SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation

We prepared our interim condensed consolidated financial statements that accompany these notes in conformity with accounting principles generally accepted in the United States of America (U.S. GAAP) for interim information and in accordance with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X.

The interim financial information is unaudited, but reflects all normal adjustments that are, in our opinion, necessary to provide a fair statement of results for the interim periods presented. Certain information and note disclosures normally included in the annual financial statements have been omitted pursuant to those instructions. This interim information should be read in conjunction with the consolidated financial statements for the year ended December 31, 2017, contained in our Annual Report on Form 10-K and filed with the U.S. Securities and Exchange Commission (SEC) on March 16, 2018. Interim results may not be indicative of our full-fiscal year performance.

Corporate Organization

The KeyW Holding Corporation (Holdco or KeyW) was incorporated in Maryland in December 2009. Holdco is a holding company and conducts its operations through The KeyW Corporation (Opco), and its wholly owned subsidiaries. As used herein, the terms “KeyW”, the “Company,” and “we,” “us,” and “our” refer to Holdco and, unless the context requires otherwise, its subsidiaries, including Opco.

KeyW is a provider of advanced engineering and technology solutions to support the collection, processing, analysis and dissemination of information across the full spectrum of the Intelligence, Cyber and Counterterrorism Communities’ missions. Our solutions protect our nation and its allies, and are designed to meet the critical needs of agile intelligence and U.S. Government national security priorities. Our core capabilities include advanced cyber operations and training; geospatial intelligence; cloud and data analytics; engineering; and intelligence analysis and operations. Other KeyW offerings include a suite of Intelligence Surveillance and Reconnaissance (ISR) solutions deployed from an advanced sensor delivery platform, proprietary products-including electro-optical, hyperspectral and synthetic aperture radar sensors-and other products that we manufacture and integrate with hardware and software to meet unique and evolving intelligence mission requirements.

KeyW's solutions focus on Intelligence Community (IC) customers, including the Federal Bureau of Investigation (FBI), Department of Homeland Security (DHS), National Security Agency (NSA), the National Geospatial Intelligence Agency (NGA), the Army Geospatial Center (AGC) and other agencies within the IC and Department of Defense (DoD). In addition, we provide products and services to U.S. federal, state and local law enforcement agencies, foreign governments and other entities in the Cyber and Counterterrorism markets. We believe the combination of our advanced solutions, understanding of our customers’ mission; longstanding and successful customer relationships; operational capabilities; and highly skilled, cleared workforce will help expand our footprint in our core markets.

Principles of Consolidation

The condensed consolidated financial statements include the transactions of KeyW, Opco and their wholly owned subsidiaries from the date of their acquisition. All intercompany accounts and transactions have been eliminated.

Prior Period Financial Statement Correction of Immaterial Errors

During the second quarter of 2018, we identified errors related to the accounting for self-constructed assets dating back to 2014. These errors resulted in an overstatement of property and equipment, net and an understatement of accumulated deficit. Specifically, we determined that certain selling general and administrative and overhead costs should not have been capitalized as part of self-constructed assets and that depreciation expense was not recognized in a timely basis on certain self-constructed assets that were placed into service in prior periods. Additionally, we identified certain self-constructed assets previously presented as property and equipment, net which should have been classified as inventory.

We assessed the materiality of these errors on our financial statements for prior periods in accordance with the SEC Staff Accounting Bulletin (SAB) No. 99, Materiality, codified in Accounting Standards Codification (ASC) 250, Presentation of Financial Statements, and concluded that they were not material to any prior annual or interim periods. However, the aggregate amount of the prior period corrections of immaterial errors through March 31, 2018, was approximately a $3.8 million increase to accumulated deficit and would have been material to the quarterly amounts within our current Consolidated Statements of Operations. Consequently, in accordance with ASC 250 (specifically SAB No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements), we have corrected these errors for all prior periods presented by revising the consolidated financial statements and other financial information included herein. We also corrected the timing of immaterial previously recorded out-of-period adjustments and reflected them in the revised prior period financial statements, where applicable. Periods not presented herein will be revised, as applicable, in future filings.

The effects of the correction of immaterial errors on our Condensed Consolidated Balance Sheet were as follows (in thousands):



	December 31, 2017
	As Previously Reported			Adjustment			As Revised
Inventories, net	$	20,496		$	3,841		$	24,337
Property and equipment, net	43,283			(7,142		)	36,141
TOTAL ASSETS	686,907			(3,301		)	683,606
Deferred tax liability, net	19,174			193			19,367
TOTAL LIABILITIES	375,895			193			376,088
Accumulated deficit	(111,939		)	(3,494		)	(115,433		)
TOTAL STOCKHOLDERS' EQUITY	311,012			(3,494		)	307,518

The effects of the correction of immaterial errors on our Condensed Consolidated Statements of Operations were as follows (in thousands):



	Three months ended June 30, 2017
	As Previously Reported			Adjustment			As Revised
Cost of revenue, excluding amortization	$	94,181		$	347		$	94,528
Operating expenses	36,159			317			36,476
Operating loss	(9,886		)	(664		)	(10,550		)
Loss before income taxes	(14,663		)	(664		)	(15,327		)
Income tax expense (benefit), net	3,124			(65		)	3,059
Net loss	(17,787		)	(599		)	(18,386		)

Basic net loss per share	$	(0.36	)	$	(0.01	)	$	(0.37	)
Diluted loss per share	$	(0.36	)	$	(0.01	)	$	(0.37	)



	Six months ended June 30, 2017
	As Previously Reported			Adjustment			As Revised
Cost of revenue, excluding amortization	$	142,070		$	576		$	142,646
Operating expenses	56,143			748			56,891
Operating loss	(11,153		)	(1,324		)	(12,477		)
Loss before income taxes	(18,547		)	(1,324		)	(19,871		)
Income tax (benefit) expense, net	3,124			(65		)	3,059
Net loss	(21,671		)	(1,259		)	(22,930		)

Basic net loss per share	$	(0.45	)	$	(0.03	)	$	(0.48	)
Diluted loss per share	$	(0.45	)	$	(0.03	)	$	(0.48	)

The effects of the correction of immaterial errors on our Condensed Consolidated Statements of Cash Flows were as follows (in thousands):



	Six months ended June 30, 2017
	As Previously Reported		Adjustment		As Revised
Net Loss	(21,671	)	(1,259	)	(22,930	)
Depreciation and amortization expense	8,912		768		9,680
Deferred taxes	3,127		(65	)	3,062
Inventory, net	(2,200	)	(1,439	)	(3,639	)
Net cash used in operating activities	(2,846	)	(1,995	)	(4,841	)
Purchase of property and equipment	(5,674	)	1,995		(3,679	)
Net cash used in investing activities	(241,765	)	1,995		(239,770	)

Revenue Recognition

Effective January 1, 2018, we adopted the requirements of Accounting Standards Update (ASU) 2014-09 and related amendments, Revenue from Contracts with Customers (ASC 606), which superseded all prior revenue recognition methods and industry-specific guidance. For additional information on our adoption of the new standard refer to the Recently Adopted Accounting Pronouncements section below.

The majority of our revenues are from long-term contracts with the U.S. federal government that can span several years. The Company performs under various types of contracts including cost reimbursement (cost-plus-fixed-fee, cost-plus-award-fee), time-and-materials, fixed-price-level-of-effort, and firm-fixed-price contracts.

Under the guidance of ASC 606, the Company evaluates whether it has an enforceable contract with a customer with rights of the parties and payment terms identified, and collectability is probable. The Company also evaluates if a contract has multiple promises and if each promise should be accounted for as separate performance obligations or as a single performance obligation. Multiple promises in a contract are typically separated if they are distinct, both individually and in the context of the contract. If multiple promises in a contract are highly interrelated or comprise a series of distinct services performed over time, they are combined into a single performance obligation.

Contract modifications are evaluated to determine whether they should be accounted for as part of the original contract or as a separate contract. We consider contract modifications to exist when the modification either creates new or changes the existing enforceable rights and obligations. Contract modifications are accounted for as a separate contract if the modification adds distinct goods or services and increases the contract value by its standalone selling price. Modifications that are not determined to be a separate contract are accounted for either has a prospective adjustment to the original contract if the goods or services in the modification are distinct from those transferred before the modification or as a cumulative adjustment if the goods and services are not distinct and are part of a single performance obligation that is partially satisfied. The Company’s services contracts frequently provide customers an option to renew for an additional period of time under the same terms and conditions as the original contract. The renewal options typically do not provide the customer any material rights under the contract and therefore are treated as separate contracts when they include distinct goods or services at standalone selling prices.

Transaction prices for contracts with the U.S. government are typically determined through a competitive procurement process and are based on estimated or actual costs of providing the goods or services in accordance with applicable regulations. Transaction prices for non-U.S. government customers are based on specific negotiations with each customer. In certain instances, our contracts contain award fees, incentive fees, or other provisions that can either increase or decrease the transaction price. The variable amounts generally are awarded upon achievement of certain performance metrics or program milestones and can be based upon customer discretion. We estimate variable consideration at the most likely amount to which we expect to be entitled. Our estimates of variable consideration and determination of whether to include estimated amounts in the transaction price are based largely on an assessment of the Company’s anticipated performance and all information (historical, current and forecasted) that is reasonably available to us and the potential of a significant reversal of revenue. The Company excludes any taxes collected or imposed when determining the transaction price.

A contract’s transaction price is allocated to each distinct performance obligation and recognized when, or as, the performance obligation is satisfied. For contracts with multiple performance obligations, we allocate the contract’s transaction price to each performance obligation using our best estimate of the standalone selling price of each distinct good or service in the contract. Substantially none of the Company’s contracts contain a significant financing component, which would require an adjustment to the transaction price of the contract.

The Company recognizes revenue on a majority of its contracts over time as there is continuous transfer of control to the customer over the contract's period of performance. Continuous transfer of control is typically supported by contract clauses which allow our customers to unilaterally terminate a contract for convenience, pay for costs incurred plus a reasonable profit, and take control of work-in-process. Revenue recognized over time is generally based on the extent of progress towards completion of the related performance obligations. The selection of the method to measure progress towards completion requires judgment and is based on the nature of the products or services provided. In certain instances, typically for firm-fixed-price contracts, we use the cost-to-cost measure of progress for our contracts because it best depicts the transfer of control to the customer which occurs as we incur costs on our contracts. Under the cost-to-cost measure of progress, the extent of progress towards completion is measured based on the ratio of costs incurred to date to the total estimated costs at completion of the performance obligation. Revenues, including estimated fees or profits, are recorded proportionally as costs are incurred. Costs to fulfill generally include direct labor, materials and subcontractors’ costs, other direct costs and an allocation of indirect costs. In other instances, generally for cost reimbursable, time-and-materials, and fixed-price-level-of-effort contracts, revenue is recognized based on a right to invoice practical expedient as the Company is able to invoice the customer in an amount that corresponds directly with the value received by a customer for the Company’s performance completed to date. In some instances, typically for the sale of products that have an alternative use, the Company recognizes revenue at a point in time using a rate per unit as units are delivered and the customer obtains legal title of the asset.

Changes in estimates related to contracts accounted for using the cost-to-cost method of accounting are recognized in the period in which such changes are made on a cumulative catch-up basis, which recognizes in the current period the cumulative effect of the changes on current and prior periods based on a performance obligations’ percentage of completion. For the three and six months ended June 30, 2018, there were no material modifications recorded related to work previously performed on projects prior to the execution of formal modifications or amendments. A significant change in one or more estimates could affect the profitability of one or more of our performance obligations. When estimates of total costs to be incurred on a performance obligation exceed total estimates of revenue to be earned, a provision for the entire loss on the performance obligation is recognized in the period the loss is determined.

Cost of Revenue

Cost of revenue consists primarily of compensation expenses for program personnel, the fringe benefits associated with this compensation and other direct expenses incurred to complete programs, including cost of materials, depreciation and subcontract efforts.

Receivables

Receivables consist of amounts billed and currently due from customers and amounts currently due from customers that are not yet billed (unbilled receivables). Receivables are stated at the amount management expects to collect from outstanding balances. Management provides for probable uncollectible amounts through a charge to earnings and a credit to an allowance for doubtful accounts based on its assessment of the status of individual accounts. Balances that are still outstanding after management has used reasonable collection efforts are written-off through a charge to the allowance and a credit to accounts receivable. For the six months ended June 30, 2018 and 2017, there were no material impairment losses or changes to the allowance.

Use of Estimates

Management uses estimates and assumptions in preparing these condensed consolidated financial statements in accordance with U.S. GAAP. Those estimates and assumptions affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities, and the reported revenues and expenses. Significant estimates include amortization lives, depreciation lives, proportional performance revenue, inventory obsolescence reserves, income taxes and stock compensation expense. Actual results could vary from the estimates that were used.

Cash and Cash Equivalents

We consider all highly liquid investments purchased with maturities of three months or less, when purchased, to be cash equivalents.

Loss per Share

Basic net loss per share is calculated by dividing net loss by the weighted average number of common shares outstanding during the period. Diluted loss per share is calculated by dividing net loss by the diluted weighted average common shares, which reflects the potential dilution of stock options, warrants, and contingently issuable shares that could share in our loss if the securities were exercised. As the Company incurred a net loss for the three and six months ended June 30, 2018 and 2017, none of the potential dilution of stock options, warrants, and contingently issuable shares were included in the diluted share calculation for those periods as they would have been anti-dilutive.

The following table presents the calculation of basic and diluted net loss per share (in thousands except per share amounts):



	Three months ended June 30,						Six months ended June 30,
	2018			2017			2018			2017
Net loss	(11,394		)	(18,386		)	$	(14,792	)	$	(22,930	)
Weighted average shares – basic	49,872			49,546			49,865			48,061
Effect of dilutive potential common shares	—			—			—			—
Weighted average shares – diluted	49,872			49,546			49,865			48,061

Net loss per share – basic	$	(0.23	)	$	(0.37	)	$	(0.30	)	$	(0.48	)
Net loss per share – diluted	$	(0.23	)	$	(0.37	)	$	(0.30	)	$	(0.48	)
Anti-dilutive share-based awards, excluded	3,714			3,062			3,714			3,062

Employee equity share options, restricted shares and warrants granted by the Company are treated as potential common shares outstanding in computing diluted loss per share. Diluted shares outstanding include the dilutive effect of in-the-money options and in-the-money warrants and unvested restricted stock. The dilutive effect of such equity awards is calculated based on the average share price for each fiscal period using the treasury stock method. Under the treasury-stock method, the amount the employee must pay for exercising stock options and the amount of compensation cost for future service that the Company has not yet recognized are collectively assumed to be used to repurchase shares. As the Company incurred a net loss for the three and six months ended June 30, 2018 and 2017, none of the outstanding dilutive share-based awards were included in the diluted share calculation for those periods as they would have been anti-dilutive.

The Company uses the if-converted method for calculating any potential dilutive effect of the conversion spread of our Convertible Senior Notes due 2019 (the Convertible Senior Notes) on diluted earnings per share, if applicable. The conversion spread will have a dilutive impact on diluted earnings per share of common stock when the average market price of our common stock for a given period exceeds the Notes' conversion price of $14.83. As of June 30, 2018, 1.5 million shares related to the Notes have been excluded from the computation of diluted earnings per share as the effect would be anti-dilutive since the conversion price of the Notes exceeded the average market price of the Company’s common shares for the three and six months ended June 30, 2018.

Recently Adopted Accounting Pronouncements

In May 2014, the FASB issued ASU 2014-09 and related amendments, Revenue from Contracts with Customers (ASC 606), an accounting pronouncement related to revenue recognition. ASC 606 supersedes the guidance in former ASC Topic 605, Revenue Recognition, and provides a single, comprehensive revenue recognition model for all contracts with customers. This standard contains principles that an entity will apply to determine the measurement of revenue and timing of when it is recognized. The entity will recognize revenue to reflect the transfer of goods or services to customers at an amount that the entity expects to be entitled to in exchange for those goods or services. ASC 606 is effective for fiscal years, and interim periods within those years, beginning after December 15, 2017.

Effective January 1, 2018, we adopted ASC 606 using the modified retrospective method. ASC 606 was not applied to contracts that were complete at December 31, 2017, and comparative information for the prior fiscal year has not been retrospectively adjusted. For contracts that were modified before the effective date, we elected the practical expedient which enabled the Company to reflect the aggregate effect of all modifications when identifying performance obligations and allocating the transaction price. The adoption of ASC 606 did not have a material impact on the Company’s condensed consolidated financial statements. The Company recorded a $1.0 million increase to accumulated deficit on January 1, 2018, as the accumulative impact of ASC 606 adoption. The primary impact related to certain contracts (or contract components) that were previously recognized on a separate basis which are now combined under ASC 606 into a single performance obligation, as they are not capable of being distinct under the new guidance. The adoption of ASC 606 did not have a significant impact on the Company’s revenue recognition policy as revenues on a majority of the Company’s contracts continue to be recognized over time.

As a result of applying the modified retrospective method to adopt the new guidance, the following adjustments were made on the condensed consolidated balance sheet as of January 1, 2018:



	As Revised						Adjusted
	December 31, 2017			Adjustments			January 1, 2018
	(in thousands)
Assets:
Unbilled receivables	$	37,785		$	1,166		$	38,951
Inventories, net	24,337			(292		)	24,045
Prepaid expenses	2,266			(403		)	1,863
Liabilities:
Accrued expenses	$	17,862		$	49		$	17,911
Deferred revenue	6,090			1,743			7,833
Deferred tax liability, net	19,367			(325		)	19,042
Equity:
Accumulated deficit	$	(115,433	)	$	(996	)	$	(116,429	)

Recently Issued Accounting Pronouncements

In February 2016, the FASB issued ASU 2016-02, Leases (ASC 842) which will supersede the current lease guidance under ASC 840 and makes several changes such as requiring an entity to recognize a right-of-use asset and corresponding lease obligation on the balance sheet. The ASU also requires enhanced disclosures of key information about leasing arrangements. The new standard is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years, and should be adopted under the modified retrospective approach. We are currently evaluating the impact of this pronouncement on our condensed consolidated financial statements.