2. Summary of Significant Accounting Policies

Basis of Accounting and Consolidation

The accompanying consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles (U.S. GAAP). Our consolidated financial statements include the accounts of Colt Defense LLC and its wholly-owned subsidiaries. All intercompany transactions and balances have been eliminated in consolidation.

Reclassification of Prior Period Amounts

Certain prior period amounts have been reclassified to conform to the current year’s presentation.

Use of Estimates

The preparation of consolidated financial statements in conformity with U.S. GAAP requires us 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. Actual results could differ materially from those estimates.

Cash and Cash Equivalents

Cash and cash equivalents consists of cash and short-term, highly liquid investments with original maturities of three months or less at the date of purchase.

Restricted Cash

Restricted cash at December 31, 2012 and 2011 consists of funds deposited to secure standby letters of credit primarily for performance guarantees related to our international business.

Revenue, Accounts Receivable and Credit Policies

We recognize revenue when evidence of an arrangement exists, delivery of the product or service has occurred and title and risk of loss have passed to the customer, the sales price is fixed or determinable, and collectability of the resulting receivable is reasonably assured. For certain “bill and hold” sales to the U.S. and Canadian governments, such sales and related accounts receivable are recognized upon inspection and acceptance of the rifles, including title transfer, by a government official and after we place the accepted rifles in a government approved location at our premises where they are held waiting shipping instructions. The sales value of such bill and hold sales where the shipments were still located at our premises at December 31, 2012, 2011 and 2010 were $0, $6,840 and $9,026, respectively.

We account for revenues and earnings under two long-term government contracts/programs with interrelated multiple elements (procurement of parts, manufacturing and refurbishment services) using concepts of proportionate performance. These contracts effect reported results for all periods presented. We estimate the total profit on each contract as the difference between the total estimated revenue and total estimated cost of the contract and recognize that profit over the remaining life of the contract using an output measure (the ratio of rifles completed to the total number of rifles to be refurbished under the contract). We compute an earnings rate for each contract, including general and administrative expense, to determine operating earnings. We review the earnings rate quarterly to assess revisions in contract values and estimated costs at completion. Any changes in earnings rates and recognized contract to date earnings resulting from these assessments are made in the period the revisions are identified. Contract costs include production costs, related overhead and allocated general and administrative costs. Amounts billed and collected on this contract in excess of revenue recorded are reflected as customer advances and deferred income in the Consolidated Balance Sheets.

Anticipated contract losses are charged to operations as soon as they are identified. Anticipated losses cover all costs allocable to the contracts, including certain general and administrative expenses. If a contract is cancelled by the government for its convenience, we can make a claim against the customer for fair compensation for worked performed plus costs of settling and paying claims by terminated subcontractors, other settlement expenses and a reasonable profit on costs incurred. When we have a customer claim, revenue arising from the claims process is either recognized as revenue or as an offset against a potential loss only when the amount of the claim can be estimated reliably and its realization is probable. We had no claims recorded at any year-end presented.

Credit is extended based on an evaluation of each customer’s financial condition. Generally, collateral is not required, other than in connection with some foreign sales. If the circumstances warrant, we require foreign customers to provide either a documentary letter of credit or a prepayment.

Credit losses are provided for, primarily using a specific identification basis. Once a customer is identified as high risk based on the payment history and creditworthiness, we will provide an allowance for the estimated uncollectible portion. Accounts are considered past due based on the original invoice date. Write-offs of uncollectible accounts receivable occur when all reasonable collection efforts have been made. Neither provisions nor write-offs were material for any period presented. Our allowance for doubtful accounts at December 31, 2012 was $0 and at December 31, 2011 was $1.

	Total
Balance at December 31, 2010	$	216
Provision for (recovery of) doubtful accounts	(209		)
Write-offs	(6		)
Balance at December 31, 2011	$	1
Provision for (recovery of) doubtful accounts	1
Write-offs	(2		)
Balance at December 31, 2012	$	—

Accounts receivable represent amounts billed and currently due from customers. There were no material amounts that were not expected to be collected within one year from the balance sheet date.

Inventories

Inventories are stated at the lower of cost, determined using the first-in, first-out method, or market. Cost includes materials, labor and manufacturing overhead related to the purchase and production of inventories.

We review market value based on historical usage and estimates of future demand. Based on these reviews, inventory write-downs are recorded, as necessary, to reflect estimated obsolescence, excess quantities and declines in market value.

Property and Equipment

Property and equipment are recorded at cost. Depreciation of building and equipment (including assets recorded under capital leases) and amortization of leasehold improvements are computed using the straight-line method over the estimated useful life of the assets or for leasehold improvements, over the life of the lease term if shorter. Depreciation and amortization of property and equipment for the years ended December 31, 2012, 2011 and 2010 was $4,891, $4,633 and $3,712, respectively. We did not enter into any capital leases during 2012 or 2011.

Expenditures that improve or extend the lives of property and equipment are capitalized. Expenditures for maintenance and repairs are charged to expense as incurred.

Property and equipment consist of:

	December 31,						Estimated
	2012			2011			Useful Life
Land	$	362		$	354		—
Building	2,718			2,521			33
Machinery and equipment	37,749			34,086			7-10
Furniture, fixtures and leasehold improvements	6,378			6,089			3-5
	47,207			43,050
Less accumulated depreciation and amortization	(28,162		)	(23,531		)
	19,045			19,519
Construction in process	3,089			3,070
Property and equipment, net	$	22,134		$	22,589

Goodwill

Goodwill is tested for impairment annually as of the end of our third fiscal quarter, or when events or circumstances indicate that its value may have declined. Impairment exists when the carrying amount of goodwill exceeds its fair market value. Management estimates the fair value of each reporting unit primarily using the income approach. Specifically the discounted cash flow (“DCF”) model was utilized for the valuation of each reporting unit. Management develops cash flow forecasts based on existing firm orders, expected future orders, contracts with suppliers, labor agreements and general market conditions. We discount the cash flow forecasts using the weighted-average cost of capital method at the date of evaluation. We also calculate the fair value of our reporting units using the market approach in order to corroborate our DCF model results. These methodologies used in the current year are consistent with those used in the prior year.

Since December 2012, there has been an extremely sharp increase in political and public support for new “gun control” laws and regulations in the United States. Some proposed legislation, including legislation that has been introduced and is under active consideration in Congress and in state legislatures, would ban and/or restrict the sale of substantially all of our products, in their current configurations, into the commercial market, either throughout the United States or in particular states. We considered this potential adverse change in our business climate to be a Triggering Event. Therefore, in addition to our annual goodwill impairment testing, we also performed a sensitivity analysis to determine the impact that a material decrease in LE/Commercial sales would have on our valuation. As of December 31, 2012, the fair value of our reporting units was substantially in excess of carrying value for all scenarios that we tested.

There were no impairment indicators of any goodwill during 2012, 2011 or 2010. Changes in the carrying amount of goodwill are as follows:

	Total
Balance at December 31, 2010	$	14,950
Effect of foreign currency translation	(237		)
Balance at December 31, 2011	14,713
Effect of foreign currency translation	234
Balance at December 31, 2012	$	14,947

As of December 31, 2012 and 2011, there was an accumulated impairment of $1,245 on the gross book value of $16,192.

Intangible Assets

We review long-lived assets, including intangible assets subject to amortization, for impairment whenever events or changes in circumstances indicate that their carrying amount may not be recoverable. Impairment losses, where identified, are determined as the excess of the carrying value over the estimated fair value of the long-lived asset. We assess the recoverability of the carrying value of assets held for use based on a review of projected undiscounted cash flows. When long-lived assets are reclassified to “held for sale”, we compare the asset’s carrying amount to its estimated fair value less cost to sell to evaluate impairment. No long-lived assets have been reclassified to held for sale for any period presented.

The net carrying value of our intangible assets with finite lives follows:

	As of December 31, 2012
	Gross										Estimated
	Carrying			Accumulated							Useful
	Amount			Amortization				Net			Life
Customer relationship
Canadian Government		$	2,533		$	(640	)		$	1,893	30
Customer relationships other	7,219			(4,603			)	2,616			20
Technology-based intangibles	3,610			(2,082			)	1,528			15
	$		13,362	$		(7,325	)	$		6,037

	As of December 31, 2011
	Gross										Estimated
	Carrying			Accumulated							Useful
	Amount			Amortization				Net			Life
Customer relationship
Canadian Government		$	2,478		$	(544	)		$	1,934	30
Customer relationships other	7,062			(4,091			)	2,971			20
Technology-based intangibles	3,610			(1,880			)	1,730			15
	$		13,150	$		(6,515	)	$		6,635

Amortization expense for these intangible assets for the years ended December 31, 2012, 2011 and 2010 was $704, $742 and $749, respectively, of which $202 in 2012, $201 in 2011 and $201 in 2010 were included in cost of sales in the Consolidated Statements of Operations. The Company expects to record annual amortization expense of $666, $635, $604, $573 and $542 for 2013, 2014, 2015, 2016 and 2017, respectively. The Canadian government customer intangible and technology based intangibles are amortized using the straight-line method. The other customers’ intangibles are amortized using the sum of the years’ digits method.

Prepaid License Fee

The prepaid license fee (see Note 11) is being amortized over its initial 20-year term. Amortization expense was $101 per year in 2012, 2011 and 2010.

Deferred Financing Costs

Deferred financing costs are amortized over the term of the related debt as a component of interest expense.

Warranty Costs

We generally warrant our military products for a period of one year and record the estimated costs of such product warranties at the time the sale is recorded. For direct foreign sales, posting a warranty bond for periods ranging from one to five years is occasionally required. Our estimated warranty costs are based upon actual past experience, our current production environment as well as specific and identifiable warranty. As of December 31, 2012 and 2011, the balance of our warranty reserve was $167 and $139, respectively.

Self-Funded Medical Plan

We maintain a self-funded employee group medical plan under which the liability is limited by individual and aggregate stop loss insurance coverage. Included in accrued expense in the accompanying Consolidated Balance Sheets is a liability for reported claims outstanding, as well as an estimate of incurred but unreported claims, based on our best estimate of the ultimate cost not covered by stop loss insurance. The actual amount of the claims could differ from the estimated liability recorded of $1,396 and $340 at December 31, 2012 and 2011, respectively.

Accrued Expenses

Accrued expenses consisted of:

	December 31,
	2012		2011
Accrued compensation and benefits	$	5,770	$	4,984
Accrued taxes	5,293		2,267
Accrued interest	3,230		2,923
Accrued commissions	1,229		2,872
Other accrued expenses	4,793		3,143
	$	20,315	$	16,189

Advertising Costs

We expense advertising as incurred. Advertising expense was $1,219 in 2012, $1,653 in 2011 and $774 in 2010.

Research and Development Costs

Research and development costs consist primarily of compensation and benefits and experimental work materials for our employees who are responsible for the development and enhancement of new and existing products. Research and development costs incurred to develop new products and to enhance existing products, which are not specifically covered by contracts, and those costs related to our share of research and development activity in connection with cost-sharing arrangements are charged to expense as incurred. Research and development expenses were $4,747 in 2012, $5,578 in 2011 and $4,536 in 2010.

Research and development costs incurred under contracts with customers are included as a contract cost and reported as a component of cost of sales when revenue from such contracts is recognized. Government research and development support, not associated with specific contracts, is recorded as a reduction to cost of sales in the period earned.

Income Taxes

In accordance with the provisions of ASC Topic 740, an uncertain income tax position will not be recognized in the financial statements unless it is more-likely-than-not to be sustained. As of December 31, 2012 and 2011, we had no reserves for any uncertain tax positions.

Common Unit Compensation Expense

We use the Black-Scholes option pricing model to estimate the fair value of all unit-based compensation awards on the date of grant. The fair value of each time-based award is expensed on a straight-line basis over the requisite service period. For performance-based awards, compensation expense is recognized when it is probable that the performance conditions will be met.

Foreign Currency Translation

The functional currency for our Canadian operation is the Canadian dollar. We translate the balance sheet accounts of our Canadian operation at the end-of-period exchange rates and its income statement accounts at the average exchange rates for each month. The resulting foreign currency translation adjustments are recorded as a component of accumulated other comprehensive income or loss, which is included in members’ deficit.

Our Canadian operation is subject to foreign currency exchange rate risk relating to receipts from customers, payments to suppliers and some intercompany transactions in currencies other than the Canadian dollar. As a matter of policy, we do not engage in interest rate or currency speculation. We have no derivative financial instruments to hedge this exposure. In our Consolidated Statements of Operations, we had a foreign currency gain of $155 for 2012 and foreign currency losses of $294 and $685 for 2011 and 2010, respectively.

Fair Value Measurements

The fair value of an asset or liability is the amount at which the instrument could be exchanged or settled in a current transaction between willing parties where neither is compelled to buy or sell. The carrying values for cash, accounts receivable, accounts payable, accrued expenses and other current assets and liabilities approximate their fair values due to their short maturities. The carrying value of our long-term debt of $247,567 and $247,186 at December 31, 2012 and 2011, respectively, was recorded at amortized cost. The estimated fair value of long-term debt of approximately $161,250 and $172,500 at December 31, 2012 and 2011, respectively, was based on quoted market prices, which are Level 1 inputs.

Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The inputs used to measure fair value fall into the following hierarchy.

Level 1:		Unadjusted quoted prices in active markets for identical assets or liabilities.

Level 2:		Unadjusted quoted prices in active markets for similar assets or liabilities, or unadjusted quoted prices for identical or similar assets or liabilities in markets that are not active, or inputs other than quoted prices that are observable for the asset or liability.

Level 3:		Unobservable inputs for the asset or liability.

During 2012 and 2011, we did not have any financial assets and liabilities reported at fair value and measured on a recurring basis or any significant non-recurring measurements of nonfinancial assets and nonfinancial liabilities.

Retirement Benefits

We have pension and other post retirement benefit costs and obligations which are dependent on various assumptions. Our major assumptions relate primarily to discount rates, long-term return on plan assets and medical cost trend rates. We base the discount rate assumption on current investment yields of high quality fixed income investments during the retirement benefits maturity period. Long-term return on plan assets is determined based on historical portfolio results and management’s expectation of the future economic environment, as well as target asset allocations.

Our medical cost trend assumptions are developed based on historical cost data, the near-term outlook, an assessment of likely long-term trends and the cap limiting our required contributions. Actual results that differ from our assumptions are accumulated and are amortized generally over the estimated future working life of the plan participants.

Recent Accounting Pronouncements

Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income - In February 2013, the Financial Accounting Standards Board (“FASB”) issued ASU 2013-02, which requires disclosure of significant amounts reclassified out of accumulated other comprehensive income by component and their corresponding effect on the respective line items of net income. This guidance is effective for the Company beginning in the first quarter of 2013. We are currently evaluating what impact, if any, ASU 2013-02 will have on our financial statements.

Presentation of Comprehensive Income — In June 2011, the FASB issued ASU 2011-05, which requires an entity to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income, or in two separate but consecutive statements. This update eliminates the option to present components of other comprehensive income as part of the statement of equity, but it does not change the items that must be reported in other comprehensive income or when an item of other comprehensive income must be reclassified to net income. In December 2011, FASB issued ASU 2011-12, which amends ASU 2011-05. This amendment defers the requirement to present components of reclassifications of other comprehensive income on the face of the income statement. Both standards were effective for us beginning on January 1, 2012. The adoption of these standards had no impact on our operating results or financial position.

Intangibles — Goodwill and Other — In September 2011, FASB issued ASU 2011-08, which provides entities the option to perform a qualitative assessment in order to determine whether additional quantitative impairment testing is necessary. This amendment was effective for reporting periods beginning after December 15, 2011. This amendment does not impact the quantitative testing methodology, should it be necessary. We adopted this standard on January 1, 2012 and it had no impact on our operating results or financial position.

Fair Value Measurement — In May 2011, FASB issued an amendment to revise the wording used to describe the requirements for measuring fair value and for disclosing information about fair value measurements. For many of the requirements, the FASB does not intend for the amendments to result in a change in the application of existing fair value measurement requirements, such as specifying that the concepts of the highest and best use and valuation premise in a fair value measurement are relevant only when measuring the fair value of nonfinancial assets. Other amendments change a particular principle or requirement for measuring fair value or for disclosing information about fair value measurements such as specifying that, in the absence of a Level 1 input, a reporting entity should apply premiums or discounts when market participants would do so when pricing the asset or liability. We adopted this standard on January 1, 2012 and it had no impact on our operating results or financial position.

Revision to the consolidated financial statements

In connection with the preparation of the consolidated financial statements for the year ended December 31, 2012 certain errors were identified that affected our reported results for the years ended December 31, 2010 and 2011 and our quarterly reported results in 2011 and 2012. These errors related to the post-retirement health plan accounting and, as previously reported, a sales transaction recognized in the first quarter of 2012 that should have been recognized in the second quarter of 2012. As a result of these errors, we concluded that we would revise our consolidated financial statements for the years ended December 31, 2011 and 2010 and each quarter of 2011 and certain quarters within 2012. Based on an analysis of qualitative and quantitative factors, these errors were deemed immaterial, individually and in the aggregate, to all of the periods presented.

A description of the errors follows:

Post-retirement health plan accounting- We identified errors related to certain actuarial assumptions used in the calculation of claims data, administrative fees and a cap on benefits for a certain group of retirees. As of January 1, 2008, our accumulated deficit was overstated by $1,168 related to the overstatement of the post-retirement liability of $1,396 and understatement of accumulated other comprehensive income of $229 related to this error.

As a result of this error, the post-retirement health expense that we recorded in cost of sales for the year ended December 31, 2010 was overstated by $105 and for the year ended December 31, 2011 was understated by $208. The errors also had the effect of increasing the other comprehensive loss by $1,272 for the year ended December 31, 2010 and increasing other comprehensive income by $317 for the year ended December 31, 2011. These errors also resulted in the overstatement of the reported accrued post-retirement liability by $338 and understatement of accumulated comprehensive loss of $727 at December 31, 2011. Further, as of December 31, 2011, the accrued post-retirement health liability current balance was decreased by $281 and the accrued post-retirement liability long-term balance was increased by $281 to properly reflect the long-term nature of the liability.

Sales cut-off— During the first quarter of 2012, we recognized a sales transaction that should have been recognized in the second quarter of 2012. To correct the error, we decreased net sales by $724 and decreased cost of goods sold by $271 for the quarter ended March 31, 2012 and increased net sales by $724 and increased cost of goods sold by $271 for the quarter ended June 30, 2012.

Impact of the revision

Based on an analysis of qualitative and quantitative factors, these errors were deemed immaterial, individually and in the aggregate, to all periods previously reported. The effects of the revision on our Consolidated Statements of Operations for the years ended December 31, 2011 and 2010 follow:

For the year ended December 31, 2011

	Previously Reported		Adjustments			Revised
Cost of sales	$	143,270	$	208		$	143,478
Gross profit	65,540		(208		)	65,332
Operating income	32,711		(208		)	32,503
(Loss) income from continuing operations before provision for foreign income taxes	8,367		(208		)	8,159
(Loss) income from continuing operations	5,196		(208		)	4,988
Net (loss) income	5,196		(208		)	4,988
Net (loss) income attributable to Colt Defense LLC members	5,196		(208		)	4,988

For the year ended December 31, 2010

	Previously Reported			Adjustments			Revised
Cost of sales	$	131,383		$	(105	)	$	131,278
Gross profit	44,422			105			44,527
Operating income	18,373			105			18,478
(Loss) income from continuing operations before provision for foreign income taxes	(7,882		)	105			(7,777		)
(Loss) income from continuing operations	(10,381		)	105			(10,276		)
Net (loss) income	(11,254		)	105			(11,149		)
Net (loss) income attributable to Colt Defense LLC members	(11,170		)	105			(11,065		)

The effects of the revision on our Consolidated Statements of Comprehensive Loss for the years ended December 31, 2011 and 2010 follow:

For the year ended December 31, 2011

	Previously Reported			Adjustments			Revised
Net (loss) income	$	5,196		$	(208	)	$	4,988
Change in pension and postretirement benefit plans, net	(5,519		)	317			(5,202		)
Comprehensive loss	(767		)	109			(658		)

For the year ended December 31, 2010

	Previously Reported			Adjustments			Revised
Net (loss) income	$	(11,254	)	$	105		$	(11,149	)
Change in pension and postretirement benefit plans, net	(1,817		)	(1,272		)	(3,089		)
Comprehensive loss	(11,656		)	(1,167		)	(12,823		)

The effects of the revisions on our Consolidated Balance Sheet as of December 31, 2011 follow:

	Previously Reported			Adjustments			Revised
Pension and retirement obligations — current portion	$	890		$	(281	)	$	609
Total current liabilities	41,488			(281		)	41,207
Pension and retirement obligations	17,953			(57		)	17,896
Total long-term liabilities	266,640			(57		)	266,583
Total liabilities	308,128			(338		)	307,790
Accumulated deficit	(130,769		)	1,065			(129,704		)
Accumulated other comprehensive loss	(12,403		)	(727		)	(13,130		)
Total deficit	(143,172		)	338			(142,834		)

The effects of the revision on our consolidated statements of cash flows for the years ended December 31, 2011 and 2010:

For the year ended December 31, 2011

	Previously Reported			Adjustments			Revised
Cash flows from operating activities:
Net (loss) income	$	5,196		$	(208	)	$	4,988
Accrued pension and retirement liabilities	(830		)	208			(622		)

For the year ended December 31, 2010

	Previously Reported			Adjustments			Revised
Cash flows from operating activities:
Net (loss) income	$	(11,254	)	$	105		$	(11,149	)
Accrued pension and retirement liabilities	(970		)	(105		)	(1,075		)

2010 and 2009 Revisions

As previously reported, during the first quarter of 2011, we identified a $3,259 understatement of goodwill related to our acquisition of Colt Canada and corresponding understatement of deferred tax liabilities. These understatements are attributable to the initial application of purchase accounting in 2005. We corrected this immaterial error through revision of our previously reported historical financial statements. As a result, our net loss for the year ended December 31, 2010 decreased by $160 to $(11,254). Our December 31, 2009 opening total deficit balance in our Consolidated Statements of Changes in Deficit decreased by $1,673. Based on an analysis of qualitative and quantitative factors, this error was deemed immaterial to all periods previously reported.

Prior Period Adjustments

During the first quarter of 2011, fourth quarter of 2011 and the full year of 2011, the Company recorded pre-tax adjustments of $127, $316 and $621, respectively, related to immaterial errors in prior periods. Management has concluded based on its quantitative and qualitative analysis such amounts are not material to our current or prior period interim and annual financial statements.