Summary of Significant Accounting Policies

All references to the “Company” and “Kratos” refer to Kratos Defense & Security Solutions, Inc., a Delaware corporation, and its subsidiaries.


(a)	Basis of Presentation

The information as of April 1, 2018 and for the three months ended April 1, 2018 and March 26, 2017 is unaudited. The condensed consolidated balance sheet as of December 31, 2017 was derived from the Company’s audited consolidated financial statements at that date. In the opinion of management, these unaudited condensed consolidated financial statements include all adjustments, consisting of normal recurring adjustments necessary for a fair presentation of the Company’s financial position, results of operations and cash flows for the interim periods presented. The results have been prepared in accordance with the instructions to Form 10-Q and do not necessarily include all information and footnotes necessary for presentation in accordance with accounting principles generally accepted in the U.S. (“GAAP”) These unaudited condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and the related notes included in the Company’s audited annual consolidated financial statements for the fiscal year ended December 31, 2017, included in the Company’s Annual Report on Form 10-K filed with the U.S. Securities and Exchange Commission (the “SEC”) on February 28, 2018 (the “Form 10-K”). Interim operating results are not necessarily indicative of operating results expected in subsequent periods or for the year as a whole.

As discussed in “Discontinued Operations” in Note 3, on February 28, 2018, the Company entered into an agreement to sell the operations of its Public Safety & Security business unit which had previously been reported as a separate reportable business segment. Accordingly, PSS (as defined below) and its subsidiaries have been classified as held for sale and reported in discontinued operations in the condensed consolidated financial statements for all periods presented.


(b)	Principles of Consolidation

The condensed consolidated financial statements include the accounts of the Company and its 100% owned subsidiaries for which all inter-company transactions have been eliminated in consolidation.


(c)	Fiscal Year

The Company has a 52/53 week fiscal year ending on the last Sunday of the calendar year, with interim fiscal periods ending on the last Sunday of each calendar quarter. The three month periods ended April 1, 2018 and March 26, 2017 consisted of 13-week periods. There are 52 calendar weeks in the fiscal year ending on December 30, 2018 and 53 calendar weeks in the fiscal year ending on December 31, 2017.

(d) Accounting Estimates

There have been no significant changes in the Company’s accounting estimates for the three months ended April 1, 2018 as compared to the accounting estimates described in the Form 10-K.

(e) Accounting Standards Updates

In November 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2016-18 (“ASU 2016-18”), Statement of Cash Flows (Topic 230) - Restricted Cash, which requires that restricted cash and cash equivalents be included with cash and cash equivalents when reconciling beginning-of-period and end-of-period total amounts shown on the consolidated statements of cash flows. The new standard is effective for public entities for fiscal years beginning after December 15, 2017 and for interim periods therein. The Company adopted ASU 2016-18 as of January 1, 2018. The adoption of the ASU 2016-18 did not have a material impact on the Company's consolidated financial statements.

In August 2016, the FASB issued ASU 2016-15 (“ASU 2016-15”), Classification of Certain Cash Receipts and Cash Payments. ASU 2016-15 is designed to clarify how entities should classify cash receipts and cash payments in the statement of cash flows. ASU 2016-15 became effective for the Company beginning January 1, 2018. The standard requires retrospective application. The adoption of the ASU 2016-15 did not have a material impact on the Company's consolidated financial statements.

In February 2016, the FASB issued ASU 2016-02 (“ASU 2016-02”), Leases. ASU 2016-02 requires that lessees recognize assets and liabilities for the rights and obligations underlying leases with a lease term of more than one year. The amendments in this ASU are effective for annual periods beginning after December 15, 2018. The FASB has proposed a change that would allow a company to elect an optional transition method that applies the new lease requirements through a cumulative-effect adjustment in the period of adoption. The Company expects to adopt the standard on December 31, 2018 using the proposed optional transition method if finalized in its current form. The Company is reviewing its leases to determine the impact of the adoption of ASU 2016-02 on its consolidated financial statements.

Effective January 1, 2018, the Company adopted ASU 2014-09, Revenue from Contracts with Customers, as amended (Topic 606) (“ASC 606”), which establishes a broad principle that requires entities to assess the products or services promised in contracts with customers at contract inception to determine the appropriate unit at which to record revenues, which is referred to as a performance obligation. Revenue is recognized when control of the promised products or services is transferred to customers at an amount that reflects the consideration to which the entity expects to be entitled to in exchange for those products or services. The new standard supersedes GAAP guidance on revenue recognition and requires the use of more estimates and judgments than the present standards. In addition, the standard requires disclosure of the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers.

ASC 606 may be applied either retrospectively or through the use of a modified-retrospective method. The full retrospective method requires companies to recast each prior reporting period presented as if the new guidance had always existed. Under the modified retrospective method, companies would recognize the cumulative effect of initially applying the standard as an adjustment to the opening balance of retained earnings at the date of initial application. The Company adopted the new revenue standard through the use of the modified-retrospective method. The cumulative effects of applying the new guidance to all contracts with customers that were not completed as of January 1, 2018 was recorded as a decrease in opening equity of $0.2 million. Additional disclosures have been included in Note 2 in accordance with the ASU. The following changes were made to our condensed consolidated balance sheet on January 1, 2018 as a result of the adoption of ASC 606 (in millions):



	Balance at January 1, 2018			ASC 606 Adjustment			Adjusted Balance at January 1, 2018
	Balance at January 1, 2018			ASC 606 Adjustment			Adjusted Balance at January 1, 2018
Assets
Unbilled receivable, net	$	138.1		$	1.3		$	139.4
Inventoried costs	49.0			(0.3		)	48.7

Liabilities
Accrued expenses	$	40.9		$	(0.6	)	$	40.3
Billings in excess of costs and earnings on uncompleted contracts	42.8			1.8			44.6

Stockholders’ Equity
Accumulated deficit	$	(720.8	)	$	(0.2	)	(721.0		)

The following table summarizes the impacts of ASC 606 adoption on the Company’s operating income from continuing operation for the three months ended April 1, 2018 (in millions):



	For the period ended April 1, 2018
			Balances Without Adoption of ASC 606		Effect of Change Higher/(Lower)
	As Reported		Balances Without Adoption of ASC 606		Effect of Change Higher/(Lower)
Service revenues	$	46.0	$	46.0	$	—
Product sales	97.0		89.3		7.7
Total revenues	143.0		135.3		7.7
Cost of service revenue	32.9		32.9		—
Cost of product sales	69.3		65.1		4.2
Total costs	102.2		98.0		4.2
Gross profit	40.8		37.3		3.5
Selling, general and administrative expenses	29.8		29.8		—
Total operating income from continuing operations	$	7.0	$	3.5	$	3.5

The following table summarizes the impacts of ASC 606 adoption on the Company’s balance sheet as of April 1, 2018 (in millions):



	April 1, 2018
				Balances Without Adoption of ASC 606			Effect of Change Higher/(Lower)
	As Reported			Balances Without Adoption of ASC 606			Effect of Change Higher/(Lower)
Assets
Accounts receivable	$	57.7		$	55.6		$	2.1
Unbilled receivables	151.2			147.1			4.1
Inventoried costs	48.2			52.4			(4.2		)

Liabilities
Billings in excess of costs and earnings on uncompleted contracts	38.2			39.7			(1.5		)

Stockholders’ Equity
Accumulated deficit	$	(723.2	)	$	(726.7	)	$	3.5

Other than the adjustments noted above, there have been no changes in the Company’s significant accounting policies for the three months ended April 1, 2018 as compared to the significant accounting policies described in the Form 10-K.


(f)	Fair Value of Financial Instruments

The carrying amounts and the related estimated fair values of the Company’s long-term debt financial instruments not measured at fair value on a recurring basis at April 1, 2018 and December 31, 2017 are presented in Note 9. The carrying value of all other financial instruments, including cash equivalents, accounts receivable, accounts payable, accrued expenses, billings in excess of cost and earnings on uncompleted contracts, income taxes payable and short-term debt, approximated their estimated fair values at April 1, 2018 and December 31, 2017 due to the short-term nature of these instruments.


(g)	Reclassifications

Certain prior year amounts have been reclassified to conform to the current year presentation