CONDUENT Inc (CNDT) FY 2022 MD&A

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following Management’s Discussion and Analysis (MD&A) is intended to provide a reader of our financial statements with a narrative from the perspective of management on our financial condition, results of operations, liquidity, and certain other factors that may affect our future results. Unless otherwise noted, transactions and other factors significantly impacting our financial condition, results of operations and liquidity are discussed in order of magnitude. Our MD&A is presented in six sections:

•Overview;

•Financial Information and Analysis of Results of Operations;

•Metrics;

•Capital Resources and Liquidity;

•Critical Accounting Estimates and Policies; and

•Recent Accounting Changes.

This MD&A is provided as a supplement to, and should be read in conjunction with, our Consolidated Financial Statements and the accompanying notes in this Form 10-K for the year ended December 31, 2022. This MD&A provides additional information about our operations, current developments, financial condition, cash flows and results of operations.

The year-over-year comparisons in this MD&A are as of and for the years ended December 31, 2022 and 2021, unless stated otherwise. The discussion of 2021 results and related year-over-year comparisons as of and for the years ended December 31, 2021 and 2020 are found in Item 7 of Part II of our Form 10-K for the year ended December 31, 2021.

Throughout the MD&A, we refer to various notes to our Consolidated Financial Statements which appear in Item 8 of this Form 10-K, and the information contained in such notes is incorporated by reference into the MD&A in the places where such references are made.

Overview

With revenues of $3.9 billion, we are a leading provider of business process services with expertise in transaction-intensive processing, analytics and automation. We serve as a trusted business partner in both the front office and back office, enabling personalized, seamless interactions on a massive scale that improve end-user experience.

Headquartered in Florham Park, New Jersey, we have a team of approximately 62,000 people as of December 31, 2022, servicing customers from service centers in 25 countries. In 2022, 10% of our revenue was generated outside the U.S.

Our reportable segments correspond to how we organize and manage the business and are aligned to the industries in which our clients operate. These three segments are:

•Commercial – Our Commercial segment provides business process services and customized solutions to clients in a variety of commercial industries. Across the Commercial segment, we operate on our clients’ behalf to deliver mission-critical solutions and services to reduce costs, improve efficiencies and enable revenue growth for our clients and their consumers and employees.

•Government – Our Government segment provides government-centric business process services to U.S. federal, state and local and foreign governments for public assistance, health services, program administration, transaction processing and payment services. The solutions in this segment help governments respond to changing rules for eligibility and increasing citizen expectations.

•Transportation – Our Transportation segment provides systems, support, and revenue-generating solutions to government transportation agency clients. We deliver mission-critical public safety, mobility and digital payment solutions that streamline operations, increase revenue and reduce congestion while creating safe, seamless travel experiences for consumers and have a positive impact on the environment.

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Significant 2022 Actions

•Disposition and Portfolio Review – On February 8, 2022, we closed a transaction with Symplr Software, Inc. to sell our Midas suite of patient safety, quality and advanced analytics solutions (Midas business) for cash consideration of $322 million resulting in a pre-tax gain of $166 million. The Midas business represented approximately $7 million, $70 million and $72 million of revenue in 2022, 2021 and 2020, respectively. Refer to Note 4 – Assets/Liabilities Held for Sale and Divestiture in the Consolidated Financial Statements for additional information. During the fourth quarter, we concluded our long-range planning processes which included a full evaluation of our portfolio of solutions and identified incremental opportunities to streamline the portfolio.

•New Business Signings – In 2022 we introduced a new primary signings metric Annual Contract Value (ACV), which provides more focus on the near-term revenue generation of new business signings as compared to the traditional view of Total Contract Value (TCV). This ACV metric has increased sequentially each quarter in 2022, totaling $724 million in 2022, an increase of 16.8% versus 2021 excluding the impact of Government stimulus payments.

•Strategic Growth Efforts – During the latter part of 2022, we dedicated a small number of senior associates with the mission to accelerate future revenue growth by selling existing solutions into new and adjacent markets and geographies. The results of this action are becoming visible, for example, by the collaboration with a major bank to launch a Digital Payments Hub delivering faster, easier, and more secure payments.

•Operational Service Levels – We continue to make significant improvements with our operational and technology service levels, and while we will always believe there is room for improvement in these areas, we have reached a standard consistent with the markets that we operate in. These operational improvements together with the significant progress being made in closing out major litigation cases, position us well with a solid foundation to embark on the next chapter of our journey.

Significant 2021 Actions

•Stabilizing Revenue – Revenue of $4,140 million for the year ended December 31, 2021 was a decline of 0.55%, a significantly improved trend compared with the prior year.

•Strong Net Annual Recurring Revenue (ARR) Activity results – In the fourth quarter of 2020, we introduced the Net ARR Activity metric, a trailing twelve-month metric that measures the revenue from recurring services provided to a client inclusive of all new business annual recurring revenue, notification of lost clients and contractual impacts to price and volume. We have seen steady positive growth in this metric from $60 million in the fourth quarter of 2020 to $128 million in the fourth quarter of 2021, an increase of 113%. This increase was driven by new business ARR signings of $402 million for the year ended December 31, 2021, an increase of 16% compared to that of the prior year, and stronger retention of existing clients.

•Debt Refinancing – On October 15,, 2021, we closed on a debt refinancing which extended our maturity profile. The debt refinancing transactions were as follows:

◦Term Loan A due 2026 in the amount of $265 million;

◦Term Loan B due 2028 in the amount of $515 million;

◦Senior Notes due 2029 in the amount of $520 million; and

◦Revolving Credit Facility maturing 2026 in the amount of $550 million.

Upon closing the debt refinancing, $100 million was borrowed under the new Revolving Credit Facility. The net proceeds of the new Term Loan A, Term Loan B, Senior Notes and $100 million of borrowing under the Revolving Credit Facility were used to repay the borrowings under the previous credit facilities that were outstanding on October 15, 2021. This $100 million was repaid on February 11, 2022. Refer to Note 11 – Debt to the Consolidated Financial Statements for definition of 2016 Credit Facilities and additional information on the debt refinancing.

•Global Labor Market Dynamics – To address the significant change in the labor market environment, we responded by strengthening our talent acquisition organization and processes and maintaining an appropriate mix of work-from-home and work-from-office roles, which has resulted in increasing hire rates and improved ratings on Comparably and Glassdoor.

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Macroeconomic and Geopolitical Uncertainty

Given the nature of our business and our global operations, the effects of global macroeconomic and geopolitical uncertainty, including COVID-19 pandemic related factors (as discussed in more detail below) could have a materially adverse effect on our business, results of operations and financial condition.

Financial Information

The section below provides a comparative discussion of our consolidated results of operations for the year ended December 31, 2022 and 2021. See Item 7. MD&A–Financial Information in our Annual Report on Form 10-K for the year ended December 31, 2021, for a comparative discussion of our consolidated results of operations between 2021 and 2020.

Revenue

Revenue for 2022 decreased 7%, compared to the prior year. This is primarily due to lower federal stimulus revenue in the Government segment, lost business from prior years, the impact of the disposition of the Midas business, as well as negative foreign exchange translation impact, partially offset by higher interest rates positively impacting our BenefitWallet business, and the ramp of new business.

Cost of Services (excluding depreciation and amortization)

Cost of services for 2022 decreased 4%, compared to the prior year, mainly driven by lost business from prior years, the disposition of the Midas business, increased operational efficiency and favorable foreign exchange translation impact. The decrease in cost was less than the decrease in revenue due to lower federal stimulus revenue which had a higher margin.

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Selling, General and Administrative (SG&A) (excluding depreciation and amortization)

SG&A for 2022 decreased 19%, compared to the prior year, driven by the recovery of $14 million of defense costs as part of the settlement with insurance carriers relating to the previously disclosed State of Texas matter, progress in our efficiency initiatives, most notably within shared technology infrastructure, as well as lower variable employee costs. The prior year also included $32 million of costs related to an abandonment of an internal project initiated in 2018. Refer to Note 6 – Land, Buildings, Equipment and Software, Net for additional information on the abandonment of the internal project and Note 16 – Contingencies and Litigation for additional information on the State of Texas matter.

Depreciation and Amortization

Depreciation and amortization for 2022 decreased 35%, compared to the prior year, primarily due to a portion of certain customer relationship intangible assets being fully amortized in the first quarter of 2022.

Restructuring and Related Costs

We engage in a series of restructuring programs related to downsizing our employee base, reducing our real estate footprint, exiting certain activities, outsourcing certain internal functions, consolidating our data centers and engaging in other actions designed to reduce our cost structure and improve productivity. The following are the components of our Restructuring and related costs:

__________

(1)Represents professional support costs associated with certain strategic transformation programs.

(2)Relates to approximate headcount reductions worldwide associated with Severance and related costs

Refer to Note 9 – Restructuring Programs and Related Costs to the Consolidated Financial Statements for additional information regarding our restructuring programs.

Interest Expense

Interest expense represents interest on long-term debt and the amortization of debt issuance costs. On October 15, 2021, we completed the refinancing of our previously outstanding debt, which extended the maturity profile of our debt. The increase in Interest expense for 2022, compared to the prior year, was driven primarily by higher interest rates on our refinanced credit facilities, partially offset by a lower total outstanding debt balance. Refer to Note 11 – Debt to the Consolidated Financial Statements for additional information.

Goodwill Impairment

The goodwill impairment for 2022 related to the write-down of the carrying value of the Commercial reporting unit. Refer to Note 8 – Goodwill and Intangible Assets, Net to the Consolidated Financial Statements for additional information.

(Gain) Loss on Divestitures and Transaction Costs

The divestiture of the Midas business in the first quarter of 2022 resulted in a pre-tax gain of $166 million. Additionally, professional fees and other costs related to certain consummated and non-consummated transactions considered by us are included in this financial statement line item.

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Litigation Settlements (Recoveries), Net

Litigation settlements (recoveries), net for 2022 primarily consisted of $24 million of insurance recoveries recorded in the first quarter of 2022 related to the previously disclosed State of Texas matter. Refer to Note 16 – Contingencies and Litigation to the Consolidated Financial Statements for additional information.

Other (Income) Expenses, Net

Other (income) expenses, net for 2022 and 2021 primarily includes interest income on cash investments and foreign currency transaction losses (gains). 2021 also included an impairment loss on an equity investment.

Income Taxes

The 2022 effective tax rate was (43.9)%, compared to (9.7)% for 2021. The 2022 rate was negative and lower than the U.S. statutory rate of 21% due to pre-tax book loss and an increase in taxes due to the geographic mix of income, and non-deductible expenses primarily driven by book and tax basis differences in the Midas divestiture goodwill and the Commercial reporting unit goodwill impairment. The 2021 rate was lower than the U.S. statutory rate of 21%, primarily due to the geographic mix of income, valuation allowances, non-deductible expenses and tax settlement adjustments, partially offset by tax credits.

Excluding the impact of amortization, restructuring, the divestiture of the Midas business, insurance recoveries, goodwill impairment and discrete tax items, the normalized effective tax rate for 2022 was 34.3%. The 2021 rate was 26.6% excluding the impact of amortization, restructuring and discrete tax items. The increase in the normalized effective tax rate is primarily due to the mix of book pre-tax income weighted more heavily in 2022 towards foreign jurisdictions with higher tax rates and losses in jurisdictions with valuation allowances.

In recent years, government agencies and global organizations have had an increased focus on the issues of taxation of multinational corporations. During 2021, following a framework agreement reached between almost all member countries of the Organization for Economic Co-operation and Development (OECD) the OECD released rules around global taxation of the digital services businesses and a global minimum tax rate, commonly referred to as Pillar 1 and Pillar 2 of the Base Erosion and Profit Shifting (BEPS) initiative, respectively. Pillar 1 addresses the broader challenge of a digitalized economy and focuses on the allocation of group profits among taxing jurisdictions based on a market-based concept rather than historical “permanent establishment” concepts. Pillar 1 is directed at companies with revenues greater than 20 billion Euro and is not applicable to Conduent. Pillar 2 addresses the remaining BEPS risk of profit shifting to entities in low-tax jurisdictions by introducing a global minimum tax rate and a proposed withholding tax on certain base eroding payments. Pillar 2 may have limited application to Conduent, but we do not anticipate a material impact based on current guidance. On December 15, 2022, EU member states unanimously adopted the Minimum Tax Directive of Pillar 2. Member states have until December 31, 2023 to transpose the Minimum Tax Directive into national legislation.

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Operations Review of Segments

Our financial performance is based on Segment Profit (Loss) and Segment Adjusted EBITDA for the following three segments:

•Commercial,

•Government, and

•Transportation.

Other includes our divestitures and our Student Loan business, which the Company exited in the third quarter of 2018.

Unallocated Costs includes IT infrastructure costs that are shared by multiple reportable segments, enterprise application costs and certain corporate overhead expenses not directly attributable or allocated to our reportable segments.

The section below provides a comparative discussion of our financial performance by segment between the years ended December 31, 2022 and 2021. See Item 7. MD&A - Operations Review of Segments in our Annual Report on Form 10-K for the year ended December 31, 2021 for a comparative discussion of our consolidated results of operations by segment between 2021 and 2020.

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Segment Performance Review

Commercial Segment

Revenue

Commercial revenue for 2022 decreased, compared to the prior year, due to the impact of our largest client normalizing to lower post pandemic call volumes, the merger of two of our clients resulting in lower volumes as well as unfavorable exchange rate movement, partially offset by higher interest rates positively impacting our BenefitWallet business, recognition of the revenue benefit associated with a minimum annual volume commitment contract with a large client and strong net new business ramp.

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Segment Profit and Adjusted EBITDA

Increases in the Commercial segment profit and adjusted EBITDA for 2022, compared to the prior year, were mainly driven by higher interest rates positively impacting our BenefitWallet business, recognition of the revenue benefit associated with a minimum annual volume commitment contract with a large client, increased operational efficiency and expense reductions resulting from progress in our efficiency initiatives more than offsetting the dynamics of a challenging labor market in certain geographies. Revenue mix also had a slightly negative impact on segment margin where we had strong signings in our Customer Experience Management service solution, which has slightly lower margins.

Government Segment

Revenue

Government revenue for 2022 decreased, compared to the prior year, primarily driven by significantly lower federal stimulus revenue, while increases in volume, price and new business substantially offset lost business from prior years.

Segment Profit and Adjusted EBITDA

Decreases in the Government segment profit and adjusted EBITDA for 2022, compared to the prior year, were mainly driven by lower Federal stimulus revenue.

Transportation Segment

Revenue

Transportation revenue for 2022 decreased, compared to the prior year, driven by unfavorable exchange rate movement, particularly the Euro, slower implementation of new business contracts, and a one-time revenue benefit in the prior year period.

Segment Profit and Adjusted EBITDA

Transportation segment profit and adjusted EBITDA for 2022 decreased, compared to the prior year, driven by a one-time item benefiting the prior year period, the impact of net new and lost business, as well as the impact of unfavorable exchange rate movement.

Other

Revenue, Segment Profit (Loss) and Adjusted EBITDA

The decline in revenue, segment profit and Adjusted EBITDA for 2022 was primarily due to the sale of the Midas business. The current year includes slightly more than one month of activity versus the prior year, which includes a full twelve months of activity.

Unallocated Costs

The decrease in segment loss is primarily due to a portion of the recovery of defense costs as part of the settlement with insurance carriers relating to the previously disclosed State of Texas and shareholder matters which was allocated to SG&A, progress with our efficiency initiatives and lower variable employee costs, as well as $32 million of costs related to the abandonment of an internal project recorded in the prior year.

Metrics

Signings

Signings are defined as estimated future revenues from contracts signed during the period, including renewals of existing contracts. TCV is the estimated total contractual revenue related to signed contracts. TCV signings is defined as estimated future revenues from contracts signed during the period, including renewals of existing contracts. Due to the inconsistency of when existing contracts end, quarterly and yearly comparisons are not a good measure of renewal performance. New business ACV is calculated as TCV divided by the contract term, in months, multiplied by 12 for an annual measure.

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For the year ended December 31, 2022, the Company signed $732 million of new business ACV, up 1% from the prior year, primarily due to strong signings in Government Healthcare Solutions and Customer Experience Management being partially offset by $106 million of federal stimulus signings in the prior year.

For the year ended December 31, 2022, the Company signed $1,887 million of new business TCV, representing a 11% increase compared to the prior year. Renewal TCV for the year ended December 31, 2022 was $2,477 million, a decrease of 13% compared to the prior year due to timing on renewals; however the renewal rate for the year ended December 31, 2022 was consistent with the prior year.

The amounts in the following table exclude the impact of divestitures.

___________

(1)New business ARR measures the revenue from recurring services provided to the client for any new business signing. ARR represents the recurring services provided to a customer with the opportunity for renewal at the end of the contract term.

(2)New business NRR measures the non-recurring revenue for any new business signing, including (i) signing value of any contract with term less than 12 months and (ii) signing value of project based revenue, not expected to continue long term.

(3)Adjusted to remove Midas new business signings. In addition, 2021 amounts have been revised to exclude a large client we no longer consider in these metrics.

The total new business pipeline at the end of December 31, 2022 and 2021 was $22.6 billion and $21.4 billion, respectively. Total new business pipeline is defined as total new business TCV pipeline of deals in all sell stages. This extends past the next twelve-month period to include total pipeline, excluding the impact of divested business as required.

Net ARR Activity

The Net ARR Activity metric is defined as Projected Annual Recurring Revenue for contracts signed in the prior 12 months, less the annualized impact of any client losses, contractual volume and price changes, and other known impacts for which the Company was notified in that same time period, which could positively or negatively impact results. The metric annualizes the net impact to revenue. Timing of revenue impact varies and may not be realized within the forward 12-month timeframe. The metric is for indicative purposes only. This metric excludes COVID-related volume impacts and non-recurring revenue signings. This metric is not indicative of any specific 12-month timeframe.

The Net ARR Activity metric for the trailing twelve months for each of the prior five quarters was as follows:

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Capital Resources and Liquidity

As of December 31, 2022 and 2021, total cash and cash equivalents were $582 million (of which approximately $111 million was cash in foreign locations) and $415 million (of which approximately $132 million was cash in foreign locations), respectively. We also have a $550 million Revolving Credit Facility for our various cash needs, of which none has been utilized for borrowings and $2 million has been utilized for letters of credit as of December 31, 2022. On February 11, 2022, we repaid the then-outstanding borrowing under the Revolving Credit Facility of $100 million.

As of December 31, 2022, there was a total of $1,282 million of outstanding borrowings under our Term Loan A, Term Loan B and Senior Notes, of which $18 million was due within one year. Refer to Note 11 – Debt to the Consolidated Financial Statements for additional information regarding our debt.

In February 2019, we reached a settlement agreement and release with the State of Texas (State) and the Texas Department of Health and Human Services, which was amended in May 2019 (Texas Agreement). Pursuant to the terms of the Texas Agreement, the Company was required to pay the State $236 million, of which $118 million was paid in 2019 and the remaining $118 million was paid in January 2020.

In order to provide financial flexibility and finance certain investments and projects, we may continue to utilize external financing arrangements. However, we believe that our cash on hand, projected cash flow from operations, sound balance sheet and our Revolving Credit Facility will continue to provide sufficient financial resources to meet our expected business obligations for at least the next twelve months.

Cash Flow Analysis

The following summarizes our cash flows for the two years ended December 31, 2022, as reported in our Consolidated Statements of Cash Flows in the accompanying Consolidated Financial Statements:

Operating Activities

The net decline in cash flow provided by operating activities of $99 million was primarily attributable to lower Adjusted EBITDA, increases in equipment to support new business in our Transportation segment, higher income tax payments and higher cash interest payments, partially offset by improved accounts receivable Days Sales Outstanding (DSO) and the insurance recovery related to the previously disclosed State of Texas matter.

Investing Activities

The increase in cash provided by investing activities of $315 million was primarily due to the proceeds from the divestiture of the Midas business, partially offset by slightly increased spending related to modernizing our infrastructure and productivity tools.

Financing Activities

Financing activities for 2022 primarily reflect the repayment of the $100 million borrowed under the Revolving Credit Facility, normal scheduled debt repayments and dividends on our Series A Preferred Stock. Financing activities for 2021 primarily reflect the net activity related to our 2021 debt refinancing, payment of the previously outstanding $34 million of Senior Notes due 2024 and dividends on our Series A Preferred Stock, partially offset by the $100 million borrowed from the Revolving Credit Facility.

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Sales of Accounts Receivable

The net impact from the sales of accounts receivable on net cash provided by (used in) operating activities for the years ended December 31, 2022, 2021 and 2020 was $54 million, $(10) million and $(22) million, respectively. The net impact from the sales of accounts receivable represents the difference between current and prior year fourth quarter accounts receivable sales adjusted for the effects of collections prior to the end of the year.

Financial Instruments

Refer to Note 12 – Financial Instruments to the Consolidated Financial Statements for additional information.

Material Cash Requirements from Contractual Obligations

We believe our balances of cash and cash equivalents, which totaled $582 million as of December 31, 2022, along with cash generated by operations and amounts available for borrowing under our Revolving Credit Facility, will be sufficient to satisfy our cash requirements over the next 12 months and beyond.

At December 31, 2022, our material cash requirements include the following contractual and other obligations.

Debt

As of December 31, 2022, we had total outstanding debt with floating and fixed rates totaling $1,335 million, of which $35 million was due within 12 months. Future interest payments associated with this debt, which has maturities through 2029, are forecast to be $543 million, of which $98 million is due within 12 months. Refer to Note 11 – Debt to the Consolidated Financial Statements for additional information.

Leases

In the normal course of business, we enter lease arrangements for certain equipment and facilities. As of December 31, 2022, total fixed lease payables were $271 million, of which $79 million was due within 12 months. Refer to Note 7 – Leases to the Consolidated Financial Statements for additional information.

Estimated Purchase Commitments

We have committed to purchasing certain materials and services to support our operations. The total of these commitments was $112 million as of December 31, 2022, of which $81 million is due within the next 12 months.

Additionally, subsequent to December 31, 2022, we have entered into certain long-term purchase commitments with a third-party technology vendor totaling approximately $309 million over the next 5 years, of which $62 million is due within the next 12 months.

Other Contingencies and Commitments

As more fully discussed in Note 16 – Contingencies and Litigation to the Consolidated Financial Statements, we are involved in a variety of claims, lawsuits, investigations and proceedings concerning: securities law; governmental entity contracting, servicing and procurement law; intellectual property law; employment law; the Employee Retirement Income Security Act (ERISA); and other laws and regulations. In addition, guarantees, indemnifications and claims may arise during the ordinary course of business from relationships with suppliers and customers. Nonperformance under a contract including a guarantee, indemnification or claim could trigger an obligation of the Company.

We determine whether an estimated loss from a contingency should be accrued by assessing whether a loss is deemed probable and can be reasonably estimated. Should developments in any of these areas cause a change in our determination as to an unfavorable outcome and result in the need to recognize a material accrual, or should any of these matters result in a final adverse judgment or be settled for significant amounts, they could have a material adverse effect on our results of operations, cash flows and financial position in the period or periods in which such change in determination, judgment or settlement occurs. Refer to Note 16 – Contingencies and Litigation to the Consolidated Financial Statements for additional information.

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Off-Balance Sheet Arrangements

As of December 31, 2022, we do not believe we have any off-balance sheet arrangements that have, or are reasonably likely to have, a material current or future effect on financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.

In addition, refer to the preceding discussion of the Company's contractual cash obligations and other commercial commitments and Note 16 – Contingencies and Litigation to the Consolidated Financial Statements for additional information regarding contingencies, guarantees and indemnifications.

Critical Accounting Estimates and Policies

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America (U.S. GAAP) requires us to make estimates and assumptions in certain circumstances that affect amounts reported in the accompanying Consolidated Financial Statements and notes thereto. In preparing our Consolidated Financial Statements, we have made our best estimates and judgments of certain amounts included in the Consolidated Financial Statements giving due consideration to materiality. However, application of these accounting policies involves the exercise of judgment and use of assumptions as to future uncertainties and, as a result, actual results could differ from these estimates. Senior management has discussed the development and selection of the critical accounting policies, estimates and related disclosures included herein with the Audit Committee of the Board of Directors. We consider these as critical to understanding our Consolidated Financial Statements, as their application places the most significant demands on management's judgment, since financial reporting results rely on estimates of the effects of matters that are inherently uncertain. In instances where different estimates could have reasonably been used, we disclose the impact of these different estimates on our operations. In certain instances, the accounting rules are prescriptive; therefore, it would not have been possible to reasonably use different estimates. Changes in assumptions and estimates are reflected in the period in which they occur. The impact of such changes could be material to our results of operations and financial condition in any quarterly or annual period.

Specific risks associated with these critical accounting policies are discussed in MD&A, where such policies affect our reported and expected financial results. For a detailed discussion of the application of these and other accounting policies, refer to Note 1 – Basis of Presentation and Summary of Significant Accounting Policies to the Consolidated Financial Statements.

Assets/Liabilities Held for Sale

We classify assets as held for sale in the period when the following conditions are met: (i) management, having the authority to approve the action, commits to a plan to sell the asset (disposal group); (ii) the asset (disposal group) is available for immediate sale in its present condition subject only to terms that are usual and customary for sales of such assets (disposal group); (iii) an active program to locate a buyer and other actions required to complete the plan to sell the asset (disposal group) have been initiated; (iv) the sale of the asset (disposal group) is probable, and transfer of the asset (disposal group) is expected to qualify for recognition as a completed sale within one year, except if events or circumstances beyond our control extend the period of time required to sell the asset (disposal group) beyond one year; (v) the asset (disposal group) is being actively marketed for sale at a price that is reasonable in relation to its current fair value; and (vi) actions required to complete the plan indicate that it is unlikely that significant changes to the plan will be made or that the plan will be withdrawn.

A long-lived asset (disposal group) that is classified as held for sale is initially measured at the lower of its carrying value or fair value less any costs to sell. Any loss resulting from this measurement is recognized in the period in which the held for sale criteria are met. Conversely, gains are not recognized on the sale of a long-lived asset (disposal group) until the date of sale.

The fair value of a long-lived asset (disposal group) less any costs to sell is assessed each reporting period it remains classified as held for sale and any subsequent changes are reported as an adjustment to the carrying value of the asset (disposal group), as long as the new carrying value does not exceed the carrying value of the asset at the time it was initially classified as held for sale. Upon determining that a long-lived asset (disposal group) meets the criteria to be classified as held for sale, the Company reports the assets and liabilities of the disposal group in the line items Assets held for sale and Liabilities held for sale, respectively, in the Consolidated Balance Sheets.

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On December 29, 2021, the Company signed a definitive agreement to sell its Midas Suite of Solutions (Midas business) to Symplr Software, Inc. This action was taken because of the Company's strategy to streamline its portfolio and its consideration of divestitures of select businesses to enhance shareholder and client value. As of December 31, 2021, the Company determined that this business met the conditions above to be classified as held for sale. Refer to Note 4 – Assets/Liabilities Held for Sale and Divestiture to the Consolidated Financial Statements for additional information.

Revenue Recognition

Application of the accounting principles in U.S. GAAP related to the measurement and recognition of revenue requires us to make judgments and estimates. Complex arrangements with nonstandard terms and conditions may require significant contract interpretation to determine the appropriate accounting. Refer to Note 1 – Basis of Presentation and Summary of Significant Accounting Policies and Note 2 – Revenue to the Consolidated Financial Statements for additional information regarding our revenue recognition policies.

Goodwill

Goodwill is not amortized but rather tested for impairment annually, or more frequently if an event or circumstance indicates that impairment may have been incurred. Events or circumstances that might indicate an interim evaluation is warranted include, among other things, unexpected adverse business conditions, macro and reporting unit specific economic factors, supply costs, unanticipated adverse events or conditions impacting revenues, cash flows or profitability, unanticipated competitive activities and acts by governments and courts. Refer to Note 1 – Basis of Presentation and Summary of Significant Accounting Policies and Note 8 – Goodwill and Intangible Assets, Net to the Consolidated Financial Statements for additional information regarding our goodwill policies.

Application of the interim and annual goodwill impairment test requires judgment, including the identification of reporting units, assignment of assets and liabilities to reporting units, assignment of goodwill to reporting units and the assessment of the fair value of each reporting unit. We currently have three reporting units which correlate to our three reportable segments: Commercial, Government and Transportation.

As of January 1, 2022, we underwent an internal reorganization in our Commercial reportable segment resulting in the previous four Commercial operating segments being combined into one single operating segment and reporting unit, led by a single segment manager.

We considered the reorganization in the first quarter of 2022 a triggering event and performed an interim qualitative goodwill impairment assessment of the reporting units before and after the reorganization and concluded no impairment existed at the time of the change.

Additionally, as part of the reorganization in the first quarter of 2022, certain clients were reassigned from the Government reportable segment to the Commercial reportable segment. This change resulted in less than 1% of goodwill being reallocated between the reporting units within the two reportable segments.

Our annual quantitative impairment test of goodwill was performed as of October 1, 2022.

Goodwill is tested for impairment using a qualitative assessment and/or a quantitative assessment. In our quantitative assessment, we estimate the fair value of each reporting unit by weighting the results from the Income Approach (discounted cash flow methodology) and Market Approach. The Income Approach utilizes a discounted cash flow analysis based upon the forecasted future business results of its reporting units. The Market Approach utilizes the guideline public company method. These valuation approaches require significant judgment and consider several factors that include, but are not limited to, expected future cash flows, growth rates and discount rates and comparable multiples from publicly traded companies in our industry. In addition, we are required to make certain assumptions and estimates regarding the current economic environment, industry factors and the future profitability of our businesses.

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When performing our discounted cash flow analysis for each reporting unit, we incorporate the use of projected financial information and discount rates that are developed using market participant-based assumptions. The cash-flow projections are based on three-year financial forecasts developed by management that include revenue and expense projections, restructuring activities, capital spending trends and investment in working capital to support anticipated revenue growth or other changes in the business. The selected discount rates consider the risk and nature of the respective reporting units' cash flows, appropriate capital structure and rates of return that market participants would require to invest their capital in our reporting units.

We believe these assumptions are appropriate and reflect our forecasted long-term business model and consider our historical results as well as the current economic environment and markets that we serve. The most significant assumptions used in the goodwill analysis relate to revenue growth rates, discount rate and long-term organic growth rate for the Commercial reporting unit and discount rates and long-term organic growth rates for the Government and Transportation reporting units.

Based on our quantitative assessments, we concluded that the fair value of our reporting units exceeded their respective carrying values and, accordingly, we did not record any goodwill impairment charge as a result of our annual quantitative impairment test of goodwill as of October 1, 2022. If we used different assumptions for revenue growth rates, discount rates or long-term organic growth rates in these annual assessments, our calculated fair values of our reporting units could be higher or lower which could result in a goodwill impairment.

After completing the annual impairment test, the Commercial reporting unit experienced lower than expected new customer contract signings (all subsequent to November 1, 2022), and an unexpected softening of the future business pipeline for certain solutions. Management believed these were driven by macroeconomic conditions present in the fourth quarter of 2022. The combination of these factors led management, in December 2022, to review the Commercial reporting unit and further evaluate the portfolio. These factors triggered the need for management to perform a goodwill impairment assessment for this reporting unit as of December 31, 2022, which resulted in a pre-tax impairment charge of $358 million.

In connection with the Commercial reporting unit impairment assessment, we first performed a recoverability assessment of long-lived assets and concluded that such assets were not impaired.

Income Taxes

We are subject to income taxes in the United States and numerous foreign jurisdictions. The determination of our provision for income taxes requires significant judgment, the use of estimates and the interpretation and application of complex tax laws. Our provision is based on nonrecurring events as well as recurring factors, including the taxation of foreign income. In addition, our provision will change based on discrete or other nonrecurring events such as audit settlements, tax law changes, changes in valuation allowances and other factors, that may not be predictable. If there is a significant unusual or one-time item recognized in our operating results, the taxes attributable to that item would be separately calculated and recorded at the same time as the unusual or one-time item.

We record the estimated future tax effects of temporary differences between the tax bases of assets and liabilities and amounts reported in our Consolidated Balance Sheets, as well as operating loss and tax credit carryforwards. We follow very specific and detailed guidelines in each tax jurisdiction regarding the recoverability of any tax assets recorded in our Consolidated Balance Sheets and provide valuation allowances as required. We regularly review our deferred tax assets for recoverability considering historical profitability, projected future taxable income, the expected timing of the reversals of existing temporary differences and tax planning strategies. Gross deferred tax assets of $239 million and $265 million had valuation allowances of $102 million and $82 million at December 31, 2022 and 2021, respectively.

We are subject to ongoing tax examinations and assessments in various jurisdictions. Accordingly, we may incur additional tax expense based upon our assessment of the more-likely-than-not outcomes of such matters. In addition, when applicable, we adjust previously recorded tax expense to reflect examination results. Our ongoing assessments of the more-likely-than-not outcomes of examinations and related tax positions require judgment and can materially increase or decrease our effective tax rate, as well as impact our operating results. Unrecognized tax benefits were $12 million, $23 million and $23 million at December 31, 2022, 2021 and 2020, respectively.

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Refer to Note 15 – Income Taxes to the Consolidated Financial Statements for additional information regarding deferred income taxes and unrecognized tax benefits.

Loss Contingencies

We are currently involved in various claims and legal proceedings. At least quarterly, we review the status of each significant matter and assess its potential financial exposure considering all available information including, but not limited to, the impact of negotiations, settlements, rulings, advice of legal counsel and other updated information and events pertaining to a particular matter. If the potential loss from any claim or legal proceeding is considered probable and the amount can be reasonably estimated, we accrue a liability for the estimated loss. The estimated losses are recorded within Litigation settlements (recoveries), net in the Company's income statement. Significant judgment is required in both the determination of probability and the determination as to whether an exposure is reasonably estimable. Because of uncertainties related to these matters, accruals are based only on the best information available at the time. As additional information becomes available, we reassess the potential liability related to pending claims and litigation and may revise estimates. These revisions in the estimates of the potential liabilities could have a material impact on the results of operations and financial position. Our policy is to expense legal defense costs related to such matters as incurred. These costs are recorded within Selling, general and administrative expenses in the Company's income statement. Any insurance recoveries for litigation settlements and defense costs are recorded when such recoveries are deemed probable and collectability is reasonably assured. Such recoveries are recorded in the same financial statement line as the related costs to which the recoveries relate.

Refer to Note 16 – Contingencies and Litigation to the Consolidated Financial Statements for additional information regarding loss contingencies.

Recent Accounting Changes

See Note 1 – Basis of Presentation and Summary of Significant Accounting Policies for information on accounting standards adopted during the current year, as well as recently issued accounting standards not yet required to be adopted and the expected impact of the adoption of these accounting standards. To the extent we believe the adoption of new accounting standards has had or will have a material impact on our consolidated results of operations, financial condition or liquidity, we also discuss the impact in the applicable section(s) of this MD&A.

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