Parker-Hannifin Corp (PH) FY 2021 MD&A

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

Forward-Looking Statements

Forward-looking statements contained in this and other written and oral reports are made based on known events and circumstances at the time of release, and as such, are subject in the future to unforeseen uncertainties and risks. Often but not always, these statements may be identified from the use of forward-looking terminology such as “anticipates,” “believes,” “may,” “should,” “could,” “potential,” “continues,” “plans,” “forecasts,” “estimates,” “projects,” “predicts,” “would,” “intends,” “expects,” “targets,” “is likely,” “will,” or the negative of these terms and similar expressions, and include all statements regarding future performance, earnings projections, events or developments. Neither the Company nor any of its respective associates or directors, officers or advisers, provides any representation, assurance or guarantee that the occurrence of the events expressed or implied in any forward-looking statements in this document will actually occur. The Company cautions readers not to place undue reliance on these statements. It is possible that the future performance and earnings projections of the Company, including its individual segments, may differ materially from past performance or current expectations, depending on economic conditions within its mobile, industrial and aerospace markets, and the Company’s ability to maintain and achieve anticipated benefits associated with announced realignment activities, strategic initiatives to improve operating margins, actions taken to combat the effects of the current economic environment, and growth, innovation and global diversification initiatives. Additionally, the actual impact of changes in tax laws in the United States and foreign jurisdictions and any judicial or regulatory interpretation thereof on future performance and earnings projections may impact the Company’s tax calculations. A change in the economic conditions in individual markets may have a particularly volatile effect on segment performance.

Among other factors which may affect future performance are:

•the impact of the global outbreak of COVID-19 and governmental and other actions taken in response;

•changes in business relationships with and purchases by or from major customers, suppliers or distributors, including delays or cancellations in shipments;

•disputes regarding contract terms or significant changes in financial condition, changes in contract cost and revenue estimates for new development programs and changes in product mix;

•ability to identify acceptable strategic acquisition targets; uncertainties surrounding timing, successful completion or integration of acquisitions and similar transactions, including the integration of Lord and Exotic and the proposed acquisition of Meggitt; and our ability to effectively manage expanded operations from the acquisitions of Lord and Exotic and the proposed acquisition of Meggitt;

•the ability to successfully divest businesses planned for divestiture and realize the anticipated benefits of such divestitures;

•the determination to undertake business realignment activities and the expected costs thereof and, if undertaken, the ability to complete such activities and realize the anticipated cost savings from such activities;

•ability to implement successfully capital allocation initiatives, including timing, price and execution of share repurchases;

•availability, limitations or cost increases of raw materials, component products and/or commodities that cannot be recovered in product pricing;

•ability to manage costs related to insurance and employee retirement and health care benefits;

•legal and regulatory developments and changes;

•additional liabilities relating to changes in tax rates or exposure to additional income tax liabilities;

•ability to enter into, own, renew, protect and maintain intellectual property and know-how;

•leverage and future debt service obligations;

•potential impairment of goodwill;

•compliance costs associated with environmental laws and regulations;

•potential labor disruptions;

•uncertainties surrounding the ultimate resolution of outstanding legal proceedings, including the outcome of any appeals;

•global competitive market conditions, including U.S. trade policies and resulting effects on sales and pricing;

•global economic factors, including manufacturing activity, air travel trends, currency exchange rates, difficulties entering new markets and general economic conditions such as inflation, deflation, interest rates, credit availability and changes in consumer habits and preferences;

•local and global political and economic conditions;

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•inability to obtain, or meet conditions imposed for, required governmental and regulatory approvals;

•government actions and natural phenomena such as floods, earthquakes, hurricanes and pandemics;

•increased cyber security threats and sophisticated computer crime; and

•success of business and operating initiatives.

The Company makes these statements as of the date of the filing of its Annual Report on Form 10-K for the year ended June 30, 2021, and undertakes no obligation to update them unless otherwise required by law.

Overview

The Company is a global leader in motion and control technologies. For more than a century, the Company has engineered the success of its customers in a wide range of diversified industrial and aerospace markets.

By aligning around our purpose, Enabling Engineering Breakthroughs that Lead to a Better Tomorrow, Parker is better positioned for the challenges and opportunities of tomorrow.

The Win Strategy 3.0 is Parker's business system that defines the goals and initiatives that drive growth, transformation and success. It works with our purpose, which is a foundational element of The Win Strategy, to engage team members and create responsible and sustainable growth. Our shared values shape our culture and our interactions with stakeholders and the communities in which we operate and live.

We believe many opportunities for profitable growth are available. The Company intends to focus primarily on business opportunities in the areas of energy, water, food, environment, defense, life sciences, infrastructure and transportation. We believe we can meet our strategic objectives by:

•Serving the customer and continuously enhancing its experience with the Company;

•Successfully executing The Win Strategy initiatives relating to engaged people, premier customer experience, profitable growth and financial performance;

•Maintaining a decentralized division and sales company structure;

•Fostering a safety-first and entrepreneurial culture;

•Engineering innovative systems and products to provide superior customer value through improved service, efficiency and productivity;

•Delivering products, systems and services that have demonstrable savings to customers and are priced by the value they deliver;

•Enabling a sustainable future by providing innovative technology solutions that offer a positive, global environmental impact and operating responsibly by reducing our energy use and emissions;

•Acquiring strategic businesses;

•Organizing around targeted regions, technologies and markets;

•Driving efficiency by implementing lean enterprise principles; and

•Creating a culture of empowerment through our values, inclusion and diversity, accountability and teamwork.

Our order rates provide a near-term perspective of the Company's outlook particularly when viewed in the context of prior and future order rates. The Company publishes its order rates on a quarterly basis. The lead time between the time an order is received and revenue is realized generally ranges from one day to 12 weeks for mobile and industrial orders and from one day to 18 months for aerospace orders.

In March 2020, the World Health Organization declared the outbreak of COVID-19 a pandemic. We continue to monitor the impact of the COVID-19 pandemic, which has negatively impacted demand and continues to create economic uncertainty. Disruption within the aerospace industry, which is facing the consequences of travel restrictions and considerably lower demand, was significant and is expected to continue. The extent to which our business and results of operations will be impacted by the pandemic over the long term will depend on future developments that cannot be accurately predicted at this time. These developments include the availability, acceptance, distribution and effectiveness of vaccines; new information concerning the severity and spread of COVID-19 and its variants; and actions by government authorities to contain the pandemic or mitigate its economic, public health and other impacts.

We continue to prioritize the safety of our team members. To minimize the spread of COVID-19 in our workplaces, we implemented rigorous prevention, screening and hygiene protocols. Additionally, we are strategically managing costs through reductions in discretionary spending. We continue to prioritize capital expenditures related to safety and strategic investments.

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At the same time, we are appropriately addressing the ongoing needs of our business so that we may continue to serve our customers.

The discussion below is structured to separately discuss the financial statements presented in Part II, Item 8 of this Annual Report on Form 10-K. The term "year" and references to specific years refer to the applicable fiscal year. Discussion of the 2019 financial statements is included in Part II, Item 7 of the Company's 2020 Annual Report on Form 10-K.

CONSOLIDATED STATEMENT OF INCOME

The Consolidated Statement of Income summarizes the Company's operating performance. The discussion below compares the operating performance in 2021 and 2020.

*Year ended June 30, 2020 amounts have been adjusted to reflect the change in inventory accounting method, as described in Notes 1 and 7 to the Consolidated Financial Statements.

Net sales in 2021 increased from the 2020 amount due to higher volume in both the Diversified Industrial International and Diversified Industrial North American businesses, partially offset by lower volume in the Aerospace Systems Segment. The effect of currency rate changes increased net sales in 2021 by approximately $257 million, of which $244 million was attributable to the Diversified Industrial International operations. Prior-year acquisitions contributed approximately $394 million in net sales during 2021.

Gross profit margin (calculated as net sales less cost of sales, divided by net sales) increased in 2021 primarily due to higher margins in all businesses. Gross profit margin in 2021 included net foreign currency transaction gains of $11 million and $10 million in 2021 and 2020, respectively. Gross profit margin also benefited from the absence of acquisition-related expenses, which were included in cost of sales in 2020, of $69 million. Cost of sales included business realignment and acquisition integration charges of $35 million in 2021 compared to $60 million in 2020.

Selling, general and administrative expenses ("SG&A") decreased eight percent in 2021 primarily due to benefits from lower discretionary spending and wage and salary expense resulting from actions taken in response to business conditions resulting from the COVID-19 pandemic. During 2021, SG&A also benefited from the absence of acquisition-related expenses of $119 million, which were incurred in 2020. These benefits were partially offset by higher intangible asset amortization expense related to prior-year acquisitions and higher stock compensation expense. SG&A also included business realignment and acquisition integration charges of $23 million and $38 million in 2021 and 2020, respectively.

Interest expense in 2021 decreased due to both lower interest rates and lower average debt outstanding.

Other (income), net included the following:

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Gain on disposal of assets in 2021 primarily consists of a gain of $101 million on the sale of land. In 2020, it includes gains of $12 million on the sale of real estate, partially offset by net losses on divestitures and asset sales and writedowns.

Effective tax rate in 2021 was higher than 2020 primarily due to an overall decrease in discrete tax benefits.

BUSINESS SEGMENT INFORMATION

The Business Segment information presents sales and operating income on a basis that is consistent with the manner in which the Company's various businesses are managed for internal review and decision-making.

Diversified Industrial Segment

The Diversified Industrial Segment operations experienced the following percentage changes in net sales:

The above presentation reconciles the percentage changes in net sales of the Diversified Industrial Segment reported in accordance with U.S. GAAP to percentage changes in net sales adjusted to remove the effects of acquisitions made within the prior four fiscal quarters as well as the effects of currency exchange rates (a non-GAAP measure). The effects of acquisitions and currency exchange rates are removed to allow investors and the Company to meaningfully evaluate the percentage changes in net sales on a comparable basis from period to period.

Sales in 2021 for the Diversified Industrial North American operations increased 3.4 percent from 2020. Acquisitions increased sales by $188 million, and the effect of currency exchange rates increased sales by approximately $8 million. Excluding acquisitions and the effect of currency rate changes, sales in 2021 for the Diversified Industrial North American operations increased 0.4 percent from prior-year levels reflecting higher demand from distributors and end users in the refrigeration, cars and light truck, farm and agriculture and life sciences markets, partially offset by a decrease in end-user demand in the oil and gas and general industrial machinery markets.

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Sales in the Diversified Industrial International operations increased 17.3 percent in 2021. Acquisitions increased sales by approximately $136 million in 2021. The effect of currency rate changes increased sales by $244 million, reflecting the weakening of the U.S. dollar primarily against currencies in the Eurozone countries, China and the United Kingdom. Excluding acquisitions and the effect of currency rate changes, sales in 2021 for the Diversified Industrial International operations increased 8.9 percent from 2020 levels primarily due to higher demand from distributors and end users in both the mobile and industrial markets. During 2021, the Asia Pacific region, Europe, and Latin America accounted for approximately 60 percent, 26 percent, and 14 percent, respectively, of the increase in sales.

Within the Asia Pacific region, the increase in sales was primarily due to higher demand from distributors and end users in the construction equipment, semiconductor, cars and light truck, general industrial machinery, engine and life sciences markets, partially offset by a decrease in end-user demand in the oil and gas market.

Within Europe, the increase in sales was primarily due to higher demand from distributors and end users in the construction equipment, heavy-duty truck and power generation markets, partially offset by a decrease in end-user demand in the general industrial machinery, oil and gas and marine markets.

Within Latin America, the increase in sales was primarily due to higher demand from distributors and end users in the farm and agriculture, construction equipment, cars and light truck and heavy-duty truck markets, partially offset by a decrease in end-user demand in the oil and gas market.

Operating margins in 2021 increased in both the Diversified Industrial North American and International operations primarily due to higher sales volume and benefits from overall cost reductions, including lower discretionary spending, wage and salary reductions, current and prior-year restructuring actions in response to business conditions resulting from the COVID-19 pandemic, the absence of acquisition-related expenses, and productivity improvements.

The following business realignment and acquisition integration charges are included in Diversified Industrial North America and Diversified Industrial International operating income:

During 2021, business realignment charges primarily include actions taken to address the impact of COVID-19 on our business, but also include charges related to the Company’s simplification initiative. The simplification initiative is aimed at reducing organizational and process complexity and is being implemented by operating units around the world. During 2020, business realignment charges primarily include charges related to the Company’s simplification initiative, but also include permanent workforce reductions to address the impact of COVID-19 on our business. Acquisition integration charges relate to the 2020 acquisition of Lord.

The majority of the Diversified Industrial International business realignment and acquisition integration charges were incurred in Europe. We anticipate that cost savings realized from the workforce reduction measures taken during 2021 will increase operating income for 2022 by approximately one percent in both the Diversified Industrial North American and International operations. In 2022, we expect to continue to take actions necessary to structure appropriately the operations of the Diversified Industrial Segment. These actions are expected to result in approximately $40 million in business realignment and acquisition integration charges in 2022. However, continually changing business conditions could impact the ultimate costs we incur.

The increase in Diversified Industrial Segment backlog in 2021 was primarily due to orders exceeding shipments in both the North American and International businesses, with each business accounting for approximately 50 percent of the change. Within the International business, this increase in backlog was primarily related to orders exceeding shipments in both Europe and the Asia Pacific region. Backlog consists of written firm orders from a customer to deliver products and, in the case of blanket purchase orders, only includes the portion of the order for which a schedule or release date has been agreed to with the customer. The dollar value of backlog is equal to the amount that is expected to be billed to the customer and reported as a sale.

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Aerospace Systems Segment

Sales in 2021 were lower than the 2020 level primarily due to lower volume in the commercial OEM and aftermarket businesses due to the market conditions as a result of COVID-19. This decrease was partially offset by higher volume in the military OEM and aftermarket businesses as well as a $71 million increase in sales from prior-year acquisitions.

Operating margin decreased in 2021 primarily due to lower sales volume in the commercial OEM and aftermarket businesses and lower aftermarket profitability. Lower sales volume and aftermarket profitability were partially offset by lower engineering development expenses, overall cost reductions, lower business realignment and acquisition integration charges and the benefits from such actions.

The disruption in the aerospace industry due to the COVID-19 pandemic has been significant and we have taken actions necessary to structure appropriately the operations of the Aerospace Systems Segment. We do not currently intend to incur significant additional business realignment and acquisition integration charges in 2022. However, continually changing business conditions could impact the ultimate costs we incur. We anticipate that cost savings realized from the workforce reduction measures taken during 2021 will increase segment operating income for 2022 by approximately two percent.

The increase in backlog in 2021 was primarily due to orders exceeding shipments in the military OEM business, partially offset by shipments exceeding orders in the military aftermarket and commercial OEM and aftermarket businesses. Backlog consists of written firm orders from a customer to deliver products and, in the case of blanket purchase orders, only includes the portion of the order for which a schedule or release date has been agreed to with the customer. The dollar value of backlog is equal to the amount that is expected to be billed to the customer and reported as a sale.

Corporate general & administrative expenses

Corporate general and administrative expenses increased slightly in 2021 primarily due to increases in stock compensation expense, deferred compensation expense and charitable contributions. These increases were partially offset by benefits from lower discretionary spending and wage and salary expense as a result of actions taken in response to business conditions resulting from the COVID-19 pandemic.

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Other (income) expense (in the Business Segment Information)

*Year ended June 30, 2020 amounts have been adjusted to reflect the change in inventory accounting method, as described in Notes 1 and 7 to the Consolidated Financial Statements.

Foreign currency transaction primarily relates to the impact of changes in foreign exchange rates on cash, marketable securities and other investments and intercompany transactions. Prior-year acquisition expenses primarily relate to the acquisitions of Lord and Exotic. Gain on disposal of assets in 2021 primarily consists of a gain of $101 million on the sale of land. In 2020, it includes gains of $12 million on the sale of real estate, partially offset by net losses on divestitures and asset sales and writedowns..

CONSOLIDATED BALANCE SHEET

The Consolidated Balance Sheet shows the Company's financial position at year end, compared with the previous year end. This discussion provides information to assist in assessing factors such as the Company's liquidity and financial resources.

*Year ended June 30, 2020 amounts have been adjusted to reflect the change in inventory accounting method, as described in Notes 1 and 7 to the Consolidated Financial Statements.

Cash (comprised of cash and cash equivalents and marketable securities and other investments) includes $467 million and $726 million held by the Company's foreign subsidiaries at June 30, 2021 and 2020, respectively. The Company does not permanently reinvest certain foreign earnings. The distribution of these earnings could result in non-federal U.S. or foreign taxes. All other undistributed foreign earnings remain permanently reinvested. Refer to Note 5 to the Consolidated Financial Statements in Part II, Item 8 of this Annual Report on Form 10-K for further discussion.

Trade accounts receivable, net are receivables due from customers for sales of product. Days sales outstanding relating to trade receivables for the Company was 50 days in 2021 and 54 days in 2020. We believe that our receivables are collectible and appropriate allowances for credit losses have been recorded.

Inventories as of June 30, 2021 increased by $127 million (which includes an increase of $41 million from the effect of foreign currency translation). After consideration of the effect of foreign currency translation, inventories increased primarily due to an increase in the Diversified Industrial Segment, partially offset by a decrease in the Aerospace Systems Segment. Days supply of inventory on hand was 75 days in 2021 and 89 days in 2020.

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Notes payable and long-term debt payable within one year decreased from 2020 primarily due to the repayment of commercial paper notes outstanding. Refer to Note 9 to the Consolidated Financial Statements in Part II, Item 8 of this Annual Report on Form 10-K for further discussion.

Long-term debt decreased from 2020 primarily due to the repayment of term loans. Refer to Note 10 to the Consolidated Financial Statements in Part II, Item 8 of this Annual Report on Form 10-K for further discussion.

Shareholders' equity activity during 2021 included a decrease of $100 million related to share repurchases, an increase of $664 million related to pensions and postretirement benefits resulting from investment gains on plan assets and an increase of $328 million related to foreign currency translation adjustments.

CONSOLIDATED STATEMENT OF CASH FLOWS

The Consolidated Statement of Cash Flows reflects cash inflows and outflows from the Company's operating, investing and financing activities.

A summary of cash flows follows:

Cash flows from operating activities in 2021 reflects an increase in net income of $545 million and an increase of $12 million from cash provided by working capital items. We remain focused on managing our inventory and other working capital requirements.

Cash flows from investing activities in 2021 includes net proceeds from the sale of land of approximately $111 million. Cash flows from investing activities in 2020 includes $5,076 million of acquisition-related activity. It also includes $121 million of proceeds from the redemption of company-owned life insurance investments associated with the Company's deferred compensation programs as well as proceeds of $44 million related to the settlement of a cross-currency swap.

Cash flows from financing activities in 2021 includes net commercial paper repayments of $723 million and term loan repayments of $1,210 million. Cash flows from financing activities in 2020 includes proceeds from the issuance of the $925 million and $800 million term loans and the repayment of approximately $740 million of long-term debt. Refer to Note 10 to the Consolidated Financial Statements in Part II, Item 8 of this Annual Report on Form 10-K for further discussion. The Company repurchased 0.3 million common shares for $100 million during 2021 compared to the repurchase of 0.8 million common shares for $147 million in 2020.

Dividends have been paid for 284 consecutive quarters, including a yearly increase in dividends for the last 65 years. The current annual dividend rate is $4.12 per common share.

Our goal is to maintain an investment-grade credit profile. The rating agencies periodically update our credit ratings as events occur. At June 30, 2021, the long-term credit ratings assigned to the Company's senior debt securities by the credit rating agencies engaged by the Company were as follows:

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We continue to actively monitor our liquidity position and working capital needs and prioritize capital expenditures related to safety and strategic investments. The Company remains in a stable overall capital resources and liquidity position that is adequate to meet its projected needs. In March 2020, the Company suspended the share repurchase program in response to business uncertainty resulting from the COVID-19 pandemic. During February 2021, the Company reinitiated the share repurchase program and repurchased shares totaling $100 million during the remainder of the fiscal year.

The Company has a line of credit totaling $2,500 million through a multi-currency revolving credit agreement with a group of banks, all of which was available as of June 30, 2021. The credit agreement expires in September 2024; however, the Company has the right to request a one-year extension of the expiration date on an annual basis, which request may result in changes to the current terms and conditions of the credit agreement. Advances from the credit agreement can be used for general corporate purposes, including acquisitions, and for the refinancing of existing indebtedness. The credit agreement requires the payment of an annual facility fee, the amount of which is dependent upon the Company’s credit ratings. Although a lowering of the Company’s credit ratings would increase the cost of future debt, it would not limit the Company’s ability to use the credit agreement nor would it accelerate the repayment of any outstanding borrowings. Refer to Note 9 to the Consolidated Financial Statements in Part II, Item 8 of this Annual Report on Form 10-K for further discussion.

The Company is currently authorized to sell up to $2,500 million of short-term commercial paper notes. There were no outstanding commercial paper notes as of June 30, 2021, and the largest amount of commercial paper notes outstanding during the last quarter of 2021 was $203 million.

The Company’s credit agreements and indentures governing certain debt securities contain various covenants, the violation of which would limit or preclude the use of the credit agreements for future borrowings, or might accelerate the maturity of the related outstanding borrowings covered by the indentures. Based on the Company’s rating level at June 30, 2021, the most restrictive financial covenant provides that the ratio of debt to debt-shareholders' equity cannot exceed 0.65 to 1.0. At June 30, 2021, the Company's debt to debt-shareholders' equity ratio was 0.44 to 1.0. We are in compliance and expect to remain in compliance with all covenants set forth in the credit agreement and indentures.

On August 2, 2021, the Company announced that it reached an agreement on the terms of a recommended cash acquisition of the entire issued and to be issued ordinary share capital of Meggitt for 800 pence per share, or approximately £6,308 million. We intend to fund the proposed acquisition with cash and new debt. The proposed acquisition remains subject to customary closing conditions, including regulatory clearances and approval by Meggitt’s shareholders.

In connection with the proposed acquisition, the Company entered into a bridge credit agreement (the "Bridge Credit Agreement") on August 2, 2021. Under the Bridge Credit Agreement, lenders are committed to provide senior, unsecured financing in the aggregate principal amount of £6,524 million. Any borrowings made under the Bridge Credit Agreement would mature 364 days from the initial funding date. The commitments are intended to be drawn to finance the proposed acquisition of Meggitt only to the extent that we do not arrange for alternative financing prior to closing.

Contractual Obligations - The total amount of gross unrecognized tax benefits, including interest, for uncertain tax positions was $119 million at June 30, 2021. Payment of these obligations would result from settlements with worldwide taxing authorities. Due to the difficulty in determining the timing of the settlements, these obligations are not included in the following summary of the Company's fixed contractual obligations. References to Notes are to the Notes to the Consolidated Financial Statements in Part II, Item 8 of this Annual Report on Form 10-K.

OFF-BALANCE SHEET ARRANGEMENTS

The Company does not have off-balance sheet arrangements.

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CRITICAL ACCOUNTING POLICIES

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America ("GAAP") requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. The policies discussed below are considered by management to be more critical than other policies because their application places the most significant demands on management's judgment.

Revenue Recognition - Revenues are recognized when control of performance obligations, which are distinct goods or services within the contract, is transferred to the customer. Control is transferred when the customer has the ability to direct the use of and obtain the benefits from the goods or services. A majority of our revenues are recognized at a point in time when control is transferred to the customer, which is generally at the time of shipment. However, a portion of our revenues are recognized over time if the customer simultaneously receives control as we perform work under a contract, if the customer controls the asset as it is being produced, or if the product has no alternative use and we have a contractual right to payment.

For contracts where revenue is recognized over time, we use the cost-to-cost, efforts expended or units of delivery method depending on the nature of the contract, including length of production time. The estimation of costs and efforts expended requires judgment on the part of management due to the duration of the contractual agreements as well as the technical nature of the products involved. Adjustments to these estimates are made on a consistent basis and a contract reserve is established when the estimated costs to complete a contract exceed the expected contract revenues.

When there are multiple performance obligations within a contract, the transaction price is allocated to each performance obligation based on its standalone selling price. The primary method used to estimate a standalone selling price is the price observed in standalone sales to customers for the same product or service. Revenue is recognized when control of the individual performance obligations is transferred to the customer.

We consider the contractual consideration payable by the customer and assesses variable consideration that may affect the total transaction price. Variable consideration is included in the estimated transaction price when there is a basis to reasonably estimate the amount, including whether the estimate should be constrained in order to avoid a significant reversal of revenue in a future period. These estimates are based on historical experience, anticipated performance under the terms of the contract and our best judgment at the time.

Impairment of Goodwill and Long-Lived Assets - We test goodwill for impairment at the reporting unit level on an annual basis and between annual tests whenever events or circumstances indicate the carrying value of a reporting unit may exceed its fair value. Our six reporting units are equivalent to our operating segments. As quoted market prices are not available for our reporting units, determining whether an impairment occurred requires the valuation of the respective reporting unit, which is estimated using both income-based and market-based valuation methods. The income-based valuation method utilizes a discounted cash flow model which requires several assumptions, including future sales growth and operating margin levels as well as assumptions regarding future industry-specific market conditions. Each reporting unit regularly prepares discrete operating forecasts and uses these forecasts as the basis for the assumptions in the discounted cash flow analysis. Within the discounted cash flow models, the Company uses a discount rate, commensurate with its cost of capital but adjusted for inherent business risks, and an appropriate terminal growth factor. The market-based valuation performed for each reporting unit includes an analysis consisting of market-adjusted multiples based on key data points for guideline public companies. We also reconcile the estimated aggregate fair value of our reporting units resulting from these procedures to our overall market capitalization.

At December 31, 2020, the Company performed its annual goodwill impairment test for each of its six reporting units. The results of this test indicated the fair value substantially exceeded carrying value for all reporting units. We continually monitor our reporting units for impairment indicators and update assumptions used in the most recent calculation of a reporting unit's fair value as appropriate. We did not identify any events or circumstances during 2021 that required performance of an interim impairment test.

Long-lived assets held for use, which primarily includes finite-lived intangible assets and property, plant and equipment, are evaluated for impairment whenever events or circumstances indicate that the undiscounted net cash flows to be generated by their use over their expected useful lives and eventual disposition are less than their carrying value. The long-term nature of these assets requires the estimation of their cash inflows and outflows several years into the future and only takes into consideration technological advances known at the time of the impairment test. During 2021, the Company did not record any material impairment related to long-lived assets.

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Pensions - The annual net periodic expense and benefit obligations related to the Company's defined benefit plans are determined on an actuarial basis. This determination requires critical assumptions regarding the discount rate, long-term rate of return on plan assets, increases in compensation levels and amortization periods for actuarial gains and losses. Assumptions are determined based on Company data and appropriate market indicators and are evaluated each year as of the plans' measurement date. Changes in the assumptions to reflect actual experience as well as the amortization of actuarial gains and losses could result in a material change in the annual net periodic expense and benefit obligations reported in the financial statements.

For the Company's domestic qualified defined benefit plan, a 50 basis point change in the assumed long-term rate of return on plan assets is estimated to have an $18 million increase in annual pension expense and a 50 basis point decrease in the discount rate is estimated to increase annual pension expense by $27 million. As of June 30, 2021, $707 million of past years' net actuarial losses related to the Company's domestic qualified defined benefit plan are subject to amortization in the future. These losses will generally be amortized over approximately seven years and will negatively affect earnings in the future. Any actuarial gains experienced in future years will help reduce the effect of the net actuarial loss amortization. Further information on pensions is provided in Note 12 to the Consolidated Financial Statements in Part II, Item 8 of this Annual Report on Form 10-K.

Income Taxes - Significant judgment is required in determining the Company's income tax expense and in evaluating tax positions. Deferred income tax assets and liabilities have been recorded for the differences between the financial accounting and income tax basis of assets and liabilities. Factors considered by the Company in determining the probability of realizing deferred income tax assets include forecasted operating earnings, available tax planning strategies and the time period over which the temporary differences will reverse. The Company reviews its tax positions on a regular basis and adjusts the balances as new information becomes available. For those tax positions where it is more likely than not that a tax benefit will be sustained, the largest amount of tax benefit with a greater than 50 percent likelihood of being realized upon examination by a taxing authority that has full knowledge of all relevant information will be recorded. For those income tax positions where it is not more likely than not that a tax benefit will be sustained, no tax benefit has been recognized in the Consolidated Financial Statements. Further information on income taxes is provided in Note 5 to the Consolidated Financial Statements in Part II, Item 8 of this Annual Report on Form 10-K.

Loss Contingencies - The Company has a number of loss exposures incurred in the ordinary course of business such as environmental claims, product liability and litigation reserves. Establishing loss accruals for these matters requires management's estimate and judgment with regards to risk exposure and ultimate liability or realization. We review these loss accruals periodically and make adjustments to reflect the most recent facts and circumstances.

RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

Recently issued accounting pronouncements are described in Note 1 to the Consolidated Financial Statements, included in Part II, Item 8 of this Annual Report on Form 10-K.

In November 2020, the SEC issued Final Rule Release No. 33-10890, Management’s Discussion and Analysis, Selected Financial Data, and Supplementary Financial Information. This rule, which became effective on February 10, 2021, amended certain SEC disclosure requirements in order to modernize, simplify and enhance certain financial disclosure requirements in Regulation S-K. Specifically, the amendments eliminate the requirement for Selected Financial Data, streamline the requirement to disclose Supplementary Financial Information, and amend Management's Discussion and Analysis. The final rule is applicable for fiscal years ending on or after August 9, 2021, however, early adoption on an Item-by-Item basis is permitted after February 10, 2021. We early adopted the amendments to two items resulting in the elimination of Item 301, Selected Financial Data, from Part II, Item 6 of this report and the omission of Regulation S-K Item 302(a), Supplementary Financial Information, from the notes to our consolidated financial statements in Part II, Item 8 of this report.

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