1. Organization and Summary of Significant Accounting Policies

Archrock, Inc., formerly Exterran Holdings, Inc., together with its subsidiaries (“Archrock”, “our”, “we”, or “us”) is a pure play United States of America (“U.S.”) natural gas contract operations services business and the leading provider of natural gas compression services to customers in the oil and natural gas industry throughout the U.S. and a leading supplier of aftermarket services to customers that own compression equipment in the U.S. We operate in two primary business lines: contract operations and aftermarket services. In our contract operations business line, we use our fleet of natural gas compression equipment to provide operations services to our customers. In our aftermarket services business line, we sell parts and components and provide operations, maintenance, overhaul and reconfiguration services to customers who own compression equipment.

Principles of Consolidation

The accompanying consolidated financial statements include Archrock and its wholly-owned and majority-owned subsidiaries. All intercompany accounts and transactions have been eliminated in consolidation. Certain prior year amounts have been reclassified to conform to the current year presentation.

For financial reporting purposes, we consolidate the financial statements of Archrock Partners, L.P. (together with its subsidiaries, the “Partnership”) with those of our own and reflect its operations in our contract operations business segment. We control the Partnership through our ownership of its general partner. Public ownership of the Partnership’s net assets and earnings is presented as a component of noncontrolling interest in our consolidated financial statements. The borrowings of the Partnership are presented as part of our consolidated debt. However, we do not have any obligation for the payment of interest or repayment of borrowings incurred by the Partnership.

Use of Estimates in the Consolidated Financial Statements

The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the U.S. (“GAAP”) requires management to make estimates and assumptions that affect the reported amount of assets, liabilities, revenue and expenses, as well as the disclosures of contingent assets and liabilities. Because of the inherent uncertainties in this process, actual future results could differ from those expected at the reporting date. Management believes that the estimates and assumptions used are reasonable.

Cash and Cash Equivalents

We consider all highly liquid investments purchased with an original maturity of three months or less to be cash equivalents.

Revenue Recognition

Contract operations revenue is recognized when earned, which generally occurs monthly when service is provided under our customer contracts. Aftermarket services revenue is recognized as products are delivered and title is transferred or services are performed for the customer.

Concentrations of Credit Risk

Financial instruments that potentially subject us to concentrations of credit risk consist of cash and cash equivalents and accounts receivable. We believe that the credit risk in temporary cash investments is limited because our cash is held in accounts with multiple financial institutions. Trade accounts receivable are due from companies of varying size engaged principally in oil and natural gas activities throughout the U.S. We review the financial condition of customers prior to extending credit and generally do not obtain collateral for trade receivables. Payment terms are on a short-term basis and in accordance with industry practice. We consider this credit risk to be limited due to these companies’ financial resources, the nature of products and services we provide and the terms of our contract operations customer service agreements.

We maintain allowances for doubtful accounts for estimated losses resulting from our customers’ inability to make required payments. The determination of the collectability of amounts due from our customers requires us to use estimates and make judgments regarding future events and trends, including monitoring our customers’ payment history and current creditworthiness to determine that collectability is reasonably assured, as well as consideration of the overall business climate in which our customers operate. Inherently, these uncertainties require us to make judgments and estimates regarding our customers’ ability to pay amounts due to us in order to determine the appropriate amount of valuation allowances required for doubtful accounts. We review the adequacy of our allowance for doubtful accounts quarterly. We determine the allowance needed based on historical write-off experience and by evaluating significant balances aged greater than 90 days individually for collectability. Account balances are charged off against the allowance after all means of collection have been exhausted and the potential for recovery is considered remote. During the years ended December 31, 2015, 2014 and 2013, we recorded bad debt expense of $3.1 million, $1.7 million and a recovery of bad debt expense of $0.2 million, respectively.

Inventory

Inventory consists of parts used for maintenance of natural gas compression equipment. Inventory is stated at the lower of cost or market using the average-cost method. A reserve is recorded against inventory balances for estimated obsolescence based on specific identification and historical experience.

Property, Plant and Equipment

Property, plant and equipment are recorded at cost and depreciated using the straight-line method over their estimated useful lives as follows:



Compression equipment, facilities and other fleet assets	3 to 30 years
Buildings	20 to 35 years
Transportation, shop equipment and other	3 to 10 years

Major improvements that extend the useful life of an asset are capitalized. Repairs and maintenance are expensed as incurred. When property, plant and equipment is sold, retired or otherwise disposed of, the gain or loss is recorded in other (income) expense, net. Interest is capitalized during the construction period on equipment and facilities that are constructed for use in our operations. The capitalized interest is included as part of the cost of the asset to which it relates and is amortized over the asset’s estimated useful life.

Computer software

Certain costs related to the development or purchase of internal-use software are capitalized and amortized over the estimated useful life of the software, which ranges from three to five years. Costs related to the preliminary project stage and the post-implementation/operation stage of an internal-use computer software development project are expensed as incurred.

Long-Lived Assets

We review long-lived assets, including property, plant and equipment and identifiable intangibles that are being amortized, for impairment whenever events or changes in circumstances, including the removal of compressor units from our active fleet, indicate that the carrying amount of an asset may not be recoverable. An impairment loss exists when estimated undiscounted cash flows expected to result from the use of the asset and its eventual disposition are less than its carrying amount. When necessary, an impairment loss is recognized and represents the excess of the asset’s carrying value as compared to its estimated fair value and is charged to the period in which the impairment occurred. Identifiable intangibles are amortized over the assets’ estimated useful lives.

Goodwill

Goodwill acquired in connection with business combinations represents the excess of consideration over the fair value of tangible and identifiable intangible net assets acquired. Certain assumptions and estimates are employed in determining the fair value of assets acquired and liabilities assumed, as well as in determining the allocation of goodwill to the appropriate reporting unit.

We review the carrying value of our goodwill for potential impairment in the fourth quarter of every year, or whenever events or other circumstances indicate that we may not be able to recover the carrying amount. We first assess qualitative factors to evaluate whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount as the basis for determining whether it is necessary to perform the two-step goodwill impairment test. We may elect to perform the two-step goodwill impairment test without completing a qualitative assessment.

If a two-step process goodwill impairment test is elected or required, the first step is to compare the implied fair value of our reporting unit with its carrying value (including the goodwill). If the implied fair value of the reporting unit is higher than the carrying value, no impairment is deemed to exist and no further testing is required. If, however, the implied fair value of the reporting unit is below the recorded carrying value, then a second step must be performed to determine the goodwill impairment required, if any. We calculate the implied fair value of the reporting unit goodwill by allocating the estimated fair value of the reporting unit to all of the assets and liabilities of the reporting unit as if the reporting unit had been acquired in a business combination. If the carrying value of the reporting unit’s goodwill exceeds the implied fair value of the goodwill, we recognize an impairment loss for that excess amount.

Determining the fair value of a reporting unit under the first step of the goodwill impairment test is judgmental in nature and involves the use of significant estimates and assumptions, which have a significant impact on the fair value determined. We determine the fair value of our reporting unit using both the expected present value of future cash flows and a market approach. Each approach is weighted 50% in determining our calculated fair value. The present value of future cash flows is estimated using our most recent forecast and the weighted average cost of capital. The market approach uses a market multiple on the earnings before interest expense, provision for income taxes and depreciation and amortization expense of comparable peer companies. Significant estimates for our reporting unit included in our impairment analysis are our cash flow forecasts, our estimate of the market’s weighted average cost of capital and market multiples.

Beginning in late 2014 and extending throughout 2015, the energy markets experienced a significant reduction in oil and natural gas prices which has had a significant impact on the financial performance and operating results of many oil and natural gas companies. Such declines accelerated in the fourth quarter of 2015, resulting in higher borrowing costs for companies and a substantial reduction in forecasted capital spending across the energy industry leading to lower projected growth rates over the short-term. Such declines impacted our future cash flow forecasts, our market capitalization, and the market capitalization of peer companies. We identified these conditions as a triggering event, which required us to perform a goodwill impairment test as of December 31, 2015. As of this filing, we have not completed the goodwill impairment analysis, due to the complexities involved in determining the implied fair value of goodwill in the second step of the goodwill impairment test. However, based on the work performed to date, we have concluded that an impairment is probable and can be reasonably estimated. Accordingly, we recorded a full impairment of our remaining goodwill in the fourth quarter of 2015 of $3.7 million which is presented in goodwill impairment on the consolidated statement of operations. We expect to finalize the goodwill impairment analysis during the first quarter of 2016 and any resulting adjustment to the impairment will be recorded at that time.

Other (Income) Expense, Net

Other (income) expense, net, is primarily comprised of gains and losses from the sale of used assets.

Income Taxes

We account for income taxes under the asset and liability method, which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events included in the consolidated financial statements. Under this method, deferred tax assets and liabilities are determined based on the differences between the consolidated financial statements and tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in income in the period that includes the enactment date.

We record net deferred tax assets to the extent we believe these assets will more likely than not be realized. In making such a determination, we consider all available positive and negative evidence, including future reversals of existing taxable temporary differences, projected future taxable income, tax-planning strategies and results of recent operations. In the event we were to determine that we would be able to realize our deferred income tax assets in the future in excess of their net recorded amount, we would make an adjustment to the deferred tax asset valuation allowance, which would reduce the provision for income taxes.

We record uncertain tax positions in accordance with the accounting standard on income taxes under a two-step process whereby (1) we determine whether it is more likely than not that the tax positions will be sustained based on the technical merits of the position and (2) for those tax positions that meet the more-likely-than-not recognition threshold, we recognize the largest amount of tax benefit that is greater than 50 percent likely to be realized upon ultimate settlement with the related tax authority.

Hedging and Use of Derivative Instruments

We use derivative financial instruments to minimize the risks and/or costs associated with financial activities by managing our exposure to interest rate fluctuations on a portion of our debt obligations. We do not use derivative financial instruments for trading or other speculative purposes. We record interest rate swaps on the balance sheet as either derivative assets or derivative liabilities measured at their fair value. The fair value of our derivatives is estimated using a combination of the market and income approach based on forward London Interbank Offered Rate (“LIBOR”) curves. Changes in the fair value of the derivatives designated as cash flow hedges are deferred in accumulated other comprehensive income (loss), net of tax, to the extent the contracts are effective as hedges until settlement of the underlying hedged transaction. To qualify for hedge accounting treatment, we must formally document, designate and assess the effectiveness of the transactions. If the necessary correlation ceases to exist or if the anticipated transaction becomes improbable, we would discontinue hedge accounting and apply mark-to-market accounting. Amounts paid or received from interest rate swap agreements are charged or credited to interest expense and matched with the cash flows and interest expense of the debt being hedged, resulting in an adjustment to the effective interest rate.

Income (Loss) Attributable to Archrock Common Stockholders Per Common Share

Basic income (loss) attributable to Archrock common stockholders per common share is computed using the two-class method, which is an earnings allocation formula that determines net income per share for each class of common stock and participating security according to dividends declared and participation rights in undistributed earnings. Under the two-class method, basic income (loss) attributable to Archrock common stockholders per common share is determined by dividing income (loss) attributable to Archrock common stockholders after deducting amounts allocated to participating securities, by the weighted average number of common shares outstanding for the period. Participating securities include our unvested restricted stock and certain stock settled restricted stock units that have nonforfeitable rights to receive dividends or dividend equivalents, whether paid or unpaid. During periods of net loss, no effect is given to participating securities because they do not have a contractual obligation to participate in our losses.

Diluted income (loss) attributable to Archrock common stockholders per common share is computed using the weighted average number of shares outstanding adjusted for the incremental common stock equivalents attributed to outstanding options and warrants to purchase common stock, restricted stock units, stock to be issued pursuant to our employee stock purchase plan and convertible senior notes, unless their effect would be anti-dilutive.

The following table summarizes net income (loss) attributable to Archrock common stockholders used in the calculation of basic and diluted income (loss) per common share (in thousands):



	Years Ended December 31,
	2015			2014			2013
Loss from continuing operations attributable to Archrock stockholders	$	(166,226	)	$	(44,829	)	$	(35,626	)
Income from discontinued operations, net of tax	60,408			142,995			158,790
Net income (loss) attributable to Archrock shareholders	(105,818		)	98,166			123,164
Less: Net income attributable to participating securities	(514		)	(495		)	—
Net income (loss) attributable to Archrock common stockholders	$	(106,332	)	$	97,671		$	123,164

The following table shows the potential shares of common stock that were included in computing diluted income (loss) attributable to Archrock common stockholders per common share (in thousands):



	Years Ended December 31,
	2015		2014		2013
Weighted average common shares outstanding including participating securities	69,389		67,175		65,655
Less: Weighted average participating securities outstanding	(956	)	(941	)	(1,201	)
Weighted average common shares outstanding — used in basic income (loss) per common share	68,433		66,234		64,454
Net dilutive potential common shares issuable:
On exercise of options and vesting of restricted stock units	*		*		*
On settlement of employee stock purchase plan shares	*		*		*
On exercise of warrants	*		*		*
On conversion of 4.25% convertible senior notes due 2014	**		*		*
On conversion of 4.75% convertible senior notes due 2014	**		**		*
Weighted average common shares outstanding — used in diluted income (loss) per common share	68,433		66,234		64,454


*	Excluded from diluted income (loss) per common share as their inclusion would have been anti-dilutive.


**	Not applicable as the debt instrument was not outstanding during the period.

There were no adjustments to net income (loss) attributable to Archrock common stockholders for the diluted earnings (loss) per common share calculation during the years ended December 31, 2015, 2014 and 2013.

The following table shows the potential shares of common stock issuable that were excluded from computing diluted income (loss) attributable to Archrock common stockholders per common share as their inclusion would have been anti-dilutive (in thousands):



	Years Ended December 31,
	2015	2014	2013
Net dilutive potential common shares issuable:
On exercise of options where exercise price is greater than average market value for the period	572	515	734
On exercise of options and vesting of restricted stock units	214	490	547
On settlement of employee stock purchase plan shares	—	1	2
On exercise of warrants	—	10,666	12,426
On conversion of 4.25% convertible senior notes due 2014	—	7,073	15,334
On conversion of 4.75% convertible senior notes due 2014	—	—	119
Net dilutive potential common shares issuable	786	18,745	29,162

Comprehensive Income (Loss)

Components of comprehensive income (loss) are net income (loss) and all changes in equity during a period except those resulting from transactions with owners. Our accumulated other comprehensive income (loss) consists of foreign currency translation adjustments, changes in the fair value of derivative financial instruments, net of tax, that are designated as cash flow hedges and to the extent the hedge is effective, amortization of terminated interest rate swaps and adjustments related to changes in our ownership of the Partnership.

The following tables present the changes in accumulated other comprehensive income (loss) by component, net of tax and excluding noncontrolling interest, during the years ended December 31, 2013, 2014 and 2015:



	Derivatives Cash Flow Hedges				Foreign Currency Translation Adjustment				Total
Accumulated other comprehensive income (loss), January 1, 2013	$	(2,984	)		$	26,893			$	23,909
Loss recognized in other comprehensive income (loss), net of tax	(476		)	⁽¹⁾	(2,960		)		(3,436		)
Loss reclassified from accumulated other comprehensive income (loss), net of tax	2,114			⁽²⁾	7,491			⁽³⁾	9,605
Other comprehensive income attributable to Archrock stockholders	1,638				4,531				6,169
Accumulated other comprehensive income (loss), December 31, 2013	$	(1,346	)		$	31,424			$	30,078
Loss recognized in other comprehensive income (loss), net of tax	(1,295		)	⁽⁴⁾	(11,871		)		(13,166		)
(Gain) loss reclassified from accumulated other comprehensive income (loss), net of tax	1,730			⁽⁵⁾	(2,777		)	⁽⁶⁾	(1,047		)
Other comprehensive income (loss) attributable to Archrock stockholders	435				(14,648		)		(14,213		)
Accumulated other comprehensive income (loss), December 31, 2014	$	(911	)		$	16,776			$	15,865
Loss recognized in other comprehensive income (loss), net of tax	(2,713		)	⁽⁷⁾	(3,558		)		(6,271		)
(Gain) loss reclassified from accumulated other comprehensive income (loss), net of tax	2,054			⁽⁸⁾	(13,218		)	⁽⁹⁾	(11,164		)
Other comprehensive loss attributable to Archrock stockholders	(659		)		(16,776		)		(17,435		)
Accumulated other comprehensive income (loss), December 31, 2015	$	(1,570	)		$	—			$	(1,570	)


⁽¹⁾	During the year ended December 31, 2013, we recognized a loss of $0.5 million and a tax benefit of $0.1 million, in other comprehensive income (loss), net of tax, related to changes in the fair value of derivative financial instruments.


⁽²⁾	During the year ended December 31, 2013, we reclassified a $3.2 million loss to interest expense and a tax benefit of $1.1 million to provision for (benefit from) income taxes in our consolidated statements of operations from accumulated other comprehensive income (loss).

⁽³⁾

During the year ended December 31, 2013, we reclassified losses of $7.5 million related to foreign currency translation adjustments to income from discontinued operations, net of tax in our consolidated statements of operations. These amounts represent cumulative foreign currency translation adjustments associated with Exterran Corporation’s contract operations and aftermarket services businesses in Canada and United Kingdom entity that were sold during the year ended December 31, 2013.


⁽⁴⁾	During the year ended December 31, 2014, we recognized a loss of $2.0 million and a tax benefit of $0.7 million, in other comprehensive income (loss), net of tax, related to changes in the fair value of derivative financial instruments.


⁽⁵⁾	During the year ended December 31, 2014, we reclassified a $2.6 million loss to interest expense and a tax benefit of $0.9 million to provision for (benefit from) income taxes in our consolidated statements of operations from accumulated other comprehensive income (loss).

⁽⁶⁾

During the year ended December 31, 2014, we reclassified a gain of $2.8 million related to foreign currency translation adjustments to discontinued operations, net of tax, in our consolidated statements of operations. This amount represents cumulative foreign currency translation adjustments associated with Exterran Corporation’s contract operations and aftermarket services businesses in Australia, which were sold in December 2014, that previously had been recognized in accumulated other comprehensive income (loss).


⁽⁷⁾	During the year ended December 31, 2015, we recognized a loss of $4.1 million and a tax benefit of $1.4 million, in other comprehensive income (loss), net of tax, related to changes in the fair value of derivative financial instruments.


⁽⁸⁾	During the year ended December 31, 2015, we reclassified a $3.2 million loss to interest expense and a tax benefit of $1.1 million to provision for (benefit from) income taxes in our consolidated statements of operations from accumulated other comprehensive income (loss).

⁽⁹⁾

During the year ended December 31, 2015, we reclassified a loss of $13.2 million related to foreign currency translation adjustments to additional paid in capital, in our consolidated balance sheet. This amount represents cumulative foreign currency translation adjustments associated with the businesses of Exterran Corporation which were spun-off in November 2015, that previously had been recognized in accumulated other comprehensive income (loss). See Note 2 (‘Discontinued Operations”) for further discussion of the Spin-off.

Financial Instruments

Our financial instruments consist of cash, receivables, payables, interest rate swaps and debt. At December 31, 2015 and 2014, the estimated fair values of these financial instruments approximated their carrying amounts as reflected in our consolidated balance sheets. The fair value of our fixed rate debt was estimated based on quoted market yields in inactive markets, which are Level 2 inputs. The fair value of our floating rate debt was estimated using a discounted cash flow analysis based on interest rates offered on loans with similar terms to borrowers of similar credit quality, which are Level 3 inputs. See Note 11 (“Fair Value Measurements”) for additional information regarding the fair value hierarchy.

The following table summarizes the carrying amount and fair value of our debt as of December 31, 2015 and 2014 (in thousands):



	December 31, 2015				December 31, 2014
	Carrying Amount		Fair Value		Carrying Amount		Fair Value
Fixed rate debt	$	691,465	$	524,000	$	1,040,295	$	960,000
Floating rate debt	897,000		897,000		985,500		986,000
Total debt	$	1,588,465	$	1,421,000	$	2,025,795	$	1,946,000

GAAP requires that all derivative instruments (including certain derivative instruments embedded in other contracts) be recognized in the balance sheet at fair value and that changes in such fair values be recognized in earnings (loss) unless specific hedging criteria are met. Changes in the values of derivatives that meet these hedging criteria will ultimately offset related earnings effects of the hedged item pending recognition in earnings.