Note 1 – Significant Accounting Policies

Business

Qualstar Corporation and Subsidiary (collectively, “Qualstar”, the “Company”, “we”, “us” or “our”), was incorporated in California in 1984. Qualstar is a leading provider of high efficiency and high density power solutions marketed under the N2Power brand, and of data storage systems marketed under the Qualstar brand. Originally Qualstar was formed to develop and manufacture tape drives for the personal computer and workstation marketplaces. Commencing in 1995, Qualstar focused its efforts on designing, developing, manufacturing and selling data storage systems used to store, retrieve and manage electronic data primarily in the network computing environment. Tape libraries consist of cartridge tape drives, tape cartridges and robotics to move the tape cartridges from their storage locations to the tape drives under software control. Qualstar’s libraries provide storage solutions for organizations requiring backup, recovery, and archival storage of critical electronic information. Qualstar’s data storage systems are compatible with commonly used operating systems, including UNIX, Windows and Linux and a wide range of storage management software. In July 2002, Qualstar purchased the assets of N2Power, Incorporated, a supplier of ultra-small high efficiency open frame switching power supplies. Power supplies are sold with the N2Power brand name as well as under a private label brand name to original equipment manufacturers.

We design our products at our location in California, and we sell our products globally through authorized resellers and directly to original equipment manufacturers (“OEMs”). N2Power utilizes contract manufacturers in Asia to produce our power solutions products. Our storage products are manufactured by us at our factory in Simi Valley, California and by our OEM supplier in other parts of the world. Our research, development and engineering facility is located in Simi Valley, California. On June 30, 2014, Qualstar formed Qualstar Corporation Singapore Private Limited, a Singapore corporation to enable us to hire and expand our engineering and product development staff in Singapore and to support Qualstar’s overall product expansion.

The consolidated financial statements include our accounts and the accounts of our wholly-owned subsidiary in Singapore. All significant intercompany accounts and transactions have been eliminated in consolidation.

On January 4, 2016, we changed our fiscal year from June 30 to December 31. As a result, we are reporting financial information for the transition period from July 1, 2015 through December 31, 2015. Subsequent to this transition period, we will cover the period beginning January 1 and ending December 31, which will be our fiscal year. We refer in these financial statements to the period beginning on July 1, 2015 and ended on December 31, 2015 as the “transition period.” We refer in these financial statements to the period beginning on July 1, 2014 and ended on June 30, 2015 as “fiscal 2015” and the period beginning on July 1, 2013 and ended on June 30, 2014 as “fiscal 2014.” In these financial statements, we compare financial results for the transition period, which are audited, with the financial results for July 1, 2014 through December 31, 2014, which are unaudited. We also compare the financial results for fiscal 2015 and fiscal 2014 which are audited.

Accounting Principles

The consolidated financial statements and accompanying notes are prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”).

Estimates and Assumptions

Preparing financial statements in accordance with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses. Examples include estimates of loss contingencies, product life cycles and inventory obsolescence, bad debts, sales returns, share-based compensation forfeiture rates, the potential outcome of future tax consequences of events that have been recognized in our consolidated financial statements or tax returns, and determining when investment impairments are other-than-temporary. Actual results and outcomes may differ from management’s estimates and assumptions.

Revenue Recognition

We recognize revenue in accordance with Accounting Standards Codification (“ASC”) 605, “Revenue Recognition,” when there is persuasive evidence that an arrangement exists, title and risk of loss have passed, delivery has occurred or the services have been rendered, the sales price is fixed or determinable and collection of the related receivable is reasonably assured. Title and risk of loss generally pass to our customers upon shipment. In limited circumstances where either title or risk of loss pass upon destination or acceptance or when collection is not reasonably assured, we defer revenue recognition until such events occur. In general, customers are allowed to return the product, free of penalty, within thirty days of shipment, if the product does not conform to its specifications.

We record an allowance for estimated sales returns based on past experience and current knowledge of our customer base. Our experience has been such that only a very small percentage of products are returned. Should our experience change, however, we may require additional allowances for sales returns.

Revenue for established products that have previously satisfied a customer’s acceptance requirements and provide for full payment tied to shipment is generally recognized upon shipment and passage of title. In limited cases where a prior history of customer acceptance cannot be demonstrated or sales where customer payment dates are not determinable or when collection is not reasonably assured, revenue is deferred until customer acceptance occurs or payment has been received. On the limited shipments where sales are not recognized, gross profit is generally recorded as deferred profit in our balance sheet representing the difference between the receivable recorded and the inventory shipped.

At December 31, 2015, we had deferred revenue of approximately $1,097,000 and no deferred profit. At June 30, 2015, we had deferred revenue of approximately $1,055,000 and no deferred profit and at June 30, 2014 we had deferred revenue of approximately $1,197,000 and deferred profit of approximately, $8,000.

Cash and Cash Equivalents

Qualstar classifies as cash equivalents only cash and those investments that are highly-liquid, interest-earning investments with maturities of three months or less from the date of purchase. $100,000 is restricted for use as collateral for the corporate credit cards.

Marketable Securities

Marketable securities consisted primarily of high-quality U.S. corporate securities and U.S. federal government debt securities. Our marketable securities portfolio consist of short-term securities with original maturities of greater than three months from the date of purchase and remaining maturities of less than one year. Marketable securities are recorded at fair value using the specific identification method; unrealized gains and losses are reflected in other comprehensive income (loss) until realized; realized gains and losses are included in earnings when the underlying securities are sold and are derived using the specific identification method for determining the cost of securities sold. An $11,000 loss and $2,000 gain from the sale of marketable securities were recorded in fiscal 2015 and 2014, respectively. All of Qualstar’s marketable securities were classified as available-for-sale at June 30, 2014. Qualstar did not have any marketable securities as of December 31, 2015 or June 30, 2015.

The Company reviews its marketable securities for any potential investment impairments in accordance with ASC 320, “Investments – Debt and Equity Securities,” in order to determine if impairment exists and if so, the classification of the impairment as “temporary” or “other-than-temporary.” A temporary impairment charge results in an unrealized loss being recorded in the other comprehensive income (loss) component of shareholders’ equity. An other-than-temporary impairment charge is recorded as a realized loss in the Consolidated Statement of Comprehensive Loss and reduces net income (loss) for the applicable accounting period. The differentiating factors between temporary and other-than-temporary impairment are primarily the length of time and the extent to which the market value has been less than cost, the financial condition and near-term prospects of the issuer and the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in market value.

Concentration of Credit Risk, Other Concentration Risks and Significant Customers

Qualstar sells its products primarily through value added resellers located worldwide. Ongoing credit evaluations of customers’ financial condition are performed by Qualstar, and generally, collateral is not required. Potential uncollectible accounts have been provided for in the financial statements.

We are exposed to foreign currency and interest rate risks. Our interest income is sensitive to changes in the general level of U.S. interest rates, particularly since all of our investments are in US fixed income securities. We have no outstanding debt nor do we utilize auction rate securities or derivative financial instruments in our investment portfolio. Cash and other investments may be in excess of FDIC insurance limits.

Our financial results could be affected by changes in foreign currency exchange rates or weak economic conditions in foreign markets. As all sales are currently made in U.S. dollars, a strengthening of the dollar could make our products less competitive in foreign markets. Sales outside North America represented approximately 41.9% of net revenues for the six months ended December 31, 2015, 54.0% of net revenues in fiscal 2015, 44.2% of net revenues in fiscal 2014.

Revenues from Qualstar’s largest customer totaled approximately 10.7% and 11.9% of revenues for the six months ended December 31, 2015 and 2014, respectively. Revenues from Qualstar’s largest customer totaled approximately 11.1% and 10.6% of revenues for the years ended June 30, 2015 and 2014, respectively. At December 31, 2015, the largest customer’s accounts receivable balance, net of specific allowances, totaled approximately 1.5% of net accounts receivable. At June 30, 2015, the largest customer’s accounts receivable balance, net of specific allowances, totaled approximately 10.0% of net accounts receivable. At June 30, 2014, the largest customer’s accounts receivable balance, net of specific allowances, totaled approximately 13.2% of net accounts receivable.

Suppliers

The primary suppliers of our power supplies segment, N2Power, are located in China. The primary supplier of our tape storage products is located in California and Germany. If a manufacturer should be unable to deliver products to us in a timely basis or at all, our power supply or data storage business could be adversely affected. Though we have many years of favorable experience with these suppliers, there can be no assurance that circumstances might not change and compel a supplier to curtail or terminate deliveries to us.

Allowance for Doubtful Accounts

The allowance for doubtful accounts reflects our best estimate of probable losses inherent in the accounts receivable balance. We determine the allowance based on known troubled accounts, historical experience, and other currently available evidence. Activity in the allowance for doubtful accounts was as follows (in thousands):

Description	Balance at Beginning of Period		Charged to Costs and Expenses		Charged to Other Accounts		Deductions (1)			Balance at End of Period
Six Months Ended December 31, 2015	$	15		84						$	99
Year Ended June 30, 2015	$	92	$	—	$	—	$	(77	)	$	15
Year Ended June 30, 2014	$	68	$	49	$	—	$	(25	)	$	92

__________________________

(1)	Uncollectible accounts written off, net of recoveries.

Inventories, net

Inventories are stated at the lower of cost (first-in, first-out basis) or market. Cost includes materials, labor, and manufacturing overhead related to the purchase and production of inventories. We regularly review inventory quantities on hand, future purchase commitments with our suppliers, and the estimated utility of our inventory. If our review indicates a reduction in utility below carrying value, we reduce our inventory to a new cost basis.

Property and Equipment, net

Property and equipment are recorded at cost less accumulated depreciation and amortization. Depreciation expense is computed using the straight-line method. Leasehold improvements are amortized over the shorter of the estimated useful life of the asset or the term of the lease. Estimated useful lives are as follows:

Machinery and equipment (in years)	5	-	7
Furniture and fixtures (in years)	5	-	7
Leasehold Improvements	3	-	5
Computer equipment (in years)	3	-	5

Expenditures for normal maintenance and repairs are charged to expense as incurred, and improvements are capitalized. Upon the sale or retirement of property or equipment, the asset cost and related accumulated depreciation are removed from the respective accounts and any gain or loss is included in the results of operations.

Long-Lived Assets

Qualstar reviews the impairment of long-lived assets whenever events or changes in circumstances indicate the carrying amount of any asset may not be recoverable, in accordance with ASC 360, “Property, Plant and Equipment.” An impairment loss would be recognized when the estimated undiscounted future cash flows expected to result from the use of the asset and its eventual disposition is less than the carrying amount. If impairment is indicated, the amount of the loss to be recorded is based upon an estimate of the difference between the carrying amount and the fair value of the asset. Fair value is based upon discounted cash flows expected to result from the use of the asset and its eventual disposition and other valuation methods. No impairment losses of long-lived assets were recognized during the periods presented.

Shipping and Handling Costs

Qualstar records all customer charges for outbound shipping and handling to freight revenue. All inbound and outbound shipping and fulfillment costs are classified as costs of goods sold.

Warranty Obligations

We provide a three year advance replacement warranty on all XLS and RLS models that includes replacement of components, or if necessary, complete libraries. XLS libraries sold in North America also include one year of onsite service. Customers may purchase extended replacement service coverage and on-site service if they are located in the United States, Canada, and selected countries in Europe, Asia Pacific and Latin America. All customers may purchase extended replacement or on-sight (where applicable) service coverage after the three year warranty has ended.

We provide a three year warranty on all power supplies that includes repair or if necessary, replacement of the power supply.

A provision for costs related to warranty expense is recorded when revenue is recognized, which is estimated based on historical warranty costs incurred. Customers may purchase extended advance replacement service coverage and on-site service if they are located in the United States, Canada and most countries within Europe.

Activity in the liability for product warranty (included in other accrued liabilities) for the periods presented is as follows (in thousands):

	December 31,			June 30,
	2015			2015			2014
Beginning balance	$	154		$	159		$	190
Cost of warranty claims		(113	)		(55	)		(45	)
Accruals for product warranties		146			50			14
Ending balance	$	187		$	154		$	159

Engineering

All engineering costs are charged to expense as incurred. These costs consist primarily of engineering salaries, benefits, outside consultant fees, purchased parts and supplies directly involved in the design and development of new products, and facilities and other internal costs.

Advertising

Advertising and promotion expenses include costs associated with direct and indirect marketing, trade shows and public relations. Qualstar expenses all costs of advertising and promotion as incurred. Advertising and promotion expenses for the six months ended December 31, 2015 and 2014 were approximately $58,000 and $140,000 (unaudited), respectively. Advertising and promotion expenses for the years ended June 30, 2015 and 2014 were approximately $150,000 and $232,000, respectively.

Fair Value of Financial Instruments

All financial assets and liabilities and nonfinancial assets and liabilities that are recognized or disclosed at fair value in the consolidated financial statements on a recurring basis (at least annually). ASC 820 “Fair Value Measurements and Disclosures” defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements.

ASC 820 defines fair value as the price that would be received upon sale of an asset or paid upon transfer of a liability in an orderly transaction between market participants at the measurement date and in the principal or most advantageous market for that asset or liability. The fair value should be calculated based on assumptions that market participants would use in pricing the asset or liability, not on assumptions specific to the entity. In addition, the fair value of liabilities should include consideration of non-performance risk including our own credit risk.

In addition to defining fair value, ASC 820 expands the disclosure requirements around fair value and establishes a fair value hierarchy for valuation inputs. The hierarchy prioritizes the inputs into three levels based on the extent to which inputs used in measuring fair value is observable in the market. Each fair value measurement is reported in one of the three levels that are determined by the lowest level input that is significant to the fair value measurement in its entirety. These levels are:

•	Level 1 – inputs are based upon unadjusted quoted prices for identical instruments traded in active markets.

•

Level 2 – inputs are based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market or can be corroborated by observable market data for substantially the full term of the assets or liabilities.

•

Level 3 – inputs are generally unobservable and typically reflect management’s estimates of assumptions that market participants would use in pricing the asset or liability. The fair values are therefore determined using model-based techniques that include option pricing models, discounted cash flow models, and similar techniques.

In general, and where applicable, we use quoted prices in active markets for identical assets to determine fair value. This pricing methodology applies to our Level 1 investments such as U.S. treasuries and agency securities and exchange-traded mutual funds. If quoted prices in active markets for identical assets are not available to determine fair value, then we use quoted prices for similar assets or inputs other than the quoted prices that are observable either directly or indirectly. These investments are included in Level 2 and consist primarily of corporate bonds, mortgage-backed securities, and certain agency securities.

Assets and Liabilities Measured at Fair Value on a Recurring Basis

The following table presents our assets and liabilities measured at fair value on a recurring basis at December 31, 2015, June 30, 2015 and 2014 (in thousands):

	December 31, 2015

	Adjusted Cost		Unrealized Gains		Unrealized Losses		Fair Value		Cash & Cash Equivalents
Level 1:
Cash	$	928	$	-	$	-	$	928	$	928
Money Market Funds		3,035		-		-		3,035		3,035
Total	$	3,963	$	-	$	-	$	3,963	$	3,963

	June 30, 2015

	Adjusted Cost		Unrealized Gains		Unrealized Losses		Fair Value		Cash & Cash Equivalents
Level 1:
Cash	$	663	$	-	$	-	$	633	$	633
Money Market Funds		4,033		-		-		4,033		4,033
Total	$	4,696	$	-	$	-	$	4,696	$	4,696

	June 30, 2014

	Adjusted Cost		Unrealized Gains		Unrealized Losses		Fair Value		Cash & Cash Equivalents		Short-term Marketable Securities		Long-term Marketable Securities
Level 1:
Cash	$	617	$	-	$	-	$	617	$	617	$	-	$	-
Money Market Funds		4,845		-		-		4,845		4,845		-		-
Subtotal		5,462		-		-		5,462		5,462		-		-
Level 2:
U.S. Agency Securities		332		-		-		332		-		332		-
Corporate securities		1,354		1		-		1,355		-		1,355		-
Municipal securities		76		-		-		76		-		76		-
Subtotal		1,762		1		-		1,763		-		1,763		-
Total	$	7,224	$	1	$	-	$	7,225	$	5,462	$	1,763	$	-

The carrying amounts reported in the consolidated balance sheets for cash and cash equivalents, short-term marketable securities, accounts receivable and accounts payable approximate their fair values due to the short term nature of these financial instruments.

Share-Based Compensation

We account for share-based compensation in accordance with ASC 718, “Compensation – Stock Compensation.” In accordance with the provisions of ASC 718, share-based compensation cost is measured at the grant date based on fair value of the award and is recognized as expense over the applicable vesting period of the stock award (generally four years) using the straight-line method.

Income Taxes

Income taxes are accounted for using the liability method in accordance with ASC 740, “Income Taxes.” Under this method, deferred tax liabilities and assets are recognized for the expected future tax consequences of temporary differences between the financial statement and tax bases of assets and liabilities, and for the expected future tax benefit to be derived from tax credits and loss carry forwards. Current income tax expense or benefit represents the amount of income taxes expected to be payable or refundable for the current year. A valuation allowance is established when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized.

Comprehensive Loss

Comprehensive loss includes unrealized gains and losses on debt and equity securities classified as available-for-sale and included as a component of shareholders’ equity.

Loss per Share

Basic loss per share has been computed by dividing net loss by the weighted average number of common shares outstanding. Diluted loss per share has been computed by dividing net loss by the weighted average common shares outstanding plus dilutive securities or other contracts to issue common stock as if these securities were exercised or converted to common stock.

The following table sets forth the calculation for basic and diluted loss per share for the periods indicated, in thousands, except per share amounts:

	Six Months Ended December 31 ,						Year Ended June 30,
	2015			2014			2015			2014
				(unaudited)
Loss:
Net loss	$	(1,885	)	$	(567	)	$	(1,308	)	$	(5,624	)
Shares:
Weighted average shares for basic and diluted loss per share		12,253			12,253			12,253			12,253
Loss per share	$	(0.15	)	$	(0.05	)	$	(0.11	)	$	(0.46	)

Shares issuable under stock options of 260,000, 242,000, 258,000, and 74,000 for the six months ended December 31, 2015 and 2014 and for the years ended June 30, 2015 and 2014

, respectively, have been excluded from the computation of diluted loss per share as the effect would be antidilutive.

Reclassifications

Certain prior year amounts have been reclassified to conform to the current period presentation, with no changes to previously reported stockholders equity or comprehensive loss.

Recent Accounting Guidance

Recent accounting guidance not yet adopted

In May 2014, the FASB issued ASU 2014-09 to clarify the principles for recognizing revenue and to develop a common revenue standard for U.S. GAAP and IFRS that will remove inconsistencies and weaknesses in revenue requirements, provide a more robust framework for addressing revenue issues, improve comparability of revenue recognition practices across entities, industries, jurisdictions, and capital markets, provide more useful information to users of financial statements through improved disclosure requirements, and simplify the preparation of financial statements by reducing the number of requirements to which an entity must refer. The new guidance will be effective for reporting periods beginning after December 15, 2016.

In August 2015, the FASB issued ASU 2015-14 as an update of ASU 2014-09. The purpose is to allow more time to implement the guidance in Update 2014-09. This Update defers the effective date of Update 2014-09 to annual reporting periods beginning after December 15, 2017. The Company is still evaluating the impact on the consolidated financial statements.

In June 2014, the FASB issued ASU 2014-12 to resolve the diverse accounting treatment of share-based payment awards that require specific performance targets to be achieved in order for employees to become eligible to vest in the awards. The new guidance will be effective for us beginning after December 15, 2017, and is not expected to impact our consolidated financial statements.

In August 2014, the FASB issued ASU 2014-15.

This standard sets forth management’s responsibility to evaluate, each reporting period, whether there is substantial doubt about our ability to continue as a going concern, and if so, to provide related footnote disclosures. The standard is effective for annual reporting periods ending after March 15, 2016 and interim periods within annual periods beginning after March 15, 2016. We are currently evaluating this new standard and after adoption, we will incorporate this guidance in our assessment of going concern. This new standard

is not expected to impact our consolidated financial statements.

In January 2015, the FASB issued ASU 2015-01 to eliminate the concept of extraordinary and unusual items, simplifying the income statement presentation. The standard is effective for fiscal and interim periods within those fiscal years, beginning after December 15, 2015

, and is not expected to impact our consolidated financial statements.

In February 2015, the FASB issued ASU 2015-02 to change the analysis that a reporting entity must perform to determine whether it should consolidate certain types of legal entities. The standard is effective for fiscal and interim periods within those fiscal years, beginning after December 15, 2015. We are currently evaluating this new standard and after adoption, we will incorporate this guidance in our analysis for consolidations. This new standard

is not expected to impact our consolidated financial statements.

In July 2015, the FASB issued ASU 2015-11 to simplify the measurement of inventory. The objective is to identify, evaluate, and improve areas of GAAP for which cost and complexity can be reduced while maintaining or improving the usefulness of the information provided to users of financial statements. The standard is effective for fiscal years beginning after December 15, 2016

, and is not expected to impact our consolidated financial statements

In February, 2016, the FASB issued ASU 2016-02 to increase transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet and disclosing key information about leasing arrangements. For related party leases, the basis will be the legally enforceable terms and conditions of the arrangement. This standard is effective for fiscal years beginning after December 15, 2018. The Company is evaluating the impact it may have on its consolidated financial statements.