10-K

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-K

(Mark One)
þ	ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
	For the Fiscal Year Ended August 31, 2006
o	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
	For the transition period from          to

Commission File Number 0-11488

Penford Corporation

(Exact name of registrant as specified in its charter)

Washington	91-1221360
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)
7094 S. Revere Parkway Centennial, Colorado	80112-3932 (Zip Code)
(Address of principal Executive Offices)

Registrant’s telephone number, including area code:

(303) 649-1900

Securities registered pursuant to Section 12(b) of the Act:

Title of Each Class	Name of Each Exchange on Which Registered
Common Stock, $1.00 par value	Nasdaq Global Market
Common Stock Purchase Rights	Nasdaq Global Market

Securities registered pursuant to Section 12(g) of the Act:

None

Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o   No þ

Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes o  No þ

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for at least the past 90 days.  Yes þ  No o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  þ

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer” and “large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one).

Large accelerated filer  o     Accelerated filer  þ     Non-accelerated filer  o     

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o   No þ

The aggregate market value of the Registrant’s Common Stock held by non-affiliates of the Registrant as of February 28, 2006, the last business day of the Registrant’s second quarter of fiscal 2006, was approximately $81.5 million based upon the last sale price reported for such date on the Nasdaq Global Market. For purposes of making this calculation, Registrant has assumed that all the outstanding shares were held by non-affiliates, except for shares held by Registrant’s directors and officers and by each person who owns 5% or more of the outstanding Common Stock. However, this does not necessarily mean that there are not other persons who may be deemed to be affiliates of the Registrant.

The number of shares of the Registrant’s Common Stock (the Registrant’s only outstanding class of stock) outstanding as of November 7, 2006 was 8,954,387.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Registrant’s definitive Proxy Statement relating to the 2007 Annual Meeting of Shareholders are incorporated by reference into Part III of this Form 10-K.

PENFORD CORPORATION

FISCAL YEAR 2006 FORM 10-K ANNUAL REPORT

TABLE OF CONTENTS

			Page
PART I
	Item 1.	Business		2
	Item 1A	Risk Factors		8
	Item 1B	Unresolved Staff Comments		10
	Item 2.	Properties		10
	Item 3.	Legal Proceedings		11
	Item 4.	Submission of Matters to a Vote of Security Holders		11
PART II
	Item 5.	Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchasers of Equity Securities		12
	Item 6.	Selected Financial Data		12
	Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		13
	Item 7A.	Quantitative and Qualitative Disclosures About Market Risk		24
	Item 8.	Financial Statements and Supplementary Data		26
	Item 9.	Changes in and Disagreements with Accountants on Accounting and Financial Disclosure		58
	Item 9A.	Controls and Procedures		58
	Item 9B.	Other Information		58
PART III
	Item 10.	Directors and Executive Officers of the Registrant		58
	Item 11.	Executive Compensation		58
	Item 12.	Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters		58
	Item 13.	Certain Relationships and Related Transactions		59
	Item 14.	Principal Accountant Fees and Services		59
PART IV
	Item 15.	Exhibits and Financial Statement Schedules		59
Signatures				61
Restated and Amended Articles of Incorporation
Deferred Compensation Plan
Subsidiaries of the Registrant
Consent of Independent Registered Public Accounting Firm
Power of Attorney
Certifications of CEO Pursuant to Section 302
Certifications of CFO Pursuant to Section 302
Certifications of CEO and CFO Pursuant to Section 906

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PART I

Forward-looking Statements

The statements contained in this Annual Report on Form 10-K (“Annual Report”) that are not historical facts, including, but not limited to statements found in the Notes to Consolidated Financial Statements and in Item 1 — Business and Item 7 — Management’s Discussion and Analysis of Financial Condition and Results of Operations, are forward-looking statements that represent management’s beliefs and assumptions based on currently available information. Forward-looking statements can be identified by the use of words such as “believes,” “may,” “will,” “looks,” “should,” “could,” “anticipates,” “expects,” or comparable terminology or by discussions of strategies or trends.

Although the Company believes that the expectations reflected in such forward-looking statements are reasonable, it cannot give any assurances that these expectations will prove to be correct. Such statements by their nature involve substantial risks and uncertainties that could significantly affect expected results. Actual future results could differ materially from those described in such forward-looking statements, and the Company does not intend to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. Among the factors that could cause actual results to differ materially are the risks and uncertainties discussed in this Annual Report, including those referenced below, and those described from time to time in other filings with the Securities and Exchange Commission which include, but are not limited to, competition; the possibility of interruption of business activities due to equipment problems, accidents, strikes, weather or other factors; product development risk; changes in corn and other raw material prices and availability; expectations regarding the construction cost of the ethanol facility and the timing of ethanol production; changes in general economic conditions or developments with respect to specific industries or customers affecting demand for the Company’s products including unfavorable shifts in product mix; unanticipated costs, expenses or third party claims; the risk that results may be affected by construction delays, cost overruns, technical difficulties, nonperformance by contractors or changes in capital improvement project requirements or specifications; interest rate, chemical and energy cost volatility; foreign currency exchange rate fluctuations; changes in assumptions used for determining employee benefit expense and obligations; or other unforeseen developments in the industries in which Penford operates.

Item 1:  Business

Description of Business

Penford Corporation (which, together with its subsidiary companies, is referred to herein as “Penford” or the “Company”) is a developer, manufacturer and marketer of specialty natural-based ingredient systems for industrial and food applications. Penford Corporation is a Washington corporation originally incorporated in September 1983. The Company commenced operations as a publicly-traded company on March 1, 1984.

The Company uses its carbohydrate chemistry expertise to develop ingredients with starch as a base for value-added applications in several markets including papermaking and food products. The Company manages its business in three segments. The first two, industrial ingredients and food ingredients are, broad categories of end-market users, primarily served by the Company’s U.S. operations. The third segment consists of geographically separate operations in Australia and New Zealand. The Australian and New Zealand operations are engaged primarily in the food ingredients business. Financial information about Penford’s segments and geographic areas is included in Note 16 to the Consolidated Financial Statements.

Penford’s family of products provides functional characteristics to customers’ products. Carbohydrate-based specialty starches possess binding and film-forming attributes that provide convenient and cost-effective solutions that make customers’ products perform better. The Company has extensive research and development capabilities, which are used in understanding the complex chemistry of carbohydrate-based materials and their application.

Penford has specialty processing capabilities for a variety of modified starches. Specialty products for industrial applications are designed to improve the strength and quality of customers’ products and efficiencies in the manufacture of coated and uncoated paper and paper packaging products. These starches are principally

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ethylated (chemically modified with ethylene oxide), oxidized (treated with sodium hypochlorite) and cationic (carrying a positive electrical charge). Ethylated and oxidized starches are used in coatings and as binders, providing strength and printability to fine white, magazine and catalog paper. Cationic and other liquid starches are generally used in the paper-forming process in paper production, providing strong bonding of paper fibers and other ingredients. Penford’s products are a cost-effective alternative to synthetic ingredients.

Specialty starches produced for food applications are used in coatings to provide crispness, improved taste and texture, and increased product life for products such as French fries sold in quick-service restaurants. Food-grade starch products are also used as moisture binders to reduce fat levels, modify texture and improve color and consistency in a variety of foods such as canned products, sauces, whole and processed meats, dry powdered mixes and other food and bakery products.

In June 2006, the Company announced plans to invest $42 million for up to 40 million gallons of ethanol production capacity per year at its Cedar Rapids, Iowa facility. The Company currently expects the facility to be producing ethanol by the end of calendar 2007. Penford has much of the infrastructure within the Cedar Rapids plant to participate in the ethanol market with sufficient grain handling, separation processes, utilities and logistic capabilities. The existing factory is centrally located near rail and ground transport arteries and the ethanol facility will occupy available space within the existing site footprint. In October 2006, Penford refinanced its credit facility and obtained a $45 million capital expansion loan commitment maturing December 2012 to finance construction of the ethanol plant.

In November 2002, Penford sold certain assets of its resistant starch business to National Starch Corporation (“National Starch”) for $2.5 million. In fiscal 2003, Penford also exclusively licensed to National Starch certain rights to its resistant starch patent portfolio (the “RS Patents”) for applications in human nutrition. Under the terms of the agreements, Penford received an initial licensing fee of $2.25 million and will receive annual royalties for a period of seven years or until a maximum of $11.0 million in royalties has been received by Penford. The licensing fee is being amortized over the life of the agreement. The royalty payments are subject to a minimum of $7 million over the first five years of the licensing agreement.

On September 11, 2006, in connection with the settlement of litigation in which Penford’s Australian subsidiary companies were plaintiffs, Penford granted to Cargill Incorporated (“Cargill”), in exchange for a one-time payment, a license under the RS Patents in certain non-human nutrition applications. In addition, Penford entered into an agreement with Cargill and National Starch pursuant to which National Starch granted to Cargill a sublicense, with royalties payable to Penford, of rights under the RS Patents in human nutrition applications. As part of the settlement agreement, Penford will receive certain other benefits, including an acceleration and extension of certain royalties under its 2002 license with National Starch.

Raw Materials

Corn:  Penford’s North American corn wet milling plant is located in Cedar Rapids, Iowa, the middle of the U.S. corn belt. Accordingly, the plant has truck-delivered corn available throughout the year from a number of suppliers at prices consistent with those available in the major U.S. grain markets.

Penford Australia’s corn wet milling facilities in Lane Cove, Australia, and Auckland, New Zealand are sourced through truck-delivered corn at contracted prices with regional independent farmers and merchants. The corn sourced in Australia and New Zealand is contracted prior to harvest (March — June). Corn used in Australia is purchased and stored for use in both the current and following year. The corn sourced in New Zealand is purchased forward for future delivery. Corn is also purchased from Australia as necessary to supplement the corn sourced and processed in New Zealand.

Potato Starch:  The Company’s facilities in Idaho Falls, Idaho; Richland, Washington; and Plover, Wisconsin use starch recovered as by-products from potato processors as the primary raw material to manufacture modified potato starches. The Company enters into contracts typically having durations of one to three years with potato processors in the United States, Canada and Mexico to acquire potato-based raw materials.

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Wheat Products:  Penford Australia’s Tamworth facility uses wheat flour as the primary raw material for the production of its wheat products, including wheat starch, wheat gluten and glucose syrup. Tanker trucks from a local flour mill currently supply wheat flour under a four-year supply agreement which expires in December 2007.

Chemicals:  The primary chemicals used in the manufacturing processes are readily available commodity chemicals. The prices for these chemicals are subject to price fluctuations due to market conditions.

Natural Gas:  The primary energy source for most of Penford’s plants is natural gas. Penford contracts its natural gas supply with regional suppliers, generally under short-term supply agreements, and at times uses futures contracts to hedge the price of natural gas in North America. In August 2005, the Company entered into a contract with a regional supplier of methane gas from a landfill near the Cedar Rapids, Iowa facility. This fuel provides a portion of the energy required to generate power for the manufacturing plant.

Corn, potato starch, wheat flour, chemicals and natural gas are not presently subject to availability constraints, although drought conditions in Australia have periodically impacted the prices of corn and wheat in that area and strong demand has substantially increased natural gas and chemical prices. Although supplies are readily available, current forecasts for wheat production in Australia indicate that the existing drought will impact the future price for that raw material. Penford’s current potato starch requirements constitute a material portion of the available North American supply. Penford estimates that it purchases approximately 50-55% of the recovered potato starch in North America. It is possible that, in the long term, continued growth in demand for potato starch-based ingredients and new product development could result in capacity constraints.

Over half of the Company’s manufacturing costs arise from the costs of corn, potato starch, wheat flour, chemicals and natural gas. The remaining portion consists of the costs of labor, distribution, depreciation and maintenance of manufacturing plant and equipment, and other utilities. The prices of raw materials may fluctuate, and increases in prices may affect Penford’s business adversely. To mitigate this risk, Penford hedges a portion of corn and gas purchases with futures and options contracts in the U.S. and enters into short term supply agreements for other production requirements in all locations.

Research and Development

Penford’s research and development efforts cover a range of projects including technical service work focused on specific customer support projects requiring coordination with customers’ research efforts to develop innovative solutions to specific customer requirements. These projects are supplemented with longer-term, new product development and commercialization initiatives. Research and development expenses were $6.2 million, $5.8 million and $6.1 million for fiscal years ended August 31, 2006, 2005 and 2004, respectively.

At the end of fiscal 2006, Penford had 36 scientists, including seven PhD’s who comprise a body of expert knowledge of carbohydrate characteristics and chemistry.

Patents, Trademarks and Tradenames

Penford owns a number of patents, trademarks and tradenames.

Penford has approximately 220 current patents and pending patent applications, most of which are related to technologies in French fry coatings, coatings for the paper industry and high amylose resistant starch. Penford’s issued patents expire at various times between 2007 and 2023. The annual cost to renew all of the Company’s patents is approximately $0.1 million. However, most of Penford’s products are currently made with technology that is broadly available to companies that have the same level of scientific expertise and production capabilities as Penford.

Specialty starch ingredient brand names for industrial applications include, among others, Penford^® Gums, Pensize^® binders, Penflex^® sizing agent, Topcat^® cationic additive and the Apollo^® starch series. Product brand names for food ingredient applications include PenBind^®, PenCling^®, PenPlus^®, CanTab^®, MAPS^tm, Mazaca^tm and Fieldcleer^tm.

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Quarterly Fluctuations

Penford’s revenues and operating results vary from quarter to quarter. In particular, the Company experiences seasonality in its Australian operations. The Company has lower sales volumes and gross margins in Australia and New Zealand’s summer months, which occur during Penford’s second fiscal quarter. This seasonal decline is caused by the closure of some customers’ plants for public holidays and maintenance during this period. Decreased consumption of some foods which use the Company’s products, such as packaged bread, also contributes to this seasonal trend. Sales volumes of the Food Ingredients — North America products used in French fry coatings are also generally lower during Penford’s second fiscal quarter due to decreased consumption of French fries during the post-holiday season.

Working Capital

Penford generally carries a one to 45 day supply of materials required for production, depending on the lead time for specific items. Penford manufactures finished goods to customer orders or anticipated demand. The Company is therefore able to carry less than a 30 day supply of most products. Terms for trade receivables and trade payables are standard for the industry and region and generally do not exceed 30-day terms except for trade receivables for export sales.

Environmental Matters

Penford’s operations are governed by various Federal, state, local and foreign environmental laws and regulations. In the United States, such laws and regulations include the Clean Air Act, the Clean Water Act, the Resource Conservation and Recovery Act, the EPA Oil Pollution Control Act, the Occupational Safety and Health Administration’s hazardous materials regulations, the Toxic Substances Control Act, the Comprehensive Environmental Response Compensation and Liability Act, and the Superfund Amendments and Reauthorization Act. In Australia, Penford is subject to the environmental requirements of the Protection of the Environment Operations Act, the Dangerous Goods Act, the Ozone Protection Act, the Environmentally Hazardous Chemicals Act, and the Contaminated Land Management Act. In New Zealand, the Company is subject to the Resource Management Act, the Dangerous Goods Act, the Hazardous Substances and New Organisms Act and the Ozone Protection Act.

Permits are required by the various environmental agencies which regulate the Company’s operations. Penford believes that it has obtained all necessary material environmental permits required for its operations. Penford believes that its operations are in compliance with applicable environmental laws and regulations in all material aspects of its business. Penford estimates that annual compliance costs, excluding operational costs for emission control devices, wastewater treatment or disposal fees, are approximately $1.7 million.

Penford has adopted and implemented a comprehensive corporate-wide environmental management program. The program is managed by the Corporate Director of Environmental, Health and Safety and is designed to structure the conduct of Penford’s business in a safe and fiscally responsible manner that protects and preserves the health and safety of employees, the communities surrounding the Company’s plants, and the environment. The Company continuously monitors environmental legislation and regulations which may affect Penford’s operations.

During fiscal 2006, there have been no material impacts on the Company’s operations resulting from compliance with environmental regulations. No unusual expenditures for environmental facilities and programs are anticipated in the coming year.

Principal Customers

Penford sells to a variety of customers and has several relatively large customers in each business segment. However, over the last three years Penford has had no customers that annually purchased its products in amounts in excess of 10% of sales.

Competition

In its primary markets, Penford competes directly with approximately five other companies that manufacture specialty starches for the papermaking industry and approximately six other companies that manufacture specialty

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food ingredients. Penford competes indirectly with a larger number of companies that provide synthetic and natural-based ingredients to industrial and food customers. Some of these competitors are larger companies, and have greater financial and technical resources than Penford. Application expertise, quality and service are the major competitive advantages for Penford.

Employees

At August 31, 2006, Penford had 571 total employees. In North America, Penford had 323 employees, of which approximately 41% are members of a trade union. The collective bargaining agreement covering the Cedar Rapids-based manufacturing workforce expires in August 2009. Penford Australia had 249 employees, of which 70% are members of trade unions in Australia and New Zealand. The union contracts for the Lane Cove, Australia, and the New Zealand facilities have expiration dates of December 2007 and April 2007, respectively. The Tamworth, Australia, union agreement expired in September 2006 and is currently being renegotiated. The Company does not expect any significant issues in renewing the contract.

Sales and Distribution

Sales are generated using a combination of direct sales and distributor agreements. In many cases, Penford supports its sales efforts with technical and advisory assistance to customers. Penford generally ships its products upon receipt of purchase orders from its customers and, consequently, backlog is not significant.

Customers for industrial corn-based starch ingredients purchase products through fixed-price contracts or formula-priced contracts for periods covering three months to two years or on a spot basis. In fiscal 2006, approximately 67% of these sales were under fixed price contracts, with 33% representing formula price and spot business.

Since Penford’s customers are generally other manufacturers and processors, most of the Company’s products are distributed via rail or truck to customer facilities in bulk, except in Australia and New Zealand where most dry product is packaged in 25kg bags.

Foreign Operations and Export Sales

Penford further expanded into foreign markets with its acquisition of Penford Australia in September 2000. Penford Australia is the primary producer of corn starch products in Australia and New Zealand. Penford Australia manufactures products used to enhance the quality of packaged food products, generally through providing the texture and viscosity required by its customers for products such as sauces and gravies. Penford Australia’s starch products are also used in industrial applications including mining, paper, corrugating and building materials. The Company’s operations in Australia and New Zealand include three manufacturing facilities for processing specialty corn starches and wheat-related products. Competition is mainly from imported products, except in wheat flour based starches where there is one other producer in Australia. Export sales from Penford’s businesses in the U.S. and Australia/New Zealand accounted for approximately 13%, 16% and 19% of total sales in fiscal 2006, 2005 and 2004, respectively.

Available Information

Penford’s Internet address is www.penx.com. On the investor relations section of its web site, the Company provides free access to Penford’s annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and any amendments to those reports, as soon as reasonably practicable after such material is filed electronically with, or furnished to, the Securities and Exchange Commission (“SEC”). The information found on Penford’s web site shall not be considered to be part of this or any other report filed with or furnished to the SEC.

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Executive Officers of the Registrant

Name	Age		Title
Thomas D. Malkoski		50	President and Chief Executive Officer
Russell A. Allwell		42	Managing Director, Penford Australia and Penford New Zealand
Steven O. Cordier		50	Senior Vice President, Chief Financial Officer and Assistant Secretary
Timothy M. Kortemeyer		40	Vice President and President, Penford Products Co.
Wallace H. Kunerth		58	Vice President and Chief Science Officer
Christopher L. Lawlor		56	Vice President — Human Resources, General Counsel and Secretary
John R. Randall		62	Vice President and President, Penford Food Ingredients

Mr. Malkoski joined Penford Corporation as Chief Executive Officer and was appointed to the Board of Directors in January 2002. He was named President of Penford Corporation in January 2003. From 1997 to 2001 he served as President and Chief Executive Officer of Griffith Laboratories, North America, a formulator, manufacturer and marketer of ingredient systems to the food industry. Previously, he served as Vice President/Managing Director of the Asia Pacific and South Pacific regions for Chiquita Brands International. Mr. Malkoski began his career at the Procter and Gamble Company, a marketer of consumer brands, progressing through major product category management responsibilities.

Mr. Allwell joined Penford as Managing Director of its Australian and New Zealand operations in April 2006. Prior to joining Penford, Mr. Allwell had been the General Manager Retail Sales for George Weston Foods, a manufacturer of baked goods and other foods, since 2003. From 1996 to 2003, Mr. Allwell served in various senior management roles with Berri Ltd., a beverage manufacturer, including as Director of Strategy from 2000 to 2003, as Marketing Director from 1997 to 2003, and as General Manager — New Ventures from 1996 to 1997. Prior to that, Mr. Allwell served in various management, sales and marketing positions with Simplot Australia, Kraft Foods, Calbecks Ltd. and Humes ARC Ltd.

Mr. Cordier is Penford’s Senior Vice President, Chief Financial Officer and Assistant Secretary. He joined Penford in July 2002 as Vice President and Chief Financial Officer, and was promoted to Senior Vice President in November 2004. From September 2005 to April 2006, Mr. Cordier served as the interim Managing Director of Penford’s Australian and New Zealand operations. He came to Penford from Sensient Technologies Corporation, a manufacturer of specialty products for the food, beverage, pharmaceutical and technology industries. He served as Treasurer from 1995 to 1997 and as Vice President and Treasurer from 1997 to 1999. He completed his term at Sensient as Vice President, Administration from 1999 to 2002. During his tenure at Sensient, he had responsibility for treasury, investor relations and finance functions. In his different positions, he also managed other aspects of operations such as engineering, information technology and marketing. From 1990 to 1995, he was employed in various financial management positions at International Flavors & Fragrances, a manufacturer of flavors and fragrances for the food, beverage and cosmetic industries.

Mr. Kortemeyer has served as Vice President of Penford Corporation since October 2005 and President of Penford Products Co., Penford’s industrial ingredients business, since June 2006. He served as General Manager of Penford Products from August 2005 to June 2006. Mr. Kortemeyer joined Penford in 1999 and served as a Team Leader in the manufacturing operations of Penford Products until 2001. From 2001 until 2003, he was an Operations Manager and Quality Assurance Manager. From July 2003 to November 2004, Mr. Kortemeyer served as the business unit manager of the Company’s co-products business, and from November 2004 until August 2005, as the director of the Company’s specialty starches product lines, responsible for sales, marketing and business development.

Dr. Kunerth has served as Penford’s Vice President and Chief Science Officer since 2000. From 1997 to 2000, he served in food applications research management positions in the Consumer and Nutrition Sector at Monsanto Company, a provider of hydrocolloids, high intensity sweeteners, agricultural products and integrated solutions for

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industrial, food and agricultural customers. Before Monsanto, he was the Vice President of Technology at Penford’s food ingredients business from 1993 to 1997.

Mr. Lawlor joined Penford in April 2005 as Vice President-Human Resources, General Counsel and Secretary. From 2002 to April 2005, Mr. Lawlor served as Vice President-Human Resources for Sensient Technologies Corporation, a manufacturer of specialty chemicals and food products. From 2000 to 2002, he was Assistant General Counsel for Sensient. Mr. Lawlor was Vice President-Administration, General Counsel and Secretary for Kelley Company, Inc., a manufacturer of material handling and safety equipment from 1997 to 2000. Prior to joining Kelley Company, Mr. Lawlor was employed as an attorney at a manufacturer of paper and packaging products and in private practice with national and regional law firms.

Mr. Randall is Vice President of Penford Corporation and President of Penford Food Ingredients. He joined Penford in February 2003 as Vice President and General Manager of Penford Food Ingredients and was promoted to President of the Food Ingredients division in June 2006. Prior to joining Penford, Mr. Randall was Vice President, Research & Development/Quality Assurance of Griffith Laboratories, USA, a specialty foods ingredients business, from 1998 to 2003. From 1993 to 1998, Mr. Randall served in various research and development positions with KFC Corporation, a quick-service restaurant business, most recently as Vice President, New Product Development. Prior to 1993, Mr. Randall served in research and development leadership positions at Romanoff International, Inc., a manufacturer and marketer of gourmet specialty food products, and at Kraft/General Foods.

Item 1A:  Risk Factors

Increases in energy and chemical costs may reduce the Company’s profitability.

Energy and chemicals comprised approximately 13% and 12%, respectively, of the cost of manufacturing the Company’s products in fiscal year 2006. Natural gas is used extensively in the Industrial Ingredients — North America business to dry starch products, and, to a lesser extent, in the Company’s other business segments. Chemicals are used in all of Penford’s businesses to modify starch for specific product applications and customer requirements. The prices of these inputs to the manufacturing process fluctuate based on anticipated changes in supply and demand, weather and the prices of alternative fuels, including petroleum. Penford may use short-term purchase contracts or exchange traded futures or option contracts to reduce the price volatility of natural gas; however, these strategies are not available for the chemicals the Company purchases. Penford may not be able to pass on increases in energy and chemical costs to its customers and margins and profitability would be adversely affected.

The availability and cost of agricultural products Penford purchases are vulnerable to weather and other factors beyond its control.

In fiscal 2006, approximately 27% of Penford’s manufacturing costs were the costs of agricultural raw materials, corn, wheat flour and maize. Weather conditions, plantings and global supply, among other things, have historically caused volatility in the supply and prices of these agricultural products. The Company may not be able to pass through the increases in the cost of agricultural raw materials to its customers. To manage price volatility in the commodity markets, the Company may purchase inventory in advance or enter into exchange traded futures or options contracts. Despite these hedging activities, Penford may not be successful in limiting its exposure to market fluctuations in the cost of agricultural raw materials. Increases in the cost of corn, wheat flour, maize and potato starch due to weather conditions or other factors beyond Penford’s control and that cannot be passed through to customers will reduce Penford’s future profitability.

The loss of a major customer could have an adverse effect on Penford’s results of operations.

None of the Company’s customers constituted 10% of sales in the last three years. However, in fiscal year 2006, sales to the top ten customers and sales to the largest customer represented 43% and 8%, respectively, of total consolidated net sales. Customers place orders on an as-needed basis and generally can change their suppliers without penalty. If the Company lost one or more of its major customers, or if one or more of its customers significantly reduced its orders, sales and results of operations would be adversely affected.

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Changes in interest rates will affect Penford’s profitability.

At August 31, 2006, $20.7 million of the Company’s outstanding debt, including amounts outstanding under the Australian grain inventory financing facility, was subject to variable interest rates which move in direct relation to the U.S. or Australian London InterBank Offered Rate (“LIBOR”), the Australian bank bill rate (“BBSY”), or the prime rate in the U.S., depending on the selection of borrowing options. Significant changes in these interest rates would materially affect Penford’s profitability.

Unanticipated changes in tax rates or exposure to additional income tax liabilities could affect Penford’s profitability.

Penford is subject to income taxes in the United States, Australia and New Zealand. The Company’s effective tax rates could be adversely affected by changes in the mix of earnings in countries with differing statutory tax rates, changes in the valuation of deferred tax assets and liabilities or changes in tax laws. The carrying value of deferred tax assets, which are predominantly in the United States, is dependent on Penford’s ability to generate future taxable income in the United States. The amount of income taxes paid is subject to the Company’s interpretation of applicable tax laws in the jurisdictions in which Penford operates. The Company is subject to audits by tax authorities. While the Company believes it has complied with all applicable income tax laws, there can be no assurance that a tax authority will not have a different interpretation of the law or that any additional taxes imposed as a result of tax audits will not have an adverse effect on the Company’s results of operations.

Profitability is subject to risks associated with changes in foreign exchange currency rates.

In the ordinary course of business, Penford is subject to risks associated with changing foreign exchange rates. In fiscal year 2006, approximately 30% of the Company’s revenue was denominated in currencies other than the U.S. dollar. Penford’s revenues and results of operations are affected by fluctuations in exchange rates between the U.S. dollar and other currencies.

Provisions of Washington law could discourage or prevent a potential takeover.

Washington law imposes restrictions on certain transactions between a corporation and certain significant shareholders. The Washington Business Corporation Act generally prohibits a “target corporation” from engaging in certain significant business transactions with an “acquiring person,” which is defined as a person or group of persons that beneficially owns 10% or more of the voting securities of the target corporation, for a period of five years after such acquisition, unless the transaction or acquisition of shares is approved by a majority of the members of the target corporation’s board of directors prior to the time of the acquisition. Such prohibited transactions include, among other things, (1) a merger or consolidation with, disposition of assets to, or issuance or redemption of stock to or from, the acquiring person; (2) a termination of 5% or more of the employees of the target corporation as a result of the acquiring person’s acquisition of 10% or more of the shares; and (3) allowing the acquiring person to receive any disproportionate benefit as a shareholder.

After the five year period, a “significant business transaction” may occur if it complies with “fair price” provisions specified in the statute. A corporation may not “opt out” of this statute. This provision may have the effect of delaying, deterring or preventing a change of control in the ownership of the Company.

The Company may not be able to implement ethanol production as planned or at all.

Penford’s ability to implement ethanol production as planned is subject to uncertainty. The Company recently announced this project and a considerable amount of work is only in preliminary stages. As of August 31, 2006, the Company had not yet secured all necessary permits and had not entered into all necessary engineering, construction and procurement contracts. The Company has secured $45 million of financing for this project which it believes is adequate for completion; however, the Company could face financial risks if this amount of financing is not sufficient to complete the construction of the ethanol facility. The Company may be adversely affected by environmental, health and safety laws, regulations and liabilities in implementing ethanol production. Changes in the markets for ethanol and/or legislation and regulations could materially and adversely affect ethanol demand.

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Other uncertainties

The Company’s consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States. These accounting principles require management to make estimates, judgments and assumptions to fairly present results of operations and financial position. Management believes that its estimates, judgments and assumptions are reasonable based upon information available at the time this report was prepared. To the extent there are material differences between estimates, judgments and assumptions and actual results, the financial statements will be affected. See “Critical Accounting Policies” in Item 7 — Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Item 1B:  Unresolved Staff Comments

Not applicable.

Item 2:  Properties

Penford’s facilities as of August 31, 2006 are as follows:

	Bldg. Area		Land Area		Owned/
	(Sq. Ft.)		(Acres)		Leased	Function of Facility
North America:
Centennial, Colorado		25,200		—	Leased	Corporate headquarters, administrative offices and research laboratories
Cedar Rapids, Iowa		759,000		29	Owned	Manufacture of corn starch products, administration offices and research laboratories
Idaho Falls, Idaho		30,000		4	Owned	Manufacture of potato starch products
Richland, Washington		45,000		—	Owned	Manufacture of potato and tapioca starch products
		9,600		4.9	Leased
Plover, Wisconsin		54,000		10	Owned	Manufacture of potato starch products
Australia/New Zealand:
Lane Cove, New South Wales		75,700		7	Owned	Manufacture of corn starch products, administrative offices and research laboratories
Tamworth, New South Wales		94,600		6	Owned	Manufacture of wheat starch and glutten products
				477	Owned	Effluent dispersion
Tamworth, New South Wales		—		425	Leased	Agricultural and effluent dispersion
				225	Leased	Agricultural use
Auckland, New Zealand		104,700		5	Owned	Manufacture of corn starch products
		—		3	Leased

Penford’s production facilities are strategically located near sources of raw materials. The Company believes that its facilities are maintained in good condition and that the capacities of its plants are sufficient to meet current production requirements. The Company invests in expansion, improvement and maintenance of property, plant and equipment as required.

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Item 3:  Legal Proceedings

In October 2004, Penford Products Co. (“Penford Products”), a wholly-owned subsidiary of the Company, was served with a lawsuit filed by Graphic Packaging International, Inc. (“Graphic”) in the Fourth Judicial District Court, Ouachita Parish, State of Louisiana. The petition seeks monetary damages for alleged breach of contract, negligence and tortious misrepresentation. These claims arise out of an alleged agreement obligating Penford Products to supply goods to Graphic and Penford Products’ alleged breach of such agreement, together with conduct related to such alleged breach. Penford has filed an answer generally denying all liability and has countersued for damages. During the fourth quarter of the Company’s fiscal year 2006, the parties continued to conduct discovery. Based upon discovery responses made by Graphic, Graphic is seeking damages of approximately $3.3 million. Penford is seeking damages of approximately $675,000.

The Company is involved in various other claims and litigation arising in the normal course of business. In the judgment of management, which relies in part on information from Company counsel, the ultimate resolution of these actions will not materially affect the consolidated financial statements of the Company.

Item 4:  Submission of Matters to a Vote of Security Holders

No matter was submitted to a vote of shareholders during the fourth quarter of fiscal 2006.

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PART II

Item 5:   Market for the Registrant’s Common Equity, Related Shareholder Matters and Issuer Purchases of Equity Securities

Market Information and Holders of Common Stock

Penford’s common stock, $1.00 par value, trades on The Nasdaq Global Market under the symbol “PENX.” On November 7, 2006, there were 533 shareholders of record. The high and low closing prices of Penford’s common stock during the last two fiscal years are set forth below.

	Fiscal 2006				Fiscal 2005
	High		Low		High		Low
Quarter Ended November 30	$	14.78	$	12.64	$	18.00	$	14.01
Quarter Ended February 28	$	16.48	$	11.80	$	17.38	$	14.15
Quarter Ended May 31	$	18.00	$	13.62	$	16.65	$	13.24
Quarter Ended August 31	$	17.85	$	13.59	$	16.09	$	13.68

Dividends

During each quarter of fiscal year 2006 and 2005, the Board of Directors declared a $0.06 per share cash dividend. On October 31, 2006, the Board of Directors declared a dividend of $0.06 per common share payable on December 1, 2006 to shareholders of record as of November 10, 2006. On a periodic basis, the Board of Directors reviews the Company’s dividend policy which is impacted by Penford’s earnings, financial condition, and cash and capital requirements. Future dividend payments are at the discretion of the Board of Directors. Penford has included the payment of dividends in its planning for fiscal 2007.

Item 6:  Selected Financial Data

	Year Ended August 31,
	2006			2005			2004			2003			2002
	(Dollars in thousands, except share and per share data)
Operating Data:
Sales	$	318,419		$	296,763		$	279,386		$	262,467		$	231,450
Cost of sales		273,476			263,542			241,298			218,784			189,067
Gross margin percentage		14.1	%		11.2	%		13.6	%		16.6	%		18.3	%
Net income	$	4,228		$	2,574	(1)	$	3,702	(2)	$	8,436	(3)	$	3,816	(4)
Diluted earnings per share	$	0.47		$	0.29		$	0.42		$	1.03		$	0.49
Dividends per share	$	0.24		$	0.24		$	0.24		$	0.24		$	0.24
Average common shares and equivalents		9,004,190			8,946,195			8,868,050			8,227,549			7,794,304
Balance Sheet Data:
Total assets	$	250,668		$	249,917		$	252,191		$	250,893		$	239,970
Capital expenditures		14,905			9,413			15,454			8,772			7,384
Long-term debt		53,171			62,107			75,551			76,696			77,632
Total debt		67,007			66,129			80,326			79,696			96,411
Shareholders’ equity		107,452			100,026			95,719			87,885			68,964

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(1)	Includes a pre-tax gain of $1.2 million related to sale of land in Australia, a $0.7 million pre-tax gain related to the sale of an investment and a $1.1 million pre-tax write off of unamortized deferred loan costs. See Note 12 to the Consolidated Financial Statements. Includes a tax benefit of $2.5 million related to 2001 through 2004 that the Company recognized in 2005 when the Company determined that it was probable that the extraterritorial income exclusion deduction on its U.S. federal income tax returns for those years would be sustained. See Note 13 to the Consolidated Financial Statements.
(2)	Includes pre-tax charges of $1.3 million related to the restructuring of business operations and $0.7 million related to a pre-tax non-operating expense for the write off of unamortized deferred loan costs. See Notes 12 and 14 to the Consolidated Financial Statements.
(3)	Includes a pre-tax gain of $1.9 million related to the sale of certain assets to National Starch.
(4)	Includes pre-tax charges of approximately $1.4 million related to a strategic restructuring of business operations and $0.5 million related to the write off of Penford’s 2001 investment in an early stage technology company.

Item 7:   Management’s Discussion and Analysis of Financial Condition and Results of Operations

Results of Operations

Executive Overview

Penford generates revenues, income and cash flows by developing, manufacturing and marketing specialty natural-based ingredient systems for industrial and food applications. The Company develops and manufactures ingredients with starch as a base which provide value-added applications to its customers. Penford’s starch products are manufactured primarily from corn, potatoes, and wheat and are used as binders and coatings in paper and food production.

In analyzing business trends, management considers a variety of performance and financial measures, including sales revenue growth, sales volume growth, gross margins and operating income of the Company’s business segments. Penford manages its business in three segments. The first two, Industrial Ingredients and Food Ingredients are broad categories of end-market users, served by operations in the United States. The third segment is the geographically separate operations in Australia and New Zealand. The Australian and New Zealand operations are engaged primarily in the food ingredients business.

Consolidated fiscal 2006 sales grew 7.3% to $318.4 million from $296.8 million a year ago on sales volume increases in all business segments and more favorable pricing in the Industrial Ingredients business. Gross margin as a percent of sales expanded 2.9% from 11.2% last year to 14.1% in fiscal 2006 primarily due to higher production volumes in each of the business units, and higher unit pricing and favorable product mix in the Industrial Ingredients segment. The industrial business unit contributed $9.5 million of the total $11.7 million gain in gross margin with improvements in energy usage and corn procurement and recovery from incremental strike costs, partially offset by rising unit costs of natural gas, chemicals and distribution.

In the fourth quarter of fiscal 2004 and the first quarter of fiscal 2005, the Company experienced a union strike at its Industrial Ingredient’s Cedar Rapids manufacturing facility. Penford incurred $4.2 and $4.1 million in additional production costs for 2004 and 2005, respectively, in connection with the strike.

Operating expenses as a percent of sales rose to 9.3% in fiscal 2006 from 8.9% in fiscal 2005 on $1.0 million of stock-based compensation expenses and $2.6 million in increased employee costs. Interest expense rose $0.3 million in fiscal 2006 to $5.9 million from $5.6 million last year due to increased short-term interest rates on the Company’s revolving line of credit.

The effective tax rate for fiscal 2006, at 20%, is lower than the statutory tax rate of 34% due to the tax benefits of foreign sales from the United States, lower tax rates on foreign earnings and research and development tax credits. The Company’s tax provision for fiscal 2005 was a tax benefit of $4.9 million. Included in this benefit, as more fully described below, was a tax benefit of $2.5 million for fiscal years 2001 through 2004 which the Company

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recognized in 2005 when the Company determined it was probable that the extraterritorial income exclusion deduction on its U.S. federal income tax returns for those years would be sustained.

In June 2006, the Company announced plans to invest $42 million for up to 40 million gallons of ethanol production capacity per year at its Cedar Rapids, Iowa facility. The Company expects the facility to be producing ethanol by the end of calendar 2007. Penford has much of the infrastructure within the Cedar Rapids plant to participate in the ethanol market with sufficient grain handling, separation processes, utilities and logistic capabilities. The existing factory is centrally located near rail and ground transport arteries and the ethanol facility will occupy available space within the existing site footprint. In October 2006, Penford refinanced its credit facility and obtained a $45 million capital expansion loan commitment maturing December 2012 to finance construction of the ethanol plant.

Fiscal 2006 Compared to Fiscal 2005

Industrial Ingredients — North America

	Year Ended August 31,
	2006			2005
	(Dollars in thousands)
Sales	$	165,850		$	147,782
Cost of sales	$	144,656		$	136,127
Gross margin		12.8	%		7.9	%
Income (loss) from operations	$	9,121		$	(147	)

Industrial ingredients fiscal 2006 sales of $165.9 million increased $18.1 million, or 12%, over 2005, primarily driven by a volume increase of 9%. More favorable pricing and product mix contributed 2% of the sales increase for the year.

Gross margin increased $9.5 million, or 82%, over fiscal 2005 to $21.2 million, and, as a percent of sales, expanded to 12.8% in fiscal 2006 compared to 7.9% a year ago. Approximately $8.8 million of the margin growth is due to higher unit pricing, favorable product mix and increases in manufacturing volumes. Improvements in energy usage of $2.6 million, favorable corn procurement of $2.2 million and recovery from $4.1 million in incremental strike-related costs incurred during fiscal 2005 also contributed to increased margin. These favorable effects were partially offset by increased unit costs of natural gas and chemicals of $3.2 million and $3.3 million, respectively, as well as $1.2 million in higher distribution expenses.

Income from operations increased $9.3 million over last year due to the increase in the gross margin. Operating expenses, which included $0.2 million in severance costs, declined to 5.5% of sales in fiscal 2006, compared to 6.1% of sales the prior year. Research and development expenses remained comparable to last year at 1.8% of sales.

Food Ingredients — North America

	Year Ended August 31,
	2006			2005
	(Dollars in thousands)
Sales	$	57,156		$	53,661
Cost of sales	$	41,954		$	38,964
Gross margin		26.6	%		27.4	%
Income from operations	$	7,819		$	7,404

Sales at the Food Ingredients — North America business rose 7% over the prior year driven by an 8% volume increase. Annual sales volumes in the dairy and protein end markets grew 42% over last year. Sales of formulations for potato coatings and sweeteners increased 7% and 18%, respectively. Revenues from nutrition (low-carbohydrate) applications declined by $4.6 million in fiscal 2006.

Gross margin as a percent of sales declined by 80 basis points in fiscal 2006, due to the decrease in sales of higher margin nutrition products and higher chemical and energy costs of $0.7 million. Improved plant utilization

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from increased production volumes partially offset the unfavorable product mix. Fiscal 2006 operating and research and development expenses increased by $0.1 million and declined to 12.9% of sales compared to 13.6% in fiscal 2005.

Australia/New Zealand Operations

	Year Ended August 31,
	2006			2005
	(Dollars in thousands)
Sales	$	96,121		$	96,231
Cost of sales	$	87,575		$	89,362
Gross margin		8.9	%		7.1	%
Income from operations	$	1,735		$	1,331

The Australian business reported sales of $96.1 million in fiscal 2006 compared to $96.2 million a year ago. A 3% sales volume increase was offset by unfavorable foreign currency exchange rates. Sales in local currencies increased 1% as volume increases were partially offset by lower unit pricing.

Gross margin expanded to 8.9% of sales in fiscal 2006 from 7.1% last year as the Tamworth, Australia facility improved its production yields and plant utilization upon completion of a reconfiguration of its manufacturing processes in fiscal 2005. Lower wheat and New Zealand grain costs also contributed $0.6 million to the gross margin improvements.

Operating expenses rose to 5.6% of sales from 4.5% a year ago on $0.9 million of employee severance costs incurred during fiscal 2006.

Corporate Operating Expenses

Corporate operating expenses increased to $9.4 million in fiscal 2006 from $7.6 million in 2005. The Company expensed $0.7 million in stock-based compensation costs for corporate employees during fiscal 2006 after adoption of Statement of Financial Accounting Standards No. 123R, “Share-Based Payment.”. See Note 9 to the Consolidated Financial Statements. Legal and professional fees increased $0.4 million and employee costs, including contributions to the Company’s defined contribution plan, increased $0.5 million.

Fiscal 2005 Compared to Fiscal 2004

Industrial Ingredients — North America

	Year Ended August 31,
	2005			2004
	(Dollars in thousands)
Sales	$	147,782		$	143,612
Cost of sales	$	136,127		$	127,948
Gross margin		7.9	%		10.9	%
Income (loss) from operations	$	(147	)	$	3,846

Sales in the industrial ingredients business increased $4.2 million, or 3%, in 2005 driven by favorable pricing and product mix as well as an 18% increase in sales of specialty products, partially offset by a 2% decrease in sales volumes.

Gross margin as a percent of sales declined to 7.9% from 10.9% in fiscal 2004, reflecting a $2.4 million increase in natural gas and other utility costs, a $4.4 million increase in the unit cost of chemicals used in the manufacturing process, $0.9 million in increased maintenance costs as capital projects were deferred during the union strike in the first quarter, and increases in distribution and employee benefit costs. These adverse effects on gross margin were partially offset by improvements in pricing and product mix discussed above. The decline in operating income was due to the decrease in gross margin. Operating and research and development expenses as a percent of sales in 2005 were comparable to 2004.

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In the first quarter of fiscal 2005, the Company experienced a labor strike by union employees at its Cedar Rapids manufacturing plant. The strike, which began August 1, 2004, was settled on October 17, 2004, with the union and the Company signing a five-year contract. The Company incurred approximately $4.1 million in incremental strike-related costs during fiscal 2005 compared to approximately $4.2 million of incremental costs in fiscal 2004.

Food Ingredients — North America

	Year Ended August 31,
	2005			2004
	(Dollars in thousands)
Sales	$	53,661		$	47,518
Cost of sales	$	38,964		$	35,451
Gross margin		27.4	%		25.4	%
Income from operations	$	7,404		$	5,046

Food ingredients fiscal 2005 sales rose 13% over the prior year on an 11% volume increase and favorable product mix. Sales volumes expanded in the nutrition, dairy and protein product categories. Increases in sales of nutrition (low-carbohydrate) applications contributed $4.0 million of the total $6.1 million annual sales increase.

Gross margin as a percent of sales expanded in fiscal 2005, primarily due to the increased sales volumes of higher margin nutrition products. Also contributing to the favorable gross margin were improved manufacturing yields and plant utilization at all of the food ingredient manufacturing facilities. Income from operations increased by 47% due to the growth in gross margin. Fiscal 2005 operating and research and development expenses remained comparable to the prior year and declined to 13.6% of sales compared to 14.8% in fiscal 2004.

Australia/New Zealand Operations

	Year Ended August 31,
	2005			2004
	(Dollars in thousands)
Sales	$	96,231		$	89,128
Cost of sales	$	89,362		$	78,770
Gross margin		7.1	%		11.6	%
Income from operations	$	1,331		$	4,549

Annual fiscal 2005 reported sales rose $7.1 million, or 8%, in fiscal 2005 to $96.2 million. The strengthening of the Australian and New Zealand dollars during the year contributed approximately $5.7 million to the total sales increase. Sales in local currencies increased 2.7% as a 7% increase in volumes was partially offset by continued price competition from imported goods.

Gross margin declined to 7.1% of sales in fiscal 2005 from 11.6% in the prior year. Approximately one-half of the decrease is due to rising global costs of oil-based manufacturing inputs, primarily chemicals, freight and energy. The remaining reduction in margin is primarily due to lower manufacturing yields and plant utilization as the Company reconfigured manufacturing processes in its Tamworth, Australia facility. Income from operations was also negatively impacted by the same factors affecting gross margin.

Corporate Operating Expenses

Corporate operating expenses increased to $7.6 million in fiscal 2005 from $5.9 million in 2004, primarily due to a $0.9 million increase in professional fees related to the initial attestation on internal control over financial reporting required by the Sarbanes Oxley Act of 2002, and $0.6 million in higher employee costs.

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Non-Operating Income (Expense)

Other non-operating income consists of the following:

	Year Ended August 31,
	2006			2005			2004
	(Dollars in thousands)
Royalty and licensing income	$	1,827		$	1,386		$	2,217
Loss on extinguishment of debt		—			(1,051	)		(665	)
Gain on sale of Tamworth farm		78			1,166			—
Gain on sale of investment		—			736			150
Other		(9	)		(28	)		285
	$	1,896		$	2,209		$	1,987

In fiscal 2003, the Company exclusively licensed to National Starch Corporation (“National Starch”) certain rights to its resistant starch patent portfolio for applications in human nutrition. Under the terms of the licensing agreement, the Company received an initial licensing fee of $2.25 million ($1.6 million net of transaction expenses) which is being amortized over the life of the royalty agreement. The royalty payments are subject to a minimum of $7 million over the first five years of the licensing agreement. The Company recognized $1.8 million, $1.4 million and $2.2 million in income during fiscal 2006, 2005 and 2004, respectively, related to the licensing fee and royalties. The Company has recognized $6.6 million in royalty income from the inception of the agreement through August 31, 2006.

In 2005 and 2004, the Company refinanced its secured term and revolving credit facilities and wrote off $1.1 million and $0.7 million, respectively, of unamortized debt issuance costs related to these credit agreements. See Note 5 to the Consolidated Financial Statements.

In fiscal 2005, Penford sold a parcel of land near its wheat starch plant in Tamworth, New South Wales, Australia, that was used for disposal of effluent from the Tamworth manufacturing process for $1.9 million, and recognized a gain on the sale of $1.2 million.

In the second quarter of fiscal 2006, the Company sold a parcel of land suitable only for agricultural purposes in Tamworth, New South Wales, Australia to a third-party purchaser for $0.7 million. The Company leases back the property from the purchaser under two lease terms and arrangements: i) a small parcel of land will be leased for 25 years beginning August 2006 with annual rent of approximately $0.015 million converted to U.S. dollars at the Australian dollar exchange rate at August 31, 2006 and ii) the majority of land sold will be leased for one year beginning August 2006 with annual rental of approximately $0.08 million converted to U.S. dollars at the Australian dollar exchange rate at August 31, 2006. The total gain on the sale was $0.3 million. The gain of $0.1 million in excess of the present value of the lease payments was recognized during the second quarter of fiscal 2006. The remaining gain of $0.2 million is being recognized proportionally over the terms of the leases discussed above.

In fiscal 2005, the Company sold a majority of its investment in a small Australian start-up company and recognized a $0.7 million pre-tax gain on the transaction. In fiscal 2004, the Company sold its investment in an early-stage technology company and recognized a gain of $0.2 million.

Interest expense

Interest expense was $5.9 million, $5.6 million and $4.5 million in 2006, 2005 and 2004, respectively. Interest expense rose in fiscal 2006 on higher short-term interest rates on the Company’s revolving line credit and short-term borrowings. The increase in interest expense in 2005 compared to 2004 is due to an increase in the average interest rate between years of 160 basis points.

In September 2005, the Company entered into interest rate swap agreements with several banks to fix the interest rates on $40 million of U.S. dollar denominated term debt at 4.18% and on $10 million of U.S. dollar equivalent Australian dollar denominated term debt at 5.54%, plus the applicable margin under the Company’s

17

credit agreement. These swap agreements were in place during fiscal 2006 and eliminated the interest rate volatility on the Company’s term debt.

Income taxes

The effective tax rates for 2006, 2005 and 2004 were 20%, 209% and 27%, respectively. The effective tax rate for fiscal 2006 is lower than the statutory tax rate of 34% due to the tax benefits of the extraterritorial income exclusion (“EIE”) deduction, lower tax rates on foreign earnings and research and development tax credits.

The tax benefit recognized for 2005 of $4.9 million included a $2.5 million tax benefit relating to the Company’s incremental EIE deduction on its U.S. federal income tax returns for fiscal years 2001 through 2004. In 2005, the Company determined that it was probable that the EIE deduction would be sustained. See Note 13 to the Consolidated Financial Statements. Other factors impacting the effective tax rate for 2005 were the benefits resulting from the 2005 EIE deduction, research and development tax credits, and lower foreign tax rates.

The effective tax rate for 2004 was lower than the overall U.S. federal statutory rate of 34% primarily due to the tax benefits of foreign sales, research and development tax credits, and lower foreign tax rates.

In October 2004, the American Jobs Creation Act of 2004 (the “Act”) was enacted into law. Effective for tax years beginning after December 31, 2004 (fiscal 2006 for Penford), the Act provides for a special deduction from U.S. taxable income equal to a stipulated percentage of a U.S. company’s qualified income from domestic manufacturing activities, as defined, to be phased-in through 2010. The impact of this deduction on the Company’s effective tax rate for fiscal 2006 was insignificant. Also, the extraterritorial income exclusion deduction, which favorably impacts the Company’s effective tax rate, will be phased-out over a two-year period.

Liquidity and Capital Resources

The Company’s primary sources of short- and long-term liquidity are cash flow from operations and its five-year revolving line of credit.

Operating Activities

At August 31, 2006, Penford had working capital of $32.1 million, and $57.3 million outstanding under its credit agreement. Cash flow from operations was $11.4 million, $21.1 million and $20.4 million in fiscal 2006, 2005 and 2004, respectively. The decrease in cash flow from operations in fiscal 2006 is due to a change in the Company’s financing of Australian grain purchases from vendor financing to bank financing. See “Financing Activities” below for a discussion of the grain facility in Australia. Cash flow from operations increased in fiscal 2005 as working capital became a source of cash compared with a use in 2004.

Penford maintains two defined benefit pension plans in the U.S. Rising discount rates have decreased the Company’s underfunded plan status (plan assets compared to benefit obligations). Based on the current underfunded status of the plans and the actuarial assumptions being used for 2007, Penford estimates that it will be required to make minimum contributions to the pension plans of $1.1 million during fiscal 2007.

Investing Activities

Capital expenditures were $14.9 million, $9.4 million and $15.5 million in fiscal 2006, 2005 and 2004, respectively. Capital expenditures declined in 2005 compared to 2004 as projects were deferred during the union strike in the first quarter of 2005. Penford expects capital expenditures, including $35 million in expenditures for the Company’s ethanol production facility, to be approximately $55 million in fiscal 2007.

Financing Activities

Long-term Debt — Fiscal 2005 Credit Facility

On August 22, 2005, Penford entered into a $105 million Amended and Restated Credit Agreement (“Agreement”) with a group of U.S. and Australian banks, which refinanced the Company’s previous $105 million secured term and revolving credit facilities. Under the Agreement, Penford may borrow $50 million in term loans

18

and $55 million in revolving lines of credit. The Company may borrow the Australian dollar equivalent of U.S. $10 million in term loans and a maximum of U.S. $15 million in an alternative currency, which is defined in the Agreement as the Australian dollar or other currency approved by the lenders. See Note 5 to the Consolidated Financial Statements.

Substantially all of Penford’s U.S. assets secure the credit facility and the Agreement includes, among other things, financial covenants with limitations on indebtedness and capital expenditures and maintenance of fixed charge and leverage ratios. Pursuant to the terms of the credit agreement, Penford’s borrowing availability was $29.5 million at August 31, 2006.

Long-term Debt — Fiscal 2007 Credit Facility

On October 5, 2006, Penford entered into a $145 million Second Amended and Restated Credit Agreement (the “2007 Agreement”) among the Company; Harris N.A.; LaSalle Bank National Association; Cooperative Centrale Raiffeisen-Boorleenbank B.A., “Rabobank Nederland” (New York Branch); U.S. Bank National Association; and the Australia and New Zealand Banking Group Limited.

The 2007 Agreement refinances the Company’s previous $105 million secured term and revolving credit facilities. Under the 2007 Agreement, the Company may borrow $40 million in term loans and $60 million in revolving lines of credit. The lenders’ revolving credit loan commitment may be increased under certain conditions. In addition, the 2007 Agreement provides the Company with $45 million in new capital expansion funds which may be used by the Company to finance the construction of its planned ethanol production facility in Cedar Rapids, Iowa. The capital expansion funds may be borrowed as term loans from time to time prior to October 5, 2008.

The final maturity date for the term and revolving loans under the 2007 Agreement is December 31, 2011. Beginning on December 31, 2006, the Company must repay the term loans in twenty equal quarterly installments of $1 million, with the remaining amount due at final maturity. The final maturity date for the capital expansion loans is December 31, 2012. Beginning on December 31, 2008, the Company must repay the capital expansion loans in equal quarterly installments of $1.25 million through September 30, 2009 and $2.5 million thereafter, with the remaining amount due at final maturity. Interest rates under the 2007 Agreement are based on either the London Interbank Offering Rates (“LIBOR”) in Australia or the U.S., or the prime rate, depending on the selection of available borrowing options under the 2007 Agreement.

The 2007 Agreement provides that the Total Funded Debt Ratio, which is computed as funded debt divided by earnings before interest, taxes, depreciation and amortization (as defined in the 2007 Agreement) shall not exceed 3.25 through November 30, 2006. Subsequent to November 30, 2006, the maximum Total Funded Debt Ratio varies between 3.00 and 4.50. In addition, the Company must maintain a minimum tangible net worth of $65 million, and a Fixed Charge Coverage Ratio, as defined in the 2007 Agreement, of not more than 1.50 in fiscal 2007, 1.25 in fiscal 2008 and 1.50 in fiscal 2009 and thereafter. Annual capital expenditures, exclusive of capital expenditures incurred in connection with the Company’s ethanol production facility, are limited to $20 million.

The Company’s obligations under the 2007 Agreement are secured by substantially all of the Company’s U.S. assets.

Short-term Borrowings

The Company’s short-term borrowings consist of an Australian revolving line of credit. On March 1, 2006, the Company’s Australian subsidiary entered into a variable-rate revolving grain inventory financing facility with an Australian bank for a maximum of $30.5 million U.S. dollars at the exchange rate at August 31, 2006. This facility expires on February 28, 2007 and carries an effective interest rate equal to the Australian one-month bank bill rate (“BBSY”) plus approximately 2%. Payments on this facility are due as the grain financed is withdrawn from storage. The amount outstanding under this arrangement, which is classified as a current liability on the balance sheet, was $9.5 million at August 31, 2006. The Company expects to renew this financing facility at maturity in February 2007 under similar terms.

19

Dividends

In fiscal 2006, Penford paid dividends on its common stock of $2.1 million at a quarterly rate of $0.06 per share. On October 31, 2006, the Board of Directors declared a dividend of $0.06 per common share payable on December 1, 2006 to shareholders of record as of November 10, 2006. On a periodic basis, the Board of Directors reviews the Company’s dividend policy which is impacted by the Company’s earnings, financial condition and cash and capital requirements. Future dividend payments are at the discretion of the Board of Directors. Penford has included the continuation of quarterly dividends in its planning for fiscal 2007.

Critical Accounting Policies

The Company’s consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States. These accounting principles require management to make estimates, judgments and assumptions to fairly present results of operations and financial position. Management believes that its estimates, judgments and assumptions are reasonable based upon information available at the time this report was prepared. To the extent there are material differences between estimates, judgments and assumptions and the actual results, the financial statements will be affected.

In many cases, the accounting treatment of a particular transaction is significantly dictated by generally accepted accounting principles and does not require judgment or estimates. There are also areas in which management’s judgments in selecting among available alternatives would not produce a materially different result. Management has reviewed the accounting policies and related disclosures with the Audit Committee. The notes to the consolidated financial statements contain a summary of the Company’s accounting policies. The accounting policies that management believes are the most important to the financial statements and that require the most difficult, subjective and complex judgments include the following:

•  Evaluation of the allowance for doubtful accounts receivable

•  Hedging activities

•  Benefit plans

•  Valuation of goodwill

•  Self-insurance program

•  Income taxes

•  Stock-based compensation

A description of each of these follows:

Evaluation of the Allowance for Doubtful Accounts Receivable

Management makes judgments about the Company’s ability to collect outstanding receivables and provide allowances for the portion of receivables that the Company may not be able to collect. Penford estimates the allowance for uncollectible accounts based on historical experience, known troubled accounts, industry trends, economic conditions, how recently payments have been received, and ongoing credit evaluations of its customers. If the estimates do not reflect the Company’s future ability to collect outstanding invoices, Penford may experience losses in excess of the reserves established. At August 31, 2006, the allowance for doubtful accounts receivable was $0.9 million.

Hedging Activities

Penford uses derivative instruments, primarily futures contacts, to reduce exposure to price fluctuations of commodities used in the manufacturing processes in the United States. Penford has elected to designate substantially all of these activities as hedges. This election allows the Company to defer gains and losses on those derivative instruments until the underlying commodity is used in the production process. To reduce exposure to variable short-term interest rates, Penford uses interest rate swap agreements.

20

The requirements for the designation of hedges are very complex, and require judgments and analysis to qualify as hedges as defined by Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended (“SFAS No. 133”). These judgments and analyses include an assessment that the derivative instruments used are effective hedges of the underlying risks. If the Company were to fail to meet the requirements of SFAS No. 133, or if these derivative instruments are not designated as hedges, the Company would be required to mark these contracts to market at each reporting date. Penford had deferred gains (losses), net of tax of ($272,000) and $282,000 at August 31, 2006 and 2005, respectively, which are reflected in accumulated other comprehensive income in both years.

Benefit Plans

Penford has defined benefit plans for its U.S. employees providing retirement benefits and coverage for retiree health care. Qualified actuaries determine the estimated cost of these plans annually. These actuarial estimates are based on assumptions of the discount rate used to calculate the present value of future payments, the expected investment return on plan assets, the estimate of future increases in compensation rates and the estimate of increases in the cost of medical care. The Company makes judgments about these assumptions based on historical investment results and experience as well as available historical market data and trends. However, if these assumptions are wrong, it could materially affect the amounts reported in the financial statements. Disclosure about these estimates and assumptions are included in Note 10 to the Consolidated Financial Statements. See “Defined Benefit Plans” in this Item 7.

Valuation of Goodwill

Penford is required to assess on an annual basis, whether the value of goodwill reported on the balance sheet has been impaired, or more often if conditions exist that indicate that there might be an impairment. These assessments require extensive and subjective judgments to assess the fair value of goodwill. While the Company engages qualified valuation experts to assist in this process, their work is based on the Company’s estimates of future operating results and allocation of goodwill to the business units. If future operating results differ materially from the estimates, the value of goodwill could be adversely impacted. See Note 4 to the Consolidated Financial Statements.

Self-insurance Program

The Company maintains a self-insurance program covering portions of workers’ compensation and group health liability costs. The amounts in excess of the self-insured levels are fully insured by third party insurers. Liabilities associated with these risks are estimated in part by considering historical claims experience, severity factors and other actuarial assumptions. Projections of future losses are inherently uncertain because of the random nature of insurance claims occurrences and changes that could occur in actuarial assumptions. The financial results of the Company could be significantly affected if future claims and assumptions differ from those used in determining the liabilities.

Income Taxes

The determination of the Company’s provision for income taxes requires significant judgment, the use of estimates and the interpretation and application of complex tax laws. The Company’s provision for income taxes reflects a combination of income earned and taxed in the various U.S. federal and state, as well as Australian and New Zealand taxing jurisdictions. Jurisdictional tax law changes, increases or decreases in permanent differences between book and tax items, accruals or adjustments of accruals for tax contingencies or valuation allowances, and the Company’s change in the mix of earnings from these taxing jurisdictions all affect the overall effective tax rate.

In evaluating the exposures connected with the various tax filing positions, the Company establishes an accrual, when, despite management’s belief that the Company’s tax return positions are supportable, management believes that certain positions may be successfully challenged and a loss is probable. When facts and circumstances change, these accruals are adjusted.

21

Stock-Based Compensation

Beginning September 1, 2005, the Company recognizes stock-based compensation in accordance with SFAS No. 123R, “Share-Based Payment.” Under the fair value recognition provisions of this statement, share-based compensation cost is measured at the grant date based on the fair value of the award and is recognized as expense over the requisite service period of the award. Determining the appropriate fair value model and calculating the fair value of the share-based awards at the date of grant requires judgment, including estimating stock price volatility, forfeiture rates, the risk-free interest rate, dividends and expected option life.

If circumstances change, and the Company uses different assumptions for volatility, interest, dividends and option life in estimating the fair value of stock-based awards granted in future periods, stock-based compensation expense may differ significantly from the expense recorded in the current period. SFAS No. 123R requires forfeitures to be estimated at the date of grant and revised in subsequent periods if actual forfeitures differ from those estimated. Therefore, if actual forfeiture rates differ significantly from those estimated, the Company’s results of operations could be materially impacted.

Contractual Obligations

As more fully described in Notes 5 and 8 to the Consolidated Financial Statements, the Company is a party to various debt and lease agreements at August 31, 2006 that contractually commit the Company to pay certain amounts in the future. The purchase obligations at August 31, 2006 represent an estimate of all open purchase orders and contractual obligations through the Company’s normal course of business for commitments to purchase goods and services for production and inventory needs, such as raw materials, supplies, manufacturing arrangements, capital expenditures and maintenance. The majority of terms allow the Company or suppliers the option to cancel or adjust the requirements based on business needs.

The following table summarizes such contractual commitments:

	2007		2008-2009		2010-2011		2012 & After		Total
Long-term Debt and Capital Lease Obligations	$	4,295	$	8,088	$	8,012	$	37,071	$	57,466
Short-term Borrowings		9,541		—		—		—		9,541
Operating Lease Obligations		5,759		9,327		3,561		1,246		19,893
Purchase Obligations		57,275		17,814		—		—		75,089
	$	76,870	$	35,229	$	11,573	$	38,317	$	161,989

Defined Benefit Pension and Postretirement Benefit Plans

Penford maintains defined benefit pension plans and defined benefit postretirement health care plans in the U.S.

The most significant assumptions used to determine benefit expense and benefit obligations are the discount rate and the expected return on assets assumption. See Note 10 to the Consolidated Financial Statements for the assumptions used by Penford.

The discount rate used by the Company in determining benefit expense and benefit obligations reflects the yield of high quality (AA or better rating by a recognized rating agency) corporate bonds whose cash flows are expected to match the timing and amounts of projected future benefit payments. Benefit obligations and expense increase as the discount rate is reduced. The discount rates to determine net periodic expense used in 2004 (6.4%), 2005 (6.25%) and 2006 (5.5%) reflect the decline in bond yields over the past several years. Lowering the discount rate by 0.25% would increase pension expense by approximately $0.3 million and other postretirement benefit expense by $0.05 million. During fiscal 2006, bond yields rose and Penford has increased the discount rate for calculating its benefit obligations at August 31, 2006, as well as net periodic expense for fiscal 2007, to 6.15%.

The expected long-term return on assets assumption for the pension plans represents the average rate of return to be earned on plan assets over the period the benefits included in the benefit obligation are to be paid. Pension

22

expense increases as the expected return on plan assets decreases. In developing the expected rate of return, the Company considers long-term historical market rates of return as well as actual returns on the Company’s plan assets, and adjusts this information to reflect expected capital market trends. Penford also considers forward looking return expectations by asset class, the contribution of active management and management fees paid by the plans. The plan assets are held in qualified trusts and anticipated rates of return are not reduced for income taxes. The expected long-term return on assets assumption used to calculate net periodic pension expense was 8.0% for fiscal 2006. A 0.5% decrease (increase) in the expected return on assets assumptions would increase (decrease) pension expense by approximately $0.2 million based on plan assets at August 31, 2006. The expected return on plan assets used in calculating fiscal 2007 pension expense is 8%.

Unrecognized net loss amounts reflect the difference between expected and actual returns on pension plan assets as well as the effects of changes in actuarial assumptions. Unrecognized net losses in excess of certain thresholds are amortized into net periodic pension and postretirement benefit expense over the average remaining service life of active employees. As of August 31, 2006, unrecognized losses from all sources are $5.7 million for the pension plans and $1.2 million for the postretirement health care plan. Amortization of unrecognized net loss amounts is expected to increase net pension expense by approximately $0.2 million in fiscal 2007. Amortization of unrecognized net losses is not expected to impact the net postretirement health care expense in fiscal 2007.

Penford recognized pension expense of $2.4 million, $1.9 million and $1.7 million in 2006, 2005 and 2004, respectively. Penford expects pension expense to be approximately $1.7 million in fiscal 2007. The Company contributed $3.3 million, $3.6 million and $1.1 million to the pension plans in fiscal 2006, 2005 and 2004, respectively. Penford estimates that it will be required to make minimum contributions to the pension plans of $1.1 million during fiscal 2007.

The Company recognized benefit expense for its postretirement health care plan of $1.2 million, $1.0 million and $1.4 million in fiscal 2006, 2005 and 2004, respectively. Penford expects to recognize approximately $1.0 million in postretirement health care benefit expense in fiscal 2007. The Company contributed $0.7 million, $0.5 million, and $0.5 million in fiscal 2006, 2005 and 2004 to the postretirement health care plans and estimates that it will contribute $0.7 million in fiscal 2007.

Future changes in plan asset returns, assumed discount rates and various assumptions related to the participants in the defined benefit plans will impact future benefit expense and liabilities. The Company cannot predict what these changes will be.

Recent Accounting Pronouncements

In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement No. 123 (revised 2004), “Share-Based Payment” (“SFAS No. 123R”). SFAS No. 123R, which is effective for the first annual period beginning after June 15, 2005, requires all share-based payments to employees, including grants of stock options, to be recognized in the financial statements based on their fair values. In March 2005, the SEC issued Staff Accounting Bulletin No. 107 (“SAB 107”) regarding the SEC’s interpretation of SFAS No. 123R. The Company adopted SFAS No. 123R and SAB 107 effective September 1, 2005. See Note 9 to the Consolidated Financial Statements for further detail.

Effective September 1, 2005, the Company adopted FASB Statement No. 151, “Inventory Costs — an Amendment of ARB No. 43, Chapter 4” (“SFAS No. 151”). SFAS No. 151 clarifies the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material, requiring that those items be recognized as current-period charges. In addition, SFAS No. 151 requires that allocation of fixed production overheads be based on the normal capacity of the production facilities. The adoption of SFAS No. 151 did not have a material effect on the Company’s results of operation, financial position or liquidity.

Effective September 1, 2005, the Company adopted FASB Interpretation No. 47, “Accounting for Conditional Asset Retirement Obligations” (“FIN No. 47”), which requires an entity to recognize a liability for the fair value of a conditional asset retirement obligation when incurred if the liability’s fair value can be reasonably estimated. The adoption of FIN No. 47 had no effect on the Company’s results of operations, financial position or liquidity.

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In June 2006, the FASB ratified the Emerging Issues Task Force (“EITF”) consensus on EIFT Issue No. 06-2, “Accounting for Sabbatical Leave and Other Similar Benefits Pursuant to FASB Statement No. 43.” EITF Issue No. 06-2 requires companies to accrue the costs of compensated absences under a sabbatical or similar benefit arrangement over the requisite service period. EITF Issue No. 06-2 is effective for years beginning after December 15, 2006. The Company is evaluating the impact this issue may have on its results of operations, financial position and cash flows.

In July 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109 (“FIN 48”). FIN 48 clarifies the accounting for the uncertainty in income taxes recognized by prescribing a recognition threshold that a tax position is required to meet before being recognized in the financial statements. It also provides guidance on derecognition, classification, interest and penalties, interim period accounting and disclosure. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company is currently evaluating the potential impact that the adoption of FIN 48 will have on its consolidated financial statements.

Item 7A:   Quantitative and Qualitative Disclosures About Market Risk

Market Risk Sensitive Instruments and Positions

Penford is exposed to market risks that are inherent in the financial instruments that are used in the normal course of business. Penford may use various hedge instruments to manage or reduce market risk, but the Company does not use derivative financial instrument transactions for speculative purposes. The primary market risks are discussed below.

Interest Rate Risk

The Company’s exposure to market risk for changes in interest rates relates to its variable-rate borrowings. At August 31, 2006, $20.7 million of the Company’s debt, including amounts outstanding under the Australian grain inventory financing facility, carried variable interest rates, which are generally set for one to six months. The market risk associated with a 1% adverse change in interest rates at August 31, 2006, is approximately $0.2 million.

In September 2005, the Company entered into interest rate swap agreements with several banks to fix the interest rates on $40 million of U.S. dollar denominated term debt at 4.18% and on $10 million of U.S. dollar equivalent Australian dollar denominated term debt at 5.54%, plus the applicable margin under the Company’s credit agreement.

Foreign Currency Exchange Rates

The Company has U.S.-Australian and Australian-New Zealand dollar currency exchange rate risks due to revenues and costs denominated in Australian and New Zealand dollars with the Company’s foreign operation, Penford Australia. Currently, cash generated by Penford Australia’s operations is used for capital investment in Australia and payment of debt denominated in Australian dollars. At August 31, 2006, approximately 31% of total debt was denominated in Australian dollars.

The Company has not maintained any derivative instruments to mitigate the U.S.-Australian dollar currency exchange translation exposure. This position is reviewed periodically, and based on the Company’s review, may result in the incorporation of derivative instruments in the Company’s hedging strategy. The currency exchange rate risk between Penford’s Australian and New Zealand operations is not significant. For the year ended August 31, 2006, a 10% change in the foreign currency exchange rates compared with the U.S. dollar would have impacted fiscal 2006 reported net income by approximately $0.1 million.

From time to time, Penford enters into foreign exchange forward contracts to manage exposure to receivables and payables denominated in currencies different from the functional currencies of the selling entities. As of August 31, 2006, Penford did not have any foreign exchange forward contracts outstanding. At that date, the Company had U.S. dollar denominated trade receivables of $0.6 million at Penford Australia.

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Commodities

The availability and price of corn, Penford’s most significant raw material, is subject to fluctuations due to unpredictable factors such as weather, plantings, domestic and foreign governmental farm programs and policies, changes in global demand and the worldwide production of corn. To reduce the price risk caused by market fluctuations, Penford generally follows a policy of using exchange-traded futures and options contracts to hedge exposure to corn price fluctuations in North America. These futures and options contracts are designated as hedges. The changes in market value of these contracts have historically been, and are expected to continue to be, highly effective in offsetting the price changes in corn. A majority of the Company’s sales contracts for corn-based industrial starch ingredients contain a pricing methodology which allows the Company to pass-through the majority of the changes in the commodity price of corn and corn by-products.

Penford’s net corn position in the U.S. consists primarily of inventories, purchase contracts and exchange traded futures and options contracts that hedge Penford’s exposure to commodity price fluctuations. The fair value of the position is based on quoted market prices. The Company has estimated its market risk as the potential loss in fair value resulting from a hypothetical 10% adverse change in prices. As of August 31, 2006 and 2005, the fair value of the Company’s net corn position was approximately $0.02 million and $0.2 million, respectively. The market risk associated with a 10% adverse change in corn prices at August 31, 2006 and 2005, is estimated at $2,000 and $19,000, respectively.

Over the past years, prices for natural gas have increased over historic levels. Prices for natural gas fluctuate due to anticipated changes in supply and demand and movement of prices of related or alternative fuels. To reduce the price risk caused by sudden market fluctuations, Penford generally enters into short-term purchase contracts or uses exchange-traded futures and options contracts to hedge exposure to natural gas price fluctuations. These futures and options contracts are designated as hedges. The changes in market value of these contracts have historically been, and are expected to continue to be, closely correlated with the price changes in natural gas.

Penford’s exchange traded futures and options contracts hedge production requirements. The fair value of these contracts is based on quoted market prices. The Company has estimated its market risk as the potential loss in fair value resulting from a hypothetical 10% adverse change in prices. As of August 31, 2006 and 2005, the fair value of the natural gas exchange-traded futures and options contracts was a loss of approximately $0.3 million and a gain of approximately $0.9 million, respectively. The market risk associated with a 10% adverse change in natural gas prices at August 31, 2006 and 2005 is estimated at $27,000 and $90,000, respectively.

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Item 8:  Financial Statements and Supplementary Data

TABLE OF CONTENTS

	Page
Consolidated Balance Sheets		27
Consolidated Statements of Operations		28
Consolidated Statements of Comprehensive Income		28
Consolidated Statements of Cash Flows		29
Consolidated Statements of Shareholders’ Equity		30
Notes to Consolidated Financial Statements		31
Report of Management on Internal Control Over Financial Reporting		55
Reports of Independent Registered Public Accounting Firm		56

26

Consolidated Balance Sheets

	August 31,
	2006			2005
	(Dollars in thousands)
ASSETS
Current assets:
Cash	$	939		$	5,367
Trade accounts receivable, net		44,593			39,653
Inventories		34,953			34,801
Prepaid expenses		4,649			5,084
Other		4,782			4,032
Total current assets		89,916			88,937
Property, plant and equipment, net		124,829			125,267
Restricted cash value of life insurance		10,278			10,132
Other assets		989			1,040
Other intangible assets, net		2,785			3,121
Goodwill, net		21,871			21,420
Total assets	$	250,668		$	249,917
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
Cash overdraft, net	$	961		$	777
Current portion of long-term debt and capital lease obligations		4,295			4,022
Short-term borrowings		9,541			—
Accounts payable		31,686			35,941
Accrued liabilities		11,360			12,626
Total current liabilities		57,843			53,366
Long-term debt and capital lease obligations		53,171			62,107
Other postretirement benefits		13,606			13,091
Deferred income taxes		5,924			4,353
Other liabilities		12,672			16,974
Total liabilities		143,216			149,891
Commitments and contingencies		—			—
Shareholders’ equity:
Preferred stock, par value $1.00 per share, authorized 1,000,000 shares, none issued		—			—
Common stock, par value $1.00 per share, authorized 29,000,000 shares, issued 10,909,153 shares in 2006 and 10,849,487 in 2005, including treasury shares		10,909			10,849
Additional paid-in capital		39,427			37,728
Retained earnings		78,131			76,040
Treasury stock, at cost, 1,981,016 shares		(32,757	)		(32,757	)
Accumulated other comprehensive income		11,742			8,166
Total shareholders’ equity		107,452			100,026
Total liabilities and shareholders’ equity	$	250,668		$	249,917

The accompanying notes are an integral part of these statements.

27

Consolidated Statements of Operations

	Year Ended August 31,
	2006		2005			2004
	(Dollars in thousands, except share
	and per share data)
Sales	$	318,419	$	296,763		$	279,386
Cost of sales		273,476		263,542			241,298
Gross margin		44,943		33,221			38,088
Operating expenses		29,477		26,413			23,063
Research and development expenses		6,198		5,796			6,115
Restructure costs		—		—			1,334
Income from operations		9,268		1,012			7,576
Interest expense		5,902		5,574			4,492
Other non-operating income, net		1,896		2,209			1,987
Income (loss) before income taxes		5,262		(2,353	)		5,071
Income tax expense (benefit)		1,034		(4,927	)		1,369
Net income	$	4,228	$	2,574		$	3,702
Weighted average common shares and equivalents outstanding, assuming dilution		9,004,190		8,946,195			8,868,050
Earnings per common share:
Basic	$	0.48	$	0.29		$	0.42
Diluted	$	0.47	$	0.29		$	0.42
Dividends declared per common share	$	0.24	$	0.24		$	0.24

Consolidated Statements of Comprehensive Income

	Year Ended August 31,
	2006			2005			2004
	(Dollars in thousands)
Net income	$	4,228		$	2,574		$	3,702
Other comprehensive income (loss):
Change in fair value of derivatives, net of tax benefit (expense) of ($271), $156 and $274		492			(303	)		(609	)
Loss (gain) from derivative transactions reclassified into earnings from other comprehensive income, net of tax benefit (expense) of ($152), $350 and $425		(294	)		679			945
Foreign currency translation adjustments		536			3,271			3,694
(Increase) decrease in minimum pension liability, net of applicable income tax benefit (expense) of ($1,530), $365 and $150		2,842			(677	)		(278	)
Other comprehensive income		3,576			2,970			3,752
Total comprehensive income	$	7,804		$	5,544		$	7,454

The accompanying notes are an integral part of these statements.

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Consolidated Statements of Cash Flows

	Year Ended August 31,
	2006			2005			2004
	(Dollars in thousands)
Operating activities:
Net income	$	4,228		$	2,574		$	3,702
Adjustments to reconcile net income to net cash from operations:
Depreciation and amortization		15,583			17,025			17,689
Loss on early extinguishment of debt		—			1,051			665
Gain on sale of investment		—			(736	)		—
Gain on sale of land		(78	)		(1,166	)		—
Deferred income tax benefit		(293	)		(5,410	)		(618	)
Stock-based compensation		1,150			91			159
Other		(625	)		246			842
Change in operating assets and liabilities:
Trade receivables		(4,836	)		(122	)		(1,482	)
Inventories		187			(2,042	)		(3,519	)
Prepaid expenses		449			(914	)		(7	)
Accounts payable and accrued liabilities		(4,944	)		12,102			2,544
Taxes payable		(500	)		(2,406	)		862
Other		1,064			763			(454	)
Net cash flow from operating activities		11,385			21,056			20,383
Investing activities:
Acquisitions of property, plant and equipment, net		(14,905	)		(9,413	)		(15,454	)
Proceeds from investments		—			3,525			—
Proceeds from sale of land		612			1,870			—
Other		(80	)		(150	)		(433	)
Net cash used by investing activities		(14,373	)		(4,168	)		(15,887	)
Financing activities:
Proceeds from short-term borrowings		13,916			—			—
Payments on short-term borrowings		(4,744	)		—			—
Proceeds from revolving line of credit		22,920			57,830			39,459
Payments on revolving line of credit		(27,907	)		(48,177	)		(65,082	)
Proceeds from long-term debt		—			22,396			50,039
Payments on long-term debt		(3,980	)		(47,867	)		(26,362	)
Exercise of stock options		508			682			2,145
Payment of loan fees		(224	)		(905	)		(1,736	)
Increase in cash overdraft		184			776			—
Payment of dividends		(2,132	)		(2,117	)		(2,090	)
Other		70			(8	)		—
Net cash used by financing activities		(1,389	)		(17,390	)		(3,627	)
Effect of exchange rate changes on cash and cash equivalents		(51	)		(46	)		(651	)
Net increase (decrease) in cash and cash equivalents		(4,428	)		(548	)		218
Cash and cash equivalents, beginning of year		5,367			5,915			5,697
Cash and cash equivalents, end of year	$	939		$	5,367		$	5,915
Supplemental disclosure of cash flow information
Cash paid during the year for:
Interest	$	5,240		$	4,754		$	3,621
Income taxes, net	$	1,342		$	563		$	2,581
Noncash investing and financing activities:
Capital lease obligations incurred for certain equipment leases	$	102		$	85		$	—

The accompanying notes are an integral part of these statements.

29

Consolidated Statements of Shareholders’ Equity

	Year Ended August 31,
	2006			2005			2004
	(Dollars in thousands)
Common stock
Balance, beginning of year	$	10,849		$	10,784		$	10,585
Exercise of stock options		51			65			199
Issuance of restricted stock, net		9			—			—
Balance, end of year		10,909			10,849			10,784
Additional paid-in capital
Balance, beginning of year		37,728			36,911			34,628
Exercise of stock options		457			617			1,946
Tax benefit of stock option exercises		101			109			262
Stock based compensation		1,150			91			75
Issuance of restricted stock, net		(9	)		—			—
Balance, end of year		39,427			37,728			36,911
Retained earnings
Balance, beginning of year		76,040			75,585			73,985
Net income		4,228			2,574			3,702
Dividends declared		(2,137	)		(2,119	)		(2,102	)
Balance, end of year		78,131			76,040			75,585
Treasury stock		(32,757	)		(32,757	)		(32,757	)
Accumulated other comprehensive income (loss):
Balance, beginning of year		8,166			5,196			1,444
Change in fair value of derivatives, net of tax		492			(303	)		(609	)
Loss (gain) from derivative transactions reclassified into earnings from other comprehensive income, net of tax		(294	)		679			945
Foreign currency translation adjustments		536			3,271			3,694
(Increase) decrease in minimum pension liability, net of tax		2,842			(677	)		(278	)
Balance, end of year		11,742			8,166			5,196
Total shareholders’ equity	$	107,452		$	100,026		$	95,719

The accompanying notes are an integral part of these statements.

30

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1 — Summary of Significant Accounting Policies

Business

Penford Corporation (“Penford” or the “Company”) is a developer, manufacturer and marketer of specialty natural-based ingredient systems for industrial and food ingredient applications. The Company operates manufacturing facilities in the United States, Australia and New Zealand. Penford’s products provide binding and film-forming characteristics that improve customer’s products through convenient and cost-effective solutions made from renewable sources. Sales of the Company’s products are generated using a combination of direct sales and distributor agreements.

The Company has extensive research and development capabilities, which are used in understanding the complex chemistry of carbohydrate-based materials and in developing applications to address customer needs. In addition, the Company has specialty processing capabilities for a variety of modified starches.

Penford manages its business in three segments. The first two, industrial ingredients and food ingredients are broad categories of end-market users, primarily served by the U.S. operations. The third segment is the geographically separate operations in Australia and New Zealand. The Australian and New Zealand operations are engaged primarily in the food ingredients business.

Basis of Presentation

The accompanying consolidated financial statements include the accounts of Penford and its wholly owned subsidiaries. All material intercompany balances and transactions have been eliminated. Certain reclassifications have been made to prior years’ financial statements in order to conform with the current year presentation.

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 the reported amounts of assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Estimates are used in accounting for, among other things, the allowance for doubtful accounts, accruals, the determination of assumptions for pension and postretirement employee benefit costs, and the useful lives of property and equipment. Actual results may differ from previously estimated amounts.

Cash and Cash Equivalents

Cash and cash equivalents consist of cash and temporary investments with maturities of less than three months when purchased. Amounts are reported in the balance sheets at cost, which approximates fair value.

Allowance for Doubtful Accounts and Concentration of Credit Risk

The allowance for doubtful accounts reflects the Company’s best estimate of probable losses in the accounts receivable balances. Penford estimates the allowance for uncollectible accounts based on historical experience, known troubled accounts, industry trends, economic conditions, how recently payments have been received, and ongoing credit evaluations of its customers. Activity in the allowance for doubtful accounts for fiscal 2006, 2005 and 2004 is as follows (Dollars in thousands):

	Balance		Charged to
	Beginning of		Costs and		Deductions			Balance
	Year		Expenses		and Other			End of Year
Year ended August 31:
2006	$	401	$	359	$	(91	)	$	851
2005	$	364	$	196	$	159		$	401
2004		538		250		424			364

31

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

In 2006, the increase in the allowance for doubtful accounts reflects an additional reserve of approximately $0.5 million for a bankrupt customer in the industrial ingredients segment.

Approximately half of the Company’s sales in fiscal 2006, 2005 and 2004 were made to customers who operate in the North American paper industry. This industry has suffered an economic downturn, which has resulted in the closure of a number of smaller mills. In fiscal 2004, the Industrial Ingredients — North America business wrote off receivable amounts which became uncollectible primarily due to bankruptcies in the paper industry.

Financial Instruments

The carrying value of financial instruments including cash and cash equivalents, receivables, payables and accrued liabilities approximates fair value because of their short maturities. The Company’s bank debt reprices with changes in market interest rates and, accordingly, the carrying amount of such debt approximates fair value.

Inventories

Inventory is stated at the lower of cost or market. Inventory is valued using the first-in, first-out (“FIFO”) method, which approximates actual cost. Capitalized costs include materials, labor and manufacturing overhead related to the purchase and production of inventories.

Goodwill and Other Intangible Assets

In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets,” goodwill is not amortized, but instead is tested for impairment at least annually, or more frequently if there is an indication of impairment.

Patents are amortized using the straight-line method over their estimated period of benefit. At August 31, 2006, the weighted average remaining amortization period for patents is eight years. Intangible pension assets are not amortized. Penford has no intangible assets with indefinite lives.

Property, Plant and Equipment

Property, plant and equipment are recorded at cost. Expenditures for maintenance and repairs are expensed as incurred. The Company uses the straight-line method to compute depreciation expense assuming average useful lives of three to forty years for financial reporting purposes. Depreciation of $15,527,000, $16,326,000 and $16,990,000 was recorded in 2006, 2005 and 2004, respectively. For income tax purposes, the Company generally uses accelerated depreciation methods.

Interest is capitalized on major construction projects while in progress. No interest was capitalized in 2006, 2005 and 2004.

Income Taxes

The provision for income taxes includes federal, state, and foreign taxes currently payable and deferred income taxes arising from temporary differences between financial and income tax reporting methods. Deferred taxes are recorded using the liability method in recognition of these temporary differences. Deferred taxes are not recognized on temporary differences from undistributed earnings of foreign subsidiaries of approximately $14.6 million, as these earnings are deemed to be permanently reinvested. The amount of unrecognized deferred tax liability associated with these temporary differences is approximately $5.4 million.

Revenue Recognition

Revenue from sales of products and shipping and handling revenue are recognized at the time goods are shipped, and title transfers to the customer. Costs associated with shipping and handling is included in cost of sales.

32

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Research and Development

Research and development costs are expensed as incurred, except for costs of patents, which are capitalized and amortized over the life of the patents. Research and development costs expensed were $6.2 million, $5.8 million and $6.1 million in fiscal 2006, 2005 and 2004, respectively. Patent costs of $134,000, $19,000 and $39,000 were capitalized in 2006, 2005 and 2004, respectively.

Foreign Currency Translation

Assets and liabilities of subsidiaries whose functional currency is deemed to be other than the U.S. dollar are translated at year end rates of exchange. Resulting translation adjustments are accumulated in the currency translation adjustments component of other comprehensive income. Income statement amounts are translated at average exchange rates prevailing during the year. For fiscal years 2006 and 2005, the net foreign currency transaction gain (loss) recognized in earnings was not material.

Derivatives

Penford uses derivative instruments to manage the exposures associated with commodity prices, interest rates and energy costs. The derivative instruments are marked-to-market and any resulting unrealized gains and losses, representing the fair value of the derivative instruments, are recorded in other current assets or accounts payable in the consolidated balance sheets. The fair value of derivative instruments included in other current assets at August 31, 2006 was $1.0 million.

For derivative instruments designated as fair value hedges, the gain or loss on the derivative instruments as well as the offsetting loss or gain on the hedged firm commitments are recognized in current earnings as a component of cost of goods sold. At August 31, 2006, derivative instruments designated as fair value hedges are not material. For derivative instruments designated as cash flow hedges, the effective portion of the gain or loss on the derivative instruments is reported as a component of other comprehensive income, net of applicable income taxes, and recognized in earnings when the hedged exposure affects earnings. The Company recognizes the gain or loss on the derivative instrument as a component of cost of goods sold in the period when the finished goods produced from the hedged item are sold or, for interest rate swaps, as a component of interest expense in the period the forecasted transaction is reported in earnings. If it is determined that the derivative instruments used are no longer effective at offsetting changes in the price of the hedged item, then the changes in market value would be recognized in current earnings as a component of cost of good sold or interest expense. There was no ineffectiveness related to the Company’s hedging activities related to interest rate swaps. At August 31, 2006, the amount in other comprehensive income related to derivative transactions which the Company expects to recognize in earnings in fiscal 2007 is not material.

Significant Customer and Export Sales

The Company has several relatively large customers in each business segment. However, over the last three years Penford had no customers that exceeded 10% of sales. Export sales accounted for approximately 13%, 16% and 19% of consolidated sales in fiscal 2006, 2005 and 2004, respectively.

Stock-Based Compensation

Beginning September 1, 2005, the Company recognizes stock-based compensation in accordance with SFAS No. 123R, “Share-Based Payment.” The Company utilizes the Black-Scholes option-pricing model to determine the fair value of stock options on the date of grant. This model derives the fair value of stock options based on certain assumptions related to expected stock price volatility, expected option life, risk-free interest rate and dividend yield. See Note 9 for further detail.

33

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Recent Accounting Pronouncements

In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement No. 123 (revised 2004), “Share-Based Payment” (“SFAS No. 123R”). SFAS No. 123R, which is effective for the first annual period beginning after June 15, 2005, requires all share-based payments to employees, including grants of stock options, to be recognized in the financial statements based on their fair values. In March 2005, the SEC issued Staff Accounting Bulletin No. 107 (“SAB 107”) regarding the SEC’s interpretation of SFAS No. 123R. The Company adopted SFAS No. 123R and SAB 107 effective September 1, 2005. See Note 9 for further detail.

Effective September 1, 2005, the Company adopted FASB Statement No. 151, “Inventory Costs — an Amendment of ARB No. 43, Chapter 4” (“SFAS No. 151”). SFAS No. 151 clarifies the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material, requiring that those items be recognized as current-period charges. In addition, SFAS No. 151 requires that allocation of fixed production overheads be based on the normal capacity of the production facilities. The adoption of SFAS No. 151 did not have a material effect on the Company’s results of operation, financial position or liquidity.

Effective September 1, 2005, the Company adopted FASB Interpretation No. 47, “Accounting for Conditional Asset Retirement Obligations” (“FIN No. 47”), which requires an entity to recognize a liability for the fair value of a conditional asset retirement obligation when incurred if the liability’s fair value can be reasonably estimated. The adoption of FIN No. 47 had no effect on the Company’s results of operations, financial position or liquidity.

In June 2006, the FASB ratified the Emerging Issues Task Force (“EITF”) consensus on EITF Issue No. 06-2, “Accounting for Sabbatical Leave and Other Similar Benefits Pursuant to FASB Statement No. 43.” EITF Issue No. 06-2 requires companies to accrue the costs of compensated absences under a sabbatical or similar benefit arrangement over the requisite service period. EITF Issue No. 06-2 is effective for years beginning after December 15, 2006. The Company is evaluating the impact this issue may have on its results of operations, financial position and cash flows.

In July 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 clarifies the accounting for the uncertainty in income taxes recognized by prescribing a recognition threshold that a tax position is required to meet before being recognized in the financial statements. It also provides guidance on derecognition, classification, interest and penalties, interim period accounting and disclosure. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company is currently evaluating the potential impact that the adoption of FIN 48 will have on its consolidated financial statements.

Note 2 — Inventories

Components of inventory are as follows:

	August 31,
	2006		2005
	(Dollars in thousands)
Raw materials	$	18,531	$	17,666
Work in progress		449		614
Finished goods		15,973		16,521
Total inventories	$	34,953	$	34,801

To reduce the price volatility of corn used in fulfilling some of its starch sales contracts, Penford, from time to time, uses readily marketable exchange-traded futures as well as forward cash corn purchases. The exchange-traded futures are not purchased or sold for trading or speculative purposes and are designated as hedges. The changes in market value of such contracts have historically been, and are expected to continue to be, effective in offsetting the price changes of the hedged commodity. Penford also at times uses exchange-traded futures to hedge corn inventories. Hedges are designated as cash flow hedges at the time the transaction is established and are recognized

34

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

in earnings in the time period for which the hedge was established. Hedged transactions are within 12 months of the time the hedge is established. The amount of ineffectiveness related to the Company’s hedging activities was not material.

Note 3 — Property and equipment

Components of property and equipment are as follows:

	August 31,
	2006			2005
	(Dollars in thousands)
Land	$	16,659		$	15,943
Plant and equipment		322,169			304,247
Construction in progress		7,078			11,022
		345,906			331,212
Accumulated depreciation		(221,077	)		(205,945	)
Net property and equipment	$	124,829		$	125,267

The above table includes approximately $0.1 million of equipment under capital leases for both years. Changes in Australian and New Zealand currency exchange rates have increased net property, plant and equipment in fiscal 2006 by approximately $0.9 million.

Note 4 — Goodwill and other intangible assets

Goodwill represents the excess of acquisition costs over the fair value of the net assets of Penford Australia, which was acquired on September 29, 2000. The Company evaluates annually, or more frequently if certain indicators are present, the carrying value of its goodwill under provisions of SFAS No. 142.

In accordance with this standard, Penford does not amortize goodwill. The Company completed the annual update as of June 1, 2006 and determined there was no impairment to the recorded value of goodwill. In order to identify potential impairments, Penford compared the fair value of each of its reporting units with its carrying amount, including goodwill. Penford then compared the implied fair value of its reporting units’ goodwill with the carrying amount of that goodwill. The implied fair value of the reporting units was determined using primarily discounted cash flows. This testing was performed on Penford’s Food Ingredients — North America and the Australia/New Zealand operations reporting units, which are the same as two of the Company’s business segments. Since there was no indication of impairment, Penford was not required to complete the second step of the process which would measure the amount of any impairment. On a prospective basis, the Company is required to continue to test its goodwill for impairment on an annual basis, or more frequently if certain indicators arise.

The Company’s goodwill of $21.9 million and $21.4 million at August 31, 2006 and 2005 respectively, represents the excess of acquisition costs over the fair value of the net assets of Penford Australia. The increase in the carrying value of goodwill since August 31, 2005 reflects the impact of exchange rate fluctuations between the Australian and U.S. dollar on the translation of this asset.

Penford’s intangible assets consist of patents which are being amortized over the weighted average remaining amortization period of eight years as of August 31, 2006 and an intangible pension asset. There is no residual value

35

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

associated with patents. The carrying amount and accumulated amortization of intangible assets are as follows (Dollars in thousands):

	August 31, 2006				August 31, 2005
	Carrying		Accumulated		Carrying		Accumulated
	Amount		Amortization		Amount		Amortization
Intangible assets:
Patents	$	2,162	$	1,217	$	2,250	$	1,156
Intangible pension asset(1)		1,840		—		2,027		—
	$	4,002	$	1,217	$	4,277	$	1,156

(1) Not covered by the scope of SFAS No. 142

Amortization expense related to intangible assets was $0.1 million in each of 2006, 2005 and 2004. The estimated aggregate annual amortization expense for patents is approximately $0.1 million for each of the next five fiscal years, 2007-2011

Note 5 — Debt

	August 31,
	2006		2005
	(Dollars in thousands)
Secured credit agreements — revolving loans, 7.11% weighted average interest rate at August 31, 2006	$	11,188	$	16,116
Secured credit agreements — term loans, 6.86% weighted average interest rate at August 31, 2006		46,133		49,936
Grain inventory financing facility — revolving loan, 7.66% weighted average interest rate at August 31, 2006		9,541		—
Capital lease obligations		145		77
		67,007		66,129
Less: current portion and short-term borrowings		13,836		4,022
Long-term debt	$	53,171	$	62,107

On August 22, 2005, Penford entered into a $105 million Amended and Restated Credit Agreement. This agreement refinances the previous secured term and revolving credit facilities. Under the agreement, the Company may borrow $50 million in term loans and $55 million in revolving lines of credit. The Company may borrow the Australian dollar equivalent of U.S. $10 million in term loans and a maximum of U.S. $15 million in an alternative currency, which is defined in the Agreement as the Australian dollar or other currency approved by the lenders. The revolving lines of credit and term loans expire on August 22, 2010. Interest rates under the credit facility are based on either the London Interbank Offering Rates (“LIBOR”) in Australia or the U.S., or the prime rate, depending on the selection of available borrowing options under the Agreement.

Substantially all of Penford’s U.S. assets secure the credit facility and the credit agreement includes, among other things, financial covenants with limitations on indebtedness and capital expenditures and maintenance of fixed charge and leverage ratios. Penford was in compliance with the credit agreement covenants at August 31, 2006. Pursuant to the terms of the credit agreement, Penford’s borrowing availability was $29.5 million at August 31, 2006.

On October 5, 2006, Penford Corporation (the “Company”) entered into a $145 million Second Amended and Restated Credit Agreement. The Agreement refinances the Company’s previous $105 million secured term and revolving credit facilities. See Note 19 for further details.

36

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

At August 31, 2006, the Company had $11.2 million and $46.1 million outstanding, respectively, under the revolving credit and term loan portions of its $105 million credit facility. As of August 31, 2006, approximately $20.7 million of the Company’s outstanding debt, including amounts outstanding under the Australian grain inventory financing facility, is subject to variable interest rates. Under interest rate swap agreements with several banks, the Company’s fixed rate debt is $36.8 million of U.S. dollar denominated term debt at 4.18% and $9.3 million of U.S. dollar equivalent Australian dollar denominated term debt at 5.58%, plus the applicable margin under the Company’s credit agreement.

The Company’s short-term borrowings consist of an Australian revolving line of credit. On March 1, 2006, the Company’s Australian subsidiary entered into a variable-rate revolving grain inventory financing facility with an Australian bank for a maximum of $30.5 million U.S. dollars at the exchange rate at August 31, 2006. This facility expires on February 28, 2007 and carries an effective interest rate equal to the Australian one-month bank bill rate (“BBSY”) plus approximately 2%. Payments on this facility are due as the grain financed is withdrawn from storage. The amount outstanding under this arrangement, which is classified as a current liability on the balance sheet, was $9.5 million at August 31, 2006.

As of August 31, 2006, Penford borrowed $46.1 million in term loans, of which $9.3 million U.S. dollar equivalent was denominated in Australian dollars, and the Company borrowed $11.2 million on its revolving lines of credit, of which $2.1 million U.S. dollar equivalent was denominated in Australian dollars. The maturities of debt existing at August 31, 2006 for the fiscal years beginning with fiscal 2007 are as follows (dollars in thousands):

2007	$	13,836
2008		4,052
2009		4,036
2010		4,012
2011		4,000
2012		37,071
	$	67,007

Included in the Company’s long term debt at August 31, 2006 is $145,000 of capital lease obligations, of which $45,000 is considered current portion of long term debt. See Note 8.

Note 6 — Stockholders’ Equity

Common Stock

	Year Ended August 31,
	2006		2005		2004
Common shares outstanding
Balance, beginning of year		10,849,487		10,784,200		10,584,715
Exercise of stock options		50,972		65,287		199,441
Issuance of restricted stock, net		8,694		—		44
Balance, end of year		10,909,153		10,849,487		10,784,200

Common Stock Purchase Rights

On June 16, 1988, Penford distributed a dividend of one right (“Right”) for each outstanding share of Penford common stock. The Rights will become exercisable if a purchaser acquires 15% of Penford’s common stock or makes an offer to acquire common stock. In the event that a purchaser acquires 15% of the common stock of Penford, each Right shall entitle the holder, other than the acquirer, to purchase one share of common stock of Penford at a price of $100. In the event that Penford is acquired in a merger or transfers 50% or more of its assets or

37

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

earnings to any one entity, each Right entitles the holder to purchase common stock of the surviving or purchasing company having a market value of twice the exercise price of the Right. The Rights may be redeemed by Penford at a price of $0.01 per Right and expire on June 16, 2008.

Note 7 — Other Comprehensive Income (Loss)

The components of other comprehensive income (loss) are as follows:

	August 31,
	2006			2005
	(Dollars in thousands)
Net unrealized gain on derivatives, net of tax	$	480		$	282
Foreign currency translation adjustments		13,393			12,857
Minimum pension liability, net of tax		(2,131	)		(4,973	)
	$	11,742		$	8,166

The earnings associated with the Company’s investment in Penford Australia are considered to be permanently invested and no provision for U.S. income taxes on the related translation adjustment has been provided.

Note 8 — Leases

Certain of the Company’s property, plant and equipment is leased under operating leases ranging from one to fifteen years with renewal options. Rental expense under operating leases was $6.3 million, $5.4 million and $5.2 million in 2006, 2005 and 2004, respectively. Future minimum lease payments for fiscal years beginning with the fiscal year ending August 31, 2006 for noncancelable operating and capital leases having initial lease terms of more than one year are as follows (dollars in thousands):

	Capital			Operating
	Leases			Leases
2007	$	57		$	5,759
2008		59			4,906
2009		39			4,421
2010		12			2,643
2011		—			918
Thereafter		—			1,246
Total minimum lease payments		167		$	19,893
Less: amounts representing interest		(22	)
Net minimum lease payments	$	145

Note 9 — Stock-based Compensation Plans

On January 24, 2006, the shareholders approved the Penford Corporation 2006 Long-Term Incentive Plan (the “2006 Incentive Plan”) pursuant to which various stock-based awards may be granted to employees, directors and consultants. Prior to the approval of the 2006 Incentive Plan, the Company awarded stock options to employees and officers through the Penford Corporation 1994 Stock Option Plan (the “1994 Plan”) and to members of its Board under the Stock Option Plan for Non-Employee Directors (the “Directors’ Plan”). The 1994 Plan was suspended when the 2006 Plan became effective. The Directors’ Plan expired in August 2005. As of August 31, 2006, the aggregate number of shares of the Company’s common stock that may be issued as awards under the 2006 Incentive Plan is 789,476. In addition, any shares previously granted under the 1994 Plan which are subsequently forfeited or not exercised will be available for future grants under the 2006 Incentive Plan.

38

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Non-qualified stock options granted under the 1994 Plan generally vest ratably over four years and expire ten years from the date of grant. Non-qualified stock options granted under the 2006 Incentive Plan generally vest ratably over four years and expire seven years from the date of grant. Non-qualified options granted under the Directors’ Plan were granted at 75% of the fair market value of the Company’s common stock on the date of grant. Options granted under the Directors’ Plan vested six months after the grant date and expire at the earlier of ten years after the date of grant or three years after the date the non-employee director ceases to be a member of the Board.

General Option Information

A summary of the stock option activity for the three years ended are as follows:

								Weighted
						Weighted		Average
						Average		Remaining		Aggregate
	Number of			Option Price		Exercise		Term		Intrinsic
	Shares			Range		Price		(In Years)		Value
Outstanding Balance, August 31, 2003		1,134,983		$	5.77 - 17.69	$	12.94
Granted		50,660			9.83 - 14.50		11.52
Exercised		(199,441	)		5.77 - 14.88		10.76
Cancelled		(13,539	)		12.44 - 13.73		13.41
Outstanding Balance, August 31, 2004		972,663			5.77 - 17.69		13.31
Granted		224,235			12.75 - 16.34		15.69
Exercised		(62,378	)		5.77 - 14.50		10.45
Cancelled		(26,985	)		12.75 - 14.50		12.99
Outstanding Balance, August 31, 2005		1,107,535			6.02 - 17.69		13.96
Granted		248,500			13.32 - 16.03		14.81
Exercised		(50,972	)		6.02 - 13.92		15.35
Cancelled		(134,000	)		12.79 - 17.69		16.75
Outstanding Balance, August 31, 2006		1,171,063			6.18 - 17.69		13.98		6.39	$	2,300,471
Options Exercisable at August 31,
2004		598,175			5.77 - 17.69		13.29
2005		689,735			6.02 - 17.69		13.57
2006		721,938			6.18 - 17.69		13.38		5.60	$	1,872,189

The aggregate intrinsic value disclosed in the table above represents the total pretax intrinsic value, based on the Company’s closing stock price of $15.64 as of August 31, 2006 that would have been received by the option holders had all option holders exercised on that date. The intrinsic value of options exercised during fiscal years 2006, 2005 and 2004 was $274,700, $327,400 and $763,300, respectively.

The weighted average grant date fair value of stock options granted under the 2006 Incentive Plan during fiscal year 2006 was $7.18 and under the 1994 Plan during fiscal years 2006, 2005 and 2004 was $6.01, $7.71 and $7.82, respectively. The weighted average grant date fair value of stock options granted under the Directors’ Plan during fiscal 2005 and 2004 was $10.30 and $6.82, respectively. There were no options granted to directors during fiscal 2006 and options granted to directors during fiscal 2005 were cancelled in fiscal 2005 in exchange for cash because of certain changes in the tax laws.

39

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

As of August 31, 2006, the Company had $1.7 million of unrecognized compensation costs related to non-vested stock option awards that is expected to be recognized over a weighted average period of 1.6 years.

The following table summarizes information concerning outstanding and exercisable options as of August 31, 2006:

	Options Outstanding
			Wtd. Avg.				Options Exercisable
			Remaining		Wtd. Avg.				Wtd. Avg.
	Number of		Contractual		Exercise		Number of		Exercise
Range of Exercise Prices	Options		Life (Years)		Price		Options		Price
$ 6.02 - 12.50		161,622		4.94	$	10.38		150,497	$	10.26
12.51 - 14.00		517,941		6.46		12.98		377,441		12.91
14.01 - 17.69		491,500		6.79		16.23		194,000		16.73
		1,171,063						721,938

Adoption of SFAS No. 123R

On September 1, 2005, the Company adopted SFAS No. 123R which requires the measurement and recognition of compensation cost for all share-based payment awards made to employees and directors based on estimated fair values.

Prior to the adoption of SFAS No. 123R, the Company accounted for its stock-based employee compensation related to stock options under the intrinsic value recognition and measurement principles of APB Opinion No. 25, “Accounting for Stock Issued to Employees” and the disclosure alternative prescribed by SFAS No. 123, “Accounting for Stock-Based Compensation,” as amended by SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure.” Accordingly, the Company presented pro forma information for the periods prior to the adoption of SFAS No. 123R and no compensation cost was recognized for the stock-based compensation plans other than the grant date intrinsic value for the options granted under the Directors’ Plan and restricted stock awards prior to September 1, 2005.

The Company has elected to use the modified prospective transition method for adopting SFAS No. 123R which requires the recognition of stock-based compensation cost on a prospective basis; therefore, prior period financial statements have not been restated. Under this method, the provisions of SFAS No. 123R are applied to all awards granted after the adoption date and to awards not yet vested with unrecognized expense at the adoption date based on the estimated fair value at grant date as determined under the original provisions of SFAS No. 123. Pursuant to the requirements of SFAS No. 123R, the Company will continue to present the pro forma information for periods prior to the adoption date.

Valuation and Assumptions

The Company utilizes the Black-Scholes option-pricing model to determine the fair value of stock options on the date of grant. This model derives the fair value of stock options based on certain assumptions related to expected stock price volatility, expected option life, risk-free interest rate and dividend yield. The Company’s expected volatility is based on the historical volatility of the Company’s stock price over the most recent period commensurate with the expected term of the stock option award. The estimated expected option life is based primarily on historical employee exercise patterns and considers whether and the extent to which the options are in-the-money. The risk-free interest rate assumption is based upon the U.S. Treasury yield curve appropriate for the term of the Company’s stock options awards and the selected dividend yield assumption was determined in view of the Company’s historical and estimated dividend payout. The Company has no reason to believe that the expected volatility of its stock price or its option exercise patterns would differ significantly from historical volatility or option exercises.

40

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

The fair value of the options was estimated on the date of grant using the following assumptions for each stock option plan during fiscal years 2006, 2005 and 2004.

	Year Ended August 31,
	2006 Incentive Plan							1994 Plan
	2006			2005		2004		2006			2005			2004
Expected volatility		51	%		—		—		52	%		58	%		59	%
Expected life (years)		5.5			—		—		5.0			4.1			3.8
Interest rate (percent)		4.9-5.1			—		—		4.4 - 4.5			3.7 - 4.0			1.9 - 4.1
Dividend yield		1.6	%		—		—		1.7	%		1.6	%		1.5	%

	Year Ended August 31,
	Directors’ Plan
	2006		2005			2004
Expected volatility		—		58	%		59	%
Expected life (years)		—		5.0			2.7
Interest rate (percent)		—		3.7 - 4.0			1.9 - 4.1
Dividend yield		—		1.6	%		1.5	%

There were no stock options granted under the Directors’ Plan in fiscal 2006 and options granted to directors in fiscal 2005 were cancelled in exchange for cash because of changes in the tax laws.

SFAS No. 123R

The Company recognizes stock-based compensation expense utilizing the accelerated multiple option approach over the requisite service period, which equals the vesting period. For fiscal year 2006, the Company recognized $1.1 million in stock-based compensation costs. In 2006, 2005 and 2004, the Company recognized $42,000, $42,000 and $93,000, respectively, of stock-based compensation cost related to Director’s discounted stock options and restricted stock awards. The following table summarizes the stock-based compensation cost under SFAS No. 123R for fiscal year 2006 and the effect on the Company’s Condensed Consolidated Statements of Operations (in thousands):

	2006
Cost of sales	$	70
Operating expenses		999
Research and development expenses		38
Total stock-based compensation expense	$	1,107
Tax benefit		410
Total stock-based compensation expense, net of tax	$	697

See Note 16 for stock-based compensation costs recognized in the financial statements of each business segment.

41

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Pro-forma Information under SFAS 123 for Periods Prior to Fiscal 2006

If the fair value recognition provisions of SFAS 123 had been applied to stock-based compensation for fiscal years 2005 and 2004, the Company’s pro forma net income and basic and diluted earnings per share would have been as follows:

	2005			2004
	(In thousands, except per share data)
Net income, as reported	$	2,574		$	3,702
Add: Stock-based employee compensation expense included in reported net income, net of tax		36			81
Less: Stock-based employee compensation expense determined under the fair value method for all awards, net of tax		(898	)		(1,181	)
Net income, pro forma	$	1,712		$	2,602
Earnings per share:
Basic — as reported	$	0.29		$	0.42
Basic — pro forma	$	0.19		$	0.30
Diluted — as reported	$	0.29		$	0.42
Diluted — pro forma	$	0.19		$	0.29

Restricted Stock

Non-employee directors receive restricted stock under the 1993 Non-Employee Director Restricted Stock Plan, which provides that beginning September 1, 1993 and every three years thereafter, each non-employee director shall receive $18,000 worth of common stock of the Company, based on the last reported sale price of the stock on the preceding trading day. One-third of the shares vest on each anniversary of the date of the award. The Company recognizes compensation cost for restricted stock ratably over the vesting period. On September 1, 2005, 8,694 shares of restricted common stock of the Company, all of which were unvested at August 31, 2006, were granted to the non-employee directors.

Note 10 — Pensions and Other Postretirement Benefits

Penford maintains two noncontributory defined benefit pension plans that cover substantially all North American employees and retirees.

The Company also maintains a postretirement health care benefit plan covering its North American bargaining unit hourly retirees.

42

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Obligations and Funded Status

The following represents information summarizing the Company’s pension and other postretirement benefit plans. A measurement date of August 31, 2006 was used for all plans.

	Year Ended August 31,
	Pension Benefits						Other Benefits
	2006			2005			2006			2005
	(Dollars in thousands)
Change in benefit obligation:
Benefit obligation at September 1	$	39,132		$	32,786		$	15,041		$	14,652
Service cost		1,673			1,066			391			352
Interest cost		2,102			2,065			785			775
Plan participants’ contributions		—			—			148			112
Amendments		—			1,124			—			(1,523	)
Actuarial (gain) loss		(1,052	)		127			(840	)		(82	)
Change in assumptions		(3,312	)		3,746			(1,104	)		1,387
Benefits paid		(1,808	)		(1,782	)		(800	)		(632	)
Benefit obligation at August 31	$	36,735		$	39,132		$	13,621		$	15,041
Change in plan assets:
Fair value of plan assets at September 1	$	26,759		$	21,594		$	—		$	—
Actual return on plan assets		2,262			3,387			—			—
Company contributions		3,308			3,560			652			520
Plan participants’ contributions		—			—			148			112
Benefits paid		(1,808	)		(1,782	)		(800	)		(632	)
Fair value of the plan assets at August 31	$	30,521		$	26,759		$	—		$	—
Funded status:
Plan assets less than projected benefit obligation	$	(6,214	)	$	(12,373	)	$	(13,621	)	$	(15,041	)
Unrecognized net actuarial loss		5,655			10,734			1,234			3,321
Unrecognized prior service cost		1,840			2,027			(1,219	)		(1,371	)
Net asset (liability)	$	1,281		$	388		$	(13,606	)	$	(13,091	)
Recognized as:
Intangible pension asset	$	1,840		$	2,027		$	—		$	—
Accrued benefit liability		(3,838	)		(9,289	)		(13,606	)		(13,091	)
Other comprehensive income		3,279			7,650			—			—
	$	1,281		$	388		$	(13,606	)	$	(13,091	)

Selected information related to the Company’s defined benefit pension plans that have benefit obligations in excess of fair value of plan assets is presented below (Dollars in thousands):

	August 31,
	2006		2005
Projected benefit obligation	$	36,735	$	39,132
Accumulated benefit obligation	$	34,359	$	36,048
Fair value of plan assets	$	30,521	$	26,759

43

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

At August 31, 2006, the Company recorded a reduction to minimum pension liability of $4,371,000 to reflect the excess of the fair value of plan assets over the accumulated benefit obligations. This charge is reflected in other comprehensive income, net of tax.

Effective August 1, 2004, the Company’s postretirement health care benefit plan covering bargaining unit hourly employees was closed to new entrants and to any current employee who did not meet minimum requirements as to age plus years of service.

The defined benefit pension plans for salary and hourly employees were closed to new participants effective January 1, 2005 and August 1, 2004, respectively.

Net Periodic Benefit Cost

	Year Ended August 31,
	Pension Benefits									Other Benefits
	2006			2005			2004			2006			2005			2004
	(Dollars in thousands)
Components of net periodic benefit cost
Service cost	$	1,673		$	1,066		$	915		$	391		$	352		$	505
Interest cost		2,102			2,065			1,889			785			775			852
Expected return on plan assets		(2,150	)		(1,868	)		(1,736	)		—			—			—
Amortization of transition obligation		—			—			121			—			—			—
Amortization of prior service cost		187			194			109			(152	)		(152	)		—
Amortization of actuarial loss		602			480			437			143			38			59
Benefit cost	$	2,414		$	1,937		$	1,735		$	1,167		$	1,013		$	1,416

Assumptions

The Company assesses its benefit plan assumptions on a regular basis. Assumptions used in determining plan information are as follows:

	August 31,
	Pension Benefits						Other Benefits
	2006		2005		2004		2006		2005		2004
Weighted-average assumptions used to calculate net periodic expense:
Discount rate		5.50%		6.25%		6.40%		5.50%		6.25%		6.40%
Expected return on plan assets		8.00%		8.00%		8.50%
Rate of compensation increase		4.00%		4.00%		4.00%
Weighted-average assumptions used to calculate benefit obligations at August 31:
Discount rate		6.15%		5.50%		6.25%		6.15%		5.50%		6.25%
Expected return on plan assets		8.00%		8.00%		8.00%
Rate of compensation increase		4.00%		4.00%		4.00%

The expected long-term return on assets assumption for the pension plans represents the average rate of return to be earned on plan assets over the period the benefits included in the benefit obligation are to be paid. In developing the expected rate of return, the Company considers long-term historical market rates of return as well as actual returns on the Company’s plan assets, and adjusts this information to reflect expected capital market trends.

44

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Penford also considers forward looking return expectations by asset class, the contribution of active management and management fees paid by the plans. The plan assets are held in qualified trusts and anticipated rates of return are not reduced for income taxes. The expected long-term return on assets assumption used to calculate net periodic pension expense was 8.0% for fiscal 2006. A 0.5% decrease (increase) in the expected return on assets assumptions would increase (decrease) pension expense by approximately $0.2 million based on the assets of the plans at August 31, 2006. The expected return on plan assets to be used in calculating fiscal 2007 pension expense is 8%.

The discount rate used by the Company in determining pension expense and pension obligations reflects the yield of high quality (AA or better rating by a recognized rating agency) corporate bonds whose cash flows are expected to match the timing and amounts of projected future benefit payments. The discount rates to determine net periodic expense used in 2004 (6.4%), 2005 (6.25%) and 2006 (5.50%) reflect the decline in bond yields over the last several years. During fiscal 2006, bond yields rose and Penford has increased the discount rate for calculating its benefit obligations at August 31, 2006, as well as net periodic expense for fiscal 2007, to 6.15%. Lowering the discount rate by 0.25% would increase pension expense by approximately $0.3 million and other postretirement benefit expense by $0.05 million.

Unrecognized net loss amounts reflect the difference between expected and actual returns on pension plan assets as well as the effects of changes in actuarial assumptions. Unrecognized net losses in excess of certain thresholds are amortized into net periodic pension and postretirement benefit expense over the average remaining service life of active employees. Amortization of unrecognized net loss amounts is expected to increase net pension expense by approximately $0.2 million in fiscal 2007. Amortization of unrecognized net losses is not expected to impact the net postretirement health care expense in fiscal 2007.

	2006			2005			2004
Assumed health care cost trend rates:
Current health care trend assumption		10.00	%		10.00	%		12.00	%
Ultimate health care trend rate		4.75	%		4.75	%		4.75	%
Year ultimate health care trend is reached		2015			2014			2013

The assumed health care cost trend rate could have a significant effect on the amounts reported. A one-percentage-point change in the assumed health care cost trend rate would have the following effects (in thousands):

	1-Percentage-		1-Percentage-
	Point		Point
	Increase		Decrease
	(Dollars in thousands)
Effect on total of service and interest cost components in fiscal 2006	$	161	$	(133	)
Effect on postretirement accumulated benefit obligation as of August 31, 2006	$	1,696	$	(1,720	)

Plan Assets

The weighted average asset allocations of the investment portfolio for the pension plans at August 31 are as follows:

	Target			August 31,
	Allocation			2006			2005
U.S. equities		60	%		55	%		55	%
International equities		10	%		15	%		15	%
Fixed income investments		25	%		25	%		25	%
Real estate		5	%		5	%		5	%
Cash and other investments		—			—			—

45

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

The assets of the pension plans are invested in units of common trust funds actively managed by Frank Russell Trust Company, a professional fund investment manager. The investment strategy for the defined benefit pension assets is to maintain a diversified asset allocation in order to minimize the risk of large losses and maximize the long-term risk-adjusted rate of return. No plan assets are invested in Penford shares. There are no plan assets for the Company’s postretirement health care plans.

Contributions and Benefit Payments

The Company’s funding policy for the defined benefit pension plans is to contribute amounts sufficient to meet the statutory funding requirements of the Employee Retirement Income Security Act of 1974. The Company contributed $3.3 million, $3.6 million and $1.1 million in fiscal 2006, 2005 and 2004, respectively. The Company expects to contribute $1.1 million to its defined benefit pension plans during fiscal 2007. Penford funds the benefit payments of its postretirement health care plans on a cash basis; therefore, the Company’s contributions to these plans in fiscal 2007 will approximate the benefit payments below.

Expected benefit payments are based on the same assumptions used to measure the benefit obligations and include benefits attributable to estimate future employee service.

			Other
	Pension		Postretirement
2007	$	1.9	$	0.7
2008		1.9		0.7
2009		2.0		0.7
2010		2.0		0.7
2011		2.0		0.8
2012-2016	$	11.2	$	4.8

Note 11 — Other Employee Benefits

Savings and Stock Ownership Plan

The Company has a defined contribution savings plan where eligible North American-based employees can elect a maximum salary deferral of 16%. The plan provides a 100% match on the first 3% of salary contributions and a 50% match on the next 3% per employee. The Company’s matching contributions were $882,000, $750,000 and $777,000 for fiscal years 2006, 2005 and 2004, respectively.

The plan also includes an annual profit-sharing component that is awarded by the Board of Directors based on achievement of predetermined corporate goals. This feature of the plan is available to all employees who meet the eligibility requirements of the plan. There were no profit-sharing contributions paid to participants for fiscal years 2006, 2005 and 2004.

Deferred Compensation Plan

The Company provides its directors and certain employees the opportunity to defer a portion of their salary, bonus and fees. The deferrals earn interest based on Moody’s current Corporate Bond Yield. Deferred compensation interest of $184,000, $188,000 and $225,000 was accrued in 2006, 2005 and 2004, respectively.

Supplemental Executive Retirement Plan

The Company sponsors a supplemental executive retirement plan, a non-qualified plan, which covers certain employees. No current executive officers participate in this plan. For fiscal 2006, 2005 and 2004, the net periodic pension expense accrued for this plan was $305,000, $302,000 and $185,000, respectively. Net periodic benefit expense for fiscal 2004 is net of curtailment gains of $133,000, resulting from the termination of one participant in

46

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

2004. The accrued obligation related to the plan was $3.9 million and $3.8 million for fiscal years 2006 and 2005, respectively.

Health Care and Life Insurance Benefits

The Company offers health care and life insurance benefits to most active North American employees. Costs incurred to provide these benefits are charged to expense as incurred. Health care and life insurance expense, net of employee contributions, was $4,345,000, $4,656,000 and $4,595,000 in 2006, 2005 and 2004, respectively.

Superannuation Fund

The Company contributes to superannuation funds on behalf of the employees of Penford Australia. Australian law requires the Company to contribute at least 9% of each employee’s eligible pay. In New Zealand, the Company sponsors a superannuation benefit plan whereby it contributes 7.5% and 5% of eligible pay for salaried and hourly employees, respectively. The Company contributions to superannuation funds were $1,074,000, $1,085,000 and $1,079,000 in 2006, 2005 and 2004, respectively.

Note 12 — Other Non-operating Income

Other non-operating income consists of the following:

	Year Ended August 31,
	2006			2005			2004
	(Dollars in thousands)
Royalty and licensing income	$	1,827		$	1,386		$	2,217
Loss on extinguishment of debt		—			(1,051	)		(665	)
Gain on sale of Tamworth farm		78			1,166			—
Gain on sale of investment		—			736			150
Other		(9	)		(28	)		285
	$	1,896		$	2,209		$	1,987

In February 2006, the Company sold a parcel of land suitable only for agricultural purposes in Tamworth, New South Wales, Australia to a third-party purchaser for $0.7 million. The Company leases back the property from the purchaser under two lease terms and arrangements: i) a small parcel of land is leased for 25 years beginning August 2006 with annual rent of approximately $0.015 million converted to U.S. dollars at the Australian dollar exchange rate at August 31, 2006 and ii) the majority of land sold is leased for one year beginning August 2006 with annual rental of approximately $0.08 million converted to U.S. dollars at the Australian dollar exchange rate at August 31, 2006. The total gain on the sale was $0.3 million. The gain of $0.1 million in excess of the present value of the lease payments was recognized during the second quarter of fiscal 2006. The remaining gain of $0.2 million will be recognized proportionally over the terms of the leases discussed above.

In 2005 and 2004, the Company refinanced its secured term and revolving credit facilities and wrote off $1.1 million and $0.7 million, respectively, of unamortized debt issuance costs related to these credit agreements. See Note 5.

In the first quarter of fiscal 2003, the Company sold certain assets of its resistant starch Hi-maize business to National Starch Corporation (“National Starch”). The Company recorded a $1.9 million gain on the sale of these assets. The Company also exclusively licensed to National Starch certain rights to its resistant starch intellectual property portfolio for applications in human nutrition. Under the terms of the licensing agreement, the Company received an initial licensing fee of $2.25 million ($1.6 million net of transaction expenses) which is being amortized over the life of the royalty agreement. The royalty payments are subject to a minimum of $7 million over the first five years of the licensing agreement. The Company recognized $1.8 million, $1.4 million and $2.2 million in

47

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

income during fiscal 2006, 2005 and 2004, respectively, related to the licensing fee and royalties. The Company has recognized $6.6 million in royalty income from the inception of the agreement through August 31, 2006.

In the fourth quarter of 2005, the Company sold a parcel of land suitable for residential real estate development in Tamworth, New South Wales, Australia, to a third-party purchaser for $1.9 million in cash, recognizing a gain on the sale of $1.2 million. The Company has leased the property from the purchaser for 12 months with an option to renew the lease for an additional 6 months. The annual rental on the property converted to U.S. dollars at the Australian dollar exchange rate at August 31, 2006 is $0.08 million.

In the third quarter of fiscal 2005, the Company sold a majority of its investment in a small Australian start-up company and recognized a $0.7 million pre-tax gain on the transaction.

Note 13 — Income Taxes

Income (loss) before income taxes is as follows:

	Year Ended August 31,
	2006		2005			2004
	(Dollars in thousands)
Domestic	$	3,502	$	(4,635	)	$	(151	)
Foreign		1,760		2,282			5,222
Total	$	5,262	$	(2,353	)	$	5,071

Income tax expense (benefit) consists of the following:

	Year Ended August 31,
	2006			2005			2004
	(Dollars in thousands)
Current:
Federal	$	68		$	(353	)	$	364
State		709			170			284
Foreign		550			666			1,339
		1,327			483			1,987
Deferred:
Federal		529			(4,579	)		(692	)
State		(536	)		(573	)		(317	)
Foreign		(286	)		(258	)		391
		(293	)		(5,410	)		(618	)
Total	$	1,034		$	(4,927	)	$	1,369

	Year Ended August 31,
	2006		2005			2004
	(Dollars in thousands)
Comprehensive tax expense (benefit) allocable to:
Income (loss) before taxes	$	1,034	$	(4,927	)	$	1,369
Comprehensive income (loss)		1,649		(871	)		(849	)
	$	2,683	$	(5,798	)	$	520

48

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

A reconciliation of the statutory federal tax to the actual provision (benefit) for taxes is as follows:

	Year Ended August 31,
	2006			2005			2004
	(Dollars in thousands)
Statutory tax rate		34	%		34	%		34	%
Statutory tax on income	$	1,789		$	(800	)	$	1,724
State taxes, net of federal benefit		114			(245	)		(22	)
Nondeductible depreciation and amortization		76			97			75
Tax credits, including research and development credits		(136	)		(247	)		(60	)
Extraterritorial income exclusion benefit		(546	)		(2,970	)		(340	)
Lower statutory rate on foreign earnings		(82	)		(449	)		(163	)
Other		(181	)		(313	)		155
Total provision	$	1,034		$	(4,927	)	$	1,369

The significant components of deferred tax assets and liabilities are as follows:

	August 31,
	2006			2005
	(Dollars in thousands)
Deferred tax assets:
Alternative minimum tax credit	$	466		$	2,636
Research and development credit		—			492
Postretirement benefits		7,957			9,196
Provisions for accrued expenses		1,988			1,911
Other		1,663			1,077
Total deferred tax assets		12,074			15,312
Deferred tax liabilities:
Depreciation		16,513			18,396
Other		393			165
Total deferred tax liabilities		16,906			18,561
Net deferred tax liabilities	$	4,832		$	3,249
Recognized as:
Other current assets	$	1,092		$	1,104
Long-term deferred income taxes		(5,924	)		(4,353	)
Total net deferred tax liabilities	$	4,832		$	3,249

At August 31, 2006, the Company had federal alternative minimum tax credit carryforwards of $0.5 million, which do not expire under current tax law.

The Company has not provided for U.S. federal income and foreign withholding taxes on undistributed earnings from non-U.S. operations as of August 31, 2006 because the Company intends to reinvest such earnings indefinitely outside of the United States.

In August 2005, the Company received a report from the Internal Revenue Service (“IRS”) regarding the audit of the Company’s U.S. federal income tax returns for fiscal years ended August 31, 2001 and 2002. The IRS has challenged the deductibility of interest expense, loss on extinguishment of debt and debt issuance costs in those years. At August 31, 2006, these tax returns are before the IRS’s Appeals Division. No assurance can be given that these tax matters will be resolved in the Company’s favor in view of the inherent uncertainties and complexity involved in tax proceedings. Although the Company believes that its tax return positions are supportable, management has recorded a current tax liability for its best estimate of the probable loss on certain of these positions.

49

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

In 2004, the Company filed amended U.S. federal income tax returns for fiscal years ended August 31, 2001 and 2002, increasing the extraterritorial income exclusion (“EIE”) deduction. The methodology that was used to determine the incremental EIE deduction for those years was also utilized for the federal income tax returns for fiscal years ended August 31, 2003, 2004 and 2005. Penford had not recognized the tax benefit associated with the incremental EIE deduction for fiscal years 2001 through 2004 because the Company had concluded that it was not probable, as defined in FASB Statement No. 5, “Accounting for Contingencies,” that the deduction would be sustained. In its tax audits of the fiscal 2001 and 2002 federal income tax returns, the IRS did not challenge the Company’s EIE deduction for those years. Accordingly, in the fourth quarter of 2005, the Company recognized the incremental tax benefit of this deduction for fiscal years 2001 through 2004. The amount of tax benefit recognized for years prior to 2005 was $2.5 million.

Note 14 — Restructuring Costs

In the first quarter of fiscal 2004, the Company’s Australian business began implementing an organizational and operational restructure plan at its Tamworth, New South Wales, manufacturing facility. During fiscal 2004, a total of 16 employees were terminated and $0.6 million was expensed as restructuring costs related to severance and fringe benefits. All severance and related benefits had been paid by August 31, 2004. In the fourth quarter of fiscal 2004, the Australian business segment wrote off $0.2 million of equipment in connection with the Tamworth restructuring. The fiscal 2004 costs of this restructure have been classified as operating expenses in the Statement of Operations.

In the second quarter of fiscal 2004, the Company’s Industrial Ingredients — North America business implemented a workforce reduction of 38 employees. In connection therewith, $0.5 million was charged to operating expense as restructuring costs. All severance and related costs were paid at August 31, 2004.

Note 15 — Earnings Per Common Share

The following table presents the computation of basic and diluted earnings per share:

	Year Ended August 31,
	2006		2005		2004
	(Dollars in thousands, except share and
	per share data)
Net income	$	4,228	$	2,574	$	3,702
Weighted average common shares outstanding		8,899,999		8,826,916		8,733,059
Net effect of dilutive stock options		104,191		119,279		134,991
Weighted average common shares and equivalents outstanding, assuming dilution		9,004,190		8,946,195		8,868,050
Earnings per common share:
Basic	$	0.48	$	0.29	$	0.42
Diluted	$	0.47	$	0.29	$	0.42

Weighted-average stock options omitted from the denominator of the earnings per share calculation because they were antidilutive were 536,775, 346,388 and 214,000 for 2006, 2005 and 2004, respectively.

Note 16 — Segment Reporting

Financial information for the Company’s three segments is presented below. The first two segments, Industrial Ingredients — North America and Food Ingredients — North America, are broad categories of end-market users served by the Company’s U.S. operations. The Industrial Ingredients segment provides carbohydrate-based starches for industrial applications, primarily in the paper and packaging products industries. The Food Ingredients segment produces specialty starches for food applications. The third segment is the geographically separate operations in Australia and New Zealand. The Australian and New Zealand operations produce specialty starches used primarily

50

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

in the food ingredients business. See Part 1, Item 1, “Business,” for a description of the products for each segment. A fourth item for “corporate and other” activity has been presented to provide reconciliation to amounts reported in the consolidated financial statements. Corporate and other represents the activities related to the corporate headquarters such as public company reporting, personnel costs of the executive management team, corporate-wide professional services and consolidation entries. The elimination of intercompany sales between Australia/New Zealand operations and Food Ingredients — North America is presented separately since the chief operating decision maker views segment results prior to intercompany eliminations. The accounting policies of the reportable segments are the same as those described in Note 1.

	Year Ended August 31,
	2006			2005			2004
	(Dollars in thousands)
Sales
• Industrial ingredients — North America	$	165,850		$	147,782		$	143,612
• Food ingredients — North America		57,156			53,661			47,518
• Australia/New Zealand operations		96,121			96,231			89,128
• Corporate and other		(708	)		(911	)		(872	)
	$	318,419		$	296,763		$	279,386
Depreciation and amortization
• Industrial ingredients — North America	$	7,812		$	8,832		$	9,783
• Food ingredients — North America		3,301			3,311			3,263
• Australia/New Zealand operations		4,199			4,306			4,069
• Corporate and other		271			576			574
	$	15,583		$	17,025		$	17,689
Income (loss) from operations
• Industrial ingredients — North America	$	9,121		$	(147	)	$	3,846
• Food ingredients — North America		7,819			7,404			5,046
• Australia/New Zealand operations		1,735			1,331			4,549
• Corporate and other		(9,407	)		(7,576	)		(5,865	)
	$	9,268		$	1,012		$	7,576
Capital expenditures, net
• Industrial ingredients — North America	$	8,858		$	4,211		$	5,753
• Food ingredients — North America		1,651			1,742			1,929
• Australia/New Zealand operations		4,323			3,319			7,750
• Corporate and other		73			141			22
	$	14,905		$	9,413		$	15,454

	August 31,
	2006		2005
	(Dollars in thousands)
Total assets
• Industrial ingredients — North America	$	98,733	$	96,860
• Food ingredients — North America		31,714		33,158
• Australia/New Zealand operations		104,491		105,310
• Corporate and other		15,730		14,589
	$	250,668	$	249,917
Total goodwill — Australia/New Zealand	$	21,871	$	21,420

51

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Reconciliation of total income from operations for the Company’s segments to income before income taxes as reported in the consolidated financial statements follows:

	Year Ended August 31,
	2006			2005			2004
	(Dollars in thousands)
Income from operations	$	9,268		$	1,012		$	7,576
Other non-operating income		1,895			2,201			1,968
Investment income		1			8			19
Interest expense		(5,902	)		(5,574	)		(4,492	)
Income (loss) before income taxes	$	5,262		$	(2,353	)	$	5,071

Sales, attributed to the point of origin, are as follows:

	Year Ended August 31,
	2006		2005		2004
	(Dollars in thousands)
Sales
• United States	$	222,298	$	200,532	$	190,258
• Australia/New Zealand		96,121		96,231		89,128
	$	318,419	$	296,763	$	279,386

Sales, attributed to the area to which the product was shipped, are as follows:

	Year Ended August 31,
	2006		2005		2004
	(Dollars in thousands)
United States	$	198,439	$	175,741	$	157,305
Australia/New Zealand		79,919		74,222		68,068
Japan		18,334		19,343		17,671
Canada		11,718		13,063		17,602
Other		10,009		14,394		18,740
	$	318,419	$	296,763	$	279,386

	August 31,
	2006		2005
	(Dollars in thousands)
Long-lived assets, net
• North America	$	82,556	$	82,986
• Australia/New Zealand		64,144		63,701
	$	146,700	$	146,687

52

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

With the adoption of SFAS No. 123R on September 1, 2005, the Company recognized $1.1 million in stock-based compensation expense for fiscal 2006. The following table summarizes the stock-based compensation expense related to stock option awards by segment for fiscal year 2006.

	(Dollars in thousands)
Industrial Ingredients — North America	$	217
Food Ingredients — North America		123
Australia/New Zealand operations		49
Corporate		718
	$	1,107

Prior to September 1, 2005, the Company presented pro forma information for the periods prior to the adoption of SFAS No. 123R and no compensation expense was recognized for the stock-based compensation plans other than for the Directors’ Plan and restricted stock awards. See Note 9.

Note 17 — Quarterly Financial Data (Unaudited)

	First		Second			Third		Fourth
Fiscal 2006	Quarter		Quarter			Quarter		Quarter		Total
	(Dollars in thousands, except per share data)
Sales	$	77,903	$	77,078		$	79,130	$	84,308	$	318,419
Cost of sales		67,503		68,534			67,070		70,369		273,476
Gross margin		10,400		8,544			12,060		13,939		44,943
Net income (loss)		196		(511	)		1,991		2,552		4,228
Earnings (loss) per common share:
Basic	$	0.02	$	(0.06	)	$	0.22	$	0.29	$	0.48
Diluted	$	0.02	$	(0.06	)	$	0.22	$	0.28	$	0.47
Dividends declared	$	0.06	$	0.06		$	0.06	$	0.06	$	0.24

	First			Second			Third		Fourth
Fiscal 2005	Quarter(1)			Quarter(1)			Quarter(1)		Quarter(1)		Total
	(Dollars in thousands, except per share data)
Sales	$	72,065		$	69,219		$	76,101	$	79,378	$	296,763
Cost of sales		68,836			62,059			66,061		66,586		263,542
Gross margin		3,229			7,160			10,040		12,792		33,221
Net income (loss)		(3,826	)		(992	)		2,585		4,807		2,574
Earnings (loss) per common share:
Basic	$	(0.43	)	$	(0.11	)	$	0.29	$	0.54	$	0.29
Diluted	$	(0.43	)	$	(0.11	)	$	0.29	$	0.54	$	0.29
Dividends declared	$	0.06		$	0.06		$	0.06	$	0.06	$	0.24

(1) The Company’s operating results for the third quarter of fiscal 2005 included a $0.7 million pre-tax gain related to the sale of an investment and the operating results for the fourth quarter of fiscal 2005 included the following items: (i) $1.1 million pre-tax write off of unamortized transaction costs related to the Company’s refinancing of its credit facility; (ii) $1.2 million pre-tax gain on sale of land and (iii) recognition of tax benefit of $3.2 million related to current and prior years extraterritorial income exclusion deduction. The tax benefit of $2.5 million related to 2001 through 2004 was recognized in 2005 when the Company determined that it was probable that the deduction on the U.S. federal income tax returns would be sustained. See Note 12 and 13.

53

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Note 18 — Legal Proceedings

In October 2004, Penford Products Co. (“Penford Products”), a wholly-owned subsidiary of the Company, was served with a lawsuit filed by Graphic Packaging International, Inc. (“Graphic”) in the Fourth Judicial District Court, Ouachita Parish, State of Louisiana. The petition seeks monetary damages for alleged breach of contract, negligence and tortious misrepresentation. These claims arise out of an alleged agreement obligating Penford Products to supply goods to Graphic and Penford Products’ alleged breach of such agreement, together with conduct related to such alleged breach. Penford has filed an answer generally denying all liability and has countersued for damages. During the fourth quarter of the Company’s fiscal year 2006, the parties continued to conduct discovery. Based upon discovery responses made by Graphic, Graphic is seeking damages of approximately $3.3 million. Penford is seeking damages of approximately $675,000.

The Company is involved in various other claims and litigation arising in the normal course of business. In the judgment of management, which relies in part on information from Company counsel, the ultimate resolution of these actions will not materially affect the consolidated financial statements of the Company.

Note 19 — Subsequent Event

On October 5, 2006, Penford Corporation (the “Company”) entered into a $145 million Second Amended and Restated Credit Agreement (the “Agreement”) among the Company; Harris N.A.; LaSalle Bank National Association; Cooperative Centrale Raiffeisen-Boorleenbank B.A., “Rabobank Nederland” (New York Branch); U.S. Bank National Association; and the Australia and New Zealand Banking Group Limited.

The Agreement refinances the Company’s previous $105 million secured term and revolving credit facilities. Under the Agreement, the Company may borrow $40 million in term loans and $60 million in revolving lines of credit. The lenders’ revolving credit loan commitment may be increased under certain conditions. In addition, the Agreement provides the Company with $45 million in new capital expansion funds which may be used by the Company to finance the construction of its planned ethanol production facility in Cedar Rapids, Iowa. The capital expansion funds may be borrowed as term loans from time to time prior to October 5, 2008.

The final maturity date for the term and revolving loans under the Agreement is December 31, 2011. Beginning on December 31, 2006, the Company must repay the term loans in twenty equal quarterly installments of $1 million, with the remaining amount due at final maturity. The final maturity date for the capital expansion loans is December 31, 2012. Beginning on December 31, 2008, the Company must repay the capital expansion loans in equal quarterly installments of $1.25 million through September 30, 2009 and $2.5 million thereafter, with the remaining amount due at final maturity. Interest rates under the Agreement are based on either the London Interbank Offering Rates (“LIBOR”) in Australia or the U.S., or the prime rate, depending on the selection of available borrowing options under the Agreement.

The Agreement provides that the Total Funded Debt Ratio, which is computed as funded debt divided by earnings before interest, taxes, depreciation and amortization (as defined in the Agreement) shall not exceed 3.25 through November 30, 2006. Subsequent to November 30, 2006, the maximum Total Funded Debt Ratio varies between 3.00 and 4.50. In addition, the Company must maintain a minimum tangible net worth of $65 million, and a Fixed Charge Coverage Ratio, as defined in the Agreement, of not more than 1.50 in fiscal 2007, 1.25 in fiscal 2008 and 1.50 in fiscal 2009 and thereafter. Annual capital expenditures, exclusive of capital expenditures incurred in connection with the Company’s ethanol production facility, are limited to $20 million.

The Company’s obligations under the Agreement are secured by substantially all of the Company’s assets and those of its principal domestic subsidiary, Penford Products Co.

54

REPORT OF MANAGEMENT ON INTERNAL CONTROL OVER FINANCIAL REPORTING

Our management is responsible for establishing and maintaining adequate internal control over financial reporting for the Company. Internal control over financial reporting is a process to provide reasonable assurance regarding the reliability of our financial reporting for external purposes in accordance with accounting principles generally accepted in the United States of America. Internal control over financial reporting includes maintaining records that in reasonable detail accurately and fairly reflect the Company’s transactions; providing reasonable assurance that transactions are recorded as necessary for preparation of the Company’s financial statements; providing reasonable assurance that receipts and expenditures of the Company’s assets are made in accordance with management’s authorization; and providing reasonable assurance that unauthorized acquisition, use or disposition of the Company’s assets that could have a material effect on the financial statements would be prevented or detected on a timely basis. Because of its inherent limitations, internal control over financial reporting is not intended to provide absolute assurance that a misstatement of the Company’s financial statements would be prevented or detected.

Management conducted an evaluation of the effectiveness of the Company’s internal controls over financial reporting based on the framework in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation, management concluded that the Company’s internal control over financial reporting was effective as of August 31, 2006. Ernst & Young LLP has issued an audit report on management’s assessment of the Company’s internal control over financial reporting as of August 31, 2006.

55

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors and Shareholders of Penford Corporation

We have audited the accompanying consolidated balance sheets of Penford Corporation as of August 31, 2006 and 2005, and the related consolidated statements of operations, comprehensive income, shareholders’ equity, and cash flows for each of the three years in the period ended August 31, 2006. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Penford Corporation at August 31, 2006 and 2005, and the consolidated results of its operations and its cash flows for each of the three years in the period ended August 31, 2006 in conformity with U.S. generally accepted accounting principles.

As discussed in Note 9 to the consolidated financial statements, effective September, 1, 2005, the Company adopted Statement of Financial Accounting Standards No. 123(R), “Share-Based Payment.”

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Penford Corporation’s internal control over financial reporting as of August 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated November 9, 2006 expressed an unqualified opinion thereon.

/s/  Ernst & Young LLP

Denver, Colorado

November 9, 2006

56

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors and Shareholders of Penford Corporation

We have audited management’s assessment, included in the accompanying Report of Management on Internal Controls over Financial Reporting, that Penford Corporation maintained effective internal control over financial reporting as of August 31, 2006, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Penford Corporation’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the company’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, management’s assessment that Penford Corporation maintained effective internal control over financial reporting as of August 31, 2006, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, Penford Corporation maintained, in all material respects, effective internal control over financial reporting as of August 31, 2006, based on the COSO criteria.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Penford Corporation as of August 31, 2006 and 2005, and the related consolidated statements of operations, comprehensive income, shareholders’ equity, and cash flows for each of the three years in the period ended August 31, 2006 of Penford Corporation and our report dated November 9, 2006 expressed an unqualified opinion thereon.

/s/  Ernst & Young LLP

Denver, Colorado

November 9, 2006

57

Item 9.   Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.

Not applicable.

Item 9A.   Controls and Procedures.

Under the supervision and with the participation of management, including the Chief Executive Officer and Chief Financial Officer, the Company has evaluated the effectiveness of its disclosure controls and procedures pursuant to Exchange Act Rule 13a-15(b) as of the end of the period covered by this report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that these disclosure controls and procedures are effective. Management’s report on internal control over financial reporting and the related report of the Company’s registered independent public accounting firm are included at the end of Item 8 above. There were no changes in the Company’s internal control over financial reporting during the quarter ended August 31, 2006 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

Item 9B.   Other Information.

Not applicable.

PART III

Item 10.   Directors and Executive Officers of the Registrant.

The information set forth under the headings “Election of Directors” and “Section 16(a) Beneficial Ownership Reporting Compliance” in the definitive Proxy Statement for the 2007 Annual Meeting of Shareholders (the “2007 Proxy Statement”), to be filed not later than 120 days after the end of the fiscal year covered by this report, is incorporated herein by reference. Information regarding the Executive Officers of the Registrant is set forth in Part I, Item 1.

The Company has adopted a Code of Business Conduct and Ethics (the “Code”) that is applicable to all employees, consultants and members of the Board of Directors, including the Chief Executive Officer, Chief Financial Officer and Corporate Controller. This Code embodies the commitment of the Company and its subsidiaries to conduct business in accordance with the highest ethical standards and applicable laws, rules and regulations. The Company will provide any shareholder a copy of the Code, without charge, upon written request to the Company’s Secretary.

Item 11.   Executive Compensation.

The information set forth under the heading “Executive Compensation” in the 2007 Proxy Statement is incorporated herein by reference.

Item 12.   Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.

The information set forth under the heading “Security Ownership of Certain Beneficial Owners and Management” in the 2007 Proxy Statement is incorporated herein by reference.

58

Securities Authorized for Issuance under Equity Compensation Plans

The following table provides information regarding Penford’s equity compensation plans at August 31, 2006. The Company has no equity compensation plans that have not been approved by security holders.

					Number of Securities
	Number of Securities				Remaining Available for
	to be Issued Upon		Weighted-Average		Future Issuance Under
	Exercise of		Exercise Price of		Equity Compensation Plans
	Outstanding Options,		Outstanding Options,		(Excluding Securities
Plan Category	Warrants and Rights		Warrants and Rights		Reflected in Column(a))
Equity compensation plans approved by security holders:
1994 Stock Option Plan(1)		900,500	$	14.18		—
1993 Non-Employee Director Restricted Stock Plan(2)		—		—		10,039
2006 Long-Term Incentive Plan		150,000	$	15.78		789,476
Stock Option Plan for Non-Employee Directors(3)		120,563	$	10.25		—
Total		1,171,063	$	13.96		799,515

(1)	This plan has been terminated and no additional options are available for grant. The options which were not granted under the 1994 Stock Option Plan at January 24, 2006 or which are subsequently forfeited or not exercised are available for issuance under the 2006 Long-Term Incentive Plan.
(2)	Each Director receives a grant of $18,000 of restricted stock every three years. The restricted stock vests one-third on each anniversary of the grant date.
(3)	This plan has been terminated and no additional options will be granted under this plan.

Item 13.   Certain Relationships and Related Transactions.

The information relating to certain relationships and related transactions of the Company is set forth under the heading “Change-in-Control Arrangements” in the 2007 Proxy Statement and is incorporated herein by reference.

Item 14.   Principal Accountant Fees and Services.

Information concerning principal accountant fees and services appears under the heading “Fees Paid to Ernst & Young LLP” in the 2007 Proxy Statement and is incorporated herein by reference.

PART IV

Item 15.   Exhibits and Financial Statement Schedules.

(a)(1) Financial Statements

The consolidated balance sheets as of August 31, 2006 and 2005 and the related consolidated statements of operations, comprehensive income, cash flows and shareholders’ equity for each of the three years in the period ended August 31, 2006 and the reports of the independent registered public accounting firm are included in Part II, Item 8.

59

(2) Financial Statement Schedules

All schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are omitted because they are not applicable or the information is included in the Consolidated Financial Statements in Part II, Item 8.

(3) Exhibits

See index to Exhibits on page 62.

(b) Exhibits

See Item 15(a)(3), above.

(c) Financial Statement Schedules

None

60

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on this 14th day of November 2006.

Penford Corporation

/s/  Thomas D. Malkoski

Thomas D. Malkoski

President and Chief Executive Officer

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated below on November 14, 2006.

Signature	Title
/s/  Thomas D. Malkoski Thomas D. Malkoski	President, Chief Executive Officer and Director (Principal Executive Officer)
/s/  Steven O. Cordier Steven O. Cordier	Senior Vice President and Chief Financial Officer (Principal Financial and Accounting Officer)
/s/  Paul H. Hatfield Paul H. Hatfield	Chairman of the Board of Directors
/s/  William E. Buchholz William E. Buchholz	Director
/s/  Jeffrey T. Cook Jeffrey T. Cook	Director
/s/  R. Randolph Devening R. Randolph Devening	Director
/s/  John C. Hunter III John C. Hunter III	Director
/s/  Sally G. Narodick Sally G. Narodick	Director
/s/  James E. Warjone James E. Warjone	Director

61

INDEX TO EXHIBITS

Exhibits identified in parentheses below, on file with the Securities and Exchange Commission, are incorporated by reference. Copies of exhibits can be obtained at no cost by writing to Penford Corporation, 7094 S. Revere Parkway, Centennial, Colorado 80112.

Exhibit No.			Item
	2	.1	Starch Australasia Share Sale Agreement completed as of September 29, 2000 among Penford Holdings Pty. Limited, a wholly owned subsidiary of Registrant, and Goodman Fielder Limited (filed as an exhibit to Registrant’s File No. 000-11488, Form 8-K/A dated September 29, 2000, filed December 12, 2000)
	3	.1	Restated and Amended Articles of Incorporation, as amended
	3	.2	Bylaws of Registrant as amended and restated as of October 28, 2005 (filed as an exhibit to Registrant’s File No. 000-11488, Form 10-K for the fiscal year ended August 31, 2005)
	3	.3	Section 3.2 of the Registrant’s Amended and Restated Bylaws (filed as an exhibit to Registrant’s File No. 000-11488, Form 8-K filed November 3, 2005)
	4	.1	Amended and Restated Rights Agreement dated as of April 30, 1997 (filed as an exhibit to Registrant’s File No. 000-11488, Amendment to Registration Statement on Form 8-K/A dated May 5, 1997, filed May 5, 1997)
	10	.1	Penford Corporation Deferred Compensation Plan, dated September 1, 2001*
	10	.2	Form of Change of Control Agreement and Annexes between Penford Corporation and Messrs. Lawlor, Cordier, Kunerth, Malkoski and Randall and certain other key employees (a representative copy of these agreements is filed as an exhibit to Registrant’s File No. 000-11488, Form 10-Q for the quarter ended February 28, 2006, filed April 10, 2006)*
	10	.3	Penford Corporation 1993 Non-Employee Director Restricted Stock Plan (filed as an exhibit to Registrant’s File No. 000-11488, Form 10-Q for the quarter ended November 30, 1993)*
	10	.4	Penford Corporation 1994 Stock Option Plan as amended and restated as of January 8, 2002 (filed as an exhibit to Registrant’s File No. 000-11488, Proxy Statement filed with the Commission on January 18, 2002)*
	10	.5	Penford Corporation Stock Option Plan for Non-Employee Directors (filed as a exhibit to Registrant’s File No. 000-11488, Form 10-Q for the quarter ended May 31, 1996, filed July 15, 1996)*
	10	.6	Penford Corporation 2006 Long-Term Incentive Plan (incorporated by reference to Appendix A to Registrant’s Proxy Statement filed December 20, 2005)*
	10	.7	Form of Penford Corporation’s 2006 Long-Term Incentive Plan Stock Option Grant Notice, including the Stock Option Agreement and Notice of Exercise (incorporated by reference to the exhibits to the Registrant’s Current Report on Form 8-K filed February 21, 2006)*
	10	.8	Separation Agreement dated as of July 31, 1998 between Registrant and Penwest Pharmaceuticals Co. (filed as an exhibit to Registrant’s File No. 000-11488, Form 8-K dated August 31, 1998, filed September 15, 1998)
	10	.9	Amended and Restated Credit Agreement dated August 22, 2005 (filed as an exhibit to Registrant’s File No. 000-11488, Form 8-K dated August 22, 2005, filed August 26, 2005).
	10	.10	First Amendment to Amended and Restated Credit Agreement (filed as an exhibit to Registrant’s File No. 000-11488, Form 10-Q for the quarter ended May 31, 2006, filed July 10, 2006).
	10	.11	Second Amended and Restated Credit Agreement dated as of October 5, 2006 (filed as an exhibit to Registrant’s File No. 000-11488, Form 8-K dated October 5, 2006, filed October 10, 2006)
	10	.12	Director Special Assignments Policy dated August 26, 2005 (filed as an exhibit to Registrant’s File No. 000-11488, Form 8-K dated August 26, 2005, filed September 1, 2005)*
	10	.13	Non-Employee Director Compensation Term Sheet (filed as an exhibit to Registrant’s File No. 000-11488, Form 10-K for the year ended August 31, 2006, filed November 14, 2005)*
	21		Subsidiaries of the Registrant
	23		Consent of Independent Registered Public Accounting Firm
	24		Power of Attorney
	31	.1	Certifications of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
	31	.2	Certifications of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
	32		Certifications of Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley act of 2002

* Denotes management contract or compensatory plan or arrangement

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EX-3.1

Exhibit 3.1

ARTICLES OF AMENDMENT
OF
PENWEST, LTD.

     Pursuant to RCW 23B.10.060, the undersigned corporation adopts the following Articles of Amendment to its Restated Articles of Incorporation:

     FIRST: The name of the corporation is PENWEST, LTD. (the “Corporation”).

     SECOND: The Restated Articles of Incorporation are hereby amended as follows:

     Article I is hereby deleted in its entirety and replaced with a new Article I to read as follows:

ARTICLE I
NAME

     The name of the corporation (the “Corporation”) is Penford Corporation.

     THIRD: The foregoing amendment was adopted by the Board of Directors of the Corporation on October 8, 1997 in accordance with the provisions of RCW 23B.10.020. Shareholders action was not required.

	PENWEST, LTD.
Date: October 10, 1997		By:	/s/ EDMUND O. BELSHEIM, JR.
		Name: Edmund O. Belsheim, Jr.
		Title: Vice President

RESTATED ARTICLES OF INCORPORATION
OF
PENWEST, LTD.

     Pursuant to RCW 23B.10.070 these Restated Articles of Incorporation are submitted for filing:

     1. The name of the corporation is PENWEST, LTD.

     2. The Restated Articles are as follows:

ARTICLE I
NAME

     The name of the corporation (the “Corporation”) is PENWEST, LTD.

ARTICLE II
REGISTERED OFFICE AND AGENT

     The address of the registered office of the Corporation is 520 Pike Street, 26th Floor, Seattle, Washington 98101, and the name of the registered agent at such address is C T CORPORATION SYSTEM.

ARTICLE III
PURPOSE

     The purpose of the Corporation is to create the maximum continuing rate of value growth through long-term profit on invested capital and the growth of that capital.

     To accomplish this purpose, the Board of Directors, management and employees of the Corporation will strive to:

- Properly select business opportunities versus risk;

- Develop and maintain strategic direction for all business segments;

- Develop and maintain superior management and organizational structures;

- Encourage employee involvement in the business process;

- Provide all employees the opportunity of a value growth environment of good employment, training, advancement and recognition of their achievements;

- Create market understanding of the intrinsic values so created:

- Conduct its business legally and ethically within the free enterprise system

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as a responsible corporate citizen.

     In carrying out this purpose, the Corporation is authorized to engage in any lawful act or activity for which corporations may be organized under the Washington Business Corporation Act.

ARTICLE IV
SHARES

     1. The total number of shares of all classes of stock which the Corporation shall have authority to issue is 30,000,000 shares to be divided into two classes consisting of 29,000,000 shares of common stock of the par value of $1.00 per share (hereinafter designated “Common Stock”) and 1,000,000 shares of preferred stock of the par value of $1.00 per share (hereinafter designated “Preferred Stock”). The Common Stock shall have one (1) vote for each share. The Preferred Stock shall have such full or limited or absence of voting powers and designations, preferences, limitations and relative rights as shall be stated and expressed in the resolution or resolutions of the Board of Directors of the Corporation providing for the issue of such shares of Preferred Stock subject to the following limitations: (a) no share of Preferred Stock shall have voting powers in excess of one (1) vote per share; provided, however, if the Preferred Stock is convertible into Common Stock as of a record date on which a matter is submitted to a vote of the holders of Common Stock, then such shares of Preferred Stock may, in the resolution providing for the issue of such shares and subject to any restrictions or conditions set forth in the resolution, be granted the right to vote the number of shares of Common Stock which would be issued upon such conversion as of the record date; and (b) no shares of Preferred Stock shall be given a preference over the Common Stock in the event of any liquidation, dissolution, winding up, merger or consolidation of an amount greater than the per share fair market value of the consideration received upon the issuance of the shares of Preferred Stock as reasonably determined in good faith by the Board of Directors of the Corporation plus accrued but unpaid dividends.

     The Preferred Stock may be issued in one or more series of stock and each such series, subject to the limitations set forth above, may have such designations, preferences, limitations and relative rights as shall be stated and expressed in a resolution or resolutions providing for the issue of such Preferred Stock adopted by the Board of Directors pursuant to the authority hereby granted.

     The Preferred Stock may have voting powers, designations, preferences, limitations and relative rights that negate or supersede the provisions of Article VIII hereof (so long as the resolution or resolutions adopting the same are approved by the unanimous vote of the Board of Directors).

     2. The shares of stock of the Corporation may be issued by the Corporation from time to time for such consideration, not less than the par value thereof except as otherwise provided by law, as from time to time may be fixed by the Board of Directors of the Corporation; and all issued shares of the capital stock of the Corporation shall be deemed fully paid and non-assessable and the holders of such shares shall not be liable thereunder to the Corporation or to its creditors.

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     3. No shareholder of the Corporation shall have any preemptive right to acquire additional shares of stock or securities convertible into shares of stock of the Corporation.

ARTICLE V
DURATION

     The existence of the Corporation is to be perpetual.

ARTICLE VI
PAYMENT FOR CORPORATE DEBTS

     The private property of the shareholders shall not be subject to the payment of corporate debts to any extent whatsoever.

ARTICLE VII
CERTAIN DEFINITIONS

     For purposes of these Articles, the following defined terms shall have the meanings set forth below. All references in these Articles to statutes, rules or regulations shall include a reference to said statutes, rules or regulations as currently in effect or hereafter amended.

     (a) The terms “Affiliate” and “Associate” shall have the respective meanings ascribed to such terms in Rule 12b-2 of the Securities Exchange Act of 1934.

     (b) The term “Beneficial Owner” and correlative terms shall have the meanings ascribed to them in Rule 13d-3 and related interpretive releases promulgated and issued under the Securities Exchange Act of 1934. Without limitation, any shares of Voting Stock of the Corporation which any Related Person has the right to vote or to acquire pursuant to any agreement, or upon exercise of conversion rights, warrants or options, or otherwise, shall be deemed “Beneficially Owned” by such Related Person.

     A person shall be a Beneficial Owner of any Voting Stock:

          (1) which such person or any of its Affiliates or Associates beneficially owns, directly or indirectly; or

          (2) which such person or any of its Affiliates or Associates has (a) the right to acquire (whether such right is exercisable immediately or only after the passage of time) pursuant to any agreement, arrangement or understanding or upon the exercise of conversion rights, exchange rights, warrants or options, or otherwise, or (b) the right to vote pursuant to any agreement, arrangement or understanding; or

          (3) which are beneficially owned, directly or indirectly, by any other person with which such person or any of its Affiliates or Associates has any agreement, arrangement or understanding for the purpose of acquiring, holding, voting or disposing of any shares of Voting Stock.

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     (c) The term “Board of Directors” or the “Board” means the group of individuals elected by the shareholders as directors of the Corporation or appointed by the directors to fill a vacancy on the Board.

     (d) The term “Continuing Director” shall mean, with respect to any proposed Major Transaction, a director who was a member of the Board of Directors of the Corporation immediately prior to the time that any Related Person involved in the proposed Major Transaction acquired 20% or more of the outstanding shares of Voting Stock of the Corporation.

     (e) The term “Disinterested Director” means any member of the Board of Directors who is unaffiliated with any Interested Shareholder and/or Substantial Shareholder and was a member of the Board prior to the time that any Interested Shareholder or Substantial Shareholder became an Interested Shareholder or Substantial Shareholder, and any successor of a Disinterested Director who is unaffiliated with any Interested Shareholder or Substantial Shareholder and is recommended to succeed a Disinterested Director by a majority of Disinterested Directors then on the Board.

     (f) The term “Fair Market Value” means (i) in the case of stock, the Market Price, and (ii) in the case of property other than cash or stock, the fair market value of such property on the date in question as determined by the Board in good faith.

     (g) The term “Interested Shareholder” shall mean any person (other than the Corporation or any Subsidiary) who or which:

          (1) is the Beneficial Owner, directly or indirectly, of 5% or more of the voting power of the outstanding Voting Stock; or

          (2) is an Affiliate of the Corporation and at any time within the two-year period immediately prior to the date in question was the Beneficial Owner, directly or indirectly, of five percent (5%) or more of the voting power of the then outstanding Voting Stock; or

          (3) is an assignee of or has otherwise succeeded to any shares of Voting Stock which were, at any time within the two-year period immediately prior to the date in question, beneficially owned by any Interested Shareholder, if such assignment or succession shall have occurred in the course of a transaction or series of transactions not involving a public offering within the meaning of the Securities Act of 1933.

     (h) The term “Major Transaction” shall mean (1) any merger or consolidation of the Corporation or a Subsidiary with or into a Related Person, (2) any sale, lease, exchange, transfer or other disposition, including without limitation a mortgage or other security device, of all or any Substantial Part of the assets of the Corporation (including without limitation any securities of a Subsidiary) or of a Subsidiary, to a Related Person, (3) any merger or consolidation of a Related Person with or into the Corporation or a Subsidiary, (4) any sale, lease, exchange, transfer or other disposition of all or any Substantial Part of the assets of a Related Person to the Corporation or a Subsidiary, (5) the issuance of any securities of the Corporation or a Subsidiary to a Related Person, (6) the acquisition by the Corporation or a Subsidiary of any securities of a Related Person, (7) any reclassification of Voting Stock of the Corporation, or any recapitalization involving Voting Stock of the Corporation, proposed by a Related Person within

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five years after such Related Person became a Related Person, (8) any loan or other extension of credit by the Corporation or a Subsidiary to a Related Person or any guarantees by the Corporation or a Subsidiary of any loan or other extension of credit by any person to a Related Person, and (9) any agreement, contract or other arrangement providing for any of the transactions described in this definition of Major Transaction.

     (i) The term “Market Price” means: the last closing sale price immediately preceding the time in question of a share of the stock in question on the Composite Tape for New York Stock Exchange-Listed Stocks, or if such stock is not quoted on the Composite Tape, on the New York Stock Exchange, or if such stock is not listed on such Exchange, on the principal United States securities exchange registered under the Securities Exchange Act of 1934 on which such stock is listed, or if such stock is not listed on any such exchange, the last closing bid quotation with respect to a share of such stock immediately preceding the time in question on the National Association of Securities Dealers, Inc. Automated Quotations System or any system then in use (or any other system of reporting or ascertaining quotations then available), or if such stock is not so quoted, the fair market value at the time in question of a share of such stock as determined by the Board in good faith.

     (j) The term “other consideration to be received” shall, for the purposes of subparagraph 1(d)(1) of Article VIII, include without limitation Voting Stock of the Corporation retained by its existing public shareholders in the event of a Major Transaction which is a merger or consolidation in which the Corporation is the surviving corporation.

     (k) The term “Outside Director” shall mean, with respect to any proposed Major Transaction, a director who is not (1) an officer or employee of the Corporation or of any Subsidiary or any relative of an officer or employee, (2) a Related Person or an officer, director or employee, Associate or Affiliate of a Related Person, or a relative of any of the foregoing, or (3) a person having a direct or indirect material business relationship with the Corporation or any Subsidiary.

     (l) The term “Related Person” shall mean any individual, corporation, partnership or other person or entity and each member of any “person” as such term is defined in Section 13(d)(3) of the Securities Exchange Act of 1934 which, together with its Affiliates and Associates, or other members of such “person” and any other person or entity with which it or its Affiliates or Associates has any agreement, arrangement, or understanding, directly or indirectly, for the purpose of acquiring, holding, voting or disposing of Voting Stock of the Corporation, is the Beneficial Owner of 20% or more in the aggregate of the outstanding shares of Voting Stock of the Corporation, and any Affiliate, Associate or member of such “person,” or any such other persons or entities.

     (m) The term “Subsidiary” means any corporation or other entity of which a majority of any class of equity security is beneficially owned, directly or indirectly, by the Corporation; provided, however, that for the purposes of the definitions of Interested Shareholder and Substantial Shareholder set forth in paragraphs (g) and (o) of this Article VII, the term “Subsidiary” shall mean only a corporation of which a majority of the voting power of the capital stock entitled to vote generally in the election of directors is owned, directly or indirectly, by the Corporation.

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     (n) The term “Substantial Part” shall mean more than ten percent (10%) of the total assets of the person or entity in question, as of the end of its most recent fiscal year ending prior to the time the determination is being made.

     (o) The term “Substantial Shareholder” shall mean any person (other than the Corporation or any Subsidiary) who or which:

          (1) is the Beneficial Owner, directly or indirectly, of 40% or more of the voting power of the outstanding Voting Stock; or

          (2) is an Affiliate of the Corporation and at any time within the two-year period immediately prior to the date in question was the Beneficial Owner, directly or indirectly, of 40% or more of the voting power of the then outstanding Voting Stock; or

          (3) is an assignee of or has otherwise succeeded to any shares of Voting Stock which were at any time within the two-year period immediately prior to the date in question beneficially owned by any Substantial Shareholder, if such assignment or succession shall have occurred in the course of a transaction or series of transactions not involving a public offering within the meaning of the Securities Act of 1933.

     (p) The term “Voting Stock” shall mean all Common Stock and any other shares entitled to vote for the election of Directors of the Corporation.

     (q) For the purposes of determining whether a person is an Interested Shareholder or a Substantial Shareholder pursuant to paragraphs (g) and (o) of this Article VII, the number of shares of Voting Stock deemed to be outstanding shall include shares deemed owned through application of paragraph (b) of this Article VII, but shall not include any other shares of Voting Stock which may be issuable pursuant to any agreement, arrangement or understanding, or upon exercise of conversion rights, warrants or options, or otherwise.

ARTICLE VIII
HIGHER THAN MAJORITY VOTE OF SHAREHOLDERS REQUIRED
IN THE EVENT OF CERTAIN TRANSACTIONS

     1. Subject to the provisions of any series of Preferred Stock which may at the time be outstanding, any Major Transaction shall require the affirmative vote of the holders of not less than 80% of the outstanding Voting Stock of the Corporation, which shall include the affirmative vote of at least 50% of the outstanding Voting Stock held by shareholders other than the Related Person involved in such Major Transaction; provided, however, that such voting requirement shall not be applicable if:

          (a) The Major Transaction was approved by the Board either (i) prior to the Related Person involved in the Major Transaction having become a Related Person, or (ii) after such Related Person became such but only if the Related Person has sought and obtained the unanimous approval by the Board of such Related Person’s acquisition of 20% or more of the outstanding shares of Voting (b) Stock prior to such acquisition being consummated; or

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          (c) The Major Transaction involves solely the Corporation and a Subsidiary none of whose stock is Beneficially Owned by a Related Person (other than Beneficial Ownership arising solely because of control of the Corporation); provided that each shareholder of the Corporation receives the same type of consideration in such transaction in proportion to his stock holdings; or

          (d) Prior to becoming a Related Person, such Related Person made a tender offer for Voting Stock which (i) conformed in all respects to federal laws and regulations governing such a transaction whether or not the Corporation or such stock was then regulated by or registered under said laws, (ii) committed such Related Person to take all shares tendered if it took any shares, and (iii) resulted in such Related Person acquiring at least 75% of the shares of each class of Voting Stock held by persons other than such Related Person; or

          (e) All the following conditions are satisfied:

               (1) The cash or Fair Market Value of the property, securities or other consideration to be received per share (as adjusted for stock splits, stock dividends, reclassification of shares into a lesser number and similar events) by holders of Common Stock of the Corporation in the Major Transaction is not less than the higher of (i) the highest per share price (including brokerage commissions, soliciting dealer’s fees, dealer-management compensation, and other expenses, including, but not limited to, costs of newspaper advertisements, printing expenses and attorneys’ fees, paid by such Related Person in acquiring any of its holdings of the Corporation’s Common Stock or (ii) an amount which bears the same or a greater percentage relationship to the Market Price of the Corporation’s Common Stock immediately prior to the announcement of such Major Transaction as the highest per share price determined in (i) above bears to the Market Price of the Corporation’s Common Stock immediately prior to the commencement of acquisition of the Corporation’s Common Stock by such Related Person; and

               (2) After becoming a Related Person and prior to the consummation of such Major Transaction, (i) such Related Person shall not have acquired any shares of stock, directly or indirectly, from the Corporation or a Subsidiary (except upon conversion of convertible securities acquired by it prior to becoming a Related Person or upon compliance with the provisions of this Article VIII or as a result of a pro rata stock dividend or stock split) and (ii) such Related Person shall not have received the benefit, directly or indirectly (except proportionately as a shareholder), of any loans, advances, guarantees, pledges or other financial assistance or tax credits provided by the Corporation or a Subsidiary, or made any major changes in the Corporation’s business or equity capital structure without the unanimous vote of the members of the Board then in office; and

               (3) A proxy statement responsive to the requirements of the Securities Exchange Act of 1934, whether or not the Corporation is then subject to such requirements, shall be mailed to all shareholders of the Corporation for the purpose of soliciting shareholder approval of such Major Transaction and shall contain at the front thereof, in a prominent place any recommendations as to the advisability (or inadvisability) of the Major Transaction which the Continuing Directors, or any Outside Directors, may choose to state.

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     2. The Board of Directors of the Corporation shall have the power and duty to determine for the purposes of this Article VIII, on the basis of information known to the Corporation, whether (a) any corporation, person or other entity “Beneficially Owns,” directly or indirectly, more than twenty percent (20%) of the shares of the Voting Stock, (b) any corporation, person or other entity is an Affiliate or Associate of another and (c) any proposed sale, lease, exchange or other disposition of part of the assets of the Corporation or any of its Affiliates involves a Substantial Part of the assets of the Corporation or such Affiliate, provided that assets involved in any single transaction or series of related transactions having an aggregate fair market value of more than fifteen percent (15%) of the total consolidated assets of the Corporation and its Affiliates shall always be deemed to constitute a “Substantial Part” for purposes of this Article VIII. Any such determination made in good faith shall be conclusive and binding for all purposes of this Article VIII.

     3. Nothing contained in this Article VIII shall be construed to relieve any Related Person from any fiduciary obligation imposed by law.

ARTICLE IX
RESTRICTIONS ON SHARE REPURCHASES AND OTHER TRANSACTIONS

     1. Any purchase by the Corporation of shares of Voting Stock from an Interested Shareholder, other than pursuant to an offer to the holders of all of the outstanding shares of the same class of Voting Stock as those so purchased, at a per share price in excess of the Market Price at the time of such purchase of the shares so purchased, shall require the affirmative vote of the holders of that amount of the voting power of the Voting Stock equal to the sum of (i) the voting power of the shares of Voting Stock of which the Interested Shareholder is the Beneficial Owner and (ii) a majority of the voting power of the remaining outstanding shares of Voting Stock, voting together as a single class.

     2. In addition to any affirmative vote required by law or these Articles of Incorporation:

          (a) any merger or consolidation of the Corporation or any Subsidiary with (1) any Interested Shareholder or (2) any other corporation (whether or not itself an Interested Shareholder) which is, or after such merger or consolidation would be, an Affiliate of an Interested Shareholder; or

          (b) any sale, lease, exchange, mortgage, pledge, transfer or other disposition (in one transaction or a series of transactions) to or with any Interested Shareholder or any Affiliate of any Interested Shareholder of any assets of the Corporation or any Subsidiary having an aggregate Fair Market value of $2,000,000 or more; or

          (c) the issuance or transfer by the Corporation or any Subsidiary (in one transaction or a series of transactions) of any securities of the Corporation or any Subsidiary having an aggregate Fair Market Value of $2,000,000 or more to any Interested Shareholder or any Affiliate of any Interested Shareholder in exchange for cash, securities or other property (or a combination thereof); or

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          (d) the adoption of any plan or proposal for the liquidation or dissolution of the Corporation proposed by or on behalf of an Interested Shareholder or any Affiliate of any Interested Shareholder; or

          (e) any reclassification of securities (including any reverse stock split), or recapitalization of the Corporation, or any merger or consolidation of the Corporation with any Subsidiary or any other transaction (whether or not with or into or otherwise involving an Interested Shareholder) which has the effect, directly or indirectly, of increasing the proportionate share of the outstanding shares of any class of equity or convertible securities of the Corporation or any Subsidiary which is directly or indirectly owned by any Interested Shareholder or any Affiliate of any Interested Shareholder;

shall require either (a) the approval of a majority of the Disinterested Directors or (b) the affirmative vote of the holders of that amount of voting power of the Voting Stock equal to the sum of (1) the voting power of the shares of Voting Stock of which the Interested Shareholder is the Beneficial Owner and (2) a majority of the voting power of the remaining outstanding shares of Voting Stock, voting together as a single class; provided, however, that no such vote shall be required for (i) the purchase by the Corporation of shares of Voting Stock from an Interested Shareholder unless such vote is required by Section 1 of this Article IX, (ii) any transaction with an Interested Shareholder who is also a Related Person as defined in Article VII and to which the provisions of Article VIII apply and are complied with, or (iii) any transaction with an Interested Shareholder who has Beneficially Owned all his shares of Voting Stock for two years or more.

     3. At any election of directors of the Corporation on or after the date on which any Substantial Shareholder becomes a Substantial Shareholder, and until such time as there is no longer any Substantial Shareholder, there shall be cumulative voting for election of directors so that any holder of shares of Voting Stock entitled to vote in such election shall be entitled to as many votes as shall equal the number of directors to be elected multiplied by the number of votes to which such shareholder’s shares would be entitled except for the provisions of this Section 3, and such shareholder may cast all of such votes for a single director, or distribute such votes among as many candidates as such shareholder sees fit. In any such election of directors, one or more candidates for the Board may be nominated by a majority of the Disinterested Directors and by any person who is the Beneficial Owner of 1% or more of the outstanding shares of Voting Stock. With respect to any candidates nominated by a majority of the Disinterested Directors or by any person who is the Beneficial Owner of 1% or more of the outstanding shares of Voting Stock, there shall be included in any proxy statement or other communication with respect to such election to be sent to holders of shares of Voting Stock by the Corporation during the period in which there is a Substantial Shareholder, at the expense of the Corporation, descriptions and other statements of or with respect to such candidates submitted by them or on their behalf, which shall receive equal space, coverage and treatment as is received by candidates nominated by the Board or management of the Corporation provided that such information is received on a timely basis and complies with applicable federal and state securities laws.

     4. It shall be the duty of any Interested Shareholder:

          (a) to give or cause to be given written notice to the Corporation, immediately upon becoming an Interested Shareholder, of such person’s status as an Interested Shareholder

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and of such other information as the Corporation may reasonably require with respect to identifying all owners and amount of ownership of the outstanding Voting Stock of which such Interested Shareholder is a Beneficial Owner, and

          (b) to notify the Corporation promptly in writing of any change in the information provided in subparagraph (a) of this Section 4; provided, however, that the failure of an Interested Shareholder to comply with the provisions of this Section 4 shall not in any way be construed to prevent the Corporation from enforcing the provisions of Sections 1 through 3 of this Article IX.

     5. A majority of the Disinterested Directors of the Corporation shall have the power and duty to determine for the purposes of this Article IX, on the basis of information known to them after reasonable inquiry, (a) whether a person is an Interested Shareholder or a Substantial Shareholder, (b) the number of shares of Voting Stock Beneficially Owned by any person, (c) whether a person is an Affiliate or an Associate of another person and (d) whether a transaction or a series of transactions constitutes one of the transactions specified in Section 2 hereof. The good faith determination of a majority of the Disinterested Directors shall be conclusive and binding for all purposes of this Article IX.

ARTICLE X
ELECTION OF DIRECTORS

     1. The number of directors of the Corporation shall be specified in the Bylaws, and such number may from time to time be increased or decreased in such manner as may be prescribed in the Bylaws, provided the number of directors of the Corporation shall not be less than seven (7).

     2. Directors shall be classified with respect to the time for which they shall severally hold office by dividing them into three classes, as nearly equal in number as possible. Those of the first class shall be elected for a term of office to expire at the first annual meeting of shareholders after their election, those of the second class shall be elected for a term of office to expire at the second annual meeting of shareholders after their election, and those of the third class shall be elected for a term of office to expire at the third annual meeting of shareholders after their election. Thereafter, the class of directors then being elected shall be elected to hold office for a term of office to expire at the third succeeding annual meeting of shareholders after their election. Each director shall hold office for the term for which elected and until such director’s successor shall have been elected and qualified.

     3. At a meeting of shareholders called expressly for that purpose, any director, any class of directors, or the entire Board of Directors may be removed from office as a director at any time (a) for cause by the shareholders entitled to elect such director if the number of votes cast to remove the director exceeds the number of votes cast not to remove the director, and if cumulative voting is then in effect, then a director may not be removed if the number of votes sufficient to elect such director is voted against the director’s removal, or (b) without cause by the affirmative vote which satisfies the requirements of Article XI applicable to an amendment, modification, or repeal of certain of these Articles.

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     4. Vacancies in the Board of Directors, including vacancies resulting from an increase in the number of directors, shall be filled only by the affirmative vote of a majority of the remaining directors then in office, though less than a quorum, or by the sole remaining director. The term of a director elected to fill a vacancy shall expire at the next annual meeting of shareholders at which directors are elected. No decrease in the number of directors constituting the Board of Directors shall shorten the term of any incumbent director.

     5. All corporate powers shall be exercised by the Board of Directors except as otherwise provided by law or these Articles of Incorporation.

     6. Except as otherwise provided in these Articles of Incorporation, shareholders of the Corporation shall not have the right to cumulate votes in the election of directors.

ARTICLE XI
RESTRICTIONS ON CERTAIN AMENDMENTS

     The provisions set forth in this Article XI and in Articles III, VII, VIII, IX, X and XVII herein may not be repealed or amended in any respect, unless such action is approved by the affirmative vote of the holders of not less than 80% of the outstanding shares of Voting Stock of the Corporation, subject to the provisions of any series of Preferred Stock which may at the time be outstanding, provided, however, that if there is a shareholder of the Corporation which is a Related Person, such 80% vote must include the affirmative vote of at least 50% of the outstanding Voting Stock held by shareholders other than the Related Person.

ARTICLE XII
POWERS OF DIRECTORS

     The directors shall have power to make and to alter or amend the Bylaws and shall have all such other powers as they may be afforded by applicable law.

ARTICLE XIII
LIMITATION OF LIABILITY

     To the fullest extent permitted by the Washington Business Corporation Act as the same exists or may hereafter be amended, a director of the Corporation shall not be liable to the Corporation or its shareholders for monetary damages for conduct as a director. Any amendments to or repeal of this Article XIII shall not adversely affect any right or protection of a director for or with respect to any acts or omissions of such director occurring prior to such amendment or repeal.

ARTICLE XIV
INDEMNIFICATION OF DIRECTORS, OFFICERS, EMPLOYEES AND AGENTS

     1. The Corporation shall have the following powers:

          (a) The Corporation may indemnify and hold harmless to the fullest extent not prohibited by applicable law each person who was or is made a party to or is threatened to be made a party to or is involved (including, without limitation, as a witness) in any actual or

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threatened action, suit or other proceeding, whether civil, criminal, derivative, administrative or investigative, by reason of the fact that he or she is or was a director, officer, employee or agent of the Corporation or, being or having been such a director, officer, employee or agent, he or she is or was serving at the request of the Corporation as a director, officer, employee, agent, trustee, or in any other capacity of another corporation or of a partnership, joint venture, trust or other enterprise, including service with respect to employee benefit plans, whether the basis of such proceeding is alleged action or omission in an official capacity or in any other capacity while serving as a director, officer, employee, agent, trustee or in any other capacity, against all expense, liability and loss (including, without limitation, attorneys’ fees, judgments, fines, ERISA excise taxes or penalties and amounts to be paid in settlement) actually or reasonably incurred or suffered by such person in connection therewith. Such indemnification may continue as to a person who has ceased to be a director, officer, employee or agent of the Corporation and shall inure to the benefit of his or her heirs and personal representatives.

          (b) The Corporation may pay expenses incurred in defending any such proceeding in advance of the final disposition of any such proceeding; provided, however, that the payment of such expenses in advance of the final disposition of a proceeding shall be made to or on behalf of a director, officer, employee or agent only upon delivery to the Corporation of an undertaking, by or on behalf of such director, officer, employee or agent, to repay all amounts so advanced if it shall ultimately be determined that such director, officer, employee or agent is not entitled to be indemnified under this Article XIV or otherwise, which undertaking may be unsecured and may be accepted without reference to financial ability to make repayment.

          (c) The Corporation may enter into contracts with any person who is or was a director, officer, employee or agent of the Corporation in furtherance of the provisions of this Article XIV and may create a trust fund, grant a security interest in property of the Corporation, or use other means (including, without limitation, a letter of credit) to ensure the payment of such amounts as may be necessary to effect indemnification as provided in this Article XIV.

          (d) If the Washington Business Corporation Act (the “Act”) is amended in the future to expand or increase the power of the Corporation to indemnify, to pay expenses in advance of final disposition, to enter into contracts, or to expand or increase any similar or related power, then, without any further requirement of action by the shareholders or directors of the Corporation, the powers described in this Article XIV shall be expanded and increased to the fullest extent permitted by the Act, as so amended.

          (e) No indemnification shall be provided under this Article XIV to any such person if the Corporation is prohibited by the nonexclusive provisions of the Act or other applicable law as then in effect from paying such indemnification. For example, no indemnification shall be provided to any director in respect of any proceeding, whether or not involving action in his or her official capacity, in which he or she shall have been finally adjudged to be liable on the basis of intentional misconduct or knowing violation of law by the director, or from conduct of the director in violation of Section 23B.08.310 of the Act, or that the director personally received a benefit in money, property or services to which the director was not legally entitled.

13

     2. The Corporation shall indemnify and hold harmless any person who is or was a director or officer of the Corporation, and pay expenses in advance of final disposition of a proceeding, to the full extent to which the Corporation is empowered.

     3. The Corporation may, by action of its Board of Directors from time to time, indemnify and hold harmless any person who is or was an employee or agent of the Corporation, and pay expenses in advance of final disposition of a proceeding, to the full extent to which the Corporation is empowered, or to a lesser extent which the Board of Directors may determine.

     4. The rights to indemnification and payment of expenses in advance of final disposition of a proceeding conferred by or pursuant to this Article XIV shall be contract rights.

     5. A director, officer, employee or agent (“claimant”) shall be presumed to be entitled to indemnification and/or payment of expenses under this Article XIV upon submission of a written claim (and, in an action brought to enforce a claim for expenses incurred in defending any proceeding in advance of its final disposition, where the undertaking in subsection 1(b) above has been delivered to the Corporation) and thereafter the Corporation shall have the burden of proof to overcome the presumption that the claimant is so entitled.

     If a claim under this Article XIV is not paid in full by the Corporation within sixty (60) days after a written claim has been received by the Corporation, except in the case of a claim for expenses incurred in defending a proceeding in advance of its final disposition, in which case the applicable period shall be twenty (20) days, the claimant may at any time thereafter bring suit against the Corporation to recover the unpaid amount of the claim and, to the extent successful in whole or in part, the claimant shall be entitled to be paid also the expense of prosecuting such claim. Neither the failure of the Corporation (including its board of directors, its shareholders or independent legal counsel) to have made a determination prior to the commencement of such action that indemnification of or reimbursement or advancement of expenses to the claimant is proper in the circumstances nor an actual determination by the Corporation (including its board of directors, its shareholders or independent legal counsel) that the claimant is not entitled to indemnification or to the reimbursement or advancement of expenses shall be a defense to the action or create a presumption that the claimant is not so entitled.

     6. The right to indemnification and payment of expenses in advance of final disposition of a proceeding conferred in this Article XIV shall not be exclusive of any other right which any person may have or hereafter acquire under any statute, provision of the articles of incorporation, bylaws, agreement, vote of shareholders or disinterested directors or otherwise.

     7. The Corporation may purchase and maintain insurance, at its expense, to protect itself and any director, officer, employee, agent or trustee of the Corporation or another corporation, partnership, joint venture, trust or other enterprise against any expense, liability or loss, whether or not the Corporation would have the power to indemnify such person against such expense, liability or loss under the Act.

     8. Any repeal or modification of this Article XIV shall not adversely affect any right of any person existing at the time of such repeal or modification.

14

     9. If any provision of this Article XIV or any application thereof shall be invalid, unenforceable or contrary to applicable law, the remainder of this Article XIV, or the application of such provision to persons or circumstances other than those as to which it is held invalid, unenforceable or contrary to applicable law, shall not be affected thereby and shall continue in full force and effect.

     10. For purposes of this Article XIV, applicable law shall at all times be construed as the applicable law in effect at the date indemnification may be sought, or the law in effect at the date of the action, omission or other event giving rise to the situation for which indemnification may be sought, whichever is selected by the person seeking indemnification. As of the date hereof, applicable law shall include Section 23B.08.500 through .600 of the Act.

ARTICLE XV
MERGERS, SHARE EXCHANGES, AND OTHER TRANSACTIONS

     Except as otherwise expressly provided in these Articles, a merger, share exchange, sale of substantially all of the Corporation’s assets, or dissolution must be approved by the affirmative vote of a majority of the Corporation’s outstanding shares entitled to vote, or if separate voting by voting groups is required, then by not less than a majority of all the votes entitled to be cast by that voting group.

ARTICLE XVI
CORPORATION’S ACQUISITION OF ITS OWN SHARES

     The Corporation may purchase, redeem, receive, take or otherwise acquire, own and hold, sell, lend, exchange, transfer or otherwise dispose of, pledge, use and otherwise deal with and in its own shares. As a specific modification of Section 231B.06.310 of the Act, pursuant to the authority in Section 23B.02.020(5)(c) of the Act to include provisions related to the management of the business and the regulation of the affairs of the Corporation, shares of the Corporation’s stock acquired by it pursuant to this Article XVI shall be considered “Treasury Stock” and so held by the Corporation. The shares so acquired by the Corporation shall not be considered as authorized and unissued but rather as authorized, issued, and held by the Corporation. The shares so acquired shall not be regarded as canceled or as a reduction to the authorized capital of the Corporation unless specifically so designated by the Board of Directors in an amendment to these Articles. The provisions of this Article XVI do not alter or effect the status of the Corporation’s acquisition of its shares as a “distribution” by the Corporation as defined in Section 23B.01.400(6) of the Act, nor alter or effect the limitations on distributions by the Corporation as set forth in Section 23B.06.400 of the Act. Any shares so acquired by the Corporation, unless otherwise specifically designated by the Board of Directors, at the time of acquisition, shall be considered on subsequent disposition as transferred rather than reissued. Nothing in this Article XVI limits or restricts the right of the Corporation to resell or otherwise dispose of any of its shares previously acquired for such consideration and according to such procedures as established by the Board of Directors.

15

ARTICLE XVII
SPECIAL SHAREHOLDER MEETINGS

     Special meetings of the shareholders of the Corporation for any purpose or purposes may be called at any time by the Board of Directors, or by a committee of the Board of Directors which has been duly designated by the Board of Directors and whose powers and authority, as provided in a resolution of the Board of Directors or in the bylaws of the Corporation, include the power to call such meeting, but such special meetings may not be called by any other person or persons.

ARTICLE XVIII
INCORPORATOR

     The name and address of the incorporator are: Edmund O. Belsheim, Jr., Two Union Square, 601 Union Street, Seattle, Washington 98101.

     Dated: November 10, 1995.

/s/ Jeffrey T. Cook  

Jeffrey T. Cook 

Vice President and Chief Financial Officer 

16

EX-10.1

EXHIBIT 10.1

PENFORD CORPORATION

DEFERRED COMPENSATION PLAN

Effective September 1, 1989

Restated September 1, 2001

TABLE OF CONTENTS

	PAGE
ARTICLE I—PURPOSE		1
1.1 Purpose		1
1.2 Effective Date		1
ARTICLE II—DEFINITIONS		1
2.1 Account		1
2.2 Base Annual Salary		1
2.3 Beneficiary		1
2.4 Board		1
2.5 Bonus		2
2.6 Change in Control		2
2.7 Committee		2
2.8 Compensation		2
2.9 Corporation		2
2.10 Deferral Commitment		3
2.11 Deferral Period		3
2.12 Determination Date		3
2.13 Director		3
2.14 Early Retirement Date		3
2.15 Elective Deferred Compensation		3
2.16 Executive		3
2.17 Fees		3
2.18 Financial Hardship		3
2.19 Interest		4
2.20 Normal Retirement Date		4
2.21 Participant		4
2.22 Participation Agreement		4
2.23 Plan		4
2.24 Plan Benefit		4
2.25 Plan Year		4
2.26 Retirement		5
2.27 Retirement Plan		5
2.28 Termination		5
ARTICLE III—ELIGIBILITY AND DEFERRAL COMMITMENTS		5
3.1 Eligibility and Participation		5
3.2 Deferral Election		5
3.3 Modification of Deferral Commitment		6

(i)

TABLE OF CONTENTS

	PAGE
ARTICLE IV—DEFERRED COMPENSATION ACCOUNT		6
4.1 Account		6
4.2 Interest; Determination of Accounts		6
4.3 Statement of Account		7
ARTICLE V—PLAN BENEFITS		7
5.1 Plan Benefit		7
5.2 Commencement of Payments		8
5.3 Form of Benefit Payment		8
5.4 Hardship Distributions		8
5.5 Accelerated Distribution		10
5.6 Supplemental Retirement Benefit		10
5.7 Golden Parachute Payments		10
5.8 Withholding on Benefit Payments		10
5.9 Valuation and Settlement		10
5.10 Payment to Guardian		10
ARTICLE VI—BENEFICIARY DESIGNATION		11
6.1 Beneficiary Designation		11
6.2 Changes to Designation		11
6.3 Change in Marital Status		11
6.4 No Beneficiary Designation		12
6.5 Effect of Payment		12
ARTICLE VII—ADMINISTRATION		12
7.1 Committee; Duties		12
7.2 Agents		12
7.3 Binding Effect of Decisions		12
7.4 Indemnity of Committee		12
ARTICLE VIII—CLAIMS PROCEDURE		13
8.1 Claim		13
8.2 Denial of Claim		13
8.3 Review of Claim		13
8.4 Final Decision		13
ARTICLE IX—AMENDMENT AND TERMINATION OF THE PLAN		13
9.1 Amendment		13
9.2 Corporation’s Right to Terminate		14

(ii)

TABLE OF CONTENTS

	PAGE
ARTICLE X—MISCELLANEOUS		15
10.1 Unfunded Plan		15
10.2 Unsecured General Creditor		15
10.3 Trust Fund		15
10.4 Nonassignability		15
10.5 Not a Contract of Employment		16
10.6 Protective Provisions		16
10.7 Governing Law		16
10.8 Validity		16
10.9 Notice		16
10.10 Successors		17

(iii)

PENFORD CORPORATION

DEFERRED COMPENSATION PLAN

ARTICLE I—PURPOSE

1.1 Purpose

     Penford Corporation (the “Corporation”) adopts this Deferred Compensation Plan (the “Plan”) to provide current tax planning opportunities as well as supplemental funds for Retirement or death for certain employees and Directors of the Corporation. It is intended that the Plan will aid in attracting and retaining employees and Directors of exceptional ability by providing them with this benefit.

1.2 Effective Date

     The Plan, effective as of September 1, 1989 and restated September 1, 1996, is amended by this restatement, as of September 1, 2001.

ARTICLE II—DEFINITIONS

     For purposes of this Plan, the following terms shall have the meanings indicated, unless the context clearly indicates otherwise:

2.1 Account

     “Account” means the record maintained by the Corporation for each Participant in accordance with Article IV with respect to any deferral of Compensation or Fees pursuant to this Plan.

2.2 Base Annual Salary

     “Base Annual Salary” means the annual compensation payable to an Executive, excluding Bonuses and noncash compensation.

2.3 Beneficiary

     “Beneficiary” means the person, persons or entity designated under Article VI to receive any Plan Benefits payable after a Participant’s death.

2.4 Board

     “Board” means the Compensation and Benefits Committee of the Board of Directors of Penford Corporation or any successor thereto.

PAGE 1 - DEFERRED COMPENSATION PLAN

2.5 Bonus

     “Bonus” means the compensation derived under the Corporation’s “Management Incentive Plan” and payable in any year in a lump sum to an Executive.

2.6 Change in Control

     A Change in Control shall have occurred if:

     (a) Any Person is or becomes the beneficial owner, directly or indirectly, of securities of the Corporation representing more than fifty percent (50%) of the voting power of the outstanding Voting Stock,

     (b) The effective date of a merger, consolidation, reorganization or dissolution in which the Corporation is not the surviving entity, or

     (c) During any period of two (2) consecutive years, individuals who constitute the Board of Directors of the Corporation at the beginning of any such period cease for any reason to constitute at least a majority thereof, unless the election, or the nomination for election by the Corporation’s shareholders, of each new director was approved by a vote of at least two-thirds (2/3) of the directors then still in office who were directors of the Corporation at the beginning of such period. “Person” means an individual, firm, corporation or other entity, together with all Affiliates and Associates of such Person, but shall not include the Corporation, any subsidiary of the Corporation or any employee benefit plan of the Corporation. “Affiliate” and “Associate” shall have the respective meanings ascribed to such terms in Rule 12b-2 of the Securities Exchange Act of 1934, as amended. “Voting Stock” means the common stock of the Corporation and any other shares entitled to vote for the election of directors of the Corporation.

2.7 Committee

     “Committee” means a committee of three (3) persons appointed by the Chief Executive Officer of the Company to administer the Plan pursuant to Article VII.

2.8 Compensation

     “Compensation” means the following, determined before reduction for amounts deferred under this Plan:

     (a) For an Executive, the total Base Annual Salary and Bonus remuneration payable by the Corporation to the Executive for services.

     (b) For a Director, all of the fees payable by the Corporation for service on the Board.

2.9 Corporation

     “Corporation” means Penford Corporation, a Washington corporation, or any successor thereto, and any corporations or other entities affiliated with or subsidiary to it that may be selected by the Board.

PAGE 2 - DEFERRED COMPENSATION PLAN

2.10 Deferral Commitment

     “Deferral Commitment” means a Base Annual Salary Deferral Commitment or a Bonus Deferral Commitment made by an Executive or a Fee Deferral Commitment made by a Director pursuant to Article III and for which a Participation Agreement has been submitted by the Executive or Director to the Committee.

2.11 Deferral Period

     “Deferral Period” means the period during which a Participant has elected to defer a portion of his Compensation. The Deferral Period shall be a Plan Year.

2.12 Determination Date

     “Determination Date” means the last day of each calendar month.

2.13 Director

     “Director” means a member of the Board.

2.14 Early Retirement Date

     “Early Retirement Date” means the date on which a Participant terminates employment with Employer, the earlier of the date on or after such Participant’s attainment of age fifty-five (55) and completion of twenty (20) Years of Service or age sixty-two (62) and completion of ten (10) Years of Service, but prior to the Participant’s Normal Retirement Date.

2.15 Elective Deferred Compensation

     “Elective Deferred Compensation” means the amount of Compensation or Fees that the Executive or Director elects to defer pursuant to a Deferral Commitment.

2.16 Executive

     “Executive” means one of a select group of management or highly compensated employees of the Corporation, as designated by the Committee and approved by the Board for participation in the Plan.

2.17 Fees

     “Fees” means Board meeting, committee meeting, annual retainer and committee chairmanship fees.

2.18 Financial Hardship

     “Financial Hardship” means a severe financial hardship to the Participant resulting from a sudden and unexpected illness or accident of the Participant or of a dependent of the Participant, loss of the Participant’s property due to casualty, or other similar extraordinary and unforeseeable circumstances arising as a result of events beyond the control of the Participant. Financial Hardship shall be determined by the

PAGE 3 - DEFERRED COMPENSATION PLAN

Committee on the basis of information supplied by the Participant in accordance with the standards set forth by the Committee.

2.19 Interest

     “Interest” means the monthly equivalent of an annual yield that is two (2) percentage points higher than the annual yield of the Moody’s Average Corporate Bond Yield Index for the preceding month, as published by Moody’s Investor Service, Inc. (or any successor thereto), or, if such index is no longer published, a substantially similar index selected by the Board. At no time shall the Interest Rate be less than six percent (6%) annually.

2.20 Normal Retirement Date

     “Normal Retirement Date” means the date on which a Participant terminates employment with Employer on or after such Participant’s attainment of age sixty-five (65).

2.21 Participant

     “Participant” means an Executive or Director who has elected to defer Compensation or Fees during any Deferral Period.

2.22 Participation Agreement

     “Participation Agreement” means the agreement submitted by an Executive or Director to the Committee prior to the beginning of the Deferral Period, with respect to one (1) or more Deferral Commitments made for such Deferral Period.

2.23 Plan

     “Plan” means this Deferred Compensation Plan as amended from time to time.

2.24 Plan Benefit

     “Plan Benefit” means:

     (a) The Deferred Compensation Account benefit payable to a Participant as calculated pursuant to Article IV and payable under Sections 5.1 through 5.5; and

     (b) The Supplemental Retirement Benefit payable to an Executive under Section 5.6.

2.25 Plan Year

          “Plan Year” means the fiscal year of the Corporation.

PAGE 4 - DEFERRED COMPENSATION PLAN

2.26 Retirement

     “Retirement” means:

     (a) For an Executive, termination from service on or after the Early Retirement Date or Normal Retirement Date. The Committee, in its sole discretion, may deem any separation from service as a Retirement.

     (b) For a Director, termination from service on the Board at or after age seventy (70).

2.27 Retirement Plan

     “Retirement Plan” means the Penford Corporation Retirement Plan effective March 1, 1984 as amended from time to time.

2.28 Termination

     Termination means:

     (a) For an Executive, leaving employment with the Corporation prior to Retirement.

     (b) For a Director, leaving the Board prior to Retirement.

ARTICLE III—ELIGIBILITY AND DEFERRAL COMMITMENTS

3.1 Eligibility and Participation

     (a) Eligibility. The Committee shall specify the name of each Executive who shall be initially entitled to participate in the Plan as of the next succeeding Plan Year. These names shall be submitted to the Board for approval. Once designated eligible, an Executive may participate in the Plan each year without further approval until such time, if any, that the Committee determines that the Executive’s employment status no longer deserves reward through participation in the Plan. Notwithstanding that determination, no account shall be paid out until Retirement or Termination. All Directors are eligible to participate each year.

     (b) Participation. An eligible individual may elect to participate in the Plan with respect to any Deferral Period by submitting a Participation Agreement to the Committee by the thirtieth (30^th) day of the month immediately preceding the beginning of the Deferral Period.

     (c) Part-Year Participation. When an individual first becomes eligible to participate during a Deferral Period, a Participation Agreement may be submitted to the Committee within thirty (30) days following notification of the individual of eligibility to participate, which will be effective only with regard to Compensation earned following such submission.

3.2 Deferral Election

     (a) Election by Executive. Prior to September 1, 2001, an Executive could elect to defer receipt of a certain whole percentage or flat dollar amount, up to fifty percent (50%), of the Base

PAGE 5 - DEFERRED COMPENSATION PLAN

Annual Salary and a certain whole percentage or flat dollar amount, up to one hundred percent (100%), of any Bonus payable to him or her as an employee of the Corporation. Beginning September 1, 2001, an Executive may elect to defer receipt of a certain whole percentage or flat dollar amount, up to twenty-five percent (25%), of the Base Annual Salary and a certain whole percentage or flat dollar amount, up to fifty percent (50%), of any Bonus payable to him or her as an employee of the Corporation for the next Plan Year; provided, however, that any such election to defer shall apply only with respect to Base Annual Salary or any Bonus payable to the Executive by the Corporation prior to the Executive’s termination of employment for any reason.

     (b) Election by Director. A Director may elect to defer receipt of a certain whole percentage or flat dollar amount, up to one hundred percent (100%), of Fees for the next Plan Year.

     (c) Minimum Deferral. Total deferrals by a Participant in a year must be fifteen hundred dollars ($1,500) or more. In any partial first year of participation, no minimum deferral shall be required.

3.3 Modification of Deferral Commitment

     Deferral Commitments shall be irrevocable except that the Committee may, in its sole discretion, reduce the amount to be deferred or waive the remainder of the Deferral Commitment upon a finding that the Participant has suffered a Financial Hardship. A finding of Financial Hardship shall not limit a Participant’s ability to participate in succeeding Deferral Periods. In the event a Participant becomes disabled under the Penford Long-Term Disability Plan, deferrals will be immediately suspended.

ARTICLE IV—DEFERRED COMPENSATION ACCOUNT

4.1 Account

     The Corporation shall establish on its books a separate account for each Participant who elects to defer Compensation under the Plan, and shall credit to the account of each Participant the Elective Deferred Compensation. The credit shall be entered on the Corporation’s books of account at the time that Compensation or Fees not deferred are paid to the Participant. Any withholding of taxes or other amounts with respect to Deferred Compensation that is required by state, federal, or local law shall be withheld from the Participant’s corresponding nondeferred compensation to the maximum extent possible and the remaining amount shall reduce the amount credited to the Participant’s Account.

4.2 Interest; Determination of Accounts

     Each Participant’s Account as of each Determination Date shall consist of the balance of the Participant’s Account as of the immediately preceding Determination Date, plus the Participant’s Elective Deferred Compensation credited and any Interest earned, minus the amount of any distributions made, since the immediately preceding Determination Date. Interest earned shall be calculated as of each Determination Date based upon the average daily balance of the Account since the preceding Determination Date and shall be credited to the Participant’s Account at that time.

PAGE 6 - DEFERRED COMPENSATION PLAN

4.3 Statement of Account

     A report shall be issued by the Corporation to each Participant setting forth his or her Account balance under the Plan as of the immediately preceding Determination Date as soon as practicable after the close of each Plan Year or such other time as the Committee deems appropriate.

ARTICLE V—PLAN BENEFITS

5.1 Plan Benefit

     The Corporation shall pay Plan Benefits pursuant to this Article V equal to the Participant’s Account to each Participant who terminates employment for any reason.

     (a) Early Withdrawals. A Participant’s Account may be distributed to the Participant before Termination of employment or service on the Board as follows:

     (i) Early Withdrawals. A Participant may elect in a Participation Agreement to withdraw all or any portion of the amount deferred by that Participation Agreement as of a date specified in the election. For elections made for a Plan Year prior to September 1, 1996, such withdrawal shall be made for the purchase of a primary residence or the costs of providing a secondary education to a dependent. If at the time the withdrawal is scheduled said reason does not exist, the early withdrawal election shall be null and void. For elections made for a Plan Year beginning September 1, 1996 or thereafter, such withdrawal shall be made for any reason, which reason need not be disclosed by the Participant. Such date shall not be sooner than seven (7) years after the date the Deferral Period commences. The amount withdrawn shall not exceed the amount of Compensation deferred, without Interest.

     (ii) Form of Payment. Withdrawals shall be paid in a lump sum and shall be charged to the Participant’s Account as a distribution.

     (b) Retirement and Termination Benefits. If an Executive terminates employment with Corporation, or if a Director terminates service on the Board, for any reason except death, Corporation shall pay the Participant benefits equal to the balance in the Account.

     (c) Death Benefit.

     (i) Pretermination. If a Participant dies while employed by Corporation or serving on the Board, Corporation shall pay to the Participant’s Beneficiary benefits equal to the balance in the Account. The benefit shall be paid in the form elected by the Participant in the form of payment designation, or, if no such election is on file, in a lump sum.

     (ii) Posttermination. If a Participant dies following the Participant’s Retirement or Termination of employment with Corporation or service on the Board, Corporation shall pay the Participant’s Beneficiary benefits equal to the balance, if any, in the Account. Payments shall continue to be made in the same form as those made to the Participant prior to death.

PAGE 7 - DEFERRED COMPENSATION PLAN

5.2 Commencement of Payments

     (a) Deferred Compensation Account. Payment of any Deferred Compensation Account benefits under the Plan shall be made as of, or commence as of, the earlier of:

     (i) A date elected by the Participant as specified in the applicable Participation Agreement between the Corporation and the Participant; or

     (ii) The settlement date as provided in Section 5.9.

     (b) Supplemental Retirement Benefits. Supplemental Retirement Benefits under Section 5.6 shall be made as of, or commence as of, the earliest date for which a monthly payment is payable to or for the Participant under the Retirement Plan.

5.3 Form of Benefit Payment

     At the time the Participant elects to defer Compensation, the Participant shall also elect the form of benefit payment. The Participant may elect a different form of benefit payment for payments made due to either Retirement, Termination prior to Retirement or Termination within twenty-four (24) months following a Change in Control.

     (a) Alternative Forms. Alternative forms of benefit payment are:

     (i) In equal annual installments, the number of such installments not to exceed ten (10), as designated by the Participant;

     (ii) In a single sum payment; or

     (iii) In a combination of partial lump sum payment, and balance in installments, not to exceed ten (10) years.

     Such election shall be irrevocable.

     (b) Small Accounts. If the Participant’s Account is under five thousand dollars ($5,000) on the valuation date, the benefit shall be paid in a lump sum.

     (c) Installments. If payment is by installments, the amount of the installments shall be redetermined each year on the twelve (12) month anniversary of the valuation date based upon the remaining Account balance, the remaining number of installments and Interest equal to the rate in effect as of the preceding month.

5.4 Hardship Distributions

     Notwithstanding the foregoing provisions of this Article V, payment from the Participant’s Deferred Compensation Account may be made to the Participant or a Beneficiary following the death of a Participant in the sole discretion of the Committee by reason of Financial Hardship. A payment based upon Financial Hardship of the Participant may not exceed the amount required to meet the immediate financial need created by the hardship and not reasonably available from other sources of the Participant.

PAGE 8 - DEFERRED COMPENSATION PLAN

Any resumption of the Participant’s deferrals under the Plan shall be made only at the election of the Participant in accordance with Article III herein.

PAGE 9 - DEFERRED COMPENSATION PLAN

5.5 Accelerated Distribution

     Notwithstanding any other provision of the Plan, within twenty-four (24) months following a Change in Control or at any time following Retirement or Termination of employment or service on the Board, a Participant shall be entitled to receive, upon written request to the Committee, a lump sum distribution equal to ninety percent (90%) of the vested Account balance as of the Determination Date immediately preceding the date on which the Committee receives the written request. The remaining balance of ten percent (10%) shall be forfeited by the Participant. A Participant who receives a distribution under this Section 5.5 shall not participate in the Plan for twelve (12) calendar months following the election. The amount payable under this Section shall be paid in a lump sum within sixty-five (65) days following the receipt of the notice by the Committee from the Participant. Following the death of the Participant, the designated Beneficiary may, at any time, request an accelerated distribution under this Section.

5.6 Supplemental Retirement Benefit

     Employer shall restore an amount equal to any reduction in a Participant’s Retirement Plan or Social Security benefits because of deferrals under this Plan to the extent the Retirement Plan or Social Security benefits are not restored by any other Employer-provided plan or agreement.

5.7 Golden Parachute Payments

     If any benefit payable under this Plan would constitute an excess parachute payment under Section 280G of the Internal Revenue Code of 1986, or any successor provision, the amount payable shall be increased to the extent necessary to result in the Participant’s receiving the same net amount after all applicable taxes have been paid as the net after-tax amount the Participant would have received if the benefit had not been subject to additional taxes due to being treated as an excess parachute payment.

5.8 Withholding on Benefit Payments

     The Corporation shall withhold from payments made hereunder any taxes required to be withheld from such payments under federal, state or local law. However, a Beneficiary may elect not to have withholding for federal income tax purposes pursuant to Section 3405(a)(2) of the Internal Revenue Code, or any successor provision thereto.

5.9 Valuation and Settlement

     The last day of the month following the month of Retirement, Termination or death shall be the valuation date. If a lump sum is elected, the amount of the lump sum shall be based on the value of the Participant’s Account on the valuation date. If a combination of lump sum and installments is elected, the lump sum will be paid on the settlement date and installments will commence on the twelve (12) month anniversary of the valuation date. If installment payments are elected, the amount of the installment payments shall be based on the value of the Participant’s Account on the valuation date. The date on which installment payments commence shall be the settlement date. The settlement date shall be no more than thirty-five (35) days after the valuation date. All payments shall be made as of the first day of the month.

5.10 Payment to Guardian

     If a Plan benefit is payable to a minor or a person declared incompetent or to a person incapable of handling the disposition of property, the Committee may direct payment of such Plan benefit to the

PAGE 10 - DEFERRED COMPENSATION PLAN

guardian, legal representative or person having the care and custody of such minor, incompetent or person. The Committee may require proof of incompetency, minority, incapacity or guardianship as it may deem appropriate prior to distribution of the Plan benefit. Such distribution shall completely discharge the Committee and the Corporation from all liability with respect to such benefit.

ARTICLE VI—BENEFICIARY DESIGNATION

6.1 Beneficiary Designation

     Each Participant shall have the right, at any time, to designate any person or persons or an entity as his Beneficiary or Beneficiaries (both primary as well as secondary) to whom benefits under this Plan shall be paid in the event of a Participant’s death prior to complete distribution of the benefits due under the Plan. Each Beneficiary Designation shall be in written form prescribed by the Committee and will be effective only when filed with the Committee during the Participant’s lifetime. Designation by a married Participant of a Beneficiary other than the Participant’s spouse shall not be effective without spousal execution of a written consent acknowledging the effect of the designation unless such consent cannot be obtained because the spouse cannot be located.

6.2 Changes to Designation

     Any Beneficiary designation may be changed by the Participant without the consent of the previously named Beneficiary by the filing of a new designation with the Committee subject to the spousal consent required in Section 6.1 above. The filing of a new Beneficiary designation shall cancel all designations previously filed, unless the designation clearly indicates that such designation controls the account attributable to deferrals made during the election period in which the designation is filed.

6.3 Change in Marital Status

     If the Participant’s marital status changes after the Participant has designated a Beneficiary, the following shall apply:

     (a) If the Participant is married at death but was unmarried when the designation was made, the designation shall be void unless the spouse has consented to it in the manner prescribed above.

     (b) If the Participant is unmarried at death but was married when the designation was made:

     (i) The designation shall be void if the spouse was named as Beneficiary.

     (ii) The designation shall remain valid if a nonspouse Beneficiary was named.

     (c) If the Participant was married when the designation was made and is married to a different spouse at death, the designation shall be void unless the new spouse has consented to it in the manner prescribed above.

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6.4 No Beneficiary Designation

     If any Participant fails to designate a Beneficiary in the manner provided above, if the designation is void, or if the Beneficiary designated by a deceased Participant dies before the Participant or before complete distribution of the Participant’s benefits, the Participant’s Beneficiary shall be the person in the first of the following classes in which there is a survivor:

     (a) The Participant’s surviving spouse;

     (b) The Participant’s children in equal shares, except that if any of the children predecease the Participant but leave issue surviving, then such issue shall take by right of representation the share the parent would have taken if living;

     (c) The Participant’s estate.

6.5 Effect of Payment

     The payment to the deemed Beneficiary shall completely discharge the Corporation’s obligations under this Plan.

ARTICLE VII—ADMINISTRATION

7.1 Committee; Duties

     This Plan shall be administered by a committee of three (3) persons appointed by the Chief Executive Officer of the Company. The Committee shall have such powers and duties as may be necessary to discharge its responsibilities. These powers shall include, but not be limited to, interpretation of the Plan provisions, determination of amounts due to any Participant, the rights of any Participant or Beneficiary under this Plan, the right to require any necessary information from any Participant, determine the amounts credited to Participant’s Account and Interest earned, and any other activities deemed necessary or helpful.

7.2 Agents

     The Committee may, from time to time, employ other agents and delegate to them such administrative duties as it sees fit, and may from time to time consult with counsel who may be counsel to the Corporation.

7.3 Binding Effect of Decisions

     The decision or action of the Committee in respect of any question arising out of or in connection with the administration, interpretation and application of the Plan and the rules and regulations promulgated hereunder shall be final and conclusive and binding upon all persons having any interest in the Plan.

7.4 Indemnity of Committee

     To the extent permitted by applicable law, the Corporation shall indemnify, hold harmless and defend the members of the Committee against any and all claims, loss, damage, expense or liability aris-

PAGE 12 - DEFERRED COMPENSATION PLAN

ing from any action or failure to act with respect to this Plan, on account of such member’s service on the Committee, except in the case of gross negligence or willful misconduct.

ARTICLE VIII—CLAIMS PROCEDURE

8.1 Claim

     Any person claiming a benefit, requesting an interpretation or ruling under the Plan, or requesting information under the Plan shall present the request in writing to the Committee, which shall respond in writing as soon as practicable.

8.2 Denial of Claim

     If the claim or request is denied, the written notice of denial shall state:

     (a) The reasons for denial, with specific reference to the Plan provisions on which the denial is based,

     (b) A description of any additional material or information required and an explanation of why it is necessary, and

     (c) An explanation of the Plan’s claims review procedure.

8.3 Review of Claim

     Any person whose claim or request is denied or who has not received a response within thirty (30) days may request review by notice given in writing to the Committee. The claim or request shall be reviewed by the Committee who may, but shall not be required to, grant the claimant a hearing. On review, the claimant may have representation, examine pertinent documents, and submit issues and comments in writing.

8.4 Final Decision

     The decision on review shall normally be made within sixty (60) days. If an extension of time is required for a hearing or other special circumstances, the claimant shall be notified and the time limit shall be one hundred twenty (120) days. The decision shall be in writing and shall state the reasons and the relevant Plan provisions. All decisions on review shall be final and bind all parties concerned.

ARTICLE IX—AMENDMENT AND TERMINATION OF THE PLAN

9.1 Amendment

     The Board may at any time amend the Plan in whole or in part provided, however, that no amendment shall be effective to decrease or restrict the amount credited to any Account maintained under the Plan as of the date of amendment. Changes in the definition of “Interest” shall be subject to the following restrictions:

PAGE 13 - DEFERRED COMPENSATION PLAN

     (a) Notice. A change shall not become effective before the first day of the Plan Year which follows the adoption of the amendment and at least thirty (30) days’ written notice of the amendment to the Executive.

     (b) Change in Control. Any change in the definition of Interest after a Change in Control shall apply only to those amounts credited to the Executive’s Account after the Change in Control.

9.2 Corporation’s Right to Terminate

     The Board may at any time partially or completely terminate the Plan if, in its judgment, the tax, accounting, or other effects of the continuance of the Plan, or potential payments thereunder, would not be in the best interests of the Corporation.

     (a) Partial Termination. The Board may partially terminate the Plan by instructing the Committee not to accept any additional Deferral Commitments. In the event of such a partial termination, the Plan shall continue to operate and be effective with regard to Deferral Commitments entered into prior to the effective date of such partial termination.

     (b) Complete Termination. The Board may completely terminate the Plan by instructing the Committee not to accept any additional Deferral Commitments, and terminate all ongoing Deferral Commitments. In the event of such a complete termination, the Plan shall cease to operate and, prior to a Change in Control, the Committee shall pay out to each Participant the balance in his Account in equal annual installments amortized over the period listed below based on the Account balance at the time of such complete termination:

Appropriate Account Balance	Payout Period
Less than $10,000	2 Years
$10,000 but less than $50,000	5 Years
More than $50,000	10 Years

          Interest earned on the unpaid balance in the Participant’s Account shall be the applicable Interest rate on the Determination Date immediately preceding the effective date of such complete termination.

          Upon Plan termination prior to a Change in Control, any Participant who is retired and receiving installment payments will receive the account balance in a lump sum.

          After a Change in Control, the benefits shall be paid to each Participant in the form elected by each Participant.

PAGE 14 - DEFERRED COMPENSATION PLAN

ARTICLE X—MISCELLANEOUS

10.1 Unfunded Plan

     This Plan is intended to be an unfunded plan maintained primarily to provide deferred compensation benefits for a select group of “management or highly-compensated employees” within the meaning of Sections 201, 301, and 401 of the Employee Retirement Income Security Act of 1974, as amended (“ERISA”), and therefore to be exempt from the provisions of Parts 2, 3 and 4 of Title I of ERISA. Accordingly, the Plan shall terminate and no further benefits shall accrue hereunder in the event it is determined by a court of competent jurisdiction or by an opinion of counsel that the Plan constitutes an employee pension benefit plan within the meaning of Section 3(2) of ERISA which is not so exempt. In the event of a termination under this Section 10.1, all ongoing Deferral Commitments shall terminate, no additional Deferral Commitments will be accepted by the Committee, and the amount of each Participant’s Account balance shall be distributed to such Participant at such time and in such manner as the Committee, in its sole discretion, determines.

10.2 Unsecured General Creditor

     Participants and their Beneficiaries, heirs, successors and assigns shall have no legal or equitable rights, interest or claims in any property or assets of the Corporation, nor shall they be Beneficiaries of, or have any rights, claims or interests in any life insurance policies, annuity contracts or the proceeds therefrom owned or which may be acquired by the Corporation. Except as may be provided in Section 10.3, such policies, annuity contracts or other assets of the Corporation shall not be held under any trust for the benefit of the Participants, their Beneficiaries, heirs, successors or assigns, or held in any way as collateral security for the fulfilling of the obligations of the Corporation under this Plan. Any and all of the Corporation’s assets and policies shall be, and remain, the general, unpledged, unrestricted assets of the Corporation. The Corporation’s obligation under the Plan shall be that of an unfunded and unsecured promise to pay money in the future.

10.3 Trust Fund

     The Corporation shall be responsible for the payment of all benefits provided under the Plan. At its discretion, the Corporation may establish one (1) or more trusts, with such trustees as the Board may approve, for the purpose of providing for the payment of such benefits. Although such trust or trusts may be irrevocable, the assets thereof shall be subject to the claims of all the Corporation’s creditors in the event of insolvency. To the extent any benefits provided under the Plan are actually paid from any such trust, the Corporation shall have no further obligation with respect thereto, but to the extent not so paid, such benefits shall remain the obligation of, and shall be paid by, the Corporation.

10.4 Nonassignability

     Neither a Participant nor any other person shall have the right to commute, sell, assign, transfer, pledge, anticipate, mortgage or otherwise encumber, transfer, hypothecate or convey in advance of actual receipt the amounts, if any, payable hereunder, or any part thereof, which are, and all rights to which are, expressly declared to be unassignable and nontransferable. No part of the amounts payable shall, prior to actual payment, be subject to seizure or sequestration for the payment of any debts, judgments, alimony or separate maintenance owed by a Participant or any other person, nor be transferable by operation of law in the event of a Participant’s or any other person’s bankruptcy or insolvency.

PAGE 15 - DEFERRED COMPENSATION PLAN

10.5 Not a Contract of Employment

     The terms and conditions of this Plan shall not be deemed to constitute a contract of employment between the Corporation and the Participant, and the Participant (or the Participant’s Beneficiary) shall have no rights against the Corporation except as may otherwise be specifically provided herein. Moreover, nothing in this Plan shall be deemed to give a Participant the right to be retained in the service of the Corporation or to interfere with the right of the Corporation to discipline or discharge the Participant at any time.

10.6 Protective Provisions

     A Participant will cooperate with the Corporation by furnishing any and all information requested by the Corporation, in order to facilitate the payment of benefits hereunder, and by taking such physical examinations as the Corporation may deem necessary and taking such other actions as may be requested by the Corporation.

10.7 Governing Law

     The provisions of this Plan shall be construed and interpreted according to the laws of the State of Washington, except as preempted by federal law.

10.8 Validity

     If any provision of this Plan shall be held illegal or invalid for any reason, said illegality or invalidity shall not affect the remaining parts hereof, but this Plan shall be construed and enforced as if such illegal and invalid provisions had never been inserted herein.

10.9 Notice

     Any notice or filing required or permitted to be given to the Committee under the Plan shall be sufficient if in writing and hand delivered, or sent by registered or certified mail, to any member of the Committee or the Secretary of the Corporation. Such notice shall be deemed given as of the date of delivery or, if delivery is made by mail, as of the date shown on the postmark on the receipt for registration or certification. Mailed notice to the Committee shall be directed to the Corporation’s address. Mailed notice to a Participant or Beneficiary shall be directed to the individual’s last known address in the Corporation’s records.

PAGE 16 - DEFERRED COMPENSATION PLAN

10.10 Successors

     The provisions of this Plan shall bind and inure to the benefit of the Corporation and its successors and assigns. The term successors as used herein shall include any corporate or other business entity which shall, whether by merger, consolidation, purchase or otherwise acquire all or substantially all of the business and assets of the Corporation, and successors of any such corporation or other business entity.

	PENFORD CORPORATION
By:
	President and CEO
Dated:

PAGE 17 - DEFERRED COMPENSATION PLAN

EX-21

Exhibit 21

SUBSIDIARIES OF THE REGISTRANT

Year Ended August 31, 2006

		Percent
Name	Incorporation	Owned
Penford Corporation	Washington
Penford Products Co.	Delaware		100	%
Penford Holdings Pty. Limited	New South Wales, Australia		100	%
Penford Australia Limited	New South Wales, Australia		100	%
Penford New Zealand Ltd.	New Zealand		100	%
Penford Export Corporation	U.S. Virgin Islands		100	%

EX-23

Exhibit 23

Consent of Independent Registered Public Accounting Firm

We consent to the incorporation by reference in the following Registration Statements:

(1)	Registration Statement (Form S-8, No. 333-92356) pertaining to the Penford Corporation 1994 Stock Option Plan,
(2)	Registration Statement (Form S-8, No. 033-88946) pertaining to the Penford Corporation Savings and Stock Ownership Plan,
(3)	Registration Statement (Form S-8, No. 333-133160) pertaining to the Penford Corporation 2006 Long-term Incentive Plan,
(4)	Registration Statement (Form S-8, No. 033-58799) pertaining to the 1994 Stock Option Plan, and
(5)	Registration Statement (Form S-8, No. 333-23433) pertaining to the 1994 Stock Option Plan;

of our report dated November 9, 2006, with respect to the consolidated financial statements of Penford Corporation, our report dated November 9, 2006, with respect to Penford Corporation management’s assessment of the effectiveness of internal control over financial reporting and the effectiveness of internal control over financial reporting of Penford Corporation included in this Annual Report (Form 10-K) of Penford Corporation.

/s/Ernst & Young LLP  

ERNST & YOUNG LLP  

Denver, Colorado
November 9, 2006

EX-24

Exhibit 24

POWER OF ATTORNEY

     KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Thomas D. Malkoski, Steven O. Cordier and Margaret Von der Schmidt and each of them, severally as attorney-in-fact for him or her in any and all capacities to sign the Annual Report on Form 10-K of Penford Corporation for the fiscal year ended August 31, 2006, and to file such document and any amendments, with exhibits thereto, and any other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that said attorney-in-fact, or his or her substitute or substitutes, may do or cause to be done by virtue hereof.

Signature	Date
/s/ William E. Buchholz   William E. Buchholz, Director	October 31, 2006
/s/ Jeffrey T. Cook   Jeffrey T. Cook, Director	October 31, 2006
/s/ R. Randolph Devening   R. Randolph Devening, Director	October 31, 2006
/s/ Paul H. Hatfield   Paul H. Hatfield, Director	October 31, 2006
/s/ John C. Hunter III   John C. Hunter III	October 31, 2006
/s/ Sally G. Narodick   Sally G. Naroldick	October 31, 2006
/s/ James E. Warjone   James E. Warjone	October 31, 2006

EX-31.1

Exhibit 31.1

CERTIFICATIONS

I, Thomas D. Malkoski, certify that:

     1. I have reviewed this annual report on Form 10-K of Penford Corporation;

     2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report;

     3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report;

     4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

     a) designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared;

     b) designed such internal control over financing reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

     c) evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this annual report based on such evaluation; and

     d) disclosed in this annual report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

     5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent functions):

     a) all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

     b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

	PENFORD CORPORATION
Date: November 14, 2006	/s/ Thomas D. Malkoski
	Thomas D. Malkoski
	Chief Executive Officer

EX-31.2

Exhibit 31.2

CERTIFICATIONS

I, Steven O. Cordier, certify that:

     1. I have reviewed this annual report on Form 10-K of Penford Corporation;

     2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report;

     3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report;

     4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

     a) designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared;

     b) designed such internal control over financing reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

     c) evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this annual report based on such evaluation; and

     d) disclosed in this annual report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

     5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent functions):

     a) all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

     b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

	PENFORD CORPORATION
Date: November 14, 2006	/s/ Steven O. Cordier
	Steven O. Cordier
	Chief Financial Officer

EX-32

Exhibit 32

CERTIFICATION PURSUANT TO
SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002
(18 U.S.C.SECTION 1350)

          In connection with the Annual Report of Penford Corporation (the “Company”) on Form 10-K for the period ended August 31, 2006, as filed with the Securities and Exchange Commission (the “Report”), Thomas D. Malkoski, Chief Executive Officer of the Company, and Steven O. Cordier, Chief Financial Officer of the Company, respectively, do each hereby certify, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. Section 1350), that to his knowledge:

          (1) The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and

          (2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

  /s/ Thomas D. Malkoski

Thomas D. Malkoski

Chief Executive Officer

Dated: November 14, 2006

  /s/ Steven O. Cordier

Steven O. Cordier

Chief Financial Officer

Dated: November 14, 2006