NOTE A

—THE COMPANY AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Nature of Business

The Company, founded in

1993,

develops and markets proprietary fingerprint identification biometric technology and software solutions.

The Company was a pioneer in developing automated, finger identification technology that supplements or compliments other methods of identification and verification, such as personal inspection identification, passwords, tokens, smart cards, ID cards, PKI, credit card, passports, driver’s licenses, OTP or other form of possession or knowledge-based credentialing. Additionally, advanced BIO-key® technology has been, and is, used to improve both the accuracy and speed of competing finger-based biometrics.

Basis of Presentation

The Company has incurred significant losses to date, and at

December

31,

2017,

it had an accumulated deficit of approximately

$67.1

million. In addition, broad commercial acceptance of the Company’s technology is critical to the Company’s success and ability to generate future revenues. At

December 31, 2017,

total cash and cash equivalents were approximately

$289,000,

as compared to approximately

$1,061,000

December 31, 2016.

As discussed below, the Company has financed itself in the past through access to the capital markets by issuing secured and convertible debt securities, convertible preferred stock,

common stock, and through factoring receivables. The Company currently requires approximately

$592,000

per month to conduct operations and pay dividend obligations, a monthly amount that it has been unable to achieve through revenue generation.

If the Company is unable to generate sufficient revenue

to meet our goals, it will need to obtain additional

third

-party financing to (i) conduct the sales, marketing and technical support necessary to execute its plan to substantially grow operations, increase revenue and serve a significant customer base; and (ii) provide working capital.

assurance can be given that any form of additional financing will be available on terms acceptable to the Company, that adequate financing will be obtained by the Company in order to meet its needs, or that such financing would

not

be dilutive to existing shareholders.

The accompanying financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America ("GAAP"), which contemplate continuation of the Company as a going concern, and assumes continuity of operations, realization of assets and the satisfaction of liabilities and commitments in the normal course of business. The matters described in the preceding paragraphs raise substantial doubt about the Company

’s ability to continue as a going concern. Recoverability of a major portion of the recorded asset amounts shown in the accompanying balance sheet is dependent upon the Company’s ability to meet its financing requirements on a continuing basis, and become profitable in its future operations. The accompanying consolidated financial statements do

not

include any adjustments relating to the recoverability and classification of recorded assets or the amounts and classification of liabilities that might be necessary should the Company be unable to continue in existence.

Effective

December 29, 2016,

the Company implemented a reverse stock split of its outstanding common stock at a ratio of

for

shares. All share figures and results are reflected on a post-split basis.

Summary of Significant Accounting Policies

A summary of the significant accounting policies consistently applied in the preparation of the accompanying consolidated financial statements follows:

Basis of Consolidation

The accompanying consolidated financial statements include the accounts of BIO-key International,

Inc. and its wholly-owned subsidiaries (collectively, the “Company”). Intercompany accounts and transactions have been eliminated in consolidation.

Use of Estimates

Our consolidated financial statements are prepared in accordance with GAAP as set forth in the Financial Accounting Standards Board

’s (FASB) Accounting Standards Codification (ASC) and consider the various staff accounting bulletins and other applicable guidance issued by the U.S. Securities and Exchange Commission (SEC). These accounting principles require us to make certain estimates, judgments and assumptions. The Company believes that the estimates, judgments and assumptions upon which it relies are reasonable based upon information available to us at the time that these estimates, judgments and assumptions are made. These estimates, judgments and assumptions can affect the reported amounts of assets and liabilities as of the date of the financial statements as well as the reported amounts of revenues and expenses during the periods presented. To the extent there are material differences between these estimates, judgments or assumptions and actual results, its consolidated financial statements will be affected. In many cases, the accounting treatment of a particular transaction is specifically dictated by GAAP and does

not

require management’s judgment in its application. There are also areas in which management’s judgment in selecting among available alternatives would

not

produce a materially different result.

Revenue Recognition

Revenues from software licensing are recognized in accordance with ASC

985

605,

"Software Revenue Recognition." Accordingly, revenue from software licensing is recognized when all of the following criteria are met: persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collectability is probable.

The Company intends to enter into arrangements with end users for items which

may

include software license fees, and services or various combinations thereof. For each arrangement, revenues will be recognized when evidence of an agreement has been documented, the fees are fixed or determinable, collection of fees is probable, delivery of the product has occurred and

other significant obligations remain.

Multiple-Element Arrangements: For multiple-element arrangements, the Company applies the residual method in accordance with ASC

985

605.

The residual method requires that the portion of the total arrangement fee attributable to the undelivered elements be deferred based on its

vendor-specific objective evidence ("VSOE") of fair value and subsequently recognized as the service is delivered. The difference between the total arrangement fee and the amount deferred for the undelivered elements is recognized as revenue related to the delivered elements, which is generally the software license. VSOE of fair value for all elements in an arrangement is based upon the normal pricing for those products and services when sold separately. VSOE of fair value for support services is additionally determined by the renewal rate in customer contracts. The Company has established VSOE of fair value for support as well as consulting services.

License Revenues: Amounts allocated to license revenues are recognized at the time of delivery of the software and all other revenue recognition criteria discussed above have been met.

Revenue from licensing software, which requires significant customization and modification, is recognized using the percentage of completion method, based on the hours of effort incurred by the Company in relation to the total estimated hours to complete. In instances where

third

party hardware, software or services form

a significant portion of a customer’s contract, the Company recognizes revenue for the element of software customization by the percentage of completion method described above. Otherwise,

third

party hardware, software, and services are recognized upon shipment or acceptance as appropriate. If the Company makes different judgments or utilizes different estimates of the total amount of work expected to be required to customize or modify the software, the timing and revenue recognition, from period to period, and the margins on the project in the reporting period,

may

differ materially from amounts reported. Anticipated contract losses are recognized as soon as they become known and are estimable.

Service Revenues: Revenues from services are comprised of maintenance and consulting and implementation services. Maintenance revenues include providing for unspecified when-and-if available product updates and customer telephone support services, and are recognized ratably over the term of the service period. Consulting services are generally sold on a time-and-materials basis and include a range of services including installation of software and assisting in the design of interfaces to allow the software to operate in customized environments. Services are generally separable from other elements under the arrangement since performance of the services are

not

essential to the functionality of any other element of the transaction and are described in the contract such that the total price of the arrangement would be expected to vary as the result of the inclusion or exclusion of the services. Revenues from services are generally recognized as the services are performed.

The Company provides customers, free of charge or at a minimal cost, testing kits which potential licensing customers

may

use to test compatibility/acceptance of the Company’s technology with the customer’s intended applications.

Costs and other expenses: Includes professional compensation and other direct contract expenses, as well as costs attributable to the support of client service professional staff, depreciation and amortization costs related to assets used in revenue-generating activities, and other costs attributable to serving the Company

’s client base. Professional compensation consists of payroll costs and related benefits including stock-based compensation and bonuses. Other direct contract expenses include costs directly attributable to client engagements, such as out-of-pocket costs including travel and subsistence for client service professional staff, costs of hardware and software and costs of subcontractors. The allocation of lease and facilities charges for occupied offices is included in costs of service.

The Company accounts for its warranties under the FASB ASC

450,

“Contingencies.” The Company generally warrants that its products are free from defects in material and workmanship for a period of

one

year from the date of initial receipt by its customers. The warranty does

not

cover any losses or damage that occurs as a result of improper installation, misuse or neglect or repair or modification by anyone other than the Company or its authorized repair agent. The Company

’s policy is to accrue anticipated warranty costs based upon historical percentages of items returned for repair within

one

year of the initial sale. The Company’s repair rate of products under warranty has been minimal, and a historical percentage has

not

been established. The Company’s software license agreements generally include certain provisions for indemnifying customers against liabilities if the Company’s software products infringe upon a

third

party’s intellectual property rights. The Company has

not

provided for any reserves for warranty liabilities as it was determined to be immaterial.

Cash

Equivalents

Cash equivalents consist of liquid investments with original maturities of

three

months or less.

December 31, 2017

and

2016,

cash equivalents consisted of a money market account.

Accounts Receivable

Accounts receivable are carried at original amount less an estimate made for doubtful receivables based on a review of all outstanding amounts on a monthly basis. Management determines the allowance for doubtful receivables by regularly evaluating individual customer receivables and considering a customer

’s financial condition, credit history, and current economic conditions. Accounts receivable are written off when deemed uncollectible. During the quarter ended

September 30, 2016,

the Company reclassified a past due receivable to non-current, as management concluded that collection

may

not

occur in the near term. As a result of the payment delays, at

December 31, 2017

the Company has reserved

$1,000,000,

which represents

57%

of the remaining balance owed under the contract. Recoveries of accounts receivable previously written off are recorded when received. Accounts receivable at

December 31, 2017

and

2016

consisted of the following:

	December 31,
	201 7			201 6

Accounts receivable - current	$	2,889,731		$	1,577,031
Accounts receivable - non current		1,760,000			2,070,000
		4,649,731			3,647,031
Allowance for doubtful accounts - current		(13,785	)		(13,785	)
Allowance for doubtful accounts - non current		(1,000,000	)		(500,000	)
		(1,013,785	)		(513,785	)

Accounts receivable, net of allowances for doubtful accounts	$	3,635,946		$	3,133,246

The allowance for doubtful accounts for the years ended

December 31,

201

and

2016

is as follows:

	Balance at Beginning of Year		Charged to Costs and Expenses		Deductions From Reserves		Balance at End of Year
Year Ended December 31, 201 7
Allowance for Doubtful Accounts	$	513,785	$	500,000	$	-	$	1,013,785
Year Ended December 31, 201 6
Allowance for Doubtful Accounts	$	13,785	$	500,000	$	-	$	513,785

The bad debt expense is recorded in selling, general, and administrative expense.

Software License Rights

Software license rights acquired for re-sale to end users are recorded as assets when purchased and are stated at the lower of cost or estimated net realizable value.

The cost of the software license rights has been initially allocated pro-rata to the maximum number of resalable end-user licenses in the rights contract. Licenses are amortized to cost of sales over the greater of the following:

) an estimate of the economic use of such license rights over a

year period with weighting towards the beginning of the term,

) straight line method over

ten

years or

) ratably at cost basis as each end user license is resold to a customer. Management re-evaluates the total sub-licenses it expects to sell during the proceeding

twelve

months and will adjust the allocation of the current portion vs. non-current portion of software rights.

The rights are also evaluated by management on a periodic basis to determine if estimated future net revenues, on a per sub-license basis, support the recorded basis of each license. If the estimated net revenues are less than the current carrying value of the capitalized software license rights, the Company will reduce the rights to their net realizable value.

Equipment and Leasehold Improvements, Intangible Assets and

Depreciation and Amortization

Equipment and leasehold improvements are stated at cost.

Depreciation is provided for in amounts sufficient to relate the cost of depreciable assets to operations over the estimated service lives, principally using straight-line methods. Leasehold improvements are amortized over the shorter of the life of the improvement or the lease term, using the straight-line method.

The estimated useful lives used to compute depreciation and amortization for financial reporting purposes are as follows:

	Years
Equipment and leasehold improvements
Equipment (years)	3	-	5
Furniture and fixtures (years)	3	-	5
Software (years)		3
Leasehold improvements	life or lease term

Intangible assets consist of patents.

Patent costs are capitalized until patents are awarded. Upon award, such costs are amortized using the straight-line method over their respective economic lives. If a patent is denied, all costs are charged to operations in that year.

Impairment or Disposal of Long Lived Assets, including Intangible Assets

The Company reviews long-lived assets, including intangible assets subject to amortization, whenever events or changes in circumstances indicate that the carrying amount of such an asset

may

not

be recoverable. Recoverability of these assets is measured by comparison of their carrying amount to the future undiscounted cash flows the assets are expected to generate. If such assets are considered impaired, the impairment to be recognized is equal to the amount by which the carrying value of the assets exceeds their fair value determined by either a quoted market price, if any, or a value determined by utilizing a discounted cash flow technique. In assessing recoverability, the Company must make assumptions regarding estimated future cash flows and discount factors. If these estimates or related assumptions change in the future, the Company

may

be required to record impairment charges. Intangible assets with determinable lives are amortized over their estimated useful lives, based upon the pattern in which the expected benefits will be realized, or on a straight-line basis, whichever is greater.

The Company did

not

record any impairment charges in any of the years presented.

Advertising Expense

The Company expenses the costs of advertising as incurred. Advertising expenses for

201

and

2016

were approximately

$386,000

and

$299,000,

respectively.

10.

Deferred Revenue

Deferred revenue includes customer advances and amounts that have been billed per the contractual terms but have

not

been recognized as revenue. The majority of these amounts are related to maintenance contracts for which the revenue is recognized ratably over the applicable term, which generally is

months from the date the customer is delivered the products.

11.

Research and Development Expenditures

Research and development expenses include costs directly attributable to the conduct of research and development programs primarily related to the development of our software products and improving the efficiency and capabilities of our existing software. Such costs include salaries, payroll taxes, employee benefit costs, materials, supplies, depreciation on research equipment, services provided by outside contractors, and the allocable portions of facility costs, such as rent, utilities, insurance, repairs and maintenance, depreciation and general support services. All costs associated with research and development are expensed as incurred.

12.

Earnings Per Share of Common Stock (“EPS”)

The Company

’s EPS is calculated by dividing net income (loss) applicable to common stockholders by the weighted-average number of common shares outstanding during the reporting period. Diluted EPS includes the effect from potential issuances of common stock, such as stock issuable pursuant to the conversion of preferred stock, exercise of stock options and warrants, when the effect of their inclusion is dilutive. See Note R - Earnings Per Share “EPS” for additional information.

13.

Accounting for Stock-Based Compensation

The Company accounts for share based compensation in accordance with the provisions of ASC

718

10,

“Compensation

— Stock Compensation,” which requires measurement of compensation cost for all stock awards at fair value on date of grant and recognition of compensation over the service period for awards expected to vest. The majority of its share-based compensation arrangements vest over either a

three

four

year vesting schedule. The Company expenses its share-based compensation under the ratable method, which treats each vesting tranche as if it were an individual grant. The fair value of stock options is determined using the Black-Scholes valuation model, and requires the input of highly subjective assumptions. These assumptions include estimating the length of time employees will retain their vested stock options before exercising them (the “expected option term”), the estimated volatility of its common stock price over the option’s expected term, the risk-free interest rate over the option’s expected term, and the Company’s expected annual dividend yield. Changes in these subjective assumptions can materially affect the estimate of fair value of stock-based compensation and consequently, the related amount recognized as an expense in the consolidated statements of operations. As required under the accounting rules, the Company reviews its valuation assumptions at each grant date and, as a result, the Company is likely to change its valuation assumptions used to value employee stock-based awards granted in future periods. The values derived from using the Black-Scholes model are recognized as expense over the service period, net of estimated forfeitures (the number of individuals that will ultimately

not

complete their vesting requirements). The estimation of stock awards that will ultimately vest requires significant judgment. The Company considers many factors when estimating expected forfeitures, including types of awards, employee class, and historical experience. Actual results, and future changes in estimates,

may

differ substantially from current estimates.

The following table presents share-based compensation expenses included in the Company

’s consolidated statements of operations:

	Year ended December 31,
	2017		2016

Selling, general and administrative	$	864,036	$	353,056
Research, development and engineering		108,728		74,786
	$	972,764	$	427,842

Valuation Assumptions for Stock Options

For

201

and

2016,

1,234,167

and

27,087

stock options were granted, respectively. The fair value of each option was estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions:

	Year ended December 31,
	2017			2016
Weighted average Risk free interest rate		1.92	%		1.11	%
Expected life of options (in years)		4.51			4.50
Expected dividends		0	%		0	%
Weighted average Volatility of stock price		138	%		93	%

The stock volatility for each grant is determined based on the review of the experience of the weighted average of historical daily price changes of the Company

’s common stock over the expected option term. The expected term was determined using the simplified method for estimating expected option life, which qualify as “plain-vanilla” options; and the risk-free rate is based on the U.S. Treasury yield curve in effect at the time of grant for periods corresponding with the expected life of the option.

14.

Derivative Liabilities

In connection with the issuances of equity instruments or debt, the Company

may

issue options or warrants to purchase common stock. In certain circumstances, these options or warrants

may

be classified as liabilities, rather than as equity. In addition, the equity instrument or debt

may

contain embedded derivative instruments, such as conversion options or listing requirements, which in certain circumstances

may

be required to be bifurcated from the associated host instrument and accounted for separately as a derivative liability instrument.

The Company early-adopted the new provisions issued

July 2017,

for derivative liability instruments under FASB ASU

2017

11,

Earnings Per Share (Topic

260

), Distinguishing Liabilities from Equity (Topic

480

) and Derivatives and Hedging (Topic

815

2017

11,

down round features do

not

meet the criteria for derivative accounting and

liability is to be recorded until an actual issuance of securities triggers the down-round feature. Prior to these provisions, the liabilities were recorded without the actual issuance of the securities triggering the down-round feature.

Income Taxes

The provision for, or benefit from, income taxes includes deferred taxes resulting from the temporary differences in income for financial and tax purposes using the liability method. Such temporary differences result primarily from the differences in the carrying value of assets and liabilities. Future realization of deferred income tax assets requires sufficient taxable income within the carryback, carryforward period available under tax law. The Company evaluates, on a quarterly basis whether, based on all available evidence, if it is probable that the deferred income tax assets are realizable. Valuation allowances are established when it is more likely than

not

that the tax benefit of the deferred tax asset will

not

be realized. The evaluation, as prescribed by ASC

740

10,

“Income Taxes,” includes the consideration of all available evidence, both positive and negative, regarding historical operating results including recent years with reported losses, the estimated timing of future reversals of existing taxable temporary differences, estimated future taxable income exclusive of reversing temporary differences and carryforwards, and potential tax planning strategies which

may

be employed to prevent an operating loss or tax credit carryforward from expiring unused. Because of the Company

’s historical performance and estimated future taxable income, a full valuation allowance has been established.

The Company accounts for uncertain tax provisions in accordance with ASC

740

05,

“Accounting for Uncertainty in Income Taxes.” The ASC clarifies the accounting for uncertainty in income taxes recognized in an enterprise

’s financial statements. The ASC prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The ASC provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure and transition.

Recent Accounting Pronouncements

May 2014

, FASB issued ASU

No.

2014

09,

Revenue from Contracts with Customers: Topic

606

(“

ASC

606”

), to supersede nearly all existing revenue recognition guidance under U.S. GAAP. The standard contains a comprehensive new revenue recognition model that requires revenue to be recognized in a manner to depict the transfer of goods or services to a customer at an amount that reflects the consideration expected to be received in exchange for those goods and services. The FASB has issued several amendments to the standard, including clarifications on disclosure of prior-period performance obligations and remaining performance obligations.

The Company will adopt ASC

606

effective

January 1, 2018

using the

modified retrospective transition method. While the Company is finalizing the impact this standard has on its consolidated financial statements and related disclosures, the Company expects the new standard will

not

have a material impact on the timing of its revenue recognition. The Company expects that certain contract acquisition costs such as sales commissions, will be amortized over an expected benefit period that is longer than the Company’s current policy of expensing these amounts over either the contract term or up-front, depending on the size of the order. The Company does

not

expect the adoption of ASC

606

to have any impact on its operating cash flows.

July 2015,

the FASB issued ASU

No.

2015

11,

"Inventory (Topic

330

): Simplifying the Measurement of Inventory" ("ASU

2015

11"

). The amendments in ASU

2015

clarifies the measurement of inventory to be the lower of cost or realizable value and would only apply to inventory valued using the FIFO or average costing methods. ASU

2015

is effective for fiscal years beginning after

December 15, 2016,

including interim periods within those fiscal years. The reporting entity should apply the amendments prospectively with earlier application permitted as of the beginning of an interim or annual reporting period. The adoption of ASU

2015

did

not

materially impact the Company

’s consolidated financial statements.

February 2016,

the FASB issued ASU

2016

02,

“Leases”. The new standard establishes a right-of-use (ROU) model that requires a lessee to record a ROU asset and a lease liability on the balance sheet for all leases with terms longer than

months. Leases will be classified as either finance or operating, with classification affecting the pattern of expense recognition in the income statement. The new standard is effective for fiscal years beginning after

December 15, 2018,

including interim periods within those fiscal years. A modified retrospective transition approach is required for capital and operating leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements, with certain practical expedients available. The Company is currently evaluating the impact of its pending adoption of the new standard on its consolidated financial statements, but expects that it will increase its assets and liabilities

for amounts yet to be determined.

August 2014,

the FASB issued ASU

No.

2014

15,

“Disclosure of Uncertainties about an Entity's Ability to Continue as a Going Concern”. Prior to ASU

2014

15,

a definition for substantial doubt did

not

exist. However, the new guidance says that substantial doubt exists when relevant conditions and events, considered in the aggregate, indicate that it is probable that the entity will be unable to meet its obligations as they become due within

one

year after the date that the financial statements are available to be issued. The FASB's definition could be perceived as a higher threshold than current practice as the term “probable” means likely to occur. Under the new standard, management should evaluate all relevant known conditions, or those that can be reasonably expected to happen as of the date the financial statements are to be issued. This evaluation should be both qualitative and quantitative in nature, and should include conditions that might give rise to substantial doubt. ASU

2014

is effective for fiscal years beginning after

December 15, 2016,

including interim periods within those fiscal years. The Company adopted ASU

2014

as of

January 1, 2017.

March 2016,

the FASB issued Accounting Standards Update

2016

09,

“Compensation

– Stock Compensation: Improvements to Employee Share-Based Payment Accounting” (“ASU

2016

09”

). ASU

2016

requires, among other things, that excess tax benefits and tax deficiencies be recognized as income tax expense or benefit in the income statement rather than as additional paid-in capital, changes the classification of excess tax benefits from a financing activity to an operating activity in the statement of cash flows, and allows forfeitures to be accounted for when they occur rather than estimated. ASU

2016

is effective for public companies for interim and annual periods beginning after

December 15, 2016.

The Company will continue to estimate forfeitures at each reporting period, rather than electing an accounting policy change to record the impact of such forfeitures as they occur. The adoption did

not

have a material impact on the Company's consolidated financial statements.

July 2017,

the FASB issued ASU

2017

11,

Earnings Per Share (Topic

260

), Distinguishing Liabilities from Equity (Topic

480

) and Derivatives and Hedging (Topic

815

): I. Accounting for Certain Financial Instruments with Down Round Features; II. Replacement of the Indefinite Deferral for Mandatorily Redeemable Financial Instruments of Certain Nonpublic Entities and Certain Mandatorily Redeemable Non-controlling Interests with a Scope Exception. Part I of this update addresses the complexity of accounting for certain financial instruments with down round features. Down round features are features of certain equity-linked instruments (or embedded features) that result in the strike price being reduced on the basis

of the pricing of future equity offerings. Current accounting guidance creates cost and complexity for entities that issue financial instruments (such as warrants and convertible instruments) with down round features that require fair value measurement of the entire instrument or conversion option. Under ASU

2017

11,

down round features do

not

meet the criteria for derivative accounting and

liability is to be recorded until an actual issuance of securities triggers the down-round feature. Part II of this update addresses the difficulty of navigating Topic

480,

Distinguishing Liabilities from Equity, because of the existence of extensive pending content in the FASB Accounting Standards Codification. This pending content is the result of the indefinite deferral of accounting requirements about mandatorily redeemable financial instruments of certain nonpublic entities and certain mandatorily redeemable non-controlling interests. The amendments in Part II of this update do

not

have an accounting effect. This ASU is effective for fiscal years, and interim periods within those years, beginning after

December 15, 2018,

with early adoption permitted. The adoption of ASU

2017

11,

during the fiscal

2017

year did

not

have any impact on the condensed consolidated financial statements, however our disclosures with respect to equity instruments with down round features have been updated. See Note N for updated disclosures.

Management does

not

believe that any other recently issued, but

not

yet effective, accounting standard if currently adopted would have a material effect on the accompanying consolidated financial statements.

Reclassifications

Reclassifications occurred to certain prior year amounts in order to conform to the current year classifications. The reclassifications have

effect on the reported net loss.