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[December 20, 2012]
CSP INC /MA/ - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations
(Edgar Glimpses Via Acquire Media NewsEdge) The discussion below contains certain forward-looking statements related to statements concerning future revenues and future business plans. Actual results may vary from those contained in such forward-looking statements.
Overview of Fiscal 2012 Results of Operations CSP Inc. operates in two segments: • Systems - the Systems segment consists of our MultiComputer Division which designs, commercially develops and manufactures signal processing computer platforms that are used primarily in military applications and the process control and data acquisition ("PCDA") proprietary hardware business of our Modcomp subsidiary.
• Service and System Integration - the Service and System Integration segment includes the computer systems' maintenance and integration services and third-party computer hardware and software products businesses of our Modcomp subsidiary.
Highlights include: • Revenue increased by approximately $11.2 million, or 15%, to $84.8 million for the year ended September 30, 2012 versus $73.6 million for the year ended September 30, 2011.
• For the year ended September 30, 2012, we had an operating profit of approximately $5.0 million versus an operating profit of approximately $0.8 million for the year ended September 30, 2011, for an increase of approximately $4.2 million.
• For the year ended September 30, 2012, net income was approximately $6.6 million, which includes $1.7 million of tax benefit versus net income of approximately $0.4 million for the year ended September 30, 2011, for an increase of approximately $6.2 million.
• Net cash provided by operating activities was approximately $6.3 million for the year ended September 30, 2012 compared to net cash provided by operating activities of $1.5 million for the year ended September 30, 2011.
The increase in revenues of $11.2 million referred to above resulted from significant growth in revenues from both our Systems and our Service and System Integration segments. Revenues in the Systems segment increased from $7.8 million for fiscal 2011 to $11.1 million for fiscal 2012 for an increase of approximately $3.3 million, while, in our Service and System Integration segment revenues increased by approximately $7.8 million from $65.8 million the year ended September 30, 2011 to $73.7 million for the year ended September 30, 2012.
The revenue increase in the Systems segment was largely driven by higher royalty revenues which were $6.4 million for fiscal 2012 versus $1.7 million in fiscal 2011. Royalty revenues are particularly significant because there is no cost of sales associated with royalty revenues, hence the profit margin is 100% on this revenue. This $4.7 million increase in royalty revenue was partially offset by lower product revenue in fiscal 2012 versus fiscal 2011 which decreased product revenue by $1.4 million.
In the Service and System Integration segment we experienced significant growth in both product and service revenues. Product revenues for the segment increased by $6.3 million which was a 13% increase from $49.1 million in fiscal 2011 to $55.4 million in fiscal 2012. Service revenue in the segment increased by $1.6 million which was a 9% increase from $16.7 million in fiscal 2011 to $18.3 million in fiscal 2012. The product revenue increase was derived in large part from our German operation, where product sales increased by $4.1 million. This increase was due substantially to a significant contract with a large European telecommunications customer, pursuant to which we were engaged as a significant supplier for their global IT security infrastructure build out. The increase in services revenue in the segment was derived entirely from our German operation and was also as a result of this telecommunications customer.
In assessing the outlook for fiscal 2013, anticipating that we will not realize significant royalty revenue, we must assume a less optimistic view for the Systems segment for next year in comparison to the robust operating results we realized for fiscal 2012. In addition, based on the risks associated with the economic environment within the defense market, we plan to manage the Systems segment assuming relatively weak demand for fiscal 2013. In the Service and System Integration segment, we will continue to have a cautiously optimistic outlook for fiscal 2013, in terms of revenue, where much will depend upon the level of overall growth in the private sector economy both domestically and in our European markets. We plan to focus our attention and resources in the Service and System Integration segment on higher-margin business and away from low margin business as we move forward. While this may put pressure on sales growth in fiscal 2013, we believe this strategy will achieve profitable growth for the long term.
17--------------------------------------------------------------------------------The following table details our results of operations in dollars and as a percentage of sales for the years ended September 30, 2012 and 2011: September % September % 30, 2012 of sales 30, 2011 of sales (Dollar amounts in thousands) Sales $ 84,807 100 % $ 73,645 100 % Costs and expenses: Cost of sales 64,386 76 % 57,276 78 % Engineering and development 1,720 2 % 1,785 2 % Selling, general and administrative 15,847 19 % 13,775 19 % Total costs and expenses 81,953 97 % 72,836 99 % Income from proceeds of officer life insurance settlement 2,115 3 % - - Operating income 4,969 6 % 809 1 % Other expense (100 ) - (94 ) - Income before income taxes 4,869 6 % 715 1 % Income tax expense (benefit) (1,740 ) (2 )% 346 - Net income $ 6,609 8 % $ 369 1 % Sales The following table details our sales by operating segment for the years ended September 30, 2012 and 2011: Service and System % of Systems Integration Total Total (Dollar amounts in thousands) For the Year Ended September 30, 2012: Product $ 4,214 $ 55,369 $ 59,583 70 % Services 6,927 18,297 25,224 30 % Total $ 11,141 $ 73,666 $ 84,807 100 % % of Total 13 % 87 % 100 % Service and System % of Systems Integration Total Total For the Year Ended September 30, 2011: Product $ 5,624 $ 49,110 $ 54,734 74 % Services 2,198 16,713 18,911 26 % Total $ 7,822 $ 65,823 $ 73,645 100 % % of Total 11 % 89 % 100 % Service and System % Systems Integration Total increase Increase (Decrease) Product $ (1,410 ) $ 6,259 $ 4,849 9 % Services 4,729 1,584 6,313 33 % Total $ 3,319 $ 7,843 $ 11,162 15 % % increase 42 % 12 % 15 % 18-------------------------------------------------------------------------------- As shown above, total revenues increased by approximately $11.2 million, or 15%, for the year ended September 30, 2012 compared to the year ended September 30, 2011. Revenue in the Systems segment increased for the current year versus the prior year by approximately $3.3 million, while revenues in the Service and System Integration segment increased by approximately $7.8 million.
Product revenues increased by approximately $4.8 million, or 9%, for the year ended September 30, 2012 compared to the comparable period of the prior fiscal year. Product revenues in the Service and System Integration segment increased by approximately $6.3 million while in the Systems segment product revenue decreased by approximately $1.4 million for the year ended September 30, 2012 versus the year ended September 30, 2011.
In the US division of the Service and System Integration segment, product sales increased by approximately $0.8 million, sales in this segment's German division increased by of approximately $4.1 million and in the UK division sales increased by approximately $1.3 million.
In the US division, product sales were bolstered by sales to several new customers in both the IT Infrastructure, Higher Education and Healthcare industry verticals. While we did experience decreases in sales to some of our prior year large customers across several industry verticals, the acquisition of new customers was enough to overcome the decreases in product sales to previously acquired customers. Therefore, while we experienced significant customer turnover, the pipeline for sales to new customers more than made up for the turnover.
In Germany, the $4.1 million increase was net of an unfavorable foreign currency impact of approximately $1.3 million, which means on a volume basis in constant dollars the increase was approximately $5.4 million. This sales volume increase was driven by increased sales to the division's largest customer, a large UK-based wireless carrier, of approximately $4.6 million, and sales to a newly acquired customer of $5.7 million. There can be no assurance that there will be significant sales to either or both of these customers in the future. These increases were offset by decreases to two of the divisions long-term customers. The aggregate decrease in sales volume to these two customers amounted to approximately $3.3 million. Additionally, sales to all other customers in the German division decreased by an aggregate of approximately $1.6 million.
The increase in sales in the UK division was the result of increased third party product sales versus the prior year. This was the result of the Company's efforts to start up a third-party reseller business, offering a wider array of third-party technology products within the UK operation.
The decrease in product revenues in the Systems segment of approximately $1.4 million was due to a decrease in sales to our Japanese defense department customer of approximately $0.2 million, and a decrease of $1.2 million in sales of parts, components and spares to existing US defense department customers.
As shown in the table above, service revenues increased by approximately $6.3 million, or 33%. This increase was made up of an increase in the Systems segment of $4.7 million and an increase in the Service and System Integration segment of approximately $1.6 million. The increase in the Systems segment service revenue was due to higher royalty income recorded in the year ended September 30, 2012 which was approximately $6.4 million versus $1.7 million for the year ended September 30, 2011. The increase in service revenues in the Service and System Integration segment was primarily from the German division, where service revenue increased by approximately $1.7 million. In Germany, there was an unfavorable currency fluctuation impact to service revenues of approximately $1.0 million, which means sales volume in constant dollars increased by approximately $2.7 million. This increase in sales volume was driven by increased service revenues to the German division's largest customer, a UK-based wireless carrier, of approximately $2.8 million, offset by decreases in service revenues of approximately $0.1 million of all other customers combined.
Our sales by geographic area, based on the location to which the products were shipped or services rendered, are as follows: For the Year ended, September 30, September 30, $ Increase % Increase 2012 % 2011 % (Decrease) (Decrease) (Dollar amounts in thousands) Americas $ 47,163 56 % $ 43,528 59 % $ 3,635 8 % Europe 34,053 40 % 26,273 36 % 7,780 30 % Asia 3,591 4 % 3,844 5 % (253 ) (7 )% Totals $ 84,807 100 % $ 73,645 100 % $ 11,162 15 % The increase in Americas revenue for the year ended September 30, 2012 versus the year ended September 30, 2011 was primarily the result of the fluctuations described above in the Systems segment where combined product and service sales to US customers increased by an aggregate $3.6 million.
The increase in sales in Europe was primarily the result of the higher sales described above from the German and UK divisions of the Service and System Integration segment. The decrease in Asia sales was the result of the decrease in sales to our existing customer that supplies a large Japanese defense program (see discussion above).
19--------------------------------------------------------------------------------Cost of Sales, Gross Profit and Gross Margins The following table details our cost of sales, gross profit and gross margins by operating segment for the fiscal years ended September 30, 2012 and 2011: Service and System % of Systems Integration Total Total (Dollar amounts in thousands) For the Year Ended September 30, 2012: Cost of Sales: Product $ 2,508 $ 47,718 $ 50,226 78 % Services 283 13,877 14,160 22 % Total $ 2,791 $ 61,595 $ 64,386 100 % % of Total 4 % 96 % 100 % % of Sales 25 % 84 % 76 % Gross Profit: Product $ 1,706 $ 7,651 $ 9,357 46 % Services 6,644 4,420 11,064 54 % Total $ 8,350 $ 12,071 $ 20,421 100 % % of Total 41 % 59 % 100 % Gross Margins: Product 40 % 14 % 16 % Services 96 % 24 % 44 % Total 75 % 16 % 24 % For the Year Ended September 30, 2011: Cost of Sales: Product $ 2,391 $ 42,419 $ 44,810 78 % Services 330 12,136 12,466 22 % Total $ 2,721 $ 54,555 $ 57,276 100 % % of Total 5 % 95 % 100 % % of Sales 35 % 83 % 78 % Gross Profit: Product $ 3,233 $ 6,691 $ 9,924 61 % Services 1,868 4,577 6,445 39 % Total $ 5,101 $ 11,268 $ 16,369 100 % % of Total 31 % 69 % 100 % Gross Margins: Product 57 % 14 % 18 % Services 85 % 27 % 34 % Total 65 % 17 % 22 % Increase (decrease) Cost of Sales: Product $ 117 $ 5,299 $ 5,416 12 % Services (47 ) 1,741 1,694 14 % Total $ 70 $ 7,040 $ 7,110 12 % % Increase (decrease) 3 % 13 % 12 % % of Sales (10 )% 1 % (2 )% Gross Profit: Product $ (1,527 ) $ 960 $ (567 ) (6 )% Services 4,776 (157 ) 4,619 72 % Total $ 3,249 $ 803 $ 4,052 25 % % increase (decrease) 64 % 7 % 25 % Change in Gross Margin percentage: Product (17 )% - (2 )% Services 11 % (3 )% 10 % Total 10 % (1 )% 2 % 20-------------------------------------------------------------------------------- Total cost of sales increased by approximately $7.1 million when comparing the year ended September 30, 2012 versus the year ended September 30, 2011. This increase in cost of sales of 12% overall is consistent with the increase in sales of 15% overall as described previously. The resulting higher gross profit margin ("GPM") of 24% for the year ended September 30, 2012 versus 22% for 2011 was due to several factors which are discussed below.
In the Service and System Integration segment, the overall GPM was 16% for the year ended September 30, 2012 versus 17% for the prior year. Product GPM in the segment remained unchanged at 14% when comparing the year ended September 30, 2012 to the year ended September 30, 2011, while the segment's service GPM decreased from 27% to 24%. This decrease in service GPM was attributable primarily to increased costs of training new billable service engineer employees due to significant employee turnover in the German division of the segment. Additionally, we experienced greater use of contractors versus in-house resources to provide billable services in Germany.
In the Systems segment, the overall GPM increased from 65% to 75% as shown in the table above. This was because in the current year period, royalty revenue, which carries a 100% GPM, made up a much greater percentage of total Systems segment revenue (57%), versus the prior year royalty revenue which was 21% of total Systems segment revenue. Offsetting the favorable GPM impact of the greater royalty revenue in the current year however, was the impact of significantly lower product GPM in the current year versus the prior year. As shown in the table above, the GPM on product sales was 40% for the current year versus the prior year product GPM of 57%. This is due to the current year lower volume of production and product sales resulting in proportionately lower absorption of fixed factory overhead, therefore these fixed costs were proportionately higher versus production and sales volume, which resulted in the low GPM on product sales in the current year. In addition, we incurred significantly higher nonrecurring engineering charges for re-tooling and other services from our outside fabrication houses for the year ended September 30, 2012 versus the prior year.
21--------------------------------------------------------------------------------Engineering and Development Expenses The following table details our engineering and development expenses by operating segment for the year ended September 30, 2012 and 2011: For the Year ended, September 30, % of September 30, % of 2012 Total 2011 Total $ Decrease % Decrease (Dollar amounts in thousands) By Operating Segment: Systems $ 1,720 100 % $ 1,785 100 % $ (65 ) (4 )% Service and System Integration - - - - - - Total $ 1,720 100 % $ 1,785 100 % $ (65 ) (4 )% The $0.1 million decrease in engineering and development expenses displayed above was due to lower engineering consulting expenditures in connection with the development of the next generation of MultiComputer products in the Systems segment.
Selling, General and Administrative The following table details our selling, general and administrative ("SG&A") expense by operating segment for the years ended September 30, 2012 and 2011: For the Year ended, September 30, % of September 30, % of 2012 Total 2011 Total $ Increase % Increase (Dollar amounts in thousands) By Operating Segment: Systems $ 5,515 35 % $ 3,908 28 % $ 1,607 41 % Service and System Integration 10,332 65 % 9,867 72 % 465 5 % Total $ 15,847 100 % $ 13,775 100 % $ 2,072 15 % The increase in SG&A expense in the Systems segment was was due in part to approximately $0.7 million in higher incentive compensation expense resulting from the higher revenues, gross profit and operating results for the year ended September 30, 2012, versus the prior year and a decrease in the cash surrender value of officer life insurance policies of approximately $1.0 million, related to a policy on our former chief executive, who became deceased in fiscal 2012. The increase in the Service & System Integration segment was due to an increase in incentive compensation expense from the more favorable revenue, gross profit and overall operating results for the year ended September 30, 2012 versus the comparable period in the prior year.
Proceeds from officer life insurance settlement We recognized approximately $2.1 million for the settlement from a life insurance policy for our former chief executive officer, who died during fiscal 2012. We received the cash proceeds from this settlement subsequent to year end, in October 2012.
22--------------------------------------------------------------------------------Other Income/Expenses The following table details our other income/expenses for the years ended September 30, 2012 and 2011: For the Year ended, September 30, September 30, Increase 2012 2011 (Decrease) (Amounts in thousands) Interest expense $ (85 ) $ (86 ) $ 1 Interest income 44 44 - Foreign exchange gain (loss) (60 ) (16 ) (44 ) Other income (expense), net 1 (36 ) 37 Total other expense, net $ (100 ) $ (94 ) $ (6 ) Other income (expense), net, for the years ended September 30, 2012 and 2011was not significant nor was the change from the prior year period to that of the current year.
Income Taxes The Company recorded an income tax benefit of approximately $1.7 million, which reflected an effective tax benefit rate of (36)% for the year ended September 30, 2012, compared to income tax expense of approximately $0.3 million for the year ended September 30, 2011, which reflected an effective tax rate of 48%.
We realized a tax benefit for the year ended September 30, 2012, despite the fact that we had positive earnings before taxes for the year. This was because we reduced the valuation allowance on our deferred tax assets, which had been accumulated over the past several years. The recording and ultimate reversal of valuation allowances for our deferred tax asset requires significant judgment associated with past and projected performance. In assessing the realizability of deferred tax assets, we consider our taxable future earnings and the expected timing of the reversal of temporary differences. In prior years, we recorded a valuation allowance which reduced the gross deferred tax asset to an amount that we believed was more likely than not to be realized because our inability to project future profitability beyond fiscal year 2012 in the U.S. and cumulative losses incurred in recent years in the United Kingdom represented sufficient negative evidence to record a valuation allowance against certain deferred tax assets.
As of September 30, 2012, management assessed the positive and negative evidence in the U.S operations, and estimated we will have sufficient future taxable income to utilize the existing deferred tax assets. Significant objective positive evidence included the cumulative profits that we realized over the most recent years. This evidence enhances our ability to consider other subjective evidence such as our projections for future growth. Other factors we considered are the likelihood for continued royalty income in future years, and our expectation that the Service and Systems Integration segment will continue to be profitable in future years. On the basis of this evaluation, as of September 30, 2012, we have concluded that our US deferred tax asset is more likely than not to be realized. Therefore, we reversed the U.S. valuation allowance of $3.0 million, resulting in an overall tax benefit for the year ended September 30, 2012. It should be noted however, that the amount of the deferred tax asset realized could be adjusted in future years, if estimates of taxable income during the carryforward periods are reduced, or if objective negative evidence in the form of cumulative losses is present.
We continue to maintain a full valuation allowance against our United Kingdom 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.
Liquidity and Capital Resources Our primary source of liquidity is our cash and cash equivalents, which increased by approximately $4.6 million to $20.5 million as of September 30, 2012 from $15.9 million as of September 30, 2011. At September 30, 2012, cash equivalents consisted of money market funds which totaled $3.5 million.
23 -------------------------------------------------------------------------------- Significant sources of cash for the year ended September 30, 2012 included net income of approximately $6.6 million, an increase in A/P and accrued expenses of approximately $1.6 million, an increase in deferred revenue of approximately $0.8 million, a decrease in inventories of approximately $0.5 million, a decrease in accounts receivable of approximately $0.8 million, a decrease in cash surrender value of officers' life insurance of approximately $0.9 million and depreciation and amortization of approximately $0.4 million. Offsetting these sources of cash, significant uses of cash were an increase in officer life insurance settlement receivable of approximately $2.2 million, a decrease in deferred tax assets of approximately $2.9 million, an increase in other assets of approximately $0.7 million, purchases of property and equipment of $0.6 million and payment of dividends of approximately $0.8 million.
Cash held by our foreign subsidiaries located in Germany and the United Kingdom totaled approximately $9.8 million as of September 30, 2012 and $5.6 million as of September 30, 2011. This cash is included in our total cash and cash equivalents reported above. We consider this cash to be permanently reinvested into these foreign locations because repatriating it would result in unfavorable tax consequences. Consequently, it is not available for activities that would require it to be repatriated to the U.S.
If cash generated from operations is insufficient to satisfy working capital requirements, we may need to access funds through bank loans or other means.
There is no assurance that we will be able to raise any such capital on terms acceptable to us, on a timely basis or at all. 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 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 generated from operations and availability on our lines of credit will be sufficient to provide for the Company's working capital and capital expenditure requirements for the foreseeable future.
24--------------------------------------------------------------------------------Critical Accounting 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 The Company recognizes product revenue from customers at the time of transfer of title and risk of loss which is generally at the time of shipment, provided that persuasive evidence of an arrangement exists, the price is fixed or determinable and collectability of sales proceeds is reasonably assured. We include freight billed to our customers as sales and the related freight costs as cost of sales.
The Company reduces revenue for estimated customer returns.
The Company recognizes revenue from software licenses when persuasive evidence of an arrangement exists, delivery of the product has occurred and the fee is fixed or determinable and collectability is probable. When delivery of services accompany software sales, and vendor specific objective evidence does not exist, and the only undelivered element is services that do not involve significant modification, or customization, of software, then the entire fee is recognized as the services are performed. If no pattern of performance is discernible, the fee is recognized straight line over the service period.
The Company also offers training, maintenance agreements and support services.
The Company has established fair value on its training, maintenance and support services based on prices charged in separate sales to customers at prices established and published in its standard price lists. These prices are not discounted. Revenue from these service obligations under maintenance contracts is deferred and recognized on a straight-line basis over the contractual period, which is typically three to twelve months, if all other revenue recognition criteria have been met. Support services provided on a time and material basis are recognized as provided if all of the revenue recognition criteria have been met for that element and the support services have been provided. Training revenue is recognized when performed.
In certain multiple-element revenue arrangements, the Company is obligated to deliver to its customers multiple products and/or services ("multiple elements"). In these transactions, the Company allocates the total revenue to be earned under the arrangement among the various elements based on the Company's best estimate of the standalone selling price. The allocation is based on vendor specific objective evidence, third party evidence or estimated selling price when that element is sold separately. The Company recognizes revenue related to the delivered products or services only if the above revenue recognition criteria are met and the delivered element has standalone value.
In October 2009, the FASB issued Accounting Standards Update ("ASU") 2009-13 - "Multiple-Deliverable Revenue Arrangements-a Consensus of the FASB Emerging Issues Task Force" ("ASU 2009-13") and ASU 2009-14 - "Certain Revenue Arrangements that Contain Software Elements." ("ASU 2009-14"). ASU 2009-13 amended previously existing revenue recognition accounting principles regarding multiple-deliverable revenue arrangements. The consensus provides accounting principles and application guidance on whether multiple deliverables exist, how the arrangement should be separated, and how the consideration should be allocated. This guidance eliminates the requirement to establish verifiable, objective evidence of the fair value of undelivered products and services and also eliminates the residual method of allocating arrangement consideration. The new guidance provides for separate revenue recognition based upon management's estimate of the selling price for an undelivered item when there is no other means to determine the fair value of that undelivered item. Under the previous guidance, if the fair value of all of the elements in the arrangement was not determinable, then revenue was deferred until all of the items were delivered or fair value was determined. This pronouncement was effective prospectively for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010, with early adoption permitted.
ASU 2009-14 removes the sale of tangible products containing software components and non-software components that function together to deliver the tangible product's essential functionality from the scope of software revenue recognition guidance. The Company adopted these standards as of October 1, 2009.
25 -------------------------------------------------------------------------------- Adoption of the new revenue recognition guidance has had an impact on the pattern and timing of revenue recognition. In some cases, revenue that would have been deferred pursuant to the previously existing multiple-element revenue recognition guidance, has been recognized pursuant to the newly issued guidance. This is because in some cases we are not able to determine vendor-specific objective evidence ("VSOE") or third-party evidence of the service element in our arrangements. Under the new guidance, because the requirement to determine fair value of undelivered elements has been eliminated, and we may use estimated selling price to allocate revenue to elements in an arrangement, we are now more likely to be able to separate arrangements into separate units of accounting, and thereby recognize the delivered elements (typically product revenue) without having delivered the other elements in the arrangements (typically services).
Description of multiple-deliverable arrangements and Software Elements In many cases, our multiple-deliverable arrangements involve initial shipment of hardware (including tangible products that include software and non-software elements), software products and subsequent delivery of services which add value to the products that have been shipped. In some instances, services are performed prior to product shipment, but more typically services are performed subsequent to shipment of the hardware products. The timing of the delivery and performance of deliverables may vary case-by-case. We evaluate whether we can determine VSOE or third-party evidence to allocate revenue among the various elements in an arrangement. When VSOE or third-party evidence cannot be determined, we use estimated selling prices to allocate revenue to the various elements. Estimated selling prices are determined using the targeted gross margin for each element and calculating the gross revenue for each element that would have been required to achieve the targeted gross margin, and allocating revenue to each element based on those relative values.
Typically, product revenue which may consist of hardware (including tangible products that include software and non-software elements) and/or software elements are recognized upon shipment, or when risk of loss passes to the customer. Services elements are typically recognized upon completion for fixed-price service arrangements, and as services are performed for time and materials service arrangements. For software elements that include services that do not involve significant production, modification or customization, and VSOE does not exist, the entire fee allocable to that element is recognized as the services are performed. If no pattern of performance is discernible, the fee is recognized straight line over the service period. The period over which services are delivered typically ranges from approximately sixty to ninety days, or longer in some cases.
For tangible products containing software components and non-software components, we determine whether these elements function together to deliver the tangible product essential functionality. If the software and non-software components of the tangible product function together to deliver the tangible product's essential functionality, software revenue recognition guidance is not applied, but rather other appropriate revenue recognition guidance as described above.
The following policies are applicable to the Company's major categories of segment revenue transactions: Systems Segment Revenue Revenue in the Systems segment consists of product and service revenue.
Generally, product revenue is recognized when product is shipped, provided that all revenue recognition criteria are met. Service revenue consists principally of royalty revenue related to the licensing of certain of the Company's proprietary system technology and repair services. The Company recognizes royalty revenues upon notification by the customer of shipment of the systems produced pursuant to the royalty agreement. Repair service revenue is generally based upon a fixed price and is recognized upon completion of the repair.
From time to time we enter into multiple element arrangements in the Systems segment. We follow the accounting policies described above for such arrangements.
The Company's standard sales agreements generally do not include customer acceptance provisions. However, in certain instances when arrangements include a customer acceptance provision or there is uncertainty about customer acceptance, revenue is deferred until the Company has evidence of customer acceptance.
Customers generally do not have the right of return, once customer acceptance has occurred.
Service and System Integration Segment Revenue Revenue in the Service and System Integration segment consists of product and service revenue.
Revenue from the sale of third-party hardware and third-party software is recognized when the revenue recognition criteria are met. The Company's standard sales agreements generally do not include customer acceptance provisions.
However, in certain instances when arrangements include a customer acceptance provision or there is uncertainty about customer acceptance, revenue is deferred until the Company has evidence of customer acceptance. Customers do not have the right of return.
26-------------------------------------------------------------------------------- Service revenue is comprised of information technology consulting development, installation, implementation and maintenance services. We follow the accounting policies described above for service transactions. For arrangements that include a customer acceptance provision, or if there is uncertainty about customer acceptance of services rendered, revenue is deferred until the Company has evidence of customer acceptance.
For sales that are financed by customers through leases with a third party, when risk of loss does not pass to the customer until the lease is executed, revenue is recognized upon cash receipt and execution of the lease.
We sell certain third party service contracts, which are evaluated to determine whether the sale of such service revenue should be recorded as gross sales or net sales in accordance with the sales recognition criteria as required by accounting principles generally accepted in the U.S. We must determine whether we act as a principal in the transaction and assume the risks and rewards of ownership or if we are simply acting as an agent or broker. Under gross sales recognition, the entire selling price is recorded in sales and our cost to the third-party service provider or vendor is recorded in cost of goods sold. Under net sales recognition, the cost to the third-party service provider or vendor is recorded as a reduction to sales resulting in net sales equal to the gross profit on the transaction and there are no costs of goods sold. We use the net sales recognition method for the third party service contracts that we sell when we are not the primary obligor on the contract. We use the gross sales recognition for the third party service contracts that we sell when we act as principal and are the primary obligor.
Product Warranty Accrual Our product sales generally include a 90-day to one-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.
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 other than goodwill at any time during the two years ended September 30, 2012.
Intangible assets subject to amortization are amortized over their estimated useful lives, generally three to ten years, and are carried at cost, less accumulated amortization. The remaining useful lives of intangible assets are evaluated on an annual basis. Intangible assets subject to amortization are also tested for recoverability whenever events or changes in circumstances indicate that their carrying amount may not be recoverable. 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.
27--------------------------------------------------------------------------------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 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 income, 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 United Kingdom (the "U.K."), Germany and in the U.S. In the U.K. and Germany, 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 both the U.K. and Germany are closed to newly hired employees and have been for the two years ended September 30, 2012. In the U.S., the Company also 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, 2012. 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 advisor 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.
New Accounting Pronouncements In June 2011, the FASB issued Accounting Standards Update 2011-05, Comprehensive Income (Topic 220) - Presentation of Comprehensive Income ("ASU 2011-05"), which requires all non-owner changes in stockholders' equity to be presented either in a single continuous statement of comprehensive income or in two separate but consecutive statements. ASU 2011-05 is effective for fiscal years and interim periods within those years beginning after December 15, 2011.
Inflation and Changing Prices Management does not believe that inflation and changing prices had significant impact on sales, revenues or income (loss) during fiscal 2012 or 2011. There is no assurance that the Company's business will not be materially and adversely affected by inflation and changing prices in the future.
28 --------------------------------------------------------------------------------Item 8. Financial Statements and Supplementary Data The consolidated financial statements are included herein.
Page Report of Independent Registered Public Accounting Firm 35 Consolidated Balance Sheets as of September 30, 2012 and 2011 36 Consolidated Statements of Operations for the years ended September 30, 2012 and 2011 37 Consolidated Statements of Shareholders' Equity and Comprehensive income (loss) for the years ended September 30, 2012 and 2011 38 Consolidated Statements of Cash Flows for the years ended September 30, 2012 and 2011 39 Notes to Consolidated Financial Statements 40
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