Description of Business and Summary of Significant Accounting Policies

Description of business— Illinois Tool Works Inc. (the "Company" or "ITW") is a global manufacturer of a diversified range of industrial products and equipment with approximately 85 divisions in 57 countries. The Company primarily serves the automotive OEM/tiers, commercial food equipment, construction, general industrial, and automotive aftermarket end markets.

Consolidation and translation— The financial statements include the Company and its majority-owned subsidiaries. The Company follows the equity method of accounting for investments where the Company has a significant influence but not a controlling interest. Intercompany transactions are eliminated from the financial statements. Foreign subsidiaries’ assets and liabilities are translated to U.S. dollars at end-of-period exchange rates. Revenues and expenses are translated at average rates for the period. Translation adjustments are reported as a component of accumulated other comprehensive income (loss) in stockholders’ equity.

Reclassifications— Certain reclassifications of prior year data have been made to conform to current year reporting.

Use of estimates— The preparation of the Company’s financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and the notes to financial statements. Actual results could differ from those estimates.

Acquisitions— The Company accounts for acquisitions under the acquisition method, in which assets acquired and liabilities assumed are recorded at fair value as of the date of acquisition. The operating results of the acquired companies are included in the Company’s consolidated financial statements from the date of acquisition.

Operating revenue— Operating revenue is recognized when persuasive evidence of an arrangement exists, product has shipped and the risks and rewards of ownership have transferred or services have been rendered, the price to the customer is fixed or determinable, and collectibility is reasonably assured, which is generally at the time of product shipment. Typical sales arrangements are for standard products and provide for transfer of ownership and risk of loss at the time of shipment. In limited circumstances where significant obligations to the customer are unfulfilled at the time of shipment, typically involving installation and customer acceptance, revenue recognition is deferred until such obligations have been completed. Customer allowances and rebates, consisting primarily of volume discounts and other short-term incentive programs, are estimated at the time of sale based on historical experience and known trends and are recorded as a reduction in reported revenues.

Research and development expenses— Research and development expenses are recorded as expense in the year incurred. These costs were $223 million in 2016, $218 million in 2015 and $227 million in 2014.

Advertising expenses— Advertising expenses are recorded as expense in the year incurred. These costs were $58 million in 2016, $58 million in 2015 and $66 million in 2014.

Income taxes— The Company utilizes the asset and liability method of accounting for income taxes. Deferred income taxes are determined based on the estimated future tax effects of differences between the financial and tax bases of assets and liabilities given the provisions of the enacted tax laws. Valuation allowances are established when it is estimated that it is more likely than not that the tax benefit of the deferred tax asset will not be realized.

Cash and equivalents— Cash and equivalents include cash on hand and instruments having original maturities of three months or less. Cash and equivalents are stated at cost, which approximates fair value.

Trade receivables— Trade receivables are net of allowances for doubtful accounts which includes reserves for uncollectible accounts, customer credits and cash discounts. The Company estimates the allowance for uncollectible accounts based on the greater of a specific reserve or a reserve calculated based on the historical write-off percentage over the last two years. In addition, reserves for customer credits and cash discounts are estimated based on past experience. The changes in the allowance for doubtful accounts during 2016, 2015 and 2014 were as follows:



In millions	2016			2015			2014
Beginning balance	$	42		$	43		$	46
Provision charged to expense	7			7			7
Write-offs, net of recoveries	(6		)	(5		)	(7		)
Acquisitions and divestitures	1			—			—
Foreign currency translation	(1		)	(3		)	(3		)
Ending balance	$	43		$	42		$	43

Inventories— Inventories are stated at the lower of cost or net realizable value and include material, labor and factory overhead. The last-in, first-out ("LIFO") method is used to determine the cost of inventories at certain U.S. businesses. The first-in, first-out ("FIFO") method, which approximates current cost, is used for all other inventories. Inventories priced at LIFO were approximately 22% of total inventories as of both December 31, 2016 and 2015. If the FIFO method was used for all inventories, total inventories would have been approximately $86 million and $81 million higher than reported at December 31, 2016 and 2015, respectively. The major classes of inventory at December 31, 2016 and 2015 were as follows:



In millions	2016			2015
Raw material	$	407		$	415
Work-in-process	126			130
Finished goods	629			622
LIFO reserve	(86		)	(81		)
Total inventories	$	1,076		$	1,086

Net plant and equipment— Net plant and equipment are stated at cost, less accumulated depreciation. Renewals and improvements that increase the useful life of plant and equipment are capitalized. Maintenance and repairs are charged to expense as incurred. Net plant and equipment consisted of the following at December 31, 2016 and 2015:



In millions	2016			2015
Land	$	186		$	179
Buildings and improvements	1,297			1,272
Machinery and equipment	3,036			2,972
Equipment leased to others	160			156
Construction in progress	104			76
Gross plant and equipment	4,783			4,655
Accumulated depreciation	(3,131		)	(3,078		)
Net plant and equipment	$	1,652		$	1,577

The Company’s U.S. businesses primarily compute depreciation on an accelerated basis. The majority of the Company's international businesses compute depreciation on a straight-line basis. The ranges of useful lives used to depreciate plant and equipment are as follows:



Buildings and improvements	5—50 years
Machinery and equipment	3—12 years
Equipment leased to others	Term of lease

Depreciation was $246 million in 2016, $244 million in 2015 and $262 million in 2014. There was no depreciation included in Income from discontinued operations in 2014.

Goodwill and intangible assets— Goodwill represents the excess cost over fair value of the net assets of acquired businesses. The Company does not amortize goodwill and intangible assets that have indefinite lives. Amortizable intangible assets are being amortized on a straight-line basis over their estimated useful lives of 3 to 20 years.

The Company performs an impairment assessment of goodwill and intangible assets with indefinite lives annually, or more frequently if triggering events occur, based on the estimated fair value of the related reporting unit or intangible asset. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants.

When performing its annual impairment assessment, the Company evaluates the goodwill assigned to each of its reporting units for potential impairment by comparing the estimated fair value of the relevant reporting unit to the carrying value. The Company uses various Level 2 and Level 3 valuation techniques to determine the fair value of its reporting units, including discounting estimated future cash flows based on a detailed cash flow forecast prepared by the relevant reporting unit and market multiples of relevant public companies. If the fair value of a reporting unit is less than its carrying value, an impairment loss, if any, is recorded for the difference between the implied fair value and the carrying value of the reporting unit's goodwill.

The Company's indefinite-lived intangible assets consist of trademarks and brands. The estimated fair values of these intangible assets are determined based on a Level 3 valuation method using a relief-of-royalty income approach derived from internally forecasted revenues of the related products. If the fair value of the trademark or brand is less than its carrying value, an impairment loss is recorded for the difference between the estimated fair value and carrying value of the intangible asset.

Accrued warranties— The Company accrues for product warranties based on historical experience. The changes in accrued warranties during 2016, 2015 and 2014 were as follows:



In millions	2016			2015			2014
Beginning balance	$	46		$	49		$	50
Charges	(41		)	(37		)	(41		)
Provision charged to expense	42			36			43
Acquisitions and divestitures	1			—			—
Foreign currency translation	(3		)	(2		)	(3		)
Ending balance	$	45		$	46		$	49

New Accounting Pronouncements

In May 2014, the Financial Accounting Standards Board (the "FASB") issued authoritative guidance to change the criteria for revenue recognition. The core principle of the new standard is that revenue should be recognized to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. In addition, several new revenue recognition disclosures will be required. This guidance is effective for the Company beginning January 1, 2018, with early adoption permitted. The Company expects to adopt the new revenue accounting guidance effective January 1, 2018 and is in the process of completing its analysis of the impact this guidance will have on the consolidated financial statements and related disclosures.

In February 2016, the FASB issued authoritative guidance to change the criteria for recognizing leasing transactions. Under the new guidance, a lessee will be required to recognize a lease liability and lease asset for all leases, including operating leases, with a lease term greater than twelve months in the statement of financial position. Subsequent measurement, including presentation of expenses and cash flows, will depend on the classification of the lease as either a financing or operating lease. In addition, several new disclosures will be required. This guidance is effective for the Company beginning January 1, 2019, with early adoption permitted. While the Company has not yet completed its evaluation of the impact the new lease accounting guidance will have on the consolidated financial statements and related disclosures, the Company expects to recognize right of use assets and liabilities for its operating leases in the statement of financial position upon adoption.

In March 2016, the FASB issued authoritative guidance that includes several changes to simplify the accounting for stock-based compensation, including the accounting for income taxes, forfeitures, statutory tax withholding requirements and classification of tax benefits in the statement of cash flows. Among the more significant changes, the new guidance requires that the income tax effects associated with the settlement of stock-based awards after adoption of the guidance be recognized through income tax expense rather than directly in equity. Additionally, the income tax effects related to excess tax benefits will be presented as an operating cash flow in the statement of cash flows rather than a financing activity for all current and prior periods presented. The Company adopted this guidance effective January 1, 2017. For the twelve months ended December 31, 2016 and 2015, the Company had classified $29 million and $20 million, respectively, of excess tax benefits as a financing activity in the statement of cash flows which will be presented as an operating cash flow under the new guidance. The expected effect on income tax expense or net cash provided from operating activities related to stock-based awards settled after adoption of the new guidance will depend on inputs such as the stock price at the time of settlement and the number of awards settled in the period presented.

In October 2016, the FASB issued authoritative guidance requiring the recognition of the income tax consequences of an intra-entity transfer of an asset, other than inventory, when the transfer occurs rather than when transferred to a third party as required under the current guidance. The new guidance is effective for the Company beginning January 1, 2018, with early adoption permitted. The Company is currently assessing the potential impact the guidance will have upon adoption.

In January 2017, the FASB issued authoritative guidance that simplifies the assessment of goodwill for impairment when the estimated fair value of a reporting unit is less than its carrying value by eliminating the requirement to determine the fair value of goodwill. Under the new guidance, the amount of goodwill impairment will be determined by the amount the carrying value of the reporting unit exceeds its fair value. The new guidance is effective for the Company beginning January 1, 2020, with early adoption permitted. The Company performs its annual goodwill impairment assessment process in the third quarter, or more frequently if triggering events occur. Adoption of this new guidance is not expected to have a material impact on the Company's operating results, financial position or cash flows.