Summary of Significant Accounting Policies (Policies)

3 Months Ended

Mar. 31, 2018

The Castle Group, Inc. was incorporated under the laws of the State of Utah on August 21, 1981. The Castle Group, Inc. operates in the hotel and resort management industry in the State of Hawaii, New Zealand, and the Commonwealth of Saipan under the trade name “Castle Resorts and Hotels.” The accounting and reporting policies of The Castle Group, Inc. conform with accounting principles generally accepted in the United States of America (“GAAP”) and to practices accepted within the hotel and resort management industry.

Principles of Consolidation

The consolidated financial statements include the accounts of The Castle Group, Inc. and its wholly-owned subsidiaries: Hawaii Reservations Center Corp., HPR Advertising, Inc., Castle Resorts & Hotels, Inc., Castle Resorts & Hotels Thailand Ltd., NZ Castle Resorts and Hotels Limited (a New Zealand Corporation), NZ Castle Resorts and Hotels’ wholly-owned subsidiary, Mocles Holdings Limited (a New Zealand Corporation), Castle Resorts & Hotels NZ Ltd., Castle Group LLC (Guam), Castle Resorts & Hotels Guam Inc. and KRI Inc. dba Hawaiian Pacific Resorts (Interactive). Collectively, all of the companies above are referred to as “the Company” throughout these consolidated financial statements and accompanying notes. All significant inter-company transactions have been eliminated in the consolidated financial statements.

Basis of Presentation

The accompanying condensed consolidated financial statements have been prepared without audit, pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles have been condensed or omitted. In the opinion of management, the accompanying interim financial statements contain all adjustments, consisting of normal recurring accruals, necessary for a fair presentation. The results of operations for the three month periods ended March 31, 2018 and 2017, are not necessarily indicative of the results for a full-year period as the tourism industry that the Company relies on is highly seasonal. It is suggested that these condensed consolidated financial statements be read in conjunction with the consolidated financial statements and notes thereto included in Castle’s most recent Annual Report on Form 10-K for the year ended December 31, 2017, filed with the SEC on April 2, 2018. The Company’s significant accounting policies are set forth in Note 1 to the consolidated financial statements in its Annual Report on Form 10-K for the year ended December 31, 2017.

Revenue Recognition

On January 1, 2018, the Company adopted the requirements of Accounting Standards Update ("ASU") No. 2014-09, Revenue from Contracts with Customers (Topic 606) ("ASU 2014-09").The adoption of Topic 606 had no impact on the Company’s consolidated financial statements.

Recognition of revenue occurs when a customer obtains control of promised goods or services in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. ASU 2014-09 defines a five-step process to achieve this core principle. Refer to “new accounting pronouncements” for additional information.

The Company recognizes revenue from the management of resort properties according to terms of its various management contracts, which fall under two basic types of agreements, a Gross Contract and a Net Contract.

Under a “Gross Contract” the Company records revenue on a daily basis based on a percentage of the gross rental fee earned from the rental of hotel or condominium units. Under the Gross Contract, the Company is responsible for all of the operating expenses for the hotel or condominium unit and the Company records the expenses of operating the rental program at the property covered by the agreement as managed properly expense on the Company’s consolidated statements of comprehensive income. These expenses include housekeeping, food and beverage, maintenance, front desk, sales and marketing, advertising and all other operating costs at the property covered by the agreement. Management services comprise various activities that are considered an integrated service and a single performance obligation in the context of the contract.

Under a “Net Contract”, the Company receives a management fee that is based on a percentage of the gross rental proceeds earned from the rental of hotel or condominium units. Under the Net Contract, the owner of the hotel or condominium unit is responsible for all of the operating expenses of the rental program covering the owner’s unit and the Company also typically receives an incentive management fee, which is based on the net operating profit of the covered property. The incentive management fee, except for the one contract mentioned in Note 2 below, is based on a percentage net operating profit as defined in each contract, and is recorded as net operating profits are earned on a daily basis at our properties. For the contract mentioned in Note 2 below, our incentive management fee is contingent on the hotel achieving certain annual profitability targets. We will recognize an incentive fee receivable each month to the extent it is probable that we will not reverse a significant portion of the fees in a subsequent period. However, due to the profitability hurdles in the contract, incentive fees are considered contract assets until the risk related to the achievement of the profitability metric no longer exists. Once the annual profitability hurdle has been met, the incentive fee receivable balance will be reflected within accounts receivable.

Additionally, the Company employs on-site personnel to provide services such as housekeeping, maintenance and administration to property owners under the Company’s management agreements and for such services the Company recognizes revenue in an amount equal to the employee related payroll, payroll taxes and employee benefits incurred. Management services comprise various activities that are considered an integrated service and a single performance obligation in the context of the contract. The Company records revenues on its net contracts on a daily basis which includes a percentage of revenues earned from guests staying at the respective property and the daily amount of payroll and related payroll costs that are incurred at the property. The Company does not record the operating expenses of the property covered by the agreement, other than the employee related costs.

Under both types of agreements, a liability is recognized for any deposits received for which services have not yet been rendered.

The difference between the Gross and Net Contracts is that under a Gross Contract, all expenses, and therefore the ownership of any profits or the covering of any operating loss, belong to and is the responsibility of the Company; under a Net Contract, all expenses, and therefore the ownership or any profits or the covering of any operating loss belong to and is the responsibility of the owner of the property.

The Company also recognizes revenue from the operation of restaurants and bars at its New Zealand property. Revenue as presented in our consolidated statements of comprehensive income, represents food and beverage product sold. Revenue from restaurant sales is recognized when food and beverage products are sold on a daily basis. Taxes collected from customers and remitted to governmental authorities are excluded from revenue.

Disaggregated Revenues

The following tables present our revenues disaggregated by the nature of the product or services provided by the Company and by geographic region:

	Three Months Ending March 31, 2018	Three Months Ending March 31, 2017
Gross contract revenue	$4,193,349	$3,848,103
Net contract revenue	2,510,837	2,312,229
Food and beverage revenue	392,105	420,883
Other revenue	400	300
Total Revenue	$7,096,691	$6,581,515

The Company records revenue from the USA domestic operations and also New Zealand operations. Revenues from these two geographic regions were:

	Three Months Ending March 31, 2018	Three Months Ending March 31, 2017
United States	$6,220,942	$5,625,760
New Zealand	875,749	955,755
Total Revenue	$7,096,691	$6,581,515

Deferred Compensation

The company has accounted for deferred compensation by recording an expense associated with the present value of the deferred stock compensation over the requisite vesting period. The total present value of the deferred compensation using a discount rate of 5.75% is amortized from the date of issuance to the retirement of the liability. A long term liability has been recorded to accumulate the deferred compensation that will be paid in future years.

In November 2017, the Company, as part of an amendment to the employment contracts with its Chief Executive Officer and Chief Operating Officer, granted a total of 1,750,000 fully vested warrants. The contracts also called for deferred compensation of $1,000,000 payable to the Chief Executive Officer in ten annual installments of $100,000 beginning November 1, 2027, and $500,000 payable to the Chief Operating Officer in ten annual installments of $50,000 beginning November 1, 2017. The deferred compensation was valued using a sinking fund approach and the Company expensed $27,435 for the three months ended March 31, 2018 and the deferred compensation was $36,635 and $9,200 as of March 31, 2018 and December 31, 2017, respectively.

Reclassification

Reclassifications

The Company has reclassified certain prior-period amounts to conform to the current-period presentation.

For presentation of the three months ended March 31, 2017, the Company reclassified $420,883 from Managed property revenue to Food and beverage revenue and also reclassified $384,946 from Managed property expense to Food and beverage expense.

New Accounting Pronouncements

Note 2 New Accounting Pronouncements

From time to time, new accounting pronouncements are issued by the Financial Accounting Standards Board (“FASB”) that are adopted by the Company as of the specified effective date. If not discussed, management believes that the impact of recently issued standards, which are not yet effective, will not have a material impact on the Company’s financial statements upon adoption.

Our qualitative evaluation of ASU 2014-09 included identifying the potential differences in the timing and/or method of revenue recognition for our contracts and, ultimately, the expected impact on our business processes, systems and controls. As part of this evaluation, we have reviewed our customer contracts and applied the five-step model of the new standard to each contact type identified that’s associated to our material revenue streams and have compared the results to our current accounting practices.

Areas of impact will include the timing of revenue recognition during the calendar year of certain incentive fees which we receive from one of our managed properties. If our right to consideration is conditional on future performance under the contract, the balance is classified as a contract asset. The timing of our revenue recognition for this contract will have no effect on our annual financial statements, however it may impact our quarterly interim financial statement as we will accelerate the recognition of our incentive fee on a pro-rated basis over the fiscal year if it is determined that this incentive fee shall be earned during the fiscal year. For the first quarter ended March 31, 2018 and 2017, we did not recognize any incentive fees from this contract as it was not certain or likely that the recording of any revenue from this contract would not be subject to reversal in the future. Under the terms of this management agreement, we earn incentive management fees based on a percentage of hotel profitability. The incentive fee is contingent on the hotel achieving certain annual profitability targets. We recognize an incentive fee receivable each month to the extent it is probable that we will not reverse a significant portion of the fees in a subsequent period. However, due to the profitability hurdles in the contract, incentive fees are considered contract assets until the risk related to the achievement of the profitability metric no longer exists. Once the annual profitability hurdle has been met, the incentive fee receivable balance will be reflected within accounts receivable.

Our payments from customers are based on the billing terms established in our contracts. Customer billings are classified as accounts receivable when our right to consideration is unconditional. Payments received in advance of performance under the contract are classified as contract liabilities and recognized as revenue as we perform under the contract. At March 31, 2018 and December 31, 2017, we recorded $2,156,125 and $2,780,982 of payments received in advance of performance in the form or advance deposits received from guests of the properties we manage under a Gross contract.

The Company does not currently incur costs to obtain or fulfill a contract that would be considered contract assets under Topic 606.

In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842). The new standard establishes a right-of-use (“ROU”) model that requires a lessee to record a ROU asset and a lease liability on the balance sheet for all leases with terms longer than 12 months. Leases will be classified as either finance or operating, with classification affecting the pattern of expense recognition in the income statement. The new standard is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. A modified retrospective transition approach is required for lessees for capital and operating leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements, with certain practical expedients available. The Company has $816,088 of operating lease obligations as of March 31, 2018 and upon adoption of this standard it will record a ROU asset and lease liability for present value of these leases which will have a material impact on the balance sheet. However, the statement of comprehensive income recognition of lease expenses is not expected to change from the current methodology.

In March 2016, the FASB issued ASU 2016-09, Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting. The objective of this update is to simplify several aspects of the accounting for employee share-based payment transactions, including the income tax consequences, classification of awards as either equity or liabilities, and classification on the statement of cash flows. This ASU is effective for fiscal years beginning after December 15, 2016, including interim periods within those fiscal years. The Company has adopted ASU 2016-09 effective January 1, 2017 and the necessary disclosures are provided within this Form 10-Q for the period ending March 31, 2018. The adoption of ASU 2016-09 does not have a material impact on the Company’s financial condition or results of operations.

In August 2016, the FASB issued ASU 2016-15 Statement of Cash Flows (Topic 230), Classification of Certain Cash Receipts and Cash Payments. The standard provides specific guidance over eight identified cash flow issues in order to reduce diversity in practice over the presentation and classification of certain types of cash receipts and cash payments. The effective date of the standard will be for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2017 and early adoption is permitted. Entities should apply the standard using a retrospective transition method to each period presented. The Company adopted the new guidance effective January 1, 2018 and it did not have a material impact on the Consolidated Statements of Cash Flows.

In January 2017, the FASB issued ASU 2017-04, Intangibles - Goodwill and Other/ ASU 2017-04 simplifies the accounting for goodwill impairment by eliminating Step 2 of the current goodwill impairment test, which required a hypothetical purchase price allocation. Goodwill impairment will now be the amount by which the reporting unit’s carrying value exceeds its fair value, limited to the carrying value of the goodwill. ASU 2017-04 is effective for financial statements issued for fiscal years, and interim periods beginning after December 15, 2019. Upon adoption, the Company will follow the guidance in this standard for the goodwill impairment testing.

CASTLE GROUP INC 10-Q