Nature of Business and Significant Accounting Policies

FLIR Systems, Inc. (the "Company") is a world leader in sensor systems that enhance perception and awareness. The Company was founded in 1978 and has since become a premier designer, manufacturer, and marketer of thermal imaging systems. The Company’s advanced sensors and integrated sensor systems enable the gathering and analysis of critical information through a wide variety of applications in commercial, industrial, and government markets worldwide.

The Company’s goal is to both enable its customers to benefit from the valuable information produced by advanced sensing technologies and to deliver sustained superior financial performance for its shareholders. The Company creates value for its customers by providing advanced surveillance and tactical defense capabilities, improving personal and public safety and security, facilitating air, ground, and maritime navigation, enhancing enjoyment of the outdoors, providing infrastructure inefficiency information, conveying pre-emptive structural deficiency data, displaying process irregularities, and enabling commercial business opportunities through its continual support and development of new thermal imaging data and analytics applications. The Company’s business model meets the needs of a multitude of customers—it sells off-the-shelf products to a wide variety of markets in an efficient, timely, and affordable manner as well as offers a variety of system configurations to suit specific customer requirements. Centered on the design of products for low cost manufacturing and high volume distribution, the Company’s commercial operating model has been developed over time and provides it with a unique ability to adapt to market changes and meet its customers’ needs.

Principles of consolidation

The accompanying consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All intercompany accounts and transactions were eliminated.

Reclassification

The amounts shown in the Consolidated Statement of Income for the year ended December 31, 2010 have been adjusted to reflect the reclassification of certain business units that were previously reported as discontinued operations to continued operations.

Foreign currency translation

The assets and liabilities of the Company’s subsidiaries outside the United States are translated into United States dollars at current exchange rates in effect at the balance sheet date. Revenues and expenses are translated at monthly average exchange rates. Resulting translation adjustments are reflected in accumulated other comprehensive earnings within shareholders’ equity. Transaction gains and losses that arise from exchange rate fluctuations on transactions denominated in currencies other than the functional currency are reflected as other income, net, in the Consolidated Statements of Income as incurred.

The cumulative translation adjustment included in accumulated other comprehensive earnings is a loss of $6.1 million and a gain of $6.4 million at December 31, 2011 and 2010, respectively. Transaction gains and losses included in other income, net, are a net gain of $1.1 million, a net gain of $0.7 million, and a net loss of $3.9 million for the years ended December 31, 2011, 2010 and 2009, respectively.

Revenue recognition

Revenue is primarily recognized when persuasive evidence of an arrangement exists, upon delivery of the product to the customer at a fixed or determinable price with a reasonable assurance of collection, passage of title and risk of loss to the customer as indicated by the shipping terms and fulfillment of all significant obligations.

The Company designs, markets and sells products primarily as commercial, off-the-shelf products. Certain customers request different system configurations, based on standard options or accessories that the Company offers. In general, revenue arrangements do not involve acceptance provisions based upon customer specified acceptance criteria. In those limited circumstances when customer specified acceptance criteria exist, revenue is deferred until customer acceptance if the Company cannot demonstrate the system meets those specifications prior to shipment. For any contracts with multiple elements (i.e., training, installation, additional parts, etc.) the Company allocates revenue among the deliverables primarily based upon objective and reliable evidence of fair value of each element in the arrangement. If objective and reliable evidence of fair value of any element is not available, we use an estimated selling price for purposes of allocating the total arrangement consideration among the elements. Credit is not extended to customers and revenue is not recognized until the Company has determined that the risk of uncollectability is minimal.


Note 1.	Nature of Business and Significant Accounting Policies—(Continued)

The Company’s products are sold with warranty provisions that require it to remedy deficiencies in quality or performance of the Company’s products over a specified period of time, generally twelve to twenty-four months, at no cost to its customers. Warranty reserves are established at the time that revenue is recognized at levels that represent the Company’s estimate of the costs that will be incurred to fulfill those warranty requirements.

Provisions for estimated losses on sales or related receivables are recorded when identified. Revenue includes certain shipping and handling costs and is stated net of representative commissions and sales taxes. Service revenue is deferred and recognized over the contract period, as is the case for extended warranty contracts, or recognized as services are provided.

Cost of goods sold

Cost of goods sold includes materials, labor and overhead costs incurred in the manufacturing of products and services sold in the period as well as warranty costs. Material costs include raw materials, purchased components and sub-assemblies, outside processing and inbound freight costs. Labor and overhead costs consist of direct and indirect manufacturing costs, including wages and fringe benefits, operating supplies, depreciation, occupancy costs, and purchasing, receiving and inspection costs.

Research and development

Expenditures for research and development activities are expensed as incurred.

Cash equivalents

The Company considers short-term investments that are highly liquid, readily convertible into cash and have maturities of less than three months when purchased to be cash equivalents. Cash equivalents at December 31, 2011 and 2010 were $192.6 million and $27.2 million, respectively, which were primarily investments in money market funds.

Accounts receivable and allowance for doubtful accounts

Accounts receivable are stated at the amounts the Company expects to collect. Credit limits are established through a process of reviewing the financial history and stability of each customer. The Company regularly evaluates the collectability of its trade receivables balances based on a combination of factors. If it is determined that a customer will be unable to fully meet its financial obligation, the Company records a specific allowance to reduce the related receivable to the amount expected to be recovered. In addition, the Company also records an allowance for all other customers based on certain other factors including the length of time the receivables are past due and historical collection experience with individual customers.

Inventories

Inventories are generally stated at the lower of cost or market and include materials, labor, and manufacturing overhead. Cost is determined based on a currently adjusted standard cost basis that approximates actual manufacturing cost on a first-in, first-out basis.

Inventory write-downs are recorded when conditions exist to indicate that inventories are likely to be in excess of anticipated demand or are obsolete based upon the Company’s assumptions about future demand for its products and market conditions. The Company regularly evaluates its ability to realize the value of inventories based on a combination of factors including the following: historical usage rates, forecasted sales or usage, product end of life dates, estimated current and future market values and new product introductions. When recorded, write-downs reduce the carrying value of the Company’s inventories to their net realizable value and create a new cost-basis in the inventories. Write-downs are reflected in cost of goods sold in the Consolidated Statements of Income.

Demonstration units

The Company’s products which are being used as demonstration units are stated at the lower of cost or market and are included in prepaid expenses and other current assets in the Consolidated Balance Sheets. Demonstration units are available for sale and the Company periodically evaluates them as to marketability and realizable values. The carrying value of demonstration units was $32.4 million and $28.7 million at December 31, 2011 and 2010, respectively.


Note 1.	Nature of Business and Significant Accounting Policies—(Continued)

Property and equipment

Property and equipment are stated at cost and are depreciated using a straight-line methodology over their estimated useful lives. Repairs and maintenance are charged to expense as incurred.

Goodwill

Goodwill is reviewed in June of each year, or more frequently if required, for impairment to determine if events or changes in business conditions indicate that the carrying value of the assets may not be recoverable.

Intangible assets

Intangible assets, other than goodwill and intangible assets with indefinite useful lives, are amortized using a straight-line methodology over their estimated useful lives. Intangible assets with indefinite useful lives are evaluated annually for impairment.

Long-lived assets

Long-lived assets are reviewed for impairment when circumstances indicate that the carrying amounts may not be recoverable. Impairment exists when the carrying value is greater than the expected undiscounted future cash flows expected to be provided by the asset. If impairment exists, the asset is written down to its fair value.

Advertising costs

Advertising costs, which are included in selling, general and administrative expenses, are expensed as incurred. Advertising costs for the years ended December 31, 2011, 2010 and 2009 were $11.1 million, $9.2 million and $8.2 million, respectively.

Cost-basis investments

The Company has private company investments, which consist of investments for which the Company does not have the ability to exercise significant influence, and are accounted for under the cost method. The investments are carried at cost and adjusted only when the Company believes that events have occurred that are likely to have a significant other-than-temporary adverse effect on the estimated fair value of the investments. If no such events have occurred, the fair value of the investments is not calculated as it is not practicable to do so. The carrying value of those investments at December 31, 2011 and 2010 was $10.5 million and $10.4 million, respectively. The investments are included in other assets in the Consolidated Balance Sheets.

Contingencies

The Company is subject to the possibility of loss contingencies arising in the normal course of business. An estimated loss is accrued when the Company determines that it is probable that an asset has been impaired or a liability has been incurred and the amount can be reasonably estimated. The Company regularly evaluates current available information to determine whether such accruals should be adjusted.

Earnings per share

Basic earnings per share is based on the weighted average number of shares of common stock outstanding during the period. Diluted earnings per share is computed similar to basic earnings per share except that the weighted shares outstanding are increased to include additional shares from the assumed exercise of stock options, if dilutive, assumed issuance of unvested restricted stock awards and from the assumed conversion of the convertible notes.


Note 1.	Nature of Business and Significant Accounting Policies—(Continued)

The following table sets forth the reconciliation of the numerator and denominator utilized in the computation of basic and diluted earnings per share (in thousands):



	Year Ended December 31,
	2011			2010⁽¹⁾			2009
Numerator for earnings per share:
Earnings from continuing operations	$	222,652		$	248,374		$	230,213
Loss from discontinued operations	(1,178		)	(248		)	—
Net earnings for basic earnings per share	221,474			248,126			230,213
Interest associated with convertible notes, net of tax	—			935			3,585
Net earnings available to common shareholders—diluted	$	221,474		$	249,061		$	233,798
Denominator for earnings per share:
Weighted average number of common shares outstanding	158,323			156,141			149,405
Assumed exercise of stock options and vesting of restricted stock awards, net of shares assumed reacquired under the treasury stock method	2,528			3,196			3,518
Assumed conversion of convertible notes	—			2,293			8,646
Diluted shares outstanding	160,851			161,630			161,569

_______________

(1) Amounts have been adjusted for the reclassification of certain discontinued operations to continuing operations.

The effect of stock-based compensation awards for the years ended December 31, 2011, 2010 and 2009 that aggregated 352,000, 418,000 and 515,000 shares have been excluded for purposes of diluted earnings per share since the effect would have been anti-dilutive.

Supplemental cash flow disclosure (in thousands)



	Year Ended December 31,
	2011		2010		2009
Cash paid for:
Interest	$	1,119	$	1,631	$	2,972
Taxes	$	106,215	$	111,778	$	116,733
Non-cash transactions:
Conversion of convertible notes to common stock	$	—	$	58,752	$	132,637
Stock issued for business acquisition	$	—	2,121		—

Stock-based compensation

The Company uses the Black-Scholes option pricing model to estimate the fair value of all stock-based compensation awards on the date of grant, except for restricted stock unit awards which are valued at the fair market value of the Company’s common stock on the date of grant. The Company recognizes the compensation expense for time-based options and restricted stock unit awards on a straight-line basis over the requisite service period of each award. The compensation expense for each tranche of performance-based options is recognized over the vesting period of the applicable tranche because each tranche is independent of the others and if the performance criteria of earnings per share targets in a particular year are not met, the related tranche does not vest.


Note 1.	Nature of Business and Significant Accounting Policies—(Continued)

The following table sets forth the stock-based compensation expense and related tax benefit recognized in the Consolidated Statements of Income for the years ended December 31, 2011, 2010 and 2009 (in thousands):



	Year Ended December 31,
	2011			2010			2009
Cost of goods sold	$	3,306		$	3,694		$	3,297
Research and development	5,195			5,015			4,943
Selling, general and administrative	16,416			16,866			15,715
Stock-based compensation expense before income taxes	24,917			25,575			23,955
Income tax benefit	(6,976		)	(8,011		)	(7,011		)
Total stock-based compensation expense after income taxes	$	17,941		$	17,564		$	16,944

Stock-based compensation expense capitalized in the Consolidated Balance Sheets as of December 31, 2011, 2010 and 2009 is as follows (in thousands):



	December 31,
	2011		2010		2009
Capitalized in inventory	$	819	$	673	$	896

As of December 31, 2011, the Company had approximately $33.3 million of total unrecognized stock-based compensation costs, net of estimated forfeitures, to be recognized over a weighted average period of 1.8 years.

The fair value of the stock-based awards, as determined under the Black-Scholes model, granted in the years ended December 31, 2011, 2010 and 2009 reported above was estimated with the following weighted-average assumptions:



	2011		2010		2009
Stock option awards:
Risk-free interest rate	1.0	%	1.6	%	1.5	%
Expected dividend yield	0.7	%	—	%	—	%
Expected term	4.3 years		4.3 years		4.3 years
Expected volatility	42.3	%	45.1	%	46.9	%
Employee stock purchase plan:
Risk-free interest rate	0.1	%	0.2	%	0.3	%
Expected dividend yield	0.8	%	—	%	—	%
Expected term	6 months		6 months		6 months
Expected volatility	33.1	%	27.1	%	49.5	%

The Company uses the United States Treasury (constant maturity) interest rate on the date of grant as the risk-free interest rate and uses historical volatility as the expected volatility. The Company’s determination of expected term is based on an analysis of historical and expected exercise patterns. In 2011 and 2010, all stock options granted were time-based options. In 2009, approximately 30 percent of stock options granted were performance-based options and approximately 70 percent were time-based options. The difference in the nature of these awards has been taken into consideration in determining the expected term. The Company uses an estimated forfeiture rate of 5 percent of the stock-compensation expense of non-executive employees based on an analysis of historical and expected forfeitures.


Note 1.	Nature of Business and Significant Accounting Policies—(Continued)

The weighted-average fair value of stock-based compensation awards granted and vested, and the intrinsic value of options exercised during the period were (in thousands, except per share amounts):



	Years Ended December 31,
	2011		2010		2009
Stock option awards:
Weighted average grant date fair value per share	$	11.61	$	11.52	$	9.96
Total fair value of awards granted	$	4,613	$	7,299	$	10,534
Total fair value of awards vested	$	8,492	$	7,281	$	6,964
Total intrinsic value of options exercised	$	21,234	$	33,920	$	34,648
Restricted stock unit awards:
Weighted average grant date fair value per share	$	34.35	$	29.91	$	25.38
Total fair value of awards granted	$	21,822	$	16,011	$	16,793
Employee stock purchase plan:
Weighted average grant date fair value per share	$	6.99	$	6.59	$	8.37
Total fair value of shares estimated to be issued	$	2,359	$	1,885	$	1,073

The total amount of cash received from the exercise of stock options in the years ended December 31, 2011, 2010 and 2009 was $13.8 million, $15.5 million and $17.0 million, respectively, and the related tax benefit realized from the exercise of the stock options was $5.5 million, $8.3 million and $9.2 million, respectively.

The Company elected to adopt the “long-haul” method to calculate the historical pool of windfall tax benefits, which calculates on a grant by grant basis, the windfall or excess tax benefit that arose upon the exercise of each stock option, based on a comparison to the total tax deduction to the “as-if” deferred tax asset that would have been recorded had the Company followed the recognition provisions of Financial Accounting Standards Board Accounting Standards Codification (“FASB ASC”) Topic 718, “Compensation-Stock Compensation,” since its effective date of January 1, 2006. Additionally, the Company elected to adopt the “tax-law ordering” method of measuring the timing in which tax deductions on stock option exercises should be recognized in the consolidated financial statements.

Concentration of risk

Financial instruments that potentially subject the Company to concentration of credit risk consist primarily of trade receivables. Concentration of credit risk with respect to trade receivables is limited because a relatively large number of geographically diverse customers make up the Company’s customer base, thus diversifying the trade credit risk. The Company controls credit risk through credit approvals, credit limits and monitoring procedures. The Company performs credit evaluations for all new customers and requires letters of credit, bank guarantees and advanced payments, if deemed necessary.

A substantial portion of the Company’s revenue is derived from sales to United States and foreign government agencies (see Note 17). The Company also purchases certain key components from sole or limited source suppliers.

The Company maintains cash deposits with major banks that from time to time may exceed federally insured limits. The Company periodically assesses the financial condition of the institutions and instruments in which it invests, and adjusts its investment balances to mitigate the risk of principal loss.

Use of estimates

The preparation of financial statements in conformity with United States generally accepted accounting principles requires management to make estimates and judgments that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenue and expenses during the reporting period. Significant estimates and judgments made by management of the Company include matters such as collectability of accounts receivable, realizability of inventories, recoverability of deferred tax assets, impairment of goodwill and other long-lived assets, loss contingencies and adequacy of warranty accruals. Actual results could differ from those estimates. The Company believes that the estimates used are reasonable.


Note 1.	Nature of Business and Significant Accounting Policies—(Continued)

Accumulated other comprehensive earnings

Accumulated other comprehensive earnings includes cumulative translation adjustments and changes in minimum liability for pension plans. Foreign currency translation adjustments included in comprehensive income were not tax affected as investments in international affiliates are deemed to be indefinite in duration.

Recent accounting pronouncements

In June 2011, the FASB issued Accounting Standards Update No. 2011-05, “Presentation of Comprehensive Income” (“ASU 2011-05”) to improve the comparability, consistency, and transparency of financial reporting and to increase the prominence of items reported in other comprehensive income. ASU 2011-05 is effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. Accordingly, the Company adopted ASU 2011-05 on January 1, 2012.

In September 2011, the FASB issued Accounting Standards Update No. 2011-08, “Testing Goodwill for Impairment” (“ASU 2011-08”) to simplify how entities test goodwill for impairment. ASU 2011-08 is effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011. Accordingly, the Company adopted ASU 2011-08 on January 1, 2012.