Northrop Grumman 2012 Annual Report Download - page 47

NORTHROP GRUMMAN CORPORATION
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Changes in contract estimates occur for a variety of reasons, including changes in contract scope, changes in
estimated revenue, and changes in contract cost estimates. These changes are often driven by events such as changes
in estimated incentive fees, unanticipated risks affecting contract costs, the resolution of risk at lower or higher cost
than anticipated, and changes in indirect cost allocations, such as overhead and general and administrative expenses.
We employ an extensive contract management process involving several functional organizations and numerous
personnel who are skilled at managing contract activities. Changes in estimates are frequent; the company performs
on a broad portfolio of long-term contracts, many of which include complex and customized aerospace and
electronic equipment and software, that often includes technology at the forefront of science. Significant changes in
estimates on a single contract could have a material effect on the company's consolidated financial position or
annual results of operations, and where such changes occur, separate disclosure is made of the nature, underlying
conditions and financial impact of the change. For the impacts of changes in estimates on our consolidated statement
of earnings, see the Consolidating Operating Results section above and Note 1 to the consolidated financial
statements in Part II, Item 8.
Cost Estimation – The cost estimation process is based on the professional knowledge of our engineers, program
managers and financial professionals, and draws on their significant experience and judgment. Such costs are
typically incurred over a period of several years, and estimation of these costs requires the use of judgment. Factors
that are considered in estimating the cost of the work to be completed include the availability, productivity and cost
of labor, the nature and complexity of the work to be performed, the effect of change orders, the availability and cost
of materials, the effect of any delays in performance, and the level of indirect cost allocations. We update our
contract estimates at least annually and more frequently as determined by the occurrence of events or changes in
circumstances. We generally review and reassess our cost and revenue estimates for each significant contract on a
quarterly basis.
Goodwill
Overview – We allocate the purchase price of acquired businesses to the underlying tangible and intangible assets
acquired and liabilities assumed based upon their respective fair values, with the excess recorded as goodwill. Such
fair value assessments require judgments and estimates that can be affected by contract performance and other
factors over time, which may cause final amounts to differ materially from original estimates. Adjustments to the
fair value of purchased assets and liabilities after the initial measurement period are recognized in net earnings.
Impairment Testing – We perform an annual impairment test of our goodwill as of November 30th, or between
annual tests if events occur or circumstances change that suggest goodwill should be evaluated. When testing
goodwill, we compare the fair value of each of our four reporting units to their carrying values.
To determine the fair value of our reporting units, we primarily use the income approach based on the cash flows
that the reporting unit expects to generate in the future, consistent with our operating plans. This income valuation
method requires management to project revenues, operating expenses, working capital, capital spending and cash
flows for the reporting units over a multi-year period, as well as determine the weighted-average cost of capital
(WACC) used as a discount rate and terminal value assumptions.
The WACC takes into account the relative weights of each component of our consolidated capital structure (equity
and debt) and represents the expected cost of new capital adjusted as appropriate to consider lower risk profiles
associated with longer-term contracts and barriers to market entry. The terminal value assumptions are applied to the
final year of the discounted cash flow model. Impairment assessment inherently involves management judgments as
to assumptions about expected future cash flows and the impact of market conditions on those assumptions. Due to
the many variables inherent in the estimation of a business’s fair value and the relative size of our recorded
goodwill, differences in assumptions may have a material effect on the results of our impairment analysis.
We also corroborate the fair values determined under the income approach using the market valuation method to
estimate the fair value of our reporting units, by utilizing industry multiples (including relevant control premiums) of
operating earnings. If the carrying value exceeds the fair value, we determine the fair value of the reporting unit’s
individual assets and liabilities and calculate the implied fair value of goodwill.
The results of our annual goodwill impairment test as of November 30, 2012, indicated that the estimated fair value
of our reporting units exceed their carrying value. There were no impairment charges recorded in the years ended
December 31, 2012, 2011 and 2010.
Fair values for three of our four reporting units substantially exceeded their respective carrying values as of our
annual impairment testing on November 30, 2012. At our other reporting unit, Information Systems, fair value
exceeds carrying value by approximately five percent. Information Systems carrying value includes goodwill of $5.3