Penford (PENX) 10-K 2011 FY Annual report

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-K

(Mark One)

x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the Fiscal Year Ended August 31, 2011

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from              to             

Commission File Number 0-11488

Penford Corporation

(Exact name of registrant as specified in its charter)

Washington	91-1221360
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)
7094 S. Revere Parkway Centennial, Colorado	80112-3932
(Address of Principal Executive Offices)	(Zip Code)

Registrant’s telephone number, including area code: (303) 649-1900

Securities registered pursuant to Section 12(b) of the Act:

Title of Each Class	Name of Each Exchange on Which Registered
Common Stock, $1.00 par value	The NASDAQ Global Market

Securities registered pursuant to Section 12(g) of the Act: None

Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  ¨    No  x

Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes  ¨    No  x

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for at least the past 90 days.    Yes  x    No  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ¨    No  ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  x

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definition of “accelerated filer” and “large accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one).

Large accelerated filer	¨	Accelerated filer	x	Non-accelerated filer  ¨	Smaller reporting company	¨
				(Do not check if a smaller reporting company)

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

The aggregate market value of the Registrant’s Common Stock held by non-affiliates of the Registrant as of February 28, 2011, the last business day of the Registrant’s second quarter of fiscal 2011, was approximately $64.6 million based upon the last sale price reported for such date on The NASDAQ Global Market. For purposes of making this calculation, Registrant has assumed that all the outstanding shares were held by non-affiliates, except for shares held by Registrant’s directors and officers and by each person who owns 10% or more of the outstanding Common Stock. However, this does not necessarily mean that there are not other persons who may be deemed to be affiliates of the Registrant.

The number of shares of the Registrant’s Common Stock outstanding as of November 3, 2011 was 11,346,601.

Documents Incorporated by Reference

Portions of the Registrant’s definitive Proxy Statement relating to the 2012 Annual Meeting of Shareholders are incorporated by reference into Part III of this Form 10-K.

PENFORD CORPORATION

FISCAL YEAR 2011 FORM 10-K ANNUAL REPORT

TABLE OF CONTENTS

		Page
	PART I
Item 1.	Business		3
Item 1A.	Risk Factors		9
Item 1B.	Unresolved Staff Comments		13
Item 2.	Properties		14
Item 3.	Legal Proceedings		14
Item 4.	Reserved		15
	PART II
Item 5.	Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchasers of Equity Securities		15
Item 6.	Selected Financial Data		17
Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		19
Item 7A.	Quantitative and Qualitative Disclosures About Market Risk		31
Item 8.	Financial Statements and Supplementary Data		33
Item 9.	Changes in and Disagreements with Accountants on Accounting and Financial Disclosure		70
Item 9A.	Controls and Procedures		70
Item 9B.	Other Information		70
	PART III
Item 10.	Directors, Executive Officers and Corporate Governance		71
Item 11.	Executive Compensation		71
Item 12.	Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters		71
Item 13.	Certain Relationships and Related Transactions, and Director Independence		72
Item 14.	Principal Accountant Fees and Services		72
	PART IV
Item 15.	Exhibits and Financial Statement Schedules		72
	Signatures		73
	Exhibit Index		74

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PART I

Item 1:  Business

Description of Business

Penford Corporation (which, together with its subsidiary companies, is referred to herein as “Penford” or the “Company”) is a developer, manufacturer and marketer of specialty natural-based ingredient systems for food and industrial ingredient applications, including fuel grade ethanol. The Company’s strategically-located manufacturing facilities in the United States provide it with broad geographic coverage of its target markets. The Company has significant research and development capabilities, which are used in understanding the complex chemistry of carbohydrate-based materials and in development applications to address customer needs.

Penford is a Washington corporation originally incorporated in September 1983. The Company commenced operations as a publicly-traded company on March 1, 1984.

Penford operates in two business segments, Industrial Ingredients and Food Ingredients. Each of the Company’s businesses utilizes the Company’s carbohydrate chemistry expertise to develop starch-based ingredients for value-added applications that improve the quality and performance of customers’ products. Financial information about Penford’s segments and geographic areas is included in Note 19 to the Consolidated Financial Statements. Additional information on Penford’s two business segments follows:

- Industrial Ingredients, which in fiscal years 2011, 2010 and 2009 generated approximately 74%, 72% and 73%, respectively, of Penford’s revenue, is a supplier of chemically modified specialty starches to the paper and packaging industries. Through a commitment to research and development, Industrial Ingredients develops customized product applications that help its customers realize improved manufacturing efficiencies and advancements in product performance. Industrial Ingredients has specialty processing capabilities for a variety of modified starches. Specialty products for industrial applications are designed to improve the strength and performance of customers’ products and efficiencies in the manufacture of coated and uncoated paper and paper packaging products. These starches are principally ethylated (chemically modified with ethylene oxide), oxidized (treated with sodium hypochlorite) and cationic (carrying a positive electrical charge). Ethylated and oxidized starches are used in coatings and as binders, providing strength and printability to fine white, magazine and catalog paper. Cationic and other liquid starches are generally used in the paper-forming process in paper production, providing strong bonding of paper fibers and other ingredients.

The Company’s Industrial Ingredients segment also produces and sells fuel grade ethanol from its facility in Cedar Rapids, Iowa. Ethanol production gives the Company the ability to select an additional output choice to capitalize on changing industry conditions and selling opportunities. Sales of ethanol in fiscal years 2011, 2010 and 2009 were 45%, 37% and 29%, respectively, of this segment’s reported revenue.

- Food Ingredients, which in fiscal years 2011, 2010 and 2009 generated approximately 26%, 28% and 27%, respectively, of Penford’s revenue, is a developer and manufacturer of specialty starches and dextrins to the food manufacturing and food service industries. Its expertise is in leveraging the inherent characteristics from potato, corn, tapioca and rice to help improve its customers’ product performance. Food Ingredients’ specialty starches produced for food applications are used in coatings to provide crispness, improved taste and texture, and increased product life for products such as french fries sold in restaurants. Food-grade starch products are used to reduce fat levels, modify texture, and improve color and consistency in a variety of foods such as canned products, sauces, whole and processed meats, dry powdered mixes and bakery products. Food-grade starch products are also used as moisture binders and in companion pet products, such as dog treats and chews.

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Discontinued Operations

In August 2009, the Company’s Board of Directors made a determination that the Company would exit from the business conducted by the Company’s Australia/New Zealand Operations. As a result of this determination, on September 2, 2009, the Company completed the sale of its subsidiary company, Penford New Zealand Limited (“Penford New Zealand”), and on November 27, 2009, the Company completed the sale of the operating assets of another subsidiary company, Penford Australia Limited (“Penford Australia”), including its two remaining Australian plants.

The Australia/New Zealand Operations developed, manufactured and marketed ingredient systems, including specialty starches and sweeteners for food and industrial applications. Until September 2, 2009, the Company operated a corn wet milling facility in Auckland, New Zealand through Penford New Zealand. Until November 27, 2009, the Company operated a corn wet milling facility in Lane Cove, Australia and a wheat starch manufacturing facility in Tamworth, Australia through Penford Australia.

The financial data for the Australia/New Zealand Operations have been presented as discontinued operations. The financial statements have been prepared in compliance with the provisions of Financial Accounting Standards Board Accounting Standards Codification 205-10, “Presentation of Financial Statements – Discontinued Operations” (“ASC 205-10”). Accordingly, for all periods presented herein, the Consolidated Balance Sheets, Statements of Operations and Statements of Cash Flows have been conformed to this presentation. The Australia/New Zealand Operations was previously reported as the Company’s third operating segment. See Note 17 to the Consolidated Financial Statements for further details.

Unless otherwise indicated, all amounts, analyses and discussions in this Annual Report on Form 10-K pertain to the Company’s continuing operations.

Raw Materials

Corn: Penford’s North American corn wet milling plant is located in Cedar Rapids, Iowa, the middle of the U.S. corn belt. Accordingly, the plant has truck-delivered corn available throughout the year from a number of suppliers at prices consistent with those available in the major U.S. grain markets.

Potato Starch: The Company’s facilities in Idaho Falls, Idaho; Richland, Washington; and Plover, Wisconsin use starch recovered as by-products from potato processors as the primary raw material to manufacture modified potato starches. The Company enters into contracts typically having durations of one to three years with potato processors in the United States and Canada to acquire potato-based raw materials.

Chemicals: The primary chemicals used in the manufacturing processes are readily available commodity chemicals. The prices for these chemicals are subject to price fluctuations due to market conditions.

Natural Gas: The primary energy source for most of Penford’s plants is natural gas. Penford contracts its natural gas supply with regional suppliers, generally under short-term supply agreements, and regularly uses futures contracts to hedge the price of natural gas.

Corn, potato starch, chemicals and natural gas are not currently subject to availability constraints; however, demand for these items can significantly affect the prices. Penford’s current potato starch requirements constitute a material portion of the available North American supply. Penford estimates that it purchases approximately 50% of the recovered potato starch in North America. It is possible that, in the long term, continued growth in demand for potato starch-based ingredients and new product development could result in capacity constraints.

Over half of the Company’s manufacturing costs consist of the costs of corn, potato starch, chemicals and natural gas. The remaining portion consists of the costs of labor, distribution, depreciation and maintenance of manufacturing plant and equipment, and other utilities. The prices of raw materials may fluctuate, and increases

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in costs may affect Penford’s business adversely. To mitigate this risk, Penford hedges a portion of corn and gas purchases with futures and options contracts in the U.S. and enters into short-term supply agreements for other production requirements.

Research and Development

Penford’s research and development efforts cover a range of projects including technical service work focused on specific customer support projects which require coordination with customers’ research efforts to develop innovative solutions to specific customer requirements. These projects are supplemented with longer-term, new product development and commercialization initiatives. Research and development expenses were $4.8 million, $4.4 million and $4.3 million for fiscal years 2011, 2010 and 2009, respectively.

At the end of fiscal 2011, Penford had 20 scientists, including six with a Ph.D. degree with expert knowledge of carbohydrate characteristics and chemistry.

Patents, Trademarks and Trade Names

Penford owns a number of patents, trademarks and trade names. The Company has approximately 57 current patents and pending patent applications, most of which are related to technologies in french fry coatings, coatings for the paper industry, and animal and human nutrition. Penford’s issued patents expire at various times between 2012 and 2027. The annual cost to maintain all of the Company’s patents is not significant. Most of Penford’s products are currently made with technology that is broadly available to companies that have the same level of scientific expertise and production capabilities as Penford.

Specialty starch ingredient brand names for industrial applications include, among others, Penford^® gums, Pensize^® binders, Penflex^® sizing agent, Topcat^® cationic additive and the Apollo^® starch series. Product brand names for food ingredient applications include PenBind^®, PenCling^® and PenPlus^®.

Quarterly Fluctuations

Penford’s revenues and operating results vary from quarter to quarter. Sales volumes of the Food Ingredients products used in french fry coatings are generally lower during Penford’s second fiscal quarter due to decreased consumption of french fries during the post-holiday season. The cost of natural gas in North America is generally higher in the winter months than the summer months.

Working Capital

The Company’s growth is funded through a combination of cash flows from operations and short- and long-term borrowings. For more information, see the “Liquidity and Capital Resources” section under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Item 7 and the audited consolidated financial statements and the related notes included elsewhere in this Annual Report on Form 10-K.

Penford generally carries a one- to 45-day supply of materials required for production, depending on the lead time for specific items. Penford manufactures finished goods to customer orders or anticipated demand. The Company is therefore able to carry less than a 30-day supply of most products. Terms for trade receivables and trade payables are standard for the industry and region and generally do not exceed 30-45 day terms except for trade receivables for export sales.

Environmental Matters

Penford’s operations are governed by various federal, state, and local environmental laws and regulations. These laws and regulations include the Clean Air Act, the Clean Water Act, the Resource Conservation and Recovery Act, the EPA Oil Pollution Control Act, the Occupational Safety and Health Administration’s hazardous materials regulations, the Toxic Substances Control Act, the Comprehensive Environmental Response Compensation and Liability Act, and the Superfund Amendments and Reauthorization Act.

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Permits are required by the various environmental agencies that regulate the Company’s operations. Penford believes that it has obtained all necessary material environmental permits required for its operations. Penford believes that its operations are in compliance with applicable environmental laws and regulations in all material aspects of its business. Penford estimates that annual compliance costs, excluding operational costs for emission control devices, wastewater treatment or disposal fees, are approximately $1.1 million.

Penford has adopted and implemented a comprehensive corporate-wide environmental management program. The program is managed and designed to structure the conduct of Penford’s business in a safe and fiscally responsible manner that protects and preserves the health and safety of employees, the communities surrounding the Company’s plants, and the environment. The Company continuously monitors environmental legislation and regulations that may affect Penford’s operations.

During fiscal 2011, compliance with environmental regulations did not have a material impact on the Company’s operations. No unusual expenditures for environmental facilities and programs are anticipated in fiscal 2012.

Principal Customers

Penford sells to a variety of customers and has several relatively large customers in each business segment. The Company’s sales of ethanol to its sole ethanol customer, Eco-Energy, Inc., represented approximately 34%, 27% and 21% of the Company’s net sales for fiscal years 2011, 2010 and 2009, respectively. Eco-Energy, Inc. is a marketer and distributor of bio-fuels in the United States and Canada. The Company’s second largest customer, Domtar, Inc., represented approximately 8%, 8% and 11% of the Company’s net sales for fiscal years 2011, 2010 and 2009, respectively. Domtar, Inc. and Eco-Energy are customers of the Company’s Industrial Ingredients business.

Competition

In its primary markets, Penford competes directly with approximately five other companies that manufacture specialty starches for the papermaking industry, approximately six other companies that manufacture specialty food ingredients, and numerous producers of fuel grade ethanol. Penford competes indirectly with a larger number of companies that provide synthetic and natural-based ingredients to industrial and food customers. Some of these competitors are larger companies, and have greater financial and technical resources than Penford. Application expertise, quality and service are the major competitive advantages for Penford.

Employees

At August 31, 2011, Penford had 333 employees, of which approximately 40% were members of a trade union. The collective bargaining agreement covering the Cedar Rapids-based manufacturing workforce expires in August 2012.

Sales and Distribution

Sales are generated using a combination of direct sales and distributor agreements. In many cases, Penford supports its sales efforts with technical and advisory assistance to customers. Penford generally ships its products upon receipt of purchase orders from its customers and, consequently, backlog is not significant.

Since Penford’s customers are generally other manufacturers and processors, most of the Company’s products are distributed via rail or truck to customer facilities in bulk.

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Export Sales

Export sales from Penford’s businesses in the U.S. accounted for approximately 9%, 9% and 8% of total sales in fiscal 2011, 2010 and 2009, respectively. See Note 19 to the Consolidated Financial Statements for sales by country to which the product was shipped.

Available Information

Penford’s Internet address iswww.penx.com. The Company makes available, free of charge through its Internet site, the Company’s annual reports on Form 10-K; quarterly reports on Form 10-Q; current reports on Form 8-K; Directors and Officers Forms 3, 4 and 5; and amendments to those reports, as soon as reasonably practicable after electronically filing such materials with, or furnishing them to, the Securities and Exchange Commission (“SEC”). The information found on Penford’s web site will not be considered to be part of this or any other report or other filing filed with or furnished to the SEC. The SEC also maintains an Internet site which contains reports, proxy and information statements, and other information regarding issuers that file information electronically with the SEC. The SEC’s Internet address iswww.sec.gov.

In addition, the Company makes available, through the Investor Relations section of its Internet site, the Company’s Code of Business Conduct and Ethics and the written charters of the Audit, Governance and Executive Compensation and Development Committees.

Executive Officers of the Registrant

Name	Age		Title
Thomas D. Malkoski		55	President and Chief Executive Officer
Steven O. Cordier		55	Senior Vice President, Chief Financial Officer and Assistant Secretary
Timothy M. Kortemeyer		45	Vice President; President, Industrial Ingredients
Wallace H. Kunerth		63	Vice President and Chief Science Officer
Christopher L. Lawlor		61	Vice President - Human Resources, General Counsel and Secretary
John R. Randall		67	Vice President; President, Food Ingredients

Mr. Malkoski joined Penford Corporation as Chief Executive Officer and was appointed to the Board of Directors in January 2002. He was named President of Penford Corporation in January 2003. From 1997 to 2001, he served as President and Chief Executive Officer of Griffith Laboratories, North America, a formulator, manufacturer and marketer of ingredient systems to the food industry. Previously, he served in various senior management positions, including as Vice President/Managing Director of the Asia Pacific and South Pacific regions for Chiquita Brands International, an international marketer and distributor of bananas and other fresh produce. Mr. Malkoski began his career at the Procter and Gamble Company, a marketer of consumer brands, progressing through major product category management responsibilities. Mr. Malkoski holds a Masters of Business Administration degree from the University of Michigan.

Mr. Cordier is Penford’s Senior Vice President, Chief Financial Officer and Assistant Secretary. He joined Penford in July 2002 as Vice President and Chief Financial Officer, and was promoted to Senior Vice President in November 2004. From September 2005 to April 2006, Mr. Cordier served as the interim Managing Director of Penford’s Australian and New Zealand operations. He came to Penford from Sensient Technologies Corporation, a manufacturer of specialty products for the food, beverage, pharmaceutical and technology industries, where he held a variety of senior financial management positions.

Mr. Kortemeyer has served as Vice President of Penford Corporation since October 2005 and President, Industrial Ingredients since June 2006. He served as General Manager of Penford Products from August 2005 to June 2006. Mr. Kortemeyer joined Penford in 1999 and served as a Team Leader in the manufacturing operations

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of Penford Products until 2001. From 2001 until 2003, he was an Operations Manager and Quality Assurance Manager. From July 2003 to November 2004, Mr. Kortemeyer served as the business unit manager of the Company’s co-products business, and from November 2004 until August 2005, as the director of the Company’s specialty starches product lines, responsible for sales, marketing and business development.

Dr. Kunerth has served as Penford’s Vice President and Chief Science Officer since 2000. From 1997 to 2000, he served in food applications research management positions in the Consumer and Nutrition Sector at Monsanto Company, a provider of hydrocolloids, high intensity sweeteners, agricultural products and integrated solutions for industrial, food and agricultural customers. Before Monsanto, he was the Vice President of Technology at Penford’s food ingredients business from 1993 to 1997.

Mr. Lawlor joined Penford in April 2005 as Vice President-Human Resources, General Counsel and Secretary. From 2002 to April 2005, Mr. Lawlor served as Vice President-Human Resources for Sensient Technologies Corporation, a manufacturer of specialty chemicals and food products. From 2000 to 2002, he was Assistant General Counsel for Sensient. Mr. Lawlor was Vice President-Administration, General Counsel and Secretary for Kelley Company, Inc., a manufacturer of material handling and safety equipment from 1997 to 2000. Prior to joining Kelley Company, Mr. Lawlor was employed as an attorney at a manufacturer of paper and packaging products and in private practice with two national law firms.

Mr. Randall is Vice President of Penford Corporation and President, Food Ingredients. He joined Penford in February 2003 as Vice President and General Manager of Penford Food Ingredients and was promoted to President of the Food Ingredients division in June 2006. Prior to joining Penford, Mr. Randall was Vice President, Research & Development/Quality Assurance of Griffith Laboratories, USA, a specialty foods ingredients business, from 1998 to 2003. From 1993 to 1998, Mr. Randall served in various research and development positions with KFC Corporation, a quick-service restaurant business, most recently as Vice President, New Product Development. Prior to 1993, Mr. Randall served in research and development leadership positions at Romanoff International, Inc., a manufacturer and marketer of gourmet specialty food products, and at Kraft/General Foods.

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Item 1A:  Risk Factors

Risks Related to Penford’s Business

The availability and cost of agricultural products Penford purchases are vulnerable to weather and other factors beyond its control. The Company’s ability to pass through cost increases for these products is limited by worldwide competition and other factors.

In fiscal 2011, approximately 49% of Penford’s manufacturing costs were the costs of corn, potato starch and other agricultural raw materials. Weather conditions, plantings, government programs and policies, and energy costs and global supply, among other things, have historically caused volatility in the supply and prices of these agricultural products. Due to local and/or international competition, the Company may not be able to pass through the increases in the cost of agricultural raw materials to its customers. To manage price volatility in the commodity markets, the Company may purchase inventory in advance or enter into exchange traded futures contracts. Despite these hedging activities, the Company may not be successful in limiting its exposure to market fluctuations in the cost of agricultural raw materials. Increases in the cost of corn, potato starch and other agricultural raw materials due to weather conditions or other factors beyond Penford’s control and that cannot be passed through to customers will reduce Penford’s future profitability.

Increases in energy and chemical costs may reduce Penford’s profitability.

Energy and chemicals comprised approximately 9% and 10%, respectively, of the cost of manufacturing the Company’s products in fiscal 2011. Penford uses natural gas extensively in its Industrial Ingredients business to dry starch products, and, to a lesser extent, in the Food Ingredients business. The Company uses chemicals in all of the businesses to modify starch for specific product applications and customer requirements. The prices of these inputs to the manufacturing process fluctuate based on anticipated changes in supply and demand, weather and the prices of alternative fuels, including petroleum. The Company may use short-term purchase contracts or exchange traded futures contracts to reduce the price volatility of natural gas; however, these strategies are not available for the chemicals the Company purchases. If the Company is unable to pass on increases in energy and chemical costs to its customers, margins and profitability would be adversely affected.

The loss of a major customer could have an adverse effect on Penford’s results of operations.

The Company’s sales of ethanol to its sole ethanol customer, Eco-Energy, Inc., represented approximately 34%, 27% and 21% of the Company’s net sales for fiscal years 2011, 2010 and 2009, respectively. Eco-Energy, Inc. is a marketer and distributor of bio-fuels in the United States and Canada. The Company’s second largest customer, Domtar, Inc., represented approximately 8%, 8% and 11% of the Company’s net sales for fiscal years 2011, 2010 and 2009, respectively. Sales to the top ten customers represented 65%, 65% and 69% of net sales for fiscal years 2011, 2010 and 2009, respectively. Generally, the Company does not have multi-year sales agreements with its customers. Many customers place orders on an as-needed basis and generally can change their suppliers without penalty. If Penford lost one or more major customers, or if one or more major customers significantly reduced its orders, sales and results of operations would be adversely affected.

The Company is substantially dependent on its manufacturing facilities; any operational disruption could result in a reduction of the Company’s sales volumes and could cause it to incur substantial losses.

Penford’s revenues are, and will continue to be, derived from the sale of starch-based ingredients and ethanol that the Company manufactures at its facilities. The Company’s operations may be subject to significant interruption if any of its facilities experiences a major accident or is damaged by severe weather or other natural disasters, as occurred as a result of the flood of the Cedar River at the Company’s Cedar Rapids, Iowa facility in fiscal 2008. In addition, the Company’s operations may be subject to labor disruptions and unscheduled downtime, or other operational hazards inherent in the industry, such as equipment failures, fires, explosions,

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abnormal pressures, blowouts, pipeline ruptures, transportation accidents and natural disasters. Some of these operational hazards may cause personal injury or loss of life, severe damage to or destruction of property and equipment or environmental damage, and may result in suspension of operations and the imposition of civil or criminal penalties. The Company’s insurance may not be adequate to fully cover the potential operational hazards described above or that it will be able to renew this insurance on commercially reasonable terms or at all.

The agreements governing the Company’s debt and preferred stock contain various covenants that limit its ability to take certain actions and also require the Company to meet financial maintenance tests, and Penford’s failure to comply with any of the debt covenants could have a material adverse effect on the Company’s business, financial condition and results of operations.

The agreements governing Penford’s outstanding debt contain a number of significant covenants that, among other things, limit its ability to:

• incur additional debt or liens;

• consolidate or merge with any person or transfer or sell all or substantially all of its assets;

• make investments or acquisitions;

• pay dividends or make certain other restricted payments;

• enter into transactions with affiliates; and

• create dividend or other payment restrictions with respect to subsidiaries.

In addition, the Company’s revolving credit facility requires it to comply with specific financial ratios and tests, under which it is required to achieve specific financial and operating results. Events beyond the Company’s control may affect its ability to comply with these provisions. A breach of any of these covenants would result in a default under the Company’s revolving credit facility. In the event of any default that is not cured or waived, the Company’s lenders could elect to declare all amounts borrowed under the revolving credit facility, together with accrued interest thereon, due and payable, which could permit acceleration of other debt. If any of the Company’s debt is accelerated, there is no assurance that the Company would have sufficient assets to repay that debt or that it would be able to refinance that debt on commercially reasonable terms or at all.

Changes in interest rates may affect Penford’s profitability.

As of August 31, 2011, approximately $22.1 million of its outstanding debt was subject to variable interest rates which move in direct relation to the London InterBank Offered Rate (“LIBOR”), or the prime rate in the United States, depending on the selection of borrowing options. Any significant changes in these interest rates would materially affect the Company’s profitability by increasing or decreasing its borrowing costs.

Unanticipated changes in tax rates or exposure to additional income tax liabilities could affect Penford’s profitability.

The Company is subject to income taxes in the federal and various state jurisdictions in the United States. The Company’s effective tax rates could be adversely affected by changes in the mix of earnings in tax jurisdictions with differing statutory tax rates, changes in the valuation of deferred tax assets and liabilities or changes in tax laws. The carrying value of deferred tax assets is dependent on the Company’s ability to generate future taxable income in the United States. The amount of income taxes paid is subject to interpretation of applicable tax laws in the jurisdictions in which the Company operates. Although the Company believes it has complied with all applicable income tax laws, there is no assurance that a tax authority will not have a different interpretation of the law or that any additional taxes imposed as a result of tax audits will not have an adverse effect on the Company’s results of operations.

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Pension expense and the funding of pension obligations are affected by factors outside the Company’s control, including the performance of plan assets, interest rates, actuarial data and experience, and changes in laws and regulations.

The future funding obligations for the Company’s two U.S. defined benefit pension plans qualified with the Internal Revenue Service depend upon the level of benefits provided for by the plans, the future performance of assets set aside in trusts for these plans, the level of interest rates used to determine funding levels, actuarial data and experience and any changes in government laws and regulations. The pension plans hold a significant amount of equity and fixed income securities. When the values of these securities decline, pension expense can increase and materially affect the Company’s results. Decreases in interest rates that are not offset by contributions and asset returns could also increase the Company’s obligations under such plans. The Company is legally required to make contributions to the pension plans in the future, and those contributions could be material. The Company expects to contribute $2.8 million to its pension plans during fiscal 2012.

The current capital and credit market conditions may adversely affect the Company’s access to capital, cost of capital and business operations.

The general economic and capital market conditions in the United States and other parts of the world have deteriorated significantly and have adversely affected access to capital and increased the cost of capital. If these conditions continue or become worse, the Company’s future cost of debt and equity capital and its access to capital markets could be adversely affected. An inability to obtain adequate financing from debt and equity sources could force the Company to self-fund strategic initiatives or even forgo some opportunities, potentially harming its financial position, results of operations and liquidity.

Economic conditions may impair the businesses of the Company’s customers and end user markets, which could adversely affect the Company’s business operations.

As a result of the current economic downturn and macro-economic challenges currently affecting the economy of the United States and other parts of the world, the businesses of some of the Company’s customers may not be successful in generating sufficient revenues. Customers may choose to delay or postpone purchases from the Company until the economy and their businesses strengthen. The Company’s Industrial Ingredients business is dependent upon end markets for paper and ethanol in North America. Paper markets have been under competitive pressure from imports and over-capacity and may be further stressed by the continuing economic downturn. In fiscal 2011, one of the Company’s paper industry customers shut down its mill operations and one paper industry customer filed for reorganization in bankruptcy. The Company’s Industrial Ingredients business increased its reserve for uncollectible accounts by $1.2 million for these customers. Ethanol markets have been under pressure from declining oil prices and increasing ethanol production capacity in the United States. Decisions by current or future customers to forego or defer purchases and/or customers’ inability to pay the Company for its products may adversely affect the Company’s earnings and cash flow.

Penford depends on its senior management team; the loss of any member could adversely affect its operations.

Penford’s success depends on the management and leadership skills of its senior management team. The loss of any of these individuals, particularly Thomas D. Malkoski, the Company’s President and Chief Executive Officer, or Steven O. Cordier, the Company’s Chief Financial Officer, or the Company’s inability to attract, retain and maintain additional personnel, could prevent it from fully implementing its business strategy. There is no assurance that it will be able to retain its existing senior management personnel or to attract additional qualified personnel when needed.

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Penford is subject to stringent environmental and health and safety laws, which may require it to incur substantial compliance and remediation costs, thereby reducing profits.

Penford is subject to many federal, state and local environmental and health and safety laws and regulations, particularly with respect to the use, handling, treatment, storage, discharge and disposal of substances and hazardous wastes used or generated in its manufacturing processes. Compliance with these laws and regulations is a significant factor in the Company’s business. Penford has incurred and expects to continue to incur expenditures to comply with applicable environmental laws and regulations. The Company’s failure to comply with applicable environmental laws and regulations and permit requirements could result in civil or criminal fines or penalties or enforcement actions, including regulatory or judicial orders enjoining or curtailing operations or requiring corrective measures, installation of pollution control equipment or remedial actions.

The Company may be required to incur costs relating to the investigation or remediation of property, including property where it has disposed of its waste, and for addressing environmental conditions. Some environmental laws and regulations impose liability and responsibility on present and former owners, operators or users of facilities and sites for contamination at such facilities and sites without regard to causation or knowledge of contamination. Consequently, there is no assurance that existing or future circumstances, the development of new facts or the failure of third parties to address contamination at current or former facilities or properties will not require significant expenditures by the Company.

The Company expects to continue to be subject to increasingly stringent environmental and health and safety laws and regulations. It is difficult to predict the future interpretation and development of environmental and health and safety laws and regulations or their impact on the Company’s future earnings and operations. The Company anticipates that compliance will continue to require increased capital expenditures and operating costs. Any increase in these costs, or unanticipated liabilities arising, for example, out of discovery of previously unknown conditions or more aggressive enforcement actions, could adversely affect the Company’s results of operations, and there is no assurance that they will not have a material adverse effect on its business, financial condition and results of operations.

Penford’s unionized workforce could cause interruptions in the Company’s provision of services.

As of August 31, 2011, approximately 40% of the Company’s 333 employees were members of a trade union. Although the Company’s relations with the relevant union are stable and the Company’s labor contract does not expire until August 2012, there is no assurance that the Company will not experience work disruptions or stoppages in the future, which could have a material adverse effect on its business and results of operations and adversely affect its relationships with its customers.

Risk Factors Relating to Penford’s Common Stock

Penford’s stock price has fluctuated significantly; the trading price of its common stock may fluctuate significantly in the future.

The trading price of the Company’s common stock has fluctuated significantly. In fiscal 2011, the stock price ranged from a low of $4.50 on September 1, 2010 and September 23, 2010 to a high of $7.95 on November 9, 2010. The trading price of Penford’s common stock may fluctuate significantly in the future as a result of a number of factors, including:

• actual and anticipated variations in the Company’s operating results;

• general economic and market conditions, including changes in demand for the Company’s products;

• interest rates;

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• geopolitical conditions throughout the world;

• perceptions of the strengths and weaknesses of the Company’s industries;

• the Company’s ability to pay principal and interest on its debt when due;

• developments in the Company’s relationships with its lenders, customers and/or suppliers;

• announcements of alliances, mergers or other relationships by or between the Company’s competitors and/or its suppliers and customers; and

• quarterly variations in the Company’s results of operations due to, among other things, seasonality in demand for products and fluctuations in the cost of raw materials

The stock markets in general have experienced broad fluctuations that have often been unrelated to the operating performance of particular companies. These broad market fluctuations may adversely affect the trading price of the Company’s common stock. Accordingly, Penford’s common stock may trade at prices significantly below an investor’s cost and investors could lose all or part of their investment in the event that they choose to sell their shares.

Provisions of Washington law could discourage or prevent a potential takeover.

Washington law imposes restrictions on certain transactions between a corporation and certain significant shareholders. The Washington Business Corporation Act generally prohibits a “target corporation” from engaging in certain significant business transactions with an “acquiring person,” which is defined as a person or group of persons that beneficially owns 10% or more of the voting securities of the target corporation, for a period of five years after such acquisition, unless the transaction or acquisition of shares is approved by a majority of the members of the target corporation’s board of directors prior to the time of the acquisition. Such prohibited transactions include, among other things, (1) a merger or consolidation with, disposition of assets to, or issuance or redemption of stock to or from, the acquiring person; (2) a termination of 5% or more of the employees of the target corporation as a result of the acquiring person’s acquisition of 10% or more of the shares; and (3) allowing the acquiring person to receive any disproportionate benefit as a shareholder. After the five year period, a “significant business transaction” may occur if it complies with “fair price” provisions specified in the statute. A corporation may not “opt out” of this statute.

Item 1B:  Unresolved Staff Comments

None.

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Item 2:  Properties

Penford’s facilities as of August 31, 2011 are as follows:

	Bldg.  Area (Approx. Sq. Ft.)			Land Area (Acres)		Owned/ Leased	Function of Facility
Centennial, Colorado		25,200			—	Leased	Corporate headquarters and research laboratories
Cedar Rapids, Iowa		759,000	*		29	Owned	Manufacture of corn starch products and research laboratories
Idaho Falls, Idaho		30,000			4	Owned	Manufacture of potato starch products
Richland, Washington		—			4.4	—	Manufacture of potato and tapioca starch products
(owned and leased)
Building 1		45,000			—	Owned
Building 2		9,600			—	Leased
Plover, Wisconsin (two facilities, one of which is located on leased land)		—			—	—	Manufacture of potato starch products
Facility 1		45,000			9.5	Owned
Facility 2		15,000			3.3	Owned
						(leased land)

  * Approximately 119,150 square feet are subject to a long-term lease to the purchaser of the Company’s former dextrose business

Penford’s production facilities are strategically located near sources of raw materials. The Company believes that its facilities are maintained in good condition and that the capacities of its plants are sufficient to meet current production requirements. The Company invests in expansion, improvement and maintenance of property, plant and equipment as required.

Item 3:  Legal Proceedings

The Company filed suit on January 23, 2009 in the United States District Court for the Northern District of Iowa against two insurance companies, National Union Fire Insurance Company of Pittsburgh, Pennsylvania, owned by American International Group, Inc. (“AIG”), and ACE American Insurance Company (“ACE”), due to the insurers’ denial of certain insurance coverage for damages that the Company suffered from the flood that struck the Company’s Cedar Rapids, Iowa plant in June 2008. On January 19, 2010, the presiding judge ruled that flood coverage language contained in the applicable insurance policy was “ambiguous” and that the interpretation of the policy was “a question of fact reserved for a jury.” At the conclusion of the jury trial subsequently conducted in August 2010, the presiding judge dismissed the Company’s claims without issuing a written opinion. In the fall of 2010, the Company appealed the dismissal to the United States Court of Appeals for the Eighth Circuit. The Company’s appeal has not yet been decided. The Company cannot at this time determine the likelihood of any outcome of the appeal or estimate the amount of any judgment that might be awarded.

In June 2011, the Company was notified that a complaint had been filed in the United States District Court for the District of New Jersey alleging that certain pet chew products supplied to a customer by the Company’s subsidiary, Penford Products Co. (“Penford Products”), infringe upon a patent owned by T.F.H. Publications, Inc. (“TFH”). The customer requested that Penford Products defend this lawsuit pursuant to the terms of its supply

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agreement with Penford Products. The Company believes that its products do not infringe upon the patent and has commenced a defense of the lawsuit. The Company cannot at this time determine the likelihood of any outcome or estimate any damages that might be awarded.

In July 2011, the purchaser of the Company’s Lane Cove, New South Wales, Australia operating assets filed a claim for $787,000 pursuant to the sale agreement. See Note 17 to the Consolidated Financial Statements.

The Company regularly evaluates the status of claims and legal proceedings in which it is involved in order to assess whether a loss is probable or there is a reasonable possibility that a loss may have been incurred and to determine if accruals are appropriate. For the matters identified in the preceding two paragraphs, management is unable to provide additional information regarding any possible loss because, among other reasons, (i) the matters are in early stages; (ii) the Company currently believes that the claims are not adequately supported; and (iii) there are significant factual issues to be resolved. With regard to these matters, management does not believe, based on currently available information, that the eventual outcomes will have a material adverse effect on the Company’s financial condition, although the outcomes could be material to the Company’s operating results for any particular period, depending, in part, upon the operating results for such period.

The Company is involved from time to time in various other claims and litigation arising in the normal course of business. In the judgment of management, which relies in part on information obtained from the Company’s outside legal counsel, the ultimate resolution of these other matters will not materially affect the consolidated financial position, results of operations or liquidity of the Company.

Item 4:  Reserved

PART II

Item 5:  Market for the Registrant’s Common Equity, Related Shareholder Matters and Issuer Purchases of

      Equity Securities

Market Information and Holders of Common Stock

Penford’s common stock, $1.00 par value, trades on The NASDAQ Global Market under the symbol “PENX.” On November 3, 2011, there were 393 shareholders of record. The high and low closing prices of Penford’s common stock during the last two fiscal years are set forth below.

	Fiscal 2011				Fiscal 2010
	High		Low		High		Low
Quarter Ended November 30	$	7.95	$	4.50	$	9.63	$	5.68
Quarter Ended February 28	$	7.27	$	5.50	$	12.15	$	7.94
Quarter Ended May 31	$	6.35	$	5.22	$	11.68	$	7.44
Quarter Ended August 31	$	6.49	$	5.04	$	8.25	$	4.83

Dividends

In April 2009, the Board of Directors suspended payment of dividends. The Company may not declare or pay any dividends on its common stock without first obtaining approval from the holders of a majority of the Series A Preferred Stock. See Note 5 to the Consolidated Financial Statements for further details.

Issuer Purchases of Equity Securities

None

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Performance Graph

The following graph compares the Company’s cumulative total shareholder return on its common stock for a five-year period (September 1, 2006 to August 31, 2011) with the cumulative total return of the Nasdaq Market Index and all companies traded on the Nasdaq Stock Market (“Nasdaq”) with a market capitalization of $100—$200 million, excluding financial institutions. The graph assumes that $100 was invested on September 1, 2006 in the Company’s common stock and in the stated indices. The comparison assumes that all dividends are reinvested. The Company’s performance as reflected in the graph is not indicative of the Company’s future performance.

ASSUMES $100 INVESTED ON SEPTEMBER 1, 2006

ASSUMES DIVIDEND REINVESTED

FISCAL YEAR ENDING AUGUST 31, 2011

	2006		2007		2008		2009		2010		2011
PENFORD CORPORATION		100.00		228.44		108.69		42.70		32.49		36.47
NASDAQ MARKET INDEX (U.S.)		100.00		120.88		109.33		94.74		100.35		122.93
NASDAQ MARKET CAP ($100-200M)		100.00		107.78		77.43		58.92		49.62		48.36

Management does not believe there is either a published index or a group of companies whose overall business is sufficiently similar to the business of Penford to allow a meaningful benchmark against which the Company can be compared. The Company sells products based on specialty carbohydrate chemistry to several distinct markets, making overall comparisons to one of these markets misleading with respect to the Company as a whole. For these reasons, the Company has elected to use non-financial companies traded on Nasdaq with a similar market capitalization as a peer group.

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Item 6:  Selected Financial Data

The following table sets forth certain selected financial information for the five fiscal years as of and for the period ended August 31, 2011. The amounts have been restated to reflect the reclassification of discontinued operations and should be read in conjunction with the consolidated financial statements and the notes to these statements included in Item 8.

	Year Ended August 31,
	2011			2010			2009			2008			2007
	(Dollars in thousands, except share and per share data)
Operating Data:
Sales	$	315,441		$	254,274		$	255,556		$	239,581		$	257,944
Cost of sales	$	281,606		$	230,820		$	243,265		$	194,993		$	203,886
Gross margin percentage		10.7%			9.2%			4.8%			18.6%			21.0%
Income (loss) from continuing operations(2)	$	(5,117	)	$	(9,629	)	$	(6,645	)	$	(10,808	)(1)	$	11,283	(1)
Income (loss) from discontinued operations(3)	$	-		$	16,312		$	(58,142	)	$	(1,892	)	$	2,234
Net income (loss)	$	(5,117	)	$	6,683		$	(64,787	)	$	(12,700	)	$	13,517
Diluted earnings (loss) per share from continuing operations	$	(0.42	)	$	(0.84	)	$	(0.59	)	$	(1.02	)	$	1.22
Diluted earnings (loss) per share from discontinued operations	$	-		$	1.41		$	(5.21	)	$	(0.18	)	$	0.24
Diluted earnings (loss) per share	$	(0.42	)	$	0.57		$	(5.80	)	$	(1.20	)	$	1.46
Dividends declared per common share	$	-		$	-		$	0.12		$	0.24		$	0.24
Average common shares and equivalents–assuming dilution		12,250,914			11,600,885			11,170,493			10,565,432			9,283,125
Balance Sheet Data (as of August 31):
Total assets	$	212,414		$	208,408		$	258,245		$	320,433		$	288,388
Capital expenditures		8,295			5,980			5,379			38,505			32,782
Long-term debt		23,802			21,038			71,141			59,860			63,403
Total debt		24,223			21,467			92,382			67,889			67,459
Redeemable preferred stock, Series A(4)		38,982			34,104			-			-			-
Shareholders’ equity		85,465			83,572			79,359			160,362			125,676

(1) Includes pre-tax charges of $1.4 million and $2.4 million in fiscal years 2008 and 2007, respectively, related to the settlement of litigation.

(2) In the third quarter of fiscal 2010, the Company refinanced its bank debt. See Note 6 to the Consolidated Financial Statements. In connection with the refinancing, the Company recorded a pre-tax non-cash charge to earnings of approximately $1.0 million related to unamortized transaction fees associated with the prior credit facility. In addition, the Company terminated its interest rate swap agreements with several banks in the third quarter of fiscal 2010 and recorded a loss of approximately $1.6 million. In the second quarter of fiscal 2009, the Company’s Food Ingredients business segment sold assets related to its dextrose product line to a third-party purchaser and recorded a $1.6 million gain on the sale. In the fourth quarter of fiscal 2008, the Company’s Cedar Rapids, Iowa manufacturing facility suffered severe flooding which suspended production for most of the fourth quarter. The Company recorded pre-tax costs of $27.6 million, net of insurance recoveries in fiscal year 2008 and net insurance recoveries of $9.1 million in fiscal 2009. See Note 18 to the Consolidated Financial Statements.

(3) In August 2009, the Company recorded a $33.0 million non-cash asset impairment charge related to the property, plant and equipment of the Australia/New Zealand Operations. In the second quarter of fiscal 2009, the Australia/New Zealand Operations recorded a $13.8 million non-cash goodwill impairment charge. See Note 17 to the Consolidated Financial Statements. In the second quarter of fiscal 2010, the liquidation of the remaining net assets of Penford Australia was substantially complete and, as a result, $13.8 of currency translation adjustments were

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reclassified from accumulated other comprehensive income into earnings. Includes a pre-tax gain of $0.7 million related to the sale of land in New Zealand in fiscal year 2008.

(4) In the third quarter of fiscal 2010, the Company issued $40 million of Series A 15% cumulative non-voting, non-convertible preferred stock (“Series A Preferred Stock”) and 100,000 shares of Series B voting convertible preferred stock (“Series B Preferred Stock”) in a private placement to Zell Credit Opportunities Master Fund, L.P., an investment fund managed by Equity Group Investments, a private investment firm (the “Investor”). Proceeds from the preferred stock issuance of $40.0 million were used to repay bank debt. See Note 5 to the Consolidated Financial Statements.

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Item 7:  Management’s Discussion and Analysis of Financial Condition and Results of Operations

This Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) should be read in conjunction with the Company’s consolidated financial statements and the accompanying notes. The notes to the Consolidated Financial Statements referred to in this MD&A are included in Part II Item 8, “Financial Statements and Supplementary Data.” Unless otherwise noted, all amounts and analyses are based on continuing operations.

Overview

Penford generates revenues, income and cash flows by developing, manufacturing and marketing specialty natural-based ingredient systems for industrial and food applications and by producing and selling fuel grade ethanol. The Company develops and manufactures ingredients with starch as a base, providing value-added applications to its customers. Penford’s starch products are manufactured primarily from corn and potatoes and are used principally as binders and coatings in paper and food production and as an ingredient in fuel.

In analyzing business trends, management considers a variety of performance and financial measures, including sales revenue growth, sales volume growth, and gross margins and operating income of the Company’s business segments. Penford manages its business in two segments. Industrial Ingredients and Food Ingredients are broad categories of end-market users, served by operations in the United States. See Item 1 and Note 19 to the Consolidated Financial Statements for additional information regarding the Company’s business segment operations.

In June 2008, the Company’s Industrial Ingredients plant in Cedar Rapids, Iowa was temporarily shut down due to record flooding of the Cedar River and government-ordered mandatory evacuation of the plant and surrounding areas. The Company sustained substantial damage to this facility and the plant was shut down from mid-June 2008 until the end of August 2008. In fiscal 2009, the Company recorded flood-related costs of $7.6 million and insurance recoveries of $16.7 million. The Company is seeking additional payments from its insurers for damages arising from the flooding in June 2008 and has filed a lawsuit against the insurers. See Notes 18 and 21 to the Consolidated Financial Statements for additional information.

In August 2009, the Company’s Board of Directors made a determination that the Company would exit from the business conducted by the Company’s Australia/New Zealand Operations. On September 2, 2009, the Company completed the sale of Penford New Zealand Limited. On November 27, 2009, the Company’s Australian operating subsidiary, Penford Australia Limited, completed the sale of substantially all of its operating assets to two unrelated parties. The financial data for the Australia/New Zealand Operations have been presented as discontinued operations. See Note 17 to the Consolidated Financial Statements.

Consolidated Results of Operations

Consolidated fiscal 2011 sales expanded $61.2 million, or 24.1%, over the prior year, driven by pricing improvements in the Industrial Ingredients business and favorable sales volume and pricing for non-coating applications in the Food Ingredients segment. Average unit pricing for ethanol improved 44% in fiscal 2011 and higher corn costs drove higher pricing for industrial starch as corn costs are passed through to customers. The market for industrial starch continues to be highly price competitive.

Fiscal 2011 consolidated gross margin increased to $33.8 million from $23.5 million in fiscal 2010. Consolidated gross margin expanded primarily due to improvements in gross margin at the Industrial Ingredients business through higher ethanol pricing and favorable volume and product mix at the Food Ingredients segment. Consolidated income from operations was $4.4 million in fiscal 2011 compared to an operating loss of $4.9 million in fiscal 2010. The expansion in operating income in fiscal 2011 was due to the improvement in gross margin, offset by $1.1 million of increased administrative and employee costs.

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Interest expense in fiscal 2011 was $9.4 million compared with $7.5 million in fiscal 2010. Interest expense increased in fiscal 2011 due to the increase in the dividend rate on the Series A Preferred Stock issued in April 2010 over the interest rate for the Company’s bank debt plus the accretion of the discount on the Series A Preferred Stock.

In fiscal 2011, the Company recorded $0.3 million of tax expense on a pretax loss of $4.8 million, resulting in an effective tax rate of (7)%. The effective tax rate for fiscal 2011 varied from the U.S. federal statutory rate of 35% primarily due to tax incentives for the production of ethanol of $1.0 million, offset by $7.7 million of dividends and discount accretion on the preferred stock which are recorded as interest expense for financial reporting purposes but are not deductible in the computation of taxable income. See Note 15 to the Consolidated Financial Statements.

Results of Operations

Fiscal 2011 Compared to Fiscal 2010

Industrial Ingredients

	Year Ended August 31,
	2011			2010
	(Dollars in thousands)
Sales – industrial starch	$	127,471		$	115,681
Sales – ethanol		105,730			68,335
Total sales	$	233,201		$	184,016
Gross margin	$	7,523		$	461
Loss from operations	$	(4,718	)	$	(11,512	)

Industrial Ingredients fiscal 2011 sales of $233.2 million grew $49.2 million, or 26.7%, from fiscal 2010. Industrial starch sales of $127.5 million increased 10.2% primarily on a higher pass through of corn costs to customers, offset by a 7% decrease in volume. Sales of the Company’s Liquid Natural Additives products, included in the industrial starch sales amount, improved 19% driven by a volume increase of 14% and higher average unit pricing of 4%. During fiscal 2011, the Industrial Ingredients business continued to shift more of its manufacturing mix to the production of ethanol. Sales of ethanol constituted 45% of industrial sales in fiscal 2011 compared to 37% in fiscal 2010. Revenue expanded 55% to $105.7 million as pricing per gallon improved 44% and volume increased 8%.

Gross margin improved $7.0 million to $7.5 million in fiscal 2011 from $0.5 million a year ago. Margins improved due to higher ethanol pricing of $32.2 million, favorable energy costs of $2.0 million, improvements in manufacturing yields of $2.2 million, and reduced distribution costs of $1.2 million, offset by higher corn costs of $27.5 million, higher chemical costs of $1.6 million, and unfavorable industrial starch pricing and mix of $1.5 million.

The loss from operations for fiscal 2011 improved $6.8 million to $4.7 million from a loss of $11.5 million last year, primarily due to the increase in gross margin. Operating expenses of $9.6 million were comparable to fiscal 2010. An increase in the reserve for uncollectible accounts of $1.5 million in fiscal 2011 due to two paper industry customers, and higher employee costs, license fees and other expenses of $0.8 million were offset by a $2.3 million reduction in legal costs.

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Food Ingredients

	Year Ended August 31,
	2011		2010
	(Dollars in thousands)
Sales	$	82,240	$	70,258
Gross margin	$	26,311	$	22,993
Income from operations	$	18,037	$	15,145

Sales of $82.2 million for the year ended August 31, 2011, increased 17.1%, or $12.0 million, on volume growth of 7% and favorable product mix and pricing of 10%. Sales of non-coating applications expanded 44%, with revenues from gluten-free applications and pet chews and treats more than doubling. Sales of coating applications declined 11% due to lower volume.

Gross margin improved $3.3 million due to the favorable pricing and mix of product sales and growth in non-coating sales. Income from operations grew 19% on the increase in gross margin. Operating expenses increased $0.3 million to $6.2 million on higher employee costs. Research and development expenses increased $0.1 million to $2.1 million.

Corporate Operating Expenses

Corporate operating expenses increased to $8.8 million in fiscal 2011 from $8.4 million a year ago, primarily due to an increase in employee-related costs.

Fiscal 2010 Compared to Fiscal 2009

Industrial Ingredients

	Year Ended August 31,
	2010			2009
	(Dollars in thousands)
Sales – industrial starch	$	115,681		$	131,709
Sales – ethanol		68,335			54,817
Total sales	$	184,016		$	186,526
Gross margin	$	461		$	(9,327	)
Loss from operations	$	(11,512	)	$	(11,154	)

Industrial Ingredients fiscal 2010 sales of $184.0 million declined $2.5 million, or 1.3%, from fiscal 2009. Industrial starch sales of $115.7 million declined 12% from fiscal 2009 sales of $131.7 million on competitive pricing and lower pass through of corn costs to customers, offset by volume increases of 5%. The industrial starch business continued to be impacted by weak demand for printing and writing paper products. Sales of the Company’s Liquid Natural Additives products, included in the industrial starch sales amount, improved 28% driven by volume increases. During fiscal 2010, the Industrial Ingredients business shifted more of its manufacturing mix to the production of ethanol. Sales of ethanol expanded 25% to $68.3 million from $54.8 million in fiscal 2009 as both volume and pricing improved.

Gross margin improved to $0.5 million in fiscal 2010 from a negative margin of $9.3 million in fiscal 2009. Margins improved due to the impact of increased volumes of both industrial starch and ethanol of $4.6 million, favorable ethanol pricing of $2.0 million, improved manufacturing yields and efficiencies of $9.0 million, favorable energy costs and yields of $6.7 million and reduced distribution costs of $2.4 million, offset by unfavorable industrial starch pricing and mix of $14.7 million.

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The loss from operations for fiscal 2010 increased $0.4 million to $11.5 million; however, the operating loss for fiscal 2009 of $11.2 million included $9.1 million of net insurance recoveries related to the Cedar Rapids flooding in fiscal 2008. Excluding the impact of the net insurance recoveries, operating income increased by $8.8 million driven by the increase in gross margin. Operating expenses increased by $1.2 million primarily due to increased legal costs related to the litigation against the Company’s insurance carriers (see Note 21 to the Consolidated Financial Statements). Research and development expenses of $2.4 million were comparable to last year.

Food Ingredients

	Year Ended August 31,
	2010		2009
	(Dollars in thousands)
Sales	$	70,258	$	69,030
Gross margin	$	22,993	$	21,618
Income from operations	$	15,145	$	13,512

Sales of $70.3 million for the year ended August 31, 2010, increased 1.8%, or $1.2 million, on volume growth of 8% partially offset by unfavorable product mix and pricing. In the second quarter of fiscal 2009, the Company sold its dextrose product line which generated $1.9 million in sales for fiscal 2009. Excluding dextrose product sales in fiscal 2009, the Food Ingredients sales for fiscal 2010 increased $3.2 million, or 4.7%. Sales of applications to growth end markets, protein, bakery and pet chews, grew 16%.

Gross margin improved $1.4 million on lower raw material, distribution and energy costs. Income from operations grew 12% on an increase in gross margin. Operating expenses declined $0.4 million to $5.9 million compared to fiscal 2009 and research and development expenses increased $0.1 million to $1.9 million.

Corporate Operating Expenses

Corporate operating expenses decreased to $8.4 million in fiscal 2010 from $9.3 million in fiscal 2009, primarily due to a decrease in professional fees and employee related costs.

Non-Operating Income (Expense)

Other non-operating income (expense) consists of the following:

	Year Ended August 31,
	2011		2010			2009
	(Dollars in thousands)
Loss on extinguishment of debt	$	—	$	(1,049	)	$	—
Loss on interest rate swap termination		—		(1,562	)		—
Gain on sale of dextrose product line		—		—			1,562
Gain on foreign currency transactions		—		419			127
Other		115		271			226
	$	115	$	(1,921	)	$	1,915

On April 7, 2010, the Company refinanced its bank debt. See Note 6 to the Consolidated Financial Statements. In connection with the refinancing, the Company recorded a pre-tax non-cash charge to earnings of approximately $1.0 million in fiscal 2010 related to unamortized transaction fees associated with the prior credit facility. In addition, the Company terminated its interest rate swap agreements with several banks and recorded a loss of approximately $1.6 million.

In fiscal 2009, the Company’s Food Ingredients business segment sold assets related to its dextrose product line to a third-party purchaser for $2.9 million, net of transaction costs. The Company recorded a $1.6 million gain on the sale.

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The Company recognized a gain on foreign currency transactions on Australian dollar denominated assets and liabilities as disclosed in the table above.

Interest expense

Interest expense was $9.4 million, $7.5 million and $5.6 million in fiscal years 2011, 2010 and 2009, respectively. Interest expense for fiscal years 2011 and 2010 increased over the previous years primarily due to the increase in the dividend rate on the Series A Preferred Stock issued in April 2010 over the interest rate for the Company’s bank debt. The accretion of the discount on the Series A Preferred Stock and the amortization of issuance costs, which are included in interest expense, were $1.2 million and $0.5 million for the years ended August 31, 2011 and 2010, respectively. On April 7, 2010, the Company issued $40 million of preferred stock at a dividend rate of 15%, the proceeds of which were used to repay outstanding bank debt. Prior to the $40 million repayment, the Company paid interest at LIBOR (London Interbank Offered Rate) plus 5%. See Notes 5 and 6 to the Consolidated Financial Statements.

Income taxes

The effective tax rates for fiscal years 2011, 2010 and 2009 were (7)%, 33% and 34%, respectively. In fiscal 2011, the Company recorded $0.3 million of tax expense on a pretax loss of $4.8 million. The effective tax rate for fiscal 2011 varied from the U.S. federal statutory rate of 35% primarily due to tax incentives for the production of ethanol of $1.0 million, offset by $7.7 million of dividends and discount accretion on the preferred stock which are recorded as interest expense for financial reporting purposes but are not deductible in the computation of taxable income.

The effective tax rate for fiscal 2010 is lower than the U.S. federal statutory rate of 35% primarily due to tax incentives for the production of ethanol of $1.0 million, offset by the effect of state taxes and $2.9 million of dividends and discount accretion on the preferred stock as described above. In fiscal 2009, the effective tax rate is lower than the U.S. federal statutory rate of 35% primarily due to adjustments to the unrecognized tax benefits and adjustments resulting from filing current and amended tax returns, offset by state income taxes. See Note 15 to the Consolidated Financial Statements.

At August 31, 2011, the Company had $13.6 million of net deferred tax assets. A valuation allowance has not been provided on the net U.S. deferred tax assets as of August 31, 2011. The determination of the need for a valuation allowance requires significant judgment and estimates. The Company evaluates the requirement for a valuation allowance each quarter. The tax benefits of operating losses incurred in fiscal 2009 have been carried back to offset taxable income in prior years. The Company believes that it is more likely than not that future operations will generate sufficient taxable income to realize its deferred tax assets. Dividends on the Series A Preferred Stock, as well as accretion of the related discount, are not deductible for tax return purposes. There can be no assurance that management’s current plans will be achieved or that a valuation allowance will not be required in the future.

Results of Discontinued Operations

In fiscal 2010, the Company sold the operating assets of its Australia/New Zealand Operations, which were previously reported in the Consolidated Financial Statements as an operating segment.

The financial results of the Australia/New Zealand Operations for fiscal years 2010 and 2009 have been classified as discontinued operations in the Consolidated Financial Statements. Australian administrative expenses for the year ended August 31, 2011 of $102,000 were included in income from continuing operations. The net assets of the Australia/New Zealand Operations as of August 31, 2011 have been reported as assets and liabilities of the continuing operations in the Consolidated Balance Sheets.

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At August 31, 2011, the remaining net assets of the Australia/New Zealand Operations consist of $0.3 million of cash and $0.8 million of other net assets, primarily a receivable from the purchaser of one of the Company’s Australian manufacturing facilities. Proceeds from the sale included $2.0 million in escrow to be released in four equal installments payable at six months, ten months, twenty months and thirty months from November 27, 2009. Penford Australia received the first two installments of $0.5 million each in May 2010 and September 2010. The remaining escrowed payments of $1.0 million are subject to the buyer’s right to make warranty claims under the sale contract. In July 2011, the purchaser filed a claim with the Company for $787,000. The Company believes that the claim is without merit and intends to contest the claim vigorously. At August 31, 2011, no reserve relating to this $1.0 million receivable has been established.

Liquidity and Capital Resources

The Company’s primary sources of short- and long-term liquidity are cash flow from operations and its revolving line of credit, which expires on April 7, 2015. The Company expects to generate sufficient cash flow from operations and to have sufficient borrowing capacity and ability to fund its cash requirements during fiscal 2012.

Operating Activities

At August 31, 2011, Penford had working capital from continuing operations of $43.9 million, and $22.1 million outstanding under its $60 million revolving credit facility. Cash flow generated from continuing operations was $2.9 million in fiscal year 2011 compared with $10.1 million in fiscal year 2010. The decline in operating cash flow was primarily due to working capital requirements. Working capital used $9.9 million of cash during the year ended August 31, 2011 compared to cash contributed by working capital of $8.9 million during fiscal 2010. Changes in working capital requirements were due to (1) increases in inventories and accounts receivable due to higher sales as well as the higher cost of corn, (2) a $6.4 million contribution to the Company’s pension plans in fiscal 2011, and (3) offset by income tax refunds received of $3.4 million.

Cash used in operations was $11.2 million in fiscal year 2009 compared with cash provided by operations of $10.1 million in fiscal 2010. Cash generated by operations in fiscal 2010 grew as working capital requirements, which had declined in fiscal 2009 during the flood recovery, stabilized during the year.

Investing Activities

Capital expenditures were $8.3 million, $6.0 million and $5.4 million in fiscal years 2011, 2010 and 2009, respectively. Penford expects capital expenditures to be approximately $16 million in fiscal 2012. Repayments of intercompany loans by the Company’s Australian discontinued operations in fiscal 2010 are reflected as cash provided by investing activities.

Financing Activities

Bank Debt

In fiscal year 2007, Penford entered into a $145 million Second Amended and Restated Credit Agreement (the “2007 Agreement”) among the Company; Harris N.A. (which has been replaced by the Bank of Montreal); LaSalle Bank National Association (now Bank of America); Cooperative Centrale Raiffeisen-Boorleenbank B.A., “Rabobank Nederland” (New York Branch); U.S. Bank National Association; and the Australia and New Zealand Banking Group Limited.

On April 7, 2010, the Company issued $40 million of preferred stock and, on April 8, 2010, used the proceeds to pay a portion of the outstanding bank debt obligations under the 2007 Agreement. Also on April 7, 2010, the Company refinanced its bank debt. The Company entered into a $60 million Third Amended and Restated Credit Agreement (the “2010 Agreement”) among the Company; Penford Products Co.; Bank of Montreal; Bank of America National Association; and Cooperatieve Centrale Raiffeisen-Boerenleenbank B.A., “Rabobank Nederland” New York Branch.

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The 2010 Agreement refinanced the unpaid debt remaining under the 2007 Agreement. Under the 2010 Agreement, the Company may borrow $60 million in revolving lines of credit. The lenders’ revolving credit loan commitment may be increased under certain conditions. On August 31, 2011, the Company had $22.1 million outstanding under the 2010 Agreement. Under the 2010 Agreement, there are no scheduled principal payments prior to maturity on April 7, 2015. As of August 31, 2011, all of the Company’s outstanding bank debt was subject to variable interest rates. Substantially all of the Company’s assets secure the 2010 Agreement.

Interest rates under the 2010 Agreement are based on either the London Interbank Offering Rates (“LIBOR”) or the prime rate, depending on the selection of available borrowing options under the 2010 Agreement. The Company may choose a borrowing rate of 1-month, 3-month or 6-month LIBOR. Pursuant to the 2010 Agreement, the interest rate margin over LIBOR ranges between 3% and 4%, depending upon the Total Funded Debt Ratio (as defined).

The 2010 Agreement provides that the Total Funded Debt Ratio, which is computed as funded debt divided by earnings before interest, taxes, depreciation and amortization (as defined in the 2010 Agreement) shall not exceed 3.00. In addition, the Company must maintain a Fixed Charge Coverage Ratio, as defined in the 2010 Agreement, of not less than 1.35. Annual capital expenditures are restricted to $15 million (excluding certain capital expenditures specified in the 2010 Agreement) if the Total Funded Debt Ratio is greater than 2.00 for the two most recent fiscal quarters. The Company’s obligations under the 2010 Agreement are secured by substantially all of the Company’s assets. The Company was in compliance with the covenants in the 2010 Agreement as of August 31, 2011.

During the first quarter of fiscal 2010, the Iowa Department of Economic Development (“IDED”) awarded financial assistance to the Company as a result of the temporary shutdown of the Cedar Rapids, Iowa plant in the fourth quarter of fiscal 2008 due to record flooding of the Cedar River. The IDED provided two five-year non interest bearing loans as follows: (1) a $1.0 million loan to be repaid in 60 equal monthly payments of $16,667 beginning December 1, 2009, and (2) a $1.0 million loan which is forgivable if the Company maintains certain levels of employment at the Cedar Rapids plant. The proceeds of these Iowa loans were used to repay outstanding debt under the 2007 Agreement in the first quarter of fiscal 2010. At August 31, 2011, the Company had $1.6 million outstanding related to the IDED loans.

In connection with the refinancing, the Company recorded a pre-tax non-cash charge to earnings of $1.0 million in fiscal 2010 related to unamortized transaction fees associated with the prior credit facility. The Company also terminated its interest rate swaps in fiscal 2010 and recorded a charge to earnings of $1.6 million.

Preferred Stock

On April 7, 2010, the Company issued $40 million of Series A 15% cumulative non-voting, non-convertible preferred stock (“Series A Preferred Stock”) and 100,000 shares of Series B voting convertible preferred stock (“Series B Preferred Stock”) in a private placement to Zell Credit Opportunities Master Fund, L.P., an investment fund managed by Equity Group Investments, a private investment firm (the “Investor”). Proceeds from the preferred stock issuance of $40.0 million were used to repay bank debt on April 8, 2010. See Note 5 to the Consolidated Financial Statements.

The Company recorded the Series A Preferred Stock and the Series B Preferred Stock at their relative fair values at the time of issuance. The Series A Preferred Stock of $32.3 million was recorded as a long-term liability due to its mandatory redemption feature and the Series B Preferred Stock of $7.7 million was recorded as equity. The discount on the Series A Preferred Stock is being amortized into income using the effective interest method over the contractual life of seven years. At August 31, 2011, the carrying value of the Series A Preferred Stock liability of $39.0 million includes $5.3 million of accrued dividends, and $1.4 million of discount accretion for the period from the date of issuance to August 31, 2011. The accrued dividends represent the 9% dividends that may be paid or accrued at the option of the Company. Dividends on the Series A Preferred Stock and the discount accretion are recorded as interest expense in the consolidated statements of operations.

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The holders of the Series A Preferred Stock are entitled to cash dividends of 6% on the sum of the outstanding Series A Preferred Stock plus accrued and unpaid dividends. In addition, dividends equal to 9% of the outstanding Series A Preferred Stock may accrue or be paid currently at the discretion of the Company.

Dividends

In April 2009, the Board of Directors suspended payment of dividends. The Company may not declare or pay any dividends on its common stock without first obtaining approval from the holders of a majority of the Series A Preferred Stock. See Note 5 to the Consolidated Financial Statements for further details.

Critical Accounting Estimates

The Company’s consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States. The process of preparing financial statements requires management to make estimates, judgments and assumptions that affect the Company’s financial position and results of operations. These estimates, judgments and assumptions are based on the Company’s historical experience and management’s knowledge and understanding of the current facts and circumstances. Management believes that its estimates, judgments and assumptions are reasonable based upon information available at the time this report was prepared. To the extent there are material differences between estimates, judgments and assumptions and the actual results, the financial statements will be affected.

Management has reviewed the accounting estimates and related disclosures with the Audit Committee of the Board of Directors. The estimates that management believes are the most important to the financial statements and that require the most difficult, subjective and complex judgments include the following:

• Evaluation of the allowance for doubtful accounts receivable

• Hedging activities

• Benefit plans

• Long-lived Assets

• Valuation of goodwill

• Self-insurance program

• Income taxes

• Stock-based compensation

A description of each of these follows:

Evaluation of the Allowance for Doubtful Accounts Receivable

Management makes judgments about the Company’s ability to collect outstanding receivables and provides allowances for the portion of receivables that the Company may not be able to collect. Penford estimates the allowance for uncollectible accounts based on historical experience, known troubled accounts, industry trends, economic conditions, how recently payments have been received, and ongoing credit evaluations of its customers. If the estimates do not reflect the Company’s future ability to collect outstanding invoices, Penford may experience losses in excess of the reserves established. At August 31, 2011, the allowance for doubtful accounts receivable was $1.3 million compared with an allowance of $0.4 million at August 31, 2010. The increase in the allowance was due to two of the Company’s paper industry customers. See Note 1 to the Consolidated Financial Statements.

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Hedging Activities

Penford uses derivative instruments, primarily exchange traded futures contracts, to reduce exposure to price fluctuations of commodities used in the manufacturing processes in the United States. The Company relies upon exchange settlement to address the default risk exposure. Penford has elected to designate these activities as hedges. This election allows the Company to defer gains and losses on those derivative instruments until the underlying commodity is used in the production process.

The requirements for the designation of hedges are very complex, and require judgments and analyses to qualify as hedges as defined by generally accepted accounting principles in the United States. These judgments and analyses include an assessment that the derivative instruments used are effective hedges of the underlying risks. If the Company were to fail to meet the requirements to qualify for derivative accounting, or if these derivative instruments are not designated as hedges, the Company would be required to mark these contracts to market at each reporting date. See Note 13 to the Consolidated Financial Statements.

Benefit Plans

Penford has defined benefit plans for some employees, providing retirement benefits and coverage for retiree health care. Qualified third-party actuaries assist management in determining the expense and funded status of these employee benefit plans. Management makes several estimates and assumptions in order to measure the expense and funded status, including interest rates used to discount certain liabilities, rates of return on plan assets, rates of compensation increases, employee turnover rates, anticipated mortality rates, and increases in the cost of medical care. The Company makes judgments about these assumptions based on historical investment results and experience as well as available historical market data and trends. However, if these assumptions are wrong, it could materially affect the amounts reported in the Company’s future results of operations. Disclosure about these estimates and assumptions are included in Note 11 to the Consolidated Financial Statements. See “Defined Benefit Pension and Postretirement Benefit Plans” below.

Long-lived Assets

The Company reviews long-lived assets for impairment when events or circumstances indicate that the carrying values may not be recoverable. An impairment loss would be recognized when estimated undiscounted future cash flows from the operation and disposition of the asset group are less than the carrying amount of the asset group. Asset groups have identifiable cash flows independent of other asset groups. Measurement of an impairment loss would be based on the excess of the carrying amount of the asset group over its fair value. Fair value is measured using discounted cash flows or independent appraisals, as appropriate. Estimating future cash flows requires significant judgment by management in such areas as future economic and industry-specific conditions, product pricing and sales volume and capital expenditures.

Valuation of Goodwill

Penford is required to assess, on an annual basis, whether the value of goodwill reported on the balance sheet has been impaired, or more often if conditions exist that indicate that there might be impairment. These assessments require extensive and subjective judgments to assess the fair value of goodwill. While the Company engages qualified valuation experts to assist in this process, their work is based on the Company’s estimates of future operating results and allocation of goodwill to the business units. If future operating results differ materially from the estimates, the value of goodwill could be adversely impacted.

Self-Insurance Program

The Company maintains a self-insurance program covering portions of workers’ compensation and group health liability costs. The amounts in excess of the self-insured levels are fully insured by third-party insurers. Liabilities associated with these risks are estimated in part by considering historical claims experience, severity

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factors and other actuarial assumptions. Projections of future losses are inherently uncertain because of the random nature of insurance claims occurrences and changes that could occur in actuarial assumptions. The financial results of the Company could be significantly affected if future claims and assumptions differ from those used in determining these liabilities.

Income Taxes

The determination of the Company’s provision for income taxes requires significant judgment, the use of estimates and the interpretation and application of complex tax laws. The Company’s provision for income taxes reflects a combination of income earned and taxed in the various U.S. federal and state taxing jurisdictions. Jurisdictional tax law changes, increases or decreases in permanent differences between book and tax items, accruals or adjustments of accruals for tax contingencies or valuation allowances, and the Company’s change in the mix of earnings from these taxing jurisdictions all affect the overall effective tax rate.

At August 31, 2011, the Company had $13.6 million of net deferred tax assets. A valuation allowance has not been provided on the net U.S. deferred tax assets as of August 31, 2011. The determination of the need for a valuation allowance requires significant judgment and estimates. The Company evaluates the requirement for a valuation allowance each quarter. The Company expects to recover its tax assets through future taxable income; however, there can be no assurance that management’s current plans will be achieved or that a valuation allowance will not be required against all or a portion of the net deferred tax assets in the future.

A tax benefit from an uncertain tax position may be recognized when it is “more likely than not” that the tax return position will be sustained upon examination by the applicable taxing authorities based on the technical merits of the position. The amount recognized is measured as the largest amount of tax benefit that has a greater than 50% likelihood of being realized upon settlement. See Note 15 to the Consolidated Financial Statements. The liability for unrecognized tax benefits contains uncertainties because the Company is required to make assumptions and to apply judgment to estimate the exposures associated with the various tax filing positions. Management believes that the judgments and estimates it uses in evaluating its tax filing positions are reasonable; however, actual results could differ, and the Company may be exposed to significant gains and losses and the Company’s effective tax rate in a given financial statement period could be materially affected.

Stock-Based Compensation

The Company recognizes stock-based compensation in accordance with ASC 718. Under the fair value recognition provisions of this statement, share-based compensation cost is measured at the grant date based on the fair value of the award and is recognized as expense over the requisite service period of the award. Determining the appropriate fair value model and calculating the fair value of the share-based awards at the date of grant requires judgment, including estimating stock price volatility, forfeiture rates, the risk-free interest rate, dividends and expected option life. See Note 10 to the Consolidated Financial Statements.

If circumstances change, and the Company uses different assumptions for volatility, interest, dividends and option life in estimating the fair value of stock-based awards granted in future periods, stock-based compensation expense may differ significantly from the expense recorded in the current period. ASC 718 requires forfeitures to be estimated at the date of grant and revised in subsequent periods if actual forfeitures differ from those estimated. Therefore, if actual forfeiture rates differ significantly from those estimated, the Company’s results of operations could be materially impacted.

Contractual Obligations

As more fully described in Notes 5, 6 and 9 to the Consolidated Financial Statements, the Company is a party to various debt, preferred stock and lease agreements at August 31, 2011 that contractually commit the Company to pay certain amounts in the future. The purchase obligations at August 31, 2011 represent an estimate of all open purchase orders and contractual obligations through the Company’s normal course of business for

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commitments to purchase goods and services for production and inventory needs, such as raw materials, supplies, manufacturing arrangements, capital expenditures and maintenance. The majority of terms allow the Company or suppliers the option to cancel or adjust the requirements based on business needs.

The following table summarizes such contractual commitments at August 31, 2011 (in thousands):

	2012		2013-2014		2015-2016		2017 & After		Total
Long-term debt and capital lease obligations	$	421	$	650	$	23,153	$	-	$	24,224
Postretirement medical(1)		731		1,702		1,909		6,079		10,421
Defined benefit pensions(2)		2,800		-		-		-		2,800
Dividends on preferred stock(3)		2,812		6,433		7,686		37,241		54,172
Redemption of preferred stock(4)		-		-		-		40,000		40,000
Operating lease obligations		3,330		4,375		1,544		305		9,554
Purchase obligations		72,327		12,582		300		-		85,209
	$	82,421	$	25,742	$	34,592	$	83,625	$	226,380

⁽¹⁾ Estimated contributions to the unfunded postretirement medical plan made in amounts needed to fund benefit payments for participants through fiscal 2021 based on actuarial assumptions.

⁽²⁾ Estimated contributions to the defined benefit pension plans for fiscal year 2012. The actual amounts funded in 2012 may differ from the amounts listed above. Contributions in fiscal years 2013 through 2017 and beyond are excluded as those amounts are unknown.

⁽³⁾ Payments for dividends on the Series A Preferred Stock represent the 6% dividends due and payable in cash each quarter until redemption. The 9% dividends which may be paid in cash or accrued each quarter until redemption are assumed to be accrued and paid at redemption. Redemption is assumed to occur on April 7, 2017.

⁽⁴⁾  Redemption of the Series A Preferred Stock is assumed to occur on April 7, 2017.

Off-Balance Sheet Arrangements

The Company has no off-balance sheet arrangements that have or are reasonably likely to have a current or future material effect on the Company’s financial condition, changes in financial conditions, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.

Defined Benefit Pension and Postretirement Benefit Plans

Penford maintains defined benefit pension plans and defined benefit postretirement health care plans in the United States.

The most significant assumptions used to determine benefit expense and benefit obligations are the discount rate and the expected return on assets assumption. See Note 11 to the Consolidated Financial Statements for the assumptions used by Penford.

The discount rate used by the Company in determining benefit expense and benefit obligations reflects the yield of high quality (AA or better rating by a recognized rating agency) corporate bonds whose cash flows are expected to match the timing and amounts of projected future benefit payments. Benefit obligations and expense increase as the discount rate is reduced. The discount rates to determine net periodic expense used in 2009 (6.92%), 2010 (5.98%) and 2011 (5.64%) reflect the changes in bond yields over the past several years. Lowering the discount rate by 25 basis points would increase pension expense by approximately $0.2 million and other postretirement benefit expense by less than $0.1 million. During fiscal 2011, bond yields rose and Penford has increased the discount rate for calculating its benefit obligations at August 31, 2011, as well as net periodic expense for fiscal 2012, to 5.87%.

The expected long-term return on assets assumption for the pension plans represents the average rate of return to be earned on plan assets over the period the benefits included in the benefit obligation are to be paid. Pension expense increases as the expected return on plan assets decreases. In developing the expected rate of

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return, the Company considers long-term historical market rates of return as well as actual returns on the Company’s plan assets, and adjusts this information to reflect expected capital market trends. Penford also considers forward looking return expectations by asset class, the contribution of active management and management fees paid by the plans. The plan assets are held in qualified trusts and anticipated rates of return are not reduced for income taxes. The expected long-term return on assets assumption used to calculate net periodic pension expense was 8.0% for fiscal 2011. A 50 basis point decrease (increase) in the expected return on assets assumptions would increase (decrease) pension expense by approximately $0.2 million based on plan assets at August 31, 2011. The expected return on plan assets used in calculating fiscal 2012 pension expense is 8.0%.

Unrecognized net loss amounts reflect the difference between expected and actual returns on pension plan assets as well as the effects of changes in actuarial assumptions. Unrecognized net losses in excess of certain thresholds are amortized into net periodic pension and postretirement benefit expense over the average remaining service life of active employees. As of August 31, 2011, unrecognized losses from all sources are $11.5 million for the pension plans and unrecognized losses of $0.7 million for the postretirement health care plan. Amortization of unrecognized net loss amounts is expected to increase net pension expense by approximately $0.8 million in fiscal 2012. Amortization of unrecognized net losses is expected to increase net postretirement health care expense by less than $0.1 million in fiscal 2012.

Penford recognized pension expense of $3.7 million, $3.8 million and $2.0 million in fiscal years 2011, 2010 and 2009, respectively. Penford expects pension expense to be approximately $2.3 million in fiscal 2012. The Company contributed $6.4 million, $3.4 million and $1.1 million to the pension plans in fiscal years 2011, 2010 and 2009, respectively. Penford estimates that it will be required to make minimum contributions to the pension plans of $2.8 million during fiscal 2012. Because of the decline in general economic and capital market conditions, the Company expects that pension plan funding contributions will increase over the medium and long term.

The Company recognized benefit expense for its postretirement health care plan of $1.2 million, $1.6 million and $1.0 million in fiscal years 2011, 2010 and 2009, respectively. Penford expects to recognize approximately $1.0 million in postretirement health care benefit expense in fiscal 2012. The Company contributed $0.5 million in each fiscal years 2011, 2010 and 2009 to the postretirement health care plans and estimates that it will contribute $0.6 million in fiscal 2012.

Future changes in plan asset returns, assumed discount rates and various assumptions related to the participants in the defined benefit plans will affect future benefit expense and liabilities. The Company cannot predict what these changes will be.

Recent Accounting Pronouncements

In June 2011, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update No. 2011-05,Comprehensive Income (“ASU 2011-05”). To increase the prominence of items reported in other comprehensive income, the FASB eliminated the option of presenting components of other comprehensive income as part of the statement of changes in stockholders’ equity. ASU 2011-05 requires that all nonowner changes in stockholders’ equity be presented either in a single continuous statement of comprehensive income or in two separate but consecutive statements. Regardless of the presentation of the components of other comprehensive income, ASU 2011-05 requires that the Company present on the face of the financial statements the reclassification adjustments for items that are reclassified from other comprehensive income to net income. The requirements of ASU 2011-05 will be effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. The implementation of ASU 2011-05 is not expected to have a material impact on the Company’s consolidated financial statements.

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Forward-looking Statements

This Annual Report on Form 10-K (“Annual Report”), including, but not limited, to statements found in the Notes to Consolidated Financial Statements and in Item 1 – Business and Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations, contains statements that are forward-looking statements within the meaning of the federal securities laws. In particular, statements pertaining to anticipated operations and business strategies contain forward-looking statements. Likewise, statements regarding anticipated changes in the Company’s business and anticipated market conditions are forward-looking statements. Forward-looking statements involve numerous risks and uncertainties and should not be relied upon as predictions of future events. Forward-looking statements depend on assumptions, dates or methods that may be incorrect or imprecise, and the Company may not be able to realize them. Forward-looking statements can be identified by the use of forward-looking terminology such as “believes,” “expects,” “may,” “will,” “should,” “seeks,” “approximately,” “intends,” “plans,” “estimates,” or “anticipates,” or the negative use of these words and phrases or similar words or phrases. Forward-looking statements can be identified by discussions of strategy, plans or intentions. The following factors, among others, could cause actual results and future events to differ materially from those set forth or contemplated in the forward-looking statements:

• competition;

• the possibility of interruption of business activities due to equipment problems, accidents, strikes, weather or other factors;

• product development risk;

• changes in corn and other raw material prices and availability;

• changes in general economic conditions or developments with respect to specific industries or customers affecting demand for the Company’s products including unfavorable shifts in product mix;

• unanticipated costs, expenses or third-party claims;

• the risk that results may be affected by construction delays, cost overruns, technical difficulties, nonperformance by contractors or changes in capital improvement project requirements or specifications;

• interest rate, chemical and energy cost volatility;

• changes in returns on pension plan assets and/or assumptions used for determining employee benefit expense and obligations;

• other unforeseen developments in the industries in which Penford operates,

• the Company’s ability to successfully operate under and comply with the terms of its bank credit agreement, as amended;

• other factors described in Part I, Item 1A “Risk Factors.”

Item 7A:  Quantitative and Qualitative Disclosures about Market Risk

Market Risk Sensitive Instruments and Positions

Penford is exposed to market risks that are inherent in the financial instruments that are used in the normal course of business. Penford may use various hedge instruments to manage or reduce market risk, but the Company does not use derivative financial instrument transactions for speculative purposes. The primary market risks are discussed below.

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Interest Rate Risk

The Company’s exposure to market risk for changes in interest rates relates to its variable-rate borrowings. As of August 31, 2011, all of the Company’s outstanding bank debt is subject to variable interest rates, which are generally set for one or three months. The market risk associated with a 100 basis point adverse change in interest rates at August 31, 2011 is approximately $0.2 million.

Commodities

The availability and price of corn, Penford’s most significant raw material, is subject to fluctuations due to unpredictable factors such as weather, plantings, domestic and foreign governmental farm programs and policies, changes in global demand and the worldwide production of corn. To reduce the price risk caused by market fluctuations, Penford generally follows a policy of using exchange-traded futures to hedge exposure to corn price fluctuations in North America. These futures contracts are designated as hedges. A majority of the Company’s sales contracts for corn-based industrial starch ingredients contain a pricing methodology which allows the Company to pass-through the majority of the changes in the commodity price of net corn.

Penford’s net corn position in the U.S. consists primarily of inventories, purchase contracts and exchange-traded futures contracts that hedge Penford’s exposure to commodity price fluctuations. The fair value of the position is based on quoted market prices. The Company has estimated its market risk as the potential loss in fair value resulting from a hypothetical 10% adverse change in prices. As of August 31, 2011 and 2010, the fair value of the Company’s net corn position was approximately $3.2 million and $1.6 million, respectively. The market risk associated with a 10% adverse change in corn prices at August 31, 2011 and 2010 is approximately $323,000 and $161,000, respectively.

Prices for natural gas fluctuate due to anticipated changes in supply and demand and movement of prices of related or alternative fuels. To reduce the price risk caused by sudden market fluctuations, Penford generally enters into short-term purchase contracts or uses exchange-traded futures contracts to hedge exposure to natural gas price fluctuations. These futures contracts are designated as hedges.

Penford’s exchange traded futures contracts hedge production requirements. The fair value of these contracts is based on quoted market prices. The Company has estimated its market risk as the potential loss in fair value resulting from a hypothetical 10% adverse change in prices. As of August 31, 2011 and 2010, the fair value of the natural gas exchange-traded futures contracts was a loss of approximately $0.5 million and a loss of approximately $1.2 million, respectively. The market risk associated with a 10% adverse change in natural gas prices at August 31, 2011 and 2010 is estimated at $45,000 and $125,000, respectively.

Selling prices for ethanol fluctuate based on the availability and price of manufacturing inputs and the status of various government regulations and tax incentives. To reduce the risk of the price variability of ethanol, Penford enters into exchange-traded futures contracts to hedge exposure to ethanol price fluctuations. These futures contracts have been designated as hedges.

Penford’s exchange traded futures contracts hedge the forecasted sales of ethanol. The fair value of these contracts is based on quoted market prices. The Company has estimated its market risk as the potential loss in fair value resulting from a hypothetical 10% adverse change in prices. As of August 31, 2011, the fair value of the ethanol exchange traded futures contracts was a loss of $1.3 million and the market risk associated with a 10% change in ethanol prices is estimated at $130,000. There were no ethanol futures contracts outstanding at August 31, 2010.

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Item 8:  Financial Statements and Supplementary Data

TABLE OF CONTENTS

	Page
Consolidated Balance Sheets		34
Consolidated Statements of Operations		35
Consolidated Statements of Comprehensive Income (Loss)		35
Consolidated Statements of Cash Flows		36
Consolidated Statements of Shareholders’ Equity		38
Notes to Consolidated Financial Statements		39
Reports of Independent Registered Public Accounting Firms		68

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Consolidated Balance Sheets

	August 31,
	2011			2010
(In thousands, except per share data)
Assets
Current assets:
Cash and cash equivalents	$	281		$	315
Trade accounts receivable, net		29,482			26,749
Inventories		32,733			19,849
Prepaid expenses		5,991			5,237
Income tax receivable		92			3,678
Other		5,498			5,287
Total current assets		74,077			61,115
Property, plant and equipment, net		107,372			111,930
Restricted cash value of life insurance		7,909			7,951
Deferred tax assets		12,695			16,493
Other assets		2,132			2,615
Other intangible assets, net		332			407
Goodwill, net		7,897			7,897
Total assets	$	212,414		$	208,408
Liabilities and Shareholders’ Equity
Current liabilities:
Cash overdraft, net	$	6,903		$	4,385
Current portion of long-term debt and capital lease obligations		421			429
Accounts payable		15,268			14,650
Accrued liabilities		7,563			6,536
Total current liabilities		30,155			26,000
Long-term debt and capital lease obligations		23,802			21,038
Redeemable preferred stock, Series A (Note 7)		38,982			34,104
Other postretirement benefits		16,193			16,891
Pension benefit liability		11,217			20,597
Other liabilities		6,600			6,206
Total liabilities		126,949			124,836
Commitments and contingencies
Shareholders’ equity:
Common stock, par value $1.00 per share, authorized 29,000 shares, issued 13,328 shares in 2011 and 29,000 shares, issued 13,354 in 2010, including treasury shares		13,243			13,190
Preferred stock, Series B (Note 5)		100			100
Additional paid-in capital		103,070			102,303
Retained earnings		9,368			14,586
Treasury stock, at cost, 1,981 shares		(32,757	)		(32,757	)
Accumulated other comprehensive loss		(7,559	)		(13,850	)
Total shareholders’ equity		85,465			83,572
Total liabilities and shareholders’ equity	$	212,414		$	208,408

The accompanying notes are an integral part of these statements.

34

Consolidated Statements of Operations

	Year Ended August 31,
	2011			2010			2009
	(Dollars in thousands, except share and per share data)
Sales	$	315,441		$	254,274		$	255,556
Cost of sales		281,606			230,820			243,265
Gross margin		33,835			23,454			12,291
Operating expenses		24,618			23,943			23,501
Research and development expenses		4,772			4,371			4,348
Flood related costs, net of insurance proceeds		-			-			(9,109	)
Income (loss) from operations		4,445			(4,860	)		(6,449	)
Interest expense		9,364			7,550			5,557
Other non-operating income (expense), net		115			(1,921	)		1,915
Loss from continuing operations before income taxes		(4,804	)		(14,331	)		(10,091	)
Income tax (benefit)		313			(4,702	)		(3,446	)
Loss from continuing operations		(5,117	)		(9,629	)		(6,645	)
Income (loss) from discontinued operations, net of tax		-			16,312			(58,142	)
Net income (loss)	$	(5,117	)	$	6,683		$	(64,787	)
Weighted average common shares and equivalents outstanding, basic and diluted		12,250,914			11,600,885			11,170,493
Earnings (loss) per common share:
Basic and diluted loss per share from continuing operations	$	(0.42	)	$	(0.84	)	$	(0.59	)
Basic and diluted earnings (loss) per share from discontinued operations		-			1.41			(5.21	)
Basic and diluted earnings (loss) per share	$	(0.42	)	$	0.57		$	(5.80	)
Dividends declared per common share	$	-		$	-		$	0.12

The accompanying notes are an integral part of these statements.

Consolidated Statements of Comprehensive Income (Loss)

	Year Ended August 31,
	2011			2010			2009
	(Dollars in thousands)
Net income (loss)	$	(5,117	)	$	6,683		$	(64,787	)
Other comprehensive income (loss):
Change in fair value of derivatives, net of tax benefit (expense) of $2,826, $530 and $(1,255)		(4,611	)		(864	)		2,047
Loss (gain) from derivative transactions reclassified into earnings from other comprehensive income, net of tax benefit (expense) of $3,630, $1,555 and $(1,837)		5,924			2,537			(2,998	)
Foreign currency translation adjustments		-			930			(7,635	)
Gain from foreign currency translation reclassified into earnings		-			(13,420	)		-
Actuarial gain (loss) on postretirement liabilities, net of tax benefit (expense) of $(2,450), $780 and $5,441		3,997			(1,272	)		(8,879	)
Loss from postretirement liabilities reclassified to earnings, net of tax benefit of $601, $645 and $119		981			1,053			194
Other comprehensive income (loss)		6,291			(11,036	)		(17,271	)
Total comprehensive income (loss)	$	1,174		$	(4,353	)	$	(82,058	)

The accompanying notes are an integral part of these statements.

35

Consolidated Statements of Cash Flows

	Year Ended August 31,
	2011			2010			2009
	(Dollars in thousands)
Operating activities:
Net income (loss)	$	(5,117	)	$	6,683		$	(64,787	)
Less: Net income (loss) from discontinued operations	$	—		$	16,312		$	(58,142	)
Net loss from continuing operations	$	(5,117	)	$	(9,629	)	$	(6,645	)
Adjustments to reconcile net loss from continuing operations to net cash provided by (used in ) operations:
Depreciation and amortization		14,415			14,791			14,455
Stock-based compensation		1,117			1,611			2,656
Loss (gain) on sale and disposal of assets		6			(2	)		(1,554	)
Deferred income tax expense (benefit)		142			(4,578	)		—
Loss (gain) on derivative transactions		(1,620	)		(3,134	)		3,457
Foreign currency transaction gain		—			(419	)		(127	)
Loss on early extinguishment of debt		—			1,049			—
Accrued interest on preferred stock (Series A)		3,859			1,452			—
Change in operating assets and liabilities:
Trade accounts receivable		(2,769	)		5,250			(20,111	)
Inventories		(11,264	)		1,405			4,760
Decrease (increase) in margin accounts		1,975			(502	)		2,299
Prepaid expenses		(754	)		(383	)		(1,429	)
Accounts payable and accrued liabilities		1,637			(598	)		(15,987	)
Income tax receivable		3,557			(138	)		4,222
Insurance recovery receivable		—			—			8,000
Other		(2,269	)		3,893			(5,176	)
Net cash flow provided by (used in ) operating activities – continuing operations		2,915			10,068			(11,180	)
Investing activities:
Acquisitions of property, plant and equipment, net		(8,295	)		(5,980	)		(5,379	)
Proceeds from sale of dextrose product line		—			—			2,857
Net proceeds received from sale of discontinued operations and other		42			20,712			725
Net cash provided by (used in) investing activities – continuing operations		(8,253	)		14,732			(1,797	)
Financing activities:
Proceeds from revolving line of credit		38,550			30,700			55,931
Payments on revolving line of credit		(35,350	)		(58,033	)		(24,500	)
Proceeds from issuance of long-term debt		—			2,000			—
Payments on long-term debt		(200	)		(45,992	)		(7,750	)
Proceeds from issuance of preferred stock		—			40,000			—
Issuance costs of preferred stock		—			(1,995	)		—
Payments on capital lease obligations		(253	)		(245	)		(263	)
Payment of loan fees		—			(1,227	)		(1,574	)
Increase (decrease) in cash overdraft		2,518			4,385			(1,301	)
Payment of dividends		—			—			(2,026	)
Other		39			19			—
Net cash provided by (used in) financing activities – continuing operations		5,304			(30,388	)		18,517

36

Cash flows from discontinued operations:
Net cash (used in) provided by operating activities		-			6,329			(1,713	)
Net cash used in investing activities		-			(2,848	)		(290	)
Net cash (used in) provided by financing activities		-			(3,399	)		2,044
Effect of exchange rate changes on cash and cash equivalents		-			(353	)		59
Net cash (used in) provided by discontinued operations		-			(271	)		100
Increase (decrease) in cash and cash equivalents		(34	)		(5,859	)		5,640
Cash and cash equivalents of continuing operations , beginning of year		315			5,540			-
Cash balance of discontinued operations, beginning of year		-			634			534
Cash and cash equivalents, end of year		315			315			6,174
Less: cash balance of discontinued operations, end of year		-			-			634
Cash and cash equivalents of continuing operations, end of year	$	281		$	315		$	5,540
Supplemental disclosure of cash flow information
Cash paid during the year for:
Interest	$	3,815		$	4,939		$	3,596
Income taxes refunded, net	$	(3,373	)	$	(172	)	$	(10,300	)
Noncash investing and financing activities:
Capital lease obligations incurred for certain equipment leases	$	10		$	34		$	-

The accompanying notes are an integral part of these statements.

37

Consolidated Statements of Shareholders’ Equity

	Year Ended August 31,
	2011			2010			2009
	(Dollars in thousands)
Common stock
Balance, beginning of year	$	13,190		$	13,157		$	13,127
Issuance of restricted stock, net		53			33			30
Balance, end of year		13,243			13,190			13,157
Preferred stock
Balance, beginning of year		100			—			—
Issuance of preferred stock, Series B		—			100			—
Balance, end of year		100			100			—
Additional paid-in capital
Balance, beginning of year		102,303			93,829			91,443
Tax deficiency on stock option and awards		(297	)		(321	)		(256	)
Stock based compensation		1,117			1,586			2,672
Issuance of restricted stock, net		(53	)		(33	)		(30	)
Issuance of preferred stock		—			7,242			—
Balance, end of year		103,070			102,303			93,829
Retained earnings
Balance, beginning of year		14,586			7,944			74,092
Net income (loss)		(5,117	)		6,683			(64,787	)
Dividends declared		—			—			(1,352	)
Other		(101	)		(41	)		(9	)
Balance, end of year		9,368			14,586			7,944
Treasury stock		(32,757	)		(32,757	)		(32,757	)
Accumulated other comprehensive income (loss):
Balance, beginning of year		(13,850	)		(2,814	)		14,457
Change in fair value of derivatives, net of tax		(11,464	)		(864	)		2,047
Loss (gain) from derivative transactions reclassified into earnings from other comprehensive income, net of tax		12,777			2,537			(2,998	)
Foreign currency translation adjustments		—			930			(7,635	)
Gain from foreign currency translation reclassified into earnings		—			(13,420	)		—
Net (increase) decrease in postretirement liabilities, net of tax		4,978			(219	)		(8,685	)
Balance, end of year		(7,559	)		(13,850	)		(2,814	)
Total shareholders’ equity	$	85,465		$	83,572		$	79,359

The accompanying notes are an integral part of these statements.

38

Notes to Consolidated Financial Statements

Note 1 — Organization and Business and Summary of Significant Accounting Policies

Business

Penford Corporation (“Penford” or the “Company”) is a developer, manufacturer and marketer of specialty natural-based ingredient systems for industrial and food ingredient applications and ethanol. Penford’s products provide convenient and cost-effective solutions derived from renewable sources. Sales of the Company’s products are generated using a combination of direct sales and distributor agreements.

The Company has extensive research and development capabilities, which are used in understanding the complex chemistry of carbohydrate-based materials and in developing applications to address customer needs. In addition, the Company has specialty processing capabilities for a variety of modified starches.

Penford manages its business in two segments. The Industrial Ingredients and Food Ingredients segments, located in the U.S., are broad categories of end-market users. The Industrial Ingredients segment is a supplier of chemically modified specialty starches to the paper and packaging industries and a producer of ethanol. The Food Ingredients segment is a developer and manufacturer of specialty starches and dextrin to the food manufacturing and food service industries. See Note 19 for financial information regarding the Company’s business segments.

Basis of Presentation

The accompanying consolidated financial statements include the accounts of Penford and its wholly owned subsidiaries. All material intercompany balances and transactions have been eliminated. Certain reclassifications have been made to prior years’ financial statements in order to conform to the current year presentation.

Discontinued Operations

In August 2009, the Company committed to a plan to exit from the business conducted by the Company’s Australia/New Zealand Operations. On September 2, 2009, the Company completed the sale of Penford New Zealand Limited (“Penford New Zealand”). On November 27, 2009, the Company completed the sale of the operating assets of its subsidiary company Penford Australia Limited (“Penford Australia”), including its two remaining Australian plants. The financial results of the Australia/New Zealand Operations have been classified as discontinued operations in the consolidated statement of operations. See Note 17 for additional information regarding discontinued operations. At August 31, 2011, the remaining net assets of the Australia/New Zealand Operations, consisting of $0.3 million of cash and $0.8 million of other net assets, primarily a receivable from the purchaser of one of the Company’s Australian manufacturing facilities, have been reported as assets and liabilities of the continuing operations of the Company. Unless otherwise indicated, amounts and discussions in these notes pertain to the Company’s continuing operations.

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Estimates are used in accounting for, among other things, the allowance for doubtful accounts, accruals, the determination of assumptions for pension and postretirement employee benefit costs, useful lives of property and equipment, the assessment of a potential impairment of goodwill, and income taxes including the determination of a need for a valuation allowance for deferred tax assets. Actual results may differ from previously estimated amounts.

39

Cash and Cash Equivalents

Cash and cash equivalents consist of cash and temporary investments with maturities of less than three months when purchased. Amounts are reported in the balance sheets at cost, which approximates fair value.

Cash Overdrafts

Cash overdrafts represent the amount by which outstanding checks issued, but not yet presented to banks for disbursement, exceed balances on deposit in the applicable bank accounts. The changes in cash overdrafts are included as a component of cash flows from financing activities in the consolidated statements of cash flows.

Allowance for Doubtful Accounts and Concentration of Credit Risk

The allowance for doubtful accounts reflects the Company’s best estimate of probable losses in the accounts receivable balances. Penford estimates the allowance for uncollectible accounts based on historical experience, known troubled accounts, industry trends, economic conditions, how recently payments have been received, and ongoing credit evaluations of its customers. Activity in the allowance for doubtful accounts for fiscal 2011, 2010 and 2009 is as follows (dollars in thousands):

	Balance Beginning of Year		Charged to Costs and Expenses			Deductions and Other			Balance End of Year
Year ended August 31:
2011	$	350	$	958		$	(3	)	$	1,305
2010	$	605	$	(218	)	$	(37	)	$	350
2009	$	550	$	(2	)	$	57		$	605

Approximately 40%, 45% and 52% of the Company’s sales in fiscal 2011, 2010 and 2009, respectively, were made to customers who operate in the paper industry. This industry suffered an economic downturn, which has resulted in the closure of a number of mills. In fiscal 2011, the allowance for uncollectible accounts increased primarily related to two paper industry customers.

Inventories

Inventory is stated at the lower of cost or market. Inventory is valued using the first-in, first-out (“FIFO”) method, which approximates actual cost. Capitalized costs include materials, labor and manufacturing overhead related to the purchase and production of inventories.

Goodwill and Other Intangible Assets

In accordance with Accounting Standards Codification (“ASC” or the “Codification”) 350, “Intangibles - Goodwill and Other,” goodwill is not amortized, but instead is tested for impairment at least annually or more frequently if there is an indication of impairment.

The Company evaluates its goodwill for impairment annually and whenever events or circumstances make it more likely than not that an impairment may have occurred. To determine whether goodwill is impaired, Penford compares the fair value of each reporting units to that report unit’s carrying amount. If the fair value of the reporting unit is greater than its carrying amount goodwill is not considered impaired. If the fair value of the reporting unit is lower than its carrying amount, Penford then compares the implied fair value of the reporting unit’s goodwill with the carrying amount of that goodwill and if the carrying value is higher than the fair value, impairment is recorded. The implied fair value of a reporting unit is determined using a discounted cash flow method considering the Company’s market capitalization.

Patents are amortized using the straight-line method over their estimated period of benefit. At August 31, 2011, the weighted average remaining amortization period for patents is four years. Penford has no intangible assets with indefinite lives.

40

Property, Plant and Equipment

Property, plant and equipment are recorded at cost. Expenditures for maintenance and repairs are expensed as incurred. The Company uses the straight-line method to compute depreciation expense assuming average useful lives of three to forty years for financial reporting purposes. Equipment and vehicle leases generally have average useful lives ranging from three to twelve years and real estate between twelve to forty-six years. Depreciation, which includes depreciation of assets under capital leases, of $12.8 million, $13.1 million and $13.8 million was recorded in fiscal years 2011, 2010 and 2009, respectively. For income tax purposes, the Company generally uses accelerated depreciation methods.

Interest is capitalized on major construction projects while in progress. No interest was capitalized in fiscal years 2011, 2010 and 2009.

Income Taxes

The provision for income taxes includes federal and state taxes currently payable and deferred income taxes arising from temporary differences between financial and income tax reporting methods. Deferred taxes are recorded using the liability method in recognition of these temporary differences. A valuation allowance is provided to the extent that it is more likely than not that deferred tax assets will not be realized. The Company has not provided deferred taxes related to its investment in foreign subsidiaries, which are classified as discontinued operations, as it does not expect future distributions from the subsidiaries or repayments of permanent advances.

Revenue Recognition

Revenue from sales of products and shipping and handling revenue are recognized at the time goods are shipped and title transfers to the customer. This transfer is considered complete when a sales agreement is in place, delivery has occurred, pricing is fixed or determinable and collection is reasonably assured. Costs associated with shipping and handling is included in cost of sales.

Research and Development

Research and development costs are expensed as incurred, except for costs of patents, which are capitalized and amortized over the lives of the patents. Research and development costs expensed were $4.8 million, $4.4 million and $4.3 million in fiscal 2011, 2010 and 2009, respectively.

Foreign Currency

Assets and liabilities of subsidiaries whose functional currency is deemed to be other than the U.S. dollar are translated at year end rates of exchange. Resulting translation adjustments are accumulated in the currency translation adjustments component of other comprehensive income. Statement of Operations amounts are translated at average exchange rates prevailing during the year. The net foreign currency transaction gain (loss) recognized in earnings was $0.4 million and $0.1 million for fiscal years 2010 and 2009, respectively.

Derivatives

Penford uses derivative instruments to manage the exposures associated with commodity prices, interest rates and energy costs. The derivative instruments are reported at fair value in other current assets or accounts payable in the consolidated balance sheets.

For derivative instruments designated as fair value hedges, the gain or loss on the derivative instruments as well as the offsetting gain or loss on the hedged firm commitments are recognized in current earnings as a component of cost of goods sold. For derivative instruments designated as cash flow hedges, the effective portion

41

of the gain or loss on the derivative instruments is reported as a component of other comprehensive income (loss), net of applicable income taxes, and recognized in earnings when the hedged exposure affects earnings. The Company recognizes the gain or loss on the derivative instrument as a component of cost of goods sold in the period when the finished goods produced from the hedged item are sold or, for interest rate swaps, as a component of interest expense in the period the forecasted transaction is reported in earnings. If it is determined that the derivative instruments used are no longer effective at offsetting changes in cash flows or fair value of the hedged item, then the changes in fair value would be recognized in current earnings as a component of cost of good sold or interest expense.

Significant Customer and Export Sales

The Company has several relatively large customers in each business segment. The Company’s sales of ethanol to its sole ethanol customer, Eco-Energy, Inc., represented approximately 34%, 27% and 21% of the Company’s net sales for fiscal years 2011, 2010 and 2009, respectively. Eco-Energy, Inc. is a marketer and distributor of bio-fuels in the United States and Canada. The Company’s second largest customer, Domtar, Inc., represented approximately 8%, 8% and 11% of the Company’s net sales for fiscal years 2011, 2010 and 2009, respectively. Domtar, Inc. and Eco-Energy are customers of the Company’s Industrial Ingredients business. Export sales accounted for approximately 9%, 9% and 8% of consolidated sales in fiscal 2011, 2010 and 2009, respectively.

Stock-Based Compensation

The Company recognizes stock-based compensation in accordance with Financial Accounting Standards Board (“FASB”) ASC 718, “Compensation – Stock Compensation.” The Company utilizes the Black-Scholes option-pricing model to determine the fair value of stock options on the date of grant. This model derives the fair value of stock options based on certain assumptions related to expected stock price volatility, expected option life, risk-free interest rate and dividend yield. See Note 10 for further detail.

Recent Accounting Pronouncements

In June 2011, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update No. 2011-05,Comprehensive Income (“ASU 2011-05”). To increase the prominence of items reported in other comprehensive income, the FASB eliminated the option of presenting components of other comprehensive income as part of the statement of changes in stockholders’ equity. ASU 2011-05 requires that all nonowner changes in stockholders’ equity be presented either in a single continuous statement of comprehensive income or in two separate but consecutive statements. Regardless of the presentation of the components of other comprehensive income, ASU 2011-05 requires that the Company present on the face of the financial statements the reclassification adjustments for items that are reclassified from other comprehensive income to net income. The requirements of ASU 2011-05 will be effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. The implementation of ASU 2011-05 is not expected to have a material impact on the Company’s consolidated financial statements.

Note 2 — Inventories

Components of inventory are as follows:

	August 31,
	2011		2010
	(Dollars in thousands)
Raw materials	$	14,799	$	8,708
Work in progress		1,752		1,299
Finished goods		16,182		9,842
Total inventories	$	32,733	$	19,849

42

To reduce the price volatility of corn used in fulfilling some of its starch sales contracts, Penford, from time to time, uses readily marketable exchange-traded futures as well as forward cash corn purchases. The exchange-traded futures are not purchased or sold for trading or speculative purposes and are designated as hedges. See Note 13.

Note 3 — Property and equipment

Components of property and equipment are as follows:

	August 31,
	2011			2010
	(Dollars in thousands)
Land	$	10,552		$	10,307
Plant and equipment		330,273			324,904
Construction in progress		6,375			4,272
		347,200			339,483
Accumulated depreciation		(239,828	)		(227,553	)
Net property and equipment	$	107,372		$	111,930

The above table includes approximately $0.5 million and $0.7 million of equipment under capital leases for fiscal years 2011 and 2010, respectively.

Note 4 — Goodwill and other intangible assets

The Company’s goodwill of $7.9 million at August 31, 2011 and 2010, relates to the Company’s Food Ingredients reporting unit. The Company completed its evaluation of the carrying value of goodwill as of June 1, 2011 and determined there was no impairment to the recorded value of goodwill. In order to identify potential impairments, Penford compared the fair value of its Food Ingredients reporting unit with its carrying amount, including goodwill. Penford then compared the implied fair value of goodwill with the carrying amount of that goodwill. The implied fair value of the reporting unit was determined using the discounted cash flow method, the implied market capitalization method and the guideline company method. Since there was no indication of impairment, Penford was not required to complete the second step of the process which would measure the amount of any impairment. At June 1, 2011, the fair value of the Food Ingredients reporting unit was substantially in excess of its carrying value, and there are no changes in that conclusion as of August 31, 2011.

Penford’s intangible assets consist of patents which are being amortized over the weighted average remaining amortization period of four years as of August 31, 2011. There is no residual value associated with patents. The carrying amount and accumulated amortization of intangible assets are as follows (dollars in thousands):

	August 31, 2011				August 31, 2010
	Carrying Amount		Accumulated Amortization		Carrying Amount		Accumulated Amortization
Intangible assets:
Patents	$	1,768	$	1,436	$	1,768	$	1,361

Amortization expense related to intangible assets was $0.1 million in each of fiscal years 2011, 2010 and 2009. The estimated aggregate annual amortization expense for patents is not significant for the next five fiscal years, 2012 through 2016.

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Note 5 — Preferred Stock Subject to Mandatory Redemption

On April 7, 2010, the Company issued $40 million of Series A 15% cumulative non-voting, non-convertible preferred stock (“Series A Preferred Stock”) and 100,000 shares of Series B voting convertible preferred stock (“Series B Preferred Stock”) in a private placement to Zell Credit Opportunities Master Fund, L.P., an investment fund managed by Equity Group Investments, a private investment firm (the “Investor”). Proceeds from the preferred stock issuance of $40.0 million were used to repay bank debt on April 8, 2010. The Company has 1,000,000 shares of authorized preferred stock, $1.00 par value, of which 200,000 shares are issued and outstanding at August 31, 2010 in two series as shown below.

	Shares Issued and Outstanding
Series A 15% Cumulative Non-Voting Non-Convertible Preferred Stock, redeemable		100,000
Series B Voting Convertible Preferred Stock		100,000

The Company recorded the Series A Preferred Stock and the Series B Preferred Stock at their relative fair values at the time of issuance. The Series A Preferred Stock of $32.3 million was recorded as a long-term liability due to its mandatory redemption feature and the Series B Preferred Stock of $7.7 million was recorded as equity. The discount on the Series A Preferred Stock is being amortized into income using the effective interest method over the contractual life of seven years. At August 31, 2011, the carrying value of the Series A Preferred Stock liability of $39.0 million includes $5.3 million of accrued dividends, and $1.4 million of discount accretion for the period from the date of issuance to August 31, 2011. The accrued dividends represent the 9% dividends that may be paid or accrued at the option of the Company. Dividends on the Series A Preferred Stock and the discount accretion are recorded as interest expense in the consolidated statements of operations.

The holders of the Series A Preferred Stock are entitled to cash dividends of 6% on the sum of the outstanding Series A Preferred Stock plus accrued and unpaid dividends. In addition, dividends equal to 9% of the outstanding Series A Preferred Stock may accrue or be paid currently at the discretion of the Company. Dividends are payable quarterly beginning May 31, 2010.

The Series A Preferred Stock is mandatorily redeemable on April 7, 2017 at a per share redemption price equal to the original issue price of $400 per share plus any accrued and unpaid dividends. At any time on or after April 7, 2012, the Company may redeem, in whole or in part, the shares of the Series A Preferred Stock at a per share redemption price of the original issue price plus any accrued and unpaid dividends.

The Company may not declare or pay any dividends on its common stock or incur new indebtedness that exceeds a specified ratio without first obtaining approval from the holders of a majority of the Series A Preferred Stock.

The Company also granted to the investor certain information and inspection rights and the right to elect one director to the Company’s Board of Directors while any shares of Series A Preferred Stock remain outstanding. On April 9, 2010, the Board of Directors, upon the recommendation of the investor, elected Matthew Zell, a Managing Director of Equity Group Investments, to be the director designated by the holders of the Series A Preferred Stock.

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Note 6 — Debt

	August 31,
	2011		2010
	(Dollars in thousands)
Secured credit agreements — revolving loans, 3.40% weighted average interest rate at August 31, 2011	$	22,100	$	18,900
Iowa Department of Economic Development loans		1,633		1,834
Capital lease obligations		490		733
		24,223		21,467
Less: current portion and short-term borrowings		421		429
Long-term debt and capital lease obligations	$	23,802	$	21,038

In fiscal year 2007, Penford entered into a $145 million Second Amended and Restated Credit Agreement (the “2007 Agreement”) among the Company; Harris N.A. (which has been replaced by the Bank of Montreal); LaSalle Bank National Association (now Bank of America); Cooperative Centrale Raiffeisen-Boorleenbank B.A., “Rabobank Nederland” (New York Branch); U.S. Bank National Association; and the Australia and New Zealand Banking Group Limited.

On April 7, 2010, the Company used the proceeds from the preferred stock issuance discussed above to pay a portion of the outstanding bank debt obligations under the 2007 Agreement. Also on April 7, 2010, the Company refinanced its bank debt. The Company entered into a $60 million Third Amended and Restated Credit Agreement (the “2010 Agreement”) among the Company; Penford Products Co.; Bank of Montreal; Bank of America National Association; and Cooperatieve Centrale Raiffeisen-Boerenleenbank B.A., “Rabobank Nederland” New York Branch.

The 2010 Agreement refinanced the unpaid debt remaining under the 2007 Agreement. Under the 2010 Agreement, the Company may borrow $60 million in revolving lines of credit. The lenders’ revolving credit loan commitment may be increased under certain conditions. On August 31, 2011, the Company had $22.1 million outstanding under the 2010 Agreement, which is subject to variable interest rates. Under the 2010 Agreement, there are no scheduled principal payments prior to maturity on April 7, 2015. Substantially all of the Company’s assets secure the 2010 Agreement.

Interest rates under the 2010 Agreement are based on either the London Interbank Offering Rates (“LIBOR”) or the prime rate, depending on the selection of available borrowing options under the 2010 Agreement. The Company may choose a borrowing rate of 1-month, 3-month or 6-month LIBOR. Pursuant to the 2010 Agreement, the interest rate margin over LIBOR ranges between 3% and 4%, depending upon the Total Funded Debt Ratio (as defined).

The 2010 Agreement provides that the Total Funded Debt Ratio, which is computed as funded debt divided by earnings before interest, taxes, depreciation and amortization (as defined in the 2010 Agreement) shall not exceed 3.00. In addition, the Company must maintain a Fixed Charge Coverage Ratio, as defined in the 2010 Agreement, of not less than 1.35. Annual capital expenditures are restricted to $15 million (excluding certain capital expenditures specified in the 2010 Agreement) if the Total Funded Debt Ratio is greater than 2.00 for two consecutive fiscal quarters. The Company’s obligations under the 2010 Agreement are secured by substantially all of the Company’s assets. Pursuant to the 2010 Agreement, the Company may not declare or pay dividends on, or make any other distributions in respect of, its common stock. The Company was in compliance with the covenants in the 2010 Agreement as of August 31, 2011.

In connection with the refinancing, the Company recorded a pre-tax non-cash charge to earnings of $1.0 million in the third quarter of fiscal 2010 related to unamortized transaction fees associated with the prior credit facility. The Company also terminated its interest rate swaps in the third quarter of fiscal 2010 and recorded a charge to earnings of $1.6 million.

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During the first quarter of fiscal 2010, the Iowa Department of Economic Development (“IDED”) awarded financial assistance to the Company as a result of the temporary shutdown of the Cedar Rapids, Iowa plant in the fourth quarter of fiscal 2008 due to record flooding of the Cedar River. The IDED provided two five-year non interest bearing loans as follows: (1) a $1.0 million loan to be repaid in 60 equal monthly payments of $16,667 beginning December 1, 2009, and (2) a $1.0 million loan which is forgivable if the Company maintains certain levels of employment at the Cedar Rapids plant. The proceeds of these Iowa loans were used to repay outstanding debt under the 2007 Agreement in the first quarter of fiscal 2010. At August 31, 2011, the Company had $1.6 million outstanding related to the IDED loans.

The maturities of debt existing at August 31, 2011 for the fiscal years beginning with fiscal 2012 are as follows (dollars in thousands):

2012	$	421
2013		447
2014		203
2015		23,152
	$	24,223

Included in the Company’s long-term debt at August 31, 2011 is $0.5 million of capital lease obligations, of which $0.2 million is considered current portion of long-term debt. See Note 9.

Note 7 — Stockholders’ Equity

Common Stock

	Year Ended August 31,
	2011		2010		2009
Common shares outstanding
Balance, beginning of year		13,189,581		13,157,387		13,127,369
Issuance of restricted stock, net		53,804		32,194		30,018
Balance, end of year		13,243,385		13,189,581		13,157,387

Preferred Stock, Series B

On April 7, 2010, the Company issued $40 million of Series A 15% cumulative non-voting, non-convertible preferred stock (“Series A Preferred Stock”) and 100,000 shares of Series B voting convertible preferred stock (“Series B Preferred Stock”) in a private placement to Zell Credit Opportunities Master Fund, L.P., an investment fund managed by Equity Group Investments, a private investment firm (the “Investor”). See Note 5 for further details. Series B Preferred Stock was recorded at its relative fair value of $7.7 million at the time of issuance and recorded as equity. The holders of the Series B Preferred Stock are entitled to dividends equal to the per share dividend declared and paid on the Company’s common stock times the number of shares of common stock into which the Series B Preferred Stock is then convertible. The Series B Preferred Stock is not redeemable and dividends on the Series B Preferred Stock are non-cumulative. In the event the Company voluntarily or involuntarily liquidates, dissolves or winds up, the holders of shares of Series B Preferred Stock at the time of such event shall be entitled to participate in any liquidating distribution based on the amount payable to holders of the Company’s common stock at the same time that distributions of assets are made to the holders of the common stock. Holders of the Series B Preferred Stock shall participate in such distributions on a basis as if each share of Series B Preferred Stock had been converted, immediately prior to such liquidating distribution, into the number of shares of common stock at the then applicable conversion rate.

At any time prior to April 7, 2020, at the option of the holder, the outstanding Series B Preferred Stock may be converted into shares of the Company’s common stock at a conversion rate of ten shares of common stock per one share of Series B Preferred Stock, subject to adjustment in the event of stock dividends, distributions, splits,

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reclassifications and the like. If any shares of Series B Preferred Stock have not been converted into shares of common stock prior to April 7, 2020, the shares of Series B Preferred Stock will automatically convert into shares of common stock. The holders of the Series B Preferred Stock shall have the right to one vote for each share of common stock into which the Series B Preferred Stock is convertible.

In connection with this investment, the Company also agreed to register the shares of Common Stock issuable upon conversion of the Series B Preferred Stock. The registration statement for these shares of Common Stock became effective on June 7, 2010.

Until April 7, 2012, the Investor may not acquire any additional shares of common stock, and may not, with limited exceptions, transfer the Series B Preferred Stock, or the Company’s Common Stock into which the Series B Preferred Stock is convertible.

Note 8 — Accumulated Other Comprehensive Loss

The components of accumulated other comprehensive losses are as follows:

	August 31,
	2011			2010
	(Dollars in thousands)
Net unrealized loss on derivatives, net of tax	$	731		$	(582	)
Postretirement obligations, net of tax		(8,290	)		(13,268	)
		$    (7,559)			$    (13,850)

Note 9 — Leases

Certain of the Company’s property, plant and equipment is leased under operating leases. Equipment and vehicle leases generally have lease terms ranging from one to fifteen years with renewal options and real estate leases range between five to twenty years with renewal options. In fiscal 2011, rental expense under operating leases was $5.4 million. In fiscal 2010, rental expense under operating leases was $6.0 million, net of sublease rental income of approximately $0.1 million and fiscal 2009; rental expense under operating leases was $6.8 million, net of sublease rental income of approximately $0.3 million. Future minimum lease payments for fiscal years beginning with fiscal year 2011 for noncancelable operating and capital leases having initial lease terms of more than one year are as follows (dollars in thousands):

	Capital     Leases			Operating Leases Minimum Lease     Payments
2012	$	258		$	3,330
2013		255			2,589
2014		3			1,786
2015		3			922
2016		—			622
Thereafter		—			305
Total minimum lease payments		519		$	9,554
Less: amounts representing interest		(29	)
Net minimum lease payments	$	490

Note 10 — Stock-based Compensation Plans

Penford maintains the 2006 Long-Term Incentive Plan (the “2006 Incentive Plan”) pursuant to which various stock-based awards may be granted to employees, directors and consultants. As of August 31, 2011, the aggregate number of shares of the Company’s common stock that are available to be issued as awards under the

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2006 Incentive Plan is 31,017. In addition, any shares previously granted under the 1994 Stock Option Plan which are subsequently forfeited or not exercised will be available for future grants under the 2006 Incentive Plan. Non-qualified stock options granted under the 2006 Incentive Plan generally vest ratably for periods from one to four years and expire seven years from the date of grant.

General Option Information

A summary of the stock option activity for the year ended August 31, 2011 is as follows:

	Number of         Shares			Option Price         Range		Weighted Average Exercise          Price		Weighted Average Remaining Term (in         years)		Aggregate Intrinsic         Value
Outstanding Balance, August 31, 2010		1,264,564		$	7.59 — 21.73	$	15.07
Granted		98,000			4.66 — 6.88		6.59
Exercised		-
Cancelled		(28,679	)		6.88 — 17.07		11.40
Outstanding Balance, August 31, 2011		1,333,885			4.66 — 21.73		14.52		2.68	$	8,400
Options Exercisable at August 31, 2011		1,158,635		$	7.73 — 21.73	$	14.95		2.31	$	-

The aggregate intrinsic value disclosed in the table above represents the total pretax intrinsic value, based on the Company’s closing stock price of $5.50 per share as of August 31, 2011 that would have been received by the option holders had all option holders exercised on that date. No stock options were exercised in fiscal years 2011, 2010 and 2009.

Valuation and Expense Under ASC 718

The Company utilizes the Black-Scholes option-pricing model to determine the fair value of stock options on the date of grant. This model derives the fair value of stock options based on certain assumptions related to expected stock price volatility, expected option life, risk-free interest rate and dividend yield. The Company’s expected volatility is based on the historical volatility of the Company’s stock price over the most recent period commensurate with the expected term of the stock option award. The estimated expected option life is based primarily on historical employee exercise patterns and considers whether and the extent to which the options are in-the-money. The risk-free interest rate assumption is based upon the U.S. Treasury yield curve appropriate for the term of the Company’s stock options awards and the selected dividend yield assumption was determined in view of the Company’s historical and estimated dividend payout. The Company has no reason to believe that the expected volatility of its stock price or its option exercise patterns would differ significantly from historical volatility or option exercises.

Under the 2006 Incentive Plan, the Company granted 98,000 stock options during fiscal 2011, (i) 80,000 stock options which vest one year from the date of grant, and (ii) 18,000 stock options which vest ratably over four years. The Company estimated the fair value of stock options granted during fiscal 2011 using the following weighted-average assumptions and resulting in the following weighted-average grant date fair value:

	2011
Expected volatility	71%
Expected life (years)	4.3
Interest rate	1.1-2.8%
Dividend yield	0%
Weighted-average fair values	$3.62

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No stock options were granted in fiscal years 2010 and 2009. As of August 31, 2011, the Company had $0.3 million of unrecognized compensation costs related to non-vested stock option awards that are expected to be recognized over a weighted average period of 1.1 years.

Restricted Stock Awards

The grant date fair value of the Company’s restricted stock awards is equal to the fair value of Penford’s common stock at the grant date. The following table summarizes the restricted stock award activity for the twelve months ended August 31, 2011 as follows:

	Number of         Shares			Weighted Average Grant Date         Fair Value
Nonvested at August 31, 2010		154,707		$	15.67
Granted		-
Vested		(70,475	)		16.87
Cancelled		-
Nonvested at August 31, 2011		84,232		$	14.67

No restricted stock awards were granted in fiscal year 2011. The weighted average grant date fair value of awards granted in fiscal years 2010 and 2009 was $6.60 and $10.12, respectively. The total fair value of awards vested in 2011, 2010, and 2009 was $1.2 million, $1.0 million and $1.1 million, respectively. On January 1, 2010 and 2009, each non-employee director received an award of 2,301 and 1,976 shares of restricted stock under the 2006 Incentive Plan at the last reported sale price of the stock on the preceding trading day, which vested one year from grant date of the award. The Company recognizes compensation cost for restricted stock ratably over the vesting period.

As of August 31, 2011, the Company had $0.1 million of unrecognized compensation costs related to non-vested restricted stock awards that is expected to be recognized over a weighted average period of 1.1 years.

Compensation Expense

The Company recognizes stock-based compensation expense utilizing the accelerated multiple option approach over the requisite service period, which equals the vesting period. The following table summarizes the total stock-based compensation cost for fiscal years 2011, 2010 and 2009 and the effect on the Company’s consolidated statements of operations (dollars in thousands):

	2011			2010			2009
Cost of sales	$	130		$	170		$	307
Operating expenses		949			1,413			2,300
Research and development expenses		38			28			49
Income (loss) from discontinued operations		-			(25	)		16
Total stock-based compensation expense	$	1,117		$	1,586		$	2,672
Income tax benefit		(424	)		(603	)		(1,015	)
Total stock-based compensation expense, net of tax	$	693		$	983		$	1,657

Note 11 — Pensions and Other Postretirement Benefits

Penford maintains two noncontributory defined benefit pension plans that cover approximately 75% of its employees. The defined benefit pension plans for salaried and bargaining unit hourly employees were closed to new participants effective January 1, 2005 and August 1, 2004, respectively.

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The Company also maintains a postretirement health care benefit plan covering its bargaining unit hourly retirees. Effective August 1, 2004, the Company’s postretirement health care benefit plan covering bargaining unit hourly employees was closed to new entrants and to any current employee who did not meet minimum requirements as to age plus years of service.

Obligations and Funded Status

The following represents information summarizing the Company’s pension and other postretirement benefit plans. A measurement date of August 31, 2011 was used for all plans.

	Year Ended August 31,
	Pension Benefits						Other Benefits
	2011			2010			2011			2010
	(Dollars in thousands)
Change in benefit obligation:
Benefit obligation at September 1	$	48,875		$	43,861		$	17,580		$	18,345
Service cost		1,617			1,608			272			353
Interest cost		2,696			2,633			972			1,077
Plan participants’ contributions		—			—			134			145
Actuarial (gain) loss		(1,099	)		463			333			10
Change in assumptions		(2,560	)		2,215			(1,736	)		(1,668	)
Benefits paid		(1,984	)		(1,905	)		(631	)		(682	)
Benefit obligation at August 31	$	47,545		$	48,875		$	16,924		$	17,580
Change in plan assets:
Fair value of plan assets at September 1	$	28,278		$	25,818		$	—		$	—
Actual return on plan assets		3,618			991			—			—
Company contributions		6,416			3,374			497			537
Plan participants’ contributions		—			—			134			145
Benefits paid		(1,984	)		(1,905	)		(631	)		(682	)
Fair value of the plan assets at August 31	$	36,328		$	28,278		$	—		$	—
Funded status:
Net liability – Plan assets less than projected benefit obligation	$	(11,217	)	$	(20,597	)	$	(16,924	)	$	(17,580	)
Recognized as:
Current accrued benefit liability	$	—		$	—		$	(731	)	$	(689	)
Non-current accrued benefit liability		(11,217	)		(20,597	)		(16,193	)		(16,891	)
Net Amount Recognized	$	(11,217	)	$	(20,597	)	$	(16,924	)	$	(17,580	)

Accumulated other comprehensive loss consists of the following amounts that have not yet been recognized as components of net benefit cost (dollars in thousands):

	August 31, 2011					August 31, 2010
	Pension Benefits		Other Benefits			Pension Benefits		Other Benefits
Unrecognized prior service cost (credit)	$	1,545	$	(459	)	$	1,773	$	(611	)
Unrecognized net actuarial loss		11,545		740			18,029		2,208
Total	$	13,090	$	281		$	19,802	$	1,597

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Selected information related to the Company’s defined benefit pension plans that have benefit obligations in excess of fair value of plan assets is presented below (dollars in thousands):

	August 31,
	2011		2010
Projected benefit obligation	$	47,545	$	48,875
Accumulated benefit obligation	$	46,113	$	46,142
Fair value of plan assets	$	36,328	$	28,278

Net Periodic Benefit Cost

	Year Ended August 31,
	Pension Benefits									Other Benefits
	2011			2010			2009			2011			2010			2009
	(Dollars in thousands)
Components of net periodic benefit cost
Service cost	$	1,617		$	1,608		$	1,420		$	272		$	353		$	259
Interest cost		2,696			2,633			2,581			972			1,077			913
Expected return on plan assets		(2,234	)		(2,022	)		(2,428	)		—			—			—
Amortization of prior service cost		228			244			253			(152	)		(152	)		(152	)
Amortization of actuarial loss		1,441			1,312			211			65			294			—
Benefit cost	$	3,748		$	3,775		$	2,037		$	1,157		$	1,572		$	1,020

Assumptions

The Company assesses its benefit plan assumptions on a regular basis. Assumptions used in determining plan information are as follows:

	August 31,
	Pension Benefits									Other Benefits
	2011			2010			2009			2011			2010			2009
Weighted-average assumptions used to calculate net periodic expense:
Discount rate		5.64	%		5.98	%		6.92	%		5.64	%		5.98	%		6.92	%
Expected return on plan assets		8.00	%		8.00	%		8.00	%
Rate of compensation increase		4.00	%		4.00	%		4.00	%
Weighted-average assumptions used to calculate benefit obligations at August 31:
Discount rate		5.87	%		5.64	%		5.98	%		5.87	%		5.64	%		5.98	%
Expected return on plan assets		8.00	%		8.00	%		8.00	%
Rate of compensation increase		3.00	%		4.00	%		4.00	%

The expected long-term return on assets assumption for the pension plans represents the average rate of return to be earned on plan assets over the period the benefits included in the benefit obligation are to be paid. In developing the expected rate of return, the Company considers long-term historical market rates of return as well as actual returns on the Company’s plan assets, and adjusts this information to reflect expected capital market trends. Penford also considers forward looking return expectations by asset class, the contribution of active management and management fees paid by the plans. The plan assets are held in qualified trusts and anticipated rates of return are not reduced for income taxes. The expected long-term return on assets assumption used to calculate net periodic pension expense was 8.0% for fiscal 2011. A decrease (increase) of 50 basis points in the expected return on assets assumptions would increase (decrease) pension expense by approximately $0.2 million based on the assets of the plans at August 31, 2011. The expected return on plan assets to be used in calculating fiscal 2012 pension expense is 8.0%.

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The discount rate used by the Company in determining pension expense and pension obligations reflects the yield of high quality (AA or better rating by a recognized rating agency) corporate bonds whose cash flows are expected to match the timing and amounts of projected future benefit payments. The discount rates to determine net periodic expense used in 2009 (6.92%), 2010 (5.98%) and 2011 (5.64%) reflect the change in bond yields over the last several years. During fiscal 2011, bond yields rose and Penford has increased the discount rate for calculating its benefit obligations at August 31, 2011, as well as net periodic expense for fiscal 2012, to 5.87%. Lowering the discount rate by 25 basis points would increase pension expense by approximately $0.2 million and other postretirement benefit expense by less than $0.1 million.

Unrecognized net loss amounts reflect the difference between expected and actual returns on pension plan assets as well as the effects of changes in actuarial assumptions. Unrecognized net losses in excess of certain thresholds are amortized into net periodic pension and postretirement benefit expense over the average remaining service life of active employees. Amortization of unrecognized net loss amounts is expected to increase net pension expense by approximately $0.8 million in fiscal 2012. Amortization of unrecognized net losses is expected to increase net postretirement health care expense by less than $0.1 million in fiscal 2012.

Assumed health care cost trend rates:	2011			2010			2009
Current health care trend assumption		8.00	%		8.00	%		9.00	%
Ultimate health care trend rate		4.50	%		4.50	%		4.75	%
Year ultimate health care trend is reached		2029			2028			2016

The assumed health care cost trend rate could have a significant effect on the amounts reported. A one-percentage-point change in the assumed health care cost trend rate would have the following effects:

	1-Percentage- Point Increase		1-Percentage- Point Decrease
	(Dollars in thousands)
Effect on total of service and interest cost components in fiscal 2011	$	199	$	(162	)
Effect on postretirement accumulated benefit obligation as of August 31, 2011	$	2,315		$    (1,945)

Plan Assets

The weighted average asset allocations of the investment portfolio for the pension plans at August 31 are as follows:

	Target			August 31,
	Allocation			2011			2010
U.S. equities		55	%		56	%		56	%
International equities		15	%		16	%		16	%
Fixed income investments		25	%		26	%		26	%
Real estate		5	%		2	%		2	%

The assets of the pension plans are invested in units of common trust funds actively managed by Russell Trust Company, a professional fund investment manager. The investment strategy for the defined benefit pension assets is to maintain a diversified asset allocation in order to minimize the risk of large losses and maximize the long-term risk-adjusted rate of return. No plan assets are invested in Penford shares. There are no plan assets for the Company’s postretirement health care plans.

See Note 13, “Fair Value Measurements and Derivative Instruments,” for a description of the fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The Company’s employee pension plan assets are principally comprised of the following types of investments:

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Common collective trust funds: The fair value of these funds is based on the cumulative net asset value of their underlying investments. The investments in common collective trust funds are comprised of equity funds, fixed income funds and international equity funds. The funds are valued at net asset value based on the closing market value of the units bought or sold as of the valuation date and are classified in Level 2 of the fair value hierarchy.

Real estate equity funds: The real estate equity funds are composed of underlying investments in primarily nine established income-producing real estate funds and short-term investment funds. The underlying fund net asset values are based on the values of the real estate assets as determined by appraisal. The appraisals are conducted in accordance with Appraisal Institute guidelines including consideration of projected income and expenses of the property as well as recent sales of similar properties. The underlying funds value all real estate investments quarterly and all real estate investments are independently appraised at least once per year as required by the Global Investment Performance Standards. Redemption requests are considered quarterly and are subject to notice of 110 days. The real estate fund is included in Level 3 of the fair value hierarchy.

The following table presents the fair value of the pension plan’s assets by major asset category as of August 31, 2011.

	Quoted Prices In Active Markets for Identical Instruments (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total
			(in thousands)
Common collective trust funds	$		$	35,651	$	-	$	35,651
Real estate equity funds		-		-		677		677
Fair value of plan assets	$	-	$	35,651	$	677	$	36,328

The following table summarizes the changes in fair value of the pension plan’s real estate equity fund (Level 3) for fiscal year ended August 31, 2011.

	Real Estate Equity Fund
	(in thousands)
Balance, August 31, 2010	$	566
Actual return on plan assets:
Relating to assets still held at the reporting date		111
Relating to assets sold during the period		-
Purchases and sales		-
Transfers in (out) of Level 3		-
Balance, August 31, 2011	$	677

Contributions and Benefit Payments

The Company’s funding policy for the defined benefit pension plans is to contribute amounts sufficient to meet the statutory funding requirements of the Employee Retirement Income Security Act of 1974 and the Pension Protection Act of 2006. The Company contributed $6.4 million, $3.4 million and $1.1 million in fiscal 2011, 2010 and 2009, respectively. The Company estimates that the minimum pension plan funding contribution during fiscal 2012 will be approximately $2.8 million.

Penford funds the benefit payments of its postretirement health care plans on a cash basis; therefore, the Company’s contributions to these plans in fiscal 2012 will approximate the benefit payments below.

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Expected benefit payments are based on the same assumptions used to measure the benefit obligations and include benefits attributable to estimate future employee service.

	Pension		Other Postretirement
	(Dollars in millions)
2012	$	2.1	$	0.7
2013		2.3		0.8
2014		2.4		0.9
2015		2.5		0.9
2016		2.6		1.0
2017-2021	$	15.8	$	6.1

Note 12 — Other Employee Benefits

Savings and Stock Ownership Plan

The Company has a defined contribution savings plan by which eligible employees can elect a maximum salary deferral of 16%. The plan provides a 100% match on the first 3% of salary contributions and a 50% match on the next 3% per employee. The Company’s matching contributions were $908,000, $897,000 and $935,000 for fiscal years 2011, 2010 and 2009, respectively.

Deferred Compensation Plan

The Company provided its directors and certain employees the opportunity to defer a portion of their salary, bonus and fees. The plan was closed to new contributions effective January 31, 2011. The deferrals earn interest based on Moody’s current Corporate Bond Yield. Deferred compensation interest of $197,000, $204,000 and $231,000 was accrued in fiscal years 2011, 2010 and 2009, respectively.

Supplemental Executive Retirement Plan

The Company sponsors a supplemental executive retirement plan, a non-qualified plan, which covers certain employees. No current executive officers participate in this plan. For fiscal 2011, 2010 and 2009, the net periodic pension expense accrued for this plan was $370,000, $343,000 and $342,000, respectively. The accrued obligation related to the plan was $2.7 million and $2.5 million for fiscal years 2011 and 2010, respectively. The plan was amended in fiscal 2011 such that no participant in the plan would accrue any additional benefits after January 31, 2011.

Health Care and Life Insurance Benefits

The Company offers health care and life insurance benefits to most active employees. Costs incurred to provide these benefits are charged to expense as incurred. Health care and life insurance expense, net of employee contributions, was $4.5 million, $4.7 million and $4.3 million in fiscal years 2011, 2010 and 2009, respectively.

Note 13 — Fair Value Measurements and Derivative Instruments

Fair Value Measurements

Fair value is defined as the price that would be received from selling an asset or paid to transfer a liability (an exit price) in Penford’s principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. A fair value hierarchy was established that requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when

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measuring fair value. Observable inputs are inputs that reflect the assumptions market participants would use in pricing the asset or liability developed based on market data obtained from sources outside the reporting entity. Unobservable inputs are inputs that reflect Penford’s own assumptions based on market data and on assumptions that market participants would use in pricing the asset or liability developed based on the best information available in the circumstances. The three levels of inputs that may be used to measure fair value are:

• Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the entity has the ability to access at the measurement date.

• Level 2 inputs are other than quoted prices included within Level 1 that are observable for assets and liabilities such as (1) quoted prices for similar assets or liabilities in active markets, (2) quoted prices for identical or similar assets or liabilities in markets that are not active, or (3) inputs that are derived principally or corroborated by observable market date by correlation or other means.

• Level 3 inputs are unobservable inputs to the valuation methodology for the assets or liabilities.

Presented below are the fair values of the Company’s derivatives as of August 31, 2011 and 2010:

As of August 31, 2011	(Level 1)		(Level 2)		(Level 3)		Total
			(in thousands)
Current assets (Other Current Assets):
Commodity derivatives(1)		$    (3,153)		$    -		$    -		$    (3,153)

(1) On the consolidated balance sheets, commodity derivative assets and liabilities have been offset by cash collateral due and paid under master netting arrangements which are recorded together in Other Current Assets. The cash collateral offset was $5.1 million at August 31, 2011.

As of August 31, 2010	(Level 1)		(Level2)		(Level3)		Total
			(in thousands)
Current assets (Other Current Assets):
Commodity derivatives(1)		$    (2,789)		$    -		$    -		$    (2,789)

(1) On the consolidated balance sheets, commodity derivative assets and liabilities have been offset by cash collateral due and paid under master netting arrangements which are recorded together in Other Current Assets. The cash collateral offset was $4.5 million at August 31, 2010.

Other Financial Instruments

The carrying value of cash and cash equivalents, receivables and payables approximates fair value because of their short maturities. The Company’s bank debt interest rate reprices with changes in market interest rates and, accordingly, the carrying amount of such debt approximates fair value.

In the first quarter of fiscal 2010, the Company received two non-interest bearing loans from the State of Iowa totaling $2.0 million. The carrying value of the debt at August 31, 2011 was $1.6 million and the fair value of the debt was estimated to be $1.4 million. See Note 6.

The fair value of the Series A Preferred Stock was determined using the market approach in comparing yields on similar debt securities. The discount on the Series A Preferred Stock is being amortized into income using the effective interest method over the contractual life of seven years. The carrying value of the Series A Preferred Stock at August 31, 2011 was $39.0 million and the estimated fair value was $43.3 million.

Interest Rate Swap Agreements

The Company used interest rate swaps to manage the variability of interest payments associated with its floating-rate debt obligations. The interest payable on the debt effectively became fixed at a certain rate and reduced the impact of future interest rate changes on future interest expense. Unrealized gains and losses on

55

interest rate swaps were included in accumulated other comprehensive income (loss). The periodic settlements on the swaps were recorded as interest expense. At August 31, 2011, the Company had no outstanding interest rate swaps and no gains or losses remaining in other comprehensive income (loss).

Commodity Contracts

The Company uses forward contracts and readily marketable exchange-traded futures on corn and natural gas to manage the price risk of those inputs to its manufacturing process. The Company also uses futures contracts to manage the variability of the cash flows from the forecasted sales of ethanol. The Company has designated these instruments as hedges.

For derivative instruments designated as fair value hedges, the gain or loss on the derivative instruments as well as the offsetting gain or loss on the hedged firm commitments and/or inventory are recognized in current earnings as a component of cost of sales. For derivative instruments designated as cash flow hedges, the effective portion of the gain or loss on the derivative instruments is reported as a component of other comprehensive income (loss), net of applicable income taxes, and recognized in earnings when the hedged exposure affects earnings. The Company recognizes the gain or loss on the derivative instrument as a component of cost of sales in the period when the finished goods produced from the hedged item are sold. If it is determined that the derivative instruments used are no longer effective at offsetting changes in the price of the hedged item, then the changes in fair value would be recognized in current earnings as a component of cost of goods sold.

To reduce the price volatility of corn used in fulfilling some of its starch sales contracts, Penford from time to time uses readily marketable exchange-traded futures as well as forward cash corn purchases. The exchange-traded futures are not purchased or sold for trading or speculative purposes and are designated as hedges. Penford also uses exchange-traded futures to hedge corn inventories and firm corn purchase contracts.

Prices for natural gas fluctuate due to anticipated changes in supply and demand and movement of prices of related or alternative fuels. To reduce the price risk caused by sudden market fluctuations, Penford generally enters into short-term purchase contracts or uses exchange-traded futures contracts to hedge exposure to natural gas price fluctuations. These futures contracts are designated as hedges.

Selling prices for ethanol fluctuate based on the availability and price of manufacturing inputs and the status of various government regulations and tax incentives. To reduce the risk of the price variability of ethanol, Penford enters into exchange-traded futures contracts to hedge exposure to ethanol price fluctuations. These futures contracts have been designated as hedges.

Hedged transactions are generally expected to occur within 12 months of the time the hedge is established. The deferred gain (loss), net of tax, recorded in other comprehensive income at August 31, 2011 that is expected to be reclassified into income within 12 months is $0.7 million.

As of August 31, 2011, Penford had purchased corn positions of 5.8 million bushels, of which 3.7 million bushels represented equivalent firm priced starch and ethanol sales contract volume, resulting in an open position of 2.1 million bushels.

As of August 31, 2011, the Company had the following outstanding futures contracts:

Corn Futures	2,875,000	Bushels
Natural Gas Futures	730,000	mmbtu (millions of British thermal units)
Ethanol Swaps	6,870,000	Gallons

56

The following tables provide information about the fair values of the Company’s derivatives, by contract type, as of August 31, 2011 and 2010.

	Assets					Liabilities
In thousands		Fair Value August 31					Fair Value August 31
	Balance Sheet Location	2011		2010		Balance Sheet Location	2011		2010
Cash Flow Hedges:
Corn Futures	Other Current Assets	$	137	$	-	Other Current Assets	$	-	$	-
Natural Gas Futures	Other Current Assets		-		-	Other Current Assets		454		1,082
Ethanol Futures	Other Current Assets		-		-	Other Current Assets		1,289		-
Fair Value Hedges:
Corn Futures	Other Current Assets		-		28	Other Current Assets		1,547		1,735
Total Derivatives
Designated as Hedging Instruments		$	137	$	28		$	3,290	$	2,817

The following tables provide information about the effect of derivative instruments on the financial performance of the Company for the year ended August 31, 2011 and August 31, 2010.

In thousands	Amount of Gain (Loss) Recognized in OCI						Amount of Gain (Loss) Reclassified from AOCI into Income						Amount of Gain (Loss) Recognized in Income
	Year Ended August 31						Year Ended August 31						Year Ended August 31
	2011			2010			2011			2010			2011			2010
Cash Flow Hedges:
Corn Futures(1)	$	(4,949	)	$	384		$	(7,418	)	$	349		$	(162	)	$	(194	)
Natural Gas Futures(1)		(579	)		(3,170	)		(1,332	)		(2,168	)		(85	)		-
Ethanol Futures(1)		(1,909	)		(590	)		(804	)		(493	)		-			-
Interest Rate Contracts(2)(4)		-			(395	)		-			(662	)		-			(1,562	)
FX Contracts(1)		-			-			-			(26	)		-			-
		$    (7,437)			$    (3,771)			$    (9,554)			$    (3,000)			$    (247)			$    (1,756)
Fair Value Hedges:
Corn Futures(1) (3)													$	28		$	85

(1) Gains and losses reported in cost of goods sold

(2) Gains and losses reported in interest expense

(3) Hedged items are firm commitments and inventory

(4) Amount of loss recognized in income was reported in non-operating income (expense)

Note 14 — Other Non-operating Income (Expense)

Other non-operating income (expense) consists of the following:

	Year Ended August 31,
	2011		2010			2009
	(Dollars in thousands)
Loss on extinguishment of debt	$	—	$	(1,049	)	$	—
Loss on interest rate swap termination		—		(1,562	)		—
Gain on sale of dextrose product line		—		—			1,562
Gain (loss) on foreign currency transactions		—		419			127
Other		115		271			226
	$	115	$	(1,921	)	$	1,915

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On April 7, 2010, the Company refinanced its bank debt. See Note 6. In connection with the refinancing, the Company recorded a pre-tax non-cash charge to earnings of approximately $1.0 million in the third quarter of fiscal 2010 related to unamortized transaction fees associated with the prior credit facility. In addition, the Company terminated its interest rate swap agreements with several banks and recorded a loss of approximately $1.6 million.

In the second quarter of fiscal 2009, the Company’s Food Ingredients business segment sold assets related to its dextrose product line to a third-party purchaser for $2.9 million, net of transaction costs. The Company recorded a $1.6 million gain on the sale.

The Company recognized a gain (loss) on foreign currency transactions on Australian dollar denominated assets and liabilities as disclosed in the table above.

Note 15 — Income Taxes

The majority of the Company’s loss from continuing operations before income taxes for fiscal years 2011, 2010 and 2009 of $4.8 million, $14.3 million and $10.1 million, respectively, is related to the Company’s domestic operations. See Note 17 for foreign income (loss) before income taxes and foreign tax expense. The majority of the Company’s foreign operations are included in the discontinued operations presentation in the consolidated financial statements.

Income tax expense (benefit) on continuing operations consists of the following:

	Year Ended August 31,
	2011		2010			2009
	(Dollars in thousands)
Current:
Federal	$	34	$	(332	)	$	(3,305	)
State		137		208			(141	)
		171		(124	)		(3,446	)
Deferred:
Federal		9		(4,447	)		291
State		133		(131	)		(291	)
		142		(4,578	)		-
Total	$	313	$	(4,702	)	$	(3,446	)
	Year Ended August 31,
	2011		2010			2009
	(Dollars in thousands)
Comprehensive tax expense (benefit) allocable to:
Income (loss) before taxes	$	313	$	(4,702	)	$	(3,446	)
Discontinued operations		-		(4,495	)		1,149
Comprehensive income (loss)		3,856		891			(5,906	)
	$	4,169	$	(8,306	)	$	(8,203	)

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A reconciliation of the statutory federal tax to the actual provision (benefit) for taxes is as follows:

	Year Ended August 31,
	2011			2010			2009
	(Dollars in thousands)
Statutory tax rate		35	%		35	%		35	%
Statutory tax on income	$	(1,682	)	$	(5,016	)	$	(3,532	)
State taxes, net of federal benefit		52			33			(221	)
Non-deductible expenses related to preferred stock		2,687			1,020			-
Research credit		(195	)		(54	)		(181	)
Ethanol credit		(975	)		(975	)		-
Foreign tax loss with no benefit		200			34			-
Prior year true up		79			306			36
Unrecognized tax benefits		67			(139	)		422
Other		80			89			30
Total provision (benefit)	$	313		$	(4,702	)	$	(3,446	)

The significant components of deferred tax assets and liabilities are as follows:

	August 31,
	2011		2010
	(Dollars in thousands)
Deferred tax assets:
Alternative minimum tax credit	$	3,108	$	3,108
Postretirement benefits		12,377		14,669
Provisions for accrued expenses		1,893		2,280
Stock-based compensation		2,357		2,392
Deferred flood losses		2,625		3,257
Net operating loss carryforward		8,242		9,497
Tax credit carryforwards		4,325		2,508
Other		2,487		2,374
Total deferred tax assets		37,414		40,085
Deferred tax liabilities:
Depreciation		21,678		21,659
Other		2,132		613
Total deferred tax liabilities		23,810		22,272
Net deferred tax assets	$	13,604	$	17,813
Recognized as:
Other current assets	$	909	$	1,320
Deferred tax asset		12,695		16,493
Total net deferred tax assets	$	13,604	$	17,813

At August 31, 2011, in the United States, the Company had a U.S. federal alternative minimum tax credit carryforward of $3.1 million with no expiration, research and development credit carryforwards of $1.3 million expiring 2025 through 2031, a small ethanol producer credit of $3.0 million expiring 2014, and a net operating loss carryforward of $20.6 million expiring in 2030. The Company also has U.S. state net operating loss carryforwards of $24.9 million with various expiration dates.

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At August 31, 2011, the Company had $13.6 million of net deferred tax assets. A valuation allowance has not been provided on the net U.S. deferred tax assets as of August 31, 2011. The determination of the need for a valuation allowance requires significant judgment and estimates. The Company evaluates the requirement for a valuation allowance each quarter as the Company incurred book losses in fiscal 2009, 2010 and 2011. The Company’s losses in fiscal years 2008 and 2009 were incurred as a result of severe flooding in Cedar Rapids, Iowa, which shut down the Company’s manufacturing facility for most of the fourth quarter of fiscal 2008. The tax benefits of operating losses incurred in fiscal 2008 and 2009 have been carried back to offset taxable income in prior years. While there have been losses since 2008 for reasons indicated above, the Company believes that it is more likely than not that future operations will generate sufficient taxable income to realize its deferred tax assets. Dividends on the Series A Preferred Stock, as well as accretion of the related discount, which are included in interest expense in the Consolidated Statement of Operations, are not deductible for U.S. federal income tax purposes. There can be no assurance that management’s current plans will be achieved or that a valuation allowance will not be required in the future.

Deferred tax liabilities or assets are not recognized on temporary differences from undistributed earnings of foreign subsidiaries and from foreign exchange translation gains or losses on permanent advances to foreign subsidiaries as the Company does not expect that the divestiture of its foreign subsidiaries will result in any tax benefit or expense.

The total amount of gross unrecognized tax benefits was $1.2 million at August 31, 2011, all of which, if recognized, would impact the Company’s effective tax rate. A reconciliation of the beginning and ending amount of unrecognized tax benefits is as follows (dollars in thousands):

	2011			2010
Unrecognized tax benefits at beginning of year	$	1,131		$	1,281
Additions for tax positions related to prior years		82			118
Reductions for tax positions related to prior years		-			-
Additions for tax positions related to current year		97			160
Reductions due to lapse of applicable statute of limitations		(90	)		(428	)
Settlements with taxing authorities		-			-
Unrecognized tax benefits at end of year	$	1,220		$	1,131

The Company’s policy is to recognize interest and penalty expense associated with uncertain tax positions as a component of income tax expense (benefit) in the consolidated statements of operations. As of August 31, 2011 and 2010, the Company had $0.2 million of accrued interest and penalties included in the long-term tax liability. During fiscal 2011, the Company increased the liability for unrecognized tax benefits by $22,000 for interest and $40,000 for penalties.

The Company files tax returns in the U.S. federal jurisdiction and various U.S. state jurisdictions, and is subject to examination by taxing authorities in all of those jurisdictions. From time to time, the Company’s tax returns are reviewed or audited by various U.S. state taxing authorities. The Company believes that adjustments, if any, resulting from these reviews or audits would not be material, individually or in the aggregate, to the Company’s financial position, results of operations or liquidity. It is reasonably possible that the amount of unrecognized tax benefits related to certain of the Company’s tax positions will increase or decrease in the next twelve months as audits or reviews are initiated and settled. At this time, an estimate of the range of a reasonably possible change cannot be made. In January 2011, the U.S. Internal Revenue Service (“IRS”) notified the Company that its tax refund of $3.5 million resulting from a carryback of tax losses from fiscal year 2009 to fiscal years 2006 and 2007 is being evaluated to determine whether the refund will be examined or accepted without examination. The Company has also been notified by the state of Alabama of an audit. The Company is not subject to income tax examinations by U.S. federal or state jurisdictions for fiscal years prior to 2007.

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Note 16 — Earnings (loss) per Common Share

The Company applies ASC 260-10-45, “Participating Securities and the Two-Class Method” (“ASC 260-10-45”) which requires all outstanding unvested share-based payment awards that contain rights to non-forfeitable dividends participate in undistributed earnings with common shareholders and, therefore, are included in computing earnings per share under the two-class method. Under the two-class method, net earnings are reduced by the amount of dividends declared in the period for each class of common stock and participating security. The remaining undistributed earnings are then allocated to common stock and participating securities, based on their respective rights to receive dividends. Restricted stock awards granted to certain employees and directors under the Company’s 2006 Incentive Plan which contain non-forfeitable rights to dividends at the same rate as common stock, are considered participating securities.

Basic earnings (loss) per share reflect only the weighted average common shares outstanding during the period. Diluted earnings (loss) per share reflect weighted average common shares outstanding and the effect of any dilutive common stock equivalent shares.Diluted earnings (loss) per share is calculated by dividing net income (loss) by the average common shares outstanding plus additional common shares that would have been outstanding assuming the exercise of in-the-money stock options, using the treasury stock method. The following table presents the reconciliation of income from continuing operations to income from continuing operations applicable to common shares and equivalents and the computation of diluted weighted average shares outstanding for the fiscal years 2011, 2010 and 2009.

	Year Ended August 31,
	2011			2010			2009
	(in thousands)
Numerator:
Loss from continuing operations	$	(5,117	)	$	(9,629	)	$	(6,645	)
Less: Allocation to participating securities		-			(84	)		(11	)
Loss from continuing operations applicable to common shares and equivalents	$	(5,117	)	$	(9,713	)	$	(6,656	)
Income (loss) from discontinued operations	$	-		$	16,312		$	(58,142	)
Less: Allocation to participating securities		-			-			-
Income (loss) from discontinued operations applicable to common shares and equivalents	$	-		$	16,312		$	(58,142	)
Net income (loss)	$	(5,117	)	$	6,683		$	(64,787	)
Less: Allocation to participating securities		-			(84	)		(11	)
Net income (loss) applicable to common shares and equivalents	$	(5,117	)	$	6,599		$	(64,798	)
Denominator:
Weighted average common shares and equivalents outstanding, basic		12,251			11,601			11,170
Dilutive stock options and awards		-			-			-
Weighted average common shares and equivalents outstanding, diluted		12,251			11,601			11,170

The 100,000 shares of Series B Preferred Stock are included in the weighted average common shares and equivalents computation of basic earnings per share.

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Weighted-average restricted stock awards of 98,158, 146,668 and 90,868 for fiscal years 2011, 2010 and 2009, respectively, were excluded from the calculation of diluted earnings per share because they were antidilutive. Weighted-average stock options omitted from the denominator of the earnings per share calculation because they were antidilutive were 1,325,945, 1,309,273 and 1,371,701 for 2011, 2010 and 2009, respectively.

Note 17 — Discontinued Operations

As discussed in Note 1, the Company sold its Australia/New Zealand operations in 2009. At August 31, 2011, the remaining net assets of the Australia/New Zealand Operations consist of $0.3 million of cash and $0.8 million of other net assets, primarily a receivable from the purchaser of one of the Company’s Australian manufacturing facilities. Proceeds from the sale included $2.0 million in escrow to be released in four equal installments. Penford Australia received the first two installments of $0.5 million each. The remaining escrowed payments of $1.0 million are subject to the buyer’s right to make warranty claims under the sale contract. In July 2011, the purchaser filed a claim with the Company for $787,000. The Company believes that the claim is without merit and intends to contest the claim vigorously. At August 31, 2011, no allowance relating to this $1.0 million receivable has been established.

The following table summarizes the financial information for discontinued operations related to the Australia/New Zealand Operations. Interest expense on debt directly attributable to the Australia/New Zealand Operations has been allocated to discontinued operations.

	Year Ended August 31,
	2010			2009
	(Dollars in thousands)
Sales	$	16,992		$	78,030
Loss from operations	$	(1,848	)	$	(57,754	)
Interest expense		444			973
Gain on sale of assets		199			-
Reclassification of currency translation adjustments into earnings		13,420			-
Other non-operating income, net		490			1,734
Income (loss) from discontinued operations before taxes		11,817			(56,993	)
Income tax expense (benefit)		(4,495	)		1,149
Income (loss) from discontinued operations, net of tax	$	16,312		$	(58,142	)

The Company believes that it is more likely than not that the net deferred tax benefit of $11.0 million recorded for the Australian operations will not be realized. The Company’s discontinued Australian operations recorded a valuation allowance as of August 31, 2011 of $11.0 million against the entire Australian net deferred tax asset. The valuation allowance increased $0.1 million in fiscal 2011.

Note 18 — Cedar Rapids Flood

On June 12, 2008, the Company’s Cedar Rapids, Iowa plant, operated by the Industrial Ingredients business, was temporarily shut down due to record flooding of the Cedar River and government-ordered mandatory evacuation of the plant and surrounding areas.

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During fiscal years 2009 and 2008, the Company recorded flood restoration costs of $45.6 million, and insurance recoveries of $27.2 million. The components of the costs and recoveries for fiscal 2009 are as follows:

(Dollars in thousands)
Repairs of buildings and equipment	$	6,346
Site remediation		348
Write off of inventory and fixed assets		71
Other		820
		7,585
Insurance recoveries		(16,694	)
Net flood recoveries	$	(9,109	)

Note 19 — Segment Reporting

Financial information from continuing operations for the Company’s two segments, Industrial Ingredients and Food Ingredients, is presented below. Industrial Ingredients and Food Ingredients, are broad categories of end-market users served by the Company’s U.S. operations. The Industrial Ingredients segment provides carbohydrate-based starches for industrial applications, primarily in the paper and packaging products and fuel industries. The Food Ingredients segment produces specialty starches for food applications. A third item for “corporate and other” activity has been presented to provide reconciliation to amounts reported in the consolidated financial statements. Corporate and other represents the activities related to the corporate headquarters such as public company reporting, personnel costs of the executive management team, corporate-wide professional services and consolidation entries. The accounting policies of the reportable segments are the same as those described in Note 1.

	Year Ended August 31,
	2011			2010			2009
	(Dollars in thousands)
Sales
Industrial ingredients
Industrial Starch	$	127,471		$	115,681		$	131,709
Ethanol		105,730			68,335			54,817
	$	233,201		$	184,016		$	186,526
Food ingredients		82,240			70,258			69,030
	$	315,441		$	254,274		$	255,556
Depreciation and amortization
Industrial ingredients	$	10,812		$	10,850		$	11,081
Food ingredients		2,110			2,341			2,759
Corporate and other		1,493			1,600			615
	$	14,415		$	14,791		$	14,455
Income (loss) from continuing operations
Industrial ingredients	$	(4,718	)	$	(11,512	)	$	(11,154	)
Food ingredients		18,037			15,145			13,512
Corporate and other		(8,874	)		(8,493	)		(8,807	)
	$	4,445		$	(4,860	)	$	(6,449	)
Capital expenditures, net
Industrial ingredients	$	6,625		$	4,713		$	3,683
Food ingredients		1,663			1,267			1,696
Corporate and other		7			-			-
	$	8,295		$	5,980		$	5,379

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	August 31,
	2011		2010
	(Dollars in thousands)
Total assets
Industrial ingredients	$	138,412	$	133,738
Food ingredients		42,252		36,542
Corporate and other		31,750		38,128
	$	212,414	$	208,408

At August 31, 2011, the remaining net assets of the Australia/New Zealand Operations, consisting of $0.3 million of cash and $0.8 million of other net assets, have been reported as assets of the continuing operations in “Corporate and other.” All other assets are located in the United States.

Reconciliation of income (loss) from operations for the Company’s segments to income (loss) before income taxes as reported in the consolidated financial statements follows:

	Year Ended August 31,
	2011			2010			2009
	(Dollars in thousands)
Income (loss) from operations	$	4,445		$	(4,860	)	$	(6,449	)
Interest expense		(9,364	)		(7,550	)		(5,557	)
Other non-operating income (expense)		115			(1,921	)		1,915
Loss from continuing operations before income taxes	$	(4,804	)	$	(14,331	)	$	(10,091	)

Sales, attributed to the area to which the product was shipped, are as follows:

	Year Ended August 31,
	2011		2010		2009
	(Dollars in thousands)
United States	$	288,571	$	231,042	$	234,081
Canada		4,027		3,738		5,137
Mexico		9,221		6,996		5,552
Columbia		6,802		6,227		5,925
Other		6,820		6,271		4,861
Non-United States		26,870		23,232		21,475
Total	$	315,441	$	254,274	$	255,556

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Note 20 — Quarterly Financial Data (Unaudited)

Fiscal 2011	First Quarter		Second Quarter			Third Quarter			Fourth Quarter			Total
	(Dollars in thousands, except per share data)
Sales	$	72,266	$	74,304		$	85,233		$	83,638		$	315,441
Cost of sales		63,009		67,461			74,815			76,321			281,606
Gross margin		9,257		6,843			10,418			7,317			33,835
Income (loss) from continuing operations		336		(1,575	)		(709	)		(3,169	)		(5,117	)
Income (loss) from discontinued operations		-		-			-			-			-
Net income (loss)		336		(1,575	)		(709	)		(3,169	)		(5,117	)
Earnings (loss) per common share:
Basic – continuing operations	$	0.03	$	(0.13	)	$	(0.06	)	$	(0.26	)	$	(0.42	)
Basic – discontinued operations		-		-			-			-			-
Basic earnings (loss) per share	$	0.03	$	(0.13	)	$	(0.06	)	$	(0.26	)	$	(0.42	)
Diluted – continuing operations	$	0.03	$	(0.13	)	$	(0.06	)	$	(0.26	)	$	(0.42	)
Diluted – discontinued operations		-		-			-			-			-
Diluted earnings (loss) per share	$	0.03	$	(0.13	)	$	(0.06	)	$	(0.26	)	$	(0.42	)
Dividends declared	$	-	$	-		$	-		$	-		$	-

Fiscal 2010	First Quarter		Second Quarter			Third Quarter			Fourth Quarter			Total
	(Dollars in thousands, except per share data)
Sales	$	67,070	$	62,293		$	61,909		$	63,002		$	254,274
Cost of sales		56,442		56,231			58,644			59,503			230,820
Gross margin		10,628		6,062			3,265			3,499			23,454
Income (loss) from continuing operations		1,056		(1,801	)		(5,758	)		(3,126	)		(9,629	)
Income (loss) from discontinued operations		3,482		13,048			(218	)		-			16,312
Net income (loss)		4,538		11,247			(5,976	)		(3,126	)		6,683
Earnings (loss) per common share:
Basic – continuing operations	$	0.09	$	(0.17	)	$	(0.49	)	$	(0.26	)	$	(0.84	)
Basic – discontinued operations		0.31		1.16			(0.02	)		-			1.41
Basic earnings (loss) per share	$	0.40	$	0.99		$	(0.51	)	$	(0.26	)	$	0.57
Diluted – continuing operations	$	0.09	$	(0.17	)	$	(0.49	)	$	(0.26	)	$	(0.84	)
Diluted – discontinued operations		0.31		1.16			(0.02	)		-			1.41
Diluted earnings (loss) per share	$	0.40	$	0.99		$	(0.51	)	$	(0.26	)	$	0.57
Dividends declared	$	-	$	-		$	-		$	-		$	-

In the second quarter of fiscal 2010, the liquidation of the remaining net assets of Penford Australia was substantially completed, as a result, $13.8 million of currency translation adjustments were reclassified from accumulated other comprehensive income into second quarter income (loss) from discontinued operations. See Note 17.

Note 21 – Legal Proceedings and Contingencies

The Company filed suit on January 23, 2009 in the United States District Court for the Northern District of Iowa against two insurance companies, National Union Fire Insurance Company of Pittsburgh, Pennsylvania, owned by American International Group, Inc. (“AIG”), and ACE American Insurance Company (“ACE”), due to the insurers’ denial of certain insurance coverage for damages that the Company suffered from the flood that struck the Company’s Cedar Rapids, Iowa plant in June 2008. On January 19, 2010, the presiding judge ruled that flood coverage language contained in the applicable insurance policy was “ambiguous” and that the interpretation of the policy was “a question of fact reserved for a jury.” At the conclusion of the jury trial

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subsequently conducted in August 2010, the presiding judge dismissed the Company’s claims without issuing a written opinion. In the fall of 2010, the Company appealed the dismissal to the United States Court of Appeals for the Eighth Circuit. The Company’s appeal has not yet been decided. The Company cannot at this time determine the likelihood of any outcome of the appeal or estimate the amount of any judgment that might be awarded.

In June 2011, the Company was notified that a complaint had been filed in the United States District Court for the District of New Jersey alleging that certain pet chew products supplied to a customer by the Company’s subsidiary, Penford Products Co. (“Penford Products”), infringe upon a patent owned by T.F.H. Publications, Inc. (“TFH”). The customer requested that Penford Products defend this lawsuit pursuant to the terms of its supply agreement with Penford Products. The Company believes that its products do not infringe upon the patent and has commenced a defense of the lawsuit. The Company cannot at this time determine the likelihood of any outcome or estimate any damages that might be awarded.

In July 2011, the purchaser of the Company’s Lane Cove, New South Wales, Australia operating assets filed a claim for $787,000 pursuant to the sale agreement. See Note 17.

The Company regularly evaluates the status of claims and legal proceedings in which it is involved in order to assess whether a loss is probable or there is a reasonable possibility that a loss may have been incurred and to determine if accruals are appropriate. For the matters identified in the preceding two paragraphs, management is unable to provide additional information regarding any possible loss because, among other reasons, (i) the matters are in early stages; (ii) the Company currently believes that the claims are not adequately supported; and (iii) there are significant factual issues to be resolved. With regard to these matters, management does not believe, based on currently available information, that the eventual outcomes will have a material adverse effect on the Company’s financial condition, although the outcomes could be material to the Company’s operating results for any particular period, depending, in part, upon the operating results for such period.

The Company is involved from time to time in various other claims and litigation arising in the normal course of business. In the judgment of management, which relies in part on information obtained from the Company’s outside legal counsel, the ultimate resolution of these other matters will not materially affect the consolidated financial position, results of operations or liquidity of the Company.

Note 22 – Subsequent Event

On November 9, 2011, Penford Carolina, LLC, a Delaware limited liability company (“Purchaser”) and a wholly-owned subsidiary of Penford Corporation (“Penford”), entered into a Business Sale and Membership Interest Purchase Agreement (the “Purchase Agreement”) with each of R. Bentley Cheatham, Dwight Carlson and Steven P. Brower (collectively, the “ Sellers”) together with three limited liability companies owned by the Sellers.

Pursuant to the terms of the Purchase Agreement, at the closing Purchaser would acquire 100% of the limited liability company interests in Carolina Starches, LLC, a South Carolina limited liability company (“Carolina Starches”) wholly-owned by Sellers, in exchange for $6 million in cash (“Cash Payment”) and the assumption of $3.5 million in debt. As part of the transactions contemplated by the Purchase Agreement, Purchaser would enter into asset purchase agreements at the closing with two of the limited liability companies owned by the Sellers pursuant to which these companies would transfer to Purchaser substantially all of the their assets. Purchaser would also enter into a real property lease agreement at the closing with another limited liability company owned by Sellers, pursuant to which Purchaser will lease a facility from such company.

In addition to the Cash Payment, at the closing Penford would enter into a separate stock option agreement with each of the three Sellers pursuant to which Penford would grant each Seller an option to purchase up to 55,000 shares of the Company’s common stock, $1.00 par value per share (the “Shares”), at an exercise price

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equal to the closing per Share price as of the close of business on the closing date (the “Tranche A Option”), and a second option to purchase up to 50,000 Shares at an exercise price equal to the closing price per Share as of the close of business on the date that the earnout condition described below is satisfied (the “Tranche B Option”). Both the Tranche A Option and the Tranche B Option would be subject to three year vesting terms, with one-third of the options vesting on each anniversary of the grant date. The Tranche B Option also would be subject to an earnout condition requiring the earnings before interest and income taxes attributable to Carolina Starches to exceed a specified threshold. Penford anticipates completing the transactions contemplated by the Purchase Agreement in the second quarter of fiscal year 2012. The consummation of the transaction is subject to various customary conditions, which may be waived by the applicable parties, including conditions to closing that:

• Purchaser is satisfied with the results of certain due diligence inquiries regarding Carolina Starches and its related companies; and

• the absence of any material adverse change in the business, financial condition and operations of Carolina Starches and its related companies.

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors and Shareholders

Penford Corporation:

We have audited the accompanying consolidated balance sheets of Penford Corporation and subsidiaries (the Company) as of August 31, 2011 and 2010, and the related consolidated statements of operations and comprehensive income (loss), cash flows, and shareholders’ equity. We also have audited Penford Corporation’s internal control over financial reporting as of August 31, 2011, based on criteria established inInternal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Penford Corporation’s management is responsible for these consolidated financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Annual Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on these consolidated financial statements and an opinion on the Company’s internal control over financial reporting based on our audits.

We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the consolidated financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risks that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in a reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Penford Corporation and subsidiaries as of August 31, 2011 and 2010, and the results of their operations and their cash flows for the years then ended, in conformity with U.S. generally accepted accounting principles. Also in our opinion, Penford Corporation maintained, in all material respects, effective internal control over financial reporting as of August 31, 2011, based on criteria established inInternal Control – Integrated Framework issued by COSO.

/s/ KPMG LLP

Denver, Colorado

November 10, 2011

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors and Shareholders of Penford Corporation

We have audited the accompanying consolidated statements of operations, comprehensive loss, shareholders’ equity and cash flows of Penford Corporation for the year ended August 31, 2009. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated results of Penford Corporation’s operations and its cash flows for the year ended August 31, 2009, in conformity with U.S. generally accepted accounting principles.

/s/ Ernst & Young LLP

Denver, Colorado

November 13, 2009,

except for Note 16, as to which the date is

November 11, 2010

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Item 9.  Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.

Not applicable.

Item 9A.  Controls and Procedures.

Disclosure Controls and Procedures

Penford maintains disclosure controls and procedures that are designed to ensure that material information required to be disclosed in the Company’s periodic reports filed or submitted under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission. The Company’s disclosure controls and procedures are also designed to ensure that information required to be disclosed in the reports the Company files or submits under the Exchange Act is accumulated and communicated to the Company’s management, including its principal executive and principal financial officers, or persons performing similar functions, as appropriate, to allow timely decisions regarding required disclosure.

Under the supervision and with the participation of management, including the Chief Executive Officer and Chief Financial Officer, the Company has evaluated the effectiveness of its disclosure controls and procedures pursuant to Exchange Act Rule 13a-15(b) as of August 31, 2011. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that these disclosure controls and procedures are effective as of August 31, 2011.

Internal Control Over Financial Reporting

Management’s report on internal control over financial reporting and the related reports of the Company’s registered independent public accounting firms are included below and at the end of Item 8 above. There were no changes in the Company’s internal control over financial reporting during the quarter ended August 31, 2011 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

Management’s Annual Report on Internal Control Over Financial Reporting

Management is responsible for establishing and maintaining adequate internal control over financial reporting for the Company. Internal control over financial reporting is a process to provide reasonable assurance regarding the reliability of our financial reporting for external purposes in accordance with accounting principles generally accepted in the United States of America. Internal control over financial reporting includes maintaining records that in reasonable detail accurately and fairly reflect the Company’s transactions; providing reasonable assurance that transactions are recorded as necessary for preparation of the Company’s financial statements; providing reasonable assurance that receipts and expenditures of the Company’s assets are made in accordance with management’s authorization; and providing reasonable assurance that unauthorized acquisition, use or disposition of the Company’s assets that could have a material effect on the financial statements would be prevented or detected on a timely basis. Because of its inherent limitations, internal control over financial reporting is not intended to provide absolute assurance that a misstatement of the Company’s financial statements would be prevented or detected.

Management conducted an evaluation of the effectiveness of the Company’s internal controls over financial reporting based on the framework in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation, management concluded that the Company’s internal control over financial reporting was effective as of August 31, 2011.

Item 9B.  Other Information.

Not applicable.

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PART III

Item 10.  Directors, Executive Officers and Corporate Governance.

The applicable information set forth under the headings “Election of Directors,” “Information About the Board and Its Committees,” and “Section 16(a) Beneficial Ownership Reporting Compliance” in the definitive Proxy Statement for the 2012 Annual Meeting of Shareholders (the “2012 Proxy Statement”), to be filed not later than 120 days after the end of the fiscal year covered by this report, is incorporated herein by reference. Information regarding the Executive Officers of the Registrant is set forth in Part I, Item 1.

The Company has adopted a Code of Business Conduct and Ethics (the “Code”) that is applicable to all employees, consultants and members of the Board of Directors, including the Chief Executive Officer, Chief Financial Officer and Corporate Controller. This Code embodies the commitment of the Company and its subsidiaries to conduct business in accordance with the highest ethical standards and applicable laws, rules and regulations. The Code is available on the Company’s Internet site ate www.penx.com under the Investor Relations section.

Item 11.  Executive Compensation.

The applicable information set forth under the headings “Executive Compensation,” “Director Compensation” and “Information About the Board and Its Committees” in the 2012 Proxy Statement is incorporated herein by reference.

Item 12.  Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.

The applicable information set forth under the heading “Security Ownership of Certain Beneficial Owners and Management” in the 2012 Proxy Statement is incorporated herein by reference.

Securities Authorized for Issuance under Equity Compensation Plans

The following table provides information regarding Penford’s equity compensation plans at August 31, 2011. The Company has no equity compensation plans that have not been approved by security holders.

Plan category	(a) Number of securities to be issued upon exercise of outstanding options, warrants and rights		(b) Weighted- average exercise price of outstanding options, warrants and rights		(c) Number of securities remaining available for future issuance under equity compensation plans (excluding securities reflected in column (a))
Equity compensation plans approved by security holders:
1994 Stock Option Plan (1)		652,000	$	14.17		-
2006 Long-Term Incentive Plan(2)		627,500	$	15.32		31,017
Stock Option Plan for Non-Employee Directors(3)		54,385	$	9.65		-
Total		1,333,885	$	14.52		31,017

(1) This plan has been terminated and no additional options are available for grant. The options which are subsequently forfeited or not exercised are available for issuance under the 2006 Long-Term Incentive Plan.

(2) Shares available for issuance under the 2006 Long-Term Incentive Plan can be granted pursuant to stock options, stock appreciation rights, restricted stock or units or performance based cash awards. Does not include 84,232 issued but unvested shares of common stock at August 31, 2011.

(3) This plan has been terminated and no additional options will be granted under this plan.

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Item 13.  Certain Relationships and Related Transactions, and Director Independence

The applicable information relating to certain relationships and related transactions of the Company is set forth under the heading “Transactions with Related Persons” in the 2012 Proxy Statement and is incorporated herein by reference. Information related to director independence is set forth under the heading of “Information About the Board and Its Committees” in the 2012 Proxy Statement and is incorporated herein by reference.

Item 14.  Principal Accountant Fees and Services.

The applicable information concerning principal accountant fees and services appears under the heading “Fees Paid to KPMG LLP” in the 2012 Proxy Statement and is incorporated herein by reference.

PART IV

Item 15.  Exhibits and Financial Statement Schedules.

(a)(1)Financial Statements

Financial statements required to be filed for the registrant under Items 8 or 15 are included in Part II, Item 8.

    (2) Financial Statement Schedules

All schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are omitted because they are not applicable or the information is included in the Consolidated Financial Statements in Part II, Item 8.

    (3)Exhibits

See index to Exhibits on page 73.

    (b)Exhibits

See Item 15(a)(3), above.

    (c)Financial Statement Schedules

None

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SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on this 10^th day of November 2011.

PENFORD CORPORATION

/s/ Thomas D. Malkoski

Thomas D. Malkoski

President and Chief Executive Officer

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated below on November 10, 2011.

Signature	Title
/s/ Thomas D. Malkoski	President, Chief Executive Officer and Director
Thomas D. Malkoski	(Principal Executive Officer)
/s/ Steven O. Cordier	Senior Vice President and Chief Financial Officer
Steven O. Cordier	(Principal Financial and Accounting Officer)
/s/ Paul H. Hatfield	Chairman of the Board of Directors
Paul H. Hatfield
/s/ William E. Buchholz	Director
William E. Buchholz
/s/ Jeffrey T. Cook	Director
Jeffrey T. Cook
/s/ R. Randolph Devening	Director
R. Randolph Devening
/s/ John C. Hunter III	Director
John C. Hunter III
/s/ Sally G. Narodick	Director
Sally G. Narodick
/s/ Edward F. Ryan	Director
Edward F. Ryan
/s/ James E. Warjone	Director
James E. Warjone
/s/ Matthew Zell	Director
Matthew Zell

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INDEX TO EXHIBITS

Exhibits identified in parentheses below, on file with the Securities and Exchange Commission, are incorporated by reference. Copies of exhibits can be obtained at no cost by writing to Penford Corporation, 7094 S. Revere Parkway, Centennial, Colorado 80112.

Exhibit No.		Item
	3.1	Restated and Amended Articles of Incorporation, as amended (filed as an exhibit to Registrant’s File No. 000-11488, Form 10-K for the fiscal year ended August 31, 2006)
	3.2	Bylaws of Registrant as amended and restated as of October 29, 2008 (filed as an exhibit to Registrant’s File No. 000-11488, Current Report on Form 8-K filed October 31, 2008)
	3.3	Articles of Amendment of Penford Corporation for Series A 15% Cumulative Non-Voting Non-Convertible Preferred Stock (filed as an exhibit to Registrant’s File No. 000-11488, Form 8-K dated April 6, 2010, filed April 9, 2010)
	3.4	Articles of Amendment of Penford Corporation for Series B Voting Convertible Preferred Stock (filed as an exhibit to Registrant’s File No. 000-11488, Form 8-K dated April 6, 2010, filed April 9, 2010)
	3.5	Amendment to Amended and Restated Bylaws of Penford Corporation (filed as an exhibit to Registrant’s File No. 000-11488, Form 8-K dated April 6, 2010, filed April 9, 2010)
	10.1	Penford Corporation Deferred Compensation Plan, amended and restated as of January 1, 2005 (filed as an exhibit to Registrant’s File No. 000-11488, Form 10-K for the year ended August 31, 2007, filed November 9, 2007) *
	10.2	Form of Change of Control Agreement and Annexes between Penford Corporation and Messrs. Cordier, Kortemeyer, Kunerth, Lawlor, Malkoski and Randall and certain other key employees (a representative copy of these agreements is filed as an exhibit to Registrant’s File No. 000-11488, Form 10-Q for the quarter ended February 28, 2006, filed April 10, 2006)*
	10.3	Form of Amendment to Change in Control Agreement (filed as an exhibit to Registrant’s File No. 000-11488, Form 10-Q for the quarter ended November 30, 2008, filed January 9, 2009)*
	10.4	Form of Second Amendment to Change in Control Agreement*
	10.5	Penford Corporation 1993 Non-Employee Director Restricted Stock Plan (filed as an exhibit to Registrant’s File No. 000-11488, Form 10-Q for the quarter ended November 30, 1993)*
	10.6	Penford Corporation 1994 Stock Option Plan as amended and restated as of January 8, 2002 (filed as an exhibit to Registrant’s File No. 000-11488, Proxy Statement filed with the Commission on January 18, 2002)*
	10.7	Penford Corporation Stock Option Plan for Non-Employee Directors (filed as a exhibit to Registrant’s File No. 000-11488, Form 10-Q for the quarter ended May 31, 1996, filed July 15, 1996)*
	10.8	Penford Corporation 2006 Long-Term Incentive Plan (incorporated by reference to Appendix A to Registrant’s File No. 000-11488, Proxy Statement filed December 20, 2005)*
	10.9	Form of Penford Corporation’s 2006 Long-Term Incentive Plan Stock Option Grant Notice, including the Stock Option Agreement and Notice of Exercise (incorporated by reference to the exhibits to the Registrant’s File No. 000-11488, Current Report on Form 8-K filed February 21, 2006)*

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Exhibit No.		Item
	10.10	Form of Penford Corporation 2006 Long-Term Incentive Plan Restricted Stock Award Notice and Agreement (filed as an exhibit to Registrant’s File No. 000-11488, Form 10-K for the year ended August 31, 2007, filed November 9, 2007) *
	10.11	Second Amended and Restated Credit Agreement dated as of October 5, 2006 (filed as an exhibit to Registrant’s File No. 000-11488, Form 8-K dated October 5, 2006, filed October 10, 2006)
	10.12	First Amendment to Second Amended and Restated Credit Agreement (filed as an exhibit to Registrant’s File No. 000-11488, Form 10-Q for the quarter ended May 31, 2008, filed July 10, 2008)
	10.13	Second Amendment to Second Amended and Restated Credit Agreement, Resignation of Agent and Appointment of Successor Agent dated as of February 26, 2009 (filed as an exhibit to Registrant’s File No. 000-11488, Form 8-K dated February 26, 2009, filed March 3, 2009)
	10.14	Third Amendment to Second Amended and Restated Credit Agreement (filed as an exhibit to Registrant’s File No. 000-11488, Form 10-Q for the quarter ended May 31, 2009, filed July 10, 2009)
	10.15	Director Special Assignments Policy dated August 26, 2005 (filed as an exhibit to Registrant’s File No. 000-11488, Form 8-K dated August 26, 2005, filed September 1, 2005)*
	10.16	Non-Employee Director Compensation Term Sheet (filed as an exhibit to Registrant’s File No. 000-11488, Form 10-K for the year ended August 31, 2007, filed November 9, 2007) *
	10.17	Form of Performance-Based Cash Award Agreement under the 2006 Long-Term Incentive Plan (filed as an exhibit to Registrant’s File No. 000-11488, Form 10-Q for the quarter ended November 30, 2009, filed January 8, 2010) *
	10.18	Securities Purchase Agreement by and between Penford Corporation and Zell Credit Opportunities Master Fund, L.P., dated April 7, 2010 (filed as an exhibit to Registrant’s File No. 000-11488, Form 8-K dated April 6, 2010, filed April 9, 2010)
	10.19	Investor Rights Agreement by and between Penford Corporation and Zell Credit Opportunities Master Fund, L.P., dated April 7, 2010 (filed as an exhibit to Registrant’s File No. 000-11488, Form 8-K dated April 6, 2010, filed April 9, 2010)
	10.20	Standstill Letter Agreement by and between Penford Corporation and Zell Credit Opportunities Master Fund, L.P., dated April 7, 2010 (filed as an exhibit to Registrant’s File No. 000-11488, Form 8-K dated April 6, 2010, filed April 9, 2010)
	10.21	Third Amended and Restated Credit Agreement among the Company, Penford Products Co., Bank of Montreal, Bank of America National Association and Cooperatieve Centrale Raiffeisen-Boerenleenbank B.A., “Rabobank Nederland” New York Branch, dated April 7, 2010 (filed as an exhibit to Registrant’s File No. 000-11488, Form 8-K dated April 6, 2010, filed April 9, 2010)
	21	Subsidiaries of the Registrant
	23.1	Consent of Ernst & Young LLP
	23.2	Consent of KPMG LLP
	24	Power of Attorney
	31.1	Certifications of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
	31.2	Certifications of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
	32	Certifications of Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley act of 2002

* Denotes management contract or compensatory plan or arrangement

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