Cavitation Technologies, Inc. - Annual Report: 2014 (Form 10-K)

Management assesses the carrying value of property and equipment whenever events or changes in circumstances indicate that the carrying value may not be recoverable. If there is indication of impairment, management prepares an estimate of future cash flows expected to result from the use of the asset and its eventual disposition. If these cash flows are less than the carrying amount of the asset, an impairment loss is recognized to write down the asset to its estimated fair value. For the years ended June 30, 2014 and 2013, the Company did not recognize any impairment for its property and equipment.

Capitalized patent costs represent legal fees associated with procuring and filing patent applications. The Company accounts for patents in accordance with ASC 350-30, General Intangibles Other Than Goodwill. The Company has five patents issued in fiscal 2013, 2012 and 2011. As of June 30, 2014, we have a total of 25 patents pending. The patents have duration of twenty years from filing date. We amortize our patents over a four year period which we believe is a reasonable estimate based upon our estimate of time until the next generation of reactors is developed or until other forms of competition appear.

As of June 30, 2014 and 2013, the Company had remaining unamortized patent costs of $67,473 and $70,315. At June 30, 2014, future estimated patent amortization costs are:

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Impairment of Intangible and Long-Lived Assets

In accordance with ASC 350-30 (General Intangibles Other than Goodwill), the Company evaluates amortizable intangibles and long-lived assets for impairment whenever events or changes in circumstances indicate that their net book value may not be recoverable. When such factors and circumstances exist, the Company compares the projected undiscounted future cash flows associated with the related asset or group of assets over their estimated useful lives against their respective carrying amount. Impairment, if any, is based on the excess of the carrying amount over the fair value, based on market value when available, or discounted expected cash flows, of those assets and is recorded in the period in which the determination is made. Based on the Company annual impairment tests, management believes there is no impairment of its intangibles and long-lived assets as of June 30, 2014 and 2013. There can be no assurance, however, that market conditions will not change or demand for the Company's products under development will continue. Either of these could result in future impairment of intangibles and long-lived assets.

The Company periodically issues stock options and warrants to employees and non-employees in non-capital raising transactions for services and for financing costs. The Company accounts for stock option and warrant grants issued and vesting to employees based on the authoritative guidance provided by the Financial Accounting Standards Board whereas the value of the award is measured on the date of grant and recognized over the vesting period. The Company accounts for stock option and warrant grants issued and vesting to non-employees in accordance with the authoritative guidance of the Financial Accounting Standards Board whereas the value of the stock compensation is based upon the measurement date as determined at either a) the date at which a performance commitment is reached, or b) at the date at which the necessary performance to earn the equity instruments is complete. Non-employee stock-based compensation charges generally are amortized over the vesting period on a straight-line basis. In certain circumstances where there are no future performance requirements by the non-employee, option grants are immediately vested and the total stock-based compensation charge is recorded in the period of the measurement date.

The fair value of the Company's common stock option grant is estimated using the Black-Scholes option pricing model, which uses certain assumptions related to risk-free interest rates, expected volatility, expected life of the common stock options, and future dividends. Compensation expense is recorded based upon the value derived from the Black-Scholes option pricing model, and based on actual experience. The assumptions used in the Black-Scholes option pricing model could materially affect compensation expense recorded in future periods.

The Company accounts for income taxes in accordance with ASC 740-10, Income Taxes.  The Company recognizes deferred tax assets and liabilities to reflect the estimated future tax effects, calculated at anticipated future tax rates, of future deductible or taxable amounts attributable to events that have been recognized on a cumulative basis in the financial statements. A valuation allowance related to a deferred tax asset is recorded when it is more likely than not that some portion of the deferred tax asset will not be realized. Deferred tax assets and liabilities are adjusted for the effects of the changes in tax laws and rates of the date of enactment.

ASC 740-10 prescribes a recognition threshold that a tax position is required to meet before being recognized in the financial statements and provides guidance on recognition, measurement, classification, interest and penalties, accounting in interim periods, disclosure and transition issues. The Company classifies interest and penalties as a component of interest and other expenses. To date, there have been no interest or penalties assessed or paid.

The Company measures and records uncertain tax positions by establishing a threshold for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return.  Only tax positions meeting the more-likely-than-not recognition threshold at the effective date may be recognized or continue to be recognized.

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Advertising costs

Advertising costs (including marketing expense) incurred in the normal course of operations are expensed as incurred. Advertising expenses amounted to $7,871 and $20,092 for the years ended June 30, 2014 and 2013 respectively.

Research and development expenses relate primarily to the development, design, testing of preproduction prototypes and models, compensation, and consulting fees, and are expensed as incurred.

The Company provides a limited warranty with every set of reactors sold, typically 2 to 5 years. The Company has not experienced significant claims under its warranty policy, and management determined no accrual for warranty reserve was necessary at June 30, 2014 or 2013.

Basic net income (loss) per share is computed by dividing net income (loss) by the weighted average number of common shares outstanding for the period. Diluted net income (loss) per share is computed similar to basic net income (loss) per share except that the denominator is increased to include the number of additional common shares that would have been outstanding if the potentially dilutive securities had been issued. At June 30, 2014 potentially dilutive securities include options to acquire 13,611,815 shares of common stock and warrants to acquire 63,066,514 shares of common stock. At June 30, 2013 potentially dilutive securities include options to acquire 13,611,815 shares of common stock and warrants to acquire 18,433,867 shares of common stock.

Net loss per share is computed by dividing net loss by the weighted average number of shares of common stock outstanding for the period. Basic and diluted net loss per common share is the same for all periods presented with a net loss because all warrants and stock options outstanding are anti-dilutive.

In May 2014, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update No. 2014-09 (ASU 2014-09), Revenue from Contracts with Customers. ASU 2014-09 will eliminate transaction- and industry-specific revenue recognition guidance under current U.S. GAAP and replace it with a principle based approach for determining revenue recognition. ASU 2014-09 will require that companies recognize revenue based on the value of transferred goods or services as they occur in the contract. The ASU also will require additional disclosure about the nature, amount, timing and uncertainty of revenue and cash flows arising from customer contracts, including significant judgments and changes in judgments and assets recognized from costs incurred to obtain or fulfill a contract. ASU 2014-09 is effective for reporting periods beginning after December 15, 2016, and early adoption is not permitted. Entities can transition to the standard either retrospectively or as a cumulative-effect adjustment as of the date of adoption. Management is currently assessing the impact the adoption of ASU 2014-09 and has not determined the effect of the standard on our ongoing financial reporting.

In April 2014, the FASB issued Accounting Standards Update No. 2014-08 (ASU 2014-08), Presentation of Financial Statements (Topic 205) and Property, Plant and Equipment (Topic 360). ASU 2014-08 amends the requirements for reporting discontinued operations and requires additional disclosures about discontinued operations. Under the new guidance, only disposals representing a strategic shift in operations or that have a major effect on the Company's operations and financial results should be presented as discontinued operations. This new accounting guidance is effective for annual periods beginning after December 15, 2014.

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In August 2014, the FASB issued Accounting Standards Update No. 2014-15 (ASU 2014-15), Disclosure of Uncertainties about an Entity's Ability to Continue as a Going Concern, which provides guidance on determining when and how to disclose going-concern uncertainties in the financial statements. The new standard requires management to perform interim and annual assessments of an entity's ability to continue as a going concern within one year of the date the financial statements are issued. An entity must provide certain disclosures if conditions or events raise substantial doubt about the entity's ability to continue as a going concern. The ASU applies to all entities and is effective for annual periods ending after December 15, 2016, and interim periods thereafter, with early adoption permitted.

Other recent accounting pronouncements issued by the FASB, including its Emerging Issues Task Force, the American Institute of Certified Public Accountants, and the Securities and Exchange Commission did not or are not believed by management to have a material impact on the Company's present or future consolidated financial statements.

Our revenue is almost entirely dependent on Desmet Ballestra who is our exclusive distribution agent with regard to the CTi Nano Neutralization® System for edible oils. During fiscal 2014 and 2013, 100% and 97%, respectively, of our revenue was derived from Desmet sales efforts (see Note 4).

On May 14, 2012 we signed a global R and D, Marketing and Technology License Agreement with the n.v. Desmet Ballestra Group s.a. (Desmet), a Belgian company that is actively marketing the NANO Neutralization System, the key component of which is the Company's reactor to soybean and other vegetable oil refiners. The Agreement provides Desmet (licensee) a limited, exclusive license and right to develop, design and supply Nano Reactor® systems which incorporate Nano Reactor® devices on a global basis but is limited to oils and fats and oleo chemical applications. CTi (licensor) remains owner of the current patents and patent applications but Desmet will be co-owner of any new process patent applications jointly developed. Desmet has agreed to provide, under certain conditions, limited monthly advance payments of $125,000 against future sales to CTi. Desmet shall be entitled to immediately terminate the present agreement in case the claims of current US Patent Application Number 12/484,981 are not granted as such or are cancelled. In addition, Desmet may terminate the agreement on August 1 of any particular year if they have not installed at least 6 Nano Reactor® devices in the previous 12 month period. CTi may terminate the Agreement for material default. As of the date of this report, the 6 Nano Reactors has been installed and Desmet has not indicated any termination of the agreement. This Agreement supersedes a previous agreement dated November 1, 2010, amended on June 1, 2011 and on September 2, 2011.

Desmet, together with its affiliates, is a global engineering and equipment supply firm engaged in the development, design and supply of process equipment for oils and fats processing facilities including vegetable oil refining, biofuel, oleo chemical, seed crushing, surfactant and detergent markets. Desmet supplies these markets with competitive services based on the latest globally sourced technologies.

The Company and Desmet have worked together to determine the appropriate sales approach and installation process. The Company's Nano Neutralization is designed to be used as an add-on process to an existing neutralization system within soybean and other vegetable oil refineries. Desmet purchases Nano Reactor Systems from the Company and installs them at the refinery as part of an integrated neutralization system. We are therefore substantially dependent on Desmet to identify prospects, complete sales contracts, install the system and manage relationships with end-users.

During the years ended June 30, 2014 and 2013, we recorded revenues from Desmet amounting to $1,855,707 and $1,223,210. In addition, we received advances of $1,375,000 in each of the fiscal years 2014 and 2013 respectively. As of June 30, 2014 and 2013, Desmet has advanced to us an excess of funds of $734,956 and $1,215,663 which will be recognized as revenue as sales orders are shipped.

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Note 5 - Property and Equipment

Property and equipment consisted of the following as of June 30, 2014 and June 30, 2013:

Depreciation expense for the years ended June 30, 2014 and 2013 amounted to $72,227 and $59,605, respectively.

As of June 30, 2014 and 2013, the Company had accrued unpaid salaries to officers and former officers amounting to $1,030,331 and $1,016,223, respectively.

On December 17, 2012 we issued a convertible promissory note payable to a private party, in the amount of $100,000 with an interest rate of 12% per annum and due May 31, 2014. The note is unsecured, convertible into shares of our common stock at a conversion price of $0.03 any time during the life of the note. Also, 3,333,333 fully vested warrants with a fair value of $90,106 were issued in connection with this note. The warrants are exercisable at $0.07/share and will expire in 3 years. The fair value of the warrants was recorded as a note discount and was being amortized to interest expense over the term of the note. As of June 30, 2013, the outstanding balance of note amounted to $100,000 less unamortized note discount of $55,174 resulting in a net balance of $44,826.

On December 2, 2013 the $100,000 Note was converted into 3,333,333 shares of the Company's common stock and the unamortized balance of the note discount of $55,174 was recognized as interest expense.

As of June 30, 2012, we had received $185,000 from West Point Partners, LLC, whose managing partner is the Company's Principal Accounting Officer. These funds were due on demand, and accrued an annual interest rate of 12%. As of June 30, 2013, outstanding balance of the loan amounted to $185,000 and accrued interest of $26,650.

On April 1, 2014, we granted an aggregate of 7,610,000 shares of common stock with a fair value of $684,900 along with 7,610,000 warrants with a fair value of $683,983 to settle this demand note with a face value of $185,000 and accrued interest of $43,300. The shares have not been issued as June 30, 2014, and will be issued in reliance on Section 4(2) of the Securities Act of 1933, as amended. The shares were not offered via general solicitation to the public. The Company issued rule 144 shares in connection with these issuances. No sales commissions or other remuneration was paid in connection with this issuance.

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Note 9 - Short-Term Loans

As of June 30, 2012, we had received $34,521 from a third party, Strategic IR. These funds were due on demand and pay an annual interest rate of 12%. As of June 30, 2013, outstanding balance of the loan amounted to $34,521 and accrued interest of $4,950.

On April 1, 2014, we granted an aggregate of 1,419,251 shares of common stock to Strategic IR with a fair value of $127,733 along with 1,419,251 warrants with a fair value of $127,432 to settle this demand note with a face value of $34,521 and accrued interest of $8,057. The shares have not been issued as June 30, 2014, and will be issued in reliance on Section 4(2) of the Securities Act of 1933, as amended. The shares were not offered via general solicitation to the public. The Company issued rule 144 shares in connection with these issuances. No sales commissions or other remuneration was paid in connection with this issuance.

During fiscal 2014, the Company issued 1,000,000 shares of common stock with a recorded value of $90,000 as payment to a service provider. These shares were valued at fair value at the date of issuance.

On June 30, 2014 we issued 15,133,330 shares of common stock to various entities and individuals in exchange for net cash proceeds of $1,021,500. The shares were issued in reliance on Section 4(2) of the Securities Act of 1933, as amended. The shares were not offered via general solicitation to the public. The Company issued rule 144 shares in connection with these issuances.

The Company also issued 3,333,333 shares of common stock to convert $100,000 of outstanding principal under the convertible promissory notes (see Note 7). A total of 9,029,251 shares of common stock are issuable as of June 30, 2014 relating to the settlement of demand notes outstanding with a principal value of $219,521 and accrued interest balance of $51,357 (see Notes 8 and 9). 

In July and August 2012, the Company acquired previously issued 1,500,000 shares of common stock for a note conversion in the year ended June 30, 2013 for total costs of $25,460. The amount paid was reflected as a reduction to paid in capital.

In October 2012, pursuant to a settlement agreement with a former officer, the former officer returned 2,000,000 shares of common stock and options to purchase 10,000,000 shares of commons stock granted to him in February 2012. In exchange for the return of these equity instruments, the Company granted the former officer warrants to purchase 7,500,000 shares of common stock with a fair value of $140,043 using a Black-Scholes Option Pricing Model. The warrants vested immediately, exercisable at $0.05/share and will expire in 10 years after grant. Furthermore, the Company also reversed previously recognized compensation expense of $43,069 pertaining to the unvested portion of the returned options. As result, the Company recognized a total cost of $96,974 pursuant to the settlement agreement which is included as part of General and Administrative Expense in the accompanying Statement of Operations for the year ended June 30, 2013.

In December 2012 and May 2013, we issued an aggregate of 2,771,000 shares of common stock to a Director, employees and consultants with a fair value of $113,930. Included in this issuance was a 500,000 shares of common stock issued to a Director in exchange for the cancellation of his 500,000 fully vested options granted in February 2012. The shares of common stock issued were valued at the market price on the date of issuance.

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In December 2012 6,800,858 shares of common stock previously issued to the Company's Officers and a service provider were cancelled. In exchange for the cancellation, the Company issued options to purchase 6,800,858 shares of common stock with a fair value of $201,920 using a Black-Scholes Option Pricing Model. The options vest immediately, exercisable at $0.03/share and will expire in 10 years after grant.

On March 17, 2009, the Company  filed Amended and Restated Articles of Incorporation and created two  new series of preferred stock, the first of which is designated Series A Preferred Stock and the second of which is designated as Series B Preferred Stock. The total number of shares of Common Stock which this corporation shall have authority to issue is 1,000,000,000 shares of Common Stock and 10,000,000 shares of Preferred Stock of which 5,000,000 shares are designated as Series A Preferred Stock, and 5,000,000 shares are designated as Series B Preferred Stock, with the rights, preferences and privileges of the Series B Preferred Stock to be designated by the Board of Directors. Each share of Common Stock and Preferred Stock has a par value of $0.001. As of June 30, 2014 and 2013, there are no shares of Series A or Series B Preferred Stock outstanding.

The Company has not adopted a formal stock option plan, however, it has assumed outstanding stock options resulting from the acquisition of its wholly-owned subsidiary, Hydrodynamic Technology, Inc. In addition, the Company has made periodic non- plan grants. A summary of the stock option activity from June 30, 2014 and 2013 is as follows:

No options were issued in fiscal 2014, and 1,424,021 options previously granted to a former Officer and Director had either expired, were cancelled or replaced with warrants.

In October 2012, pursuant to a settlement agreement with a former officer, the Company cancelled 10,000,000 options granted to the former officer in February 2012 (see Common Stock above for further discussion).

In May 2013, the Company cancelled 500,000 options granted to a Director in February 2012 (see Common Stock above for further discussion).

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In December 2012 and May 2013, the Company granted options to employees to purchase a total of 3,750,000 shares of common stock with a fair value of $113,233 using the Black-Scholes Option Pricing Model. The options vest immediately, exercisable at $0.03/share and will expire in 10 years after grant.

In December 2012, the Company granted options to purchase 6,800,858 shares of common stock to Officers and a service provider with a fair value of $74,189 using the Black-Scholes Option Pricing Model.

The intrinsic value of the outstanding options was $590,043 and $0 as of June 30, 2014 and 2013, respectively. The following table summarizes additional information concerning options outstanding and exercisable at June 30, 2014.

A summary of the Company's warrant activity and related information from as of June 30, 2014 and 2013 is as follows.

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2014

In October 2013, the Company granted employees warrants to purchase 9,100,000 shares of common stock at $0.04/share, vesting immediately and expiring in 5 and 10 years from grant date. The fair value of the warrants amounted to $363,882 using the Black-Scholes Merton valuation model with the following average assumptions: risk-free interest rate of 0.90%; dividend yield of 0%; volatility of 232%; and an expected life of 3.75 years.

In October 2013, the Company granted consultants warrants to purchase 13,100,000 shares of common stock at prices ranging from $0.04 up to $0.045/share, vest over a period of one year and expiring in 5 and 10 years from grant date. The fair value of the warrants that vest during the current fiscal year amounted to $726,299 using the Black-Scholes Merton valuation model with the following average assumptions: risk-free interest rate of 2.58%; dividend yield of 0%; volatility of 200%; and an expected life of 9.75 years.

In April 2014, the Company issued 9,029,251 warrants to demand note holders pursuant to a conversion agreement (see Notes 8 and 9).

In April 2014, the Company granted a new Board member warrant to purchase 1,000,000 shares of common stock at $0.08/share which vest over a period of one year and expiring in 5 years from grant date. The fair value of the warrants that vest during the fiscal year ended June 30, 2014 amounted to $3,324 using the Black-Scholes Merton valuation model with the following average assumptions: risk-free interest rate of 3.34%; dividend yield of 0%; volatility of 185%; and an expected life of 9.75 years.

In June of 2014, the Company issued warrants to purchase 15,133,330 shares of common stock to the purchasers of common stock offering at $0.12 per share, vesting immediately and expiring in 5 years from grant date. Pursuant to the term of the grant, the underlying shares of common stock must be registered with the SEC within one year after its purchase otherwise, the warrant will be considered cashless.

In October 2012, pursuant to settlement agreement with a former officer, Company issued 7,500,000 warrants (see Common Stock for further discussion).

In December 2012, the Company issued 3,333,333 warrants to a note holder pursuant to convertible note offering (see Note 7).

In May 2013, the Company granted warrants to Officers to purchase a total of 4,000,000 shares of common stock with a fair value of $197,549 using the Black-Scholes Option Pricing Model. The warrants vest immediately, exercisable at $0.05/share and will expire in 10 years after grant.

In May 2013, the Company also granted warrants to an employee and a service provider to purchase a total of 870,600 shares of common stock with a fair value of $37,347 using the Black-Scholes Option Pricing Model. The warrants vest immediately, exercisable at $0.05/share up to $0.07/share and will expire in 3 to 10 years after grant.

As of June 30, 2014, total compensation cost related to non-vested warrant award not yet recorded is approximately $262,535. The intrinsic value of the outstanding warrants was $1,551,329 and $0 as of June 30, 2014 and 2013, respectively. The following table summarizes additional information concerning warrants outstanding and exercisable at June 30, 2014.

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The table below represents the assumptions for valuing the options and warrants granted in fiscal 2014 and 2013:

The assumptions used in the Black Scholes models referred to above are based upon the following data: (1) The contractual life of the underlying non-employee options is the expected life. The expected life of the employee option is estimated by considering the contractual term of the option, the vesting period of the option, the employees' expected exercise behavior and the post-vesting employee turnover rate. (2) The expected stock price volatility was based upon the Company's historical stock price over the expected term of the option. (3) The risk free interest rate is based on published U.S. Treasury Department interest rates for the expected terms of the underlying options. (4) The expected dividend yield was based on the fact that the Company has not paid dividends to common shareholders in the past and does not expect to pay dividends to common shareholders in the future. (5) The expected forfeiture rate is based on historical forfeiture activity and assumptions regarding future forfeitures based on the composition of current grantees.

Total income tax expense differed from the amounts computed by applying the U.S. Federal income tax rate of 34% to income before income tax expense as a result of the NOL carry forward. Therefore, the company's effective tax rate is 0.0%. The Company files income tax returns in the United States ("Federal") and California ("State") jurisdictions. The Company is subject to Federal and State income tax examinations by tax authorities for all years since its inception.

At June 30, 2014, the Company had Federal and State net operating loss carry forwards available to offset future taxable income of approximately $8.1 million and $8.1 million, respectively. These carry forwards will begin to expire in the years ending June 30, 2027 and June 30, 2017, respectively, subject to IRS limitations, including change in ownership.

The Company periodically evaluates the likelihood of the realization of deferred tax assets, and adjusts the carrying amount of the deferred tax assets by a valuation allowance to the extent the future realization of the deferred tax assets is not judged to be more likely than not. The Company considers many factors when assessing the likelihood of future realization of our deferred tax assets, including recent cumulative earnings experience by taxing jurisdiction, expectations of future taxable income or loss, the carry-forward periods available to us for tax reporting purposes, and other relevant factors.

At June 30, 2014, based on the weight of available evidence, including cumulative losses in recent years and expectations of future taxable income, the Company determined that it was more likely than not that its deferred tax assets would not be realized. Accordingly, the Company has recorded a valuation allowance for 100% of its cumulative deferred tax assets.

As a result of the implementation of certain provisions of ASC 740-10, the Company performed an analysis of its previous tax filings and determined that there were no positions taken that it considered uncertain. Therefore, there were no unrecognized tax benefits as of June 30, 2014.

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Future changes in the unrecognized tax benefit are not expected to have an impact on the effective tax rate due to the existence of the valuation allowance. The Company estimates that the unrecognized tax benefit will not change within the next twelve months. The Company will continue to classify income tax penalties and interest, if any, as part of interest and other expenses in its consolidated statements of operations. There is no interest or penalties accrued as of June 30, 2014.

The following summarizes the open tax years for each major jurisdiction: