NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Nature of Operations

We are a drilling and completion tool technology company. We design and manufacture new drill bit and horizontal drill string enhancement tools and refurbish 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. 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. The closing of that reorganization occurred in conjunction with our initial public offering which was completed 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 nine months ended September 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 nine months ended September 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.

Effective with its IPO in May 2014, 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 nine months ended September 30, 2016 and 2015.

On August 5, 2016, the Company issued warrants exercisable for 250,000 shares of common stock at $1.00 per share as part of the Bridge Financing (as defined in Note 5 below). These warrants have a five-year term expiring in August 2021. These warrants were anti-dilutive for the three and nine months ended September 30, 2016.

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 nine months ended September 30, 2016.

Revenue Recognition

The Company operates as a drilling and completion tool technology company that sells, rents and repairs/refurbishes drill string enhancement tools and drill bits for use by customers engaged in the oil and gas and mining industries. Revenue is classified into two groups: (1) Tool Revenue, which consists of revenue from tool sales, tool rental and other related revenue, and (2) Contract Services, which consists of drill bit manufacturing and refurbishment revenue and revenue from the sale of other machined tools.

Tool sales, rentals and other related revenue. We rent or sell our tools and repair the tools we manufacture. In some instances, such as with the Drill-N-Ream^®, we may receive royalty revenue based on the activity of the tools by end users.

Tool Sales: Revenue for tool sales is recognized upon shipment of tools.

Tool Rental: Rental revenue is recognized upon completion of the customer’s job for which the tool was rented. While the duration of the rents vary by job and number of runs, these rents are generally less than one month. The rental agreements are typically based on the price per run or footage drilled and do not have any minimum rental payments or term.

Other Related Revenue: We receive revenue from the repair of tools upon delivery of the repaired tool to the customer. Royalty revenue is recognized when our customer invoices their customer for the use of our tools.

Contract Services

Drill Bit Manufacturing and Refurbishment: Since 1996, we have refurbished PDC drill bits for Baker Hughes. We are currently operating under a four-year vendor agreement with Baker Hughes (the “Vendor Agreement”) that was renewed in 2014. We recognize revenue for our PDC drill bit services upon shipment of the drill bit. Shipping and handling costs related to refurbishing services are paid directly by Baker Hughes at the time of shipment. By contract, we can only refurbish and manufacture oil or gas drill bits for Baker Hughes, but we are not contractually prohibited from manufacturing drill bits for the mining industry.

Other Machined Tools. We also design and manufacture other new tools and component parts for other oil and gas industry participants from time to time. We recognize revenue for the manufacture of other machined tools and parts upon their shipment to the customer. Shipping and handling costs related to product sales are recorded gross as a component of both the sales price and cost of the product sold.

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 September 30, 2016, the Company adjusted the current income tax payable of $2,000 down to $0 and a full valuation allowance has been applied to the 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.

These three issuances of options issued during March 2016 were part of decreasing the base salary of employees and directors in exchange for salary for options plan, issued out of the 2015 Incentive Plan.

Liquidity

At September 30, 2016, we had working capital of approximately $1.5 million. Our principal sources of liquidity have been cash flow from operations, the March 2016 credit facility with Federal National Commercial Credit (“FNCC”) and the August 5, 2016, Bridge Financing intended to provide us with liquidity until we could close the public offering (see Note 5: Long-term Debt and Note 9: Subsequent Events). Our principal uses of cash are operating expenses, working capital requirements, capital expenditures and debt service payments.

Public Offering: On September 30, 2016, we priced a public offering of common stock at $1.00 per share. The transaction closed on October 5, 2016 and was recorded as a receivable and common stock subscribed. Net of underwriting discounts, commissions and offering expenses, net proceeds were approximately $5.1 million. The Company used the proceeds to repay its $1 million Bridge Financing, FNCC indebtedness and pay the remaining $500,000 plus accrued interest on the Hard Rock Note (see Note 5 – Long-term Debt). We will use the remaining funds from the offering and cash flows from operations to service on going debt obligations, which include real property leases and equipment loans, as well as for general corporate purposes, including growth working capital (see Note 9 - Subsequent Events).

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. We will continue to work to grow revenue and review additional cost cutting measures with the plan to be cash flow positive. If we are unable to do this, 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. The Company may need to raise additional capital through equity and debt financing to support its business and possible expansions thereof and for its corporate general and administrative expenses. While the Company is considering a full range of financing options, we cannot provide any assurance that financing will be available to us in the future on acceptable terms.

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 is 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.