BASIS OF PREPARATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Business

Oclaro, Inc., a Delaware corporation, is sometimes referred to in this Annual Report on Form 10-K as “Oclaro,” “we,” “us,” or “our.”

During our fiscal year 2017, we were one of the leading providers of optical components and modules for the long-haul, metro and data center markets. Leveraging more than three decades of laser technology innovation and photonics integration, we provide differentiated solutions for optical networks and high-speed interconnects driving the next wave of streaming video, cloud computing, application virtualization and other bandwidth-intensive and high-speed applications.

Basis of Preparation

The consolidated financial statements include the accounts of Oclaro and our subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation.

The consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America ("GAAP"), which contemplate the continuation of a company as a going concern. As of July 1, 2017, we held $257.5 million in cash, restricted cash and short-term investments, comprised of $219.3 million in cash and cash equivalents, $0.7 million in current restricted cash, and $37.6 million in short-term investments; and we had working capital of $388.6 million.

Use of Estimates

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenue and expenses during the reported periods. Examples of significant estimates and assumptions made by management involve the fair value of other intangible assets and long-lived assets, valuation allowances for deferred tax assets, the fair value of stock-based compensation, the fair value of embedded derivatives related to convertible debt, the fair value of pension liabilities, estimates for allowances for doubtful accounts and valuation of excess and obsolete inventories. These judgments can be subjective and complex and consequently actual results could differ materially from those estimates and assumptions.

Business Combinations and Dispositions

In fiscal year 2014, we sold both our Oclaro Switzerland GmbH subsidiary and associated laser diodes and pump business (the “Zurich Business”) and our optical amplifier and micro-optics business (the “Amplifier Business”) to II-VI Incorporated ("II-VI"). These sales are more fully discussed in Note 3, Business Combinations and Dispositions. These sales are reported as discontinued operations, which require retrospective restatement of prior periods to classify the results of operations as discontinued operations. The notes to our consolidated financial statements relate to our continuing operations only, unless otherwise indicated.

In fiscal year 2015, we sold our industrial and consumer business of Oclaro Japan located at our Komoro, Japan facility to Ushio Opto Semiconductors, Inc. ("Ushio Opto"). The transaction is more fully discussed in Note 3, Business Combinations and Dispositions.

Out of Period Adjustment

In fiscal year 2015, we recorded an out-of-period adjustment of approximately $2.0 million in cost of goods sold in our consolidated statement of operations. The adjustment, which increased cost of goods sold, also increased accrued liabilities and decreased inventory, and was made to correct our fiscal year 2014 inventory valuation and the value of our purchase commitment accrual. We determined that the adjustment did not have a material impact to our current or prior period consolidated financial statements.

Fiscal Years

We operate on a 52/53 week year ending on the Saturday closest to June 30. Our fiscal years ended July 1, 2017, July 2, 2016 and June 27, 2015 had 52 weeks, 53 weeks and 52 weeks, respectively.

Reclassifications

For presentation purposes, we have reclassified certain prior period amounts to conform to the current period financial statement presentation. These reclassifications did not affect our consolidated revenues, net income, cash flows, cash and cash equivalents or stockholders’ equity as previously reported.

Cash and Cash Equivalents

We consider all liquid investment securities with an original maturity date of three months or less to be cash equivalents. Any realized gains and losses on liquid investment securities are included in other income (expense), net in our consolidated statements of operations.

The following table provides details regarding our cash and cash equivalents at the dates indicated:



	July 1, 2017		July 2, 2016
	(Thousands)
Cash and cash equivalents:
Cash-in-bank	$	79,259	$	70,925
Money market funds	99,037		25,004
Commercial paper	22,981		—
Corporate bonds	2,012		—
U.S. agency securities	15,981		—
	$	219,270	$	95,929

As of July 1, 2017, $69.9 million of the $219.3 million of our cash and cash equivalents was held by our foreign subsidiaries. If these funds are needed for our operations in the United States, we could be required to accrue and pay additional taxes to repatriate these funds.

Restricted Cash

As of July 1, 2017, we had restricted cash of $1.1 million, including $0.4 million in other non-current assets, consisting of collateral for the performance of our obligations under certain facility lease agreements, collateral to secure certain of our credit card accounts and deposits for value-added taxes in foreign jurisdictions.

Short-Term Investments

We classify short-term investments, which consist primarily of securities purchased with original maturities at date of purchase of more than three months and less than one year, as “available for sale securities.” These short-term investments are reported at market value, with the aggregate unrealized holding gains and losses reported as a component of accumulated other comprehensive income in stockholders’ equity. All realized gains and losses and unrealized losses resulting from declines in fair value that are other than temporary and not involving credit losses are recorded in the consolidated statements of operations in the period they occur.

The following table provides details regarding our short-term investments at the dates indicated:



	July 1, 2017		July 2, 2016
	(Thousands)
Short-term investments:
Commercial paper	$	23,459	$	—
Corporate bonds	10,094		—
U.S. Treasury securities	4,006		—
	$	37,559	$	—

Concentration of Credit Risks

We place our cash and cash equivalents with and in the custody of financial institutions, which at times, are in excess of amounts insured. Management monitors the ongoing creditworthiness of these institutions. To date, we have not experienced significant losses on these investments.

Our trade accounts receivable are concentrated with companies in the telecom industry. At July 1, 2017, one customer accounted for a total of 20 percent of our net accounts receivable. At July 2, 2016, four customers accounted for a total of 63 percent of our net accounts receivable, with each individually accounting for more than 10 percent of our net accounts receivable.

Allowance for Doubtful Accounts

We perform ongoing credit evaluations of our customers and record specific allowances for doubtful accounts when a customer is unable to meet its financial obligations, as in the case of bankruptcy filings or deteriorated financial position. Estimates are used in determining allowances for customers based on factors such as current trends, the length of time the receivables are past due and historical collection experience. We write off a receivable account when all rights, remedies and recourses against the account and its principals are exhausted and record a benefit when previously reserved accounts are collected. We recorded additional provisions as allowances for doubtful accounts in fiscal year 2015 of less than $0.1 million. In fiscal years 2016 and 2017 we did not record any additional provisions as allowances for doubtful accounts.

Inventories

Inventories, consisting of raw materials, work-in-process and finished goods are stated at the lower of cost (first in, first out basis) or market. We plan production based on orders received and a forecast demand. These production estimates are dependent on assessment of current and expected orders from our customers, including consideration that orders are subject to cancellation with limited advance notice prior to shipment. We assess the valuation of our inventory, including significant inventories held by contract manufacturers on our behalf, on a quarterly basis. Products may be unsalable because they are technically obsolete due to substitute products, specification changes or excess inventory relative to customer forecasts. We adjust the carrying value of inventory using methods that take these factors into account. If we find that the cost basis of our inventory is greater than the current market value, we write the inventory down to the estimated selling price, less the estimated costs to complete and sell the product.

The following table provides details regarding our inventories at the dates indicated:



	July 1, 2017		July 2, 2016
	(Thousands)
Inventories:
Raw materials	$	32,421	$	23,751
Work-in-process	35,094		32,819
Finished goods	33,553		19,799
	$	101,068	$	76,369

Capitalized Software Costs

We capitalize certain development costs incurred in connection with our internal use software once an application has reached the development stage and until the software is substantially complete and ready for its intended use. These costs can include external direct costs of materials and services consumed in the project and internal costs, such as the payroll and benefits expenses attributable to those employees directly associated with the development of the software. Related maintenance and training costs are expensed as incurred. Capitalized software costs are included in property, plant and equipment. We capitalized $9.4 million of internal use software costs during the year ended July 1, 2017, and did not capitalize any internal use software costs during the year ended July 2, 2016.

Property and Equipment

Property and equipment are stated at cost. Depreciation is computed using the straight-line method based upon the estimated useful lives of the assets, which generally range from three to seven years. Leasehold improvements are amortized using the straight-line method over the estimated useful lives or the term of the related lease, whichever is shorter. When assets are retired or otherwise disposed of, the assets and related accumulated depreciation are removed from the accounts. Gains or losses resulting from asset dispositions are included in (gain) loss on sale of property and equipment in the accompanying consolidated statements of operations. Repair and maintenance costs are expensed as incurred.

The following table provides details regarding our property and equipment, net at the dates indicated:



	July 1, 2017			July 2, 2016
	(Thousands)
Property and equipment, net:
Buildings and improvements	$	10,222		$	10,389
Plant and machinery	99,779			59,696
Fixtures, fittings and equipment	3,225			3,005
Computer equipment	15,901			9,846
	129,127			82,936
Less: accumulated depreciation	(14,794		)	(17,891		)
	$	114,333		$	65,045

During the year ended July 1, 2017, we disposed and/or sold approximately $13.0 million of fully depreciated property and equipment related to our high-bit products.

Property and equipment includes assets under capital leases of $3.7 million and $5.9 million at July 1, 2017 and July 2, 2016, respectively. Amortization associated with assets under capital leases is recorded in depreciation expense.

Depreciation expense was $20.8 million, $15.8 million and $17.5 million for the fiscal years ended July 1, 2017, July 2, 2016 and June 27, 2015, respectively.

Other Intangible Assets

We review our other intangible assets for impairment whenever events or changes in circumstances indicate that the carrying amount of these assets may not be recoverable. The values assigned to other intangible assets are based on estimates and judgments regarding expectations for the success and life cycle of products and technologies acquired.

Other intangible assets with definite lives are amortized over their estimated useful lives, which is generally from 1 to 11 years and 15 years as to one specific customer contract.

Impairment of Long-Lived Assets

We review property and equipment and certain identifiable intangibles for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of these assets is measured by comparing their carrying amounts to market prices or the future undiscounted cash flows the assets are expected to generate. If property and equipment or certain identifiable intangibles are considered to be impaired, the impairment to be recognized would equal the amount by which the carrying value of the asset exceeds its fair value based on market prices or future discounted cash flows.

In the fourth quarter of fiscal year 2015, upon completing our impairment assessment, we determined that while no impairment existed, certain of our other intangible assets related to our integrated photonics product line had shorter estimated useful lives than initially anticipated. Accordingly, we adjusted the estimated useful lives of these other intangible assets.

Derivative Financial Instruments

Our operating results are subject to fluctuations based upon changes in the exchange rates between the currencies in which we collect revenues and pay expenses. A majority of our revenues are denominated in U.S. dollars, while a significant portion of our expenses are denominated in United Kingdom (U.K.) pounds sterling, Japanese yen, Chinese yuan and euros, in which we pay expenses in connection with operating our facilities in the United Kingdom, Japan, China and Italy. Historically, we have entered into foreign currency forward exchange contracts in an effort to mitigate a portion of our exposure to exchange rate fluctuations between the U.S. dollar and the U.K. pound sterling.

We recognize all derivatives, such as foreign currency forward exchange contracts, on our consolidated balance sheets at fair value regardless of the purpose for holding the instrument. If the derivative is a hedge, depending on the nature of the hedge, changes in the fair value of the derivative will either be offset against the change in fair value of the hedged assets, liabilities or firm commitments through operating results or recognized in accumulated other comprehensive income until the hedged item is recognized in operating results in our consolidated statements of operations.

During the year ended July 1, 2017, we entered into foreign currency forward exchange contracts, which expired in the same fiscal quarters in which they were opened. In connection with these hedges, during the years ended July 1, 2017 and July 2, 2016, we recorded net losses on foreign currency transactions of $0.5 million and $0.3 million, respectively, within our consolidated statement of operations. At July 1, 2017 and July 2, 2016, we had no outstanding foreign currency forward exchange contracts.

Accrued Expenses and Other Liabilities

The following table provides details for our accrued expenses and other liabilities at the dates indicated:



	July 1, 2017		July 2, 2016
	(Thousands)
Accrued expenses and other liabilities:
Trade payables	$	7,805	$	6,429
Compensation and benefits related accruals	13,837		14,038
Warranty accrual	4,124		3,827
Accrued restructuring, current	—		204
Purchase commitments in excess of future demand, current	4,009		1,723
Other accruals	12,724		8,597
	$	42,499	$	34,818

Warranty

We generally provide a warranty for our products ranging from 12 months to 36 months from the date of sale, although warranties for certain of our products may be longer. We accrue for the estimated costs to provide warranty services at the time revenue is recognized. Our estimate of costs to service our warranty obligations is based on historical experience and expectation of future conditions. To the extent we experience increased warranty claim activity or increased costs associated with servicing those claims, our warranty costs would increase, resulting in a decrease in gross profit.

Revenue Recognition

We recognize product revenue when (i) persuasive evidence of an arrangement exists, (ii) the product has been shipped and title has transferred, (iii) collectability is reasonably assured, (iv) the fees are fixed or determinable and (v) there are no uncertainties with respect to customer acceptance.

Research and Development Costs

Research and development costs are expensed as incurred.

Advertising Costs

Advertising costs are expensed as incurred. Our advertising costs for the years ended July 1, 2017, July 2, 2016 and June 27, 2015 were not significant.

Restructuring Expenses

We record costs associated with employee terminations and other exit activities when the liability is incurred. Employee termination benefits are recorded when the benefit arrangement is communicated to the employee and no significant future services are required. If employees are required to render service until they are terminated in order to receive the termination benefits, the fair value of the termination date liability is recognized ratably over the future service period. Lease cancellation and commitment costs are recorded when we cease using the facility. Lease cancellation and commitment costs are calculated using estimated future lease commitments less estimated sublease income, based on current market conditions. See Note 5, Restructuring Liabilities.

Stock-Based Compensation

We use grant date fair value to value restricted stock awards, restricted stock units and performance shares. We use the Black-Scholes option pricing model to value the fair value of stock options and stock appreciation rights.

We record compensation expense for time-based awards using the straight-line method and estimate forfeitures when recognizing compensation expense, and we adjust our estimate of forfeitures over the requisite service period based on the extent to which actual forfeitures differ, or are expected to differ, from such estimates. Changes in estimated forfeitures are recognized through a cumulative catch-up adjustment in the period of change. Pursuant to our adoption of Accounting Standards Update ("ASC") No. 2016-09, Compensation: Improvements to Employee Share-Based Payment Accounting, in the first quarter of fiscal year 2018, we will transition from estimating forfeitures to recording forfeitures as they occur. This change in accounting principle with regards to forfeitures will be adopted using a modified retrospective approach.

The amount of stock-based compensation expense recognized in any one period related to performance shares can vary based on the achievement or anticipated achievement of the performance conditions. If the performance conditions are not met or not expected to be met, no compensation cost would be recognized on the underlying performance shares, and any previously recognized compensation expense related to those performance shares would be reversed.

Stock options have a term of seven to ten years and generally vest over a two to four year service period, and restricted stock awards and restricted stock units generally vest over a one to four year service period, and in certain cases each may vest earlier based upon the achievement of specific performance-based objectives as set by our board of directors or may be subject to additional vesting conditions based upon achievement of such performance-based objectives.

Foreign Currency Transactions and Translation Gains and Losses

The assets and liabilities of our foreign operations are translated from their respective functional (local) currencies into U.S. dollars at the rates in effect at the consolidated balance sheet dates, and revenue and expense amounts are translated at the average rate during the applicable periods reflected on the consolidated statements of operations. Foreign currency translation adjustments are recorded as accumulated other comprehensive income, except for the translation adjustment of short-term intercompany loans or payables which are recorded as gain (loss) on foreign currency transactions in our consolidated statements of operations. Gains and losses from foreign currency transactions, realized and unrealized in the event of foreign currency transactions not designated as hedges, and those transactions denominated in currencies other than our functional currency, are recorded as gain (loss) on foreign currency transactions in our consolidated statements of operations.

Income Taxes

We account for income taxes using an asset and liability based approach. Deferred income tax assets and liabilities are recorded based on the differences between the financial statement and tax bases of assets and liabilities using enacted tax rates. Valuation allowances are provided against deferred income tax assets which are not likely to be realized.

Net Income (Loss) Per Share

Basic net income (loss) per share is computed using only the weighted-average number of shares of common stock outstanding for the applicable period, while diluted net income (loss) per share is computed assuming conversion of all potentially dilutive securities, such as stock options, stock appreciation rights, unvested restricted stock awards, warrants and shares issuable in connection with convertible notes during such period. For the fiscal year ended June 27, 2015, we excluded such dilutive securities from the computation of diluted shares outstanding since we incurred a net loss from continuing operations in this period and their inclusion would have an anti-dilutive effect.

Recent Accounting Pronouncements

In March 2017, the Financial Accounting Standards Board ("FASB") issued ASU No. 2017-07, Compensation - Retirement Benefits: Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost, changing the presentation of net periodic benefit cost in the income statement. The guidance will be effective for us in the first quarter of fiscal year 2019, with early adoption permitted. We are currently evaluating the likely impact the implementation of this standard will have on our financial statements and footnote disclosures.

In January 2017, the FASB issued ASU No. 2017-01, Business Combinations: Clarifying the Definition of a Business, providing guidance for evaluating whether transactions should be accounted for as acquisitions (or disposals) of assets or businesses. The definition of a business affects many areas of accounting including acquisitions, disposals, goodwill and consolidation. The guidance will be effective for us in the first quarter of fiscal year 2019. We are currently evaluating the likely impact the implementation of this standard will have on our financial statements and footnote disclosures.

In November 2016, the FASB issued ASU No. 2016-18, Statement of Cash Flows: Restricted Cash to standardize the presentation of transfers between cash and restricted cash in the cash flow statement. Amounts described as restricted cash should be included with cash and cash equivalents when reconciling the beginning-of-period and end-of-period total amounts shown on the statement of cash flows. The guidance will be effective for us in the first quarter of fiscal year 2019, with early adoption permitted. We are currently evaluating the likely impact the implementation of this standard will have on our financial statements and footnote disclosures.

In October 2016, the FASB issued ASU No. 2016-16, Income Taxes: Intra-Entity Transfers of Assets Other Than Inventory, to reduce the complexity related to the accounting for the income tax consequences of intra-entity transfers of assets other than inventory. This guidance will be effective for us in the first quarter of fiscal year 2019, with early adoption permitted. We are currently evaluating the likely impact the implementation of this standard will have on our financial statements and footnote disclosures.

In August 2016, the FASB issued ASU No. 2016-15, Statement of Cash Flows: Classification of Certain Cash Receipts and Cash Payments to reduce the diversity in practice related to the presentation and classification of various cash flow scenarios. This guidance will be effective for us in the first quarter of fiscal year 2019, with early adoption permitted. We are currently evaluating the likely impact the implementation of this standard will have on our financial statements and footnote disclosures.

In May 2014 and May 2016, the FASB issued ASU 2014-09, Revenue from Contracts with Customers and ASU 2016-12, Revenue from Contracts with Customers: Narrow-Scope Improvements and Practical Expedients, respectively. These updates clarify the principles for recognizing revenue and develop a common revenue standard for GAAP and International Financial Reporting Standards. The standard outlines a single comprehensive model for entities to use in accounting for revenue arising from contracts with customers and supersedes most current revenue recognition guidance. The guidance permits two methods of adoption, the full retrospective method applying the standard to each prior reporting period presented, or the modified retrospective method with a cumulative effect of initially applying the guidance recognized at the date of initial application. We currently plan on adopting this guidance on July 1, 2018, the start to our first quarter of fiscal year 2019, using the modified retrospective method with a cumulative catch up adjustment and providing additional disclosures comparing results to previous rules. We are currently evaluating the likely impact the implementation of this standard will have on our financial statements and footnote disclosures.

In March 2016, the FASB issued ASU No. 2016-09, Compensation: Improvements to Employee Share-Based Payment Accounting, which simplifies several aspects of the accounting for employee share-based payment transactions, including the income tax consequences, classification of awards, and classification on the statement of cash flows. This guidance will be effective for us in the first quarter of fiscal 2018. Pursuant to the adoption of ASU No. 2016-09, we plan to make the election to record forfeitures when they occur. This change in accounting principle with regards to forfeitures will be adopted using a modified retrospective approach. We expect that the adoption of ASU No. 2016-09 will result in an adjustment of $0.3 million in our accumulated deficit and additional paid-in capital during the first quarter of fiscal year 2018.

In February 2016, the FASB issued ASU No. 2016-02, Leases, which requires recognizing lease assets and lease liabilities on the balance sheet and disclosing key information about leasing arrangements. This guidance will be effective for us in the first quarter of fiscal year 2020, with early adoption permitted. We are currently evaluating the likely impact the implementation of this standard will have on our financial statements and footnote disclosures.