Spectra Systems Corporation
Annual Report 2015

Plain-text annual report

S p e c t r a S y s t e m s C o r p o r a t i o n A n n u a l r e p o r t a n d a c c o u n t s 2 0 1 5 A leading provider of advanced technology‑based security solutions Spectra Systems Corporation Annual report and accounts 2015 Spectra Systems Corporation is an established world leader in providing security technology, from banknotes and products to electronic gaming. Spectra provides an integrated solution of engineered materials for authentication and hardware and software systems which verify the unique signatures of the authentication materials. WE OPERATE IN 35 COUNTRIES WE HAVE 29 STAFF IN OUR OFFICES FOUR ACQUISITIONS SINCE 2012 41 CUSTOMERS Review of the year IFC Corporate statement 1 2 4 Our strategy 6 Highlights Spectra at a glance Chief Executive Officer’s statement Corporate governance Board of Directors and 8 senior management 10 Directors’ report Independent auditors’ report Financial statements 15 16 Balance sheets 17 18 Statements of income and other comprehensive income Statements of stockholders’ equity 19 Statements of cash flows 20 Notes to the financial information Shareholder and corporate information 32 Discover more online www.spsy.com Our strategy Page 4 Chief Executive Officer’s statement Page 6 Financial highlights – Revenue exceeded analyst expectations at US$14.1 million (2014: US$16.9 million) – Adjusted EBITDA1 at US$1.1 million (2014: US$2.1 million) – Adjusted earnings1 per share of US$0.02 (2014: US$0.05) – Strong balance sheet and positive operating cash flow in 2015 with cash of US$9.8 million (2014: US$9.8 million) at 31 December 1 Before stock compensation expense and exceptional items. Operational highlights – G7 Sensor contract completion resulted in the release of US$2.0 million of restricted cash – Reduced operating expenses by US$0.9 million on completion of G7 Sensor program – Phosphour sales exceeded last three years’ average by 20% – Brand authentication sales exceeded management forecast by 50% – Secure Transactions Group performed in line with expectations HIGHLIGHTS Revenue (US$’000) 14,114 (2014: 16,906) 6 0 9 6 1 , 4 1 1 , 4 1 2 7 5 , 1 1 9 7 3 9 , 12 13 14 15 The overall business continues to create profits and has developed a number of new revenue sources that will sustain growth Review of the yearSPECTRA AT A GLANCE Spectra is a highly responsive organization that develops customized solutions for its customers. Our solutions Authentication systems Secure transactions Spectra’s sophisticated capabilities allow us to invent, develop and manufacture integrated solutions comprised of a system of taggant materials and sensor equipment to authenticate banknotes at high processing speeds. Our solutions are used by: – two G8 central banks; Spectra’s Secure Transactions Group is the leading supplier of real-time fraud control and risk management systems to government-sanctioned gaming operators. Currently deployed in North America, Europe and Asia, our integrity systems monitor and audit more than US$20 billion in annual sales for online, internet and mobile phone-based lotteries and pari-mutuel organizations. – 18 other central banks for currency authentication; and Our products have been engineered to provide: – a major G8 country for passport security. – fully automated independent real-time monitoring; and – vendor independence – designed for any gaming system. Banknote cleaning Smartphone authentication of product brands Spectra’s new technology has the potential to substantially reduce central bank costs and environmental issues in disposing of soiled banknotes. Two United States patents on the use of supercritical fluids for cleaning and decontaminating banknotes in circulation were issued in 2015. TruBrand™ and TruNote™ Spectra’s new technology enables end users to verify products and banknotes with a smartphone. This technology eliminates the need for costly readers and allows the consumer to authenticate the product themselves. 2 Spectra Systems Corporation Annual report and accounts 2015We believe that we have a number of transformation opportunities ahead in all aspects of our business Our customers Acquisition of key specialty phosphour company Our customers include a G8 central bank organization and one of the world’s largest commercial security printers and papermakers, which supplies the Company’s technology to a second G8 central bank and numerous other central banks. Our solutions are used by: – 20 central banks; – commercial security printers and papermakers; – Crane & Co; – national lotteries in six countries; – suppliers of security threads for world currencies; – Intralot SA; – Scientific Games International; and – GTECH S.p.A. Overview Spectra Systems Corporation, a leader in machine-readable high speed banknote authentication, completed the acquisition of certain specialty phosphour assets primarily used in the authentication of world banknotes. Most importantly, in addition to the assets, Spectra has acquired long-standing customer relationships related to the assets, including a major world supplier of banknote inks. The ability to integrate these assets and relationships with our existing phosphour business will further bolster our stable government-based business income streams Nabil M. Lawandy Chief Executive Officer 3 Spectra Systems Corporation Annual report and accounts 2015Review of the yearOUR STRATEGY The Company’s strategy for increasing revenue and earnings is based on: Strategic aim Development strategy Progress Introduce machine‑readable, multi‑code security for polymer banknotes and existing overt security features Upgrade our software security products with an outlook to new forms of gaming Develop security materials for polymer substrates. Co-development with polymer banknote supplier and printer. Integrate our machine-readable technologies into brand product packaging, holograms, and labels, with a focus on Asia. Increased sales in brand authentication with new MultiSureTM codes. Increase our Secure Transactions Group revenues by: First sales of tablet-based dashboard for real-time monitoring. – Providing higher value product upgrades to existing customers. – Modifying our products to compliment daily fantasy sports enterprises. Advanced smartphone authentication technology Increase palette of unique material codes for smartphone authentication. First new TruBrandTM customer announced in China. – Market TruNoteTM to central banks. Trials underway for large tobacco opportunity. – Focus on multiple opportunities in Asian markets. Introduction of TruNoteTM for smartphone authentication of banknotes. Increase phosphour sales Acquire specialty phosphour company. Actively upsell phosphours in our other security products. Acquired specialty phosphour company in January 2016. – Increased phosphour sales beyond US banknotes into Asia and Europe. 4 Spectra Systems Corporation Annual report and accounts 2015Outlook New opportunities include G7 and other central banks. Executed nine-year contract for machine-readable authentication of government certificates in China. Growing fantasy sports enterprise opportunities within all professional sports, in the USA and Europe. Legislation on the horizon to better police this gaming area. Full pipeline for all three areas of smartphone technology. – TruNoteTM: Banknotes. – TruStampTM: Tax Stamps. – TruBrandTM: Brand goods. TruNoteTM well received at the 2016 Banknote Conference®. New opportunities with long-standing acquisition customers. Incorporation of phosphours in our smartphone products. Our markets Spectra Systems’ market opportunity has expanded once more with the introduction of our smartphone authentication solutions for products, tax stamps, and banknotes. The ability to empower anyone with a smartphone to authenticate products and banknotes containing our materials transforms the market opportunity beyond a reader-constrained model. With nearly 150 billion banknotes manufactured yearly at a cost approaching US$10 billion annually along with the increasing demands for governments to reduce costs, we continue to market our banknote cleaning technology. AerisTM machines have the potential to generate over US$1 billion of hardware sales with ongoing service revenue once the long central bank sales cycle plays out. AerisTM has no competition and, now that patents have been issued, the market is ours exclusively. Our TruBrandTM, TruStampTM, and TruNoteTM suite of solutions are the only materials-based smartphone authentication technologies in the world and rely on our proprietary materials. This is a powerful combination of new and disruptive technologies introduced by one company, which, in the span of two years, has gone from concept to market ready products for sale. The combination of the banknote authentication market, where we are one of several competing companies, along with our introduction of highly innovative technologies, where we will be the sole supplier, dramatically expands the market potential of this sector and our business within the coming years. Our high speed, machine-readable banknote authentication technology is currently utilized by 20 central banks to prevent sophisticated counterfeiting of their currency and will facilitate our ability to introduce both AerisTM and the TruNoteTM version of our smartphone authentication technology. Spectra’s secure internal control system (ICS) software products have been augmented with new capabilities since the acquisitions and have resulted in revenue growth with existing customers as well as with new ones. Along with expansion in internet-based lotteries, we hope to be the first supplier of ICS systems to the rapidly growing fantasy sports gaming industry throughout the world. Spectra’s suite of portable reader-based solutions can be used for authenticating and tracking consumer and tax-bearing products, both locally and through cloud-based internet connections. With the introduction of TruBrandTM and TruStampTM, our smartphone and consumable materials-based products for brand and tax stamp authentication, we expect this segment of our business to grow rapidly and steadily over the next five years. 5 Spectra Systems Corporation Annual report and accounts 2015Review of the yearCHIEF EXECUTIVE OFFICER’S STATEMENT Through achieving key commercial milestones, Spectra Systems has out performed market expectations in 2015. Introduction Through achieving key commercial milestones, as described in the Review of operations below, Spectra Systems has again out performed market expectations in 2015. For the second year running, Spectra has generated over US$1.0 million EBITDA and continued to gain traction with its organic and acquired business lines. – Continued strong momentum with the evaluation process by a G7 central bank of a new covert security feature for polymer notes. – Reduced operating expenses by US$0.9 million on completion of the G7 sensor program. – Brand authentication sales of US$1.5 million (2014: US$0.6 million) exceeded management expectations by 50%. Revenue for the year was US$14.1 million (2014: US$16.9 million). EBITDA for the year, before stock compensation expense and exceptional items, amounted to US$1.1 million, compared to a prior year of US$2.1 million. Revenue was partially driven by the completion of a major hardware sensor program. Although an order for hardware of this magnitude is unlikely in 2016, we are near the closure of a significant renewal contract with our major central bank customer which is in the process of evaluating a significant five-year contract for materials. The contract is expected to reimburse the costs incurred in building the manufacturing facility and would enhance the visibility of future revenues. Improved margins from both cost-cutting initiatives as well as lower manufacturing costs from the in-house facility are long-lived and will contribute to profitability going forward. Cash at the period end amounted to US$9.8 million (2014: US$9.8 million). The Company has sufficient resources to execute on its growth plans with its existing cash reserves. Review of operations Authentication Systems The Authentication Systems business generated revenue of US$12.8 million (2014: US$15.5 million) and EBITDA of US$1.1 million (2014: US$1.9 million). The drop-off, which was foreseen, is due to an exceptional year in 2014 of materials sales and of phosphour sales, which had reached their highest ever levels. Particular achievements included: – Renewed license agreement for covert materials and sensors to achieve minimum quantities and a 7% price increase. – Commenced negotiations in 2015 concerning specialty phosphour assets, which resulted in their acquisition by the Company in January 2016. – Executed a new nine-year US$5.5 million contract for authentication of an Asian government’s documents commencing in June 2016. – Initiated several trials of the TruBrandTM smartphone-based authentication technology, primarily in China. Although the hardware sales-based earnings in 2015 are not expected to repeat at this level again in 2016, they should be compensated by the sale of contracted document authentication products which will begin in June of 2016. Secure Transactions Group technologies The Secure Transactions Group, formed around the various gaming technology acquisitions made in 2012, performed in line with management expectations, generating EBITDA of US$0.5 million (2014: US$0.6 million) on revenue of US$1.3 million (2014: US$1.4 million). The Secure Transactions Group has won several new contracts and has succeeded in introducing new tablet products to facilitate the tracking and monitoring of gaming transaction flow by lottery officials. This new "dashboard" product was recently adopted in Norway, which we hope will validate the benefits of the product and help promote additional sales of this and related support options. Banknote cleaning While there was no revenue contribution from the business line in 2015 or 2014, development expenses related to the product validation and marketing amounted to US$0.5 million (2014: US$0.4 million). With the completion of the development phase, the program costs associated with this new technology will now contract to basic marketing expenses. The Board continues to be particularly excited by this technology, which has the potential to substantially reduce central bank costs and environmental issues in disposing of soiled banknotes. It was therefore delighted that two US patents on the use of supercritical fluids for cleaning and decontaminating banknotes in circulation were issued to the Company in January 2015. 6 Spectra Systems Corporation Annual report and accounts 2015The Company’s prospects have dramatically increased with the growth of the authentication business outside of banknotes The near-term opportunities are: – The rapidly advancing Reserve Bank of India tender in which we are partnered with our long-time licensee using a new modification of our current product. – The potential selection of our new covert technology for polymer notes by an existing G7 central bank customer introducing a new denomination in the next two years. The longer-term opportunities are: – The joint development and licensing of a multi-code polymer technology by a major printer of banknotes. – The sale of our latest smartphone technology, TruNoteTM, for the authentication of banknotes with a particular focus on its use by the visually impaired. We are pleased that we are able to supplement our sustained and growing profitability with a number of near-term and longer-term prospects. We are particularly delighted that the authentication business outside of banknotes is increasing ahead of expectations and that it can provide a smoothing of our less predictable, but long term, banknote business, with its characteristically extended sales cycles and delays. Furthermore, we believe that we have a number of transformative opportunities ahead in all aspects of our business and are in a position to reduce our research efforts once these opportunities have been fully resolved, replacing them with a less costly applications support team. The Board is optimistic about the future of the Company and its growth through both increased sales, and continued prudent and properly timed cost-cutting initiatives. Nabil M. Lawandy Chief Executive Officer May 23, 2016 The adoption cycle of the AerisTM product is expected to be long-term based on the risk average nature of the banknote industry. The Company is therefore looking to partner with a credible industry hardware supplier to advance the adoption of AerisTM. We also expect that, with the costs of development behind us, we will be in a position to mount a cost effective and lean marketing effort to attract a central bank to evaluate the technology, either directly with us, or through a partner or licensee. Strategy The Company’s strategy for increasing revenue and earnings is based on: – Focusing on larger central banks with existing technology and penetrating the polymer banknote authentication market. – Attracting additional customers for our phosphour product offerings which have been significantly increased with the acquisition of related specialty assets in January this year. – Concentrating our marketing efforts for smartphone authentication in Asia in all sectors from linens to tobacco and electronics. – Expanding our Secure Transactions Group contributions by introducing new hardware options, as well as anticipating new opportunities in monitoring internet-based gaming and new betting formats currently in conflict with regulators, such as daily fantasy sports enterprises. – Controlling operating costs while maintaining strong capabilities for delivery of products with a reduced emphasis on research and development. Prospects The Company’s prospects have dramatically increased with the growth of the authentication business outside of banknotes. This growth is evidenced by the nearly 50% growth in sales of the brand, document, and tax stamp authentication products since the acquisition of that business in 2014. In addition to continued growth of this business line, we have initiated a number of customer trials, primarily in China, for our TruBrandTM smartphone-based authentication technology which we are confident will lead to sales in 2016. The opportunities for TruBrandTM are in the tens of billions of units in China and have the potential to create a high margin revenue stream in the very near future. We are targeting four specific opportunities in the banknote security area, two of which are relatively near term and two of which are somewhat longer term. 7 Spectra Systems Corporation Annual report and accounts 2015Review of the yearBOARD OF DIRECTORS AND SENIOR MANAGEMENT BOARD OF DIRECTORS BJ Penn Non-executive Chairman Nabil M. Lawandy President and Chief Executive Officer Mr. Penn was Acting Secretary of the US Navy from March to May 2009, having previously been Assistant Secretary of the Navy (Installations and Environment) from March 2005. He was also Director, Industrial Base Assessments from October 2001 to March 2005, with responsibility for the overall health of the US defense industrial base. He commenced his career as a Naval Aviator, having received his BS from Purdue University, West Lafayette, and his MS from the George Washington University, Washington, DC. Mr. Penn has been a member of the Board since June 2010 and became Chairman of the Board on 7 June 2011. Dr. Lawandy is the founder, President and Chief Executive Officer of the Company. From 1981 to 1999, Dr. Lawandy was a tenured full professor of Engineering and Physics at Brown University in Providence, Rhode Island. He holds a BA in Physics, and an MSc and PhD in Chemistry, each from the Johns Hopkins University. He has authored over 170 reviewed scientific papers and is an inventor on 52 US and 27 foreign issued patents. He has also received a Presidential Young Investigator award, an Alfred P. Sloan Fellowship, a Rolex Award for Enterprise and a Samuel Slater Award for Innovation. Donald Stanford Non-executive Director Martin Jaskel Non-executive Director Mr. Stanford, who was until 2001 the Chief Technical Officer of GTECH Corporation, is an Adjunct Professor of Computer Science and Engineering at Brown University. He holds a BA in International Relations and an MS in Computer Science and Applied Mathematics, both from Brown University. Over 30 years, he has held every technical leadership position, including Vice President of Advanced Development and Chief Technology Officer. Mr. Stanford serves on several boards including Spectra Systems, Times Squared Academy Charter School and the Business Innovation Factory. Mr. Stanford is a member of the R.I. Science and Technology Advisory Council. He is also an Adjunct Professor in the School of Engineering and is an instructor in the Program in Innovation, Management and Entrepreneurship (PRIME). He serves on the Brown advisory councils to the President and the School of Engineering. In 1999 Don received the Black Engineer of the Year Award for Professional Achievement. In 1999 he also received the Honorable Thurgood Marshall award for community service from the NAACP. In 2002 he received the Brown Graduate School’s Distinguished Graduate award and the R.I. Professional Engineer’s Award for Community Service. Key Audit Committee Compensation Committee Government Security Committee Nominating Committee Martin Jaskel has over 40 years of involvement in the financial services industry. He began in the UK government bond market as a broker with leading firms, latterly as a Partner in W Greenwell & Co. In 1986 as an element of the deregulation of the UK markets, W Greenwell was sold to Midland Bank and became the leading Gilt Edged Market Maker, of which he was a Director. In 1988 he was appointed Director of Global Sales and Marketing of Midland Montagu Treasury (the Treasury division of Midland Bank) after chairing a committee to redesign the distribution of Treasury products. In 1990 he was appointed Director of Global Sales at NatWest Treasury and rebuilt the neglected franchise global distribution of Treasury and Capital Markets products. In 1994 he was promoted to Managing Director of Global Trade and Banking Services. He sat on the Advisory Board of ECGD, the UK export-import bank, was responsible for several years for signing off all the UK exposure to BAE and Airbus and sat on several government and Bank of England advisory boards. In 1997 he left NatWest and founded a financial services consultancy, which included a consultancy at KPMG Corporate Finance and the corporate FX division of Travelex plc, and an interim appointment as the Managing Director of a private real estate company with a £500 million portfolio of commercial and residential property. In 2005 he joined European American Capital Limited, an FSA authorized and regulated specialized advisory bank, as Senior Advisor. He has wide experience as a Non- executive Director of both publicly quoted and private companies. 8 Spectra Systems Corporation Annual report and accounts 2015 SENIOR MANAGEMENT Douglas A. Anderson Chief Financial Officer, Company Secretary and Treasurer Mr. Anderson joined the Company as Chief Financial Officer in December 2006 and was appointed Company Secretary in June 2011. Prior to joining the Company, Mr. Anderson was employed by Bluestreak Inc., a global marketing technology company, where he served as President. Mr. Anderson also held several financial positions including Director and Secretary of Bluestreak’s wholly owned UK subsidiary, Bluestreak International Limited. Prior to Bluestreak, he was responsible for financial and account operations at Log On America, a publicly traded telecommunication company. He also spent three years at Ernst & Young advising clients on financial strategy, accounting and compliance needs. Mr. Anderson holds an MBA from Boston University and a BA from the University of Rhode Island. William Goltsos Vice President, Engineering Dr. Goltsos was appointed Vice President, Engineering, in April 2000. From September 1996 to April 2000, he served as Senior Systems Engineer. Prior to that, from 1992 to 1996, he served as a staff member of the MIT/Lincoln Laboratory’s Optical Communications Group. Dr. Goltsos holds a BSc in Physics from Rensselaer Polytechnic Institute and an MSc and PhD in Physics from Brown University. James Cherry Director of Authentication Systems Mr. Cherry serves as Director of Authentication Systems. He joined the Company in 2002 from Auspex Systems, an enterprise network data storage system business, where he had been involved in marketing and product management for seven years. Prior to that, he had worked for five years at DuPont in product management. Scott Tillotson Director of Secure Transactions Mr. Tillotson serves as Director of the Secure Transactions Group. Mr. Tillotson has held a variety of positions with Spectra for nine years and GTECH Corporation, a leader in the lottery industry, for eight years in product marketing and management. Prior to that, he worked for the IBM Corporation as an Account Executive and Systems Engineer. Scott holds a BSEE from Purdue University. Andrei Smuk Director of Research and Development Dr. Smuk, who joined the Company in 2000, was appointed Director of Research and Development in 2006. He is responsible for the development of advanced materials and innovative sensor systems. He received a PhD in Physics from Brown University in 2000 and an MS in Applied Physics from the Moscow Institute of Physics and Technology in 1994. 9 Spectra Systems Corporation Annual report and accounts 2015Corporate governance DIRECTORS’ REPORT for the year ended December 31, 2015 The Directors present their report and the audited consolidated financial statements for the year ended December 31, 2015. Domicile Spectra Systems Corporation is a C corporation and is registered and domiciled in the United States of America. Principal activity The principal activity of the Company is to invent, develop and sell integrated optical systems that provide customers with increased efficiency, security tracking and product life. The integrated systems combine consumables and engineered optical materials with software and hardware for use in applications. The Company also provides software tools to the lottery and gaming industries for fraud, money laundering and match fixing detection, and statistical analysis. Results and dividends The Company’s statements of income and other comprehensive income are set out on page 17 and show the result for the year. There is no federal or state income tax liability on the respective income tax returns due to timing differences arising between items of income and expenses recorded on the books and those reported on the tax returns. Additionally, the Company has approximately US$26 million in federal and US$4 million in state net operating loss carryforwards to offset future income reported on the respective tax returns. The Directors do not recommend the payment of a dividend (2014 and 2015: US$nil). Review of business and future developments A review of the operations of the Group is contained in the Group at a glance review on page 2. Principal risks and uncertainties and financial risk management Complex products Certain of the products produced by the Company are highly complex and are designed to be used in complex systems. Failure to correct errors or other problems identified after deployment could result in events that may have a negative effect on the Company’s business and financial conditions. The Company’s markets may become impacted by technological change Markets for the Company’s products may become characterized by rapidly changing technology, evolving industry standards and increasingly sophisticated customer requirements. The introduction of products embodying new technology and the emergence of new industry standards could render the Company’s existing products obsolete and unmarketable, and may exert price pressures on existing products. If the Company could not then develop products that remain competitive in terms of technology and price and that meet customer needs, this could have a negative impact on the business. Expiry of patents All patents, have a limited duration of enforceability. United States patents generally have a duration of 20 years from the filing date. Once a patent expires, the invention disclosed in the patent may be freely used by the public without accounting to the patent owner, as long as there are no other unexpired patents that embrace an aspect of the invention. There is no certainty that any improvement, new use, or new formulation will be patented to extend the protection of the underlying invention, or provide additional coverage to adequately protect the invention. As a result, the public may have the right to freely use the invention described in and previously protected by an expired patent. Dependence on key personnel The success of the Company’s revenues are dependent on a limited number of employees, in particular the Chief Executive Officer and other managers with technological and development input. The Company has endeavored to ensure its key employees are incentivized but cannot guarantee the retention of these staff. It also has the benefit of key man insurance. Forward‑looking statements All statements, other than statements of historical fact, contained in this document constitute “forward-looking statements”. In some cases, forward-looking statements can be identified by terms such as “may”, “intend”, “might”, “will”, “should”, “could”, “would”, “believe”, or the negative of these terms and similar expressions. Such forward-looking statements are based on assumptions and estimates, and involve risks, uncertainties and other factors which may cause the actual results, financial condition, performance or achievements of the Company, or industry results, to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. New factors may emerge from time to time that could cause the Company’s business not to develop as it expects and it is not possible for the Company to predict all such factors. Given these uncertainties, investors are cautioned not to place any undue reliance on such forward-looking statements. Except as required by law, the Company disclaims any obligation to update any such forward-looking statements in this document to reflect future events or developments. 10 Spectra Systems Corporation Annual report and accounts 2015Key performance indicators – Revenue of US$14.1 million (2014: US$16.9 million). – Adjusted EBITDA before taxation of US$1.1 million (2014: US$2.1 million). – Adjusted earnings per share, in cents, of US$0.02 (2014: US$0.05). – Basic earnings per share, in cents, of US$0.00 (2014: US$0.02). Post reporting date events On January 28, 2016, the Company acquired certain specialty phosphour assets primarily used in the authentication of world banknotes. The total consideration amounted to US$3.12 million. Financial instruments Details of the use of financial instruments by the Company are contained in Note B to the financial statements. Directors’ responsibilities The Directors are responsible for preparing the Director’s report and the financial statements on the basis of preparation set out in Note A to the financial statements and in accordance with United States Generally Accepted Accounting Principles (US GAAP). The Directors of the Company are responsible for the document in which the financial information is included. In preparing these financial statements, the Directors are required to: – select suitable accounting policies and then apply them consistently; – make judgments and accounting estimates that are reasonable and prudent; and – state whether they have been prepared in accordance with US GAAP, subject to any material departures disclosed and explained in the financial statements. The Directors are responsible for keeping adequate accounting records that are sufficient to show and explain the Company’s transactions, disclose with reasonable accuracy at any time the financial position of the Company and enable them to ensure that the financial statements comply with all legal requirements. They are also responsible for safeguarding the assets of the Company and hence for taking reasonable steps for the prevention and detection of fraud and other irregularities. Directors’ interests The Directors’ beneficial interests in the common stock of the Company were as follows: Ordinary shares O. Salam N.M. Lawandy R. Puton M. Jaskel December 31, 2015 2014 3,594,464 1,833,570 314,514 9,960 3,594,464 1,833,570 314,514 9,960 5,802,508 5,802,508 Substantial shareholdings The following shareholders held 3% or more of the issued common stock of the Company at December 31, 2015: Worsley Investors Fund O. Salam N.M. Lawandy H. Heye N. Slater Ordinary shares 6,870,000 3,594,464 1,883,570 1,813,850 1,415,000 % of issued 15.18 7.94 4.16 4.01 3.13 15,576,884 34.42 11 Spectra Systems Corporation Annual report and accounts 2015Corporate governanceDIRECTORS’ REPORT continued for the year ended December 31, 2015 Directors’ compensation The following table details the Directors’ earned compensation for the year ended December 31, 2015: Executive Directors N.M. Lawandy Non‑executive Directors B. Penn O. Salam M. Jaskel R. Puton D. Stanford J. Donohue Total Salary and bonus Benefits Board fees Total compensation $ 475,000 $ 31,268 $ — $ 506,268 — — — — — — — — — — — — 12,000 12,000 12,000 12,000 12,000 12,000 12,000 12,000 12,000 12,000 12,000 12,000 $ 475,000 $ 31,268 $ 72,000 $ 578,268 Directors’ share options At December 31, 2015, Directors had options or warrants to purchase ordinary shares under the Company’s stock option plan as follows: N.M. Lawandy B. Penn O. Salam M. Jaskel R. Puton D. Stanford Options held at December 31, 2015 Weighted average exercise price Options vested at December 31, 2015 2,449,229 $ 120,000 125,000 120,000 128,000 120,000 3,062,229 $ 0.69 0.60 0.62 0.60 0.62 0.60 0.67 2,374,229 120,000 125,000 120,000 128,000 120,000 2,987,229 Corporate governance At December 31, 2015, the Board comprised one Executive Director, Nabil M. Lawandy, and six Non-executive Directors, BJ Penn, as Chairman, Martin Jaskel, Donald Stanford, Oussama Salam, Roland Puton, and Jeffrey Donohue. On April 12, 2016, the Board contracted to four members in response to a G7 central bank customer security requirement relating to the composition of the Board. At the date of the report, the Board comprised one Executive Director, Nabil M. Lawandy, and three independent Non-executive Directors, BJ Penn, as Chairman, Martin Jaskel, and Donald Stanford. The Board usually meets at least every three months to closely monitor the progress of the Company towards the achievement of budgets, targets, and strategic objectives. The Board also operates four Committees: the Audit Committee, the Compensation Committee, the Nominating Committee, and the Government Security Committee. The Audit Committee comprises Martin Jaskel, Nabil M. Lawandy, and Donald Stanford. It has primary responsibility for monitoring the quality of internal controls and ensuring that the financial performance of the Company is properly measured and reported on. It will receive and review reports from the Company’s management and auditors relating to the interim and annual accounts, and the accounting and internal control systems in use throughout the Company. The Audit Committee intends to meet no less than three times each financial year and will have unrestricted access to the Company’s auditors. The Compensation Committee comprises Martin Jaskel, BJ Penn, and Donald Stanford. It reviews the performance of the Executive Director and makes recommendations to the Board on matters relating to their remuneration and terms of employment. The Committee also makes recommendations to the Board on proposals for the granting of share options and other equity incentives pursuant to any share options scheme or equity incentive scheme in operation from time to time. The Nominating Committee comprises Martin Jaskel, as Chairman, BJ Penn, and Donald Stanford. The Committee seeks and nominates qualified candidates for election or appointment to Spectra’s Board of Directors. 12 Spectra Systems Corporation Annual report and accounts 2015The Government Security Committee comprises BJ Penn, as chairman, and Nabil M. Lawandy. It is responsible for ensuring the implementation within the Company of all procedures, organizational matters and other aspects pertaining to the security and safeguarding of information, including the exercise of appropriate oversight and the monitoring of operations to ensure that protective measures are effectively maintained and implemented. The Board intends to comply with Rule 21 of the AIM Rules relating to directors’ dealings and will also take all reasonable steps to ensure compliance by the Company’s applicable employees; the Company has adopted a share dealing code for this purpose on substantially the same terms as the Model Code. Website publication The Directors are responsible for ensuring the annual report and the financial statements are made available on a website. Financial statements are published on the Company’s website in accordance with legislation in the United Kingdom governing the preparation and dissemination of financial statements, which may vary from legislation in other jurisdictions. The maintenance and integrity of the Company’s website is the responsibility of the Directors. The Directors’ responsibility also extends to the ongoing integrity of the financial statements contained therein. Auditors All of the current Directors have made themselves aware of any information needed by the Company’s auditors for the purposes of its audit and to establish that the auditors are aware of that information. The Directors are not aware of any relevant information of which the auditors are unaware. Miller Wachman LLP has expressed its willingness to continue as the Company’s auditors and a resolution to re-appoint Miller Wachman LLP will be proposed at the Annual General Meeting. By order of the Board Douglas A. Anderson Company Secretary May 23, 2016 13 Spectra Systems Corporation Annual report and accounts 2015Corporate governanceFINANCIAL STATEMENTS Independent auditors’ report 15 16 Balance sheets 17 Statements of income and other comprehensive income 18 Statements of stockholders’ equity 19 Statements of cash flows 20 Notes to the financial information 32 Shareholder and corporate information INDEPENDENT AUDITORS’ REPORT To the Board of Directors and Stockholders of Spectra Systems Corporation Providence, Rhode Island We have audited the accompanying financial statements of Spectra Systems Corporation, which comprise the balance sheets as of December 31, 2015 and 2014, and the related statements of income and other comprehensive income, stockholders’ equity and cash flows for the year then ended, and the related notes to the financial statements. Management’s responsibility for the financial statements Management is responsible for the preparation and fair presentation of these financial statements in accordance with accounting principles generally accepted in the United States of America; this includes the design, implementation, and maintenance of internal control relevant to the preparation and fair presentation of financial statements that are free from material misstatement, whether due to fraud or error. Auditors’ responsibility Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free from material misstatement. An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the financial statements. The procedures selected depend on the auditors’ judgment, including the assessment of the risks of material misstatement of the financial statements, whether due to fraud or error. In making those risk assessments, the auditors consider internal control relevant to the entity’s preparation and fair presentation of the financial statements in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the entity’s internal control. Accordingly, we express no such opinion. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of significant accounting estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our audit opinion. Opinion In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Spectra Systems Corporation as of December 31, 2015 and 2014, and the results of its operations and its cash flows for the years then ended in accordance with accounting principles generally accepted in the United States of America. Miller Wachman LLP Boston, Massachusetts May 17, 2016 15 Spectra Systems Corporation Annual report and accounts 2015Financial statementsBALANCE SHEETS December 31, 2015 and 2014 Assets Current assets  Cash and cash equivalents   Accounts receivable, net of allowance for doubtful accounts of $12,650 and $20,000 at December 31, 2015 and 2014  Other receivables  Inventory  Prepaid expenses  Deferred tax assets Total current assets Property, plant and equipment, net Other assets  Intangible assets, net  Restricted cash and investments  Deferred tax assets  Other assets Total other assets Total assets Liabilities and stockholders’ equity Current liabilities  Accounts payable  Accrued expenses and other liabilities  Deferred revenue Total current liabilities Non-current liabilities  Deferred revenue Total non-current liabilities Total liabilities Stockholders’ equity  Common stock, $0.01 par value, 125,000,000 shares authorized  45,251,370 shares issued and outstanding  Additional paid in capital – common stock  Accumulated other comprehensive loss  Accumulated deficit Total stockholders’ equity 2015 2014 $ 9,808,487 $ 9,772,846 4,198,356 52,705 2,824,195 124,975 170,000 17,178,718 2,867,526 4,627,355 1,073,558 819,000 19,285 6,539,198 1,702,438 50,653 4,195,180 111,319 215,000 16,047,436 2,824,282 4,092,210 2,500,000 774,000 183,941 7,550,151 $ 26,585,442 $ 26,421,869 $ 1,463,698 $ 1,564,641 1,247,273 4,275,612 277,222 277,222 738,878 1,223,676 2,165,744 4,128,298 292,653 292,653 4,552,834 4,420,951 452,514 54,936,776 (86,291) 452,514 54,913,613 (60,063) (33,270,391) (33,305,146) 22,032,608 22,000,918 Total liabilities and stockholders’ equity $ 26,585,442 $ 26,421,869 The accompanying notes are an integral part of these financial statements. 16 Spectra Systems Corporation Annual report and accounts 2015STATEMENTS OF INCOME AND OTHER COMPREHENSIVE INCOME for the years ended December 31, 2015 and 2014 Revenues  Product  Service  Royalty Total revenues Cost of sales Gross profit Operating expenses  Research and development  General and administrative  Sales and marketing Total operating expenses (Loss)/income from operations Other income/(expense)  Interest income  Other income  Foreign currency (loss)/gain Total other income Income before provision for income taxes Provision for income taxes Net income Earnings per share  Earnings per share, basic and diluted  Weighted average number of common shares Other comprehensive (loss)/income  Unrealized loss on currency exchange  Reclassification for realized loss/(gain) in net income Total other comprehensive loss Comprehensive income The accompanying notes are an integral part of these financial statements. 2015 2014 $ 11,672,565 $ 14,163,982 1,747,474 693,824 14,113,863 7,402,407 6,711,456 2,549,341 3,525,747 655,395 6,730,483 (19,027) 86,648 769 (33,635) 53,782 34,755 — 1,928,431 813,936 16,906,349 8,208,984 8,697,365 3,033,934 3,775,627 659,322 7,468,883 1,228,482 69,727 250 2,349 72,326 1,300,808 257,000 $ $ 34,755 $ 1,043,808 — $ 0.02 45,251,370 45,251,370 $ (59,863) $ 33,635 (26,228) (52,817) (2,349) (55,166) $ 8,527 $ 988,642 17 Spectra Systems Corporation Annual report and accounts 2015Financial statementsSTATEMENTS OF STOCKHOLDERS’ EQUITY for the years ended December 31, 2015 and 2014 Common stock Shares Amounts Additional paid in capital Accumulated deficit Other comprehensive loss Total stockholders’ equity Balance at December 31, 2013 45,251,370 $ 452,514 $ 54,855,662 $ (34,348,954) $ (4,897) $ 20,954,325 Compensation cost related to amortization of stock options Reclassification for realized gain in net income Unrealized loss on currency exchange Net income 57,951 57,951 (2,349) (2,349) (52,817) (52,817) 1,043,808 1,043,808 Balance at December 31, 2014 45,251,370 $ 452,514 $ 54,913,613 $ (33,305,146) $ (60,063) $ 22,000,918 Compensation cost related to amortization of stock options Reclassification for realized loss in net income Unrealized loss on currency exchange Net income 23,163 23,163 33,635 33,635 34,755 (59,863) (59,863) 34,755 Balance at December 31, 2015 45,251,370 $ 452,514 $ 54,936,776 $ (33,270,391) $ (86,291) $ 22,032,608 The accompanying notes are an integral part of these financial statements. 18 Spectra Systems Corporation Annual report and accounts 2015STATEMENTS OF CASH FLOWS for the years ended December 31, 2015 and 2014 Cash flows from operating activities  Net income  Adjustments to reconcile net income/(loss) to net cash from operating activities: 2015 2014 $ 34,755 $ 1,043,808   Depreciation and amortization   Stock based compensation expense   Allowance for doubtful accounts   Inventory obsolescence   Provision for income taxes   Changes in operating assets and liabilities:    Accounts receivable    Other receivable    Deferred contract costs    Inventory    Prepaid expenses    Other assets    Accounts payable    Accrued expenses and other liabilities    Deferred revenue    Contingent liability Net cash used in operating activities Cash flows from investing activities  Decrease in restricted cash and investments  Deposits for property, plant, and equipment  Payment of patent and trademark costs  Asset acquisitions  Purchases of property, plant, and equipment Net cash provided by/(used in) investing activities Effect of exchange rate changes on cash and cash equivalents Net increase/(decrease) in cash and cash equivalents Cash and cash equivalents at beginning of the year 866,673 23,163 75,671 — (2,499,512) (2,052) — 1,295,314 (17,853) 1,989 453,617 160,922 (921,685) 801,889 57,951 20,000 — 257,000 539,244 (45,706) 9,892 (1,226,462) 45,542 49,014 (894,010) 264,732 (668,455) — (2,000,000) (528,998) (1,745,561) 1,426,442 — (326,192) (213,917) (288,584) — (162,000) (308,863) (1,042,441) (354,859) 597,749 (1,868,163) (33,110) 35,641 9,772,846 (48,167) (3,661,891) 13,434,737 Cash and cash equivalents at end of the year $ 9,808,487 $ 9,772,846 Supplemental disclosure of cash flow information Income taxes paid Non-cash investing activities Acquisition of patents through accounts payable Acquisition of property, plant and equipment through accounts payable The accompanying notes are an integral part of these financial statements. $ $ $ 500 $ 500 228,536 $ 44,000 $ — — 19 Spectra Systems Corporation Annual report and accounts 2015Financial statementsNOTES TO THE FINANCIAL INFORMATION for the years ended December 31, 2015 and 2014 Note A – Corporate information Spectra Systems Corporation (the “Company”), develops and sells integrated optical systems that provide customers with increased efficiency, security tracking and product life. The integrated systems combine consumables and engineered optical materials with software and hardware for use in applications. The Company develops and sells its integrated solutions across a spectrum of markets, including currency manufacturing and cleaning, branded products, industrial logistics, and other highly sensitive documents. The Company also provides software tools to the lottery and gaming industries for fraud, money laundering and match fixing detection. The Company was incorporated on July 3, 1996 in Delaware as Spectra Acquisition Corp. On August 26, 1996, the Company purchased substantially all of the assets of SSC Science Corporation (SSCSC) and changed its name to Spectra Science Corporation. The assets were purchased for US$1,6 million in cash plus common stock warrants. The acquisition was accounted for using the purchase method of accounting. On June 8, 2001, the Company changed its name to Spectra Systems Corporation. On July 25, 2011, the Company raised $20,241,179, net of offering costs, on the London Stock Exchange in a placing of 18,592,320 common shares at a placing price of £0.753 per new common share, representing 41.09% of the enlarged common share capital of the Company. As a result of the offering, anti-dilution provisions found in the Company’s Amended and Restated Certificate of Incorporation converted all of the issued and outstanding preferred shares into 17,185,052 common shares, giving 26,659,050 common shares in issue at the time of the placing. On June 6, 2012, the Company acquired, all of the assets of ESI Integrity, Inc., including its proprietary source codes, multi-year contracts, long-standing customer relationships, and assumed liabilities. $1,425,000 was paid in consideration for the assets. On September 14, 2012, the Company acquired certain assets of Lapis Software Associates LLC including, their proprietary source codes, multi-year and long-standing customer relationships, and assumed liabilities. $726,000 was paid in consideration for the assets. On February 28, 2014, the Company acquired certain assets of Inksure Technologies, Inc., including their long-standing customer relationships and authentication technology. $1,356,000 was paid in consideration for the assets (see Note O). On September 30, 2015, the Company acquired certain assets of Solaris Nanosciences, Inc. including technology and customer relationships, in exchange for $213,917 in cash. The Company also recorded $184,000 in contingent payments based on a royalty payment arrangement for anticipated continuing business. On January 28, 2016, the Company acquired certain specialty phosphour assets primarily used in the authentication of world banknotes. The total consideration amounted to $3,120,000 (see Note O). Note B – Significant accounting policies Use of Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and judgments that affect the amounts reported in the financial statements and accompanying notes. The accounting estimates that require management’s most difficult and subjective judgments include the assessment of recoverability of property, plant, and equipment; the valuation of inventory; intangible assets; and the recognition and measurement of income tax assets and liabilities. The actual results may differ materially from management’s estimates. Cash and Cash Equivalents The Company considers highly liquid investment purchases with a maturity of 90 days or less at date of acquisition to be cash equivalents. Restricted Cash and Investments Restricted cash and investments represents money market investments held as collateral for certain performance agreements entered into by the Company in 2015 and 2014 as required in accordance with terms of a services contract. At December 31, 2015 and 2014, the agreement required $500,000 and $2,500,000 respectively be maintained as collateral. The collateral will be released as the Company meets contractual milestones. Restricted cash and investments of $1,073,558 as of December 31, 2015 is a certificate of deposit, of which $500,000 is restricted. 20 Spectra Systems Corporation Annual report and accounts 2015Note B – Significant accounting policies continued Concentration of Credit Risk and Significant Customers Financial instruments, which potentially subject the Company to concentrations of credit risk, consist principally of cash and cash equivalents and trade accounts receivable. The Company’s cash management policies restrict investments to low-risk highly liquid securities, and the Company restricts its transactions to financial institutions with a good credit standing. The Company has cash, including restricted cash, on deposit with two financial institutions which are insured by the Federal Deposit Insurance Corporation (FDIC) up to $250,000 per institution. As of December 31, 2015, the amount in excess of the FDIC limit was $9,332,000. Also included in cash at December 31, 2015 is $34,338 of cash in bank accounts in the United Kingdom and Canada. Both accounts are not FDIC insured. Concentrations of credit risk with respect to trade accounts receivable are limited due to the concentration of business with government entities. The following table summarizes the number of customers that individually comprise greater than 10% of total revenues and their aggregate percentage of the Company’s total revenues: Year ended December 31, 2015 2014 Number of significant customers 3 3 Percentage of total revenues 72% 78% The following table summarizes the number of customers that individually comprise greater than 10% of total accounts receivable and their aggregate percentage of the Company’s total accounts receivable: Year ended December 31, 2015 2014 Number of significant customers 2 2 Percentage of total receivables 80% 59% Fair Value of Financial Instruments The carrying amounts of the Company’s financial instruments, which include cash and cash equivalents, accounts receivable and accounts payable, are carried in the financial statements at amounts that approximate their fair market values at December 31, 2015 and 2014. Fair value is the price that would be received from selling an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair value is estimated by applying the following hierarchy, which prioritizes the inputs used to measure fair value into three levels and bases the categorization within the hierarchy upon the lowest level of input that is available and significant to the fair value measurement: Level 1 – Quoted prices in active markets for identical assets or liabilities. Level 2 – Observable inputs other than quoted prices in active markets for identical assets and liabilities, quoted prices for identical or similar assets or liabilities in inactive markets, or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities. Level 3 – Inputs that are generally unobservable and typically reflect management’s estimate of assumptions that market participants would use in pricing the asset or liability. As of December 31, 2015 and 2014, the Company had certificates of deposit of $1,073,558 and $1,055,053, respectively, which is included in restricted cash and investments of $1,073,558 and $2,500,000, respectively. The Company considers this certificate of deposit as a Level 2 investment. Foreign Currency Translation The functional currency of the Company’s foreign operations is the applicable local currency, the Canadian dollar. The functional currency is translated into US dollars for balance sheet accounts using currency exchange rates in effect as of the balance sheet date and for revenue and expense accounts using an average exchange in effect during the applicable period. The translation adjustments are deferred as a separate component of stockholders’ equity in accumulated other comprehensive loss. Accounts Receivable Accounts receivable are stated at the amount management expects to collect from outstanding customer accounts. Management provides for uncollectible accounts through a provision for bad debt expense. At December 31, 2015 and 2014, the Company had allowances for doubtful accounts of $12,650 and $20,000 respectively. 21 Spectra Systems Corporation Annual report and accounts 2015Financial statementsNote B – Significant accounting policies continued Inventory Inventories are stated at the lower of cost or market. Cost is determined using the first-in, first-out method. The Company regularly reviews inventory quantities on hand and records a provision to write down excess and obsolete inventory to its estimated net realizable value if less than cost. Intangible Assets Intangible assets including goodwill are recorded at the purchase price. Amortization is calculated using the straight-line method over the estimated useful lives of assets ranging from seven to 15 years. Amortization is not recorded on goodwill items. The Company evaluates the possible impairment of long-term assets annually and/or whenever events or circumstances indicate the carrying value of the asset may not be recoverable. Property and Equipment Property and equipment is stated on the basis of purchase price. Depreciation is calculated using the straight-line method over the following estimated useful lives: Laboratory equipment Computer and office equipment Furniture and fixtures 3–7 years 3–5 years 7 years Leasehold improvements Shorter of lease term or estimated useful life Software Manufacturing equipment 3–5 years 5–7 years Maintenance and repairs are charged to expense as incurred. When assets are retired or otherwise disposed of, the assets and related allowances for depreciation and amortization are eliminated from accounts and any resulting gain or loss is reflected in net income. Investment in Affiliates The Company accounts for investments in affiliates under the cost method of accounting if the Company owns less than 20% of the affiliates’ outstanding capital. As of December 31, 2015, the Company held a 19% ownership in an affiliate (SpectraMed), and a 10% ownership in an affiliate (Solaris). These affiliates have had significant losses in prior years and the Company had previously reduced its investments in these affiliates to $0. Accounting for Stock-Based Compensation In accounting for the Employee Stock Option Plan (the Plan), the Company uses the Black-Scholes option pricing model to calculate compensation costs associated with options granted to employees. Total compensation costs are recorded over the option vesting period, generally three years. The Company recorded compensation costs of $23,163 and $57,951 for 2015 and 2014, respectively, under the Plan. Revenue Recognition Product revenue includes sales of pigments and security taggants, delivery of prototypes, and contracts with multiple elements including nonrecurring engineering and follow-on manufacturing. Service revenue includes research and development services provided for a fixed price or provided for a specific period. Revenues related to sales of pigments and security taggants, and research and development services provided for a specific period are generally recognized when products are shipped or services are provided, the risk of loss has passed to the customer, the sales price is fixed or determinable, and collectibility is reasonably assured. Revenue from multiple element arrangements is deferred until all elements of the contract are delivered, unless all of the following criteria have been met: (1) the product or service has been delivered; (2) the fee for the delivered element is not subject to forfeiture, refund or concession based on performance or delivery of the undelivered element; and (3) the fair value of the delivered element is determined based upon the price charged by the Company or the price charged by competitors when similar services or products are sold separately, in which case the revenues for each element will be recognized independently in accordance with the Company’s policy. The Company enters into arrangements that can include various combinations of software, services and hardware. Where elements are delivered over different periods of time, and when allowed under US GAAP, revenue is allocated to the respective elements based on their relative selling prices at the inception of the arrangement, and revenue is recognized as each element is delivered. 22 Spectra Systems Corporation Annual report and accounts 2015NOTES TO THE FINANCIAL INFORMATION continuedfor the years ended December 31, 2015 and 2014 Note B – Significant accounting policies continued Revenue Recognition continued Revenue from fixed-price development contracts is recognized on the percentage-of-completion method, measured by the percentage of effort incurred to date to estimated total effort for each contract. That method is used because management considers total effort to be the best available measure of progress on the contracts. Because of inherent uncertainties in estimating effort, it is at least reasonably possible that the estimates used will change within the near term. Royalties are recognized when they are earned based on sales or use of technologies by third parties, except where future income is not anticipated to cover nonrefundable advances received when the excess royalty is taken to income. Research and Development Internal research and development costs are expensed as incurred. Certain third party research and development costs are capitalized in connection with contracted work. These costs are expensed as certain milestones are achieved. Overhead, general and administrative, and training costs are expensed as incurred. Advertising Costs Advertising costs are charged to expense when incurred. No advertising expense was incurred in 2015 or 2014. Income Tax Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income taxes. The benefits from net operating losses carried forward may be impaired or limited in certain circumstances. In addition, a valuation allowance can be provided for deferred tax assets when it is more likely than not that all or some portion of the deferred tax asset will not be realized. The Company had a deferred tax asset of $989,000 at December 31, 2015 and 2014. For 2015, there is no federal or state income tax liability on those respective income tax returns. Shipping and Handling The Company reports the cost of shipping and handling as an operating expense. Shipping and handling expense was $245,019 and $231,356 for 2015 and 2014, respectively. Subsequent Events On January 28, 2016, the Company completed the acquisition of certain specialty phosphour assets primarily used in the authentication of world banknotes. The total consideration amounted to US$3.1 million of which US$2.8 million was paid in cash on closing with US$0.3 million held in escrow for twelve months. See Note O. Note C – Related party transactions 100% of the sales of the Company’s phosphour products, which amounted to approximately $1,211,000 and $1,650,000 for the years ended December 31, 2015 and 2014, respectively, were to a company owned by a shareholder. On September 30, 2015, the Company purchased certain assets, including technology and customer relationships, from Solaris Nanosciences, Inc. (Solaris) in exchange for $213,917 in cash. The Company also recorded $184,000 in contingent payments based on a royalty payment arrangement for anticipated continuing business. The agreement requires the Company to pay Solaris 10% of any revenues hereafter received by the Company from the commercial exploitation of the assets. The Chief Executive Officer of Solaris is also the Chief Executive Officer of Spectra. Note D – Inventories Inventories consist of the following: Raw materials Finished goods December 31, 2015 2014 $ 2,111,413 $ 3,952,203 712,782 242,977 $ 2,824,195 $ 4,195,180 23 Spectra Systems Corporation Annual report and accounts 2015Financial statementsNote E – Property and equipment Property and equipment consists of the following: Laboratory equipment Computer and office equipment Furniture and fixtures Leasehold improvements Software Manufacturing equipment Total Less: accumulated depreciation December 31, 2015 2014 $ 981,343 $ 963,950 629,544 136,850 1,802,635 348,483 2,604,386 6,503,241 611,911 136,850 1,802,635 361,621 2,151,154 6,028,121 (3,635,715) (3,203,839) $ 2,867,526 $ 2,824,282 Depreciation expense amounted to $449,173 and $429,290 for the years ended December 31, 2015 and 2014, respectively. Note F – Intangible assets Intangible assets consist of the following: Patents Customer relationships Non-compete agreements Developed technology Tradename Trademarks Goodwill Total Less: accumulated amortization December 31, 2015 2014 $ 2,120,741 $ 1,531,013 1,943,000 1,730,000 177,440 632,000 30,000 17,739 1,564,863 6,485,783 177,440 510,000 30,000 17,739 1,536,946 5,533,138 (1,858,428) (1,440,928) $ 4,627,355 $ 4,092,210 Amortization expense amounted to $417,500 and $369,175 for the years ended December 31, 2015 and 2014, respectively. Estimated amortization expense for the next five years is as follows: Year ending December 31, 2016 2017 2018 2019 2020 Thereafter 24 $ 432,813 413,389 378,715 339,643 259,837 1,238,095 $ 3,062,492 Spectra Systems Corporation Annual report and accounts 2015NOTES TO THE FINANCIAL INFORMATION continuedfor the years ended December 31, 2015 and 2014 Note G – Other assets Other assets consist of the following: Rental deposits License agreements Equipment deposits Note H – Accrued expenses and other liabilities Accrued expenses and other liabilities consist of the following: Royalties Employee compensation Contingent costs Professional fees Property and franchise taxes Product warranty Other Note I – Income taxes The approximate components of the income tax provision are as follows: Income tax benefit computed at: Federal statutory rate – current State statutory rate – current Federal deferred State deferred Change in valuation allowance Provision for income taxes December 31, 2015 2014 $ 18,786 $ 499 — 19,453 2,488 162,000 $ 19,285 $ 183,941 December 31, 2015 2014 $ 808,510 $ 303,441 184,000 82,830 90,629 25,000 70,231 668,019 269,723 — 64,793 101,086 25,000 95,055 $ 1,564,641 $ 1,223,676 December 31, 2015 2014 $ (54,000) $ (10,000) 89,000 16,000 (50,000) (9,000) 726,000 128,000 (41,000) (538,000) $ — $ 257,000 A reconciliation of the statutory federal income tax rate with our effective income tax rate was as follows: Statutory federal rate State income taxes, net of income tax benefit Non-deductible expenses and other Change in valuation allowance Effective tax rate December 31, 2015 34.0% 1.2% (44.8%) 9.6% 0% 2014 34.0% 3.0% 1.0% (18.2%) 19.8% 25 Spectra Systems Corporation Annual report and accounts 2015Financial statementsNote I – Income taxes continued Approximate deferred income tax assets are as follows: Depreciation and amortization Deferred revenue Deferred rent Federal and state tax credits Inventory Bad debts Contingent liability Net operating loss carryforward Valuation allowance Total deferred income tax assets December 31, 2015 2014 $ (138,000) $ (94,000) (492,000) 7,000 (471,000) 8,000 1,054,000 1,039,000 189,000 5,000 — 240,000 8,000 — 9,048,000 8,985,000 (8,684,000) (8,726,000) $ 989,000 $ 989,000 The Company uses an effective tax rate of 40% consisting of a federal rate of 34% and a state rate of 6%, net of federal effect. At December 31, 2015, the Company had net operating loss carryforwards expiring between 2018 and 2036 for United States federal income tax purposes of approximately $26,000,000 and $4,000,000 expiring between 2018 and 2019 for state income tax purposes. A valuation allowance has been established for $8,684,000 and $8,726,000 as of December 31, 2015 and 2014, respectively, for the deferred tax benefit related to those loss carryforwards and other deferred tax assets. At December 31, 2015, the Company also had approximately $740,000 and $313,000 of tax credit carryforwards that are available to offset federal and state liabilities, respectively. The credits will begin to expire between 2016 and 2030 for federal liabilities and between 2017 and 2020 for state liabilities. The utilization of the tax carryforwards described above are dependent upon future profitability prior to any expiration dates. Additionally, alternative minimum taxes, if any, and substantial changes in ownership, tax laws and regulations may substantially limit their realization. Note J – Accounting for uncertainty in income taxes The Company accounts for the effect of any uncertain tax positions based on a “more likely than not” threshold to the recognition of the tax positions being sustained, based on the technical merits of the position under scrutiny by the applicable taxing authority. If a tax position or positions are deemed to result in uncertainties of those positions, the unrecognized tax benefit is estimated based on a “cumulative probability assessment” that aggregates the estimated tax liability for all uncertain tax positions. The Company is not currently under examination by any taxing jurisdiction. The Company’s federal and state income tax returns are generally open for examination for three years following the date filed. Note K – Commitments Lease Commitments The Company holds four real estate leases. The Company’s lease agreement for corporate office space expired September 30, 2012 and is now in a month-to-month arrangement. The Company signed a five-year lease agreement for a new space in East Providence beginning in November 2013 and expiring in October 2017. To support our “ICS” business, the Company signed a two-year lease from February 2013 through January 2015. In 2014, the Company renewed the lease for another two years from February 2015 through January 2017. The Company’s lease for laboratory space in East Providence was extended through May 31, 2017. Rent expense was $419,990 and $434,592 for the years ended December 31, 2015 and 2014, respectively. 26 Spectra Systems Corporation Annual report and accounts 2015NOTES TO THE FINANCIAL INFORMATION continuedfor the years ended December 31, 2015 and 2014Note K – Commitments continued Lease Commitments continued Future minimum lease payments are as follows: Year ending December 31, 2016 2017 $ $ 337,615 198,559 536,173 License and Supply Agreements In 1996, and subsequently amended in 1999 and 2002, the Company entered into a license agreement under which the Company obtained a nonexclusive right to use certain technology through the term of the licensor’s patents on such technology. The license agreement contains provisions for royalties to be paid on sales of products developed under the agreement. For the years ended December 31, 2015 and 2014, the Company recorded $224,904 and $461,095, respectively, in royalty expenses. Note L – Stockholders’ equity Common and Preferred Stock On July 25, 2011, the Company raised $20,241,179, net of offering costs, on the London Stock Exchange in a placing of 18,592,320 common shares at a placing price of £0.753 per new common share, representing 41.09% of the enlarged common share capital of the Company. As a result of the offering, anti-dilution provisions found in the Company’s Amended and Restated Certificate of Incorporation converted all of the issued and outstanding preferred shares into 17,185,052 common shares giving 26,659,050 common shares in issue at the time of the placing. At December 31, 2015, there were 45,251,370 common shares issued and outstanding and no preferred shares in issue. Warrants – WH Ireland Warrant Agreement Pursuant to a warrant agreement dated July 19, 2011, the Company created and issued warrants to WH Ireland under Regulation D under the US Securities Act, which entitles the holder to subscribe for up to 452,514 common shares at an exercise price of £0.753 per share. The warrants expired on July 25, 2014. Under the Black-Scholes pricing model, the Company estimated the fair value of the warrants to be $273,318. These costs have been included as part of the 2011 offering costs. Stock Option Plan In December 1996, the Company’s Board of Directors, who control a majority of the shares of the Company, approved the 1997 Stock Option Plan (the “1997 Plan”). The 1997 Plan provided that key employees, non-employee Directors, and certain consultants and advisors may be granted either nonqualified or incentive stock options for the purchase of the Company’s common stock at the fair market value, on the date of the grant. Stock options generally vest over three years. The options would be exercisable over a period up to ten years from the date of grant. In February 2002, the Company adopted the 2002 Stock Plan (the “2002 Plan”) which provided for the grant of incentive stock options and nonqualified stock options, stock awards, and stock purchase rights for the purchase of up to 1,500,000 shares of the Company’s common stock to officers, employees, consultants and Directors of the Company. The Board of Directors is responsible for the administration of the 2002 Plan. The Board determines the term of each option, the option exercise price, the number of shares for which each option is granted and the rate at which each option is exercisable. Incentive stock options may be granted to an officer or employee at an exercise price per share of not less than the fair value per common share on the date of the grant (not less than 110% of fair value in the case of holders of more than 10% of the Company’s voting stock) and with a term not to exceed ten years from the date of the grant (five years for incentive stock options granted to holders of more than 10% of the Company’s voting stock). Nonqualified stock options may be granted to consultants or Directors at an exercise price per share of not less than 85% of the fair value of the common stock. Upon the effective date of the 2002 Plan, the 1997 Plan was terminated. The termination did not affect the previously issued options. 27 Spectra Systems Corporation Annual report and accounts 2015Financial statements Note L – Stockholders’ equity continued Stock Option Plan continued In 2007, the number of shares available for grant under the 2002 Plan increased from 1,500,000 to 3,500,000. In May 2007, the Company adopted the 2007 Stock Plan (the”2007 Plan”) which provided for the grant of incentive stock options and nonqualified stock options, stock awards, and stock purchase rights for the purchase of up to 14,100,000 shares of the Company’s common stock to officers, employees, consultants and Directors of the Company. The Board of Directors is responsible for administration of the 2007 Plan. The Board determines the term of each option, the option exercise price, the number of shares for which each option is granted and the rate at which each option is exercisable. The 2007 plan and the 2002 Plan existed at December 31, 2015. At December 31, 2015, 2,176,464 options were issued under the 2002 Plan and 3,491,476 options were issued under the 2007 Plan. 344,451 options were issued without a plan. 8,087,609 options were available for grant under the 2007 Plan. Information related to stock options granted by the Company is summarized as follows (including certain options granted outside of the Plans): December 31, 2015 December 31, 2014 Number of shares under option Weighted average exercise price Number of shares under option Weighted average exercise price Outstanding at beginning of year 6,141,491 $ Granted Exercised Forfeited/canceled Outstanding at end of year — — (129,100) $ 6,012,391 $ 0.74 — — 0.73 0.74 6,533,103 $ 45,000 $ — (436,412) $ 6,141,491 $ 0.74 0.36 — 0.58 0.74 The following table summarizes information about stock options outstanding at December 31, 2015: Exercise price range $0.30–$0.84 $0.85–$1.23 Options outstanding Options exercisable Number of outstanding shares 3,511,725 2,500,666 6,012,391 Weighted average contractual life (years) Weighted average exercise price 3.79 $ 1.30 $ 0.57 0.99 Number of shares 3,421,169 2,500,666 $ $ 5,921,835 Weighted average exercise price 0.57 1.00 The Company currently uses the Black-Scholes option pricing model to determine the fair value of its stock options. The valuations determined using this model are affected by assumptions regarding a number of complex and various subjective variables including stock price, volatility, expected life of options, risk free interest rates, and expected dividends, if any. The assumptions used to value stock option grants for the year ended December 31, 2015 are as follows: Risk free rate Expected life 0.09% – 0.10% 5 years Assumed volatility 52.80% – 53.63% Expected dividends Expected forfeitures None 75.0% Unrecognized Compensation costs As of December 31, 2015, there was approximately $3,000 of unrecognized compensation costs, adjusted for estimated forfeitures, related to unvested stock-based payments granted to our employees, Directors and consultants. Total unrecognized compensation costs will be adjusted for future changes in estimated forfeitures and recognized over the remaining vesting periods of the stock grants. 28 Spectra Systems Corporation Annual report and accounts 2015NOTES TO THE FINANCIAL INFORMATION continuedfor the years ended December 31, 2015 and 2014 Note M – Employee retirement plan In 1999, the Company adopted a defined contribution plan (the Plan), established under the guidelines of Section 401(k) of the Internal Revenue Code (IRC), which covers all employees. Employees are eligible to participate in the Plan at the beginning of the first month following the date of hire. Employees may contribute up to the maximum, allowed by the IRC of eligible pay on a pretax basis. The Company made a matching contribution of 50% of employee contributions up to 4% of eligible salary. Company matching contributions vest at 25% after one year of service, 50% at the end of two years of service and 100% at the end of three years of service. For the years ended December 31, 2015 and 2014, the Company’s matching contribution was $41,419 and $53,792, respectively. Note N – Contingent liability In December 2011, the Company was notified by a corporate shareholder regarding a license agreement between the Company and the shareholder dated March 8, 1999. The shareholder had stated that the Company owed the shareholder approximately $2,100,000 in total for the years 2004 through 2010 based on their interpretation of the license agreement. The Company disagreed with the shareholder’s interpretation of the license agreement. In 2014, the Company and the shareholder reached a settlement which terminated the agreement and liabilities that would otherwise have continued through the remainder of the agreement. To settle the dispute for all past amounts due and all future amounts that may be due, the Company agreed to pay the shareholder $2,000,000 along with relieving a receivable owed to the Company from the shareholder in the amount of approximately $129,000. Accordingly, the Company recorded a contingent liability expense of $1,789,040 in 2013 after offsetting accruals. Note O – Business combinations Acquisition of certain assets from Inksure Technologies, Inc. On February 28, 2014, the Company acquired certain assets from Inksure Technologies, Inc., a leader in brand protection and tax stamp authentication headquartered in New York City, NY. The acquisition was strategic for the Company allowing us to extend our reach into tax stamps and the authentication of commercial product brands. The Company will support the customers with resources existing in its banknote authentication division. The total purchase price was $1,356,000 in cash with deferred consideration of $35,000, dependent upon achieving a commercial milestone. The purchase price included Inksure’s long-standing customer relationships and authentication technology. We report Inksure as part of our authentication systems. Acquisition of certain specialty phosphour assets On January 29, 2016, the Company acquired certain specialty phosphour assets primarily used in the authentication of world banknotes. The total consideration amounted to $3,120,000, of which $2,805,000 million was paid in cash on closing with $315,000 held in escrow for twelve months. Most importantly, in addition to the assets, Spectra has acquired long-standing customer relationships related to the assets including a major world supplier of banknote inks. Spectra will incorporate the company’s assets within its existing phosphour business and is not making any incremental hires to support the increased revenue. We report this acquisition as part of our authentication systems. The following tables provide further detail of these acquisitions: Date of acquisition Reporting business segment Cash consideration paid to former owners Allocation of purchase price:  Accounts receivable  Inventories  Property, plant, and equipment  Goodwill  Identifiable intangible assets Total assets acquired Specialty phosphour January 1, 2016 Authentication systems $ 3,120,000 — 235,000 — 904,000 1,981,000 $ 3,120,000 29 Spectra Systems Corporation Annual report and accounts 2015Financial statements Specialty phosphour Weighted average amortization period years Total 15.00 $ 1,100,000 10.00 3.00 870,000 11,000 12.74 $ 1,981,000 Inksure February 28, 2014 Authentication systems $ 1,356,000 136,000 246,000 — 260,000 817,000 1,459,000 — (103,000) (103,000) $ 1,356,000 Inksure Weighted average amortization period years Total 10.00 $ 600,000 10.00 5.00 3.00 120,000 30,000 67,000 9.06 $ 817,000 Note O – Business combinations continued Acquisition of certain specialty phosphour assets continued Identifiable intangible assets Customer relationships Developed technology Non-compete agreements Weighted average amortization period and total Date of acquisition Reporting business segment Cash consideration paid to former owners Allocation of purchase price:  Accounts receivable  Inventories  Property, plant, and equipment  Goodwill  Identifiable intangible assets Total assets acquired Deferred revenue Other liabilities Total liabilities acquired Net assets assumed Identifiable intangible assets Customer relationships Developed technology Trade name Non-compete agreements Weighted average amortization period and total 30 Spectra Systems Corporation Annual report and accounts 2015NOTES TO THE FINANCIAL INFORMATION continuedfor the years ended December 31, 2015 and 2014 Note P – Segment reporting In accordance with ASC 280, management has identified three operating segments. The first is the Authentication Systems Group, which captures the hardware, software, and materials related to banknote, tax stamp, and other high value goods. The second segment is the Secure Software Transactions Group. This group is characterized as providing an Internal Control System (ICS) software offering to the lottery and gaming industries. ICS provides tools for fraud, money laundering and match fixing detection, and statistical analysis. The third group is the Banknote Cleaning Group. This group captures the technology related to cleaning soiled banknotes. Overall development expense across all divisions was approximately $955,000 for the year 2015. Information for each reportable segment as of December 31, 2015 and 2014 is as follows: Gross sales Income/(loss) from operations Depreciation and amortization Capital expense Segment assets 2014 Secure Software Transactions $ 1,378,849 $ 106,471 $ 188,075 $ 4,152 $ 3,663,548 Authentication Systems 15,527,500 Banknote Cleaning — 1,455,180 (333,169) 600,156 13,668 186,688 164,019 22,359,111 399,210 Total segments $ 16,906,349 $ 1,228,482 $ 801,899 $ 354,859 $ 26,421,869 2015 Secure Software Transactions $ 1,321,822 $ 162,058 $ 202,957 $ 18,517 $ 3,147,070 Authentication Systems 12,792,041 357,509 Banknote Cleaning — (538,594) 626,843 36,873 22,690 247,377 22,633,632 804,740 Total segments $ 14,113,863 $ (19,027) $ 866,673 $ 288,584 $ 26,585,442 Note Q – Income per share The calculation of income per share figures for the years ended December 31, 2015 and 2014 is based on the profit attributable to ordinary shareholders of $34,755 and $1,043,808, respectively, divided by the weighted average number of shares in issue, shown in the table. For 2015 and 2014, the exercise price of all options exceeded the average market price of the shares in issue and therefore are not considered in the calculations. 31 Spectra Systems Corporation Annual report and accounts 2015Financial statementsSHAREHOLDER AND CORPORATE INFORMATION English Law Legal Counsel Covington & Burling LLP 265 Strand London WC2R 1BH United Kingdom +44 (0) 207 067 2000 US Based Legal Counsel Adler, Pollock & Sheehan, PC One Citizens Plaza, 8th Floor Providence, RI 02903 United States of America +1 401 274 7200 Registrar Computershare Investor Services PLC 2nd Floor Vintners’ Place 68 Upper Thames Street London EC4V 3BJ +44 (0) 870 703 0300 Registered office Spectra Systems Corporation 321 South Main Street, Suite 102 Providence, RI 02903 United States of America +1 401 274 4700 Nominated Advisor WH Ireland Limited 24 Martin Lane London EC4R 0DR United Kingdom +44 (0) 207 220 1666 Broker WH Ireland Limited 24 Martin Lane London EC4R 0DR United Kingdom +44 (0) 207 220 1666 Auditors and Reporting Accountants Miller Wachman LLP 100 Cambridge Street, 13th Floor Boston, MA 02114 United States of America +1 617 338 6800 RSM Tenon Audit Limited 66 Chiltern Street London W1U 4JT United Kingdom +44 (0) 207 535 1400 32 Spectra Systems Corporation Annual report and accounts 2015Design Portfolio is committed to planting trees for every corporate communications project, in association with Trees for Cities. Spectra Systems Corporation 321 South Main Street Providence, RI 02903 USA tel: 401.274.4700 fax: 401.274.3127 email: info@spsy.com S p e c t r a S y s t e m s C o r p o r a t i o n A n n u a l r e p o r t a n d a c c o u n t s 2 0 1 5 

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