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 2013 Results of Operations
CSPI 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.
Key results include:
• Revenue increased by approximately
for the year ended
• For year ended
officer life insurance settlement of approximately
such income was recognized in the ended
the settlement during the current fiscal year. • For the year ended
September 30, 2013, we had an operating profit of
$5.0 millionfor the year ended September 30, 2012, for a decrease of approximately $4.3 million.
• For the year ended
million versus net income of approximately
$6.6 millionfor the year ended September 30, 2012, for an decrease of approximately $6.2 million.
• Net cash provided by operating activities was approximately
for the year ended
September 30, 2013compared to net cash provided by operating activities of $6.3 millionfor the year ended September 30, 2012. The increase in revenues of $2.8 millionresulted from strong growth in revenues from our Service and System Integration segment partially offset by a decrease in revenues from our Systems segment. Revenues in the Service and System Integration segment increased by approximately $7.0 millionfrom $73.7 millionthe year ended September 30, 2012to $80.6 millionfor the year ended September 30, 2013, while Systems segment revenue decreased from $11.1 millionfor fiscal 2012 to $7.0 millionfor fiscal 2013 for a decrease of approximately $4.1 million. In the Service and System Integration segment we experienced growth in both product and service revenues. Product revenues for the segment increased by $5.0 million, which was a 9% increase from $55.4 millionin fiscal 2012 to $60.4 millionin fiscal 2013. Service revenue in the segment increased by $2.0 millionwhich was an 11% increase from $18.3 millionin fiscal 2012 to $20.3 millionin fiscal 2013. The product revenue increase was derived in large part from our U.S. operation, where product sales increased by approximately $14.1 million. The increase in services revenues was due substantially to an increase in the German division, where service revenue increased by approximately $1.2 millionand an increase in the US division of approximately $0.7 million. In Germany, the increase was driven by service sales to new customers of approximately $0.8 millionand favorable foreign exchange of approximately $0.2 million. In the US division, the increase in service revenues was from higher third party maintenance revenue. The revenue decrease in the Systems segment was largely the result of lower royalty revenues which were $6.4 millionfor fiscal 2012 versus $0.8 millionin fiscal 2013. 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 $5.6 milliondecrease in royalty revenue was partially offset by higher product revenue in fiscal 2013 versus fiscal 2012 which increased by approximately $1.3 million. In assessing the outlook for fiscal 2014, we expect to receive orders for royalties to fulfill a full rate production phase of the E2D program during the year. As a result, anticipating that we will realize significant royalty revenue, we are assuming a more optimistic view for the Systems segment for next year in comparison to the operating results we realized for fiscal 2013. 15 -------------------------------------------------------------------------------- However, based on the risks associated with the economic environment within the defense market, we plan to manage the Systems segment with a cautiously optimistic outlook for fiscal 2014. In the Service and System Integration segment, we also have a cautiously optimistic outlook for fiscal 2014, 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 consulting and managed service business as we move forward. While this may put pressure on sales growth in fiscal 2014, we believe this strategy will achieve profitable growth for the long term.
The following table details our results of operations in dollars and as a percentage of sales for the years ended
% % September 30, 2013 of sales September 30, 2012 of sales (Dollar amounts in thousands) Sales $ 87,619 100 % $ 84,807 100 % Costs and expenses: Cost of sales 69,036 79 % 64,386 76 % Engineering and development 1,857 2 % 1,720 2 % Selling, general and administrative 16,025 18 % 15,847 19 % Total costs and expenses 86,918 99 % 81,953 97 % Income from proceeds of officer life insurance settlement - - % 2,115 3 % Operating income 701 1 % 4,969 6 % Other expense (12 ) - % (100 ) - % Income before income taxes 689 1 % 4,869 6 % Income tax expense (benefit) 321 - % (1,740 ) (2 )% Net income $ 368 1 % $ 6,609 8 % Sales The following table details our sales by operating segment for the years ended
September 30, 2013and 2012: Service and System % of Systems Integration Total Total (Dollar amounts in thousands) For the Year Ended September 30, 2013: Product $ 5,483 $ 60,361 $ 65,84475 % Services 1,517 20,258 21,775 25 % Total $ 7,000 $ 80,619 $ 87,619100 % % of Total 8 % 92 % 100 % Service and System % of Systems Integration Total Total For the Year Ended September 30, 2012: Product $ 4,214 $ 55,369 $ 59,58370 % Services 6,927 18,297 25,224 30 % Total $ 11,141 $ 73,666 $ 84,807100 % % of Total 13 % 87 % 100 % 16
Service and System % Systems Integration Total increase Increase (Decrease) Product
$ 1,269 $ 4,992 $ 6,26111 % Services (5,410 ) 1,961 (3,449 ) (14 )% Total $ (4,141 ) $ 6,953 $ 2,8123 % % increase (37 )% 9 % 3 % As shown above, total revenues increased by approximately $2.8 million, or 3%, for the year ended September 30, 2013compared to the year ended September 30, 2012. Revenue in the Service and System Integration segment increased by approximately $7.0 million, while revenues in the Systems segment decreased for the current year versus the prior year by approximately $4.1 million. Product revenues increased by approximately $6.3 million, or 11%, for the year ended September 30, 2013compared to the prior fiscal year. Product revenues in the Service and System Integration segment increased by approximately $5.0 millionwhile in the Systems segment product revenue increased by approximately $1.3 millionfor the year ended September 30, 2013versus the year ended September 30, 2012. In the US division of the Service and System Integration segment, product sales increased by approximately $14.1 million, sales in this segment's German division decreased by approximately $8.2 millionand in the UKdivision product sales decreased by approximately $0.9 million. In the US division, the increase in product sales was due in part to sales to new customers (customers to which no sales were made in the prior year), which totaled approximately $5.0 millionfor the year ended September 30, 2013. In addition, sales increased to large existing customers in the IT hosting vertical by an aggregate of approximately $13.6 million. These increases were partially offset by aggregate net decreases to existing customers across all other verticals of approximately $4.5 million. In Germany, the $8.2 milliondecrease in product revenue was driven by decreased sales to the division's largest customer, a large UK-based wireless carrier, to which product sales decreased by approximately $3.2 million. In addition, product sales to another of the division's largest customers from the previous year decreased by approximately $5.3 million. Partially offsetting these decreases, new customer sales totaled approximately $1.2 million. Sales to all other customers decreased by a net of approximately $0.9 million. The decrease in product sales in the UKdivision was the result of weaker demand from our UKcustomer base in the current-year. The increase in product revenues in the Systems segment of approximately $1.3 millionwas due to an increase of $1.4 millionin sales of parts, components and spares to existing US defense department customers, and an increase of $0.6 milliondue to hardware sales to a commercial customer. These increases were partially offset by a decrease in sales to our Japanese defense department customer of approximately $0.7 million. As shown in the table above, service revenues decreased by approximately $3.4 million, or 14%. This decrease was made up of a decrease in the Systems segment of $5.4 millionand an increase in the Service and System Integration segment of approximately $2.0 million. The decrease in the Systems segment service revenue was due to lower royalty revenue recorded in the year ended September 30, 2013which was approximately $0.8 millionversus $6.4 millionfor the year ended September 30, 2012. The increase in service revenues in the Service and System Integration segment was primarily from the German division, where service revenue increased by approximately $1.2 millionand an increase in the US division of approximately $0.7 million. In Germany, the increase was driven by service sales to new customers of approximately $0.8 millionand favorable foreign exchange of approximately $0.2 million. In the US division, the increase in service revenues was from higher third party maintenance revenue. 17 --------------------------------------------------------------------------------
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 2013 % 2012 % (Decrease) (Decrease) (Dollar amounts in thousands) Americas
$ 59,11668 % $ 47,16356 % $ 11,95325 % Europe 25,512 29 % 34,053 40 % (8,541 ) (25 )% Asia 2,991 3 % 3,591 4 % (600 ) (17 )% Totals $ 87,619100 % $ 84,807100 % $ 2,8123 % The increase in Americasrevenue for the year ended September 30, 2013versus the year ended September 30, 2012was from an increase in the US division of the Service and System Integration segment to customers in the Americasof approximately $15.5 million, partially offset by decreases in sales to US customers in the Systems segment of approximately $3.6 million. The decrease in sales in Europewas primarily the result of the lower sales in the German and UKdivisions of the Service and System Integration segment. The decrease in Asiasales was the result of the decrease in sales to our existing customer that supplies a large Japanese defense program (see discussion above). 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, 2013and 2012: Service and System % of Systems Integration Total Total (Dollar amounts in thousands) For the Year Ended September 30, 2013: Cost of Sales: Product $ 2,439 $ 51,584 $ 54,02378 % Services 270 14,743 15,013 22 % Total $ 2,709 $ 66,327 $ 69,036100 % % of Total 4 % 96 % 100 % % of Sales 39 % 82 % 79 % Gross Profit: Product $ 3,044 $ 8,777 $ 11,82164 % Services 1,247 5,515 6,762 36 % Total $ 4,291 $ 14,292 $ 18,583100 % % of Total 23 % 77 % 100 % Gross Margins: Product 56 % 15 % 18 % Services 82 % 27 % 31 % Total 61 % 18 % 21 % For the Year Ended September 30, 2012: Cost of Sales: Product $ 2,508 $ 47,718 $ 50,22678 % Services 283 13,877 14,160 22 % Total $ 2,791 $ 61,595 $ 64,386100 % % of Total 4 % 96 % 100 % % of Sales 25 % 84 % 76 % 18
Service and System % of Systems Integration Total Total Gross Profit: Product
$ 1,706 $ 7,651 $ 9,35746 % Services 6,644 4,420 11,064 54 % Total $ 8,350 $ 12,071 $ 20,421100 % % of Total 41 % 59 % 100 % Gross Margins: Product 40 % 14 % 16 % Services 96 % 24 % 44 % Total 75 % 16 % 24 % Increase (decrease) Cost of Sales: Product $ (69 ) $ 3,866 $ 3,7978 % Services (13 ) 866 853 6 % Total $ (82 ) $ 4,732 $ 4,6507 % % Increase (decrease) (3 )% 8 % 7 % % of Sales 14 % (2 )% 3 % Gross Profit: Product $ 1,338 $ 1,126 $ 2,46426 % Services (5,397 ) 1,095 (4,302 ) (39 )% Total $ (4,059 ) $ 2,221 $ (1,838 )(9 )% % increase (decrease) (49 )% 18 % (9 )% Change in Gross Margin percentage: Product 16 % 1 % 2 % Services (14 )% 3 % (13 )% Total (14 )% 2 % (3 )% Total cost of sales increased by approximately $4.7 millionwhen comparing the year ended September 30, 2013versus the year ended September 30, 2012. A significant factor which caused this increase in cost of sales was the overall increase in sales as discussed previously, however whereas sales increased by 3%, cost of sales increased by 7% . The resulting lower gross profit margin ("GPM") of 21% for the year ended September 30, 2013versus 24% for 2012 was due to several factors which are discussed below. In the Systems segment, the overall GPM decreased from 75% to 61% as shown in the table above. This was because in fiscal year 2013 royalty revenue, which carries a 100% GPM, was $0.8 million, or 11% of total Systems segment revenue, versus the prior year royalty revenue which was $6.4 millionor 57% of total Systems segment revenue. Partially offsetting the unfavorable GPM impact of the lower royalty revenue in the current year however, was the impact of higher product GPM in the current year versus the prior year. As shown in the table above, the GPM on product sales was 56% for the current year versus the prior year product GPM of 40%. This is due to the current year higher volume of production and product sales resulting in proportionately greater absorption of fixed factory overhead, therefore these fixed costs were proportionately lower versus production and sales volume, which resulted in the low GPM on product sales in the prior year. In the Service and System Integration segment, the overall GPM was 18% for the year ended September 30, 2013versus 16% for the prior year. Product GPM in the segment increased to 15% from 14% when comparing the year ended September 30, 2013to the year ended September 30, 2012, while the segment's service GPM also increased from 24% to 27%. The increase in the product GPM was due to smaller deal size and more favorable product mix in fiscal year 2013 versus fiscal 2012, while the increase in service GPM was due primarily to higher utilization of in-house service engineers in providing billable services in Germany, and higher third-party maintenance revenue for the current fiscal year versus the prior year. 19
Engineering and Development Expenses
The following table details our engineering and development expenses by operating segment for the year ended
For the Year ended, % of % of September 30, 2013 Total September 30, 2012 Total $ Decrease % Decrease (Dollar amounts in thousands) By Operating Segment: Systems $ 1,857 100 % $ 1,720 100 %
$ 1378 % Service and System Integration - - - - - - Total $ 1,857 100 % $ 1,720 100 % $ 1378 % The $0.1 millionincrease in engineering and development expenses displayed above was due to higher 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, 2013and 2012: For the Year ended, % of % of September 30, 2013 Total September 30, 2012 Total $ Increase % Increase (Dollar amounts in thousands) By Operating Segment: Systems $ 4,037 25 % $ 5,515 35 % $ (1,478 )(27 )% Service and System Integration 11,988 75 % 10,332 65 % 1,656 16 % Total $ 16,025 100 % $ 15,847 100 % $ 1781 % SG&A expenses increased in the Service and System Integration segment by approximately $1.7 millionwhen comparing the fiscal year ended September 30, 2013versus the prior year. This increase was due primarily to higher commissions and other incentive compensation expense which increased by approximately $0.7 million, due to the higher gross profit, and operating profit in the segment, higher salary expenses for additional headcount and promotions of approximately $0.9 million. The decrease in SG&A expense in the Systems segment was due in large part to a non-recurring reduction in the cash surrender value of officer life insurance of approximately $0.9 million, related to a policy on our former chief executive, who died in fiscal 2012. In addition, retirement expense was lower by approximately $0.4 millionand bonus expense was lower by approximately $0.5 millionthe year ended September 30, 2013, versus the prior year. The reductions in expenses were partially offset by higher legal expenses of approximately $0.3 millionin connection with a proxy challenge during the year ended September 30, 2013.
Proceeds from officer life insurance settlement
In fiscal year 2012, we recognized approximately
$2.1 millionfor the settlement from a life insurance policy for our former chief executive officer, who died during fiscal 2012. No such settlements occurred during for the fiscal year ended September 30, 2013. 20 --------------------------------------------------------------------------------
The following table details our other income/expenses for the years ended
For the Year ended, September 30, 2013 September 30, 2012 Increase (Decrease) (Amounts in thousands) Interest expense $ (86 ) $ (85 ) $ (1 ) Interest income 32 44 (12 ) Foreign exchange gain (loss) (18 ) (60 ) 42 Other income (expense), net 60 1 59 Total other expense, net $ (12 ) $ (100 ) $ 88
Other income (expense), net, for the years ended
The Company recorded an income tax expense of approximately
$0.3 million, which reflected an effective tax expense rate of 47% for the year ended September 30, 2013, compared to income tax benefit of approximately $1.7 millionfor the year ended September 30, 2012, which reflected an effective tax benefit rate of 36%. As of September 30, 2013, 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, 2013, we have concluded that our US deferred tax asset is more likely than not to be realized. 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 such as cumulative losses is present. 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 reversed the U.S. valuation allowance of $3.0 millionon our deferred tax assets, which had been accumulated over the past several years, resulting in this overall tax benefit. 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 Kingdomrepresented sufficient negative evidence to record a valuation allowance against certain deferred tax assets. We continue to maintain a full valuation allowance against our United Kingdomdeferred 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 decreased by approximately
$1.9 millionto $18.6 millionas of September 30, 2013from $20.5 millionas of September 30, 2012. At September 30, 2013, cash equivalents consisted of money market funds which totaled $3.5 million.
Significant sources of cash for the year ended
Significant uses of cash included a decrease in accounts payable and accrued expenses of approximately
$3.3 million, payment of dividends of approximately $1.4 million, an increase in accounts receivable of approximately $1.1 millionand purchases of property and equipment of $0.9 million. Cash held by our foreign subsidiaries located in Germanyand the United Kingdomtotaled approximately $6.6 millionas of September 30, 2013and $9.8 millionas of September 30, 2012. 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. 22 --------------------------------------------------------------------------------
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.
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, in accordance with
Financial Accounting Standards Board("FASB") Accounting Standards Codification ("FASC") Section 985-605-25 Software - Revenue Recognition ("FASC 985-605-25"). 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. In accordance with FASC 985-605-25, 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 is followed. 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. The Company follows Sections 605-25 Revenue Recognition - Multiple Element Arrangements ("FASC 605-25"). FASC 605-25 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 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. 23 -------------------------------------------------------------------------------- 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. In accordance with FASC 605-25, we evaluate whether we can determine Vendor Specific Objective Evidence ("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. 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. 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 FASC 605-45 Principal Agent Considerations. 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 24 --------------------------------------------------------------------------------
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.
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 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, 2013. 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. 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. 25
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."), Germanyand 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 Germanyare closed to newly hired employees and have been for the two years ended September 30, 2013. 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, 2013. 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. Inflation and Changing Prices Management does not believe that inflation and changing prices had significant impact on sales, revenues or income (loss) during fiscal 2013 or 2012. There is no assurance that the Company's business will not be materially and adversely affected by inflation and changing prices in the future. 26