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CTI GROUP HOLDINGS INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations.(Edgar Glimpses Via Acquire Media NewsEdge) Overview The Company is comprised of four business segments: Electronic Invoice Management ("EIM"), Telemanagment ("Telemanagement"), Voice Over Internet Protocol ("VoIP") and Patent Enforcement Activities ("Patent Enforcement"). EIM designs, develops and provides services and software tools that enable telecommunication service providers to better meet the needs of their enterprise customers. EIM software and services are provided and sold directly to telecommunication service providers who then market and distribute such software to their enterprise customers. Using the Company's software and services, telecommunication service providers are able to electronically invoice their enterprise customers in a form and format that enables the enterprise customers to improve their ability to analyze, allocate and manage telecommunications expenses while driving internal efficiencies into their invoice receipt, validation, approval and payment workflow processes. Telemanagement designs, develops and provides software and services used by enterprise, governmental and institutional end users to manage their telecommunications service and equipment usage. VoIP designs, develops and provides software and services that enable managed and hosted customers of service providers to analyze voice, video, and data usage, record and monitor communications, and perform administration and back office functions such as cost allocation or client bill back. These applications are commonly available in the market as enterprise-grade products. Customers typically purchase the VoIP products when upgrading or acquiring a new enterprise communications platform. Patent Enforcement involves the licensing, protection, enforcement and defense of the Company's intellectual property and rights. The Company realizes patent license fee and enforcement revenues. These revenues are realized once the Company has received a signed settlement or judgment and the collection of the receivable is deemed probable. The Company generates its revenues and cash from several sources: software sales, license fees, processing fees, implementation fees, training and consulting services, and enforcement revenues. The Company's software products and services are subject to changing technology and evolving customer needs which require the Company to continually invest in research and development in order to respond to such demands. The limited financial resources available to the Company require the Company to concentrate on those business segments and product lines which the Company believes will provide the greatest returns on investment. The EIM segment, as compared to the other business segments, provides the predominant share of income from operations and cash flow from operations. The majority of Telemanagement segment revenues are derived from its United Kingdom operations. The Company reported revenue in the EIM segment of $4.9 million and $4.8 million for the six months ended June 30, 2011 and 2010, respectively, and $2.3 million and $2.1 million for the three months ended June 30, 2011 and 2010, respectively. For the Telemanagement segment, the Company recorded revenues of $2.6 million and $2.4 million for the six months ended June 30, 2011 and 2010, respectively, and $1.2 million and $1.3 million for the three months ended June 30, 2011 and 2010, respectively. The VoIP segment recorded revenue of approximately $707,000 and $318,000 for the six months ended June 30, 2011 and 2010, respectively, and $461,000 and $198,000 for the three months ended June 30, 2011 and 2010, respectively. The Patent Enforcement segment recorded revenue of $0 and $40,500 for the six months ended June 30, 2011 and 2010 and no revenue for the three months ended June 30, 2011 and 2010. The Company believes that as voice and data services continue to commoditize, service providers will seek alternative business models to replace revenue lost as a result of pricing pressures. One such business model is the delivery of managed or hosted voice and video services. Traditionally, organizations that required advanced voice and video services would purchase enabling communications hardware and software, operate and maintain this equipment, and depreciate the associated capital expense over time. This approach had two major disadvantages for such organizations. The first being that organizations would experience significant capital and operational expenditures related to acquiring these advanced services. The second being that the capabilities of the acquired equipment would not materially improve as voice and video service technology evolved. Service providers recognized these challenges and began, as part of their next generation network ("NGN") strategies, to deliver managed and hosted service offerings that do not require the customer to purchase expensive equipment up-front and virtually eliminate the operational expenditures associated with managing and maintaining an enterprise-grade communications network. Service providers incrementally improve revenue by enabling competitive voice and video features while reducing costs by delivering these services on high-capacity, low-cost NGNs. Due to the profitability and average revenue per user advantage possible by delivering such managed and hosted service offerings, providers not only look at acquiring new customers but converting legacy customers onto the NGN platform. The Company believes that this conversion process is significant. Many legacy features and functions are not available on NGN platforms, primarily due to the immaturity of the service delivery model. 16-------------------------------------------------------------------------------- Table of Contents The Company's VoIP applications will help eliminate customer resistance to conversion to next generation platforms, while creating new revenue opportunities for service providers through the delivery of compelling value added services. In 2007, the Company marketed two applications, emPulse, a web-based communications traffic analysis solution, and SmartRecord® IP, which enable service providers to selectively intercept communications on behalf of their hosted and managed service customers. These applications also enable managed and hosted service customers of service providers to analyze voice, video, and data usage, record and monitor communications, and perform administration and back office functions such as cost allocation or client bill back. These applications were released as enterprise-grade products. The Company anticipates that customers will purchase these products when upgrading or acquiring a new enterprise communications platform. The Company has taken the business benefits of these enterprise-grade applications and has delivered provider-grade managed and hosted service applications, enabling service providers to create a new recurring revenue stream, while ensuring that enterprise customers have the tools necessary and relevant to their particular line of business or vertical. Financial Condition In the six months ended June 30, 2011, the stockholders' equity decreased $629,640 from $5,230,794 as of December 31, 2010 to $4,601,154 as of June 30, 2011 primarily as a result of the three months ended June 30, 2011 net loss of $624,214. The Company realized an increase in net current assets (current assets less current liabilities) of approximately $2,609,105 which was primarily attributable to a large sale in the six months ended June 30, 2011. At June 30, 2011, cash and cash equivalents were $4,652,545 compared to $680,046 at December 31, 2010, and such increase was primarily attributable to cash provided by operating activities offset by cash used in investing and financing activities. Cash provided by operating activities in the six months ended June 30, 2011 amounted to $6,494,015 which was primarily related a large sale that was recorded as deferred revenue and depreciation and amortization of $947,341 partially off-set by the net operating loss of $(624,214). Cash used in financing activities related to a repayment of all debt of $1,330,016. Cash utilized in investing activities of $1,161,041 related to additions to property, equipment which was primarily related to the aforementioned large sale that was recorded in deferred revenue. The Company generates approximately 76% of its revenues from operations in the United Kingdom where the functional currency, the UK pound, has improved by 3.2% in relation to the US dollar during the six month period ended June 30, 2011 when compared to December 31, 2010. In October 2010, in order to supplement the Company's liquidity, Fairford advanced to the Company $500,000. Subsequent to the advancement, the Company issued to Fairford a demand note, in the aggregate principal amount of $500,000 bearing interest at LIBOR plus 4%. The demand note had no term and was due on demand. Principal and interest outstanding under the Company's revolving loan facility matured on December 30, 2010. The revolving loan facility, however, allowed for repayment to be made within ten days of the maturity date before a default in debt would be declared. Outstanding principal under the revolving loan facility amounted to $825,000 on December 30, 2010. On January 3, 2011, in order to supplement the Company's liquidity which enabled the Company to repay the revolving loan facility with PNC, Fairford advanced to the Company $825,000. On January 20, 2011, the board of directors approved the terms of Fairford's advancement and the form of demand note. Subsequent to the advancement and approval by the board of directors, the Company issued to Fairford a demand note, in the aggregate principal amount of $825,000 bearing interest at LIBOR plus 4%. The demand note had no term and was due on demand. The advances from Fairford of $1,325,000 documented in the form of two demand promissory notes were repaid and cancelled on May 10, 2011. Accumulated interest paid under the promissory notes amounted to $23,919. In March 2011, the Company received a purchase order for EIM licenses in the UK totaling approximately $6 million and received payment of approximately $7 million in May 2011, which includes VAT tax remittance. The EIM license agreement expands services provided to an existing customer and the revenue will be recognized over the term of the three-year license and service agreement. The license agreement does contain a termination clause which enables the customer to cancel the agreement after two years of service and return 80% of the unearned prepaid license fee. The maximum prepaid fee which could be claimed would be approximately $1.5 million. The Company believes that this source of liquidity along with the cash on hand, and anticipated increased cash generated from future operating activities will be sufficient to support its operations over the next twelve months 17 -------------------------------------------------------------------------------- Table of Contents Results of Operations (Six Months Ended June 30, 2011 Compared to Six Months Ended June 30, 2010) Revenues Revenues from operations for the six months ended June 30, 2011 increased $598,867, or 8.0%, to $8,116,956 as compared to $7,518,089 for the six months ended June 30, 2010. Revenues derived from the U.K. operations represent 76.3% and 69.8% of total revenues for the six months ended June 30, 2011 and 2011, respectively. The U.K. revenues increased by $942,585, or 17.8%, to $6,189,692 for the six months ended June 30, 2011 compared to $5,287,607 for the six months ended June 30, 2010. The increase in U.K. revenue was primarily due to the increase in demand in the EIM, VoIP, and Telemanagement segments. The U.S. revenues decreased by $343,718, or 15.1%, to $1,927,264 for the six months ended June 30, 2011 compared to $2,270,982 for the six months ended June 30, 2010. The decrease in U.S. revenues was primarily related to a decrease in the revenue recognized in the US EIM segment. The Company earns a substantial portion of its revenue from a single EIM customer. This customer represented 12.2% of the total revenues for the six months ended June 30, 2011 and 16.6% for the six months ended June 30, 2010. The Company believes that the portion of revenue from the single largest EIM customer will continue to decline due to the erosion of the customer's customer base. Cost of Products and Services Excluding Depreciation and Amortization Cost of products and services, excluding depreciation and amortization, for the six months ended June 30, 2011, increased $28,678, or 1.2%, to $2,374,002 as compared to $2,345,324 for the six months ended June 30, 2010. The increase was primarily related to an increase in revenue. The cost of products and services, excluding depreciation and amortization, was 29.2% of revenue for the six months ended June 30, 2011 as compared to 31.4% of revenue for the six months ended June 30, 2010. The decrease in percentage of cost of products and services was due to a slight decrease in costs and corresponding 8% increase in revenues. Patent License Fee and Enforcement Cost Patent license fee and enforcement cost for the six months ended June 30, 2011 decreased by $68,909, or 649.9%, to a credit of $58,306 as compared to $10,603 for the six months ended June 30, 2010. The decrease was primarily due to an adjustment to the estimated legal acrrual being recognized in the six months ended June 30, 2011 and decreased professional fees associated with cost absorption of certain out-of-pocket expenses by the Company's attorneys in connection with certain patent enforcement activities. Selling, General and Administrative Costs Selling, general and administrative expenses for the six months ended June 30, 2011 increased $259,554, or 6.9%, to $4,001,874 compared to $3,742,320 for the six months ended June 30, 2010. The increase in Selling, general and administrative expenses was primarily due to increased selling costs related to a increase in revenue. Research and Development Expense Research and development expense for the six months ended June 30, 2011 increased $85,900, or 7.0%, to $1,312,487 as compared to $1,226,587 for the six months ended June 30, 2010. The increase was primarily due to a decrease in research and development being capitalized in the six months ended June 30, 2011. Research and development costs that were capitalized during the six months ended June, 2011 and June 30, 2010 amounted to $322,973 and $440,507, respectively. Depreciation and Amortization Depreciation and amortization for the six months ended June 30, 2011 increased $151,231, or 19.0%, to $947,341 from $796,110 in the six months ended June 30, 2010. The increase was primarily associated with depreciation and amortization of fixed assets acquired and software capitalized in 2010. Amortization expense of developed software amounted to $415,922 and $307,573 for the six months ended June 30, 2011 and 2010, respectively. Amortization expense of developed software, which relates to cost of sales, was presented as depreciation and amortization expense. Other Income and Expense Net interest expense decreased $21,863, or 52.5%, to $19,786 for the six months ended June 30, 2011 compared to $41,649 for the six months ended June 30, 2010. The Company repaid all notes payable in the six months ended June 30, 2011. 18-------------------------------------------------------------------------------- Table of Contents The Company realized a loss on disposal of equipment of $0 for the six months ended June 30, 2011 and an income from disposal of equipment of $51 for the six months ended June 30, 2010. Taxes The Company records a valuation allowance against its net deferred tax asset to the extent management believes that it is more likely than not that the asset will not be realized. As of June 30, 2011, the Company's valuation allowance related only to the net deferred tax assets in the United States. The tax expense for the six months ended June 30, 2011 and June 30, 2010 of $143,986 and $26,095, respectively, was due to the pre-tax loss in the United Kingdom of $311,349 for the six months ended June 30, 2011 and a pretax income of $174,295 for the six months ended June 30, 2010. Net Loss Net loss decreased $46,436 to $624,214 for the six months ended June 30, 2011 compared to a net loss of $670,650 for the six months ended June 30, 2010. The decrease in net loss was primarily associated with the decrease in patent enforcement costs and an increase in revenue. Results of Operations (Three Months Ended June 30, 2011 Compared to Three Months Ended June 30, 2010) Revenues Revenues from operations for the three months ended June 30, 2011 increased $422,558, or 11.8%, to $4,000,590 as compared to $3,578,032 for the three months ended June 30, 2010. Revenues derived from the U.K. operations represent 74.6% and 65.5% of total revenues for the three months ended June 30, 2011 and 2010, respectively. The U.K. revenues increased by $683,773 or 27.2 %, to $2,983,364 for the three months ended June 30, 2011 compared to $2,344,591 for the three months ended June 30, 2010. The increase in U.K. revenue was primarily due to the increase in demand in the EIM, VoIP, and Telemanagement segments. The U.S. revenues decreased by $216,215, or 17.5%, to $1,017,226 for the three months ended June 30, 2011 compared to $1,233,441 for the three months ended June 30, 2010. The decrease in U.S. revenues was primarily related to a decrease in the revenue recognized in the U.S. EIM segment. The Company earns a substantial portion of its revenue from a single EIM customer. This customer represented 12.2% of the total revenues for the three months ended June 30, 2011 and 17.3% for the three months ended June 30, 2010. The Company believes that the portion of revenue from the single largest EIM customer will continue to decline due to the erosion of the customer's customer base. Cost of Products and Services Excluding Depreciation and Amortization Cost of products and services, excluding depreciation and amortization, for the three months ended June 30, 2011, decreased $80,144, or 7.0%, to $1,063,016 as compared to $1,143,160 for the three months ended June 30, 2010. The decrease in cost was primarily due to a decrease in outsourced development. The cost of products and services, excluding depreciation and amortization, was 26.6% of revenue for the three months ended June 30, 2011 as compared to 31.9% of revenue for the three months ended June 30, 2010. The decrease in percentage of cost of products and services was due to a decrease in costs and corresponding 11.8% increase in revenues. Patent License Fee and Enforcement Cost Patent license fee and enforcement cost for the three months ended June 30, 2011 decreased by $7,614, or 14.9%, to a credit of $58,688 as compared to a credit of $51,074 for the three months ended June 30, 2010. The decrease was primarily due to an adjustment to the estimated legal accrual being recognized in the three months ended June 30, 2011 and decreased professional fees associated with cost absorption of certain out-of-pocket expenses by the Company's attorneys in connection with certain patent enforcement activities. Selling, General and Administrative Costs Selling, general and administrative expenses for the three months ended June 30, 2011 increased $108,503, or 5.8%, to $1,969,685 compared to $1,861,182 for the three months ended June 30, 2010. The increase in Selling, general and administrative expenses was primarily due to increased selling costs related to the increase in revenue. Research and Development Expense Research and development expense for the three months ended June 30, 2011 increased $18,710, or 2.7%, to $699,379 as compared to $680,669 for the three months ended June 30, 2010. Research and development costs that were capitalized during the three months ended June 30, 2011 and June 30, 2010 amounted to $10,259 and $145,678, respectively. 19-------------------------------------------------------------------------------- Table of Contents Depreciation and Amortization Depreciation and amortization for the three months ended June 30, 2011 increased $105,252, or 26.5%, to $502,692 from $397,440 in the three months ended June 30, 2010. The increase was primarily associated with depreciation and amortization of fixed assets acquired and software capitalized in 2010. Amortization expense of developed software amounted to $214,502 and $144,014 for the three months ended June 30, 2011 and 2010, respectively. Amortization expense of developed software, which relates to cost of sales, was presented as depreciation and amortization expense. Other Income and Expense Interest expense decreased $16,950, or 76.5%, to $5,202 for the three months ended June 30, 2011 compared to $22,152 for the three months ended June 30, 2010. The decrease in interest expense was primarily due to the Company paying all notes payable in the three months ended June 30, 2011. Taxes The Company records a valuation allowance against its net deferred tax asset to the extent management believes that it is more likely than not that the asset will not be realized. As of June 30, 2011, the Company's valuation allowance related to the net deferred tax assets in the United States. The tax (benefit) / expense for the three months ended June 30, 2011 and June 30, 2010 of $101,002 and $(27,978), respectively, was due to the pre-tax (loss) / income in the United Kingdom of $284,469 and $(228,368), respectively. Net Loss Net loss decreased $165,821 to $281,698 for the three months ended June 30, 2011 compared to a net loss of $447,519 for the three months ended June 30, 2010. The decrease in net loss was primarily associated with the decreased patent enforcement costs and the increase in revenue. Liquidity and Capital Resources Historically, the Company's principal needs for funds have been for operating activities (including costs of products and services, patent enforcement activities, selling, general and administrative expenses, research and development, and working capital needs) and capital expenditures, including software development. Cash flows from operations and existing cash and cash equivalents have been adequate to meet the Company's business objectives. Cash and cash equivalents, increased $3,972,499 to $4,652,545 as of June 30, 2011 compared to $680,046 as of December 31, 2010. The increase in cash, cash equivalents, and short-term investments during the six months ended June 30, 2011 was predominately related to cash provided by operating activities which amounted to $6,494,015, primarily related a large sale that was recorded as deferred revenue and depreciation and amortization of $947,341 partially off-set by the net operating loss of $624,214. The deferred revenue relates to a prepaid order of approximately $6 million in May 2011. Cash spent on property, equipment, and software of $1,161,041 and cash used in financing activities of $1,330,016 partially offset the cash provided by operating activities. The effect of foreign currency exchange rates on cash and cash equivalents was a loss of $30,459. Cash is generated from (or utilized in) the income/(loss) from operations for each segment (see Note 11 to the Consolidated Financial Statements (unaudited) of Part I, Item 1 of this Form 10-Q). The EIM, Telemanagement, VoIP, and Patent Enforcement segments represented income / (loss) from operations for the six months ended June 30, 2011 of $620,189, $388,948, $(980,837) and $58,306, respectively. The Corporate Allocation expense generated an operating loss of $(547,048) for the six months ended June 30, 2011. The United States location generated a loss from operations for the six months ended June 30, 2011 of $(772,708) which was primarily associated with losses generated in the VoIP segment and the Corporate Allocations expense. The United Kingdom location generated an income from operations for the same period of $312,266. For the six months ended June 30, 2010, the EIM, Telemanagement, VoIP, and Patent Enforcement segments represented income / (loss) from operations for the six months ended June 30, 2010 of $842,025, $261,836, $(1,218,765) and $29,544, respectively. The Corporate Allocation expense generated an operating loss of $(517,495) for the six months ended June 30, 2010. The United States location generated a loss from operations for the six months ended June 30, 2010 of $(428,182) which was primarily associated with losses generated in the VoIP segment and the Corporate Allocations expense. The United Kingdom location generated a loss from operations for the same period of $(174,673). 20-------------------------------------------------------------------------------- Table of Contents The Company had available a revolving loan with PNC Bank ("PNC"). The revolving loan expired on December 30, 2010. The loan agreement allowed for repayment to be made within ten days of the maturity date before a default in debt would be declared. Outstanding principal under the Loan Agreement amounted to $825,000 on December 30, 2010. On January 3, 2011, in order to supplement the Company's liquidity which enabled the Company to repay the revolving loan facility with PNC, Fairford Holdings Limited, a British Virgin Islands company ("Fairford") advanced $825,000 to the Company. As of June 30, 2011, Fairford beneficially owned 63.7% of the Company's outstanding Class A common stock. On January 20, 2011, the board of directors approved the terms of Fairford's advancement and the form of demand note. Subsequent to the advancement and approval by the board of directors, the Company issued to Fairford a demand note, in the aggregate principal amount of $825,000 bearing interest at LIBOR plus 4%. The demand note had no term and was due on demand. In October 2010, in order to supplement the Company's liquidity, Fairford advanced $500,000 to the Company. Subsequent to the advancement, the Company issued to Fairford a demand note, in the aggregate principal amount of $500,000 bearing interest at LIBOR plus 4%. The demand note had no term and was due on demand. In March 2011, the Company received a purchase order for EIM licenses in the UK totaling approximately $6 million and received payment of approximately $7 million in May 2011, which includes VAT tax remittance. The EIM license agreement expands services provided to an existing customer and the revenue will be recognized over the term of the three-year license and service agreement. The license agreement does contain a termination clause which enables the customer to cancel the agreement after two years of service and return 80% of the unearned prepaid license fee. The maximum prepaid fee which could be claimed would be approximately $1.5 million. The Company believes that this source of liquidity along with the cash on hand, and anticipated increased cash generated from future operating activities will be sufficient to support its operations over the next twelve months. The advances from Fairford of $1,325,000 documented in the form of two demand promissory notes were repaid and cancelled in May 2011. Accumulated interest under the promissory notes amounted to $23,919. Off-Balance Sheet Arrangements The Company has no material off-balance sheet arrangements. Critical Accounting Policies and Estimates The discussion and analysis of the Company's financial condition and results of operations are based upon the Company's consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, the Company evaluates its estimates, including those related to revenue recognition, bad debts, depreciation and amortization, investments, income taxes, capitalized software, goodwill, restructuring costs, accrued compensation, contingencies and litigation. The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. The Company believes the following critical accounting policies affect the more significant judgments and estimates used in the preparation of the consolidated financial statements. For the description of other critical accounting policies used by the Company, see Item 8. "Financial Statements and Supplementary Date - Notes to Consolidated Financial Statements - Note 1" in the Company's Annual Report on Form 10-K for the year ended December 31, 2010. Income Taxes. The Company is required to estimate its income taxes. This process involves estimating the Company's actual current tax obligations together with assessing differences resulting from different treatment of items for tax and accounting purposes which result in deferred income tax assets and liabilities. The Company accounts for income taxes using the liability method. Under the liability method, a deferred tax asset or liability is determined based on the difference between the financial statement and tax bases of assets and liabilities, as measured by the enacted tax rates assumed to be in effect when these differences are expected to reverse. 21-------------------------------------------------------------------------------- Table of Contents The Company's deferred tax assets are assessed for each reporting period as to whether it is more likely than not that they will be recovered from future taxable income, including assumptions regarding on-going tax planning strategies. To the extent the Company believes that recovery is uncertain, the Company has established a valuation allowance for assets not expected to be recovered. Changes to the valuation allowance are included as an expense or benefit within the tax provision in the statement of operations. As of June 30, 2011, the Company's valuation allowance related only to net deferred tax assets in the United States. As a result, the Company's tax expense relates to the UK operations and the Company does not anticipate recording significant tax charges or benefits related to operating gains or losses for the Company's US operations. The Company recognizes a tax position 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 50% likely of being realized on examination. For tax positions not meeting the "more likely than not" test, no tax benefit is recorded. The Company and its subsidiaries are subject to U.S. federal income tax as well as income tax of the state of Indiana and foreign income tax in the United Kingdom. The Company does not expect the total amount of unrecognized tax benefits to significantly increase in the next twelve months. The Company recognizes interest and/or penalties related to income tax matters in income tax expense. The Company did not have any amounts accrued for interest and penalties at June 30, 2011. The Company's tax filings are subject periodically to regulatory review and audit. Research and Development and Software Development Costs. Research and development costs are charged to operations as incurred. Software Development Costs are considered for capitalization when technological feasibility is established. The Company bases its determination of when technological feasibility is established based on the development team's determination that the Company has completed all planning, designing, coding and testing activities that are necessary to establish that the product can be produced to meet its design specifications including, functions, features, and technical performance requirements. Goodwill and Intangible Assets. The Company considers the goodwill and related intangible assets related to CTI Billing Solutions Limited to be the premium the Company paid for CTI Billing Solutions Limited. For accounting purposes, these assets are maintained at the corporate level and the Company considers the functional currency with respect to these assets the U.S. dollar. Goodwill is tested for impairment on an annual basis and between annual tests in certain circumstances, and written down when impaired. There was an impairment of $2,127,401 on goodwill in 2010 and no further impairment has been identified in 2011. Purchased intangible assets other than goodwill are amortized over their useful lives unless these lives are determined to be indefinite. Purchased intangible assets are carried at cost, less accumulated amortization. Amortization is computed over the estimated useful lives of the respective assets, generally 3-15 years. Intangible assets consist of patents, purchased technology, trademarks and trade names, and customer lists. The Company has allocated goodwill and a significant component of its intangible assets to CTI Billing Solutions Limited, as that entity is considered a separate reporting unit. The Company performed its annual impairment analysis on goodwill as of October 1, 2010, to coincide with the calendar date set in past years for this analysis. The Company's analysis considered the projected cash flows of the reporting unit and gave consideration to appropriate factors in determining a discount rate to be applied to these cash flows. The Company engaged the same outside firm as was used in past years to assist in this analysis. The Company is satisfied as to the qualifications and independence of this firm with respect to their ability to assist in this analysis. The results of this analysis indicated that there was a Step One impairment as of the date of our annual impairment determination and the Step Two impairment resulted in a $2,127,401 impairment to goodwill and no impairment to intangibles. The Company's Class A common stock price dropped significantly in the fourth quarter of 2008 and has remained at low levels. As of August 2, 2011, the Company's Class A common stock closed at $0.06 per share and the "market cap" for the Company's stock was approximately $1.7 million which was well below the Company's reported book value at June 30, 2011 of approximately $4.6 million. The Company recognizes that the market for our stock is significantly below our book value which the Company attributes to a number of factors including very limited trading in the Company's Class A common stock; a significant portion of the Company's Class A common stock (approximately 77%) is beneficially owned by a majority stockholder, an overall "flight to quality" by investors in which many "penny stocks" such as CTI's have been significantly downgraded in terms of pricing and an overall lack of public awareness of its operations. While the Company cannot quantify the impacts of these factors in terms of how they impact the difference between book value and our stock's "market cap" The Company does not believe that the market in its Class A common stock is sufficiently sophisticated to make a proper determination of the value of the Company's Class A common stock such that it should drive the Company to reach a conclusion that impairment of its goodwill has occurred when the Company believes that generally accepted valuation techniques using its most recent assessments as to the future performance of our business indicate that it is not impaired. The Company will continue in the future to be aware of the market cap in our assessment of its goodwill and may more frequently update its analysis of goodwill impairment in light of this situation. 22-------------------------------------------------------------------------------- Table of Contents Because of the Company's continued low "market cap", the Company reviewed the assumptions utilized in the impairment determination and again found that there existed no impairment. The Company's operations of the business unit are primarily based on recurring revenues and have not experienced an adverse change in anticipated performance considered in the impairment analysis. The business units operating performance subsequent to the goodwill impairment analysis has exceeded anticipated performance through the most recent period that information is available. The Company believes that the year-end analysis is sufficiently current and no formal analysis has been performed at June 30, 2011. Long-Lived Assets. The Company reviews the recoverability of the carrying value of its long-lived assets on an annual basis. Long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. When such events occur, the Company compares the carrying amount of the assets to the undiscounted expected future cash flows. If this comparison indicates there is impairment, the amount of the impairment is typically calculated using discounted expected future cash flows. Revenue Recognition and Accounts Receivable Reserves. The Company records revenue when it is realized, or realizable, and earned. Revenues from software licenses are recognized upon shipment, delivery or customer acceptance, based on the substance of the arrangement or as defined in the sales agreement provided there are no significant remaining vendor obligations to be fulfilled and collectability is reasonably assured. Software sales revenue is generated from licensing software to new customers and from licensing additional users and new applications to existing customers. The Company's sales arrangements typically include services in addition to software. Service revenues are generated from support and maintenance, processing, training, consulting, and customization services. For sales arrangements that include bundled software and services, the Company accounts for any undelivered service offering as a separate element of a multiple-element arrangement. Amounts deferred for services are determined based upon vendor-specific objective evidence of the fair value of the elements. Support and maintenance revenues are recognized on a straight-line basis over the term of the agreement. Revenues from processing, training, consulting, and customization are recognized as provided to customers. If the services are essential to the functionality of the software, revenue from the software component is deferred until the essential service is complete. If an arrangement to deliver software or a software system, either alone or together with other products or services, requires significant production, modification, or customization of software, the service element does not meet the criteria for separate accounting set forth in the guidance related to software revenue recognition. If the criteria for separate accounting are not met, the entire arrangement is accounted for in conformity with guidance related to contract accounting. The Company carefully evaluates the circumstances surrounding the implementations to determine whether the percentage-of-completion method or the completed-contract method should be used. Most implementations relate to the Company's Telemanagement products and are completed in less than 30 days once the work begins. The Company uses the completed-contract method on contracts that will be completed within 30 days since it produces a result similar to the percentage-of-completion method. On contracts that will take over 30 days to complete, the Company uses the percentage-of-completion method of contract accounting. The Company also realizes patent license fee and enforcement revenues. These revenues are realized once the Company has received a signed settlement or judgment and the collection of the receivable is deemed probable. The Company maintains an allowance for doubtful accounts for estimated losses resulting from the inability of its customers to make required payments. The Company continuously monitors collections and payments from its customers and the allowance for doubtful accounts is based on historical experience and any specific customer collection issues that the Company has identified. If the financial condition of its customers were to deteriorate resulting in an impairment of their ability to make payments, additional allowances may be required. Where an allowance for doubtful accounts has been established with respect to customer receivables, as payments are made on such receivables or if the customer goes out of business with no chance of collection, the allowances will decrease with a corresponding adjustment to accounts receivable as deemed appropriate. Legal Costs Related to Patent Enforcement Activities. Hourly legal costs incurred while pursuing patent license fee and enforcement revenues are expensed as incurred. Legal fees that are contingent on the successful outcome of an enforcement claim are recorded when the patent license fee and enforcement revenues are realized. 23 -------------------------------------------------------------------------------- Table of Contents Stock Based Compensation. The Company recognizes the cost of employee services received in exchange for awards of equity instruments, such as stock options and restricted stock, based on the fair value of those awards at the date of grant. The Company uses the Black-Scholes-Merton formula to calculate the fair value of the stock options. The Company recognizes compensation cost net of a forfeiture rate and recognizes the compensation cost for only those awards expected to vest on a straight-line basis over the requisite service period of the award, which is generally the vesting term. The Company estimated the forfeiture rate based on its historical experience and its expectations about future forfeitures. Included within selling, general and administrative expense for the three months ended June 30, 2011 and June 30, 2010 was $9,379 and $9,378, respectively, of stock-based compensation. Included within selling, general and administrative expense for the six months ended June 30, 2011 and June 30, 2010 was $18,758 and $30,999, respectively, of stock-based compensation. Stock-based compensation expenses are recorded in the Corporate Allocation segment as these amounts are not included in internal measures of segment operating performance. The Company estimates it will recognize approximately $38,000, $24,000, $0 and $0 for the fiscal years ending December 31, 2011, 2012, 2013 and 2014, respectively, of compensation costs for nonvested stock options previously granted to employees. New Accounting Pronouncements FASB ASU No. 2009-13 - Revenue Recognition (Topic 605): Multiple-Deliverable Revenue Arrangements. This ASU also provides principles and application guidance on whether multiple deliverables exist, how the arrangement should be separated, and the consideration allocated, requires an entity to allocate revenue in an arrangement using estimated selling prices of deliverables if a vendor does not have vendor-specific objective evidence or third-party evidence of selling price, eliminates the use of the residual method and requires an entity to allocate revenue using the relative selling price method. The consensus significantly expands the disclosure requirements for multiple-deliverable revenue arrangements. This ASU should be applied on a prospective basis for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010, with earlier application permitted. Alternatively, an entity can elect to adopt this ASU on a retrospective basis. The adoption of this ASU had no effect on the Company's results of operations or financial position. FASB ASU No. 2009-14 - Software (Topic 985): Certain Revenue Arrangements That Include Software Elements. This ASU removes tangible products from the scope of the software revenue guidance and provides guidance on determining whether software deliverables in an arrangement that includes a tangible product are within the scope of the software revenue model or the guidance in revenue arrangements with multiple deliverables model, ASU No. 2009-13. Generally, if the software contained in or part of the arrangement with the tangible product is essential to the tangible product's functionality, then the software is excluded from the software revenue guidance. The ASU also provides factors to consider in evaluating whether the software was essential to the tangible product or not. The disclosure requirements, effective date, and transition methods for this ASU are the same as those for ASU No. 2009-13. An entity must adopt both ASUs in the same period using the same transition method. The adoption of this ASU had no effect on the Company's results of operations or financial position. FASB issued ASU 2010-6 Improving Disclosures about Fair Measurements in January 2010 ("ASU 2010-6"). ASU 2010-6 provides amendments to subtopic 820-10 that require separate disclosure of significant transfers in and out of Level 1 and Level 2 fair value measurements and the presentation of separate information regarding purchases, sales, issuances and settlements for Level 3 fair value measurements. Additionally, ASU 2010-6 provides amendments to subtopic 820-10 that clarify existing disclosures about the level of disaggregation and inputs and valuation techniques. ASU 2010-6 is effective for financial statements issued for interim and annual periods ending after December 15, 2010. The adoption of this Topic did not have a material impact on the Company's financialstatements and disclosures. 24 -------------------------------------------------------------------------------- Table of Contents |