This management's discussion and analysis of financial condition and results of
operations and other portions of this filing contain forward-looking information
that involves risks and uncertainties. Our actual results could differ
materially from those anticipated by the forward-looking information. You should
review the "Special Note Regarding Forward Looking Statements" and "Risk
Factors" sections of this annual report for a discussion of important factors
that could cause actual results to differ materially from the results described
in or implied by the forward-looking statements contained in the following
discussion and analysis. The following discussion should be read in conjunction
with our financial statements and the related notes included elsewhere in this
filing.
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Observations on effects of novel coronavirus and Russia/Ukraine Conflict
On March 11, 2020, the World Health Organization characterized the novel coronavirus outbreak as a pandemic. The outbreak has and continues to adversely affect the economies of the U.S., U.K., and other international markets and economies in which we operate. As a result of the World Health Organization characterizing the COVID-19 outbreak as a pandemic, national, state, and local governments have and continue to take actions such as declaring a state of emergency, implementing social distancing and other guidelines, and shutting down and/or limiting the opening or operation of certain businesses which are not considered essential. In these times of pandemic, our top priorities are to protect the health, well-being, and safety of our employees and partners, while still focusing on the key drivers of our business. To that end, and to insure we continue to operate safely and cautiously while also meeting our public health responsibilities, the Company has adopted flexible business practices including allowing most employees to work remotely in all locations. COVID-19 has adversely affected the distribution channel leading to significantly longer lead times when ordering product. Manufacturers are not producing as much product as prior to the pandemic due to disruptions, resulting in supply shortages. Additionally, recent global shipping delays have exacerbated this problem. The TS segment has many vendors it transacts with and supply shortages are pervasive with many of them. The HPP segment has and continues to experience shortages with their vendors as well. If we are unable to successfully resolve these disruptions and shortages, the timing and amount of our future results may be materially impacted. The HPP segment secured a $1.8 million contract for real-time networking monitoring for cyber attack detection in the first quarter of fiscal year 2021, but due to the delays by manufacturers the sale is anticipated to be recognized fully in revenue in fiscal year 2023 when we can obtain the product from the manufacturers. Related to the supply shortage and potentially inflation, we have experienced price increases for our products, which we try to pass on to the customer. We recognize the pandemic has created a dynamic and uncertain situation in the national economy, and we continue to closely monitor the latest information to make timely, informed business decisions and public disclosures regarding the potential impact of the pandemic on our operations. Despite reduced infection rates and ever-increasing vaccination rates in the United States, many nations and certain pockets within the United States are still battling various strains/variants of the novel coronavirus, creating ongoing uncertainties as to when economies will return to business as usual and what that will look like, what regulatory measures or voluntary actions will be further implemented to limit the spread of COVID-19 and its variants and the duration of any such measures. The extent, severity and impact of any further spread of COVID-19 variants or resurgence of COVID-19 in a given geographic region after it has hit its "peak," and the extent to which herd immunity will be achieved through the vaccination process is still uncertain. In summary, the scope of this pandemic and its effects are unprecedented, and we cannot at this time make a reasonable estimate on the extent or duration of the impacts on our business. As of September 30, 2022, the Russian/Ukrainian military conflict has not had a direct significant impact on revenue as we do not have any recurring customers in either country. However, we do have customers and suppliers in surrounding regions which may be affected and further escalation of the Russian-Ukraine military conflict and geopolitical tensions related to such military conflict could adversely affect our business, financial condition and results of operations, by among other things, cyber attacks, supply disruptions, lower consumer demand, and changes to foreign exchange rates and financial markets. It is not possible at this time to predict the size of the impact or consequences of the conflict to the Company and our customers and suppliers.
Overview of Fiscal 2022 Results of Operations
Revenue increased by approximately $5.2 million, or 10%, to $54.4 million for the fiscal year ended September 30, 2022 versus $49.2 million for the fiscal year ended September 30, 2021.
Gross profit margin percentage increased, from 33% of revenues for the fiscal year ended September 30, 2021 to 35% for the fiscal year ended September 30, 2022.
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We generated an operating loss of $40 thousand for the fiscal year ended September 30, 2022 as compared to an operating loss of approximately $1.4 million for the fiscal year ended September 30, 2021.
Other income, (expense) net was $2.0 million for the fiscal year ended September 30, 2022 as compared to $2.0 million for the prior year.
A one-time gain of $465k occurred in fiscal year 2021, which was a purchase price adjustment of a subsidiary (Modcomp GmbH) that was sold in fiscal year 2018. This is classified as discontinued operations. There are no further amounts to be received in connection with the purchase agreement from the original sale.
The Company recorded an income tax provision of approximately $50 thousand for the fiscal year ended September 30, 2022, which reflected an effective tax rate of 3% for the year ended September 30, 2022. The provision is primarily driven by the state tax expense. For the fiscal year ended September 30, 2021, the income tax provision was $444 thousand, which reflected an effective tax rate of 39%. The provision is primarily driven by the recording of a partial valuation allowance against US deferred tax assets that are not more-likely-than-not to be realized partially offset by current year federal R&D credits and the benefit resulting from the carryback of federal net operating losses to years in which the statutory federal tax rate was 34%.
The following table details our results of operations in dollars and as a percentage of sales for the fiscal years ended:
% %
September 30, 2022 of sales September 30, 2021 of sales
(Dollar amounts in thousands)
Sales $ 54,361 100 % $ 49,208 100 %
Costs and expenses:
Cost of sales 35,534 65 % 33,059 67 %
Engineering and development 3,084 6 % 2,887 6 %
Selling, general and administrative 15,783 29 % 14,624 30 % Total costs and expenses 54,401 100 % 50,570 103 % Operating loss (40) - % (1,362) (3) % Other income, (expense) net 1,979 4 % 2,040 4 % Income before income taxes 1,939 4 % 678 1 % Income tax expense 50 - % 444 1 %
Net income from continuing operations $ 1,889 3 % $ 234 - % Gain on sale of discontinued operations -
- % 465 1 % Net income $ 1,889 3 % $ 699 1 % Revenues Revenue increased by approximately $5.2 million, or approximately 10%, to $54.4 million for the fiscal year ended September 30, 2022 versus $49.2 million for the fiscal year ended September 30, 2021. Our TS segment revenue increased by approximately $5.9 million consisting of an increase of $7.1 million in our U.S. division, partially offset by a decrease of $1.2 million in our U.K. division. Our HPP segment revenue decreased by approximately $0.8 million or 17%.
TS segment revenue changes by products and services for the fiscal years ended September 30 were as follows:
September 30, Increase
2022 2021 $ %
(Dollar amounts in thousands)
Products $ 34,172 $ 32,100 $ 2,072 6 %
Services 16,346 12,485 3,861 31 %
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Total $ 50,518 $ 44,585 $ 5,933 13 %
The increase in TS segment product revenue of $2.1 million during the period was the result of a $3.1 million increase in the U.S. division, partially offset by a decrease of approximately $1.0 million in the U.K. division. As the economic environment returns to pre-pandemic levels it has led to customers' budgets not being as constrained as prior year leading to increased sales in the U.S. division. The increase in our U.S. division product revenue year over year was primarily associated with several major customers, partially offset by a decrease with several other customers. The decrease in the U.K. division year over year was primarily associated with a decrease with one major customer. The increase in TS segment service revenue of $3.9 million as compared to the prior year was due to a $4.0 million increase in the U.S. division, partially offset with a $0.1 million decrease in the U.K. division. In fiscal year 2022 as compared to the prior year, the U.S. division had an increase of $1.5 million in managed services, an increase of $1.3 million in services provided by the Company and third party services, and an increase of $1.2 million in third party maintenance revenue.
HPP segment revenue changes by product and services for the fiscal years ended September 30 were as follows:
September 30, Decrease
2022 2021 $ %
(Dollar amounts in thousands)
Products $ 2,516 $ 3,126 $ (610) (20) %
Services 1,327 1,497 (170) (11) %
Total $ 3,843 $ 4,623 $ (780) (17) %
The decrease in HPP product revenue of $0.6 million in the fiscal year ended
September 30, 2022 was primarily the result of an approximately $0.6 million
decrease in Multicomputer product line shipments for the fiscal year ended
September 30, 2022 as compared to the fiscal year ended September 30, 2021. The
decrease in HPP service revenue of approximately $0.2 million for the fiscal
year ended September 30, 2022 period was primarily the result of a $0.4 million
decrease in royalty revenues on high-speed processing boards related to the E2D
program, partially offset with higher ARIA sales of $0.2 million as compared to
the fiscal year ended September 30, 2021.
Our total revenues by geographic area based on the location to which the products were shipped or services rendered were as follows:
September 30, Increase (decrease)
2022 % 2021 % $ %
(Dollar amounts in thousands)
Americas $ 52,486 96 % $ 45,321 92 % $ 7,165 16 %
Europe 1,407 3 % 3,203 7 % (1,796) (56) %
Asia 468 1 % 684 1 % (216) (32) %
Totals $ 54,361 100 % $ 49,208 100 % $ 5,153 10 %
The $7.2 million increase in the Americas revenue for the fiscal year ended September 30, 2022 as compared to the fiscal year ended September 30, 2021 was primarily due to increased revenue by our TS-US division of approximately $7.7 million, partially offset with a decrease of $0.2 million attributable to the TS-UK division combined with decreased sales by our HPP segment of approximately $0.3 million. The $1.8 million decrease in Europe revenue for the fiscal year ended September 30, 2022 as compared to the prior year period was primarily due to decreased sales by our TS-UK division of approximately $1.0 million, a decrease in sales by our TS-US division of approximately $0.5 million, and a decrease of $0.3 million in our HPP segment. The $0.2 million decrease in Asia revenue for the fiscal year ended September 30, 2022 as compared to the prior year period was the result of decreased revenue by our HPP segment of $0.1 million combined with a $0.1 million decrease in our TS-U.S. division.
Gross Margins
Our gross margin ("GM") increased by $2.7 million to $18.8 million for fiscal year 2022 as compared to GM of approximately $16.1 million for fiscal year 2021. The total GM as a percentage of revenue increased to 35% for fiscal
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year 2022 from 33% for fiscal year 2021. The increase in total GM as a
percentage of revenue was primarily attributed to a significantly higher
increase in service revenue, which has a higher GM as a percentage of revenue,
versus product revenue. The improved product GM as a percentage of revenue has
been a focus in fiscal year 2022, particularly in the TS segment. The 8%
decrease in HPP GM as a percentage of revenue from prior year was due to
decreased royalty sales, which are nearly all margin.
The following table summarizes GM changes by segment for fiscal years ended September 30:
September 30,
2022 2021 Increase (decrease)
(Dollar amounts in thousands)
GM$ GM% GM$ GM% GM$ GM%
TS $ 16,879 33 % $ 13,405 30 % $ 3,474 3 %
HPP 1,948 51 % 2,744 59 % (796) (8) %
Total $ 18,827 35 % $ 16,149 33 % $ 2,678 2 %
The impact of product mix within our TS segment on gross margins for the fiscal years ended September 30 was as follows:
September 30,
2022 2021 Increase
GM$ GM% GM$ GM% GM$ GM%
(Dollar amounts in thousands)
Products $ 6,818 20 % $ 5,898 18 % $ 920 2 %
Services 10,061 62 % 7,507 60 % 2,554 2 %
Total $ 16,879 33 % $ 13,405 30 % $ 3,474 3 %
The overall TS segment GM as a percentage of revenue increased to 33% in fiscal
year 2022 from 30% in fiscal year 2021. The increase in GM as a percentage of
revenue was primarily attributed to increased GM as a percentage of revenue for
both product and service revenue than in fiscal year 2021. The $0.9 million
increase in our TS segment product GM in fiscal year 2022 as compared to the
prior year resulted from an increase in GM in the U.S. division. The $2.6
million increase in the TS segment service GM in fiscal year 2022 as compared to
the prior year primarily resulted from increased service GM of $2.7 million in
the U.S. division, partially offset by a decrease of $0.1 million in the U.K.
division.
The impact of product mix on gross margins within our HPP segment for the fiscal years ended September 30 was as follows:
September 30,
2022 2021 Decrease
(Dollar amounts in thousands)
GM$ GM% GM$ GM% GM$ GM%
Products $ 893 35 % $ 1,304 42 % $ (411) (7) %
Services 1,055 80 % 1,440 96 % (385) (16) %
Total $ 1,948 51 % $ 2,744 59 % $ (796) (8) %
The overall HPP segment GM as a percentage of revenue decreased to 51% in
fiscal year 2022 from 59% in fiscal year 2021. The 8% decrease in GM as
a percentage of sales in the HPP segment was primarily attributed to the impact
of a decrease of $0.4 million in high margin Multicomputer royalty revenues,
which is nearly all GM and recorded as service revenue. The GM as a percentage
of sales from products decreased primarily due to product mix in fiscal year
2022 as compared to the prior year.
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Engineering and Development Expenses
Our engineering and development expenses are only in our HPP segment. These expenses had an increase of $0.2 million, primarily due to increased consulting costs, from $2.9 million in fiscal year 2021 to $3.1 million for fiscal year 2022. Fiscal year 2022 and 2021 expenses were primarily for product engineering expenses incurred in connection with the development of the ARIA SDS cyber security products and ARIA Zero Trust (AZT).
Selling, General and Administrative
The following table details our selling, general and administrative ("SG&A")
expenses by operating segment for the years ended September 30, 2022 and 2021:
Year ended $ %
% of % of Increase Increase
2022 Total 2021 Total (Decrease) (Decrease)
(Dollar amounts in thousands)
By Operating Segment:
TS segment $ 12,032 76 % $ 10,190 70 % $ 1,842 18 %
HPP segment 3,751 24 % 4,434 30 % (683) (15) %
Total $ 15,783 100 % $ 14,624 100 % $ 1,159 8 %
The TS segment SG&A spending increase of approximately $1.8 million for the fiscal year ended September 30, 2022 when compared to the prior year was primarily due to an increase in variable compensation of $1.5 million and an increase in salaries and other expenses of $0.3 million.
The HPP segment SG&A spending decrease of $0.7 million for the fiscal year ended September 30, 2022 when compared to the prior year was primarily attributed to decreased headcount and consulting expenses.
Other Income/Expenses
The following table details our other income (expense) for the years ended
September 30, 2022 and 2021:
Year ended
Increase
September 30, 2022 September 30, 2021 (Decrease)
(Amounts in thousands)
Foreign exchange gain (loss) $ 1,692 $(488) $ 2,180 Interest expense (360) (350) (10) Interest income 650 575 75 Gain on debt forgiveness - 2,196 (2,196)
Other income (expense), net (3) 107 (110)
Total other income (expense), net $ 1,979 $ 2,040 $ (61)
For the year ended September 30, 2022 the largest change was the foreign
exchange gain increase of $2.2 million due to the U.S. dollar significantly
strengthening against the British Pound and the largest change for the year
ended September 30, 2021 was a gain on debt forgiveness of $2.2 million for the
Payroll Protection Program loans. These two items had a net effect of nearly
zero. The $0.1 million decrease to total other income (expense), net for the
year ended September 30, 2022 as compared to the prior year period is due to a
nonrecurring rebate we received in the prior year that originated several years
ago, which we did not anticipate receiving.
The U.K. division has significant bank accounts with U.S. dollars and Euros. In
consolidation, U.S. dollars and Euros are remeasured into the functional
currency, British Pounds, of our U.K. subsidiary. This non-cash remeasurement is
included in foreign exchange gain or loss on the income statement and the
foreign exchange gain or loss is primarily from a U.S. Dollar and Euro bank
account. The US dollar and Euro strengthened relative to the British Pound when
comparing the exchange rate as of September 30, 2022 to September 30, 2021,
which caused the foreign exchange gain.
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Interest income is primarily related to agreements that have payment terms in excess of one year (see Note 3 Accounts and Long-Term Receivable in Item 1 to this Annual Report on Form 10-K for details) from the TS-US segment as interest income recognized in each agreement decreases as principal payments are made. There were three new agreements in fiscal year 2022, which caused an increase in interest income. The interest expense increase of $10 thousand for the year ended September 30, 2022 as compared to the prior year period is related to three total new multi-year agreements with vendors in the TS U.S. division in the second and fourth quarters of fiscal year 2021. Payments on these agreements contain both principal and interest expense. In fiscal year 2022 there was a full year of interest expense compared to less than three full quarters in the prior year. As principal payments are made the interest expense decreases and this was slightly offset by the full year of interest expense from these agreements. See Note 9 Accounts payable and accrued expenses, and Other noncurrent liabilities in Item 1 to this Annual Report on Form 10-K. The other income decrease of $110 thousand for the year ended September 30, 2022 as compared to the prior year period is primarily related to a nonrecurring rebate we received in the prior year that originated several years ago, which we did not anticipate receiving.
Income Taxes
The Company recorded an income tax provision of approximately $50 thousand for
the fiscal year ended September 30, 2022, which reflected an effective tax rate
of 2.6% for the year ended September 30, 2022. The provision is primarily driven
by the state tax expense. For the fiscal year ended September 30, 2021, the
income tax provision was $444 thousand, which reflected an effective tax rate of
38.8%. The provision is primarily driven by the recording of a partial valuation
allowance against US deferred tax assets that are not more-likely-than-not to be
realized partially offset by current year federal R&D credits and the benefit
resulting from the carryback of federal net operating losses to years in which
the statutory federal tax rate was 34%.
During the period ended September 30, 2022, management assessed the positive and
negative evidence in the U.S. operations and concluded that it is more likely
than not that the deferred tax assets as of September 30, 2022 will not be
realized in light of recent results, the ongoing impacts of the coronavirus
("COVID-19") pandemic, and the resulting economic fallout. In assessing the
realizability of deferred tax assets, we consider taxable income in prior
carryback years, as permitted under the tax law, our forecasted taxable
earnings, tax planning strategies, and the expected timing of the reversal of
temporary differences. This determination requires significant judgment,
including assumptions about future taxable income that are based on historical
and projected information and is performed on a jurisdiction-by-jurisdiction
basis.
We also continue to maintain a full valuation allowance against our U.K.
deferred tax assets as we have experienced cumulative losses and do not have any
indication that the operation will be profitable in the future to an extent that
will allow us to utilize much of our net operating loss carryforwards. To the
extent that actual experience deviates from our assumptions, our projections
would be affected and hence our assessment of realizability of our deferred tax
assets may change.
Gain on Discontinued Operations
CSPi sold all stock of Modcomp GmbH to Reply AG on July 31, 2018 for $14.4
million cash and a gain of $18.1 million. This sale was recorded in fiscal year
2018. An additional €400 thousand was included in escrow as part of the Share
Purchase and Assignment Agreement to potentially be received later as a purchase
price adjustment in fiscal year 2021. This amount was received in July 2021 and
recorded as a gain from discontinued operations in the Consolidated Statements
of Operations. No income taxes were provided as the transaction was a tax-free
exchange in the U.K. There are no other amounts that will be received as part of
the agreement.
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Liquidity and Capital Resources
Our primary source of liquidity is our cash and cash equivalents, which increased by $4.0 million to $24.0 million as of September 30, 2022 from $20.0 million as of September 30, 2021.
Our significant source of cash for the year ended September 30, 2022 is
primarily related to the $2.9 million net change between an increase in accounts
receivable and long-term receivable of $4.1 million netted with an increase of
$7.0 million in accounts payable and accrued expenses, and other-long-term
liabilities. We have multi-year agreements on both the receivables (including
long-term) and payables (long-term portion in other long-term liabilities).
During the fourth quarter of fiscal year 2022 we entered into a $12.8 million
sales agreement with a financing component, which includes receiving three
payments with the final payment due in fiscal year 2024. We received the first
payment in the fourth quarter of fiscal year 2022 of approximately $4.3 million.
Our cost of sale for this agreement was paid in full in the first quarter of
fiscal year 2023 and significantly decreased our cash balance. This is the
largest driver for the increase in accounts payable. The revenue for this
transaction was recorded net during the fourth quarter of fiscal year 2022. The
other significant sources of cash were net borrowings of $2.2 million on our
line of credit, tax refunds of approximately $0.6 million, and life insurance
proceeds received of $0.3 million.
Other significant uses of cash for the year ended September 30, 2022 included
paying $0.9 million of insurance policy loans back, payments for leases of $0.8
million, repayments on debt of $0.7 million, contributions to the pension and
defined contribution plans of $0.5 million, purchases of common stock of $0.2
million, purchases of property, equipment, and improvements of $0.2 million, and
dividends of $0.1 million.
Our cash held by our foreign subsidiary in the United Kingdom totaled
approximately $8.8 million as of September 30, 2022, which consisted of 0.4
million Euros, 0.2 million British Pounds, and 8.2 million U.S. Dollars. This
cash is included in our total cash and cash equivalents reported within our
financial statements. Due to the pension obligation in the U.K., we maintain a
large balance of cash in the U.K., most of the cash is from the sale of Modcomp
GmbH in fiscal year 2018. Subsequent to September 30, 2022 approximately 3.5
million U.S. Dollars was transferred from the foreign subsidiary in the U.K. to
Modcomp, Inc. (TS-US) to use in operations.
As of September 30, 2022 and September 30, 2021, the Company maintained a line
of credit with a capacity of up to $15.0 million for inventory accessible to
both the HPP and TS segments. This line of credit also includes availability of
a limited cash withdrawal of up to $1.0 million. Amounts of $11.9 million and
$14.1 million were available as of September 30, 2022 and September 30, 2021,
respectively. As of September 30, 2022 and September 30, 2021 there were no cash
withdrawals outstanding. For a further discussion of the Company's line of
credit, including its financial covenants, see Item 1, Note 12 Line of Credit.
On April 17, 2021, the Company and Modcomp, Inc., its wholly owned subsidiary
each received a loan ("SBA Loans") in the form of a promissory note from Paragon
Bank in the amounts of $827,000 and $1,353,600, respectively under the Paycheck
Protection Program, which was established under the recently enacted Coronavirus
Aid, Relief, and Economic Security Act ("CARES Act") administered by the U.S.
Small Business Administration. The SBA loans had a two-year term and carried an
annual fixed interest rate of 1%. The SBA Loans were forgiven in full by the SBA
in the first quarter of fiscal year 2021.
If cash generated from operations is insufficient to satisfy working capital
requirements, we may need to access funds through bank loans or other means. If
we are unable to secure additional financing, we may not be able to complete
development or enhancement of products, take advantage of future opportunities,
respond to competition, retain key employees, or continue to effectively operate
our business.
Based on our current plans and business conditions, management believes that the
Company's available cash and cash equivalents, the cash received from the SBA
loans, the cash generated from operations, and availability on our line of
credit will be sufficient to provide for the Company's working capital and
capital expenditure requirements for at least 12 months from the date of this
filing.
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Critical Accounting Estimates and Policies
Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. On an on-going basis, we evaluate our estimates, including those related to uncollectible receivables, inventory valuation, goodwill and intangibles, income taxes, deferred compensation, revenue recognition, retirement plans, restructuring costs and contingencies. We base our estimates on historical performance and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements: revenue recognition, valuation allowances, specifically the allowance for doubtful accounts and net deferred tax asset valuation allowance, inventory valuation, intangibles, and pension and retirement plans.
Revenue Recognition
See Note 1 Summary of Significant Accounting Policies, in the Consolidated Financial Statements for additional information regarding our revenue recognition policies. The following areas involve significant judgment and estimates:
Allocating transaction price with agreements with multiple components including leasing and/or a financing component
A financing component exists when at contract inception the period between the transfer of a promised good and/or service to the customer differs from when the customer pays for the good and/or service. As a practical expedient, we have elected not to adjust the amount of consideration for effects of a significant financing component when it is anticipated the promised good or service will be transferred and the subsequent payment will be one year or less. Certain contracts contain a financing component including managed services contracts with financing of hardware and software. The interest rate used reflects the approximate interest rate consistent with a separate financing transaction with the customer at the inception of the agreement. Revenues from arrangements which include financing are allocated considering relative standalone selling prices of lease and non-lease components within the agreement. The lease component includes hardware, which is subject to ASC 842, Leases. The non-lease components are subject to ASC 606, Revenue from Contracts with Customers. When product and non-managed services are sold together, the allocation of the transaction price to each performance obligation is calculated based on the estimated relative selling price or a budgeted cost-plus margin approach, as appropriate. Due to the complex nature of these contracts, there is significant judgment in allocating the transaction price. These estimates are periodically reviewed by project managers, engineers, and other staff involved to ensure estimates remain appropriate. For items sold separately, including hardware, software, professional services, maintenance contracts, other services, and third-party service contracts, there is no allocation as there is one performance obligation.
Professional Services Sold Without Products
The input method using labor hours expended relative to the total expected hours
is used to recognize revenue for professional services. Only the hours that
depict our performance toward satisfying a performance obligation are used to
measure progress. An estimate of hours for each professional service agreement
is made at the beginning of each contract based on prior experience and
monitored throughout the performance of the services. This method is most
appropriate as it depicts the measure of progress towards satisfaction of the
performance obligation.
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Gross versus Net Revenue
We recognize revenue from third-party service contracts as either gross sales or
net sales depending on whether we are acting as a principal party to the
transaction or acting as an agent or broker based on control and timing. We are
a principal if we control the good or service before that good or service is
transferred to the customer. We record revenue as gross when we are a principal
party to the arrangement and net of cost when we are acting as a broker or agent
for a third party. Under gross sales recognition, the entire selling price is
recorded in revenue and our cost to the third-party service provider or vendor
is recorded in cost of sales. Under net sales recognition, the cost to the
third-party service provider or vendor is recorded as a reduction to revenue
resulting in net sales equal to the gross profit on the transaction. Third-party
service contracts are sold in different combinations with hardware, software,
and services. When we are an agent, revenue is typically recorded at a point in
time. When we are the principal, revenue is recognized over the contract term.
We have concluded we are the agent in sales of third-party maintenance, software
or hardware support, and certain security software that is sold with integral
third-party delivered software maintenance that include critical updates.
Product Warranty Accrual
Our product sales generally include a 90-day to three-year hardware warranty. At time of product shipment, we accrue for the estimated cost to repair or replace potentially defective products. Estimated warranty costs are based upon prior actual warranty costs for substantially similar products.
Engineering and Development Expenses
Engineering and development expenses include payroll, employee benefits, stock-based compensation and other headcount-related expenses associated with product development. Engineering and development expenses also include third-party development and programming costs. We consider technological feasibility for our software products to be reached upon the release of the software, accordingly, no internal software development costs have been capitalized.
Income Taxes
We use the asset and liability method of accounting for income taxes whereby
deferred tax assets and liabilities are recognized for the estimated future tax
consequences attributable to differences between the financial statement
carrying amounts of existing assets and liabilities and their respective tax
bases. Deferred tax assets and liabilities are measured using enacted tax rates
in effect for the year in which those temporary differences are expected to be
recovered or settled. The effect on deferred tax assets and liabilities of a
change in tax rates is recognized in income in the period that includes the
enactment date. We also reduce deferred tax assets by a valuation allowance if,
based on the weight of available evidence, it is more likely than not that some
portion or all of the recorded deferred tax assets will not be realized in
future periods. This methodology requires estimates and judgments in the
determination of the recoverability of deferred tax assets and in the
calculation of certain tax liabilities. Valuation allowances are recorded
against the gross deferred tax assets that management believes, after
considering all available positive and negative objective evidence, historical
and prospective, with greater weight given to historical evidence, that it is
more likely than not that these assets will not be realized.
In addition, we are required to recognize in the consolidated financial
statements, those tax positions determined to be more-likely-than-not of being
sustained upon examination, based on the technical merits of the positions as of
the reporting date. If a tax position is not considered more-likely-than-not to
be sustained based solely on its technical merits, no benefits of the position
are recognized.
In addition, the calculation of the Company's tax liabilities involves dealing
with uncertainties in the application of complex tax regulations in a multitude
of jurisdictions. The Company records liabilities for estimated tax obligations
in the U.S. and other tax jurisdictions. These estimated tax liabilities include
the provision for taxes that may become payable in the future.
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Intangible Assets
Intangible assets that are not subject to amortization are also required to be tested annually, or more frequently if events or circumstances indicate that the asset may be impaired. We did not have intangible assets with indefinite lives at any time during the two years ended September 30, 2022. Intangible assets subject to amortization are amortized over their estimated useful lives, generally three to ten years, and are carried at net book value. The remaining useful lives of intangible assets are evaluated on an annual basis. If the fair value of an intangible asset subject to amortization is determined to be less than its carrying value, then an impairment charge is recorded to write down that asset to its fair value.
Inventories
Inventories are stated at the lower of cost or market, with cost determined using the first-in, first-out method. The recoverability of inventories is based upon the types and levels of inventories held, forecasted demand, pricing, competition and changes in technology. We write down our inventory for estimated obsolescence or unmarketable inventory equal to the difference between the cost of inventory and the estimated market value based upon assumptions about future demand and market conditions. If actual market conditions are less favorable than those projected by management, additional inventory write-downs may be required.
Pension and Retirement Plans
The funded status of pension and other post-retirement benefit plans is recognized prospectively on the consolidated balance sheet. Gains and losses, prior service costs and credits and any remaining transition amounts that have not yet been recognized through pension expense will be recognized in accumulated other comprehensive loss, net of tax, until they are amortized as a component of net periodic pension/post-retirement benefits expense. Additionally, plan assets and obligations are measured as of our fiscal year-end balance sheet date (September 30). We have defined benefit and defined contribution plans in the U.K. and in the U.S. In the U.K., the Company provides defined benefit pension plans for certain employees and former employees and defined contribution plans for the majority of the employees. The defined benefit plans in the U.K. are closed to newly hired employees and have been for the two years ended September 30, 2022. In the U.S., the Company provides defined contribution plans that cover most employees and supplementary retirement plans to certain employees and former employees who are now retired. These supplementary retirement plans are also closed to newly hired employees and have been for the two years ended September 30, 2022. These supplementary plans are funded through whole life insurance policies. The Company expects to recover all insurance premiums paid under these policies in the future, through the cash surrender value of the policies and any death benefits or portions thereof to be paid upon the death of the participant. These whole life insurance policies are carried on the balance sheet at their cash surrender values as they are owned by the Company and not assets of the defined benefit plans. In the U.S., the Company also provides for officer death benefits and post-retirement health insurance benefits through supplemental post-retirement plans to certain officers. The Company also funds these supplemental plans' obligations through whole life insurance policies on the officers. Pension expense is based on an actuarial computation of current future benefits using estimates for expected return on assets, expected compensation increases and applicable discount rates. Management has reviewed the discount rates and rates of return with our consulting actuaries and investment advisers and concluded they were reasonable. A decrease in the expected return on pension assets would increase pension expense. Expected compensation increases are estimated based on historical and expected increases in the future. Increases in estimated compensation increases would result in higher pension expense while decreases would lower pension expense. Discount rates are selected based upon rates of return on high quality fixed income investments currently available and expected to be available during the period to maturity of the pension benefit. A decrease in the discount rate would result in greater pension expense while an increase in the discount rate would decrease pension expense.
The Company funds its pension plans in amounts sufficient to meet the requirements set forth in applicable employee benefits laws and local tax laws. Liabilities for amounts in excess of these funding levels are accrued and reported in the consolidated balance sheets.
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Inflation and Changing Prices
Management does not believe that inflation and changing prices had significant
impact on sales, revenues or income during fiscal years 2022 or 2021. However,
we have seen a trend of significantly increasing prices, specifically with
integrated circuit vendors. We try to pass these price increases to our
customers, but certain economic factors and technological advances have placed
downward pressure on pricing. There is no assurance that the Company's business
will not be materially and adversely affected by inflation and changing prices
in the future.
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