KEY TRONIC CORP 10-K

Item 8: FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Report of Independent Registered Public Accounting Firm To the Shareholders and the Board of Directors of Key Tronic Corporation Opinion on the Financial Statements We have audited the accompanying consolidated balance sheets of Key Tronic Corporation (the “Company”) as of July 1, 2023 and July 2, 2022, the related consolidated statements of income, comprehensive income, shareholders’ equity, and cash flows for the years 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 consolidated financial position of the Company as of July 1, 2023 and July 2, 2022, and the consolidated results of its operations and its cash flows for the years then ended, in conformity with accounting principles generally accepted in the United States of America. Basis for Opinion These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s 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. 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 audits 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 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 to 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. Critical Audit Matter The critical audit matter communicated below is a matter arising from the current period audit of the consolidated financial statements that was communicated or required to be communicated to the audit committee and that (1) relates to accounts or disclosures that are material to the consolidated 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 matter below, providing a separate opinion on the critical audit matter or on the accounts or disclosures to which it relates. As described in Notes 1 and 12 to the consolidated financial statements, the Company reported revenue of $588.1 million for the year ended July 1, 2023, of which $573.4 million related to revenue recognized over time. The Company has determined that for the majority of its contracts the Company is manufacturing products for which there is no alternative use due to the unique nature of the customer-specific product, intellectual property, and other contract restrictions. The Company has an enforceable right to payment including a reasonable profit for performance completed to date with respect to these contracts. As a result, revenue is recognized under these contracts over-time based on the input cost-to-cost method as it better depicts the transfer of control. This input method is based on the ratio of costs incurred to date as compared to the total estimated costs at completion of the performance obligation. We identified revenue recognized over time on contracts for manufacturing products as a critical audit matter. Management’s calculation includes reports with varying elements, to estimate costs incurred to date for various performance obligations. Auditing management’s estimates used in the calculation of revenue recognized over time involved especially challenging and subjective auditor judgment when performing audit procedures and evaluating the results of those procedures. The primary procedures we performed to address this critical audit matter included: 26 • Testing the design, implementation, and operating effectiveness of internal controls relating to revenue recognized over time, including controls over the quarterly calculation of in-process contracts, and the related contract assets. • Evaluating the methodology of estimating costs incurred to date on in-process contracts and testing the completeness and accuracy of the system generated reports used to estimate costs incurred by recalculating the expected costs on in-process contracts, vouching to source documents, tracing in-process orders to subsequent sales and shipping documentation within a reasonable period after year-end, identifying and testing significant assumptions used in the revenue calculation, and performing data validation procedures. • Comparing margins realized to trending historic margins, and comparing total revenue recognized to independent expectations of total revenues disaggregated by revenue stream. • Performing cutoff procedures to test that revenue transactions were recorded in the appropriate period. /s/ Moss Adams LLP Seattle, Washington September 26, 2023 We have served as the Company’s auditor since 2021 . 27 KEY TRONIC CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (In thousands) July 1, 2023 July 2, 2022 ASSETS Current assets: Cash and cash equivalents $ 3,603 $ 1,707 Trade receivables, net of allowance for doubtful accounts of $ 23 and $ 12 150,600 135,876 Contract assets 29,925 21,974 Inventories, net 137,911 155,741 Other 27,510 24,710 Total current assets 349,549 340,008 Property, plant and equipment, net 28,870 26,012 Operating lease right-of-use assets, net 16,202 16,731 Other assets: Deferred income tax asset 12,254 10,055 Other 11,397 14,117 Total other assets 23,651 24,172 Total assets $ 418,272 $ 406,923 LIABILITIES AND SHAREHOLDERS ’ EQUITY Current liabilities: Accounts payable $ 115,899 $ 121,393 Accrued compensation and vacation 13,351 11,836 Current portion of debt, net 7,849 7,402 Other 14,867 23,036 Total current liabilities 151,966 163,667 Long-term liabilities: Term loans 6,726 5,716 Revolving loan 114,805 94,577 Operating lease liabilities 10,317 12,023 Deferred income tax liability 274 64 Other long-term obligations 3,567 5,998 Total long-term liabilities 135,689 118,378 Total liabilities 287,655 282,045 Commitments and contingencies (Note 9) Shareholders’ equity: Common stock, no par value—shares authorized 25,000 ; issued and outstanding 10,762 and 10,762 shares, respectively 47,728 47,474 Retained earnings 82,986 77,829 Accumulated other comprehensive (loss) income ( 97 ) ( 425 ) Total shareholders’ equity 130,617 124,878 Total liabilities and shareholders’ equity $ 418,272 $ 406,923 See accompanying notes to consolidated financial statements. 28 KEY TRONIC CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (In thousands, except per share amounts) Fiscal Year Ended July 1, 2023 July 2, 2022 Net sales $ 588,135 $ 531,815 Cost of sales 540,663 488,601 Gross profit 47,472 43,214 Research, development and engineering expenses 9,735 9,821 Selling, general and administrative expenses 25,715 24,598 Gain on insurance proceeds, net of losses ( 4,301 ) — Total operating expenses 31,149 34,419 Operating income 16,323 8,795 Interest expense, net 10,023 5,104 Income before income taxes 6,300 3,691 Income tax provision 1,143 314 Net income $ 5,157 $ 3,377 Net income per share — Basic $ 0.48 $ 0.31 Weighted average shares outstanding — Basic 10,762 10,762 Net income per share — Diluted $ 0.47 $ 0.31 Weighted average shares outstanding — Diluted 10,938 11,063 See accompanying notes to consolidated financial statements. 29 KEY TRONIC CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (In thousands) Fiscal Year Ended July 1, 2023 July 2, 2022 Comprehensive income: Net income $ 5,157 $ 3,377 Other comprehensive income: Unrealized gain (loss) on hedging instruments, net of tax 328 ( 2,497 ) Comprehensive income $ 5,485 $ 880 Other comprehensive income for fiscal years 2023 and 2022 is reflected net of tax provision (benefit) of approximately $ 0 and $( 0.8 ) million, respectively. See accompanying notes to consolidated financial statements. 30 KEY TRONIC CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands) Fiscal Year Ended July 1, 2023 July 2, 2022 Operating activities: Net income $ 5,157 $ 3,377 Adjustments to reconcile net income to cash used in operating activities: Depreciation and amortization 9,542 7,562 Amortization of interest rate swap 328 301 Amortization of deferred loan costs 154 143 Noncash lease expense 5,712 4,261 Inventory write-down to net realizable value 427 950 Provision for warranty 313 446 Provision for doubtful accounts 37 67 Gain on disposal of assets ( 21 ) ( 12 ) Gain on insurance proceeds, net of losses ( 4,301 ) — Share-based compensation expense 254 293 Deferred income taxes ( 1,989 ) 481 Changes in operating assets and liabilities Trade receivables ( 14,760 ) ( 25,619 ) Contract assets ( 7,951 ) 2,807 Inventories 17,403 ( 19,362 ) Other assets ( 1,684 ) ( 5,912 ) Accounts payable ( 5,494 ) 28,569 Accrued compensation and vacation 1,515 365 Other liabilities ( 15,953 ) ( 3,624 ) Cash used in operating activities ( 11,311 ) ( 4,907 ) Investing activities: Purchases of property and equipment ( 9,771 ) ( 6,813 ) Proceeds from sale of fixed assets 1,925 14 Prepayments on finance lease obligations ( 188 ) ( 1,252 ) Proceeds from insurance 3,500 — Cash used in investing activities ( 4,534 ) ( 8,051 ) Financing activities: Payment of financing costs ( 245 ) ( 118 ) Proceeds from issuance of long term debt 4,375 11,594 Repayments of long-term debt ( 2,417 ) ( 2,143 ) Borrowings under revolving credit agreement 596,121 581,893 Repayments of revolving credit agreement ( 575,802 ) ( 577,703 ) Principal payments on finance leases ( 4,291 ) ( 2,331 ) Cash provided by financing activities 17,741 11,192 Net increase (decrease) in cash and cash equivalents 1,896 ( 1,766 ) Cash and cash equivalents, beginning of period 1,707 3,473 Cash and cash equivalents, end of period $ 3,603 $ 1,707 Supplemental cash flow information: Interest payments $ 802 $ 5,110 Income tax payments, net of refunds $ 1,414 $ 1,315 Recognition of operating lease liabilities and right-of-use assets $ 5,184 $ 5,247 Recognition of financing lease liabilities and right-of-use assets $ 1,940 $ 13,096 See accompanying notes to consolidated financial statements. 31 KEY TRONIC CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY (In thousands) Shares Common Stock Retained Earnings Accumulated Other Comprehensive Income (Loss) Total Shareholders’ Equity Balances, July 3, 2021 10,762 47,181 74,452 2,072 $ 123,705 Net income — — 3,377 — 3,377 Unrealized gain on hedging instruments, net of tax — — — ( 2,497 ) ( 2,497 ) Share-based compensation — 293 — — 293 Balances, July 2, 2022 10,762 $ 47,474 $ 77,829 $ ( 425 ) $ 124,878 Net income — 5,157 — 5,157 Unrealized loss on hedging instruments, net of tax — — — 328 328 Share-based compensation — 254 — — 254 Balances, July 1, 2023 10,762 $ 47,728 $ 82,986 $ ( 97 ) $ 130,617 See accompanying notes to consolidated financial statements. 32 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SIGNIFICANT ACCOUNTING POLICIES Business Key Tronic Corporation and subsidiaries (the Company) is engaged in contract manufacturing for original equipment manufacturers (OEMs) and also manufactures keyboards and other input devices. The Company’s headquarters are located in Spokane Valley, Washington with manufacturing operations in Oakdale, Minnesota; Fayetteville, Arkansas; Corinth, Mississippi; and foreign manufacturing operations in Juarez, Mexico; Shanghai, China; and Da Nang, Vietnam. Due to the COVID-19 pandemic, the Company has seen extreme shifts in demand from its customer base, supply chain and logistics risks. The possibility of future temporary closures, as well as adverse fluctuations in customer demand, freight and expedite costs, precautionary safety expenses and labor shortages, collectability of accounts, and future supply chain disruptions during the rapidly changing COVID-19 environment can materially impact operating results. Additionally, continued adverse macroeconomic conditions and significant currency exchange fluctuations can also materially impact operating results. Liquidity Historically, we have financed operations and met our capital expenditure requirements primarily through cash flows provided by operations and borrowings under our credit facilities. We generated operating and net income of $ 16.3 million and $ 5.2 million, respectively, during the 12-month period ended July 1, 2023 and have positive working capital of $ 197.6 million as of July 1, 2023. Due to the timing between the procurement of raw materials, production cycle and payment from our customers, we have relied on borrowings on our credit facilities to fund operations as the Company increased its revenues and backlog during fiscal year 2023. Based on current projections, we anticipate generating cash from operations as revenue slightly decreases in the first quarter of fiscal year 2024 and decreasing working capital requirements as existing backlog is manufactured and shipped. As of July 1, 2023, we have limited additional borrowing capacity on our credit facility. We are in discussions with multiple financial institutions to extend the borrowing capacity on our credit facility. If we are unable to meet projected operating results or extend our borrowing capacity, we may need to delay the purchase of raw materials or require our customers to fund inventory raw material costs ahead of production. Other options to increase our liquidity include factoring receivables or leveraging foreign owned assets for additional borrowing capacity. We believe that projected cash from operations, funds available under our asset-based revolving credit facility and additional financing options will be sufficient to meet our working and fixed capital requirements for at least the next 12 months. Reclassifications Certain prior period reclassifications were made to conform with the current period presentation. These reclassifications had no effect on reported income, comprehensive income, cash flows, total assets, or shareholders' equity as previously reported. Principles of Consolidation The consolidated financial statements include the Company and its wholly owned subsidiaries in the United States, Mexico, China and Vietnam. Intercompany balances and transactions have been eliminated during consolidation. Use of Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Estimates include the allowance for doubtful receivables, calculating inventory impairments related to obsolete and non-saleable inventories to value at net realizable value, deferred tax assets and liabilities, uncertain tax positions, impairment of long-lived assets, medical self-funded insurance liability, long-term incentive compensation accrual, the provision for warranty costs, and the fair value of stock appreciation rights granted under the Company’s share-based compensation plan. Due to uncertainties with respect to the assumptions and estimates, actual results could differ from those estimates. Cash and Cash Equivalents The Company considers investments with an original maturity of three months or less to be cash equivalents. Cash equivalents are carried at cost, which approximates fair value. The Company may have cash and cash equivalents at financial institutions that are in excess of federally insured limits from time to time. Allowance for Doubtful Accounts 33 The Company evaluates the collectability of accounts receivable and records an allowance for doubtful accounts, which reduces the receivables to an amount that management reasonably estimates will be collected. A specific allowance is recorded against receivables considered to be impaired based on the Company’s knowledge of the financial condition of the customer. In determining the amount of the allowance, the Company considers several factors including the aging of the receivables, the current business environment and historical experience. After all attempts to collect a receivable have failed, the receivable is written off against the allowance. Inventories Inventories are stated at the lower of cost or net realizable value. Inventory valuation is determined using the first-in, first-out (FIFO) method. Customer orders are based upon forecasted quantities of product manufactured for shipment over defined periods. Raw material inventories are purchased to fulfill these customer requirements. Within these arrangements, customer demands for products frequently change, sometimes creating excess and obsolete inventories. The Company regularly reviews raw material inventories by customer for both excess and obsolete quantities. Wherever possible, the Company attempts to recover its full cost of excess and obsolete inventories from customers or, in some cases, through other markets. When it is determined that the Company’s carrying cost of such excess and obsolete inventories cannot be recovered in full, a charge is taken against income for the difference between the carrying cost and the estimated realizable amount. We also reserve for inventory related to specific customers covered by lead-time assurance agreements when those customers are experiencing financial difficulties or reimbursement is not reasonably assured. Property, Plant and Equipment Property, plant and equipment are carried at cost and depreciated using straight-line methods over the expected useful lives of the assets. Repairs and maintenance costs are expensed as incurred. Leases Lease assets and liabilities are initially recognized based on the present value of lease payments over the lease term calculated using the Company’s incremental borrowing rate, unless the implicit rate is readily determinable. Our incremental borrowing rate represents the rate of interest that we would have to pay to borrow on a collateralized basis over a similar term in a similar economic environment. Lease assets also include any lease prepayments. Lease terms include options to extend or terminate the lease when it is reasonably certain that those options will be exercised. Leases are classified as finance or operating, with classification affecting the pattern and classification of expense recognition in the consolidated statements of income. For further information, please refer to Footnote “Leases” of the “Notes to Consolidated Financial Statements.” Impairment of Long-lived Assets The Company, using its best estimates based on reasonable and supportable assumptions and projections, reviews assets for impairment whenever events or changes in circumstances have indicated that the carrying amount of its assets might not be recoverable. Impaired assets are reported at the lower of cost or fair value. Accrued Warranty An accrual is made for expected warranty costs, with the related expense recognized in cost of goods sold. Management reviews the adequacy of this accrual quarterly based on historical analyses and anticipated product returns. Self-funded Insurance The Company self-funds its domestic employee health plans. The Company contracts with a separate administrative service company to supervise and administer the programs and act as its representative. The Company reduces its risk under this self-funded platform by purchasing stop-loss insurance coverage for high dollar individual claims. In addition, if the aggregate annual claims amount to more than 125 percent of expected claims for the plan year this insurance will also pay those claims amounts exceeding that level. The Company estimates its exposure for claims incurred but not paid at the end of each reporting period and uses historical claims data supplied by the Company’s broker to estimate its self-funded insurance liability. This liability is subject to a total limitation that varies based on employee enrollment and factors that are established at each annual contract renewal. Actual claims experience may differ from the Company’s estimates. Costs related to the administration of the plan and related claims are expensed as incurred. Revenue Recognition The first step in its process for revenue recognition is to identify the contract with a customer. A contract is defined as an agreement between two or more parties that creates enforceable rights and obligations. A contract can be written, oral, or implied. The Company generally enters into manufacturing service agreements (“MSA”) with its customers that outlines the terms of the business relationship between the customer and the Company. This includes matters such as warranty, 34 indemnification, transfer of title and risk of loss, liability for excess and obsolete inventory, pricing, payment terms, etc. The Company will also bid on a program-by-program basis for customers in which an executed MSA may not be in place. In these instances, as well as when we have an MSA in place, we receive customer purchase orders for specific quantities and timing of products. As a result, the Company considers its contract with a customer to be the combination of the MSA and the purchase order. The transaction price is fixed and set forth in each purchase order. In the Company's normal course of business, there are no variable pricing components, or material amounts refunded to customers in the form of refunds or rebates. The Company assesses whether control of the product or services promised under the contract is transferred to the customer at a point in time (shipment) or over time (as we manufacture the product). The Company is first required to evaluate whether its contracts meet the criteria for 'over-time' or 'point-in-time' recognition. The Company has determined that for the majority of its contracts the Company is manufacturing products for which there is no alternative use due to the unique nature of the customer-specific product, IP and other contract restrictions. The Company has an enforceable right to payment including a reasonable profit for performance completed to date with respect to these contracts. As a result, revenue is recognized under these contracts 'over-time' based on the input cost-to-cost method as it better depicts the transfer of control. This input method is based on the ratio of costs incurred to date as compared to the total estimated costs at completion of the performance obligation. For all other contracts that do not meet these criteria, such as manufacturing contracts for which the terms do not provide an enforceable right to payment for performance completed to date, the Company recognizes revenue when it has transferred control of the related manufactured products which generally occurs upon shipment to the customer. Revenue from engineering services is recognized over time as the services are performed. Shipping and Handling Fees The Company classifies costs associated with shipping and handling fees as a component of cost of goods sold. Customer billings related to shipping and handling fees are reported as revenue. Research, Development and Engineering Research, development and engineering expenses include unreimbursed contract manufacturing costs as well as design and engineering costs associated with the production of contract manufacturing programs. Research, development and engineering costs are expensed as incurred. Income Taxes Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the estimated future tax consequences and benefits attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, as well as tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which temporary differences and carryforwards are expected to be recovered or settled. The effect on deferred tax assets and liabilities for a change in tax rates is recognized in the period that includes the enactment date. Valuation allowances are established when necessary to reduce deferred tax assets to the amount that is more likely than not to be realized. We utilize a two-step approach to recognizing and measuring uncertain tax positions. The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates it is more likely than not that the position will be sustained on audit, including resolution of related appeals or litigation processes, if any. The second step is to measure the tax benefit as the largest amount which is more than 50% likely of being realized upon ultimate settlement. We consider many factors when evaluating and estimating our tax positions and tax benefits, which may require periodic adjustments based on new assessments and changes in estimates and which may not accurately forecast actual outcomes. Our policy is to recognize interest and penalties related to the underpayment of income taxes as a component of income tax provision. The tax years 2003 through the present remain open to examination by the major U.S. taxing jurisdictions to which we are subject. For further discussions, please refer to Footnote “Income Taxes” of the “Notes to Consolidated Financial Statements.” Derivative Instruments and Hedging Activities The Company has previously entered into foreign currency forward contracts and an interest rate swap which are accounted for as cash flow hedges in accordance with ASC 815, Derivatives and Hedging . The effective portion of the gain or loss on the derivative is reported as a component of accumulated other comprehensive income (AOCI) and is reclassified into earnings in the same period in which the underlying hedged transaction affects earnings. The derivative’s effectiveness represents the change in fair value of the hedge that offsets the change in fair value of the hedged item. As of July 1, 2023, the Company did not have any outstanding foreign currency forward contracts. Earnings Per Common Share Basic earnings per common share is computed by dividing net income by the weighted average number of common shares outstanding during the period. Diluted earnings per common share is computed by dividing net income by the combination of other potentially dilutive weighted average common shares and the weighted average number of common shares outstanding 35 during the period using the treasury stock method. The computation assumes the proceeds from the exercise of stock options were used to repurchase common shares at the average market price during the period. The computation of diluted earnings per common share does not assume conversion, exercise, or contingent issuance of common stock equivalent shares that would have an anti-dilutive effect on earnings per share. Foreign Currency Transactions The functional currency of the Company’s subsidiaries in Mexico, China and Vietnam is the U.S. dollar. Realized foreign currency transaction gains and losses for local currency denominated assets and liabilities are included in cost of goods sold. Fair Value of Financial Instruments The carrying values of cash and cash equivalents, accounts receivable, current liabilities, and non-current operating lease liability are reflected on the balance sheets at July 1, 2023 and July 2, 2022, reasonably approximate their fair value. The Company had an outstanding balance on the line of credit of $ 115.4 million as of July 1, 2023 and $ 95.1 million as of July 2, 2022, with a carrying value that reasonably approximates the fair value. The Company had an outstanding balance on the term loan of $ 3.4 million as of July 1, 2023 and $ 4.6 million as of July 2, 2022, with a carrying value that reasonably approximates the fair value. The equipment term loans were $ 6.5 million as of July 1, 2023 and $ 3.3 million as of July 2, 2022, with a carrying value that reasonably approximates the fair value. Share-based Compensation The Company’s incentive plan may provide for equity awards to employees in the form of stock options, stock appreciation rights, restricted stock, restricted stock units, stock awards, stock units, performance shares, performance units, and other stock-based awards. Compensation cost is recognized on a straight-line basis over the requisite employee service period, which is generally the vesting period, and is included in cost of goods sold, research, development and engineering, and selling, general, and administrative expenses. Share-based compensation is recognized only for those awards that are expected to vest, with forfeitures estimated at the date of grant based on historical experience and future expectations. Newly Adopted and Recent Accounting Pronouncements In January 2021, FASB issued Accounting Standard Update (ASU) 2021-01, Reference Rate Reform (Topic 848) to identify alternative reference rates that are more observable or transaction based and less susceptible to manipulation. The Company is currently assessing the effects on its consolidated financial statements, and it intends to adopt the guidance as it becomes effective. In March of 2020, the FASB issued ASU 2020-03, Codification Improvements to Financial Instruments, which clarifies specific issues raised by stakeholders. Specifically, the ASU clarifies the following: 1) that all entities are required to provide the fair value option disclosures in ASC 825, Financial Instruments 2) clarifies that the portfolio exception in ASC 820, Fair Value Measurement, applies to nonfinancial items accounted for as derivatives under ASC 815, Derivatives and Hedging; 3) clarifies that for purposes of measuring expected credit losses on a net investment in a lease in accordance with ASC 326, Financial Instruments - Credit Losses, the lease term determined in accordance with ASC 842, Leases, should be used as the contractual term; 4) clarifies that when an entity regains control of financial assets sold, it should recognize an allowance for credit losses in accordance with ASC 326; and 5) aligns the disclosure requirements for debt securities in ASC 320, Investments - Debt Securities, with the corresponding requirements for depository and lending institutions in ASC 942, Financial Services - Depository and Lending. The amendments in the ASU have various effective dates and transition requirements which are dependent on timing of adoption of ASU 2016-13. The Company is currently assessing the effects on its consolidated financial statements, and it intends to adopt the guidance as they become effective. In June 2016, the FASB issued ASU 2016-13 “Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments” and also issued subsequent amendments to the initial guidance: ASU 2018-19, ASU 2019-04 and ASU 2019-05, which replaces the existing incurred loss impairment model with an expected credit loss model and requires a financial asset measured at amortized cost to be presented at the net amount expected to be collected. The guidance is effective for the Company beginning in the first quarter of fiscal year 2024 with early adoption permitted. The Company is currently assessing the impact on its consolidated financial statements, and it intends to adopt the guidance when it becomes effective in the first quarter of fiscal year 2024. Fiscal Year The Company operates on a 52/53 week fiscal year. Fiscal years end on the Saturday nearest June 30. As such, fiscal years 2023 and 2022 ended on July 1, 2023 and July 2, 2022, respectively. Fiscal years 2022 and 2023 were 52 week years. 36 2. INVENTORIES Net inventory as of July 1, 2023 is $ 137.9 million compared to $ 155.7 million as of July 2, 2022. Substantially all of the Company’s inventory balances are raw materials. 3. PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment consists of the following: Life July 1, 2023 July 2, 2022 (in years) (in thousands) Land — $ 4,034 $ 4,034 Buildings and improvements 3 to 30 26,459 25,841 Equipment 1 to 10 77,823 71,180 Furniture and fixtures 3 to 5 5,418 5,286 Total Property, Plant and Equipment 113,734 106,341 Accumulated depreciation ( 84,864 ) ( 80,329 ) Property, Plant and Equipment, net $ 28,870 $ 26,012 Fiscal Year Ended July 1, 2023 July 2, 2022 (in thousands) Depreciation expense $ 4,700 $ 4,940 4. LONG-TERM DEBT On August 14, 2020, the Company entered into a loan agreement with Bank of America. The Loan Agreement replaces the Company’s prior amended and restated credit agreement, as amended, with Wells Fargo Bank. The Loan Agreement provides for a five-year asset-based senior secured revolving credit facility of up to $ 93 million, maturing on August 14, 2025. On September 3, 2021, the Company entered into an amendment to the Company's current loan agreement with Bank of America. The amendment increases the Company's current credit facility of $ 93 million to $ 120 million, subject to the Company's borrowing base, maturing on September 3, 2026. On August 26, 2022, the Company entered into a third amendment to the loan agreement with Bank of America. The amendment removed the cash flow leverage ratio covenant and increased the interest rate by 25 basis points. In the third quarter of fiscal year 2023, the Company entered into equipment financing agreements with Ameris Bank dba Balboa Capital ("Balboa Capital") totaling $ 4.4 million related to the Company’s existing manufacturing equipment that bears an interest rate range of 6 % - 8 % and matures in the third quarter of fiscal 2029. Under these agreements, equal monthly payments of $ 75,000 commenced in the third quarter of fiscal year 2023 and will continue through the maturity of the equipment financing facility in the third quarter of fiscal 2029. The Company had an outstanding balance $ 4.1 million as of July 1, 2023. As of July 1, 2023, the Company had an outstanding balance under the asset-based revolving credit facility of $ 115.4 million, $ 0.3 million in outstanding letters of credit and $ 4.6 million available for future borrowings. As of July 2, 2022, the Company had an outstanding balance under the asset-based revolving credit facility of $ 95.1 million, $ 0.3 million in outstanding letters of credit and $ 10.8 million available for future borrowings. On August 14, 2020, the Company also entered into a $ 5.0 million equipment financing facility with Bank of America relating to the Company’s existing U.S. manufacturing equipment that bears interest at 4.85 % and matures on August 14, 2025. Under this loan agreement, equal monthly payments of approximately $ 94,000 commenced on September 14, 2020 and will continue through the maturity of the equipment financing facility on August 14, 2025. As of July 1, 2023, the Company had an outstanding balance of $ 2.3 million. As of July 2, 2022, the Company had an outstanding balance of $ 3.3 million. Generally, the interest rate applicable to loans under the Bank of America loan agreement will be, at the Company’s option: (i)(A) the base rate which is the highest of (a) the Prime Rate for such day, (b) the Federal Funds Rate for such day plus 0.50 %, or (c) Term SOFR for a one month interest period as of such day, plus 1.00 % (provided that in no event shall the base rate be less than zero), plus the applicable interest margin for base rate loans; and (B) SOFR rate for an applicable interest period, plus 37 the applicable interest margin for SOFR rate loans. Depending on average daily excess borrowing availability over applicable periods under the Credit Facility, applicable interest margins on: (x) base rate loans will be 1.50 - 2.00 %; and (y) SOFR rate loans will be 2.50 - 3.00 %, resetting on a quarterly basis beginning in early 2021. If there is an event of default under the loan agreement, all loans and other obligations will bear interest at a rate of an additional 2.00 % on the last change rates above otherwise applicable interest rates. In addition to interest charges, the Company is required to pay a fee of 0.25 % per annum on the unused portion of the Credit Facility, monthly in arrears. On November 24, 2020, the Company entered into a $ 6.0 million financing facility related to the Company’s existing real estate located in Mexico that bears interest at 5.52 % and matures on April 24, 2026. Under this loan agreement, equal monthly payments of $ 100,000 commenced on May 24, 2021 and will continue through the maturity of the financing facility on April 24, 2026. The Company had an outstanding balance of $ 3.4 million and $ 4.6 million as of July 1, 2023 and July 2, 2022, respectively. The interest rates on outstanding debt as of July 1, 2023 range from 4.85 % - 8.22 % compared to 4.50 % - 5.52 % as of July 2, 2022. Debt maturities as of July 1, 2023 for the next five years are as follows (in thousands): Fiscal Years Ending Amount 2024 $ 2,862 2025 2,959 2026 1,905 2027 116,166 2028 - Thereafter $ 1,367 Total debt $ 125,259 Unamortized debt issuance costs 591 Long-term debt, net of debt issuance costs $ 124,668 The Company must comply with certain financial covenants, including a fixed charge coverage ratio and a cash flow leverage ratio. The credit agreement requires the Company to grant certain inspection rights to Bank of America, limit or restrict the Company’s cash management; limit or restrict the ability of the Company to incur additional liens, make acquisitions or investments, incur additional indebtedness, engage in mergers, consolidations, liquidations, dissolutions, or dispositions, pay dividends or other restricted payments, prepay certain indebtedness, engage in transactions with affiliates, and use proceeds. Management believes the Company was in compliance with all financial covenants as of July 1, 2023. 5. INCOME TAXES Income tax benefit consists of the following: Fiscal Year Ended July 1, 2023 July 2, 2022 (in thousands) Current income tax provision (benefit): United States $ 998 $ ( 2,179 ) Foreign 2,134 2,012 3,132 ( 167 ) Deferred income tax provision (benefit): United States ( 2,130 ) 443 Foreign 141 38 ( 1,989 ) 481 Total income tax provision $ 1,143 $ 314 The Company has gross tax credit carryforwards of approximately $ 9.8 million at July 1, 2023 consisting of federal research and development (R&D) tax credits. Management has reviewed all deferred tax assets for purposes of determining whether a valuation allowance may be required. A valuation allowance against deferred tax assets is required if it is more likely than not that some of the deferred tax assets will not be realized. Based upon the Company’s profitability, forecasted income, and evaluation of all other positive and negative evidence, management determined that it is more likely than not that the deferred tax assets will be realized. 38 In the fourth quarter of fiscal year 2022, the Company, with its fiscal year 2021 federal income tax return, made automatic changes in tax accounting methods that created a fiscal year 2021 tax net operating loss. This loss was carried back to the tax years ending in 2016, 2017, and 2019, resulting in a tax benefit of $ 0.6 million due to the higher federal income tax rate in effect in the years ending in 2016 and 2017. On January 27, 2021, the Company received official notice from the Vietnamese tax authorities, confirming tax benefits awarded related to the Company’s principal product line in Vietnam (the “Tax Holiday”). Under the Tax Holiday, the tax rate applied to income derived from this product line will be zero percent for four years beginning with fiscal year 2021, then five percent for nine years, then ten percent for one year (as opposed to the normal twenty percent Vietnamese statutory rate). The Company evaluated tax law changes and regulatory guidance issued through the quarter. Such changes and regulations include guidance under Sec. 162(m), Sec. 245A, Sec. 951A, foreign tax credits, and rules relating to consolidated NOL carryback claims, a new book minimum tax on certain large corporations, and an excise tax on corporate stock buybacks among other provisions. The Company evaluated the ongoing impact of these law and regulatory changes, which did not have a material impact on its provision for income taxes. Subsequent to the end of the fiscal year ending June 27, 2020, the Treasury Department issued final regulations applicable to the Company’s position with respect to the U.S. taxability of foreign earnings under the global intangible low taxed income (also known as “GILTI”) regime and the deductibility of interest expense under IRC Section 163(j). These regulations did not have a material impact to the Company's income tax positions. The 2017 Tax Cuts and Jobs Act (TCJA) mandated that, for tax years after fiscal year 2022, certain costs incurred for research and development (R&D) activities would no longer be allowed for immediate deduction but would be capitalized and amortized over 5 years (for R&D activities performed domestically) or 15 years (for R&D activities performed abroad). The Company began capitalizing and amortizing such costs in fiscal year 2023, resulting in an increase to income taxes payable that was largely offset by the utilization of R&D credit carryovers. On March 27, 2020, the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) was enacted in response to the COVID-19 pandemic. The CARES Act, among other things, permits net operating loss (NOL) carryovers and carrybacks to offset 100% of taxable income for taxable years beginning before 2021. In addition, the CARES Act allows NOLs incurred in years beginning in 2018, 2019, and 2020 to be carried back to each of the five preceding taxable years to generate a refund of previously paid income taxes. The Company is taking advantage of this NOL carryback provision by carrying back the fiscal year 2021 NOL to the fiscal 2016 and 2017 years, as described above. In addition, the CARES Act contains modifications on the limitation of business interest for tax years beginning in 2019 and 2020. The modifications to Section 163(j) increase the allowable business interest deduction from 30% of adjusted taxable income to 50% of adjusted taxable income. This modification did not have a material impact on the fiscal year 2020 or fiscal year 2021 provisions for income taxes. Also, under the CARES Act, AMT credits not previously refunded for the tax year beginning in 2018 are refundable in the tax year beginning in 2019 rather than in years beginning in 2019-2021, and taxpayers can elect to claim 100% of the AMT credits in the first taxable year beginning in 2018 by applying for a tentative refund claim on or before December 31, 2020. The Company has made this election by applying for a tentative refund claim. The Company took advantage of the deferred payment payroll taxes provision, resulting in decreased deductible payroll tax payments, and increased taxable income, in fiscal years 2020 and 2021. Other aspects of the CARES Act did not have a material impact on the Company’s consolidated financial position, results of operations, or cash flows. In future years, repatriations of cash will generally be tax-free in the U.S. However, withholding taxes in China may still apply to any such future repatriations. Management has not changed its indefinite investment assertions regarding to the portion of accumulated earnings and profits in China that may be repatriated in the future. Accordingly, management estimates that future repatriations of cash from China may result in approximately $ 0.8 million of withholding tax. There would be no offsetting foreign tax credits in the U.S. and as such, this potential liability is a direct cost associated with actual repatriations. Withholding taxes will not apply to future repatriations from Mexico or Vietnam. The Company expects to repatriate a portion of its foreign earnings based on increased net sales growth driving additional capital requirements domestically, cash requirements for potential acquisitions and to implement certain tax strategies. The Company expects to repatriate approximately $ 7.6 million from China, in the future. All other unremitted foreign earnings are expected to remain permanently reinvested for planned fixed assets purchases and improvements in foreign locations. 39 The Company’s effective tax rate differs from the federal tax rate as follows: Fiscal Year Ended July 1, 2023 July 2, 2022 (in thousands) Federal income tax provision at statutory rates $ 1,322 $ 775 State income taxes, net of federal tax effect ( 25 ) 86 Foreign tax rate differences 137 336 Federal rate differences applied to net operating loss carryback — ( 593 ) Effect of income tax credits ( 1,020 ) ( 920 ) Previously unrecognized tax benefits ( 75 ) 146 Inflation adjustments 118 178 Tax penalties & interest — 179 Global Intangible Low-Taxed Income (GILTI) tax 33 59 Provision to return reconciliation 52 ( 91 ) Equity compensation shortfall 73 104 Foreign Exchange Gains/Losses Unrealized for Tax Purposes 277 23 Other 251 32 Income tax provision (benefit) $ 1,143 $ 314 Prior year presentation of certain items in the above table has been adjusted to reflect current year classification. The domestic and foreign components of income before income taxes were: Fiscal Year Ended July 1, 2023 July 2, 2022 (in thousands) Domestic $ ( 1,086 ) $ ( 2,890 ) Foreign 7,386 6,581 Income before income taxes $ 6,300 $ 3,691 40 Deferred income tax assets and liabilities consist of the following at: July 1, 2023 July 2, 2022 (in thousands) Deferred tax assets: Net operating loss $ — $ 486 Tax credit carryforwards, net 6,812 7,990 Inventory 267 247 Identifiable intangibles 308 370 Accruals 2,421 2,406 PPE 1,328 1,200 ASC 606 deferred costs 4,802 4,216 Lease liabilities 3,775 3,671 Interest expense deduction carryforward 977 580 Research and development expenses 3,860 — Other 271 465 Deferred income tax assets $ 24,821 $ 21,631 Deferred tax liabilities: Accrued withholding tax - unremitted earnings ( 754 ) ( 754 ) Right-of-use assets ( 3,857 ) ( 3,663 ) Tax capital lease liabilities ( 2,832 ) ( 2,385 ) ASC 606 accelerated revenue ( 4,599 ) ( 3,736 ) Other ( 799 ) ( 1,102 ) Deferred income tax liabilities $ ( 12,841 ) $ ( 11,640 ) Net deferred income tax assets $ 11,980 $ 9,991 Balance sheet caption reported in: Long-term deferred income tax asset $ 12,254 $ 10,055 Long-term deferred income tax liability ( 274 ) ( 64 ) Net deferred income tax asset $ 11,980 $ 9,991 Uncertain Tax Positions: The Company has R&D tax credits that approximate $ 9.8 million that have 20 -year carryforwards before expiring. The Company’s R&D tax credits expire in various fiscal years from 2032 to 2043. As of July 1, 2023, the Company had unrecognized tax benefits of $ 3.0 million related to its gross R&D tax credits. The unrecognized tax benefits relate to certain R&D tax credits generated from 2003 to 2023. A reconciliation of the beginning and ending amount of unrecognized tax benefits is as follows: Fiscal Year Ended July 1, 2023 July 2, 2022 (in thousands) Beginning Balance $ 2,998 $ 4,863 Additions based on tax positions related to the current year 120 286 Adjustment to prior year tax positions & amended tax returns ( 15 ) ( 2,296 ) Lapse of statute of limitations ( 75 ) 145 Ending Balance $ 3,028 $ 2,998 The $ 3.0 million of unrecognized tax benefits at the end of fiscal year 2023, if recognized, would reduce the effective tax rate. Management does not anticipate any material changes to this amount during the next 12 months. The Company recognizes interest accrued related to unrecognized tax benefits and penalties in its income tax provision. The Company has not recognized any interest or penalties in the fiscal years presented in these financial statements, except for 41 $ 0.2 million in fiscal year 2022. The Company is subject to income tax in the U.S. federal jurisdiction, various state jurisdictions, Mexico, China and Vietnam. Certain years remain subject to examination but there are currently no ongoing exams in any taxing jurisdiction. 6. EARNINGS PER SHARE Basic earnings per share (EPS) is calculated by dividing net income (the numerator) by the weighted-average number of common shares outstanding (the denominator) during the period. Diluted EPS is computed by including both the weighted-average number of shares outstanding and any dilutive common share equivalents in the denominator. The following table presents a reconciliation of the denominator and the number of antidilutive common share awards that were not included in the diluted earnings per share calculation. These antidilutive securities occur when equity awards outstanding have an option price greater than the average market price for the period: Fiscal Year Ended (in thousands, except per share information) July 1, 2023 July 2, 2022 Net income $ 5,157 $ 3,377 Weighted average shares outstanding– basic 10,762 10,762 Effect of dilutive common stock awards 176 301 Weighted average shares outstanding – diluted 10,938 11,063 Net income per share – basic $ 0.48 $ 0.31 Net income per share – diluted $ 0.47 $ 0.31 Antidilutive SARs not included in diluted earnings per share 376 619 7. STOCK OPTION AND BENEFIT PLANS The Company’s incentive plan provides for equity and liability awards to employees and non-employee directors in the form of stock options, stock appreciation rights (SARs), restricted stock, restricted stock units, stock awards, stock units, performance shares, performance units, and other stock-based or cash-based awards. Compensation cost is recognized on a straight-line basis over the requisite employee service period, which is generally the vesting period, and is recorded as employee compensation expense in cost of goods sold, research, development and engineering, and selling, general and administrative expenses. Share-based compensation is recognized only for those awards that are expected to vest, with forfeitures estimated at the date of grant based on historical experience and future expectations. In addition to service conditions, these SARs contain a performance condition. The additional performance condition is based upon the achievement of Return on Invested Capital (ROIC) goals relative to a peer group. All awards with performance conditions are measured over the vesting period and are charged to compensation expense over the requisite service period based on the number of shares expected to vest. The SARs cliff vest after a three-year period from date of grant and expire five years from date of grant. On July 29, 2022, the Compa ny granted 145,000 SARs under the 2010 Incentive Plan to certain key employees and outside directors at a strike price of $ 5.10 and a grant date fair value of $ 2.09 . As of July 1, 2023, 140,000 remain outstanding. The grant date fair value for the awards granted during fiscal year 2023, were estimated using the Black Scho les option valuation method with the following weighted average assumptions as of July 29, 2022: Fiscal Year 2023 July 29, 2022 Expected dividend yield — % Risk – free interest rate 3.01 % Expected volatility 48.56 % Expected life 4.00 On August 9, 2021, the Compa ny granted 165,000 SARs under the 2010 Incentive Plan to certain key employees and outside directors at a strike price of $ 7.17 and a grant date fair value of $ 2.73 . As of July 1, 2023, 140,000 remain outstanding. The grant date fair value for the awards granted during fiscal year 2022, were estimated using the Black Scho les option valuation method with the following weighted average assumptions as of August 9, 2021: 42 Fiscal Year 2022 August 9, 2021 Expected dividend yield — % Risk – free interest rate 0.62 % Expected volatility 48.58 % Expected life 4.00 On July 23, 2020, the Company granted 155,000 SARs under the 2010 Incentive Plan to certain key employees and outside directors at a strike price of $ 6.94 and a grant date fair value of $ 2.32 . As of July 1, 2023, 130,000 remain outstanding. The grant date fair value for the awards granted during fiscal year 2021, were estimated using the Black Scholes option valuation method with the following weighted average assumptions as of July 23, 2020: Fiscal Year 2021 July 23, 2020 Expected dividend yield — % Risk – free interest rate 0.17 % Expected volatility 42.85 % Expected life 4.00 Share-based compensation expense is recognized only for those awards that are expected to vest, with forfeitures estimated at the date of grant based on the Company’s historical experience and future expectations. This forfeiture rate will be revised, if necessary, in subsequent periods if actual forfeitures differ from the amount estimated. Share-based compensation expense for fiscal years ended July 1, 2023 and July 2, 2022 was $ 0.3 million and $ 0.3 million, respectively. The Black-Scholes option valuation model is used by the Company for estimating the fair value of SARs. Option valuation models require the input of highly subjective assumptions, particularly for the expected term and expected stock price volatility. Changes in these assumptions can materially affect the fair value estimates. There were no SARs exercised during fiscal year 2023 and fiscal year 2022. As of July 1, 2023, total unrecognized compensation expense related to nonvested share-based compensation arrangements was approximately $ 0.3 million. This expense is expected to be recognized over a weighted-average period of 1.90 years. 43 The following table summarizes the Company’s Options and SARs activity for all plans from July 3, 2022 through July 1, 2023: SARs Available For Grant SARs Outstanding Aggregate Intrinsic Value (in thousands) Weighted Average Exercise Price Weighted Average Remaining Contractual Life (in years) Balances, July 3, 2021 688,084 791,250 $ — $ 7.15 1.9 Shares authorized — $ — SARs granted ( 165,000 ) 165,000 $ 7.17 SARs forfeited 197,500 ( 197,500 ) $ 8.17 SARs exercised Balances, July 2, 2022 720,584 758,750 $ — $ 6.89 2.1 Shares authorized — — SARs granted ( 145,000 ) 145,000 5.10 SARs forfeited 277,500 ( 277,500 ) 7.03 SARs exercised — — — — Balances, July 1, 2023 853,084 626,250 $ — $ 6.41 2.2 Exercisable at July 1, 2023 226,250 $ — $ 6.45 0.6 Additional information regarding SARs outstanding and exercisable as of July 1, 2023, is as follows: Range of Exercise Prices Number Outstanding Weighted Avg. Remaining Contractual Life (yrs.) Weighted Avg. Exercise Price Number Exercisable Weighted Avg. Exercise Price $ 4.93 – $ 7.43 525,000 2.1 $ 6.06 120,000 $ 4.93 $ 7.44 – $ 9.44 101,250 14.6 8.17 106,250 8.17 $ 4.93 to $ 9.44 626,250 2.2 $ 6.41 226,250 $ 6.45 The Company has defined contribution plans available to U.S. employees who have attained age 21. Company contributions to the plans were approximately $ 1.1 million and $ 0.9 million during fiscal years 2023 and 2022, respectively. 8. COMMITMENTS AND CONTINGENCIES Litigation and Other Matters The Company is party to certain lawsuits or claims in the ordinary course of business. The Company does not believe that these proceedings, individually or in the aggregate, will have a material adverse effect on the financial position, results of operations or cash flow of the Company. Warranties The Company provides warranties on certain product sales. Allowances for estimated warranty costs are recorded during the period of sale. The determination of such allowances requires the Company to make estimates of product return rates and expected costs to repair or to replace the products under warranty. If actual return rates and/or repair and replacement costs differ significantly from management's estimates, adjustments to recognize additional cost of sales may be required in future periods. As of July 1, 2023 and July 2, 2022, the reserve for warranty costs was approximately $ 29,000 and $ 31,000 , respectively. Leases Please refer to Footnote “Leases” of the “Notes to Consolidated Financial Statements” for information regarding lease commitments. 44 Internal Investigation During fiscal year 2021, the Company’s Audit Committee completed an internal investigation arising from a notification from an employee regarding certain alleged accounting irregularities. In January 2021, the Company determined that improper accounting resulted in an understatement of cost of goods sold and an overstatement of inventories. Subsequent to the matter identified in January 2021, additional inventory accounting errors unrelated to the investigation were also identified by management. The investigation did not result in a restatement of our previously filed financial statements. The Company is cooperating with the Securities and Exchange Commission’s (the “SEC”) inquiries related to the internal investigation. The Company cannot currently form an estimate of any possible loss or range of loss, including any potential monetary penalties; or other remedies potentially imposed by the SEC. Indemnification Rights Under the Company’s bylaws, the Company’s directors and officers have certain rights to indemnification by the Company against certain liabilities that may arise by reason of their status or service as directors or officers. The Company maintains director and officer insurance, which may cover certain liabilities arising from its obligation to indemnify its directors and officers and former directors in certain circumstances. 9. DERIVATIVE FINANCIAL INSTRUMENTS As of July 1, 2023, the Company did not have any outstanding foreign currency forward contracts. During the fiscal year ended July 2, 2022, the Company entered into $ 13.9 million of foreign currency forward contracts and settled $ 24.6 million of such contracts. On November 6, 2019, the Company entered into an interest rate swap contract with an effective date of November 6, 2019 and a termination date of September 30, 2022, related to the borrowings outstanding under the term loan with Wells Fargo Bank. This interest rate swap contract was terminated on August 14, 2020 when the Company entered into a loan and security agreement with Bank of America. At date of termination this interest rate swap was in a liability position of $ 148,400 , which will be amortized to interest expense over the original term of the swap. On November 6, 2019, the Company entered into an interest rate swap contract with an effective date of November 6, 2019 and a termination date of November 1, 2023, related to the borrowings outstanding under the line of credit with Wells Fargo Bank. This interest rate swap contract was terminated on August 14, 2020 when the Company entered into a loan and security agreement with Bank of America. At date of termination this interest rate swap was in a liability position of $ 776,500 , which will be amortized to interest expense over the original term of the swap. The following table summarizes the gain (loss) on derivative instruments, net of tax, on the Consolidated Statements of Income for the fiscal year 2023 (in thousands): Derivatives Designated as Hedging Instruments Classification of Gain (Loss) Reclassified from Accumulated OCI into Income (Effective Portion) AOCI Balance as of July 2, 2022 Effective Portion Recorded In AOCI Effective Portion Reclassified From AOCI Into Income AOCI Balance as of July 1, 2023 Forward contracts Cost of sales $ ( 79 ) $ — $ 79 $ — Interest rate swap Interest expense ( 346 ) — 249 ( 97 ) Total $ ( 425 ) $ — $ 328 $ ( 97 ) The following table summarizes the gain (loss) on derivative instruments, net of tax, on the Consolidated Statements of Income for the fiscal year 2022 (in thousands): Derivatives Designated as Hedging Instruments Classification of Gain (Loss) Reclassified from Accumulated OCI into Income (Effective Portion) AOCI Balance as of July 3, 2021 Effective Portion Recorded In AOCI Effective Portion Reclassified From AOCI Into Income AOCI Balance as of July 2, 2022 Forward contracts Cost of sales $ 2,721 $ 950 $ ( 3,750 ) $ ( 79 ) Interest rate swap Interest expense ( 649 ) — 303 ( 346 ) Total $ 2,072 $ 950 $ ( 3,447 ) $ ( 425 ) As of July 1, 2023, the Company does not have any foreign exchange contracts with credit-risk-related contingent features. The Company is subject to the risk of fluctuating interest rates from our line of credit and foreign currency risk resulting from our China operations. The Company does not currently manage these risk exposures by using derivative instruments. 45 10. FAIR VALUE MEASUREMENTS The Company has adopted ASC 820, Fair Value Measurements, which defines fair value, establishes a framework for assets and liabilities being measured and reported at fair value and expands disclosures about fair value measurements. There are three levels of fair value hierarchy inputs used to value assets and liabilities which include: Level 1 – inputs are quoted market prices for identical assets or liabilities; Level 2 – inputs other than quoted market prices included in Level 1 that are observable for the asset or liability, either directly or indirectly; and Level 3 – inputs are unobservable inputs for the asset or liability. There have been no changes in the fair value methodologies used at July 1, 2023 and July 2, 2022. The carrying values of cash and cash equivalents, accounts receivable, contract assets, and current liabilities are reflected on the balance sheets at July 1, 2023 and July 2, 2022, reasonably approximate their fair value. The Company’s long-term debt, which is measured at amortized cost, primarily consists of an asset-based revolving credit facility, lease liability, and equipment loans. These borrowings bear interest at SOFR plus 2.5 % per the loan agreement. Each of these rates is a variable floating rate dependent upon current market conditions and the Company’s current credit risk as discussed in Footnote “Long-Term Debt” of the “Notes to Consolidated Financial Statements.” As a result of the determinable market rates for our asset-based revolving credit facility and equipment loans, they are classified within Level 2 of the fair value hierarchy. Further, the carrying value of each of these instruments reasonably approximates their fair value as of July 1, 2023 and July 2, 2022. 46 11. ENTERPRISE-WIDE DISCLOSURES Operating segments are defined in ASC Topic 280, Segment Reporting as components of an enterprise for which separate financial information is available that is evaluated regularly by the chief operating decision maker, or decision making group, in deciding how to allocate resources and in assessing performance. The Company’s chief operating decision maker is its Chief Executive Officer. As of July 1, 2023, the Company operates and internally manages a single operating segment, Electronics Manufacturing Services as this is the only discrete financial information that is regularly reviewed by the chief operating decision maker. This segment provides integrated electronic and mechanical engineering, assembly, sourcing and procurement, logistics, and new product testing for our customers. Products and Services Of the revenues for the years ended July 1, 2023 and July 2, 2022, contract manufacturing sales and services were $ 588.1 million and $ 531.8 million, respectively. Geographic Areas Net sales and long-lived assets (property, plant, and equipment) by geographic area for the years ended and as of July 1, 2023 and July 2, 2022 are summarized in the following table. Net sales set forth below are based on the shipping destination. Long-lived assets information is based on the physical location of the asset and includes property, plant and equipment, net, and operating lease right-of-use assets, net. Fiscal Year Ended (in thousands) 2023 2022 Geographic net sales: Domestic (U.S.) $ 502,274 $ 438,018 Foreign $ 85,861 $ 93,797 Total $ 588,135 $ 531,815 Long-lived assets: United States $ 21,799 $ 14,440 Mexico $ 18,203 22,473 Vietnam $ 4,547 5,228 China $ 523 601 Total $ 45,072 $ 42,742 Percentage of net sales made to customers located in the following countries: Fiscal Year Ended 2023 2022 United States 85 % 82 % China 14 16 Other foreign countries (a) 1 2 Canada — — Total 100 % 100 % (a) No other individual foreign country accounted for 10% or more of the foreign sales in fiscal years 2023 or 2022. Significant Customers The percentage of net sales to and trade accounts receivables from significant customers were as follows: Percentage of Net Sales Fiscal Year Percentage of Trade Accounts Receivable Fiscal Year 2023 2022 2023 2022 Customer A 12 % 12 % 16 % 13 % 47 12. REVENUE Revenue Recognition The Company specializes in services ranging from product manufacturing to engineering and tooling services. The first step in its process for revenue recognition is to identify the contract with a customer. A contract is defined as an agreement between two or more parties that creates enforceable rights and obligations. A contract can be written, oral, or implied. The Company generally enters into manufacturing service agreements (“MSA”) with its customers that outlines the terms of the business relationship between the customer and the Company. This includes matters such as warranty, indemnification, transfer of title and risk of loss, liability for excess and obsolete inventory, pricing, payment terms, etc. The Company will also bid on a program-by-program basis for customers in which an executed MSA may not be in place. In these instances, as well as when we have an MSA in place, we receive customer purchase orders for specific quantities and timing of products. As a result, the Company considers its contract with a customer to be the combination of the MSA and the purchase order. The transaction price is fixed and set forth in each purchase order. In the Company's normal course of business, there are no variable pricing components, or material amounts refunded to customers in the form of refunds or rebates. The Company assesses whether control of the product or services promised under the contract is transferred to the customer at a point in time (shipment) or over time (as we manufacture the product). The Company is first required to evaluate whether its contracts meet the criteria for 'over-time' or 'point-in-time' recognition. The Company has determined that for the majority of its contracts the Company is manufacturing products for which there is no alternative use due to the unique nature of the customer-specific product, IP and other contract restrictions. The Company has an enforceable right to payment including a reasonable profit for performance completed to date with respect to these contracts. As a result, revenue is recognized under these contracts 'over-time' based on the input cost-to-cost method as it better depicts the transfer of control. This input method is based on the ratio of costs incurred to date as compared to the total estimated costs at completion of the performance obligation. For all other contracts that do not meet these criteria, such as manufacturing contracts for which the terms do not provide an enforceable right to payment for performance completed to date, the Company recognizes revenue when it has transferred control of the related manufactured products which generally occurs upon shipment to the customer. Revenue from engineering services is recognized over time as the services are performed. The Company’s typical payment terms are 30 to 45 days and its sales arrangements do not contain any significant financing component for its customers. The Company generally provides a warranty for workmanship on its manufacturing contracts. Although we offer warranties on our products, our warranties are considered to be assurance-type in nature and do not cover anything beyond ensuring that the product is functioning as intended. Based on the guidance in ASC 606, assurance-type warranties do not represent separate performance obligations; therefore, the primary performance obligation in the majority of our contracts is the delivery of a specific good through the purchase order submitted by our customer. The Company elected to not disclose information about remaining performance obligations as they are part of contracts that that have expected durations of one year or less. The Company has elected to expense costs to obtain contracts as incurred as these costs are immaterial to the financial statements. During fiscal 2023 and 2022, no revenues were recognized from performance obligations satisfied or partially satisfied in previous periods. Contract Balances A contract asset is recognized when the Company has recognized revenue, but has not issued an invoice for payment. Contract assets are classified separately on the condensed consolidated balance sheet and transferred to receivables when the right to payment becomes unconditional. The following table summarizes the activity in the Company’s contract assets during the twelve months ended July 1, 2023 (in thousands): Contract Assets Beginning balance, July 2, 2022 $ 21,974 Revenue recognized 573,444 Amounts collected or invoiced ( 565,493 ) Ending balance, July 1, 2023 $ 29,925 48 The following table summarizes the activity in the Company’s contract assets during the twelve months ended July 2, 2022 (in thousands): Contract Assets Beginning balance, July 3, 2021 24,781 Revenue recognized 515,831 Amounts collected or invoiced ( 518,638 ) Ending balance, July 2, 2022 $ 21,974 Disaggregation of Revenue The following table presents the Company’s revenue disaggregated for the twelve months ended July 1, 2023 and the twelve months ended July 2, 2022 (in thousands): Revenue Recognition July 1, 2023 July 2, 2022 Over-Time $ 573,444 $ 515,831 Point-in-Time 14,691 15,984 Total 588,135 $ 531,815 Revenues and associated costs from engineering design, development services and tooling, which are performed under contract of short term durations, are recognized over time as the services are performed. Revenue from engineering design, development services and tooling represented approximately 6.6 % and 9.6 % of total revenue in fiscal year 2023 and 2022, respectively. 13. LEASES The Company has several commitments under operating and financing leases for warehouses, manufacturing facilities, office buildings, and equipment with initial terms that expire at various dates during the next 1 year to 10 years. The Company has some leases that include an extension clause. Management has considered the likelihood of exercising each extension option included and estimated the duration of the extension option, for those leases management determined to be reasonably certain, in calculating the lease term for measurement of the right of use asset and liability. For operating leases, management assumed a discount rate of 4 %. The weighted average discount rate is disclosed in the tables below. The components of lease cost were as follows as of July 1, 2023 and July 2, 2022 (in thousands): Year Ended Year Ended Lease cost Classification July 1, 2023 July 2, 2022 Operating lease cost Cost of sales $ 4,519 $ 6,442 Operating lease cost Selling, general and administrative expenses 737 929 Financing lease cost Cost of sales $ 3,891 $ 2,054 Financing lease cost Selling, general and administrative expenses $ 161 $ 64 Total lease cost $ 9,308 $ 9,489 Fixed lease cost $ 8,171 $ 7,941 Short-term lease cost $ 1,137 $ 1,548 Total lease cost $ 9,308 $ 9,489 49 Amounts reported in the Consolidated Balance Sheet as of July 1, 2023 and July 2, 2022 were (in thousands, except weighted average lease term and discount rate): July 1, 2023 July 2, 2022 Operating Leases: Operating lease right of use assets $ 16,202 $ 16,731 Operating lease liabilities (1) 16,202 16,731 Weighted-average remaining lease term (in years) Operating leases 4.55 5.28 Weighted-average discount rate Operating leases 4.00 % 4.00 % Financing Leases (2) : Financing lease right of use assets $ 9,718 $ 12,464 Financing lease liabilities 8,278 11,211 Weighted-average remaining lease term (in years) Financing leases 1.89 2.56 Weighted-average discount rate Financing leases 9.96 % 8.82 % (1) For fiscal year 2023 and 2022, the current portion of the total operating lease liabilities is classified under Other Current Liabilities . (2) The total finance lease right of use assets of $ 9.7 million is classified under Other Long-term Assets . The current portion of the total finance lease liabilities of $ 4.7 million is classified under Current portion of debt, net, resulting in $ 3.6 million classified in Other Long-term Liabilities section of the condensed consolidated balance sheet. 50 Other information related to leases was as follows (in thousands): July 1, 2023 July 2, 2022 Cash paid for amounts included in the measurement of lease liabilities: Operating cash flows from operating leases 5,714 4,261 Financing cash flows used in financing leases 4,291 2,331 Future lease payments under non-cancellable leases as of July 1, 2023 are as follows (in thousands): Fiscal Years Ending Operating Leases Finance Leases 2024 $ 5,134 $ 4,711 2025 3,987 3,290 2026 3,365 670 2027 2,464 71 2028 1,551 — Thereafter 1,689 — Total undiscounted lease payments 18,190 8,742 Less: present value discount 1,988 464 Total lease liabilities $ 16,202 $ 8,278 Item 9: CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES None