Note 1:   Basis of Presentation and Summary of Significant Account Policies

The balance sheet as of June 30, 2015, which has been derived from audited financial statements, and the unaudited interim financial statements as of and for the three and six months ended December 31, 2015 and December 31, 2014,September 30, 2016, have been prepared by The L.S. Starrett Company (the “Company”) in accordance with accounting principles generally accepted in the United States of America for interim financial reporting.  Accordingly, they do not include all of the information and notes required by generally accepted accounting principles for complete financial statements.  These unaudited financial statements, which, in the opinion of management, reflect all adjustments (including normal recurring adjustments) necessary for a fair presentation, should be read in conjunction with the financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended June 30, 2015.2016.  Operating results are not necessarily indicative of the results that may be expected for any future interim period or for the entire fiscal year.

The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires management to make judgments, assumptions and estimates that affect amounts reported in the consolidated financial statements and accompanying notes.  Note 2 to the Company’s Consolidated Financial Statements included in the Annual Report on Form 10-K for the year ended June 30, 20152016 describes the significant accounting policies and methods used in the preparation of the consolidated financial statements.

Note 2:Recent Accounting Pronouncements

In May 2014, the FASB issued a new standard related to the “Revenue from Contracts with Customers” which amends the existing accounting standards for revenue recognition. The standard requires entities to recognize revenue when it transfers promised goods or services to customers in an amount that reflects the consideration the entity expects to be entitled to in exchange for those goods or services. This standard is applicable for fiscal years beginning after December 15, 2017 and for interim periods within those years and early adoption is not permitted.years. Earlier application will be permitted only as of annual reporting periods beginning after December 15, 2016, including interim reporting periods within that reporting period. The Company expects to adopt this standard on July 1, 2018.2017. The Company is currently evaluating the impact of the adoption of this standard on its consolidated financial statements.

Accounting Standards Update (ASU)In July 2015, the FASB issued ASU No. 2015-11, "Inventory -(Topic 330): Simplifying the Measurement of Inventory" requires companiesInventory." Previous to measure most inventory at the lowerissuance of cost or net realizable value, thereby simplifying the current guidance under which a company mustthis ASU, ASC 330 required that an entity measure inventory at the lower of cost or market. This Update eliminates the need to determine replacement cost and evaluate whether said cost is within a quantitative range. This Update also further aligns U.S. GAAP and international accounting standards. For public companies, the guidance in ASU 2015-11 specifies that “market” is defined as “net realizable value,” or the estimated selling price in the ordinary course of business, less reasonably predictable costs of completion, disposal, and transportation. This ASU is effective for fiscal years, and for interim periods within those fiscal years, beginning after December 15, 2016. Application is to be applied prospectively with earlier application permitted as of the beginning of an interim or annual reporting period. The adoption of ASU No. 2015-11 will not have a material impact on our consolidated financial statements. 

In February 2016, the FASB issued ASU No. 2016-02, “Leases (Topic 842)”.  The ASU requires that organizations that lease assets recognize assets and liabilities on the balance sheet for the rights and obligations created by those leases.  The ASU will affect the presentation of lease related expenses on the income statement and statement of cash flows and will increase the required disclosures related to leases.  This ASU is effective for annual periods beginning after December 15, 2018, and interim periods thereafter, with early adoption permitted.  The Company is currently evaluating the impact of ASU No. 2016-02 on its consolidated financial statements.  It is expected that a key change upon adoption will be the balance sheet recognition of leased assets and liabilities and that any changes in income statement recognition will not be material.

In March 2016, the FASB issued ASU No. 2016-09, "Compensation - Stock Compensation (Topic 718), Improvements to Employee Share-Based Payment Accounting." The ASU affects the accounting for employee share-based payment transactions as it relates to accounting for income taxes, accounting for forfeitures, and statutory tax withholding requirements. This ASU is effective for annual periods beginning after December 15, 2016, and interim periods thereafter. Early adoption is permitted. Management does not expect ASU 2015-11 to have a material impact on the Company's financial statements and disclosures.

Accounting Standards Update 2015-17, “Balance Sheet Classification of Deferred Taxes” requires that companies classify all deferred taxes as non-current assets or liabilities. This change is applicable for fiscal years beginning after December 15, 2016 and for interim periods within those years. Thereperiods with early adoption permitted. The Company has adopted the new guidance prospectively in the first quarter of fiscal 2017.The Company is nocurrently evaluating the impact to earnings as a result of this change; however, current assets will be reduced by the amount of the current deferred tax asset as that amount will be included with the long term deferred tax asset upon adoption of this ASU.standard on its consolidated financial statements. 

Note 3:  Stock-based Compensation

On September 5, 2012, the Board of Directors adopted TheL.S.The L.S. Starrett Company 2012 Long Term Incentive Plan (the “2012 Stock Plan”). The 2012 stock plan was approved by shareholders on October 17, 2012. The 2012 Stock Plan permits the granting of the following types of awards to officers, other employees and non-employee directors: stock options; restricted stock awards; unrestricted stock awards; stock appreciation rights; stock units including restricted stock units; performance awards; cash-based awards; and awards other than previously described that are convertible or otherwise based on stock. The 2012 Stock Plan provides for the issuance of up to 500,000 shares of common stock.      

Options granted vest in periods ranging from one year to three years and expire ten years after the grant date. Restricted stock units (“RSU”) granted generally vest from one year to three years. Vested restricted stock units will be settled in shares of common stock. As of December 31, 2015,September 30, 2016, there were 20,000 stock options and 73,367105,634 restricted stock units outstanding. In addition, there were 391,600346,600 shares available for grant under the 2012 Stock Plan as of December 31, 2015.September 30, 2016.

For stock option grants the fair value of each grant is estimated at the date of grant using the Binomial Options pricing model. The Binomial Options pricing model utilizes assumptions related to stock volatility, the risk-free interest rate, the dividend yield, and employee exercise behavior. Expected volatilities utilized in the model are based on the historic volatility of the Company’s stock price. The risk free interest rate is derived from the U.S. Treasury Yield curve in effect at the time of the grant. The expected life is determined using the average of the vesting period and contractual term of the options (Simplified Method).

No stock options were granted during the sixthree months ended December 31, 2015September 30, 2016 and 2014.2015.

The weighted average contractual term for stock options outstanding as ofDecember 31, 2015ofSeptember 30, 2016 was 76.25 years.  The aggregateThere was no intrinsic value of stock options outstanding as ofDecember 31, 2015 was $0.1 million.ofSeptember 30, 2016. Stock options exercisable as ofDecember 31, 2015ofSeptember 30, 2016 were 20,000.20,000.In recognizing stock compensation expense for the 2012 Stock Incentive Plan management has estimated that there will be no forfeitures of options.

The Company accounts for stock options and RSU awards by recognizing the expense of the grant date fair value ratably over vesting periods generally ranging from one year to three years. The related expense is included in selling, general and administrative expenses. 

There were 40,20045,000 RSU awards with a fair value of $15.11$10.86 per RSU granted during the sixthree months ended December 31, 2015.September 30, 2016. There were 9,06712,733 RSUs settled during the sixthree months ended December 31, 2015.September 30, 2016.  The aggregate intrinsic value of RSU awards outstanding as of December 31, 2015September 30, 2016 was $1.2$1.0 million. As of December 31, 2015September 30, 2016 all vested awards had been issued and settled.

On February 5, 2013, the Board of Directors adopted The L.S. Starrett Company 2013 Employee Stock Ownership Plan (the “2013 ESOP”).The. The purpose of the plan is to supplement existing Company programs through an employer funded individual account plan dedicated to investment in common stock of the Company, thereby encouraging increased ownership of the Company while providing an additional source of retirement income.  The plan is intended as an employee stock ownership plan within the meaning of Section 4975 (e) (7) of the Internal Revenue Code of 1986, as amended. U.S. employees who have completed a year of service are eligible to participate.

Compensation expense related to all stock based plans for the sixthree month periods ended December 31,September 30, 2016 and 2015 and 2014 was $0.2 million and $0.1 million respectively.for both periods.  As of December 31, 2015,September 30, 2016, there was $1.1$1.4 million of total unrecognized compensation costs related to outstanding stock-based compensation arrangements. Of this cost $0.7$1.1 million relates to performance based RSU grants that are not expected to be awarded. The remaining $0.4$0.3 million is expected to be recognized over a weighted average period of 2.21.8 years.

Note 4:   Inventories

Inventories consist of the following (in thousands):

Note 5:   Goodwill and Intangible Assets

The Company’s acquisition of Bytewise in 2011 gave rise to a goodwill asset balance.goodwill. The Company performed a qualitative analysis in accordance with ASU 2011-08 for its October 1, 2015 annual assessment of goodwill (commonly referred to as “Step Zero”). From a qualitative perspective, in evaluating whether it is more likely than not that the fair value of the reporting unit exceeds its respective carrying amount, relevant events and circumstances were taken into account, with greater weight assigned to events and circumstances that most affect the fair value or the carrying amounts of its assets. Items that were considered included, but were not limited to, the following: macroeconomic conditions, industry and market conditions, cost factors, overall financial performance and changes in management or key personnel. After assessing these and other factors the Company determined that it was more likely than not that the fair value of the reporting unit exceeded its carrying amount as of October 1, 2015.

Amortizable intangible assets consist of the following (in thousands):

Note 6:  Pension and Post-retirement Benefits

Net periodic benefit costs for the Company's defined benefit pension plans consist of the following (in thousands):

Note 7:   Debt

Debt including capitalized lease obligations, is comprised of the following (in thousands):

Note 8:   Income TaxesTax

The Company is subject to U.S. federal income taxestax and various state, local and foreign income taxes in numerous jurisdictions.  The Company’s domestic and foreign tax liabilities are subject to the allocation of revenues and expenses in different jurisdictions and the timing of recognizing revenues and expenses.  Additionally, the amount of income taxes paid is subject to the Company’s interpretation of applicable tax laws in the jurisdictions in which it files.

The Company provides for income taxes on an interim basis based on an estimate of the effective tax rate for the year. This estimate is reassessed on a quarterly basis. Discrete tax items are accounted for in the quarterly period in which they occur.

The tax expense for the secondfirst quarter of fiscal 20162017 was $534,000$717,000 on a profit before tax of $992,000$1,476,000 (an effective tax rate of 53.8%48.6%). The tax expense for the secondfirst quarter of fiscal 20152016 was $1,876,000$660,000 on a profit before tax for the quarter of $4,323,000$482,000 (an effective tax rate of 43.4%). For the first half of fiscal 2016, tax expense was $1,194,000 on profit before tax of $1,474,000 (an effective tax rate of 81.0%) and for the first half of fiscal 2015, tax expense was $2,694,000 on profit before tax of $6,064,000 (tax rate of 44.4%136.9%). The tax rate in the first quarter of fiscal 2017 is higher than the U.S. statutory rate of approximately 40% as a result of discrete adjustments primarily for the impact of a tax rate change in the U.K. applied to deferred tax assets which increased tax expense by $298,000 in the quarter. The tax rate for the first quarter of fiscal 2016 was higher than the U.S. federal and state statutory rate of approximately 40% primarily due to losses in some foreign jurisdictions for which no tax benefit is recognized. In the first quarter of fiscal 2016, there was a discrete reduction to tax expense of $54,000 related to returnprovision to provisionreturn adjustments in the United Kingdom (UK). In addition, in the second quarter of fiscal 2016, there were discrete adjustments of an increase for interest on audit exposures of $46,000 and a decrease for return to provision adjustments in the U.S. of $146,000. In the first half of fiscal 2015, there was a discrete reduction to tax expense of $108,000 related to use of tax loss carryforwards and a reduction of the tax liability for audits related to the expiration of the statute of limitations; $33,000 of this was recorded in the second quarter of fiscal 2015.UK.

U.S. Federal tax returns through fiscal 20112012 are generally no longer subject to review by tax authorities; however, tax loss carryforwards from years before fiscal 2012 are still subject to adjustment. As of December 31, 2015,September 30, 2016, the Company has substantially resolved all open income tax audits and there were no other local or federal income tax audits in progress. In international jurisdictions including Australia, Brazil, Canada, China, Germany, Mexico, New Zealand, Singapore and the UK, which comprise a significant portion of the Company’s operations, the years that may be examined vary by country. The Company’s most significant foreign subsidiary in Brazil is subject to audit for the calendar years 20102011 – 2014. During2015. The Company has identified no new uncertain tax positions during the three month period ended September 30, 2016 for which it is currently likely that the total amount of unrecognized tax benefits will significantly increase or decrease within the next twelve months, it is possible that the Company will recognize a reduction of $0.4 million in its long term tax obligations due to the lapse of the applicable statute of limitations.months.

Accounting for income taxes requires estimates of future benefits and tax liabilities. Due to the temporary differences in the timing of recognition of items included in income for accounting and tax purposes, deferred tax assets or deferred tax liabilities are recorded to reflect the impact arising from these differences on future tax payments. With respect to recorded deferred tax assets, the Company assesses the likelihood that the asset will be realized by addressing the positive and negative evidence to determine whether realization is more likely than not to occur. If realization is in doubt because of uncertainty regarding future profitability, the Company provides a valuation allowance related to the asset to the extent that it is more likely than not that the deferred tax asset will not be realized. Should any significant changes in the tax law or the estimate of the necessary valuation allowance occur, the Company would record the impact of the change, which could have a material effect on ourthe Company’s financial position.

No valuation allowance has been recorded for the Company’s domestic federal net operating loss (NOL) carry-forwards.deferred tax assets related to temporary differences in items included in taxable income. The Company continues to believe that due to forecasted future taxable income and certain tax planning strategies available, it is more likely than not that it will be able to utilize the tax benefit provided by those differences. In the U.S. federal NOL carryforwards., there is a valuation allowance against foreign tax credits to the extent they are limited. In certain other countries where Company operations are in a loss position, the deferred tax assets for tax loss carryforwards and other temporary differences are fully offset by a valuation allowance.

In November 2015, the FASB issued Accounting Standards Update No. 2015-17 ("ASU 2015-17") regarding ASC Topic 740 "Income Taxes: Balance Sheet Classification of Deferred Taxes." The amendments in ASU 2015-17 eliminate the requirement to bifurcate Deferred Taxes between current and non-current on the balance sheet and requires that all deferred tax liabilities and assets be classified as noncurrent on the balance sheet. The amendments for ASU 2015-17 can be applied retrospectively or prospectively and early adoption is permitted. The Company has  adopted  the new guidance prospectively in the first quarter of fiscal 2017. Implementation has no effect on the Consolidated Statement of Operations but does result in a change in classification of $4.5 million of deferred tax assets from short-term to long-term.

Note 9:  Contingencies

The Company is involved in certain legal matters which arise in the normal course of business. These matters are not expected to have a material impact on the Company’s financial condition, results of operations or cash flows.

Note 10. Segment Information

The segment information and the accounting policies of each segment are the same as those described in the notes to the consolidated financial statements entitled “Financial Information by Segment & Geographic Area” included in our Annual Report on Form 10-K for the year ended June 30, 2016. Our business is aggregated into two reportable segments based on geography of operations: North American Operations and International Operations. Segment income is measured for internal reporting purposes by excluding corporate expenses. Other income and expense, including interest income and expense, and income taxes are excluded entirely from the table below. The restructuring charge of $343,000 is included in the unallocated column. There were no significant changes in the segment operations or in the segment assets from the Annual Report. Financial results for each reportable segment are as follows (in thousands):

¹ Excludes $2,357 of North American segment intercompany sales to the International segment and $3,082 of International segment intercompany sales to the North American segment.

²Excludes $1,910 of North American segment intercompany sales to the International segment and $2,262 of International segment intercompany sales to the North American segment.