Cavitation Technologies, Inc. - Quarter Report: 2014 March (Form 10-Q)

See accompanying notes,which are an integral part of these condensed consolidated financial statements

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CAVITATION TECHNOLOGIES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
Nine months ended March 31, 2014 and 2012

Cavitation Technologies, Inc. (referred to herein, unless otherwise indicated, as "the Company," "CTi," "we," "us," and "our") a Nevada corporation originally incorporated on January 29, 2007 under the name Bio Energy, Inc. CTi has developed, patented, and commercialized proprietary technology that may be used in liquid processing applications. CTi's patented Nano Reactor® is the critical component of CTi Nano Neutralization® System which is commercially proven to reduce operating costs and increase yields in refining vegetable oils. CTi has two patented systems and has filed several national and international patents to employ its proprietary technology in applications including, vegetable oil refining, waste water treatment, biodiesel, algae oil extraction, and alcoholic beverage enhancement.

The accompanying unaudited condensed consolidated financial statements of Cavitation Technologies, Inc. have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and pursuant to the requirements for reporting on Form 10-Q and Regulation S-K for scaled disclosures for smaller reporting companies. Accordingly, they do not include all the information and footnotes required by accounting principles generally accepted in United States of America for complete financial statements. However, such information reflects all adjustments (consisting solely of normal recurring adjustments), which are, in the opinion of management, necessary for the fair presentation of the consolidated financial position and the consolidated results of operations. Results shown for interim periods are not necessarily indicative of the results to be obtained for a full fiscal year.

The consolidated balance sheet information as of June 30, 2013 was derived from the audited consolidated financial statements included in the Company's Annual Report on Form 10-K filed with the SEC on October 15, 2013. These interim financial statements should be read in conjunction with that report.

The accompanying condensed consolidated financial statements have been prepared in conformity with generally accepted accounting principles which contemplate continuation of the Company as a going concern.  During the nine months ended March 31, 2014, the Company incurred a net loss of $207,253 and utilized $71,721 of cash in operations. As of March 31, 2014, the Company had a working capital deficiency of $1,520,817 and a stockholders' deficit of $1,306,575.   These factors, among others, raise substantial doubt about the Company's ability to continue as a going concern. Our independent auditors, in their report on our audited financial statements for the fiscal year ended June 30, 2013 expressed substantial doubt about our ability to continue as a going concern. The accompanying condensed consolidated financial statements do not include adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts and classification of liabilities that may result from an inability of the Company to continue as a going concern. Management's plan is to generate income from operations by continuing to license our technology globally through our strategic partner, the Desmet Ballestra Group (Desmet). Desmet has agreed to provide us monthly advances of $125,000 against future sales. During the nine months ended March 31, 2014, advances received from Desmet amounted to $1,000,000. We will also attempt to raise additional debt and/or equity financing to fund operations and to provide additional working capital. However, there is no assurance that such financing will be consummated or obtained in sufficient amounts necessary to meet the Company's needs, that the Company will be able to achieve profitable operations or that the Company will be able to meet its future contractual obligations. Should management fail to obtain such financing, the Company may curtail its operations.

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Note 2 - Significant Accounting Policies

The consolidated financial statements include the accounts of Cavitation Technologies, Inc. and its wholly owned subsidiary Hydrodynamic Technology, Inc. Inter-company transactions and balances have been eliminated through consolidation.

FASB Accounting Standards Codification ("ASC") 820-10 requires entities to disclose the fair value of financial instruments, both assets and liabilities recognized and not recognized on the balance sheet for which it is practicable to estimate fair value. ASC 820-10 defines the fair value of a financial instrument as the amount at which the instrument could be exchanged in a current transaction between willing parties. As of March 31, 2014, the carrying value of certain accounts such as inventory, accounts payable, accrued expenses, accrued payroll and short-term loans approximate fair value due to the short-term nature of such instruments.

The following table presents information about the Company's assets and liabilities measured and reported in the financial statements at fair value on a recurring basis as of March 31, 2014 and indicates the fair value hierarchy of the valuation techniques utilized to determine such fair value. The three levels of the fair value hierarchy are as follows:

• Level 1 - Valuations based on unadjusted quoted prices in active markets for identical assets or liabilities that the entity has the ability to access.
• Level 2 - Valuations based on quoted prices for similar assets or liabilities, quoted prices in markets that are not active, or other inputs that are observable or can be corroborated by observable data for substantially the full term of the assets or liabilities.
• Level 3 - Valuations based on inputs that are unobservable, supported by little or no market activity and that are significant to the fair value of the assets or liabilities.

At March 31, 2014 and June 30, 2013, the fair values of cash, inventory and accounts payable approximate their carrying values.

The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the U.S requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the financial statement date, and reported amounts of revenue and expenses during the reporting period. Significant estimates are used in valuing our stock options, warrants, convertible notes, and common stock issued for services, among other items. Actual results could differ from these estimates.

Revenues are recognized when persuasive evidence of an agreement exists; delivery has occurred, including transfer of title and risk of loss for product sales, or services have been rendered for service revenues; the price to the buyer is fixed or determinable; and collectability is reasonably assured.

The Company is also entitled to certain profit share from its distributor from the sale of the reactors. The profit share is non-refundable and is recorded upon shipment of the reactors to the distributor.

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Patents

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 two patents issued in fiscal 2012 and 2011, and another 3 patents granted in fiscal 2014. As of March 31, 2014, we have a total of 30 patents pending. The patents have duration of twenty years from filing date.

We amortize our patents over a four year estimated life. As of March 31, 2014 and June 30, 2013 the Company had remaining unamortized patent costs of $69,426 and $70,315 respectively.

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 March 31, 2014. 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.

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Income Taxes

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.

The Company provides a limited warranty with every set of reactors sold, typically 2 years. The Company has not experienced significant claims under its warranty policy, and management determined no accrual for warranty reserve was necessary at March 31, 2014.

Our revenue are 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 2013 and for the nine months ended March 31, 2014, 97% and 100% of revenue, respectively, were derived from Desmet sales efforts (see Note 3).

The Company's computation of earnings per share ("EPS") includes basic and diluted EPS.  Basic EPS is measured as the income (loss) available to common stockholders divided by the weighted average common shares outstanding for the period.  Diluted EPS is similar to basic EPS but presents the dilutive effect on a per share basis of potential common shares (e.g., warrants and options) as if they had been converted at the beginning of the periods presented, or issuance date, if later.  Potential common shares that have an anti-dilutive effect (i.e., those that increase income per share or decrease loss per share) are excluded from the calculation of diluted EPS.

Income (loss) per common share is computed by dividing net income (loss) by the weighted average number of shares of common stock outstanding during the respective periods. Basic and diluted (loss) per common share is the same for periods in which the company reported an operating loss because all warrants and stock options outstanding are anti-dilutive.

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A reconciliation of basic and diluted shares for the three months ended March 31, 2014 and 2013 follows:

There were no adjustments to net loss required for purposes of computing diluted earnings per share. Warrants, options and other potentially dilutive securities that are antidilutive and have been excluded from the dilutive calculations when their exercise or conversion price exceeds the average stock market price during the period or the effect would be anti-dilutive when applied to a net loss during the period(s) presented. The following table sets forth the shares excluded from the diluted calculation for the three month periods presented as follows:

Such securities could potentially dilute earnings per share in the future.

In April 2014, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (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. The Company is currently evaluating the impact of adopting ASU 2014-08 on the Company's results of operations or financial condition.

Other accounting pronouncements did not or are not believed by management to have a material impact on the Company's present or future consolidated financial statements.

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Note 3 - Agreement with Desmet Ballestra

On May 14, 2012 we signed a global Research and Development, 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. 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 nine months ended March 31, 2014 and 2013, we recorded revenues of $1,855,707 and $1,223,115 from Desmet. The Company received advances of $1,000,000 and $750,000 in each nine months ended March 31, 2014 and 2013. As of March 31, 2014 and June 30, 2013, Desmet has advanced to us an excess of funds of $359,956 and $1,215,663, respectively which will be recognized as revenue as sales orders are shipped.

Property and equipment consisted of the following as of March 31, 2014 and June 30, 2013:

Depreciation expense for the nine months ended March 31, 2014 and 2013 amounted to $52,469 and $43,342, respectively.

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Note 5 - Convertible Note

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. Upon issuance of the note, the trading price of the Company's common stock was also $0.03/share which is the same as the note's conversion price. As such, there was no cost of beneficial conversion feature recorded. 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 $100,000 less 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.

In July 2012, we received a loan from West Point Partners, LLC in the aggregate of $185,000. The loan is due on demand, unsecured and pays an annual interest rate of 12% per annum. As of June 30, 2013, outstanding balance of the loan amounted to $185,000 an accrued interest of $26,650.

During the nine months ended March 31, 2014, the Company recognized interest expense of $16,650. As of March 31, 2014, the entire loan of $185,000 is still outstanding with unpaid interest of $43,350.

The managing partner of West Point Partners, LLC is the Company's Prinicpal Accounting Officer.

Note 7 - Short-Term Loan

In July 2012, we had received a loan of $34,521 from a third party, Strategic IR. The loan is due on demand, unsecured and pays an annual interest rate of 12% per annum. As of June 30, 2013, outstanding balance of the loan amounted to $34,521 and accrued interest of $4,950.

During the nine months ended March 31, 2014, the Company recognized interest expense of $3,107. As of March 31, 2014, the entire loan of $34,521 is still outstanding with unpaid interest of $8,057.

As of March 31, 2014 and June 30, 2013, the Company had accrued unpaid salaries due to officers amounting to $936,866. In addition, the Company also accrued the estimated payroll taxes due to this unpaid payroll of $79,357.

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Note 9 - Stockholders' Deficit

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 grants. A summary of the stock option activity from March 31, 2014 is as follows:

The intrinsic value of the outstanding options was $708,051 as of March 31, 2014. The following table summarizes additional information concerning options outstanding and exercisable at March 31, 2014.

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Warrants

A summary of the Company's warrant activity and related information for the nine months ended on March 31, 2014 is as follows.

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 $0.04 up to $0.45/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 nine month period ended March 31, 2014 amounted to $563,327 using the Black-Scholes Merton valuation model with the following average assumptions: risk-free interest rate of 3.00%; dividend yield of 0%; volatility of 210%; and an expected life of 8.26 years.

As of March 31, 2014, total compensation cost related to non-vested warrant award not yet recorded is approximately $389,089. The intrinsic value of the outstanding warrants was $1,659,491 as of March 31, 2014. The following table summarizes additional information concerning warrants outstanding and exercisable at March 31, 2014.

In April 2014, the Company granted a consultant 1 million shares of our common stock with a fair value of approximately $90,000 as an incentive for the consultant's continuous involvement with the Company.

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ITEM 2.  Management's Discussion and Analysis of Financial Condition and Results of Operations.

Hydrodynamic Technology, Inc. was incorporated January 29, 2007 as a California corporation. It is a wholly owned subsidiary of Cavitation Technologies, Inc., a Nevada corporation originally incorporated under the name Bio Energy, Inc. We design and engineer environmentally friendly technology based systems that are designed to serve large, growing, global markets such as vegetable oil refining, renewable fuels, water treatment, algae oil extraction, biodiesel production, water-oil emulsions and crude oil yield enhancement.  Our systems are designed to process industrial liquids at a lower cost and higher yield than conventional technology. We are a process and product development firm that has developed, patented, and commercialized proprietary technology.

CTi has developed, patented, and commercialized proprietary technology that can be used for processing of industrial fluids. CTi's patented Nano Reactor® is the critical components of the CTi Nano Neutralization® System which is commercially proven to reduce operating costs and increase yields in processing oils and fats. CTi has two issued patents relating to our Nano Reactor® systems and has filed several national and international patents to employ its proprietary technology in applications including, vegetable oil refining, biodiesel production, waste water treatment, algae oil extraction, and alcoholic beverage enhancement.

During the nine months ended March 31, 2014, we recorded revenue of $1,855,707. Net loss for the nine months of fiscal 2014 is $207,253. Net cash used in operating activities of $71,721 and net cash used in investing activities of $50,229 was funded largely with Company's cash reserves at the beginning of the period as well as advances from Desmet.

We are engaged in merchandising our Neutralization System which is designed to help refine vegetable oils such as soybean, canola, sunflower and rapeseed.  Our near term goal is to continue to merchandise our systems through our partner, Desmet Ballestra. Even though the Company's revenue increased significantly in last fiscal year, the Company incurred a net loss of $207,253 during the nine months ended March 31, 2014. As of March 31, 2014, the Company had a working capital deficiency of $1,530,817 and a stockholders' deficit of $1,306,575.   The accompanying financial statements have been prepared in conformity with generally accepted accounting principles which contemplate continuation of the Company as a going concern.

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Management's plan is to generate income from operations by licensing our technology globally through our strategic partner, the Desmet Ballestra Group (Desmet). Desmet has agreed to provide us monthly advances of $125,000 against future sales. During the nine months ended March 31, 2014, advances received from Desmet amounted to $1,000,000 and we received a total of $2,500,000 as of May 15, 2014. These funds service operational expenses on a monthly basis. 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. This Agreement supersedes a previous agreement dated November 1, 2010, amended on June 1, 2011 and on September 2, 2011. In addition to these advances, we anticipate that we will need additional funding, and we will attempt to raise additional debt and/or equity financing to fund operations and to provide additional working capital. However, there is no assurance that such financing will be consummated or obtained in sufficient amounts necessary to meet the Company's needs, or that the Company will be able to meet its future contractual obligations. Should management fail to obtain such financing, the Company may curtail its operations.

The accompanying condensed consolidated financial statements do not include adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts and classification of liabilities that may result from an inability of the Company to continue as a going concern. As a result of the aforementioned factors, our independent auditors, in their report on our audited financial statements for the fiscal year ended June 30, 2013, expressed substantial doubt about our ability to continue as a going concern.

CTi's critical accounting policies and estimates are included in its Annual Report on Form 10-K for the year ended June 30, 2013, and did not change for the nine months ended March 31, 2014.

The following is a comparison of our results of operations for the three months ended March 31, 2014 and 2013.

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Revenue

During the three months ended March 31, 2014, our revenue consisted primarily of NANO Neutralization System reactor sales of $1,360,441 to Desmet customers in in India, Brazil and the US. This compares with $529,327 recorded during the same period in fiscal 2013 for sale of reactors to Desmet customers in South Dakota and Argentina.

During the three months ended March 31, 2014, our cost of sales amounted to $102,625 which was the result of the reactor sales described above and primarily consists of the cost incurred for manufacturing Nano reactors and engineering work involved to assemble them. This compares with $16,726 recorded during the same period in fiscal 2013. The change was mainly due to increase in the capacity and number of reactors shipped.

Operating expenses for the three months ended March 31, 2014 amounted to $427,548 compared with $314,988 for the same period in 2013, an increase of $112,560, or 36%. In both periods, the major expense component was salaried compensation. In the third quarter of fiscal 2014, compensation amounted to $89,034 or 21% of total costs compared with $80,638, or 24% of total costs in the same period of fiscal 2013. This increase in compensation in the third quarter of fiscal 2014 was attributable largely to higher reliance on salaried officer compensation. Also, the increase in expenses in the current period as compared to fiscal 2013 was attributable to the fair value of warrants vested from prior grants to a consultant, which amounted to $182,902 or 44% of total operating expenses.

Research and Development (R&D) expenses remained relatively low. R&D expenses amounted to $2,044 in the third quarter of fiscal 2014, which represented a reduction of $16,297 as compared to the same period in the prior fiscal year. It is our intention to pursue R&D as our cash position permits.

Interest expense of $6,586 during current quarter was composed entirely of non-cash expenses related to accrued interest on short term loans outstanding. In the third quarter of fiscal 2013, Interest Expense of $26,948 consisted of a non-cash expense of $16,122 relating to convertible notes amortization, $6,586 in non-cash, accrued interest relating primarily to short term loans, and cash interest paid mostly to convertible note holders in the amount of over $4,000.

During the period ended March 31, 2014, the Company recorded a net income of $823,682. The Company deemed not to record any provision for income tax since the Company estimate that it will record a taxable loss for the twelve months ending June 30, 2014. Furthermore, due to net losses from prior periods, the Company has accumulated significant Net Operating Loss carryover that can be used to off-set future tax obligations.

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Results of Operations for the Nine Months Ended March 31, 2014 Compared to the Nine Months Ended March 31, 2013

The following is a comparison of our results of operations for the nine months ended March 31, 2014 and 2013.

During the nine months ended March 31, 2014, our revenue consisted primarily of NANO Neutralization System reactor sales to Desmet customers in the US, Brazil, Uruguay, South Korea, India and Ecuador, and amounted to $1,855,707. This compares with $1,223,115 recorded during the same period in fiscal 2013 associated primarily with the sale of a NANO Neutralization System to customers located in Argentina and South Dakota, as well as final acceptance of our systems by Desmet's customers in Europe and the US.

During the nine months ended March 31, 2014, our cost of sales amounted to $119,258 which was the result of the revenue transactions described above and primarily consists of the cost incurred for manufacturing Nano reactors and engineering work involved to assemble them. This compares with $21,665 recorded during the same period in fiscal 2013. The change was mainly due to increase in the capacity and number of reactors shipped.

Operating expenses for the nine months ended March 31, 2014 amounted to $1,861,771 compared with $1,147,283 for the same period in 2013, an increase of $714,448, or 62%. The increase was attributable largely to a $769,870 increase in General & Administrative Expenses (G&A) (attributable mostly to non-cash costs of $927,209 relating to the vesting of options and warrants issued for services) and $55,389 decrease in R&D expenses.

The primary expenditures during the first three quarters of fiscal 2014 were approximately $154,000 for professional service fees such as auditors, attorneys, and SEC related services, $89,000 in consulting fees excluding items relating to vested options and warrants, $82,000 in Interest expenses, $63,000 in Insurance expenses and $272,000 in salaries and salary related expenses and $927,209 relating to the vesting of options and warrants issued for services. The expenses for the same period of fiscal 2013 were $140K for professional service fees such as auditors, attorneys, and SEC related services, consulting fees of $95K, insurance expense of $75K (mostly health insurance accrual), and depreciation and commission expenses of about $43K each, and $495K in salaries and salary related expenses. The increase in compensation in the first half of fiscal 2014 was attributable largely to the issuance of options and warrants to officers and consultants and decrease in salaries expense was mostly due to reduction in management.

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Interest Expense

Interest expense decreased by $12,107, or 13%, for the nine months ended March 31, 2014 as compared to 2013. Interest expense for the fiscal 2014 consisted of a non-cash expense of $55,174 relating to convertible notes, $19,756 in mostly non-cash, accrued interest relating primarily to short term loans, and cash interest paid to convertible note holders in the amount of $5,000.

The Interest Expense for the fiscal 2013, by comparison, included a non-cash expense of $38,247 relating to convertible notes, $27,522 in mostly non-cash, accrued interest relating primarily to short term loans, and cash interest paid to convertible note holders in the amount of about $52K. Cash interest payments on our loan from the National Bank of California declined to $11,020 during fiscal 2013 as the outstanding balance declined from $370,271 at March 31, 2012 to $0 on March 31, 2013.

The accompanying condensed consolidated financial statements have been prepared in conformity with generally accepted accounting principles which contemplate continuation of the Company as a going concern.  During the nine months ended March 31, 2014, the Company incurred a net loss of $207,253 and utilized $71,721 cash in operations. As of March 31, 2014, the Company had a working capital deficiency of $1,530,817 and a stockholders' deficit of $1,306,575.   These factors, among others, raise substantial doubt about the Company's ability to continue as a going concern. Our independent auditors, in their report on our audited financial statements for the fiscal year ended June 30, 2013 expressed substantial doubt about our ability to continue as a going concern. The accompanying condensed consolidated financial statements do not include adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts and classification of liabilities that may result from an inability of the Company to continue as a going concern.

Management's plan is to generate income from operations by continuing to license our technology globally through our strategic partner, the Desmet Ballestra Group (Desmet). Desmet has agreed to provide us monthly advances of $125,000 against future sales. During the nine months ended March 31, 2014, advances received from Desmet amounted to $1,000,000. We will also attempt to raise additional debt and/or equity financing to fund operations and to provide additional working capital. However, there is no assurance that such financing will be consummated or obtained in sufficient amounts necessary to meet the Company's needs, that the Company will be able to achieve profitable operations or that the Company will be able to meet its future contractual obligations. Should management fail to obtain such financing, the Company may curtail its operations.

On March 31, 2014, we had cash on hand in the amount of $120,026. In addition to the funds on hand, we will require additional funds to continue to operate our business. This includes expenses we will incur in connection with costs to manufacture and ship our products; costs to design and implement an effective system of internal controls and disclosure controls and procedures; costs of maintaining our status as a public company by filing periodic reports with the SEC and costs required to protect our intellectual property. In addition, we have contractual commitments for salaries to our executive officers. In light of our financial commitments over the next several months and its liquidity constraints, we have implemented cost reduction measures in all areas of operations. We intend to review these measures on an ongoing basis and make additional decisions as may be required.

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Cash Flow

Net cash used in operating activities during the nine months ended March 31, 2014 amounted to $71,721 compared with $278,717 for the same period in fiscal 2013. Funding for the operating and investing activities was provided by $1,000,000 in advances from our distributor, and partially from cash reserves. For the first nine months of fiscal 2014, we paid approximately $272,000 in compensation, $250,000 in fixed operating costs, $150,000 in professional services fees, $63,000 in various insurance premiums, and $5,000 in interest payments, and other obligations, including consulting fees, of about $360,000. During the nine months ended March 31, 2013, the net cash used in operating activities was used largely to pay salary and related expenses, R&D, interest expense and professional fees such as attorneys, consultants and accountants.

Net cash used in investing activities during the nine months ended March 31, 2014 was relating to $18,512 in capitalized patents and $31,717 for property, plant, and equipment. During the same period ended March 31, 2013, we invested $28,153 into capitalized patents and $51,186 for property, plant, and equipment.

For the nine months of fiscal 2014, funding was provided by advances from Desmet of $1,000,000 and cash reserves. For the first three quarters of fiscal 2013, financing activities were funded by $1 million in advances against sales from Desmet along with $153,000 in convertible debt. With this funding, we repaid $55,000 in existing convertible debt, $350,000 of principal on the bank loan, and $53,000 in repayment of a convertible note payable as well as interest on various notes and $155,000 in short term loans. Net cash provided by financing activities during the nine months ended March 31, 2013 amounted to $540,000.

Not applicable for smaller reporting companies.

In accordance with rule 13a-15(a), CTi management must maintain disclosure controls and procedures as defined in Rule 13a-15(e) of the Securities and Exchange Act of 1934, or the Exchange Act, to provide reasonable assurance that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission rules and forms, and accumulated and communicated to the Company's management, including its principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure.

In accordance with Rule 13a-15(b) and (c), management must also evaluate the effectiveness of these disclosure control and procedures at the end of each fiscal year. As of March 31, 2014, the Company carried out an evaluation, under the supervision and with the participation of its principal executive officer and principal financial officer, of the effectiveness of the design and operation of the Company's disclosure controls and procedures. Based upon that evaluation, the Company's principal executive officer and principal financial officer concluded that these disclosure controls and procedures were not effective as of March 31, 2014.

There were no changes in internal control over financial reporting during the third quarter of fiscal 2014 that have materially affected or are reasonably likely to materially affect the company's internal control over financial reporting.

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PART II - OTHER INFORMATION

We know of no material, existing or pending legal proceeding against our Company, nor are we involved as a plaintiff in any material proceeding or pending litigation. There are no proceedings in which any of our directors, officers or affiliates, or any registered or beneficial shareholder, is an adverse party or has a material interest adverse to our interest.

None.

None

None

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Item 6 - EXHIBITS, FINANCIAL STATEMENT SCHEDULES

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SIGNATURES

Pursuant to the requirements of the securities Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

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