Allison Transmission Holdings Inc (ALSN) FY 2023 MD&A

ITEM 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion contains forward-looking statements regarding industry trends, our expectations regarding our future performance, liquidity and capital resources and other non-historical statements that involve risks and uncertainties. Our actual results may differ materially from those discussed in or implied by the forward-looking statements as a result of various factors, including, without limitation, those set forth under Part I, Item 1A., “Risk Factors,” and other matters included elsewhere in this Annual Report on Form 10-K. The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and the notes thereto included elsewhere in this Annual Report on Form 10-K.

This section of this Annual Report on Form 10-K generally discusses 2023 and 2022 items and year-over-year comparisons between 2023 and 2022. A detailed discussion of 2021 items and year-over-year comparisons between 2022 and 2021 that are not included in this Annual Report on Form 10-K can be found in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7. of our Annual Report on Form 10-K for the year ended December 31, 2022, as filed with the SEC on February 16, 2023.

Overview

We design and manufacture vehicle propulsion solutions, including commercial-duty on-highway, off-highway and defense fully automatic transmissions and electric hybrid and fully electric systems. The business was founded in 1915 and has been headquartered in Indianapolis, Indiana since inception. Allison is traded on the New York Stock Exchange under the symbol, “ALSN”.

We have a global presence by serving customers in North America, Asia, Europe, South America, and Africa, with approximately 75% of our revenues being generated in North America in 2023. We serve customers through an independent network of approximately 1,600 independent distributor and dealer locations worldwide.

Trends Impacting Our Business

In January 2024, the UAW Local 933 ratified a new four-year collective bargaining agreement with us that expires in November 2027. We expect to have a significant increase in labor costs under the terms of this new agreement.

Our net sales are driven by commercial vehicle production, which tends to be highly correlated to macroeconomic conditions and continues to be impacted by global supply chain constraints. In 2024, we expect higher net sales driven by price increases on certain products and the continued execution of growth initiatives.

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Full Year 2023 and 2022 Net Sales by End Market (in millions)

North America On-Highway end market net sales were up 13% for the year ended December 31, 2023 compared to the year ended December 31, 2022, principally driven by strength in demand for Class 8 vocational and medium-duty trucks and price increases on certain products.

Global Off-Highway net sales were down 22% for the year ended December 31, 2023 compared to the year ended December 31, 2022, principally driven by lower demand in the energy sector, partially offset by higher demand in the mining and construction sectors outside of North America.

Defense end market net sales were up 14% for the year ended December 31, 2023 compared to the year ended December 31, 2022, principally driven by increased demand for Wheeled and Tracked vehicle applications.

Outside North America On-Highway end market net sales were up 3% for the year ended December 31, 2023 compared to the year ended December 31, 2022, principally driven by price increases on certain products and the continued execution of our growth initiatives.

Service Parts, Support Equipment and Other end market net sales were up 18% for the year ended December 31, 2023 compared to the year ended December 31, 2022, principally driven by higher demand for global service parts, support equipment and aluminum die cast components and price increases on certain products.

Key Components of our Results of Operations

Net sales

We generate our net sales primarily from the sale of vehicle propulsion solutions, service and component parts, support equipment, defense kits, engineering services, royalties and extended transmission coverage to a wide array of OEMs, distributors and the U.S. government. Sales are recorded in accordance with the terms of the contract, net of provisions for customer incentives and other rebates. Engineering services are recorded as net sales in accordance with the terms of the contract. The associated costs are recorded in cost of sales. We also have royalty agreements with third parties that provide net sales as a result of joint efforts in developing marketable products.

Cost of sales

Our primary components of cost of sales are purchased parts, the overhead expense related to our manufacturing operations and direct labor associated with the manufacture and assembly of vehicle propulsion solutions and parts. For the year ended December 31, 2023, direct material costs were approximately 67%, overhead costs were approximately 26% and direct labor costs were approximately 7% of total cost of sales. We are subject to changes in our cost of sales caused by movements in underlying commodity prices. We seek to hedge against this risk by using LTAs. See Part II, Item 7A., “Quantitative and Qualitative Disclosures about Market Risk—Commodity Price Risk” included in this Annual Report on Form 10-K.

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Selling, general and administrative

The principal components of our selling, general and administrative expenses are salaries and benefits for our office personnel, advertising and promotional expenses, product warranty expense, expenses relating to certain information technology systems and amortization of our intangible assets.

Engineering — research and development

We incur costs in connection with research and development programs that are expected to contribute to future earnings. Such costs are expensed as incurred.

Non-GAAP Financial Measures

We use Adjusted Earnings before Interest, Taxes, Depreciation, and Amortization (“EBITDA”) and Adjusted EBITDA as a percent of net sales to measure our operating profitability. We believe that Adjusted EBITDA and Adjusted EBITDA as a percent of net sales provide management, investors and creditors with useful measures of the operational results of our business and increase the period-to-period comparability of our operating profitability and comparability with other companies. Adjusted EBITDA as a percent of net sales is also used in the calculation of management’s incentive compensation program. The most directly comparable GAAP measure to Adjusted EBITDA and Adjusted EBITDA as a percent of net sales is Net income and Net income as a percent of net sales, respectively. Adjusted EBITDA is calculated as earnings before interest expense, net, income tax expense, amortization of intangible assets, depreciation of property, plant and equipment and other adjustments as defined by the Second Amended and Restated Credit Agreement dated as of March 29, 2019 as amended (the “Credit Agreement”), governing ATI's Term Loan. Adjusted EBITDA as a percent of net sales is calculated as Adjusted EBITDA divided by net sales.

We use Adjusted free cash flow to evaluate the amount of cash generated by our business that, after the capital investment needed to maintain and grow our business and certain mandatory debt service requirements, can be used for repayment of debt, stockholder distributions and strategic opportunities, including investing in our business. We believe that Adjusted free cash flow enhances the understanding of the cash flows of our business for management, investors and creditors. Adjusted free cash flow is also used in the calculation of management’s incentive compensation program. The most directly comparable GAAP measure to Adjusted free cash flow is Net cash provided by operating activities. Adjusted free cash flow is calculated as Net cash provided by operating activities after additions of long-lived assets.

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The following is a reconciliation of Net income and Net income as a percent of net sales to Adjusted EBITDA and Adjusted EBITDA as a percent of net sales and a reconciliation of Net cash provided by operating activities to Adjusted free cash flow:

(a)
Represents stock-based compensation expense (recorded in Cost of sales, Selling, general and administrative, and Engineering — research and development).

(b)
Represents gains (recorded in Other income (expense), net) related to investments in co-development agreements to expand our position in propulsion solution technologies.

(c)
Represents losses (gains) (recorded in Other income (expense), net) related to an investment in the common stock of Jing-Jin Electric Technologies Co. Ltd.

(d)
Represents losses (recorded in Other income (expense), net) on intercompany financing transactions for our India facility.

(e)
Represents expenses (recorded in Selling, general and administrative and Engineering — research and development) for earnouts related to our acquisition of Vantage Power Limited.

(f)
Represents a curtailment loss (recorded in Selling, general and administrative) for our European subsidiary's defined benefit pension plan.

(g)
Represents adjustments (recorded in Cost of sales) related to a 2018 to 2021 retirement incentive program for certain employees represented by the UAW pursuant to the UAW Local 933 collective bargaining agreement that was effective through November 2023.

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Results of Operations

The following table sets forth certain financial information for the years ended December 31, 2023 and 2022. The following table and discussion should be read in conjunction with the information contained in our consolidated financial statements and the notes thereto included in Part II, Item 8., of this Annual Report on Form 10-K.

Comparison of years ended December 31, 2023 and 2022

Net sales

Net sales for the year ended December 31, 2023 were $3,035 million compared to $2,769 million for the year ended December 31, 2022, an increase of 10%. The increase was principally driven by a $170 million, or 13%, increase in net sales in the North America On-Highway end market principally driven by strength in demand for Class 8 vocational and medium-duty trucks and price increases on certain products, a $108 million, or 18%, increase in net sales in the Service Parts, Support Equipment and Other end market principally driven by higher demand for global service parts, support equipment and aluminum die cast components and price increases on certain products, a $20 million, or 14%, increase in net sales in the Defense end market principally driven by increased demand for Wheeled and Tracked vehicle applications and a $14 million, or 3%, increase in net sales in the Outside North America On-Highway end market principally driven by price increases on certain products and the continued execution of our growth initiatives, partially offset by a $46 million, or 22%, decrease in Global Off-Highway net sales principally driven by lower demand in the energy sector, partially offset by higher demand in the mining and construction sectors outside of North America.

Cost of sales

Cost of sales for the year ended December 31, 2023 was $1,565 million compared to $1,472 million for the year ended December 31, 2022, an increase of 6%. The increase was principally driven by higher direct material and manufacturing expense commensurate with increased net sales and higher direct material costs.

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Gross profit

Gross profit for the year ended December 31, 2023 was $1,470 million compared to $1,297 million for the year ended December 31, 2022, an increase of 13%. The increase was principally driven by $155 million of price increases on certain products and $70 million related to increased net sales, partially offset by $36 million of higher manufacturing expense and $15 million of higher direct material costs. Gross profit as a percent of net sales for the year ended December 31, 2023 increased 160 basis points compared to the same period in 2022 principally driven by price increases on certain products and increased net sales, partially offset by increased cost of sales.

Selling, general and administrative

Selling, general and administrative expenses for the year ended December 31, 2023 were $357 million compared to $328 million for the year ended December 31, 2022, an increase of 9%. The increase was principally driven by $12 million of higher commercial activities spending, $8 million of higher incentive compensation expense and $9 million of higher product warranty expense.

Engineering — research and development

Engineering expenses for the year ended December 31, 2023 were $194 million compared to $185 million for the year ended December 31, 2022, an increase of 5%. The increase was principally driven by increased product initiatives spending.

Interest expense, net

Interest expense, net for the year ended December 31, 2023 was $107 million compared to $118 million for the year ended December 31, 2022, a decrease of 9%. The decrease was principally driven by higher interest income on cash equivalents, partially offset by $4 million of higher interest expense on ATI's Term Loan due to higher variable interest rates, net of the favorable impact from interest rate hedges.

Other income (expense), net

Other income (expense), net for the year ended December 31, 2023 was $15 million compared to ($21) million for the year ended December 31, 2022. The change was principally driven by $21 million of favorable change in marketable securities, $11 million of favorable foreign exchange and $6 million of favorable change associated with assets held in a rabbi trust, partially offset by $3 million of unfavorable change in technology-related investment gains.

Income tax expense

Income tax expense for the year ended December 31, 2023 was $154 million resulting in an effective tax rate of 19%, compared to $114 million of income tax expense and an effective tax rate of 18% for the year ended December 31, 2022. The increase in income tax expense was principally driven by increased taxable income.

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Liquidity and Capital Resources

We generate cash primarily from operations to fund our operating, investing and financing activities. Our principal uses of cash are operating expenses, capital expenditures, working capital needs, debt service, dividends on common stock, stock repurchases, and strategic growth initiatives, including investments, acquisitions and collaborations. Our ability to generate cash in the future and our future uses of cash are subject to general economic, financial, competitive, legislative, regulatory and other factors that may be beyond our control. We had total available cash and cash equivalents of $555 million and $232 million as of December 31, 2023 and 2022, respectively. Of the available cash and cash equivalents, $134 million was deposited in operating accounts and $421 million was invested in U.S. government backed securities as of December 31, 2023, compared to $121 million deposited in operating accounts and $111 million invested in U.S. government backed securities as of December 31, 2022.

As of December 31, 2023, the total of cash held by foreign subsidiaries was $88 million, the majority of which was at our subsidiaries located in China, the Netherlands, India and Japan. We manage our worldwide cash requirements considering available funds among the subsidiaries through which we conduct our business and the cost effectiveness with which those funds can be accessed. As a result, we do not currently anticipate that local liquidity restrictions will preclude us from funding our targeted expectations or operating needs with local resources.

We have not recognized any deferred tax liabilities associated with earnings in foreign subsidiaries, except for our subsidiary located in China, as they are intended to be permanently reinvested and used to support foreign operations or have no associated tax requirements. We have recorded a deferred tax liability of $3 million for the tax liability associated with the remittance of previously taxed income and unremitted earnings for our subsidiary located in China. The remaining deferred tax liabilities, if recorded, related to unremitted earnings that are indefinitely reinvested are not material.

Our liquidity requirements are significant, primarily due to our debt service requirements. As of December 31, 2023, we had $618 million of indebtedness associated with ATI’s Term Loan, $400 million of indebtedness associated with ATI’s 4.75% Senior Notes due October 2027 (“4.75% Senior Notes”), $500 million of indebtedness associated with ATI’s 5.875% Senior Notes due June 2029 (“5.875% Senior Notes”) and $1,000 million of indebtedness associated with ATI’s 3.75% Senior Notes due January 2031 (“3.75% Senior Notes” and, together with the 4.75% Senior Notes and 5.875% Senior Notes, the “Senior Notes”). Short-term and long-term debt service liquidity requirements consist of $2 million of minimum required quarterly principal payments on ATI’s Term Loan through its maturity date of March 2026 and periodic interest payments on ATI’s Term Loan and the Senior Notes. There are no required quarterly principal payments on the Senior Notes. Long-term debt service liquidity requirements also consist of the payment in full of any remaining principal balance of ATI’s Term Loan and the Senior Notes upon their respective maturity dates.

We made $7 million of principal payments on the Term Loan during each of the years ended December 31, 2023 and 2022. Our ability to make payments on and refinance our indebtedness and to fund planned capital expenditures and growth initiatives will depend on our ability to generate cash in the future.

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The Senior Secured Credit Facility provides for a $650 million Revolving Credit Facility, net of an allowance for up to $75 million in outstanding letter of credit commitments. As of December 31, 2023, we had $645 million available under the Revolving Credit Facility, net of $5 million in letters of credit. As of December 31, 2023, we had no amounts outstanding under the Revolving Credit Facility. If we have commitments outstanding on the Revolving Credit Facility at the end of a fiscal quarter, the Senior Secured Credit Facility requires us to maintain a specified maximum first lien net leverage ratio of 5.50x. Additionally, within the terms of the Senior Secured Credit Facility, a first lien net leverage ratio at or below 4.00x results in the elimination of excess cash flow payments on the Senior Secured Credit Facility for the applicable year. As of December 31, 2023, our first lien net leverage ratio was 0.06x. The Senior Secured Credit Facility also provides certain financial incentives based on our first lien net leverage ratio. A first lien net leverage ratio at or below 4.00x and above 3.50x results in a 25 basis point reduction to the applicable margin on the Revolving Credit Facility. A first lien net leverage ratio at or below 3.50x results in an additional 25 basis point reduction to the applicable margin on the Revolving Credit Facility. These reductions remain in effect as long as we achieve a first lien net leverage ratio at or below the related threshold.

In addition, the Credit Agreement includes, among other things, customary restrictions (subject to certain exceptions) on our ability to incur certain indebtedness, grant certain liens, make certain investments, engage in acquisitions, consolidations and mergers, declare or pay certain dividends, and repurchase shares of our common stock. The indentures governing the Senior Notes contain negative covenants restricting or limiting our ability to, among other things, incur or guarantee additional indebtedness, incur liens, pay dividends on, redeem or repurchase our capital stock, make certain investments, permit payment or dividend restrictions on certain of our subsidiaries, sell assets, engage in certain transactions with affiliates, and consolidate or merge or sell all or substantially all of our assets. As of December 31, 2023, we were in compliance with all covenants under the Senior Secured Credit Facility and indentures governing the Senior Notes.

Our credit ratings and outlook are reviewed periodically by Moody’s Investors Service, Inc. (“Moody’s”) and Fitch Ratings, Inc. (“Fitch”). As of December 31, 2023, our credit ratings from both Moody's and Fitch are shown in the table below:

We anticipate that our capital expenditures and cash income taxes in 2024 will be comparable to 2023.

Our Board of Directors has authorized us to repurchase up to $4,000 million of our common stock pursuant to the Repurchase Program. During 2023, we repurchased approximately $263 million of our common stock under the Repurchase Program. All of the repurchase transactions during 2023 were settled in cash during the same period. As of December 31, 2023, we had approximately $773 million available under the Repurchase Program.

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The following table shows our sources and uses of funds for the years ended December 31, 2023, 2022 and 2021 (dollars in millions):

Generally, cash provided by operating activities has been adequate to fund our operations. We have significant liquidity, including $555 million of cash and cash equivalents and $645 million available under the Revolving Credit Facility, net of $5 million in letters of credit, as of December 31, 2023. At this time, we believe cash provided by operating activities, cash and cash equivalents and borrowing capacity under the Revolving Credit Facility will be sufficient to meet our known and anticipated cash requirements for the next twelve months and thereafter.

Cash provided by operating activities

Operating activities for the year ended December 31, 2023 generated $784 million of cash compared to $657 million for the year ended December 31, 2022. The increase was principally driven by higher gross profit and lower operating working capital requirements, partially offset by higher cash income taxes.

Cash used for investing activities

Investing activities for the year ended December 31, 2023 used $129 million of cash compared to $183 million for the year ended December 31, 2022. The decrease was principally driven by a $42 million decrease in capital expenditures and $23 million in cash paid for business acquisitions during 2022 that did not reoccur in 2023, partially offset by $5 million of equity investments in 2023 and a $4 million decrease in proceeds from technology-related investments.

Cash used for financing activities

Financing activities for the year ended December 31, 2023 used $332 million of cash compared to $367 million for the year ended December 31, 2022. The decrease was principally driven by a $26 million increase in proceeds from the exercise of stock options and a $15 million decrease in stock repurchases under the Repurchase Program.

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Critical Accounting Estimates

The preparation of the consolidated financial statements in accordance with GAAP requires management to make estimates and assumptions that affect the reported amounts of some assets and liabilities and, in some instances, the reported amounts of net sales and expenses during the applicable reporting period. Differences between actual amounts and estimates are recorded in the period identified. Estimates can require a significant amount of judgment, and a different set of judgments could result in changes to our reported results. A summary of our critical accounting estimates is included below.

Revenue Recognition

Revenue recognition contains uncertainties because it requires management to make assumptions and to apply judgment to estimate the amount of sales incentives and provision for government price reductions. Distributor and customer sales incentives, consisting of allowances and other rebates, are estimated at the time of sale based upon history and experience and are recorded as a reduction to net sales. Incentive programs are generally product specific or region specific. Some factors used in estimating the cost of incentives include the number of transmissions that will be affected by the incentive program and the rate of acceptance of any incentive program. If the actual number of affected transmissions differs from this estimate, or if a different mix of incentives is actually paid, the impact on net sales would be recorded in the period that the change was identified. Assuming our current mix of sales incentives, a 10% change in sales incentives would correspondingly change our earnings by approximately $9 million.

Under the terms of certain previous U.S. government contracts, there were price reduction clauses and provisions for potential price reductions which were estimated at the time of sale based upon history and experience, and finalized after completion of U.S. government audits. Given our current price reduction reserve for government contracts, a 10% adjustment in our price reduction reserve would correspondingly change our earnings by approximately $5 million. Since 2014, Allison contracts with the U.S. Government have generally been firm, fixed price contracts and therefore have not required re-calculation of pricing based on cost principles.

Further information is provided in "Note 2. Summary of Significant Accounting Policies” of Notes to Consolidated Financial Statements included in Part II, Item 8., of this Annual Report on Form 10-K.

Goodwill and Other Intangible Assets

We have elected to perform our annual impairment tests for goodwill and indefinite-lived intangible assets on October 31 of every year using a multi-step impairment test. In Step 0, we have the option to evaluate various qualitative factors to determine the likelihood of impairment. If we determine that the fair value is more likely than not less than the carrying value, then we are required to perform Step 1. If we do not elect to perform Step 0, we can voluntarily proceed directly to Step 1. In Step 1, we perform a quantitative analysis to compare the fair value to our carrying value. If the fair value exceeds the carrying value, no impairment is recorded, and we are not required to perform further testing. If the carrying value exceeds fair value, we would record an impairment loss equal to the difference.

A qualitative assessment contains uncertainties because it requires management to make assumptions and to apply judgment to assess business changes, economic outlook, financial trends and forecasts, growth rates, credit ratings, equity ratings, discount rates, industry data and other relevant qualitative factors.

A quantitative analysis contains uncertainties because it is performed utilizing a discounted cash flow model which includes key assumptions, such as financial forecasts; net sales growth derived from market information, industry reports, marketing programs and future new product introductions; operating margin improvements derived

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from cost reduction programs and fixed cost leverage driven by higher sales volumes; and a risk-adjusted discount rate.

Goodwill represents the excess of purchase price paid over the fair value of net assets acquired. In accordance with the Financial Accounting Standards Board’s (“FASB”) authoritative accounting guidance on goodwill, we do not amortize goodwill but rather evaluate it for impairment on an annual basis, or more often if events or circumstances change that could cause goodwill to become impaired. Goodwill is tested for impairment at the reporting unit level, which is the same as our one operating and reportable segment. We do not aggregate any components into our reporting unit.

Goodwill impairment testing for 2023 was performed using the Step 0 analysis by assessing certain qualitative trends and factors. These trends and factors were compared to, and based on, the assumptions used in prior years. After reviewing the various qualitative factors mentioned above, our 2023 annual goodwill impairment test indicated that the fair value for the reporting unit more likely than not exceeded its carrying value, indicating no impairment.

Other intangible assets have both indefinite and finite useful lives. Intangible assets with indefinite useful lives are not amortized but are tested annually for impairment, or more often if events or circumstances change that could cause intangible assets with indefinite useful lives to become impaired. After reviewing the various qualitative factors mentioned above, our annual 2023 indefinite-lived intangible assets impairment tests, as of October 31, 2023, indicated that the fair value of our indefinite-lived intangible assets more likely than not exceeded their respective carrying values, indicating no impairment.

Intangible assets with finite lives are amortized over their estimated useful lives and reviewed for impairment when circumstances change that would create a triggering event. Customer relationships are amortized over the life in which expected benefits are to be consumed. The other remaining finite life intangibles are amortized on a straight-line basis over their useful lives. We evaluate the remaining useful life of the other intangible assets on a periodic basis to determine whether events or circumstances warrant a revision to the remaining useful life. Assumptions and estimates about future values and remaining useful lives of our intangible and other long-lived assets are complex and subjective. Such assumptions and estimates can be affected by a variety of factors, including external factors such as industry and economic trends, and internal factors, such as changes in our business strategy and internal forecasts. Although management believes the historical assumptions and estimates are reasonable and appropriate, different assumptions and estimates could materially impact our reported financial results. Further information is provided in "Note 6. Goodwill and Other Intangible Assets” of Notes to Consolidated Financial Statements included in Part II, Item 8., of this Annual Report on Form 10-K.

Impairment of Long-Lived Assets

The carrying value of long-lived assets is evaluated whenever events or circumstances indicate that the carrying value of a long-lived asset may not be recoverable. Events or circumstances that would result in an impairment review primarily include a significant change in the use of an asset, or the planned sale or disposal of an asset. The asset would be considered impaired when there is no future use planned for the asset or the future net undiscounted cash flows generated by the asset or asset group are less than its carrying value. An impairment loss would be recognized based on the amount by which the carrying value exceeds fair value.

Assumptions and estimates used to determine cash flows in the evaluation of impairment and the fair values used to determine the impairment are subject to a degree of judgment and complexity. Any changes to the assumptions and estimates resulting from changes in actual results or market conditions from those anticipated may affect the carrying value of long-lived assets and could result in an impairment charge.

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Warranty

Provisions for estimated expenses related to product warranties are made at the time products are sold. Warranty claims arise when a transmission fails while in service during the relevant warranty period. The warranty reserve is adjusted in Selling, general and administrative expense based on our current and historical warranty claims paid and associated repair costs. These estimates are established using historical information including the nature, frequency, and average cost of warranty claims and are adjusted as actual information becomes available. From time to time, we may initiate a specific field action program. As a result of the uncertainty surrounding the nature and frequency of specific field action programs, the liability for such programs is recorded when we commit to an action. We review and assess the liability for these programs on a quarterly basis. We also assess our ability to recover certain costs from our suppliers and record a receivable from the supplier when we believe a recovery is probable. Warranty costs may differ from those estimated if actual claim rates are higher or lower than our historical rates. Further information is provided in "Note 10. Product Warranty Liabilities” of Notes to Consolidated Financial Statements included in Part II, Item 8., of this Annual Report on Form 10-K, which contains a summary of the activity in our warranty liability account for 2023, 2022 and 2021, including adjustments to pre-existing warranties.

Pension and Post-retirement Benefit Plans

Pension and OPEB costs are based upon various actuarial assumptions and methodologies as prescribed by authoritative accounting guidance. These assumptions include discount rates, expected return on plan assets, health care cost trend rates, inflation, rate of compensation increases, population demographics, mortality rates and other factors. We review all actuarial assumptions on an annual basis.

A change in the discount rate can have a significant impact on determining our benefit obligations. Our current discount rate is determined by matching the plans’ projected cash flows to a yield curve based on long-term, fixed income debt instruments available as of the measurement date of December 31, 2023. The effect of a one percentage point decrease in the assumed discount rate would result in an increase in the December 31, 2023 defined benefit pension plans obligation of approximately $17 million. Similarly, a one percentage point decrease in the assumed discount rate would result in an increase in the December 31, 2023 OPEB obligation of approximately $7 million.

Further information is provided in "Note 15. Employee Benefit Plans” of Notes to Consolidated Financial Statements included in Part II, Item 8., of this Annual Report on Form 10-K, which contains our review on various actuarial assumptions.

Income Taxes

Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the expected future tax consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. The future tax benefits associated with operating loss and tax credit carryforwards are recognized as deferred tax assets. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. When releasing income tax effects from accumulated other comprehensive loss, we utilize the portfolio securities approach.

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The need to establish a valuation allowance against the deferred tax assets is assessed at least quarterly based on a more-likely-than-not realization threshold, in accordance with the FASB authoritative accounting guidance on income taxes. Appropriate consideration is given to all positive and negative evidence related to that realization. This assessment considers, among other matters, the nature, frequency and severity of recent losses, forecasts of future profitability, the duration of statutory carryforward periods, and experience with tax attributes expiring unused and tax planning alternatives. The weight given to these considerations depends upon the degree to which they can be objectively verified.

Further information on income taxes is provided in "Note 16. Income Taxes” of Notes to Consolidated Financial Statements included in Part II, Item 8., of this Annual Report on Form 10-K.

Business Combinations

We use the acquisition method to account for business combinations. The assets acquired and liabilities assumed are recorded at their respective estimated fair value at the date of acquisition. Any excess purchase price over the fair values of the acquired net assets is recorded as goodwill. Determining the fair values of assets acquired and liabilities assumed requires management's judgment and includes the use of estimates with respect to timing and amount of future cash flows, market rate assumptions, actuarial assumptions, appropriate discount rates and other relevant factors.

Recently Issued Accounting Pronouncements

Refer to "Note 2. Summary of Significant Accounting Policies” in Part II, Item 8., of this Annual Report on Form 10-K.

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