Note

Description of Business and Summary of Accounting Policies

Description of Business

Cyanotech Corporation (the “Company”) cultivates and produces high-value, high-quality natural products derived from microalgae for the nutritional supplements market. The Company currently cultivates, on a large-scale basis,

two

microalgal species from which its

two

major product lines are derived. The Company manufactures all of its products in the United States and sells its products worldwide. As the Company’s operations are solely related to microalgae-based products, management of the Company considers its operations to be in

one

industry segment. Correspondingly, the Company records revenue and cost of sales information by product category.

Basis of Presentation

The accompanying consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America. The accompanying consolidated financial statements include the accounts of Cyanotech Corporation and its wholly owned subsidiary, Nutrex Hawaii, Inc. (“Nutrex Hawaii” or “Nutrex”). All significant intercompany balances and transactions have been eliminated in consolidation.

Liquidity

As of

March 31, 2018,

the Company had cash of

$1.3

million and working capital of

$7.9

million compared to

$1.4

million and

$6.2

million, respectively, at

March 31, 2017.

August 30, 2016,

the Credit Agreement, which the Company and First Foundation Bank (the Bank) entered into on

June 3, 2016,

became effective. The Credit Agreement allows the Company to borrow up to

$2.0

million on a revolving basis. At

March 31, 2018,

the Company had borrowed

$0.5

million and had

$1.5

million available on the line. On

May 29, 2018,

the Company borrowed

$0.5

million and had

$1.0

million available on the line. The line of credit was renewed on

August 30, 2017

and will expire on

August 30, 2018,

the Company intends to renew or replace it with another line of credit on or before the expiration date.

As of

March 31, 2018,

the Company had

$6.4

million of term loans payable to the Bank that require the payment of principal and interest monthly through

August 2032.

Pursuant to the term loans, the Company is subject to annual financial covenants, customary affirmative and negative covenants and certain subjective acceleration clauses. The Company was in compliance with these financial covenants at

March 31, 2018.

March 31, 2017,

the Company's current ratio of

1.92:1,

fell short of the Bank's annual requirement of

2.10:1.

The Bank provided the Company with a letter stating they found the Company to be in compliance with this covenant requirement and all other financial covenants as of

March 31, 2017,

and did

not

consider this shortfall to be a default under the Loan Agreements.

Funds generated by operating activities and available cash continue to be the Company's most significant sources of liquidity for working capital requirements, debt service and funding of maintenance levels of capital expenditures. Based upon the Company's fiscal

2019

operating plan and related cash flow projections and the Company's projected consolidated financial position as of

March 31, 2019,

cash flows expected to be generated by operating activities and available financing are expected to be sufficient to fund the Company's operations for at least the next

twelve

months, and the Company's current ratio is expected to be in compliance with the annual term loan covenant requirement as of

March 31, 2019.

However,

assurances can be provided that the Company will achieve its operating plan and cash flow objectives for the next fiscal year or its projected consolidated financial position as of

March 31, 2019.

Such estimates are subject to change based on future results and such change could cause future results to vary significantly from expected results.

Estimates and Assumptions

The preparation of the consolidated financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of any contingent assets and liabilities as of the date of the financial statements and the reported amounts of revenues and expenses during the period reported. Management reviews these estimates and assumptions periodically and reflects the effect of revisions in the period that they are determined to be necessary. Actual results could differ significantly from those estimates and assumptions. Significant estimates include forecast of future operating results, cash flows and financial position, inventory valuation and determination of production capacity and abnormal product costs, reserve for inventory, sales allowances, allowance for doubtful accounts and valuation of deferred tax assets.

Financial Instruments

Cash primarily consists of cash on hand and cash in bank deposits.

The Company applies a framework for measuring fair value. That framework provides a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (level

measurements) and the lowest priority to unobservable inputs (level

measurements). The

three

levels of the fair value hierarchy are described below:

	Level 1 —	Inputs to the valuation methodology are unadjusted quoted prices for identical assets or liabilities in active markets that the Company has the ability to access.
	Level 2 —	Inputs to the valuation methodology include:

	●	Quoted prices for similar assets or liabilities in active markets;
	●	Quoted prices for identical or similar assets or liabilities in inactive markets;
	●	Inputs other than quoted prices that are observable for the asset or liability; and
	●	Inputs that are derived principally from or corroborated by observable market data by correlation or other means.

If the asset or liability has a specified (contractual) term, the Level

input must be observable for substantially the full term of the asset or liability.

Level

—

Inputs to the valuation methodology are unobservable and significant to the fair value.

Cash, Accounts Receivable, Accounts Payable and Accrued Expenses

- Due to the short-term nature of these instruments, management believes that the carrying amounts approximate fair value.

Line of Credit and Long-Term Debt

- The carrying amount of our line of credit and long-term debt approximates fair value as interest rates applied to the underlying debt are adjusted quarterly to market interest rates, which approximate current interest rates for similar debt instruments of comparable maturities.

Concentration of Credit Risk

The Company maintains its cash accounts with several banks located in Hawaii. The total cash balances are insured by the Federal Deposit Insurance Corporation (“FDIC”) up to

$250,000

per bank. The Company had cash balances at

March

31,

2018

that exceeded the balance insured by the FDIC by

$829,000.

Two customers accounted for

32%

and

16%,

respectively, of our total net sales in the fiscal year ended

March 31, 2018.

Three customers accounted for

77%

of accounts receivable at

March 31, 2018.

One customer accounted for

24%

of total net sales in the fiscal year ended

March 31, 2017.

Three customers accounted for

60%

of accounts receivable at

March 31, 2017.

Two customers accounted for

19%

and

11%,

respectively, of total net sales in the fiscal year ended

March 31, 2016.

Two customers accounted for

44%

of accounts receivable at

March 31, 2016.

Our top

ten

customers generated

70%,

60%

and

58%

of our net sales during fiscal

2018,

fiscal

2017

and fiscal

2016,

respectively.

Accounts Receivable and Allowance for Doubtful Accounts

Accounts receivable are recorded at the invoiced amount and do

not

accrue interest. Credit is extended based on evaluation of the customer's financial condition. Collateral is

not

required. The allowance for doubtful accounts reflects management’s best estimate of probable credit losses inherent in the accounts receivable balance. Management determines the allowance based on historical experience, specifically identified nonpaying accounts and other currently available evidence. Management reviews its allowance for doubtful accounts monthly with a focus on significant individual past due balances over

days. All other balances are reviewed on a pooled basis. Account balances are charged off against the allowance after all means of collection have been exhausted and the potential for recovery is considered remote. The Company does

not

have any off-balance sheet credit exposure related to its customers or otherwise.

Inventories, net

Inventories are stated at the lower of cost or net realizable value. Cost is determined using the

first

-in,

first

-out (FIFO) method. Net realizable value is defined as sales price less cost to dispose and a normal profit margin. Inventory costs include materials, labor, overhead and

third

party costs.

Management provides a reserve against inventory for known or expected inventory obsolescence. The reserve is determined by specific review of inventory items for product age and quality which

may

affect salability. At

March

31,

2018

and

2017,

the inventory reserve was

$5,000

and

$3,000,

respectively.

The Company recognizes abnormal production costs, including fixed cost variances from normal production capacity, as an expense in the period incurred. Abnormal amounts of freight, handling costs and wasted material (spoilage) are recognized as current period charges and fixed production overhead costs are allocated to inventory based on the normal capacity of production facilities. Normal capacity is defined as “the production expected to be achieved over a number of periods or seasons under normal circumstances, taking into account the loss of capacity resulting from planned maintenance.” The Company expensed abnormal production costs of

$538,000,

$120,000

and

$395,000

to cost of sales for the fiscal years ended

March

31,

2018,

2017

and

2016,

respectively. Non-inventoriable fixed costs were

$271,000,

$134,000

and

$149,000

for the fiscal years ended

March

31,

2018,

2017

and

2016,

respectively, and have been included in cost of sales.

Equipment and Leasehold Improvements, net

Equipment and leasehold improvements are stated at cost. Depreciation and amortization are provided using the straight-line method over the estimated useful lives for equipment and furniture and fixtures, and the shorter of the land lease term (see Notes

and

) or estimated useful lives for leasehold improvements as follows:

Equipment (in years)	3	to	10
Furniture and fixtures (in years)	3	to	7
Leasehold improvements (in years)	10	to	25

Capital project costs are accumulated in construction-in-progress until completed, at which time the costs are transferred to the relevant asset and commence depreciation. Repairs and Maintenance costs are expensed in the period incurred. Repairs and maintenance that significantly increase the useful life or value of the asset are capitalized and depreciated over the remaining life of the asset. The Company capitalizes interest cost incurred on funds used to construct property, plant, and equipment. The capitalized interest is recorded as part of the asset to which it relates and is amortized over the asset’s estimated useful life.

Impairment of Long-Lived Assets

Management reviews long-lived assets, such as equipment, leasehold improvements and purchased intangibles subject to amortization for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset

may

not

be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to the estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized to the extent that the carrying amount exceeds the asset’s fair value. Assets to be disposed of and related liabilities would be separately presented in the consolidated balance sheet. Assets to be disposed of would be reported at the lower of the carrying value or fair value less costs to sell and would

not

be depreciated.

Accounting for Asset Retirement Obligations

Management evaluates quarterly the potential liability for asset retirement obligations under the Company’s lease for its principal facility and corporate headquarters.

liability has been recognized as of

March

31,

2018

and

2017

(see Note

Revenue Recognition

We recognize revenues when the customer takes ownership and assumes the risk of loss. We have determined that transfer of title and risk of loss generally occurs when product is received by the customer, except in instances where the shipment terms are explicitly FOB Origin, and accordingly we recognize revenue at the point of delivery to the customer. For shipments with terms of FOB Origin where transfer of title and risk of loss occurs at the point of shipping, revenue is recognized upon shipment to the customer. Sales returns and allowances are estimated and recorded as a reduction to sales in the period in which sales are recorded. We record net shipping charges and sales tax in cost of goods sold.

Research and Development

Research and development costs are expensed as incurred and consist primarily of labor, benefits and outside research.

Advertising

Advertising costs are expensed as incurred. Total advertising expense for the years ended

March

31,

2018,

2017

and

2016

was

$1,548,000,

$813,000

and

$942,000,

respectively.

Income Taxes

Income taxes are accounted for under the asset and liability method. The asset and liability method requires the recognition of deferred tax assets and liabilities for the expected future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their tax bases and operating loss and tax credit carry forwards. Deferred tax assets and liabilities are measured using income tax rates applicable to the period in which the tax difference is expected to reverse.

Judgment is required in determining any valuation allowance recorded against deferred tax assets, specifically net operating loss carryforwards, tax credit carryforwards and deductible temporary differences that

may

reduce taxable income in future periods. In assessing the need for a valuation allowance, we consider all available evidence including past operating results, estimates of future taxable income and tax planning opportunities. In the event we change our determination as to the amount of deferred tax assets that can be realized, we will adjust our valuation allowance with a corresponding impact to income tax expense in the period in which such determination is made.

In evaluating a tax position for recognition, management evaluates whether it is more-likely-than-

not

that a position will be sustained upon examination, including resolution of related appeals or litigation processes, based on the technical merits of the position. If the tax position meets the more-likely-than-

not

recognition threshold, the tax position is measured and recognized in the Company’s financial statements as the largest amount of tax benefit that, in management’s judgment, is greater than

50%

likely of being realized upon settlement. As of

March

31,

2018

and

2017,

there was

significant liability for income tax associated with unrecognized tax benefits.

The Company recognizes accrued interest related to unrecognized tax benefits as well as any related penalties in interest expense in its condensed consolidated statements of operations. As of the date of adoption and during the years ended

March

31,

2018,

2017

and

2016,

there was

accrual for the payment of interest and penalties related to uncertain tax positions.

Share-Based Compensation

The Company accounts for share-based payment arrangements using fair value. The Company currently has

liability-classified awards. Equity-classified awards, including grants of restricted stock, restricted stock units and employee stock options, are measured at the grant-date fair value of the award and are

not

subsequently remeasured unless an award is modified. The cost of equity-classified awards is recognized in the statement of operations over the period during which an employee is required to provide the service in exchange for the award, or the vesting period. All of the Company’s restricted stock, restricted stock units and stock options are service-based awards, and considered equity-classified awards; as such, they are reflected in Equity and Stock Compensation Expense accounts. All stock-based compensation has been classified as general and administrative expense in the consolidated statement of operations.

The Company utilizes the Black-Scholes option pricing model to determine the fair value of each option award. Expected volatilities are based on the historical volatility of the Company’s common stock over a period consistent with that of the expected term of the options. The expected term of the options are estimated based on factors such as vesting periods, contractual expiration dates and historical exercise behavior. The risk-free rates for periods within the contractual life of the options are based on the yields of U.S. Treasury instruments with terms comparable to the estimated option terms.

Per Share Amounts

Basic earnings (loss) per common share is calculated by dividing net income (loss) for the year by the weighted average number of common shares outstanding during the year. Diluted earnings per common share is calculated by dividing net income for the year by the sum of the weighted average number of common shares outstanding during the year plus the number of potentially dilutive common shares (“dilutive securities”) that were outstanding during the year. Dilutive securities include restricted stock units and stock options granted pursuant to the Company’s stock option plans. Dilutive securities related to the Company’s stock option plans are included in the calculation of diluted earnings per common share using the treasury stock method. Potentially dilutive securities are excluded from the computation of earnings per share in periods in which a net loss is reported, as their effect would be antidilutive. A reconciliation of the numerators and denominators of the basic and diluted income (loss) per common share calculations for the years ended

March

31,

2018,

2017

and

2016

is presented in Note

11.

New Accounting Pronouncements

May 2017,

the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU")

2017

09,

Compensation-Stock Compensation (Topic

718

) Scope of Modification Accounting.

ASU

2017

will clarify and reduce both (i) diversity in practice and (ii) cost and complexity when applying the guidance in Topic

718,

to a change to the terms and conditions of a share-based payment award. This guidance will become effective for fiscal years beginning after

December 15, 2017

and interim periods within those fiscal years. Early adoption is permitted. The amendments in this ASU should be applied prospectively to an award modified on or after the adoption date. The Company is currently evaluating the impact of this updated standard. The Company does

not

believe this update will have a significant impact on its consolidated financial statements.

November 2016,

the FASB issued ASU

2016

18,

“

Statement of Cash Flows (Topic

230

): Restricted Cash”

(“ASU

No.

2016

18”

)

This update addresses the fact that diversity exists in the classification and presentation of changes in restricted cash on the statement of cash flows under Topic

230,

Statement of Cash Flows. ASU

2016

will take effect for public companies for the fiscal years beginning after

December 15, 2017,

and interim periods within those fiscal years. This guidance is applicable to the Company’s fiscal year beginning

April 1, 2018.

The Company does

not

anticipate that this guidance will have a material impact on its consolidated financial statements and related disclosures.

August 2016,

FASB issued ASU

2016

15,

“

Statement of Cash Flows (Topic

230

)

Classification of Certain Cash Receipts and Cash Payments”

(“ASU

No.

2016

15”

). This ASU clarifies and provides specific guidance on

eight

cash flow classification issues that are

not

currently addressed by current GAAP and thereby reduces the current diversity in practice. ASU

No.

2016

is effective for public business entities for annual periods, including interim periods within those annual periods, beginning after

December 15, 2017,

with early application permitted. This guidance is applicable to the Company’s fiscal year beginning

April 1, 2018.

The Company does

not

anticipate that this guidance will have a material impact on its consolidated financial statements and related disclosures.

March 2016,

the FASB issued ASU

2016

09,

“

Compensation – Stock Compensation (Topic

718

)

Improvements to Employee Share-Based Payment Accounting” (“

ASU

No.

2016

”)

. This ASU makes several modifications to Topic

718

related to the accounting for forfeitures, employer tax withholding on share-based compensation, and the financial statement presentation of excess tax benefits or deficiencies. ASU

No.

2016

also clarifies the statement of cash flows presentation for certain components of share-based awards. The standard is effective for annual periods beginning after

December 15, 2016,

and interim periods within those annual periods, with early adoption permitted. Amendments requiring recognition of excess tax benefits and tax deficiencies in the income statement must be applied prospectively. Amendments related to the presentation of excess tax benefits on the statement of cash flows

may

be applied either prospectively or retrospectively based on the Company’s election. Amendments related to the statement of cash flows presentation of employee taxes paid when an employer withholds shares must be applied retrospectively. As of

April 1, 2017,

the Company adopted ASU

2016

and elected to present excess tax benefits as an operating activity prospectively and continues to estimate forfeitures rather than recognize them as they occur. The adoption of ASU

2016

did

not

have an impact on its consolidated financial statements and related disclosures.

February 2016,

the FASB issued ASU

2016

02,

“

Leases (Topic

842

)” (“

ASU

No.

2016

02”

). The principle objective of ASU

No.

2016

is to increase transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet. ASU

No.

2016

continues to retain a distinction between finance and operating leases but requires lessees to recognize a right-of-use asset representing its right to use the underlying asset for the lease term and a corresponding lease liability on the balance sheet for all leases with terms greater than

twelve

months. ASU

No.

2016

is effective for fiscal years and interim periods beginning after

December 15, 2018.

Early adoption of ASU

No.

2016

is permitted. Entities are required to apply the amendments at the beginning of the earliest period presented using a modified retrospective approach. This guidance is applicable to the Company’s fiscal year beginning

April 1, 2019.

The Company expects this guidance will have a material impact on its consolidated balance sheets due to the recognition of lease rights and obligations as assets and liabilities, respectively. The Company does

not

expect this guidance to have a material effect on its consolidated results of operations and cash flows.

November 2015,

the FASB issued ASU

No.

2015

17,

“

Income Taxes (Topic

740

): Balance Sheet Classification of Deferred Taxes”

. This guidance simplifies the presentation of deferred income taxes and requires that deferred tax assets and liabilities be classified as noncurrent in the classified statement of financial position. ASU

2015

will take effect for public companies for the fiscal years beginning after

December 15, 2016,

and interim periods within those fiscal years. As required, the Company adopted this standard as of

April 1, 2017

and accordingly all deferred tax assets and liabilities are classified as non-current. Prior periods were retrospectively adjusted.

July 2015,

the FASB issued ASU

No.

2015

11,

“Inventory: Simplifying the Measurement of Inventory”

, that requires inventory

not

measured using either the last in,

first

out (LIFO) or the retail inventory method to 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 cost of completion, disposal, and transportation. Prior to the issuance of the standard, inventory was measured at the lower of cost or market (where market was defined as replacement cost, with a ceiling of net realizable value and floor of net realizable value less a normal profit margin). The new standard will be effective for fiscal years beginning after

December 15, 2016,

including interim periods within those fiscal years, and will be applied prospectively. Early adoption is permitted. As required, the Company adopted this standard as of

April 1, 2017.

The adoption of this standard did

not

have a material impact on the Company's financial position or results of operations.

May 2014,

the FASB issued their converged standard on revenue recognition, Accounting Standards Update

No.

2014

09,

“

Revenue from Contracts with Customers

(Topic

606

)”

, updated in

December 2016

with the release of ASU

2016

20.

This standard outlines a single comprehensive model for companies to use in accounting for revenue arising from contracts with customers and supersedes most current revenue recognition guidance, including industry-specific guidance. The core principle of the revenue model is that an entity recognizes revenue to depict the transfer of promised goods and services in an amount that reflects the consideration to which the entity expects to be entitled to in exchange for those goods and services. In addition, the new standard requires that reporting companies disclose the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. In

August 2015,

the FASB issued ASU

2015

“

Revenue from Contracts with Customers

(Topic

606

Deferral of the Effective Date,

" which deferred the effective date of ASU

2014

to annual reporting periods beginning after

December 15, 2017,

with earlier application permitted but

not

before the original effective date.

The Company adopted ASC

606

using the modified retrospective method on

April 1, 2018.

The Company utilized a cross-functional team to implement the guidance related to the recognition of revenue from contracts with customers. The implementation approach included an assessment of customer contracts aimed at identifying contractual provisions that could result in a change in the timing or the amount of revenue recognized in comparison with prior guidance, as well as assessing the enhanced disclosure requirements of the new guidance. Revenues are generated through the sale of finished products, and will be recognized at the point in time when control of the merchandise is transferred to the customer and in an amount that considers the impact of estimated returns, discounts and other allowances that are variable in nature. The Company continues to implement changes to its business processes and controls to support the recognition and disclosure requirements under the new guidance. The Company has concluded that the impact of adoption of ASC

606

as of

April 1, 2018

not

material to its financial statements.