third party’s patents, we could be subject to substantial damages or an injunction preventing us from conducting our business.

Manufacturing & Systems Integration

We do not design or manufacture hardware products, however we provide systems integration services for one U.S. government customer. Our systems integration activities include: i) procuring hardware and software components from third party suppliers; ii) installing Aware and third party software on the purchased hardware; and iii) testing products for quality assurance prior to shipment.

We rely on single source suppliers for certain critical hardware and software components. Our dependence on single source suppliers involves several risks, including limited control over availability, quality, and delivery schedules. Any delays in delivery or shortages of such components could cause delays in the shipment of our products, which could harm our business.

Employees

At December 31, 2015, we employed 69 people, including 47 in engineering, 11 in sales and marketing, and 11 in finance and administration. Of these employees, 66 were based in Massachusetts. None of our employees are represented by a labor union. We consider our employee relations to be good.

We believe that our future success will depend in large part on the service of our technical, sales, marketing and senior management personnel and upon our ability to retain highly qualified technical, sales and marketing and managerial personnel. We cannot assure you that we will be able to retain our key managers and employees or that we will be able to attract and retain additional highly qualified personnel in the future.

DSL Discontinued Operations

From the early 1990s until 2013, we were engaged in the Digital Subscriber Line (“DSL”) industry. We sold the assets of our DSL semiconductor intellectual property business in 2009, and shut down our DSL service assurance hardware and software businesses in 2012 and 2013, respectively. Results from the shutdown of our DSL service assurance software businesses were reported in discontinued operations in the year ended December 31, 2013.

Notwithstanding the sale of DSL semiconductor intellectual property assets in 2009, we continue to receive royalty payments from two customers. DSL royalties are reported in continuing operations in accordance with ASC 205-20, Reporting Discontinued Operations, because we have continuing cash flows from this business. DSL royalties have been declining in recent years and represented approximately 2% of total revenue in 2015. We expect royalties will continue to decline in future periods.

Segment Information; Financial Information About Geographic Areas

We organize ourselves into a single segment that reports to the chief operating decision makers. Summaries of revenue by geographic regions and revenue by product group are set forth in Note 9 to our consolidated financial statements included elsewhere in this Annual Report.

Available Information

Our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, proxy statements, and amendments to reports filed pursuant to Sections 13(a) and 15(d) of the Securities Exchange Act of 1934, as amended, are made available free of charge on or through our website at www.aware.com as soon as reasonably practicable after such reports are filed with, or furnished to, the Securities and Exchange Commission (the SEC). The SEC also maintains a website, www.sec.gov, that contains reports and other information regarding issuers that file electronically with the SEC. Such reports, proxy statements, and other information may also be obtained by visiting the Public Reference Room of the SEC at 100 F Street, N.E., Washington, DC, 20549 or by calling the SEC at 1-800-SEC-0330.

Copies of our (i) Corporate Governance Principles, (ii) charters for the Audit Committee, Compensation Committee, and Nominating Committee, and (iii) Code of Ethics are available in the Investor Relations section of our website at www.aware.com.

ITEM 1A. Risk Factors

Our operating results may fluctuate significantly from period-to-period and are difficult to predict.

Individual orders can represent a meaningful percentage of our revenues and net income in any single quarter and the timing of the receipt of those orders is difficult to predict. The failure to close an order or the deferral or cancellation of an order can result in revenue and net income shortfalls for that quarter. We base our current and future expense levels on our internal operating plans and sales forecasts, and our operating costs are to a large extent fixed. As a result, we may not be able to sufficiently reduce our costs in any quarter to adequately compensate for an unexpected near-term shortfall in revenues, and even a small shortfall could disproportionately and adversely affect financial results for that quarter.

Our financial results may be negatively affected by a number of factors, including the following:

As a result of these factors, we believe that period-to-period comparisons of our revenue levels and operating results are not necessarily meaningful. You should not rely on our quarterly revenue and operating results to predict our future performance.

We derive a significant portion of our revenue directly or indirectly from government customers, and our business may be adversely affected by changes in the contracting or fiscal policies of those governmental entities.

We derive a significant portion of our revenue directly or indirectly from federal, international, state and local governments. We believe that the success and growth of our business will continue to depend on government customers purchasing our products and services either directly through us or indirectly through our channel partners. Changes in government contracting policies or government budgetary constraints may adversely affect our financial performance. Among the factors that could adversely affect our business are:

These and other factors could cause government customers or our channel partners to reduce purchases of products and services from us which would have a material adverse effect on our business, financial condition and operating results.

A significant commercial market for biometrics technology may not develop, and, even if it does, there can be no assurance our biometrics technology will be successful.

A component of our strategy to grow revenue includes expansion into commercial markets. To date, biometrics technology has received only limited acceptance in such markets. Although the recent appearance of biometric readers on popular consumer products, such as smartphones, has increased interest in biometrics as a means of authenticating and/or identifying individuals, commercial markets for biometrics technology are in the process of developing and evolving. Biometrics-based solutions compete with more traditional security methods including keys, cards, personal identification numbers and security personnel. Acceptance of biometrics as an alternative to such traditional methods depends upon a number of factors including: i) the performance and reliability of biometric solutions; ii) costs involved in adopting and integrating biometric solutions; iii) public concerns regarding privacy; and iv) potential privacy legislation.

For these reasons, we are uncertain whether there will be significant demand for biometrics technology from commercial markets. Moreover, even if there is significant demand, there can be no assurance that our biometrics products will achieve market acceptance.

We derive a significant portion of our revenue from third party channel partners.

Our future results depend upon the continued successful distribution of our products through a channel of systems integrators and OEM partners. Systems integrators, including value added resellers, use our software products as a component of the biometrics systems they deliver to their customers. OEMs embed our software products in their technology devices or software products. These channel partners typically sell their products and services to government customers.

Our failure to effectively manage our relationships with these third parties could impair the success of our sales, marketing and support activities. Moreover, the activities of these third parties are not within our direct control. The occurrence of any of the following events could have a material adverse effect on our business, financial condition and operating results:

If the biometrics market does not experience significant growth or if our products do not achieve broad acceptance both domestically and internationally, we may not be able to grow our business.

Our revenues are derived primarily from sales of biometrics products and services. We cannot accurately predict the future growth rate or the size of the biometrics market. The expansion of the biometrics market and the market for our biometrics products and services depend on a number of factors, such as:

Even if biometrics solutions gain wide market acceptance, our solutions may not adequately address market requirements and may not continue to gain market acceptance. If biometrics solutions generally or our solutions specifically do not gain wide market acceptance, we may not be able to achieve our anticipated level of growth and our revenues and results of operations would be adversely affected.

Hardware revenue is likely to decline in future periods.

In the years ended December 31, 2015, 2014 and 2013, we had hardware revenue of $1.1 million, $4.9 million and $3.2 million respectively. Gross profit on hardware revenue was $0.4 million, $1.4 million and $0.8 million in 2015, 2014 and 2013, respectively.

Hardware revenue consisted of sales of biometrics equipment to a single U.S. government customer. While we are unable to predict future hardware sales with any degree of certainty, future orders from this customer may be minimal as we believe that the bulk of its purchases may have already occurred. We have $0.3 million of hardware orders in backlog as of December 31, 2015. If we are unable to replace the lost gross profit on hardware revenue with sales of other products and services in future periods, our operating results will be adversely affected.

We face intense competition from other biometrics solutions providers.

A significant number of established companies have developed or are developing and marketing software and hardware for biometrics products and applications that currently compete with or will compete directly with our offerings. We believe that additional competitors will enter the biometrics market and become significant long-term competitors, and that, as a result, competition will increase. Companies competing with us may introduce solutions that are competitively priced, have increased performance or functionality or incorporate technological advances we have not yet developed or implemented. Our current principal competitors include:

We expect competition to intensify in the near term in the biometrics market. Many current and potential competitors have substantially greater financial, marketing, and research resources than we have. Moreover, low cost foreign competitors from third world and other countries have demonstrated a willingness to sell their products at significantly reduced prices. To compete effectively in this environment, we must continually develop and market new and enhanced solutions and technologies at competitive prices and must have the resources available to invest in significant research and development activities. Our failure to compete successfully could cause our revenues and market share to decline.

The biometrics industry is characterized by rapid technological change and evolving industry standards, which could render our existing products obsolete.

Our future success will depend upon our ability to develop and introduce a variety of new capabilities and enhancements to our existing products in order to address the changing and sophisticated needs of the marketplace. Frequently, technical development programs in the biometrics industry require assessments to be made of the future direction of technology, which is inherently difficult to predict. Delays in introducing new products and enhancements, the failure to choose correctly among technical alternatives or the failure to offer innovative products or enhancements at competitive prices may cause customers to forego purchases of our products and purchase our competitors’ products. We may not have adequate resources available to us or may not adequately keep pace with appropriate requirements in order to effectively compete in the marketplace.

Our software products may have errors, defects or bugs, which could result in delayed or lost revenue, expensive correction, liability to our customers, and claims against us.

Complex software products such as ours may contain errors, defects or bugs. Defects in the products that we develop and sell to our customers could require expensive corrections and result in delayed or lost revenue, adverse customer reaction and negative publicity about us or our products and services. Customers who are not satisfied with any of our products may also bring claims against us for damages, which, even if unsuccessful, would likely be time-consuming to defend, and could result in costly litigation and payment of damages. Such claims could harm our reputation, financial results and competitive position.

Our business may be adversely affected by our use of open source software.

The software industry is making increasing use of open source software in the development of products. We also license and integrate certain open source software components from third parties into our software. Open source software license agreements may require that the software code in these components or the software into which they are integrated be freely accessible under open source terms. Many features we may wish to add to our products in the future may be available as open source software and our development team may wish to make use of this software to reduce development costs and speed up the development process. While we carefully monitor the use of all open source software and try to ensure that no open source software is used in such a way as to require us to disclose the source code to the related product, such use could inadvertently occur. If we were required to make our software freely available, our business could be seriously harmed.

Our intellectual property is subject to limited protection.

Because we are a technology provider, our ability to protect our intellectual property and to operate without infringing the intellectual property rights of others is critical to our success. We regard our technology as proprietary. We rely on a combination of patent, trade secret, copyright, and trademark law as well as confidentiality agreements to protect our proprietary technology, and cannot assure you that we will be able to enforce the patents we own against third parties. Despite our efforts, these measures can only provide limited protection. Unauthorized third parties may try to copy or reverse engineer portions of our products or otherwise obtain and use our intellectual property. If we fail to protect our intellectual property rights adequately, our competitors may gain access to our technology, and our business would thus be harmed.

In the future, we may be involved in legal action to enforce our intellectual property rights relating to our patents, copyrights or trade secrets. Any such litigation could be costly and time-consuming for us, even if we were to prevail. Moreover, even if we are successful in protecting our proprietary information, our competitors may independently develop technologies substantially equivalent or superior to our technology. Accordingly, despite our efforts, we may be unable to prevent third parties from infringing upon or misappropriating our intellectual property or otherwise gaining access to our technology. The misappropriation of our technology or the development of competitive technology could seriously harm our business.

We may be sued by third parties for alleged infringement of their proprietary rights.

Our technology and products may infringe the intellectual property rights of others. A large and increasing number of participants in the technology industry, including companies known as non-practicing entities, have applied for or obtained patents. Some of these patent holders have demonstrated a readiness to commence litigation based on allegations of patent infringement. Third parties have asserted against us in the past and may assert against us in the future patent, copyright and other intellectual property rights to technologies that are important to our business.

Intellectual property rights can be uncertain and involve complex legal and factual questions. Moreover, intellectual property claims, with or without merit, can be time-consuming and expensive to litigate or settle, and could divert management attention away from the execution of our business plan. If we were found to have infringed the proprietary rights of others, we could be subject to substantial damages or an injunction preventing us from conducting our business.

If we are unable to attract and retain key personnel, our business could be harmed.

If any of our key employees were to leave, we could face substantial difficulty in hiring qualified successors and could experience a loss in productivity while any successor obtains the necessary training and experience. Our employment relationships are at-will and we have had key employees leave in the past. We cannot assure you that one or more key employees will not leave in the future. We intend to continue to hire additional highly qualified personnel, including software engineers and sales personnel, but may not be able to attract, assimilate or retain qualified personnel in the future. Any failure to attract, integrate, motivate and retain these employees could harm our business.

We rely on single sources of supply for certain components used in our hardware products.

We commenced sales of biometrics hardware products to a U.S. government customer in 2013. Hardware products sold to this customer integrate hardware and software purchased from third parties. We rely on single source suppliers for certain critical hardware and software components. Our dependence on single source suppliers involves several risks, including limited control over availability, quality, and delivery schedules. Any delays in delivery or shortages of such components could cause delays in the shipment of our products, which could harm our business.

Our business may be affected by government regulations.

Extensive regulation by federal, state, and foreign regulatory agencies could adversely affect us in ways that are difficult for us to predict. In addition, our business may also be adversely affected by: i) the imposition of tariffs, duties and other import restrictions on goods and services we purchase from non-domestic suppliers; or ii) by the imposition of export restrictions on products we sell internationally. Changes in current or future laws or regulations, in the United States or elsewhere, could seriously harm our business.

Adverse economic conditions could harm our business.

Unfavorable changes in economic conditions, including recessions, inflation, turmoil in financial markets, or other changes in economic conditions, could harm our business, results of operations, and financial conditions as a result of:

We are unable to predict the timing, duration, and severity of any such adverse economic conditions in the U.S. and other countries, but the longer the duration, the greater the risks we face in operating our business.

We may make acquisitions of companies.

We may make acquisitions of companies that offer complementary products, services and technologies. Any acquisitions we may complete involve a number of risks, including the risks of assimilating the operations and personnel of acquired companies, realizing the value of the acquired assets relative to the price paid, distraction of management from our ongoing businesses and potential product disruptions associated with the sale of the acquired company’s products. These factors could have a material adverse effect on our business, financial condition, operating results and cash flows. The consideration we pay for any future acquisitions could include our stock. As a result, future acquisitions could cause dilution to existing shareholders and to earnings per share.

We may have additional tax liabilities. 

We are subject to income taxes in the United States. Significant judgments are required in determining our provisions for income taxes. In the course of preparing our tax provisions and returns, we must make calculations where the ultimate tax determination may be uncertain. Our tax returns are subject to examination by the Internal Revenue Service (“IRS”) and state tax authorities. There can be no assurance as to the outcome of these examinations. If the ultimate determination of taxes owed is for an amount in excess of amounts previously accrued, our operating results, cash flows, and financial condition could be adversely affected.

The market price of our common stock has been and may continue to be subject to wide fluctuations, and this may make it difficult for shareholders to resell the common stock when they want or at prices they find attractive.

The market price of our common stock, like that of other technology companies, is volatile and is subject to wide fluctuations in response to a variety of factors, including:

Our stock price may also be affected by broader market trends unrelated to our performance. As a result, purchasers of our common stock may be unable at any given time to sell their shares at or above the price they paid for them. Moreover, companies that have experienced volatility in the market price of their stock often are subject to securities class action litigation. If we were the subject of such litigation, it could result in substantial costs and divert management's attention and resources.

If we are unable to maintain effective internal controls over financial reporting, investors could lose confidence in the reliability of our financial statements, which could result in a decline in the price of our common stock.

As a public company, we are required to enhance and test our financial, internal and management control systems to meet obligations imposed by the Sarbanes-Oxley Act of 2002. Consistent with the Sarbanes-Oxley Act and the rules and regulations of the SEC, management's assessment of our internal controls over financial reporting and the audit opinion of our independent registered accounting firm as to the effectiveness of our controls is required in connection with our filing of our Annual Report on Form 10-K. If we are unable to identify, implement and conclude that we have effective internal controls over financial reporting or if our independent auditors are unable to conclude that our internal controls over financial reporting are effective, investors could lose confidence in the reliability of our financial statements, which could result in a decrease in the value of our common stock. Our assessment of our internal controls over financial reporting may also uncover weaknesses or other issues with these controls that could also result in adverse investor reaction.

We must make judgments in the process of preparing our financial statements.

We prepare our financial statements in accordance with generally accepted accounting principles and certain critical accounting policies that are relevant to our business. The application of these principles and policies requires us to make significant judgments and estimates. In the event that our judgments and estimates differ from actual results, we may have to change them, which could materially affect our financial position and results of operations.

Moreover, accounting standards have been subject to rapid change and evolving interpretations by accounting standards setting organizations over the past few years. The implementation of new accounting standards requires us to interpret and apply them appropriately. If our current interpretations or applications are later found to be incorrect, we may have to restate our financial statements and the price of our stock could decline.

ITEM 1B. Unresolved Staff Comments

Not applicable.

ITEM 2. PROPERTIES

We believe that our existing facilities are adequate for our current needs and that additional space sufficient to meet our needs for the foreseeable future will be available on reasonable terms. We currently occupy approximately 72,000 square feet of office space in Bedford, Massachusetts, which serves as our headquarters. This site is used for our research and development, sales and marketing, and administrative activities. We own this facility.

ITEM 3. LEGAL PROCEEDINGS

From time to time we are involved in litigation incidental to the conduct of our business. We are not party to any lawsuit or proceeding that, in our opinion, is likely to seriously harm our business.

ITEM 4. MINE SAFETY DISCLOSURES

Not applicable.

PART II

ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Our common stock is the only class of stock we have outstanding, and it trades on the Nasdaq Global Market under the symbol AWRE. The following table sets forth the high and the low sales prices of our common stock as reported on the Nasdaq Global Market for the periods indicated from January 1, 2014 to December 31, 2015.

As of February 5, 2016, we had approximately 100 shareholders of record. This number does not include shareholders from whom shares were held in a “nominee” or “street” name. We paid no dividends in 2015 and 2013. In 2014, we paid a special cash dividend of $1.75 per share on July 24, 2014. We anticipate that we will continue to reinvest any earnings to finance future operations although we may also pay additional special cash dividends if our board of directors deems it appropriate.

We did not sell any equity securities that were not registered under the Securities Act of 1933 during the three months ended December 31, 2015.

Stock Performance Graph

The following stock performance graph compares the performance of Aware’s cumulative stockholder return with that of a broad market index, the Nasdaq Composite Index, and a published industry index, the RDG Technology Composite Index. The cumulative stockholder returns for shares of Aware’s common stock and for the market and industry indices are calculated assuming $100 was invested on December 31, 2010. Aware paid special cash dividends of $0.00, $2.95, $0.00, $1.75, and $0.00 per share in 2011, 2012, 2013, 2014, and 2015, respectively. The performance of the market and industry indices is shown on a total return, or dividend reinvested, basis.

COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN*
Among Aware, Inc., the NASDAQ Composite Index, and the RDG Technology Composite Index

*$100 invested on 12/31/10 in stock or index, including reinvestment of dividends.
Fiscal year ending December 31.

ITEM 6. SELECTED FINANCIAL DATA

The following selected consolidated financial and operating data set forth below with respect to our consolidated financial statements for the fiscal years ended December 31, 2015, 2014 and 2013 are derived from the consolidated financial statements included elsewhere in this Form 10-K. The data for fiscal years ended December 31, 2012 and 2011 are derived from previously filed consolidated financial statements. The data set forth below should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” our historical consolidated financial statements, and the related notes to the consolidated financial statements, which can be found in Item 7 and Item 8.

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

RESULTS OF OPERATIONS

The following table sets forth, for the years indicated, certain line items from our consolidated statements of income and comprehensive income stated as a percentage of total revenue:

Summary of Operations

We are primarily engaged in the development and sale of biometrics products and services. Our software products are used in government and commercial biometrics systems to identify or authenticate people. Principal government applications of biometrics systems include border control, visitor screening, law enforcement, national defense, intelligence, secure credentialing, access control, and background checks. Principal commercial applications include: i) user authentication for login and access to mobile devices, computers, networks, and software programs; ii) user authentication for financial transactions and purchases (online and in-person); iii) physical access control to buildings, and iv) screening and background checks of prospective employees and customers. We sell our software and services globally through systems integrators and OEMs, and directly to end user customers. We also derive a minor portion of our revenue from the sale of imaging software licenses to OEMs and systems integrators that incorporate our software into medical imaging products and medical systems.

Summary of Financial Results

We used revenue and operating income to summarize financial results over the past three years as we believe these measurements are the most meaningful way to understand our operating performance.

Revenue and operating income in 2013, 2014, and 2015 were significantly affected by a contract to provide services and hardware to the United States Navy (“Navy”) and the United States Marine Corps (“USMC”). Changes in revenue derived from these customers caused large fluctuations in our revenue as a result of: i) Navy and USMC service projects beginning and ending; and ii) the receipt and shipment of Navy hardware orders. As of December 31, 2015, we believe the bulk of the service work and hardware shipments have been completed with these customers. Looking forward, we believe we may receive orders for add-on services, hardware replacement parts for the Navy, and software licenses for the USMC.

2015 compared to 2014

Revenue and operating income in 2015 were $19.6 million and $3.9 million, respectively, which compared to revenue and operating income in 2014 of $23.7 million and $7.1 million, respectively.

Revenue decreased by $4.1 million in 2015 primarily as a result of $5.8 million of lower revenue from the Navy and USMC, which was partially offset by $1.7 million of higher net revenue from other sources. Two of the contributing factors behind higher net revenue from other sources were sales to commercial customers and a large imaging software license sale.

Operating income decreased by $3.2 million in 2015 because: i) the $4.1 million revenue decline resulted in $1.1 million less operating income; and ii) patent related income decreased by $2.1 million.

2014 compared to 2013

Revenue and operating income in 2014 were $23.7 million and $7.1 million, respectively, which compared to revenue and operating income in 2013 of $19.4 million and $5.3 million, respectively.

Revenue increased by $4.4 million in 2014 primarily as a result of $3.5 million of higher revenue from the Navy and USMC and $0.9 million of higher net revenue from other sources.

Operating income increased by $1.8 million in 2014 because: i) the $4.4 million revenue increase resulted in $0.5 million more operating income; and ii) patent related income increased by $1.3 million. Operating income in 2014 would have been higher had we not increased engineering expenses by $2.3 million to invest in product development.

Software Licenses

Software licenses consist of revenue from the sale of biometrics and imaging software products. Sales of software products depend on our ability to win proposals to supply software for biometrics systems projects either directly to end user customers or indirectly through channel partners.

Software license revenue increased 18% from $8.5 million in 2014 to $10.1 million in 2015. As a percentage of total revenue, software license revenue increased from 36% in 2014 to 51% in 2015. The $1.6 million increase in software license revenue was primarily due to: i) a $0.8 million increase in biometrics software license sales; and ii) a $0.8 million increase in imaging software license sales. The reasons for the increases in biometrics and imaging software licenses were:

We derived a significant amount of license revenue in 2015 from Certisign, a Brazilian digital identification company. This revenue was earned during the development phase of a commercial biometrics-as-a-service platform. Certisign began to roll out its biometrics service offering in early 2016 using the system we developed for it. Under our agreement, we will receive license fees based on Certisign’s revenue.

Our 2015 biometrics software license results generally aligned with trends we are witnessing in the biometrics market. These trends include: i) greater government opportunities outside of the United States; ii) emerging commercial opportunities; and iii) uneven demand by the U.S. government.

In October 2015, we signed an agreement with a systems integrator customer to license our imaging software for inclusion in a U.S. government healthcare management system. The arrangement included a $4.5 million license fee plus a $125,000 software maintenance fee. We delivered the licensed software and the customer paid us in the fourth quarter of 2015. However due to the unique nature of the transaction, we were unable to establish vendor specific objective evidence for the fair value of the maintenance element. Accordingly, we will recognize revenue over the twelve-month maintenance period that runs from October 2015 to October 2016. We recorded $0.9 million of license revenue in 2015 and deferred $3.6 million of license revenue. We intend to recognize the remaining $3.6 million of revenue over the period January 2016 to October 2016.

Software license revenue increased 4% from $8.2 million in 2013 to $8.5 million in 2014. As a percentage of total revenue, software license revenue decreased from 43% in 2013 to 36% in 2014. The dollar increase in software license revenue was primarily due to a $0.4 million increase in sales of imaging software. Sales of biometrics software licenses were essentially unchanged from 2013, which reflects approximately the same number of project wins in both years.

Software Maintenance

Software maintenance consists of revenue from the sale of software maintenance contracts. Software maintenance contracts entitle customers to receive software support and software updates, if and when they become available, during the term of the contract.

Software maintenance revenue increased 8% from $4.4 million in 2014 to $4.7 million in 2015. As a percentage of total revenue, software maintenance revenue increased from 18% in 2014 to 24% in 2015.

Software maintenance revenue increased 13% from $3.9 million in 2013 to $4.4 million in 2014. As a percentage of total revenue, software maintenance revenue decreased from 20% in 2013 to 18% in 2014.

The dollar increase in software maintenance revenue in 2015 and 2014 was primarily due to a base of maintenance revenue from contract renewals from prior periods that grows as we sell maintenance contracts with new licenses in current periods. A majority of our customers purchase software maintenance contracts when they initially purchase software licenses. Since our software is used in active biometrics systems, many of our customers continue to renew their maintenance contracts in subsequent years while systems remain operational.

Services

Services consist of fees we charge to perform software development, integration, installation, and customization services. Similar to software license revenue, services revenue depends on our ability to win biometrics systems projects either directly with government customers or in conjunction with channel partners. Services revenue will fluctuate when we commence new projects and/or when we complete projects that were started in previous periods.

Services decreased 36% from $5.2 million in 2014 to $3.3 million in 2015. As a percentage of total revenue, services decreased from 22% in 2014 to 17% in 2015. The dollar decrease in services revenue was due to a $2.8 million decrease from government customers, which was partially offset by a $0.9 million increase from commercial customers. The dollar decrease in government services revenue was primarily due to lower revenue from U.S. government customers, including the Navy and USMC. The majority of the services work on Navy and USMC projects had been completed as of the end of 2015, however we expect that we may receive orders for add-on services in the future.

Lower services revenue from government projects in 2015 was partially offset by higher revenue from two projects with customers that are developing biometrics systems for commercial applications. The majority of the services work on the commercial projects had been completed as of the end of 2015, however we expect that we may receive orders for add-on services in the future.

Due to the substantial completion of government and commercial projects in 2015, services revenue in 2016 may decline compared to comparable periods in 2015 unless we are able to replace those completed projects with new services projects. Our services backlog of $0.3 million was minimal as of December 31, 2015.

Services increased 64% from $3.1 million in 2013 to $5.2 million in 2014. As a percentage of total revenue, services increased from 16% in 2013 to 22% in 2014. The dollar increase in services revenue was due to: i) a $1.6 million increase from direct government customers; and ii) a $0.4 million increase from channel partners and direct commercial customers. The increase in direct government services was primarily due to a significant project with a U.S. government customer that commenced in the third quarter of 2013 and continued throughout 2014. The $0.4 million increase in services revenue from channel partners and direct commercial customers was attributable to an increase in projects with a number of customers in 2014 as opposed to large projects with a small number of customers.

Hardware

Hardware revenue consists of sales of biometrics equipment to a single U.S. government customer for whom we developed biometrics software. Hardware products sold to this customer integrate hardware purchased from third parties with software from other third parties as well as software from Aware. We evaluated the classification of gross versus net revenue recognition and determined gross recognition was appropriate.

Hardware revenue decreased 78% from $4.9 in 2014 to $1.1 million in 2015. As a percentage of total revenue, hardware revenue decreased from 21% in 2014 to 6% in 2015. The dollar decrease in hardware revenue was due to a decrease in units ordered by the Navy in 2015.

Hardware revenue increased 55% from $3.2 in 2013 to $4.9 million in 2014. As a percentage of total revenue, hardware revenue increased from 16% in 2013 to 21% in 2014. The dollar increase in hardware revenue was due to an increase in units ordered by the Navy in 2014.

We have a $0.3 million order for hardware products in backlog as of December 31, 2015. Beyond this order, we believe that future hardware orders from the Navy may be minimal as we believe it has completed the bulk of its purchasing. It is worth noting that our strategy does not include maintaining or growing biometrics hardware revenue. We agreed to provide hardware products as an accommodation to this important customer.

Royalties

Royalties consist primarily of royalty payments we receive under DSL silicon contracts with two customers that incorporate our silicon intellectual property (“IP”) in their DSL chipsets. We sold the assets of our DSL IP business in 2009, but we continue to receive royalty payments from these customers. Royalties are reported in continuing operations in accordance with ASC 205-20, Reporting Discontinued Operations, because we have continuing ongoing cash flows from this business.

Royalties decreased 44% from $0.7 million in 2014 to $0.4 million in 2015. As a percentage of total revenue, royalties decreased from 3% in 2014 to 2% in 2015.

Royalties decreased 21% from $0.9 million in 2013 to $0.7 million in 2014. As a percentage of total revenue, royalties decreased from 5% in 2013 to 3% in 2014.

The royalty dollar decrease in 2015 and 2014 was primarily due to lower DSL royalties from both of our licensees. We do not consider DSL royalties to be a key element of our business and we expect that this revenue will continue to decline in future periods.

Cost of Hardware

Cost of hardware consists primarily of the cost of third party equipment and software included in hardware shipments.

Cost of hardware decreased by 79% from $3.5 million in 2014 to $0.7 million in 2015. Cost of hardware as a percentage of hardware revenue decreased from 71% in 2014 to 65% in 2015, which means that product gross margins increased from 29% in 2014 to 35% in 2015. The dollar decrease in cost of hardware was due to lower unit shipments of hardware products in the current year period compared to the prior year period.

Cost of hardware increased by 47% from $2.4 million in 2013 to $3.5 million in 2014. Cost of hardware as a percentage of hardware revenue decreased from 74% in 2013 to 71% in 2014, which means that product gross margins increased from 26% in 2013 to 29% in 2014. The dollar increase in cost of hardware was due to higher unit shipments of hardware products in the current year period compared to the prior year period.

Cost of Services

Cost of services consists of engineering costs to perform customer services projects. Such costs primarily include: i) engineering salaries, stock-based compensation, fringe benefits, and facilities; and ii) engineering consultants and contractors.

Cost of services decreased 24% from $2.4 million in 2014 to $1.8 million in 2015. Cost of services as a percentage of services increased from 46% in 2014 to 54% in 2015, which means that gross margins on services decreased from 54% to 46%. The dollar decrease in cost of services was attributable to a decrease in services revenue.

Cost of services increased 57% from $1.5 million in 2013 to $2.4 million in 2014. Cost of services as a percentage of services decreased from 48% in 2013 to 46% in 2014, which means that gross margins on services increased from 52% to 54%. The dollar increase in cost of services was attributable to an increase in services revenue.

Gross margins on services of 46%, 54%, and 52% in 2015, 2014 and 2013, respectively, were a function of: i) the nature of the projects; ii) the level of engineering difficulty and labor hours required to complete project tasks; and iii) how much we were able to charge. Gross margins in these years reflect the profitability mix of customer projects. We expect that gross margins on services will continue to fluctuate in future periods based on the nature, complexity, and pricing of future projects.

Research and Development Expense

Research and development expense consists of costs for: i) engineering personnel, including salaries, stock-based compensation, fringe benefits, and facilities; ii) engineering consultants and contractors, and iii) other engineering expenses such as supplies, equipment depreciation, dues and memberships and travel. Engineering costs incurred to develop our technology and products are classified as research and development expense. As described in the cost of services section, engineering costs incurred to provide engineering services for customer projects are classified as cost of services, and are not included in research and development expense.

The classification of total engineering costs to research and development expense and cost of services was (in thousands):

Research and development expense increased 5% from $5.5 million in 2014 to $5.8 million in 2015. As a percentage of total revenue, research and development expense increased from 23% in 2014 to 29% in 2015. The increase in research and development expense was primarily due to engineers rotating off of customer projects and onto internal development projects.

As the table above indicates, total engineering costs decreased from $7.9 million in 2014 to $7.6 million in 2015. The spending decrease is due to the following factors, which in the aggregate resulted in $0.3 million less expense: i) higher compensation expenses for engineers hired in 2014 for which there was a partial year of expense in 2014 versus a full year in 2015; ii) higher amortization expenses for acquired technology; iii) lower compensation and contractor expenses due to the termination of employees and contractors working on government service projects; iv) lower contractor expenses due to the termination of contractors working on internal development projects; and v) lower recruiting fees due to reduced hiring in 2015. Our engineering headcount declined by one head in 2015. We believe our engineering organization was adequately staffed as of December 31, 2015.

Research and development expense increased 35% from $4.1 million in 2013 to $5.5 million in 2014. As a percentage of total revenue, research and development expense increased from 21% in 2013 to 23% in 2014.

As the table above indicates, total engineering costs increased from $5.6 million in 2013 to $7.9 million in 2014. The spending increase was primarily due to the hiring of engineering employees and contractors. In the 18 month period from June 30, 2013 to December 31, 2014, engineering headcount, excluding contractors, grew from 30 to 48 employees. The expansion of our engineering organization during this period was designed to provide the resources we required to: i) pursue new product development initiatives; and ii) staff customer engineering services projects.

As we described in the strategy section in Part 1 of this Form 10-K, we intend to introduce new products that will allow us to offer more complete biometrics solutions. We believe this strategy will allow us to sell more software into biometrics systems projects in order to grow our revenue. Our preference is to develop such products internally, however to the extent we are unable to do that, we may purchase or license technologies from third parties. We anticipate that we will continue to focus our future research and development activities on enhancing existing products and developing new products.

Selling and Marketing Expense

Selling and marketing expense primarily consists of costs for: i) sales and marketing personnel, including salaries, sales commissions, stock-based compensation, fringe benefits, travel, and facilities; and ii) advertising and promotion expenses.

Sales and marketing expense increased 5% from $3.7 million in 2014 to $3.9 million in 2015. As a percentage of total revenue, sales and marketing expense increased from 16% in 2014 to 20% in 2015. The dollar increase in selling and marketing expense was primarily due to the addition of one employee in our sales organization which was partially offset by the departure of another employee in the second half of the year.

Sales commissions were $35,000 higher in 2015 despite a $4.1 million decrease in total revenue. The small commission increase was due to higher license sales and Brazilian sales agent commissions. There was not a significant reduction of commission expense related to hardware and royalties, which declined by a total of $4.2 million in 2015, because we pay reduced commissions on hardware sales and no commissions on royalties.

Sales and marketing expense increased 12% from $3.3 million in 2013 to $3.7 million in 2014. As a percentage of total revenue, sales and marketing expense decreased from 18% in 2013 to 16% in 2014. The dollar increase in selling and marketing expense was primarily due to higher sales commissions on higher revenue in 2014, and the addition of one sales and marketing employee in early 2014.

General and Administrative Expense

General and administrative expense consists primarily of costs for: i) officers, directors and administrative personnel, including salaries, bonuses, director compensation, stock-based compensation, fringe benefits, and facilities; ii) professional fees, including legal and audit fees; iii) public company expenses; and iv) other administrative expenses, such as insurance costs and bad debt provisions.

General and administrative expense decreased 5% from $3.7 million in 2014 to $3.5 million in 2015. As a percentage of total revenue, general and administrative expense increased from 15% in 2014 to 18% in 2015. The dollar decrease in general and administrative expense in 2015 was primarily due to lower stock-based compensation and patent filing costs.

General and administrative expense increased 4% from $3.5 million in 2013 to $3.7 million in 2014. As a percentage of total revenue, general and administrative expense decreased from 18% in 2013 to 15% in 2014. The increase in general and administrative expense in 2014 was primarily due to an increase in stock-based compensation which was partially offset by lower patent filing expenses.

Patent Related Income

The composition of patent related income in 2015, 2014 and 2013 was as follows:

Year ended December 31, 2015. We had a $43,000 gain on the sale of patent assets in 2015, which is described below:

We sold a portion of our patent portfolio pertaining to home networking technology to an unrelated third party for $50,000. The proceeds from the sale were reduced by $7,000 of transaction costs, which consisted primarily of fees from the law firm that assisted us in the sale. We recorded a gain of $43,000 on the sale.

Future patent sales are likely to be minimal as our remaining patents and patent applications pertain primarily to biometrics and imaging compression. Our current intent is to retain these patents for use in the business.

Year ended December 31, 2014. We had a $2.1 million gain on the sale of patent assets in 2014, which is described below:

We sold a portion of our patent portfolio pertaining to DSL diagnostic technology to an unrelated third party for $2.6 million. The proceeds from the sale were reduced by $0.5 million of transaction costs, which consisted primarily of fees from the law firm that assisted us in the sale. We recorded a gain of $2.1 million on the sale.

The DSL diagnostic technology in the patents we sold in 2014 was related to our DSL Service Assurance business that we shut down in 2012 and 2013 and reported in discontinued operations in those periods. We do not consider our patent related activities to be a component of the operating business from which the underlying technology was derived, but rather as a component of corporate general and administrative expenses. Accordingly the gain on the sale of these patents was reported in income from continuing operations.

The gains on the sale of patents was included in income from continuing operations pursuant to ASC 360-10, Impairment or Disposal of Long-Lived Assets, and Rule 5-03 of Regulation S-X.

Year ended December 31, 2013. We had $0.8 million of income from a patent arrangement in 2013, which is described below:

We entered into an arrangement with an unaffiliated third party in 2010 under which we assigned certain patents in return for royalties on proceeds from patent monetization efforts by the third party. Such third party has engaged in various patent monetization activities, including enforcement, litigation and licensing. The party reported and we recorded $0.8 million of income from this arrangement in the year ended December 31, 2013.

We continue to have a contractual relationship with this third party. However, we are unable to predict how much more income we might receive from this arrangement, if any, because:

Other Income/(Expense)

We recorded other income of $12,000 and $23,000 in the years ended December 31, 2015 and 2013, respectively, and other expense of $59,000 in the year ended December 31, 2014. Other income or expense in all three years consisted of realized gains or losses on sales or calls of high yield bond investments.

Interest Income

Interest income decreased 33% from $225,000 in 2014 to $151,000 in 2015. The dollar decrease was primarily due to i) lower levels of high yield bond investments held in 2015 as compared to 2014; and ii) lower cash balances as a result of a $39.9 million dividend payment in July 2014.

Interest income decreased 31%, or $103,000, from $328,000 in 2013 to $225,000 in 2014. The dollar decrease was primarily due to i) lower levels of high yield bond investments held in 2014 as compared to 2013; and ii) lower cash balances as a result of a $39.9 million dividend payment in July 2014.

Income Taxes

We are subject to income taxes in the United States and we use estimates in determining our provisions for income taxes. We account for income taxes using the asset and liability method for accounting and reporting income taxes. Deferred tax assets and liabilities are recognized based on temporary differences between the financial reporting and income tax bases of assets and liabilities using statutory rates.

A discussion of income taxes for the years ended December 31, 2015, 2014, and 2013 follows:

Year ended December 31, 2015. We recorded a benefit from income taxes of $0.5 million for the year ended December 31, 2015, all of which was included in continuing operations. The benefit from income taxes was the result of a $1.9 million tax benefit from the reversal of a reserve for uncertain tax positions, which was partially offset by $1.4 million of income taxes on pre-tax income based on the U.S. statutory rate of 34%, increased by state income taxes, and reduced by research tax credits and permanent adjustments.

As previously reported, the Internal Revenue Service (“IRS”) commenced an examination of our tax return for the year ended December 31, 2012 in September 2014. In July 2015, the IRS notified us that it had completed its examination and that it had no changes to our reported tax. As a result of the completion of the IRS examination, we determined that a $1.9 million reserve for uncertain tax positions we had established on federal research and development credits was no longer required. We reversed the reserve in the third quarter of 2015.

As of December 31, 2015, we had a total of $1.0 million of deferred tax assets for which we had recorded no valuation allowance. We will continue to assess the level of valuation allowance in future periods. Should evidence regarding the realizability of tax assets change at a future point in time, the valuation allowance will be adjusted accordingly.

In addition to deferred tax assets carried on our balance sheet, we also had net federal and state research and development credit carryforwards available at December 31, 2015 of $5.5 million and $0.1 million. These credits were not recorded as tax assets as they relate to excess stock compensation deductions that may not be recorded as tax assets under generally accepted accounting principles until the amounts have been utilized to reduce our tax liability. To the extent that these assets can be used to reduce taxes, the benefit must be recorded as a reduction to additional paid-in capital. In 2015, we recorded a tax benefit of $0.6 million to equity related to the use of these tax credits to reduce our tax liability.

Year ended December 31, 2014. Total income tax expense for the year ended December 31, 2014 was $2.7 million, all of which was recorded in continuing operations. Income tax expense for 2014 was based on the U.S. statutory rate of 34%, increased by state income taxes, and reduced by Federal research tax credits and permanent adjustments.

In 2014, we recorded a tax benefit of $1.2 million that reduced our tax liability. This benefit was recorded in equity as it was related to federal and state research tax credits that represented excess stock compensation deductions.

Year ended December 31, 2013. Total income tax expense for the year ended December 31, 2013 was $1.2 million, including $1.9 million that was recorded in continuing operations less a tax benefit of $0.7 million that was recorded in discontinued operations. Income tax expense for 2013 was based on the U.S. statutory rate of 34%, increased by state income taxes, and reduced by Federal research tax credits and permanent adjustments. Tax expense in 2013 also reflects two items related to 2012, including: i) a tax benefit of $95,000 related to the 2012 research tax credit. This credit was extended retroactively back to January 1, 2012, by the American Taxpayer Relief Act of 2012, which was enacted on January 2, 2013; and ii) a tax benefit of $148,000 related to a reduction in the estimate of the 2012 tax expense recorded in our 2012 financial statements.

In 2013, we recorded a tax benefit of $128,000 that reduced our tax liability. This benefit was recorded in equity as it was related to federal and state research tax credits that represented excess stock compensation deductions.

Loss from discontinued operation, net of income taxes. 

Loss from discontinued operations, net of income taxes reflects results from our discontinued DSL Service Assurance Segment. This segment includes results from our DSL software product line that we shut down in 2013. Loss from DSL discontinued operations was (in thousands):

LIQUIDITY AND CAPITAL RESOURCES

In recent years, we have financed the company with our cash balances, cash generated from operations, and cash received from the sale of patent assets. Equity financing has not been a meaningful source of financing for us in recent years. Cash flows from operating, investing and financing activities are described below.

Cash flow from operating activities

In the years ended December 31, 2015, 2014, and 2013, our operating activities provided net cash of $6.7 million, $6.3 million, and $2.8 million, respectively. A discussion of cash flow from operating activities for each of the last three years follows:

Year ended December 31, 2015. Cash provided by operating activities of $6.7 million in 2015 was primarily the result of net income of $4.6 million, which was increased for non-cash items related to depreciation and amortization of $0.6 million and stock-based compensation expense of $0.7 million. Cash provided by operating activities was reduced by a $1.9 million non-cash item related to the reversal of a reserve for uncertain tax positions that was included as a tax benefit in net income. Cash provided by operating activities also included $2.7 million of cash associated with a reduction of working capital items. The reduction of working capital includes a significant increase in deferred revenue as a result of a $4.6 million revenue transaction payment in 2015 for which we deferred $3.7 million of license and maintenance revenue.

Year ended December 31, 2014. Cash provided by operating activities of $6.3 million in 2014 was primarily the result of net income of $4.6 million, which was increased for non-cash items related to depreciation and amortization of $0.5 million and stock-based compensation expense of $0.9 million. Cash provided by operating activities also included $2.4 million of cash associated with a reduction of working capital items. Cash provided by these sources was partially offset by a $2.1 million gain on the sale of patent assets that was included in $4.6 million of net income, but was included in cash flow from investing activities in the statements of cash flow.

Year ended December 31, 2013. Cash provided by operations of $2.8 million in 2013 was primarily the result of net income of $2.6 million, which was increased for non-cash items related to depreciation and amortization of $0.5 million and stock-based compensation expense of $0.7 million. Cash provided from these sources was partially offset by $1.0 million of net cash used to fund working capital items.

Cash flow from investing activities

In the year ended December 31, 2015 and 2014, our investing activities provided net cash of $0.1 million and $3.4 million, respectively. In the year ended December 31, 2013, our investing activities used net cash of $1.4 million. A discussion of cash flow from investing activities for each of the last three years follows:

Year ended December 31, 2015. Cash provided by investing activities of $0.1 million in 2015 was primarily the result of $0.5 million of proceeds from the sale of investments, which was partially offset by $0.1 million of capital expenditures and $0.3 million used to purchase other assets.

Year ended December 31, 2014. Cash provided by investing activities of $3.4 million in 2014 was primarily the result of $2.1 million of net proceeds from the sale of patent assets and $1.4 million of proceeds from the sale of investments. Cash provided from these sources was partially offset by $0.1 million of capital expenditures.

Year ended December 31, 2013. Cash used by investing activities of $1.4 million in 2013 was primarily the result of $0.2 million of capital expenditures, $0.9 million of net investment purchases, and $0.3 million used to purchase other assets.

We have no material commitments for capital expenditures.

Cash flow from financing activities

In the years ended December 31, 2015 and 2013, our financing activities provided net cash of $0.4 million and $122,000, respectively. In the year ended December 31, 2014, our financing activities used net cash of $38.4 million. A discussion of cash flow from financing activities for each of the last three years follows:

Year ended December 31, 2015. Cash provided by financing activities of $0.4 million in 2015 was primarily the result of a $0.6 million tax benefit related to excess stock-based compensation, which was partially offset by $0.2 million used to repurchase stock from employees in connection with stock issuances under a stock grant program.

Year ended December 31, 2014. Cash used by financing activities of $38.4 million in 2014 was primarily the result of a $39.9 million dividend payment and $0.2 million used to repurchase stock from employees in connection with stock issuances under a stock grant program. Cash used by these two items was partially offset by: i) a $1.2 million tax benefit related to excess stock-based compensation; and ii) $0.5 million of proceeds from the exercise of stock options.

Year ended December 31, 2013. Cash provided by financing activities of $122,000 in 2013 was primarily the result of $65,000 of proceeds from the issuance of stock under employee stock programs and $128,000 of excess tax benefits from stock-based compensation. Cash provided by these two factors was partially offset by $71,000 used to repurchase stock from employees in connection with stock issuances under a stock grant program.

At December 31, 2015, we had cash and cash equivalents of $51.2 million and investments of $0.9 million. While we cannot assure you that we will not require additional financing, or that such financing will be available to us, we believe that our cash and cash equivalents and investments will be sufficient to fund our operations for at least the next twelve months.

To date, inflation has not had a material impact on our financial results. There can be no assurance, however, that inflation will not adversely affect our financial results in the future.

OFF-BALANCE SHEET ARRANGEMENTS

We do not currently have any arrangements with unconsolidated entities, such as entities often referred to as structured finance, special purpose entities, or variable interest entities which are often established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. Accordingly, we are not exposed to any financing, liquidity, market or credit risk if we had such relationships.

CONTRACTUAL OBLIGATIONS

We have various contractual obligations impacting our liquidity. The following represents our contractual obligations as of December 31, 2015 (in thousands):

CRITICAL ACCOUNTING POLICIES

We consider certain accounting policies related to revenue recognition, stock-based compensation, income taxes, and the allowance for doubtful accounts to be critical policies.

Revenue recognition. We derive revenue from five sources: (i) software licenses; (ii) software maintenance; (iii) software services; iv) hardware; and (v) royalties.

We recognize revenue when there is persuasive evidence of an arrangement, the sales price is fixed or determinable, collection of the related receivable is reasonably assured, and delivery has occurred or services have been rendered. As described below, we make significant judgments during the process of determining revenue for any particular accounting period.

In determining revenue recognition, we assess whether fees associated with revenue transactions are fixed or determinable based on the terms of the contract and based on payment terms. If the fee is not fixed or determinable, we defer the fee and recognize revenue as amounts become due and payable. We assess whether collection is reasonably assured based on a number of factors, including past transaction history with the customer and the credit-worthiness of the customer. If we determine that collection of a fee is not reasonably assured, we defer the fee and recognize revenue at the time collection becomes reasonably assured.

We must also make judgments with respect to the recognition of revenue for multiple element revenue arrangements. We recognize revenue for multiple element arrangements as follows:

Software and software related multiple element arrangements:

We sell software licenses, software maintenance and software services in various combinations of multiple element arrangements. We apply the provisions of ASC 985-605, Software Revenue Recognition, to these arrangements because all the elements are software or software related. The various combinations of multiple element arrangements and our revenue recognition for each are described below:

Hardware and software multiple element arrangements:

Our revenue recognition policies are described more fully in Note 2, Summary of Significant Accounting Policies, in the Notes to our Consolidated Financial Statements.

Stock-Based Compensation. We grant stock and stock options to our employees and directors, although stock option grants in recent years have been minimal. We measure stock-based compensation cost at the grant date based on the fair value of the award and recognize it as expense over the applicable vesting period of the award using the straight-line basis.

For stock awards, we determine the fair value of the award by using the fair market value of our stock on the date of grant, provided the number of shares in the grant is fixed on the grant date.

For stock options, we use the Black-Scholes valuation model to estimate the fair value of the award. This valuation model takes into account the exercise price of the award, as well as a variety of significant assumptions. The assumptions used to estimate the fair value of stock options include the expected term, the expected volatility of our stock over the expected term, the risk-free interest rate over the expected term, and our expected annual dividend yield.

Income taxes. As part of the process of preparing our consolidated financial statements we are required to estimate our actual current tax expense. We must also estimate temporary and permanent differences that result from differing treatment of certain items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included in our consolidated balance sheet. We must then assess the likelihood that our deferred tax assets will be recovered from future taxable income and to the extent we believe recovery is not likely, we must establish a valuation allowance. To the extent we establish a valuation allowance or increase this allowance in a period for deferred tax assets, which have been recognized, we must include an expense with the tax provision in the statement of operations. Conversely, to the extent we decrease our valuation allowance in a period for deferred tax assets, which have been previously reserved, we must include a tax benefit with the tax provision in the statement of operations.

Significant management judgment is required in determining our provision for income taxes, our deferred tax assets, and any valuation allowance recorded against our net deferred tax assets. Our deferred tax assets primarily relate to temporary differences that result from differing treatment of certain items for tax and accounting purposes. As of December 31, 2015, we had a total of $1.0 million of deferred tax assets for which we had recorded no valuation allowance.

We will continue to assess the level of valuation allowance required in future periods. Should evidence regarding the realizability of tax assets change at a future point in time, the valuation allowance will be adjusted accordingly.

Allowance for doubtful accounts. We make judgments as to our ability to collect outstanding receivables and provide allowances for receivables when collection becomes doubtful. Provisions are made based upon a specific review of all significant outstanding invoices. If the judgments we make to determine the allowance for doubtful accounts do not reflect the future ability to collect outstanding receivables, additional provisions for doubtful accounts may be required.

RECENT ACCOUNTING PRONOUNCEMENTS

In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers (Topic 606). The ASU is the result of a joint project by the FASB and the International Accounting Standards Board (“IASB”) to clarify the principles for recognizing revenue and to develop a common revenue standard for GAAP and International Financial Reporting Standards (“IFRS”) that would: remove inconsistencies and weaknesses, provide a more robust framework for addressing revenue issues, improve comparability of revenue recognition practices across entities, jurisdictions, industries, and capital markets, improve disclosure requirements and resulting financial statements, and simplify the presentation of financial statements. The core principle of the new guidance is that an entity should recognize revenue to depict 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 ASU is effective for annual reporting periods beginning after December 15, 2016. Early adoption is not permitted. On July 9, 2015, the FASB voted to delay the effective date of the new revenue standard by one year, but to permit entities to choose to adopt the standard as of the original effective date. We are currently evaluating the effect that the updated standard will have on our consolidated financial statements and related disclosures.

In November 2015, the FASB issued Accounting Standard Update ("ASU") 2015-17, "Balance Sheet Classification of Deferred Taxes," which requires that deferred tax liabilities and assets be classified as noncurrent in a classified statement of financial position to simplify the presentation of deferred income taxes. The standard is effective prospectively for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2017, with early adoption permitted. The Company did not early adopt this standard. The effect of early adoption would not have been material as it would have only resulted in a $184,000 reclass of short term deferred tax assets to long term deferred tax assets on our December 31, 2015 consolidated balance sheets.

With the exception of the two standards above, there have been no other recently issued accounting pronouncements that are of significance or potential significance to us that we have not adopted as of December 31, 2015.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Our exposure to market risk relates primarily to our investment portfolio, and the effect that changes in interest rates would have on that portfolio. Our investment portfolio at December 31, 2015 consisted of two elements:

We do not use derivative financial instruments for speculative or trading purposes.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

Report of Independent Registered Public Accounting Firm

To the Board of Directors and Stockholders of Aware, Inc.

We have audited the accompanying consolidated balance sheets of Aware, Inc. (“the Company”) as of December 31, 2015 and 2014, and the related consolidated statements of income and comprehensive income, stockholders’ equity (deficit) and cash flows for each of the three years in the period ended December 31, 2015 and the financial statement schedule of Aware, Inc. listed in Item 15(a). We also have audited the Company’s internal control over financial reporting as of December 31, 2015, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission in 2013. The Company’s management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on these financial statements and an opinion on the Company's internal control over financial reporting based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audit of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.

A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (a) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (b) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (c) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2015 and 2014, and the results of its operations and its cash flows for the years in the three-year period ended December 31, 2015, in conformity with accounting principles generally accepted in the United States of America, and in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2015, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission in 2013.

/s/ RSM US LLP

Boston, Massachusetts

February 12, 2016

AWARE, INC.

CONSOLIDATED BALANCE SHEETS

(in thousands, except share data)

The accompanying notes are an integral part of the consolidated financial statements.

AWARE, INC.

CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME

(in thousands, except per share data)

The accompanying notes are an integral part of the consolidated financial statements.

AWARE, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

The accompanying notes are an integral part of the consolidated financial statements.

AWARE, INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

(in thousands)

The accompanying notes are an integral part of the consolidated financial statements.

AWARE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

We are a leading provider of software and services to the biometrics industry. Our software products are used in government and commercial biometrics systems, which are capable of determining or verifying an individual’s identity. We also offer engineering services related to software customization, integration, and installation, as well as complete systems development. We sell our biometrics software products and services globally through systems integrators, OEMs, and directly to end user customers

Basis of Presentation - The consolidated financial statements include the accounts of Aware, Inc. and its subsidiary (“the Company”). All significant intercompany transactions have been eliminated.

Use of Estimates – The preparation of our financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amount of revenues and expenses during the reporting period. The most significant estimates included in the financial statements pertain to revenue recognition, reserves for doubtful accounts, useful lives of fixed assets, valuation allowance for deferred income tax assets, and accrued liabilities. Actual results could differ from those estimates.

Fair Value Measurements - The Financial Accounting Standards Board (“FASB”) Codification defines fair value, and establishes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The hierarchy gives the highest priority to the unadjusted quoted prices in active markets for identical assets or liabilities (level 1 measurements) and the lowest priority to unobservable inputs (level 3 measurements). The three levels of the fair value hierarchy under the FASB Codification are: i) Level 1 – valuations that are based on quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date; ii) Level 2 – valuations that are based on quoted prices in markets that are not active or for which all significant inputs are observable, either directly or indirectly; and iii) Level 3 – valuations that require inputs that are both significant to the fair value measurement and unobservable.

Cash and cash equivalents, which primarily include money market mutual funds, were $51.2 million and $44.0 million as of December 31, 2015 and December 31, 2014, respectively. We classified our cash equivalents of $43.0 million and $34.3 million as of December 31, 2015 and 2014, respectively, within Level 1 of the fair value hierarchy because they are valued using quoted market prices.

Our investments, which consist of high yield corporate debt securities, are also classified within Level 1 of the fair value hierarchy because they are valued using quoted market prices. Debt securities with maturities greater than one year are classified as long term assets. We categorize our investments as available-for-sale securities, and carry them at fair value in our financial statements. We had $0.9 million and $1.4 million of available-for-sale investments as of December 31, 2015 and December 31, 2014, respectively.

As of December 31, 2015, our assets that are measured at fair value on a recurring basis and whose carrying values approximate their respective fair values include the following (in thousands):

AWARE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

As of December 31, 2014, our assets that are measured at fair value on a recurring basis and whose carrying values approximate their respective fair values include the following (in thousands):

Cash and Cash Equivalents – Cash and cash equivalents, which consist primarily of money market funds and demand deposits, are stated at fair value. All highly liquid investments purchased with an original maturity of three months or less are considered cash equivalents. Our cash balances exceed the Federal Deposit Insurance Corporation limits. The Company does not believe it is exposed to significant credit risk related to cash and cash equivalents.

Investments - At December 31, 2015 and 2014, we categorized all investment securities as available-for-sale, since we may liquidate these investments currently. In calculating realized gains and losses, cost is determined using specific identification. Unrealized gains and losses on available-for-sale securities are excluded from earnings and reported in a separate component of stockholders’ equity called Accumulated Comprehensive Income.

Realized gains on investments were $12,000 and $23,000 in the years ended December 31, 2015 and 2013, respectively. Realized losses on investments were $59,000 in the year ended December 31, 2014.

Unrealized losses on investments were $53,000 and $156,000 in the years ended December 31, 2015, and 2013. Unrealized gains on investments were $162,000 in the year ended December 31, 2014.

The amortized cost of our corporate debt securities was $1.0 million at December 31, 2015. Corporate debt securities comprising investments mature in 2017 and 2018.

Allowance for Doubtful Accounts – Accounts are charged to the allowance for doubtful accounts as they are deemed uncollectible based on a periodic review of the accounts.

Inventories – Inventories are stated at the lower of cost or net realizable value. Cost is determined by the first-in, first-out (“FIFO”) method. We evaluate all inventories for net realizable value on a quarterly basis, and record provisions for excess and obsolete inventory when required. We had no inventory or reserve for excess and obsolete inventory as of December 31, 2015.

Property and Equipment – Property and equipment is stated at cost. Depreciation and amortization of property and equipment is provided using the straight-line method over the estimated useful lives of the assets. Upon retirement or sale, the costs of the assets disposed of and the related accumulated depreciation are removed from the accounts and any resulting gain or loss on disposal is included in the determination of income or loss. Expenditures for repairs and maintenance are charged to expense as incurred.

The estimated useful lives of assets used by us are:

AWARE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Impairment of Long-Lived Assets – We review long-lived assets for impairment whenever events or changes in business circumstances indicate that the carrying amount of the assets may not be fully recoverable or that the useful lives of these assets are no longer appropriate. Each impairment test is based on a comparison of the undiscounted cash flows estimated to be generated by those assets over their estimated economic life to the related carrying value of those assets to determine if the assets are impaired. If an impairment is indicated, the asset is written down to its estimated fair value. The cash flow estimates used to identify the potential impairment reflect our best estimates using appropriate assumptions and projections at that time. We believe that no significant impairment of our long-lived assets has occurred as of December 31, 2015 and 2014.

Revenue Recognition – We recognize revenue when there is persuasive evidence of an arrangement, the sales price is fixed or determinable, collection of the related receivable is reasonably assured, and delivery has occurred or services have been rendered.

Persuasive evidence of an arrangement: We use contracts signed by both the customer and us or written purchase orders issued by the customer as evidence of an arrangement.

Product delivery: We deem delivery to have occurred: (i) upon shipment when products are shipped FOB shipping point, or (ii) upon delivery at a customer’s location when products are shipped FOB destination, or (iii) when software is delivered electronically. If customer acceptance provisions apply, revenue is not recognized until delivery has occurred and we have received such acceptance. If we are required to provide installation services, revenue is not recognized until installation is complete.

Fixed or determinable fee: We consider fees to be fixed or determinable if the fee is not subject to refund or adjustment and the payment terms are within normal established practices. If the fee is not fixed or determinable, we recognize the revenue as amounts become due and payable.

Collection is deemed probable: We conduct a credit review for significant transactions at the time of the arrangement to determine the credit-worthiness of the customer. Collection is deemed probable if we expect that the customer will pay amounts under the arrangement as payments become due.

We categorize revenue as software licenses, software maintenance, services, hardware, or royalties. In addition to the general revenue recognition policies described above, specific revenue recognition policies apply to each category of revenue.

Software licenses

Software licenses consist of revenue from the sale of software licenses for biometrics and imaging applications. Our software licenses typically provide customers with the right to use our software in perpetuity. We recognize revenue from software licenses upon delivery when licenses are sold in single element arrangements, because we have no post-delivery obligations, including contractual or implied Post Contract Support (“PCS”).

Software maintenance

Software maintenance consists of revenue from the sale of software maintenance contracts for biometrics and imaging software. Software maintenance contracts entitle customers to receive software support and software updates, if and when they become available, during the term of the maintenance contract. We recognize software maintenance revenue ratably over the related contract period.

Services

Service revenue consists of fees from biometrics customers for software engineering services we provide to them. We recognize services revenue as services are delivered when services are sold in single element arrangements.

Hardware

Hardware revenue consists of sales of biometrics equipment to a single U.S. government customer. We recognize hardware revenue upon delivery and acceptance of the equipment by the customer.

AWARE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Royalties

Royalties consist primarily of royalty payments we receive under DSL silicon contracts with two customers that incorporate our silicon intellectual property (“IP”) in their DSL chipsets. We sold the assets of our DSL IP business in 2009, but we continue to receive royalty payments from these customers. Royalties are reported in continuing operations in accordance with ASC 205, Reporting Discontinued Operations, because we have continuing ongoing cash flows from this business.

Since we cannot reasonably estimate royalty revenue, such revenue is recognized in the quarter in which a final report is received from a customer. Royalty reports are typically received in the quarter immediately following the quarter in which sales of royalty-bearing products occur.

Multiple element arrangements with software and software related elements

In addition to selling software licenses, software maintenance and software services in single element arrangements, we also sell these three products as part of multiple element arrangements. We apply the provisions of ASC 985-605, Software Revenue Recognition, to these arrangements because all the elements are software or software related. The various combinations of multiple element arrangements and our revenue recognition for each are described as follows:

Multiple element arrangement with hardware and software elements

We also have a multiple element arrangement with one customer that involves the delivery of hardware, software maintenance, and software services. We determined that these elements qualified as separate units of accounting under ASC 605, Revenue Recognition, because they have value to the customer on a standalone basis. We recognize revenue from this arrangement as follows: i) hardware revenue is recognized upon delivery and acceptance of the equipment by the customer; ii) maintenance revenue is recognized ratably over the related contract period; and iii) service revenue is recognized as services are delivered.

Income Taxes – We compute deferred income taxes based on the differences between the financial statement and tax basis of assets and liabilities using enacted rates in effect in the years in which the differences are expected to reverse. We establish a valuation allowance to offset temporary deductible differences, net operating loss carryforwards and tax credits when it is more likely than not that the deferred tax assets will not be realized.

AWARE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

We recognize the tax benefit from an uncertain tax position only if it is more-likely-than-not that the tax position will be sustained upon examination by the taxing authorities, based on the technical merits of the tax position. The evaluation of an uncertain tax position is based on factors that include, but are not limited to, changes in the tax law, the measurement of tax positions taken or expected to be taken in tax returns, the effective settlement of matters subject to audit, and changes in facts or circumstances related to a tax position. Any changes to these estimates, based on the actual results obtained and/or a change in assumptions, could impact our tax provision in future periods. Interest and penalty charges, if any, related to unrecognized tax benefits would be classified as a provision for income tax in the statement of income.

Capitalization of Software Costs – We capitalize certain internally developed software development costs after technological feasibility of the product has been established. No software costs were capitalized for the years ended December 31, 2015, 2014 and 2013, because such costs incurred subsequent to the establishment of technological feasibility, but prior to commercial availability, were immaterial.

Research and Development Costs – Costs incurred in the research and development of our products are expensed as incurred.

Concentration of Credit Risk – At December 31, 2015 and 2014, we had cash and cash equivalents, in excess of federally insured deposit limits of approximately $51.0 million and $43.7 million, respectively.

Concentration of credit risk with respect to net accounts receivable consisted of amounts owed by the following customers that comprised more than 10% of net accounts receivable at December 31:

Concentration of credit risk with respect to our investment portfolio consisted of $0.5 million and $0.4 million with two issuers of corporate debt securities, respectively, at December 31, 2015, and $0.5 million, $0.5 million, and $0.4 million with three issuers of corporate debt securities, respectively, at December 31, 2014.

Stock-Based Compensation – We grant stock and stock options to our employees and directors. We measure stock-based compensation cost at the grant date based on the fair value of the award and recognize stock-based compensation expense on a straight-line basis over the requisite service period of the award.

For stock awards, we determine the fair value of the award by using the fair market value of our stock on the date of grant; provided the number of shares in the grant is fixed on the grant date.

For stock options, we use the Black-Scholes option valuation model to estimate the fair value of the award. This valuation model takes into account the exercise price of the award, as well as a variety of significant assumptions. The assumptions used to estimate the fair value of stock options include the expected term, the expected volatility of our stock over the expected term, the risk-free interest rate over the expected term, and our expected annual dividend yield.

Computation of Earnings per Share – Basic earnings per share is computed by dividing income available to common shareholders by the weighted average number of common shares outstanding. Diluted earnings per share is computed by dividing income available to common shareholders by the weighted average number of common shares outstanding plus additional common shares that would have been outstanding if dilutive potential common shares had been issued. For the purposes of this calculation, stock options are considered common stock equivalents in periods in which they have a dilutive effect. Stock options that are antidilutive are excluded from the calculation.

Fair Value of Financial Instruments – The carrying amounts of cash and cash equivalents, accounts receivable, accounts payable and accrued expenses approximate fair value because of their short-term nature.

AWARE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

The carrying amount of investments is based on the fair value of the individual securities in our investment portfolio.

Advertising Costs – Advertising costs are expensed as incurred and were not material for 2015, 2014, and 2013.

Recent Accounting Pronouncements – In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers (Topic 606). The ASU is the result of a joint project by the FASB and the International Accounting Standards Board (“IASB”) to clarify the principles for recognizing revenue and to develop a common revenue standard for GAAP and International Financial Reporting Standards (“IFRS”) that would: remove inconsistencies and weaknesses, provide a more robust framework for addressing revenue issues, improve comparability of revenue recognition practices across entities, jurisdictions, industries, and capital markets, improve disclosure requirements and resulting financial statements, and simplify the presentation of financial statements. The core principle of the new guidance is that an entity should recognize revenue to depict 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 ASU is effective for annual reporting periods beginning after December 15, 2016. Early adoption is not permitted. On July 9, 2015, the FASB voted to delay the effective date of the new revenue standard by one year, but to permit entities to choose to adopt the standard as of the original effective date. We are currently evaluating the effect that the updated standard will have on our consolidated financial statements and related disclosures.

In November 2015, the FASB issued Accounting Standard Update ("ASU") 2015-17, "Balance Sheet Classification of Deferred Taxes," which requires that deferred tax liabilities and assets be classified as noncurrent in a classified statement of financial position to simplify the presentation of deferred income taxes. The standard is effective prospectively for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2017, with early adoption permitted. The Company did not early adopt this standard. The effect of early adoption would not have been material as it would have only resulted in a $184,000 reclass of short term deferred tax assets to long term deferred tax assets on our December 31, 2015 consolidated balance sheets.

With the exception of the two standards above, there have been no other recently issued accounting pronouncements that are of significance or potential significance to us that we have not adopted as of December 31, 2015.

Reclassifications - Certain prior period amounts on our consolidated balance sheets were reclassified to be consistent with the current period presentation. Specifically, $2,000 of inventory at December 31, 2014 was included in prepaid expenses and other current assets, and certain accrued expense line items at December 31, 2014 were condensed into one accrued expenses line item.

Segments – We organize ourselves into a single segment reporting to the chief operating decision makers. We have sales outside of the United States, which are described in Note 9. All long-lived assets are maintained in the United States.

The composition of patent related income in 2015, 2014 and 2013 was as follows:

Year ended December 31, 2015. We had a $43,000 gain on the sale of patent assets in 2015, which is described below:

We sold a portion of our patent portfolio pertaining to home networking technology to an unrelated third party for $50,000. The proceeds from the sale were reduced by $7,000 of transaction costs, which consisted primarily of fees from the law firm that assisted us in the sale. We recorded a gain of $43,000 on the sale.

AWARE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Year ended December 31, 2014. We had a $2.1 million gain on the sale of patent assets in 2014, which is described below:

We sold a portion of our patent portfolio pertaining to DSL diagnostic technology to an unrelated third party for $2.6 million. The proceeds from the sale were reduced by $0.5 million of transaction costs, which consisted primarily of fees from the law firm that assisted us in the sale. We recorded a gain of $2.1 million on the sale.

The DSL diagnostic technology in the patents we sold in 2014 was related to our DSL Service Assurance business that we shut down in 2012 and 2013 and reported in discontinued operations in those periods. We do not consider our patent related activities to be a component of the operating business from which the underlying technology was derived, but rather as a component of corporate general and administrative expenses. Accordingly the gain on the sale of these patents was reported in income from continuing operations.

The gains on the sale of patents was included in income from continuing operations pursuant to ASC 360-10, Impairment or Disposal of Long-Lived Assets, and Rule 5-03 of Regulation S-X.

Year ended December 31, 2013. We had $0.8 million of income from a patent arrangement in 2013, which is described below:

We entered into an arrangement with an unaffiliated third party in 2010 under which we assigned certain patents in return for royalties on proceeds from patent monetization efforts by the third party. Such third party has engaged in various patent monetization activities, including enforcement, litigation and licensing. The party reported and we recorded $0.8 million of income from this arrangement in the year ended December 31, 2013.

We continue to have a contractual relationship with this third party. However, we are unable to predict how much more income we might receive from this arrangement, if any, because:

Our board of directors approved the shutdown of our DSL service assurance software product line in 2013. This product line was previously a component of our DSL Service Assurance Segment. Results from the DSL Service Assurance Segment have been reported as discontinued operations because we no longer have any significant continuing involvement with, or cash flows from, this segment.

Loss from the discontinued DSL Service Assurance Segment was (in thousands):

AWARE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

In 2013, we incurred one-time shutdown costs related to the software product line of approximately $2.9 million. Such costs comprise: i) $3.7 million of payments to customers to terminate contracts, which were offset by $1.2 million of deferred revenue obligations that were relieved as a result of such contract terminations; ii) $0.3 million of severance and employee-related costs; and iii) $48,000 of asset write-offs. All such costs were incurred and included in loss from discontinued operations for the year ended December 31, 2013. All DSL service assurance software product line exit costs were paid in 2013, with the exception of $0.1 million of severance costs, which were paid in early January 2014.

There were no assets or liabilities remaining on the balance sheet as of December 31, 2015 related to the DSL Service Assurance Segment.

Property and equipment consisted of the following at December 31 (in thousands):

Depreciation expense was $0.4 million, $0.4 million, and $0.5 million for the years ended December 31, 2015, 2014, and 2013, respectively. In 2015, 2014 and 2013, we identified $0.1 million, $0.1 million, and $0.3 million of assets no longer in use and retired the assets and related accumulated depreciation.

We recorded a benefit from income taxes of $0.5 million in the year ended December 31, 2015, all of which was included in continuing operations. We made provisions for income taxes related to continuing operations in the years ended December 31, 2014 and 2013 of $2.7 million and $1.9 million, respectively. The components of the provision for income taxes are as follows (in thousands):