Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
Overview
We are a leading global provider of communications technology to service providers and enterprises. We provide a broad range of software and high-performance hardware products, solutions and services that enable the secure delivery of data and voice communications for residential consumers and for small, medium and large enterprises and industry verticals such as finance, education, government, utilities and transportation. Our mission is to create a recognized global technology leader providing cloud-centric solutions that enable the secure exchange of information, with unparalleled scale, performance and elasticity. Headquartered in Plano, Texas, we have a global presence with research and development and/or sales and support locations in over thirty-five countries around the world.
Impact of COVID-19 on Our Business
In 2020, a novel strain of the coronavirus (COVID-19) was declared by the World Health Organization to be a global pandemic. The COVID-19 pandemic has had a negative effect on the global economy, disrupting the various manufacturing, commodity and financial markets and increasing volatility, and has impeded global supply chains, including that of our IP Optical Networks operating segment. Continued dampened global economic conditions as a result of the COVID-19 pandemic may cause our customers to restrict spending or delay purchases for an indeterminate period of time and consequently cause our revenues to decline. In addition, our ability to deliver our solutions as agreed upon with our customers depends on the ability of our global contract manufacturers, vendors, licensors and other business partners to deliver products or perform services we have procured from them. While, to date, we have not experienced material issues, if the continuing COVID-19 pandemic impairs the ability of our business partners to support us on a timely basis, or negatively impacts the demand for our customers' other products and services, our ability to perform our customer contracts as well as the demand for our solutions may suffer. In addition, disruptions from the COVID-19 pandemic could include, and with respect to our IP Optical Networks operating segment have included, disruption of logistics necessary to import, export and deliver our solutions. The COVID-19 pandemic has also limited the ability of our associates to perform their work due to illness caused by the pandemic or local, state or federal orders requiring associates to remain at home. Concerns over the economic impact of the COVID-19 pandemic have also caused extreme volatility in financial and other capital markets which has and may continue to adversely impact our stock price. Such volatility may also adversely impact our ability to access capital markets if and when we would be required to do so. The degree to which the COVID-19 pandemic ultimately impacts our business, financial position and results of operations will depend on future developments beyond our control, including the severity of the pandemic, the frequency and duration of future waves of infection, the effectiveness and timing of any vaccines, the extent of actions to contain or treat the virus, how quickly and to what extent normal economic and operating conditions can resume, and the severity and duration of the global economic downturn that results from the pandemic.
As a response to the ongoing COVID-19 pandemic, we have implemented plans to manage our costs. As part of that plan, we implemented a temporary wage reduction of 10% to 50% applicable to the base salary of most of our employees, which salary reduction has now ended. We have significantly limited the addition of new employees and third-party contracted services, eliminated all travel except where necessary to meet customer or regulatory needs, and acted to limit discretionary spending. To the extent the business disruption continues for an extended period, additional cost management actions will be considered. Any future asset impairment charges, increases in the allowance for doubtful accounts or restructuring charges could be more likely and will be dependent on the severity and duration of this crisis.
Presentation
Unless otherwise noted, all financial amounts, excluding tabular information, in this MD&A are rounded to the nearest million dollar amount, and all percentages, excluding tabular information, are rounded to the nearest percentage point.
Reclassification of Amortization of Acquired Intangible Assets
In 2020, we reclassified amounts recorded for amortization of acquired intangible assets in prior presentations from Cost of revenue - product and Sales and marketing to a separate line included in operating expenses in our consolidated statements of operations. Our Management believes this presentation enhances the comparability of our financial statements to industry peers. These reclassifications did not impact our operating income (loss), net income (loss) or earnings (loss) per share for any historical periods. These reclassifications also did not impact our consolidated balance sheets or consolidated statements of cash flows.
These reclassifications resulted in reductions to Cost of revenue - product and Sales and marketing of $37.6 million and
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$11.6 million, respectively, reclassified to Amortization of acquired intangible assets in the year ended December 31, 2019. The reduction to Cost of revenue - product increased our product gross profit as a percentage of product revenue ("product gross margin") and our total gross profit as a percentage of revenue ("total gross margin) by 14 and 7 percentage points, respectively.
These reclassifications resulted in reductions to Cost of revenue - product and Sales and marketing of $39.0 million and $10.7 million, respectively, reclassified to Amortization of acquired intangible assets in the year ended December 31, 2018. The reduction to Cost of revenue - product increased our product gross profit as a percentage of product revenue and our total gross profit as a percentage of revenue by 14 and 7 percentage points, respectively.
Business Acquisitions
ECI Telecom Group Ltd
On March 3, 2020 (the "ECI Acquisition Date"), we completed the acquisition of ECI in accordance with the terms of the Agreement and Plan of Merger, dated as of November 14, 2019, by and among Ribbon, an indirect wholly-owned subsidiary of Ribbon ("Merger Sub"), Ribbon Communications Israel Ltd., ECI, and ECI Holding (Hungary) kft, pursuant to which Merger Sub merged with and into ECI, with ECI surviving such merger as a wholly-owned subsidiary of Ribbon (the "ECI Acquisition"). Prior to the ECI Acquisition Date, ECI was a privately-held global provider of end-to-end packet-optical transport and software-defined networking ("SDN") and network function virtualization ("NFV") solutions for service providers, enterprises and data center operators. Ribbon believes the ECI Acquisition positions the Company for growth and enhances its competitive strengths by expanding its product portfolio beyond solutions primarily supporting voice applications to include data applications and optical networking.
As consideration for the ECI Acquisition, we issued the ECI shareholders and certain others 32.5 million shares of Ribbon common stock with a fair value of $108.6 million (the "Stock Consideration") and paid $322.5 million of cash, comprised of $183.3 million to repay ECI's outstanding debt, including both principal and interest, and $139.2 million paid to ECI's selling shareholders (the "Cash Consideration"). In addition, ECI shareholders received $33.4 million from the sale of certain of ECI's real estate assets. Cash Consideration was financed through cash on hand and committed debt financing consisting of a new $400 million term loan facility and new $100 million revolving credit facility, which was undrawn at the ECI Acquisition Date. The ECI Acquisition has been accounted for as a business combination and the financial results of ECI have been included in our consolidated financial statements for the periods subsequent to the ECI Acquisition Date.
Anova Data, Inc.
On February 28, 2019 (the "Anova Acquisition Date"), we acquired the business and technology assets of Anova Data, Inc. ("Anova"), a private company headquartered in Westford, Massachusetts (the "Anova Acquisition"). Anova is a provider of advanced analytics solutions and its next generation products provide a cloud-native, streaming analytics platform for network and subscriber optimization and monetization. The Company believes that the Anova Acquisition will reinforce and extend Ribbon's strategy to expand into network optimization, security and data monetization via big data analytics and machine learning.
As consideration for the Anova Acquisition, we issued 2.9 million shares of our common stock with a fair value of $15.2 million to Anova's sellers and equity holders on the Anova Acquisition Date and held back an additional 330,000 shares of our common stock with a fair value of $1.7 million (the "Deferred Purchase Consideration"), of which 316,551 shares were issued after post-closing adjustments on March 4, 2020. The Deferred Purchase Consideration was included as a component of Accrued expenses and other in our consolidated balance sheet at December 31, 2019. The Anova Acquisition has been accounted for as a business combination and the financial results of Anova have been included in our consolidated financial statements for the periods subsequent to the Anova Acquisition Date.
Edgewater Networks, Inc.
On August 3, 2018 (the "Edgewater Acquisition Date") we completed our acquisition of Edgewater Networks, Inc. ("Edgewater"), a private company headquartered in San Jose, California (the "Edgewater Acquisition"). Edgewater is a market leader in Network Edge Orchestration for the small and medium enterprise and UC market. We believe that the acquisition of Edgewater allows us to offer our global customer base a complete core-to-edge product portfolio, end-to-end service assurance and analytics solutions, and a fully integrated SD-WAN service.
As consideration for the Edgewater Acquisition, we paid, in the aggregate, $46.4 million of cash, net of cash acquired, and
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issued 4.2 million shares of Ribbon common stock to Edgewater's selling shareholders and holders of vested in-the-money options and warrants to acquire common stock of Edgewater (the "Edgewater Selling Stakeholders") on the Edgewater Acquisition Date. The cash payment was funded through our then-current credit facility. We had previously agreed to pay the Edgewater Selling Stakeholders an additional $30.0 million of cash, $15.0 million of which was to be paid six months from the Edgewater Acquisition Date and the other $15.0 million of which was to be paid as early as nine months from the Edgewater Acquisition Date (the exact timing of which would depend on the amount of revenue generated from the sales of Edgewater products in 2018) (the "Edgewater Deferred Consideration").
On February 15, 2019, we and the Edgewater Selling Stakeholders agreed to reduce the amount of Edgewater Deferred Consideration from $30 million to $21.9 million and agreed that all such deferred consideration would be payable on March 8, 2019. We paid the Edgewater Selling Stakeholders $21.9 million on March 8, 2019 and recorded the $8.1 million reduction to the Edgewater Deferred Consideration in Other income (expense), net, in our consolidated statement of operations for the year ended December 31, 2019.
The Edgewater Acquisition has been accounted for as a business combination and the financial results of Edgewater have been included in our consolidated financial statements for the period subsequent to the Edgewater Acquisition Date.
Sale of Kandy Communications Business
On August 5, 2020, we announced that we had entered into a definitive agreement (the "Kandy Purchase Agreement") with American Virtual Cloud Technologies, Inc. ("AVCT") to sell our cloud-based enterprise services business (the "Kandy Communications Business"). Under the Kandy Purchase Agreement, AVCT would purchase the assets and assume certain liabilities associated with the Kandy Communications Business, as well as all of the outstanding interests in our Kandy Communications LLC subsidiary (the "Kandy Sale").
On December 1, 2020, we and AVCT entered into an amended and restated Purchase Agreement (the “Amended Kandy Agreement”). Under the terms of the Amended Kandy Agreement, AVCT agreed to pay us $45.0 million, subject to certain adjustments, in the form of units of AVCT’s securities (the “AVCT Units”), with each AVCT Unit consisting of: (i) $1,000 in principal amount of AVCT’s Series A-1 convertible debentures (the “Debentures”); and (ii) one warrant to purchase 100 shares of AVCT common stock, $0.0001 par value (the “Warrants”), as consideration for the Kandy Sale (the "Kandy Consideration"). The Kandy Sale was completed on December 1, 2020 (the "Kandy Sale Date"), and we received 43,778 AVCT Units as sale consideration on that date.
The Debentures bear interest at a rate of 10% per annum, which will be added to the principal amount of the Debentures, except upon maturity, in which case accrued and unpaid interest is payable in cash. The entire principal of each Debenture, together with accrued and unpaid interest thereon, is due and payable on the earlier of the May 1, 2023 maturity date or the occurrence of a Change in Control as defined in the Amended Kandy Agreement. Each Debenture is convertible, in whole or in part, at any time at our option into that number of shares of AVCT common stock, calculated by dividing the principal amount being converted, together with all accrued and unpaid interest thereon, by the applicable conversion price, initially $3.45. The Debentures are subject to mandatory redemption if the AVCT stock price is at or above $6.00 per share for 40 trading days in any 60 consecutive trading day period, subject to the satisfaction of certain other conditions. The conversion price is subject to customary adjustments including, but not limited to, stock dividends, stock splits and reclassifications. At our option, up to $5.0 million of the Debentures may be redeemed by AVCT at par in the event AVCT raises at least $50.0 million in its offering of AVCT Units. As of February 19, 2021, the stock had traded above $6.00 for 40 days within a 60 consecutive day trading period and accordingly, the Debentures will be converted to shares of AVCT common stock upon the completion of customary and regulatory filings by AVCT.
The Warrants are independent of the Debentures and entitle us to purchase 4,377,800 shares of AVCT common stock at an exercise price of $0.01 per share. The Warrants expire on December 1, 2025, and were immediately exercisable on the Kandy Sale Date.
We had not redeemed any of the Debentures or exercised any of the Warrants as of December 31, 2020. We are also subject to a lock-up provision which limits our ability to sell any shares of AVCT common stock underlying the Debentures and the Warrants prior to June 1, 2021, except in certain transactions.
We determined that the AVCT Units had a fair value of $84.9 million at the Kandy Sale Date, comprised of the Debentures with a fair value of $66.3 million and the Warrants with a fair value of $18.6 million. The value of the net assets sold to AVCT totaled $1.3 million, resulting in a gain on the sale of $83.6 million. This amount is included as a component of Other income (expense), net, in our consolidated statement of operations for the year ended December 31, 2020.
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The fair value of the Debentures was calculated using a Lattice-based valuation approach, which utilizes a binomial tree to model the different paths the price of AVCT's common stock might take over the Debentures' life by using assumptions regarding the stock price volatility and risk-free interest rate. These results are then used to calculate the fair value of the Debentures at each measurement date. The Company uses the Black-Scholes valuation model for estimating the fair value of the Warrants at each measurement date. The fair value of the Warrants is affected by AVCT's stock price as well as valuation assumptions, including the volatility of AVCT's stock price, expected term of the option, risk-free interest rate and expected dividends. Both the Lattice and Black-Scholes valuation models are based on available market data, giving consideration to all of the rights and obligations of each instrument and precluding the use of "blockage" discounts or premiums in determining the fair value of a large block of financial instruments.
We will calculate the fair value of the Debentures and Warrants at each quarter-end and record any adjustments to the fair values in Other income (expense), net. At December 31, 2020, the aggregate fair value of the Debentures and Warrants was calculated as $115.2 million, resulting in a gain of $30.3 million in the increase in fair values of the Debentures and Warrants. This gain is included as a component of Other income (expense), net, in our consolidated statement of operations. The fair values of the Debentures and Warrants are reported as Investments in our consolidated balance sheet at December 31, 2020. The results of the Kandy Communications Business are excluded from our consolidated results for the period subsequent to the Kandy Sale Date.
Litigation Settlement
On April 22, 2019, we and Metaswitch Networks Ltd., Metaswitch Networks Corp and Metaswitch Inc. (collectively, "Metaswitch") agreed to a binding mediator's proposal that resolves the six previously disclosed lawsuits between the Company and Metaswitch (the "Lawsuits"). We and Metaswitch signed a Settlement and Cross-License Agreement on May 29, 2019 (the "Royalty Agreement"). Pursuant to the terms of the Royalty Agreement, Metaswitch agreed to pay us an aggregate amount of $63.0 million, which included cash payments of $37.5 million during the second quarter of 2019 and $25.5 million payable in three installments annually, beginning June 26, 2020, with such installment payments accruing interest at a rate of 4% per year. As part of the Royalty Agreement, we and Metaswitch have (i) released the other from all claims and liabilities; (ii) licensed each party's existing patent portfolio to the other party; and (iii) requested the applicable courts to dismiss the Lawsuits. We received $37.5 million of aggregate payments from Metaswitch in the second quarter of 2019 and recorded notes receivable for future payments of $25.5 million, comprised of $8.5 million in Other current assets and $17.0 million in Other assets in our consolidated balance sheet at December 31, 2019. We recorded the $63.0 million gain in Other income (expense), net, in our consolidated statement of operations for the year ended December 31, 2019. We received $37.5 million of aggregate payments from Metaswitch in the second quarter of 2019 and $9.5 million, including $1.0 million of interest, in the second quarter of 2020.
On July 6, 2020, we and Metaswitch signed a First Supplemental Agreement to the Settlement and Cross-License Agreement (the "Supplemental Agreement") under which Metaswitch could elect to repay the outstanding amounts under the Royalty Agreement early in exchange for a reduction of $0.25 million to the outstanding principal, from $17.0 million to $16.75 million, and the payment of no further interest by Metaswitch effective June 26, 2020. We recorded the reduction to the outstanding principal as a reduction to interest income. On July 14, 2020, Metaswitch paid us the remaining outstanding balance of $16.75 million.
Operating Segments
Our chief operating decision maker (the "CODM") is our president and chief executive officer. Effective in the fourth quarter of 2020 and in connection with the ECI Acquisition, our CODM began to assess our performance based on the performance of two separate organizations within Ribbon: the Cloud and Edge operating segment ("Cloud and Edge") and the IP Optical Networks operating segment ("IP Optical Networks"). We previously operated in a single segment, as our CODM made decisions and assessed performance at the company level, and for periods prior to the ECI Acquisition, there are no financial results for IP Optical Networks to report.
Our Cloud and Edge operating segment is primarily comprised of the legacy Ribbon business and provides secure and reliable software and hardware products, solutions and services for enabling Voice over Internet Protocol ("VoIP") communications, Voice over Long-Term Evolution ("VoLTE") and Voice Over 5G ("VoNR") communications and Unified Communications and Collaboration ("UC&C") within service provider and enterprise networks and from the cloud. Our Cloud and Edge products are increasingly software-centric and cloud-native for deployment on private, public or hybrid cloud infrastructures, in data centers, on enterprise premises and within service provider networks. Our Cloud and Edge product portfolio consists of our Session Border Controller ("SBC") products and our Network Transformation ("NTR") products.
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Our IP Optical Networks operating segment is primarily comprised of the former ECI business and provides high-performance, secure and reliable hardware and software products solutions for IP networking, switching, routing and optical transport designed to support and enable technologies like 5G, distributed cloud computing and corresponding applications by delivering ultra-low cost-per-bit transport and multi-service flexibility. Our IP Optical Networks portfolio offers multiple solutions, including 5G-native solutions for mobile backhaul, metro and edge aggregation, core networking, data center interconnect, legacy NTR and transport solutions for wholesale carriers. This portfolio is offered to service provider, enterprise and industry verticals with critical transport network infrastructures including utilities, government, defense, transportation, and education and research.
Financial Overview
Financial Results
We reported income from operations of $2 million for 2020 and a loss from operations of $189 million for 2019. We reported net income of $89 million for 2020 and a net loss of $130 million for 2019.
Our revenue was $844 million in 2020, comprised of $583 million attributable to Cloud and Edge and $261 million attributable to IP Optical Networks. Our revenue was $563 million in 2019. Our gross profit was $493 million in 2020, comprised of $384 million attributable to Cloud and Edge and $109 million attributable to IP Optical Networks. Our gross profit was $355 million in 2019. Our gross profit as a percentage of revenue ("total gross margin") was 58% in 2020 and 63% in 2019. In 2020, our Cloud and Edge total gross margin was 66% and our IP Optical Networks total gross margin was 42%.
Our operating expenses were $491 million in 2020 and $544 million in 2019. Our 2020 operating expenses included $61 million of amortization of acquired intangible assets, $17 million of acquisition-, disposal- and integration-related expense, and $16 million of restructuring and related expense. Our 2019 operating expenses included $164 million for the impairment of goodwill, $49 million of amortization of acquired intangible assets, $13 million of acquisition-, disposal- and integration-related expense, and $16 million of restructuring expense.
We recorded stock-based compensation expense of $14 million in 2020 and $13 million in 2019. The expense recorded in 2019 includes $2 million of incremental expense related to the accelerated vesting of RSUs and PSUs held by our former president and chief executive officer in connection with his separation from the Company effective December 31, 2019.
See "Results of Operations" in this MD&A for additional discussion of our results of operations for the years ended December 31, 2020 and 2019.
Restructuring and Cost Reduction Initiatives
In 2020, we implemented a restructuring plan to eliminate certain positions and redundant facilities, primarily in connection with the ECI Acquisition, to further streamline our global footprint and improve our operations (the "2020 Restructuring Initiative"). The 2020 Restructuring Initiative includes facility consolidations and a reduction in workforce, including severance aggregating $1.1 million for three former executives of ECI. In connection with this initiative, we expect to eliminate duplicate functions arising from the ECI Acquisition and support our efforts to integrate the two companies. In connection with the 2020 Restructuring Initiative, we recorded restructuring and related expense of $14.0 million in 2020, comprised of $11.5 million for severance and related costs for approximately 190 employees, including the former executives of ECI, $2.0 million for variable and other facilities-related costs, and $0.5 million for accelerated amortization of lease assets. We expect these amounts will be fully paid in 2021. We expect to record additional restructuring and related expense approximating $8 million under the 2020 Restructuring Initiative in the aggregate for severance and planned facility consolidations.
In June 2019, we implemented a restructuring plan to further streamline our global footprint, improve our operations and enhance our customer delivery (the "2019 Restructuring Initiative"). The 2019 Restructuring Initiative includes facility consolidations, refinement of our research and development activities, and a reduction in workforce. The facility consolidations under the 2019 Restructuring Initiative (the "Facilities Initiative") include a consolidation of our North Texas sites into a single campus, housing engineering, customer training and support, and administrative functions, as well as a reduction or elimination of certain excess and duplicative facilities worldwide. In addition, we intend to substantially consolidate our global software laboratories and server farms into two lower cost North American sites. We continue to evaluate our properties included in the Facilities Initiative for accelerated amortization and/or right-of-use asset impairment. We expect that the actions under the Facilities Initiative will be completed in 2021.
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In connection with the 2019 Restructuring Initiative, we recorded restructuring and related expense of $2.3 and $11.2 million in 2020 and 2019, respectively. The amount recorded in 2020 was comprised of $0.5 million for severance and related costs for approximately 5 employees, $1.7 million for variable and other facilities-related costs and $0.1 million for accelerated amortization of lease assets. The amount recorded in 2019 was comprised of $6.1 million for severance and related costs for approximately 120 employees, $1.4 million for variable and other facilities-related costs and $3.7 million for accelerated amortization of lease assets. We expect that the amount accrued for severance and related costs will be paid in 2021. We estimate that we will record nominal, if any, future expense related to this initiative.
Accelerated rent amortization is recognized from the date that we commence the plan to fully or partially vacate a facility, for which there is no intent or ability to enter into a sublease, through the final vacate date. We recorded $0.6 million and $3.7 million of expense for accelerated rent amortization in the years ended December 31, 2020 and 2019, respectively. These amounts are included as components of Restructuring and related expense. The accelerated rent amortization recorded in connection with our restructuring initiatives reduced our Operating lease right-of-use assets in our consolidated balance sheets at December 31, 2020 and 2019. We continue to evaluate our properties included in the Facilities Initiative for accelerated amortization and/or right-of-use asset impairment. We may incur additional future expense if we are unable to sublease other locations included in the Facilities Initiative.
In connection with the Sonus-GENBAND merger (the "GENBAND Merger") in 2017, we implemented a restructuring plan in the fourth quarter of 2017 to eliminate certain redundant positions and facilities within the combined companies (the "GENBAND Merger Restructuring Initiative"). We recorded a nominal adjustment for changes in estimated severance and related costs in 2020. We recorded $5 million in 2019, virtually all of which was for severance and related costs for approximately 40 employees. We recorded $16 million of restructuring expense related to this initiative in 2018, comprised of $15 million for severance and related costs for approximately 275 employees and $1 million in connection with redundant facilities located in the Czech Republic, Canada and the U.S. The actions under the GENBAND Merger Restructuring Initiative were completed in the second quarter of 2019, with the related payments completed in 2020.
We assumed GENBAND's restructuring liability aggregating $4 million at the Merger Date (the "GENBAND Restructuring Initiative"), primarily related to headcount reductions. We recorded $1 million of restructuring expense in 2018 for changes in estimated costs for previously recorded initiatives, primarily changes in negotiated severance to employees in certain international locations and changes in estimated sublease income for restructured facilities. In connection with the adoption of ASC 842 effective January 1, 2019, we wrote off the remaining restructuring accrual related to facilities. The GENBAND Restructuring Initiative is complete.
Critical Accounting Policies and Estimates
Management's discussion and analysis of the financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. We base our estimates and judgments on historical experience, knowledge of current conditions and beliefs of what could occur in the future given available information. We consider the following accounting policies to be both those most important to the portrayal of our financial condition and those that require the most subjective judgment. If actual results differ significantly from management's estimates and projections, there could be a material effect on our consolidated financial statements. The significant accounting policies that we believe are the most critical include revenue recognition, the valuation of inventory, debentures and warrants received as sale consideration, warranty accruals, loss contingencies and reserves, stock-based compensation, business combinations, goodwill and intangible assets and accounting for income taxes.
Revenue Recognition. We derive revenue from two primary sources: products and services. Product revenue is generated from sales of our stand-alone software, as well as software with attached hardware that function together to deliver the products' essential functionality. Both software and hardware are also sold on a standalone basis. Services include customer support (software updates and technical support), consulting, design services, installation services and training. A typical contract includes both product and services. Generally, contracts with customers contain multiple performance obligations. For these contracts, we account for individual performance obligations separately if they are distinct. The transaction price is allocated to the separate performance obligations on a relative standalone selling price basis. SSPs are typically estimated based on observable transactions when these services are sold on a standalone basis.
The software licenses typically provide a perpetual right to use our software. We also sell term-based software licenses that expire and Software-as-as-Service ("SaaS")-based software, which are referred to as subscription arrangements. We do not
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customize our software nor are installation services required, as the customer has a right to utilize internal resources or a third-party service company. The software and hardware are delivered before related services are provided and are functional without professional services or customer support. We have concluded that our software licenses are functional intellectual property that are distinct, as the user can benefit from the software on its own. The product revenue is typically recognized upon transfer of control or when the software is made available for download, as this is the point that the user of the software can direct the use of, and obtain substantially all of the remaining benefits from, the functional intellectual property. We begin to recognize software revenue related to the renewal of subscription software licenses at the start of the subscription period.
Service revenue includes revenue from customer support and other professional services. We offer warranties on our products. Certain of our warranties are considered to be assurance-type in nature, ensuring that the product is functioning as intended. Assurance-type warranties do not represent separate performance obligations. We also sell separately-priced maintenance service contracts which qualify as service-type warranties and represent separate performance obligations. We do not allow and have no history of accepting product returns.
Customer support includes software updates on a when-and-if-available basis, telephone support, integrated web-based support and bug fixes or patches. We sell our customer support contracts at a percentage of list or net product price related to the support. Customer support revenue is recognized ratably over the term of the customer support agreement, which is typically one year.
Our professional services include consulting, technical support, resident engineer services, design services and installation services. Because control transfers over time, revenue is recognized based on progress toward completion of the performance obligation. The method to measure progress toward completion requires judgment and is based on the nature of the products or services to be provided. We generally use the input method to measure progress for our contracts because we believe it best depicts the transfer of assets to the customer which occurs as we incur costs for the contracts. However, in some instances, we use the output method because it best depicts the transfer of asset to the customer. Under the cost-to-cost measure of progress, the progress toward completion is measured based on the ratio of costs incurred to date to the total estimated costs at completion of the performance obligation. When the measure of progress is based upon expended labor, progress toward completion is measured as the ratio of labor time expended to date versus the total estimated labor time required to complete the performance obligation. Revenue is recorded proportionally as costs are incurred or as labor is expended. Costs to fulfill these obligations include internal labor as well as subcontractor costs.
We offer customer training courses, for which the related revenue is typically recognized as the training services are performed.
Our contracts with customers often include promises to transfer multiple products and services to the customer. Determining whether products and services are considered distinct performance obligations that should be accounted for separately versus together may require significant judgment.
Judgment is required to determine the SSP for each distinct performance obligation. In instances where SSP is not directly observable, such as when we do not sell the product or service separately, we determine the SSP using information that may include market conditions and other observable inputs. We typically have more than one SSP for individual products and services due to the stratification of those products and services by customers and circumstances. In these instances, the Company may use information such as the size of the customer and geographic region in determining the SSP.
Valuation of Inventory. We review inventory for both potential obsolescence and potential loss of value periodically. In this review, we make assumptions about the future demand for and market value of the inventory and, based on these assumptions, estimate the amount of any excess, obsolete or slow-moving inventory.
We write down our inventories if they are considered to be obsolete or at levels in excess of forecasted demand. In these cases, inventory is written down to estimated realizable value based on historical usage and expected demand. Inherent in our estimates of market value in determining inventory valuation are estimates related to economic trends, future demand for our products and technical obsolescence of our products. If future demand or market conditions are less favorable than our projections, additional inventory write-downs could be required and would be reflected in the cost of revenue in the period the revision is made. To date, we have not been required to revise any of our assumptions or estimates used in determining our inventory valuations.
We write down our evaluation equipment at the time of shipment to our customers, as it is not probable that the inventory value will be realizable.
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Debentures and Warrants. We have Debentures and Warrants that we received as sale consideration in connection with the Kandy Sale, which we account for in accordance with Accounting Standards Codification ("ASC") 820, Fair Value Measurement ("ASC 820)".
We calculate the fair value of the Debentures using a Lattice-based valuation approach, which utilizes a binomial tree to model the different paths the price of AVCT's common stock might take over the Debentures' life by using assumptions regarding the stock price volatility and risk-free interest rate. These results are then used to calculate the fair value of the Debentures at each measurement date. We use the Black-Scholes valuation model for estimating the fair value of the Warrants at each measurement date. The fair value of the Warrants is affected by AVCT's stock price as well as valuation assumptions, including the volatility of AVCT's stock price, expected term of the option, risk-free interest rate and expected dividends. Both the Lattice and Black-Scholes valuation models are based on available market data, giving consideration to all of the rights and obligations of each instrument and precluding the use of "blockage" discounts or premiums in determining the fair value of a large block of financial instruments.
We are calculating the fair value of the Debentures and Warrants at each quarter-end and recording any adjustments to the fair values in Other income (expense), net. The fair values of the Debentures and Warrants are reported as Investments in our consolidated balance sheet at December 31, 2020.
Warranty Accruals. We record warranty liabilities for estimated costs of fulfilling our obligations under standard limited hardware and software warranties at the time of sale. The liability for standard warranties is included in Accrued expenses and other and Other long-term liabilities in our consolidated balance sheet. The specific warranty terms and conditions vary depending upon the country in which we do business, but generally include material costs, technical support, labor and associated overhead over a period ranging from one to three years. We provide for the estimated costs to fulfill customer warranty obligations for certain of our products upon recognition of the related revenue. Warranty is included as a component of Cost of revenue in our consolidated statements of operations, and is determined based on actual warranty cost experience, estimates of component failure rates and our management's industry experience. Our sales contracts do not permit the right of return of the product by the customer after the product has been accepted.
Loss Contingencies and Reserves. We are subject to ongoing business risks arising in the ordinary course of business that affect the estimation process of the carrying value of assets, the recording of liabilities and the possibility of various loss contingencies. An estimated loss contingency is accrued when it is probable that a liability has been incurred or an asset has been impaired and the amount of loss can be reasonably estimated. We regularly evaluate current information available to determine whether such amounts should be adjusted and record changes in estimates in the period they become known. We are subject to various legal claims. We reserve for legal contingencies and legal fees when the amounts are probable and reasonably estimable.
Stock-Based Compensation. Our stock-based compensation cost is measured at the grant date based on the fair value of the award and is recognized as expense over the requisite service period, which is generally the vesting period.
We use the Black-Scholes valuation model for estimating the fair value on the date of grant of employee stock options. Determining the fair value of stock option awards at the grant date requires judgment regarding certain valuation assumptions, including the volatility of our stock price, expected term of the option, risk-free interest rate and expected dividends. Changes in such assumptions and estimates could result in different fair values and could therefore impact our earnings. Such changes, however, would not impact our cash flows. The fair value of restricted stock awards, restricted stock units and performance-based awards is based upon our stock price on the grant date.
We grant performance-based stock units, some of which include a market condition, to certain of our executives. We use a Monte Carlo simulation approach to model future stock price movements based upon the risk-free rate of return, the volatility of each entity, and the pair-wise covariance between each entity. These results are then used to calculate the grant date fair values of the performance-based stock units.
The amount of stock-based compensation expense recorded in any period for unvested awards requires estimates of the amount of stock-based awards that are expected to be forfeited prior to vesting, as well as assumptions regarding the probability that performance-based stock awards without market conditions will be earned.
Business Combinations. We allocate the purchase price of acquired companies to identifiable assets acquired and liabilities assumed at their acquisition date fair values. Goodwill as of the acquisition date is measured as the excess of consideration transferred over the net of the acquisition date fair values of the assets acquired and the liabilities assumed and represents the expected future economic benefits arising from other assets acquired in the business combination that are not
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individually identified and separately recognized. Significant management judgments and assumptions are required in determining the fair value of assets acquired and liabilities assumed, particularly acquired intangible assets which are principally based upon estimates of the future performance and cash flows expected from the acquired business and applied discount rates. While we use our best estimates and assumptions as part of the purchase price allocation process to accurately value assets acquired and liabilities assumed at a business combination date, our estimates and assumptions are inherently uncertain and subject to refinement. If different assumptions are used, it could materially impact the purchase price allocation and our financial position and results of operations. Any adjustments to assets acquired or liabilities assumed subsequent to the purchase price allocation period are included in operating results in the period in which the adjustments are determined. Intangible assets typically are comprised of in-process research and development, developed technology, customer relationships, trade names and internal use software.
Goodwill and Intangible Assets. Goodwill is not amortized, but instead is tested for impairment annually, or more frequently if indicators of potential impairment exist. Intangible assets with estimated lives and other long-lived assets are reviewed for impairment when events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of intangible assets with estimated lives and other long-lived assets is measured by comparing the carrying amount of the asset to future net undiscounted pretax cash flows expected to be generated by the asset. If these comparisons indicate that an asset is not recoverable, we will recognize an impairment loss for the amount by which the carrying value of the asset exceeds the related estimated fair value.
Judgment is required in determining whether an event has occurred that may impair the value of goodwill, identifiable intangible assets or other long-lived assets. Factors that could indicate an impairment may exist include significant underperformance relative to plan or long-term projections, strategic changes in business strategy, significant negative industry or economic trends, a significant change in circumstances relative to a large customer, a significant decline in our stock price for a sustained period and a decline in our market capitalization to below net book value. We must make assumptions about future control premiums, market comparables, cash flows, operating plans, discount rates and other factors to determine recoverability.
Prior to 2020, our annual test for impairment of goodwill was completed as of November 30. Effective in 2020, we changed our annual goodwill impairment test date from November 30 to October 1. This change did not have a material impact on our consolidated financial statements.
As described above, effective in the fourth quarter of 2020, we determined that we had two operating segments: Cloud and Edge, and IP Optical Networks. For the purpose of testing goodwill for impairment, all goodwill is assigned to a reporting unit, which may be either an operating segment or a portion of an operating segment. We determined that the goodwill assigned to the Cloud and Edge reporting unit was $225 million and the goodwill assigned to the IP Optical Networks reporting unit was $192 million. We perform a fair value analysis using both an Income and Market approach, which encompasses a discounted cash flow analysis and a guideline public company analysis using selected multiples. We assess each valuation methodology based upon the relevance and availability of the data at the time the valuation is performed and the methodologies are weighted appropriately. Upon completion of our 2020 annual test for goodwill impairment, we determined that there was no impairment of goodwill for either of our reporting units.
We previously operated as a single operating segment with one reporting unit and consequently we evaluated goodwill for impairment based on an evaluation of the fair value of the Company as a whole. Based on the results of our 2019 annual impairment test, we determined that our carrying value exceeded our fair value. We performed a fair value analysis using both an income and market approach as described above. We determined that the amount of the impairment was $164 million and recorded an impairment charge in the fourth quarter of 2019. The impairment charge is reported separately in our consolidated statement of operations for the year ended December 31, 2019.
Leases. We account for our leases in accordance with Accounting Standards Codification ("ASC") 842, Leases ("ASC 842"), which we adopted effective January 1, 2019 using the alternative transition method, which allowed entities to initially apply ASC 842 at the adoption date with no adjustments to prior period lease costs for comparability. We have operating and finance leases for corporate offices, research and development facilities, and certain equipment. Operating leases are reported separately in our consolidated balance sheets at December 31, 2020 and 2019. Assets acquired under finance leases are included in Property and equipment, net, in our consolidated balance sheets at December 31, 2020 and 2019.
We determine if an arrangement is a lease at inception. A contract is determined to contain a lease component if the arrangement provides us with a right to control the use of an identified asset. Lease agreements may include lease and non-lease components. In such instances for all classes of underlying assets, we do not separate lease and non-lease components but rather, account for the entire arrangement under leasing guidance. Leases with an initial term of 12 months or less are not
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recorded on the balance sheet and lease expense for these leases is recognized on a straight-line basis over the lease term.
For operating leases, lease expense for minimum fixed lease payments is recognized on a straight-line basis over the lease term. The expense for finance leases includes both interest and amortization expense components, with the interest component calculated based on the effective interest method and the amortization component calculated based on straight-line amortization of the right-of-use asset over the lease term. Lease contracts may contain variable lease costs, such as common area maintenance, utilities and tax reimbursements that vary over the term of the contract. Variable lease costs are not included in minimum fixed lease payments and as a result, are excluded from the measurement of the right-of-use assets and lease liabilities. We expense all variable lease costs as incurred.
Accounting for Income Taxes. Our provision for income taxes is comprised of a current and a deferred portion. The current income tax provision is calculated as the estimated taxes payable or refundable on tax returns for 2020. We provide for deferred income taxes resulting from temporary differences between financial and taxable income. Such differences arise primarily from tax net operating loss ("NOL") and credit carryforwards, depreciation, deferred revenue, stock-based compensation expense, accruals and reserves.
We assess the recoverability of any tax assets recorded on the balance sheet and provide any necessary valuation allowances as required. In evaluating our ability to recover our deferred tax assets, we consider all available positive and negative evidence, including our past operating results, the existence of cumulative income in the most recent years, changes in the business in which we operate and our forecast of future taxable income. In determining future taxable income, we make assumptions, including the amount of state, federal and international pre-tax operating income, the reversal of temporary differences and the implementation of feasible and prudent tax planning strategies. These assumptions require significant judgment about the forecasts of future taxable income and are consistent with the plans and estimates we are using to manage our underlying businesses. Such assessment is completed on a jurisdiction-by-jurisdiction basis.
At December 31, 2020, we had valuation allowances of $496 million to offset deferred tax assets of $582 million. These valuation allowances mainly relate to our U.S. and Israel operations. In the event we determine it is more likely than not that we will be able to use a deferred tax asset in the future in excess of its net carrying value, the valuation allowance would be reduced, thereby increasing net earnings and increasing equity in the period such determination is made. We have recorded net deferred tax assets in some of our other international subsidiaries. These amounts could change in future periods based upon our operating results and changes in tax law.
We provide for income taxes during interim periods based on the estimated effective tax rate for the full year. We record a cumulative adjustment to the tax provision in an interim period in which a change in the estimated annual effective tax rate is determined.
We have provided for income taxes on the undistributed earnings of our non-U.S. subsidiaries as of December 31, 2020, excluding Ireland and Israel. These subsidiaries, excluding Ireland and Israel, are cost-plus or limited risk distributors that are not anticipated to need to use excess funds locally. Accordingly, we are required to recognize and book deferred taxes for 2020. The deferred taxes are booked on the entire outside basis differences related to the foreign subsidiaries, the largest of these differences being undistributed earnings. At December 31, 2020, Ribbon had a deferred tax liability of $15.7 million related to withholding taxes in various countries.
We assess all material positions taken in any income tax return, including all significant uncertain positions, in all tax years that are still subject to assessment or challenge by relevant taxing authorities. Assessing an uncertain tax position begins with the initial determination of the position's sustainability and is measured at the largest amount of benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. As of each balance sheet date, unresolved uncertain tax positions must be reassessed, and we determine whether (i) the factors underlying the sustainability assertion have changed and (ii) the amount of recognized tax benefit is still appropriate. The recognition and measurement of tax benefits require significant judgment. Judgments concerning the recognition and measurement of a tax benefit might change as new information becomes available.
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Results of Operations
Years Ended December 31, 2020 and 2019
Revenue. Revenue for the years ended December 31, 2020 and 2019 was as follows (in thousands, except percentages):
Year endedDecember 31, Increasefrom prior year
Segment revenue for the years ended December 31, 2020 and 2019 was as follows (in thousands):
The increase in our product revenue in 2020 compared to 2019 was primarily the result of the inclusion of $192 million of product revenue attributable to our IP Optical Networks segment in the current year since the ECI Acquisition Date, coupled with $13 million of higher sales in 2020 of our Cloud and Edge products compared to 2019. The increase in sales of our Cloud and Edge products in the current year was primarily attributable to higher sales of certain of our SBC products (i.e., our SBC 5000 series products and SBC 7000 products), partially offset by lower sales of our EdgeMarc products.
In 2020, 30% of our product revenue was attributable to sales to enterprise customers, compared to 27% in 2019. These sales were made through both our direct sales team and indirect sales channel partners. In 2020, 29% of our product revenue was from indirect sales through our channel partner program, compared to 36% in 2019.
The timing of the completion of customer projects and revenue recognition criteria satisfaction may cause our product revenue to fluctuate from one period to the next.
Service revenue is primarily comprised of software and hardware maintenance and support (“maintenance revenue”) and network design, installation and other professional services (“professional services revenue”).
Service revenue for the years ended December 31, 2020 and 2019 was comprised of the following (in thousands, except percentages):
Year endedDecember 31, Increasefrom prior year
Segment service revenue for the years ended December 31, 2020 and 2019 was comprised of the following (in thousands):
The increase in maintenance revenue was primarily attributable to the inclusion of $46 million of revenue from IP Optical Networks in the 2020 period from the ECI Acquisition Date, partially offset by a slight decrease in maintenance revenue attributable to Cloud and Edge. The increase in professional services revenue was attributable to the inclusion of $22 million of
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revenue from IP Optical Networks in the 2020 period from the ECI Acquisition Date, coupled with $12 million of higher revenue from Cloud and Edge professional services primarily related to Network Transformation and SBC deployments.
The following customers contributed 10% or more of our revenue in the years ended December 31, 2020 and 2019:
Year endedDecember 31,
Verizon Communications Inc. 15% 17%
AT&T Inc. * 12%
* Less than 10% of total revenue.
Revenue earned from customers domiciled outside the United States was 55% of revenue in 2020 and 39% of revenue in 2019. Due to the timing of project completions, we expect that the domestic and international components as a percentage of our revenue may fluctuate from quarter to quarter and year to year. Our total revenue for the years ended December 31, 2020 and 2019 was disaggregated geographically as follows (in thousands):
Our deferred product revenue was $8 million at December 31, 2020 and $5 million at December 31, 2019. Our deferred service revenue was $115 million at December 31, 2020 and $116 million at December 31, 2019. Our deferred revenue balance may fluctuate as a result of the timing of revenue recognition, customer payments, maintenance contract renewals, contractual billing rights and maintenance revenue deferrals included in multiple element arrangements.
We expect that our total revenue in 2021 will increase as compared to our 2020 total revenue as our strategy to grow our IP Optical market share in North America gains momentum and capital spending in India recovers to 2019 levels.
Cost of Revenue/Gross Margin. Our cost of revenue consists primarily of amounts paid to third-party manufacturers for purchased materials and services, royalties, inventory valuation adjustments, warranty costs, and manufacturing and services personnel and related costs. Our cost of revenue and gross margins for the years ended December 31, 2020 and 2019 were as follows (in thousands, except percentages):
Year endedDecember 31, Increasefrom prior year
Cost of revenue
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Gross margin
Total gross margin 58.4 % 63.0 %
Our segment cost of revenue and gross margins for the years ended December 31, 2020 and 2019 were as follows (in thousands, except percentages):
Gross margin
The decrease in our product gross margin in 2020 compared to 2019 was primarily due to the inclusion of IP Optical Networks products from the ECI Acquisition, which include a higher hardware component. The increase in our Cloud and Edge product gross margin in 2020 compared to 2019 was primarily attributable to higher software sales in 2020.
The decrease in our service gross margin in 2020 compared to 2019 was primarily due to the inclusion in 2020 of IP Optical Networks' historically lower service gross margin, partially offset by the increase in our Cloud and Edge service gross margin in 2020 compared to 2019, which was primarily due to our recent cost reduction and restructuring initiatives.
We believe that our total gross margin will decrease slightly in 2021 compared to 2020, primarily due to higher expected sales from IP Optical Networks, which have historically lower margins due to the higher hardware content in their products.
Research and Development. Research and development ("R&D") expenses consist primarily of salaries and related personnel expenses and prototype costs for the design, development, testing and enhancement of our products. Research and development expenses for the years ended December 31, 2020 and 2019 were as follows (in thousands, except percentages):
Year endedDecember 31, Increasefrom prior year
The increase in R&D expenses in 2020 compared to 2019 was primarily attributable to the inclusion of IP Optical Networks' R&D expenses in the current year for the period since the ECI Acquisition, which added $62 million in R&D operating expenses, principally employee- and infrastructure-related costs. This increase was partially offset by $9 million of lower costs in our Cloud and Edge segment, primarily employee- and infrastructure-related, arising from our previous cost reduction and restructuring initiatives.
Some aspects of our R&D efforts require significant short-term expenditures, the timing of which may cause significant variability in our expenses. We believe that rapid technological innovation is critical to our long-term success, and we are tailoring our investments to meet the requirements of our customers and market. We believe that our R&D in 2021 will increase compared to 2020, primarily due to incremental investment in our IP Optical Networks segment to address the global market opportunity.
Sales and Marketing. Sales and marketing expenses consist primarily of salaries and related personnel costs, commissions, travel and entertainment expenses, promotions, customer trial and evaluations inventory and other marketing and
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sales support expenses. Sales and marketing expenses for the years ended December 31, 2020 and 2019 were as follows (in thousands, except percentages):
Year endedDecember 31, Increasefrom prior year
The increase in sales and marketing expenses in 2020 compared to 2019 was primarily attributable to the inclusion of IP Optical Networks' sales and marketing expenses in the current year for the period since the ECI Acquisition, which added $43 million in sales and marketing expenses, principally employee- and infrastructure-related costs. This increase was partially offset by $10 million of lower costs in our Cloud and Edge segment, primarily employee- and infrastructure-related, arising from our previous cost reduction and restructuring initiatives.
We believe that our sales and marketing expenses will increase modestly in 2021 compared with 2020, primarily due to higher employee-related expenses and higher costs, assuming COVID-19 restrictions begin to ease.
General and Administrative. General and administrative expenses consist primarily of salaries and related personnel costs for executive and administrative personnel, and audit, legal and other professional fees. General and administrative expenses for the years ended December 31, 2020 and 2019 were as follows (in thousands, except percentages):
Year endedDecember 31, Increasefrom prior year
The increase in general and administrative expenses in 2020 compared to 2019 was primarily attributable to the inclusion of IP Optical Networks' general and administrative expenses in the current year for the period since the ECI Acquisition, which added $17 million in general and administrative expenses, principally employee-related expenses. This increase was partially offset by $8 million of lower costs in our Cloud and Edge segment, primarily legal fees and employee-related expenses.
We believe that our general and administrative expenses in 2021 will be consistent with our 2020 levels, and decline in future years as we realize additional integration synergies.
Amortization of Acquired Intangible Assets. Amortization of acquired intangible assets for the years ended December 31, 2020 and 2019 was as follows (in thousands, except percentages):
Year endedDecember 31, Increasefrom prior year
The increase in 2020 amortization of acquired intangible assets compared to 2019 was primarily due to expense related to the intangible assets arising from the ECI Acquisition. Amortization of acquired intangible assets is reported separately in the consolidated statements of operations.
Impairment of Goodwill. Prior to 2020, our annual test for impairment of goodwill was completed as of November 30. Effective in 2020, we changed our annual goodwill impairment test date from November 30 to October 1. This change did not have a material impact on our consolidated financial statements. Our annual test for impairment in 2020 did not result in an impairment for either of our two reporting units.
We previously operated as a single operating segment with one reporting unit and consequently evaluated goodwill for impairment based on an evaluation of the fair value of the Company as a whole. Based on the results of our 2019 annual impairment test, we determined that our carrying value exceeded our fair value and accordingly, we recorded an impairment charge of $164 million in 2019. Impairment of goodwill is reported separately in the consolidated statements of operations.
Acquisition-, Disposal- and Integration-Related. Acquisition-, disposal- and integration-related expenses include those expenses related to acquisitions that we would otherwise not have incurred. Acquisition- and disposal-related expenses include professional and services fees, such as legal, audit, consulting, paying agent and other fees. Integration-related expenses
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represent incremental costs related to combining the Company's systems and processes with those of acquired businesses, such as third-party consulting and other third-party services.
We recorded $17 million of acquisition-, disposal- and integration-related expenses in 2020, comprised of $13 million of acquisition-related expenses, $2 million of disposal-related expenses and $2 million of integration-related expenses. The acquisition-related expenses primarily related to the ECI Acquisition and, to a lesser extent, other acquisition-related activities. The disposal-related expenses related to the Kandy Sale. The integration-related expenses related to our ongoing integration activities, primarily related to the ECI Acquisition.
We recorded $13 million of acquisition-, disposal and integration-related expenses in 2019, comprised of $9 million of acquisition-related expenses and $4 million of integration-related expenses. The acquisition-related expenses primarily related to the then-pending ECI Acquisition and, to a lesser extent, the Anova Acquisition and other acquisition-related activities. The integration-related expenses related to our ongoing integration activities, primarily related to the GENBAND Merger.
Acquisition-, disposal- and integration-related expenses are reported separately in the consolidated statements of operations.
Restructuring and Related. We have been committed to streamlining operations and reducing operating costs by closing and consolidating certain facilities and reducing our worldwide workforce. Please see the additional discussion of our restructuring initiatives in the "Restructuring and Cost Reduction Initiatives" section of the Overview of this Management's Discussion and Analysis of Financial Condition and Results of Operations.
We recorded restructuring and related expense of $16 million in 2020, comprised of $12 million for severance and related costs, and $4 million for variable and other facilities-related costs, including accelerated amortization of lease assets. We recorded $16 million of restructuring and related expense in 2019, comprised of $11 million for severance and related costs, $1 million for variable and other facilities-related costs and $4 million for accelerated amortization of lease assets.
Although we have eliminated positions as part of our restructuring initiatives, we continue to hire in certain areas that we believe are important to our future growth. Restructuring and related expense is reported separately in the consolidated statements of operations.
Interest (Expense) Income, net. Interest expense and interest income for the years ended December 31, 2020 and 2019 were as follows (in millions, except percentages):
Year endedDecember 31, Increase (decrease)from prior year
Interest income in 2020 primarily represents interest earned on the outstanding note receivable from Metaswitch, which was paid in full in the third quarter of 2020. Interest expense in 2020 was primarily comprised of $14.4 million of interest on our outstanding term debt, and $4.2 million in the aggregate related to amortization of debt issuance costs, interest on other borrowings and finance leases, and interest expense in connection with the factoring of certain accounts receivable. Interest expense in 2020 also included the write-off of $2.9 million of debt issuance costs in connection with the amendment of the 2020 Credit Facility and the retirement of the 2019 Credit Facility (as defined below).
Interest income in 2019 was primarily earned from an outstanding $25.5 million three-year note receivable bearing interest at 4%. Interest expense in 2019 primarily related to revolver and term borrowings and the promissory note issued to certain of GENBAND's equityholders in connection with the GENBAND Merger.
Other Income (Expense), Net. We recorded other income, net aggregating $113 million in 2020, primarily in connection with the Kandy Sale, which was comprised of $83.6 million from the gain on the sale, and $30.3 million related to the increase in the fair value of the Debentures and Warrants from the Kandy Sale Date through December 31, 2020. We recorded a gain of $63.0 million from the settlement of litigation with Metaswitch in 2019 and a gain of $8.1 million from the reduction of deferred purchase consideration in connection with the Edgewater Acquisition. These gains were the primary components of our Other income (expense), net, in 2020 and 2019 and were partially offset primarily by expense related to foreign currency translation.
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Income Tax Provision. We recorded income tax provisions of $4.7 million in 2020 and $7.2 million in 2019. The provision recorded in 2020 was primarily the result of the gain from the Kandy Sale and foreign operations. The provision recorded in 2019 was primarily the result of foreign operations.
During 2020 and 2019, we performed an analysis to determine if, based on all available evidence, we considered it more likely than not that some portion or all of the recorded deferred tax assets will not be realized in a future period. As a result of our evaluations, we concluded that there was insufficient positive evidence to overcome the more objective negative evidence related to our cumulative losses and other factors. Accordingly, we maintained a valuation mainly against our U.S. and Israel deferred tax assets. A similar analysis and conclusion was made with regard to the valuation allowance on the deferred tax assets of our foreign subsidiaries. The Ireland subsidiary's business model changed in 2020 to a limited risk distributor. As a result, the decision was made to release a portion of the valuation allowance because of the future income. The valuation allowance for the capital loss carryforward will remain, since there are no current plans to generate capital gains.
Off-Balance Sheet Arrangements
We have no off-balance sheet arrangements that have or are reasonably likely to have a current or future material effect on our financial position, changes in financial position, revenue or expenses, results of operations, liquidity, capital expenditures or capital resources.
Liquidity and Capital Resources
Our consolidated statements of cash flows are summarized as follows (in thousands):
Year endedDecember 31,
We had cash and restricted cash aggregating $136 million at December 31, 2020, and $45 million of cash at December 31, 2019. We had cash held by our non-U.S. subsidiaries aggregating $46 million at December 31, 2020 and $12 million at December 31, 2019. If we elect to repatriate all of the funds held by our non-U.S. subsidiaries as of December 31, 2020, we do not believe that the amounts of potential withholding taxes that would arise from the repatriation would have a material effect on our liquidity.
On April 29, 2019, we, as guarantor, and Ribbon Communications Operating Company, Inc., as borrower, entered into a syndicated, amended and restated credit facility (the "2019 Credit Facility"), which replaced our previous credit facility, which we had entered into in 2018. The 2019 Credit Facility provided for a $50 million term loan facility that was advanced in full on April 29, 2019, and a $100 million revolving line of credit. At December 31, 2019, we had an outstanding term loan debt balance of $49 million and an outstanding revolving line of credit balance of $8 million with a combined average interest rate of 3.30%, and $5 million of outstanding letters of credit at an interest rate of 1.50%.
The indebtedness and other obligations under the 2019 Credit Facility were unconditionally guaranteed on a senior secured basis by the Company and each other material U.S. domestic subsidiary of the Company (collectively, the "Guarantors"). The 2019 Credit Facility was secured by first-priority liens on substantially all of the assets of the Borrower and the Guarantors, including the Company.
The 2019 Credit Facility required periodic interest payments on any outstanding borrowings under the facility. The Borrower could repay all revolving loans under the 2019 Credit Facility at any time without premium or penalty (other than customer LIBOR breakage costs), subject to certain notice requirements.
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Revolving loans under the 2019 Credit Facility bore interest at our option at either the Eurodollar ("LIBOR") rate plus a margin ranging from 1.50% to 3.00% per year or the base rate (the highest of the Federal Funds rate plus 0.50%, or the prime rate announced from time to time in The Wall Street Journal) plus a margin ranging from 0.50% to 2.00% per year (such margins being referred to as the “Applicable Margin”). The Applicable Margin varied depending on our consolidated leverage ratio (as defined in the 2019 Credit Facility). The base rate and the LIBOR rate were each subject to a zero percent floor.
The 2019 Credit Facility required compliance with certain financial covenants, including a minimum consolidated quick ratio, minimum consolidated fixed charge coverage ratio and maximum consolidated leverage ratio, all of which were defined in the 2019 Credit Facility and tested on a quarterly basis. We were in compliance with all covenants of the 2019 Credit Facility at December 31, 2019.
On March 3, 2020, we entered into the 2020 Credit Facility, by and among us, as a guarantor, Ribbon Communications Operating Company, Inc., as the borrower ("Borrower"), Citizens Bank, N.A. ("Citizens"), as administrative agent, a lender, issuing lender, swingline lender, joint lead arranger and bookrunner, Santander Bank, N.A., as a lender, joint lead arranger and bookrunner, and the other lenders party thereto (each, together with Citizens Bank, N.A. and Santander Bank, N.A., referred to individually as a "Lender", and collectively, the "Lenders"). The proceeds from the 2020 Credit Facility were used, in part, to pay off in full all obligations of the Company under the 2019 Credit Facility.
The 2020 Credit Facility provides for $500 million of commitments from the lenders to the Borrower, comprised of $400 million in term loans (the "2020 Term Loan Facility") and a $100 million facility available for revolving loans (the "2020 Revolving Credit Facility"). Under the 2020 Revolving Credit Facility, a $30 million sublimit is available for letters of credit and a $20 million sublimit is available for swingline loans. Under the 2020 Credit Facility, we were originally required to make quarterly principal payments aggregating approximately $10 million in the first year, $20 million per year for the following three years and $30 million in the last year, with the remaining balance due on the maturity date.
The indebtedness and other obligations under the 2020 Credit Facility are unconditionally guaranteed on a senior secured basis by the Company, Edgewater Networks, Inc., a wholly-owned subsidiary of the Company, and GENBAND Inc., a wholly-owned subsidiary of the Company (together, the "Guarantors"). The 2020 Credit Facility is secured by first-priority liens on substantially all of the assets of the Borrower and the Guarantors, including substantially all of the assets of the Company.
The 2020 Credit Facility requires compliance with certain financial covenants, including a minimum Consolidated Fixed Charge Coverage Ratio and a maximum Consolidated Net Leverage Ratio (each as defined in the 2020 Credit Agreement, and each tested on a quarterly basis).
In addition, the 2020 Credit Facility contains various covenants that, among other restrictions, limit our and our subsidiaries’ ability to incur or assume indebtedness; grant or assume liens; make acquisitions or engage in mergers; sell, transfer, assign or convey assets; repurchase equity and make dividend and certain other restricted payments; make investments; engage in transactions with affiliates; enter into sale and leaseback transactions; enter into burdensome agreements; change the nature of its business; modify their organizational documents; or amend or make prepayments on certain junior debt.
The 2020 Credit Facility contains events of default that are customary for a secured credit facility. If an event of default relating to bankruptcy or other insolvency events with respect to the Company or any of its subsidiaries occurs, all obligations under the 2020 Credit Facility will immediately become due and payable. If any other event of default exists under the 2020 Credit Facility, the lenders can accelerate the maturity of the obligations outstanding under the 2020 Credit Facility and exercise other rights and remedies, including charging a default rate of interest equal to 2.00% per year above the rate that would otherwise be applicable. In addition, if any event of default exists under the 2020 Credit Facility, the lenders can commence foreclosure or other actions against the collateral.
On August 18, 2020 (the "First Amendment Effective Date"), we entered into the First Amendment to the 2020 Credit Facility. Pursuant to an assignment and assumption agreement entered into by Citizens and certain affiliates of Whitehorse Capital on the First Amendment Effective Date (collectively, "HIG Whitehorse"), and consented to by Citizens and the Borrower, $75 million of the 2020 Term Loan Facility, designated as the Term B Loan (the "Term B Loan") was assigned from Citizens to HIG Whitehorse. The remaining $325 million of the 2020 Term Loan Facility that was not assigned to HIG Whitehorse was deemed the Term A Loan (the "Term A Loan" and, together with the Term B Loan, the "Amended 2020 Term Loan Facility").
The Term A Loan and amounts under the 2020 Revolving Credit Facility mature in March 2025. The Term A Loan and 2020 Revolving Credit Facility bear interest at the Borrower's option at either the LIBOR rate plus a margin ranging from 1.50% to 3.50% per year, or the base rate (the highest of the Federal Funds Effective Rate (as defined in the 2020 Credit
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Agreement) plus 0.50%, or the prime rate announced from time to time in The Wall Street Journal) plus a margin ranging from 0.50% to 2.50% per year (the "Applicable Margin"). The Applicable Margin varies depending on our Consolidated Net Leverage Ratio (as defined in the 2020 Credit Agreement). The base rate and the LIBOR rate are each subject to a zero percent floor. We are required to make quarterly principal payments on the Term A Loan aggregating approximately $10 million in the first year, $16 million in each of the next two years, $20 million in the fourth year and $16 million in the last year, with the final payment approximating $244 million due on the maturity date. The Borrower can prepay all amounts under the Term A Loan and the 2020 Revolving Credit Facility at any time without premium or penalty (other than customary LIBOR breakage costs), subject to certain notice requirements. The First Amendment did not change the terms applied to the Term A Loan or the Revolving Credit Facility under the 2020 Credit Facility.
The Term B Loan is scheduled to mature in March 2026 and bears interest, at the Borrower's option, at either the LIBOR rate plus a margin of 7.50% per year, or the base rate (the highest of the Federal Funds Effective Rate (as defined in the 2020 Credit Facility) plus 0.50%, or the prime rate announced from time to time in The Wall Street Journal, plus a margin of 6.50% per year. The Term B Loan has a lower rate of amortization than the Term A Loan and is subject to a 1.0% premium if voluntarily repaid in connection with a repricing transaction (as defined in the First Amendment) occurring prior to the six month anniversary of the First Amendment Effective Date. We are required to make quarterly principal payments totaling approximately $1 million in the first year and $8 million in the aggregate over the next four and a half years, with the final payment approximating $66 million due on the maturity date.
The First Amendment reduced the Borrower's ability to incur new tranches of term loans, or increases in commitments under the Amended 2020 Term Loan Facility or the 2020 Revolving Credit Facility. Specifically, such indebtedness can be incurred up to an aggregate dollar amount equal to 75% of the Company's Consolidated Adjusted EBITDA (as defined in the 2020 Credit Facility), reduced from 100% prior to the First Amendment, as of the most recently ended fiscal quarter for which financial statements have been delivered to the lenders, plus additional amounts, so long as the Borrower's Consolidated Net Leverage Ratio (as defined in the 2020 Credit Facility) does not exceed 2.25:1.00, reduced from 2.75:1.00 prior to the First Amendment. The First Amendment also reduced the amount of Unrestricted Cash (as defined in the 2020 Credit Facility) used in calculating the Borrower's Consolidated Net Leverage Ratio from $25 million to $10 million.
On December 1, 2020, we entered into a Second Amendment to the 2020 Credit Facility to obtain consent for an equity exchange with AVCT as well as amend certain provisions of the 2020 Credit Facility.
We were in compliance with all covenants of the 2020 Credit Facility at December 31, 2020.
At December 31, 2020, we had an outstanding Term A Loan balance of $318.5 million at an average interest rate of 3.4%, and the Term B Loan had an outstanding balance of $74.6 million at average interest rate of 8.40%. The 2020 Revolving Credit Facility did not have an outstanding balance but had $5.6 million of letters of credit outstanding with an interest rate of 2.5%.
We are exposed to financial market risk related to foreign currency fluctuations and changes in interest rates. These exposures are actively monitored by management. To manage the volatility related to the exposure to changes in interest rates, we have entered into a derivative financial instrument. Management's objective is to reduce, where it is deemed appropriate to do so, fluctuations in earnings and cash flows associated with changes in interest rates. Our policies and practices are to use derivative financial instruments only to the extent necessary to manage exposures. We do not hold or issue derivative financial instruments for trading or speculative purposes.
As a result of exposure to interest rate movements, during March 2020, we entered into an interest rate swap arrangement, which effectively converted our $400 million term loan with its variable interest rate based upon one-month LIBOR to an aggregate fixed rate of 0.904%, plus a leverage-based margin as defined in the 2020 Credit Facility. The notional amount of this swap as of December 31, 2020 was $400 million, and the swap matures on March 3, 2025, the same date the Term A Loan and 2020 Revolving Credit Facility mature.
Our objectives in using interest rate derivatives are to add stability to interest expense and to manage our exposure to interest rate movements. To accomplish this objective, we are using an interest rate swap as part of our interest rate risk management strategy. Interest rate swaps designated as cash flow hedges involve the receipt of variable amounts from a counterparty in exchange for making fixed-rate payments over the life of the agreements without exchange of the underlying notional amount.
The effective portion of changes in the fair value of derivatives designated and that qualify as cash flow hedges is recorded in accumulated other comprehensive (loss) income in the consolidated balance sheet and is subsequently reclassified into earnings in the period that the hedged forecasted transactions affect earnings. During the year ended December 31, 2020, such
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a derivative was used to hedge the variable cash flows associated with the 2020 Credit Agreement. Any ineffective portion of the change in fair value of the derivative would be recognized directly in earnings. However, during the year ended December 31, 2020, we recorded no hedge ineffectiveness.
Amounts reported in accumulated other comprehensive (loss) income related to our derivative will be reclassified to interest expense as interest is accrued on our variable-rate debt. Based upon projected forward rates, we estimate as of December 31, 2020 that $3.2 million may be reclassified as an increase to interest expense over the next 12 months.
From time to time, we may enter into uncommitted and unsecured short-term loans which we use for financing exports in China. Three of these loans, aggregating $3.5 million at a weighted average interest rate of 3.97%, were entered into in March 2020, two of which were with China Zheshang Bank and one of which was with Bank of Communications Hangzhou Branch. These loans expired and were paid in full at various dates in June and July 2020. In July 2020, we entered into an uncommitted and unsecured short-term loan in the amount of $0.7 million at an interest rate of 4.0% with Bank of Communications Hangzhou Branch that expired and was paid in full in November 2020.
We use letters of credit, performance and bid bonds in the course of our business. At December 31, 2020, we had $32.6 million of letters of credit, bank guarantees, performance and bid bonds outstanding (collectively, "Guarantees"), comprised of the $5.6 million of letters of credit under the 2020 Credit Facility described above, and $27.0 million of Guarantees under various uncommitted facilities. At December 31, 2020, we had cash collateral of $2.7 million supporting the Guarantees under our uncommitted facilities. This cash collateral is included in Restricted cash in our consolidated balance sheet at December 31, 2020.
In connection with the GENBAND Merger, on October 27, 2017, we issued a promissory note for approximately $23 million to certain of GENBAND's equity holders (the "Promissory Note"). On April 29, 2019, concurrently with the closing of the 2019 Credit Facility as discussed above, we repaid in full all outstanding amounts under the Promissory Note, totaling $24.7 million and comprised of $22.5 million of principal plus $2.2 million of interest converted to principal. We did not incur any early termination penalties in connection with this repayment.
Our IP Optical Networks segment maintains customer receivables factoring agreements with a number of financial institutions. Under the terms of these agreements, we may transfer receivables to the financial institutions, on a non-recourse basis, provided that the financial institutions approve the receivables in advance. During the year ended December 31, 2020, we received $119.8 million of cash from the sale of certain accounts receivable and recorded $0.9 million of interest expense in connection with these transactions.
In the second quarter of 2019, our Board approved a stock repurchase program pursuant to which we may repurchase up to $75 million of our common stock prior to April 18, 2021. Repurchases under the program may be made in the open market, in privately negotiated transactions or otherwise, with the amount and timing of repurchases depending on the market conditions and corporate discretion. This program does not obligate us to acquire any particular amount of common stock and the program may be extended, modified, suspended or discontinued at any time at the Board's discretion. During the year ended December 31, 2019, we repurchased and retired 1 million shares of our common stock for a total purchase price of $5 million, including transaction fees. We did not repurchase any shares during the year ended December 31, 2020. We had $70.5 million remaining under the program for future purchases at December 31, 2020.
Our operating activities provided $102 million and $56 million of cash in 2020 and 2019, respectively.
Cash provided by operating activities in 2020 was primarily the result of our net income, lower other operating assets, inventory and accounts receivable, higher accrued expenses and other long-term liabilities, and our non-cash operating income and expenses such as the gain on the Kandy Sale, amortization of intangible assets, stock-based compensation, depreciation, and amortization of debt issuance costs. These amounts were partially offset by lower accounts payable and deferred revenue. The decrease in other operating assets was primarily due to the payments received from Metaswitch aggregating $26 million in connection with the 2019 litigation settlement and subsequent supplemental agreement to accelerate the payment of amounts outstanding. The increase in accrued expenses and other long-term liabilities was primarily due to the derivative liability we recorded in connection with our interest rate swap, which we entered into in the first quarter of 2020.
Cash provided by operating activities in 2019 was generated from $106 million from our 2019 results, net of non-cash items comprising goodwill impairment, depreciation and amortization, stock-based compensation and other amounts, and $8 million received from increased efficiency of inventory, partially offset by cash used for higher other operating assets and accounts receivable aggregating $21 million, and lower liabilities of $37 million. The decrease in our liabilities was primarily related to lower accounts payable and accrued expenses and other long-term liabilities. The decrease in accounts payable
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relates to the timing and amounts of purchases of both services and tangible goods and their related payment arrangements. The decrease in accrued expenses and other long-term liabilities primarily relates to lower accruals for employee-related expenses.
Our investing activities used $330 million and $4 million of cash in 2020 and 2019, respectively. Our 2020 investing activities were comprised of $347 million of cash paid as cash consideration for ECI and $26 million paid for property and equipment, partially offset by $43 million of cash proceeds from the sale of land in connection with the ECI Acquisition. Our 2019 activities were comprised of $11 million paid for property and equipment, partially offset by $7 million of maturities of marketable securities.
Our financing activities provided $319 million of cash in 2020 and used $51 million of cash in 2019.
Cash provided by financing activities in 2020 was primarily due to $479 million of proceeds from term debt, which was comprised of $400 million from the 2020 Credit Facility, $75 million from the Term B Loan under the Amended 2020 Credit Facility (concurrent with the repayment of the same amount of original debt under the 2020 Credit Facility as noted below) and $4 million of proceeds from short-term loans in China for the financing of certain export activities. These proceeds were partially offset by the repayment of the $75 million of debt that was extinguished in connection with the First Amendment, the repayment of $57 million outstanding under the 2019 Credit Facility (comprised of $8 million under the revolving credit facility and $49 million of long-term debt), the payment of $14 million of debt issuance costs in connection with the 2020 Credit Facility and the First Amendment and the repayment of principal aggregating $10 million related to the 2020 Credit Facility and short-term loans in China. We also paid $2 million for withholding obligations related to the net share settlement of restricted stock awards upon vesting and $1 million for principal payments on finance leases.
In 2019, we repaid outstanding borrowings of $165 million under our credit facilities, comprised of $164 million for borrowings under the revolving line of credit and $1 million for borrowings under the term loan. We also repaid $25 million on the note to certain of the former GENBAND equityholders and the deferred purchase consideration of $22 million to the selling Edgewater shareholders. We spent $5 million to repurchase and retire shares of our common stock on the open market and used $1 million to pay withholding obligations related to the net share settlement of restricted stock awards upon vesting. We also spent $1 million for principal payments on our finance lease obligations and $1 million for debt issuance costs. Our borrowings totaled $167 million, comprised of $117 million of borrowings under the revolving line of credit and $50 million of term loan debt under the 2019 Credit Facility. Cash proceeds from the sale of our common stock under our ESPP and from option exercises totaled approximately $1 million.
Contractual Obligations
Our contractual obligations at December 31, 2020 consisted of the following (in thousands):
Payments due by period
Total Less than 1 year 1-3 years 3-5 years More than 5 years
Finance lease obligations $ 1,469 $ 914 $ 555 $ — $ —
Restructuring severance obligations 5,410 5,410 — — —
__________________________________
* Debt obligations - principal represents the outstanding balance on our 2020 Credit Facility of $393.1 million at December 31, 2020.
** This liability is not subject to fixed payment terms and the amount and timing of payments, if any, that we will make related to this liability are not known. See Note 2 and Note 25 to our consolidated financial statements appearing in this Annual Report on Form 10-K for additional information.
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Based on our current expectations, we believe our current cash and available borrowings under the 2020 Credit Facility will be sufficient to meet our anticipated cash needs for working capital and capital expenditures for at least twelve months. The rate at which we consume cash is dependent on the cash needs of our future operations. We anticipate devoting substantial capital resources to continue our research and development efforts, to maintain our sales, support and marketing, to complete merger-related integration activities and for other general corporate activities. We further believe that our financial resources, along with managing discretionary expenses, will allow us to manage the anticipated impact of the COVID-19 pandemic on our business operations. Looking ahead, we have developed contingency plans to reduce costs further if the situation deteriorates further. The challenges posed by the COVID-19 pandemic on our business continue to evolve rapidly. Consequently, we continue to evaluate our financial position in light of future developments, particularly those relating to the COVID-19 pandemic. However, it is difficult to predict future liquidity requirements with certainty, and our cash and available borrowings under the 2020 Credit Facility may not be sufficient to meet our future needs, which would require us to refinance our debt and/or obtain additional financing. We may not be able to refinance our debt or obtain additional financing on favorable terms or at all.
Recent Accounting Pronouncements
The Financial Accounting Standards Board ("FASB") has issued the following accounting pronouncements, all of which became effective for us in 2020 and none of which had a material impact on our consolidated financial statements:
In March 2020, the FASB issued Accounting Standard Updates ("ASU") 2020-04, Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on Financial Reporting ("ASU 2020-04"), which provides optional expedients and exceptions for applying generally accepted accounting principles to contract modifications and hedging relationships, subject to meeting certain criteria that reference LIBOR or another reference rate expected to be discontinued.
In March 2020, the FASB issued ASU 2020-03, Codification Improvements to Financial Instruments ("ASU 2020-03"), which makes narrow-scope amendments related to topics regarding fair value option disclosures, applicability of the portfolio exception in Accounting Standards Codification ("ASC") 820 to nonfinancial items, disclosures for depository and lending institutions, cross reference to guidance in ASC 470-50 on line of credit or revolving debt arrangements, cross reference to net asset value practical expedient in ASC 820-10, interaction between ASC 842 and ASC 326 and between ASC 326 and ASC 860-20.
In August 2018, the FASB issued ASU 2018-15, Intangibles - Goodwill and Other - Internal-Use Software (Subtopic 350-40): Customer’s Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That Is a Service Contract (“ASU 2018-15”), which provides guidance on implementation costs incurred in a cloud computing arrangement (“CCA”) that is a service contract. ASU 2018-15 amends ASC 350, Intangibles - Goodwill and Other (“ASC 350”) to include in its scope implementation costs of a CCA that is a service contract and clarifies that a customer should apply the guidance in ASC 350-40 to determine which implementation costs should be capitalized in such a CCA.
In August 2018, the FASB issued ASU 2018-14, Compensation - Retirement Benefits - Defined Benefit Plans - General (Subtopic 715-20): Disclosure Framework - Changes to the Disclosure Requirements for Defined Benefit Plans (“ASU 2018-14”), which amends ASC 715, Compensation - Retirement Benefits, to add, remove and clarify disclosure requirements related to defined benefit pension and other postretirement plans.
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 changes the fair value measurement requirements of ASC 820, Fair Value Measurement.
In June 2016, the FASB issued ASU 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments ("ASU 2016-13"), which adds an impairment model that is based on expected losses rather than incurred losses. Under ASU 2016-13, an entity recognizes as an allowance its estimate of expected credit losses, which the FASB believes will result in more timely recognition of such losses. In April and May 2019, the FASB issued ASU 2019-04, Codification Improvements to Topic 326, Financial Instruments - Credit Losses, Topic 815, Derivatives and Hedging, and Topic 825, Financial Instruments ("ASU 2019-04") and ASU 2019-05 Financial Instruments - Credit Losses (Topic 326): Targeted Transition Relief ("ASU 2019-05"), respectively. ASU 2019-04 provides transition relief for entities adopting ASU 2016-13 and ASU 2019-05 clarifies certain aspects of the accounting for credit losses, hedging activities and financial instruments in connection with the adoption of ASU 2016-13.
The FASB has issued the following accounting pronouncement which became effective for us in 2021, which we do not believe will have a material impact on our consolidated financial statements upon adoption:
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The FASB issued ASU 2019-12, Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes ("ASU 2019-12"), which modifies ASC 740 to simplify the accounting for income taxes. ASU 2019-12 addresses the accounting for hybrid tax regimes, tax basis step-up in goodwill obtained in a transaction that is not a business combination, separate financial statements of legal entities not subject to tax, intraperiod tax allocation exception to incremental approach, ownership changes in investments - changes from a subsidiary to an equity method investment, ownership changes in investments - changes from an equity method investment to a subsidiary, interim period accounting for enacted changes in tax law and year-to-date loss limitation in interim period tax accounting.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
We are exposed to a variety of market risks, changes in interest rates affecting the return on our investments and foreign currency fluctuations.
To manage the volatility related to the exposure to changes in interest rates, we have entered into a derivative financial instrument. Our objective is to reduce, where it is deemed appropriate to do so, fluctuations in earnings and cash flows associated with changes in interest rates. Our policies and practices are to use derivative financial instruments only to the extent necessary to manage exposures. We do not hold or issue derivative financial instruments for trading or speculative purposes.
Amounts reported in accumulated other comprehensive (loss) income related to our derivative will be reclassified to interest expense as interest is accrued on our variable-rate debt. Our derivative had a fair value of $10.9 million at December 31, 2020, consisting of $3.1 million included in Accrued expenses and other and $7.8 million included in Other long-term liabilities on our consolidated balance sheet. Based upon projected forward rates, we estimate as of December 31, 2020 that $3.2 million may be reclassified as an increase to interest expense over the next twelve months.
At December 31, 2020, we had outstanding debt totaling approximately $393.1 million. A hypothetical movement of plus or minus 50 basis points in the interest rate of our outstanding debt would have changed our interest expense by approximately $2 million for the year ended December 31, 2020.
Based on a hypothetical 10% adverse movement in all foreign currency exchange rates, our revenue for the year ended December 31, 2020 would have been adversely affected by approximately $22 million and our net income for the year ended December 31, 2020 would have been adversely affected by approximately $7 million, although the actual effects may differ materially from this hypothetical analysis.
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Item 8. Financial Statements and Supplementary Data
Report of Independent Registered Public Accounting Firm 58
Consolidated Balance Sheets as of December 31, 2020 and 2019 61
Notes to Consolidated Financial Statements 67
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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Stockholders and the Board of Directors of Ribbon Communications Inc.
Opinion on the Financial Statements
We have audited the accompanying consolidated balance sheets of Ribbon Communications Inc. and subsidiaries (the "Company") as of December 31, 2020 and 2019, the related consolidated statements of operations, comprehensive income (loss), stockholders' equity, and cash flows for each of the three years in the period ended December 31, 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 December 31, 2020 and 2019, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2020, in conformity with accounting principles generally accepted in the United States of America.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company's internal control over financial reporting as of December 31, 2020, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 26 2021, expressed an unqualified opinion on the Company's internal control over financial reporting.
Change in Accounting Principle
As discussed in Note 2 to the financial statements, the Company adopted Accounting Standards Codification Topic 842, “Leases,” using the alternative transition approach on January 1, 2019.
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 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. 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.
Critical Audit Matters
The critical audit matters communicated below are matters arising from the current-period audit of the financial statements that were communicated or required to be communicated to the audit committee and that (1) relate to accounts or disclosures that are material to the financial statements and (2) involved our especially challenging, subjective, or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the financial statements, taken as a whole, and we are not, by communicating the critical audit matters below, providing separate opinions on the critical audit matters or on the accounts or disclosures to which they relate.
Revenue Recognition — Refer to Notes 2 and 17 to the financial statements
Critical Audit Matter Description
The Company recognizes revenue from two primary sources: products and services. Generally, contracts with customers contain multiple performance obligations, consisting of products and services. For these contracts, the Company accounts for individual performance obligations separately if they are considered distinct. When an arrangement contains more than one performance obligation, the Company will allocate the transaction price to each performance obligation on a relative standalone selling price basis. The Company utilizes the observable price of goods and services when they are sold separately to similar customers in order to estimate standalone selling price.
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Management is required to use judgment to develop its estimates of standalone selling price. Auditing the Company’s estimates of standalone selling price required a high degree of auditor judgment and an increased extent of effort, including the need to involve our data analytics specialists to assist in the testing of the standalone selling price analyses given the judgment required by management in this area.
How the Critical Audit Matter Was Addressed in the Audit
Our audit procedures related to the testing of management’s estimation of standalone selling prices included the following, among others:
•We tested the effectiveness of controls over revenue, including those over the determination of estimated standalone selling price.
•We evaluated whether management’s significant accounting policies related to the estimation of standalone selling price were appropriate.
•With the assistance of our data analytics specialists, we evaluated the estimated standalone selling price analyses prepared by the Company, including testing the underlying detail of standalone sales and the mathematical accuracy of the calculations.
Business Combinations – ECI Telecom Group Ltd. Acquisition – Refer to Notes 2 and 3 to the financial statements
Critical Audit Matter Description
The Company completed the acquisition of ECI Telecom Group Ltd. (“ECI”) on March 3, 2020 by issuing to the ECI shareholders and certain others 32.5 million shares of the Company’s common stock with a fair value of $108.6 million and paying $322.5 million of cash. The Company accounted for the acquisition under the acquisition method of accounting for business combinations. Accordingly, the purchase price was allocated to the assets acquired and liabilities assumed based on their respective fair values, including customer relationships, developed technology, and in-process research and development intangible assets with an aggregate fair value of approximately $116 million, $112 million, and $34 million, respectively. The Company used an income approach to value the acquired in-process research and development, developed technology, and customer relationships intangible assets. The fair value determination of these intangible assets required management to make significant estimates and assumptions related to forecasted future cash flows, including the selection of customer attrition rates, technology obsolescence, revenue growth rates, and discount rates.
We identified the intangible assets for ECI as a critical audit matter because of the significant estimates and assumptions management made to fair value these assets. This required a high degree of auditor judgment and an increased extent of effort, including the involvement of our fair value specialists, when performing audit procedures to evaluate the reasonableness of management’s forecasts of future cash flows, including the selection of customer attrition rates, technology obsolescence, revenue growth rates, and discount rates.
How the Critical Audit Matter Was Addressed in the Audit
Our audit procedures related to the forecasts of future cash flows and the selection of the customer attrition rates, technology obsolescence, revenue growth rates, and discount rates for the intangible assets for ECI included the following, among others:
•We tested the effectiveness of controls over the valuation of the customer relationships, developed technology, and in-process research and development intangible assets, including management’s controls over forecasts of future cash flows and the selection of the customer attrition rates, technology obsolescence, revenue growth rates, and discount rates.
•We assessed the reasonableness of fiscal year 2020 forecasted cash flows of revenues and operating margins by comparing them to ECI’s actual 2020 cash flows.
•We assessed the reasonableness of the forecasted revenue growth rates over the cash flow forecast period by comparing them to ECI’s actual revenue growth rates during the most recent historical periods as well as certain peer companies, third-party industry forecasts, and internal communications to management and the board of directors.
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•We performed sensitivity analyses of the significant assumptions used in the valuation model to evaluate the change in fair value resulting from changes in the significant assumptions.
•With the assistance of our fair value specialists, we evaluated the reasonableness of the (1) valuation methodology; (2) customer attrition rates by testing the mathematical accuracy of the rates used and comparing them to historical customer data; (3) technology obsolescence by testing the source information; (4) revenue growth rates by comparing them to industry growth rates and the projected nominal gross domestic product (GDP) growth rate; and (5) discount rates, which included testing the source information underlying the determination of the discount rates, testing the mathematical accuracy of the calculations, and developing a range of independent estimates and comparing those to the discount rates selected by management.
/s/ Deloitte & Touche LLP
Dallas, Texas
February 26, 2021
We have served as the Company's auditor since 2005.
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RIBBON COMMUNICATIONS INC.
Consolidated Balance Sheets
(in thousands, except share and per share data)
Assets
Current assets:
Restricted cash 7,269 —
Liabilities and Stockholders' Equity
Current liabilities:
Revolving credit facility — 8,000
Operating lease liabilities, net of current 72,614 37,202
Commitments and contingencies (Note 27)
Stockholders' equity:
Accumulated other comprehensive (loss) income (4,942) 2,527
See notes to the consolidated financial statements.
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RIBBON COMMUNICATIONS INC.
Consolidated Statements of Operations
(in thousands, except per share data)
Year ended December 31,
Revenue:
Cost of revenue:
Operating expenses:
Impairment of goodwill — 164,300 —
Earnings (loss) per share:
Shares used to compute earnings (loss) per share:
See notes to the consolidated financial statements.
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RIBBON COMMUNICATIONS INC.
Consolidated Statements of Comprehensive Income (Loss)
(in thousands)
Year ended December 31,
Other comprehensive income (loss), net of tax:
Unrealized loss on interest rate swap, net of reclassifications (10,948) — —
Foreign currency translation adjustments 894 194 220
Other comprehensive (loss) income, net of tax (7,469) (1,176) 634
See notes to the consolidated financial statements.
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RIBBON COMMUNICATIONS INC.
Consolidated Statements of Stockholders' Equity
(in thousands, except share data)
Common stock
Vesting of restricted stock units 1,278,062 —
Vesting of performance-based stock awards and units 57,768 —
Other comprehensive income 634 634
Vesting of restricted stock awards and units 1,504,707 —
Vesting of performance-based stock units 9,466 —
Vesting of restricted stock awards and units 2,246,690 1 1
Vesting of performance-based stock units 323,752 —
See notes to the consolidated financial statements.
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RIBBON COMMUNICATIONS INC.
Consolidated Statements of Cash Flows
(in thousands)
Year ended December 31,
Cash flows from operating activities:
Depreciation and amortization of property and equipment 17,188 11,949 11,200
Impairment of goodwill — 164,300 —
Gain on sale of business (83,552) — —
Increase in fair value of investments (30,296) — —
Reduction to deferred purchase consideration (70) (8,124) —
Changes in operating assets and liabilities:
Cash flows from investing activities:
Business acquisitions, net of cash acquired (346,852) — (46,389)
Sales/maturities of marketable securities — 7,295 18,919
Proceeds from the sale of fixed assets 43,500 — —
Cash flows from financing activities:
Proceeds from issuance of long-term debt 478,500 50,000 —
Principal payment of debt, related party — (24,716) —
Principal payments of term debt (134,188) (1,250) —
Payment of deferred purchase consideration — (21,876) —
Principal payments of finance leases (1,258) (913) (652)
Proceeds from the exercise of stock options 70 235 73
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RIBBON COMMUNICATIONS INC.
Consolidated Statements of Cash Flows (continued)
(in thousands)
Year ended December 31,
Repurchase of common stock — (4,536) —
Effect of exchange rate changes on cash and cash equivalents 260 70 (180)
Net increase (decrease) in cash and cash equivalents 91,054 949 (13,379)
Supplemental disclosure of cash flow information:
Supplemental disclosure of non-cash investing activities:
Capital expenditures incurred, but not yet paid $ 3,749 $ 2,566 $ 1,127
Property and equipment acquired under finance leases $ — $ 1,442 $ 2,178
Supplemental disclosure of non-cash financing activities:
See notes to the consolidated financial statements.
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Notes to Consolidated Financial Statements
(1) NATURE OF THE BUSINESS
Ribbon Communications Inc. ("Ribbon" or the "Company") is a leading global provider of communications technology to service providers and enterprises. The Company provides a broad range of software and high-performance hardware products, solutions and services that enable the secure delivery of data and voice communications for residential consumers and for small, medium, and large enterprises and industry verticals such as finance, education, government, utilities, and transportation. Ribbon's mission is to create a recognized global technology leader providing cloud-centric solutions that enable the secure exchange of information, with unparalleled scale, performance, and elasticity. The Company is headquartered in Plano, Texas, and has a global presence with research and development, or sales and support locations in over thirty-five countries around the world.
(2) BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation
The consolidated financial statements have been prepared in United States dollars, in accordance with accounting principles generally accepted in the United States ("GAAP").
On December 1, 2020 (the "Kandy Sale Date"), American Virtual Cloud Technologies, Inc. ("AVCT") completed the purchase of the Company's cloud-based enterprise service business (the "Kandy Communications Business"). The revenue and expenses of the Kandy Communications Business are not included in the Company's consolidated financial statements for the period subsequent to the Kandy Sale Date.
On March 3, 2020 (the "ECI Acquisition Date"), the Company merged with ECI Telecom Group Ltd ("ECI") (the "ECI Acquisition"). The financial results of ECI are included in the Company's consolidated financial statements for the period subsequent to the ECI Acquisition Date.
On February 28, 2019 (the "Anova Acquisition Date"), the Company acquired the business and technology assets of Anova Data, Inc. ("Anova"). The financial results of Anova are included in the Company's consolidated financial statements for the period subsequent to the Anova Acquisition Date.
On August 3, 2018 (the "Edgewater Acquisition Date"), the Company completed the acquisition of Edgewater Networks, Inc. ("Edgewater" and such acquisition, the "Edgewater Acquisition"). The financial results of Edgewater are included in the Company's consolidated financial statements for the period subsequent to the Edgewater Acquisition Date.
Significant Accounting Policies
Principles of Consolidation
The accompanying consolidated financial statements include the accounts of Ribbon and its wholly-owned subsidiaries. All intercompany transactions and balances have been eliminated in consolidation.
Use of Estimates and Judgments
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting periods. Significant estimates and judgments relied upon in preparing these consolidated financial statements include accounting for business combinations, revenue recognition for multiple element arrangements, inventory valuations, assumptions used to determine the fair value of stock-based compensation, intangible assets, goodwill, debentures and warrants, legal contingencies and recoverability of Ribbon's net deferred tax assets and the related valuation allowances. Ribbon regularly assesses these estimates and records changes in estimates in the period in which they become known. Ribbon bases its estimates on historical experience and various other assumptions that it believes to be reasonable under the circumstances. Actual results could differ from those
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estimates.
Reclassifications
In the fourth quarter of 2020, the Company reclassified amounts recorded for amortization of acquired intangible assets in prior presentations from Cost of revenue - product and Sales and marketing to a separate line included in operating expenses in the consolidated statements of operations, as management believes this presentation enhances the comparability of the Company's financial statements with industry peers. These reclassifications did not impact operating loss, net loss or loss per share for any historical periods. These reclassifications also did not impact the consolidated balance sheets or statements of cash flows for any historical periods. The Company did not reclassify depreciation of property and equipment related to production activities from cost of revenue to other accounts.
These reclassifications for the years ended December 31, 2019 and 2018 were as follows (in thousands):
In addition, certain other reclassifications, not affecting previously reported net loss, have been made to the previously issued financial statements to conform to the current year presentation.
Business Combinations
The Company recognizes identifiable assets acquired and liabilities assumed at their acquisition date fair values. Goodwill as of the acquisition date is measured as the excess of consideration transferred over the net of the acquisition date fair values of the assets acquired and the liabilities assumed and represents the expected future economic benefits arising from other assets acquired in the business combination that are not individually identified and separately recognized. While the Company uses its best estimates and assumptions as part of the purchase price allocation process to accurately value assets acquired and liabilities assumed at the acquisition date, its estimates are inherently uncertain and subject to refinement. As a result, during the measurement period, which may be up to one year from the acquisition date, the Company records adjustments to the assets acquired and liabilities assumed with the corresponding offset to goodwill to the extent that it identifies adjustments to the preliminary purchase price allocation. Upon the conclusion of the measurement period or final determination of the values of assets acquired and liabilities assumed, whichever comes first, any subsequent adjustments are recorded to the consolidated statements of operations.
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Revenue Recognition
The Company derives revenue from two primary sources: products and services. Product revenue includes the Company's hardware and software that function together to deliver the products' essential functionality. Software and hardware are also sold on a standalone basis. Services include customer support (software updates, upgrades and technical support), consulting, design services, installation services and training. Generally, contracts with customers contain multiple performance obligations, consisting of products and services. For these contracts, the Company accounts for individual performance obligations separately if they are considered distinct.
When an arrangement contains more than one performance obligation, the Company will allocate the transaction price to each performance obligation on a relative standalone selling price basis. The Company utilizes the observable price of goods and services when they are sold separately to similar customers in order to estimate standalone selling price.
The Company's software licenses typically provide a perpetual right to use the Company's software. The Company also sells term-based software licenses that expire and Software-as-a-Service ("SaaS")-based software which are referred to as subscription arrangements. The Company does not customize its software nor are installation services required, as the customer has a right to utilize internal resources or a third-party service company. The software and hardware are delivered before related services are provided and are functional without professional services or customer support. The Company has concluded that its software licenses are functional intellectual property that are distinct, as the user can benefit from the software on its own. Product revenue is typically recognized upon transfer of control or when the software is made available for download, as this is the point the user of the software can direct the use of, and obtain substantially all of the remaining benefits from, the functional intellectual property. The Company begins to recognize software revenue related to the renewal of subscription software licenses at the start of the subscription period.
The Company offers warranties on its products. Certain of the Company's warranties are considered to be assurance-type in nature, ensuring the product is functioning as intended. Assurance-type warranties do not represent separate performance obligations. The Company also sells separately-priced maintenance service contracts which qualify as service-type warranties and represent separate performance obligations. The Company does not allow and has no history of accepting product returns.
Services revenue includes revenue from customer support and other professional services. Customer support includes software updates on a when-and-if-available basis, telephone support, integrated web-based support and bug fixes or patches. The Company sells its customer support contracts at a percentage of list or net product price. Customer support revenue is recognized ratably over the term of the customer support agreement, which is typically one year.
The Company's professional services include consulting, technical support, resident engineer services, design services and installation services. Because control transfers over time, revenue is recognized based on progress toward completion of the performance obligation. The method to measure progress toward completion requires judgment and is based on the nature of the products or services to be provided. The Company generally uses the input method to measure progress for its contracts because it believes such method best depicts the transfer of assets to the customer, which occurs as the Company incurs costs for the contracts. However, in some instances, the Company uses the output method because it best depicts the transfer of asset to the customer. Under the cost-to-cost measure of progress, the progress toward completion is measured based on the ratio of costs incurred to date to the total estimated costs at completion of the performance obligation. When the measure of progress is based upon expended labor, progress toward completion is measured as the ratio of labor time expended to date versus the total estimated labor time required to complete the performance obligation. Revenue is recorded proportionally as costs are incurred or as labor is expended. Costs to fulfill these obligations include internal labor as well as subcontractor costs.
Customer training includes courses offered by the Company. The related revenue is typically recognized as the training services are performed.
Operating Segments
The Company's chief operating decision maker (the "CODM") is its president and chief executive officer. Effective in the fourth quarter of 2020 and in connection with the ECI Acquisition, the CODM began to assess the Company's performance based on the performance of two separate organizations within Ribbon: the Cloud and Edge segment ("Cloud and Edge") and the IP Optical Networks segment ("IP Optical Networks"). Financial information for the IP Optical Networks segment is not
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presented for any years prior to 2020, as this segment arose from the ECI Acquisition, and accordingly is not included in the Company's consolidated financial statements for the years ended December 31, 2019 and 2018.
Financial Instruments
The carrying amounts of Ribbon's financial instruments approximate their fair values and include accounts receivable, convertible debentures and warrants received as sale consideration, borrowings under a revolving credit facility, accounts payable and term debt.
Investments in marketable securities are reported at fair value, with unrealized gains and losses excluded from earnings and reported, net of tax, in Accumulated other comprehensive income (loss), which is a component of stockholders' equity. Unrealized losses that are determined to be other-than-temporary, based on current and expected market conditions, are recognized in earnings. Declines in fair value determined to be credit-related are charged to earnings. The cost of marketable securities sold is determined by the specific identification method.
Changes in fair value of investments classified as trading securities, such as the convertible debentures and warrants received as sale consideration, are recognized in earnings as components of Other income (expense), net.
Financial instruments with remaining maturities or that are due within one year from the balance sheet date are classified as current. Financial instruments with maturities or that are payable more than one year from the balance sheet date are classified as noncurrent.
Restricted Cash
The Company classifies as restricted cash all cash pledged as collateral to secure long-term obligations and all cash whose use is otherwise limited by contractual provisions. At December 31, 2020, the Company had $7.3 million of restricted cash, comprised of $4.6 million restricted in connection with a tax payment on certain fixed assets formerly held by ECI that were sold in connection with the ECI Acquisition, and $2.7 million of restricted short-term bank deposits pledged to secure certain performance and financial bonds as security for the Company's obligations under tenders, contracts and to one of its main subcontractors.
Transfers of Financial Assets
The Company's IP Optical Networks segment maintains customer receivables factoring agreements with a number of financial institutions. Under the terms of these agreements, the Company may transfer receivables to the financial institutions, on a non-recourse basis, provided that the financial institutions approve the receivables in advance. The Company maintains credit insurance policies from major insurance providers or obtains letters of credit from the customers for a majority of its factored trade receivables. The Company accounts for the factoring of its financial assets as a sale of the assets and records the factoring fees, when incurred, as a component of interest expense in the consolidated statements of operations, and the proceeds from the sales of receivables are included in cash from operating activities in the consolidated statements of cash flows. During the year ended December 31, 2020, the Company received $119.8 million of cash from the sale of certain accounts receivable and recorded $0.9 million of interest expense in connection with these transactions.
Foreign Currency Translation
For foreign subsidiaries where the functional currency is the local currency, assets and liabilities are translated into U.S. dollars at the current exchange rate on the balance sheet date. Revenue and expenses are translated at average rates of exchange prevailing during each period. Translation adjustments for these subsidiaries are included in Accumulated other comprehensive income.
For foreign subsidiaries where the functional currency is the U.S. dollar, monetary assets and liabilities are translated into U.S. dollars at the current exchange rate on the balance sheet date. Nonmonetary assets and liabilities are remeasured into U.S. dollars at historical exchange rates. Revenue and expense items are translated at average rates of exchange prevailing during each period. Translation adjustments for these subsidiaries are included in Other income (expense), net.
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Realized and unrealized foreign currency exchange gains and losses arising from transactions denominated in currencies other than the subsidiary's functional currency are reflected in earnings.
The Company records its foreign currency gains (losses) as a component of Other income (expense), net. The Company recognized net foreign currency losses of $3.0 million for the year ended December 31, 2020, $1.1 million for the year ended December 31, 2019 and $4.6 million for the year ended December 31, 2018.
Inventory
Inventory is recorded at the lower of cost or market value using the first-in, first-out convention. The Company reduces the carrying value of inventory for those items that are potentially excess, obsolete or slow-moving based on changes in customer demand, technology developments or other economic factors.
Ribbon writes down evaluation equipment (equipment at customer sites for testing and evaluation) at the time of shipment to its customers, as it is probable that the inventory value will not be realized.
Deferred product costs represent deferred cost of revenue for product shipments to customers prior to satisfaction of Ribbon's revenue recognition criteria. The Company classifies inventory that is not expected to be consumed within one year from the balance sheet date as noncurrent and includes such inventory as a component of Other assets.
Debentures and Warrants.
The Company has Debentures and Warrants that it received as sale consideration in connection with the sale of the Kandy Communications Business (see Note 4), which Ribbon accounts for in accordance with Accounting Standards Codification ("ASC") 820, Fair Value Measurement ("ASC 820)".
The Company calculates the fair value of the Debentures using a Lattice-based valuation approach, which utilizes a binomial tree to model the different paths the price of AVCT's common stock might take over the Debentures' life by using assumptions regarding the stock price volatility and risk-free interest rate. These results are then used to calculate the fair value of the Debentures at each measurement date. The Company uses the Black-Scholes valuation model for estimating the fair value of the Warrants at each measurement date. The fair value of the Warrants is affected by AVCT's stock price as well as valuation assumptions, including the volatility of AVCT's stock price, expected term of the option, risk-free interest rate and expected dividends. Both the Lattice and Black-Scholes valuation models are based on available market data, giving consideration to all of the rights and obligations of each instrument and precluding the use of "blockage" discounts or premiums in determining the fair value of a large lock of financial instruments.
The Company is calculating the fair value of the Debentures and Warrants at each quarter-end and recording any adjustments to the fair values in Other income (expense), net. The fair values of the Debentures and Warrants are reported as Investments in the Company's consolidated balance sheet at December 31, 2020.
Property and Equipment
Property and equipment are stated at cost, net of accumulated depreciation. Expenditures for maintenance and repairs are charged to expense as incurred. Depreciation is computed using the straight-line method over the estimated useful lives of the related assets, which range from two to five years. Leasehold improvements are amortized over the lesser of the lease term or five years. When an asset is sold or retired, the cost and related accumulated depreciation or amortization are eliminated, and the resulting gain or loss, if any, is recognized in income (loss) from operations in the consolidated statement of operations. The Company reviews property and equipment for impairment in the same manner as intangible assets discussed below.
Software development costs associated with internal use software are incurred in three stages of development: the preliminary project stage, the application development stage and the post-implementation stage. Costs incurred during the preliminary project and post-implementation stages are expensed as incurred. Certain qualifying costs incurred during the application development stage are capitalized as property and equipment. Internal use software is amortized on a straight-line basis over its estimated useful life of three years, beginning when the software is ready for its intended use.
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Intangible Assets and Goodwill
The Company's intangible assets are comprised of in-process research and development, developed technology, customer relationships, trade names, and internal use software. Intangible assets are reviewed for impairment when events or changes in circumstances indicate that their carrying amounts may not be recoverable based upon the estimated undiscounted cash flows. Recoverability of intangible assets with estimated lives and other long-lived assets is measured by a comparison of the carrying amount of an asset or asset group to future net undiscounted cash flows expected to be generated by the asset or asset group. If these comparisons indicate that an asset is not recoverable, the Company will recognize an impairment loss for the amount by which the carrying value of the asset or asset group exceeds the related estimated fair value. Estimated fair value is based on either discounted future operating cash flows or appraised values, depending on the nature of the asset. The Company amortizes its intangible assets over their respective useful lives, with the exception of in-process research and development, which has an indefinite life until the product is generally available, at which time such asset is typically reclassified to developed technology, and the Company begins to amortize this asset. See Note 10 for additional information regarding the Company's intangible assets.
Goodwill is recorded when the consideration for an acquisition exceeds the fair value of net tangible and identifiable intangible assets acquired. Goodwill is not amortized, but instead is tested for impairment at least annually, or more frequently if indicators of potential impairment exist, by comparing the fair value of the Company's reporting unit to its carrying value.
Prior to 2020, the Company's annual test for impairment of goodwill was completed as of November 30. Effective in 2020, the Company changed its annual goodwill impairment test date from November 30 to October 1. This change did not have a material impact on the Company's consolidated financial statements.
As described above, effective in the fourth quarter of 2020, the Company determined that it has two operating segments: Cloud and Edge, and IP Optical Networks. For the purpose of testing goodwill for impairment, all goodwill is assigned to a reporting unit, which may be either an operating segment or a portion of an operating segment. The Company's reporting units are its operating segments. The Company performs a fair value analysis using both an income and market approach, which encompasses a discounted cash flow analysis and a guideline public company analysis using selected multiples. The Company assesses each valuation methodology based upon the relevance and availability of the data at the time the valuation is performed and the methodologies are weighted appropriately. Any impairment charges are reported separately in the Company's consolidated statements of operations.
Stock-Based Compensation
The Company's stock-based compensation cost is measured at the grant date based on the fair value of the award and is recognized as expense over the requisite service period, which generally represents the vesting period, and includes an estimate of the awards that will be forfeited.
The Company uses the Black-Scholes valuation model for estimating the fair value on the date of grant of stock options. The fair value of stock option awards is affected by the Company's stock price as well as valuation assumptions, including the volatility of Ribbon's stock price, expected term of the option, risk-free interest rate and expected dividends.
The Company may grant performance-based stock units ("PSUs") that include a market condition to certain of its executives. The Company uses a Monte Carlo simulation approach to model future stock price movements based upon the risk-free rate of return, the volatility of each entity and the pair-wise covariance between each entity. These results are then used to calculate the grant date fair values of the PSUs.
Concentration of Risk
The financial instruments that potentially subject Ribbon to concentrations of credit risk are cash, restricted cash and accounts receivable. The Company's cash equivalents and investments were managed by one financial institution at December 31, 2020. Historically, the Company has not experienced significant losses due to such bank depository concentration. The Company's investments at December 31, 2020 consisted of securities of AVCT (see Note 4). The Company did not hold any investments at December 31, 2019.
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Certain components and software licenses from third parties used in Ribbon's products are procured from single sources of supply. The failure of a supplier, including a subcontractor, to deliver on schedule could delay or interrupt Ribbon's delivery of products and thereby materially adversely affect Ribbon's revenue and operating results.
Advertising Costs
Advertising costs are expensed as incurred and included as a component of Sales and marketing expense in the Company's consolidated statements of operations. Advertising expenses were $0.8 million for the year ended December 31, 2020, $0.5 million for the year ended December 31, 2019 and $0.5 million for the year ended December 31, 2018.
Loss Contingencies and Reserves
Ribbon is subject to ongoing business risks arising in the ordinary course of business, including legal claims, that affect the estimation process of the carrying value of assets, the recording of liabilities and the possibility of various loss contingencies. An estimated loss contingency is accrued when it is probable that a liability has been incurred or an asset has been impaired and the amount of loss can be reasonably estimated. Ribbon regularly evaluates current information available to determine whether such amounts should be adjusted and records changes in estimates in the period they become known.
An allowance for doubtful accounts is estimated based on the Company's assessment of the collectability of specific customer accounts.
Ribbon accrues for royalties for technology that it licenses from vendors based on established royalty rates and usage. Ribbon is periodically contacted by third parties who claim that Ribbon's products infringe on certain intellectual property of a third party. Ribbon evaluates these claims and accrues amounts when it is probable that the obligation has been incurred and the amounts are reasonably estimable.
Warranty
The Company records warranty liabilities for estimated costs of fulfilling its obligations under standard limited hardware and software warranties at the time of sale. The specific warranty terms and conditions vary depending upon the country in which the Company does business, but generally includes material costs, technical support, labor and associated overhead over a period ranging from one to three years. The Company assumed ECI's warranty liability in connection with the ECI Acquisition. At December 31, 2020, the Company's liability for product warranties was $14.9 million, of which $6.5 million was current and included in Accrued expenses and other and $8.4 million was long-term and included in Other long-term liabilities in the Company's consolidated balance sheet. The Company did not have a warranty accrual at December 31, 2019.
Research and Development Grants
The Company records grants received from the Office of the Innovation Authority of the Israeli Ministry of Economics (the "IIA") as a reduction to Research and development expense. Royalties payable to the IIA are recognized pursuant to sales of related products and are included in Cost of revenue - product.
Accounting for Leases
The Company accounts for its leases in accordance with Accounting Standards Codification ("ASC") 842, Leases ("ASC 842"), which was adopted effective January 1, 2019 using the alternative transition method, which allowed entities to initially apply ASC 842 at the adoption date with no adjustments to prior period lease costs for comparability (see Note 22). The Company has operating and finance leases for corporate offices, research and development facilities, and certain equipment. Operating leases are reported separately in the Company's consolidated balance sheets at December 31, 2020 and 2019. Assets acquired under finance leases are included in Property and equipment, net, in the consolidated balance sheets at December 31, 2020 and 2019.
The Company determines if an arrangement is a lease at inception. A contract is determined to contain a lease component if the arrangement provides the Company with a right to control the use of an identified asset. Lease agreements may include lease and non-lease components. In such instances for all classes of underlying assets, the Company does not separate lease and
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non-lease components but rather, accounts for the entire arrangement under leasing guidance. Leases with an initial term of 12 months or less are not recorded on the balance sheet and lease expense for these leases is recognized on a straight-line basis over the lease term.
For operating leases, lease expense for minimum fixed lease payments is recognized on a straight-line basis over the lease term. The expense for finance leases includes both interest and amortization expense components, with the interest component calculated based on the effective interest method and the amortization component calculated based on straight-line amortization of the right-of-use asset over the lease term. Lease contracts may contain variable lease costs, such as common area maintenance, utilities and tax reimbursements that vary over the term of the contract. Variable lease costs are not included in minimum fixed lease payments and as a result, are excluded from the measurement of the right-of-use assets and lease liabilities. The Company expenses all variable lease costs as incurred.
Accounting for Income Taxes
Deferred tax assets and liabilities are recognized for the expected future consequences of events that have been reflected in the consolidated financial statements. Deferred tax assets and liabilities are determined based on the differences between the financial reporting and tax basis of assets and liabilities and operating loss carryforwards, using tax rates expected to be in effect for the years in which the differences are expected to reverse. The Company records valuation allowances to reduce deferred income tax assets to the amount that is more likely than not to be realized.
The Company has provided for income taxes on the undistributed earnings of its non-U.S. subsidiaries as of December 31, 2020, excluding Ireland and Israel. These subsidiaries, excluding Ireland and Israel, are cost-plus or limited risk distributors that are not anticipated to need to use excess funds locally. Accordingly, the Company is required to recognize and record deferred taxes in 2020. The deferred taxes are recorded on the entire outside basis differences related to the foreign subsidiaries, the largest of these differences being undistributed earnings. At December 31, 2020, the Company had a deferred tax liability of $15.7 million related to withholding taxes in various countries.
The Company determines whether it is more likely than not that a tax position will be sustained upon examination. If it is not more likely than not that a position will be sustained, no amount of the benefit attributable to the position is recognized. The tax benefit to be recognized of any tax position that meets the more likely than not recognition threshold is calculated as the largest amount that is more than 50% likely of being realized upon resolution of the contingency. The Company accounts for interest and penalties related to uncertain tax positions as part of its provision for income taxes.
Defined Benefit Plans
The Company has defined benefit plans for some of its employees at various international locations. The Company recognizes retirement benefit assets or liabilities in the consolidated balance sheets reflecting the funded status of pension and other retirement benefit plans. Retirement benefit assets and liabilities are adjusted for the difference between the benefit obligations and the plan assets at fair value (measured at year-end), with the offset recorded directly to stockholders' equity through accumulated other comprehensive income (loss), net of tax. The amount recorded in stockholders' equity represents the after-tax unamortized actuarial gains or losses, unamortized transition obligations and unamortized prior service costs.
Recent Accounting Pronouncements
The Financial Accounting Standards Board ("FASB") has issued the following accounting pronouncements, all of which became effective for the Company in 2020 and none of which had a material impact on the Company's consolidated financial statements: