GRANITE CONSTRUCTION INCORPORATED

NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1. Basis of Presentation

The condensed consolidated financial statements included herein have been prepared by Granite Construction Incorporated (“we,” “us,” “our,” “the Company” or “Granite”) pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”), are unaudited and should be read in conjunction with our Annual Report on Form 10-K for the year ended December 31, 2017. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) have been condensed or omitted. Further, the condensed consolidated financial statements reflect, in the opinion of management, all normal recurring adjustments necessary to state fairly our financial position at September 30, 2018 and 2017 and the results of our operations and cash flows for the periods presented. The December 31, 2017 condensed consolidated balance sheet data was derived from audited consolidated financial statements, but does not include all disclosures required by U.S. GAAP.

Our operations are typically affected more by weather conditions during the first and fourth quarters of our fiscal year which may alter our construction schedules and can create variability in our revenues and profitability. Therefore, the results of operations for the three and nine months ended September 30, 2018 are not necessarily indicative of the results to be expected for the full year.

We prepared the accompanying condensed consolidated financial statements on the same basis as our annual consolidated financial statements, except for the adoption during the three months ended March 31, 2018 of Accounting Standards Update (“ASU”) No. 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments, ASU No. 2016-16, Intra-Entity Transfers of Assets Other Than Inventory, ASU No. 2016-18 'Statement of Cash Flows (Topic 230): Restricted Cash, ASU No. 2017-01, Business Combinations (Topic 805): Clarifying the Definition of a Business and ASU No. 2017-09, Compensation-Stock Compensation (Topic 718) Scope of Modification Accounting, none of which had a material impact on our condensed consolidated financial statements. In addition, during the three months ended March 31, 2018, we adopted ASU No. 2018-05, Income Taxes (Topic 740) - Amendments to SEC Paragraphs Pursuant to SEC Staff Accounting Bulletin No.118, the impact of which is disclosed in Note 16 and on January 1, 2018, we adopted Accounting Standards Codification (“ASC”) Topic 606, Revenue from Contracts with Customers and subsequently issued additional related ASUs (“Topic 606”), the impact of which is described in detail below.

On April 3, 2018, we acquired LiquiForce and on June 14, 2018, we completed the acquisition of Layne Christensen Company (“Layne”). See Note 3 for further information.

Foreign Currency Transactions and Translation: Through the acquisitions of Layne and LiquiForce, we now have operations in Latin America, Canada and Brazil which involve exposure to possible volatile movements in foreign currency exchange rates. We account for foreign currency exchange transactions and translation in accordance with ASC Topic 830, Foreign Currency Matters. In Mexico, most of our customer contracts are denominated in U.S. dollars; therefore, the functional currency is U.S. dollars. In Canada and Brazil, the functional currency is the local currency. Foreign currency transactions are remeasured into the functional currency with gains and losses included in other income, net in the condensed consolidated statements of operations. The impact from foreign currency transactions was immaterial for both the three and nine months ended September 30, 2018. Assets and liabilities in functional currency are translated into U.S. dollars at exchange rates prevailing at the balance sheet date. Revenues and expenses are translated into U.S. dollars at average foreign currency exchange rates prevailing during the reporting periods. The translation adjustments from functional currency to U.S. dollars are reported in accumulated other comprehensive income on the condensed consolidated balance sheets.

Cash, Cash Equivalents and Restricted Cash: In connection with the acquisition of Layne, we acquired restricted cash which is included in other noncurrent assets in the condensed consolidated balance sheets and consists of escrow funds and judicial deposits associated with tax related legal proceedings in Brazil. The table below presents changes in cash, cash equivalents and restricted cash on the condensed consolidated statements of cash flows and a reconciliation to the amounts reported in the condensed consolidated balance sheets (in thousands).

Nine Months Ended September 30,	2018		2017
Cash and cash equivalents, beginning of period	$	233,711	$	189,326
End of the period
Cash and cash equivalents		230,259		185,516
Restricted cash		5,599		—
Total cash, cash equivalents and restricted cash, end of period		235,858		185,516
Net increase (decrease) in cash, cash equivalents and restricted cash	$	2,147	$	(3,810	)

Inventories: Inventories consist primarily of quarry products, contract-specific materials, water well drilling materials, and sewer remediation materials that are located in the U.S. and mineral extraction and drilling supplies located in the U.S. and foreign countries, primarily Brazil and Mexico. Cost of U.S. and foreign inventories are valued at the lower of average cost or net realizable value. We reserve quarry products based on estimated quantities of materials on hand in excess of approximately one year of demand. As of September 30, 2018, inventory included $18.4 million of supplies related to the Water and Mineral Services operating group.

Assets Held for Sale: During the three months ended September 30, 2018, management approved the plan to sell certain non-core assets and the associated liabilities related to the water delivery business within our Water and Mineral Services operating group. We expect to complete the sale of the assets during the fourth quarter of 2018. The reclassification of the related assets of the disposal group includes approximately $41.8 million of property, plant and equipment and goodwill of $13.5 million.

Recent Developments: During the three months ended September 30, 2018, we revised our reportable segments, which are the same as our operating segments, as a result of a change in how our chief operating decision maker (our Chief Executive Officer) regularly reviews financial information to allocate resources and assess performance. This change is consistent with our strategic, end-market diversification strategy. Our new reportable segments which correspond to this end-market focus are: Transportation, Water, Specialty and Materials. The end-market segments Transportation, Water and Specialty replace the Construction and Large Project Construction reportable segments with the composition of our Materials segment remaining unchanged except for the addition of certain material production activity related to the acquisition of Layne. Prior-year information has been recast to reflect this change. See Note 19 for further information regarding our reportable segments.

Goodwill: As a result of the change in our reportable segments, we reassessed our reporting units and have determined we have eight reporting units in which goodwill was recorded as follows:

•

Midwest Group Transportation

•

Midwest Group Specialty

•

Northwest Group Transportation

•

Northwest Group Materials

•

California Group Transportation

•

Water and Mineral Services Group Water

•

Water and Mineral Services Group Specialty

•

Water and Mineral Services Group Materials

Goodwill was reallocated to these reporting units based on their relative fair values. The following table presents the goodwill balance by reportable segment:

(in thousands)	September 30, 2018		December 31, 2017		September 30, 2017
Transportation	$	19,798	$	19,798	$	19,798
Water		135,230		618		618
Specialty		39,821		31,437		31,437
Materials		49,847		1,946		1,946
Total goodwill	$	244,696	$	53,799	$	53,799

We perform our goodwill impairment tests annually as of November 1 and more frequently when events and circumstances occur that indicate a possible impairment of goodwill. In addition, we evaluate goodwill for impairment if events or circumstances change between annual tests indicating a possible impairment. Examples of such events or circumstances include the following:

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a significant adverse change in legal factors or in the business climate;

•

an adverse action or assessment by a regulator;

•

a more likely than not expectation that a segment or a significant portion thereof will be sold; or

•

the testing for recoverability of a significant asset group within the segment.

Due to the change in reportable segments and the resulting change to reporting units, we conducted an impairment test both before and after the change in accordance with ASC Topic 350, Intangibles - Goodwill and Other. We performed a quantitative assessment on the Kenny Large Project Construction and Kenny Construction reporting units, which were most susceptible to fluctuations in results. The results of the quantitative goodwill impairment tests indicated that the estimated fair values of these reporting units exceeded their net book values (i.e., cushion) by at least 40%.

We performed a qualitative assessment on the remaining six reporting units with goodwill balances as we determined that it was more likely than not that the fair value of these reporting units was greater than the carrying value consistent with our conclusion in 2017. After assessing the totality of events and circumstances, we determined that it is more likely than not that the fair value of these reporting units were greater than the carrying amounts; therefore, a quantitative goodwill impairment test was not performed.

Reclassifications: Certain reclassifications of prior period amounts have been made to conform to the current period presentation. These reclassifications included $2.6 million and $4.8 million during the three and nine months ended September 30, 2017, respectively, of gross profit to the Materials segment primarily from the Transportation segment to better align costs with the respective segments. These reclassifications had no impact on previously reported operating income (loss) or net income (loss), or on the consolidated balance sheets or statements of cash flows.

Effect of adopting Topic 606

The core principle of Topic 606 is that revenue will be recognized when promised goods or services are transferred to customers in an amount that reflects consideration for which entitlement is expected in exchange for those goods or services. We adopted Topic 606 using a modified retrospective transition approach and elected to apply Topic 606 to contracts with customers that are not substantially complete, i.e. less than 90% complete, as of January 1, 2018.

While the adoption of Topic 606 did not have an impact on revenue of our Materials segment, it did impact revenue of our Transportation, Water and Specialty segments specifically in the following areas:

•

Multiple performance obligations – In accordance with Topic 606, we reviewed construction contracts with customers, including those related to contract modifications, to determine if there are multiple performance obligations. Based on this review, we identified one unconsolidated joint venture contract in our Transportation segment that has multiple performance obligations.

•

Multiple contracts – We reviewed contracts containing task orders and identified one master contract in our Water segment that consists of multiple individual contracts as defined by Topic 606. Previously, revenue for this contract was forecasted and recorded at the master contract level.

•

Revenue recognition – We identified one contract in our Specialty segment where performance obligations are satisfied and control of the promised goods and services are transferred to the customer upon delivery of goods rather than over time. Previously, revenue for this contract was recognized over time.

•

Provisions for losses – We identified one unconsolidated joint venture contract in our Transportation segment that has actual and provisions for losses at the performance obligation level related to completed and uncompleted performance obligations, respectively. Previously, provisions for losses were recorded at the contract level.

The impact to retained earnings as of January 1, 2018 from the adoption of Topic 606 related to the items noted above was a net cumulative decrease of $15.2 million.

In addition, as of January 1, 2018, we began to separately present contract assets and liabilities on the condensed consolidated balance sheets. Contract assets include amounts due under contractual retainage provisions that were previously included in accounts receivable as well as costs and estimated earnings in excess of billings that were previously separately presented. Contract liabilities include billings in excess of costs and estimated earnings that were previously separately presented as well as provisions for losses that were previously included in accrued expenses and other current liabilities. See Note 7 for further information.

Notes 5, 6 and 7 include information relating to our adoption of Topic 606. Note 5 includes information regarding our revenue disaggregated by operating group, Note 6 includes information regarding unearned revenue and Note 7 includes information regarding our contract assets and liabilitis.

The accounting policies that were affected by Topic 606 and the changes thereto are as follows:

Revenue Recognition: Our revenue is primarily derived from construction contracts that can span several quarters or years and from sales of construction materials. We recognize revenue in accordance with Topic 606. Topic 606 provides for a five-step model for recognizing revenue from contracts with customers as follows:

Identify the contract

Identify performance obligations

Determine the transaction price

Allocate the transaction price

Recognize revenue

Generally, our contracts contain one performance obligation.

Contracts with customers in our Materials segment are typically defined by our customary business practices and are valued at the contractual selling price per unit. Our customary business practices are for the delivery of a separately identifiable good at a point in time which is typically when delivery to the customer occurs.

Contracts in our Transportation, Water and Specialty segments may contain multiple distinct promises or multiple contracts within a master agreement (e.g. contracts that cross multiple locations/geographies and task orders), which we review at contract inception to determine if they represent multiple performance obligations or multiple separate contracts. This review consists of determining if promises or groups of promises are distinct within the context of the contract, including whether contracts are physically contiguous, contain task orders, purchase orders or sales orders, contain termination clauses and/or contain elements not related to design and/or build.

The transaction price is the amount of consideration to which we expect to be entitled in exchange for transferring goods and services to the customer. The consideration promised in a contract with customers of our Transportation, Water and Specialty segments may include both fixed amounts and variable amounts (e.g. bonuses/incentives or penalties/liquidated damages) to the extent that a significant reversal of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved (i.e., probable and estimable). When a contract has a single performance obligation, the entire transaction price is attributed to that performance obligation. When a contract has more than one performance obligation, the transaction price is allocated to each performance obligation based on estimated relative standalone selling prices of the goods or services at the inception of the contract, which typically is determined using cost plus an appropriate margin.

Subsequent to the inception of a contract in our Transportation, Water and Specialty segments, the transaction price could change for various reasons, including the executed or estimated amount of change orders and unresolved contract modifications and claims to or from owners. Changes that are accounted for as an adjustment to existing performance obligations are allocated on the same basis at contract inception. Otherwise, changes are accounted for as separate performance obligation(s) and the separate transaction price is allocated as discussed above.

Changes are made to the transaction price from unapproved change orders to the extent the amount can be reasonably estimated and recovery is probable.

On certain projects we have submitted and have pending unresolved contract modifications and affirmative claims (“affirmative claims”) to recover additional costs and the associated profit, if applicable, to which the Company believes it is entitled under the terms of contracts with customers, subcontractors, vendors or others. The owners or their authorized representatives and/or other third parties may be in partial or full agreement with the modifications or affirmative claims, or may have rejected or disagree entirely or partially as to such entitlement.

Changes are made to the transaction price from affirmative claims with customers to the extent that additional revenue on a claim settlement with a customer is probable and estimable. A reduction to costs related to affirmative claims with non-customers with whom we have a contractual arrangement (“back charges”) is recognized when the estimated recovery is probable and the amount can be reasonably estimated. Except for contractual back charges, affirmative claims against non-customers that are unrelated to jobs are recognized as a reduction to cost or increase to other income when the claims are settled. Recognizing affirmative claims and back charge recoveries requires significant judgments of certain factors including, but not limited to, dispute resolution developments and outcomes, anticipated negotiation results, and the cost of resolving such matters and estimates.

Certain construction contracts include retention provisions to provide assurance to our customers that we will perform in accordance with the contract terms and are therefore not considered a financing benefit. The balances billed but not paid by customers pursuant to these provisions generally become due upon completion and acceptance of the project work or products by the customer. We have determined there are no significant financing components in our contracts during the nine months ended September 30, 2018.

Typically, performance obligations related to contracts in our Transportation, Water and Specialty segments are satisfied over time because our performance typically creates or enhances an asset that the customer controls as the asset is created or enhanced. We recognize revenue as performance obligations are satisfied and control of the promised good and service is transferred to the customer. Revenue in our Transportation, Water and Specialty segments is ordinarily recognized over time as control is transferred to the customers by measuring the progress toward complete satisfaction of the performance obligation(s) using an input (i.e., “cost to cost”) method. Under the cost to cost method, costs incurred to-date are generally the best depiction of transfer of control.

All contract costs, including those associated with affirmative claims, change orders and back charges, are recorded as incurred and revisions to estimated total costs are reflected as soon as the obligation to perform is determined. Contract costs consist of direct costs on contracts, including labor and materials, amounts payable to subcontractors, direct overhead costs and equipment expense (primarily depreciation, fuel, maintenance and repairs).

The accuracy of our revenue and profit recognition in a given period depends on the accuracy of our estimates of the cost to complete each project. Cost estimates for all of our significant projects use a detailed “bottom up” approach, and we believe our experience allows us to create materially reliable estimates. There are a number of factors that can contribute to changes in estimates of contract cost and profitability. The most significant of these include:

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the completeness and accuracy of the original bid;

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costs associated with scope changes;

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changes in costs of labor and/or materials;

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extended overhead and other costs due to owner, weather and other delays;

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subcontractor performance issues;

•

changes in productivity expectations;

•

site conditions that differ from those assumed in the original bid;

•

changes from original design on design-build projects;

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the availability and skill level of workers in the geographic location of the project;

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a change in the availability and proximity of equipment and materials;

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our ability to fully and promptly recover on affirmative claims and back charges for additional contract costs; and

•

the customer’s ability to properly administer the contract.

The foregoing factors, as well as the stage of completion of contracts in process and the mix of contracts at different margins may cause fluctuations in gross profit and gross profit margin from period to period. Significant changes in cost estimates, particularly in our larger, more complex projects have had, and can in future periods have, a significant effect on our profitability.

All state and federal government contracts and many of our other contracts provide for termination of the contract at the convenience of the party contracting with us, with provisions to pay us for work performed through the date of termination including demobilization cost.

Costs to obtain our contracts (“pre-bid costs”) that are not expected to be recovered from the customer are expensed as incurred and included in selling, general and administrative expenses on our consolidated statements of operations. Although unusual, pre-bid costs that are explicitly chargeable to the customer even if the contract is not obtained are included in accounts receivable on our consolidated balance sheets when we are notified that we are not the low bidder with a corresponding reduction to selling, general and administrative expenses on our consolidated statements of operations.

Unearned Revenue: Unearned revenue represents the aggregate amount of the transaction price allocated to unsatisfied or partially unsatisfied performance obligations at the end of a reporting period. We generally include a project in our unearned revenue at the time a contract is awarded, the contract has been executed and to the extent we believe funding is probable. Certain contracts contain contract options that are exercisable at the option of our customers without requiring us to go through an additional competitive bidding process or contain task orders related to master contracts under which we perform work only when the customer awards specific task orders to us. Contract options and task orders are included in unearned revenue when exercised or issued, respectively.

Substantially all of the contracts in our unearned revenue may be canceled or modified at the election of the customer; however, we have not been materially adversely affected by contract cancellations or modifications in the past. Many projects are added to unearned revenue and completed within the same fiscal quarter or year and, therefore, may not be reflected in our beginning or ending unearned revenue. Approximately $1.9 billion of the September 30, 2018 unearned revenue is expected to be recognized within the next twelve months and the remaining amount will be recognized thereafter. Unearned revenue is presented by segment and operating group in Note 6.

Contract Assets: Our contract assets include amounts due under contractual retainage provisions as well as costs and estimated earnings in excess of billings. The balances billed but not paid by customers pursuant to retainage provisions generally become due upon completion and acceptance of the project work or products by the owners. Costs and estimated earnings in excess of billings also represent amounts earned and reimbursable under contracts, including claim recovery estimates, but have a conditional right for billing and payment such as achievement of milestones or completion of the project. With the exception of customer affirmative claims, generally, such unbilled amounts will become billable according to the contract terms and generally will be billed and collected over the next twelve months. Settlement with the customer of outstanding affirmative claims is dependent on the claims resolution process and could extend beyond one year. Based on our historical experience, we generally consider the collection risk related to billable amounts to be low. When events or conditions indicate that it is probable that the amounts outstanding become unbillable, the transaction price and associated contract asset is reduced.

Costs to mobilize equipment and labor to a job site prior to substantive work beginning (“mobilization costs”) are capitalized as incurred and amortized over the expected duration of the contract. As of September 30, 2018 and January 1, 2018, we had no material capitalized mobilization costs.

Contract Liabilities: Our contract liabilities consist of provisions for losses and billings in excess of costs and estimated earnings. Provisions for losses are recognized in the consolidated statements of operations at the uncompleted performance obligation level for the amount of total estimated losses in the period that evidence indicates that the estimated total cost of a performance obligation exceeds its estimated total revenue. Billings in excess of costs and estimated earnings are billings to customers on contracts in advance of work performed, including advance payments negotiated as a contract condition. Generally, unearned project-related costs will be earned over the next twelve months.

The amounts by which each condensed consolidated balance sheet line item as of September 30, 2018 and condensed consolidated statement of operations line item for the three and nine months ended September 30, 2018 was affected by the adoption of Topic 606 relative to the previous revenue guidance are presented in the tables below (in thousands). The changes are primarily related to reclassifications on the condensed consolidated balance sheet and the impact on the condensed consolidated statement of operations from the new requirements under Topic 606. The change in retained earnings is net of the cumulative effect of initially applying Topic 606.

September 30, 2018

Condensed Consolidated Balance Sheet	As Reported		Balances Without Adoption of Topic 606		Effect of Change Higher/(Lower)
Assets
Receivables, net	$	618,070	$	733,368	$	(115,298	)
Contract assets		213,989		—		213,989
Costs and estimated earnings in excess of billings		—		141,525		(141,525	)
Deferred income taxes, net		6,408		1,136		5,272

Liabilities and equity
Contract liabilities	$	117,759	$	—	$	117,759
Billings in excess of costs and estimated earnings		—		158,228		(158,228	)
Accrued expenses and other current liabilities		296,033		286,681		9,352
Retained earnings		786,936		793,381		(6,445	)

Three Months Ended September 30, 2018

Condensed Consolidated Statement of Operations	As Reported		Balances Without Adoption of Topic 606		Effect of Change Higher/(Lower)
Revenue
Transportation	$	610,847	$	607,413	$	3,434
Water		124,292		119,977		4,315
Specialty		190,836		192,158		(1,322	)
Materials		129,616		129,616		—
Total revenue		1,055,591		1,049,164		6,427
Cost of revenue
Transportation	$	539,871	$	541,934	$	(2,063	)
Water		100,189		100,189		—
Specialty		162,737		162,737		—
Materials		108,303		108,303		—
Total cost of revenue		911,100		913,163		(2,063	)
Gross profit		144,491		136,001		8,490
Operating income		67,406		58,916		8,490
Provision for income taxes		8,692		6,603		2,089
Net income		59,097		52,697		6,400
Net income attributable to Granite Construction Incorporated		55,672		49,272		6,400

Nine Months Ended September 30, 2018

Condensed Consolidated Statement of Operations	As Reported		Balances Without Adoption of Topic 606		Effect of Change Higher/(Lower)
Revenue
Transportation	$	1,472,703	$	1,468,253	$	4,450
Water		215,951		213,157		2,794
Specialty		461,149		461,977		(828	)
Materials		276,286		276,286		—
Total revenue		2,426,089		2,419,673		6,416
Cost of revenue
Transportation	$	1,334,302	$	1,339,443	$	(5,141	)
Water		174,834		174,834		—
Specialty		395,838		395,838		—
Materials		239,972		239,972		—
Total cost of revenue		2,144,946		2,150,087		(5,141	)
Gross profit		281,143		269,585		11,558
Operating income		48,842		37,284		11,558
Provision for income taxes		7,357		4,554		2,803
Net income		43,354		34,599		8,755
Net income attributable to Granite Construction Incorporated		35,864		27,109		8,755