2. Significant Accounting Policies

Principles of Consolidation

The condensed consolidated financial statements include the accounts of the Company and its subsidiaries. All material intercompany accounts and transactions have been eliminated.

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 reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the financial statements and reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Some of the Company’s more significant estimates are those affected by critical accounting policies for revenue recognition, inventories and contingent liabilities as discussed more fully in the Company’s Annual Report on Form 10-K for the year ended December 31, 2012.

Revenue Recognition

Product Revenue

The Company earns product revenues from two methods:

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product revenues recognized under the percentage-of-completion method; and

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product revenues from the sale of products that do not qualify for the percentage-of-completion method.

Revenues recognized under the percentage-of-completion method

The Company uses the percentage-of-completion method on long-term project contracts that have the following characteristics:

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The contracts call for products which are designed to customer specifications;

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The structural designs are unique and require significant engineering and manufacturing efforts generally requiring more than one year in duration;

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The contracts contain specific terms as to milestones, progress billings and delivery dates; and

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Product requirements cannot be filled directly from the Company’s standard inventory.

For each project, the Company prepares a detailed analysis of estimated costs, profit margin, completion date and risk factors which include availability of material, production efficiencies and other factors that may impact the project. On a quarterly basis, management reviews the progress of each project, which may result in revisions of previous estimates, including revenue recognition. The Company calculates the percent complete and applies this percentage to determine the revenues earned and the appropriate portion of total estimated costs. Losses, if any, are recorded in full in the period they become known. Historically, the Company’s estimates of total costs and costs to complete have approximated actual costs incurred to complete the project.

Under the percentage-of-completion method, billings may not correlate directly to the revenue recognized. Based upon the terms of the specific contract, billings may be in excess of the revenue recognized, in which case the amounts are included in customer prepayments as a liability on the Condensed Consolidated Balance Sheets. Likewise, revenue recognized may exceed customer billings in which case the amounts are reported in trade receivables. Unbilled revenues are expected to be billed and collected within one year. As of September 30, 2013 and December 31, 2012, receivables included $55.6 million and $62.1 million of unbilled receivables, respectively. For the quarter ended September 30, 2013, there were 12 projects representing approximately 15% of the Company’s total revenue and approximately 18% of its product revenues that were accounted for using percentage-of-completion accounting, compared to 17 projects during the third quarter of 2012 which represented 21% of the Company’s total revenues and 25% of its product revenues. For the nine months ended September 30, 2013, there were 16 projects representing 13% of the Company’s total revenues and 15% of its product revenues, compared to 19 projects representing 19% of the Company’s total revenues and 22% of its product revenues for the nine months ended September 30, 2012, all of which were accounted for using percentage-of-completion accounting.

Revenues not recognized under the percentage-of-completion method

Revenues from the sale of inventory products, not accounted for under the percentage-of-completion method, are recorded at the time the manufacturing processes are complete and ownership is transferred to the customer.

Service revenue

The Company earns service revenues from three sources:

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technical advisory assistance;

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rental of running tools; and

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rework and reconditioning of customer-owned Dril-Quip products.

The Company does not install products for its customers, but it provides technical advisory assistance. At the time of delivery of the product, the customer is not obligated to buy or rent the Company’s running tools and the Company is not obligated to perform any subsequent services relating to installation. Technical advisory assistance service revenue is recorded at the time the service is rendered. Service revenues associated with the rental of running and installation tools are recorded as earned. Rework and reconditioning service revenues are recorded when the refurbishment process is complete.

The Company normally negotiates contracts for products, including those accounted for under the percentage-of-completion method, and services separately. For all product sales, it is the customer’s decision as to the timing of the product installation as well as whether Dril-Quip running tools will be purchased or rented. Furthermore, the customer is under no obligation to utilize the Company’s technical advisory services. The customer may use a third party or their own personnel.

Fair Value of Financial Instruments

The Company’s financial instruments consist primarily of cash and cash equivalents, receivables and payables. The carrying values of these financial instruments approximate their respective fair values as they are short-term in nature.

Earnings Per Share

Basic earnings per common share is computed by dividing net income by the weighted average number of shares of common stock outstanding during the period. Diluted earnings per common share is computed considering the dilutive effect of stock options and awards using the treasury stock method.

In each relevant period, the net income used in the basic and dilutive earnings per share calculations is the same. The following table reconciles the number of common shares outstanding at September 30 of each year to the weighted average number of common shares outstanding and the weighted average diluted number of common shares outstanding for the purpose of calculating basic and diluted earnings per share:


	Three months ended September 30,						Nine months ended September 30,
	2013			2012			2013			2012
	(In thousands)
Number of common shares outstanding at end of period—basic		40,691			40,432			40,691			40,432
Effect of using weighted average common shares outstanding		(8	)		(9	)		(74	)		(140	)

Weighted average basic common shares outstanding—basic		40,683			40,423			40,617			40,292
Dilutive effect of common stock options and awards		228			166			204			200

Weighted average diluted common shares outstanding—diluted		40,911			40,589			40,821			40,492