1. Summary of Significant Accounting Policies
Principles of consolidation
GSE Systems, Inc. is a leading provider of professional and technical engineering, staffing services, and simulation software to clients in the power and process industries. References in this report to “GSE,” the “Company,” “we” and “our” are to GSE Systems and its subsidiaries, collectively. All intercompany balances and transactions have been eliminated in consolidation.
Accounting estimates
The preparation of the consolidated financial statements in conformity with generally accepted accounting principles in the United States of America (U.S. 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 consolidated financial statements and the reported amounts of revenue and expenses during the reporting period. On an ongoing basis, the Company evaluates the estimates used, including, but not limited to those related to revenue recognition on long-term contracts, allowance for doubtful accounts, product warranties, valuation of goodwill and intangible assets acquired, impairment of long-lived assets to be disposed of, valuation of contingent consideration issued in business acquisitions, valuation of stock-based compensation awards and the recoverability of deferred tax assets. Actual results could differ from these estimates.
Business combinations
Business combinations are accounted for in accordance with the Financial Accounting Standards Board ("FASB") Accounting Standards Codification ("ASC"), ASC 805, Business Combinations, using the acquisition method. Under the acquisition method, the identifiable assets acquired, liabilities assumed and any non-controlling interest in the acquiree are recognized at fair value on the acquisition date, which is the date on which control is transferred to the Company. Any excess purchase price is recorded as goodwill. Transaction costs associated with business combinations are expensed as incurred.
Revenues and the results of operations of the acquired business are included in the accompanying consolidated statements of operations commencing on the date of acquisition.
Acquisitions may include contingent consideration payments based on future financial measures of an acquired company. Under ASC 805, contingent consideration is required to be recognized at fair value as of the acquisition date. We estimate the fair value of these liabilities based on financial projections of the acquired companies and estimated probabilities of achievement. At each reporting date, the contingent consideration obligation is revalued to estimated fair value, and changes in fair value subsequent to the acquisition are reflected in income or expense in the consolidated statements of operations, and could cause a material impact to our operating results. Changes in the fair value of contingent consideration obligations may result from changes in discount periods and rates, changes in the timing and amount of revenue and/or earnings estimates, and changes in probability assumptions with respect to the likelihood of achieving the various earn-out criteria.
Revenue recognition
The Company derives its revenue through three broad revenue streams: 1) System Design and Build (SDB), 2) Software, and 3) Training and Consulting services. We recognize revenue from SDB and software contracts mainly through the Performance Improvement Solutions segment and the training and consulting service contracts through both the Performance Improvement Solutions segment and Nuclear Industry Training and Consulting segment.
The SDB contracts are typically fixed-price and consist of initial design, engineering, assembly and installation of training simulators which include hardware, software, labor, and post contract support (PCS) on the software. We generally have two main performance obligations for an SDB contract: the training simulator build and PCS. The training simulator build performance obligation generally includes hardware, software, and labor. The transaction price under the SDB contracts is allocated to each performance obligation based on its standalone selling price. We recognize the training simulator build revenue over the construction and installation period using the cost-to-cost input method. In applying the cost-to-cost input method, we use the actual costs incurred to date relative to the total estimated costs to measure the work progress toward the completion of the performance obligation and recognize revenue over time as control transfers to a customer. Estimated contract costs are reviewed and revised periodically during the contract period, and the cumulative effect of any change in estimates is recognized in the period in which the change is identified. Estimated losses are recognized in the period such losses become known.
Uncertainties inherent in the performance of contracts include labor availability and productivity, material costs, change order scope and pricing, software modification and customer acceptance issues. The reliability of these cost estimates is critical to the Company's revenue recognition as a significant change in the estimates can cause the Company's revenue and related margins to change significantly from previous estimates.
Management judgments and estimates involved in the initial creation and subsequent updates to the Company’s estimates-at-completion and related profit recognized are critical for our revenue recognition associated with SDB contracts. Inputs and assumptions requiring significant management judgment included anticipated direct labor, subcontract labor, and other direct costs required to deliver on unfinished performance obligations.
The SDB contracts generally provide a one-year base warranty on the systems. The base warranty is not accounted for as a separate performance obligation under the contract because it does not provide the customer with a service in addition to the assurance that the completed project complies with agreed-upon specifications. Warranties extended beyond our typical one-year period, if any, are evaluated on a case by case basis to determine if it provides more than just assurance that the product operates as intended, which would require carve-out as a separate performance obligation.
Revenue from the sale of perpetual standalone and term software licenses, which do not require significant modification or customization, is recognized upon its delivery to the customer. Revenue from the sale of cloud-based, subscription-based software licenses is recognized ratably over the term of such licenses following delivery to the customer. Delivery is considered to have occurred when the customer receives a copy of the software and is able to use and benefit from the software.
A software license sale contract with multiple deliverables typically includes the following elements: license, installation and training services, and PCS. The total transaction price of a software license sale contract is typically fixed, and is allocated to the identified performance obligations based on their relative standalone selling prices. Revenue is recognized as the performance obligations are satisfied. Specifically, license revenue is recognized when the software license is delivered to the customer; installation and training revenue are recognized when the installation and training are completed without regard to a detailed evaluation of the point in time criteria due to the short-term nature of the installation and training services (one to two days on average); and PCS revenue is recognized ratably over the service period, as PCS is deemed as a stand-ready obligation.
The contracts within the training and consulting services revenue stream are either time and materials (T&M) based or fixed-price based. Under a typical T&M contract, the Company is compensated based on the number of hours of approved time provided by temporary workers and the bill rates which are fixed by type of work, as well as approved expenses incurred. The customers are billed on a regular basis, such as weekly, biweekly or monthly. In accordance with ASC 606-10-55-18, Revenue from contracts with customers, we elected to apply the "right to invoice" practical expedient, under which we recognize revenue in the amount to which we have the right to invoice. The invoice amount represents the number of hours of approved time worked by each temporary worker multiplied by the bill rate for the type of work, as well as approved expenses incurred. Under a typical fixed-price contract, we recognize the revenue on a Percentage of Completion basis as it relates to GSE Construction Contracts with revenue recognized based on project delivery over time. Revenue from the sale of short-term contracts with a delivery period of one month or less is recognized in the month completed.
For contracts with multiple performance obligations, we allocate the contract price to each performance obligation based on its relative standalone selling price. We generally determine standalone selling prices based on the prices charged to customers.
The transaction price for Software contracts is generally fixed, and we recognize revenue upon delivery of the software, with fees due in advance or shortly after delivery of the software.
We recognize Training and Consulting Services revenue as services are performed and bill our customers for services that we have provided on a regular basis (i.e. weekly, biweekly or monthly) and in time with revenue recognition.
Contract asset, which we classify as unbilled receivables, relates to performance under the contract for obligations that are satisfied but not yet billed. Contract assets are recognized as revenue as they occur.
Contract liability, which we classify as billing-in-excess of revenue earned, relates to payments received in advance of performance under the contract. Contract liabilities are recognized as revenue as performance obligations are satisfied.
Cash and cash equivalents
Cash and cash equivalents represent cash and highly liquid investments including money market accounts with maturities of three months or less at the date of purchase.
Contract receivables, net and contract asset and liabilities
Contract receivables include recoverable costs and accrued profit not billed which represents revenue recognized in excess of amounts billed. Contract asset (unbilled receivables) include amounts earned in performance of services that have not been invoiced. Contract liabilities include billings in excess of revenue earned on uncompleted contracts in the accompanying consolidated balance sheets represent advanced billings to clients on contracts in advance of work performed. Generally, such amounts will be earned and recognized over the next twelve months.
Billed receivables are recorded at invoiced amounts. The allowance for doubtful accounts is based on historical trends of past due accounts, write-offs, specific identification and review of customer accounts.
Impairment of long-lived assets
Long-lived assets, such as equipment, purchased software, capitalized software development costs, and intangible assets subject to amortization, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated undiscounted future cash flows, an impairment charge is recognized at the amount by which the carrying amount of the asset exceeds its fair value. Assets to be disposed of would be separately presented in the consolidated balance sheets and reported at the lower of the carrying amount or fair value less costs to sell, and would no longer be depreciated.
Development expenditures
Development expenditures incurred to meet customer specifications under contracts are charged to cost of revenue. Company sponsored development expenditures are either charged to operations as incurred and are included in research and development expenses or are capitalized as software development costs. The amounts incurred for Company sponsored development activities relating to the development of new products and services or the improvement of existing products and services, were approximately $1.0 million and $1.1 million for the years ended December 31, 2020 and 2019, respectively. Of these amounts, the Company capitalized approximately $0.3 million and $0.4 million for the years ended December 31, 2020 and 2019, respectively.
Equipment, software and leasehold improvements, net
Equipment and purchased software are recorded at cost and depreciated using the straight-line method with estimated useful lives ranging from three years to ten years. Leasehold improvements are amortized over the term of the lease or the estimated useful life, whichever is shorter, using the straight-line method. Upon sale or retirement, the cost and related depreciation are eliminated from the respective accounts and any resulting gain or loss is included in operations. Maintenance and repairs are charged to expense as incurred.
Software development costs
Certain computer software development costs, including direct labor cost, are capitalized in the accompanying consolidated balance sheets. Capitalization of computer software development costs begins upon the establishment of technological feasibility. Capitalization ceases and amortization of capitalized costs begins when the software product is commercially available for general release to customers. Amortization of capitalized computer software development costs is included in cost of revenue and is determined using the straight-line method over the remaining estimated economic life of the product, typically three years. On an annual basis, or more frequently as conditions indicate, the Company assesses the recovery of the unamortized software development costs by estimating the net undiscounted cash flows expected to be generated by the sale of the product. If the undiscounted cash flows are not sufficient to recover the unamortized software costs the Company will write-down the carrying amount of such asset to its estimated fair value based on the future discounted cash flows. The excess of any unamortized computer software costs over the related fair value is written down and charged to operations. Included in capitalized software development costs are certain expenses associated with the development software as a services. Significant changes in the sales projections could result in an impairment with respect to the capitalized software that is reported on the Company’s consolidated balance sheets.
Goodwill and intangible assets
The Company’s intangible assets include amounts recognized in connection with business acquisitions, including customer relationships, trade names, non-compete agreements and alliance agreements. Due to the impact of the COVID-19 pandemic, definite-lived intangible assets were reviewed for impairment in the first quarter of 2020. The undiscounted cash flows evidenced impairment for the DP Engineering asset group as such, we used a discounted cash flow model to determine the fair value of the DP Engineering asset group and recorded an impairment charge of $4.3 million as of the period ended March 31, 2020.
The Company’s intangible assets impairment analysis includes the use of undiscounted and discounted cash flow models that requires management to make assumptions regarding estimates of revenue growth rates and operating margins used to calculate projected future cash flows.
Intangible assets are initially valued at fair value using generally accepted valuation methods appropriate for the type of intangible asset. Amortization is recognized on a straight-line basis over the estimated useful life of the intangible asset, except for contract backlog and contractual customer relations, which are recognized in proportion to the related project revenue streams. Intangible assets with definite lives are reviewed for impairment if indicators of impairment arise. The Company does not have any intangible assets with indefinite useful lives.
We review goodwill for impairment annually as of December 31 and whenever events or changes in circumstances indicate the carrying value of goodwill may not be recoverable. We test goodwill at the reporting unit level. A reporting unit is an operating segment, or one level below an operating segment, as defined by U.S. GAAP. We have determined that we have two reporting units, which are the same as our two operating segments: (i) Performance Improvement Solutions ("Performance") and (ii) Nuclear Industry Training and Consulting ("NITC").
Goodwill represents the excess of costs over fair value of assets of businesses acquired. The Company reviews goodwill for impairment annually as of December 31 and whenever events or changes in circumstances indicate the carrying value of goodwill may not be recoverable in accordance with Accounting Standards Update ("ASU") 2011-08, Intangibles - Goodwill and Other (Topic 350): Testing Goodwill for Impairment. The Company tests goodwill at the reporting unit level.
ASU 2011-08 permits an entity to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform impairment testing. Under ASU 2011-08, an entity is not required to perform step one of the goodwill impairment test for a reporting unit if it is more likely than not that its fair value is greater than its carrying amount. Additionally, ASU 2017-04, Simplifying the Test for Goodwill Impairment by eliminating two step approach when there is indication of impairment.
On February 15, 2019, we acquired DP Engineering and preliminarily recorded goodwill and identified intangible assets as part of the acquisition. On February 23, 2019, an unexpected event occurred at one of DP Engineering's significant customers and all pending work for that customer was terminated as a result of a root cause analysis on February 28, 2019. On May 10, 2019, the Company determined that a material impairment had occurred, requiring an assessment for impairment to be completed related to $5.6 million of goodwill recorded in the acquisition. (See Note 7).
During the first quarter of fiscal 2020, We determined that the impact of the COVID-19 pandemic on its operations was an indicator of a triggering event that could result in potential impairment of goodwill. As such we performed a Step 1 goodwill analysis whereby we compared the fair value of each reporting unit to its respective carrying value, Based upon this analysis, we determined the fair value of goodwill at the reporting unit levels exceeded the carrying value and thus there was no impairment as of the period ended March 31, 2020. The Step 1 analysis was updated as of December 31, 2020 for our annual impairment test, and did not identify any impairment of goodwill as of such date. In addition, we make certain judgments and assumptions in allocating shared assets and liabilities to determine the carrying values for each of our reporting units. As of December 31, 2019, we performed a quantitative step 1 goodwill impairment test and concluded that the fair values of each of our reporting units exceeded their respective carrying values.
Our goodwill impairment analysis includes the use of a discounted cash flow model that requires management to make assumptions regarding estimates of revenue growth rates and operating margins used to calculate projected future cash flows, and risk-adjusted discount rates.
Foreign currency translation
The United States Dollar (USD) is the functional currency of GSE and subsidiaries operating in the United States. The functional currency of each of our foreign subsidiaries is the currency of the economic environment in which the subsidiary primarily does business. Our foreign subsidiaries' financial statements are translated into USD using the exchange rates applicable to the dates of the financial statements. Assets and liabilities are translated into USD using the period-end spot foreign exchange rates. Income and expenses are translated at the average exchange rate for the year. Equity accounts are translated at historical exchange rates. The effects of these translation adjustments are cumulative translation adjustments, which are reported as a component of accumulated other comprehensive income (loss) included in the consolidated statements of changes in stockholders' equity.
For any business transaction that is in a currency different from the entity's functional currency, we record a gain or loss based on the difference between the exchange rate at the transaction date and the exchange rate at the transaction settlement date (or rate at period end, if unsettled) to the foreign currency realized gain (loss) account in the consolidated statements of operations.
Income taxes
Income taxes are provided under the asset and liability method. Under this method, deferred income taxes are determined based on the differences between the consolidated financial statements and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amounts expected to be realized. A provision is made for the Company's current liability for federal, state and foreign income taxes and the change in the Company's deferred income tax assets and liabilities.
We establish accruals for uncertain tax positions taken or expected to be taken in a tax return when it is not more likely than not (i.e., a likelihood of more than fifty percent) that the position would be sustained upon examination by tax authorities that have full knowledge of all relevant information. A recognized tax position is then measured at the largest amount of benefit that is greater than 50% likely of being realized upon ultimate settlement. Favorable or unfavorable adjustment of the accrual for any particular issue would be recognized as an increase or decrease to income tax expense in the period of a change in facts and circumstances. Interest and penalties related to income taxes are accounted for as income tax expense.
Stock-based compensation
Stock-based compensation expense is based on the grant-date fair value estimated in accordance with the provisions of ASC 718, Compensation-Stock Compensation. Compensation expense related to stock-based awards is recognized on a pro rata straight-line basis based on the fair value of share awards that are scheduled to vest during the requisite service period.
Significant customers and concentration of credit risk
For the year ended December 31, 2020, we have a concentration of revenue from one individual customer, which accounted for 14.1% of our consolidated revenue. For the year ended December 31, 2019, we had a concentration of revenue from one customer, which accounted for 27.8% of our consolidated revenue. This customer is part of both Performance and NITC segments. No other individual customer accounted for more than 10% of our consolidated revenue in 2020 or 2019.
As of December 31, 2020, we have no customer that accounted over 10% of the Company’s consolidated contract receivables. As of December 31, 2019, the Company had two customers that accounted for 12.6% and 10.3% of the Company’s consolidated contract receivables.
Fair values of financial instruments
The carrying amounts of current assets and current liabilities reported in the consolidated balance sheets approximate fair value due to their short term duration.
Derivative instruments
Occasionally, the Company utilizes forward foreign currency exchange contracts to manage market risks associated with the fluctuations in foreign currency exchange rates. It is the Company's policy to use such derivative financial instruments to protect against market risk arising in the normal course of business in order to reduce the impact of these exposures. The Company minimizes credit exposure by limiting counterparties to nationally recognized financial institutions. We do not have such derivative instruments as of December 31, 2020.
COVID-19
GSE employees began working remotely during the first quarter of 2020 due to the COVID-19 pandemic and will continue to do so when practical and as mandated by local, state and federal directives and regulations. Employees almost entirely work from home within our Performance Improvement Solutions ("Performance") segment, except when required to be at the client site for essential project work. Our Performance contracts, which are considered an essential service, are permitted to and mostly continue without pause; however, we have experienced certain delays in new business. For our staff augmentation business, we have seen certain contracts for our Nuclear Industry Training and Consulting ("NITC") customers paused or delayed as clients shrink their own on-premise workforces to the minimum operating levels in response to the pandemic; as a result, our NITC segment has experienced a decline in its billable employee base since the start of the pandemic. Although we cannot fully estimate the length or gravity of the impact of the COVID-19 pandemic to our business at this time, we have experienced delays in commencing new projects and thus our ability to recognize revenue has been delayed for some contracts. We have also experienced order reductions or other negative changes to orders due to the pandemic. We routinely monitor our operating expenses as a result of contract delays and have made adjustments to keep our gross profit at a sustainable level.
Going Concern
In 2019, our operating results were negatively impacted by the loss of a major customer in our DP Engineering subsidiary. In 2020, we had several projects delayed and new orders postponed because of the COVID-19 pandemic. We have amended our credit facility with Citizens Bank in 2020 based upon expected covenant violations and have been required to curtail term debt in exchange for revised financial covenants. Scheduled term loan repayments and agreed upon curtailment required us to use $18.5 million in available cash to pay-off our term debt in 2020. As such, our working capital position on December 31, 2020 was a deficit of $2.7 million. This working capital deficit includes, $5.0 million from current maturities on our PPP loan, which we expect will be forgiven and have not received any indications to the contrary (See Note 4). If the PPP loan is not forgiven, in part or in whole, we will work with our bank to extend repayment terms as permitted to mitigate the impact on our cashflows. However, if unforgiven and unamended, our PPP loan would be due April 23, 2022, in part or in whole, and may stress our free cash flow and the business to a degree that may cause our covenants to fail.
The COVID-19 macroeconomic environment is considered fluid and although recovery is anticipated to steadily occur over the next 12 months, a further decline will stress our ability to meet covenant requirements. Further continuance of delays in commencing work on outstanding orders or a continued loss of orders, further disruption of our business because of worker illness or mandated shutdowns may also exacerbate the situation. Jurisdictions where our businesses operate across the country are pushing toward re-opening places of business and government support, through the American Rescue Plan Act of 2021, will continue support the broad economy on that path. However, the timing of these elements taking place are not predictable and may not serve to mitigate our situation or improve our specific company’s health.
We signed the Ninth Amendment and Reaffirmation Agreement (the “Nineth Amendment”) with our bank on March 29, 2021 to waive the fixed charge coverage ratio and leverage ratio for the quarters ending March 31 and June 30, 2021, and to adjust the thresholds for future covenants to ease the risk of non-compliance experienced in previous quarters (See Note 25). However, our new covenant compliance is dependent on meeting future projections, which are subject to the variability and unknown speed and extent of post-COVID-19 recovery.
The Company also maintains options to compensate for a further decline in operations to bolster cash positions by raising capital through its access to the public markets or entering alternative finance arrangements afforded to it through established financial relationships. Impact to net income could be mitigated through one or many of the various cost cutting measures at its disposal, directed at compensation, vendor augmentation or delay of investment initiatives in its corporate office.
These actions and options, which are further supported by positively trending macroeconomic conditions, and the potential to see recovering business and orders ease the risk to the bank covenants experienced in previous quarters. However, when considering the unpredictability of the above, there continues to be substantial doubt the Company will continue as a going concern over the next twelve months.