2. Summary of Significant Accounting Policies

a. Basis of Presentation

The accompanying unaudited condensed consolidated financial statements include the accounts of Clean Diesel Technologies, Inc. and its subsidiaries. In the opinion of management, all adjustments, consisting of normal recurring adjustments, necessary for a fair presentation have been reflected. The accompanying unaudited condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and related notes included in Clean Diesel Technologies, Inc.’s Annual Report on Form 10-K for the fiscal year ended December 31, 2010.

Certain financial information that is normally included in annual financial statements prepared in accordance with U.S. generally accepted accounting principles, but is not required for interim reporting purposes, has been condensed or omitted.

b. Stockholders’ Equity

Stockholders’ equity, including all share and per share amounts, has been retroactively restated to reflect the number of shares of common stock received by former CSI stockholders in the Merger and includes the effect of the one-for-six reverse stock split of CDTI’s common stock that became effective immediately prior to the closing of the Merger. See Note 3.

c. Principles of Consolidation

The condensed consolidated financial statements include the financial statements of the Company and its wholly owned subsidiaries. All significant inter-company balances and transactions have been eliminated in consolidation.

d. Concentration of Risk

For the periods presented below, certain customers accounted for 10% or more of the Company’s revenues as follows:


	Three Months Ended						Six Months Ended
	June 30,						June 30,
Customer	2011			2010			2011			2010
A		11	%		23	%		18	%		22	%
B		1	%		14	%		1	%		15	%

The customers above are automotive OEMs and relate to sales within the Catalyst segment.

The March 2011 earthquake and resulting tsunami in Japan caused a disruption to automotive production. Customer A has significant operations in Japan and has been impacted by the disaster there. Although the Company’s shipments are primarily to U.S.-based production sites, due to parts delays coming out of Japan, Customer A temporarily reduced its U.S.-based production. Customer A has announced that it plans to ramp production back up to normal production levels during the third quarter of 2011. The Company does not yet know what the effect of this decision will be on its third quarter results of operations.

For the periods presented below, certain customers accounted for 10% or more of the Company’s accounts receivable balance as follows:


	June 30,			December 31,
Customer	2011			2010
A		7	%		16	%
B		8	%		14	%

Customer A above is an automotive OEM and customer B is a diesel distributor.

For the periods presented below, certain vendors accounted for 10% or more of the Company’s raw material purchases as follows:


	Three Months Ended						Six Months Ended
	June 30,						June 30,
Vendor	2011			2010			2011			2010
A		17	%		21	%		18	%		22	%
B		11	%		12	%		9	%		14	%
C		4	%		6	%		7	%		10	%

Vendor A above is a catalyst supplier, vendor B is a precious metals supplier and vendor C is a substrate supplier.

e. Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States (“U.S. GAAP”) requires management of the Company to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Areas where significant judgments are made include but are not limited to the following: business combination accounting, impairment of goodwill and long-lived assets, stock-based compensation, the fair value of financial instruments, allowance for doubtful accounts, inventory valuation, taxes and contingent and accrued liabilities. Actual results could differ from those estimates. These estimates and assumptions are based on management’s best estimates and judgment. The Company evaluates its estimates and assumptions on an ongoing basis using historical experience and other factors, including the current economic environment, which it believes to be reasonable under the circumstances. Estimates and assumptions are adjusted when facts and circumstances dictate. As future events and their effects cannot be determined with precision, actual results could differ from these estimates. Changes in estimates resulting from continuing changes in the economic environment will be reflected in the financial statements in future periods.

f. Recapitalization Expense

Recapitalization expense consists primarily of the expense for legal, accounting and other advisory professional services related to the Company’s efforts in 2010 to explore strategic opportunities and include such costs related to the Merger.

g. Net (Loss) Income per Share

Basic net (loss) income per share is computed using the weighted average number of common shares outstanding during the period. Diluted net (loss) income per share is computed using the weighted average number of common shares and dilutive potential common shares. Dilutive potential common shares include employee stock options, other warrants and convertible notes that are convertible into the Company’s common stock. The Company had potential dilutive securities totaling 1,584,000 for the three and six months ended June 30, 2011 and 68,000 for the three and six months ended June 30, 2010.

Diluted net (loss) income per share excludes certain dilutive potential common shares outstanding as their effect is anti-dilutive. Because the Company incurred a net loss in the three and six months ended June 30, 2011 and the three months ended June 30, 2010, the effect of dilutive securities totaling 1,584,000 and 68,000 equivalent shares, respectively, has been excluded in the computation of net loss per share and net loss from continuing operations per share as their impact would be anti-dilutive. The effect of 58,000 equivalent out-of-the-money shares has been excluded in the computation of net income per share and net income from continuing operations per share for the six months ended June 30, 2010 as their impact would be anti-dilutive.

In addition to the option and warrant dilutive securities, a total of 1,510,189 shares that were issuable upon the conversion of the secured convertible notes (see Note 8) have been excluded from the computation of net (loss) income per share and net (loss) income from continuing operations per share for the three months and six months ended June 30, 2010 as their impact would be anti-dilutive for the secured convertible notes issued through June 30, 2010 and the remainder were issuable upon contingencies that had not been resolved as of June 30, 2010.

h. Comprehensive (Loss) Income

The Company’s other comprehensive income consists of foreign currency translation adjustments from those subsidiaries not using the U.S. dollar as their functional currency. Total comprehensive income (loss) is as follows (in thousands):


	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2011			2010			2011			2010
Net (loss) income	$	(3,724	)	$	(1,947	)	$	(6,047	)	$	645
Unrealized (loss) gain on foreign currency translation		(90	)		(544	)		461			(227	)

Comprehensive (loss) income	$	(3,814	)	$	(2,491	)	$	(5,586	)	$	418

i. Fair Value Measurements

Fair value is defined as an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. As such, fair value is a market-based measurement that should be determined based on assumptions that market participants would use in pricing an asset and liability. As a basis for considering such assumptions, a fair value hierarchy has been established that prioritizes the inputs used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (level 1 measurement) and the lowest priority to unobservable inputs (level 3 measurements). The three levels of the fair value hierarchy are as follows:

	•		Level 1: Quoted prices (unadjusted) in active markets for identical assets or liabilities;

	•		Level 2: Inputs other than quoted prices included within Level 1 that are either directly or indirectly observable including quoted prices for similar instruments in active markets and quoted prices for identical or similar instruments in markets that are not active; and

	•		Level 3: Unobservable inputs in which little or no market activity exists, therefore requiring an entity to develop its own assumptions about the assumptions that market participants would use in pricing.

The fair values of the Company’s cash and cash equivalents, trade accounts receivable, prepaid expenses and other current assets, accounts payable and accrued expenses and other current liabilities approximate carrying values due to the short maturity of these instruments. The fair value of borrowings under the line of credit approximates their carrying value due to their variable interest rates. The fair value of long-term debt is approximately $3.7 million at June 30, 2011. To a lesser extent, debt also includes capital lease obligations for which the carrying amount approximates the fair value.

See Note 10 regarding the fair value of the Company’s warrants.

j. Accounting Changes

In December 2010, the FASB issued ASU 2010-28, Intangibles —Goodwill and Other (Topic 350): When to Perform Step 2 of the Goodwill Impairment Test for Reporting Units with Zero or Negative Carrying Amounts (ASU 2010-28 ) to clarify when testing for goodwill impairment is required. The modifications clarify that when the carrying amount of a reporting unit is zero or negative, an entity is required to perform step 2 of the goodwill impairment test if it is more likely than not a goodwill impairment exists. The modifications are effective for fiscal years beginning after December 15, 2010 and interim periods within those years. Early adoption is not permitted. The adoption of this accounting update did not have an impact on the Company’s financial statements as of the adoption date.

k. Reclassifications

In prior periods the Company presented “Selling and marketing” expenses and “General and administrative” expenses separately on its statement of operations. Beginning with the statement of operations included in the Annual Report on Form 10-K for the year ended December 31, 2010, the Company now combines these categories of expenses into “Selling, general and administrative expenses” because there is considerable overlap between management functions pertaining to sales and marketing and general administrative duties, and as such, estimating allocation of expenses associated with these overlapping functions is not meaningful. Prior periods have been reclassified to reflect this change in presentation.