NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

In these notes, “we,” “us,” “our,” “Brown-Forman,” and the “Company” refer to Brown-Forman Corporation and its consolidated subsidiaries, collectively.

1.     Condensed Consolidated Financial Statements  

We prepared the accompanying unaudited condensed consolidated financial statements pursuant to the rules and regulations of the U.S. Securities and Exchange Commission (SEC) for interim financial information. In accordance with those rules and regulations, we condensed or omitted certain information and disclosures normally included in annual financial statements prepared in accordance with U.S. generally accepted accounting principles (GAAP). In our opinion, the accompanying financial statements include all adjustments, consisting only of normal recurring adjustments (unless otherwise indicated), necessary for a fair statement of our financial results for the periods presented in these financial statements. The results for interim periods are not necessarily indicative of future or annual results.

We suggest that you read these condensed financial statements together with the financial statements and footnotes included in our Annual Report on Form 10-K for the fiscal year ended April 30, 2018 (2018 Form 10-K). Except for adopting the new accounting standards discussed below, we prepared the accompanying financial statements on a basis that is substantially consistent with the accounting principles applied in our 2018 Form 10-K.

Recently adopted accounting standards.  As of May 1, 2018, we adopted the following Accounting Standards Updates (ASUs) issued by the Financial Accounting Standards Board (FASB):

postretirement benefit plans. The guidance requires the service cost component of the NPC to be reported in the income statement in the same line item(s) as other compensation costs arising from services rendered by the pertinent employees during the period. The other components of the NPC are to be presented separately from the service cost and outside of income from operations. In addition, the guidance allows only the service cost component of NPC to be eligible for capitalization when applicable. We applied the guidance retrospectively for the presentation in the income statement and prospectively for the capitalization of service cost. The retrospective application increased previously-reported operating income by $2 million and $7 million for the three and nine months ended January 31, 2018, respectively. As the retrospective application merely reclassified amounts from operating income to non-operating expense, there was no effect on previously-reported net income or earnings per share.

New accounting standards to be adopted.  We will adopt the following ASUs as of May 1, 2019:

We continue to make progress in implementing the new standard. We continue to evaluate and collect data about our lease arrangements, are in the process of implementing a new lease accounting system, and are identifying and making other changes to our processes and controls to meet the requirements of the new standard. Although we are unable to quantify the impact of adoption at this time, the amount of lease liabilities and right-of-use assets to be recognized on our balance sheet could be material. We do not currently expect adoption to have a material impact on our results of operations, stockholders’ equity, or cash flows.

We will adopt ASC 842 as of May 1, 2019, using a modified retrospective transition approach for leases existing at that date. For the transition, we expect to elect to use the package of practical expedients to not reassess (a) whether existing contracts are or contain leases, (b) the classification of existing leases, and (c) initial direct costs for existing leases.

There are no other new accounting standards to be adopted that we currently believe might have a significant impact on our consolidated financial statements.

Reclassifications . We have reclassified some previously reported expense amounts related to certain marketing research and promotional agency costs to conform to the current year classification. These immaterial reclassifications between advertising expenses and selling, general, and administrative expenses had no impact on operating income or net income.

2.     Net Sales  

Effective May 1, 2018, we updated our policy for recognizing revenue (“net sales”) to reflect the adoption of ASC 606. We describe the updated policy below. Also, we show how the adoption impacted our financial statements and we present disaggregated net sales information in accordance with the new standard.

Revenue recognition policy. Our net sales predominantly reflect global sales of beverage alcohol consumer products. We sell these products under contracts with different types of customers, depending on the market. The customer is most often a distributor, wholesaler, or retailer.

Each contract typically includes a single performance obligation to transfer control of the products to the customer. Depending on the contract, control is transferred when the products are either shipped or delivered to the customer, at which point we recognize the transaction price for those products as net sales. The transaction price recognized at that point reflects our estimate of the consideration to be received in exchange for the products. The actual amount may ultimately differ due to the effect of various customer incentives and trade promotion activities. In making our estimates, we consider our historical

experience and current expectations, as applicable. Adjustments recognized during the three and nine months ended January 31, 2019, for changes in estimated transaction prices of products sold in prior periods were not material.

Net sales exclude taxes we collect from customers that are imposed by various governments on our sales, and are reduced by payments to customers unless made in exchange for distinct goods or services with fair values approximating the payments.

Net sales include any amounts we bill customers for shipping and handling activities related to the products. We recognize the cost of those activities in cost of sales during the same period in which we recognize the related net sales.

Sales returns, which are permitted only in limited situations, are not material.

Customer payment terms generally range from 30 to 90 days. There are no significant amounts of contract assets or liabilities.

Impact of adoption. We adopted ASC 606 using the modified retrospective method. As a result, we recorded an adjustment that decreased retained earnings as of May 1, 2018, by $25 million (net of tax). The adjustment reflects the cumulative effect on that date of applying our updated revenue recognition policy, under which we recognize the cost of certain customer incentives earlier than we did before adopting ASC 606. Although we do not expect this change in timing to have a significant impact on a full-year basis, there is some change in the timing of recognition across periods. Additionally, some payments to customers that we classified as expenses before adopting the new standard are classified as reductions of net sales under our new policy.

The following table shows how the adoption of ASC 606 impacted our consolidated statement of operations for the three months ended January 31, 2019:

	Three Months Ended January 31, 2019
	Under Prior				As Reported Under				Effect of
(Dollars in millions, except per share amounts)	Guidance				ASC 606				Adoption
Sales	$	1,178			$	1,181			$	3
Excise taxes	277				277				—
Net sales	901				904				3
Cost of sales	333				333				—
Gross profit	568				571				3
Advertising expenses	105				103				(2		)
Selling, general, and administrative expenses	149				149				—
Other expense (income), net	(1		)		(1		)		—
Operating income	315				320				5
Non-operating postretirement expense	15				15				—
Interest income	(2		)		(2		)		—
Interest expense	23				23				—
Income before income taxes	279				284				5
Income taxes	56				57				1
Net income	$	223			$	227			$	4
Earnings per share:
Basic	$	0.46			$	0.47			$	0.01
Diluted	$	0.46			$	0.47			$	0.01

The following table shows how the adoption of ASC 606 impacted our consolidated statement of operations for the nine months ended January 31, 2019:

	Nine Months Ended January 31, 2019
	Under Prior				As Reported Under				Effect of
(Dollars in millions, except per share amounts)	Guidance				ASC 606				Adoption
Sales	$	3,344			$	3,329			$	(15	)
Excise taxes	749				749				—
Net sales	2,595				2,580				(15		)
Cost of sales	896				896				—
Gross profit	1,699				1,684				(15		)
Advertising expenses	313				303				(10		)
Selling, general, and administrative expenses	480				478				(2		)
Other expense (income), net	(13		)		(13		)		—
Operating income	919				916				(3		)
Non-operating postretirement expense	19				19				—
Interest income	(6		)		(6		)		—
Interest expense	67				67				—
Income before income taxes	839				836				(3		)
Income taxes	161				160				(1		)
Net income	$	678			$	676			$	(2	)
Earnings per share:
Basic	$	1.41			$	1.41			$	—
Diluted	$	1.40			$	1.40			$	—

The following table shows how the adoption of ASC 606 impacted our consolidated balance sheet as of January 31, 2019:

	As of January 31, 2019
	Under Prior				As Reported Under				Effect of
(Dollars in millions)	Guidance				ASC 606				Adoption
Assets
Other current assets	$	288			$	287			$	(1	)
Deferred tax assets	19				20				1
Total assets	5,163				5,163				—
Liabilities
Accounts payable and accrued expenses	$	553			$	587			$	34
Deferred tax liabilities	126				119				(7		)
Total liabilities	3,643				3,670				27
Stockholders’ Equity
Retained earnings	$	2,112			$	2,085			$	(27	)
Total stockholders’ equity	1,520				1,493				(27		)

Disaggregated revenues.

The following table shows our net sales by geography:

	Three Months Ended								Nine Months Ended
	January 31,								January 31,
(Dollars in millions)	2018				2019				2018				2019
United States	$	387			$	413			$	1,180			$	1,217
Developed International 1	275				269				716				718
Emerging 2	163				165				445				460
Travel Retail 3	34				33				108				109
Non-branded and bulk 4	19				24				66				76
Total	$	878			$	904			$	2,515			$	2,580

¹ Represents net sales of branded products to “advanced economies” as defined by the International Monetary Fund (IMF), excluding the United States. Our largest developed international markets are the United Kingdom, Australia, and Germany.

² Represents net sales of branded products to “emerging and developing economies” as defined by the IMF. Our largest emerging markets are Mexico and Poland.

³ Represents net sales of branded products to global duty-free customers, travel retail customers, and the U.S. military regardless of customer location.

⁴ Includes net sales of used barrels, bulk whiskey and wine, and contract bottling regardless of customer location.

The following table shows our net sales by product category:

	Three Months Ended								Nine Months Ended
	January 31,								January 31,
(Dollars in millions)	2018				2019				2018				2019
Whiskey 1	$	688			$	709			$	1,958			$	2,017
Tequila 2	63				68				185				200
Vodka 3	39				36				105				96
Wine 4	50				51				155				153
Rest of portfolio	19				16				46				38
Non-branded and bulk 5	19				24				66				76
Total	$	878			$	904			$	2,515			$	2,580

¹ Includes all whiskey spirits and whiskey-based flavored liqueurs, ready-to-drink, and ready-to-pour products. The brands included in this category are the Jack Daniel's family of brands, Woodford Reserve, Canadian Mist, GlenDronach, BenRiach, Glenglassaugh, Old Forester, Early Times, Slane Irish Whiskey, and Coopers' Craft.

² Includes el Jimador, Herradura, New Mix, Pepe Lopez, and Antiguo.

³ Includes Finlandia.

⁴ Includes Korbel Champagne and Sonoma-Cutrer wines.

⁵ Includes net sales of used barrels, bulk whiskey and wine, and contract bottling regardless of customer location.

3.     Income Taxes

Our consolidated interim effective tax rate is based on our expected annual operating income, statutory tax rates, and income tax laws in the various jurisdictions where we operate. Significant or unusual items, including adjustments to accruals for tax uncertainties, are recognized in the fiscal quarter in which the related event or a change in judgment occurs. The effective tax rate of 19.2% for the nine months ended January 31, 2019 , is lower than the expected tax rate of 21.9% on ordinary income for the full fiscal year, primarily due to (a) the impact of discrete items, including true-ups to prior year tax returns, (b) the impact of the current year net adjustment to the provisional repatriation U.S. tax charge that was made during fiscal 2018 (discussed below), and (c) excess tax benefits related to stock-based compensation. Our expected tax rate includes current fiscal year additions for existing tax contingency items. We expect our full year effective tax rate to be between 19.0% and 20.0% based on the tax rate of 21.9% on ordinary income for the full fiscal year adjusted for known discrete items.

On December 22, 2017, the U.S. government enacted comprehensive tax legislation commonly referred to as the Tax Cuts and Jobs Act (Tax Act). The Tax Act significantly revised the future, ongoing U.S. corporate income tax by, among other things, lowering U.S. corporate income tax rates and implementing a territorial tax system. As we have an April 30 fiscal year-end, the lower corporate income tax rate was phased in, resulting in a U.S. statutory federal rate of 30.4%  for our fiscal year ended April 30, 2018, and  21%  for our current and subsequent fiscal years. For the nine months ended January 31, 2019 , the reduction of the U.S. statutory federal rate from 35% (the pre-Tax Act rate) to 21% resulted in a tax benefit of approximately  $90 million .

There were also certain transitional impacts of the Tax Act. As part of the transition to the new territorial tax system, the Tax Act imposed a one-time repatriation tax on deemed repatriation of historical earnings of foreign subsidiaries. In addition, we adjusted our U.S. deferred tax assets and liabilities to the lower federal base rate of  21% . These transitional impacts resulted in a provisional net charge of  $43 million  for the year ended April 30, 2018, comprising of a provisional repatriation U.S. tax charge of  $91 million  and a provisional net deferred tax benefit of  $48 million . In the nine months ended January 31, 2019 , we recorded a benefit of $4 million as an adjustment to the provisional repatriation tax.

The Tax Act also established new tax laws that impact our financial statements beginning in the current fiscal year. These new laws include, but are not limited to (a) Global Intangible Low-Tax Income (GILTI), a new inclusion rule affecting non-routine income earned by foreign subsidiaries; (b) Base Erosion Anti-abuse Tax (BEAT), a new minimum tax; (c) Foreign-Derived Intangible Income (FDII), a new preferential tax rate for domestic income earned from serving foreign markets; (d) repeal of the domestic production activity deduction; and (e) limitations on the deductibility of certain executive compensation. For the nine months ended January 31, 2019 , the net impact of these provisions was approximately $8 million of additional tax.

As noted, certain income earned by foreign subsidiaries must be included in U.S. taxable income under the GILTI provisions. The FASB allows an accounting policy election to either recognize deferred taxes for temporary differences expected to reverse as GILTI in future years (deferred method) or recognize such taxes as a current period expense when incurred (period cost method). We have elected to account for GILTI using the period cost method.

Historically, we have asserted that the undistributed earnings of our foreign subsidiaries are reinvested indefinitely outside the United States. Therefore, no income taxes have been provided for any outside basis differences inherent in these subsidiaries other than those subject to the one-time repatriation tax. As of October 31, 2018, we changed our indefinite reinvestment assertion with respect to current year earnings and prior year undistributed earnings for one of those foreign subsidiaries (but not for its other outside basis differences) and repatriated approximately $120 million of cash to the United States from this subsidiary during the fiscal quarter ended January 31, 2019 . No incremental taxes are due on this distribution of cash beyond the repatriation tax recorded in fiscal year 2018. As of January 31, 2019, we changed our indefinite reinvestment assertion with respect to current year earnings and prior year undistributed earnings for additional select foreign subsidiaries (but not outside basis differences). Although these earnings are no longer indefinitely reinvested and may now be distributed within our foreign entity structure, they remain indefinitely reinvested outside the United States. No deferred taxes have been recorded as no withholding taxes would be due on their distribution. Also, any income tax related to foreign exchange fluctuations that would be due on the distribution of these earnings would be subject to the GILTI provisions and be recorded as incurred. We have not changed the indefinite reinvestment assertion on the undistributed earnings or other outside basis differences of any of our other remaining foreign subsidiaries and no deferred taxes have been provided.

The changes included in the Tax Act are broad and complex. The SEC issued rules that allowed for a measurement period of up to one year after the enactment date of the Tax Act to finalize the recording of the related tax impacts. As of January 31, 2019, the amounts recorded for the Tax Act for the one-time repatriation tax and the adjustment to our U.S. deferred tax assets and liabilities have been finalized and are no longer deemed to be provisional.

4.     Earnings Per Share  

We calculate basic earnings per share by dividing net income available to common stockholders by the weighted average number of common shares outstanding during the period. Diluted earnings per share further includes the dilutive effect of stock-based compensation awards. We calculate that dilutive effect using the “treasury stock method” (as defined by GAAP).

The following table presents information concerning basic and diluted earnings per share:

We excluded common stock-based awards for approximately 0 shares and 548,000  shares from the calculation of diluted earnings per share for the three months ended January 31, 2018 and 2019 , respectively. We excluded common stock-based awards for approximately 1,073,000 shares and 414,000  shares from the calculation of diluted earnings per share for the nine months ended January 31, 2018 and 2019 , respectively. We excluded those awards because they were not dilutive for those periods under the treasury stock method.

5.     Inventories  

Inventories are valued at the lower of cost or market. Some of our consolidated inventories are valued using the last-in, first-out (LIFO) method, which we use for the majority of our U.S. inventories. If the LIFO method had not been used, inventories at current cost would have been $290 million higher than reported as of April 30, 2018 , and $302 million higher than reported as of January 31, 2019 . Changes in the LIFO valuation reserve for interim periods are based on a proportionate allocation of the estimated change for the entire fiscal year.

6.     Goodwill and Other Intangible Assets

The following table shows the changes in goodwill (which includes no accumulated impairment losses) and other intangible assets during the nine months ended January 31, 2019:

Our other intangible assets consist of trademarks and brand names, all with indefinite useful lives.

7.     Commitments and Contingencies

We operate in a litigious environment, and we are sued in the normal course of business. Sometimes plaintiffs seek substantial damages. Significant judgment is required in predicting the outcome of these suits and claims, many of which take years to adjudicate. We accrue estimated costs for a contingency when we believe that a loss is probable and we can make a reasonable estimate of the loss, and then adjust the accrual as appropriate to reflect changes in facts and circumstances. We do not believe it is reasonably possible that these existing loss contingencies, individually or in the aggregate, would have a material adverse effect on our financial position, results of operations, or liquidity. No material accrued loss contingencies were recorded as of January 31, 2019 .

We have guaranteed the repayment by a third-party importer of its obligation under a bank credit facility that it uses in connection with its importation of our products in Russia. If the importer were to default on that obligation, which we believe is unlikely, our maximum possible exposure under the existing terms of the guaranty would be approximately $10 million (subject to changes in foreign currency exchange rates). Both the fair value and carrying amount of the guaranty are insignificant.

As of January 31, 2019 , our actual exposure under the guaranty of the importer’s obligation was approximately $6 million . We also have accounts receivable from that importer of approximately $8 million at January 31, 2019 , which we expect to collect in full.

Based on the financial support we provide to the importer, we believe it meets the definition of a variable interest entity. However, because we do not control this entity, it is not included in our consolidated financial statements.

8.     Debt

Our long-term debt (net of unamortized discount and issuance costs) consists of:

As of April 30, 2018, our short-term borrowings consisted of $215 million of commercial paper, with an average interest rate of 2.04% , and an average remaining maturity of 23 days . As of January 31, 2019 , our short-term borrowings consisted of $207 million of commercial paper, with an average interest rate of 2.67% , and an average remaining maturity of 21 days .

9.     Fair Value Measurements

The following table summarizes the assets and liabilities measured or disclosed at fair value on a recurring basis:

Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants at the measurement date. We categorize the fair values of assets and liabilities into three levels based upon the assumptions (inputs) used to determine those values. Level 1 provides the most reliable measure of fair value, while Level 3 generally requires significant management judgment. The three levels are:

We determine the fair values of our currency derivatives (forward contracts) using standard valuation models. The significant inputs used in these models, which are readily available in public markets or can be derived from observable market transactions, include the applicable spot exchange rates, forward exchange rates, and interest rates. These fair value measurements are categorized as Level 2 within the valuation hierarchy.

We determine the fair value of long-term debt primarily based on the prices at which identical or similar debt has recently traded in the market and also considering the overall market conditions on the date of valuation. These fair value measurements are categorized as Level 2 within the valuation hierarchy.

The fair values of cash, cash equivalents, and short-term borrowings approximate the carrying amounts due to the short maturities of these instruments.

We measure some assets and liabilities at fair value on a nonrecurring basis. That is, we do not measure them at fair value on an ongoing basis, but we do adjust them to fair value in some circumstances (for example, when we determine that an asset is impaired). No material nonrecurring fair value measurements were required during the periods presented in these financial statements.

10.     Derivative Financial Instruments   and Hedging Activities

Our multinational business exposes us to global market risks, including the effect of fluctuations in currency exchange rates, commodity prices, and interest rates. We use derivatives to help manage financial exposures that occur in the normal course of business. We formally document the purpose of each derivative contract, which includes linking the contract to the financial exposure it is designed to mitigate. We do not hold or issue derivatives for trading or speculative purposes.

We use currency derivative contracts to limit our exposure to the currency exchange risk that we cannot mitigate internally by using netting strategies. We designate most of these contracts as cash flow hedges of forecasted transactions (expected to occur within three years). We record all changes in the fair value of cash flow hedges (except any ineffective portion) in accumulated other comprehensive income (AOCI) until the underlying hedged transaction occurs, at which time we reclassify that amount into earnings. We assess the effectiveness of these hedges based on changes in forward exchange rates. The ineffective portion of the changes in fair value of our hedges (recognized immediately in earnings) during the periods presented in these financial statements was not material.

We had outstanding currency derivatives, related primarily to our euro, British pound, and Australian dollar exposures, with notional amounts totaling $1,098 million at April 30, 2018 and $1,190 million at January 31, 2019 .

We also use foreign currency-denominated debt to help manage our currency exchange risk. As of January 31, 2019 ,

$622 million of our foreign currency-denominated debt instruments were designated as net investment hedges. These net investment hedges are intended to mitigate foreign exchange exposure related to non-U.S. dollar net investments in certain foreign subsidiaries. Any change in value of the designated portion of the hedging instruments is recorded in AOCI, offsetting the foreign currency translation adjustment of the related net investments that is also recorded in AOCI. There was no ineffectiveness related to our net investment hedges in any of the periods presented in these financial statements.

We do not designate some of our currency derivatives and foreign currency-denominated debt as hedges because we use them to at least partially offset the immediate earnings impact of changes in foreign exchange rates on existing assets or liabilities. We immediately recognize the change in fair value of these instruments in earnings.

We use forward purchase contracts with suppliers to protect against corn price volatility. We expect to physically take delivery of the corn underlying each contract and use it for production over a reasonable period of time. Accordingly, we account for these contracts as normal purchases rather than as derivative instruments.

The following tables present the pre-tax impact that changes in the fair value of our derivative instruments and non-derivative hedging instruments had on AOCI and earnings: