NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

Note 1—Basis of Presentation and Significant Accounting Policies

Operations

William Lyon Homes, a Delaware corporation (“Parent” and together with its subsidiaries, the “Company”), is primarily engaged in designing, constructing, marketing and selling single-family detached and attached homes in California, Arizona, Nevada, Colorado (under the Village Homes brand), Washington and Oregon (each under the Polygon Northwest Homes brand).

Basis of Presentation

The preparation of the Company’s financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of the assets and liabilities as of September 30, 2014 and December 31, 2013 and revenues and expenses for the three and nine month periods ended September 30, 2014 and 2013 . Accordingly, actual results could differ from those estimates. The significant accounting policies using estimates include real estate inventories and cost of sales, impairment of real estate inventories, warranty reserves, loss contingencies, sales and profit recognition, accounting for variable interest entities, business combinations, and valuation of deferred tax assets. The current economic environment increases the uncertainty inherent in these estimates and assumptions.

The condensed consolidated financial statements include the accounts of the Company and all majority-owned and controlled subsidiaries and joint ventures, and certain joint ventures and other entities which have been determined to be variable interest entities ("VIEs") in which the Company is considered the primary beneficiary (see Note 3). The accounting policies of the joint ventures are substantially the same as those of the Company. All significant intercompany accounts and transactions have been eliminated in consolidation.

The condensed consolidated financial statements were prepared from our books and records without audit and include all adjustments (consisting of only normal recurring accruals) necessary to present a fair statement of results for the interim periods presented. Readers of this quarterly report should refer to our audited consolidated financial statements as of and for the year ended December 31, 2013 , which are included in our 2013 Annual Report on Form 10-K, as certain disclosures that would substantially duplicate those contained in the audited financial statements have not been included in this report.

Real Estate Inventories

Real estate inventories are carried at cost net of impairment losses, if any. Real estate inventories consist primarily of land deposits, land and land under development, homes completed and under construction, and model homes. All direct and indirect land costs, offsite and onsite improvements and applicable interest and other carrying charges are capitalized to real estate projects during periods when the project is under development. Land, offsite costs and all other common costs are allocated to land parcels benefited based upon relative fair values before construction. Onsite construction costs and related carrying charges (principally interest and property taxes) are allocated to the individual homes within a phase based upon the relative sales value of the homes. The Company relieves its real estate inventories through cost of sales for the estimated cost of homes sold. Selling expenses and other marketing costs are expensed in the period incurred.

A provision for warranty costs relating to the Company’s limited warranty plans is included in cost of sales and accrued expenses at the time the sale of a home is recorded. The Company generally reserves either approximately one to one and one quarter percent of the sales price of its homes, or a set amount per home closed depending on operating division, against the possibility of future charges relating to its one -year limited warranty and similar potential claims. Factors that affect the Company’s warranty liability include the number of homes under warranty, historical and anticipated rates of warranty claims, and cost per claim. The Company assesses the adequacy of its recorded warranty liability and adjusts the amounts as necessary. Changes in the Company’s warranty liability for the nine months ended September 30, 2014 and 2013 , are as follows (in thousands):

 

The Company began accruing for warranty costs for units closed in the Washington and Oregon segments in conjunction with their acquisition (see Note 2) at a set rate per home, however the Company did not assume any warranty liability for units closed prior to the Acquisition date.

Interest incurred under the Company’s debt obligations, as more fully discussed in Note 6, is capitalized to qualifying real estate projects under development. Any additional interest charges related to real estate projects not under development are expensed in the period incurred. Interest activity for the three months ended September 30, 2014 and 2013 are as follows (in thousands):

 

Construction Services

The Company accounts for construction management agreements using the Percentage of Completion Method in accordance with Financial Accounting Standards Board ("FASB") Accounting Standards Codification ("ASC") Topic 605 Revenue Recognition (“ASC 605”). Under ASC 605, the Company records revenues and expenses as a contracted project progresses, and based on the percentage of costs incurred to date compared to the total estimated costs of the contract.

The Company entered into construction management agreements to build, sell and market homes in certain communities. For such services, the Company will receive fees (generally 3 to 5 percent of the sales price, as defined) and may, under certain circumstances, receive additional compensation if certain financial thresholds are achieved.

Financial Instruments

Financial instruments that potentially subject the Company to concentrations of credit risk are primarily cash and cash equivalents, restricted cash, receivables, and deposits. The Company typically places its cash and cash equivalents in investment grade short-term instruments. Deposits, included in other assets, are due from municipalities or utility companies and are generally collected from such entities through fees assessed to other developers. The Company is an issuer of, or subject to, financial instruments with off-balance sheet risk in the normal course of business which exposes it to credit risks. These financial instruments include letters of credit and obligations in connection with assessment district bonds. These off-balance sheet financial instruments are described in more detail in Note 12.

Cash and Cash Equivalents

Short-term investments with a maturity of three months or less when purchased are considered cash equivalents. The Company’s cash and cash equivalents balance exceeds federally insurable limits as of September 30, 2014 and December 31, 2013 . The Company monitors the cash balances in its operating accounts and adjusts the cash balances between accounts based on operational needs; however, these cash balances could be negatively impacted if the underlying financial institutions fail or

are subject to other adverse conditions in the financial markets. To date, the Company has experienced no loss or lack of access to cash in its operating accounts.

Restricted Cash

Restricted cash consists of deposits made by the Company to a bank account as collateral for the use of letters of credit to guarantee the Company’s financial obligations under certain other contractual arrangements in the normal course of business.

Deferred Loan Costs

Deferred loan costs represent debt issuance costs and are primarily amortized to interest incurred using the straight line method which approximates the effective interest method.

Goodwill

In accordance with the provisions of ASC 350, Intangibles, Goodwill and Other , goodwill amounts are not amortized, but rather are analyzed for impairment at the reporting segment level. Goodwill is analyzed on an annual basis, or when indicators of impairment exist. We have determined that we have seven reporting segments, as discussed in Note 4, and we perform an annual goodwill impairment analysis during the fourth quarter of each fiscal year.

Intangible Assets

Recorded intangible assets primarily relate to brand names of acquired entities, construction management contracts, homes in backlog, and joint venture management fee contracts recorded in conjunction with FASB ASC Topic 852, Reorganizations ("ASC 852"), or FASB ASC Topic 805, Business Combinations ("ASC 805"). All Intangible assets with the exception of those relating to brand names were valued based on expected cash flows related to home closings, and the asset is amortized on a per unit basis, as homes under the contracts close. Our brand name intangible assets are deemed to have an indefinite useful life.

Income (loss) per common share

The Company computes income (loss) per common share in accordance with FASB ASC Topic 260, Earnings per Share , which requires income (loss) per common share for each class of stock to be calculated using the two-class method. The two-class method is an allocation of income (loss) between the holders of common stock and a company’s participating security holders.

Basic income (loss) per common share is computed by dividing income or loss available to common stockholders by the weighted average number of shares of common stock outstanding. For purposes of determining diluted income (loss) per common share, basic income (loss) per common share is further adjusted to include the effect of potential dilutive common shares.

Income Taxes

Income taxes are accounted for under the provisions of Financial Accounting Standards Board ASC 740 , Income Taxes,  using an asset and liability approach. Deferred income taxes reflect the net effects of temporary differences between the carrying amount of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes, and operating loss and tax credit carryforwards measured by applying currently enacted tax laws. A valuation allowance is provided to reduce net deferred tax assets to an amount that is more likely than not to be realized. ASC 740 prescribes a recognition threshold and a measurement criteria for the financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be considered “more-likely-than-not” to be sustained upon examination by taxing authorities. In addition, the Company has elected to recognize interest and penalties related to uncertain tax positions in the income tax provision.

Impact of Recent Accounting Pronouncements

In May 2014, the FASB issued Accounting Standards Update ("ASU") No. 2014-09, Revenue from Contracts with Customers (“ASU 2014-09”), which clarifies existing accounting literature relating to how and when revenue is recognized by an entity. ASU 2014-09 affects any entity that either enters into contracts with customers to transfer goods or services or enters into contracts for the transfer of nonfinancial assets and supersedes the revenue recognition requirements in Topic 605, Revenue Recognition , and most industry-specific guidance. ASU 2014-09 requires an entity to recognize revenue when it transfers promised goods or services to customers in an amount that reflects the consideration to which an entity expects to be entitled in

exchange for those goods or services. In doing so, an entity will need to exercise a greater degree of judgment and make more estimates than under the current guidance. These may include identifying performance obligations in the contract, estimating the amount of variable consideration to include in the transaction price, and allocating the transaction price to each separate performance obligation. ASU 2014-09 also supersedes some cost guidance included in Subtopic 605-35, Revenue Recognition-Construction-Type and Production-Type Contracts . ASU 2014-09 is effective for public companies for interim and annual reporting periods beginning after December 15, 2016, and is to be applied either retrospectively or using the cumulative effect transition method, with early adoption not permitted. The Company has not yet selected a transition method, and is currently evaluating the impact the adoption of ASU 2014-09 will have on its condensed consolidated financial statements and related disclosures.

Note 2—Acquisition of Polygon Northwest Homes

On August 12, 2014 , the Company completed its acquisition of the residential homebuilding business of PNW Home Builders, L.L.C. (“PNW Parent”) pursuant to the Purchase and Sale Agreement (the “Purchase Agreement”) dated June 22, 2014 among William Lyon Homes, Inc., a California corporation and wholly-owned subsidiary of Parent ("California Lyon"), PNW Parent, PNW Home Builders North, L.L.C., PNW Home Builders South, L.L.C. and Crescent Ventures, L.L.C. Prior to such completion, California Lyon assigned its interests in the Purchase Agreement to Polygon WLH LLC, a newly formed Delaware limited liability company and wholly-owned subsidiary of California Lyon (“Polygon WLH”). Pursuant to the Purchase Agreement, Polygon WLH acquired, for cash, all of the membership interests of the underlying limited liability companies and certain service companies and other assets that comprised the residential homebuilding operations of PNW Parent (such operations being referred herein as "Polygon Northwest Homes") and which conducts business as Polygon Northwest Company (“Polygon”), for an aggregate cash purchase price of $520.0 million , an additional approximately $28.0 million at closing pursuant to initial working capital adjustments, plus an additional $4.3 million of consideration, a portion of which remains subject to final adjustment in accordance with the terms of the Purchase Agreement (the “Acquisition”). The acquired entities now operate as two new divisions of the Company under the Polygon name, one in Washington, with a core market of Seattle, and the other in Oregon, with a core market of Portland.

The Company financed the Acquisition with a combination of proceeds from its issuance of $300 million in aggregate principal amount of 7.00% senior notes due 2022 , cash on hand including approximately $100 million of aggregate proceeds from several separate land banking arrangements with respect to land parcels located in California, Washington and Oregon, each of which is entitled but undeveloped, and including parcels acquired in the Acquisition, and $120 million of borrowings under a new one-year senior unsecured loan facility.

As a result of the Acquisition, the entities comprising the business of Polygon Northwest Homes became wholly-owned direct or indirect subsidiaries of the Company, and its results are included in our condensed consolidated financial statements and related disclosures from the date of the Acquisition. For the period from August 12, 2014 through September 30, 2014 , operating revenue and income before provision for income taxes from Polygon operations, were $38.9 million and $4.0 million , respectively.

The Acquisition was accounted for as a business combination in accordance with ASC 805. Under ASC 805, the Company recorded the acquired assets and assumed liabilities of Polygon Northwest Homes at their estimated fair values, with the excess allocated to Goodwill, as shown below. Goodwill represents the value the Company expects to achieve through the operational synergies and the expansion of the Company into new markets. The Company estimates that the entire $48.9 million of goodwill resulting from the Acquisition will be tax deductible. Goodwill will be allocated to the Washington and Oregon operating segments (see Note 4). A reconciliation of the consideration transferred as of the acquisition date is as follows:

As of September 30, 2014 the Company had not completed its final estimate of the fair value of the net assets of Polygon Northwest Homes, due to the Acquisition's close proximity to quarter end. As such, the estimates used as of

September 30, 2014 are subject to change. The following table summarizes the preliminary amounts for acquired assets and liabilities recorded at their fair values as of the acquisition date (in thousands):

The Company determined the fair value of real estate inventories on a project level basis using a combination of discounted cash flow models, and market comparable land transactions, where available. These methods are significantly impacted by estimates relating to i) expected selling prices, ii) anticipated sales pace, iii) cost to complete estimates, iv) highest and best use of projects prior to acquisition, and v) comparable land values. These estimates were developed and used at the individual project level, and may vary significantly between projects.

The acquisition date fair value of the Intangible asset relating to brand name was estimated using comparable values ascribed in other recent market transactions, as well as taking into account Polygon Northwest Homes market position as a leading builder in the Seattle, WA, and Portland, OR, residential markets. This asset is deemed to have an indefinite life. Additionally, the Company acquired a non-controlling interest in a joint venture mortgage business. The fair value of this investment was estimated using the discounted cash flow method, which was significantly impacted by estimated cash flow streams and income of the joint venture.

Other assets, accounts payable, and accrued expenses were generally stated at historical value due to the short-term nature of these liabilities.

The Company recorded $5.8 million in acquisition related costs for the three and nine months ended September 30, 2014 , respectively, which are included in the Condensed Consolidated Statement of Operations in Transaction expenses. Such costs were expensed as incurred in accordance with ASC 805. There were no acquisition related costs incurred during 2013.

Supplemental Pro Forma Information

The following table presents unaudited pro forma amounts for the three and nine months ended September 30, 2014 and September 30, 2013 as if the Acquisition had been completed as of January 1, 2013 (amounts in thousands, except per share data):

The unaudited pro forma operating results have been determined after adjusting the unaudited operating results of Polygon Northwest Homes to reflect the estimated purchase accounting and other acquisition adjustments including interest

expense associated with the debt used to fund a portion of the acquisition. The unaudited pro forma results presented above do not reflect any cost savings, operating synergies or revenue enhancements that the combined company may achieve as a result of the Acquisition, the costs to combine the operations of the Company and Polygon Northwest Homes or the costs necessary to achieve any of the foregoing cost savings, operating synergies or revenue enhancements. As such, the unaudited pro forma amounts are for comparative purposes only and may not necessarily reflect the results of operations which would have resulted had the acquisition been completed at the beginning of the applicable period or indicative of the results that will be attained in the future.

Note 3—Variable Interest Entities and Noncontrolling Interests

During the nine months ended September 30, 2014 , the Company formed one joint venture for the purpose of land development and homebuilding activities which we have determined to be a VIE. The Company, as the managing member, has the power to direct the activities of the VIE since it manages the daily operations and has exposure to the risks and rewards of the VIE, which is based on the allocation of income and loss per the joint venture agreement. Therefore, the Company is the primary beneficiary of the joint venture, and the VIE was consolidated as of September 30, 2014 . The Company is also party to an additional three joint ventures that were formed in prior periods, for which the Company has also determined that it is the primary beneficiary, and thus has also included them in its consolidated results as of September 30, 2014 , and December 31, 2013 .

As of September 30, 2014 , the assets of the consolidated VIEs totaled $74.5 million , of which $8.7 million was cash and cash equivalents and $62.8 million was real estate inventories. The liabilities of the consolidated VIEs totaled $44.6 million , primarily comprised of notes payable, accounts payable and accrued liabilities.

As of December 31, 2013 , the assets of the consolidated VIEs totaled $66.4 million , of which $4.7 million was cash and cash equivalents and $56.8 million was real estate inventories. The liabilities of the consolidated VIEs totaled $27.1 million , primarily comprised of notes payable, accounts payable and accrued liabilities.

Note 4—Segment Information

The Company operates one principal homebuilding business. In accordance with FASB ASC Topic 280, Segment Reporting ("ASC 280"), the Company has determined that each of its operating divisions is an operating segment.

Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision-maker in deciding how to allocate resources and in assessing performance. The Company’s Executive Chairman, Chief Executive Officer and Chief Operating Officer have been identified as the chief operating decision makers. The Company’s chief operating decision makers direct the allocation of resources to operating segments based on the profitability and cash flows of each respective segment.

The Company’s homebuilding operations design, construct and sell a wide range of homes designed to meet the specific needs in each of its markets. In accordance with ASC 280, prior to the acquisition of Polygon Northwest Homes (see Note 2), the Company's homebuilding operations had been grouped into five operating segments: Southern California, consisting of an operating division with operations in Orange, Los Angeles, Riverside, San Bernardino and San Diego counties; Northern California, consisting of an operating division with operations in Alameda, Contra Costa, San Joaquin, and Santa Clara counties; Arizona, consisting of operations in the Phoenix, Arizona metropolitan area; Nevada, consisting of operations in the Las Vegas, Nevada metropolitan area; and Colorado, consisting of operations in the Fort Collins and Granby, Colorado markets. During the three months ended September 30, 2014 , the Company added two additional operating segments as a result of the Polygon Northwest Homes Acquisition: Oregon, with operations in the Portland, Oregon metropolitan area; and Washington, consisting of operations in the Seattle, Washington metropolitan area.

Corporate develops and implements strategic initiatives and supports the Company’s operating divisions by centralizing key administrative functions such as finance and treasury, information technology, risk management and litigation and human resources.

Segment financial information relating to the Company’s operations was as follows (in thousands):

 

 

 

As of September 30, 2014 , the maturities of the Notes payable, Senior unsecured facility, 7% Senior Notes, 5 3/4% Senior Notes, and 8 1/2% Senior Notes are as follows (in thousands):

 

Maturities above exclude premium of $5.4 million as of September 30, 2014 .

Senior Notes

5 3/4% Senior Notes Due 2019

On March 31, 2014, California Lyon completed its private placement with registration rights of 5.75% Senior Notes due 2019 (the "5.75% Notes"), in an aggregate principal amount of $150 million . The 5.75% Notes were issued at 100% of their aggregate principal amount.

As of September 30, 2014 , the outstanding amount of the 5.75% Notes was $150 million . The 5.75% Notes bear interest at a rate of 5.75%  per annum, payable semiannually in arrears on April 15 and October 15, and mature on April 15, 2019 . The 5.75% Notes are unconditionally guaranteed on a joint and several unsecured basis by Parent and certain of its existing and future direct and indirect wholly-owned subsidiaries. The 5.75% Notes and the related guarantees are California Lyon’s and the guarantors’ unsecured senior obligations and rank equally in right of payment with all of California Lyon’s and the guarantors’ existing and future unsecured senior debt, including California Lyon’s $425 million in aggregate principal amount of 8.5% Senior Notes due 2020, as described below, and $300 million in aggregate principal amount of 7.00% Notes, as described above. The 5.75% Notes rank senior in right of payment to all of California Lyon’s and the guarantors’ future subordinated debt. The 5.75% Notes and the guarantees are and will be effectively junior to California Lyon’s and the guarantors’ existing and future secured debt to the extent of the value of the collateral securing such debt.

On or after April 15, 2016 , California Lyon may redeem all or a portion of the 5.75% Notes upon not less than 30 nor more than 60 days’ notice, at the redemption prices (expressed as percentages of the principal amount) set forth below plus accrued and unpaid interest to the applicable redemption date, if redeemed during the period beginning on each of the dates indicated below:

 

Prior to April 15, 2016, the 5.75% Notes may be redeemed in whole or in part at a redemption price equal to 100% of the principal amount plus a “make-whole” premium, and accrued and unpaid interest to, the redemption date.

In addition, any time prior to April 15, 2016, California Lyon may, at its option on one or more occasions, redeem the 5.75% Notes in an aggregate principal amount not to exceed 35% of the aggregate principal amount of the 5.75% Notes issued prior to such date at a redemption price (expressed as a percentage of principal amount) of 105.75% , plus accrued and unpaid interest to the redemption date, with an amount equal to the net cash proceeds from one or more equity offerings by Parent.

The indenture governing the 5.75% Notes contains covenants that limit the ability of Parent, California Lyon, and their restricted subsidiaries to, among other things: (i) incur or guarantee certain additional indebtedness; (ii) pay dividends, distributions, or repurchase equity or make payments in respect of subordinated indebtedness; (iii) make certain investments; (iv) sell assets; (v) incur liens; (vi) enter into agreements restricting the ability of the Company’s restricted subsidiaries to pay dividends or transfer assets; (vii) enter into transactions with affiliates; (viii) create unrestricted subsidiaries; and (viii) consolidate, merge or sell all or substantially all of its assets. These covenants are subject to a number of important exceptions and qualifications as described in the Indenture. The Company was in compliance with all such covenants as of September 30, 2014 .

8 1/2% Senior Notes Due 2020

On November 8, 2012, California Lyon completed its offering of 8 1/2% Senior Notes due 2020, (the "initial 8.5% notes"), in an aggregate principal amount of $325 million . The initial 8.5% Notes were issued at 100% of their aggregate principal amount.

On October 24, 2013, California Lyon completed the sale of an additional $100.0 million in aggregate principal amount of its 8.5% Senior Notes due 2020 (the “additional 8.5 % Notes”, and together with the initial 8.5% notes, the "8.5% Notes" ) at an issue price of 106.5% of their aggregate principal amount, plus accrued interest from and including May 15, 2013, resulting in net proceeds of approximately $104.6 million .

As of both September 30, 2014 and December 31, 2013 , the outstanding amount of the 8.5% Notes was $430 million , and $431 million , respectively. The 8.5% Notes bear interest at a rate of 8.5%  per annum, payable semiannually in arrears on May 15 and November 15, and mature on November 15, 2020 . The 8.5% Notes are unconditionally guaranteed on a joint and several unsecured basis by Parent and by certain of its existing and future direct and indirect wholly-owned subsidiaries. The 8.5% Notes are California Lyon's and the guarantors' senior unsecured obligations. The 8.5% Notes and the guarantees rank senior to all of California Lyon’s and the guarantors’ existing and future subordinated debt, and rank equally in right of payment with all of California Lyon's and the guarantors' existing and future unsecured senior debt, including the 5.75% Notes and the 7.00% Notes as described above. The 8.5% Notes and the guarantees are and will be effectively junior to any of California Lyon’s and the guarantors’ existing and future secured debt.

The indenture governing the 8.5% Notes contains covenants that limit the ability of Parent, California Lyon and their restricted subsidiaries to, among other things: (i) incur or guarantee certain additional indebtedness; (ii) pay dividends or make other distributions or repurchase stock; (iii) make certain investments; (iv) sell assets; (v) incur liens; (vi) enter into agreements restricting the ability of the Company’s restricted subsidiaries to pay dividends or transfer assets; (vii) enter into transactions with affiliates; (viii) create unrestricted subsidiaries; and (viii) consolidate, merge or sell all or substantially all of its assets. These covenants are subject to a number of important exceptions and qualifications as described in the Indenture. The Company was in compliance with all such covenants as of September 30, 2014 .

7% Senior Notes Due 2022

On August 11, 2014, WLH PNW Finance Corp. (“Escrow Issuer”), completed its private placement with registration rights of 7.00% Senior Notes due 2022 (the “7.00% Notes”), in an aggregate principal amount of $300 million . The 2022 Notes were issued at 100% of their aggregate principal amount. On August 12, 2014 , in connection with the consummation of the Acquisition, Escrow Issuer merged with and into California Lyon, and California Lyon assumed the obligations of the Escrow Issuer under the 2022 Notes and the related indenture by operation of law (the “Escrow Merger”). Following the Escrow Merger, California Lyon is the obligor under the 2022 Notes.