Note 1:   Basis of Presentation and Summary of Significant Account Policies

The unaudited interim financial statements as of and for the threesix months ended September 30,December 31, 2017 have been prepared by The L.S. Starrett Company (the “Company”) in accordance with accounting principles generally accepted in the United States of America for interim financial reporting.  Accordingly, they do not include all of the information and notes required by generally accepted accounting principles for complete financial statements.  These unaudited financial statements, which, in the opinion of management, reflect all adjustments (including normal recurring adjustments) necessary for a fair presentation, should be read in conjunction with the financial statements and notes thereto included in the Company’s Annual Report on Form 10-K10-K for the year ended June 30, 2017.  Operating results are not necessarily indicative of the results that may be expected for any future interim period or for the entire fiscal year.

The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires management to make judgments, assumptions and estimates that affect amounts reported in the consolidated financial statements and accompanying notes.  Note 2 to the Company’s Consolidated Financial Statements included in the Annual Report on Form 10-K10-K for the year ended June 30, 2017 describes the significant accounting policies and methods used in the preparation of the consolidated financial statements.

Note 2: Recent Accounting Pronouncements

In May 2014, the FASB issued a new standard related to “Revenue from Contracts with Customers” which amends the existing accounting standards for revenue recognition. The standard requires entities to recognize revenue when it transfers promised goods or services to customers in an amount that reflects the consideration the entity expects to be entitled to in exchange for those goods or services. This standard is applicable for fiscal years beginning after December 15,2017 and for interim periods within those years. Earlier application will be permitted only as of annual reporting periods beginning after December 15, 2016, including interim reporting periods within that reporting period. The Company expects to adopt this standard on a modified retrospective basis for its fiscal year beginning July 1,2018.

The Company primarily sells goods and recognizes revenues at point of sale or delivery, which will not change under the new standard. However, a full assessment of the new standard’s impact on all the Company’s revenue streams ahead of its implementation in the next fiscal year is still in process.

In February 2016, the FASB issued ASU No. 2016-02,2016-02, “Leases (Topic 842)842)”.  The ASU requires that organizations that lease assets recognize assets and liabilities on the balance sheet for the rights and obligations created by those leases.  The ASU will affect the presentation of lease related expenses on the income statement and statement of cash flows and will increase the required disclosures related to leases.  This ASU is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years, with early adoption permitted.  The Company is currently evaluating the impact of ASU No. 2016-022016-02 on its consolidated financial statements.  It is expected that a key change upon adoption will be the balance sheet recognition of leased assets and liabilities and that any changes in income statement recognition will not be material.

InOctober 2016, the FASB issued ASU No. 2016-16,2016-16, "Income Taxes (Topic 740)740): Intra-Entity Transfers of Assets Other Than Inventory", which is intended to improve the accounting for the income tax consequences of intra-entity transfers of assets other than inventory. This update removes the current exception in GAAP prohibiting entities from recognizing current and deferred income tax expenses or benefits related to transfer of assets, other than inventory, within the consolidated entity. The current exception to defer the recognition of any tax impact on the transfer of inventory within the consolidated entity until it is sold to a third party remains unaffected. The amendments in this update are effective for public entities for annual reporting periods beginning after December 15, 2017. Early adoption is permitted. The adoption of ASU No. 2016-162016-16 is not expected to have a material impact on the Company’s consolidated financial statements.

In January 2017, the FASB issued ASU No. 2017-01,2017-01, "Business Combinations (Topic 805)805) - Clarifying the Definition of a Business", with the objective to assist entities with evaluating whether transactions should be accounted for as acquisitions (or disposals) of assets versus businesses. The amendments in ASU 2017-012017-01 provide a screen to determine when a set of assets and activities is not a business. The screen requires that when substantially all of the fair value of the gross assets acquired (or disposed of) is concentrated in a single identifiable asset or a group of similar identifiable assets, the set is not a business. This screen is expected to reduce the number of transactions that need to be further evaluated. If the screen is not met, the amendments in ASU 2017-012017-01 (i) require that to be considered a business, a set of assets and liabilities acquired must include, at a minimum, an input and a substantive process that together significantly contribute to the ability to create output; and (ii) remove the evaluation of whether a market participant could replace missing elements. The amendments in this ASU are effective for annual and interim periods beginning after December 15, 2017 and should be applied prospectively. Early adoption is permitted for transactions for which the acquisition date occurs before the issuance date of ASU 2017-01, 2017-01,only when the transaction has not been reported in financial statements that have been issued or made available for issuance. The adoption of ASU No. 2017-012017-01 is not expected to have a material impact on the Company’s consolidated financial statements.

In January 2017, the FASB issued ASU No. 2017-04,2017-04, "Intangibles-Goodwill and Other (Topic 350)350): Simplifying the Test for Goodwill Impairment". Under the new guidance, if a reporting unit's carrying value amount exceeds its fair value, an entity will record an impairment charge based on that difference. The impairment charge will be limited to the amount of goodwill allocated to that reporting unit. The standard eliminates the requirement to calculate goodwill impairment using Step 2, which calculates anyan impairment charge by comparing the implied fair value of goodwill with its carrying amount. The standard does not change the guidance on completing Step 1 of the goodwill impairment test. The amendments in this ASU are effective for annual and interim periods beginning after December 15, 2019 and should be applied prospectively for annual and any interim goodwill impairment tests. Early adoption is permitted for entities for interim or annual goodwill impairment tests performed on testing dates after January 1, 2017. The Company is currently evaluating the impact of the update on ourits consolidated financial statements.

Note 3:  Stock-based Compensation

On September 5, 2012, the Board of Directors adopted The L.S. Starrett Company 2012 Long Term Incentive Plan (the “2012 Stock Plan”). The 2012 stock plan was approved by shareholders on October 17, 2012, and the material terms of its performance goals were recently re-approved by shareholders at the Company’s Annual Meeting held on October 18, 2017. The 2012 Stock Plan permits the granting of the following types of awards to officers, other employees and non-employee directors: stock options; restricted stock awards; unrestricted stock awards; stock appreciation rights; stock units including restricted stock units; performance awards; cash-based awards; and awards other than previously described that are convertible or otherwise based on stock. The 2012 Stock Plan provides for the issuance of up to 500,000 shares of common stock.

Options granted vest in periods ranging from one year to three years and expire ten years after the grant date. Restricted stock units (“RSU”) granted generally vest from one year to three years. Vested restricted stock units will be settled in shares of common stock. As of September 30,December 31, 2017, there were 20,000 stock options and 145,735153,235 restricted stock units outstanding. In addition, there were 292,100284,600 shares available for grant under the 2012 Stock Plan as of September 30,December 31, 2017.

For stock option grants the fair value of each grant is estimated at the date of grant using the Binomial Options pricing model. The Binomial Options pricing model utilizes assumptions related to stock volatility, the risk-free interest rate, the dividend yield, and employee exercise behavior. Expected volatilities utilized in the model are based on the historic volatility of the Company’s stock price. The risk free interest rate is derived from the U.S. Treasury Yield curve in effect at the time of the grant. The expected life is determined using the average of the vesting period and contractual term of the options (Simplified Method).

No stock options were granted during the threesix months ended September 30,December 31, 2017 and 2016.

The weighted average contractual term for stock options outstanding as of September 30,December 31, 2017 was 5.255 years.  The aggregate intrinsic value of stock options outstanding as of September 30,December 31, 2017 was negligible.less than $0.1 million. Stock options exercisable as of September 30,December 31, 2017 were 20,000.In recognizing stock compensation expense for the 2012 Stock Incentive Plan, management has estimated that there will be no forfeitures of options.

The Company accounts for stock options and RSU awards by recognizing the expense of the grant date fair value ratably over vesting periods generally ranging from one year to three years. The related expense is included in selling, general and administrative expenses. 

There were 54,50062,000 RSU awards with a fair value of $7.09$7.22 per RSU granted during the threesix months ended September 30,December 31, 2017. There were 14,400 RSUs settled during the threesix months ended September 30,December 31, 2017.  The aggregate intrinsic value of RSU awards outstanding as of September 30,December 31, 2017 was $1.3$1.3 million. As of September 30,December 31, 2017 all vested awards had been issued and settled.

On February 5, 2013, the Board of Directors adopted The L.S. Starrett Company 2013 Employee Stock Ownership Plan (the “2013“2013 ESOP”). The purpose of the plan is to supplement existing Company programs through an employer funded individual account plan dedicated to investment in common stock of the Company, thereby encouraging increased ownership of the Company while providing an additional source of retirement income.  The plan is intended as an employee stock ownership plan within the meaning of Section 4975 (e) (7)(7) of the Internal Revenue Code of 1986, as amended. U.S. employees who have completed a year of service are eligible to participate.

Compensation expense related to all stock based plans for the threesix month periods ended September 30,December 31, 2017 and 2016 was $0.1$0.2 million, and $0.1$0.2 million respectively.  As of September 30,December 31, 2017, there was $1.6$1.6 million of total unrecognized compensation costs related to outstanding stock-based compensation arrangements. Of this cost $1.1$1.4 million relates to performance based RSU grants that are not expected to be awarded. The remaining $0.5$0.2 million is expected to be recognized over a weighted average period of 1.92.0 years.

Note 4:   Inventories

In July 2015, the FASB issued ASU No. 2015-11,2015-11, "Inventory (Topic 330)330): Simplifying the Measurement of Inventory." Previous to the issuance of this ASU, ASC 330 required that an entity measure inventory at the lower of cost or market. ASU 2015-112015-11 specifies that “market” is defined as “net realizable value,” or the estimated selling price in the ordinary course of business, less reasonably predictable costs of completion, disposal, and transportation. This ASU is effective for fiscal years, and for interim periods within those fiscal years, beginning after December 15, 2016. Application is to be applied prospectively with earlier application permitted as of the beginning of an interim or annual reporting period. The adoption of ASU No. 2015-112015-11 did not have a material impact on our consolidated financial statements.

Inventories consist of the following (in thousands):

LIFO inventories were $8.58.5 million and $7.7$7.7 million at September 30,December 31, 2017 and June 30, 2017, respectively, such amounts being approximately $26.3$26.4 million and $26.2$26.2 million, respectively, less than if determined on a FIFO basis.  The use of LIFO, as compared to FIFO, resulted in a $0.1$0.2 million increase in cost of sales for the threesix months ended September 30,December 31, 2017 compared to no material changea $0.5 million decrease in cost of sales for the threesix months ended September 30, 2016.December 31, 2016.

Note 5: Business Acquisition

In fiscal 2010, the Company entered into an agreement with a private software company to invest $1.5$1.5 million in exchange for a 36% equity interest therein. In the third quarter of fiscal 2017, the CompanyCompany entered into a new agreement to invest an additional $3.6$3.6 million for an additional 64% of equity in the company. The Company paid $1.8$1.8 million in cash at closing and is obligated to pay an additional $1.8$1.8 million in cash three years subsequent to closing (discounted to $1.6$1.6 million on the purchase date). In addition, the agreement provides for the former owners to receive a 30% share of operating profits of the business over the next three years so long as they remain employed by the Company.Company. The Company has accrued for such profit sharing as an expense based on results of operations since the date of acquisition.

The acquisition has been accounted for as a business combination and the financial results of the company have been included in our consolidated financial statements since the date of acquisition. Under the acquisition method of accounting, the purchase price was allocated to net tangible and intangible assets based upon their estimated fair values as of the acquisition date.

The table below presents the allocation of the purchase price to the acquired net assets (in thousands):

Pro-forma financial information has not been presented for this acquisition because it is not considered material to the Company’s financial position or results of operations.

Note 6:   Goodwill and Intangible Assets

The Company’s acquisition of Bytewise in 2011 and the private software company in 2017 resulted in the recognition of goodwill totaling $4.67$4.67 million. TheUnder ASU 2011-08, the Company performedis required, on a qualitative analysisset date, to annually assess its goodwill in accordance with ASU 2011-08 for its October 1, 2016 annual assessment of Bytewise goodwill (commonly referredorder to as “Step Zero”). From a qualitative perspective, in evaluatingdetermine whether or notit iswas more likely than not that the fair value of the reporting unit exceedsunit’s goodwill exceeded its respective carrying amount, relevant events and circumstances were taken into account,amount. For Bytewise, this date was October 1, 2017. The Company performed a quantitative analysis in accordance with greater weight assignedASU 2011-08 for its annual assessment (commonly referred to events and circumstances that most affect the fair value or the carrying amounts of its assets. Items that were considered included, but were not limited to, the following: macroeconomic conditions, industry and market conditions, cost factors, overall financial performance and changes in management or key personnel. After assessing these and other factors the Company determined that it was more likely than not thatas “Step One”).

Determining the fair value of a reporting unit is subjective and requires the use of significant estimates and assumptions. With the assistance of an independent third-party valuation specialist, the Company estimates the fair value using an income approach based on the present value of future cash flows. The Company believes this approach yields the most appropriate evidence of fair value. The Company also utilizes the comparable company multiples method and market transaction fair value method to validate the fair value amount obtained using the income approach. The key assumptions utilized in the discounted cash flow model includes estimates of future cash flows from operating activities offset by estimated capital expenditures of the reporting unit, the estimated terminal value for the reporting unit, a discount rate based on a weighted average cost of capital, overall economic conditions, and an assessment of current market capitalization. Any unfavorable material changes to these key assumptions could potentially impact the Company’s fair value determinations.

Under the quantitative analysis, the 2017 fair value assessment of the Bytewise reporting unitgoodwill exceeded itsthe carrying amount as of October 1, 2016. by approximately 81.1%. Therefore no goodwill impairment was determined to exist. If future results significantly vary from current estimates, related projections, or business assumptions in the future due to changes in industry or market conditions, the Company may be required to record impairment charges.

The Company has yet to determineset the date at February 1^st, 2018, to test the annual impairment of the reporting unit goodwill for the software company purchased in February 2017; however, no events or circumstances have occurred which would indicate that the unit’s goodwill may be impaired and needs to be tested other than annually.

Amortizable intangible assets consist of the following (in thousands):

Amortizable intangible assets are being amortized on a straight-line basis over the period of expected economic benefit.

The estimated useful lives of the intangible assets subject to amortization range between 5 years for software development and 20 years for some trademark and trade name assets.

The estimated aggregate amortization expense for the remainder of fiscal 2018 and for each of the next five years and thereafter, is as follows (in thousands):

Note 7:  Pension and Post-retirement Benefits

The Company has two defined benefit pension plans, one for U.S. employees and another for U.K. employees.   The U.K. plan was closed to new entrants in fiscal 2009.  The Company has a postretirement medical and life insurance benefit plan for U.S. employees. The Company also has defined contribution plans.  

On December 21, 2016, the Company amended the U.S. defined benefit pension plan to freeze benefit accruals effective December 31, 2016. Consequently, the Plan will be closed to new participants and current participants will no longer earn additional benefits after December 31, 2016.

The amendment of the defined benefit pension plan triggered a pension curtailment which required a remeasurementre-measurement of the Plan's obligation as of December 31, 2016. The remeasurementre-measurement resulted in a decrease in the benefit obligation of approximately $6.9$6.9 million primarily due to an increase in the discount rate from 3.77% to 4.31%, with an additional $4.2$4.2 million decrease resulting from the impact of the curtailment. These reductions in the Plan’s benefit obligation were recorded as other comprehensive income, net of taxes.

Net periodic benefit costs for all of the Company's defined benefit pension plans consist of the following (in thousands):

Note 8:   Debt

Debt is comprised of the following (in thousands):

The Company amended its Loan and Security Agreement, which includes a Line of Credit and a Term Loan, in January 2015 with changes that took effect on2015. April 25, 2015.  Borrowings under the Line of Credit may not exceed $23.0$23.0 million.  The Line of Credit expires on April 30, 2018 and has an interest rate of LIBOR plus 1.5%.  The effective interest rate on the Line of Credit under the Loan and Security Agreement for the threesix months ended September 30,December 31, 2017 and 2016 was 3.1% and 2.4%, respectively. Since the expiration date of the loan agreement ison December 31, 2017 was within the current fiscal year, the Line of Credit has been classified as short term. As of September 30,December 31, 2017, $9.9$11.9 million was outstanding on the Line of Credit.

Availability under the Line of Credit is subject to a borrowing base comprised of accounts receivable and inventory.  The Company believes that the borrowing base will consistently produce availability under the Line of Credit in excess of $23.0 million. A 0.25% commitment fee is charged on the unused portion of the Line of Credit.

The obligations under the Credit Facility are unsecured. In the event of certain triggering events, such obligations would become secured by the assets of the Company’s domestic subsidiaries. A triggering event occurs when the Company fails to achieve any of the financial covenants noted below in consecutive quarters.

The material financial covenants of the amended Loan and Security Agreement are: 1) funded debt to EBITDA, excluding non-cash and retirement benefit expenses (“maximum leverage”), not to exceed 2.25 to 1.00,2) annual capital expenditures not to exceed $15.0 million, 3) maintain a Debt Service Coverage Rate of a minimum of 1.25 to 1.00, and 4) maintain consolidated cash plus liquid investments of not less than $10.0 million at any time.  As of December 31, 2017, the Company was not in compliance with the funded debt to EBITDA ratio, as the Company’s ratio rose to 2.58 to 1.00. This event of noncompliance was the result of the combination of lower than anticipated second quarter operating profits and the addition of the new short-term loans in Brazil.  Additionally, the Company was also not in compliance with one of its non-financial covenants related to these additional borrowings. The Company has received a waiver for both of these non-compliances, and expects to be able to meet these covenants in future periods.

On January 30, 2018, the Company executed an amendment to its Loan and Security Agreement to extend the Line of Credit through April 30, 2021. The agreement was scheduled to expire on April 30, 2018.  The amended agreement maintains the previous line of $23.0 million and the same loan covenants.

On November 22, 2011, in conjunction with the Bytewise acquisition, the Company entered into a $15.5$15.5 million term loan (the “Term Loan”) under the then existing Loan and Security Agreement.  The Term Loan is a ten year loan bearing a fixed interest rate of 4.5% and is payable in fixed monthly payments of principal and interest of $160.6 thousand.$160,640.  The Term Loan had a balance of $7.3$6.9 million at September 30,December 31, 2017.

In December 2017, the Company’s Brazilian subsidiary entered into two short-term loans with local banks in order to support the Company’s strategic initiatives. The material financial covenantsloans backed by the entity’s US dollar denominated export receivables were made with Santander Bank and Bradesco Bank and totaled $3.5 million. The Santander loan of $1.5 million has a term of 180 days and a rate of 4.19% and the amended LoanBradesco loan of $2.0 million has a term of 360 days and Security Agreement are: 1) funded debt to EBITDA, excluding non-cash and retirement benefit expenses (“maximum leverage”), not to exceed 2.25 to 1.00, 2) annual capital expenditures not to exceed $15.0 million, 3) maintain a Debt Service Coverage Raterate of a minimum of 1.25 to 1.00, and 4) maintain consolidated cash plus liquid investments of not less than $10.0 million at any time.  The Company was in compliance with all debt covenants as of September 30, 2017.4.75%.

Note 10:  Contingencies

The Company is involved in certain legal matters which arise in the normal course of business. These matters are not expected to have a material impact on the Company’s financial condition, results of operations or cash flows.