NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Nature of Operations

We are a drilling and completion tool technology company. We are a designer and manufacturer of new drill bit and horizontal drill string enhancement tools and refurbisher of PDC (polycrystalline diamond compact) drill bits for the oil, natural gas and mining services industry. Our customers are engaged in domestic and international exploration and production of oil and natural gas. We were incorporated on December 10, 2013 under the name SD Company, Inc. in order to facilitate (a) the reorganization of the entities that are now our consolidated subsidiaries and (b) the subsequent acquisition of Hard Rock Solutions, LLC. We changed our name from SD Company Inc. to Superior Drilling Products, Inc. on May 22, 2014 in conjunction with closing of that reorganization and our initial public offering which occurred on May 23, 2014. Our headquarters and principal manufacturing operations are located in Vernal, Utah.

Basis of Presentation

The accompanying consolidated condensed financial statements of the Company include the accounts of the Company, and of its wholly-owned subsidiaries (a) Superior Drilling Solutions, LLC (previously known as Superior Drilling Products, LLC), a Utah limited liability company (“SDS”), together with its wholly owned subsidiary, Superior Design and Fabrication, LLC, a Utah limited liability company (“SDF”), (b) Extreme Technologies, LLC, a Utah limited liability company (“ET”), (c) Meier Properties Series, LLC, a Utah limited liability company (“MPS”), (d) Meier Leasing, LLC, a Utah limited liability company (“ML”), and (e) Hard Rock Solutions, LLC, a Utah limited liability company (“HR”). These consolidated condensed financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”), and all significant intercompany accounts have been eliminated in consolidation.

As a company with less than $1.0 billion in revenue during its last fiscal year, which completed its initial public offering after December 2011, we qualify as an emerging growth company as defined in the Jumpstart Our Business Startups Act of 2012, or the JOBS Act. An emerging growth company may take advantage of exemptions from various reporting requirements applicable to other public companies that are not an “emerging growth company.”

Unaudited Interim Financial Information

These interim consolidated condensed financial statements for the three and six months ended June 30, 2016 and 2015, and the related footnote disclosures included herein, are unaudited. However, in the opinion of management, these unaudited interim financial statements have been prepared on the same basis as the audited financial statements, and reflect all adjustments necessary to fairly state the results for such periods. The results of operations for the three and six months ended June 30, 2016 are not necessarily indicative of the results of operations expected for the year ended December 31, 2016. These interim consolidated condensed financial statements should be read in conjunction with the audited consolidated financial statements of the Company for the years ended December 31, 2015 and 2014 and the notes thereto, which were included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2015, filed with the Securities and Exchange Commission (the “SEC”).

Basic and Diluted Earnings Per Share

Basic earnings per common share is computed by dividing net income by the weighted-average number of common shares outstanding during the period. Diluted earnings per share is calculated to give effect to potentially issuable common shares, which include stock warrants. As of June 30, 2016, the Company had warrants exercisable for 714,286 shares of common stock at $4.00 per share. These warrants have a four year term expiring in February 2018. These warrants were anti-dilutive for the three and six months ended June 30, 2016 and 2015.

During the month of March 2016, the Board of Directors granted options to acquire 309,133 shares of stock from the Company’s 2015 Long Term Incentive Plan to directors, officers and employees. All options were anti-dilutive for earnings per share for the three and six months ended June 30, 2016.

Rental and Sales Income

The Company operates as a drilling and completion tool technology company that rents drill string enhancement tools and sells tools in the completion and workover industry all for use by customers engaged in the oil and gas business. While the duration of the rents vary by job and number of runs, these rents are generally less than one month. The rental agreements do not have minimum rental payments or terms. Revenue is recognized upon completion of the job. The tools are currently rented and sold primarily to entities operating in North Dakota, Wyoming, Texas, Montana, Oklahoma, Utah, New Mexico and Colorado.

Income Taxes

The Company recognizes an asset or liability for the deferred tax consequences of all temporary differences between the tax basis of assets or liabilities and their reported amounts in the financial statements that will result in taxable or deductible amounts in future years when the reported amounts of the asset or liabilities are recovered or settled and for operating loss carry forwards. These deferred tax assets and liabilities are measured using the enacted tax rates that will be in effect when the differences are expected to reverse and the carry forwards are expected to be realized. As of June 30, 2016, a full valuation allowance has been applied to the Company’s deferred tax assets.

Share-Based Compensation

The Company follows ASC 718, Compensation- Stock Compensation (“ASC 718”), which requires the measurement and recognition of compensation expense for all share-based payment awards, including restricted stock units, based on estimated grant date fair values. Restricted stock units are valued using the market price of our common shares on the date of grant. The Company records compensation expense, net of estimated forfeitures, over the requisite service period.

On March 4, 2016, the Board of Directors granted options to acquire 78,944 shares of stock from the Company’s 2015 Long Term Incentive Plan to officers and employees based on the closing price of the Company’s common stock on the date of the grant, which was $1.73. These options vested 100% on the grant date and have a ten year term expiring on March 4, 2026. The fair value of the vested stock options were calculated using the Black-Scholes model with a volatility and discount rate over the expected term of each employee.

On March 18, 2016, the Board of Directors granted options to acquire 81,714 shares of stock from the Company’s 2015 Long Term Incentive Plan to officers and employees based on the closing price of the Company’s common stock on the date of the grant, which was $1.67. These options vested 100% on the grant date and have a ten year term expiring on March 18, 2026. The fair value of the vested stock options were calculated using the Black-Scholes model with a volatility and discount rate over the expected term of each employee.

On March 31, 2016, the Board of Directors granted options to acquire 148,475 shares of stock from the Company’s 2015 Long Term Incentive Plan to directors, officers and employees based on the closing price of the Company’s common stock on the date of the grant, which was $1.37. These options vested 100% on the grant date and have a ten year term expiring on March 31, 2026. The fair value of the vested stock options were calculated using the Black-Scholes model with a volatility and discount rate over the expected term of each employee.

Liquidity

At June 30, 2016, we had negative working capital of approximately $4.4 million. During 2015 and into 2016, our principal sources of liquidity were cash flow from operations and our new credit facility with Federal National Commercial Credit (“FNCC”). Our principal uses of cash are operating expenses, working capital requirements, capital expenditures and debt service payments. Given the current environment of the oil and gas industry, our revenue has dramatically declined in 2015 and 2016.

On August 5, 2016, we completed the Bridge Financing to provide us with liquidity for the next several months (see Note 9 – Recent Developments). Our operational and financial strategies include lowering our operating costs and capital spending to match revenue trends, managing our working capital and managing our debt to enhance liquidity. For example, to conserve cash, we implemented a salary for stock options program during the first quarter of 2016 for senior management and our board of directors.

On March 8, 2016, we entered into a $3 million financing agreement with FNCC. The financing agreement includes a $500,000 term loan collateralized with previously unencumbered manufacturing equipment and a $2.5 million accounts receivable revolving credit facility allowing up to 85% of eligible accounts receivable (see Note 5 – Long Term Debt). As of June 30, 2016, we were not in compliance with all financial covenants under the FNCC facility and we are currently in discussions with them to amend the terms of the debt.

On August 10, 2016, certain of our subsidiaries entered into an amended and restated note with the seller in our acquisition of Hard Rock Solutions, LLC (as so amended and restated, the “Hard Rock Note”). As amended and restated effective August 10, 2016, the Hard Rock Note accrues interest at 5.75% per annum and matures and is fully payable on January 15, 2020. Under the current terms of Hard Rock Note, we are required to make the following payments: payments of $1,500,000 (plus accrued interest) on or before October 15, 2016, accrued interest on each of January 15, March 15, May 15 and July 15, 2017, $500,000 (plus accrued interest) on each of January 15, March 15, May 15 and July 15, 2018, and $1,000,000 (plus accrued interest) on each of January 15, March 15, May 15 and July 15, 2019, with the remaining balance of principal and accrued interest on the Hard Rock Note due on January 15, 2020.

In connection with the amendment and restatement, we made an interest payment of approximately $304,000 on the Hard Rock Note. In addition, we issued 700,000 restricted shares of common stock (having an agreed per share value of $1.43, or $1,000,000 in the aggregate) as payment for $1,000,000 of the $1,500,000 due on the Hard Rock Note on or before October 15, 2016. Interest will continue to accrue on the Hard Rock Note based on the $1,000,000 value of the shares until such shares are registered.

During 2016, we plan on using the cash flows from operations to service our debt obligations, including the Bridge Financing, the Hard Rock Note, our FNCC indebtedness and other financing debt, real property leases and equipment loans (see Note 9 – Recent Developments). Based on current forecasts, we will need to restructure debt obligations, including with Hard Rock and FNCC, as well as raise additional capital through equity and/or debt financings. We cannot provide any assurance that financing will be available to us in the future on acceptable terms.

If we cannot raise required funds on acceptable terms, we may not be able to, among other things, (i) maintain our current general and administrative spending levels; (ii) fund certain obligations as they become due; and (iii) respond to competitive pressures or unanticipated capital requirements. This will require us to find additional avenues to decrease spending which may hinder our ability to effectively compete in the current oil and gas market.

Accounting Standards

In April 2015, FASB issued an accounting standards update for “Interest – Imputation of Interest,” which simplifies the presentation of debt issuance costs. This accounting standard update requires that debt issuance cost related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts. The new update if effective for financial statements issued for fiscal years beginning after December 15, 2015 (and interim periods within those fiscal years). The adoption of this new accounting standard update resulted in a reclassification of debt issuance costs from Other assets to Line of Credit, net and Long term debt, net. See Note 5 “Long-Term Debt” for disclosure of debt issuance costs. Adoption of this accounting standard update did not impact our statements of operations or cash flows.