SCI Engineered Materials, Inc. - Annual Report: 2016 (Form 10-K)

Our Articles of Incorporation authorize us to issue additional shares of stock.

We are authorized to issue up to 15,000,000 shares of common stock, which may be issued by our board of directors for such consideration, as they may consider sufficient without seeking shareholder approval. As of December 31, 2016, we had 4,090,804 shares outstanding and 267,668 shares underlying options that are currently exercisable resulting in 10,641,528 shares of common stock available for issue. The issuance of additional shares of common stock in the future may reduce the proportionate ownership and voting power of current shareholders.

Our Articles of Incorporation authorize us to issue up to 260,000 shares of preferred stock. The issuance of preferred stock in the future could create additional securities which would have dividend and liquidation preferences prior to the outstanding shares of common stock. These provisions could also impede a non-negotiated change in control. As of December 31, 2016, we had 24,152 shares of Series B Preferred Stock issued and outstanding.

We have not paid dividends on our common stock in the past and do not expect to do so in the future.

We have never declared or paid cash dividends on our shares of common stock and do not expect to do so in the foreseeable future. We intend to retain future earnings for use in the business. As a result, investors must rely on sales of the common stock after price appreciation, which may not occur, as the only way to realize future gains on their investments.

Not applicable.

Our office and manufacturing facilities are located at 2839 Charter Street, Columbus, Ohio, where we occupy approximately 32,000 square feet. We moved our operations into this facility in 2004. The lease on the property expires on November 30, 2024.

We are current on all operating lease liabilities.

Not applicable.

Not applicable.

PART II

Market for Common Stock

Effective January 1, 2017, due to OTCQX rule changes, our common stock began trading on the OTC Markets’ OTCQB market under the symbol “SCIA”. Prior to this date our common stock traded on the OTC Markets’ OTCQX Market Tier under the same symbol.

The following table sets forth for the periods indicated the high and low bid quotations for our common stock.

The quotations provided herein may reflect inter-dealer prices without retail mark-up, markdown, or commissions, and may not represent actual transactions.

Based on its trading price, our common stock is considered a “penny stock” for purposes of federal securities laws, and therefore has been subject to certain regulations, which are summarized below.

Our common stock is classified as a penny stock and as such, broker dealers trading our common stock will be subject to the disclosure rules for transactions involving penny stocks, which require the broker dealer to determine if purchasing our common stock is suitable for a particular investor. The broker dealer must also obtain the written consent of purchasers to purchase our common stock. The broker dealer must also disclose the best bid and offer prices available for our stock and the price at which the broker dealer last purchased or sold our common stock. These additional burdens imposed on broker dealers may discourage them from effecting transactions in our common stock, which could make it difficult for an investor to sell their shares.

Holders of Record

As of December 31, 2016, there were approximately 270 holders of record of our common stock and 4,090,804 shares outstanding. At December 31, 2016 there were approximately 40 holders of Series B Preferred stock and 24,152 shares outstanding.

Dividends

We have never paid cash dividends on our common stock and do not expect to pay any dividends on our common stock in the foreseeable future. We intend to retain future earnings for use in the business.

Equity Compensation Plan Information

The following table sets forth additional information as of December 31, 2016, concerning shares of our common stock that may be issued upon the exercise of options and rights under our existing equity compensation plans and arrangements approved by our shareholders. The information includes the number of shares covered by and the weighted average exercise price of, outstanding options and other rights, and the number of shares remaining available for future grants (excluding the shares to be issued upon exercise of outstanding options and other rights).

Equity compensation plans approved by shareholders include our 2011 Stock Option Plan and 2006 Stock Option Plan.

Not applicable.

Executive Summary

For the year ended December 31, 2016, we had total revenue of $5,465,599. This was a decrease of $2,583,036, or 32.1%, compared to the year ended December 31, 2015. Revenue decreased primarily due to reductions on price and volume of a low margin commodity compared to last year as well as a major customer’s inventory adjustment. Also, volume was lower in our thin film solar market as orders continue to be cyclical.

We are encouraged by the resumption of global growth in the thin film solar market, especially increased production of copper indium gallium selenide-based products. These represent substantial growth opportunities for us as we continue to implement our thin film solar strategy. In addition, we are pursuing several opportunities in our traditional business, including new applications for which we anticipate customer orders.

Gross profit was $1,084,401 for the year ended December 31, 2016 compared to $1,969,822 for 2015. Gross profit as a percentage of revenue (gross margin) was 19.8% for 2016 compared to 24.5% for 2015.

Operating expenses were $1,745,361 and $2,062,421 for the twelve months ended December 31, 2016 and 2015, respectively. This was a decrease of $317,060, or 15.4%. We reclassified a portion of rent expense from operating expenses (general and administrative) to cost of goods sold to accurately reflect an amount assigned to the manufacturing area of our facility. This was retroactively reclassified beginning January 1, 2015.

We continue to invest in developing new products for all of our markets including transparent conductive oxide systems for the thin film solar and transparent electronics markets. We also have ongoing development efforts with our thin film battery materials and transparent electronic products. These efforts include accelerating time to market for those products and involve research and development expense.

RESULTS OF OPERATIONS

Year 2016 compared to Year 2015

Revenue

For the year ended December 31, 2016, we had total revenue of $5,465,599 compared to $8,048,635 for the year ended December 31, 2015. This was a decrease of $2,583,036, or 32.1%, compared to the year ended December 31, 2015. Revenue decreased primarily due to reductions on price and volume of a low margin commodity compared to last year as well as a major customer’s inventory adjustment. The average cost of this low margin raw material was lower by approximately 11% during 2016 compared to 2015. Pricing of this material has fluctuated widely during the past several years. Also, volume was lower in our thin film solar market as orders continue to be cyclical.

Revenue from product sales is recognized based on shipping terms or upon shipment to customers. Provisions for discounts and rework costs for returns are established when products are shipped based on historical experience. Customer deposits represent cash received in advance of revenue earned.

Gross Profit

Gross profit was $1,084,401 for the year ended December 31, 2016 compared to $1,969,822 for the year ended December 31, 2015. This was a decrease of $885,421, or 44.9%. The decrease in gross profit was attributed to lower revenue which, as discussed above, was primarily due to reductions on price and volume of a low margin commodity. Gross margin was 19.8% for 2016 compared to 24.5% for 2015. As previously mentioned, we reclassified a portion of rent expense from operating expenses (general and administrative) to cost of goods sold to accurately reflect an amount assigned to the manufacturing area of our facility. This was retroactively reclassified beginning January 1, 2015.

General and Administrative Expense

General and administrative expense for the twelve months ended December 31, 2016 decreased to $1,080,380 from $1,170,269 for the twelve months ended December 31, 2015, or 7.7%. The year of 2016 included lower travel expense of approximately $47,000, lower bad debt expense of approximately $11,000 and lower professional fees, business insurance and office expense of approximately $18,000.

Professional Fees

Included in general and administrative expense was $192,122 and $197,699 for the year ended December 31, 2016 and 2015, respectively. These continued expenses are primarily related to SEC compliance costs for legal, accounting and stockholder relations fees.

Research and Development Expense

Research and development expense for the year ended December 31, 2016 was $319,476 compared to $438,667 for the same period in 2015, a decrease of 27.2%. The decrease was primarily due to lower sponsored research of approximately $83,000, which began in 2014 and concluded early in the first quarter of 2016. In addition, patent related expense was lower by approximately $11,000. We had a collaborative program with a university to evaluate our TCO materials in liquid crystal display applications. We continue to invest in developing new products for all of our markets including transparent conductive oxide systems for applications in display and thin film solar markets. We also have ongoing development efforts with our thin film battery materials and transparent electronic products. These efforts include accelerating time to market for those products and involve ongoing research and development expense.

Marketing and Sales Expense

Marketing and sales expense was $345,505 and $453,485 for the twelve months ended December 31, 2016 and 2015, respectively. The decrease was approximately 23.8% and primarily related to lower stock compensation expense of approximately $41,000, consulting expense of approximately $28,000, compensation of approximately $27,000 and travel expenses of approximately $7,000. We restructured the sales department for improved efficiency late in 2016.

Stock Compensation Expense

Included in operating expenses were non-cash stock based compensation costs of $170,754 and $214,057 for the years ended December 31, 2016 and 2015, respectively. The decrease was due to the forfeiture of unvested stock options due to an employee departure during 2016. Compensation cost for all stock-based awards is based on the grant date fair value and recognized over the required service (vesting) period. Unrecognized non-cash stock based compensation expense related to operating expense was $134,694 as of December 31, 2016 and will be recognized through 2019.

Interest

Interest was $45,051 and $56,698 for the twelve months ended December 31, 2016 and 2015, respectively. The decrease was due to lower principal balances.

Loss Applicable to Common Stock

Loss applicable to common stock for the twelve months ended December 31, 2016 was $730,206 compared to $173,449 for the twelve months ended December 31, 2015. The decrease was due to lower revenue and gross profit.

Common Stock

The following schedule represents our outstanding common stock during the period of 2016 through 2024 assuming all outstanding stock options are exercised during the year of expiration. Based on outstanding shares at December 31, 2016, if each shareholder exercises his or her options, it would increase our common shares by 397,671 to 4,488,475 by December 31, 2024. Assuming all such options are exercised in the year of expiration, the effect on shares outstanding is illustrated as follows:

Liquidity and Capital Resources

Cash

As of December 31, 2016 cash on hand was $730,352. Cash on-hand was $997,170 at December 31, 2015. We believe, based on forecasted sales and expenses that cash flow from operations will be adequate to sustain operations at least through December 31, 2017.

Working Capital

At December 31, 2016 working capital was $531,654 compared to $1,010,517 at December 31, 2015, a decrease of $478,863 or 47.4%. As discussed below, cash decreased approximately $267,000. Accounts receivable decreased approximately $31,000. Inventories decreased approximately $197,000 due to shipments early in 2016 and customers altering the timing of purchase orders. Accounts payable decreased approximately $40,000. Customer deposits increased approximately $94,000 due to orders received and expected to ship during the first quarter of 2017. Current debt obligations decreased approximately $27,000.

Cash from Operations

Net cash provided by operating activities was approximately $161,000 for the year ended December 31, 2016 and approximately $503,000 for the year ended December 31, 2015. Included in expenses were non cash stock based compensation costs of approximately $173,000 and $216,000 for the year ended December 31, 2016 and 2015, respectively.

Cash from Investing Activities

Cash of approximately $88,000 was used in investing activities during the year ended December 31, 2016, compared to approximately $49,000 during the year ended December 31, 2015.

Cash from Financing Activities

Cash of approximately $344,000 and $444,000 was used in financing activities for principal payments to third parties for capital lease obligations and notes payable during the twelve months ended December 31, 2016 and 2015, respectively. During 2016, proceeds of $4,200 were received from the exercise of stock options. We paid $24,152 for cumulative dividends on preferred stock during 2015.

Debt Outstanding

Total debt outstanding decreased from approximately $930,000 at December 31, 2015, to approximately $741,000 at December 31, 2016, or 20.3%. Debt issuance costs of $19,665 at December 31, 2015, and $10,226 at December 31, 2016 are netted for financial statement presentation. During 2016 we incurred a new capital lease obligation of approximately $145,000. During January 2017 we closed on a new capital lease obligation of approximately $104,000.

Liquidity

We have forecasted revenues and related costs as well as investing plans and financing needs to determine liquidity to meet cash flow requirements and believe we will have sufficient liquidity at least through December 31, 2017.  This forecast was based on current cash levels and debt obligations, and the best estimates of revenues primarily from existing customers and gave consideration to the continued and possible increased levels of uncertainty in demand in the markets in which we operate.  Our ability to maintain current operations is dependent upon our ability to achieve these forecasted results, which we believe will occur. 

Critical Accounting Policies

The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States requires management to make judgments, assumptions and estimates that affect the amounts reported in the Financial Statements and accompanying notes. Note 2 to the Financial Statements in the Annual Report on Form 10-K for the year ended December 31, 2016 describes the significant accounting policies and methods used in the preparation of the Financial Statements. Estimates are used for, but not limited to, the accounting for the allowance for doubtful accounts, inventory allowances, property and equipment depreciable lives, patents and license useful lives, revenue recognition, tax valuation allowance, stock based compensation and assessing changes in which impairment of certain long-lived assets may occur. Actual results could differ from these estimates. The following critical accounting policies are impacted significantly by judgments, assumptions and estimates used in the preparation of the Financial Statements. The allowance for doubtful accounts is based on our assessment of the collectability of specific customer accounts and the aging of the accounts receivable. If there is a deterioration of a major customer’s credit worthiness or actual defaults are higher than our historical experience, our estimates of the recoverability of amounts due us could be adversely affected. Inventory purchases and commitments are based upon future demand forecasts. If there is a sudden and significant decrease in demand for our products or there is a higher risk of inventory obsolescence because of rapidly changing technology and customer requirements, we may be required to increase our inventory allowances and our gross profit could be adversely affected. Depreciable and useful lives estimated for property and equipment, licenses and patents are based on initial expectations of the period of time these assets and intangibles will provide benefit. Changes in circumstances related to a change in our business, change in technology or other factors could result in these assets becoming impaired, which could adversely affect the value of these assets.

Inflation

We believe there has not been a significant impact from inflation on our operations during the past three fiscal years.

Safe Harbor Statement under the Private Securities Litigation Reform Act of 1995

This document contains forward-looking statements that reflect the views of management with respect to future events and financial performance. These forward-looking statements are subject to certain uncertainties and other factors that could cause actual results to differ materially from such statements. See “Risk Factors” above. These uncertainties and other factors include, but are not limited to, the words “anticipates,” “believes,” “estimates,” “expects,” “plans,” “projects,” “targets” and similar expressions which identify forward-looking statements. You should not place undue reliance on these forward-looking statements, which speak only as of the date the statements were made. We undertake no obligation to publicly update or revise any forward-looking statements.

Not applicable

Our balance sheets as of December 31, 2016 and 2015, and the related statements of operations, shareholders’ equity and cash flows for the years ended December 31, 2016 and 2015, together with the Report of Independent Registered Public Accounting Firm thereon appear beginning on Page F-1.

Not applicable.

Evaluation of Disclosure Controls and Procedures

Our management, with the participation of the Company’s Principal Executive Officer and Principal Accounting Officer, has evaluated the effectiveness of the Company’s disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end of the period covered by this report. In designing and evaluating the disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can only provide reasonable assurance of achieving the desired control objectives and management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Due to a segregation of duties material weakness described below, and based on this evaluation, the Company’s Principal Executive Officer and Principal Accounting Officer have concluded that as of December 31, 2016, the Company’s disclosure controls and procedures were not effective, at the reasonable assurance level, in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act and in ensuring that information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the Company’s management, including the Principal Executive Officer and Principal Accounting Officer, as appropriate to allow timely discussions regarding required disclosure. Until we are able to hire additional employees, we will continue to report to the Audit Committee and the Board of Directors at least monthly (and more often as necessary). We believe this will continue to mitigate this weakness. This reporting includes balance sheets, statements of operations, statements of cash flows, and other detail supporting these statements. Accordingly, we believe that the financial statements included in this report fairly present, in all material respects, our financial condition, results of operations, changes in shareholder’s equity and cash flows for all periods presented.

Inherent Limitations Over Internal Controls

Our internal control over financial reporting is 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. Our internal control over financial reporting includes those policies and procedures that: (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of our assets; (ii) 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 are being made only in accordance with authorizations of management and directors; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of assets that could have a material effect on the financial statements.

Management, including our Chief Executive Officer and Chief Financial Officer, does not expect that our internal controls will prevent or detect all errors and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of internal controls can provide absolute assurance that all control issues and instances of fraud, if any, have been detected. Also, any evaluation of the effectiveness of controls in future periods are subject to the risk that those internal controls may become inadequate because of changes in business conditions, or that the degree of compliance with the policies or procedures may deteriorate.

Management's Annual Report on Internal Control over Financial Reporting

Our management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Rule 13a-15(f) under the Securities Exchange Act of 1934, as amended). Management conducted an evaluation of the effectiveness of our internal control over financial reporting based on the criteria established in the Internal Control – Integrated Framework (2013 Framework) issued by the Committee of Sponsoring Organizations of the Treadway Commission ("COSO"). Based on this evaluation, management has concluded that our internal control over financial reporting was not effective as of December 31, 2016. The matter involving internal controls over financial reporting that management considered to be a material weakness under the standards of the Public Company Accounting Oversight Board (“PCAOB”) was insufficient segregation of duties consistent with control objectives. Management is aware of the risks associated with the lack of segregation of duties due to the small number of employees currently working with general administrative and financial matters. Due to our size and nature, segregation of all conflicting duties may not always be possible and may not be economically feasible. However, to the extent possible, the initiation of transactions, the custody of assets and the recording of transactions should be performed by separate individuals.

In order to remediate this weakness, we will need to hire additional employees. Although we will periodically reevaluate this situation, at this point we consider that the risks associated with such lack of segregation of duties and the potential benefits of adding employees to segregate such duties are not cost justified. Until we are able to hire additional employees, we will continue to report to the Audit Committee and the Board of Directors at least monthly (and more often as necessary). We believe this will continue to mitigate this weakness. This reporting includes balance sheets, statements of operations, statements of cash flows, and other detail supporting these statements.

This annual report does not include an attestation report of our registered public accounting firm regarding internal control over financial reporting. Our report was not subject to attestation by our registered public accounting firm pursuant to rules of the Securities and Exchange Commission that permits us to provide only management’s report in this annual report.

Changes in Internal Control over Financial Reporting

There were no changes in the Company’s internal control over financial reporting (as such term is defined in Exchange Act Rule 13a-15(f) and Rule 15d-15(f)) that occurred in the last fiscal quarter that materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

None.

PART III

The information required by this item is included under the captions, “Election of Directors,” “Executive Officers” and “Section 16(a) Beneficial Ownership Reporting Compliance” in our proxy statement relating to our 2017 Annual Meeting of Shareholders scheduled to be held on June 8, 2017, and is incorporated herein by reference.

We have a Business Conduct Policy applicable to all employees of SCI. Additionally, the Chief Executive Officer ("CEO") and all senior financial officers, including the principal financial officer, the principal accounting officer or controller, or any person performing a similar function (collectively, the "Senior Financial Officers") are bound by the provisions of our code of ethics relating to ethical conduct, conflicts of interest, and compliance with the law. The code of ethics is posted on our website at http://www.sciengineeredmaterials.com/corporate-governance.

We intend to satisfy the disclosure requirement under Item 10 of Form 8-K regarding any amendment to, waiver of, any provision of this code of ethics by posting such information on our website at the address and location specified above.

The information required by this item is included under the caption “Executive Compensation” in our proxy statement relating to our 2017 Annual Meeting of Shareholders scheduled to be held on June 8, 2017, and is incorporated herein by reference.

The information required by this item is included under the captions “Ownership of Common Stock by Directors and Executive Officers” and “Ownership of Common Stock by Principal Shareholders” in our proxy statement relating to our 2017 Annual Meeting of Shareholders scheduled to be held on June 8, 2017, and is incorporated herein by reference.

The information required by this item is included under the caption “Certain Relationships and Related Transactions, and Director Independence” in our proxy statement relating to our 2017 Annual Meeting of Shareholders scheduled to be held on June 8, 2017, and is incorporated herein by reference.

The information required by this item is included under the caption “Fees of the Independent Public Accounting Firms for the year ended December 31, 2016” in our proxy statement relating to our 2017 Annual Meeting of Shareholders scheduled to be held on June 8, 2017, and is incorporated herein by reference.

_____________

* Filed herewith

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities indicated on the 27^h day of February 2017.

INDEX TO FINANCIAL STATEMENTS

Report of Independent Registered Public Accounting Firm

Board of Directors and Shareholders

SCI Engineered Materials, Inc.

Columbus, Ohio

We have audited the accompanying balance sheets of SCI Engineered Materials, Inc. (the “Company”) as of December 31, 2016 and 2015 and the related statements of operations, shareholders’ equity, and cash flows for the years then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements 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 audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinions.

In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2016 and 2015, and the results of its operations and its cash flows for the years then ended in conformity with U.S. generally accepted accounting principles.

Columbus, Ohio

February 27, 2017

PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

SCI ENGINEERED MATERIALS, INC.

BALANCE SHEETS

DECEMBER 31, 2016 AND 2015

ASSETS

The accompanying notes are an integral part of these financial statements.

SCI ENGINEERED MATERIALS, INC.

BALANCE SHEETS (continued)

DECEMBER 31, 2016 AND 2015

LIABILITIES AND SHAREHOLDERS' EQUITY

The accompanying notes are an integral part of these financial statements.

SCI ENGINEERED MATERIALS, INC.

STATEMENTS OF OPERATIONS

YEARS ENDED DECEMBER 31, 2016 AND 2015

The accompanying notes are an integral part of these financial statements.

SCI ENGINEERED MATERIALS, INC.

STATEMENTS OF SHAREHOLDERS' EQUITY

YEARS ENDED DECEMBER 31, 2016 AND 2015

The accompanying notes are an integral part of these financial statements.

SCI ENGINEERED MATERIALS, INC.

STATEMENTS OF CASH FLOWS

YEARS ENDED DECEMBER 31, 2016 AND 2015

The accompanying notes are an integral part of these financial statements.

SCI ENGINEERED MATERIALS, INC.

NOTES TO FINANCIAL STATEMENTS

SCI Engineered Materials, Inc. (“SCI”, “we” or the “Company”), formerly Superconductive Components, Inc., an Ohio corporation, was incorporated in 1987.  The Company operates in one segment as a global supplier and manufacturer of advanced materials for Physical Vapor Deposition (“PVD”) Thin Film Applications.  The Company is focused on specific markets within the PVD industry (Photonics, Thin Film Solar, Glass, Thin Film Battery and Transparent Electronics).  Substantially, all of the Company’s revenues are generated from customers with multi-national operations.  Through partnerships with end users and Original Equipment Manufacturers the Company develops innovative customized solutions enabling commercial success.

A.          Cash - The Company considers all highly liquid investments purchased with an original maturity of three months or less to be cash.

B.          Fair Value of Financial Instruments - The estimated fair value of amounts reported in the financial statements have been determined using available market information and valuation methodologies, as applicable (see Note 9).

C.          Concentrations of Credit Risk - The Company’s cash balances, which are at times in excess of federally insured levels, are maintained at a large regional bank and a global investment banking group, and are continually monitored to minimize the risk of loss. The Company grants credit to most customers, who are varied in terms of size, geographic location and financial strength. Customer balances are continually monitored to minimize the risk of loss.

The Company’s two largest customers accounted for 65% and 11% of total revenue in 2015. These two customers represented 40% of the accounts receivable trade balance at December 31, 2015. The Company subsequently collected all outstanding accounts receivables as of December 31, 2015 from these customers.

The Company’s two largest customers accounted for 53% and 12% of total revenue in 2016. These two customers represented 68% of the accounts receivable trade balance at December 31, 2016. The Company expects to collect all outstanding accounts receivables as of December 31, 2016 from these customers.

D.          Accounts Receivable - The Company extends unsecured credit to customers under normal trade agreements which require payment within 30 days. The Company does not charge interest on delinquent trade accounts receivable. Unless specified by the customer, payments are applied to the oldest unpaid invoice. Accounts receivable are presented at the amount billed.

Management estimates an allowance for doubtful accounts, which was approximately $15,000 and $26,000 as of December 31, 2016 and 2015, respectively. This estimate is based upon management’s review of delinquent accounts and an assessment of the Company’s historical evidence of collections. Specific accounts are charged directly to the reserve or bad debt expense when management obtains evidence of a customer’s insolvency or otherwise determines that the account is uncollectible. Bad debt expense was $0 and $11,318 during 2016 and 2015, respectively.

SCI ENGINEERED MATERIALS, INC.

NOTES TO FINANCIAL STATEMENTS

E.          Inventories - Inventories are stated at the lower of cost or market on an acquired or internally produced lot basis, and consist of raw materials, work-in-process and finished goods. Cost includes material, labor, freight and applied overhead. Inventory reserves are established for obsolete inventory, lower of cost or market, and excess inventory quantities based on management’s estimate of net realizable value. The Company had an inventory reserve of $67,640 and $55,270 at December 31, 2016, and, 2015, respectively.

F.          Property and Equipment - Property and equipment are carried at cost. Depreciation is provided using the straight-line method based on the estimated useful lives of the assets. Useful lives range from three years on computer equipment to sixteen years on certain equipment. Leasehold improvements are amortized over the shorter of the estimated useful life or the term of the lease. Depreciation expense totaled $445,891 and $441,154 for the years ended December 31, 2016 and 2015, respectively. Expenditures for renewals and betterments are capitalized and expenditures for repairs and maintenance are charged to operations as incurred.

Long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. If the fair value is less than the carrying amount of the asset, a loss is recognized for the difference. There was no property and equipment considered impaired during 2016 or 2015.

G.          Deferred Financing Costs - Deferred financing costs are amortized over the term of the related debt using the straight-line method, the result of which is not materially different from the use of the interest method.  Deferred financing costs were $10,226 and $19,665 at December 31, 2016 and 2015, respectively.  The related amortization of these costs for the years ended December 31, 2016 and 2015 was $9,439 and is included in interest expense on the statements of operations.

H.          Intangible Assets - The Company reviews intangible assets for impairment and performs detailed testing whenever impairment indicators are present. If necessary, an impairment loss is recorded for the excess of carrying value over fair value. As a result of this review, we recorded a non-cash patent impairment charge for the remaining book value for two patents of approximately $8,000 during 2015. There were no intangible assets considered impaired during 2016.

During 2015, the Board of Directors approved the acquisition of rights to a provisional patent owned by one of the directors, and any subsequent patents for this technology related to the application of Zinc based Transparent Conductive Oxide in displays, and the value thereof for 30,000 shares of common stock of the Company. The value of the shares of common stock at the time of acquisition was $30,540.

Costs incurred to secure patents have been capitalized and amortized over the life of the patents. Cost and accumulated amortization of the patents at December 31, 2016 and 2015 were $34,935 and $0, respectively. Amortization expense related to patents was $0 and $1,372 for the years ended December 31, 2016 and 2015, respectively. Amortization expense is expected to be $0 until the provisional patent acquired during 2015 is approved.

SCI ENGINEERED MATERIALS, INC.

NOTES TO FINANCIAL STATEMENTS

I.           Debt Issuance Costs - In April 2015, the FASB issued guidance creating ASC Subtopic 835-30, Interest—Imputation of Interest (Subtopic 835-30), Simplifying the Presentation of Debt Issuance Costs. The update modifies the presentation of costs of debt issuance as a direct reduction to the face amount of the related reported debt. At December 31, 2015, debt issuance costs of $19,665 were presented on a net basis against notes payable in the accompanying balance sheet. At December 31, 2016, debt issuance costs of $10,226 were presented on a net basis against notes payable in the accompanying balance sheet.

J.           Revenue Recognition - Revenue from product sales is recognized based on shipping terms and upon shipment to customers. Provisions for discounts and rework costs for returns are established when products are shipped based on historical experience. Customer deposits represent cash received in advance of revenue earned.

K.          Stock Based Compensation - Compensation cost for all stock-based awards is based on the grant date fair value and is recognized over the required service (vesting) period. Non cash stock based compensation expense was $172,685 and $215,988 for the years ended December 31, 2016 and 2015, respectively. Non cash stock based compensation expense includes $52,595 and $54,497 for stock grants awarded to the non-employee board members during 2016 and 2015, respectively. Unrecognized compensation expense was $140,165 as of December 31, 2016 and will be recognized through 2019. There was no tax benefit recorded for this compensation cost as the expense primarily relates to incentive stock options that do not qualify for a tax deduction until, and only if, a qualifying disposition occurs.

L.          Research and Development - Research and development costs are expensed as incurred. Research and development expense for the years ended December 31, 2016 and 2015 was $319,476 and $438,667, respectively. The Company continues to invest in developing new products for all of the Company’s markets including transparent conductive oxide systems within the thin film solar industry. The Company also has ongoing development efforts with its thin film battery materials and transparent electronic products. These efforts include accelerating time to market for those products and involve ongoing research & development expense.

M.         Income Taxes - Income taxes are provided for by utilizing the asset and liability method which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the carrying amounts and the tax bases of assets and liabilities using presently enacted tax rates. Deferred tax assets are reduced by a valuation allowance which is established when “it is more likely than not” that some portion or all of the deferred tax assets will not be recognized.

SCI ENGINEERED MATERIALS, INC.

NOTES TO FINANCIAL STATEMENTS

N.          Use of Estimates - The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management 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 amounts of revenues and expenses during the reporting period. Estimates are used for, but not limited to, the accounting for the allowance for doubtful accounts, inventory allowances, property and equipment depreciable lives, patents and licenses useful lives, revenue recognition, tax valuation, stock based compensation and assessing changes in which impairment of certain long-lived assets may occur. Actual results could differ from those estimates.

O.          New Accounting Pronouncements –

Revenue from Contracts with Customers – In May 2014, the Financial Accounting Standards Board (“FASB”) issued guidance creating Accounting Standards Codification (“ASC”) Section 606, Revenue from Contracts with Customers. The new section will replace Section 605, Revenue Recognition, and creates modifications to various other revenue accounting standards for specialized transactions and industries. The section is intended to conform revenue accounting principles to a concurrently issued International Financial Reporting Standards in order to reconcile previously differing treatment between United States practices and those of the rest of the world and enhance disclosures related to disaggregated revenue information. In August 2015, the FASB deferred the effective date of the new guidance by one year, such that the updated guidance is effective for annual reporting periods beginning after December 15, 2017, and interim periods within those fiscal years. Early adoption is permitted only as of annual reporting periods beginning after December 15, 2016, including interim periods within that reporting period. The Company will continue its study of the implications of this statement to evaluate the expected impact on its financial statements.

Inventory Measurement – In July 2015, FASB issued ASU 2015-11, Inventory (Topic 330) Related to Simplifying the Measurement of Inventory which applies to all inventory except inventory that is measured using last-in, first-out (LIFO) or the retail inventory method. Inventory measured using first-in, first-out (FIFO) or average cost is covered by the new amendments. Inventory within the scope of the new guidance should be measured at the lower of cost and net realizable value. Net realizable value is the estimated selling prices in the ordinary course of business, less reasonably predictable costs of completion, disposal, and transportation. Subsequent measurement is unchanged for inventory measured using LIFO or the retail inventory method. The amendments will take effect for public business entities for fiscal years beginning after December 15, 2016, including interim periods within those fiscal years. The new guidance should be applied prospectively, and earlier application is permitted as of the beginning of an interim or annual reporting period. The Company is evaluating the impact of the standard on the financial statements.

SCI ENGINEERED MATERIALS, INC.

NOTES TO FINANCIAL STATEMENTS

Inventories consist of the following at December 31:

During 2015 the Company removed certain slow moving inventory items recognizing a corresponding decrease in its inventory reserve and no net effect on total inventory.

On August 8, 2013, the Company issued a Promissory Note (the “Note”) in the amount of $128,257 to The Huntington National Bank, as Lender, with a maturity date of August 5, 2016. This Note replaced an existing promissory note to The Huntington National Bank.

The Note was collateralized by a blanket lien on all of the Company’s assets including, without limitation, inventory, equipment and accounts receivable. Among other items, the Note provided for the following:

The interest rate on the Note was 5% at December 31, 2015. The remaining outstanding balance of $19,047 was paid during April 2016.

During 2010, the Company applied and was approved for a 166 Direct Loan to borrow up to $744,250 with the Ohio Department of Development (ODOD), now known as the Ohio Development Services Agency (ODSA). This loan was finalized in February 2011. The term of the loan is 84 months at a fixed interest rate of 3%. There is also a 0.25% annual servicing fee charged monthly on the outstanding principal balance. On August 13, 2013, ODSA and the Company agreed to a modification to the payment schedule. Interest and servicing payments of $1,656 were paid monthly from August 2013 through January 2014. Currently, monthly payments of approximately $10,400, including principal, interest and servicing fee are due through October 2018. A final payment of approximately $71,900 is due November 2018. The loan is collateralized by the related project equipment. As of December 31, 2016 there was an outstanding balance of $289,227 on this loan.

SCI ENGINEERED MATERIALS, INC.

NOTES TO FINANCIAL STATEMENTS

Debt issuance costs of $4,152 are netted against this amount for presentation in the financial statements. This loan is also subject to certain covenants, including job creation and retention. On July 21, 2014, the Company and ODSA signed a second amendment relating to the job creation and retention. The Company expects to maintain compliance with all covenants of this loan through at least December 31, 2017.

During 2010, the Company also applied and was approved for a 166 Direct Loan through the Advanced Energy Program with the Ohio Air Quality Development Authority (OAQDA) to borrow up to approximately $1.4 million (this maximum commitment by the OAQDA was subsequently reduced to $368,906 on March 20, 2012). On December 20, 2013, OAQDA and the Company signed a Fourth Amendment to the Loan Documents and agreed to a modification to the payment schedule. Interest and servicing payments of $2,121 were payable quarterly from October 2013 through March 2014. Beginning in June 2014, quarterly payments of approximately $17,300, including principal, interest at 3% and servicing fees are due through December 2017. A final payment of approximately $50,400 is due February 2018. This loan is also subject to certain covenants, including job creation. Included in the above amendment is a waiver for the job creation commitment, due to market conditions, for the duration of the term of the Loan Agreement. On July 21, 2016, OAQDA and the Company signed a Fifth Amendment to the Loan Documents and agreed to the elimination of a financial covenant. The loan is collateralized by the related project equipment. As of December 31, 2016 there was an outstanding balance of $114,512 on this loan. Debt issuance costs of $6,074 are netted against this amount for presentation in the financial statements. The Company expects to maintain compliance with all covenants of this loan through at least December 31, 2017.

An Intercreditor Agreement exists as part of the above mentioned loans with agencies of the State of Ohio. The OAQDA and ODSA agree to shared lien and security interest through mutual covenants. These covenants include, but are not limited to, the creation of an agreed upon number of jobs, filing of quarterly and annual reports and various financial covenants.

During 2015, the Company made a final payment and paid a 166 Direct Loan in full. During 2006, the Company was approved for this 166 Direct Loan from the Ohio Department of Development, now known as the ODSA, in the amount of $400,000. These funds were received in July of 2008 and were used for the purchase of production equipment and to reduce the Company’s capital lease obligations on certain equipment. The term of the loan was 84 months at a fixed interest rate of 3%. There was also a 0.25% annual servicing fee charged monthly on the outstanding principal balance. The loan was collateralized by the related project equipment. On August 8, 2013, ODSA and the Company agreed to a modification to the payment schedule. Interest and servicing payments of approximately $400 were paid monthly from August 2013 through January 2014. Beginning in February 2014, monthly payments of approximately $6,100, including principal, interest and servicing fee were paid through July 2015. A final payment of approximately $42,200 was paid in August 2015.

SCI ENGINEERED MATERIALS, INC.

NOTES TO FINANCIAL STATEMENTS

The Company was in compliance with all covenants of these loans at December 31, 2016. It is possible that the Company may not be in compliance with all covenants in future periods. If non-compliance is possible the Company will seek a waiver or amendment. In the past the lenders have granted the Company a waiver or amendment when relief was sought.

Notes payable at December 31 is included in the accompanying balance sheets as follows:

Annual maturities of notes payable, for the next five years, are as follows:

The Company leases its facilities and certain office equipment under agreements classified as operating leases expiring at various dates through 2024. Rent expense, which includes various monthly rentals for the years ended December 31, 2016 and 2015 totaled $165,769 and $154,678, respectively. Future minimum lease payments at December 31, 2016 are as follows:

SCI ENGINEERED MATERIALS, INC.

NOTES TO FINANCIAL STATEMENTS

Capital

The Company also leases certain equipment under capital leases. Future minimum lease payments, by year, with the present value of such payments, as of December 31, 2016 are shown in the following table.

The equipment under capital lease at December 31 is included in the accompanying balance sheets as follows:

These assets are amortized over a period of ten years using the straight-line method and amortization is included in depreciation expense.

The capital leases are structured such that ownership of the leased asset reverts to the Company at the end of the lease term. Accordingly, leased assets are depreciated using the Company's normal depreciation methods and lives.  In 2016, ownership of certain assets were transferred to the Company in accordance with the terms of the leases and these assets have been excluded from the leased asset disclosure above.

SCI ENGINEERED MATERIALS, INC.

NOTES TO FINANCIAL STATEMENTS

Common Stock

During 2016, the non-employee board members received 69,296 shares of common stock of the Company with an aggregate value of $52,595. The increased shares were the result of an increase in number of shares granted on a quarterly basis. This was recorded as non-cash stock compensation expense in the financial statements.

During 2015, the non-employee board members received compensation of 51,110 shares of common stock of the Company. The stock had an aggregate value of $54,497 and was recorded as non-cash stock compensation expense in the financial statements.

During the second quarter 2015, the Board of Directors approved the acquisition of rights to a provisional patent owned by one of the directors, and any subsequent patents for this technology related to the application of Zinc based Transparent Conductive Oxide in displays, and the value thereof for 30,000 shares of common stock of the Company. The value of the shares of common stock at the time of acquisition was $30,540.

Preferred Stock

Shares of preferred stock authorized and outstanding at December 31, 2016 and 2015 were as follows:

In January 1996, the Company completed an offering of 70,000 shares of $10 stated value 1995 Series B 10% cumulative non-voting convertible preferred stock. The shares are convertible to common shares at the rate of $5.00 per share. At the Company’s option, the Series B shares are redeemable at 103% of the stated value plus the amount of any accrued and unpaid cash dividends.

There was 24,152 shares outstanding of Series B convertible preferred stock at December 31, 2016 and 2015. On December 7, 2016, the Board of Directors voted not to authorize the payment of a cash dividend on convertible preferred stock, Series B, to shareholders of record as of December 31, 2016. On December 9, 2015, the Board of Directors voted not to authorize the payment of a cash dividend on convertible preferred stock, Series B, to shareholders of record as of December 31, 2015.

SCI ENGINEERED MATERIALS, INC.

NOTES TO FINANCIAL STATEMENTS

The Company had accrued dividends of $241,520 and $217,368 at December 31, 2016 and 2015, respectively. These amounts were included in convertible preferred stock, Series B on the balance sheet at December 31, 2016 and 2015.

Earnings Per Share

Basic income (loss) per share is calculated as income available (loss attributable) to common shareholders divided by the weighted average of common shares outstanding. Diluted earnings per share is calculated as diluted income available (loss attributable) to common stockholders divided by the diluted weighted average number of common shares outstanding. Diluted weighted average number of common shares gives effect to all dilutive potential common shares outstanding during the period using the treasury stock method and convertible preferred stock using the if-converted method. Diluted earnings per share exclude all diluted potential shares if their effect is anti-dilutive. For the years ended December 31, 2016 and 2015, all convertible and preferred stock and common stock options listed in Note 7 were excluded from diluted earnings per share due to being out-of-the-money or anti-dilutive.

Following is a summary of employee and director outstanding stock options outstanding and preferred stock, Series B at December 31.

The following is provided to reconcile the earnings per share calculations:

On June 10, 2011, shareholders approved the SCI Engineered Materials, Inc. 2011 Stock Incentive Plan (the “2011 Plan”). The Company adopted the 2011 Plan as incentive to key employees, directors and consultants under which options to purchase up to 250,000 shares of the Company’s common stock may be granted, subject to the execution of stock option agreements. Incentive stock options may be granted to key employees of the Company and non-statutory options may be granted to directors who are not employees and to consultants and advisors who render services to the Company. Options may be exercised for periods up to 10 years from the date of grant at prices not less than 100% of fair market value on the date of grant. As of December 31, 2016 there were no stock options outstanding from the 2011 Plan.

SCI ENGINEERED MATERIALS, INC.

NOTES TO FINANCIAL STATEMENTS

On June 9, 2006, shareholders approved the Superconductive Components, Inc. 2006 Stock Incentive Plan. The Company adopted the 2006 Plan as incentive to key employees, directors and consultants under which options to purchase up to 600,000 shares of the Company’s common stock may be granted, subject to the execution of stock option agreements. Incentive stock options may be granted to key employees of the Company and non-statutory options may be granted to directors who are not employees and to consultants and advisors who render services to the Company. Options may be exercised for periods up to 10 years from the date of grant at prices not less than 100% of fair market value on the date of grant. As of December 31, 2016 there were 397,671 stock options outstanding from the 2006 Plan which expire at various dates through November 2024.

The cumulative status at December 31, 2016 and 2015 of options granted and outstanding, as well as options which became exercisable in connection with the Stock Option Plans is summarized as follows:

Employee Stock Options

SCI ENGINEERED MATERIALS, INC.

NOTES TO FINANCIAL STATEMENTS

Non-Employee Director Stock Options

There were no options exercisable at December 31, 2016 and 2015.

Information related to the weighted average fair value of nonvested stock options for the year ended December 31, 2016 is as follows:

Exercise prices range from $0.84 to $6.00 for options at December 31, 2016. The weighted average option price for all options outstanding was $4.27 with a weighted average remaining contractual life of 4.6 years at December 31, 2015. The weighted average option price for all options outstanding was $4.39 with a weighted average remaining contractual life of 3.8 years at December 31, 2016.

SCI ENGINEERED MATERIALS, INC.

NOTES TO FINANCIAL STATEMENTS

Deferred tax assets and liabilities result from temporary differences in the recognition of income and expense for tax and financial reporting purposes. Significant components of the Company’s deferred tax assets and liabilities are as follows at December 31.

A valuation allowance has been recorded against the realizability of the net deferred tax asset such that no value is recorded for the asset in the accompanying financial statements. The valuation allowance totaled $1,932,000 and $1,743,000 at December 31, 2016 and 2015, respectively.

The Company has net operating loss carryforwards available for federal and state tax purposes of approximately $5,200,000 and $4,700,000 at December 31, 2016 and 2015, respectively, which expire in varying amounts through 2036.

For the years ended December 31, 2016 and 2015, a reconciliation of the statutory rate and effective rate for the provisions for income taxes consists of the following:

SCI ENGINEERED MATERIALS, INC.

NOTES TO FINANCIAL STATEMENTS

Components of the income tax provision are as follows:

The Company follows guidance issued by the Financial Accounting Standards Board (“FASB ASC 740”) with respect to accounting for uncertainty in income taxes.  A tax position is recognized as a benefit only if it is “more-likely-than-not” that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur.  The amount recognized is the largest amount of tax benefit that is greater than fifty percent likely of being realized on examination.  For tax positions not meeting the “more-likely-than-not” test, no tax benefit is recorded.

The Company has no unrecognized tax benefits under guidance related to tax uncertainties. The Company does not anticipate the unrecognized tax benefits will significantly change in the next twelve months. Any tax penalties or interest expense will be recognized in income tax expense. No interest and penalties related to unrecognized tax benefits were accrued at December 31, 2016 and 2015.

The Company files income tax returns in the U.S. federal jurisdiction and various state and local jurisdictions. The Company is open to federal and state tax audits until the applicable statute of limitations expire. There are currently no federal or state income tax examinations underway for the Company. The tax years 2013 through 2016 remain open to examination by the major taxing jurisdictions in which the Company operates.

The fair value of financial instruments represents the price that would be received to sell an asset or paid to transfer a liability (an exit price), and not the price that would be paid to acquire an asset or received to assume a liability (an entry price). Significant differences can arise between the fair value and carrying amount of financial instruments that are recognized at historical cost amounts.

The following methods and assumptions were used by the Company in estimating fair value disclosures for financial instruments:

SCI ENGINEERED MATERIALS, INC.

NOTES TO FINANCIAL STATEMENTS

Included in machinery and equipment is various production equipment, which per the Company’s building lease, is required to be removed upon termination of the related lease. Included in accrued expenses in the accompanying balance sheet is the asset retirement obligation that represents the expected present value of the liability to remove this equipment. There are no assets that are legally restricted for purposes of settling this asset retirement obligation.

Following is a reconciliation of the aggregate retirement liability associated with the Company’s obligation to dismantle and remove the machinery and equipment associated with its lease:

Management has forecasted revenues and related costs as well as investing plans and financing needs to determine liquidity to meet cash flow requirements and believes the Company will have sufficient liquidity at least through December 31, 2017.  This forecast was based on current cash levels and debt obligations, and the best estimates of revenues primarily from existing customers and gave consideration to the continued and possible increased levels of uncertainty in demand in the markets in which the Company operates.  The Company’s ability to maintain current operations is dependent upon its ability to achieve these forecasted results, which the Company believes will occur. 

During January 2017, the Company entered into a capital lease agreement in the amount of $103,550 for the rebuild of production equipment. This lease includes a term of 60 months and an interest rate of 6.2%.