Item 7. Management’s Discussion and Analysis
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
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 (COVID-19)
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. The Company continues to comply with such actions causing most employees to work remotely in all locations. Due to the pandemic, revenue decreased significantly for the fiscal year ended September 30, 2020 compared to fiscal year ended September 30, 2019. The largest driver of this revenue decrease was our customers having budgetary cuts or holds. However, we do anticipate returning to a regular volume of business in the future when the economy is fully open. In our HPP segment, companies have delayed decisions to purchase ARIA due to the pandemic. The pandemic has also had an adverse effect on our ability to transact one-on-one business in both segments. Due to the uncertainty of the pandemic, including but not limited to, regulatory measures or voluntary actions that have and may be put in place to limit the spread of COVID-19 and the duration of such measures, the impact of any further spread of COVID-19, or the resurgence of COVID-19 in a given geographic region after it has hit its “peak,” at this time, and the timing and rollout of any approved vaccine to combat the spread of COVID-19, we cannot make a reasonable estimate on the extent or duration of the impacts on our business.
Please refer to Item 1A Risk Factors located in Part I in this Annual Report on Form 10-K for discussion of the risks related to COVID-19 on our business, financial condition, and results of operations.
Overview of Fiscal 2020 Results of Operations
Revenue decreased by approximately $17.3 million, or 22%, to $61.8 million for the fiscal year ended September 30, 2020 versus $79.1 million for the fiscal year ended September 30, 2019.
Gross profit margin percentage increased, from 23% of revenues for the fiscal year ended September 30, 2019 to 28% for the fiscal year ended September 30, 2020.
We generated an operating loss of approximately $1.4 million for the fiscal year ended September 30, 2020 as compared to an operating loss of approximately $0.8 million for the fiscal year ended September 30, 2019.
The Company recorded an income tax provision of approximately $384 thousand, which reflected an effective tax rate of (36.2%), for the year ended September 30, 2020. 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 34.0%.
We identified an immaterial error in the first three quarters of fiscal year 2020 related to the recognition of certain revenue as “net,” when in fact the revenue should have been recorded on as “gross” basis. We revised the first three quarters of fiscal year 2020 for this error, which increased total sales and total cost of sales on the Consolidated Statements of Operations for these periods. The revision did not affect total gross profit, net income, or earnings per share. There were no effects on the Consolidated Balance Sheets or Consolidated Statements of Cash Flows. A summary of revisions for our previously reported financial statements are disclosed within this Form 10-K under Note 20.
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The following table details our results of operations in dollars and as a percentage of sales for the fiscal years ended:
%
%
September 30, 2020
of sales
September 30, 2019
of sales
(Dollar amounts in thousands)
Sales
$
61,793
100
%
$
79,061
100
%
Costs and expenses:
Cost of sales
44,626
71
%
61,035
77
%
Engineering and development
2,798
5
%
2,800
4
%
Selling, general and administrative
15,793
26
%
16,052
20
%
Total costs and expenses
63,217
102
%
79,887
101
%
Operating loss
(1,424)
(2)
%
(826)
(1)
%
Other income
362
—
%
384
—
%
Loss before income taxes
(1,062)
(2)
%
(442)
(1)
%
Income tax expense (benefit)
384
—
%
(71)
—
%
Net loss
$
(1,446)
(2)
%
$
(371)
(1)
%
Revenues
Revenue decreased by approximately $17.3 million, or 22%, to $61.8 million for the fiscal year ended September 30, 2020 versus $79.1 million for the fiscal year ended September 30, 2019. Our TS segment revenue decreased by approximately $15.2 million, or 21%, consisting of a decrease of $11.3 million in our U.S. division combined with a decrease of $3.9 million in our U.K. division. Our HPP segment revenue decreased by approximately $2.0 million, or 26%, primarily due to decreased product revenue of $3.0 million, partially offset by increased service revenue of $1.0 million.
TS segment revenue changes by products and services for the fiscal years ended September 30 were as follows:
Decrease
2020
2019
$
%
(Dollar amounts in thousands)
Products
$
44,588
$
59,611
$
(15,023)
(25)
%
Services
11,329
11,548
(219)
(2)
%
Total
$
55,917
$
71,159
$
(15,242)
(21)
%
The decrease in TS segment product revenue of $15.0 million during the period was the result of an $11.0 million decrease in the U.S. division combined with a decrease of $4.0 million in the U.K. division. Customers’ budgets have been cut or put on hold in the short term due to the pandemic leading to significantly decreased sales. The decrease in our U.S. division product revenue year over year was primarily associated with several major customers, partially offset by a significant increase with one customer. The decrease in the U.K. division year over year was primarily associated with a decrease with one major customer. The decrease in TS segment service revenue of $0.2 million as compared to the prior year was due to a $0.3 million decrease in the U.S. division, partially offset by a $0.1 million increase in the U.K. division. In fiscal year 2020 as compared to the prior year, the U.S. division had a decrease of $2.2 million in internal services and a decrease of $0.4 million from third party maintenance and services, partially offset by an increase of $2.4 million in managed services.
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HPP segment revenue changes by product and services for the fiscal years ended September 30 were as follows:
Increase (decrease)
2020
2019
$
%
(Dollar amounts in thousands)
Products
$
3,401
$
6,406
$
(3,005)
(47)
%
Services
2,475
1,496
979
65
%
Total
$
5,876
$
7,902
$
(2,026)
(26)
%
The decrease in HPP product revenue of $3.0 million in the fiscal year ended September 30, 2020 was primarily the result of an approximately $1.8 million decrease in Myricom product line shipments combined with a $1.2 million decrease in Multicomputer product line shipments for the fiscal year ended September 30, 2020 as compared to the fiscal year ended September 30, 2019. This is primarily due to the pandemic affecting customers’ budgets. The increase in HPP service revenue of approximately $1.0 million for the period was primarily the result of an approximately a $1.0 million increase in royalty revenues on high-speed processing boards related to the E2D program during the fiscal year ended September 30, 2020 as compared to the fiscal year ended September 30, 2019.
Our total revenues by geographic area based on the location to which the products were shipped or services rendered were as follows:
Decrease
2020
%
2019
%
$
%
(Dollar amounts in thousands)
Americas
$
59,178
95
%
$
72,522
92
%
$
(13,344)
(18)
%
Europe
2,282
4
%
4,056
5
%
(1,774)
(44)
%
Asia
333
1
%
2,483
3
%
(2,150)
(87)
%
Totals
$
61,793
100
%
$
79,061
100
%
$
(17,268)
(22)
%
The $13.3 million decrease in the Americas revenue for the fiscal year ended September 30, 2020 as compared to the fiscal year ended September 30, 2019 was primarily due to decreased revenue by our TS segment of approximately $13.0 million consisting of a decrease of $10.9 million from the U.S. division and a $2.1 million decrease from the U.K. 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, 2020 as compared to the prior year period was primarily due to decreased sales by our TS-UK division of approximately $1.4 million, a decrease in sales by our TS-US division of approximately $0.3 million, and a decrease in sales by our HPP segment of approximately $0.1 million. The $2.2 million decrease in Asia revenue for the fiscal year ended September 30, 2020 as compared to the prior year period was primarily the result of decreased revenue by our HPP segment of $1.6 million combined with a $0.6 million decrease in our TS-U.K. division.
Gross Margins
Our gross margins ("GM") decreased by approximately $0.8 million to $17.2 million for fiscal year 2020 as compared to GM of $18.0 million for fiscal year 2019. The GM as a percentage of revenue increased to 28% for fiscal year 2020 from 23% for fiscal year 2019. The increase in GM as a percentage of revenue was primarily attributed to a higher percentage of service revenue relative to product revenue in the HPP segment and a large decrease in TS segment product revenue with significantly improved margins relative to a slight decrease in service revenue. The improved margins are from large lower margin deals in fiscal year 2019 that did not reoccur in fiscal year 2020.
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The following table summarizes GM changes by segment for fiscal years ended September 30:
2020
2019
Increase (Decrease)
(Dollar amounts in thousands)
GM$
GM%
GM$
GM%
GM$
GM%
TS
$
13,553
24
%
$
13,889
20
%
$
(336)
4
%
HPP
3,614
62
%
4,137
52
%
(523)
10
%
Total
$
17,167
28
%
$
18,026
23
%
$
(859)
5
%
The impact of product mix within our TS segment on gross margins for the fiscal years ended September 30 was as follows:
2020
2019
Increase (Decrease)
GM$
GM%
GM$
GM%
GM$
GM%
(Dollar amounts in thousands)
Products
$
6,842
15
%
$
7,462
13
%
$
(620)
2
%
Services
6,711
59
%
6,427
56
%
284
3
%
Total
$
13,553
24
%
$
13,889
20
%
$
(336)
4
%
The overall TS segment GM as a percentage of revenue increased to 24% in fiscal year 2020 from 20% in fiscal year 2020. The increase in GM as a percentage of revenue was primarily attributed to a large relative decrease in TS segment product revenue compared to a slight decrease in service revenue in fiscal year 2020 as compared to the prior year. Additionally, both product and service GM as a percentage of revenue increased from prior year. The $0.6 million decrease in our TS segment product GM in fiscal year 2020 as compared to the prior year resulted from a decrease in GM in the U.S. division of $0.3 million combined with a decrease in the U.K division of $0.3 million. The $0.3 million increase in the TS segment service GM in fiscal year 2020 as compared to the prior year primarily resulted from increased GM as a percentage of revenue in the U.S. division despite a slight decrease in service revenue.
The impact of product mix on gross margins within our HPP segment for the fiscal years ended September 30 was as follows:
2020
2019
Increase (Decrease)
(Dollar amounts in thousands)
GM$
GM%
GM$
GM%
GM$
GM%
Products
$
1,240
36
%
$
2,719
42
%
$
(1,479)
(6)
%
Services
2,374
96
%
1,418
95
%
956
1
%
Total
$
3,614
62
%
$
4,137
52
%
$
(523)
10
%
The overall HPP segment GM as a percentage of revenue increased to 62% in fiscal year 2020 from 52% in fiscal year 2019. The 10% increase in GM as a percentage of sales in the HPP segment was primarily attributed to the impact of an increase of $1.0 million in high margin Multicomputer royalty revenues and decreased GM from product revenue as a result of decreased Multicomputer product revenue, which has a higher GM as a percentage of sales. The GM as a percentage of sales from products decreased primarily due to product mix in fiscal year 2020 as compared to the prior year.
Engineering and Development Expenses
Our engineering and development expenses are only in our HPP segment. These expenses remained relatively flat at $2.8 million for fiscal year 2020 as compared to fiscal year ended 2019. Fiscal year 2020 and 2019 expenses were primarily for product engineering expenses incurred in connection with the development of the ARIA SDS cyber security products.
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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, 2020 and 2019:
For the year ended September 30,
% of
% of
$ Increase
% Increase
2020
Total
2019
Total
(decrease)
(decrease)
(Dollar amounts in thousands)
By Operating Segment:
TS segment
$
11,247
71
%
$
11,630
72
%
$
(383)
(3)
%
HPP segment
4,546
29
%
4,422
28
%
124
3
%
Total
$
15,793
100
%
$
16,052
100
%
$
(259)
(2)
%
For fiscal year 2020 compared to fiscal year 2019, the TS segment SG&A spending decrease of approximately $0.4 million was primarily due to a decrease in variable compensation and salaries of $0.3 million and a decrease of $0.1 million for travel expense.
For fiscal year 2020 compared to fiscal year 2019, the HPP segment SG&A spending increase of $0.1 million was primarily attributed to increased employees in the sales department.
Other Income/Expenses
The following table details our other income/expenses for the years ended September 30, 2020 and 2019:
For the year ended
$ Increase
September 30, 2020
September 30, 2019
(Decrease)
(Amounts in thousands)
Interest expense
$
(228)
$
(99)
$
(129)
Interest income
582
323
259
Foreign exchange (loss) gain
(2)
157
(159)
Other income, net
10
3
7
Total other income (expense), net
$
362
$
384
$
(22)
The $22 thousand decrease to total other income (expense), net for the year ended September 30, 2020 as compared to the year ended September 30, 2019 is primarily driven by an increase of interest expense of $129 thousand and a decrease in foreign exchange gain of $159 thousand causing a foreign exchange loss of $2 thousand, partially offset by an increase in increase in interest income of $259 thousand.
The increase in interest income of $259 thousand is primarily related to agreements that have payment terms in excess of one year (see Note 2 Accounts and Long-Term Receivables) from the U.S. division of the TS Segment.
Income Taxes
The Company recorded an income tax provision of approximately $384 thousand, which reflected an effective tax rate of (36.2%), for the year ended September 30, 2020. 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 34.0%. For the year ended September 30, 2019, the income tax benefit was approximately $71 thousand, which reflected an effective tax rate of 16.1%. The tax benefit included an increase in the valuation allowance for net operating losses for state income tax related to the High Performance Products segment in which the Company also had a reversal of the uncertain tax position of $54 thousand as the statute of limitations have expired.
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During the period ended September 30, 2020, management assessed the positive and negative evidence in the U.S. operations, and concluded that it is more likely than not that a portion of its deferred tax assets as of September 30, 2020 will not be realized in light of recent results, the COVID-19 pandemic, and the resulting economic fallout. In determining the amount of the valuation allowance to record, the Company considered taxable income in prior carryback years for U.S. federal tax purposes and the reversal of existing taxable temporary differences as sources of taxable income against which a portion of its U.S. deferred tax assets is benefitted. The Company recorded a full valuation allowance against the remaining U.S. deferred tax assets in excess of these sources of taxable income. It should be noted however, that the amount of the deferred tax asset not to be realized could be adjusted in future years if estimates of taxable income during the carryforward periods are increased, or if there is objective positive evidence in the form of cumulative earnings.
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.
Liquidity and Capital Resources
Our primary source of liquidity is our cash and cash equivalents, which increased by approximately $1.2 million to $19.3 million as of September 30, 2020 from $18.1 million as of September 30, 2019.
Significant sources of cash for the year ended September 30, 2020 included proceeds from debt of $4.2 million including a $0.8 million and $1.4 million at CSP Inc. and Modcomp, Inc., respectively, under the Payroll Protection Program (see details below), a decrease in accounts and long-term receivable of $3.4 million, a decrease in other assets of $2.1 million, and a decrease in inventories of $2.1 million. Partially offsetting these significant sources of cash for the year ended September 30, 2020 were a decrease in accounts payable and accrued expenses of $8.0 million, dividends paid of $1.3 million, repayments on debt of $1.1 million, and net payments under line-of-credit agreement of $0.9 million.
On April 17, 2020, CSP, Inc. and Modcomp, Inc., its wholly owned subsidiary (collectively, the “Borrowers”) each received a loan in the form of a promissory note from Paragon Bank (“Lender”) in the amounts of $827,000 and $1,353,600, respectively (the “SBA Loans”) 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 (“SBA”). The SBA Loans have a two-year term and carry an annual fixed interest rate of 1%.
Under the Paycheck Protection Program, the SBA Loans provide for customary events of default, including, among others, those relating to failure to make payment, bankruptcy, materially false or misleading representations to Lender or SBA, and adverse changes in the financial condition or business operations that Lender believes may materially affect Borrowers’ ability to pay the SBA Loans. The Borrowers did not provide any collateral or guarantees for the SBA Loans and the Borrowers may prepay the principal of the SBA Loans at any time without penalty.
The Borrowers applied to the Lender for forgiveness of an amount due on the SBA Loans in an amount equal to the sum of certain costs during the 24-week period beginning on the date of the first disbursement of the SBA Loans. Subsequent to September 30, 2020 and as of the date of this filing, we have received notice of forgiveness from the SBA for the SBA Loans.
C ash held by our foreign subsidiary in the United Kingdom totaled approximately $9.9 million as of September 30, 2020, which consists of 0.8 million euros, 0.3 million British Pounds, and 8.5 million U.S. Dollars. This cash is included in our total cash and cash equivalents reported above. There were $1.5 million Euros converted to U.S. Dollars during the year ended September 30, 2020.
As of September 30, 2020 and September 30, 2019, the Company maintained an inventory line of credit with a borrowing capacity of $15.0 million and $20.0 million, respectively. It may be used by the TS or HPP segment in the
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U.S. to purchase inventory from approved vendors with payment terms which exceed those offered by the vendors. No interest accrues under the inventory line of credit when advances are paid within terms, however, late payments are subject to an interest charge published in the Wall Street Journal as the “prime rate” plus 5%. The prime rate was 3.25% as of September 30, 2020. The credit agreement for the inventory line of credit contains financial covenants which require the Company to maintain the following TS segment-specific financial ratios: (1) a minimum current ratio of 1.2, (2) tangible net worth of no less than $4.0 million, and (3) a maximum ratio of total liabilities to total net worth of less than 5.0:1. As of September 30, 2020 and September 30, 2019, Company borrowings, all from the TS segment, under the inventory line of credit were $1.6 million and $2.5 million, respectively, and the Company was in compliance with all covenants. As of September 30, 2020 and September 30, 2019, this line of credit also included availability of a limited cash withdrawal of up to $1.0 million and $1.5 million, respectively. As of September 30, 2020 and September 30, 2019 there were no cash withdrawals outstanding. The amount of the inventory line of credit and cash withdrawal was lowered to $15.0 million in September of 2020 primarily due to lack of need for full use of the line.
If cash generated from operations is insufficient to satisfy working capital requirements, we may need to access funds through bank loans, the equity markets, 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.
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
On October 1, 2018 the Company adopted Accounting ASU No. 2014-09, Revenue from Contracts with Customers (ASC 606) , which requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. The standard outlines a five-step model whereby revenue is recognized as performance obligations within a contract are satisfied. The standard also requires new, expanded disclosures regarding revenue recognition. The ASU replaces most existing revenue recognition guidance in GAAP. 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:
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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, the Company has 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 using a budgeted cost-plus margin approach. 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 are 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 the Company’s performance toward satisfying a performance obligation are used for progress. An estimate for professional services is made at the beginning of each contract based on prior experience and monitored throughout the services. This method is most appropriate as it depicts the measure of progress towards satisfaction of the performance obligation.
Gross versus Net Revenue
We recognize revenue from third-party service contracts as either gross sales or net sales, when the Company has fulfilled its obligation under its purchase order or contract depending on whether the Company is acting as a principal party to the transaction or simply acting as an agent or broker based on control and timing of the goods/services. The Company is a principal if it controls the good or service before that good or service is transferred to the customer. We record revenue as gross when the Company is a principal party to the arrangement and net of cost when we are acting as a broker or agent. 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 goods sold. 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. We have determined the third-party services contracts are a single performance obligation in each sale. When the Company is an agent, revenue is typically recorded at a point in time when the sale is complete. When the Company is the principal, revenue is recognized over the contract term.
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.
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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 at any time during the two years ended September 30, 2020. 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. 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.
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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, 2020. 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, 2020. 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.
Inflation and Changing Prices
Management does not believe that inflation and changing prices had significant impact on sales, revenues or income during fiscal years 2020 or 2019. 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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