Summary of Significant Accounting Policies

Fiscal Year. The fiscal year of Graco Inc. and Subsidiaries (the “Company”) is 52 or 53 weeks, ending on the last Friday in December. The years ended December 29, 2017 and December 25, 2015 were 52-week years. The year ended December 30, 2016 was a 53-week year.

Basis of Statement Presentation. The consolidated financial statements include the accounts of the parent company and its subsidiaries after elimination of intercompany balances and transactions. As of December 29, 2017, all subsidiaries are 100 percent controlled by the Company. All share and per share data have been adjusted to reflect the three-for-one stock split distributed on December 27, 2017. Certain other prior year disclosures have been revised to conform with current year reporting.

As more fully described in Note M (Divestiture), in 2015, the Company sold the Liquid Finishing business assets acquired in 2012 that were held as a cost-method investment. Investment income in the Company’s consolidated statements of earnings includes the pre-tax gain on the sale, net of transaction and other related expenses, along with dividend income received prior to the sale from after-tax earnings of Liquid Finishing.

Foreign Currency Translation. The functional currency of certain subsidiaries is the local currency. Accordingly, adjustments resulting from the translation of those subsidiaries’ financial statements into U.S. dollars are charged or credited to accumulated other comprehensive income (loss). The U.S. dollar is the functional currency for all other foreign subsidiaries. Accordingly, gains and losses from the translation of foreign currency balances and transactions of those subsidiaries are included in other expense (income), net.

Accounting Estimates. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements. Such estimates and assumptions also affect the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Fair Value Measurements. The three levels of inputs in the fair value measurement hierarchy are as follows:

Level 1 – based on quoted prices in active markets for identical assets

Level 2 – based on significant observable inputs

Level 3 – based on significant unobservable inputs

Assets and liabilities measured at fair value on a recurring basis and fair value measurement level were as follows (in thousands):



	Level	2017		2016
Assets
Cash surrender value of life insurance	2	$	16,128	$	13,785
Forward exchange contracts	2	—		571
Total assets at fair value		$	16,128	$	14,356
Liabilities
Contingent consideration	3	$	4,081	$	4,081
Deferred compensation	2	3,836		3,265
Forward exchange contracts	2	517		—
Total liabilities at fair value		$	8,434	$	7,346

Contracts insuring the lives of certain employees who are eligible to participate in certain non-qualified pension and deferred compensation plans are held in trust. Cash surrender value of the contracts is based on performance measurement funds that shadow the deferral investment allocations made by participants in certain deferred compensation plans. The deferred compensation liability balances are valued based on amounts allocated by participants to the underlying performance measurement funds.

The Company’s policy and accounting for forward exchange contracts are described below, in Derivative Instruments and Hedging Activities.

Contingent consideration liability represents the estimated value (using a probability-weighted expected return approach) of future payments to be made to previous owners of an acquired business based on its future revenues (see Note L, Acquisitions).

Disclosures related to other fair value measurements are included below in Impairment of Long-Lived Assets, in Note F (Debt) and in Note J (Retirement Benefits).

Cash Equivalents. All highly liquid investments with a maturity of three months or less at the date of purchase are considered to be cash equivalents.

Accounts Receivable. Accounts receivable includes trade receivables of $244 million in 2017 and $209 million in 2016. Other receivables totaled $12 million in 2017 and $9 million in 2016.

Inventory Valuation. Inventories are stated at the lower of cost or net realizable value. The last-in, first-out (LIFO) cost method is used for valuing most U.S. inventories. Inventories of foreign subsidiaries are valued using the first-in, first-out (FIFO) cost method.

Other Current Assets. Amounts included in other current assets were (in thousands):



	2017		2016
Prepaid income taxes	$	8,934	$	10,723
Restricted cash	9,242		9,230
Prepaid expenses and other	14,318		11,070
Total	$	32,494	$	31,023

Cash balances included within other current assets were restricted to funding of certain self-insured loss reserves.

Impairment of Long-Lived Assets. The Company evaluates long-lived assets (including property and equipment, goodwill and other intangible assets) for impairment annually in the fourth quarter, or whenever events or changes in circumstances indicate that the carrying amount may not be recoverable.

We completed our annual impairment review of all long-lived assets in the fourth quarter of 2017. No impairment charges were recorded as a result of that review. In 2016, we recorded an impairment charge of $192 million for our Oil and Natural Gas reporting unit within the Process segment. There were no impairment charges in 2015.

Property, Plant and Equipment. For financial reporting purposes, plant and equipment are depreciated over their estimated useful lives, primarily by using the straight-line method as follows:



Buildings and improvements		10 to 30 years
Leasehold improvements		lesser of 5 to 10 years or life of lease
Manufacturing equipment		lesser of 5 to 10 years or life of equipment
Office, warehouse and automotive equipment		3 to 10 years

Goodwill and Other Intangible Assets. Goodwill has been assigned to reporting units. Changes in the carrying amounts of goodwill for each reportable segment were (in thousands):



	Industrial			Process			Contractor		Total
Balance, December 25, 2015	$	153,283		$	228,473		$	12,732	$	394,488
Additions from business acquisitions	—			28,130			—		28,130
Impairment	—			(146,669		)	—		(146,669		)
Foreign currency translation	(2,727		)	(13,373		)	—		(16,100		)
Balance, December 30, 2016	150,556			96,561			12,732		259,849
Additions (adjustments) from business acquisitions	7,152			(62		)	6,413		13,503
Foreign currency translation	3,965			1,472			—		5,437
Balance, December 29, 2017	$	161,673		$	97,971		$	19,145	$	278,789

Components of other intangible assets were (dollars in thousands):



	Finite Life									Indefinite Life
	Customer Relationships			Patents and Proprietary Technology			Trademarks, Trade Names and Other			Trade Names			Total
As of December 29, 2017
Cost	$	179,826		$	18,479		$	1,071		$	59,553		$	258,929
Accumulated amortization	(54,076		)	(7,795		)	(542		)	—			(62,413		)
Foreign currency translation	(9,186		)	(727		)	(61		)	(3,486		)	(13,460		)
Book value	$	116,564		$	9,957		$	468		$	56,067		$	183,056
Weighted average life in years	13			10			4			N/A



As of December 30, 2016
Cost	$	170,284		$	17,321		$	895		$	57,853		$	246,353
Accumulated amortization	(41,599		)	(6,088		)	(337		)	—			(48,024		)
Foreign currency translation	(13,630		)	(1,055		)	(59		)	(5,249		)	(19,993		)
Book value	$	115,055		$	10,178		$	499		$	52,604		$	178,336
Weighted average life in years	13			10			4			N/A

Amortization of intangibles was $14.8 million in 2017, $17.8 million in 2016 and $17.2 million in 2015. Estimated future annual amortization expense based on the current carrying amount of other intangible assets is as follows (in thousands):



	2018		2019		2020		2021		2022		Thereafter
Estimated Amortization Expense	$	15,418	$	15,089	$	14,910	$	14,740	$	14,740	$	52,092

Other Assets. Components of other assets were (in thousands):



	2017		2016
Cash surrender value of life insurance	$	16,128	$	13,785
Capitalized software	1,784		1,812
Equity method investment	6,755		6,366
Prepaid pension	2,538		—
Deposits and other	3,015		3,350
Total	$	30,220	$	25,313

The Company has entered into contracts insuring the lives of certain employees who are eligible to participate in certain non-qualified pension and deferred compensation plans. These insurance contracts are used to fund the non-qualified pension and deferred compensation arrangements. The insurance contracts are held in a trust and are available to general creditors in the event of the Company’s insolvency. Changes in cash surrender value are recorded in operating expense and were not significant in 2016 and 2015. In 2017, increases in cash surrender value totaled $2.3 million and were offset by expenses related to the non-qualified pension and deferred compensation plans funded by the insurance contracts.

Capitalized software is amortized over its estimated useful life (generally 2 to 5 years) beginning at date of implementation.

Other Current Liabilities. Components of other current liabilities were (in thousands):



	2017		2016
Accrued self-insurance retentions	$	7,956	$	7,105
Accrued warranty and service liabilities	10,535		8,934
Accrued trade promotions	10,588		6,007
Payable for employee stock purchases	10,053		9,328
Customer advances and deferred revenue	22,632		9,400
Income taxes payable	7,564		8,608
Other	31,628		22,505
Total	$	100,956	$	71,887

Self-Insurance. The Company is self-insured for certain losses and costs relating to product liability, workers’ compensation, employee medical benefit claims and representations and warranties associated with the Liquid Finishing business divestiture. The Company has stop-loss coverage in order to limit its exposure to significant claims. Accrued self-insurance retentions are based on claims filed, estimates of claims incurred but not reported, and other actuarial assumptions. Self-insured reserves totaled $8.5 million as of December 29, 2017, and $9.8 million as of December 30, 2016, including $0.5 million and $2.7 million, respectively, classified as other long-term liabilities in the Consolidated Balance Sheets.

Product Warranties. A liability is established for estimated future warranty and service claims that relate to current and prior period sales. The Company estimates warranty costs based on historical claim experience and other factors including evaluating specific product warranty issues. Following is a summary of activity in accrued warranty and service liabilities (in thousands):



	2017			2016
Balance, beginning of year	$	8,934		$	7,870
Charged to expense	7,930			7,516
Margin on parts sales reversed	2,826			1,796
Reductions for claims settled	(9,155		)	(8,248		)
Balance, end of year	$	10,535		$	8,934

Revenue Recognition. Sales are recognized when revenue is realized or realizable and has been earned. The Company’s policy is to recognize revenue when risk and title passes to the customer. This is generally on the date of shipment, however certain sales have terms requiring recognition when received by the customer. In cases where there are specific customer acceptance provisions, revenue is recognized at the later of customer acceptance or shipment (subject to shipping terms). Payment terms are established based on the type of product, distributor capabilities and competitive market conditions. Rights of return are typically contractually limited, amounts are estimable, and the Company records provisions for anticipated returns and warranty claims at the time revenue is recognized. Historically, sales returns have been less than 3 percent of sales. Provisions for sales returns are recorded as a reduction of net sales, and provisions for warranty claims are recorded in selling, marketing and distribution expenses. From time to time, the Company may promote the sale of new products by agreeing to accept returns of superseded products. In such cases, provisions for estimated returns are recorded as a reduction of net sales.

Trade promotions are offered to distributors and end users through various programs, generally with terms of one year or less. Such promotions include cooperative advertising arrangements, rebates based on annual purchases and sales growth, coupons and reimbursement for competitive products. Payment of incentives may take the form of cash, trade credit, promotional merchandise or free product. Under cooperative advertising arrangements, the Company reimburses the distributor for a portion of its advertising costs related to the Company’s products; estimated costs are accrued at the time of sale and classified as selling, marketing and distribution expense. Rebates are accrued based on the program rates and progress toward the estimated annual sales amount and sales growth, and are recorded as a reduction of sales (cash, trade credit) or cost of products sold (free goods). The estimated costs related to coupon programs are accrued at the time of sale and classified as selling, marketing and distribution expense or cost of products sold, depending on the type of incentive offered.

Shipping and Handling. Shipping and handling costs incurred for the delivery of goods to customers are included in cost of goods sold in the accompanying Consolidated Statements of Earnings. Amounts billed to customers for shipping and handling are included in net sales.

Earnings Per Common Share. Basic net earnings per share is computed by dividing earnings available to common shareholders by the weighted average number of shares outstanding during the year. Diluted net earnings per share is computed after giving effect to the exercise of all dilutive outstanding option grants.

Comprehensive Income. Comprehensive income is a measure of all changes in shareholders’ equity except those resulting from investments by and distributions to owners, and includes such items as net earnings, certain foreign currency translation items, changes in the value of qualifying hedges and pension liability adjustments.

Derivative Instruments and Hedging Activities. The Company accounts for all derivatives, including those embedded in other contracts, as either assets or liabilities and measures those financial instruments at fair value. The accounting for changes in the fair value of derivatives depends on their intended use and designation.

As part of its risk management program, the Company may periodically use forward exchange contracts to manage known market exposures. Terms of derivative instruments are structured to match the terms of the risk being managed and are generally held to maturity. The Company does not hold or issue derivative financial instruments for trading purposes. All other contracts that contain provisions meeting the definition of a derivative also meet the requirements of, and have been designated as, normal purchases or sales. The Company’s policy is to not enter into contracts with terms that cannot be designated as normal purchases or sales.

The Company periodically evaluates its monetary asset and liability positions denominated in foreign currencies. The Company enters into forward contracts or options, or borrows in various currencies, in order to hedge its net monetary positions. These instruments are recorded at fair value and the gains and losses are included in other expense, net. The notional amounts of contracts outstanding as of December 29, 2017, totaled $34 million. The Company believes it uses strong financial counterparties in these transactions and that the resulting credit risk under these hedging strategies is not significant.

The Company uses significant other observable inputs (level 2 in the fair value hierarchy) to value the derivative instruments used to hedge net monetary positions, including reference to market prices and financial models that incorporate relevant market assumptions. Net derivative assets are reported on the balance sheet in accounts receivable and net derivative liabilities are reported as other current liabilities. The fair market value of such instruments follows (in thousands):



	2017			2016
Foreign Currency Contracts
Assets	$	—		$	621
Liabilities	(517		)	(50		)
Net Assets (Liabilities)	$	(517	)	$	571

Recent Accounting Pronouncements.

Share-based Payments

A new accounting standard that changed certain aspects of accounting for share-based payments became effective for the Company in the first quarter of 2017. Excess tax benefits on exercised stock options that were previously credited to equity now reduce the current income tax provision. The change in accounting for excess tax benefits decreased the current income tax provision and increased net earnings for the year by $36.3 million, reduced the effective income tax rate by 10 percentage points and increased diluted earnings per share by $0.21. Under the new standard, excess tax benefits are no longer reclassified out of cash flows from operating activities to financing activities in the Consolidated Statements of Cash Flows. We elected to apply the cash flow presentation requirements retrospectively to all periods presented, which resulted in an increase in previously reported net cash provided by operating activities and a decrease in net cash provided by financing activities of $6.9 million for the year ended December 30, 2016 and $1.8 million for the year ended December 25, 2015. Also under the new standard, the Company elected to account for share-based grant forfeitures as they occur. The impact of the change in accounting for forfeitures was not significant, and was reflected in share-based compensation cost in the first quarter of 2017.

Revenue Recognition

In May 2014, the Financial Accounting Standards Board (FASB) issued a final standard on revenue from contracts with customers, contained in Accounting Standards Codification Topic 606 (“ASC 606”). The new standard sets forth a single comprehensive model for recognizing and reporting revenue. ASC 606 will become effective for the Company beginning with the first quarter of 2018, and the Company plans to adopt the new accounting standard using the modified retrospective transition approach. The modified retrospective transition approach will recognize any changes from the beginning of the year of initial application through retained earnings with no restatement of comparative periods.

Because the new standard impacted our business processes, systems and controls, we developed a comprehensive change management project plan to guide the implementation. This project plan included analyzing the standard’s impact on our revenue streams and associated contracts, comparing our historical accounting policies and practices to the requirements of the new standard, and identifying differences from applying the requirements of the new standard to our contracts. We developed internal controls to ensure that we adequately evaluated our portfolio of contracts under the five-step model to ensure proper assessment of our operating results under ASC 606. We reported on the progress of the implementation to the Audit Committee and the Board of Directors on a regular basis during the project’s duration.

For most of our contracts, we will record revenue under ASC 606 at a single point in time, when control is transferred to the customer, which is consistent with past practice. We have made the necessary changes to our business processes, policies, systems and controls to support recognition and disclosure under the new standard. Further, we will include incremental disaggregated revenue and other disclosures as required in our consolidated financial statements.

Based on the results of the evaluation, nothing has come to our attention that would indicate that adoption of the new standard will have a material impact on our consolidated financial statements. Application of the transition requirements of the new standard will not have a material impact on opening retained earnings.

Presentation of Pension Cost

In March 2017, the FASB issued a final standard that changes the presentation of net periodic benefit cost related to defined benefit plans. The Company will adopt the standard when it becomes effective in fiscal 2018 and it will be applied retrospectively to all periods presented. Under the new standard, net periodic benefit costs are required to be disaggregated between service costs presented as operating expenses and other components of pension costs presented as non-operating expenses. The Company currently charges service costs to segment operations and includes other components of pension cost in unallocated corporate operating expenses. Under the new standard, unallocated corporate operating expenses will decrease, operating earnings will increase and other expense will increase by the amount of other (non-service) components of pension cost. There will be no impact on reported segment earnings, net earnings or earnings per share.

Leases

In February 2016, the FASB issued a final standard on accounting for leases. The new standard is effective for the Company in fiscal 2019 and requires most leases to be recorded on the balance sheet. The Company is evaluating the effect of the new standard on its consolidated financial statements and related disclosures and accounting systems.