TLLEQ Teletouch Communications Inc (CE)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

NOTE 1 – BASIS OF PRESENTATION AND NATURE OF BUSINESS

Basis of Presentation: Teletouch Communications, Inc. (“Teletouch”) was incorporated under the laws of the State of Delaware on July 19, 1994, and its corporate headquarters are in Fort Worth, Texas. The consolidated financial statements include the consolidated accounts of Teletouch and our wholly-owned subsidiary, Progressive Concepts, Inc., a Texas corporation (“PCI,” together with the “Company”). PCI is the primary operating business of Teletouch. In October 2012, the Company merged Teletouch Licenses, Inc., a Delaware corporation (“TLI”) and Visao Systems, Inc., a Delaware corporation (“Visao”) into Teletouch Communications, Inc. TLI was a company formed for the express purpose of owning all of the FCC licenses utilized by Teletouch to operate its two-way radio network. Following the sale of the two-way radio business on August 11, 2012 (see Note 3 – “Discontinued Two-Way Operations” for more information on the sale of the two-way business) and the related transfer of all of the Company’s remaining FCC licenses to the buyer, TLI remained a shell company with no other operations until the merger with Teletouch in October 2012. Visao was a company formed in 2004 to develop and distribute the Company’s telemetry products. The telemetry business was shutdown in 2006 and Visao was maintained as a shell company with no operations until the merger with Teletouch in October 2012. All significant intercompany accounts and transactions have been eliminated in consolidation.

Nature of Business: For over 48 years, Teletouch together with its predecessors has offered a comprehensive suite of telecommunications products and services including cellular, two-way radio, GPS-telemetry, wireless messaging and public safety equipment. As of February 28, 2013, the Company operated 8 “Hawk Electronics” branded in-line and free-standing stores and service centers in Texas. PCI is an Authorized Service Provider, billing agent and Exclusive Dealer of cellular voice, data and entertainment services though AT&T Mobility (“AT&T”) to consumers, businesses and government agencies and markets these services under the Hawk Electronics brand name. For over 28 years, PCI has offered various communication services on a direct bill basis and services 31,595 cellular subscribers as of February 28, 2013. PCI sells consumer electronics products and cellular services through its stores, Hawk-branded sub-agents stores, its own direct sales force and on the Internet at various sites, including its primary consumer-facing sites: www.hawkelectronics.com , www.hawkwireless.com and www.hawkexpress.com . The Company handles all aspects of the wireless customer relationship, including:

In addition, PCI operates a national wholesale distribution business, “PCI Wholesale,” which serves major carrier agents, rural cellular carriers, smaller consumer and automotive electronics retailers and auto dealers throughout the country and internationally, with ongoing product and sales support through its direct sales representatives, call center, and the Internet through www.pciwholesale.com and www.pcidropship.com , among other sites.

Financial Condition and Going Concern Discussion: As of February 28, 2013, the Company had approximately $756,000 cash on hand and a working capital deficit of approximately $4,195,000 compared to a working capital deficit of approximately $11,662,000 as of May 31, 2012. The reduction of the working capital deficit is attributable to the settlement agreement the Company entered into with the State of Texas related to PCI’s sales and use tax audit, closing on a new long-term credit facility with DCP Teletouch Lender, LLC (“DCP”) and using the proceeds to pay down and amend the current debt that was payable to Thermo Credit, LLC (“Thermo”) in the third quarter of fiscal year 2013 (see further discussion below). All of these events resulted in a reclassification of current debt to long-term debt and have improved the Company’s financial condition by now having new or restructured debt obligations that the Company expects to be able to service with cash on hand and cash generated through operations for the foreseeable future. During the nine months ended February 28, 2013, the Company had sufficient cash to pay its trade payable obligations as they came due, make all scheduled principal and interest payments against its debt and continue its investment in inventory to support its business operations. Furthermore, in the nine months ended February 28, 2013, the Company paid approximately $83,000 related to its 2012 Texas margin tax obligation and $647,000 against PCI’s Texas sales and use tax audit obligation.

In February 2012, Thermo notified the Company it would cease advancing any additional funds to the Company under its revolving credit facility and needed to exit the debt facility as soon as possible. Following this notice, the Company immediately began focusing on securing new debt financing to replace its existing debt facility with Thermo. On August 1, 2012, the Company executed a term sheet with DCP and on February 8, 2013, the Company entered into a Loan and Security Agreement (the “DCP Loan Agreement”) with DCP (see “DCP Revolving Credit Facility” in Note 12 for additional discussion on the terms of this new credit facility). The loan is facilitated through an asset-based revolving credit facility. The primary purpose of this new credit facility with DCP was to refinance and pay down a portion of the Company’s current indebtedness to Thermo under the terms of the April 30, 2008 Loan and Security Agreement by and between Teletouch, PCI and Thermo, as subsequently amended (the “Thermo Loan Agreement”). In order to facilitate the payment of the Company’s indebtedness to Thermo under the Thermo Loan Agreement, the parties to the Loan Agreement also entered into several amendments, subordination and other related agreements. Specifically, Teletouch, PCI and Thermo entered a certain Sixth Amendment to the Thermo Loan Agreement (“Amendment No. 6”). In addition, the parties also entered into a certain Subordination and Intercreditor Agreement by and between Thermo and DCP dated as of February 8, 2013 (the “Subordination Agreement”) for the purposes of subordinating Thermo’s security interest to that of DCP under the DCP Loan Agreement (see “Thermo Revolving Credit Facility” in Note 12 for additional discussion on the restructuring of this debt).

As a result of these financing and restructuring transactions, the Company was able to borrow $4,300,000 from DCP at closing, of which $4,000,000 was paid to Thermo against the outstanding balance of $7,148,000 owed against the Thermo Loan Agreement as of February 8, 2013. The remaining $3,148,000 due to Thermo became subordinated to DCP and is repayable under certain conditions as defined by the DCP Loan Agreement. If the now subordinated Thermo Loan Agreement is not repaid during the term the DCP Loan Agreement is outstanding, the remaining balance due to Thermo will be payable on August 1, 2016, which is six months following the January 31, 2016 maturity date of the optional extension under the DCP Loan Agreement.

As previously reported, in June 2012, the Company was assessed $1,880,000 by the State of Texas (the “State”) related to a sales and use tax audit of PCI for covering the periods from January 2006 through October 2009. On January 7, 2013, the Company and the State of Texas entered into a settlement agreement related to PCI’s sales and use tax audit obligation, whereby the Company agreed to settle its approximately $1,911,000 tax liability, which included penalties and interest assessed through January 3, 2013 of approximately $498,000, by making a series of payments to the State totaling approximately $1,414,000. Under the terms of the settlement agreement with the State, the Company was required to make a down payment against the sales tax liability of $625,000 on or before January 12, 2013 and make 35 monthly installments of $22,000 each beginning February 15, 2013, with a final payment of $18,888.10 due January 15, 2016. Prior to entering into this settlement agreement, the Company had voluntarily paid a total of $150,000 against this tax liability and the State allowed the Company to reduce its down payment by the full amount of the voluntary payments already made which resulted in the Company paying the $475,000 balance of the down payment in January 2013. The Company expects to be able to make these required payments to the State from cash provided by operations and has DCP’s consent to make such payments as they become due. See Note 11 for additional discussion related to the settlement of this tax obligation.

The Company has been advised by counsel that it can seek recovery of taxes that were not billed or collected from its customers and suppliers beginning in January 2006 and intends to make every reasonable effort to pursue the collection of such taxes. Based on a detailed review of all currently available cellular billings from August 2006 through October 2009, and a review of certain equipment sales invoices from January 2006 through October 2009, the Company has determined the total unbilled and uncollected sales tax is approximately $1,785,000 of the unbilled sales taxes that the Company will pursue for recovery. Invoices to current and former customers for these under-billed sales taxes are expected to be mailed during the fourth quarter of fiscal 2013. Under the terms of the DCP Loan Agreement, $400,000 was initially advanced to the Company as a supplemental advance and up to the first $400,000 collected from this sales tax recovery effort is required to be paid against this supplemental advance amount, with the balance of this supplemental advance to be paid down to $300,000 by May 9, 2013, $200,000 by June 8, 2013 and paid in full by July 8, 2013. The Company expects that sales tax recoveries will be sufficient to meet these repayment obligations to DCP as they come due or alternatively that it will have sufficient cash on hand to make these payments. There can be no assurance that the Company’s recovery efforts will be successful, nor can the Company estimate an amount of recovery expected from such efforts at this time.

The Company’s real estate loans with East West Bank and Jardine Capital Corporation initially matured on May 3, 2012. Both lenders have granted several extensions of the maturity date of their respective loans. As of the date of this Report, Jardine Capital Corporation has granted an extension of the maturity date of their loan through May 31, 2013, but the East West Bank loan matured on February 3, 2013 and an extension is being discussed but has not been granted. With the completion of the senior debt restructuring and the settlement of the sales tax obligation, the Company is optimistic it will be successful in securing a commitment from a new lender to finance its real estate, if needed. The Company has placed the real estate for sale and is currently negotiating a term sheet with a prospective buyer. If the real estate is sold, the Company expects the proceeds to be sufficient to pay the balance due on all of its current real estate debt. Based on the current appraisal of the real estate received in March 2013, the Company is looking to improve its operating cash positions by drawing on the equity (excess fair value over current debt owed against the real estate) in all of the Company’s real estate in Fort Worth, Texas (corporate office building on 6.0 acres, 6.93 acres of excess adjacent land and a free standing billboard on 0.08 acres of land) by selling the real estate (preferred option) or by refinancing the current debt. The Company can provide no assurance it will be successful in selling the real estate, securing new real estate financing or that East West Bank will be agreeable to extend the maturity date of their loan or that any further extensions from either mortgage lender will allow a sufficient amount of time for the Company to sell the real estate or close refinance the current debt before the current estate lenders take action against the Company and the underlying real estate collateral.

At May 31, 2012, the Company concluded and reported, that as a result of the financial condition of the Company and the amount of current debt that was unresolved at the time, that there was substantial doubt about the Company’s ability to continue as a going concern. As a result of the completion of all of the above mentioned events during the third quarter of fiscal 2013, the Company has made significant progress toward improving its financial condition and believes that it has the ability to service its current debt obligations as they become due with the exception of the real estate loans as discussed above. If either real estate lender decides to foreclose on the Company’s Fort Worth real estate, the Company believes that the fair market value of the properties sufficiently exceeds the amount of the debt and that the sale of these properties by either bank would extinguish all of the real estate debt. If this were to occur, the Company also believes that it has sufficient cash on hand and will generate sufficient cash from operations to support the relocation of the Company’s Fort Worth offices and warehouse and the expected costs of leasing a new facility.

The Company’s estimates of cash provided from operations is based on the successful execution of the current business plan by achieving planned sales and margins from its wholesale business or through aggressive cost reductions to manage cash flows from its declining cellular business. The Company can provide no assurance that it will be successful achieving its planned sales growth or that it can reduce costs to a level to maintain the needed cash flows to meet all of its obligations.

As a result of the above conditions and in accordance with generally accepted accounting principles in the United States, there continues to exist substantial doubt about the Company’s ability to continue as a going concern. The Company’s financial condition and performance against its business plan, among other factors, will be considered at May 31, 2013 and, in conjunction with the Company’s auditors, the risk of the Company being unable to meet its future obligations will be re-assessed.

NOTE 2 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Use of Estimates: The consolidated financial statements have been prepared using the accrual basis of accounting in accordance with accounting principles generally accepted in the United States of America. Preparing financial statements in conformity with generally accepted accounting principles (“GAAP”) requires management to make estimates and assumptions. Those assumptions affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could materially differ from those estimates.

Cash: We deposit our cash with high credit quality institutions. Periodically, such balances may exceed applicable FDIC insurance limits. Management has assessed the financial condition of these institutions and believes the possibility of credit loss is minimal.

Certificates of Deposit-Restricted: From time to time, the Company is required to issue a standby letter of credit to a supplier to secure a credit line extended to the Company. In these instances, funds are deposited into a certificate of deposit and the bank issues a standby letter of credit to the supplier’s benefit. All such funds are reported as restricted funds until such time as the supplier releases its rights under the letter of credit. As of February 28, 2013 and May 31, 2012, the Company had a $25,000 certificate of deposit securing a standby letter of credit with a corporate credit card provider.

Allowance for Doubtful Accounts: The Company performs credit evaluations of its customers prior to extending open credit terms. The Company does not perfect a security in any of the goods it sells causing all credit lines extended to be unsecured.

In determining the adequacy of the allowance for doubtful accounts, management considers a number of factors, including historical collections experience, aging of the receivable portfolio, financial condition of the customer and industry conditions. The Company considers accounts receivable past due when the customer’s payment in full is not received within payment terms. The Company writes-off accounts receivable when it has exhausted all collection efforts, which is generally within 90 days following the last payment received on the account.

Accounts receivable are presented net of an allowance for doubtful accounts of $142,000 and $150,000 at February 28, 2013 and May 31, 2012, respectively. Based on the information available, management believes the allowance for doubtful accounts as of those periods are adequate; however, actual write-offs may exceed the recorded allowance.

The Company evaluates its write-offs on a monthly basis. The Company determines which accounts are uncollectible, and those balances are written-off against the Company’s allowance for doubtful accounts.

Reserve for Inventory Obsolescence: Inventories are stated at the lower of cost (primarily on a moving average basis), which approximates actual cost determined on a first-in, first-out (“FIFO”) basis, or fair market value and are comprised of finished goods. In determining the adequacy of the reserve for inventory obsolescence, management considers a number of factors including recent sales trends, age of the inventory, industry market conditions and economic conditions. In assessing the reserve, management also considers price protection credits the Company expects to recover from its vendors when the vendor cost on certain inventory items is reduced shortly after the purchase of the inventory by the Company. In addition, management establishes specific valuation allowances for discontinued inventory based on its prior experience liquidating this type of inventory. Through the Company’s wholesale and internet distribution channel, it is successful in liquidating inventory that becomes obsolete. The Company has many different cellular accessory and other electronics suppliers, all of which provide reasonable notification of model changes, which allows the Company to minimize its level of discontinued or obsolete inventory. Inventories are presented net of a reserve for obsolescence of $186,000 and $155,000 at February 28, 2013 and May 31, 2012, respectively. Actual results could differ from those estimates.

Property and Equipment: Property and equipment is recorded at cost. Depreciation is computed using the straight-line method. Expenditures for major renewals and betterments that extend the useful lives of property and equipment are capitalized. Expenditures for maintenance and repairs are charged to expense as incurred. Upon the sale or abandonment of an asset, the cost and related accumulated depreciation are removed from the Company’s balance sheet, and any gains or losses on those assets are reflected in the accompanying consolidated statement of operations of the respective period. The straight-line method with estimated useful lives is as follows:

Intangible Assets: The Company’s intangible assets include both definite and indefinite lived assets. Indefinite lived intangible assets are not amortized but evaluated annually (or more frequently) for impairment under ASC 350, Intangibles-Goodwill and Other , (“ASC 350”). Definite lived intangible assets are amortized over the estimated useful life of the asset and reviewed for impairment upon any event that raises a question as to the asset’s ultimate recoverability as prescribed under ASC 360, Property, Plant and Equipment , (“ASC 360”).

Indefinite Lived Intangible Assets: The Company’s indefinite lived intangible assets consist of two perpetual licenses purchased by PCI. In May 2010, PCI purchased a perpetual trademark license to use the trademark “Hawk Electronics” (see Note – 13 “Trademark Purchase Obligation” for additional discussion). Since it has been determined the trademark license has an indefinite useful life, the carrying value of the trademark license is not amortized over a specific period of time but instead is tested for impairment at least annually in accordance with the provisions of ASC 350. In January 2013, PCI entered into a Settlement and Patent License Agreement (the “GeoTag Agreement”) with GeoTag, Inc. (“GeoTag”) for the rights to use GeoTag’s patented store locater tool on any of the Company’s websites. PCI paid GeoTag $75,000 for the use of the perpetual patent license. In addition, the perpetual patent license is a royalty-free, non-exclusive license that PCI or any of its Affiliates (as defined in the GeoTag Agreement, but includes Teletouch) can use throughout the life of the GeoTag store locator patent.

The Company evaluated the Hawk Electronics perpetual trademark license asset at May 31, 2012, in accordance with ASC 350 and determined the fair value of the license exceeded its carrying value; therefore, no impairment was recorded. The fair value of the perpetual trademark license was based upon the discounted estimated future cash flows of the Company’s cellular business which is the primary beneficiary of the Hawk brand.

Furthermore, the Company evaluates the GeoTag perpetual patent license in a manner similar to the Hawk Electronics perpetual trademark license by assessing whether events and circumstances have occurred within the Company’s cellular business that would no longer support an indefinite life for either of the perpetual licenses.

No changes have occurred in the business during the three or nine months ended February 28, 2013 that indicated impairment for either of the perpetual licenses.

Definite Lived Intangible Assets: Definite lived intangible assets consist of the capitalized cost associated with acquiring the AT&T distribution agreement, purchased subscriber base, GSA contract, TXMAS contract and loan origination costs associated with acquiring the new asset based revolving credit facility. The Company does not capitalize customer acquisition costs in the normal course of business, but would capitalize the purchase costs of acquiring customers from a third party. Intangible assets are carried at cost less accumulated amortization. Amortization on the AT&T distribution agreement is computed using the straight-line method over the contract’s remaining term through November 2014. The estimated useful lives for the intangible assets are as follows:

The Company defers certain direct costs in obtaining loans and amortizes such amounts using the straight-line method over the expected life of the loan, which approximates the effective interest method.

As of February 28, 2013, the most significant intangible assets owned by the Company are the AT&T distribution agreement and subscriber base. The AT&T cellular distribution agreement and subscriber base asset will be amortized through November 30, 2014, which is the expiration of the distribution agreement under the terms of the Third Amendment to the Distribution Agreement (see Note 5 – “Relationship With Cellular Carrier” for further discussion on the settlement of the litigation with AT&T and the resulting amended distribution agreement). Amortization expense over the 21 months remaining under the current term of the AT&T distribution agreement will be approximately $57,000 per month.

The AT&T distribution agreement asset represents a contract the Company has with AT&T, under which the Company is allowed to provide cellular services to its customers. The Company regularly forecasts the expected cash flows to be derived from the cellular subscriber base and the Company anticipates the future cash flows generated from its cellular subscriber base to exceed the carrying value of this asset.

Amortization of the AT&T distribution agreement, subscriber base, GSA and TXMAS contracts is recorded as an operating expense under the caption “Depreciation and Amortization” in the accompanying consolidated statements of operations.

Amortization of the loan origination fees is recorded under the caption “Interest expense” in the accompanying consolidated statements of operations.

The Company periodically reviews the estimated useful lives of its intangible assets, taking into consideration any events or circumstances that might result in a lack of recoverability or revised useful life.

Impairment of Long-lived Assets: In accordance with ASC 360, the Company evaluates the recoverability of the carrying value of its long-lived assets based on estimated undiscounted cash flows to be generated from such assets. If the undiscounted cash flows indicate impairment, then the carrying value of the assets evaluated is written-down to the estimated fair value of those assets. In assessing the recoverability of these assets, the Company must project estimated cash flows, which are based on various operating assumptions, such as average revenue per unit in service, disconnect rates, sales productivity ratios and expenses. Management develops these cash flow projections on a periodic basis and reviews the projections based on actual operating trends. The projections assume that general economic conditions will continue unchanged throughout the projection period and that their potential impact on capital spending and revenues will not fluctuate. Projected revenues are based on the Company’s estimate of units in service and average revenue per unit as well as revenue from various new product initiatives.

The most significant tangible long-lived asset owned by the Company is its corporate office building and the associated land in Fort Worth, Texas. The Company has received periodic appraisals of the fair value of this property, with the most recent appraisal completed in March 2013, and in each instance the appraised value exceeds the carrying value of the property.

The Company’s review of the carrying value of its tangible long-lived assets at February 28, 2013 and May 31, 2012 indicates the carrying value of these assets will be recoverable through estimated future cash flows. If the cash flow estimates, or the significant operating assumptions upon which they are based change in the future, the Company may be required to record impairment charges related to its long-lived assets.

Prepaid expenses and other current assets: The Company records certain expenses that are paid for in advance of their use or consumption as a current asset on the Company’s consolidated balance sheets.

The components of prepaid expenses and other current assets at February 28, 2013 and May 31, 2012 are as follows (in thousands):

Contingencies: The Company accounts for contingencies in accordance with ASC 450, Contingencies (“ASC 450”). ASC 450 requires that an estimated loss from a loss contingency shall be accrued when information available prior to issuance of the financial statements indicates that it is probable that an asset has been impaired or a liability has been incurred at the date of the financial statements and when the amount of the loss can be reasonably estimated. Accounting for contingencies such as legal and contract dispute matters requires us to use our judgment. We believe that our accruals or disclosures related to these matters are adequate. Nevertheless, the actual loss from a loss contingency might differ from our estimates.

Provision for Income Taxes: The Company accounts for income taxes in accordance with ASC 740, Income Taxes , (“ASC 740”) using the asset and liability approach, which requires recognition of deferred tax liabilities and assets for the expected future tax consequences of temporary differences between the carrying amounts and the tax basis of such assets and liabilities. This method utilizes enacted statutory tax rates in effect for the year in which the temporary differences are expected to reverse and gives immediate effect to changes in income tax rates upon enactment. Deferred tax assets are recognized, net of any valuation allowance, for temporary differences, net operating loss and tax credit carry forwards. Deferred income tax expense represents the change in net deferred assets and liability balances. Deferred income taxes result from temporary differences between the basis of assets and liabilities recognized for differences between the financial statement and tax basis thereon and for the expected future tax benefits to be derived from net operating losses and tax credit carry forwards. A valuation allowance is recorded when it is more likely than not that deferred tax assets will be unrealizable in future periods. As of February 28, 2013 and May 31, 2012, the Company has recorded a valuation allowance against the full amount of its net deferred tax assets. The Company will continue to evaluate its financial forecast to determine if a portion of its deferred tax assets can be realized in future periods. When the Company is charged interest or penalties related to income tax matters, the Company records such interest and penalties as interest expense in the consolidated statement of operations.

The Company’s most significant deferred tax asset is its accumulated net operating loss. The net operating loss is subject to limitations as a result of a change in control that took place during August 2011, as defined by Section 382 of the Internal Revenue Code.

Revenue Recognition: Teletouch recognizes revenue over the period the service is performed in accordance with SEC Staff Accounting Bulletin No. 104, “Revenue Recognition in Financial Statements” and ASC 605, Revenue Recognition , (“ASC 605”). In general, ASC 605 requires that four basic criteria must be met before revenue can be recognized: (1) persuasive evidence of an arrangement exists, (2) delivery has occurred or services rendered, (3) the fee is fixed and determinable and (4) collectability is reasonably assured. Teletouch believes, relative to sales of products, that all of these conditions are met; therefore, product revenue is recognized at the time of shipment.

The Company primarily generates revenues by providing recurring cellular services and through product sales. Cellular services include cellular airtime and other recurring services provided through a distributor agreement with AT&T. Product sales include sales of cellular telephones, accessories, car audio products and other services through the Company’s cellular and wholesale operations.

Cellular and other service revenues and related costs are recognized during the period in which the service is rendered. Associated subscriber acquisition costs are expensed as incurred. Product sales revenue is recognized at the time of shipment, when the customer takes title and assumes risk of loss, when terms are fixed and determinable and collectability is reasonably assured. The Company does not generally grant rights of return. However, to be competitive with AT&T’s programs, PCI offers customers a 15 day return / exchange program for new cellular subscribers. During the 15 days, a customer may return all cellular equipment and cancel service with no penalty. Reserves for returns, price discounts and rebates are estimated using historical averages, open return requests and market conditions. No reserves have been recorded for the 15 day cellular return program since only a very small number of customers utilize this return program and many fail to meet all of the requirements of the program, which include returning the phone equipment in new condition with no visible damage.

Since 1984, Teletouch’s subsidiary, PCI, has held agreements with AT&T or one of its predecessor companies, which allowed PCI to offer cellular service and provide the billing and customer services to its subscribers. PCI is compensated for the services it provides based upon sharing a portion of the monthly billings of AT&T cellular services with AT&T. PCI is responsible for the billing and collection of cellular charges from these customers and remits a percentage of the cellular billings generated to AT&T. Based on its relationship with AT&T, the Company has evaluated its reporting of revenues under ASC 605-45, Revenue Recognition, Principal Agent Considerations (“ASC 605-45”) associated with its services attached to the AT&T agreements. Included in ASC 605-45 are eight indicators that must be evaluated to support reporting gross revenue. These indicators are (i) the entity is the primary obligor in the arrangement, (ii) the entity has general inventory risk before customer order is placed or upon customer return, (iii) the entity has latitude in establishing price, (iv) the entity changes the product or performs part of the service, (v) the entity has discretion in supplier selection, (vi) the entity is involved in the determination of product or service specifications, (vii) the entity has physical loss inventory risk after customer order or during shipment and (viii) the entity has credit risk. In addition, ASC 605-45 includes three additional indicators that support reporting net revenue. These indicators are (i) the entity’s supplier is the primary obligor in the arrangement, (ii) the amount the entity earns is fixed and (iii) the supplier has credit risk. Based on its assessment of the indicators listed in ASC 605-45, the Company has concluded that the AT&T services provided by PCI should be reported on a net basis. Also in accordance with ASC 605-45, sales tax amounts invoiced to our customers have been recorded on a net basis and are not included in our operating revenues.

Deferred revenue primarily represents monthly cellular service access charges that are billed in advance by the Company.

Concentration of Credit Risk: Teletouch provides cellular services to a diversified customer base of small to mid-size businesses and individual consumers, primarily in the DFW and San Antonio markets in Texas. In addition, the Company sells cellular equipment and consumer electronics products to a large base of small to mid-size cellular carriers, agents and resellers as well as a large group of smaller electronics and car audio dealers throughout the United States. As a result, no significant concentration of credit risk exists. The Company performs periodic credit evaluations of its customers to determine individual customer credit risks and promptly terminates services or ceases shipping products for nonpayment. Additionally, during the third quarter of fiscal year 2013, the Company began insuring all new customers in its wholesale business with open credit lines exceeding $10,000 with Euler Hermes, a national trade credit insurance company, to further limit the Company’s credit risk.

Financial Instruments: Under the guidance found in Accounting Standard Codification (“ASC”) 820 Fair Value Measurements and Disclosures (“ASC 820”) , the Company is required to disclose the fair value of the financial instruments held by the Company. ASC 825 Financial Instruments , establishes a fair value hierarchy which has three levels based on the reliability of the inputs to determine the fair value. These levels include: Level 1, defined as inputs such as unadjusted quoted prices in active markets for identical assets or liabilities; Level 2, defined as inputs other than quoted prices in active markets that are either directly or indirectly observable; and Level 3, defined as unobservable inputs for use when little or no market data exists, therefore requiring an entity to develop its own assumptions. The Company’s financial instruments consist primarily of cash and cash equivalents, accounts receivables and payables, accrued liabilities and long-term debt. The carrying values of these financial instruments approximate their respective fair values as they are either short-term in nature or carry interest rates that approximate market rates.

Advertising and Pre-opening Costs: Labor costs, costs of hiring and training personnel and certain other costs relating to the opening of any new retail or service center locations are expensed as incurred. Additionally, advertising costs are expensed as incurred and are occasionally partially reimbursed based on various vendor agreements. Advertising and promotion costs were approximately $24,000 and $116,000 for the three months ended February 28, 2013 and February 29, 2012, respectively and approximately $98,000 and $281,000 for the nine months ended February 28, 2013 and February 29, 2012, respectively. Advertising reimbursements are accrued when earned and committed to by the Company’s vendor and are recorded as a reduction to advertising cost in that period.

Stock-based Compensation: At February 28, 2013, the Company had two stock-based compensation plans (both of which have expired, meaning no additional stock options can be issued under either plan) for employees and non-employee directors, which authorize the granting of various equity-based incentives including stock options and stock appreciation rights.

The Company accounts for stock-based awards to employees in accordance with ASC 718, Compensation-Stock Compensation (“ASC 718”) and for stock based awards to non-employees in accordance with ASC 505-50, Equity, Equity-Based Payments to Non-Employees (“ASC 505-50). Under both ASC 718 and ASC 505-50, we use a fair value based method to determine compensation for all arrangements where shares of stock or equity instruments are issued for compensation. For share option instruments issued, compensation cost is recognized ratably using the straight-line method over the expected vesting period.

Cash flows resulting from excess tax benefits are classified as a financing activity. Excess tax benefits are realized from tax deductions for exercised options in excess of the deferred tax asset attributable to stock compensation costs for such options. The Company did not record any excess tax benefits as a result of any exercises of stock options in the nine months ended February 28, 2013 and February 29, 2012.

To estimate the fair value of its stock options, the Company uses the Black-Scholes option-pricing model, which incorporates various assumptions including volatility, expected life and interest rates. The Company is required to make various assumptions in the application of the Black-Scholes option pricing model. The Company has determined that the best measure of expected volatility is based on an average of the previous two fiscal year’s historical daily volatility of the Company’s common stock adjusted to exclude the top 10% high and low closing trading prices during each period measured. Historical volatility factors utilized in the Company’s Black-Scholes computations for options issued in the nine months ended February 28, 2013 was 63.45% and was 72.58% for the options issued in the nine months ended February 29, 2012. The Company has elected to estimate the expected life of an award based upon the SEC approved “simplified method” noted under the provisions of Staff Accounting Bulletin No. 107 with the continued use of this method extended under the provisions of Staff Accounting Bulletin No. 110. Under this formula, the expected term is equal to: ((weighted-average vesting term + original contractual term)/2). The expected term used by the Company as computed by this method for options issued in the nine months ended February 28, 2013 and February 29, 2012 was 5.0 years. The interest rate used is the risk free interest rate and is based upon U.S. Treasury rates appropriate for the expected term. Interest rates used in the Company’s Black-Scholes calculations for options issued in the nine months ended February 28, 2013 was 0.62% and ranged from 0.91% to 1.60% for the options issued in the nine months ended February 29, 2012. Dividend yield is zero for these options as the Company does not expect to declare any dividends on its common shares in the foreseeable future.

In addition to the key assumptions used in the Black-Scholes model, the estimated forfeiture rate at the time of valuation is a critical assumption.  The Company has estimated an annualized forfeiture rate of 0.0% for the stock options granted to senior management and the Company’s directors in the nine months ended February 28, 2013 and February 29, 2012. The Company reviews the expected forfeiture rate annually to determine if that percent is still reasonable based on historical experience.

Options exercisable at February 28, 2013 and May 31, 2012 totaled 7,089,488 and 6,234,986, respectively. The weighted-average exercise price per share of options exercisable at February 28, 2013 and May 31, 2012 was $0.31 and $0.29, respectively with remaining weighted-average contractual terms of approximately 5.9 years and 6.3 years as of February 28, 2013 and May 31, 2012, respectively.

The weighted-average grant date fair value of options granted during the nine months ended February 28, 2013 and February 29, 2012 was $0.20 and $0.31, respectively.

At February 28, 2013, the total remaining unrecognized compensation cost related to unvested stock options amounted to approximately $6,000, which will be amortized over the weighted-average remaining requisite service period of 0.8 years.

Income (loss) Per Share: In accordance with ASC 260, Earnings Per Share (Topic 260) , basic income (loss) per share (“EPS”) is calculated by dividing net income (loss) by the weighted average number of common shares outstanding. Diluted EPS is calculated by dividing net income available to common shareholders by the weighted average number of common shares outstanding including any dilutive securities outstanding.

At February 28, 2013, the Company’s outstanding common stock options totaled 7,172,822. For the three months ended February 28, 2013, the Company recorded net income and 1,868,659 common stock options were determined to be dilutive securities and were included in the diluted earnings per share due to the Company’s market price of its common stock at February 28, 2013 exceeding the options’ exercise price. For the nine months ended February 29, 2013, no dilutive securities were included in the computation of diluted earnings per share due to their antidilutive effect as a result of the net loss incurred during this period.

For the three months ended February 29, 2012, no dilutive securities were included in the computation of diluted earnings per share due to their antidilutive effect as a result of the net loss incurred during this period. For the nine months ended February 29, 2012, the Company recorded net income and 3,226,207 common stock options were determined to be dilutive securities and were included in the diluted earnings per share calculation due to the Company’s market price of its common stock at February 29, 2012 exceeding the options’ exercise price.

Recently Issued Accounting Standards: The Company has reviewed all recently issued, but not yet effective, accounting pronouncements and does not believe the future adoption of any such pronouncements may be expected to cause a material impact on its consolidated financial condition or the consolidated results of its operations.

In July 2012, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2012-02, Intangibles-Goodwill and Other (Topic 350): Testing Indefinite-Lived Intangible Assets for Impairment . To be consistent with the guidance found under ASU 2011-08, Intangibles-Goodwill and Other (Topic 350): Testing Goodwill for Impairment, ASU 2012-02 is intended to simplify impairment testing for indefinite-lived intangible assets other than goodwill by adding a qualitative review step to assess whether the required quantitative impairment analysis that exists today is necessary. Under the amended rule, a company will not be required to calculate the fair value of a business that contains recorded indefinite-lived intangible assets other than goodwill unless it concludes, based on the qualitative assessment, that it is more likely than not that the fair value of that business is less than its book value. If such a decline in fair value is deemed more likely than not to have occurred, then the quantitative impairment test that exists under current GAAP must be completed; otherwise, the indefinite-lived assets other than goodwill are deemed to be not impaired and no further testing is required until the next annual test date (or sooner if conditions or events before that date raise concerns of potential impairment in the business). The amended impairment guidance does not affect the manner in which a company estimates fair value. This new standard is effective for the Company beginning June 1, 2013.

NOTE 3 – DISCONTINUED TWO-WAY OPERATIONS

On August 11, 2012, Teletouch and DFW Communications, Inc. (“DFW”) entered into an Asset Purchase Agreement (the “APA”), where the Company agreed to sell, assign, transfer and convey to DFW substantially all of the assets of the Company associated with the two-way radio and public safety equipment business, such assets including, among other things, certain related accounts receivable; inventory; fixed assets (e.g. fixtures, equipment, machinery, appliances, etc.); supplies used in connection with the business; the Company’s leases, permits and titles, including certain FCC licenses held by the Company; and DFW also assumed certain obligations, permits and contracts related to the Company’s business. Subject to certain working capital adjustments, DFW agreed to pay, at closing, as consideration for the assets of the Company an amount in cash equal to approximately $1,469,000, $168,000 of which was allocated to certain designated suppliers’ payments and $300,000 of which was allocated to real estate and goodwill. The parties to the APA further designated approximately $767,000 for working capital purposes, such amount consisting of, among other things, aged accounts receivable and inventory as of the effective date of the APA. This includes a working capital adjustment provision that provides for no more than $200,000 of post-close working capital adjustments to be charged to the Company within 90 days of the date of sale in the event of any material accounts receivable or inventory deficits. As of February 28, 2013, the Company recorded an approximately $29,000 working capital chargeback due to the non-collection of certain outstanding accounts receivable, which were sold to DFW under the APA.

The foregoing disposition of the Company’s assets, excluding the sale of the real estate, closed on August 14, 2012, having been reviewed and approved by the Company’s Board of Directors on August 10, 2012. On the August 14, 2012 closing, the Company received approximately $1,169,000 in cash consideration from DFW for all of the assets of the two-way radio and public safety equipment business, excluding the building and land located in Tyler, Texas.

On February 26, 2013, the Company completed the sale of its real estate located in Tyler, Texas (a two-way radio services and installation shop and the associated land) and received proceeds from DFW of approximately $297,000.

Summary results for the two-way operations are reflected as discontinued operations in the Company’s consolidated statement of operations for the three months and nine months ended February 28, 2013 and February 29, 2012 and are as follows:

A summary of the assets and liabilities sold in conjunction with the sale of the two-way business as determined at May 31, 2012 is as follows:

The assets and liabilities associated with the two-way business, as of May 31, 2012, are recorded under the captions “Current assets held for sale,” “Assets Held for Sale” and “Current liabilities held for sale” in the Company’s consolidated balance sheet.

Restricted Cash: The restricted cash related to the sale of the discontinued two-way operations is a result of cash received subsequent to sale the two-way business on August 11, 2012 for the payment of certain accounts receivables DFW purchased under the APA as well as the working capital chargeback related to the non-collection of certain outstanding accounts receivables that were sold to DFW. The amount owed to DFW was partially offset by operating expenses the Company paid on behalf of DFW subsequent to the sale transaction. Under the APA, the Company is obligated to reimburse DFW for such amounts and as of February 28, 2013, the restricted cash associated with the sale of the discontinued two-way business is approximately $13,000.

NOTE 4 – SETTLEMENT AND RELEASE AGREEMENT WITH AT&T

From September 2009 to November 2011, Teletouch, through its wholly-owned subsidiary, PCI, was involved in an arbitration proceeding with and against New Cingular Wireless PCS, LLC and AT&T Mobility Texas LLC (collectively, “AT&T”) relating to, among other things, certain distribution and related agreements by and between the parties. On November 23, 2011, PCI and AT&T entered into a settlement and release agreement (the “Agreement”) pursuant to which the parties agreed to settle all of their disputes subject to the foregoing arbitration.

Material terms and provisions under of the Agreement included that:

The $5,000,000 cash payment was received from AT&T on December 1, 2011. The entire $10,000,000 of initial consideration comprised of the $5,000,000 cash payment and $5,000,000 forgiveness of PCI’s oldest unpaid obligations to AT&T related to AT&T’s percentage of PCI’s monthly cellular billings was recorded in operating income on the Company’s consolidated statement of operations for the three and nine months ended February 29, 2012 under the caption “Gain on settlement with AT&T.” In addition, for the cellular subscribers that transferred from PCI to AT&T since the agreement was executed in November 2011, the Company has recorded the fees it earns for those lost subscribers under the caption “Gain on the settlement with AT&T” for the three and nine months ended February 28, 2013 and February 29, 2012.

As a condition to closing on a new senior revolving credit on February 8, 2013 (see “DCP Revolving Credit Facility” in Note 12), PCI entered into a Fourth Amendment to the the Distribution Agreement with AT&T which permits PCI sell its cellular base to AT&T prior to the November 2014 expiration of the Distribution Agreement and to pledge proceeds from the Distribution Agreement to its new lender. As discussed in (iv) above, the maximum cash payment from AT&T for the transfer of the Company’s subscriber base under the terms of the Distribution Agreement, as amended, is $8,500,000 which will be offset by any amounts due to AT&T at the date of transfer. Based on the 31,595 cellular subscribers remaining in the Company’s subscriber base at February 28, 2013 and the continuing decline in this subscriber base, the expected cash payment from AT&T upon transfer of this subscriber base at November 2014 or earlier, is substantially less than the maximum cash payment provided for under the terms of the Distribution Agreement.

NOTE 5 – RELATIONSHIP WITH CELLULAR CARRIER

The Company has historically had six distribution agreements with AT&T which provide for the Company to distribute AT&T wireless services, on an exclusive basis, in major markets in Texas and Arkansas, including the Dallas-Fort Worth, Texas Metropolitan Statistical Area (“MSA”), San Antonio, Texas MSA, Austin, Texas MSA, Houston, Texas MSA, East Texas Regional MSA and Arkansas, including primarily the Little Rock, Arkansas MSA.

As a result of the settlement and release agreement and the execution of the Third Amendment to the Distribution Agreement on November 23, 2011, the Company’s current and prior distribution agreements with AT&T were consolidated and renewed or extended for three (3) years allowing PCI to again activate new subscribers and provide many of the previously withheld wireless services and products, including the iPhone. The distribution agreement permits the Company to offer AT&T cellular phone service with identical pricing characteristics to AT&T and provide billing customer services to its customers on behalf of AT&T in exchange for certain predetermined compensation and fees, which are primarily in the form of a revenue sharing of the core wireless services the Company bills on behalf of AT&T. In addition, the Company bills the same subscribers several additional services that it offers and retains all revenues and gross margins related to those services. Under the distribution agreement, the Company is responsible for all of the billing and collection of cellular charges from its customers and remains liable to AT&T for pre-set percentages of all AT&T related cellular service customer billings. The current distribution agreement expires on November 30, 2014.

In conjunction with the Company’s recent debt restructure, the Company and AT&T entered into a Fourth Amendment to the Distribution Agreement effective February 1, 2013 as required by DCP, the Company’s new senior lender. Under the terms of the Fourth Amendment, the Company is permitted to sell its cellular base to AT&T prior to the November 2014 expiration of their respective arrangement and to pledge proceeds from the Distribution Agreement to DCP. The foregoing arrangement was evidenced by a letter agreement by and between AT&T and DCP dated as of the same date (see Note 12 “Long-Term Debt – DCP Revolving Credit Facility” for further information on the Company’s new credit facility with DCP).

Because of the volume of business transacted with AT&T, as well as the revenue generated from AT&T services, there is a significant concentration of credit and business risk involved with having AT&T as a primary vendor.

The Company reports its revenues related to the AT&T services on a net basis in accordance with ASC 605-45 as follows (in thousands):

Gross billings include gross cellular subscription billings, which are measured as the total recurring monthly cellular service charges invoiced to PCI’s cellular subscribers from which a fixed percentage of the dollars invoiced are retained by PCI as compensation for the billing and support services it provides to these subscribers. PCI remits a fixed percentage of the gross cellular subscription billings to AT&T and absorbs 100% of any bad debt associated with the gross cellular subscription billings under the terms of its distribution agreement with AT&T.

NOTE 6 – GAIN ON SETTLEMENT WITH VENDOR

During fiscal year 2013, the PCI was made aware of potential infringements upon its exclusive Authorized Master Distribution Agreement with AFC Trident, Inc. (“Trident”), a cellular accessory manufacturer and a vendor to PCI, connected to certain customer exclusivity rights. As a result, the PCI entered into settlement agreement with Trident on February 28, 2013 related to alleged violations of the distribution agreement. Under the terms of the settlement agreement, Trident agreed to (i) $150,000 cash to be paid in three installments with the first payment due on February 28, 2013, the second payment due on March 30, 2013 and the third payment due on April 29, 2013; as of the date of this Report, the first and second payments totaling $100,000 has been received by the Company (ii) a one-time reduction of approximately $11,000 related to the PCI’s outstanding balance to Trident and (iii) an authorization to return $50,000 of slow-moving Trident inventory. Additionally, in connection with the settlement agreement, PCI terminated its original distribution agreement and entered into non-exclusive distribution agreement with Trident. The $150,000 cash settlement and the $11,000 adjustment related to the balance owed to Trident are recorded under the caption “Gain on settlement with vendor” on the Company’s consolidated income statement for the three and nine months ended February 28, 2013.

Depreciation expense related to property and equipment was approximately $51,000 and $52,000 for the three months ended February 28, 2013 and February 29, 2012, respectively and approximately $157,000 and $158,000 for the nine months ended February 28, 2013 and February 29, 2012, respectively.

Property and equipment are recorded at cost. Depreciation is computed using the straight-line method. The following table contains the property and equipment by estimated useful life, net of accumulated depreciation as of February 28, 2013 (in thousands):

Total amortization expense for the three months ended February 28, 2013 and February 29, 2012 was approximately $170,000 and $161,000, respectively and approximately $510,000 and $667,000 for the nine months ended February 28, 2013 and February 29, 2012, respectively.

Texas Sales and Use Tax Audit Accrual

Based on the results of the 2006-2009 Texas sales tax audit of PCI completed in June 2012 (see Note 11 – “Texas Sales and Use Tax Obligation” for further discussion), the Company believes it has additional financial exposure for certain periods following October 2009, the last month covered under the prior sales tax audit. Similar tax computations were applied to the Company’s cellular billings through November 2010, the point at which PCI made substantial system and process changes to correct these tax computations. Other sales and use tax issues which were identified during the course of the prior sales tax audit have either been fully corrected or are in the process of being corrected by the Company.

On January 15, 2013, the Company was noticed by the State of Texas that it was preparing for a sales and use tax audit of PCI for the period beginning November 1, 2009 and ending on a date yet to be determined by the State of Texas. As of the date of this Report, this audit has not started and the period through which the audit will cover has not been determined.

In accordance with Accounting Standard Codification 450, Contingencies (“ASC 450”), the Company has determined that the potential outcome of the forthcoming sales and use tax audit represents a loss contingency, as the Company believes it is probable that it will be assessed additional taxes for the upcoming audit period. It is common practice for the State to audit a subsequent period after the discovery of a material liability in a prior audit period.

Under the guidance of ASC 450, an estimated loss from a loss contingency shall be accrued by a charge to income if both the following conditions are met: (i) information is available before the next most current financial statements are issued or are available to be issued indicates that it is probable that an asset had been impaired or a liability had been incurred as of the date of the financial statements, and (ii) the amount of such loss can be reasonably estimated. In addition, from the guidance of ASC 450, a potential loss range should be estimated and the lower end of the range should be accrued when no other amount within the range appears to be a better estimate.

The Company has estimated its potential sales and use tax exposure for the periods that have not been audited by the State to be between $340,000 and $463,000, including estimated penalties and interest of approximately $54,000 and $67,000, respectively. This estimate covers all periods following the completed sales tax audit period through the date that each identified tax issue was substantially corrected by the Company. Since the Company cannot predict the outcome of the forthcoming sales tax audit, it has recorded the low end of the estimated loss in its consolidated financials as of February 28, 2013. The Company’s estimate of the low end of the range related to the potential liability considered only the errors identified in the prior sales tax audit whereas the high end of the range was estimated using a conservative application of sales tax rates on the majority of the cellular services billed from November 2009, the end of the prior audit period, through November 2010, the month that the identified tax issues were remediated by the Company. The actual liability, as a result of a future tax audit, could fall outside of the Company’s estimated range due to items that could be identified during an audit but not considered by the Company.

NOTE 11 – TEXAS SALES AND USE TAX OBLIGATION

From October 2010 through June 2012, the State of Texas (the “State”) conducted a sales and use tax audit of the Teletouch’s subsidiary, PCI, covering the period from January 2006 to October 2009. During the second fiscal quarter of 2011, while undergoing standard preparations for the tax audit, the Company identified that there could be certain issues in connection with the prior application and interpretation of sales tax rates assessed on various services and products billed and received by PCI. However, multiple prior sales tax audits of PCI conducted by the State did not identify or determine that there were any such issues, even though PCI’s methodology for computing sales taxes was virtually identical during the prior periods. As a result, prior to receiving a final determination from the State on these sales tax matters, the Company could not accurately predict the probable outcome of this audit or any related material liability to the State. In accordance with ASC 450, the Company reported an estimated range for this potential liability of between $22,000 and $2,400,000. The lower end of the range was based on the actual results of PCI’s prior State tax audits, with the higher end of the range based on the Company’s internal review and most conservative analysis, which indicated a potential estimated liability of up to $1,900,000, plus an additional estimated potential liability of up to $500,000 for related penalties and interest on the Company’s highest possible estimated amount.

On March 27, 2012, the Company received a summary of the errors identified by the State auditor on selected billing statements and invoices, which further included computations of these errors extrapolated over the respective total billings and purchases for the audit period. Based on the information provided by the State, the Company initially recorded a sales and use tax liability related to the tax audit of approximately $1,850,000 during the quarter ended February 29, 2012, including approximately $443,000 in penalties and interest that was expected to be assessed by the State.

On June 11, 2012, the Company received notice from the State the sales and use tax audit was complete. As a result of the final audit assessments provided by the State, the Company adjusted its sales and use tax liability related to the tax audit to reflect a total obligation at May 31, 2012, of approximately $1,880,000, including approximately $466,000 in assessed penalties and interest. The sales and use tax assessed by the State, before penalties and interest, totaled approximately $1,414,000 for the tax audit period, and was comprised of approximately $6,000 of use tax related to fixed asset purchases, $126,000 of use tax due on various services purchased by the Company, $637,000 of under billed sales taxes related to cellular services billings and $645,000 of under billed sales taxes related to other billings. In addition, the State noticed the Company the final audit assessment was due and payable on July 23, 2012.

Since the Company could not pay the entire tax obligation by July 23, 2012, the Company petitioned the State on July 9, 2012 for a redetermination hearing related to PCI’s sale sales and use tax audit. In the redetermination letter submitted to the State, the Company had requested the State to review questionable audit transactions where the Company believed it was due a possible tax refund or credit adjustment. In addition, the Company had requested the State to provide repayment assistance due to the Company’s current financial condition and limited working capital. Furthermore, the Company had requested a waiver of penalty and interest that has been imposed by the State. On September 20, 2012, the Company submitted a formal compromise and payment agreement request to the State in an effort to forego the lengthy redetermination process and settle the sales tax obligation expeditiously. The Company requested that the State reduce the total tax assessment including interest and penalty to $1,250,000 and grant thirty-six month repayment terms for this obligation.

On January 7, 2013, the Company entered into a settlement agreement (the “Sales Tax Agreement”) with the State to resolve the Company’s sales and use tax liability. Under the terms of the Sales Tax Agreement, the Company agreed to settle the approximately $1,911,000 tax liability, which included penalties and interest assessed through January 3, 2013 of approximately $498,000 by making a series of payments to the State totaling approximately $1,414,000. Under the terms of the Sales Tax Agreement, the Company was obligated to make a $625,000 down payment due and payable on or before January 12, 2013, plus 35 monthly payments of $22,000 and a last payment of $18,888.10. Prior to entering into the Sales Tax Agreement, the Company had voluntarily paid a total of $150,000 against this tax liability and the State allowed the Company to reduce its down payment by the full amount of the voluntary payments already made which resulted in the Company paying the $475,000 balance of the down payment in January 2013. The Company continues to make the monthly installment payments required under the Sales Tax Agreement.

In the event the Company fails to make any of the subsequent monthly payments, the full balance of the original tax liability owed, together with applicable penalties and interest, less any payments will become due and payable in full. In addition, as a result of the Sales Tax Agreement, the State has the ability to file a tax lien on the assets of PCI. Furthermore, under the terms of the Sales Tax Agreement PCI (i) withdrew its request for a hearing and waived its right to a rehearing; (ii) waived its right to file an appeal; and (iii) agreed to close the audit period.

In accordance with ASC 470-10-45, Debt, Overall, Other Presentation Matters (“ASC 470-10-45”) the Company recorded a current and long-term Texas sales and use tax obligation of approximately $264,000 and $1,001,000, respectively on the Company’s consolidated balance sheet as of February 28, 2013 based upon the payment terms as described in the Sales Tax Agreement. Additionally, penalties and interest totaling approximately $498,000 that were assessed on the PCI sales tax audit, but subsequently forgiven under the Sales Tax Agreement, are considered a contingent liability and have been recorded under the caption “Long-term Texas sales and use tax obligation, net of current portion” on the Company’s consolidated balance sheet. If all terms of the Sales Tax Agreement are met by the Company, the State will forgive the $498,000 in penalties and interest upon receiving the final payment due on the Sales Tax Agreement.

Current portion of long-term debt at February 28, 2013 and May 31, 2012 consists of the following (in thousands):

DCP Revolving Credit Facility: On February 8, 2013, the Company entered into a Loan and Security Agreement (the “DCP Loan Agreement”) with DCP, Teletouch Lender, LLC (“DCP”), a New York based private lender. In conjunction with the DCP Loan Agreement, the Company also executed a promissory Note (the “DCP Note”) in connection with and to evidence the obligation to repay all sums advanced by DCP pursuant to the DCP Loan Agreement. The terms of the DCP Loan Agreement provides the Company the ability to borrow up to $6,000,000 under the DCP Loan Agreement’s revolving credit facility. The minimum amount that may be drawn under this revolving credit facility is $100,000 and the borrowings are limited to specific advance rates against the aggregate fair value of the Company’s eligible assets, as defined in the DCP Loan Agreement’s Borrowing Base, including an advance on the Company’s transfer of AT&T cellular subscribers, accounts receivable and inventory, less specific reserves, plus cash on hand, compared to total borrowings outstanding on any given borrowing date. The interest rate under the DCP Loan Agreement is 14% per annum (with a default interest rate of 20%) and considers interest rate reductions of 1% per quarter (to a minimum of no less than 11%) in the event the Company achieves certain minimum quarterly financial targets. The term of the loan initially matures on January 31, 2015 and may be extended for one additional year at the Company’s sole election. The Company is responsible for a monthly collateral monitoring fee of $5,250 (with a default monitoring fee of $6,375) which is payable in advance on the first day of each calendar month. Additionally, the DCP Loan Agreement requires a monthly unused commitment fee in an amount equal to (i) 0.35% per month on the first $2,000,000 of unused borrowing availability under the revolving credit facility, plus (ii) 0.20% per month on any additional borrowing availability under the revolving credit facility. The Company is obligated to pay an exit fee of 1% of the $6,000,000 loan commitment, or $60,000, at the expiration of the initial term of the DCP Loan Agreement (January 31, 2015) and certain ongoing diligence fees and expenses that are customary under this type of credit facility.

At the closing of the DCP Loan Agreement on February 8, 2013, the Company had an initial draw-down of funds under the revolving credit facility of $4,300,000, of which $400,000 was considered a supplemental advance to help pay certain closing fees. The Company was required to pay a closing fee to DCP of $180,000 as well as legal and professional fees totaling approximately $83,000 related to closing this credit facility. The supplemental advance portion of the loan bears an annual interest rate of 20% and must be paid back in installments and requires any recovery of sales taxes from the Company’s customers to be applied against the outstanding balance of this supplemental advance. The Company is required to pay the supplemental advance down to $300,000 by May 9, 2013, $200,000 by June 8, 2013 and in full by July 8, 2013.

The DCP Loan Agreement contains events of default and remedies customary for loan transactions of this sort including, among others, those related to a default in the payment of principal or interest, a material inaccuracy of a representation or warranty, a default with regard to performance of certain covenants, a material adverse change (as defined in the DCP Loan Agreement) occurs, cross default on other debt in excess of $250,000, change of control, default under the current AT&T agreement, among others. Upon the occurrence of a default, in some cases following a notice and cure period, DCP may accelerate the maturity of the loan and require the full and immediate repayment of all borrowings under the DCP Loan Agreement. The DCP Loan Agreement also contains affirmative covenants (e.g. advance notice requirements relating to changes in business and operations, material adverse effects on the Company’s business, among others), and negative covenants (e.g., with respect to the Company’s ability to place new liens on its assets, engage in transactions outside of the ordinary course of business, incur additional indebtedness, amend its organizational documents in any material respect, among others). Furthermore, the Company must meet certain quarterly financial covenants under the DCP Loan Agreement including minimum earnings and a debt service coverage ratio that ranges between 1.10 and 1.25 over the life of the revolving credit facility. If the Company does not meet the quarterly financial covenants, it will be subject to the default interest rate of 20% and / or possible acceleration of the Note. As used above, the term “change in control” includes any of the following events:  (i) if the power to direct or cause the election of the Board of Directors or equivalent governing body of the Company, is, after the closing date, transferred to, or acquired by, a person(s) who did not possess such power prior to such date, or (ii) all or substantially all of the assets of the Company are acquired by any person(s), or (iii) the Company  ceases to own 100% of the equity interests of any of its subsidiary, or (iv) any of Messrs. M. McMurrey, Hyde and Sloan cease for any reason cease to hold the office of Chairman and CEO, President and COO and CFO of the Company, respectively, or be actively engaged in the day-to-day management of the Company, unless within 90 days of such cessation, a successor to the office of the effected individual is appointed by the Company, which successor is acceptable to DCP in its commercially reasonable discretion.

Additionally, the DCP Loan Agreement contemplates an additional multiple use short term loan facility of up to $2,000,000 per loan for special order inventory purchase transactions (the “DCP Term Loans”). The DCP Term Loans facility is designed to satisfy out-of-cycle customer orders to facilitate inventory purchases at times and prices favorable to the Company. The DCP Term Loans are not a committed credit facility by DCP and the financial terms, including interest and fees, of any such DCP Term Loans will be determined on a case-by-case basis and remain entirely within the discretion of DCP.

In connection with the DCP Loan Agreement, the Company also entered into a Subscription Agreement (the “DCP Subscription Agreement”) and a Buyback Right and Agreement not to Short Securities of Teletouch (the “DCP Buyback Agreement,” and together with certain ancillary agreements and documents, and DCP Subscription Agreement, the “Equity Agreements”) pursuant to which the Company agreed to issue to DCP shares of its common stock equal to $200,000.00, based on an issue price per share computed at 90% of the prior 60-day volume weighted average closing price preceding the February 8, 2013 closing date, calculated at 530,398 shares (the “Teletouch Shares”). The DCP Buyback Agreement provides for a “call” option for the Company which is the right, but not the obligation, commencing on the effective date of the DCP Loan Agreement and for so long as the Revolving Credit Commitments (as defined in the DCP Loan Agreement) have not been terminated, the Company shall have the right, but not the obligation, at its sole discretion, to buy back all or a portion of the Teletouch Shares at the per share price of 120% of the issue price, or approximately $0.452 per share. DCP is an “accredited investor” (as such term is defined in Rule 501(a) of Regulation D under the Securities Act of 1933, as amended (the “Securities Act”)), and the Company sold the securities in reliance upon an exemption from registration contained in Section 4(2) and Rule 506 under the Securities Act. The securities sold may not be offered or sold in the United States absent registration or an applicable exemption from registration requirements.

As a condition to closing the DCP Loan Agreement, PCI and New Cingular Wireless PCS, LLC, (as successor to Southwestern Bell Wireless, Inc. (“AT&T”) entered into a Fourth Amendment dated as of February 1, 2013 (the “AT&T Fourth Amendment”) to the Distribution Agreement dated as of November 12, 1999 and subsequently amended (the “Distribution Agreement”) related to the new debt financing with DCP. Under the terms of the AT&T Fourth Amendment, PCI is permitted to sell its cellular base to AT&T prior to the November 2014 expiration of the Distribution Agreement and to pledge proceeds from the Distribution Agreement to DCP. The foregoing arrangement was evidenced by a letter agreement by and between AT&T and DCP dated as of the same date.

Under the terms of the DCP Loan Agreement, the Company is required to provide DCP with daily certified Borrowing Base reports, access to daily automated data prepared by the Company and online access to the Company’s bank accounts. As of February 28, 2013, the Company had $4,360,000 outstanding under the revolving credit facility with DCP Teletouch Lender, LLC with includes a $60,000 exit fee required under the loan and due on January 31, 2015.

Amounts borrowed under the DCP Loan Agreement are secured by a security interest on all existing and after-acquired assets of the Company.

Thermo Revolving Credit Facility: On April 30, 2008, the Company executed a Loan and Security Agreement (the “Thermo Loan Agreement”) with Thermo Credit, LLC (“Thermo”), to secure a revolving credit facility providing for availability of up to $5,000,000 allowing the Company, on a consolidated basis, to obtain revolving credit loans from Thermo from time to time. Borrowings under the revolver were limited to specific advance rates against the aggregate fair value of the Company’s assets, as defined in the Thermo Loan Agreement, including real estate, equipment, infrastructure assets, inventory, accounts receivable, intangible assets and notes receivable (collectively, the “Thermo Borrowing Base”). The annual interest rate on the under the revolving credit facility was the lesser of: (a) the maximum non-usurious rate of interest per annum permitted by applicable Louisiana law or (b) the prime rate plus 8%. The Company was also required to maintain certain financial covenants. Further, the availability under the Thermo Loan Agreement was reduced by a Monthly Step Down amount, as defined in the loan agreement. The purpose of the revolving credit facility was to finance the Company’s working capital and organizational needs and other debt obligations at the time. In order to secure their repayment obligations under the Thermo Loan Agreement, the Company granted to Thermo a lien and a security interest in substantially all of the Company’s assets, properties, accounts, inventory, goods and the like. The Company also executed a promissory note dated as of the same date payable to the Thermo in the original principal amount of $5,000,000 (the “Thermo Note”).

From August 2008 through October 2011, the Company amended the Thermo Loan Agreement on four different occasions to increase the amount of availability allowed under the credit facility, extend the maturity date of the loan, and defer monthly principal payments, among other things.

In February 2012, Thermo notified the Company of its intent to significantly modify the Borrowing Base, as defined by the loan agreement, which would subsequently accelerate the Company’s obligations due under the Thermo Loan Agreement. As a result, on March 14, 2012, effective February 29, 2012, the Company and Thermo entered into Waiver and Amendment No. 5 (“Amendment No. 5”) to the Thermo Loan Agreement, as amended to date. Under the terms of the Amendment No. 5, the Company made a payment on the outstanding balance of the loan in the amount of $2,000,000 on March 14, 2012. In consideration for the payment, Thermo agreed to waive certain financial covenants and not accelerate the collection of the loan through August 31, 2012, provided that certain financial performance targets were met by the Company and it was able to refinance its real estate debt to provide additional payments to Thermo, among other things.

Although the Company made the required $2,000,000 cash payment on March 14, 2012, the Company did not meet all of the requirements under Amendment No. 5 but was able to pay Thermo approximately $1,001,000 on August 14, 2012 as a result of the sale of the Company’s two-way business on August 11, 2013 (see Note 3 – “Discontinued Two-Way Operations” for more information on the sale of the two-way business).

On September 10, 2012 the Company received a Formal Notice of Maturity (the “Letter”) from Thermo which notified the Company the revolving credit facility had matured by its terms on August 31, 2012, and therefore under the terms of the facility, Thermo had the right to demand payment for all obligations due and payable under the credit revolving facility by September 17, 2012. Thermo further reserved all rights and remedies available to it under the documents and agreements in connection with the revolving credit facility. Even though Thermo was reserving its rights under the agreement and revolving credit facility, the Letter did not constitute a notification to the Company that Thermo was commencing the exercise of any of its rights and remedies.

In connection with the execution of the DCP Loan Agreement on February 8, 2013, Teletouch, PCI and Thermo entered into a Sixth Amendment (“Amendment No. 6”) to the Thermo Loan Agreement, as amended to date. Under the terms of Amendment No. 6, the Company agreed to pay $4,000,000 against its indebtedness to Thermo totaling $7,148,000 (including approximately $126,000 in accrued and unpaid interest and fees since January 1, 2013) upon closing the DCP Loan Agreement on February 8, 2013. The foregoing payment obligation by the Company was evidenced by an Amended and Restated Subordinated Promissory Note dated February 8, 2013 in the amount of $3,148,000 (the “Thermo Note”) which bears interest at 9.7% per annum (with a default interest rate of 18%). Amendment No. 6 also contemplates the following payments to Thermo to pay off the foregoing Note balance (provided there is no default on the loan facility with DCP): (i) $25,000 monthly payments commencing on March 1, 2013, (ii) the principal of the Thermo Note will be due and payable in 30 fully amortized payments commencing on February 1, 2014 with the final payment due on August 1, 2016, (iii) additional potential payments in the amount of up to $1,000,000 from the sales and / or the refinancing of Teletouch’s real estate in Texas, and (iv) certain excess proceeds from the planned sale of the Company’s cellular subscribers to AT&T upon the expiration of the Distribution Agreement in November 2014, i.e., after all outstanding loans against the cellular subscribers have been repaid to DCP. In addition, the parties also entered into a certain Subordination and Intercreditor Agreement by and between Thermo and DCP dated as of February 8, 2013 (the “Subordination Agreement”) for the purposes of subordinating Thermo’s security interest to that of DCP under the Loan Agreement.

On February 26, 2013, the Company received proceeds of approximately $297,000 from the sale of its real estate in Tyler, Texas. Under the terms of Amendment No. 6 and as allowed by the DCP Loan Agreement, the total amount of proceeds were subsequently paid to Thermo and applied against the balance of the Thermo Note.

As of February 28, 2013, the Company had $2,851,000 outstanding under the Thermo Note.

East West Bank Real Estate Debt (formerly United Commercial Bank): Effective May 3, 2007, the Company entered into a loan agreement with United Commercial Bank, which was subsequently acquired by East West Bank, (the “East West Debt”) to refinance previous debt in the amount of $2,850,000 at May 31, 2007. Under the agreement, the East West Debt required monthly payments of $15,131 and bore interest at the prime rate as published in the Wall Street Journal. The East West Debt matured on May 3, 2012 and the Company was noticed in the second quarter of fiscal year 2012 the East West Debt would not be renewed. Subsequently, East West Bank granted an initial extension of the debt maturity through August 3, 2012 and granted a second extension through November 3, 2012. On November 27, 2012, East West Bank granted a third extension on the maturity of the debt through February 3, 2013 and changed the terms of the loan agreement. Effective November 3, 2012, the interest rate under the agreement was amended from a variable rate to a fixed rate at 7% and required two monthly payments of $19,283.18 each. East West Bank and the Company are currently in discussions related to another possible extension on the maturity date of the loan, but as of the date of this Report the extension has not been granted. The Company has not been able to secure new financing against its real estate but believes this will be possible since it has secured a new senior credit financing facility and amended its debt agreement with Thermo. The Company can provide no assurance it will be successful in securing new real estate financing or that East West Bank will be agreeable to extend the maturity date of the loan or that any such extensions will allow a sufficient amount of time for the Company to secure the new real estate financing.

The East West Debt is collateralized by a first lien on the Company’s corporate office building, the excess land adjacent to that building and a billboard in Fort Worth, Texas owned by the Company. As of February 28, 2013, approximately $2,071,000 was outstanding under this loan with East West Bank.

Jardine Capital Corporation Real Estate Debt: Effective May 3, 2007, the Company entered into a loan agreement with Jardine Capital Corp. (the “Jardine Bank Debt”) to refinance previous debt in the amount of $650,000. The Jardine Bank Debt requires monthly payments of $7,705, bears interest at 13% and matured on May 3, 2012. The Company was noticed in the second quarter of fiscal year 2012 the Jardine Bank Debt would not be renewed. Subsequently, Jardine Capital has granted several extensions of the maturity of the loan balance and has recently granted another extension of the maturity of the loan through May 31, 2013 for a 1% extension fee (approximately $5,350) with no changes in the terms under the original agreement. The Company has not been able to secure new financing against its real estate but believes this will be possible in since it has secured new senior credit financing facility and amended its debt agreement with Thermo. The Company can provide no assurance it will be successful in securing new real estate financing or that Jardine Bank will continue to extend the current maturity date of the loan or that any such extensions will allow a sufficient amount of time for the Company to secure the new real estate financing.

The Jardine Bank Debt is collateralized by a second lien on the Company’s corporate office building, the excess land adjacent to that building and a billboard in Fort Worth, Texas owned by the Company. As of February 28, 2013, a total of approximately $537,000 was outstanding under this agreement.

NOTE 13 – TRADEMARK PURCHASE OBLIGATION

On May 4, 2010, Progressive Concepts, Inc., entered in a certain Mutual Release and Settlement Agreement (the “Agreement”) with Hawk Electronics, Inc. (“Hawk”). The settlement followed a litigation matter styled Progressive Concepts, Inc. d/b/a Hawk Electronics v. Hawk Electronics, Inc . Case No. 4-08CV-438-Y, by the Company against Hawk in the US District Court for the Northern District of Texas which alleged, among other things, infringement on the trade name Hawk Electronics , as well as counterclaims by Hawk against the Company of, among other things, trademark infringement and dilution.

Under terms of the Agreement, the parties executed mutual releases of claims against each other and agreed to file a stipulation of dismissal in connection with the pending litigation matter.  The Company agreed to, among other things, the purchase a perpetual license from Hawk to use the trademark “Hawk Electronics” for $900,000. Under the terms of the license agreement, the Company made a payment of $550,000 on June 1, 2010 and a payment of $150,000 on July 1, 2011, and a payment of $100,000 on June 29, 2012 and is obligated to make the final $100,000 payment by July 1, 2013.

As of February 28, 2013, the Company has recorded $100,000 as a current liability under current portion of trademark purchase obligation (July 1, 2013 payment).

In addition, under the terms of the agreement, the Company can continue to use the domain name www.hawkelectronics.com but will be required to pay Hawk a monthly royalty fee to use the domain name beginning August 1, 2013. A monthly royalty payment of $2,000 will be due during the first year of use with a 10% increase to the monthly fee each subsequent year the domain name is used by the Company.

The Company has approximately $26,541,000 of accumulated Net Operating Loss (“NOL”) at February 28, 2013, which is subject to expiration in various amounts from 2024 through 2032. In fiscal year 2013, the NOL is subject to limitations as a result of a change in ownership of the Company that took place during August 2011, as defined by Section 382 of the Internal Revenue Code. For fiscal year 2013, the Company has approximately $2,178,000 in NOL available to offset taxable income for the year. Realization of the deferred tax asset associated with the NOL is dependent upon generating sufficient taxable income prior to expiration of the balance of the accumulated NOL and to the limitations imposed by Section 382. Management has determined that it is unlikely that the deferred tax assets will be realized; therefore, a full valuation allowance has been established as of February 28, 2013 and May 31, 2012.

The current Company policy classifies any interest recognized on an underpayment of income taxes and any statutory penalties recognized on a tax position taken as interest and penalty expense in its consolidated statements of operations. There was an insignificant amount of interest and penalties recognized and accrued as of February 28, 2013. The Company has not taken a tax position that, if challenged, would have a material effect on the financial statements or the effective tax rate for fiscal year ended May 31, 2013 and has not recognized any additional liabilities for uncertain tax positions under the guidance of ASC 740. The Company’s tax years 2005 through 2011 for federal returns and 2009 through 2012 for state returns remain open to major taxing jurisdictions in which we operate, although no material changes to unrecognized tax positions are expected within the next year.

NOTE 15 – COMMITMENTS AND CONTINGENCIES

Teletouch leases buildings and equipment under non-cancelable operating leases with initial lease terms ranging from one to twenty years. These leases contain various renewal terms and restrictions as to use of the property. Some of the leases contain provisions for future rent increases. The total amount of rental payments due over the lease terms is charged to rent expense on the straight-line method over the term of the leases. The difference between rent expense recorded and the amount paid is recorded as deferred rental expense, which is included in accrued expenses and other liabilities in the accompanying consolidated balance sheets. The Company’s most significant lease obligation is for a suite at the Dallas Cowboys Stadium in Arlington, Texas, which is used for customer, supplier, investor relations and other corporate events. The Company is currently working to sublet all or a portion of its suite at the Dallas Cowboy Stadium, but as of the date of this Report has been unable to do so. Due to the significance of this lease compared to the Company’s other operating leases, it is separately identified in the table below. Total rent expense recorded against all operating leases, including the Dallas Cowboy’s suite lease was $201,000 and $339,000 in the three months ended February 28, 2013 and February 29, 2012, respectively and $681,000 and $1,019,000 for the nine months ended February 28, 2013 and February 29, 2012, respectively. Future minimum rental commitments under non-cancelable leases and other contractual obligations are as follows (in thousands):

(in thousands)

Twelve Months Ending February 28,

Also, on December 31, 2008, the Board of the Company approved an executive employment agreement with an effective date of June 1, 2008, by and between the Company and Thomas A. “Kip” Hyde, Jr. (the “Hyde Agreement”), as the Company’s President and Chief Operating Officer. The Hyde Agreement provided for an initial term commencing on June 1, 2008 and ending May 31, 2011, and automatically renewed for successive additional one year term(s), unless either the Company or Mr. Hyde gave the other party an advance written notice not to renew the Hyde Agreement. By its terms, on May 31, 2012, the Hyde Agreement automatically renewed for an additional one year term ending May 31, 2013.

On April 1, 2013, the Board Appointees (as defined in Note 20 – Subsequent Event) gave written notices to each of Messrs. McMurrey and Hyde that the McMurrey Agreement and the Hyde Agreement would not be renewed and would therefore expire on May 31, 2013. Said notices were notices of non-renewal of such employment agreements, and did not terminate Messrs. McMurrey’s or Hyde’s respective employment with the Company. The notices stated, in respective parts, that the Board desires that Messrs. McMurrey and Hyde remain employed by the Company, with the future terms of such employment to be determined after the Company’s Compensation Committee recommends and the Board adopts policies for the employment of executives of the Company. Messrs. McMurrey and Hyde have notified the Company that they dispute the legal effect of the above-described notices, and that they believe that their respective employment agreements have automatically renewed for a one year term ending May 31, 2014.

As a result of the disagreement over the effectiveness of the notice provided to Messrs. McMurrey and Hyde, the Company has determined to continue reporting this contractual obligation until such time as a this matter is resolved.

Guaranty

Furthermore, under the terms of the APA with DFW Communications, Inc., the Company guaranteed any payments owed to Whelen Engineering Company, Inc., a two-way public safety equipment supplier, by DFW for a total amount not to exceed $75,000. In exchange for the guarantee, DFW issued an irrevocable standby letter of credit to the Company in the amount of $75,000. The Company has the right and ability, not the obligation, to immediately draw funds as necessary under the letter of credit upon Whelen demanding payments from the Company in accordance with the guarantee.

Sales and Use Tax Audit Settlement Contingency

As part of the tax settlement agreement the Company executed with the State of Texas (the “State”) on January 7, 2013 related to PCI’s sales and use tax audit assessment for the period January 1, 2006 through October 31, 2009, the Company will be held liable for the penalties and interest that were assessed on the audit plus any additional accrued penalties and interest if the Company fails to make timely payments to the State as described in the tax settlement agreement. Otherwise, if the Company complies with the terms of the tax settlement agreement, the State will waive the $498,000 penalties and interest that has been assessed upon receiving the final payment due under the tax settlement agreement.

As of February 28, 2013, the penalties and interest totaling approximately $498,000 associated with PCI’s sales and use tax audit assessment are considered a contingent liability and these amounts are recorded under the caption “Long-term Texas sales and use tax obligation, net of current portion” on the Company’s consolidated balance sheet ( see Note 11 – “Texas Sales and Use Tax Obligation” for more information on the sales tax settlement agreement with the State).

Sales and Use Tax Audit Contingency

Due to the results of PCI’s prior sales and use tax audit, the Company has identified a sales and use tax contingency for the forthcoming audit period beginning November 1, 2009 and through a date which has not been determined by the State of Texas (see Note 10 – “Accrued Expenses and Other Current Liabilities” for more information on the sales and use tax accrual for this period).

Legal Proceeding Contingencies

Teletouch is party to various legal proceedings arising in the ordinary course of business. The Company believes there is no proceeding, either threatened or pending, against it that will result in a material adverse effect on its results of operations, financial condition or cash flows that requires an accrual or disclosure in its financial statements under ASC 450.

NOTE 16 – SHAREHOLDERS’ EQUITY

Capital Structure: Teletouch’s authorized capital structure allows for the issuance of 70,000,000 shares of common stock with a $0.001 par value and 5,000,000 shares of preferred stock with a $0.001 par value.

As a result of the Company entering into the DCP Loan Agreement on February 8, 2013, the Company executed a Subscription Agreement and Buyback Right and Agreement not to Short Teletouch Securities with DCP and agreed to issue 530,398 shares of its common stock to DCP. As of February 28, 2013, the shares issued to DCP were included in the issued and outstanding common stock of the Company (see Note 12 – “Long-Term Debt – DCP Revolving Credit Facility” for more information on the DCP equity agreements).

Change of Ownership and Voting Control of Teletouch

From November 2005 through August 2011, the majority of Teletouch’s outstanding common stock was owned and controlled by TLL Partners, LLC, a Delaware limited liability company (“TLLP”), controlled by Robert McMurrey, the Company’s Chairman and Chief Executive Officer. In August 2006, immediately prior to Teletouch’s acquisition PCI, TLLP assumed the senior debt obligations of PCI and settled the subordinated debt obligations of PCI by issuing 4,350,000 shares of its holdings of Teletouch’s common stock and converted the balance of the subordinated debt into redeemable Series A preferred units of TLLP. To secure the senior debt obligation, TLLP pledged all of its then held assets, which consisted primarily of approximately 80% of the outstanding common stock of Teletouch as of August 2006. TLLP is a holding company with no operations and was dependent upon selling a sufficient number of shares it owned in Teletouch common stock or upon the cash flows of Teletouch through the receipt of future cash dividends to service its outstanding debt obligations. When the senior debt originally matured in August 11, 2007, TLLP did not have sufficient cash or other means to repay this debt and was successful in negotiating an initial extension of the maturity date through October 11, 2007. Subsequent extensions were granted by the senior debt holder to TLLP extending the maturity date through January 31, 2011. In February 2011, TLLP negotiated a settlement of its senior debt obligations which provided for a discount against the balance due if TLLP would make a required series of discounted payments beginning February 2011 and continuing through August 19, 2011, the amended maturity date. In addition to the cash payments and as part of the settlement agreement, TLLP was obligated to transfer 2,000,000 shares of its holdings of Teletouch’s common stock to the senior lender at the maturity date.

Beginning in February 2011 and continuing through June 2011, TLLP completed sixteen (16) privately negotiated transactions and sold a total of 8,499,001 shares of its holdings of Teletouch’s common stock, which was approximately 17.4% of the Company’s outstanding common stock at June 13, 2011, the date of the last sale transaction. Following these sales transactions, TLLP continued to own 30,650,999 shares of our common stock, or 62.9% of the Company’s outstanding common stock. The Company entered into registration rights agreements with each of the purchasers and TLLP whereby it agreed to file a registration statement with the SEC covering the 8,499,001 shares sold and 12,000,000 shares owned by TLLP. This registration statement on Form S-1 was filed with the SEC on June 17, 2011 and was subsequently declared effective on July 11, 2011.

On August 11, 2011, TLLP entered into a binding agreement titled “Heads of Terms” (the “Binding Agreement”) and certain related agreements with its Series A Preferred unit holders, Stratford Capital Partners, LP (“Stratford”) and Retail & Restaurant Growth Capital, LP (“RRGC”) (together, Stratford and RRGC are hereafter referred to as the “Transferees”), whereby, on August 17, 2011 TLLP exchanged 25,000,000 shares of its holdings of the Company’s common stock (the “New Shares”) to settle in full TLLP’s approximately $18,200,000 redemption obligation on its outstanding Series A Preferred Units (the “Preferred Units”) and for additional cash consideration totaling $3,750,000 from the Transferees (the “Exchange”). The redemption rights under the Preferred Units allowed the holders to redeem the accumulated redemption value for shares of Teletouch common stock owned by TLLP and such redemption could only take place following the fiscal settlement of TLLP’s senior debt obligation. The cash received by TLLP from this transaction allowed it to make the final payment on the senior debt obligation which allowed the Preferred Units to be redeemed simultaneously. Based on the approximately $21,950,000 consideration exchanged by Transferees, TLLP realized approximately $0.88 per share in value for the shares of the Company’s common stock transferred in the Exchange. As a result of the Exchange, Stratford and RRGC received 15,000,000 shares and 10,000,000 shares, respectively, of the Company’s common stock in exchange for their respective share of the cash consideration and their respective holdings of the outstanding Preferred Units. The Exchange closed on August 17, 2011 and resulted in the cancellation of the Series A Preferred units. As contemplated by the Binding Agreement, at closing the parties entered into various agreements related to the Exchanged Shares including (1) a registration rights agreement providing for the registration of the Exchanged Shares, (2) a put and call option and transfer restriction agreement whereby TLLP would have the right to call from Stratford and RRGC the Exchanged Shares for a fifteen month period (through approximately November 17, 2012) for a call price of $1.00 per share, Stratford and RRGC would have the rights to put their Exchanged Shares to TLLP for 30 day period at the end of the call option period for a put price of $1.00 per share, and Stratford and RRCG would agree not to transfer the Exchanged Shares for a period of seven months after the date of the Exchange (through approximately March 17, 2012), (3) a voting agreement whereby Stratford and RRGC agreed to vote their Exchanged Shares in proportion to the votes of the other shareholders of Teletouch through November 16, 2012, the date of the expiration of the voting agreement, (4) a pledge and security agreement whereby TLLP pledged all of its remaining shares of Teletouch’s common stock to Stratford and RRGC as security for their put rights, (5) a mutual release of claims between various parties to the Exchange and (6) certain other ancillary documents. Following the Exchange and as of the date of this Report, Stratford owns 17,610,000 shares of Teletouch’s common stock (36.1% of outstanding shares), RRGC owns 11,740,000 shares (24.1%) and TLLP owns 3,050,999 shares (6.3%). The result of the Exchange was a change in control of the voting of common stock at Teletouch on August 17, 2011, whereby TLLP no longer controls the outcome of matters voted on by the shareholders.

Effective December 7, 2012, TLLP, Stratford and RRGC entered into Amendment No. 1 to the Put and Call and Transfer Restriction Agreement originally dated August 18, 2011.  Under Amendment No. 1, the parties agreed to extend Stratford and RRGC’s put option through January 18, 2013.  On January 16, 2013, TLLP, Stratford and RRGC entered into Amendment No. 2 to the Put and Call and Transfer Restriction Agreement to extend Stratford and RRGC’s put option to March 1, 2013. Additionally, on February 15, 2013, TLLP, Stratford and RRGC entered into Amendment No. 3 to the Put and Call and Transfer Restriction Agreement to extend Stratford and RRGC’s put option to May 30, 2013.

Registration Rights Agreement: In connection with the terms of the Binding Agreement as discussed above, on August 17, 2011, Teletouch entered into a Registration Rights Agreement (the “RRA”) with the Transferees. Prior to the closing of the Exchange, the Transferees owned all of the issued and outstanding Series A Preferred Units of TLLP. Pursuant to the RRA, the Company agreed to file with the SEC, subject to certain restrictions, by October 17, 2011, a registration statement relating to the registration of (i) 4,350,000 shares of the Company’s common stock (the “Existing Shares”) held, in the aggregate, by the Transferees as of the date of the RRA, (ii) 25,000,000 shares of the Company’s common stock (the “New Shares”) transferred to the Transferees by TLLP pursuant to the Exchange Transaction described below and (iii) 2,650,999 shares of the Company’s common stock being pledged by TLLP as security against the put option held by the Transferees as further described below (the “Pledged Shares”). (The “Existing Shares” together with the “New Shares” and the “Pledged Shares” are hereafter referred to as the “Registrable Securities.”) The RRA requires that the Company use its best efforts to cause the registration statement to be declared effective under the Securities Act of 1933 and to keep such registration continuously effective thereunder. The RRA also contains indemnification and other provisions that are customary to agreements of this nature.

On October 12, 2011, the Company filed a resale registration statement on Form S-1 with the SEC in accordance with the terms of the RRA which was subsequently declared effective by the SEC on November 1, 2011.

NOTE 17 - STOCK OPTIONS

Teletouch’s 1994 Stock Option and Stock Appreciation Rights Plan (the “1994 Plan”) was adopted in July 1994 and provided for the granting of incentive and non-incentive stock options and stock appreciation rights to officers, directors, employees and consultants to purchase not more than an aggregate of 1,000,000 shares of common stock. Under the terms of the 1994 Plan, no additional options can be granted under this Plan after July 2004 which is the tenth anniversary following the adoption of the Plan. The Compensation Committee or the Board of Directors administers the options remaining outstanding under the 1994 Plan. Exercise prices in the following table have been adjusted to give effect to the repricing that took effect in December 1999 and November 2001 (discussed below).

On August 7, 2002, the Company’s Board of Directors adopted the Teletouch 2002 Stock Option and Appreciation Rights Plan and on November 7, 2002, the common shareholders voted and ratified the plan (the “2002 Plan”). Under the 2002 Plan, Teletouch had the ability to issue options up to an aggregate of 10,000,000 shares of Teletouch’s common stock through August 7, 2012, at which time the 2002 Plan expired (10 years after adoption of the 2002 Plan). The 2002 Plan provided for options, which qualified as incentive stock options (Incentive Options) under Section 422 of the Code, as well as the issuance of non-qualified options (Non-Qualified Options). The shares issued by Teletouch under the 2002 Plan were either treasury shares or authorized but unissued shares as Teletouch’s Board of Directors determined from time to time. Pursuant to the terms of the 2002 Plan, Teletouch granted Non-Qualified Options and Stock Appreciation Rights (SARs) only to officers, directors, employees and consultants of Teletouch or any of Teletouch’s subsidiaries as selected by the Board of Directors or the Compensation Committee. The 2002 Plan also provided that the Incentive Options shall be available only to officers or employees of Teletouch or any of Teletouch’s subsidiaries as selected by the Board of Directors or Compensation Committee. The price at which shares of common stock covered by the option could have been purchased was computed as the average of the closing price of the Company’s stock for the five days preceding the grant date. To the extent that an Incentive Option or Non-Qualified Option is not exercised within the period in which it may be exercised in accordance with the terms and provisions of the 2002 Plan described above, the Incentive Option or Non-Qualified Option will expire as to the then unexercised portion. In addition, employees that cease their services with the Company and hold vested options will have the ability to exercise their vested options for a period three months after their termination date with the Company or at any time prior to the expiration of the option, whichever is shorter.

As of February 28, 2013, 906,998 Non-Qualified Options and 6,265,824 Incentive Options are outstanding under the 2002 Plan.

A summary of option activity for the nine months ended February 28, 2013 is as follows:

The following table summarizes the status of the Company’s non-vested stock options since June 1, 2012:

The Company recorded approximately $6,000 in stock based compensation expense in the consolidated financial statements for the three months ended February 28, 2013 and February 29, 2012. The Company recorded approximately $173,000 and $296,000 in stock based compensation expense in the consolidated financial statements for the nine months ended February 28, 2013 and February 29, 2012, respectively.

NOTE 18 – RELATED PARTY TRANSACTIONS

NVRDUL, LLC (“NVRDUL”) – NVRDUL is an entity controlled by Carri P. Hyde, spouse of Thomas A. Hyde, Jr., Director, President and Chief Operating Officer of the Company. Mr. Hyde has no direct involvement with the operations of NVRDUL, but is related only through marriage. The Company provides certain available office space to NVRDUL in exchange for certain public relations services. As of February 28, 2013, no balance was due to or from NVRDUL.

NOTE 19 – SEGMENT INFORMATION

ASC 280, Segment Reporting , establishes standards for reporting information about operating segments. Operating segments are defined as components of an enterprise about which separate financial information is available that is regularly evaluated by the chief operating decision maker, or decision making group, in deciding how to allocate resources and in assessing performance.

Using these criteria, the Company's two reportable segments are cellular services and wholesale distribution. The Company’s former two-way radio services business was sold on August 11, 2012 and is reported as discontinued operations for the three and nine months ended February 28, 2013 and February 29, 2012 (see Note 3 – “Two-Way Discontinued Operations” for more information on the sale of the two-way business).

The Company’s cellular business segment represents its core business, which has been acquiring, billing, and supporting cellular subscribers under a revenue sharing relationship with AT&T and its predecessor companies for over 28 years. The consumer services and retail business within the cellular segment is operated primarily under the Hawk Electronics brand name, with additional business and government sales provided by a direct sales group operating throughout all of the Company’s markets. As an Authorized Service Provider and billing agent, the Company controls the entire customer experience, including initiating and maintaining the cellular service agreements, rating the cellular plans, providing complete customer care, underwriting new account acquisitions and providing multi-service billing, collections, and account maintenance.

The Company’s wholesale business segment represents its distribution of cellular telephones, accessories, car audio and car security products to major carrier agents, rural cellular carriers, smaller consumer electronics and automotive retailers and auto dealers throughout the United States.

Corporate overhead is reported separate from the Company’s identified segments. The Corporate overhead costs include expenses for the Company’s accounting, information technology, human resources, marketing and executive management functions, as well as all direct costs associated with public company compliance matters including legal, audit and other professional services costs.

The following tables summarize the Company’s operating financial information by each segment for the three and nine months ended February 28, 2013 and February 29, 2012 (in thousands):

The Company identifies its assets by segment. Significant assets of the Company’s corporate offices include all of the Company’s cash, property and equipment, loan origination costs and the patent held for sale. The Company’s assets by segment as of February 28, 2013 and May 31, 2012 are as follows:

(1) “Other” includes assets, property and equipment, net and goodwill and intangible assets, net associated with the Company’s discontinued two-way operations. As of February 28, 2013, there were no remaining asset in this category.

During the three months and nine months ended February 28, 2013 and February 29, 2012, the Company did not have a single customer that represented more than 10% of total segment revenues.