Note 1.

SIGNIFICANT ACCOUNTING POLICIES

Consolidation Policy and Basis of Presentation – The condensed consolidated financial statements include the accounts of Katy Industries, Inc. and subsidiaries in which it has a greater than 50% voting interest or significant influence, collectively “Katy” or the “Company”. All significant intercompany accounts, profits and transactions have been eliminated in consolidation. The Condensed Consolidated Balance Sheet at September 30, 2016 and the related Condensed Consolidated Statements of Operations and Comprehensive Loss for the three and nine months ended September 30, 2016 and September 25, 2015 and Condensed Consolidated Statement of Cash Flows for the nine months ended September 30, 2016 and September 25, 2015 have been prepared without audit, pursuant to the rules and regulations of the Securities and Exchange Commission, and reflect all adjustments (consisting only of normal recurring adjustments) which are, in the opinion of management, necessary for a fair presentation of the financial condition, results of operations and cash flows of the Company for the interim periods. Interim results may not be indicative of results to be realized for the entire year. The condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto, together with management’s discussion and analysis of financial condition and results of operations, contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2015. The Condensed Consolidated Balance Sheet as of December 31, 2015 was derived from audited financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States (“GAAP”).

Fiscal Year – The Company operates and reports using a 4-4-5 fiscal year which always ends on December 31. As a result, December and January do not typically consist of five and four weeks, respectively. The three months ended September 30, 2016 and September 25, 2015 consisted of 63 shipping days each. The nine months ended September 30, 2016 and September 25, 2015 consisted of 192 and 186 shipping days, respectively.

Use of Estimates – The preparation of financial statements in conformity with GAAP 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 and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Inventories – At September 30, 2016 and December 31, 2015, approximately 60% and 67%, respectively, of Katy’s inventories were accounted for using the last-in, first-out (“LIFO”) method of costing, while the remaining inventories were accounted for using the first-in, first-out (“FIFO”) method. Current cost, as determined using the FIFO method, exceeded LIFO cost by $3.7 million at September 30, 2016 and $3.6 million at December 31, 2015. The components of inventories are as follows as of September 30, 2016 and December 31, 2015, respectively (amounts in thousands):

	September 30, 2016			December 31, 2015

Raw materials	$	7,562		$	11,262
Finished goods		9,037			12,380
Inventory reserves		(714	)		(738	)
LIFO reserve		(3,655	)		(3,637	)
	$	12,229		$	19,267

Fair Value Measurement and Financial Instruments – Fair value is a market-based measurement, not an entity-specific measurement, defined as the price that would be received to sell an asset or transfer a liability in an orderly transaction between market participants at the measurement date. Various valuation techniques exist for measuring fair value, including the market approach (comparable market prices), the income approach (present value of future income or cash flow), and the cost approach (cost to replace the service capacity of an asset or replacement cost). These valuation techniques are based upon observable and unobservable inputs. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect the Company’s market assumptions. The authoritative accounting guidance for fair value provides a hierarchy that prioritizes these two inputs to valuation techniques used to measure fair value into three broad levels.

The following is a brief description of those three levels:

Level 1: Observable inputs such as quoted prices for identical assets or liabilities in active markets.

Level 2: Observable inputs other than quoted prices that are directly or indirectly observable for the asset or liability, including quoted prices for similar assets or liabilities in active markets; quoted prices for similar or identical assets or liabilities in markets that are not active; and model-derived valuations whose inputs are observable or whose significant value drivers are observable.

Level 3: Unobservable inputs that reflect the reporting entity’s own assumptions.

The Company determines the fair value of its pension assets annually primarily based on the fair value of underlying investments and market-based inputs (Level 2) and are evaluated by a third-party. The Company does not have any unobservable inputs (Level 3).

Share-Based Payment – Compensation cost recognized during the three and nine months ended September 30, 2016 and September 25, 2015 includes compensation cost for outstanding stock appreciation rights (“SARs”) as of September 30, 2016 and September 25, 2015 based on the September 30, 2016 and the September 25, 2015 fair values, respectively. The Company re-measures the fair value of SARs each reporting period until the award is settled and compensation expense is recognized each reporting period for changes in fair value and vesting.

Compensation expense is included in selling, general and administrative expense in the Condensed Consolidated Statements of Operations. The components of compensation expense are as follows for the three and nine months ended September 30, 2016 and September 25, 2015, respectively (amounts in thousands):

	Three Months Ended					Nine Months Ended
	September 30, 2016			September 25, 2015		September 30, 2016			September 25, 2015

Stock appreciation right (income) expense	$	(35	)	$	13	$	(11	)	$	76

The fair value of SARs, a liability award, was estimated at September 30, 2016 and September 25, 2015 using a Black-Scholes option pricing model. The Company estimated the expected term by averaging the minimum and maximum lives expected for each award. In addition, the Company estimated volatility by considering its historical stock volatility over a term comparable to the remaining expected life of each award. The risk-free interest rate is the current yield available on U.S. treasury issues with a remaining term equal to each award. The Company estimates forfeitures using historical results. Its estimates of forfeitures will be adjusted over the requisite service period based on the extent to which actual forfeitures differ, or are expected to differ, from their estimate. The assumptions for expected term, volatility and risk-free rate are presented in the table below as of September 30, 2016 and September 25, 2015, respectively:

	September 30, 2016	September 25, 2015

Expected term (years)	0.7 - 4.8	0.9 - 4.8
Volatility	188.8% - 274.3%	133.1% - 313.7%
Risk-free interest rate	0.5% - 1.1%	0.3% - 1.4%

Accumulated Other Comprehensive Loss – The components of accumulated other comprehensive loss are foreign currency translation adjustments and pension and other postretirement benefits adjustments. The balance of the foreign currency translation adjustments account was $1.0 at September 30, 2016 and December 31, 2015. The balance of the pension and other postretirement benefits adjustments account was $0.7 million at September 30, 2016 and December 31, 2015.

Segment Reporting – Operating segments are components of an enterprise about which separate financial information is available that is evaluated regularly by the chief decision maker or group in deciding how to allocate resources and in assessing performance. The Company’s chief decision maker reviews the results of operations and requests for capital expenditures based on one industry segment: manufacturing, importing, distributing commercial cleaning, storage, and structural foam products. The Company’s entire revenue is generated through this segment.

Reclassifications – The Company adopted Accounting Standards Update (“ASU”) 2015-03, Interest-Imputation of Interest (Subtopic 835-30): Simplifying the Presentation of Debt Issuance Costs (“ASU 2015-03”) during the first quarter of fiscal 2016. As shown in the table below, pursuant to the guidance in ASU 2015-03, we have reclassified unamortized debt issuance costs associated with our term loan (see Note 4 for detail) in our previously reported Condensed Consolidated Balance Sheets as of December 31, 2015 to conform to our presentation as of September 30, 2016 as follows (amounts in thousands):

	As presented December 31, 2015		Reclassifications			As adjusted December 31, 2015
Other assets	$	3,882	$	(2,135	)	$	1,747
Current maturities of long-term debt		1,800		(657	)		1,143
Long-term debt		22,913		(1,478	)		21,435

As shown in the table below, pursuant to the guidance in ASU 2015-03, we have reclassified amortized debt issuance costs associated with our term loan (see Note 4 for detail) in our previously reported Condensed Consolidated Statements of Cash Flows as of September 25, 2015 to conform to our presentation as of September 30, 2016 as follows (amounts in thousands):

	As presented September 25, 2015			Reclassifications			As adjusted September 25, 2015
Amortization of debt issuance costs	$	458		$	(328	)	$	130
Accrued expenses		(1,367	)		328			(1,039	)