Leonardo DRS, Inc. 10-K

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA 89 Report of Independent Registered Public Accounting Firm To the Shareholders and the Board of Directors of Leonardo DRS, Inc. Opinion on the Financial Statements We have audited the accompanying consolidated balance sheet of Leonardo DRS, Inc. (the Company) as of December 31, 2022, the related consolidated statements of earnings, comprehensive income, cash flows and shareholders' equity for the year then ended, and the related notes (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company at December 31, 2022, and the results of its operations and its cash flows for the year then ended in conformity with U.S. generally accepted accounting principles. Basis for Opinion These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on the Company’s financial statements based on our audit. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. As part of our audit we are required to obtain an understanding of internal control over financial reporting but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. Our audit included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audit also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audit provides a reasonable basis for our opinion. Critical Audit Matters The critical audit matters communicated below are matters arising from the current period audit of the financial statements that were communicated or required to be communicated to the audit committee and that: (1) relate to accounts or disclosures that are material to the financial statements and (2) involved our especially challenging, subjective or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the consolidated financial statements, taken as a whole, and we are not, by communicating the critical audit matters below, providing separate opinions on the critical audit matters or on the accounts or disclosures to which they relate. 90 Revenue recognition based on the percentage of completion method Description of the Matter As described in Note 3 to the consolidated financial statements, revenues for the majority of contracts are recognized over time using the percentage of completion cost-to-cost method of accounting. Under this method, the costs incurred represent an appropriate measure of progress toward satisfaction of performance obligations as this measure most accurately depicts the progress of work performed and transfer of control to the customers. Due to the long-term nature of many contracts, developing the estimated total cost at completion and total transaction price often requires judgment. Factors that must be considered in estimating the cost of the work to be completed include the nature and complexity of the work to be performed, subcontractor performance and the risk and impact of delayed performance. Adjustments to original estimates for a contract's revenue, estimated costs at completion and estimated profit or loss often are required as work progresses under a contract, as experience is gained and as more information is obtained, even though the scope of work required under the contract may not change. When adjustments in estimated total costs at completion or in estimated total transaction price are determined, the related impact on revenue and operating income are recognized using the cumulative catch-up method, which recognizes in the current period the cumulative effect of such adjustments for all prior periods. Anticipated losses on contracts are recognized in full in the period in which losses become probable and estimable. Auditing the Company’s estimated costs at completion for long-term contracts that recognize revenue over time using the cost-to-cost method of accounting was challenging and complex due to the judgment involved in evaluating management’s assumptions and key estimates over the duration of these long-term contracts. The estimated costs at completion for these long-term contracts consider risks surrounding the Company’s ability to achieve the technical requirements and specifications of the contract, schedule, and other cost elements of the contract, and depend on whether the Company is able to successfully complete the various aspects of the contract. How We Addressed the Matter in Our Audit We obtained an understanding of the Company’s revenue recognition process, including management’s review of the estimated costs at completion for a sample of long-term contracts. To test the accuracy of the Company’s estimated costs at completion for these long-term contracts, our audit procedures included, among other things, evaluating the key assumptions used by management to determine such estimates. This included evaluating the historical accuracy of management’s estimates by comparing planned costs to actual costs incurred to date. We also tested the completeness and accuracy of the underlying data back to source documents and contracts. 91 Valuation of acquired intangible assets Description of the Matter As described in Note 2 to the consolidated financial statements, the Company completed an acquisition during the year ended December 31, 2022. The Company’s accounting for the acquisition included determining the fair value of the intangible assets acquired, including technology and contract assets intangibles. Auditing the Company's accounting for certain acquired intangible assets involved subjective auditor judgment due to the significant estimation required in management’s determination of the fair value of intangible assets. The significant estimations were primarily due to the sensitivity of the respective fair values to underlying assumptions including discount rates, projected revenue growth rates, obsolescence factors and profit margins. These assumptions relate to the future performance of certain of the acquired businesses, are forward-looking and could be affected by future economic and market conditions. How We Addressed the Matter in Our Audit We obtained an understanding of the Company’s process for accounting for certain acquired intangible assets including management’s review of the valuation of intangible assets, the valuation model and the assumptions used in the valuation. To test the fair value of the acquired intangible assets, our audit procedures included, among others, evaluating the Company's use of valuation methodologies, evaluating the prospective financial information, and testing the completeness and accuracy of underlying data. We utilized our valuation specialists to assist in testing the significant assumptions used to value the acquired intangible assets. For example, we compared the significant assumptions to current industry, market and economic trends, historical results of the acquired business and to other relevant factors. We also performed sensitivity analyses of the significant assumptions to evaluate the change in the fair value resulting from changes in the assumptions. /s/ Ernst & Young LLP We have served as the Company’s auditor since 2022. Tysons, Virginia March 28, 2023 92 Report of Independent Registered Public Accounting Firm To the Shareholder and Board of Directors Leonardo DRS, Inc.: Opinion on the Consolidated Financial Statements We have audited the accompanying consolidated balance sheet of Leonardo DRS, Inc. and subsidiaries (the Company) as of December 31, 2021, the related consolidated statements of earnings, comprehensive income, shareholder’s equity, and cash flows for each of the years in the two-year period ended December 31, 2021, and the related notes (collectively, the consolidated financial statements). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2021, and the results of its operations and its cash flows for each of the years in the two-year period ended December 31, 2021, in conformity with U.S. generally accepted accounting principles. Basis for Opinion These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that our audits provide a reasonable basis for our opinion. /s/ KPMG LLP We served as the Company’s auditor from 2012 to 2022. McLean, Virginia March 28, 2022, except for notes 1A, 1U, 3, 9, 15, 18, and 20, as to which the date is August 2, 2022, and note 1R, as to which the date is March 27, 2023 93 SUPPLEMENTARY DATAINDEX TO FINANCIAL STATEMENTS Ernst & Young LLP Tysons, Virginia Auditor ID: 42 KPMG LLP, McLean, VA, Auditor ID: 185 94 LEONARDO DRS, INC. Consolidated Statements of Earnings Year Ended December 31, (Dollars in millions, except per share amounts) 2022 2021 2020 Revenues Products $ 2,443 $ 2,505 $ 2,412 Services 250 374 366 Total revenues 2,693 2,879 2,778 Cost of revenues Products ( 1,928 ) ( 2,067 ) ( 2,000 ) Services ( 190 ) ( 265 ) ( 284 ) Total cost of revenues ( 2,118 ) ( 2,332 ) ( 2,284 ) Gross profit 575 547 494 General and administrative expenses ( 357 ) ( 293 ) ( 283 ) Amortization of intangibles ( 10 ) ( 9 ) ( 9 ) Other operating income (expenses), net 353 ( 9 ) ( 21 ) Operating earnings 561 236 181 Interest expense ( 34 ) ( 35 ) ( 64 ) Other, net ( 2 ) ( 1 ) ( 5 ) Earnings before taxes 525 200 112 Income tax provision 120 46 27 Net earnings $ 405 $ 154 $ 85 Net earnings per share from common stock Basic earnings per share: 1.88 $ 0.73 $ 0.40 Diluted earnings per share: 1.88 $ 0.73 $ 0.40 See accompanying Notes to Consolidated Financial Statements. 95 LEONARDO DRS, INC. Consolidated Statements of Comprehensive Income Year Ended December 31, (Dollars in millions) 2022 2021 2020 Net earnings $ 405 $ 154 $ 85 Other comprehensive income Foreign currency translation (loss) gain, net of income taxes ( 2 ) 2 1 Net unrecognized gain on postretirement obligations, net of income taxes 11 10 22 Other comprehensive income, net of income tax 9 12 23 Total comprehensive income $ 414 $ 166 $ 108 See accompanying Notes to Consolidated Financial Statements. 96 LEONARDO DRS, INC. Consolidated Balance Sheets December 31, (Dollars in millions, except per share amounts) 2022 2021 ASSETS Current assets: Cash and cash equivalents $ 306 $ 240 Accounts receivable, net 166 156 Contract assets 872 743 Inventories 319 205 Prepaid expenses 20 23 Other current assets 24 22 Total current assets 1,707 1,389 Noncurrent assets: Property plant and equipment, net 404 364 Intangible assets, net 172 52 Goodwill 1,236 1,071 Deferred tax assets 66 56 Other noncurrent assets 92 137 Total noncurrent assets 1,970 1,680 Total assets $ 3,677 $ 3,069 LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Short-term borrowings and current portion of long-term debt $ 29 $ 41 Accounts payable 457 479 Contract liabilities 233 174 Other current liabilities 323 295 Total current liabilities 1,042 989 Noncurrent liabilities: Long-term debt 365 352 Pension and other postretirement benefit plan liabilities 45 61 Other noncurrent liabilities 98 74 Total noncurrent liabilities $ 508 487 Commitments and contingencies (Note 18 ) Shareholders' equity Preferred stock, $ 0.01 par value: 10,000,000 shares authorized; none issued $ — $ — Common stock, $ 0.01 par value: 350,000,000 shares authorized; 260,234,033 shares issued and outstanding 3 2 Additional paid-in capital 5,147 4,632 Accumulated deficit ( 2,974 ) ( 2,983 ) Accumulated other comprehensive loss ( 49 ) ( 58 ) Total shareholders' equity 2,127 1,593 Total liabilities and shareholders' equity $ 3,677 $ 3,069 See accompanying Notes to Consolidated Financial Statements. 97 LEONARDO DRS, INC. Consolidated Statements of Cash Flows Year Ended December 31, (Dollars in millions) 2022 2021 2020 Operating activities Net earnings $ 405 $ 154 $ 85 Adjustments to reconcile net earnings (loss) to net cash from operating activities: Depreciation and amortization 65 58 53 Deferred income taxes ( 6 ) 31 30 Gain from divestitures ( 354 ) — — Other 5 — 3 Changes in assets and liabilities: Accounts receivable ( 1 ) ( 54 ) ( 35 ) Contract assets ( 134 ) ( 71 ) 65 Inventories ( 33 ) 42 ( 38 ) Prepaid expenses ( 1 ) 10 ( 14 ) Other current assets 3 12 3 Other noncurrent assets 24 19 22 Defined benefit obligations ( 4 ) ( 13 ) ( 9 ) Other current liabilities 14 28 30 Other noncurrent liabilities ( 8 ) ( 36 ) ( 14 ) Accounts payable ( 14 ) 1 ( 58 ) Contract liabilities 72 ( 3 ) 2 Net cash provided by operating activities 33 178 125 Investing activities Capital expenditures ( 65 ) ( 60 ) ( 56 ) Business acquisitions, net of cash acquired 19 ( 14 ) — Proceeds from sales of assets — — 5 Proceeds from sales of businesses 482 — — Net repayments received (advances) on related party note receivable — 115 ( 15 ) Cost method investment — ( 2 ) ( 4 ) Net cash provided by (used in) investing activities 436 39 ( 70 ) Financing activities Net (decrease) increase in third party borrowings (maturities of 90 days or less) ( 8 ) ( 18 ) ( 11 ) Borrowings of third party debt 223 — — Repayment of related party debt ( 992 ) ( 950 ) ( 1,170 ) Borrowings from related parties 775 930 1,105 Dividend to US Holding ( 396 ) — — Dividend from investment 3 — — Other ( 8 ) — ( 4 ) Net cash used in financing activities ( 403 ) ( 38 ) ( 80 ) Effect of exchange rate changes on cash and cash equivalents — — 1 Net increase (decrease) in cash and cash equivalents 66 179 ( 24 ) Cash and cash equivalents at beginning of year 240 61 85 Cash and cash equivalents at end of year $ 306 $ 240 $ 61 Supplemental disclosure of non-cash investing and financing activities 98 Year Ended December 31, Forgiveness of related party debt $ — $ — $ 300 Additions of property plant and equipment and long-term debt for a build-to-suit lease $ — $ — $ 49 See accompanying Notes to Consolidated Financial Statements. 99 LEONARDO DRS, INC. Consolidated Statements of Shareholders’ Equity (Dollars in millions, except per share amounts) Common stock Additional paid- in capital Accumulated other comprehensive loss Accumulated deficit Total Balance as of December 31, 2019 $ 2 $ 4,332 $ ( 93 ) $ ( 3,222 ) $ 1,019 Forgiveness of related party debt — 300 — — 300 Total comprehensive income (loss) — — 23 85 108 Balance as of December 31, 2020 2 4,632 ( 70 ) ( 3,137 ) 1,427 Forgiveness of related party debt — — — — — Total comprehensive income — — 12 154 166 Balance as of December 31, 2021 2 4,632 ( 58 ) ( 2,983 ) 1,593 Forgiveness of related party debt — — — — — Total comprehensive income — — 9 405 414 Stock Compensation Expense — 5 — — 5 Issuance of stock in business combination 1 510 — — 511 Dividend to US Holding — — — ( 396 ) ( 396 ) Balance as of December 31, 2022 $ 3 $ 5,147 $ ( 49 ) $ ( 2,974 ) $ 2,127 See accompanying Notes to Consolidated Financial Statements. 100 LEONARDO DRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1. Summary of Significant Accounting Policies A. Organization Leonardo DRS, Inc., together with its wholly owned subsidiaries (hereinafter, “DRS,” “the Company,” “us,” “our,” or “we”) is a supplier of defense electronics products, systems and military support services. The Company is controlled by Leonardo S.p.A (hereinafter, “Leonardo S.p.A.,” “the Majority Stockholder”), an Italian multi-national aerospace, defense and security company headquartered in Rome, Italy, through its ultimate sole ownership of Leonardo US Holding, LLC (“US Holding”). US Holding is the majority stockholder of the Company. DRS is a provider of defense products and technologies that are used across land, air, sea, space and cyber domains. Our diverse array of defense systems and solutions are offered to all branches of the U.S. military, major aerospace and defense prime contractors, government intelligence agencies, international military customers and industrial markets for deployment on a wide range of military platforms. We focus our capabilities in areas of critical importance to the U.S. military, such as advanced sensing, network computing, force protection and electrical power and propulsion. These capabilities directly align with our two reportable segments: Advanced Sensing and Computing and Integrated Mission Systems. The U.S. Department of Defense (“DoD”) is our largest customer and accounts for approximately 84 % and 86 % of our total revenues as an end-user for the years ended December 31, 2022 and 2021, respectively. Specific international and commercial market opportunities exist within these segments and comprise approximately 16 % and 14 % of our total revenues for the years ended December 31, 2022 and 2021. Our two reportable segments reflect the way performance is assessed and resources are allocated by our Chief Executive Officer, who is our chief operating decision maker (“CODM”). Advanced Sensing and Computing (“ASC”) The Advanced Sensing and Computing (“ASC”) segment designs, develops and manufactures sensing and network computing technology that enables real-time situational awareness required for enhanced operational decision making and execution by our customers. Our leading sensing capabilities span applications including missions requiring advanced detection, precision targeting and surveillance sensing, long range electro-optic/infrared (“EO/IR”), signals intelligence (“SIGINT) and other intelligence systems, electronic warfare (“EW”), ground vehicle sensing, next generation active electronically scanned array (“AESA”) tactical radars, dismounted soldier sensing and space sensing. Across our offering, we are focused on advancing sensor distance, precision, clarity, definition, spectral depth and effectiveness. Furthermore, we seek to leverage our multi-decade experience to optimize size, weight, power and cost tailored to our customers’ specific mission requirements. Our sensing capabilities are complemented by our rugged, trusted and cyber resilient network computing products. Our network computing offering is utilized across a broad range of mission applications including platform computing on ground and shipboard (both surface ship and submarine) for advanced battle management, combat systems, radar, command and control (“C2”), tactical networks, tactical computing and communications. Our network computing products support the DoD’s need for greater situational understanding at the tactical edge and permits data to be rapidly transmitted securely from command centers to forward-positioned defense assets. 101 LEONARDO DRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Integrated Mission Systems (“IMS”) Our Integrated Mission Systems (“IMS”) segment designs, develops, manufactures and integrates power conversion, control and distribution systems, ship propulsion systems, motors and variable frequency drives, force protection systems, transportation and logistics systems for the U.S. and allied defense customers. Our naval power and propulsion systems are providing next-generation power capabilities for the future fleet. DRS is currently a leading provider of next-generation electrical propulsion systems for the U.S. Navy. We provide power conversion, control, distribution and propulsion systems for the Navy’s top priority shipbuilding programs, including the Columbia Class ballistic missile submarine, the first modern U.S. electric drive submarine. We believe DRS is well positioned to meet the needs of an increasingly electrified fleet with our high-efficiency, power dense permanent magnet motors, energy storage systems and associated efficient, rugged and compact power conversion, electrical actuation systems, and advanced cooling technologies. DRS has a long history of providing a number of other critical products to the U.S. Navy with a significant installed base on submarines, aircraft carriers and other surface ships including motor controllers, instrumentation and control equipment, electrical actuation systems, and thermal management systems for electronics and ship stores refrigeration. Our technologies and systems help protect U.S. forces and assets against increasingly sophisticated and proliferating threats. DRS is an integrator of systems in ground vehicles for short-range air defense, counter-UAS (“C-UAS”), and vehicle survivability and protection. This integrator role includes utilizing radars, EW equipment, reconnaissance and surveillance systems, modular combat vehicle turrets, and stabilized sensor suites, and kinetic countermeasures for short-range air defense. Our force protection systems, including solutions for counter-unmanned aerial systems (C-UAS), short-range air defense systems and active protection systems used to defend ground combat vehicles help protect personnel and defense assets from these growing threats. Other The Company separately presents the unallocable costs associated with corporate functions and certain non-operating subsidiaries of the Company as Corporate & Eliminations. See Note 20 : Segment Information for further information regarding our business segments. B. Basis of presentation The accompanying Consolidated Financial Statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) and include the accounts of DRS, its wholly owned subsidiaries and its controlling interests. Interests in joint ventures that are controlled by the Company, or for which the Company is otherwise deemed to be the primary beneficiary, are consolidated. For joint ventures in which the Company does not have a controlling interest, but exerts significant influence, the Company applies the equity method of accounting. All intercompany transactions and balances have been eliminated in consolidation. Certain prior year amounts have been reclassified to conform to current year presentation. C. Use of estimates The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. The most significant of these estimates and assumptions relate to the recognition of contract revenues and estimated costs to complete contracts in process, recoverability of reported amounts of goodwill, long-lived assets and intangible assets, valuation of acquired intangibles, accounting for business combinations, valuation of stock award grants, pensions 102 LEONARDO DRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) and other postretirement benefits, the valuation of deferred tax assets and liabilities and the valuation of unrecognized tax benefits. Actual results could differ from these estimates. D. Revenue Recognition Our revenues consist of sales of products (tangible goods) and sales of services to customers. We recognize the majority of our revenue from contracts with customers using an over time, percentage of completion, cost-to-cost method of accounting measured by the ratio of cumulative costs incurred to date to estimated total contract costs at completion (the "cost-to-cost method"). On certain other contracts, primarily time and material (“T&M”) and cost-plus contracts, revenue is recognized using the right-to-invoice practical expedient as we are contractually able to bill our customers based on control transferred to the customer. See Note 3 : Revenue from Contracts with Customers for additional information regarding revenue recognition. E. Cost of Revenues Cost of revenues includes materials, labor and overhead costs incurred in the manufacturing, design, and provision of products and services sold in the period as well as warranty costs. Material costs include raw materials, purchased components and sub-assemblies, outside processing and inbound freight costs. Labor and overhead costs consist of direct and indirect manufacturing costs, including wages and fringe benefits, operating supplies, depreciation and amortization, occupancy costs, and purchasing, receiving and inspection costs. F. Cost to Fulfill a Contract Costs to fulfill a contract that are incremental direct costs incurred to fulfill a contract with a customer, including sales commissions and dealer fees, and are capitalized if material. Costs to fulfill a contract include costs directly related to a contract or a specific anticipated contract (for example, mobilization, set-up and certain design costs) that generate or enhance our ability to satisfy our performance obligations under these contracts. These costs are capitalized to the extent they are expected to be recovered from the associated contract. Capitalized costs to obtain or fulfill a contract are amortized to expense over the expected period of benefit for contracts with terms greater than one year on a systematic basis that is consistent with the pattern of transfer of the associated goods and services to the customer. As a practical expedient, capitalized costs to obtain or fulfill a contract with a term of one year or less are expensed as incurred. Capitalized costs to obtain or fulfill a contract were $ 34 million at December 30, 2022 and $ 40 million at December 31, 2021. G. Research and Development Expenses We conduct research and development (“R&D”) activities using our own funds (referred to as company-funded R&D or independent research and development (“IR&D”)) and under contractual arrangements with our customers (referred to as customer-funded R&D) to enhance existing products and services and to develop future technologies. R&D costs include basic research, applied research, concept formulation studies, design, development, and related test activities. IR&D costs are allocated to customer contracts as part of the general and administrative overhead costs and generally recoverable on our customer contracts with the U.S. Government. Customer-funded R&D costs are charged directly to the related customer contract. Substantially all R&D costs are charged to cost of revenues as incurred. Company-funded R&D costs charged to cost of revenues totaled $ 58 million, $ 48 million and $ 41 million in 2022, 2021 and 2020, respectively. H. Foreign Currency Significant transactions in foreign currencies are translated into U.S. dollars at the approximate prevailing rate at the time of the transaction. Foreign exchange transaction gains and losses in 2022, 2021 and 2020 were immaterial to the Company's results of operations. The operations of the Company's foreign subsidiaries are translated from the local (functional) currencies into U.S. dollars using weighted 103 LEONARDO DRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) average rates of exchange during each monthly period. The rates of exchange at each balance sheet date are used for translating certain balance sheet accounts and gains or losses resulting from these translation adjustments are included in the accompanying Consolidated Balance Sheet as a component of other comprehensive income. I. Cash and Cash Equivalents Cash and cash equivalents include cash on hand, deposits with banks or other short-term, highly liquid investments with original maturities of three months or less. J. Accounts Receivable Accounts receivable consist of amounts billed and currently due from customers. We maintain an allowance recorded in the Allowance for Credit Losses account that is estimated and recorded utilizing relevant information about past events, including historical experience, current conditions and a reasonable and supportable forecast that affects the collectability of the related financial asset. See Note 4 : Accounts Receivable for additional information regarding accounts receivable. K. Inventories Inventories are recorded at the lower of cost (determined by either actual, weighted average or first-in, first-out methods) or net realizable value, and include direct production costs as well as indirect costs, such as factory overhead. The net realizable value is calculated as the expected sales price in the course of normal operations net of estimated costs to finish and sell the goods. See Note 6 : Inventories for additional information regarding inventories. L. Property, Plant and Equipment Property, plant and equipment is carried at cost less accumulated depreciation. Depreciation is calculated on the straight-line method. The estimated useful lives of plant, machinery and equipment and building and building improvements generally range from 3 to 10 years and 15 to 40 years, respectively. Leasehold improvements are amortized over the shorter of the estimated useful life of the improvements or the remaining life of the lease. When assets are retired or otherwise disposed of, the cost and related accumulated depreciation or amortization are removed from the Consolidated Balance Sheet, and the net gain or loss is included in the determination of net earnings. Maintenance and repairs are charged to operations as incurred and renewals and improvements are capitalized. See Note 7 : Property, Plant and Equipment for additional information regarding property, plant and equipment. M. Goodwill Goodwill represents the excess purchase price paid to acquire a business over the fair value of net assets acquired. Goodwill is assigned to reporting units and is reviewed for impairment at the reporting unit level on an annual basis, or whenever changes in circumstances indicate that the carrying amount may not be recoverable. A reporting unit is an operating segment, or one level below that operating segment (the component level) if discrete financial information is prepared and regularly reviewed by the segment manager. Two or more components of an operating segment may be aggregated and deemed a single reporting unit if the components have similar economic characteristics. Based upon the aggregation criteria the Company concluded it had seven reporting units at both December 31, 2022 and 2021. The annual impairment test is typically performed after completion of the Company's annual financial operating plan, which occurs as of December 31. The Company uses quantitative assessments and qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is 104 LEONARDO DRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) less than its carrying value. If the optional qualitative assessment is performed (Step 0) and the Company concludes that it is more likely than not that the fair value of a reporting unit is less than its carrying amount, an additional quantitative fair value test (Step 1) is performed. When performing the Step 1 goodwill impairment test, we compare the fair values of each of our reporting units to their respective carrying values. In order to compute the fair value of our reporting units, we primarily use the income approach based on the discounted cash flows that each reporting unit expects to generate in the future, consistent with our operating plans. Determining the fair value of our reporting units requires significant judgments, including the timing and amount of future cash flows, long-term growth rates, determination of the weighted-average cost of capital and terminal value assumptions. If, based on the quantitative fair value test, the Company concludes that the carrying value of the reporting unit exceeds its fair value, the Company will recognize a goodwill impairment loss in an amount equal to that excess. The Company completed impairment tests as of December 31, 2022, 2021 and 2020 and no adjustment to the carrying value of goodwill was deemed to be necessary. See Note 9 : Goodwill for additional information regarding goodwill. N. Long-Lived Assets and Acquired Identifiable Intangible Assets Identifiable intangible assets represent assets acquired as part of the Company's business acquisitions and include customer and program/contract-related assets. The values assigned to acquired identifiable intangible assets are determined as of the date of acquisition based on estimates and judgments regarding expectations for the estimated future after-tax cash flows from those assets over their lives, including the probability of expected future contract renewals and revenues, all of which are discounted to present value. The Company assesses the recoverability of the carrying value of its long-lived assets and intangible assets with finite useful lives whenever events or changes in circumstances indicate that the carrying amount of the assets or asset group may not be recoverable. If there are any indicators of impairment present, the Company then evaluates the recoverability of the potentially impaired long-lived assets and acquired identifiable intangible assets based upon expectations of undiscounted net cash flows from such assets. If the sum of the expected future undiscounted net cash flows is less than the carrying amount of the asset or asset group, a loss is recognized for the difference between the estimated fair value and the carrying amount of the assets. Assets to be disposed of, including those of discontinued operations, are reported at the lower of the carrying amount or fair value, less the costs to sell. See Note 7 : Property, Plant and Equipment and Note 10 : Intangible Assets for additional information regarding long-lived assets and intangible assets. O. Derivative Financial Instruments The Company does not use derivative financial instruments for trading purposes. All derivative instruments are carried on the Consolidated Balance Sheet as either assets or liabilities at fair value. The classification of gains and losses resulting from changes in the fair values of derivatives depends on the intended use of the derivative and its resultant designation. The Company had no significant derivative or hedging instruments during the years ended December 31, 2022, 2021 or 2020. P. Pension and Other Postretirement Benefits The obligations for the Company's pension plans and postretirement benefit plans and the related annual costs of employee benefits are calculated based on several long-term assumptions, including discount rates for employee benefit liabilities, rates of return on plan assets, expected annual rates of salary increases for employee participants in the case of pension plans and expected annual increases in the costs of medical and other health care benefits in the case of postretirement benefit plans. These long-term assumptions are subject to revision based on changes in interest rates, financial market conditions, expected versus actual returns on plan assets, participant mortality rates and other actuarial assumptions, including future rates of salary increases, benefit formulas and levels, and rates of increase in the costs of benefits. Changes in these assumptions, if significant, can materially affect the amount of 105 LEONARDO DRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) annual net periodic benefit costs recognized in the Company's results of operations from one year to the next, the liabilities for the pension plans and postretirement benefit plans and the Company's annual cash requirements to fund these plans. See Note 14 : Pension and Other Postretirement Benefits for further information regarding our pension and postretirement plans. Q. Income Taxes We and US Holding have entered into a Tax Allocation Agreement (“Tax Allocation Agreement”), dated as of November 16, 2020, with members of an affiliated group, as defined in Section 1504(a) of the U.S. Internal Revenue Code of 1986, as amended (the “Tax Code”), members of one or more consolidated, combined, unitary or similar state tax groups and additional parties who are part of an “expanded affiliated group” for certain tax purposes. The agreement provides for the method of computing and allocating the consolidated U.S. federal tax liability of the affiliated group among its members and of allocating any state group tax liabilities among the state members for the taxable year ending December 31, 2008 and each subsequent year in which the parties are members of a group (whether federal or state). The agreement also provides for reimbursement of US Holding and/or DRS for payment of such tax liabilities, for compensation of any member for use of its “net operating loss” or “tax credits” in arriving at such tax liabilities and the allocation and payment of any refund arising from a carryback of net operating losses or tax credits from subsequent taxable years. Under the agreement, the parties have agreed to calculate and allocate their respective tax liabilities and other tax attributes for taxable years beginning with the first consolidated taxable year that included DRS (i.e., the taxable year ended December 31, 2008) as if the agreement was then in effect. Although DRS will file its federal consolidated return outside of US Holding post October 3, 2022, the Tax Allocation Agreement will remain in effect for all historic unaudited periods (federal or state) and all applicable prospective periods where the expanded affiliated relationship may warrant it. The provision for income taxes is determined using the asset and liability approach of accounting for income taxes. Under this approach, deferred taxes represent the future tax consequences expected to occur when the reported amounts of assets and liabilities are recovered or paid. Income taxes as presented attribute deferred income taxes of US Holding to DRS in a manner that is systematic, rational and consistent with the asset and liability method and the governing Tax Allocation Agreement which allocates the tax liability amongst the entities, including DRS. The provision for income taxes represents income taxes paid or payable for the current year plus the change in deferred taxes during the year. Deferred taxes result from differences between the financial and tax basis of DRS’ assets and liabilities and are adjusted for changes in tax rates and tax laws when such changes are enacted. In general, the taxable income of DRS is included in the consolidated U.S. federal and state tax returns of US Holding for the short taxable year ended October 3, 2022. Where applicable, US Holding’s current portion of U.S. federal income taxes payable were offset against DRS’ net operating loss carryforwards in the period the related tax expense was recorded. Consequently, our net operating loss carryforwards are deemed to have been settled with US Holding in each year in an amount commensurate with the carrying value of the tax effected net operating loss utilized. If management determines that some portion or all of a deferred tax asset is not “more likely than not” to be realized, a valuation allowance is recorded as a component of the income tax provision to reduce the deferred tax asset to the amounts expected to be realized. In determining whether the Company’s deferred tax assets are realizable, management considers all evidence, both positive and negative, including the history of financial reporting earnings, existing taxable temporary differences and their projected reversals, as well as projected future income and tax planning strategies. We believe it is more likely than not that we will generate sufficient taxable income in future periods to realize our deferred tax assets, subject to the valuation allowances recognized. 106 LEONARDO DRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) The Company assesses its tax positions for all periods open to examination by tax authorities based on the latest available information. Those positions are evaluated to determine whether they will more likely than not be sustained upon examination by the relevant taxing authorities. Liabilities for unrecognized tax benefits are measured based on the largest amount of benefit that is greater than 50% likely of being realized upon ultimate settlement. These unrecognized tax benefits are recorded as a component of income tax expense. Interest and penalties related to unrecognized tax benefits are not material. The implementation of a modified territorial tax system by the TCJA subjects us to tax on our Global Intangible Low-Taxed Income (“GILTI”) starting with fiscal 2019. The FASB has permitted companies to make an accounting policy decision to either (1) treat taxes due on future GILTI inclusions in U.S. taxable income as a current-period expense when incurred (“period cost method”) or (2) factor such amounts into the measurement of its deferred taxes. The Company has elected to use the period cost method. See Note 12 : Income Taxes for additional information regarding income taxes. R. Earnings Per Share Basic earnings per share (“EPS”) is computed by dividing net earnings by the weighted average number of shares of common stock outstanding during each period. The computation of diluted EPS includes the dilutive effect of outstanding stock-based compensation awards, only in periods in which such effect would have been dilutive for the period. In February 2021, the Company completed a forward stock split of 1-for- 1,450,000 shares of common stock. Additionally, on November 23, 2022, the Company completed a forward stock split of 1.451345331 -for-1 share of common stock. The consolidated financial statements have been retroactively adjusted as necessary to reflect the November 23, 2022 forward stock split for all periods presented. In addition 49,742,187 million shares of common stock were issued in connection with the RADA merger on November 28, 2022. There were 145 million and 210 million basic and diluted common shares outstanding before and after the November 23, 2022 forward stock split, respectively, for all periods presented. See Note 17 : Earnings Per Share for additional information regarding earnings per share. S. Fair Value Measurements Fair value is the price the Company would receive to sell an asset or pay to transfer a liability in an orderly transaction with a market participant on the measurement date. We are required to maximize the use of observable inputs and minimize the use of unobservable inputs in measuring fair value, and to utilize a three-level fair value hierarchy that prioritizes the inputs used to measure fair value. The three hierarchical levels used to measure fair value are as follows: Level 1 — Quoted prices in active markets for identical assets or liabilities. Level 2 — Quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in markets that are not active; and inputs other than quoted prices that are directly or indirectly observable. Level 3 — Significant inputs to the valuation model are unobservable. In certain instances, fair value is determined through information obtained from third parties using the latest available market data. In obtaining such data from third parties, we have evaluated the methodologies used to develop the estimate of fair value in order to assess whether such valuations are representative of fair value. The Company categorizes plan assets for disclosure purposes in accordance with this fair value hierarchy. Certain plan investments are measured at fair value using the net asset value (“NAV”) per share (or its equivalent) practical expedient and are therefore not categorized as Level 1, 2, or 3. NAV is defined as the total value of the fund divided by the number of the fund’s shares 107 LEONARDO DRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) outstanding. See Note 14: Pension and Other Postretirement Benefits for further information regarding our pension and postretirement plans. T. Financial Instruments Our financial instruments consist primarily of cash and cash equivalents, accounts receivable, accounts payable and accrued expenses and other current liabilities. Financial instruments are reported in the Consolidated Balance Sheet at carrying value as of December 31, 2022. However as of December 31, 2021 all of the Financial instruments are reported in the Consolidated Balance Sheet at carrying value which approximates fair value except for the 7.5 % Term loan. See Note 13: Debt for further information regarding our debt. U. Acquisitions, Investments, Variable Interest Entities and Divestitures Acquisitions Our consolidated financial statements include the operations of acquired businesses from the date of acquisition. We account for acquired businesses using the acquisition method of accounting, which requires that any assets acquired, and liabilities assumed be measured at their respective fair values on the acquisition date. The accounting for business combinations requires the Company to make significant judgments and estimates. Any excess of the fair value of consideration transferred over the assigned values of the net assets acquired is recognized as goodwill. On November 28, 2022, the Company announced the successful completion of the all-stock merger between Leonardo DRS and RADA Electronic Industries Ltd. (“RADA”), a leading Israel-based provider of small-form tactical radar, to become a combined public company. As previously disclosed, RADA shareholders retained approximately 19 % ownership in the combined Company with Leonardo DRS’s parent company, Leonardo S.p.A., (MIL: LDO), owning the remaining 81 %. The acquisition of RADA has been accounted for using the acquisition method of accounting in accordance with ASC 805, Business Combinations, with the Company as the accounting acquirer, which requires the assets acquired and liabilities assumed be recognized at their acquisition date fair value. The acquisition was completed on November 28, 2022, when each issued and outstanding ordinary share of RADA was converted and exchanged for one share of common stock of the Company. The total purchase consideration for RADA was $ 511 million and is comprised of Company’s shares issued in exchange for all issued and outstanding common shares of RADA, as well as the portion of replacement stock compensation awards’ fair value attributable to pre-combination services. See Note 2: Business Acquisitions and Dispositions for additional information regarding the transaction. During the third quarter of 2021 the Company acquired substantially all the assets of Ascendant Engineering Solutions (“AES”), an advanced gimbal producer located in Austin, TX. The purchase closed on July 28, 2021, for a purchase price of $ 11 million with an additional $ 5 million payable upon the achievement of certain financial and operational targets. AES designs, develops and manufactures high-performance, stabilized, multi-sensor gimbal systems for the growing market of Group 1, 2 and 3 unmanned aerial systems (“UAS”) serving several branches of the DoD. The Company is focused on gimbal payload opportunities in strategic U.S. government programs including those intended to counter current and next-generation anti-access and area-denial systems. We believe this acquisition enables the integration of our own Electro-Optical and Infrared systems with the gimbals of AES and is a strategic investment, offering an integrated solution for our customers in the market for lightweight military platforms including small unmanned aerial systems. The acquisition has been accounted for as a business combination and has been integrated into our ASC segment. 108 LEONARDO DRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Investments Investments where we have the ability to exercise significant influence, but do not control, are accounted for under the equity method of accounting and are included in other noncurrent assets on our Consolidated Balance Sheet. Significant influence typically exists if we have a 20% to 50% ownership interest in the investee. Under this method of accounting, our share of the net earnings or losses of the investee is included in operating profit in other income, net on our Consolidated Statements of Earnings (Loss) since the activities of the investee are closely aligned with the operations of the business segment holding the investment. We evaluate our equity method investments for impairment whenever events or changes in circumstances indicate that the carrying amounts of such investments may be impaired. If a decline in the value of an equity method investment is determined to be other than temporary, a loss is therefore recorded during the current period. The Company sold its interest in its only investment accounted for under the equity method on July 8, 2022. See Note 15: Equity Method Investments for further information regarding our equity method investments. The Company’s cost method investment consists of an investment in a private company in which we do not have the ability to exercise significant influence over its operating and financial activities. Management evaluates this investment for possible impairment quarterly. Variable Interest Entities The Company occasionally forms joint ventures and/or enters into arrangements with special purpose limited liability companies for the purpose of bidding and executing on specific projects. The Company analyzes each such arrangement to determine whether it represents a variable interest entity (“VIE”). If the arrangement is determined to be a VIE, the Company assesses whether it is the primary beneficiary of the VIE and if it is, consequently required to consolidate the VIE. The Company did not have any investment in VIEs as of December 31, 2022 or 2021. Divestitures On March 21, 2022, the Company entered into a definitive agreement to sell its Global Enterprise Solutions (“GES”) business to SES Government Solutions, Inc., a wholly-owned subsidiary of SES S.A., for a selling price of $ 450 million subject to certain working capital adjustments. The transaction was completed on August 1, 2022 and resulted in cash proceeds of $ 427 million after net working capital adjustments. The transaction netted an aggregate pretax gain net of transaction costs of $ 309 million ($ 239 million after tax) of which $ 323 million was included in Other operating income (expense) net partially reduced by aggregate transaction costs of $ 14 million included in Selling, General & Administrative costs and tax expenses of $ 70 million. GES, which was part of the ASC segment, provides commercial satellite communications to the U.S. Government and delivers satellite communications and security solutions to customers worldwide. SES S.A. has guaranteed the payment of the purchase price and performance of all other obligations of SES Government Solutions, Inc. under the agreement. The Company recorded operating income for the GES business of $ 13 million and $ 29 million for the years ended December 31, 2022 and 2021, respectively. In February 2022, the Company’s Board of Directors approved the strategic initiative to divest of the Company’s interest in Advanced Acoustic Concepts (“AAC”). On April 19, 2022, we entered into a definitive sales agreement to divest our share of our equity investment in AAC for $ 56 million to Thales Defense & Security, Inc., the minority partner in the joint venture. The transaction was completed on July 8, 2022 and resulted in proceeds of $ 56 million. The transaction netted an aggregate pretax gain of $ 31 million ($ 22 million net of taxes), The aggregate gain of $ 31 million is included in Other Operating income (expense) net offset by tax expense of $ 9 million. The proceeds generated from the GES and AAC divestitures resulted in a $ 396 million dividend to US Holding, at the time, our sole shareholder. The $ 396 million represents the proceeds generated net of our costs to sell and estimated tax obligations. The dividend was issued on August 5, 2022. 109 LEONARDO DRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) V. Share-based Compensation The fair value of stock awards is determined based on the closing market price of the Company's common stock on the grant date. Compensation expense for stock awards is measured based on the grant date fair value and recognized over the vesting period. For purposes of measuring compensation expense, the amount of shares ultimately expected to vest is estimated at each reporting date based on Company's expectations regarding the relevant service or performance criteria. For awards with a service condition only, the Company has made a policy election to recognize the compensation expense on a straight line basis. See Note 16: Share-based Compensation Plans for further information regarding our share-based compensation plans. W. New Accounting Pronouncements Recently Adopted Accounting Pronouncements Government Assistance In 2022, we adopted Accounting Standards Update (ASU) 2021-10, Government Assistance , which requires certain disclosures for those government assistance transactions for which we have applied a grant accounting model. Certain states and localities in which we operate offer or have offered various business incentives related to investment and/or job creation. Between 2018 and 2022, we received Enterprise Zone Tax Credits totaling approximately $ 10 million related to our investment in operations in Wisconsin. The credits were recorded in Other Income in the year that each of the requirements for the credits are achieved. DRS can earn as much $ 8 million in additional credits through 2025. Accounting Guidance Issued but Not Yet Adopted as of December 31, 2022: Disclosure of Supplier Finance Program Obligations In September 2022, the FASB issued ASU 2022-04, Liabilities – Supplier Finance Programs (Subtopic 405-50): Disclosure of Supplier Finance Program Obligations , which requires that a buyer in a supplier finance program disclose the key terms of supplier finance programs, the amount of obligations outstanding at the end of the reporting period that the entity has confirmed as valid to the finance provider, where these obligations are recorded in the balance sheet, and a roll forward of the obligations. The new standard is effective for fiscal years beginning after December 15, 2022, on a retrospective basis, including interim periods within those fiscal years. We are currently evaluating the impact of adopting this new pronouncement. Note 2. Business Acquisitions and Dispositions On June 21, 2022, the Company, entered into an Agreement and Plan of Merger (the “Merger Agreement”) with RADA, a leading Israel-based provider of small-form tactical radar, for an all-stock merger, with RADA surviving as a wholly owned subsidiary of the Company. The Company acquired RADA as part of the Company’s goal to become a market leader in advanced sensing and force protection. The acquisition of RADA has been accounted for using the acquisition method of accounting in accordance with ASC 805, Business Combinations, with the Company as the accounting acquirer, which requires the assets acquired and liabilities assumed be recognized at their acquisition date fair value. The acquisition was completed on November 28, 2022, when each issued and outstanding ordinary share of RADA was converted and exchanged for one share of common stock of the Company. The total purchase consideration for RADA was $ 511 million and is comprised of the Company’s shares of common stock issued in exchange for all issued and outstanding ordinary shares of RADA, as 110 LEONARDO DRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) well as the portion of replacement stock compensation awards’ fair value attributable to pre-combination services. The Company recognized transaction costs of $ 27 million in the year ended December 31, 2022. These costs were associated with advisory, legal, and consulting services and are presented in general and administrative expense in the consolidated statement of earnings. Purchase consideration - The following summarizes the purchase consideration transferred to RADA shareholders ( in millions, except per share data) : RADA ordinary shares outstanding as of November 28, 2022 50 Share exchange ratio 1 Total Company shares issued 50 Fair value of the Company common stock (RADA share price on November 28, 2022) $ 9.87 Total fair value of the Company common stock issued $ 491 Replacement share-based payment awards pre-combination vesting expense 20 Preliminary aggregate purchase consideration $ 511 Preliminary purchase price allocation - The preliminary allocation of the purchase consideration to assets acquired and liabilities assumed is based on the estimated fair values as follows ( in millions) : Assets: Cash and cash equivalents $ 19 Accounts receivable, net 12 Inventories 72 Prepaid expenses 3 Other current assets 4 Property, plant and equipment, net 26 Intangible Assets 131 Other noncurrent assets 14 Total identifiable assets acquired $ 281 Liabilities: Accounts payable $ 6 Contract liabilities 2 Other current liabilities 19 Deferred tax liabilities 5 Other noncurrent liabilities 22 Total liabilities assumed $ 54 Net assets acquired, excluding goodwill 227 Goodwill $ 284 The preliminary fair value estimates of the net assets acquired and liabilities assumed are based upon preliminary calculations and valuations, and those estimates and assumptions are subject to change as the Company obtains additional information during the measurement period (up to one year from the acquisition date). The Company has not yet finalized the determination of fair values allocated to the acquired assets and liabilities, including but not limited to the valuation of acquired intangible assets. The excess of the total consideration over the tangible assets, identifiable intangible assets, and assumed 111 LEONARDO DRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) liabilities is recorded as goodwill. Identifiable intangibles assets of $ 131 million consist of $ 90 million of technology related assets while the remaining $ 41 million consists of customer and contractual relationships. The goodwill of $ 284 million arising from the acquisition is primarily attributable to the growth opportunities related to the RADA business. None of the goodwill resulting from the acquisition is deductible for tax purposes. All of the goodwill recognized related to the RADA acquisition will be assigned to the ASC segment. Total revenue and operating earnings for RADA for the period from November 28, 2022, through December 31, 2022 were not significant. Note 3. Revenue from Contracts with Customers The Company recognizes revenue for each separately identifiable performance obligation in a contract representing an obligation to transfer a distinct good or service to a customer. In most cases, goods and services provided under the Company’s contracts are accounted for as single performance obligations due to the complex and integrated nature of our products and services. These contracts generally require significant integration of a group of goods and/or services to deliver a combined output. In some contracts, the Company provides multiple distinct goods or services to a customer. In those cases, the Company accounts for the distinct contract deliverables as separate performance obligations and allocates the transaction price to each performance obligation based on its relative standalone selling price, which is generally estimated using cost plus a reasonable margin. We classify revenues as products or services on our Consolidated Statements of Earnings based on the predominant attributes of the performance obligations. While the Company provides warranties on certain contracts, we typically do not provide for services beyond standard assurances and therefore do not consider warranties to be separate performance obligations. Typically, we enter into three types of contracts: fixed-price contracts, cost-plus contracts and T&M contracts (cost-plus contracts and T&M contracts are aggregated below as flexibly priced contracts). The majority of our total revenues are derived from fixed-price contracts; refer to the revenue disaggregation disclosures that follow. For fixed-price contracts, customers agree to pay a fixed amount, negotiated in advanced for a specified scope of work. For cost-plus contracts typically we are reimbursed for allowable or otherwise defined total costs (defined as cost of revenues plus allowable general and administrative expenses) incurred, plus a fee. The contracts may also include incentives for various performance criteria, including quality, timeliness and cost-effectiveness. In addition, costs are generally subject to review by clients and regulatory audit agencies, and such reviews could result in costs being disputed as non-reimbursable under the terms of the contract. T&M contracts provide for reimbursement of labor hours expended at a contractual fixed labor rate per hour, plus the actual costs of material and other direct non-labor costs. The fixed labor rates on T&M contracts include amounts for the cost of direct labor, indirect contract costs and profit. Revenue from contracts with customers is recognized when the performance obligations are satisfied through the transfer of control over the good or service to the customer, which may occur either over time or at a point in time. Revenues for the majority of our contracts are measured using the the over time, percentage of completion cost-to-cost method of accounting to calculate percentage of completion. We believe this is an appropriate measure of progress toward satisfaction of performance obligations as this measure most accurately depicts the progress of our work and transfer of control to our customers. Due to the long-term nature of many of our contracts, developing the estimated total cost at completion and total transaction price often requires judgment. Factors that must be considered in estimating the cost of the work to be 112 LEONARDO DRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) completed include the nature and complexity of the work to be performed, subcontractor performance and the risk and impact of delayed performance. After establishing the estimated total cost at completion, we follow a standard Estimate at Completion (“EAC”) process in which we review the progress and performance on our ongoing contracts on a routine basis . Adjustments to original estimates for a contract's revenue, estimated costs at completion and estimated profit or loss often are required as work progresses under a contract, as experience is gained and as more information is obtained, even though the scope of work required under the contract may not change and are also required if contract modifications occur. When adjustments in estimated total costs at completion or in estimated total transaction price are determined, the related impact on revenue and operating income are recognized using the cumulative catch-up method, which recognizes in the current period the cumulative effect of such adjustments for all prior periods. Any anticipated losses on these contracts are fully recognized in the period in which the losses become evident. EAC adjustments had the following impacts to revenue for the periods presented: Year Ended December 31, (Dollars in millions) 2022 2021 2020 Revenue $ ( 26 ) $ ( 34 ) $ ( 77 ) Total % of Revenue 1 % 1 % 3 % The impacts noted above are attributed primarily to changes in our firm-fixed-price development type programs as well as the impacts of inflation on certain fixed price production programs. In 2022, the adjustments consist of changes in the designs required to achieve contractual specifications for fixed priced development programs and inflationary cost increases on certain surface ship and radar programs within the Navy that resulted in a change in the programs’ estimate and related profitability. The reductions to revenue for the years ended December 31, 2021 and 2020 were related to certain masted surveillance and submarine electric propulsion programs within our IMS segment, soldier sensing programs within our ASC segment and adjustments to the measurement of variable consideration related to certain requests for equitable adjustment with the U.S. Navy also within our ASC segment. Conversely, if the requirements for the recognition of contracts over time are not met, revenue is recognized at a point in time when control transfers to the customer, which is generally upon transfer of title. In such cases, the production that is in progress and costs that will be recognized at a future point in time are reported within "inventories." Costs to obtain a contract are incremental direct costs incurred to obtain a contract with a customer, including sales commissions and dealer fees, and are capitalized if material. Costs to fulfill a contract include costs directly related to a contract or specific anticipated contract (e.g., certain design costs) that generate or enhance our ability to satisfy our performance obligations under these contracts. These costs are capitalized to the extent they are expected to be recovered from the associated contract. Contract Assets and Liabilities The timing of revenue recognition, billings and cash collections results in billed accounts receivable, unbilled receivables (contract assets), and customer advances and deposits (contract liabilities) on the Consolidated Balance Sheet. Amounts are billed as work progresses in accordance with agreed-upon contractual terms, either at periodic intervals (e.g., biweekly or monthly) or upon achievement of contractual milestones. Generally, billing occurs subsequent to revenue recognition, resulting in contract 113 LEONARDO DRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) assets. However, we sometimes receive advances or deposits from our customers before revenue is recognized, resulting in contract liabilities. Year Ended December 31, (Dollars in millions) 2022 2021 Contract assets $ 872 $ 743 Contract liabilities 233 174 Net contract assets $ 639 $ 569 Revenue recognized in 2022 and 2021 that was included in the contract liability balance at the beginning of each year was $ 129 million and $ 108 million, respectively. Contract assets related to amounts withheld by customers until contract completion are not considered a significant financing component of our contracts because the intent is to protect the customers from our failure to satisfactorily complete our performance obligations. Payments received from customers in advance of revenue recognition (contract liabilities) are not considered a significant financing component of our contracts because they are utilized to pay for contract costs within a one-year period or are requested by us to ensure the customers meet their payment obligations. Value of Remaining Performance Obligations The value of remaining performance obligations, which we also refer to as total backlog, includes the following components: • Funded - Funded backlog represents the revenue value of orders for services under existing contracts for which funding is appropriated or otherwise authorized less revenue previously recognized on these contracts. • Unfunded - Unfunded backlog represents the revenue value of firm orders for products and services under existing contracts for which funding has not yet been appropriated less funding previously recognized on these contracts. The following table summarizes the value of our backlog at December 31, 2022 and 2021, incorporating both funded and unfunded components: Backlog: Year Ended December 31, (Dollars in millions) 2022 2021 Funded $ 2,783 $ 2,510 Unfunded 1,486 351 Total Backlog $ 4,269 $ 2,861 We expect to recognize approximately 41 % of our December 31, 2022 backlog as revenue over the next 12 months, with the remainder to be recognized thereafter. Disaggregation of Revenue ASC : ASC revenue is primarily derived from U.S. government development and production contracts and is generally recognized using the over time, percentage of completion cost-to-cost method of accounting. We disaggregate ASC revenue by geographical region, customer relationship and contract 114 LEONARDO DRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) type. We believe these categories best depict how the nature, amount, timing and uncertainty of ASC revenue and cash flows are affected by economic factors: Year Ended December 31, (Dollars in millions) 2022 2021 2020 Revenue by Geographical Region United States $ 1,543 $ 1,808 $ 1,763 International 169 113 182 Intersegment Sales 21 19 13 Total $ 1,733 $ 1,940 $ 1,958 Revenue by Customer Relationship Prime contractor $ 918 $ 1,209 $ 1,063 Subcontractor 794 712 882 Intersegment Sales 21 19 13 Total $ 1,733 $ 1,940 $ 1,958 Revenue by Contract Type Firm Fixed Price $ 1,494 $ 1,667 $ 1,716 Flexibly Priced (1) 218 254 229 Intersegment Sales 21 19 13 Total $ 1,733 $ 1,940 $ 1,958 ________________ (1) Includes revenue derived from cost type and time-and-materials contracts. IMS : IMS revenue is primarily derived from U.S. government development and production contracts and is generally recognized over time using the over time, percentage of completion cost-to-cost method 115 LEONARDO DRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) of accounting. We disaggregate IMS revenue by geographical region, customer relationship and contract type. We believe these categories best depict how the nature, amount, timing and uncertainty of IMS revenue and cash flows are affected by economic factors: Year Ended December 31, (Dollars in millions) 2022 2021 2020 Revenue by Geographical Region United States $ 956 $ 913 $ 792 International 25 45 41 Intersegment Sales 2 1 1 Total $ 983 $ 959 $ 834 Revenue by Customer Relationship Prime contractor $ 186 $ 174 $ 283 Subcontractor 795 784 550 Intersegment Sales 2 1 1 Total $ 983 $ 959 $ 834 Revenue by Contract Type Firm Fixed Price $ 853 $ 831 $ 692 Flexibly Priced (1) 128 127 141 Intersegment Sales 2 1 1 Total $ 983 $ 959 $ 834 ________________ (1) Includes revenue derived from time-and-materials contracts. Note 4. Accounts Receivable Accounts receivable represent amounts billed and currently due from customers. Payment is typically received from our customers either at periodic intervals (e.g., biweekly, or monthly) or upon achievement of contractual milestones. Accounts receivable consist of the following: December 31, (Dollars in millions) 2022 2021 Accounts receivable $ 168 $ 157 Less allowance for credit losses ( 2 ) ( 1 ) Accounts receivable, net $ 166 $ 156 The Company maintains certain agreements with financial institutions to sell certain trade receivables. Pursuant to the servicing agreements, the Company collected approximately $ 10 million and $ 15 million at December 31, 2022 and 2021, respectively, of these sold receivables that had not yet been remitted to the financial institutions. These unremitted amounts collected on behalf of the financial institutions are included within short-term borrowings and current portion of long-term debt in the Consolidated Balance Sheet. See Note 5: Sale of Receivables for additional information on the sale of receivables. Note 5. Sale of Receivables The Company is party to factoring facilities with various financial institutions with an aggregate capacity of $ 325 million. The receivables sold under the factoring facilities are without recourse for any customer credit risk and result in a true sale. Receivables are derecognized in their entirety when sold, 116 LEONARDO DRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) and the Company’s continuing involvement is limited to their servicing, for which the Company receives a fee commensurate with the service provided and therefore no servicing asset or liability related to these receivables was recognized for any period presented. The fair value of the sold receivables approximated their book value due to their short-term nature. Proceeds from the sold receivables are reflected in operating cash flows on the statement of cash flows. During the years ended December 31, 2022 and 2021, the Company incurred purchase discount fees of $ 4 million and $ 2 million, respectively, which are presented in other general and administrative expenditures, net on the consolidated statements of earnings. December 31, (Dollars in millions) 2022 2021 Beginning balance $ 215 $ 262 Sales of receivables 373 646 Cash returned to purchaser ( 345 ) ( 693 ) Outstanding balance sold to purchasers (1) 243 215 Cash collected, not remitted to purchaser (2) ( 10 ) ( 15 ) Remaining sold receivables $ 233 $ 200 ________________ (1) For the calendar year 2022, the Company recorded a net increase to cash flows from operating activities of $ 28 million and for calendar year 2021 a decrease to cash flow from operating activities of $ 47 million. (2) Represents cash collected on behalf of purchasers and not yet remitted. Note 6. Inventories Inventories consists of the following: December 31, (Dollars in millions) 2022 2021 Raw materials $ 83 $ 43 Work in progress 224 161 Finished goods 12 1 Total $ 319 $ 205 Note 7. Property, Plant and Equipment Property, plant and equipment by major asset class consists of the following: December 31, (Dollars in millions) 2022 2021 Land, buildings and improvements $ 321 $ 312 Plant and machinery 190 191 Equipment and other 335 298 Total property, plant and equipment, at cost 846 801 Less accumulated depreciation ( 442 ) ( 437 ) Total property, plant and equipment, net $ 404 $ 364 117 LEONARDO DRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Depreciation expense related to property, plant and equipment was $ 55 million, $ 49 million and $ 44 million for the years ended December 31, 2022, 2021 and 2020, respectively. Land, buildings and improvements include assets under finance leases in the amount of $ 102 million and $ 104 million as of December 31, 2022 and 2021, respectively. See Note 11: Leases for additional information. As of December 31, 2022 and 2021, respectively, the Company accounted for our manufacturing facility in Menomonee Falls, WI as a build-to-suit lease with a failed sale-leaseback and is included in the Land, building, and improvements in the above table. See Note 13: Debt for additional information. Note 8. Other Liabilities A summary of significant other liabilities by balance sheet caption follows: December 31, (Dollars in millions) 2022 2021 Salaries, wages and accrued bonuses $ 63 $ 70 Fringe benefits 76 74 Litigation 10 10 Restructuring costs 4 4 Provision for contract losses 54 48 Operating lease liabilities 25 24 Taxes Payable 31 — Other (1) 60 65 Total other current liabilities $ 323 $ 295 Operating lease liabilities $ 68 $ 73 Taxes Payable 21 — Other (2) 9 1 Total other noncurrent liabilities $ 98 $ 74 ________________ (1) Consists primarily of environmental remediation reserves and warranty reserves. See Note 18: Commitments and Contingencies for more information regarding the warranty provision (2) Consists primarily of workers’ compensation liabilities. Note 9. Goodwill Changes in the carrying amount of goodwill by reportable segment are as follows: (Dollars in millions) ASC IMS Total Balance at January 1, 2021 (1) $ 638 $ 419 $ 1,057 Acquisitions 14 — 14 Balance at December 31, 2021 652 419 1,071 Acquisitions 282 — 282 Dispositions ( 117 ) $ — ( 117 ) Balance at December 31, 2022 $ 817 $ 419 $ 1,236 ________________ (1) Goodwill is reported net of $ 2,362 million and $ 606 million of accumulated impairments as of January 2021 for the ASC and IMS segments, respectively. 118 LEONARDO DRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Note 10. Intangible Assets Other intangible assets mainly refer to the fair value of existing customer contractual relationships attributable to the acquired business and patents which are being amortized over their respective lives. The fair value of intangible assets typically is determined, as of the date of acquisition, based on estimates and judgments regarding expectations for the estimated future after-tax earnings and cash flows (including cash flows for working capital) arising from backlog and follow-on sales to the customer over their estimated lives, including the probability of expected future contract renewals and sales, less a contributory assets charge, all of which is discounted to present value. The following disclosure presents certain information regarding the Company's intangible assets as of December 31, 2022 and 2021. All intangible assets are being amortized over their estimated useful lives, as indicated below, with no estimated residual values. December 31, 2022 December 31, 2021 (Dollars in millions) Gross Carrying Amount Accumulated Amortization Net Carrying Amount Gross Carrying Amount Accumulated Amortization Net Carrying Amount Acquired Intangible Assets $ 1,087 $ ( 918 ) $ 169 $ 957 $ ( 908 ) $ 49 Patents and licenses 9 ( 6 ) 3 9 ( 6 ) 3 Total intangible assets $ 1,096 $ ( 924 ) $ 172 $ 966 $ ( 914 ) $ 52 Amortization expense related to intangible assets was $ 10 million, $ 9 million, and $ 9 million respectively, for the years ended December 31, 2022, 2021 and 2020. Acquired intangible assets are amortized on a straight-line basis over their estimated useful lives of 10 to 15 years. The net acquired intangible asset balances consists primarily of technology related intangibles of $ 118 million and customer related assets of $ 49 million as of December 31, 2022. Patents and licenses are amortized on a straight-line basis over their estimated useful lives of 5 to 10 years. The estimated annual amortization expense related to intangible assets for the subsequent five years is as follows: (in millions) Year Ending December 31, Estimated Annual Amortization 2023 $ 22 2024 22 2025 22 2026 22 2027 18 Note 11. Leases The Company leases various real estate for manufacturing facilities, administrative offices, warehouses and machinery under both finance leases and operating leases. In addition, the Company leases vehicles and office equipment under operating leases. We determine whether our contracts are or contain a lease at the inception of such arrangements. A contract is or contains a lease if it conveys the right to control the use of an identified asset for a period of time in exchange for consideration. Right of use assets (“ROU”) and lease liabilities are recorded on the Consolidated Balance Sheet as of the lease commencement based on the present value of the future lease payments over the lease term. As our leases do not generally explicitly state the discount rate implicit in the lease, we use our incremental borrowing rate, which is determined based on the rate of interest that the Company would 119 LEONARDO DRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) have to pay to borrow an amount equal to the lease payments on a collateralized basis over a similar term as of the lease commencement date. In addition to the present value of the future lease payments, the calculation of the ROU asset also includes lease payments made at or before the commencement date of the lease, less any lease incentives received. The remaining lease cost is amortized over the remaining life of the lease on a straight-line basis. We evaluate ROU assets for impairment consistent with the treatment of other long-lived assets. Some of our leases include options to extend the lease terms or to terminate the lease early. We include the impact of the option in the determination of the ROU assets and liabilities when it is reasonably certain that we will exercise the option. Our U.S. and Canadian lease payments are largely fixed, but may include variable payments that do not depend on an index or rate, such as usage-based amounts, and are recorded as a lease expense in the period incurred. The lease payments in Israel are tied to the Consumer Price Index (“CPI”) as published by Israel’s Central Bureau of Statistics. These leases are paid in Israeli New Shekels (“ISL”), but recorded in U.S. Dollars on the general ledger. These leases are recalculated each quarter to recognize the changes in both the CPI and the ISL. The Company’s lease agreements do not contain any material residual value guarantees or restrictive covenants. In 2019, we have entered into a sale-leaseback transaction related to a facility in Milwaukee, WI. We have analyzed the transaction and determined the criteria to recognize a sale has been met and we have derecognized the related assets. The arrangement does not contain a repurchase option or other substantive obligations related to the property. Further, we have determined that the underlying lease meets the criteria to be classified as an operating lease. As a result, we have recognized an immaterial loss related to the transaction. As of December 31, 2022, the Company has not entered into any significant leases that have not yet commenced. We elected not to recognize a ROU asset and lease liability for leases with an initial term of 12 months or less. These leases are expensed on a straight-line basis over the lease term. The Company elected the practical expedient to not separate lease and non-lease components and to instead account for them as a single component. We have elected this practical expedient for all classes of assets. Lease Cost The Company’s total lease cost consists of the following: Year Ended December 31, (Dollars in millions) 2022 2021 2020 Operating lease cost (1) $ 25 $ 26 $ 24 Finance lease cost (2) : Amortization of right-of-use assets 10 8 7 Interest on lease liabilities 5 5 5 Total lease cost $ 40 $ 39 $ 36 ________________ (1) Operating lease expense is included within cost of products, cost of services or general and administrative expenses, dependent upon the nature and use of the ROU asset, in the Company’s Consolidated Statements of Earnings Operating lease cost includes short-term leases of approximately $ 2 million, $ 3 million and $ 5 million and an insignificant amount of variable lease cost for 2022, 2021 and 2020 . (2) Finance lease expense is recorded as depreciation and amortization expense within cost of products, cost of services or general and administrative expenses, dependent upon the nature and use of the ROU asset and interest expense, net in the Company’s Consolidated Statements of Earnings. 120 LEONARDO DRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Supplemental Balance Sheet Information Supplemental balance sheet information related to leases is as follows: December 31, (Dollars in millions) 2022 2021 ROU assets Operating leases (1) $ 83 $ 84 Finance leases (2) 102 104 Total leased assets $ 185 $ 188 Liabilities Current lease liabilities: Operating (1) $ 25 $ 24 Finance (2) 8 6 Noncurrent lease liabilities: Operating (1) 68 73 Finance (2) 105 107 Total lease liabilities $ 206 $ 210 ________________ (1) Operating lease assets are included within other noncurrent assets and operating lease liabilities are included within other current liabilities (current portion) and other noncurrent liabilities (noncurrent portion) in the Company’s Consolidated Balance Sheet. (2) Finance lease assets are included within property, plant and equipment, net and finance lease liabilities are included within short-term borrowings and current portion of long-term debt (current portion) and long-term debt (noncurrent portion) in the Company’s Consolidated Balance Sheet. Supplemental Cash Flow Information Supplemental cash flow information related to leases is as follows: Year Ended December 31, (Dollars in millions) 2022 2021 2020 Cash paid for amounts included in the measurement of lease liabilities: Operating cash flows from operating leases $ 25 $ 27 $ 27 Operating cash flows from finance leases 8 5 5 Financing cash flows from finance leases 5 5 4 Right-of-use assets obtained in exchange for new lease liabilities: Operating leases 11 18 16 Finance leases 8 4 46 121 LEONARDO DRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Weighted Average Lease Term and Discount Rate Lease terms and discount rates related to leases are as follows: December 31, 2022 2021 Weighted-average remaining lease term: Operating leases 5 years 5 years Finance leases 14 years 15 years Weighted-average discount rate: Operating leases 4.7 % 4.3 % Finance leases 4.5 % 4.6 % Maturity of Lease Liabilities: As of December 31, 2022, future minimum rental payments on leases with initial non-cancellable lease terms in excess of one year were due as follows: (Dollars in millions) Operating Leases Finance Leases Year Ending December 31, 2023 $ 30 $ 13 2024 27 13 2025 18 12 2026 12 12 2027 9 10 Thereafter 17 94 Total lease payments 113 154 Less: imputed interest 20 41 Present value of lease liabilities 93 113 Less: current maturities 25 8 Long-term lease obligations $ 68 $ 105 Note 12. Income Taxes Earnings (loss) before taxes consists of the following: Year Ended December 31, (Dollars in millions) 2022 2021 2020 Earnings before taxes Domestic $ 531 $ 203 $ 112 Foreign ( 6 ) ( 3 ) — Total $ 525 $ 200 $ 112 122 LEONARDO DRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Income tax provision (benefit) consists of the following: Year Ended December 31, (Dollars in millions) 2022 2021 2020 Current: Federal $ 93 $ ( 1 ) $ — State 24 — 3 Foreign — 1 2 117 — 5 Deferred: Federal 5 43 24 State ( 6 ) 5 — Foreign 4 ( 2 ) ( 2 ) 3 46 22 Total $ 120 $ 46 $ 27 The reconciliation from the statutory federal income tax rate to our effective income tax rate follows: Year Ended December 31, 2022 2021 2020 Statutory federal rate 21.0 % 21.0 % 21.0 % State rate, net of federal benefit 2.8 % 3.6 % 2.3 % Foreign rate differential ( 0.3 ) % ( 0.2 ) % 0.5 % Research & development credit, net of reserves ( 0.5 ) % ( 0.2 ) % ( 0.7 ) % Nondeductible expenses 0.2 % 0.9 % 0.4 % Global intangible low taxed income 0.2 % — % 0.2 % Change in valuation allowance 1.5 % ( 1.4 ) % ( 2.5 ) % Change in tax reserves — % ( 0.4 ) % 2.2 % Divestiture impact ( 1.9 ) % — % — % — % Other ( 0.1 ) % ( 0.3 ) % 0.7 % Effective tax rate 22.9 % 23.0 % 24.1 % 123 LEONARDO DRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 2022 and 2021 are as follows: December 31, (Dollars in millions) 2022 2021 Deferred tax assets: Federal net operating loss $ 4 $ 3 State net operating loss 14 16 Foreign net operating loss $ 10 $ 2 Tax credit carryforwards 4 21 Lease liabilities $ 61 $ 59 Capitalized R&D, net of amortization 32 — Accrued compensation and benefits 23 23 Contract liabilities 23 21 Accrued expenses 6 5 Pension and post-retirement plans 15 18 Inventory capitalization 7 5 Disallowed Interest 1 1 Other 8 5 Total gross deferred tax assets 208 179 Less valuation allowance 17 10 Deferred tax assets 191 169 Deferred tax liabilities: Right of use assets $ ( 57 ) $ ( 56 ) Intangible assets ( 45 ) ( 41 ) Fixed assets ( 21 ) ( 15 ) Other ( 2 ) ( 1 ) Deferred tax liabilities ( 125 ) ( 113 ) Net deferred tax asset $ 66 $ 56 Our deferred tax balance associated with our retirement benefit plans includes a deferred tax asset of $ 8 million and $ 11 million as of December 31, 2022 and 2021 respectively, that are recorded in accumulated other comprehensive earnings to recognize the funded status of our retirement plans. See Note 14: Pension and Other Postretirement Benefits for additional details. As of December 31, 2022 and 2021 the Company had U.S. federal net operating loss carryforwards of $ 31 million and $ 28 million, respectively, which we anticipate we will be able to apply prior to their expiration which commences in 2025. The annual utilization of approximately $ 25 million of certain our Federal net operating losses is subject to limitations under section 382 of the Internal Revenue Code. Our foreign net operating losses have expirations ranging from 2041 to indefinite. During 2022 we recorded a valuation allowance in Canada due to a change in the Company’s judgement regarding the realizability of their deferred tax assets, including a valuation allowance of $ 6 million against the foreign net operating losses. As of December 31, 2022 and 2021 we had apportioned state net operating loss carryforwards of $ 227 million and $ 239 million, respectively, which are associated with jurisdictions in which we currently file and the Company expects to utilize prior to expiration except for those for which we have recorded a valuation allowance. Our state net operating losses have expirations ranging from 2024 to 2041 and are offset by a valuation allowance of $ 5 million. 124 LEONARDO DRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Tax Uncertainties The Company maintains reserves for uncertain tax positions related to unrecognized income tax benefits. These reserves involve considerable judgment and estimation and are evaluated by management at least quarterly based on the best information available. The Company’s total liability for unrecognized tax benefits as of December 31, 2022, 2021 and 2020 was approximately $ 24 million, $ 22 million and $ 25 million, respectively; all of which will impact the effective tax rate when recognized. Approximately $ 2 million, $ 15 million and $ 22 million as of December 31, 2022, 2021 and 2020, respectively, have been recorded within (and as an offset to) deferred tax assets. In addition, the Company does not believe there are any tax positions for which it is reasonably possible that the unrecognized tax benefits will vary significantly over the next 12 months. The table below summarizes the activity associated with our unrecognized tax benefits: (Dollars in millions) 2022 2021 2020 Balance at January 1, $ 22 $ 25 $ 18 Increase related to prior year tax positions 1 — 3 Increase related to current year tax positions 2 1 4 Decreases related to prior year tax positions — ( 4 ) — Lapse of statute of limitations ( 1 ) — — Settlements with taxing authorities — — — Balance at December 31, $ 24 $ 22 $ 25 The Company is subject to U.S. federal income tax as well as income tax of multiple state and foreign jurisdictions. The Company has substantially concluded all U.S. federal income tax matters for years through the tax year ended December 31, 2018 except as it relates to the net operating loss carryforward and tax credit carryforwards. Substantially all material state and local matters have been concluded for years through the tax year ended December 31, 2017. The Company has substantially concluded all material tax matters in foreign jurisdictions for years through the tax years ending during 2017. As of December 31, 2022, the Company has accumulated undistributed earnings generated by our foreign subsidiaries and most have been taxed in the U.S. as a result of the Tax Cuts and Jobs Act of 2017 (the “TCJA”). The TCJA allows for a dividend received deduction for repatriation of foreign earnings. We intend to indefinitely reinvest these earnings. Should the Company’s undistributed earnings from its investment in non‐U.S. subsidiaries be distributed in the future in the form of dividends or otherwise, the Company may be subject to foreign and domestic income taxes and withholding taxes. Note 13. Debt The Company’s debt consists of the following: December 31, (Dollars in millions) 2022 2021 Term Loan A $ 225 $ — 7.5 % Term loan due November 30, 2023 (1) — 139 5.0 % Daylight term loan due October 15, 2024 (1) — 78 Finance lease and other 161 161 Short-term borrowings 10 15 Total debt principal 396 393 Less unamortized debt issuance costs and discounts ( 2 ) — Total debt, net 394 393 Less short-term borrowings and current portion of long-term debt ( 29 ) ( 41 ) Total long-term debt $ 365 $ 352 125 LEONARDO DRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) ________________ (1) The Company’s debt with related parties consists of two term loans and a working capital credit facility with US Holding, as described below. Term Loans In November 2022, the Company entered into a senior unsecured credit agreement with Bank of America in the amount of $ 500 million (the “2022 Credit Agreement”) with a maturity of November 29, 2027. The 2022 Credit Agreement provides for a term loan of $ 225 million bearing interest at a variable rate generally based on the Secured Overnight Financing Rate, (“SOFR”), plus a spread ranging from 1.48 % to 2.10 % depending on the leverage ratio, as defined in the 2022 Credit Agreement, or an alternative variable rate based on the higher of the Bank of America prime rate, the federal funds rate, or a rate generally based on SOFR, in each case subject to additional basis point spread as defined in the 2022 Credit Agreement, (“2022 Term Loan A”). Interest is payable quarterly in arrears. The outstanding balance of the 2022 Term Loan A at December 31, 2022 was $ 223 million.The fair value of Term Loan A at December 31, 2022 was approximately $ 223 million, however the Company has the ability to prepay the outstanding principal balance without penalty. In January 2009, the Company entered into a credit agreement with Finmeccanica S.p.A. (presently Leonardo S.p.A. and Majority Stockholder) in the amount of $ 2 billion (the “2009 Credit Agreement”). The 2009 Credit Agreement was subsequently assigned to US Holding and had a maturity of November 30, 2023. The 2009 Credit Agreement provided for a term loan that bore interest at a rate of 7.5 %, with interest payments due semi-annually on June 20 and December 20 in each year (the “ 7.5 % Term loan”). The outstanding balance of the 7.5 % Term loan at December 31, 2021 was $ 139 million. The fair value of this term loan at December 31, 2021 was $ 182 million; however the Company had the ability to prepay the outstanding principal balance at the carrying amount without penalty. In November 2022, the Company repaid the aggregate principal amount of $ 139 million. Upon repayment the 2009 Credit Agreement was terminated. In June 2017, the Company entered into an unsecured term loan with US Holding in the principal amount of $ 137.5 million, the proceeds of which were used to finance the acquisition of Daylight Solutions, Inc. (the “Daylight Term Loan”). The Daylight Term Loan had an outstanding balance of $ 78 million at December 31, 2021, which approximated its fair value. The Daylight Term Loan matures on October 15, 2024. The Daylight Term Loan had an interest rate of 5.0 %, with interest payments due semi-annually on April 15 and October 15. During 2022, the Company repaid the aggregate principal amount of $ 78 million. Upon repayment the 2009 Credit Agreement was terminated. Credit Facilities The 2009 Credit Agreement provided for a revolving credit facility available for working capital needs of the Company (the “Revolving Credit Facility”). As of December 31, 2021, the Revolving Credit Facility had a credit limit of $ 450 million, and an interest rate of LIBOR plus 3.5 %. There was a commitment fee of 0.25 % applied to the unused balance of the Revolving Credit Facility and there was no compensating balance requirements. There was no balance on the Revolving Credit Facility as of December 31, 2021. The 2009 Credit Agreement was terminated in November 2022. The Company also maintains uncommitted working capital credit facilities with certain financial institutions in the aggregate of $ 65 million and $ 65 million at December 31, 2022 and 2021, respectively (the “Financial Institution Credit Facilities”). The Financial Institution Credit Facilities are guaranteed by Leonardo S.p.A. The primary purpose of the Financial Institution Credit Facilities is to support standby letter of credit issuances on contracts with customers and also includes a revolving facility with a maximum borrowing limit of $ 15 million, which bears interest at LIBOR plus 0.5 %. At December 31, 2022 and 2021, there was no balance outstanding on the revolving facility. The Company had letters of credit outstanding of approximately $ 36 million and $ 35 million as of December 31, 2022 and 2021, respectively, which reduces the available capacity of the Financial Institution Credit Facilities by an equal amount. 126 LEONARDO DRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) The 2022 Credit Agreement provides for a revolving credit facility available for working capital needs of the Company, (“the 2022 Revolving Credit Facility”). As of December 31, 2022 the 2022 Revolving Credit Facility had a limit of $ 275 million loans under the 2022 Revolving Credit Facility bear interest at a variable rate generally based on the Secured Overnight Financing Rate, (“SOFR”), plus a spread ranging from 1.48 % to 2.10 % depending on the leverage ratio, as defined in the 2022 Credit Agreement, or an alternative variable rate based on the higher of the Bank of America prime rate, the federal funds rate, or a rate generally based on SOFR, in each case subject to additional basis point spread as defined in the 2022 Credit Agreement, The Company also pays a commitment fee ranging between 0.20 % and 0.35 % depending on the Company’s leverage ratio applied to the unused balance of the 2022 Revolving Credit Facility. There was no outstanding balance on the 2022 Revolving Credit Facility as of December 31, 2022. The weighted average interest rate on the 2022 Revolving Credit Facility as of December 31, 2022 and 2021 was 4.58 % and 3.67 %, respectively. Finance Lease and Other As of December 31, 2022, finance lease and other of $ 161 million includes approximately $ 113 million related to finance lease liabilities and $ 48 million related to our Menomonee Falls, WI manufacturing facility, which has been accounted for as a build-to-suit lease with a failed sale leaseback. Approximately $ 8 million has been recognized as the current portion of long-term debt for the finance lease liabilities and financing liability related to the build-to-suit arrangement. Short-term Borrowings As of December 31, 2022 and 2021, the Company recognized $ 10 million and $ 15 million, respectively, collected on behalf of the buyers of our trade receivables pursuant to our factoring arrangements as short-term borrowings and current portion of long-term debt in the Consolidated Balance Sheet, which approximates its fair value. See Note 4: Accounts Receivable and Note 5: Sale of Receivables for more information. Interest Paid Total interest paid associated with our debt was $ 34 million, $ 35 million and $ 64 million in 2022, 2021 and 2020, respectively. Our effective interest rate was approximately 5.57 %, 4.05 % and 5.19 % for the years ended December 31, 2002, 2021 and 2020, respectively. The interest expense attributable to the amortization of debt issuance costs in 2022 was not material and not applicable for 2021 and 2020. Maturities of debt as of December 31, 2022 are as follows: (Dollars in millions) Year Ending December 31, 2023 $ 29 2024 20 2025 20 2026 20 2027 187 Thereafter 120 Total principal payments $ 396 Note 14. Pension and Other Postretirement Benefits Retirement Plan Summary Information The Company maintains multiple pension plans, both contributory and non-contributory, covering employees at certain locations. Eligibility requirements for participation in the plans vary and benefits generally are based on the participant's compensation and years of service, as defined in the respective 127 LEONARDO DRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) plan. The Company's funding policy generally is to contribute in accordance with cost accounting standards that affect government contractors, subject to the Tax Code and regulations thereunder. With respect to U.S. qualified pension plans, we intend to contribute annually not less than the required minimum funding thresholds. For all periods presented, the Company made no discretionary pension contributions. Plan assets are invested primarily in equities, bonds (both corporate and U.S. government), U.S. government-sponsored entity instruments, cash and cash equivalents and real estate. The Company also provides postretirement medical benefits for certain retired employees and dependents at certain locations. Participants are eligible for these benefits when they retire from active service and meet the eligibility requirements for the Company's postretirement benefit plans. The Company's contractual arrangements with the U.S. government provide for the recovery of contributions to a Voluntary Employees' Beneficiary Association (“VEBA”) trust and, for non-funded plans, recovery of claims on a pay-as-you-go basis, subject to the Tax Code and regulations thereunder, with the retiree generally paying a portion of the costs through contributions, deductibles and coinsurance provisions. The Company also maintains certain non-contributory and unfunded supplemental retirement plans. Eligibility for participation in the supplemental retirement plans is limited, and benefits generally are based on the participant's compensation and/or years of service. 128 LEONARDO DRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) The following tables provide certain information regarding the Company's pension, postretirement and supplemental retirement plans as of December 31, 2022 and 2021: Defined Benefit Pension Plans Postretirement Benefit Plans Supplemental Retirement Plans (Dollars in millions) 2022 2021 2022 2021 2022 2021 Change in benefit obligation: Benefit obligation at beginning of year $ 215 $ 226 $ 2 $ 2 $ 22 $ 23 Service cost — — — — — — Interest cost 6 5 — — 1 1 Plan participants' contributions — — — — — — Actuarial (gain) loss ( 45 ) ( 3 ) — — ( 5 ) ( 1 ) Benefits paid ( 9 ) ( 13 ) ( 1 ) — ( 1 ) ( 1 ) (Gain) loss due to settlement ( 5 ) — — — — — Plan amendments — — — — — — Exchange rate differences and other — — — — — — Benefit obligation at end of year $ 162 $ 215 $ 1 $ 2 $ 17 $ 22 Change in plan assets: Fair value of plan assets at beginning of year $ 166 $ 151 $ 1 $ 1 $ 12 $ 11 Actual return on plan assets ( 33 ) 15 — — ( 1 ) 1 Plan participants' contributions — — — — — — Employer contributions 3 13 — — 1 1 Benefits paid ( 9 ) ( 13 ) — — ( 1 ) ( 1 ) (Loss) gain due to settlement ( 3 ) — — — — — Exchange rate differences and other — — — — — — Fair value of plan assets at end of year 124 166 1 1 11 12 Contributions between measurement date and year end — — — — — — Funded status of the plans at year end $ ( 38 ) $ ( 49 ) $ — $ ( 1 ) $ ( 6 ) $ ( 10 ) The amounts recognized in the Consolidated Balance Sheet, as of December 31, 2022 and 2021 consist of: Defined Benefit Pension Plans Postretirement Benefit Plans Supplemental Retirement Plans (Dollars in millions) 2022 2021 2022 2021 2022 2021 Noncurrent assets $ — $ — $ 1 $ 1 $ — $ — Current liabilities — — — — — — Noncurrent liabilities ( 38 ) ( 49 ) ( 1 ) ( 2 ) ( 6 ) ( 10 ) Net liability recognized $ ( 38 ) $ ( 49 ) $ — $ ( 1 ) $ ( 6 ) $ ( 10 ) 129 LEONARDO DRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Amounts recognized in accumulated other comprehensive income (before taxes) at December 31, 2022 and 2021 consist of: Defined Benefit Pension Plans Postretirement Benefit Plans Supplemental Retirement Plans (Dollars in millions) 2022 2021 2022 2021 2022 2021 Prior service cost $ — $ — $ — $ — $ — $ — Net actuarial loss (gain) 31 40 ( 1 ) ( 1 ) 2 6 Total amount recognized in accumulated other comprehensive losses (earnings) $ 31 $ 40 $ ( 1 ) $ ( 1 ) $ 2 $ 6 The aggregate accumulated benefit obligation (“ABO”) for the Company's defined benefit pension plans combined was $ 179 million and $ 237 million at December 31, 2022 and 2021, respectively. The ABO represents benefits accrued without assuming future compensation increases to plan participants and is approximately equal to our projected benefit obligation (“PBO”). The table below presents information for the pension plans with an ABO and PBO in excess of the fair value of plan assets at December 31, 2022 and 2021. (Dollars in millions) 2022 2021 Projected benefit obligation $ 179 $ 237 Accumulated benefit obligation 179 237 Fair value of plan assets 135 178 The following table summarizes the weighted average actuarial assumptions used to determine our benefit obligations at December 31, 2022 and 2021: Defined Benefit Pension Plans Postretirement Benefit Plans Supplemental Retirement Plans 2022 2021 2022 2021 2022 2021 Rate assumptions Discount rate 5.0 % 2.8 % 4.9 % 2.6 % 5.1 % 2.8 % Increase in future compensation levels N/A N/A N/A N/A N/A N/A Expected long-term return on plan assets 7.2 % 5.9 % 7.2 % 5.9 % N/A N/A Health care trend rate assumed for next year N/A N/A 5.3 % 4.6 % N/A N/A Ultimate health care trend rate N/A N/A 4.2 % 4.3 % N/A N/A Year rate reaches ultimate trend rate N/A N/A 2037 2031 N/A N/A The following table summarizes the components of net periodic benefit cost for the Company's pension, postretirement and supplemental retirement plans for the years ended December 31, 2022 and 2021 and 2020. Net actuarial gains and losses are amortized to expense when they exceed the 10% 130 LEONARDO DRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) accounting corridor, based on the greater of the plan assets or benefit obligations, over the average future lifetime for all plans that are frozen, and over the average remaining service period for active plans. Defined Benefit Pension Plans Postretirement Benefit Plans Supplemental Retirement Plans (Dollars in millions) 2022 2021 2020 2022 2021 2020 2022 2021 2020 Service cost $ — $ — $ — $ — $ — $ — $ — $ — $ — Interest cost $ 6 $ 5 $ 7 $ — $ — $ — $ 1 $ 1 $ 1 Expected return on plan assets $ ( 7 ) $ ( 7 ) $ ( 8 ) $ — $ — $ — $ — $ — $ — Amortization of net actuarial loss (gain) $ 1 $ 2 $ 3 $ — $ ( 1 ) $ ( 1 ) $ — $ — $ — Amortization of prior service cost $ — $ — $ — $ — $ — $ — $ — $ — $ — Settlement expense (income) $ 1 $ — $ 3 $ — $ — $ — $ — $ — Net periodic benefit cost $ 1 $ — $ 5 $ — $ ( 1 ) $ ( 1 ) $ 1 $ 1 $ 1 The following table summarizes the other changes in plan assets and benefit obligations recognized in other comprehensive earnings for the Company's pension, postretirement and supplemental retirement benefit plans for the years ended December 31, 2022 and 2021 and 2020: Defined Benefit Pension Plans Postretirement Benefit Plans Supplemental Retirement Plans (Dollars in millions) 2022 2021 2020 2022 2021 2020 2022 2021 2020 Net actuarial (gain) loss $ ( 8 ) $ ( 11 ) $ ( 21 ) $ — $ — $ ( 1 ) $ ( 4 ) $ ( 1 ) $ ( 1 ) Prior service cost — — — — — — — — — Amortization of net actuarial (loss) gain from prior years ( 2 ) ( 2 ) ( 6 ) — 1 1 — — — Amortization of prior service cost — — — — — — — — — Other (1) — — — — — — — — — Total recognized in other comprehensive income $ ( 10 ) $ ( 13 ) $ ( 27 ) $ — $ 1 $ — $ ( 4 ) $ ( 1 ) $ ( 1 ) ________________ (1) Includes foreign exchange translation. 131 LEONARDO DRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) The following table summarizes the weighted average actuarial assumptions used to determine our net periodic cost of the plans for the years ended December 31, 2022, 2021 and 2020: Defined Benefit Pension Plans Postretirement Benefit Plans Supplemental Retirement Plans 2022 2021 2020 2022 2021 2020 2022 2021 2020 Rate assumptions Discount rate 2.8 % 2.8 % 2.7 % 2.6 % 2.1 % 2.8 % 2.8 % 2.4 % 2.4 % Expected long - term return on plan assets 5.9 % 6.4 % 6.3 % 5.9 % 6.4 % 5.8 % N/A N/A N/A Increase in future compensation levels N/A N/A N/A N/A N/A N/A N/A N/A N/A Health care trend rate assumed for next year N/A N/A N/A 5.5 % 5.8 % 6.0 % N/A N/A N/A Ultimate health care trend rate N/A N/A N/A 4.2 % 4.5 % 4.5 % N/A N/A N/A Year rate reaches ultimate trend rate N/A N/A N/A 2031 2030 2029 N/A N/A N/A The expected long-term return on plan assets assumption represents the average rate that the Company expects to earn over the long-term on the assets of the Company's benefit plans, including those from dividends, interest income and capital appreciation. The assumption has been determined based on expectations regarding future rates of return for the plans' investment portfolio, with consideration given to the allocation of investments by asset class and historical rates of return for each individual asset class. Pension related expenses are reflected in the Costs of revenues and General and administrative expenses on the Consolidated Statement of Earnings. A one percentage increase or decrease in healthcare trend rates in the table above would have an insignificant impact to our service and interest cost and the postretirement medical obligations. Plan Assets The Retirement Committee has been authorized by the Company’s management to manage the strategic oversight of our defined benefit plan assets held in trust. The Retirement Committee has adopted an investment policy and provides oversight of a third party investment manager who reports to the Retirement Committee on a regular basis. The outsourced third party manager develops investment strategies and makes all of the day to day investment decisions related to the defined benefit plan assets in accordance with the investment policy and target asset allocation targets, therein. Presently all of the plans are governed by a single investment policy and are uniformly invested. As part of the policy statement the Company has implemented a glide path which adjusts the percentage of assets invested in return seeking assets based upon the attainment of specific funding percentages. The non-return seeking assets are invested primarily in bonds with maturities closely matching the anticipated payment of benefits. As the funding percentage increase the glide path reduce the amount of the assets invested in return seeking assets. 132 LEONARDO DRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) The table below represents all of the Company's funded pension plans' and postretirement benefit plans' weighted-average asset allocation at December 31, 2022 and 2021 by asset category: Asset Allocation 2022 2021 Asset Category Equity securities 37 % 41 % Debt securities 49 % 47 % Real estate 6 % 6 % Other, primarily cash and cash equivalents, and hedge funds 8 % 6 % The table below presents the target allocation ranges for each major asset category for the Company's benefit plans for the years ended December 31, 2022 and 2021. Target Asset Allocation Range 2022 2021 Asset Category Equity securities 30 % - 50 % 40 % - 60 % Debt securities 45 % - 65 % 30 % - 50 % Real estate — % - 10 % 5 % - 10 % Other, primarily cash and cash equivalents and hedge funds — % - 10 % 5 % - 10 % The following tables provides the fair value of plan assets held by our defined benefit plan by asset category and by fair value hierarchy level. Certain investments are measured at their NAV per share and 133 LEONARDO DRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) do not have readily determined fair values. As such, these investments are not subject to leveling in the fair value hierarchy. December 31, 2022 (Dollars in millions) Level 1 Level 2 Level 3 Total Asset category Investments measured at fair value: Cash and cash equivalents $ 10 $ — $ — $ 10 Equity securities 5 — — 5 Debt securities — — — — Total $ 15 $ — $ — $ 15 Investments measured at NAV: Collective trust funds — — — 121 Equity and fixed income funds — — — — Total $ 15 $ — $ — $ 136 December 31, 2021 (Dollars in millions) Level 1 Level 2 Level 3 Total Asset category Investments measured at fair value: Cash and cash equivalents $ 11 $ — $ — $ 11 Equity securities 6 — — 6 Debt securities — — — — Total $ 17 $ — $ — $ 17 Investments measured at NAV: Collective trust funds — — — 162 Equity and fixed income funds — — — — Total $ 17 $ — $ — $ 179 For the year ended December 31, 2023, the Company expects to contribute $ 8 million to its pension plans and an inconsequential amount to its postretirement plans. The following table presents expected pension and postretirement benefit payments over the next 10 years: (Dollars in millions) Defined Benefit Pension Plans Postretirement Benefit Plans Supplemental Retirement Plans Year Ending December 31, 2023 $ 11 $ — $ 1 2024 12 — 1 2025 12 — 1 2026 12 — 1 2027 12 — 1 2028-2032 59 1 6 Defined Contribution Plans The Company maintains defined contribution plans covering substantially all domestic full-time eligible employees. The Company's contributions to these plans for the years ended December 31, 2022, 2021 and 2020 amounted to $ 22 million, $ 22 million and $ 21 million, respectively. 134 LEONARDO DRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Note 15. Equity Method Investments Our share of net earnings related to our equity method investments was $ 1 million, $ 2 million and $ 3 million for the years ended December 31, 2022, 2021 and 2020, respectively, which was included in our Advanced Sensing and Computing business segment operating profit. Below is a list of the entities accounted for under the equity method and recorded in other noncurrent assets on our Consolidated Balance Sheet: % of Ownership Carrying Value (Dollars in millions) 2022 2021 2022 2021 Advanced Acoustics Concepts, LLC — % 51 % $ — $ 27 Note 16. Share-based Compensation Plans In November 2022, the Company established the 2022 Omnibus Equity Compensation Plan (the “2022 Equity Plan”). The 2022 Equity Plan allows for grants of stock options, stock appreciation rights, restricted shares, restricted stock units and performance-based awards. As of December 31, 2022, there were 4 million shares of the Company’s common stock reserved for future issuances under the 2022 Equity Plan. Under the 2022 Equity Plan, the Company granted restricted stock units (“RSUs”) and performance-based restricted stock units (“PRSUs”), referred to as a one-time founders award. The RSUs are subject to time-based vesting over a two -year period. The PRSUs are subject to both time and performance-based vesting based on the Company’s share price metric market condition over a two -year period. In November 2022, in conjunction with the acquisition of RADA, the Company assumed 5.4 million stock options. In accordance with the Merger Agreement, the outstanding stock options were exchanged into options to purchase the Company’s common stock. The assumed stock options are subject to the same terms and conditions as the original awards, including time-based vesting. The options are generally exercisable for 48 months following the date of vesting. In November 2022, in conjunction with the acquisition of RADA, the Company converted the 2022 long-term incentive (“LTI”) program from a cash-based plan to an equity plan. The conversion was treated as a liability to equity modification. Following the modification, equity awards were granted in the form of RSUs and PRSUs. The RSUs are subject to annual time-based vesting over a three -year period. The PRSUs are subject to both time and performance-based vesting based upon the achievement of three financial metrics over a three -year period: Relative Total Shareholder Return (“rTSR”), Revenue Growth, and Return on Invested Capital (“ROIC”). The fair value of stock options is measured on the date of the acquisition of RADA using the Black-Scholes option pricing model. The fair value of market condition PRSUs is measured on the date of grant using the Monte Carlo Simulation Model. Expense for time-based awards is recognized on a straight-line basis over the requisite service period. Forfeitures are recognized as they occur. Share-based compensation during the fiscal year ended December 31, 2022 was recorded in the Consolidated Statements of Earnings within general and administrative expenses as shown in the following table (in millions) : Total Share-Based Compensation Expense $ 5 Tax benefit recognized from Share-Based Compensation 1 There was no share-based compensation expense recognized for the fiscal years ended December 31, 2021 and 2020. Stock Options 135 LEONARDO DRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) The assumptions used in valuing stock options during the period are set forth in the following table: Year Ended December 31, 2022 Expected term (1) 0.04 – 5.18 years Expected volatility (2) 45.0 % Risk-free interest rate (3) 3.8 – 4.7 % Expected dividend yield (4) — % (1) The expected term is based upon historical experience and represents the period of time between when the options are granted and when they are expected to be exercised. (2) The computation of expected volatility is based on a blend of historical RADA volatility and leverage-adjusted historical volatility of the Company’s publicly traded peers. (3) The risk-free interest rate is based on the bootstrap adjusted U.S. Treasury Rate Yield Curve Rate as of the valuation date, term matched with expected life of the awards. (4) The expected dividend yield is based on the Company’s historical experience and expectation of future dividend payouts and may be subject to changes in the future. The weighted-average valuation date fair values for options assumed during the fiscal year ended December 31, 2022 was $ 4.58 . The following table shows a summary of all option activity under the 2022 Equity Plan: Number of Shares (in millions) Weighted Average Exercise Price Per Share Weighted Average Remaining Contractual Term (in years) Aggregate Intrinsic Value (Dollars in millions) Outstanding as of January 1, 2022 — $ — Assumed 5.38 $ 8.42 Exercised ( 0.04 ) $ 3.34 Forfeited — — Outstanding as of December 31, 2022 5.34 $ 8.45 4 $ 23 Exercisable as of December 31, 2022 4.11 $ 8.07 4 $ 20 Vested and expected to vest as of December 31, 2022 5.34 $ 8.45 4 $ 23 As of December 31, 2022, total compensation expense not yet recognized related to unvested options was approximately $ 4 million, which is expected to be recognized over a weighted average period of 3 years. The total intrinsic value of stock options exercised during the fiscal year ended December 31, 2022, was insignificant. RSUs and PRSUs The following table shows a summary of all RSU activity under the 2022 Equity Plan: 136 LEONARDO DRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Number of Shares (in millions) Weighted Average Grant Date Fair Value Unvested as of January 1, 2022 — $ — Granted 1.43 $ 9.87 Vested — $ — Forfeited — $ — Unvested as of December 31, 2022 1.43 $ 9.87 As of December 31, 2022, total compensation expense not yet recognized related to unvested RSUs was approximately $ 11 million, which is expected to be recognized over a weighted average period of 2 years. The following table shows a summary of all PRSU activity under the 2022 Equity Plan: Number of Shares (in millions) Weighted Average Grant Date Fair Value Unvested as of January 1, 2022 — $ — Granted 1.20 $ 7.20 Vested — $ — Forfeited — $ — Unvested as of December 31, 2022 1.20 $ 7.20 The Monte Carlo Model assumptions used in valuing market condition PRSUs during the period are set forth in the following table: Year Ending December 31, 2022 Grant Date Stock Price $ 9.87 Expected volatility 40.0 % Risk-free interest rate 4.4 % Expected dividend yield (4) — % As of December 31, 2022, total compensation expense not yet recognized related to unvested PRSUs was approximately $ 7 million, which is expected to be recognized over a weighted average period of 2 years. 137 LEONARDO DRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Note 17. Earnings Per Share (Dollars in millions, except per share amounts; shares in millions 2022 2021 2020 Net earnings attributable to common shareholders $ 405 $ 154 $ 85 Basic weighted average number of shares outstanding 215 210 210 Impact of dilutive share-based awards — — — Diluted weighted average number of shares outstanding 215 210 210 Earnings per share attributable to common shareholders - basic $ 1.88 $ 0.73 $ 0.40 Earnings per share attributable to common shareholders - diluted $ 1.88 $ 0.73 $ 0.40 For the year ended December 31, 2022, potential dilutive common shares primarily consisted of employee stock options, RSUs and PRSUs, however, the amount of dilutive securities included in the diluted weighted average number of shares outstanding was immaterial. For the years ended December 31, 2021 and 2020, the basic and diluted weighted average number of shares outstanding were equal as there were no dilutive securities. The computation of diluted EPS excludes the effect of the potential exercise of stock awards when the average market price of the common stock is lower than the exercise price of the stock awards during the period because the effect would be anti-dilutive. In addition, the computation of diluted EPS excludes stock awards whose issuance is contingent upon the satisfaction of certain performance vesting conditions. During the year ended December 31, 2022, there were 3 million stock awards excluded from the computation. During the years ended December 31, 2021, and 2020 there were no anti-dilutive securities. Note 18. Commitments and Contingencies Commitments The Company’s commitments are primarily related to our lease and credit agreements. See Note 11 : Leases and Note 13 : Debt for additional information on our leases and credit agreements. Contingencies From time to time, we are subject to certain legal proceedings and claims in the ordinary course of business. These matters are subject to many uncertainties, and it is possible that some of these matters ultimately could be decided, resolved or settled in a manner adverse to us. Although the precise amount of liability that may result from these matters is not ascertainable, the Company believes that any amounts exceeding the Company's recorded accruals should not materially adversely affect the Company's financial condition or liquidity. It is possible, however, that the ultimate resolution of those matters could result in a material adverse effect on the Company's results of operations and/or cash flows from operating activities for a particular reporting period. We establish reserves for specific legal matters when we determine that the likelihood of an unfavorable outcome is probable, and the loss is reasonably estimable. Some environmental laws, such as the Comprehensive Environmental Response, Compensation and Liability Act of 1980 (also known as “CERCLA” or the “Superfund law”) and similar state statutes, can impose liability upon former owners or operators for the entire cost of investigating and remediating contaminated sites regardless of the lawfulness of the original activities that led to the contamination. In July 2000, an entity which later became a subsidiary of the Company received a Section 104(e) Request for Information (“RFI”) from the National Park Service (“NPS”), pursuant to CERCLA, regarding the presence of radioactive material at a site within a national park, which site was operated by an alleged predecessor to our subsidiary over 50 years ago. Following the subsidiary’s response to the RFI, the NPS directed it and another alleged former operator to perform an Engineering Evaluation and Cost Analysis 138 LEONARDO DRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (“EE/CA”) of a portion of the site. The Company’s subsidiary made a good faith offer to conduct an alternative EE/CA work plan, but the NPS rejected this offer and opted to perform the EE/CA itself. The NPS previously posted its intention to open a formal public comment period regarding the EE/CA at the end of 2019. To the Company’s knowledge, the EE/CA has not been released and a public comment period has yet to be opened. Following completion of the EE/CA, the NPS may seek reimbursement for its investigative and remedial efforts to date, or direct one or more of the potentially responsible parties to perform any remediation that may be required by CERCLA or may enter an alternative dispute resolution proceeding to attempt to resolve each party’s share. In addition, the NPS may seek to recover damages for loss of use of certain natural resources. The Company believes that it has legitimate defenses to its subsidiary’s potential liability and that there are other potentially responsible parties for the environmental conditions at the site, including the U.S. government as owner, operator and arranger at the site. The potential liability associated with this matter could change substantially due to such factors as additional information on the nature or extent of contamination, methods of remediation that might be recommended or required, changes in the apportionment of costs among the responsible parties, whether the NPS seeks to recover additional damages, whether the NPS’s plans to investigate additional areas to identify a need for further remedial action for which the Company may be identified as a potentially responsible party and other actions by governmental agencies or private parties. The Company has recorded its best estimate of damages and its share of remediation costs related to the site to reflect what we and our advisors reasonably believe we would be liable for based on the current information and circumstances of the claim, exclusive of other potential liabilities that may be asserted in the future. In the performance of our contracts, we routinely request contract modifications that require additional funding from the customer. Most often, these requests are due to customer-directed changes in the scope of work. While we are entitled to recovery of these costs under our contracts, the administrative process with our customer may be protracted. Based on the circumstances, we periodically file requests for equitable adjustment (“REAs”) that are sometimes converted into claims. In some cases, these requests are disputed by our customer. We believe our outstanding modifications, REAs and other claims will be resolved without material impact to our results of operations, financial condition or cash flows. As a government contractor, with customers including the U.S. government as well as various state and local government entities, the Company may be subject to audits, investigations and claims with respect to its contract performance, pricing, costs, cost allocations and procurement practices. Additionally, amounts billed under such contracts, including direct and indirect costs, are subject to potential adjustments before final settlement. Management believes that adequate provisions for such potential audits, investigations, claims and contract adjustments, if any, have been made in the Consolidated Financial Statements. Restructuring costs We engage in targeted restructuring initiatives in order to rationalize headcount and align our operations in a more strategic and cost-efficient structure. In connection with these restructuring initiatives, we recorded charges totaling $ 3 million, $ 5 million and $ 12 million for the years ended December 31, 2022, 2021 and 2020, respectively. Costs incurred were related to employee termination and severance costs, as well as costs related to discontinuing product lines or closing down of locations. Charges were recorded within other operating expenses, net, with the exception of costs incurred related 139 LEONARDO DRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) to the write-down of inventory, which were recorded in cost of products. See the table below for a breakout of restructuring costs incurred by segment and by nature of cost incurred: Year Ended December 31, (Dollars in millions) 2022 2021 2020 ASC Severance $ 2 $ 5 $ 6 Facility abandonment 1 — — Inventory — — — Total ASC 3 5 6 IMS Severance — — — Facility abandonment — — 6 Inventory — — — Total IMS — — 6 Corporate Severance — — — Facility abandonment — — — Inventory — — — Total Corporate — — — Total $ 3 $ 5 $ 12 The following is a summary of changes in the restructuring provision balance during the years ended December 31, 2021 and 2022: (Dollars in millions) Balance at January 1, 2021 $ 1 Additional provision 5 Reversal and utilization ( 2 ) Balance at December 31, 2021 4 Additional provision 3 Reversal and utilization ( 3 ) Balance at December 31, 2022 $ 4 Product Warranties Product warranty costs generally are accrued in proportion to product revenue realized in conjunction with our over-time revenue recognition policy. Product warranty expense is recognized based on the term of the product warranty, generally one year to three years , and the related estimated costs, considering historical claims expense. Accrued warranty costs are reduced as these costs are incurred and as the warranty period expires, and otherwise may be modified as specific product performance issues are 140 LEONARDO DRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) identified and resolved. The following is a summary of changes in the product warranty balances during the years ended December 31, 2021 and 2022: (Dollars in millions) Balance at January 1, 2021 $ 17 Additional provision 17 Reversal and utilization ( 15 ) Balance at December 31, 2021 19 Additional provision 10 Reversal and utilization ( 11 ) Balance at December 31, 2022 $ 18 Note 19. Related Party Transactions Although we operate largely independently from Leonardo S.p.A. and the proxy agreement contains limitations on services that we may provide to and receive from Leonardo S.p.A. and its affiliates, we have historically provided, and expect to continue to provide, certain services to Leonardo S.p.A. and its affiliates to support its U.S. operations (aside from us). These services include financial, tax, trade compliance, marketing and communications and legal. The Company also has related-party sales and purchases with the Majority Stockholder and its other affiliates that occur in the regular course of business. The Company also hold an approximately 10 % interest in Hoverfly Technologies, Inc. (“Hoverfly”), which designs, develops and manufactures power-tethered unmanned aerial systems and related products. The Company is also party to an exclusive manufacturing and teaming agreement with Hoverfly where we have related-party sales and purchases with Hoverfly. Related-party sales for these transactions are included in revenues and were $ 67 million, $ 11 million and $ 26 million for the years ended December 31, 2022, 2021 and 2020, respectively. The Company has related-party purchases with the Majority Stockholder and its other affiliates that occur in the regular course of business. Related-party purchases for these transactions are included in cost of revenues and were $ 5 million and $ 4 million for the years ended December 31, 2022 and 2021, respectively. The receivables and payables related to transactions with the Majority Stockholder and its other affiliates of $ 14 million and $ 2 million, respectively, and payables of $ 1 million and $ 1 million, respectively, are included in accounts receivable and accounts payable in our Consolidated Balance Sheet as of December 31, 2022 and 2021. In addition, there was a related-party balance in contract assets of $ 5 million at December 31, 2022. Prior to acquiring RADA on November 28, 2022, the Company considered RADA a related party due to a common Board Member. As of November 28, 2022, the Company purchased $ 17 million from RADA and had paid the invoices. After November 28, 2022, all transactions with RADA are eliminated in consolidation. The Company entered into Tax Allocation Agreement with US Holding, dated as of November 16, 2020. See Note 1: Summary of Significant Accounting Policies for more information. Note 20. Segment Information Operating segments represent components of an enterprise for which separate financial information is available that is regularly reviewed by the CODM in determining how to allocate resources and assess performance. Our Chief Executive Officer is our CODM and he uses a variety of measures to assess the performance of the Company as a whole, depending on the nature of the activity. Beginning in the first quarter of 2022, the Company’s operating and reportable segments were revised into two reportable segments, ASC and IMS, to align our market strategy and capital allocation decision making with our operating structure. Prior year information was revised to reflect the new segment structure. All other 141 LEONARDO DRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) operations, which consists primarily of DRS Corporate Headquarters and certain non-operating subsidiaries of the Company, are grouped in Corporate & Eliminations. We primarily use Adjusted EBITDA to manage the Company and allocate resources. Adjusted EBITDA of our business segments includes our net earnings before income taxes, amortization of acquired intangible assets, depreciation, restructuring costs, interest, deal related transaction costs, acquisition and divestiture related expenses, foreign exchange, COVID-19 response costs, non-service pension expenditures and other one-time non-operational events. Adjusted EBITDA is used to facilitate a comparison of the ordinary, ongoing and customary course of our operations on a consistent basis from period to period and provide an additional understanding of factors and trends affecting our business segments. This measure assists the CODM in assessing segment operating performance consistently over time without the impact of our capital structure, asset base and items outside the control of the management team and expenses that do not relate to our core operations. Certain information related to our segments for the years ended December 31, 2022, 2021 and 2020, is presented in the following tables. Consistent accounting policies have been applied by all segments within the Company, within all reporting periods. A description of our reportable segments as of December 31, 2022 and 2021 has been included in Note 1: Summary of Significant Accounting Policies . Intersegment sales are generally transferred at cost to the buying segment, and the sourcing segment does not recognize a profit. Such intercompany operating income is eliminated in consolidation, so that the Company’s total revenues and operating earnings reflect only those transactions with external customers. Total revenues and intersegment revenues by segment for the years ended December 31, 2022, 2021 and 2020 consists of the following: (Dollars in millions) 2022 2021 2020 ASC $ 1,733 $ 1,940 $ 1,958 IMS 983 959 834 Corporate & Eliminations ( 23 ) ( 20 ) ( 14 ) Total revenue $ 2,693 $ 2,879 $ 2,778 (Dollars in millions) 2022 2021 2020 ASC $ 21 $ 19 $ 13 IMS 2 1 1 Total intersegment revenue $ 23 $ 20 $ 14 Depreciation by segment as of December 31, 2022, 2021 and 2020 consists of the following: (Dollars in millions) 2022 2021 2020 ASC $ 36 $ 33 $ 30 IMS 19 16 14 Total depreciation $ 55 $ 49 $ 44 Total assets by segment as of December 31, 2022 and 2021 consist of the following: (Dollars in millions) 2022 2021 ASC $ 2,167 $ 1,545 IMS 1,152 1,145 Corporate & Eliminations 358 379 Total assets $ 3,677 $ 3,069 142 LEONARDO DRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Reconciliation of reportable segment Adjusted EBITDA to Net Earnings (loss) consists of the following: (Dollars in millions) 2022 2021 2020 Adjusted EBITDA ASC $ 199 $ 220 $ 213 IMS 119 90 55 Corporate & Eliminations — — — Total Adjusted EBITDA $ 318 $ 310 $ 268 Amortization of intangibles ( 10 ) ( 9 ) ( 9 ) Depreciation ( 55 ) ( 49 ) ( 44 ) Restructuring costs ( 3 ) ( 5 ) ( 12 ) Interest expense ( 34 ) ( 35 ) ( 64 ) Deal related transaction costs ( 43 ) ( 5 ) ( 9 ) Other non-operating expense ( 2 ) ( 7 ) ( 18 ) Gain on sale of dispositions 354 — — Income tax provision ( 120 ) ( 46 ) ( 27 ) Net earnings $ 405 $ 154 $ 85 Note 21. Subsequent Events The Company has evaluated subsequent events through March 28, 2023, which represents the date on which the Consolidated Financial Statements were issued. There were no subsequent events that require disclosure. 143 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None.