Item 7. Management’s Discussion and Analysis of Financial
Condition and Results of Operations.
The following discussion and analysis should be read in conjunction
with “Selected Consolidated Financial Data” and the consolidated financial statements and related notes included in
this report.
Overview
Innovative Solutions and Support, Inc. (the “Company,”
“IS&S”, “we” or “us”) was incorporated in Pennsylvania on February 12, 1988. The
Company operates in one business segment as a systems integrator that designs, develops, manufactures, sells, and services, air
data equipment, engine display systems, standby equipment, primary flight guidance, autothrottles and cockpit display systems
for retrofit applications and original equipment manufacturers (“OEMs”). The Company supplies integrated Flight Management
Systems (“FMS”), Flat Panel Display Systems (“FPDS”), FPDS with Autothrottle, air data equipment, Integrated
Standby Units (“ISU”), ISU with Autothrottle and advanced Global Positioning System (“GPS”) receivers
that enable reduced carbon footprint navigation.
The Company has continued to position itself as a system integrator,
which provides the Company with the capability and potential to generate more substantive orders over a broader product base.
This strategy, as both a manufacturer and integrator, is designed to leverage the latest technologies developed for the computer
and telecommunications industries into advanced and cost-effective solutions for the general aviation, commercial air transport,
United States Department of Defense (“DoD”)/governmental, and foreign military markets. This approach, combined with
the Company’s industry experience, is designed to enable IS&S to develop high-quality products and systems, to reduce
product time to market and to achieve cost advantages over products offered by its competitors.
The
Company sells to both the OEM and the retrofit markets. Customers include various OEMs, commercial air transport carriers
and corporate/general aviation companies, DoD and its commercial contractors, aircraft operators, aircraft modification centers,
government agencies, and foreign militaries. Occasionally, IS&S sells its products directly to DoD; however, the Company
sells its products primarily to commercial customers for end use in DoD programs. Sales to defense contractors are generally made
on commercial terms, although some of the termination and other provisions of government contracts are applicable to these contracts.
The Company’s retrofit projects are generally pursuant to either a direct contract with a customer or a subcontract
with a general contractor to a customer (including government agencies).
Cost of sales related to product sales comprises material,
components and third-party avionics purchased from suppliers, direct labor, and overhead costs. Many of the components are standard,
although certain parts are manufactured to meet IS&S specifications. The overhead portion of cost of sales primarily comprises
salaries and benefits, building occupancy costs, supplies, and outside service costs related to production, purchasing, material
control, and quality control. Cost of sales includes warranty costs.
Cost of sales related to Engineering Development Contracts
(“EDC”) sales comprises engineering labor, consulting services, and other costs associated with specific design and
development projects. These costs are incurred pursuant to contractual arrangements and are accounted for typically as contract
costs within cost of sales, with the reimbursement accounted for as a sale in accordance with the percentage-of-completion method
or completed contract method of accounting. Company funded research and development (“R&D”) expenditures relate
to internally-funded efforts for the development of new products and the improvement of existing products. These costs are expensed
as incurred and reported as R&D expenses. The Company intends to continue investing in the development of new products that
complement current product offerings and to expense associated R&D costs as they are incurred.
Selling, general and administrative expenses consist of sales,
marketing, business development, professional services, salaries and benefits for executive and administrative personnel, facility
costs, recruiting, legal, accounting and other general corporate expenses.
IS&S
sells its products to agencies of the United States and foreign governments, aircraft operators, aircraft modification centers,
and OEMs. Customers have been and may continue to be affected by changes in economic conditions both in the United States
and abroad. Such changes may cause customers to curtail or delay their spending on both new and existing aircraft. Factors that
can impact general economic conditions and the level of spending by customers include, but are not limited to, the impact of the
ongoing COVID-19 pandemic, general levels of consumer spending, increases in fuel and energy costs, conditions in the real estate
and mortgage markets, labor and healthcare costs, access to credit, consumer confidence, and other macroeconomic factors that
affect spending behavior. Furthermore, spending by government agencies may be reduced in the future if tax revenues decline. If
customers curtail or delay their spending or are forced to declare bankruptcy or liquidate their operations because of adverse
economic conditions, the Company’s revenues and results of operations would be affected adversely. For example, earlier
in the 2020 fiscal year, certain of the Company’s customers temporarily suspended product deliveries as a result of the
COVID-19 pandemic, and while these deliveries subsequently resumed, there is a possibility that the COVID-19 pandemic will result
in other suspensions, delays or order cancellations by the Company’s customers or suppliers.
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In particular, the ongoing COVID-19 pandemic is a significant
event, driver of market trends, and source of uncertainty that may ultimately have a direct or indirect material impact on the
Company’s business, financial position, liquidity, or ability to service customers or maintain critical operations. In direct
response to the COVID-19 pandemic, the Company has taken specific actions to ensure the safety of its employees, including increased
safety measures and the transitioning of many employees to remote work.
Results of Operations
The following table sets forth statements of operations data
expressed as a percentage of total net sales for the fiscal years indicated:
Twelve Months Ending September 30,
Engineering development contracts 3.7 % 8.0 % 2.9 %
Cost of sales:
Engineering development contracts 1.0 % 3.6 % 1.4 %
Operating expenses:
Selling, general and administrative 28.2 % 33.4 % 48.2 %
Operating income (loss) 12.8 % 8.7 % (26.8 %)
Interest income 0.7 % 1.4 % 0.4 %
Income (loss) before income taxes 13.8 % 10.5 % (25.9 %)
Income tax (benefit) expense (1.3 %) 0.0 % 0.5 %
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Fiscal Year Ended September 30, 2020 Compared to Fiscal
Year Ended September 30, 2019
Net
sales. Net sales for fiscal 2020 increased $4.0 million, or 22.9%, to $21.6 million from $17.6 million for fiscal 2019.
For fiscal 2020, product sales increased $4.6 million and EDC sales decreased $0.6 million, in each case, compared to fiscal 2019.
This increase in product sales primarily reflects increased shipments for OEM programs to general aviation customers, shipments
under the U.S. Navy F-5 production contract and increased shipments of displays for retrofit programs to other military customers.
These increases were partially offset by reduced shipments of displays for retrofit programs to commercial transport customers
compared to fiscal 2019. The decrease in EDC sales was primarily the result of the completion of a development contract for a
new air data computer for the U.S. Navy F-5 aircraft and the completion of a development contract in 2019 for a foreign customer
on the P-3 aircraft.,
Cost
of sales. Cost of sales was $9.8 million or 45.3% of net sales, for fiscal 2020 compared to $7.7 million, or 43.7%
of net sales, in fiscal 2019. The increase in cost of sales was primarily the result of an increase in product sales volume. The
Company’s overall gross margin in fiscal 2020 was 54.7% compared to 56.3% in fiscal 2019. The fiscal 2020 gross margin percentage
decrease reflects increased warranty costs and material costs which was partially offset by an increase in gross margin on EDC
programs to 71.5% in fiscal 2020 as compared to 54.7% in fiscal 2019.
Research
and development. R&D expense was $3.0 million for fiscal 2020 and $2.5 million for fiscal 2019. R&D expense
decreased to 13.7% of net sales in fiscal 2020 compared to 14.2% of net sales in fiscal 2019. R&D expense in fiscal 2020 was
$0.5 million greater than fiscal 2019. This decrease in R&D expense resulted primarily from increased personnel, related benefits
and the reduction of EDC contract activity whose costs are reflected in cost of sales rather than R&D expense.
Selling,
general, and administrative (“SG&A”). SG&A expense increased $0.2 million or 3.8% to $6.1
million or 28.2% of net sales, for fiscal 2020 from $5.9 million, or 33.4%, for fiscal 2019. The increase in SG&A expense
was primarily the result of increased personnel costs and related benefits.
Interest
income, net. Net interest income of $155,000 in fiscal 2020 decreased by $95,000 as compared to fiscal 2019 interest
income of $250,000. The decrease in interest income was primarily the result of lower interest rates in fiscal 2020 as compared
to fiscal 2019.
Other
income. Other income is primarily composed of royalties earned and decreased by $14,000, to $60,000 in fiscal 2020
from $74,000 in fiscal 2019.
Income
taxes. Income tax benefit for the fiscal 2020 was $309,000 as compared to income tax expense of $2,000 for fiscal
2019. The effective tax rate benefit for fiscal 2020 was 10.43% and differs from the statutory rate due to the passing of the
CARES Act on March 27, 2020 which allowed for the carryback of the 2018 net operating loss (“NOL”) to fiscal 2017
and fiscal 2016.
Net
income. As a result of the factors described above, the Company’s net income for fiscal 2020 was $3.3 million
compared to net income of $1.9 million for fiscal 2019. On a fully diluted basis, net income per share was $0.19 for fiscal 2020,
compared to a net income of $0.11 per share for fiscal 2019.
28
Fiscal
Year Ended September 30, 2019 Compared to Fiscal Year Ended September 30, 2018
Net
sales. Net sales for fiscal 2019 increased $3.7 million, or 26.9%, to $17.6 million from $13.9 million for fiscal 2018.
For fiscal 2019, product sales increased $2.7 million and EDC sales increased $1.0 million, in each case, compared to fiscal 2018.
This increase primarily reflects increased shipments for an OEM program to a general aviation customer and displays for retrofit
programs to commercial transport customers compared to fiscal 2018. The increase in EDC sales was primarily the result of a development
contract for a new air data computer for the U.S. Navy F-5 aircraft.
Cost
of sales. Cost of sales was $7.7 million or 43.7% of net sales, for fiscal 2019 compared to $7.3 million, or 52.8% of
net sales, in fiscal 2018. The increase in cost of sales was primarily the result of an increase in product sales volume. The Company’s
overall gross margin in fiscal 2019 was 56.3% compared to 47.2% in fiscal 2018. The fiscal 2019 gross margin increase reflects
higher product gross margin primarily as a result of increased coverage of fixed costs due to increased product sales volume. The
overall gross margin increase was also impacted by an increase in gross margin on EDC programs, from 52.2% in fiscal 2018 to 54.7%
in fiscal 2019.
Research
and development. R&D expense was $2.5 million for fiscal 2019 and $3.6 million for fiscal 2018. R&D expense
decreased to 14.2% of net sales in fiscal 2019 compared to 25.8% of net sales in fiscal 2018. R&D expense in fiscal 2019 was
$1.1 million less than fiscal 2018. This decrease in R&D expense resulted primarily from reduced personnel and consultant costs
in fiscal 2019. In addition, in fiscal 2019, EDC programs required a shift of engineering resources from internal R&D.
Selling,
general, and administrative (“SG&A”). SG&A expense decreased $0.8 million or 11.9% to $5.9
million or 33.4% of net sales, for fiscal 2019 from $6.7 million, or 48.2%, for fiscal 2018. The decrease in SG&A expense was
primarily the result of reduced legal, personnel and consultant costs.
Interest
income, net. Net interest income increased by $196,000 to $250,000 for fiscal 2019 from $54,000 for fiscal 2018. The
increase in interest income was mainly a result of higher interest rates in fiscal 2019 compared to fiscal 2018.
Other
income. Other income is primarily composed of royalties earned and increased by $6,000, to $74,000 in fiscal 2019 from
$68,000 in fiscal 2018.
Income
taxes. Income tax expense for the fiscal 2019 was $2,000 as compared to income tax expense of $64,000 for fiscal
2018. The effective tax rate for fiscal 2019 was 0.10% and differs from the statutory rate mostly due to a decrease in the deferred
tax valuation allowance of approximately $375,000. The majority of this change in valuation allowance was a result of NOL usage.
The Tax Act permits an indefinite carryforward period for NOLs.
Net
income. As a result of the factors described above, the Company’s net income for fiscal 2019 was $1.9 million
compared to net loss of $3.7 million for fiscal 2018. On a fully diluted basis, net income per share was $0.11 for fiscal 2019,
compared to a net loss of $0.22 per share for fiscal 2018.
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Liquidity and Capital Resources
The following table highlights key financial measurements of
the Company:
September 30, September 30,
Twelve Months Ended September 30,
Cash flow activities:
Net cash (used in) financing activities (705,333 ) - -
(2) Excludes contract liability
(3) Calculated as: current assets divided by current liabilities
The Company’s principal source of liquidity has been cash
flows from current year operations and cash accumulated from prior years’ operations. Cash is used principally to finance
inventory, accounts receivable, contract assets, and payroll. Apart from what has been disclosed above, management is not aware
of any trends, events or uncertainties that have had or are likely to have a material impact on our liquidity, financial condition
and capital resources.
On
September 4, 2020, the Company’s Board of Directors declared a special cash dividend in the amount of $0.65 per share, payable
on October 1, 2020 to shareholders of record as of the close of business on September 15, 2020. The total dividend payment
was approximately $11.2 million and is included in restricted cash on the accompanying consolidated balance sheets. The estimated
tax characteristic of the dividend per share as of the date hereof is 35% ordinary income and 65% return of capital. This estimate
may not be representative of the actual tax characteristic of dividends for the full year. The Company’s Board of Directors
has declared an additional special cash dividend subsequent to September 30, 2020, as further described in Note 19, “Subsequent
Events,” to the consolidated financial statements, which once paid will affect this estimate. Please refer to Note
19, “Subsequent Events,” for additional information.
The Company did not pay dividends in fiscal 2019 or fiscal 2018.
The declaration and payment of any dividend in the future will be at the discretion of the Company’s Board of Directors.
The ongoing COVID-19 pandemic is a significant event, driver
of market trends, and source of uncertainty that may have a material impact on the Company’s liquidity, financial condition,
capital resources, cash flows or operating results. In direct response to the COVID-19 pandemic, the Company has taken specific
actions to seek to ensure the safety of its employees, including increased safety measures and the transitioning of many employees
to remote work.
Operating Activities
The
Company generated $2.2 million of cash in operating activities during fiscal 2020 as compared to cash generated of $2.1million
during fiscal 2019. The cash generated by operating activities for the year ended September 30, 2020 was primarily generated
by net income of $3.3 million, depreciation and amortization of $0.4 million and an increase in both contract liability of $0.3
million and accrued expenses of $0.2 million, partially offset by an increase in accounts receivable of $2.0 million.
30
The
Company generated $2.1 million of cash in operating activities during fiscal 2019 as compared to cash used of $1.7 million during
fiscal 2018. The cash generated by operating activities for the year ended September 30, 2019 was primarily generated
by net income of $1.9 million and a decrease in accounts receivable of $1.1 million, partially offset by a decrease in accounts
payable of $0.5 million and accrued expenses of $0.4 million.
Investing Activities
Cash
used in investing activities was $0.1 million for fiscal year 2020 and consisted of spending for production equipment and
laboratory test equipment. The Company plans to continue investing in capital equipment to support engineering development efforts
and operations.
Cash
used in investing activities was $0.1 million for fiscal year 2019 and consisted of spending for production equipment and
laboratory test equipment. The Company plans to continue investing in capital equipment to support engineering development efforts
and operations.
Financing Activities
Cash used by financing activities was $0.7 million for fiscal
year 2020 and consisted of tax withholding payments related to an employee’s cashless exercise of stock options of $0.9 million,
partially offset by proceeds from exercise of stock options of $0.2 million. Cash used by financing activities was $0 for fiscal
year 2019.
Summary
Future capital requirements depend upon numerous factors, including
market acceptance of the Company’s products, the timing and rate of expansion of business, acquisitions, joint ventures,
and other factors. IS&S has experienced increases in expenditures since its inception and anticipates that expenditures, excluding
the purchase of the Hawker Beechcraft B200GT, will remain relatively constant with the levels experienced in fiscal 2019 and fiscal
2018. The Company believes that its cash and cash equivalents will provide sufficient capital to fund operations for at least the
next twelve months. Further, IS&S may need to develop and introduce new or enhanced products, to respond to competitive
pressures, to invest in or acquire businesses or technologies, or to respond to unanticipated requirements or developments. If
insufficient funds are available, the Company may not be able to introduce new products or to compete effectively.
Contractual Obligations
The Company’s contractual obligations as of September 30,
2020 mature as follows:
Payments Due by Period
Less than After 5
Contractual Obligations Total 1 Year 1-3 Years 3-5 Years Years
Off-Balance Sheet Arrangements
The Company has no off-balance sheet arrangements.
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Inflation
IS&S does not believe inflation had a material effect on
its financial position or results of operations during the past three years; however, it cannot predict future effects of inflation.
Critical Accounting Policies
The preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America (“GAAP”) requires management to make estimates and assumptions
that affect reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amount of revenues and expenses during the reporting period. The Company’s most critical accounting
policies are revenue recognition, income taxes, inventory valuation, share based compensation and warranty reserves.
Revenue recognition
The Company enters into sales arrangements with customers that,
in general, provide for the Company to design, develop, manufacture and deliver large flat-panel display systems, flight information
computers, autothrottles and advanced monitoring systems that measure and display critical flight information, including data relative
to aircraft separation, airspeed, altitude, and engine and fuel data measurements.
Revenue from Contracts with Customers
The Company adopted ASC 606 on October 1, 2018 using the
modified retrospective method for all contracts not completed as of the date of adoption. The reported results for fiscal year
ended September 30, 2020 and September 30, 2019 reflect the application of ASC 606 guidance while the reported results for
the fiscal year ended September 30, 2018 were prepared under the guidance of ASC 605, “Revenue Recognition” (“ASC
605”), which is also referred to herein as “legacy GAAP” or the “previous guidance.” The adoption
of ASC 606 represents a change in accounting principles. In accordance with ASC 606, revenue is recognized when a customer obtains
control of promised goods or services. The amount of revenue recognized reflects the consideration to which the Company expects
to be entitled to receive in exchange for these goods or services. To achieve this core principle, the Company applies the following
five steps:
1) Identify the contract with a customer
The Company’s contract with its customers typically is
the form of a purchase order issued to the Company by its customers and, to a lesser degree, in the form of a purchase order issued
in connection with a formal contract executed with a customer. For the purpose of accounting for revenue under ASC 606, a contract
with a customer exists when (i) the Company enters into an enforceable contract with a customer that defines each party’s
rights regarding the goods or services to be transferred and identifies the payment terms related to these goods or services, (ii) the
contract has commercial substance and, (iii) the Company determines that collection of substantially all consideration for
goods or services that are transferred is probable based on the customer’s intent and ability to pay the promised consideration.
The Company applies judgment in determining the customer’s ability and intention to pay, which is based on a variety of factors
including the customer’s historical payment experience or, in the case of a new customer, published credit and financial
information pertaining to the customer.
2) Identify the performance obligations in the contract
Performance
obligations promised in a contract are identified based on the goods or services that will be transferred to the customer that
are both capable of being distinct, whereby the customer can benefit from the good or service either on its own or together with
other resources that are readily available from third parties or from the Company, and are distinct in the context of the contract,
whereby the transfer of the goods or services is separately identifiable from other promises in the contract. Most of our revenue
is derived from purchases under which we provide a specific product or service and, as a result, there is only one performance
obligation. In the event that a contract includes multiple promised goods or services, such as an EDC contract which includes both
engineering services and a resulting product shipment, the Company must apply judgment to determine whether promised goods
or services are capable of being distinct in the context of the contract. In these cases, the Company considers whether the customer
could, on its own, or together with other resources that are readily available from third parties, produce the physical product
using only the output resulting from the Company’s completion of engineering services. If the customer cannot produce the
physical product, then the promised goods or services are accounted for as a combined performance obligation.
32
3) Determine the transaction price
The transaction price is determined based on the consideration
to which the Company will be entitled in exchange for transferring goods or services to the customer. To the extent the transaction
price includes variable consideration, the Company estimates the amount of variable consideration that should be included in the
transaction price utilizing either the expected value method or the most likely amount method depending on the nature of the variable
consideration. Variable consideration is included in the transaction price if, in the Company’s judgment, it is probable
that a significant future reversal of cumulative revenue under the contract will not occur. None of the Company’s contracts
as of September 30, 2020 included variable consideration.
4) Allocate the transaction price to performance obligations in the contract
If the contract contains a single performance obligation, the
entire transaction price is allocated to the single performance obligation. The Company determines standalone selling price based
on the price at which the performance obligation is sold separately. If the standalone selling price is not observable through
past transactions, the Company estimates the standalone selling price by taking into account available information such as market
conditions as well as the cost of the goods or services and the Company’s normal margins for similar performance obligations.
5) Recognize revenue when or as the Company satisfies a performance obligation
The Company satisfies performance obligations either over time
or at a point in time as discussed in further detail below. Revenue is recognized at the time the related performance obligation
is satisfied by transferring a promised good or service to a customer.
Revenue
from products transferred to customers at a point in time accounted for 97% of our revenue for the fiscal year ended September 30,
2020 and is typically recognized at the time of shipment of products to the customer. The remaining revenue results from EDC contracts
and is recognized over time using an input measure (e.g., costs incurred to date relative to total estimated costs at completion)
to measure progress. Contract costs include material, components and third-party avionics purchased from suppliers, direct
labor, and overhead costs.
At September 30, 2020, we had approximately $3,640,637
of remaining performance obligations, which we also refer to as total backlog. We expect to recognize approximately 100% of our
remaining performance obligations as revenue over the next 12 months with the remaining balance thereafter.
Contract Estimates
Accounting for performance obligations in long-term contracts
that are satisfied over time involves the use of various techniques to estimate progress towards satisfaction of the performance
obligation. The Company typically measures progress based on costs incurred compared to estimated total contract costs. Contract
cost estimates are based on various assumptions to project the outcome of future events that often span more than a single year.
These assumptions include the amount of labor and labor costs, the quantity and cost of raw materials used in the completion of
the performance obligation, and the complexity of the work to be performed.
As a significant change in one or more of these estimates could
affect the profitability of our contracts, we review and update our contract-related estimates regularly. We recognize adjustments
in estimated profit on contracts under the cumulative catch-up method. Under this method, the impact of the adjustment on profit
recorded to date is recognized in the period the adjustment is identified. Revenue and profit in future periods of contract performance
is recognized using the adjusted estimate. If at any time the estimate of contract profitability indicates an anticipated loss
on the contract, we recognize the total loss in the quarter it is identified.
The impact of adjustments in contract estimates on our operating
earnings can be reflected in either operating costs and expenses or revenue. The aggregate impact of adjustments in contract estimates
did not change our revenue and operating earnings (and diluted earnings per share) for the fiscal year ended September 30,
2020. Therefore, no adjustment on any contract was material to our consolidated financial statements for the fiscal year ended
September 30, 2020.
Financial Statement Impact of Adopting ASC 606
The Company adopted ASC 606 using the modified retrospective
method. The adoption resulted in no adjustment to the Company’s retained earnings as of the adoption date, and there were
no significant changes in the Company’s consolidated statements of operations for the fiscal year ended September 30,
2020 as a result of the adoption of ASC 606 on October 1, 2018 compared to if the Company had continued to recognize revenues
under previous guidance. Additionally, there was no change to the Company’s assets or liabilities as of September 30,
2019 as a result of the adoption of ASC 606 on October 1, 2018 compared to if the Company had continued to recognize revenues
under previous guidance. The adoption of ASC 606 had no impact on the Company’s cash flows from operations.
33
Contract Balances
Contract assets consist of the right to consideration in exchange
for product offerings that we have transferred to a customer under the contract. Contract liabilities primarily relate to consideration
received in advance of performance under the contract.
Customer Service Revenue
The
Company enters into sales arrangements with customers for the repair or upgrade of its various products that are not under warranty.
The Company’s customer service revenue and cost of sales are included in product sales and product cost of sales, respectively,
on the accompanying consolidated statements of operations.
Income taxes
Income taxes are recorded in accordance with ASC Topic 740,
“Income Taxes” (“ASC Topic 740”), which utilizes a balance sheet approach to provide for income
taxes. Under this method, the Company recognizes deferred tax assets and liabilities for temporary differences between the
financial reporting basis and the tax basis of the Company’s assets, liabilities, and expected benefits of utilizing NOLs
and tax credit carry-forwards. The impact on deferred taxes of changes in tax rates and laws, if any, are applied to the years
during which temporary differences are expected to be settled, and are reflected in the consolidated financial statements in the
period of enactment. At the end of each interim reporting period, the Company prepares an estimate of the annual effective income
tax rate and applies that annual effective income tax rate to ordinary year-to-date pre-tax income for the interim period. Specific
tax items discrete to a particular quarter are recorded in income tax expense for that quarter. The estimated annual effective
tax rate used in providing for income taxes on a year-to-date basis may change in subsequent periods.
Deferred tax assets are reduced by a valuation allowance if,
based on the consideration of all available evidence, it is more likely than not that some portion of the deferred tax asset will
not be realized. Significant weight is given to evidence that can be verified objectively, and significant management judgment
is required in determining any valuation allowance recorded against net deferred tax assets. The Company evaluates deferred income
taxes on a quarterly basis to determine if a valuation allowance is required by considering available evidence. Deferred tax assets
are recognized when expected future taxable income is sufficient to allow the related tax benefits to reduce taxes that would otherwise
be payable. The sources of taxable income that may be available to realize the benefit of deferred tax assets are future reversals
of existing taxable temporary differences, future taxable income exclusive of reversing temporary differences and credit carryforwards,
taxable income in carry-back years, and tax planning strategies which are both prudent and feasible. The Company’s current
balance of the deferred tax valuation allowance is recorded against all of its federal and state deferred tax assets. The Company
will continue to assess all available evidence during future periods to evaluate any changes to the realization of its deferred
tax assets. If the Company were to determine that it would be able to realize additional federal or state deferred tax assets in
the future, it would make an adjustment to the valuation allowance which would reduce the provision for income taxes.
The accounting for uncertainty in income taxes requires a more
likely than not threshold for financial statement recognition and measurement of tax positions taken or expected to be taken in
a tax return. The Company records a liability for the difference between the (i) benefit recognized and measured for financial
statement purposes and (ii) the tax position taken or expected to be taken on the Company’s tax return. To the extent
that the Company’s assessment of such tax positions changes, the change in estimate is recorded in the period in which the
determination is made. The Company has elected to record any interest or penalties associated with uncertain tax positions as income
tax expense.
The
Company files a consolidated U.S. federal income tax return. The Company prepares and files tax returns based on the interpretation
of tax laws and regulations, and records estimates based on these judgments and interpretations. In the normal course of business,
the tax returns are subject to examination by various taxing authorities. Such examinations may result in future tax and interest
assessments by these taxing authorities, and the Company records a liability when it is probable that there will be an assessment.
The Company adjusts the estimates periodically as a result of ongoing examinations by and settlements with the various taxing authorities,
and changes in tax laws, regulations and precedent. The consolidated tax provision of any given year includes adjustments to prior
years’ income tax accruals that are considered appropriate, and any related estimated interest. Management believes that
it has made adequate accruals for income taxes. Differences between estimated and actual amounts determined upon ultimate
resolution, individually or in the aggregate, are not expected to have a material effect on the Company’s consolidated financial
position, but could possibly be material to its consolidated results of operations or cash flow of any one period.
On December 22, 2017, the U.S. government enacted the Tax
Act, which made broad and complex changes to the U.S. tax code, including, but not limited to, (1) reducing the U.S. federal
corporate tax rate from 34 percent to 21 percent; (2) bonus depreciation that will allow for full expensing of qualified property;
(3) elimination of the corporate alternative minimum tax (“AMT”) and changing how existing AMT credits can be
realized; (4) a new limitation on deductible interest expense; (5) the repeal of the domestic production activity deduction;
and (6) limitations on NOLs generated after December 31, 2017, to 80 percent of taxable income.
34
The Tax Act reduced the corporate tax rate to 21 percent, effective
January 1, 2018. Consequently, we recorded a provisional adjustment to decrease related to DTAs and DTLs with a corresponding
net adjustment to deferred income tax expense of $321,038 for the period ended December 31, 2017. This expense is offset fully
by a change in the valuation allowance.
In
March 2020, in response to the COVID-19 pandemic, the Coronavirus Aid, Relief, and Economic Security Act (the “CARES
Act”) was signed into law to provide emergency assistance to affected individuals, families, and businesses. The CARES Act
provides numerous tax provisions and other stimulus measures, including temporary changes regarding the prior and future utilization
of NOLs. The CARES Act amends the NOL provisions of the Tax Act, allowing for the carryback of losses arising in tax years beginning
before December 31, 2017, to each of the two taxable years preceding the taxable year of loss. Approximately $1,500,000 of pre-tax
NOL was carried back two years to fully offset taxable income. This carryback frees up previously utilized R&D credits, resulting
in an estimated increase in R&D credit carryforward of $196,000. The carryback created approximately $16,000 of AMT tax, which
was refunded. The cash impact of this carryback was $309,412.
Inventory valuation
The Company values inventory at the lower of cost (first-in,
first-out) or net realizable value. Inventories are written down for estimated obsolescence equal to the difference between inventory
cost and estimated net realizable value based on a combination of historical usage and assumptions based on expected usage related
to estimated future customer and market demands. The Company’s method of valuing inventory contains uncertainties because
the calculation requires management to consider inventory aging, to make assumptions regarding expected usage, and to apply judgments
on forecasted future demand, market conditions, and technological obsolescence. If actual future demand or market conditions are
less favorable than those projected by management, additional inventory write-down may be required.
Share-based compensation
The Company accounts for share-based compensation under ASC
Topic 718, “Stock Compensation” (“ASC Topic 718”), which requires the Company to measure the cost
of employee or non-employee director services received in exchange for an award of equity instruments based on the grant-date fair
value of the award using an option pricing model. The Company recognizes such cost over the period during which an employee or
non-employee director is required to provide service in exchange for the award.
Accordingly, adoption of ASC Topic 718’s fair value method
results in recording compensation costs under the Company’s stock based compensation plans. The Company determined the fair
value of its stock option awards at the date of grant using the Black-Scholes option pricing model. Option pricing models and generally
accepted valuation techniques require management to make assumptions and to apply judgment to determine the fair value of its awards.
These assumptions and judgments include estimating future volatility of the Company’s stock price, expected dividend yield,
future employee turnover rates, and future employee stock option exercise behaviors. Changes in these assumptions can materially
affect fair value estimates. The Company does not believe that a reasonable likelihood exists that there will be a material change
in future estimates or assumptions used to determine share-based compensation expense. However, if actual results are not consistent
with the Company’s estimates or assumptions, the Company would adjust its estimates. Such adjustments could have a material
impact on the Company’s financial position.
Warranty reserves
The Company offers warranties on some products of various lengths,
however the standard warranty period is twenty-four months. At the time of shipment, the Company establishes a reserve for estimated
costs of warranties based on its best estimate of the amounts necessary to settle future and existing claims using historical data
on products sold as of the balance sheet date. The length of the warranty period, the product’s failure rates, and the customer’s
usage affect warranty cost. If actual warranty costs differ from the Company’s estimated amounts, future results of operations
could be affected adversely. Warranty cost is recorded as cost of sales, and the reserve balance recorded as an accrued expense.
While the Company maintains product quality programs and processes, its warranty obligation is affected by product failure rates
and the related corrective costs. If actual product failure rates and/or corrective costs differ from the estimates, the Company
revises the estimated warranty liability accordingly.
Self-insurance reserves
Since January 1, 2014, the Company has self-insured a significant
portion of its employee medical insurance. The Company maintains a stop-loss insurance policy that limits its losses both on a
per employee basis and an aggregate basis. Liabilities associated with the risks that are retained by the Company are estimated
based upon actuarial assumptions such as historical claims experience and demographic factors. The Company estimated the total
medical claims incurred but not reported and the Company believes that it has adequate reserves for these claims at September 30,
2020 and 2019. However, the actual value of such claims could be significantly affected if future occurrences and claims differ
from these assumptions. At September 30, 2020 and 2019, the estimated liability for medical claims incurred but not reported
was $48,200 and $55,700, respectively. The Company has recorded the excess of funded premiums over estimated claims incurred but
not reported of $225,200 as a current asset in the accompanying consolidated balance sheet. During the year ended September 30,
2020, the Company has used the excess of funded premiums to reduce amounts payable for claims incurred.
35
Treasury Stock
We account for treasury stock purchased under the cost method
and include treasury stock as a component of stockholders’ equity. Treasury stock purchased with intent to retire (whether
or not the retirement is actually accomplished) is charged to common stock.
Subsequent Events
On
December 10, 2020, the Company’s Board of Directors declared a special cash dividend in the amount of $0.50 per share, payable
on or about December 30, 2020 to shareholders of record as of the close of business on December 21, 2020. The declaration and payment
of any dividend in the future will be at the discretion of the Company’s Board of Directors. See Note 19, “Subsequent
Events,” to the consolidated financial statements for additional information.
New Accounting Pronouncements
In May 2014, the FASB issued ASU 2014-09, “Revenue
from Contracts with Customers,” which provides a single, comprehensive revenue recognition model for all contracts with
customers, and contains principles to determine the measurement of revenue and timing of when it is recognized. The model will
supersede most existing revenue recognition guidance, and also requires enhanced revenue-related disclosures. Under the new standard
and its related amendments (collectively known as “ASC 606”), revenue is recognized when a customer obtains control
of promised goods or services. The amount of revenue recognized will reflect the consideration that the entity expects to receive
in exchange for those goods or services. In addition, the standard requires disclosure of the nature, amount, timing, and uncertainty
of revenue and cash flows arising from contracts with customers.
The
guidance permits two methods of adoption: retrospectively to each prior reporting period presented (full retrospective method),
or retrospectively with the cumulative effect of initially applying the guidance recognized at the date of initial application
(modified retrospective method). We adopted this guidance on October 1, 2018 using the modified retrospective method. See
Note 3, “Financial Statement Impact of Adopting ASC 606,” to the consolidated financial statements for
a discussion of the impact resulting from the adoption of this guidance.
In
February 2016, the FASB issued ASU 2016-02, “Leases (Topic 842)” (“ASU 2016-02”) as
modified, which replaces existing leasing rules with a comprehensive lease measurement and recognition standard and expanded disclosure
requirements. ASU 2016-02 will require lessees to recognize most leases on their balance sheets as liabilities, with corresponding
“right-of-use” assets and is effective for annual reporting periods beginning after December 15, 2018, subject to early
adoption. For income statement recognition purposes, leases will be classified as either a finance or an operating lease without
relying upon the bright-line tests under current GAAP. In transition, lessees and lessors are required to recognize and measure
leases at the beginning of the earliest period presented using a modified retrospective approach. The modified retrospective approach
includes a number of optional practical expedients that we may elect to apply. These practical expedients relate to the identification
and classification of leases that commenced before the effective date, initial direct costs for leases that commenced before the
effective date, and the ability to use hindsight in evaluating lessee options to extend or terminate a lease or to purchase the
underlying asset. An entity that elects to apply the practical expedients will, in effect, continue to account for leases that
commence before the effective date in accordance with previous GAAP unless the lease is modified, except that lessees are required
to recognize a right-of-use asset and a lease liability for all operating leases at each reporting date based on the present value
of the remaining minimum rental payments that were tracked and disclosed under previous GAAP. We adopted ASU 2016-02 effective
October 1, 2019 using the required modified retrospective approach. See Note 18, “Lease Recognition,” to the
consolidated financial statements for a discussion of the impact resulting from the adoption of this guidance.
In June 2016, FASB issued ASU 2016-13, Financial Instruments
– Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instrument (“ASU 2016-13”). ASU 2016-13
replaces the incurred loss impairment methodology in current U.S. GAAP with a methodology that reflects expected credit losses
and requires consideration of a broader range of reasonable and supportable information to inform credit loss estimates. ASU 2016-13
is effective for SEC small business filers for fiscal years beginning after December 15, 2022. Management is currently assessing
the impact ASU 2016-13 will have on the Company.
In June 2018, the FASB issued ASU 2018-07, “Stock-based
Compensation: Improvements to Nonemployee Share-based Payment Accounting,” (“ASU 2018-07”) which amends the
existing accounting standards for share-based payments to nonemployees. This ASU aligns much of the guidance on measuring and classifying
nonemployee awards with that of awards to employees. Under the new guidance, the measurement of nonemployee equity awards is fixed
on the grant date. This ASU becomes effective in the first quarter of fiscal year 2019 and early adoption is permitted but no earlier
than an entity’s adoption date of Topic 606. Entities will apply the ASU by recognizing a cumulative-effect adjustment to
retained earnings as of the beginning of the annual period of adoption. We adopted ASU 2018-07 effective October 1, 2018 and
the implementation had no material impact on the consolidated financial statements.
36
In August 2018, the FASB issued ASU 2018-13, “Fair
Value Measurement (Topic 820): Disclosure Framework – Changes to the Disclosure Requirements for Fair Value Measurement,”
(“ASU 2018-13”) which modifies the disclosures on fair value measurements by removing the requirement to disclose the
amount and reason for transfers between Level 1 and Level 2 of the fair value hierarchy and the policy for timing of such transfers.
The ASU expands the disclosure requirements for Level 3 fair value measurements, primarily focused on changes in unrealized gains
and losses included in other comprehensive income. For public entities, the standard is effective for fiscal years, and interim
periods within those fiscal years, beginning after December 15, 2019. Early adoption is permitted for any removed or modified
disclosures and adoption of the additional disclosures can be delayed until the effective date. The Company does not currently
expect the adoption of ASU 2018-13 to have a material impact on its consolidated financial statements.
As new accounting pronouncements are issued, we will adopt those
that are applicable.
Business Segments
The Company operates in one business segment as a systems integrator
that designs, develops, manufactures, sells, and services flight guidance and cockpit display systems for OEMs and retrofit applications.
Customers include various OEMs, commercial air transport carriers and corporate/general aviation companies, DoD and its commercial
contractors, aircraft operators, aircraft modification centers, government agencies, and foreign militaries. The Company currently
derives the majority of its revenues from the sale of this equipment and related EDC services. Most of the Company’s sales,
operating results and identifiable assets are generated in the United States. In fiscal years 2020, 2019 and 2018 net sales outside
the United States amounted to $9.4 million, $7.5 million and $4.7 million, respectively.
Item 7A. Quantitative and qualitative disclosures about market
risk.
The
Company’s operations are exposed to market risks primarily as a result of changes in interest rates. The Company does not
use derivative financial instruments for speculative or trading purposes. The Company’s exposure to market risk for changes
in interest rates relates to its cash equivalents. The Company’s cash equivalents consist of funds invested in money market
funds, which bear interest at a variable rate. The Company does not participate in interest rate hedging. A change in interest
rates earned on the Company’s cash equivalents would impact interest income and cash flows, but would not impact the fair
market value of the underlying instruments. Assuming that the balances during fiscal 2020 were to remain constant and that the
Company did not act to alter the existing interest rate sensitivity, a hypothetical 1% increase in variable interest rates would
have affected interest income by approximately $165,000. This would result in a net impact on cash of approximately $165,000
for fiscal 2020.
Item 8. Financial statements and supplementary data.
The financial statements of Innovative Solutions and Support, Inc.
listed in the index appearing under Item 8 herein are filed as part of this Report.
37
Innovative Solutions and Support, Inc.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Page
Report of Independent Registered Public Accounting Firm 39
Consolidated Balance Sheets 40
Consolidated Statements of Operations 41
Consolidated Statements of Shareholders’ Equity 42
Consolidated Statements of Cash Flows 43
Notes to Consolidated Financial Statements 44-63
38
REPORT OF INDEPENDENT
REGISTERED PUBLIC ACCOUNTING FIRM
Board of Directors and Shareholders
Innovative Solutions & Support Inc.
Opinion on the financial statements
We have audited the accompanying consolidated balance sheets
of Innovative Solutions & Support, Inc. (a Pennsylvania corporation) and subsidiaries (the “Company”) as of September
30, 2020 and 2019, the related consolidated statements of operations, changes in shareholders’ equity, and cash flows for
each of the three years in the period ended September 30, 2020, and the related notes (collectively referred to as the “financial
statements”). In our opinion, the financial statements present fairly, in all material respects, the financial position
of the Company as of September 30, 2020 and 2019, and the results of its operations and its cash flows for each of the three years
in the period ended September 30, 2020, in conformity with accounting principles generally accepted in the United States of America.
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 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 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 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 audits 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 audits provide a reasonable basis
for our opinion.
/s/ GRANT THORNTON LLP
We have served as the Company’s auditor since 2014.
Philadelphia, Pennsylvania
December 22, 2020
39
INNOVATIVE SOLUTIONS AND SUPPORT, INC.
CONSOLIDATED BALANCE
SHEETS
September 30, September 30,
ASSETS
Current assets
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities