Spectra Systems Corporation Annual Report 2018

FY2018 Annual Report · Spectra Systems Corporation

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A N ESTA BLISHED WORLD LEADER
IN P ROVIDING ADVANCED
SECURITY TECHNOLOGY

Spectra Systems Corporation
Annual report and accounts 2018

Spectra provides integrated solutions
comprised of engineered materials for
authentication and hardware and software
systems which verify the unique signatures
of the authentication materials.

Through a series of acquisitions and strategic supply
and licensing agreements, Spectra has become an industry
leader in the authentication and gaming controls markets.

2012

We operate in 35 countries.

Four acquisitions since 2012.

Over 65 customers.

We have 28 staff in our offices.

H I G H L I G H T S

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Financial highlights

Operational highlights

– Revenue up 3% for the year at

US$12,494k (2017: US$12,170k)

– Adjusted EBITDA1 up 16% at
US$5,045k (2017: US$4,349k)

– Adjusted PBTA1 up 19% at

US$4,782k (2017: US$4,010k)

– Adjusted earnings2 per share up

11% to US$9.8 cents (2017: US$8.8 cents)

– Net income up 24% at US$4,055k

(2017: US$3,280k)

– Cash generated from operations
of US$4,740k (2017: US$4,669k)

– Strong, debt-free balance sheet, with cash3

of US$12,662k (2017: US$11,181k)

– Declaring annual dividend up 17%

to US$7.0 cents per share to be paid in June

1 Before stock compensation expense and 2017 exceptional items

related to inventory write downs.

2 Before amortization, stock compensation expense and 2017

exceptional items related to inventory write downs.

3 Does not include US$1,099k (2017: US$1,099k) of restricted

cash and investments.

– Large orders for covert materials which we were

able to fulfill due to increased manufacturing capacity
resulting from our 2017 facility consolidation and
staffing redirection

– Over US$2.0 million of royalties resulting from the

exclusive licensing agreement executed in January 2018
for one of our existing products which is in use by
18 central banks through an existing licensee, a major
supplier of banknotes worldwide

– Decreased operating expenses by US$0.5 million due

to reduced royalties related to covert materials

– QC readers for TruBrand™ delivered to customer
in preparation for production of 6–10 million
cigarette packs in 2019 and first orders received
for 6–10 million boxes

– Engaged by a G20 central bank to commence Phase I
of a four-phase funded sensor development for use
with polymer banknotes

Revenue (US$ million)

12.5

(2017: 12.2)

Adjusted PBTA (US$ million)

4.8

(2017: 4.0)

4.8

4.0

12.5

12.2

11.1

16 2.0

Strategic report

Highlights

Spectra at a glance

Our strategy

Chief Executive Officer’s statement

Corporate governance

Board of Directors

11 Senior management

12 Corporate governance statement

16 Committee reports
18 Directors’ report

Financial statements

Independent auditor’s report

21
22 Balance sheets

Statements of income and other
comprehensive income

Statements of stockholders’ equity

24
25 Statements of cash flows
26
IBC

Notes to the financial information

Shareholder and corporate information

Adjusted earnings per share (US¢)

9.8

(2017: 8.8)

4.4

9.8

8.8

Discover more online
www.spsy.com

Our strategy
Page 4

Chief Executive Officer’s statement
Page 6

Annual report and accounts 2018 Spectra Systems Corporation
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S P E C T R A AT A G L A N C E
Spectra is a highly responsive
organization that develops customized
solutions for its customers.

OUR CUSTOMERS

OUR MARKETS

Our end customers include a G7 central bank
organization and one of the world’s largest
commercial security printers and papermakers,
which supplies the Company’s technology to a
second G7 central bank and numerous other
central banks. Additionally, brand authentication
customers use our technologies to protect their
consumer goods brands, while our Secure
Transactions Group provides solutions for
20 lotteries, 18 in the United States of America
and two international.

Our solutions are used by:

– 19 central banks including two G7 central banks;

– commercial security printers and papermakers;

– Crane & Co.;

– suppliers of security threads for world currencies;

– LMI Packaging Solutions;

– multi-national consumer product companies;

– Governments of Turkey, India, Malaysia and Norway;

– Intralot SA;

– Scientific Games International Inc.;

– International Game Technology PLC;

– lotteries in 18 states within the United States of America; and

– national lotteries in two countries.

Spectra’s market opportunity has expanded 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.

Our TruBrand™, TruStamp™ and TruNote™ 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 and under testing by
large volume tobacco suppliers in Asia.

Spectra’s current suite of portable reader-based solutions can be
used for authenticating and tracking consumer and tax-bearing
products. Our reader-based business has grown considerably in
Asia and has several recognizable brand owners as customers.

With over 150 billion banknotes manufactured annually
worldwide and 85% of all transactions performed using
banknotes, this business has proven to be a high quality,
long-term revenue source for the Company. With 19 central
bank customers and newly developed technologies, particularly
for polymer banknotes, we expect continued strong earnings
from this sector.

Spectra’s secure ICS software products have been augmented
with new capabilities and have resulted in revenue growth with
existing customers as well as with new ones. Along with the
expansion in internet-based lotteries, we expect to provide
cloud-based authentication for a potentially large number
of customers using our materials-based TruBrand™, TruStamp™
and TruNote™ smartphone authentication.

Spectra Systems Corporation Annual report and accounts 2018

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OUR IMPACT

24.9

billion US banknotes in circulation
with our materials.

16.5

billion banknotes pass through our
authentication sensors annually.

OUR SOLUTIONS

Authentication systems

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 all levels of security.

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– Level I: Provides unique overt, luminescent visual effects, including gas-sensitive materials.

– Level II: Provides the public with a smartphone-based solution to examine banknotes

for authenticity and denomination.

– Level III: Used by 19 central banks, including two G7 banks, our covert materials

and sensors provide the highest level of banknote security worldwide.

Secure transactions

million American passports protected
by our materials in the last ten years.

950

million dollars of energy drinks sold
annually that contain our materials.

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.

Premier Integrity ICS benefits and advantages:

– is fully automated independent real-time monitoring;

– supports both online and instant lottery games; and

– monitors online systems from all major vendors.

Smartphone authentication

Spectra’s materials-based technology enables end users to authenticate consumer
brands and banknotes with a smartphone. This technology eliminates the need for
costly readers and allows the consumer to authenticate the product themselves.

– TruBrand™, TruNote™ and TruStamp™ are materials-based technologies that do not

rely on easily counterfeited images.

– TruTrack™ allows brand owners or government authorities to collect the geographic

location, time and authentication status of each scan for monitoring and analysis purposes.

Optical materials

In the course of developing our authentication solutions for over a decade, Spectra has
created a large number of unique optical materials which are responsive to various forms
of excitation, from light to ambient environmental conditions, including gaseous
constituents. Our materials are finding new applications in process control, manufacturing
and consumer products.

million bottles of wine protected by
our technology over the past three years.

million dollars of lottery and gaming
transactions processed by Spectra
every day.

years of pari-mutuel auditing experience.

years of sports betting experience.

Annual report and accounts 2018 Spectra Systems Corporation
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O U R S T R AT E G Y

Capitalizing on developed
technologies and the power
of the internet for authentication.

Our solutions

STRATEGIC AIM

Capitalize on existing suite
of developed covert
material products

Advanced smartphone
authentication technology

Increase high margin

specialty materials sales

Implement

cost reductions

DEVELOPMENT STRATEGY

Future development of covert materials
and sensors will be externally funded

Increased focus on polymer banknotes

Additional business from existing customers

Leverage TruBrandTM smartphone technology to
create new revenue streams for both materials
as well as the Secure Transactions Group

Focus on large, billion unit opportunities

Identify areas for cost savings in both

infrastructure and staff composition

and taggants for authentication

Expand palette of TruBrandTM taggants

Internal development and licensing

Restructure staffing to focus on

PROGRESS

OUTLOOK

Discussions underway for the development
and supply of further upgraded sensor
capability to a G7 central bank in response
to a standardization requirement

Covert security product for a polymer banknote
customer in four-phase development

Obtained approval for TruBrandTM materials
on tobacco products sold in China

Adoption of TruBrandTM technology for top-tier
tobacco products in China

New opportunities include G7 and Asian
central banks

Partnerships with polymer banknote
substrate suppliers

Expectation to execute a license and supply
agreement for a covert security product for
polymer banknotes with a major G20 central
bank within the next two years

The utilization of the Secure Transactions
Group for cloud-based server authentication
of TruBrandTM

The licensing of our smartphone technology,
TruNoteTM, for the authentication of banknotes

Potential to supply polymer substrates with
embedded covert features

into Asia and Europe through partners

Successfully initiated new line of business in

of a property lease in mid-2017

consumer products, namely coffee cups

Restructuring of staff to reduce R&D spend

Consolidated operations upon the expiration

Seeking lower cost materials and services

or price reductions from suppliers

Gross margin increases resulting from

in-house manufacturing

through a banknote security thread manufacturer

Increased opportunities with long-standing

G7 customers

Additional benefits of reduced staffing

Spectra Systems Corporation Annual report and accounts 2018

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Capitalize on existing suite

Advanced smartphone

authentication technology

of developed covert

material products

Increase high margin
specialty materials sales

Implement
cost reductions

Additional business from existing customers

Leverage TruBrandTM smartphone technology to

as well as the Secure Transactions Group

Focus on large, billion unit opportunities

Develop and acquire specialty phosphor
and taggants for authentication

Identify areas for cost savings in both
infrastructure and staff composition

Expand palette of TruBrandTM taggants

Internal development and licensing
of novel phosphors

Restructure staffing to focus on
specialty materials

and supply of further upgraded sensor

capability to a G7 central bank in response

to a standardization requirement

Obtained approval for TruBrandTM

Adoption of TruBrandTM technology for top-tier

Increased phosphor sales beyond US banknotes
into Asia and Europe through partners

Successfully initiated new line of business in
consumer products, namely coffee cups

Restructuring of staff to reduce R&D spend

Consolidated operations upon the expiration
of a property lease in mid-2017

Seeking lower cost materials and services
or price reductions from suppliers

Gross margin increases resulting from
in-house manufacturing

New opportunities include G7 and Asian

The utilization of the Secure Transactions

Group for cloud-based server authentication

of TruBrandTM

The licensing of our smartphone technology,

TruNoteTM, for the authentication of banknotes

agreement for a covert security product for

Potential to supply polymer substrates with

Expectation to execute a license and supply

polymer banknotes with a major G20 central

New sales channel for phosphor materials
through a banknote security thread manufacturer

Additional benefits of reduced staffing
and leased space are planned

Increased opportunities with long-standing
G7 customers

Annual report and accounts 2018 Spectra Systems Corporation
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C H I E F E X E C U T I V E O F F I C E R ’ S S TAT E M E N T
The strong earnings from our covert
materials business has been complemented
with continued strong sales of high margin
brand authentication materials.

Introduction
Through achieving key commercial milestones,
as described in the Review of operations below,
Spectra Systems has delivered an excellent
performance for the 2018 financial year.

Revenue for the year was US$12,494k
(2017: US$12,170k) due to large orders
of covert materials by our G7 customer as
well as increased royalties resulting from the
exclusive licensing agreement executed in
January 2018 for one of our existing products
which is in use by 18 central banks through
an existing licensee, a major supplier of
banknotes worldwide. Adjusted EBITDA
(before stock compensation expense and
exceptional items) for the year increased 16%
to US$5,045k compared to the prior year of
US$4,349k, which resulted in net income up
over 24% at US$4,055k (2017: US$3,280k).

Having generated cash from operations
of US$4,740k (2017: US$4,669k), cash at
the period end amounted to US$12,662k
(2017: US$11,181k), excluding US$1,099k
of restricted cash and investments as
of both December 31, 2018 and 2017.
This is notwithstanding US$2,728k paid to
shareholders during June in the form of the
Company’s dividend of US$0.06 per share.

The Company is therefore declaring an annual
dividend up 17% at US$0.07 per share to be
paid in June. The Company will continue to have
sufficient cash resources thereafter to execute
on its growth plans.

Review of operations

Authentication Systems
The Authentication Systems business,
which includes the security phosphor
materials, generated revenue of US$11,204k
(2017: US$10,823k) and adjusted EBITDA
of US$4,584k (2017: US$3,794k).
Authentication Systems revenues are
driven by covert material sales and royalties.

The Company’s newest products are primarily
targeted towards polymer banknotes where

growth across denominations is outpacing annual
increases in paper banknote production.

Nabil M. Lawandy
Chief Executive Officer

We sell covert materials directly to one
G7 central bank and indirectly to another
G7 central bank and 17 other central banks
through our supply and licensing agreements
with a major banknote supplier and printer
which pays a license royalty for the exclusive
rights to our technology. We are pleased to
report that we continue to sustain a margin
increase from using our in-house
manufacturing facility.

The strong earnings from our covert
materials business has been complemented
with continued strong sales of high margin
brand authentication materials.

The TruBrand™ authentication business is
performing on track in spite of strained trade
relations with China and continues to have
significant prospects bolstered by the
adoption of the technology for approximately
10 million packages annually of a high profile
cigarette brand commencing early in 2019.

Our optical materials-based product, which
allows K-Cups to be compatible and functional
with Keurig coffee makers, was a success and
is expected to double its sales in 2019.

Secure Transactions Group
The Secure Transactions Group performed in
line with management expectations, generating
adjusted EBITDA of US$461k (2017: US$555k)
on revenue of US$1,290k (2017: US$1,347k).

This segment of the business is producing
solid stable revenues and earnings. During
2018, the Secure Transactions Group won
three new US state lottery contracts and
converted an existing customer to our 64-bit
Premier Integrity. The incremental revenue
from the contracts is estimated at over
US$1,300k over the full term of the contracts,
which range from five to eight years with
additional potential from software work plans
of up to US$400k. The performance of these
contracts will not require significant additional
costs and will therefore have a positive impact
on profits from 2019 through 2026. In spite
of delays relating to the release of new lottery
industry regulations which have stalled
additional revenue during 2018 from the
usual software development related to the
introduction of new games, revenues of
the Group were maintained at 2017 levels,
showing the success of the newly introduced
64-bit processor products in the Premier
Integrity offering. With these regulations
nearing finalization, we expect a strong
increase in performance in 2019.

Spectra Systems Corporation Annual report and accounts 2018

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FIRST ORDERS OF TRUBRANDTM

First orders for tobacco products
in China with TruBrandTM

Spectra Systems Corporation, a leader in machine-readable high
speed banknote authentication, brand protection technologies,
and gaming security software, is pleased to announce that it has
received the first production order for the Company’s patented
materials-based smartphone authentication product, TruBrandTM.
This first of two expected orders is from Zhejiang Tobacco
Company, one of the leading tobacco companies in China.
This launch of TruBrandTM, to be incorporated into approximately
6,000,000–8,000,000 cigarette packs to be sold in China, is aimed
at gauging acceptance of the TruBrandTM technology and further
refining the product for use in potentially billions of units for larger
volume brands in the future.

These first orders are specifically for one of the highest value cigarettes
brands in China manufactured by Zhejiang Tobacco, the Liquan
Yunduan Series, which retails for 120 RMB (US$16.80) per pack.
Lower priced brands sell for approximately US$3–US$5 per pack
and are typically in the billions of packs annually. Approximately 60%
of the price is believed to go to government tariffs.

We are delighted that Zhejiang
Tobacco has decided to increase its
commitment to the technology from

large scale manufacturing testing to
introducing the technology to the

market with a very sought-after high
end tobacco product for sale primarily
in China.

Nabil M. Lawandy
Chief Executive Officer

Strategy

The Company’s strategy for increasing
revenue and earnings is focused on brand
authentication and specialty optical materials
for security applications while maintaining
a robust effort to commercialize our covert
security technologies, particularly in the area
of polymer notes. The brand authentication
sector offers significant short-term growth
and some very large opportunities for
smartphone-based technology while the
covert banknote security area provides
long-term, multi-decade revenues once
new contracts are executed.

Through our close, multi-decade
relationship with our direct G7 customer, we
have become a trusted supplier of technology
and have been asked to bid on several sensor
upgrades, including our own sensors which
are currently in use. We are confident that this
will result in additional business and underpins
our strategy of growing our business with
existing customers in banknote security.

The Company’s newest products are primarily
targeted towards polymer banknotes where
growth across denominations is outpacing
annual increases in paper banknote production.
In addition to providing taggants for ink-based
polymer note security, we believe that moving
up in the supply chain in this area by partnering
with a global plastics supplier to provide
polymer substrates could be transformative
to our business. We believe that the ability to
provide a polymer substrate with high security
features will provide that leverage. If successful,
our revenues per polymer note would
experience a substantial increase over
just supplying the security features alone.

Annual report and accounts 2018 Spectra Systems Corporation
7

C H I E F E X E C U T I V E O F F I C E R ’ S S TAT E M E N T c o n t i n u e d

LOTTERY WINS

Two new lottery wins

Spectra Systems Corporation, a leader in machine-readable
high speed banknote authentication, brand protection
technologies and gaming security software, is pleased to
announce that it has been selected by two new US state
lottery customers, for eight and seven-year contracts,
respectively. The aggregate value of the contracts is
estimated at US$1 million over the full term with additional
potential from software work plans of up to US$0.25 million.

The performance of these contracts will not require additional
staffing or significant infrastructure costs and will therefore
have a positive impact on profits from 2019–2026.

We are particularly proud of
these contract wins as both are
new customers which selected

Spectra over our competitors
and switched over to our new
Integrity products.

Nabil M. Lawandy
Chief Executive Officer

Review of operations continued
Strategy continued
The banknote industry continues to show
resilience with a modulated response to
macro-economic realities such as lower
interest rates in Europe and Japan and a
general level of uncertainty about the stability
of the US economy. Recent Deutsche Bank
research, supported by US Federal Reserve
Bank data, has shown that there are more
US$100 bills in circulation than US$1 bills
for the first time in history. This reflects that
these high value denominations are finding
their way into mattresses rather than being
invested due to the economic climate of interest
rates and anxiety over the stability of world
markets, both of which are expected to
continue for at least the next few years when
viewed in the context of political circumstances
in the US, the Brexit ripple and China.

Higher denomination notes are the drivers
for our covert products and hence this current
trend is positive for the Company and further
underpins our strategy of continuing to provide
new technology to our existing central bank
customers, as well as using partnerships to
penetrate the less electronic transaction
driven parts of the world.

With regards to the brand authentication
business, we are focusing on large markets
for our products as a means of growth which
reflects our sales structure. As tangible progress
has been made on the tobacco TruBrand™
opportunity, with first sales to a high profile
brand in China, our strategy is to support this
first customer with the goal of including
TruBrand™ products in their other brands
which have significantly higher volumes.
Specifically we expect the current adoption
in the Yunduan brand to be in the market
beginning April of 2019 through Q2 of 2020
with the subsequent adoption of the technology
in larger volume, high value brands offered by
Zhejiang Tobacco beginning late 2020. With the
tangible progress in tobacco and a plan to grow
it initially through one supplier, we are now
able to focus more on other applications from
automotive to luxury as well as banknotes
through the TruNote™ set of higher security
smartphone taggants we have developed.

Spectra Systems Corporation Annual report and accounts 2018

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The Secure Transactions Group continues
to innovate within the lottery ICS industry,
reducing cost and increasing efficiency with
the introduction of virtualized machines.
We expect the use of VM will allow us to
win contracts from our competitors by offering
more value to the customer and continues
to be an integral part of the strategy of the
growth of Group revenues.

Prospects
The Company continues to have numerous
longer-term and shorter-term prospects.
The shorter-term opportunities are expected
in the 2019–2021 period and the longer-term
opportunities are expected in the timeframe
2022–2025.

The important, near-term opportunities are:

– continued polymer technology sensor
development and testing phases with
a G20 central bank;

– the commencement of contracted future

sensor component subsystem development
by a G7 central bank customer;

– the utilization of our phosphors for use

by a supplier of products to a major Asian
central bank;

– the potential selection of our covert

technology by a major Asian central bank
after the completion of state elections
(we have been offering our technology
since our IPO, the central bank has
cancelled tenders three times since 2010
and we are in direct competition with six
other providers of covert technology);

– the introduction of a highly secure polymer
substrate to the market both directly as well
as through partnerships with printers;

– additional TruBrand™ tobacco orders

in China for larger volume brands within
our current customer’s product offering
beginning late in 2020; and

– additional growth in the K-Cup business
with new and existing printers serving
the independent coffee market seeking
compatibility with Keurig products.

The longer-term opportunities are:

– a licensing and supply agreement for
polymer-based technology developed
through external funding with a major
central bank;

– the development and supply of further

upgraded sensor capability to a G7 central
bank following the contracted development
phase; and

– the sale of polymer banknote substrates

and sensors.

We are pleased that we are able to supplement
our sustained and growing profitability with a
number of near-term and longer-term prospects
of a significant scale. We believe that we have
a number of transformative opportunities
ahead in several aspects of our business that
will sustain and potentially accelerate our
earnings for our shareholders.

With the Company having a fourth year
of sustainable profits, reaching their highest
levels since listing and having sufficient
resources to execute on its growth plans
with its existing cash reserves, the Board
is delighted to increase the annual dividend
for a second straight year. Its dividend policy
takes account of the Group’s profitability,
underlying growth, and the maintenance
of sufficient cash reserves. The Board
therefore intends to pay an annual dividend
of US$0.07 per share on or about June 28, 2019
to shareholders of record as of June 7, 2019.

Nabil M. Lawandy
Chief Executive Officer
March 25, 2019

FUNDING SENSOR DEVELOPMENT

G20 central bank begins funding sensor development

Spectra Systems Corporation, a leader in machine-readable high speed banknote
authentication and brand protection technologies, announces that it was
engaged on Friday (May 11, 2018) to commence Phase I of a four-phase funded
sensor development with a G20 central bank for use with polymer banknotes.
The successful completion of all phases is expected to result in a long-term
sensor and materials supply agreement commencing around 2022.

Dr. Nabil Lawandy, Chief Executive Officer, stated: “We are excited that one
of our polymer security features is on track for adoption by a G20 central bank.
Once completed, this will be a decade or longer direct sale rather than a license
and supply arrangement through a partner. We expect that this will firmly
establish our capabilities and products for use in the growing polymer banknote
segment of the market.”

Annual report and accounts 2018 Spectra Systems Corporation
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B O A R D O F D I R E C T O R S
Our Board of Directors has a
collective responsibility to shareholders
for the sustainable long-term success
of the business.

BJ Penn
Non-executive Chairman
C

G N

Mr. Penn was Acting Secretary of the US Navy
from March to May 2009, having previously
been Assistant Secretary of the US Navy
(Installations and Environment) since 2005.
Mr. Penn began his career as a Naval Aviator
and was named EA-6B Pilot of the Year in 1972.
Throughout his distinguished career, significant
leadership assignments included: Executive
Officer/Commanding Officer VAQ 33, Battalion
Officer at the US Naval Academy, Air Officer in
USS America, Special Assistant to the Chief of
Naval Operations, Commanding Officer of NAS
North Island, CA, and Deputy Director of the
Navy Office of Technology Transfer & Security
Assistance. Mr. Penn left the Navy in 1995,
joining Loral Corporation as Director of
International Business. In 1996, Loral sold its
defense electronics and system integration
businesses to Lockheed Martin and Mr. Penn was
assigned to Lockheed Martin’s corporate staff.
Mr. Penn returned to the US Navy in 2001 as
Director of Industrial Base Assessments.

Mr. Penn received his BS in Industrial
Technology from Purdue University and his MS
in Human Resource Management and Personnel
Administration from the George Washington
University. Mr. Penn has also received certificates
in Aerospace Safety from the University of Southern
California and in National Security for Senior
Officials from the Kennedy School, Harvard
University. Mr. Penn serves as Trustee at the
George Washington University and is on the
Board of the Naval Aviation Museum.

Nabil Lawandy
President and
Chief Executive Officer
A

Dr. Lawandy is the founder, President
and Chief Executive Officer of the Company.
Dr. Lawandy started his career at the NASA
Goddard Space Flight Center, where he was
a pioneer in the development of sub-millimeter
optically pumped lasers. From 1981 to 1999,
Dr. Lawandy was a tenured full professor of
Engineering and Physics at Brown University,
where his work focused on instabilities in single
and multimode lasers and a wide spectrum
of non-linear optics and atom-field interaction
problems. In addition to Spectra Systems
Corporation, Dr. Lawandy has founded two
other companies, Spectra Disc Corporation
and Solaris Nanosciences, and has raised over
US$80 million in investment capital.

Dr. Lawandy holds a BA in Physics,
and an MS and PhD in Chemistry, all from
Johns Hopkins University. Dr. Lawandy has
authored over 180 reviewed scientific papers
an is an inventor on over 80 US and foreign
issued patents. His entrepreneurial and scientific
work has been covered in several high profile
publications including the London Financial Times,
the Economist, Scientific American, Science News,
the Wall Street Journal, Los Angeles Times, the
Boston Globe, Fox News and BBC Television.
Dr. Lawandy has also received a Presidential Young
Investigator Award, an Alfred P. Sloan Fellowship,
a Cottrell Award, a Rolex Award for Enterprise
and a Samuel Slater Award for Innovation.

Donald Stanford
Non-executive Director
A

Mr. Stanford, who was from 1979 until
2001 the Chief Technical Officer of GTECH
Corporation, is an Adjunct Professor of
Computer Science and Engineering at
Brown University and is an instructor in
the Program in Innovation, Management,
and Entrepreneurship (PRIME). Mr. Stanford
is also on the faculty of Brown’s School
of Professional Studies. Mr. Stanford is a
founding member of GTECH (renamed IGT)
and, over the course of 30 years, he held every
technical leadership position, including Vice
President of Advanced Development and
Chief Technology Officer. Mr. Stanford serves
on several boards including YearUp Providence
and the Business Innovation Factory. Mr. Stanford
is a founding board member of Times2 STEM
Charter School in Providence and served on its
board for 20 years. In 2008, Mr. Stanford was
re-engaged by IGT as a consultant.

Mr. Stanford is a past member of the RI Science
and Technology Advisory Council. Mr. Stanford
also served on the Brown advisory councils to
the President and the School of Engineering.
Mr. Stanford holds a BA in International Relations
and an MS in Computer Science and Applied
Mathematics, both from Brown University.
In 1999, Mr. Stanford received both the Black
Engineer of the Year Award for Professional
Achievement and the Honorable Thurgood
Marshall Award for Community Service from
the NAACP. In 2002, Mr. Stanford received the
Brown Graduate School’s Distinguished Graduate
Award and the RI Professional Engineer’s Award
for Community Service.

Key
A Audit Committee

Committee Chairman

C Compensation Committee

G Government Security Committee

N Nominating Committee

Spectra Systems Corporation Annual report and accounts 2018

S E N I O R M A N A G E M E N T
Our senior management
team highlights our
strong internal talent
base, providing clear
direction and support for
all areas of the business.

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Martin Jaskel
Non-executive Director
A C N

Brian McLain
Chief Financial Officer
and Company Secretary

James Cherry
Director of Business
Development

Mr. Cherry serves as Director of Business
Development. Mr. Cherry 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,
Mr. Cherry had worked for five years at
DuPont in product management.

Andrei Smuk
Director of Research
and Development

Dr. Smuk, who joined the Company in 2000,
was appointed Director of Research and
Development in 2006. Dr. Smuk is responsible
for the development of advanced materials and
innovative sensor systems. Dr. Smuk 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.

Mr. Jaskel has over 40 years of involvement in
the financial services industry. Mr. Jaskel began
in the United Kingdom government bond market
as a broker with leading firms, latterly as a Partner
in W Greenwell & Co. In 1986, W Greenwell
was sold to Midland Bank. In 1988, Mr. Jaskel
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, Mr. Jaskel was
appointed Director of Global Sales at NatWest
Treasury and rebuilt the franchise’s global
distribution of treasury and capital
markets products.

In 1994, Mr. Jaskel was promoted to Managing
Director of Global Trade and Banking Services.
Mr. Jaskel sat on the advisory board of ECGD,
the UK export–import bank, and sat on several
government and Bank of England advisory boards.
In 1997, Mr. Jaskel 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, Mr. Jaskel joined European American
Capital Limited, an FCA-authorized and regulated
specialized advisory bank, as a Director. Mr. Jaskel
has wide experience as a Non-executive Director
of both publicly quoted and private companies.

Mr. McLain has been Spectra’s Chief Financial
Officer since January 2017. With extensive
financial experience in both public and private
businesses, Mr. McLain is responsible for managing
all financial and administrative functions of Spectra
Systems. Before joining Spectra, Mr. McLain
served as the Corporate Controller for OMNIlife
Science, Inc. and was responsible for all financial
and accounting operations. Prior to OMNI,
Mr. McLain progressed from the role of Corporate
Controller to Vice President, Finance & Business
Solutions at SeraCare Life Sciences, Inc. which
was quoted on NASDAQ prior to being bought
out in 2012. Previously, Mr. McLain served in
various roles at International Power, a UK-owned
power producer, and Excelergy Corporation, a
venture-backed software business. Mr. McLain
started his career at Arthur Andersen, assisting
clients with financial statement preparation and
other accounting needs. Mr. McLain holds a BS
from Boston College and is a licensed Certified
Public Accountant.

William Goltsos
Vice President of Engineering
G

Dr. Goltsos has been Spectra’s Vice President,
Engineering, from April 2000 to the present.
From September 1996 to April 2000, Dr. Goltsos
served as a Senior Systems Engineer for Spectra.
Prior to that, from 1992 to 1996, Dr. Goltsos served
as a Staff Member of the MIT/Lincoln Laboratory’s
Optical Communications Group. Dr. Goltsos holds
a PhD in Physics from Brown University, an MS
in Physics from Brown University, and a BS in
Physics from Rensselaer Polytechnic Institute.

Annual report and accounts 2018 Spectra Systems Corporation
11

C O R P O R AT E G O V E R N A N C E S TAT E M E N T

Chairman’s statement

The Board of Directors recognizes the importance of sound corporate governance to give our shareholders and other stakeholders
confidence in our business. As Chairman of the Board, I have ultimate responsibility for ensuring that the Board adopts and implements
a recognized corporate governance code in accordance with our stock market listing on the AIM market of the London Stock Exchange.
Accordingly, during 2018, the Board has adopted the Quoted Companies Alliance (QCA) Corporate Governance Code 2018. The Chief
Executive Officer (CEO) has responsibility for the implementation of governance throughout our organization under the direction
of the Board.

The QCA Corporate Governance Code 2018 has ten key principles and we set out below how we apply those principles to our business.

The Honorable BJ Penn
Chairman of the Board
April 3, 2019

PRINCIPLE 1:

Establish a strategy and business model which promote long-term value for shareholders

Please refer to pages 2 through 5 for the details of our strategy and business model.

PRINCIPLE 2:

Seek to understand and meet shareholder needs and expectations
The Board is committed to understanding and meeting the needs and expectations of its shareholders and believes that
maintaining good communications is the best way to do so. The Company informs shareholders though regulatory news
announcements and on its corporate website. All shareholders are encouraged to attend the Annual General Meeting.
Subject to confidentiality and regulatory restrictions, the CEO meets with shareholders by appointment, which the
Board believes has been successful.

PRINCIPLE 3:

Take into account wider stakeholder and social responsibilities and their implications for long-term success
The long-term success of the Company is dependent on its relationships with its various stakeholders: customers,
suppliers and employees amongst others. The Company has built strong relationships with its customers and considers
itself a business partner, helping its customers develop solutions to meet their needs. The management team is in constant
contact with its customers and seeks feedback to determine customer needs. The Company also maintains relationships
with its key suppliers to ensure it is updated on new developments that may be utilized to the benefit of our customers.
Our employees are also a key factor in the successful growth of the Company. Management is in constant contact with
its employees and encourages employees to generate new ideas. To align employees with the long-term success of the
Company, key employees have been granted stock options.

Spectra Systems Corporation Annual report and accounts 2018

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PRINCIPLE 4:

Embed effective risk management, considering both opportunities and threats, throughout the organization
As a small cap company quoted on the AIM market of the London Stock Exchange, the Board is sensitive to the impact
of risks upon the Company. The Board meets with Company management on a regular basis to monitor the risks facing
the Company and identify appropriate measures to mitigate any potential impact. The Board assures itself of the efficacy
of risk management and related control systems through corporate performance and periodic reports.

PRINCIPLE 5:

Maintain the board as a well-functioning, balanced team led by the chair
The Board is responsible for formulating, reviewing and approving the Company’s strategy, budgets and corporate actions.
Please refer to page 20 for the details of our Board structure and Committees. Given the size of the Board, Committee
topics are often discussed by the full Board rather than limited to each Committee’s members. This allows the full Board
to stay informed of the particular issues being addressed by each Committee. During 2018, each Director attended 100%
of the Board meetings and the Committee meetings of which they are members.

PRINCIPLE 6:

Ensure that between them the directors have the necessary up-to-date experience, skills and capabilities
The Board of Directors brings a broad range of skills to address the challenges faced by a company that sells its products
worldwide. The Board consists of highly experienced professionals with complementary backgrounds that meet the
needs of the Company. Each Director is responsible for maintaining his or her own skill set, part of which is achieved
by remaining active in industry. The Nominating Committee of the Board is tasked with finding and nominating qualified
candidates to serve on the Board. Please refer to our Directors’ biographies on pages 10 and 11 for more information
on our Board of Directors. In addition to the Directors, our Chief Financial Officer and outside General Counsel attend
all Board meetings and bring financial, legal and business acumen to Board discussions. The Board and its Committees
will also seek external expertise and advice where required.

PRINCIPLE 7:

Evaluate board performance based on clear and relevant objectives, seeking continuous improvement
The Board evaluation process is designed to identify opportunities for improving the performance of the Board and to
ensure it has the necessary skills and experience to fulfill its responsibilities both today and in the future, through adequate
succession planning to the degree appropriate given the size of the Company. Given the current size of the Company,
the evaluation process is performed internally, by the Board, on an ongoing basis. Any deficiencies identified will be
addressed in a constructive manner and, if necessary, changes of the Board will be considered in conjunction with the
Nominating Committee.

Annual report and accounts 2018 Spectra Systems Corporation
13

C O R P O R AT E G O V E R N A N C E S TAT E M E N T c o n t i n u e d

PRINCIPLE 8:

Promote a corporate culture that is based on ethical values and behaviors

The transnational nature of our business operations requires firm action on our part to work with integrity. As a Company,
we strive to conduct ourselves according to the highest standards of ethical conduct. Throughout its operations, Spectra
seeks to avoid even the appearance of impropriety in the actions of its Directors, officers, employees and agents. The Board
has implemented policies to promote ethical conduct and relies on the management team to ensure ethical values and
behaviors are respected.

PRINCIPLE 9:

Maintain governance structures and processes that are fit for purpose and support good decision making by the board
The Board takes responsibility for the performance of the Company and ensures that all decisions are taken in the best
interest of the Company. Although the Board has delegated the operational management of the Company to the CEO
and other senior management, the Board retains oversight of their actions and retains approval authority for acquisitions,
dividend payments and significant expenditures and contracts.

The Chairman is responsible for leadership of the Board and ensuring its effectiveness. The Chairman, with the assistance
of the CEO, sets the Board’s agenda and ensures that adequate time is available for proper discussion of all items.

The CEO is responsible for running the business and implementing the decisions and policies of the Board. The CEO
is also responsible for accurate, appropriate and timely communications with shareholders.

While not a Board member, the CFO attends all Board meetings. The CFO is responsible for the Company’s finances,
human resources and compliance activities. The CFO seeks the advice of outside General Counsel when necessary.

The Non-executive Directors are appointed to provide strategic advice and independent oversight as well as to
challenge the CEO.

The Board may create or disband Committees depending on the operations of the Company. The Board has established the
following Committees to assist with oversight and governance: Audit, Compensation, Nominating and Government Security.

The Audit Committee 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 auditor relating to the interim and annual accounts and the accounting and internal
control systems in use throughout the Company. The Audit Committee will meet no less than three times each financial
year and will have unrestricted access to the Company’s auditor. The Audit Committee comprises Martin Jaskel as
Chairman, Donald Stanford and Nabil Lawandy.

The Compensation Committee reviews the performance of Executive Directors 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 option
scheme or equity incentive scheme in operation from time to time. The Compensation Committee comprises
Donald Stanford as Chairman, Martin Jaskel and BJ Penn.

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.

The Security Committee 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 monitoring of operations to ensure that protective measures are effectively
maintained and implemented. The Security Committee comprises BJ Penn as Chairman and Nabil Lawandy.

Spectra Systems Corporation Annual report and accounts 2018

PRINCIPLE 10:

Communicate how the company is governed and is performing by maintaining a dialogue with shareholders and other
relevant stakeholders

The Board is committed to maintaining good communication with all of its stakeholders, including shareholders.
The Company’s website, and its Investor Relations section in particular, provides useful information to assist
stakeholders in assessing the performance of the Company.

Results of shareholder meetings and details of votes cast will be publicly announced through the regulatory
information system. The Board will seek to understand the reasons behind any significant votes cast against
a resolution at any general meeting.

Board Committee reports are included in the Company’s annual report.

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Annual report and accounts 2018 Spectra Systems Corporation
15

C O M M I T T E E R E P O R T S

Audit Committee report

Dear Shareholder

I am pleased to present our Audit Committee report for 2018 which
describes our activities and areas of focus during the year ended
December 31, 2018. The Board is satisfied that the members of the
Audit Committee bring a wide range of skills, expertise, experience
and competence relevant to the sector in which the Company operates
and that Martin Jaskel possesses the necessary recent and relevant
financial experience to effectively chair the Committee.

The main role of the Audit Committee includes:

– monitoring the integrity of the Company’s financial statements,
including reviewing its annual and half-year financial statements
and accounting policies;

– reviewing the effectiveness of the internal controls

and risk management; and

– overseeing the relationship with the Company’s auditor,
Miller Wachman LLP, and assessing the effectiveness
of the external audit.

The Audit Committee intends to meet no less than three times each
financial year. Given the size of the Company, all Board members typically
attend the Audit Committee meetings. In addition, the Chief Financial
Officer and the Company’s outside General Counsel typically attend
the Audit Committee meetings. During 2018, the Audit Committee:

– re-appointed Miller Wachman LLP as the Company’s

external auditor;

– reviewed and recommended to the Board the approval of the 2017

annual report and the 2018 half-year results announcement;

– reviewed the accounting treatment of the licensing agreement

executed in January 2018; and

– reviewed the audit approach and scope of the audit work to be

undertaken by the external auditor and associated fee.

Martin Jaskel
Chairman
April 3, 2019

Nominating Committee report

Dear Shareholder

I am pleased to present our Nominating Committee report for 2018
which describes our activities and areas of focus during the year ended
December 31, 2018. The main role of the Committee is to review the
structure, size and composition of the Board, identify and propose to
the Board suitable candidates to fill Board positions and keep under
review the leadership needs of the Company.

Given the size of the Company, all Board members typically attend
the Nominating Committee meetings. In addition, the Chief Financial
Officer and the Company’s outside General Counsel typically attend the
Nominating Committee meetings. During 2018, the Nominating
Committee reviewed the composition, size and structure of the Board.

Martin Jaskel
Chairman
April 3, 2019

Spectra Systems Corporation Annual report and accounts 2018

Compensation Committee report

During 2018, the Compensation Committee:

Dear Shareholder

I am pleased to present our Compensation Committee report for
2018 which describes our activities and areas of focus during the
year ended December 31, 2018. The Compensation Committee reviews
the performance of Executive Directors and makes recommendations
to the Board on matters relating to their compensation 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 option scheme or equity incentive
scheme in operation from time to time. The Compensation Committee
aims to provide a competitive compensation package which will attract
and retain Directors and management with the requisite experience
and ability to manage the Company and generate superior long-term
performance. The four main elements of the compensation package
are: base salary, annual bonus, benefits and share options. Given the
size of the Company, all Board members typically attend the
Compensation Committee meetings. In addition, the Chief Financial
Officer and the Company’s outside General Counsel typically attend
the Compensation Committee meetings.

– assessed the 2017 performance of the Chief Executive Officer

and approved a bonus of US$200,000 based on the exceptional
financial results for 2017;

– benchmarked Board compensation against similar sized companies
and increased Board compensation to US$30,000 per annum; and

– approved the issuance of stock options to key employees throughout

the organization.

Donald Stanford
Chairman
April 3, 2019

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Directors’ interests

The Directors’ beneficial interests in the common stock of the Company were as follows:

Ordinary shares

N. Lawandy

M. Jaskel

December 31,

2018

2017

1,883,540

71,832

1,955,372

1,883,540

37,963

1,921,503

Directors’ compensation
The following table details the Directors’ earned compensation for the year ended December 31, 2018:

Executive Directors

N. Lawandy

Non-executive Directors

B. Penn

M. Jaskel

D. Stanford

Total

Salary
and bonus

Benefits

Board fees

Total
compensation

475,000

35,554

— $

510,554

—

27,000

475,000

35,554

81,000

591,554

Directors’ share options
At December 31, 2018, Directors had options or warrants to purchase ordinary shares under the Company’s stock option plan as follows:

N. Lawandy

B. Penn

M. Jaskel

D. Stanford

Options held at
December 31,
2018

Weighted
average
exercise price

Options vested
at December 31,
2018

4,030,292

220,000

100,000

220,000

4,570,292

0.56

0.50

0.37

0.50

0.55

4,030,292

220,000

100,000

220,000

4,570,292

Annual report and accounts 2018 Spectra Systems Corporation
17

D I R E C T O R S ’ R E P O R T

for the year ended December 31, 2018

The Directors present their report and the audited consolidated
financial statements for the year ended December 31, 2018.

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, as well as statistical analysis.

Results and dividends
The Company’s statements of income and other comprehensive
income are set out on page 23 and show the results for each year.

There are nominal federal and state income tax liabilities on the
respective income tax returns due to timing differences arising
between items of income and expense recorded on the books and
those reported on the tax returns. Additionally, the Company has
approximately US$19 million in federal net operating loss carryforwards
to offset future income reported on the respective tax returns.

The Directors intend to pay a dividend of US$0.07 per share on or
about June 28, 2019 to shareholders of record as of June 7, 2019.

Review of business and future developments
A review of the operations of the Group is contained in the Spectra
at a glance review on pages 2 and 3.

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 condition.

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 pricing pressure 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. US 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 is 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 that its key employees
are incentivized but cannot guarantee the retention of these staff.

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.

Key performance indicators (in thousands)
– Revenue of US$12,494k (2017: US$12,170k).

– Adjusted EBITDA of US$5,045k (2017: US$4,349k).

– Adjusted PBTA of US$4,782 (2017: US$4,010k).

– Adjusted earnings per share of US9.8₵ (2017: US8.8₵).

Spectra Systems Corporation Annual report and accounts 2018

Post-reporting date events
None.

Financial instruments

Details of the use of financial instruments by the Company are contained in note B of the financial statements.

Directors’ responsibilities
The Directors are responsible for preparing the Directors’ report and the financial statements on the basis of preparation set out in note A
of 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.

Substantial shareholdings
The following shareholders held 3% or more of the issued common stock of the Company at December 31, 2018:

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Mercantile Investment Company Ltd.

N. Slater

O. Salam

Herald Investment Management Ltd.

N. Lawandy

H. Heye

Ordinary
shares

6,800,000

4,091,471

3,594,464

2,929,300

1,883,540

1,813,850

21,112,625

% issued

14.94

8.99

7.90

6.44

4.14

3.99

46.40

Annual report and accounts 2018 Spectra Systems Corporation
19

D I R E C T O R S ’ R E P O R T c o n t i n u e d
for the year ended December 31, 2018

Corporate governance
At both December 31, 2018 and the date of this report, the Board comprised one Executive Director, Nabil 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.

Board attendance in 2018

N. Lawandy

B. Penn

M. Jaskel

D. Stanford

President and Chief Executive Officer

Non-executive Chairman

Non-executive Director

7/7

100%

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 as Chairman,
Nabil 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 auditor 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 auditor.

The Compensation Committee comprises Donald Stanford as Chairman,
Martin Jaskel and BJ Penn. It reviews the performance of the Executive
Directors and makes recommendations to the Board on matters relating
to 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.

The Government Security Committee comprises BJ Penn as Chairman
and Nabil 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.

Auditor

All of the current Directors have made themselves aware of any
information needed by the Company’s auditor for the purposes of its
audit and have established that the auditor is aware of that information.
The Directors are not aware of any relevant information of which the
auditor is unaware.

Miller Wachman LLP has expressed its willingness to continue as the
Company’s auditor and a resolution to re-appoint Miller Wachman LLP
will be proposed at the Annual General Meeting.

By order of the Board

Brian McLain
Company Secretary
April 3, 2019

Spectra Systems Corporation Annual report and accounts 2018

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I N D E P E N D E N T A U D I T O R ’ S R E P O R T

To the Board of Directors and Stockholders of Spectra Systems Corporation
We have audited the accompanying financial statements of Spectra Systems Corporation, which comprise the balance sheets as of December 31, 2018
and 2017, and the related statements of income and other comprehensive income, stockholders’ equity, and cash flows for the years 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.

Auditor’s responsibility

Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits 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 auditor’s 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 auditor considers 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, 2018 and 2017, 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
March 15, 2019

Annual report and accounts 2018 Spectra Systems Corporation
21

B A L A N C E S H E E T S
December 31, 2018 and 2017

Assets

Current assets

Cash and cash equivalents

Accounts receivable, net of allowance for doubtful accounts of US$69,592 and US$48,000 in 2018
and 2017, respectively

Other receivables

Inventory

Prepaid expenses

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

Taxes payable

Deferred revenue

Total current liabilities

Non-current liabilities

Deferred revenue

Total non-current liabilities

Total liabilities

Commitments and contingencies (note J)

Stockholders’ equity

Common stock, US$0.01 par value, 125,000,000 shares authorized at December 31, 2018
and 2017; 45,504,623 and 45,434,754 shares issued and outstanding at December 31, 2018
and 2017, respectively

Additional paid-in capital – common stock

Accumulated other comprehensive loss

Accumulated deficit

Total stockholders’ equity

2018

2017

12,662,410

11,180,578

1,075,335

138,615

3,269,496

141,161

17,287,017

1,586,635

6,696,867

1,099,021

1,400,000

150,215

9,346,103

1,244,507

180,794

3,754,610

115,887

16,476,376

1,794,460

6,966,367

1,099,021

1,225,000

151,391

9,441,779

28,219,755

27,712,615

269,332

827,376

2,504

703,182

1,802,394

540,389

200,242

1,520,736

8,178

1,074,184

2,803,340

457,786

2,342,783

3,261,126

455,046

55,389,977

(113,600)

454,348

55,223,989

(105,254)

(29,854,451)

(31,121,594)

25,876,972

24,451,489

Total liabilities and stockholders’ equity

28,219,755

27,712,615

The accompanying notes are an integral part of these financial statements.

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S TAT E M E N T S O F I N C O M E A N D O T H E R
C O M P R E H E N S I V E I N C O M E
for the years ended December 31, 2018 and 2017

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

Income from operations

Other income/(expense)

Interest income

Foreign currency income (loss)

Total other income, net

Income before provision for income taxes

Income tax benefit

Net income

Earnings per share

Basic

Diluted

Weighted average number of common shares

Basic

Diluted

Other comprehensive income (loss)

Unrealized gain (loss) on currency exchange

Reclassification for realized gain (loss) in net income

Total other comprehensive income (loss)

Comprehensive income

The accompanying notes are an integral part of these financial statements.

2018

2017

8,605,015

9,388,129

1,830,339

2,058,209

12,493,563

3,526,922

8,966,641

1,830,229

2,570,464

677,101

5,077,794

3,888,847

157,630

(10,643)

146,987

4,035,834

19,115

1,629,412

1,152,231

12,169,772

3,514,245

8,655,527

1,765,149

3,293,262

566,544

5,624,955

3,030,572

60,480

1,680

62,160

3,092,732

187,350

4,054,949

3,280,082

0.09

0.08

0.07

45,463,480

48,936,428

45,369,084

47,881,783

(18,989) $
10,643

(8,346)

9,739

(1,680)

8,059

4,046,603

3,288,141

Annual report and accounts 2018 Spectra Systems Corporation
23

S TAT E M E N T S O F S T O C K H O L D E R S ’ E Q U I T Y
for the years ended December 31, 2018 and 2017

Common stock

Amount

Additional
paid-in capital

Accumulated
deficit

Other
comprehensive
loss

Total
stockholders’
equity

Balance at December 31, 2016

45,251,370

452,514

$ 55,061,067

$ (32,131,338) $

(113,313) $ 23,268,930

Compensation cost related to
amortization of stock options

Reclassification for realized
loss in net income

Unrealized loss on currency exchange

Exercise of stock options

Dividends paid
Net income

—

183,384
—

—

1,834
—

—

122,956

—

39,966
—

—

(2,270,338)

3,280,082

—

122,956

(1,680)

9,739
—

—

(1,680)

9,739

41,800

(2,270,338)

3,280,082

Balance at December 31, 2017

45,434,754

454,348

$ 55,223,989

$ (31,121,594) $

(105,254) $ 24,451,489

Compensation cost related to
amortization of stock options

Reclassification for realized loss
in net income

Unrealized loss on currency exchange

Exercise of stock options

Dividends paid
Net income

Adoption impact of ASC 606

—

69,869
—

—

698
—

—

155,886

—

10,102
—

—

(2,728,117)

4,054,949

(59,689)

—

155,886

10,643

(18,989)
—

—

10,643

(18,989)

10,800

(2,728,117)

4,054,949

(59,689)

Balance at December 31, 2018

45,504,623

455,046

$ 55,389,977

$ (29,854,451) $

(113,600) $ 25,876,972

The accompanying notes are an integral part of these financial statements.

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S TAT E M E N T S O F C A S H F L O W S
for the years ended December 31, 2018 and 2017

Cash flows from operating activities
Net income

Adjustments to reconcile net income to net cash provided by operating activities:

Depreciation and amortization

Stock-based compensation expense

Deferred taxes

Allowance for doubtful accounts

Inventory obsolescence

Loss on sale of property and equipment

Changes in operating assets and liabilities:

Accounts receivable

Other receivable

Inventory

Prepaid expenses

Other assets

Accounts payable

Accrued expenses and other liabilities

Deferred revenue

Net cash provided by operating activities

Cash flows from investing activities

Restricted cash and investments

Payment of patent and trademark costs

Payment of software costs

Cash proceeds on sale of property and equipment

Purchases of property, plant, and equipment

Net cash used in investing activities

Cash flows from financing activities

Dividends paid

Proceeds from exercise of stock options

Net cash used in financing activities

Effect of exchange rate on cash and cash equivalents

Net increase in cash and cash equivalents

Cash and cash equivalents, beginning of the year

Cash and cash equivalents, end of the year

Supplemental disclosures of cash flow information

Income taxes paid

Non-cash investing activities

Acquisition of patents through accounts payable

The accompanying notes are an integral part of these financial statements.

2018

2017

4,054,949

3,280,082

1,005,025

155,886

(175,000)
6,500

250,291

1,428

147,580

57,271

234,823

(27,402)
667

69,525

(696,405)

(344,759)

1,103,388

122,956

(236,000)

35,500

92,426

32,420

1,258,223

(12,106)

(932,365)

(9,873)

3,156

(170,319)

89,042

12,965

4,740,379

4,669,495

—

(325,245)
—

—

(205,958)

(531,203)

(7,289)

(395,711)

(8,575)

405,400

(71,276)

(77,451)

(2,728,117)
10,800

(2,270,338)

41,800

(2,717,317)

(2,228,538)

(10,027)

1,481,832

11,180,578

9,204

2,372,710

8,807,868

12,662,410

11,180,578

111,351

41,331

42,943

33,008

Annual report and accounts 2018 Spectra Systems Corporation
25

N O T E S T O T H E F I N A N C I A L I N F O R M AT I O N
for the years ended December 31, 2018 and 2017

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, as well as statistical analysis.

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 and changed its name to Spectra Science Corporation. The assets were purchased for US$1,654,000
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 US$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. US$1,425,000 was paid in consideration for the assets.

On September 14, 2012, the Company acquired certain assets of Lapis Software Associates, including its proprietary source codes, multi-year
and long-standing customer relationships, and assumed liabilities. US$726,000 was paid in consideration for the assets.

On February 28, 2014, the Company acquired certain assets of Inksure Technologies, Inc., including its long-standing customer relationships
and authentication technology. US$1,356,000 was paid in consideration for the assets.

On September 30, 2015, the Company acquired certain assets of Solaris Nanosciences, Inc. (“Solaris”), including technology and customer
relationships in exchange for US$213,917 in cash. The Company also recorded US$184,000 in contingent payments based on a royalty
payment arrangement for anticipated continuing business.

On January 28, 2016, the Company acquired certain specialty phosphor assets including technology and customer relationships. The total
consideration amounted to US$3,118,489.

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 (US GAAP)
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; stock-based compensation; 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 the date of acquisition to be cash equivalents.

Restricted cash and investments

Restricted cash and investments represent a certificate of deposit held as collateral for certain performance requirements in accordance with terms
of a services contract. As of both December 31, 2018 and 2017, the agreement required that US$500,000 be maintained as collateral. The collateral
will be released as the Company meets contractual milestones. Restricted cash and investments of US$1,099,021 as of both December 31, 2018
and 2017 are certificates of deposit whose maturity exceeded 90 days at the date of acquisition, of which US$500,000 is restricted.

Significant concentrations
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 good credit standing. The Company has cash and investments, including restricted, on deposit
with financial institutions which are insured by either the Federal Deposit Insurance Corporation up to US$250,000 per institution or the Canadian
Deposit Insurance Corporation up to 100,000 Canadian Dollars per institution. The Company also maintains cash on hand which is not subject
to insurance. As of December 31, 2018, the amount of cash and investments, including restricted, not insured was US$13,188,121.

Concentrations of credit risk with respect to trade accounts receivable are limited due to the concentration of business with government entities.
The Company’s management attempts to minimize credit risk on its accounts receivable by monitoring credit exposure on a regular basis.

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Note B – Significant accounting policies continued
Significant concentrations continued
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 as of:

Number of significant customers

Percentage of total receivables

December 31,

2018

64%

2017

64%

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 for the years ended:

Number of significant customers

Percentage of total revenue

The following table summarizes the geographic concentration of revenue for the years ended:

United States of America

Europe

Rest of World

Accounts receivable

December 31,

2018

62%

2017

64%

December 31,

2018

2017

7,464,636

4,387,901

641,026

8,033,065

3,044,916

1,091,791

12,493,563

12,169,772

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, 2018 and 2017, the Company had a US$69,592 and
US$48,000 allowance for doubtful accounts, respectively.

Fair value of financial instruments
As of both December 31, 2018 and 2017, 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 due to
their short-term nature.

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 both December 31, 2018 and 2017, the Company has certificates of deposit of US$1,099,021 which is included in restricted cash
and investments. 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 rate in effect during the applicable period. The translation adjustments are deferred as a separate
component of stockholders’ equity in accumulated other comprehensive loss.

Annual report and accounts 2018 Spectra Systems Corporation
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N O T E S T O T H E F I N A N C I A L I N F O R M AT I O N c o n t i n u e d
for the years ended December 31, 2018 and 2017

Note B – Significant accounting policies continued
Inventory

Inventories are stated at the lower of cost or net realizable value. 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. Inventory includes raw materials, labor and overhead.

Intangible assets

Goodwill represents the excess of purchase price over the fair value of the net assets acquired. Goodwill is not amortized, but is subject to
at least an annual assessment for impairment or whenever events or circumstances indicate that it might be impaired.

Other intangible assets consist of patents, trademarks and various intangible assets identified as part of a business combination such as
contracts, customer relationships and technology. Patents and trademarks are recorded at cost. For intangible assets identified as part of a
business combination, values are assigned using various valuation techniques, including the present value of expected future cash flows.
Intangible assets are amortized using the straight-line method over their estimated useful lives ranging from seven to 15 years. The Company
evaluates the possible impairment of its intangible assets annually or whenever events or circumstances indicate the carrying value of the
assets 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

3–7 years

Computer and office equipment

3–5 years

Furniture and fixtures

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, 2018, 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 US$nil.

Accounting for stock-based compensation
In accounting for the employee stock option 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
using the straight-line attribution method. The Company recognizes the effects of forfeitures in compensation cost when they occur.

Revenue recognition
General

On January 1, 2018, the Company adopted ASC 606 “Revenue from Contracts with Customers” (ASC 606) using the modified retrospective
method, which was applied to customer contracts that were not completed as of January 1, 2018. In accordance with the modified retrospective
transition method, the results of operations for 2018 are presented in accordance with ASC 606, while prior periods continue to be reported
in accordance with the historical revenue recognition guidance. The adoption of ASC 606 did not have a material effect on the Company’s
financial statements.

The Company’s sources of revenues are as follows:

– Product revenue includes sales of pigments and security taggants and sales of equipment.

– Service revenue includes:

– Secure Transactions software licensing and support as well as development services to customize our software to meet specific customer needs.

– Maintenance and repair services related to manufactured equipment.

– Research and development services.

– Royalties for the use of the Company’s know-how and technology.

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Revenue recognition continued
General continued
Revenue is recognized when control of the promised goods or services is transferred to customers, in an amount that reflects the consideration
expected to be entitled to in exchange for those goods or services. This condition normally is met when the product has been delivered or upon
performance of services.

When contracts with customers include multiple performance obligations, significant judgment is involved in determining whether each
performance obligation is distinct or should be combined with other performance obligations within the contract. In addition, the transaction
price is allocated to each distinct performance obligation using an estimate of stand-alone selling price. Estimating the stand-alone selling price
requires significant judgment and is generally based on observable prices or a cost plus margin approach.

Product revenue is generally recognized upon transfer of control of the product at a point in time upon delivery of the product to the customer
pursuant to the terms of the contract.

Revenues for maintenance and repairs and research and development services are generally recognized over time as the services are
performed. Revenues for fixed price services are generally recognized over time applying input methods to estimate progress to completion.

Generally, our software contracts contain multiple promised goods and services, including the following: (i) term software license; (ii) installation
and training; (iii) unspecified future enhancements; (iv) maintenance and support; and (v) optional professional services in the future. The term
software license, installation and unspecified future enhancements are considered one performance obligation as the software is dependent on
the installation and the enhancements are critical to the utility of the software. As the enhancements are delivered over time, revenue is recognized
ratably over the term of the contract. Maintenance and support services are provided over the term of the contract and revenue is recognized
over time based on the term of the contact. Future professional services, if any, are recognized over time based on hours incurred.

During 2018, the Company executed both a supply agreement and a technology license agreement with an existing customer to continue
supplying an existing product and extend the rights to the underlying technology in perpetuity. The customer will pay reduced rates for the
product but will pay approximately US$10,500,000 in eleven payments over five years for the technology license. The extended payment terms
were negotiated by the customer to ensure supply of product and therefore do not represent a significant financing component. The Company
has combined the contracts as per the guidance in ASC 606 as both contracts were negotiated at the same time. The Company has identified
two performance obligations: (i) the option to purchase product; and (ii) the technology and stand-ready obligation as the customer is required
to pay the US$10,500,000 regardless of whether of not they purchase product and the technology cannot be used by the customer unless the
Company defaults on its obligations within the agreements. The Company allocated approximately US$1,800,000 to the option to purchase
product based on observable stand-alone selling prices and will recognize this revenue at each point in time as product is delivered. The Company
allocated approximately US$8,700,000 to the technology and stand-ready obligation based on the residual approach and will recognize this
revenue over time as royalty revenue, ratably over five years.

Revenue is reported net of incentive rebates and discounts.

The following table summarizes the type of revenue for the years ended:

Product

Maintenance, repair and research and development services

Royalties

Total Authentication Systems revenue

Secure Transactions revenue

Total revenue

December 31,

2018

2017

8,605,015

9,388,129

540,143

2,058,209

11,203,367

1,290,196

282,402

1,152,231

10,822,762

1,347,010

12,493,563

12,169,772

Credit terms are predominately short term in nature. As such, there is not a significant financing component within the customer contracts.

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for the years ended December 31, 2018 and 2017

Note B – Significant accounting policies continued
Contract liabilities and other disclosures
The Company records contract liabilities (deferred revenues) when cash payments are received or due in advance of performance.
Software customers pay an upfront license fee and equipment maintenance contracts are typically billed annually in advance. Deferred revenue
expected to be realized within one year is classified as a current liability. The following table summarizes the activity in our contract liabilities
for the reporting period:

Balance, beginning of year

Adoption of ASC 606

Currency translation

Deferral of revenue

Revenue recognized

Balance, end of year

December 31, 2018

December 31, 2017

1,531,970

59,689

(3,327)
2,894,251

(3,239,012)

1,516,205
—

1,401

(2,156,254)

2,170,618

1,243,571

1,531,970

Revenue allocated to remaining performance obligations represents contracted revenue that has not yet been recognized (“contracted
not recognized revenue”), which includes unearned revenue and amounts that will be invoiced and recognized as revenue in future periods.
Contracted not recognized revenue was approximately US$15,600,000 as of December 31, 2018, of which we expect to recognize
approximately 27% of the revenue over the next twelve months and the remainder thereafter.

Warranties
If a warranty is applicable, a warranty liability is recorded at the time of sale. The warranty liability is estimated by assessing historical
experience to the current applicable population. Warranty costs may differ from those estimated if actual claim rates are higher or lower
than our historical rates.

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.

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. For both 2018 and 2017, there is no federal or state income tax liability on those respective
income tax returns.

Advertising costs
Advertising costs are charged to expense when incurred. Advertising expense was US$7,515 and US$6,428 for 2018 and 2017, respectively.

Shipping and handling

The Company reports the cost of shipping and handling as an operating expense. Shipping and handling expense was US$110,703 and US$95,537
for 2018 and 2017, respectively.

Note C – Related party transactions
The Company sold phosphor products and received royalties amounting to approximately US$843,000 and US$2,863,000 for the years ended
December 31, 2018 and 2017, respectively, to a company owned by a shareholder.

On September 30, 2015, the Company purchased certain assets from Solaris in exchange for US$213,917 in cash. The Company also recorded
US$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. No royalty payments were made during the year ended December 31, 2018.
During the year ended December 31, 2017, the Company paid royalties of US$3,895 to Solaris.

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Note D – Inventories

Inventories consist of the following:

Raw materials

Finished goods

Total

Less: reserve for excess and obsolete inventory

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,

2018

2017

2,023,820

1,588,393

3,612,213

(342,717)

2,006,436

1,840,600

3,847,036

(92,426)

3,269,496

3,754,610

December 31,

2018

711,849

372,724

114,354

1,512,039

341,964

1,304,518

4,357,448

(2,770,813)

2017

666,550

328,034

114,354

1,487,849

340,937

1,221,851

4,159,575

(2,365,115)

1,586,635

1,794,460

Depreciation expense amounted to US$410,669 and US$401,198 for the years ended December 31, 2018 and 2017, respectively. As part of its
consolidation of East Providence operations (see note J), the Company disposed of US$331,227 of fully depreciated equipment during the year
ended December 31, 2017. During the year ended December 31, 2017, the Company sold machinery and received proceeds of US$405,400.
The Company recorded a loss of US$32,420 on the sale.

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,

2018

2017

3,151,939

3,043,000

188,440

1,502,000

30,000

131,185

2,468,863

10,515,427

(3,818,560)

2,834,431

3,043,000

188,440

1,502,000

30,000

123,448

2,468,863

10,190,182

(3,223,815)

6,696,867

6,966,367

Amortization expense amounted to US$594,356 and US$702,190 for the years ended December 31, 2018 and 2017, respectively.

Annual report and accounts 2018 Spectra Systems Corporation
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for the years ended December 31, 2018 and 2017

Note F – Intangible assets continued
Estimated amortization expense is as follows:

Year ending December 31,

2018

2019

2020

2021

2022

Thereafter

Note G – Other assets

Other assets consist of the following:

Rental deposits

Deferred contract costs

Note H – Accrued expenses and other liabilities
Accrued expenses and other liabilities consist of the following:

Royalties

Employee compensation

Contingent costs

Sales allowance and rebates

Professional fees

Property and franchise taxes

Other

Note I – Income taxes

The approximate components of the income tax provision are as follows:

Income tax provision/(benefit) computed at:

Federal statutory rate – current

State statutory rate – current

Federal deferred

State deferred

Change in valuation allowance

Income tax benefit

560,553

479,752

434,404

420,014

415,578

1,917,703

4,228,004

December 31,

2018

17,965

132,250

150,215

December 31,

2018

192,917

245,680

180,105

43,735

83,000

8,000

73,939

2017

19,141

132,250

151,391

2017

700,345

406,301

180,105

115,775

80,000

8,480

29,730

827,376

1,520,736

December 31,

2018

2017

904,000

1,204,000

300,000

(40,000)

(13,000)

212,000

(117,000)

(20,000)

(1,132,000)

(1,092,000)

19,000

187,000

Spectra Systems Corporation Annual report and accounts 2018

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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

Remeasurement of deferred taxes

Non-deductible expenses and other

Change in valuation allowance

Effective tax rate

Approximate deferred income tax assets are as follows:

Depreciation and amortization

Deferred revenue

Federal and state tax credits

Inventory

Bad debts

Net operating loss carryforward

Valuation allowance

Total deferred income tax assets

December 31,

2018

21.0%

0.3%

—

(4.6%)

(16.2%)

0.5%

December 31,

2018

(99,000) $

(335,000)
918,000

56,000

16,000

4,167,000

(3,323,000)

2017

34.0%

0.2%

(35.3%)

(5.1%)
—

(6.2%)

2017

(77,000)

(349,000)

918,000

121,000

14,000

5,053,000

(4,455,000)

1,400,000

1,225,000

The Tax Cuts and Jobs Act (“Tax Act”) was enacted on December 22, 2017. The Tax Act eliminated alternative minimum taxes and lowered
the federal corporate income tax rate from 34% to 21% effective January 1, 2018. During the year ended December 31, 2017, the Company
remeasured its net deferred tax assets using the new federal corporate income tax rate and posted a one-time reduction of US$2.0 million
in deferred tax assets to reflect the lower realization rate to be applied commencing in 2018.

As of December 31, 2018, the Company has net operating loss carryforwards expiring between 2019 and 2036 for US federal income tax purposes
of approximately US$19,000,000. A valuation allowance has been established for US$3,323,000 and US$4,455,000 as of December 31, 2018
and 2017, respectively, for the deferred tax benefit related to those loss carryforwards and other deferred tax assets.

At December 31, 2018, the Company also had approximately US$920,000 of tax credit carryforwards that are available to offset federal
and state liabilities. The credits will begin to expire between 2019 and 2029 for federal and between 2019 and 2024 for state.

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 and tax laws and regulations may substantially limit their realization.

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.

Annual report and accounts 2018 Spectra Systems Corporation
33

N O T E S T O T H E F I N A N C I A L I N F O R M AT I O N c o n t i n u e d
for the years ended December 31, 2018 and 2017

Note J – Commitments and contingencies
The Company is involved from time to time in litigation incidental to the conduct of its business. The Company is not currently a party to any
lawsuit or proceeding.

Lease commitments

The Company holds four real estate leases. During 2018, the Company signed a lease agreement for corporate office space which expires
in October 2023. The Company signed a five-year lease agreement for manufacturing and warehouse space in East Providence beginning in
November 2013 and expiring in October 2022. To support the ICS business, the Company signed a lease which has been extended through
January 2022. The Company’s lease for laboratory space in East Providence has been extended through May 31, 2020 for a portion of the
space. During 2017, the Company vacated the remaining portion of the space and consolidated its operations at its other East Providence
locations. Rent expense was US$371,214 and US$421,513 for the years ended December 31, 2018 and 2017, respectively.

Future minimum lease payments are as follows:

Year ending December 31,

2019

2020

2021

2022

2023

312,365

249,288

205,008

169,521

55,505

991,687

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 last of these patents expired
during 2018. The license agreement contains provisions for royalties to be paid on sales of products developed under the agreement. For the
years ended December 31, 2018 and 2017, the Company recorded US$36,870 and US$164,768, respectively, in royalty expense.

Note K – Stockholders’ equity

Common and preferred stock

On July 25, 2011, the Company raised US$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, 2018 there were 45,504,623 common shares issued and outstanding and no preferred shares in issue.

Stock option plan
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, and 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. Stock options generally vest over three years and are exercisable over
a period up to ten years from the date of grant. As of December 31, 2018, options to purchase 5,865,830 shares of common stock were outstanding
and 253,253 shares of common stock have been issued under the 2007 Plan. As of December 31, 2018, 7,980,917 shares of common stock
were available for grant under the 2007 Plan.

Spectra Systems Corporation Annual report and accounts 2018

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Note K – Stockholders’ equity continued
Stock option plan continued
Information related to stock options granted by the Company is summarized as follows:

Outstanding at beginning of year

Granted

Exercised

Forfeited/canceled

Outstanding at end of year

December 31, 2018

December 31, 2017

Number of shares
under option

Weighted average
exercise price

Number of shares
under option

Weighted average
exercise price

5,588,830

393,000

(96,000)

(20,000)

5,865,830

0.50

1.38

0.49

1.53

0.56

7,047,414

250,000

(255,000)

(1,453,584)

5,588,830

0.51

0.49

0.44

0.49

0.50

The following table summarizes information about stock options outstanding at December 31, 2018:

Exercise price range

US$0.30–US$0.84

US$0.85–US$1.54

Options outstanding

Options exercisable

Number of
outstanding
shares

5,092,830

773,000

5,865,830

Weighted
average
contractual life
(years)

4.53

5.99

4.72

Weighted
average
exercise price

0.45

1.30

0.56

Number of
shares

4,926,163

400,000

5,326,163

Weighted
average
exercise price

0.44

1.23

0.50

As of December 31, 2018, the weighted average contractual life for exercisable stock options was 4.27 years.

The Company’s stock price closed at US$1.35 (£1.055) on December 31, 2018. As of December 31, 2018, the aggregate intrinsic value for
outstanding and exercisable stock options was US$4,858,846 and US$4,704,472, respectively. Intrinsic value for stock options is defined as
the difference between the current market value of the stock and the exercise price. The intrinsic value represents the value that would have
been received by the option holders had the option holders exercised all of their options as of that date.

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 subjective variables including stock price, volatility, expected
life of options, risk free interest rates, and expected dividends, if any. The Company recorded stock-based compensation costs of US$155,886
and US$122,956 for the years ended December 31, 2018 and 2017, respectively. There was no stock-based compensation expense capitalized
during either year. During the year ended December 31, 2018, the weighted average grant date fair value of stock options granted was US$1.38.
The assumptions used to value stock option grants are as follows for the year ended:

Risk free rate

Expected life (years)

Assumed volatility

Expected dividends

December 31,

2018

2.6%–3.0%

6.00

46.0%–81.0%

3.9%

2017

2.1%

6.00

84.7%
None

As of December 31, 2018, there was approximately US$198,000 of unrecognized compensation cost, related to unvested stock-based payments
granted to our employees and Directors, which is expected to be recognized over a weighted average period of 1.7 years. Total unrecognized
compensation cost will be adjusted for future changes in forfeitures and recognized over the remaining vesting periods of the stock grants.

Note L – Employee retirement plan
During 1999, the Company adopted a defined contribution 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 employee retirement plan (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, 2018 and 2017, the Company’s matching contributions were US$31,084 and US$33,678, respectively.

Annual report and accounts 2018 Spectra Systems Corporation
35

N O T E S T O T H E F I N A N C I A L I N F O R M AT I O N c o n t i n u e d
for the years ended December 31, 2018 and 2017

Note M – 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 the authentication of banknotes, tax stamps and other high value goods. The second segment is
the Secure Transactions Group, which provides an Internal Control System (ICS) software offering to the lottery and gaming industries. ICS provides
tools for fraud, money laundering and match fixing detection, as well as statistical analysis. The third segment is the Banknote Cleaning Group,
which captures the technology related to cleaning soiled banknotes.

Information for each reportable segment as of December 31, 2018 and 2017 is as follows:

Gross
revenue

Income/(loss)
from operations

Depreciation and
amortization

Capital
expense

Segment
assets

2017

Secure Transactions

1,347,010

398,060

207,568

2,129

2,219,415

Authentication Systems

Banknote Cleaning

Total

2018

Secure Transactions

Authentication Systems

Banknote Cleaning

10,822,762
—

$ 12,169,772

1,290,196

11,203,367
—

2,712,999

(80,487)

3,030,572

250,187

3,689,500

(50,840)

847,753

48,067

1,103,388

180,602

773,583

50,840

69,147
—

25,023,252

469,948

71,276

$ 27,712,615

24,509

2,222,748

161,449

20,000

25,535,917

461,090

Total

$ 12,493,563

3,888,847

1,005,025

205,958

$ 28,219,755

Note N – Earnings per share

The calculation of basic earnings per share is based on the net income divided by the weighted average number of common shares outstanding.
Diluted earnings per share is calculated by considering the dilutive impact of common stock equivalents under the treasury stock method as if they
were converted into common stock as of the beginning of the period or as of the date of grant, if later. Excluded from the calculation of diluted
earnings per common share for the years ended December 31, 2018 and 2017 were 95,063 and 400,164 shares, respectively, related to stock
options because their exercise prices would render them anti-dilutive. The following table shows the calculation of basic and diluted earnings
per common share:

Numerator

Net income

Denominator

December 31,
2018

December 31,
2017

4,054,949

3,280,082

Weighted average number of common shares outstanding

45,463,480

45,369,084

Effect of dilutive securities

Stock options

Diluted weighted average number of common shares outstanding

Earnings per common share

Basic

Diluted

Note O – Subsequent events

3,472,948

48,936,428

2,512,699

47,881,783

0.09

0.08

0.07

The Company evaluated all events or transactions that occurred through March 15, 2019, the date these financial statements were available
to be issued.

On March 25, 2019, the Company declared a dividend of US$0.07 per share to be paid on or around June 28, 2019 to shareholders of record
as of June 7, 2019.

Spectra Systems Corporation Annual report and accounts 2018

S H A R E H O L D E R A N D C O R P O R AT E I N F O R M AT I O N

Registered office

Spectra Systems Corporation
40 Westminster Street, 2nd Floor
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

Auditor and Reporting Accountants

Miller Wachman LLP
100 Cambridge Street, 13th Floor
Boston, MA 02114
United States of America

+1 617 338 6800

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

Spectra Systems Corporation
40 Westminster Street, 2nd Floor,
Providence, RI 02903,
United States of America

+1 401 274 4700
email: info@spsy.com
www.spsy.com