Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

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Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Results of Operations — Fiscal Year 2017 Overview

During fiscal 2017, demand for new homes continued to reflect the stable to moderately improved trends we experienced across most of our operating markets in fiscal 2016. We continue to see varying levels of strength in new home demand and home prices across our markets, with demand in each market generally reflecting the relative strength of each market’s economy, as measured by job growth, household incomes, household formations and consumer confidence.

Our position as the largest and most geographically diverse homebuilder in the United States provides a strong platform for us to compete for new home sales. In recent years, we have focused on expanding our product offerings to more consistently include a broad range of homes for entry-level, move-up and luxury buyers across most of our markets. Our affordable entry-level homes have experienced very strong demand from homebuyers, as the entry-level segment of the new home market remains under-served, with low inventory levels relative to demand. Since the fourth quarter of fiscal 2016, we have been introducing affordable homes in communities designed for active adult buyers seeking a low-maintenance lifestyle. We plan to continue to expand our product offerings across more of our operating markets.

We believe our business is well positioned because of our broad geographic footprint and diverse product offerings, our ample supply of finished lots, land and homes, our strong balance sheet and liquidity and our experienced personnel across our operating markets. We remain focused on growing our revenues and profitability, generating positive annual cash flows from operations and managing our product offerings, pricing, sales pace, and inventory levels to optimize the return on our inventory investments.

In fiscal 2017, our number of homes closed and home sales revenues increased 14% and 16%, respectively, compared to the prior year. Our pre-tax income grew to $1.6 billion in fiscal 2017 compared to $1.4 billion in fiscal 2016 and $1.1 billion in fiscal 2015. Our pre-tax operating margin increased to 11.4% in fiscal 2017 compared to 11.1% in fiscal 2016 and 10.4% in fiscal 2015. Cash provided by operations was $435.1 million in fiscal 2017 compared to $618.0 million in fiscal 2016 and $700.4 million in fiscal 2015. In fiscal 2017, our homebuilding return on inventory (ROI) improved to 16.6% compared to 15.4% in fiscal 2016 and 12.8% in fiscal 2015. Homebuilding ROI is calculated as homebuilding pre-tax income for the year divided by average inventory. Average inventory in the ROI calculation is the sum of ending inventory balances for the trailing five quarters divided by five.

During the year, we also made significant progress in increasing our lots controlled under option purchase contracts to 50% of our total lots owned and controlled compared to 45% in the prior year. The transaction with Forestar Group Inc. (Forestar), which closed subsequent to year end, is expected to advance our strategy of increasing our access to high-quality optioned land and lot positions.

We believe that housing demand in our individual operating markets is tied closely to each market’s economy; therefore, we expect that housing market conditions will vary across our markets. If the U.S. economy continues to improve, we expect to see slow to moderate growth in housing demand, concentrated in markets where job growth is occurring. The pace and sustainability of new home demand and our future results could be negatively affected by weakening economic conditions, decreases in the level of employment and housing demand, decreased home affordability, significant increases in mortgage interest rates or tightening of mortgage lending standards.

Strategy

Our operating strategy focuses on leveraging our financial and competitive position to increase the returns on our inventory investments and generate strong profitability and cash flows, while managing risk. This strategy includes the following initiatives:

•Maintaining a strong cash balance and overall liquidity position and controlling our level of debt.
•Allocating and actively managing our inventory investments across our operating markets to diversify our geographic risk.
•Offering new home communities that appeal to a broad range of entry-level, move-up, active adult and luxury homebuyers based on consumer demand in each market.
•Modifying product offerings, sales pace, home prices and sales incentives as necessary in each of our markets to meet consumer demand.
•Managing our inventory of homes under construction relative to demand in each of our markets, including starting construction on unsold homes to capture new home demand and actively controlling the number of unsold, completed homes in inventory.
•Investing in land and land development and pursuing opportunistic acquisitions of homebuilding companies in desirable markets, while controlling the level of land and lots we own in each of our markets relative to the local new home demand.
•Increasing the amount of land and finished lots controlled through option purchase contracts by expanding relationships with land developers across the country.
•Controlling the cost of goods purchased from both vendors and subcontractors.
•Improving the efficiency of our land development, construction, sales and other key operational activities.
•Controlling our selling, general and administrative (SG&A) expense infrastructure to match production levels.

We believe our operating strategy, which has produced positive results in recent years, will allow us to maintain and improve our financial and competitive position and balance sheet strength. However, we cannot provide any assurances that the initiatives listed above will continue to be successful, and we may need to adjust components of our strategy to meet future market conditions.

Key Results

Key financial results as of and for our fiscal year ended September 30, 2017, as compared to fiscal 2016, were as follows:

Homebuilding:

•Homebuilding revenues increased 16% to $13.7 billion.
•Homes closed increased 14% to 45,751 homes, and the average closing price of those homes increased 2% to $298,400.
•Net sales orders increased 14% to 46,605 homes, and the value of net sales orders increased 16% to $13.9 billion.
•Sales order backlog increased 7% to 12,329 homes, and the value of sales order backlog increased 8% to $3.7 billion.
•Home sales gross margin decreased 20 basis points to 20.0%.
•Homebuilding SG&A expenses as a percentage of homebuilding revenues decreased by 40 basis points to 8.9%.
•Homebuilding pre-tax income increased 18% to $1.5 billion compared to $1.3 billion.
•Homebuilding pre-tax income as a percentage of homebuilding revenues was 10.8% compared to 10.7%.
•Homebuilding return on inventory improved 120 basis points to 16.6%.
•Homebuilding cash and cash equivalents totaled $973.0 million compared to $1.3 billion.
•Homebuilding inventories totaled $9.2 billion compared to $8.3 billion.
•Homes in inventory totaled 26,200 compared to 23,100.
•Owned lots totaled 125,000 compared to 112,900, and lots controlled through option purchase contracts totaled 124,000 compared to 91,600.
•Homebuilding debt was $2.5 billion compared to $2.8 billion.
•Homebuilding debt to total capital was 24.0%, improved from 29.2%.

Financial Services and Other:

•Financial services and other revenues increased 18% to $349.5 million.
•Financial services and other pre-tax income increased 27% to $112.8 million, compared to $89.1 million.
•Financial services and other pre-tax income as a percentage of financial services and other revenues was 32.3% compared to 30.1%.

Consolidated Results:

•Consolidated pre-tax income increased 18% to $1.6 billion compared to $1.4 billion.
•Consolidated pre-tax income as a percentage of consolidated revenues was 11.4% compared to 11.1%.
•Net income increased 17% to $1.0 billion compared to $886.3 million.
•Diluted earnings per share increased 16% to $2.74 compared to $2.36.
•Total equity was $7.7 billion compared to $6.8 billion.
•Book value per common share increased 13% to $20.66 compared to $18.21.
•Net cash provided by operations was $435.1 million compared to $618.0 million.

Results of Operations — Homebuilding

Our operating segments are our 41 homebuilding operating divisions, which we aggregate into six reporting segments. These reporting segments, which we also refer to as reporting regions, have homebuilding operations located in the following states:

East:Delaware, Georgia (Savannah only), Maryland, New Jersey, North Carolina, Pennsylvania, South Carolina and Virginia
Midwest:Colorado, Illinois and Minnesota
Southeast:Alabama, Florida, Georgia, Mississippi and Tennessee
South Central:Louisiana, Oklahoma and Texas
Southwest:Arizona and New Mexico
West:California, Hawaii, Nevada, Oregon, Utah and Washington

The following tables and related discussion set forth key operating and financial data for our homebuilding operations by reporting segment as of and for the fiscal years ended September 30, 2017, 2016 and 2015.

Net Sales Orders (1)Net Homes Sold
Fiscal Year Ended September 30,% Change
2017201620152017 vs 20162016 vs 2015
East6,0394,9444,85922%2%
Midwest1,8411,7661,6964%4%
Southeast15,57513,61611,70314%16%
South Central13,37412,43311,7538%6%
Southwest2,6931,7611,64553%7%
West7,0836,2945,72413%10%
46,60540,81437,38014%9%
Value (In millions)
East$1,708.9$1,388.5$1,319.823%5%
Midwest722.6669.2641.08%4%
Southeast4,068.93,547.33,053.415%16%
South Central3,339.13,045.42,849.710%7%
Southwest620.5409.0364.152%12%
West3,481.22,940.82,510.718%17%
$13,941.2$12,000.2$10,738.716%12%
Average Selling Price
East$283,000$280,800$271,6001%3%
Midwest392,500378,900377,9004%—%
Southeast261,200260,500260,900—%—%
South Central249,700244,900242,5002%1%
Southwest230,400232,300221,300(1)%5%
West491,500467,200438,6005%7%
$299,100$294,000$287,3002%2%
(1)Net sales orders represent the number and dollar value of new sales contracts executed with customers (gross sales orders), net of cancelled sales orders.
Sales Order Cancellations
Fiscal Year Ended September 30,
Cancelled Sales OrdersValue (In millions)Cancellation Rate (1)
201720162015201720162015201720162015
East1,8181,5821,536$500.3$425.4$416.723%24%24%
Midwest260241296103.691.6115.212%12%15%
Southeast4,8984,4133,6631,252.51,105.9899.224%24%24%
South Central3,9893,7953,8331,000.8942.5913.223%23%25%
Southwest864745572196.9160.4123.024%30%26%
West1,2211,1191,151616.9544.7515.715%15%17%
13,05011,89511,051$3,671.0$3,270.5$2,983.022%23%23%
(1)Cancellation rate represents the number of cancelled sales orders divided by gross sales orders.

Net Sales Orders

2017 versus 2016

The value of net sales orders increased 16% to $13.9 billion (46,605 homes) in 2017 from $12.0 billion (40,814 homes) in 2016, with increases in all of our regions. The increase in the value of sales orders was due to increased volume and to a lesser extent, increased selling prices in some regions.

The number of net sales orders increased 14%, and the average price of net sales orders increased 2% to $299,100 during 2017 compared to 2016. The increase in net sales orders reflects the continued stable to moderately improved market conditions in most of our markets. Our Phoenix market contributed the most to the higher volume in our Southwest region and our Carolina markets contributed most to the higher volume in our East region. Our sales order cancellation rate (cancelled sales orders divided by gross sales orders for the period) was 22% in fiscal 2017 compared to 23% in 2016.

We believe our business is well positioned to continue to generate increased sales volumes; however, our future sales volumes will depend on the economic strength of each of our operating markets and our ability to successfully implement our operating strategies.

2016 versus 2015

The value of net sales orders increased 12% to $12.0 billion (40,814 homes) in 2016 from $10.7 billion (37,380 homes) in 2015, with increases in all of our regions. The increase in the value of sales orders was due to increased volume and to a lesser extent, increased selling prices in most regions.

The number of net sales orders increased 9%, and the average price of net sales orders increased 2% to $294,000 during 2016 compared to 2015. Our Florida markets contributed most to the higher volume in our Southeast region and our Las Vegas market contributed most to the higher volume in our West region.

Sales Order BacklogHomes in Backlog
As of September 30,% Change
2017201620152017 vs 20162016 vs 2015
East1,5441,3011,43019%(9)%
Midwest419470412(11)%14%
Southeast4,0574,0533,511—%15%
South Central3,9563,8403,6563%5%
Southwest84365557129%15%
West1,5101,1561,08231%7%
12,32911,47510,6627%8%
Value (In millions)
East$452.8$383.0$413.018%(7)%
Midwest172.5184.0166.4(6)%11%
Southeast1,104.91,121.7977.9(1)%15%
South Central1,018.11,018.1951.3—%7%
Southwest192.7150.7124.028%22%
West785.0580.5514.235%13%
$3,726.0$3,438.0$3,146.88%9%
Average Selling Price
East$293,300$294,400$288,800—%2%
Midwest411,700391,500403,9005%(3)%
Southeast272,300276,800278,500(2)%(1)%
South Central257,400265,100260,200(3)%2%
Southwest228,600230,100217,200(1)%6%
West519,900502,200475,2004%6%
$302,200$299,600$295,1001%2%

Sales Order Backlog

Sales order backlog represents homes under contract but not yet closed at the end of the period. Many of the contracts in our sales order backlog are subject to contingencies, including mortgage loan approval and buyers selling their existing homes, which can result in cancellations. A portion of the contracts in backlog will not result in closings due to cancellations.

Home Closings and RevenueHomes Closed
Fiscal Year Ended September 30,% Change
2017201620152017 vs 20162016 vs 2015
East5,7965,1264,88013%5%
Midwest1,8921,7081,81111%(6)%
Southeast15,57113,30311,09317%20%
South Central13,25812,24911,4558%7%
Southwest2,5051,7031,49947%14%
West6,7296,2205,9108%5%
45,75140,30936,64814%10%
Home Sales Revenue (In millions)
East$1,639.1$1,431.0$1,323.515%8%
Midwest734.1651.7665.913%(2)%
Southeast4,085.73,459.32,866.218%21%
South Central3,339.12,978.52,690.112%11%
Southwest578.5388.1336.149%15%
West3,276.72,874.52,587.614%11%
$13,653.2$11,783.1$10,469.416%13%
Average Selling Price
East$282,800$279,200$271,2001%3%
Midwest388,000381,600367,7002%4%
Southeast262,400260,000258,4001%1%
South Central251,900243,200234,8004%4%
Southwest230,900227,900224,2001%2%
West487,000462,100437,8005%6%
$298,400$292,300$285,7002%2%

2017 versus 2016

Revenues from home sales increased 16% to $13.7 billion (45,751 homes closed) in 2017 from $11.8 billion (40,309 homes closed) in 2016. The increase in home sales revenues reflects the continued stable to moderately improved market conditions in most of our markets.

The number of homes closed in fiscal 2017 increased 14% from 2016 due to increases in all of our regions. Our Phoenix, Florida and Carolina markets contributed the most to higher closing volumes in our Southwest, Southeast and East regions, respectively. The average selling price of homes closed during fiscal 2017 was $298,400, up 2% from the prior year.

2016 versus 2015

Revenues from home sales increased 13% to $11.8 billion (40,309 homes closed) in 2016 from $10.5 billion (36,648 homes closed) in 2015.

The number of homes closed in fiscal 2016 increased 10% from 2015 due to increases in most of our regions. Our Florida and Phoenix markets contributed the most to higher closing volumes in our Southeast and Southwest regions, respectively. The decrease in homes closed in our Midwest region was primarily due to lower volume in our Chicago and Denver markets.

Homebuilding Operating Margin Analysis

Percentages of Related Revenues
Fiscal Year Ended September 30,
201720162015
Gross profit — Home sales20.0%20.2%19.8%
Gross profit — Land/lot sales and other15.3%13.3%8.7%
Inventory and land option charges(0.3)%(0.3)%(0.6)%
Gross profit — Total homebuilding19.6%19.9%19.2%
Selling, general and administrative expense8.9%9.3%9.5%
Goodwill impairment—%0.1%0.1%
Other (income) expense(0.1)%(0.1)%(0.1)%
Homebuilding pre-tax income10.8%10.7%9.6%

Home Sales Gross Profit

2017 versus 2016

Gross profit from home sales increased 15% to $2.7 billion in 2017 from $2.4 billion in 2016 and decreased 20 basis points to 20.0% as a percentage of home sales revenues. The 20 basis point decrease in the home sales gross profit percentage resulted from a decrease of 50 basis points due to an increase in warranty and construction defect expenses as a percentage of home sales revenues, partially offset by an improvement of 30 basis points due to a decrease in the amortization of capitalized interest and property taxes.

2016 versus 2015

Gross profit from home sales increased 15% to $2.4 billion in 2016 from $2.1 billion in 2015 and increased 40 basis points to 20.2% as a percentage of home sales revenues. The 40 basis point increase in the home sales gross profit percentage resulted from improvements of 30 basis points due to the average selling price of our homes closed increasing by more than the average cost and 10 basis points due to a decrease in the amortization of capitalized interest and property taxes as a percentage of home sales revenues.

We remain focused on managing the pricing, incentives and sales pace in each of our communities to optimize the returns on our inventory investments and adjust to local market conditions. Our gross profit margins have remained relatively stable in recent years and based on current market conditions, we expect continued stability; however, our gross profit margins could fluctuate in future periods.

Land Sales and Other Revenues

Land sales and other revenues were $88.3 million, $78.7 million and $89.6 million in fiscal 2017, 2016 and 2015, respectively. We continually evaluate our land and lot supply, and fluctuations in revenues and profitability from land sales occur based on how we manage our inventory levels in various markets. We generally purchase land and lots with the intent to build and sell homes on them. However, some of the land that we purchase includes commercially zoned parcels that we may sell to commercial developers. We may also sell residential lots or land parcels to manage our supply or for other strategic reasons. As of September 30, 2017, we had $10.4 million of land held for sale that we expect to sell in the next twelve months.

Inventory and Land Option Charges

At the end of each quarter during fiscal 2017, we reviewed the performance and outlook for all of our communities and land inventories for indicators of potential impairment and performed detailed impairment evaluations and analyses when necessary. As of September 30, 2017, we performed detailed impairment evaluations of communities and land inventories with a combined carrying value of $105.3 million and recorded impairment charges of $12.8 million during the fourth quarter to reduce the carrying value of impaired communities and land to their estimated fair value. Total impairment charges during fiscal 2017, 2016 and 2015 were $23.2 million, $20.3 million and $44.9 million, respectively.

As we manage our inventory investments across our operating markets to optimize returns and cash flows, we may modify our pricing and incentives, construction and development plans or land sale strategies in individual active communities and land held for development, which could result in the affected communities being evaluated for potential impairment. Also, if housing or economic conditions weaken in specific markets in which we operate, or if conditions weaken in the broader economy or homebuilding industry, we may be required to evaluate additional communities for potential impairment. These evaluations could result in additional impairment charges.

During fiscal 2017, we wrote off $17.0 million of earnest money deposits and pre-acquisition costs related to land option contracts that we have terminated or expect to terminate. Earnest money and pre-acquisition cost write-offs for fiscal 2016 and 2015 were $11.1 million and $15.4 million, respectively.

Selling, General and Administrative (SG&A) Expense

SG&A expense related to homebuilding activities was $1.2 billion, $1.1 billion and $1.0 billion in fiscal 2017, 2016 and 2015, respectively, increasing 11% in 2017 and 10% in 2016 from the respective prior years. As a percentage of homebuilding revenues, SG&A expense decreased 40 basis points to 8.9% in 2017 and decreased 20 basis points to 9.3% in 2016 from the respective prior years. This improvement in SG&A expense as a percentage of homebuilding revenues was achieved primarily through leverage of our fixed overhead costs resulting from the increase in homebuilding revenues.

Employee compensation and related costs were $860.2 million, $748.7 million and $679.4 million in fiscal 2017, 2016 and 2015, respectively. Compensation costs represented 70% of SG&A costs in fiscal 2017 and 68% of SG&A costs in both fiscal 2016 and 2015. These costs increased 15% in 2017 and 10% in 2016 due to increases in the number of employees and the amount of incentive compensation as compared to the respective prior years. Our homebuilding operations employed 5,876, 5,366 and 4,888 employees at September 30, 2017, 2016 and 2015, respectively.

We attempt to control our SG&A costs while ensuring that our infrastructure adequately supports our operations; however, we cannot make assurances that we will be able to maintain or improve upon the current SG&A expense as a percentage of revenues.

Interest Incurred

We capitalize interest costs incurred to inventory during active development and construction (active inventory). Capitalized interest is charged to cost of sales as the related inventory is delivered to the buyer. Interest incurred decreased 15% to $129.3 million in fiscal 2017 and decreased 10% to $152.3 million in fiscal 2016 compared to the respective prior years. These decreases were due to decreases in our average debt of 12% and 9% in fiscal 2017 and 2016, respectively, and lower average interest rates on outstanding debt during the periods. Interest charged to cost of sales was 1.4%, 1.8% and 1.9% of total cost of sales (excluding inventory and land option charges) in fiscal 2017, 2016 and 2015, respectively.

Other Income

Other income, net of other expenses, included in our homebuilding operations was $11.0 million, $12.7 million and $7.8 million in fiscal 2017, 2016 and 2015, respectively. Other income in fiscal 2016 included a $4.5 million gain from the sale of an investment in debt securities. Other income consists of interest income, rental income and various other types of ancillary income, gains, expenses and losses not directly associated with sales of homes, land and lots. The activities that result in this ancillary income or expense are not significant, either individually or in the aggregate.

Goodwill Impairment

We performed our annual goodwill impairment evaluation in the fourth quarters of fiscal 2017 and 2016. As a result of the 2017 evaluation, no impairment charges were recorded. As a result of the 2016 evaluation, a $7.2 million impairment charge was recorded to reduce the goodwill in the Huntsville operating segment in our Southeast reporting region. This operating segment had experienced lower levels of profitability than anticipated primarily due to difficult market conditions. See Note A.

Business Acquisitions

In September 2016, we acquired the homebuilding operations of Wilson Parker Homes for $91.9 million. Wilson Parker Homes operated in Atlanta and Augusta, Georgia; Raleigh, North Carolina; Columbia, South Carolina and Phoenix, Arizona. The assets acquired included approximately 380 homes in inventory, 490 lots and control of approximately 1,850 additional lots through option contracts. We also acquired a sales order backlog of 308 homes valued at $74.1 million.

Subsequent to September 30, 2017, we acquired 75% of the outstanding shares of Forestar for $558.3 million in cash, pursuant to the terms of the June 2017 merger agreement. Forestar is and will continue to be a publicly-traded residential and real estate development company listed on the New York Stock Exchange under the ticker symbol “FOR,” with operations currently in 14 markets and 10 states, where it owns, directly or through joint ventures, interests in 44 residential and mixed-use projects. Our alignment with Forestar advances our strategy of increasing our access to high-quality optioned land and lot positions to enhance operational efficiency and returns. Both companies are identifying land development opportunities to expand Forestar’s platform, and we plan to acquire a large portion of Forestar’s finished lots in accordance with the master supply agreement between the two companies. As the controlling shareholder of Forestar, we will have significant influence in guiding the strategic direction and driving the growth and operational execution necessary to increase the future value potential of Forestar.

Homebuilding Results by Reporting Region

Fiscal Year Ended September 30,
Homebuilding RevenuesHomebuilding Pre-tax Income (1)Pre-tax Income as a Percentage of Homebuilding Revenues
201720162015201720162015201720162015
East$1,640.1$1,446.5$1,333.6$153.9$138.7$94.29.4%9.6%7.1%
Midwest736.5651.7666.149.144.349.86.7%6.8%7.5%
Southeast4,087.63,463.52,890.6450.3388.4278.711.0%11.2%9.6%
South Central3,383.12,995.12,725.2439.1374.8296.613.0%12.5%10.9%
Southwest597.5388.1336.139.67.313.16.6%1.9%3.9%
West3,296.72,916.92,607.4357.3310.9285.910.8%10.7%11.0%
$13,741.5$11,861.8$10,559.0$1,489.3$1,264.4$1,018.310.8%10.7%9.6%
(1)Expenses maintained at the corporate level consist primarily of interest and property taxes, which are capitalized and amortized to cost of sales or expensed directly, and the expenses related to operating our corporate office. The amortization of capitalized interest and property taxes is allocated to each segment based on the segment’s cost of sales, while expenses associated with the corporate office are allocated to each segment based on the segment’s inventory balances.

2017 versus 2016

East Region — Homebuilding revenues increased 13% in fiscal 2017 compared to fiscal 2016, primarily due to an increase in the number of homes closed in our North and South Carolina markets. The region generated pre-tax income of $153.9 million in 2017, compared to $138.7 million in 2016. Pre-tax income was reduced by inventory impairment charges of $10.5 million and $12.3 million in 2017 and 2016, respectively, primarily in our suburban Washington, D.C. markets during 2017 and in our New Jersey market during 2016. Gross profit from home sales as a percentage of home sales revenue (home sales gross profit percentage) decreased 30 basis points in 2017 compared to 2016. As a percentage of homebuilding revenues, SG&A expenses increased by 20 basis points in 2017 compared to 2016.

Midwest Region — Homebuilding revenues increased 13% in fiscal 2017 compared to fiscal 2016, primarily due to an increase in the number of homes closed in our Minneapolis and Denver markets. The region generated pre-tax income of $49.1 million in 2017, compared to $44.3 million in 2016. Home sales gross profit percentage decreased 80 basis points in 2017 compared to 2016, largely due to higher warranty and construction defect costs in our Denver market. As a percentage of homebuilding revenues, SG&A expenses decreased by 70 basis points in 2017 compared to 2016.

Southeast Region — Homebuilding revenues increased 18% in fiscal 2017 compared to fiscal 2016, primarily due to an increase in the number of homes closed in our Florida markets. The region generated pre-tax income of $450.3 million in 2017, compared to $388.4 million in 2016. Home sales gross profit percentage decreased 60 basis points in 2017 compared to 2016, due to the average cost of homes increasing by more than the average selling price. As a percentage of homebuilding revenues, SG&A expenses decreased by 30 basis points in 2017 compared to 2016.

South Central Region — Homebuilding revenues increased 13% in fiscal 2017 compared to fiscal 2016, primarily due to an increase in the number of homes closed in our Dallas market. The region generated pre-tax income of $439.1 million in 2017, compared to $374.8 million in 2016. Home sales gross profit percentage decreased 20 basis points in 2017 compared to 2016. As a percentage of homebuilding revenues, SG&A expenses decreased by 70 basis points in 2017 compared to 2016.

Southwest Region — Homebuilding revenues increased 54% in fiscal 2017 compared to fiscal 2016, primarily due to an increase in the number of homes closed in our Phoenix market, as well as an increase in the average selling price of those homes. The region generated pre-tax income of $39.6 million in 2017, compared to $7.3 million in 2016. Pre-tax income in 2016 was reduced by inventory impairment charges of $6.0 million in our Phoenix market. Home sales gross profit percentage increased 210 basis points in 2017 compared to 2016, primarily due to the average selling price increasing while the average cost of homes decreased. The increase was also due to lower current year warranty and construction defect costs in our Phoenix market. As a percentage of homebuilding revenues, SG&A expenses decreased by 170 basis points in 2017 compared to 2016, primarily due to the significant increase in homebuilding revenues.

West Region — Homebuilding revenues increased 13% in fiscal 2017 compared to fiscal 2016, primarily due to an increase in the number of homes closed in our Las Vegas and northern California markets, as well as increases in the average selling price of homes closed in our Seattle, Portland and Sacramento markets. The region generated pre-tax income of $357.3 million in 2017, compared to $310.9 million in 2016. Home sales gross profit percentage increased 20 basis points in 2017 compared to 2016. As a percentage of homebuilding revenues, SG&A expenses decreased by 20 basis points in 2017 compared to 2016.

2016 versus 2015

East Region — Homebuilding revenues increased 8% in fiscal 2016 compared to fiscal 2015, primarily due to an increase in the number of homes closed in our Carolina markets, as well as an increase in the average selling price of those homes. The region generated pre-tax income of $138.7 million in 2016, compared to $94.2 million in 2015. Pre-tax income was reduced by inventory impairment charges of $12.3 million and $14.3 million in 2016 and 2015, respectively, primarily in our New Jersey market. Home sales gross profit percentage increased 150 basis points in 2016 compared to 2015, largely due to the average selling price increasing by more than the average cost of homes. As a percentage of homebuilding revenues, SG&A expenses decreased by 100 basis points in 2016 compared to 2015.

Midwest Region — Homebuilding revenues decreased 2% in fiscal 2016 compared to fiscal 2015, primarily due to a decrease in the number of homes closed in our Chicago and Denver markets, partially offset by an increase in the average selling price of those homes. The region generated pre-tax income of $44.3 million in 2016, compared to $49.8 million in 2015. Home sales gross profit percentage decreased 70 basis points in 2016 compared to 2015, largely due to the average cost of homes increasing by more than the average selling price. As a percentage of homebuilding revenues, SG&A expenses decreased by 10 basis points in 2016 compared to 2015.

Southeast Region — Homebuilding revenues increased 20% in fiscal 2016 compared to fiscal 2015, primarily due to an increase in the number of homes closed in our Florida markets. The region generated pre-tax income of $388.4 million in 2016, compared to $278.7 million in 2015. Home sales gross profit percentage increased 50 basis points in 2016 compared to 2015. As a percentage of homebuilding revenues, SG&A expenses decreased by 50 basis points in 2016 compared to 2015.

South Central Region — Homebuilding revenues increased 10% in fiscal 2016 compared to fiscal 2015, primarily due to an increase in the number and average selling price of homes closed in our Dallas and Fort Worth markets. The region generated pre-tax income of $374.8 million in 2016, compared to $296.6 million in 2015. Home sales gross profit percentage increased 140 basis points in 2016 compared to 2015, largely due to the average selling price increasing by more than the average cost of homes. As a percentage of homebuilding revenues, SG&A expenses increased by 10 basis points in 2016 compared to 2015.

Southwest Region — Homebuilding revenues increased 15% in fiscal 2016 compared to fiscal 2015, primarily due to an increase in the number of homes closed in our Phoenix market. The region generated pre-tax income of $7.3 million in 2016, compared to $13.1 million in 2015. Pre-tax income in 2016 was reduced by inventory impairment charges of $6.0 million in our Phoenix market. Home sales gross profit percentage decreased 80 basis points in 2016 compared to 2015, largely due to the average cost of homes increasing by more than the average selling price. As a percentage of homebuilding revenues, SG&A expenses decreased by 20 basis points in 2016 compared to 2015.

West Region — Homebuilding revenues increased 12% in fiscal 2016 compared to fiscal 2015, due to an increase in the number and average selling price of homes closed in our southern California, Portland and Las Vegas markets. The region generated pre-tax income of $310.9 million in 2016, compared to $285.9 million in 2015. Pre-tax income was reduced by inventory impairment charges of $0.3 million in 2016 and $20.4 million in 2015. The 2015 impairment charges primarily related to strategic decisions to sell land. Home sales gross profit percentage decreased 110 basis points in 2016 compared to 2015, largely due to the average cost of homes increasing by more than the average selling price. As a percentage of homebuilding revenues, SG&A expenses increased by 10 basis points in 2016 compared to 2015.

Inventories, Land and Lot Position and Homes in Inventory

We routinely enter into land/lot option contracts to purchase land or developed residential lots at predetermined prices on a defined schedule commensurate with planned development or anticipated new home demand. We also purchase undeveloped land that generally is vested with the rights to begin development or construction work, and we plan and coordinate the development of our land into residential lots for use in our homebuilding business. We manage our inventory of owned land and lots and homes under construction relative to demand in each of our markets, including starting construction on unsold homes to capture new home demand and actively controlling the number of unsold, completed homes in inventory.

Our inventories at September 30, 2017 and 2016 are summarized as follows:

September 30, 2017
Construction in Progress and Finished HomesResidential Land/Lots Developed and Under DevelopmentLand Held for DevelopmentLand Held for SaleTotal Inventory
(In millions)
East$569.3$478.1$21.0$0.5$1,068.9
Midwest335.8155.01.8—492.6
Southeast1,265.61,085.035.95.82,392.3
South Central1,050.81,132.614.11.92,199.4
Southwest203.9299.52.7—506.1
West1,070.01,257.323.22.02,352.5
Corporate and unallocated (1)110.6112.22.30.2225.3
$4,606.0$4,519.7$101.0$10.4$9,237.1
September 30, 2016
Construction in Progress and Finished HomesResidential Land/Lots Developed and Under DevelopmentLand Held for DevelopmentLand Held for SaleTotal Inventory
(In millions)
East$448.9$415.4$26.8$—$891.1
Midwest239.3189.511.90.5441.2
Southeast1,149.8870.144.85.62,070.3
South Central1,009.61,032.014.619.42,075.6
Southwest163.8189.614.13.6371.1
West906.61,315.222.53.32,247.6
Corporate and unallocated (1)116.7123.43.10.8244.0
$4,034.7$4,135.2$137.8$33.2$8,340.9
(1)Corporate and unallocated inventory consists primarily of capitalized interest and property taxes.

Our land and lot position and homes in inventory at September 30, 2017 and 2016 are summarized as follows:

September 30, 2017
Land/Lots Owned (1)Lots Controlled Under Land and Lot Option Purchase Contracts (2)Total Land/Lots Owned and ControlledHomes in Inventory (3)
East13,20017,80031,0003,500
Midwest2,6004,4007,0001,500
Southeast35,80047,50083,3008,500
South Central42,80038,70081,5007,300
Southwest8,7002,40011,1001,700
West21,90013,20035,1003,700
125,000124,000249,00026,200
50%50%100%
September 30, 2016
Land/Lots Owned (1)Lots Controlled Under Land and Lot Option Purchase Contracts (2)Total Land/Lots Owned and ControlledHomes in Inventory (3)
East13,40015,10028,5003,000
Midwest3,2002,1005,3001,200
Southeast30,60036,10066,7007,600
South Central37,70025,10062,8007,000
Southwest7,5002,0009,5001,300
West20,50011,20031,7003,000
112,90091,600204,50023,100
55%45%100%
(1)Land/lots owned include approximately 33,200 and 30,400 owned lots that are fully developed and ready for home construction at September 30, 2017 and 2016, respectively. Land/lots owned also include land held for development representing 4,800 and 7,300 lots at September 30, 2017 and 2016, respectively.
(2)The total remaining purchase price of lots controlled through land and lot option purchase contracts at September 30, 2017 and 2016 was $4.6 billion and $3.6 billion, respectively, secured by earnest money deposits of $227.6 million and $167.0 million, respectively. Our lots controlled under land and lot option purchase contracts exclude approximately 300 and 700 lots at September 30, 2017 and 2016, respectively, representing lots controlled under lot option contracts for which we do not expect to exercise our option to purchase the land or lots, but the underlying contracts have yet to be terminated. We have reserved the deposits related to these contracts.
(3)Homes in inventory include approximately 1,600 model homes at both September 30, 2017 and 2016. Approximately 13,800 and 11,800 of our homes in inventory were unsold at September 30, 2017 and 2016, respectively. At September 30, 2017, approximately 4,100 of our unsold homes were completed, of which approximately 500 homes had been completed for more than six months. At September 30, 2016, approximately 3,500 of our unsold homes were completed, of which approximately 500 homes had been completed for more than six months.

Results of Operations — Financial Services and Other

The following tables and related discussion set forth key operating and financial data for our financial services and other operations, comprising DHI Mortgage, our subsidiary title companies and other businesses, for the fiscal years ended September 30, 2017, 2016 and 2015.

Fiscal Year Ended September 30,2017 vs 20162016 vs 2015
201720162015
Number of first-lien loans originated or brokered by DHI Mortgage for D.R. Horton homebuyers25,48821,97018,82116%17%
Number of homes closed by D.R. Horton45,75140,30936,64814%10%
Percentage of D.R. Horton homes financed by DHI Mortgage56%55%51%
Number of total loans originated or brokered by DHI Mortgage for D.R. Horton homebuyers25,67722,12718,96316%17%
Total number of loans originated or brokered by DHI Mortgage27,00223,92021,31413%12%
Captive business percentage95%93%89%
Loans sold by DHI Mortgage to third parties27,25123,92620,62314%16%
Fiscal Year Ended September 30,2017 vs 20162016 vs 2015
201720162015
(In millions)
Loan origination fees$17.7$20.1$23.6(12)%(15)%
Sale of servicing rights and gains from sale of mortgage loans254.0216.0173.018%25%
Recourse (expense) benefit(2.9)(8.5)9.8(66)%(187)%
Sale of servicing rights and gains from sale of mortgage loans, net251.1207.5182.821%14%
Other revenues16.514.613.613%7%
Total mortgage operations revenues285.3242.2220.018%10%
Title policy premiums64.253.445.020%19%
Total revenues349.5295.6265.018%12%
General and administrative expense251.2220.0183.014%20%
Interest and other (income) expense(14.5)(13.5)(23.1)7%(42)%
Financial services and other pre-tax income$112.8$89.1$105.127%(15)%

Financial Services and Other Operating Margin Analysis

Percentages of Financial Services Revenues (1)
Fiscal Year Ended September 30,
201720162015
Recourse expense (benefit)0.8%2.8%(3.8)%
General and administrative expense71.3%72.3%71.7%
Interest and other (income) expense(4.1)%(4.4)%(9.1)%
Financial services and other pre-tax income32.0%29.3%41.2%
(1)Excludes the effects of recourse expense or benefit on financial services revenues.

Mortgage Loan Activity

The volume of loans originated by our mortgage operations is directly related to the number of homes closed by our homebuilding operations. In fiscal 2017 and 2016, the volume of first-lien loans originated or brokered by DHI Mortgage for our homebuyers increased 16% and 17% from the respective prior years, primarily as a result of increases in the number of homes closed by our homebuilding operations of 14% and 10%, respectively. The percentages of total home closings by our homebuilding operations for which DHI Mortgage handled the homebuyers’ financing were 56%, 55% and 51% in fiscal 2017, 2016 and 2015, respectively. These increases also contributed to our higher loan volumes.

Home closings from our homebuilding operations constituted 95%, 93% and 89% of DHI Mortgage loan originations in fiscal 2017, 2016 and 2015, respectively. These rates reflect DHI Mortgage’s consistent focus on the captive business provided by our homebuilding operations.

The number of loans sold increased 14% in fiscal 2017 and 16% in fiscal 2016 compared to the respective prior years. Virtually all of the mortgage loans held for sale on September 30, 2017 were eligible for sale to Fannie Mae, Freddie Mac or Ginnie Mae. Approximately 84% of the mortgage loans sold by DHI Mortgage during fiscal 2017 were sold to three major financial entities, one of which purchased 45% of the total loans sold.

Financial Services and Other Revenues and Expenses

Revenues from our financial services and other operations increased 18% to $349.5 million in fiscal 2017 from $295.6 million in fiscal 2016, while the number of loan originations increased 13% over that same period. Revenues from our financial services and other operations increased 12% to $295.6 million in fiscal 2016 from $265.0 million in fiscal 2015, and the number of loan originations also increased 12%. In fiscal 2017, revenues increased at a higher rate than origination volume primarily due to improved loan sale execution in the secondary market and increased revenue from title operations.

Our mortgage operations revenues were reduced by $2.9 million and $8.5 million in fiscal 2017 and 2016, respectively, to increase our loss reserves for estimated future recourse obligations and other mortgage loans, and to adjust certain mortgage loans held for sale to fair value. Our mortgage operations revenues were increased by $9.8 million in fiscal 2015 due to reductions in our loss reserves. Our loss reserves for loan recourse obligations are estimated based upon analysis of the volume of mortgages originated, loan repurchase requests received, actual repurchases and losses through the disposition of such loans or requests and discussions with our mortgage purchasers. Actual losses on mortgage loans may differ from our estimates, which may result in future changes to our loss reserves.

General and administrative (G&A) expense related to financial services and other operations was $251.2 million, $220.0 million and $183.0 million in fiscal 2017, 2016 and 2015, respectively, increasing 14% in 2017 and 20% in 2016 from the respective prior years. These increases were primarily due to increases in employee related costs due to both increased volume and the cost of compliance with mortgage industry regulations. Our financial services and other operations employed 1,859, 1,610 and 1,342 employees at September 30, 2017, 2016 and 2015, respectively.

As a percentage of financial services and other revenues (excluding the effects of recourse expense or benefit), G&A expense was 71.3%, 72.3% and 71.7% in fiscal 2017, 2016 and 2015, respectively. Fluctuations in financial services G&A expense as a percentage of revenues can be expected to occur, as some components of revenue may fluctuate differently than loan volumes, and some expenses are not directly related to mortgage loan volume or to changes in the amount of revenue earned.

Interest and other income, net of other expense, included in our financial services and other operations consists primarily of the interest income of our mortgage subsidiary.

Results of Operations — Consolidated

Income before Income Taxes

Pre-tax income was $1.6 billion, $1.4 billion and $1.1 billion in fiscal 2017, 2016 and 2015, respectively. The increase in our operating income over the three-year period is primarily due to higher revenues from increased home closings.

Income Taxes

Our income tax expense was $563.7 million, $467.2 million and $372.7 million in fiscal 2017, 2016 and 2015, respectively, and our effective tax rate was 35.2%, 34.5% and 33.2%, respectively, in those years. The effective tax rate for all years includes an expense for state income taxes, reduced by tax benefits for the domestic production activities deduction and federal energy tax credits. The effective tax rate for fiscal 2015 also includes a tax benefit for a reduction in the valuation allowance on deferred tax assets.

We previously filed three requests for advance consent for a change in tax accounting method with the Internal Revenue Service (IRS) relating to changes in the timing of income and expense recognition for tax purposes. We agreed to and signed consent agreements for two of the three requests during the quarter ended June 30, 2017. The impact of the approved tax accounting method changes was reflected in our consolidated financial statements as of June 30, 2017 as a reduction in income taxes payable of $58.2 million, a reduction in the deferred tax asset related to inventory costs of $50.1 million, an increase in the deferred tax liability related to the deferral of profit on home sales of $13.4 million and income tax expense of $5.3 million. The third request for advance consent for a change in tax accounting method will be recognized in the period in which a consent agreement is issued by the IRS and agreed to and signed by us.

At September 30, 2017 and 2016, we had deferred tax assets, net of deferred tax liabilities, of $376.2 million and $486.6 million, respectively, partially offset by valuation allowances of $11.2 million and $10.3 million, respectively. We had tax benefits of $26.2 million that exist for state net operating loss (NOL) carryforwards that will expire at various times depending on the tax jurisdiction. Of the total amount, $3.8 million of the tax benefits will expire from fiscal years 2018 to 2022, $2.7 million will expire from fiscal years 2023 to 2027 and $19.7 million will expire from fiscal years 2028 to 2036. We also had tax benefits for state tax credit carryforwards of $1.4 million that will expire from fiscal years 2018 to 2019 and $1.1 million of tax benefits for state tax credit carryforwards that have no expiration date. The accounting for deferred taxes is based upon estimates of future results. Differences between the anticipated and actual outcomes of these future results could have a material impact on our consolidated results of operations or financial position. Also, changes in existing federal and state tax laws and tax rates could affect future tax results and the valuation of our deferred tax assets and liabilities.

When assessing the realizability of deferred tax assets, we consider whether it is more likely than not that some portion or all of our deferred tax assets will not be realized. The realization of deferred tax assets is dependent upon the generation of sufficient taxable income in future periods. We record a valuation allowance when we determine it is more likely than not that a portion of the deferred tax assets will not be realized. The valuation allowance for both years relates to our state deferred tax assets for NOL carryforwards. As of September 30, 2017, we believe it is more likely than not that a portion of our state NOL carryforwards will not be realized because some state NOL carryforward periods are too brief to realize the related deferred tax assets. We will continue to evaluate both the positive and negative evidence in determining the need for a valuation allowance with respect to our remaining state NOL carryforwards.

Unrecognized tax benefits are the differences between tax positions taken or expected to be taken in a tax return and the benefits recognized for accounting purposes. We had no unrecognized tax benefits and no accrued interest or penalties related to unrecognized tax benefits at September 30, 2017 and 2016.

We are subject to federal income tax and to income tax in multiple states. The statute of limitations for our major tax jurisdictions remains open for examination for fiscal years 2014 through 2017. We are currently being audited by various states; however, to date, we are not aware of any significant findings identified by the taxing authorities.

Capital Resources and Liquidity

We have historically funded our homebuilding and financial services and other operations with cash flows from operating activities, borrowings under bank credit facilities and the issuance of new debt securities. Our current levels of cash, borrowing capacity and balance sheet leverage provide us with the operational flexibility to adjust to changes in homebuilding market conditions and allow us to increase our investments in homes, finished lots, land and land development to expand our operations and grow our profitability.

At September 30, 2017, our ratio of homebuilding debt to total capital (homebuilding notes payable divided by total equity plus homebuilding notes payable) was 24.0% compared to 29.2% at September 30, 2016. Over the long term, we intend to maintain our ratio of homebuilding debt to total capital below 35%, and we expect it to remain significantly lower than 35% throughout fiscal 2018. We believe that the ratio of homebuilding debt to total capital is useful in understanding the leverage employed in our homebuilding operations and comparing our capital structure with other homebuilders. We exclude the debt of our financial services business because it is separately capitalized, and its obligation under its repurchase facility is substantially collateralized and not guaranteed by our parent company or any of our homebuilding entities.

We regularly assess our projected capital requirements to fund growth in our business, repay debt obligations, and support other general corporate and operational needs, and we regularly evaluate our opportunities to raise additional capital. We have an automatically effective universal shelf registration statement filed with the SEC in August 2015, registering debt and equity securities that we may issue from time to time in amounts to be determined. As market conditions permit, we may issue new debt or equity securities through the public capital markets or obtain additional bank financing to fund our projected capital requirements or provide additional liquidity. In October 2017, we used cash on hand to purchase 75% of the outstanding shares of Forestar for $558.3 million. We believe that our existing cash resources, our revolving credit facility, our mortgage repurchase facility and our ability to access the capital markets will provide sufficient liquidity to fund our working capital needs and debt obligations, including the maturity of $400 million principal amount of senior notes in fiscal 2018.

Capital Resources - Homebuilding

Cash and Cash Equivalents — At September 30, 2017, cash and cash equivalents of our homebuilding segment totaled $973.0 million.

Bank Credit Facility — We have a senior unsecured revolving credit facility which was amended in September 2017 to increase its capacity from $975 million to $1.275 billion and to extend its maturity date to September 25, 2022. The uncommitted accordion feature was also amended to permit an increase in the size of the facility to $1.9 billion, subject to certain conditions and availability of additional bank commitments. The facility also provides for the issuance of letters of credit with a sublimit equal to approximately 50% of the revolving credit commitment. Letters of credit issued under the facility reduce the available borrowing capacity. The interest rate on borrowings under the revolving credit facility may be based on either the Prime Rate or London Interbank Offered Rate (LIBOR) plus an applicable margin, as defined in the credit agreement governing the facility. At September 30, 2017, there were no borrowings outstanding and $94.3 million of letters of credit issued under the revolving credit facility, resulting in available capacity of approximately $1.2 billion.

Our revolving credit facility imposes restrictions on our operations and activities, including requiring the maintenance of a maximum allowable ratio of debt to tangible net worth and a borrowing base restriction if our ratio of debt to tangible net worth exceeds a certain level. These covenants are measured as defined in the credit agreement governing the facility and are reported to the lenders quarterly. A failure to comply with these financial covenants could allow the lending banks to terminate the availability of funds under the revolving credit facility or cause any outstanding borrowings to become due and payable prior to maturity. The credit agreement governing the facility also imposes restrictions on the creation of secured debt and liens. At September 30, 2017, we were in compliance with all of the covenants, limitations and restrictions of our revolving credit facility.

Secured Letter of Credit Agreement — We have a secured letter of credit agreement which requires us to deposit cash, in an amount approximating the balance of letters of credit outstanding, as collateral with the issuing bank. The amount of cash restricted for letters of credit issued under this agreement totaled $2.5 million and $2.9 million at September 30, 2017 and 2016, respectively, and is included in homebuilding restricted cash in our consolidated balance sheets.

Public Unsecured Debt — On May 15, 2017, we repaid $350 million principal amount of our 4.75% senior notes, which were due on that date. We have $400 million principal amount of senior notes maturing in February 2018 which we currently expect to refinance. The indenture governing our senior notes imposes restrictions on the creation of secured debt and liens. At September 30, 2017, we were in compliance with all of the limitations and restrictions associated with our public debt obligations.

Repurchases of Common Stock — During fiscal 2017, we repurchased 1,850,000 shares of our common stock for $60.6 million.

Debt and Equity Repurchase Authorizations — Effective August 1, 2017, our Board of Directors authorized the repurchase of up to $500 million of debt securities and $200 million of our common stock effective through July 31, 2018. The full amount of each of these authorizations was remaining at September 30, 2017.

Capital Resources - Financial Services and Other

Cash and Cash Equivalents — At September 30, 2017, cash and cash equivalents of our financial services and other operations totaled $34.8 million.

Mortgage Repurchase Facility — Our mortgage subsidiary, DHI Mortgage, has a mortgage repurchase facility that is accounted for as a secured financing. The mortgage repurchase facility provides financing and liquidity to DHI Mortgage by facilitating purchase transactions in which DHI Mortgage transfers eligible loans to the counterparties against the transfer of funds by the counterparties, thereby becoming purchased loans. DHI Mortgage then has the right and obligation to repurchase the purchased loans upon their sale to third-party purchasers in the secondary market or within specified time frames from 45 to 60 days in accordance with the terms of the mortgage repurchase facility. In February 2017, the mortgage repurchase facility was amended to increase its capacity to $600 million and extend its maturity date to February 23, 2018. The capacity of the facility increases, without requiring additional commitments, to $725 million for approximately 30 days at each quarter end and to $800 million for approximately 45 days at fiscal year end. The capacity can also be increased to $1.0 billion subject to the availability of additional commitments.

As of September 30, 2017, $540.1 million of mortgage loans held for sale with a collateral value of $520.0 million were pledged under the mortgage repurchase facility. As a result of advance paydowns totaling $100.0 million, DHI Mortgage had an obligation of $420.0 million outstanding under the mortgage repurchase facility at September 30, 2017 at a 3.3% annual interest rate.

The mortgage repurchase facility is not guaranteed by D.R. Horton, Inc. or any of the subsidiaries that guarantee our homebuilding debt. The facility contains financial covenants as to the mortgage subsidiary’s minimum required tangible net worth, its maximum allowable ratio of debt to tangible net worth and its minimum required liquidity. These covenants are measured and reported to the lenders monthly. At September 30, 2017, DHI Mortgage was in compliance with all of the conditions and covenants of the mortgage repurchase facility.

In the past, our mortgage subsidiary has been able to renew or extend its mortgage credit facility at a sufficient capacity and on satisfactory terms prior to its maturity, and obtain temporary additional commitments through amendments to the credit facility during periods of higher than normal volumes of mortgages held for sale. The liquidity of our financial services business depends upon its continued ability to renew and extend the mortgage repurchase facility or to obtain other additional financing in sufficient capacities.

Operating Cash Flow Activities

In fiscal 2017, net cash provided by operating activities was $435.1 million compared to $618.0 million in fiscal 2016. We used $584.4 million of cash to increase our construction in progress and finished home inventory compared to $496.2 million in fiscal 2016. In both years, the expenditures were made to support the current year increase in sales and closing volumes, as well as the expected increase in the subsequent year. Cash used to increase residential land and lots inventory to fund future growth was $362.3 million in fiscal 2017 compared to $10.3 million in fiscal 2016. The most significant source of cash provided by operating activities in both years was net income.

Investing Cash Flow Activities

In fiscal 2017, net cash used in investing activities was $171.0 million compared to $112.6 million in fiscal 2016. We used $157.3 million and $86.1 million in fiscal 2017 and 2016, respectively, to purchase and construct property and equipment, including office buildings, rental properties, model home furniture and office and technology equipment to support our operations. Of the cash used for property and equipment in fiscal 2017, $54.6 million relates to our recent efforts to begin developing and constructing multi-family rental properties on land parcels we already owned, and we currently have four such projects under active construction. During fiscal 2017, we purchased $8.8 million of debt securities which were secured by residential real estate, and in fiscal 2016, we sold a previous investment in debt securities for proceeds of $35.8 million. Additionally, we paid $4.1 million during fiscal 2017 to complete our purchase of the homebuilding operations of Wilson Parker Homes, acquired in September 2016.

Financing Cash Flow Activities

We expect the short-term financing needs of our operations will be funded with existing cash, cash generated from operations and borrowings under our homebuilding and financial services credit facilities. Long-term financing needs for the growth of our operations have historically been funded with the issuance of senior unsecured debt securities through the public capital markets.

In fiscal 2017, net cash used in financing activities was $559.5 million, consisting primarily of note repayments, payments of cash dividends and repurchases of common stock, partially offset by note proceeds. Note repayments of $1.2 billion included the repayment of $350 million principal amount of our 4.75% senior notes at maturity and repayments of amounts drawn on the revolving credit facility and the mortgage repurchase facility of $835.0 million and $53.0 million, respectively. Proceeds from notes payable included draws of $835.0 million on the revolving credit facility. During fiscal 2017, we also used cash to repurchase 1,850,000 shares of our common stock for $60.6 million. During fiscal 2016, net cash used in financing activities was $586.0 million, consisting primarily of note repayments and payments of cash dividends. Note repayments of $549.7 million included the repayment of $170.2 million principal amount of our 5.625% senior notes and $372.7 million principal amount of our 6.5% senior notes at maturity.

Our Board of Directors approved and paid quarterly cash dividends of $0.10 per common share and $0.08 per common share in fiscal 2017 and 2016, respectively. In November 2017, our Board of Directors approved a cash dividend of $0.125 per common share, payable on December 15, 2017, to stockholders of record on December 1, 2017. The declaration of future cash dividends is at the discretion of our Board of Directors and will depend upon, among other things, our future earnings, cash flows, capital requirements, financial condition and general business conditions.

Contractual Cash Obligations, Commercial Commitments and Off-Balance Sheet Arrangements

Our primary contractual cash obligations are payments under our debt agreements and lease payments under operating leases. We expect to fund our contractual obligations in the ordinary course of business through a combination of our existing cash resources, cash flows generated from profits, our homebuilding and financial services credit facilities or other bank financing, and the issuance of new debt or equity securities through the public capital markets as market conditions may permit.

Our future cash requirements for contractual obligations as of September 30, 2017 are presented below:

Payments Due by Period
TotalLess Than 1 Year1 - 3 Years3 - 5 YearsMore Than 5 Years
(In millions)
Homebuilding:
Notes Payable — Principal (1)$2,461.1$409.6$1,001.5$350.0$700.0
Notes Payable — Interest (1)367.897.3140.5104.525.5
Operating Leases36.214.714.26.21.1
Purchase Obligations (2)29.727.42.3——
$2,894.8$549.0$1,158.5$460.7$726.6
Financial Services and Other:
Notes Payable — Principal (3)$420.0$420.0$—$—$—
Notes Payable — Interest (3)13.913.9———
Operating Leases2.60.81.30.5—
$436.5$434.7$1.3$0.5$—
(1)Homebuilding notes payable represent principal and interest payments due on our senior notes and our secured notes. Because the balance of our revolving credit facility was zero at September 30, 2017, we did not assume any principal or interest payments related to this facility in future periods.
(2)Purchase obligations relate to our land and lot option purchase contracts which enable us to control significant lot positions with limited capital investment. Among our land and lot option purchase contracts at September 30, 2017, there were a limited number of contracts, representing $29.7 million of remaining purchase price, subject to specific performance provisions which may require us to purchase the land or lots upon the land sellers meeting their contractual obligations. Further information about our land option contracts is provided in the “Inventories, Land and Lot Position and Homes in Inventory” section included herein.
(3)Financial services notes payable represent principal and interest payments due on our mortgage subsidiary’s repurchase facility. The interest obligation associated with this variable rate facility is based on its annual effective rate of 3.3% and principal balance outstanding at September 30, 2017.

At September 30, 2017, our homebuilding operations had outstanding letters of credit of $96.8 million and surety bonds of $1.2 billion, issued by third parties to secure performance under various contracts. We expect that our performance obligations secured by these letters of credit and bonds will generally be completed in the ordinary course of business and in accordance with the applicable contractual terms. When we complete our performance obligations, the related letters of credit and bonds are generally released shortly thereafter, leaving us with no continuing obligations. We have no material third-party guarantees.

Our mortgage subsidiary enters into various commitments related to the lending activities of our mortgage operations. Further discussion of these commitments is provided in Item 7A “Quantitative and Qualitative Disclosures About Market Risk” under Part II of this annual report on Form 10-K.

Seasonality

Although significant changes in market conditions have impacted our seasonal patterns in the past and could do so again in the future, we generally close more homes and generate greater revenues and operating income in the third and fourth quarters of our fiscal year. The seasonal nature of our business can also cause significant variations in our working capital requirements in both our homebuilding and financial services operations. As a result of seasonal activity, our quarterly results of operations and financial position at the end of a particular fiscal quarter are not necessarily representative of the balance of our fiscal year.

Inflation

We may be adversely affected during periods of high inflation, primarily because of higher financing, land, labor and material construction costs. We attempt to pass cost increases through to our customers through increased sales prices. However, during periods when housing market conditions are challenging, we may not be able to offset cost increases with higher selling prices. In addition, higher mortgage interest rates reduce the affordability of our homes to prospective homebuyers.

Forward-Looking Statements

Some of the statements contained in this report, as well as in other materials we have filed or will file with the Securities and Exchange Commission, statements made by us in periodic press releases and oral statements we make to analysts, stockholders and the press in the course of presentations about us, may be construed as “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, Section 21E of the Securities Exchange Act of 1934 and the Private Securities Litigation Reform Act of 1995. Forward-looking statements are based on management’s beliefs as well as assumptions made by, and information currently available to, management. These forward-looking statements typically include the words “anticipate,” “believe,” “consider,” “estimate,” “expect,” “forecast,” “goal,” “intend,” “objective,” “plan,” “predict,” “projection,” “seek,” “strategy,” “target,” “will” or other words of similar meaning. Any or all of the forward-looking statements included in this report and in any other of our reports or public statements may not approximate actual experience, and the expectations derived from them may not be realized, due to risks, uncertainties and other factors. As a result, actual results may differ materially from the expectations or results we discuss in the forward-looking statements. These risks, uncertainties and other factors include, but are not limited to:

•the cyclical nature of the homebuilding industry and changes in economic, real estate and other conditions;
•constriction of the credit markets, which could limit our ability to access capital and increase our costs of capital;
•reductions in the availability of mortgage financing provided by government agencies, changes in government financing programs, a decrease in our ability to sell mortgage loans on attractive terms or an increase in mortgage interest rates;
•the risks associated with our land and lot inventory;
•our ability to effect our growth strategies, acquisitions or investments successfully;
•home warranty and construction defect claims;
•the effects of a health and safety incident;
•the effects of negative publicity;
•supply shortages and other risks of acquiring land, building materials and skilled labor;
•the impact of an inflationary, deflationary or higher interest rate environment;
•reductions in the availability of performance bonds;
•increases in the costs of owning a home;
•the effects of governmental regulations and environmental matters on our homebuilding operations;
•the effects of governmental regulations on our financial services operations;
•our significant debt and our ability to comply with related debt covenants, restrictions and limitations;
•competitive conditions within the homebuilding and financial services industries;
•the effects of the loss of key personnel; and
•information technology failures and data security breaches.

We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. However, any further disclosures made on related subjects in subsequent reports on Forms 10-K, 10-Q and 8-K should be consulted. Additional information about issues that could lead to material changes in performance and risk factors that have the potential to affect us is contained in Item 1A, “Risk Factors” under Part I of this annual report on Form 10-K.

Critical Accounting Policies

General — A comprehensive enumeration of the significant accounting policies of D.R. Horton, Inc. and subsidiaries is presented in Note A to the accompanying financial statements as of September 30, 2017 and 2016, and for the years ended September 30, 2017, 2016 and 2015. Each of our accounting policies has been chosen based upon current authoritative literature that collectively comprises U.S. Generally Accepted Accounting Principles (GAAP). In instances where alternative methods of accounting are permissible under GAAP, we have chosen the method that most appropriately reflects the nature of our business, the results of our operations and our financial condition, and have consistently applied those methods over each of the periods presented in the financial statements. The Audit Committee of our Board of Directors has reviewed and approved the accounting policies selected.

Revenue Recognition — We generally recognize homebuilding revenue and related profit at the time of the closing of a sale, when title to and possession of the property are transferred to the buyer. In situations where the buyer’s financing is originated by DHI Mortgage, our 100% owned mortgage subsidiary, and the buyer has not made an adequate initial or continuing investment, the profit is deferred until the sale of the related mortgage loan to a third-party purchaser has been completed. Any profit on land sales is deferred until the full accrual method criteria are met. When appropriate, revenue and profit on long-term construction projects are recognized under the percentage-of-completion method.

We include proceeds from home closings held for our benefit at title companies in homebuilding cash. When we execute sales contracts with our homebuyers, or when we require advance payment from homebuyers for custom changes, upgrades or options related to their homes, we record the cash deposits received as liabilities until the homes are closed or the contracts are cancelled. We either retain or refund to the homebuyer deposits on cancelled sales contracts, depending upon the applicable provisions of the contract or other circumstances.

We recognize financial services revenues associated with our title operations as closing services are rendered and title insurance policies are issued, both of which generally occur simultaneously as each home is closed. We transfer substantially all underwriting risk associated with title insurance policies to third-party insurers. We typically elect the fair value option for our mortgage loan originations. Mortgage loans held for sale are initially recorded at fair value based on either sale commitments or current market quotes and are adjusted for subsequent changes in fair value until the loans are sold. Net origination costs and fees associated with mortgage loans are recognized at the time of origination. The expected net future cash flows related to the associated servicing of a loan are included in the measurement of all written loan commitments that are accounted for at fair value through earnings at the time of commitment. We generally sell the mortgages we originate and the related servicing rights to third-party purchasers within 30 days of origination. Interest income is earned from the date a mortgage loan is originated until the loan is sold.

Some mortgage loans are sold with limited recourse provisions, which can result in repurchases of loans previously sold to investors or payments to reimburse investors for loan losses. Based on historical experience, discussions with our mortgage purchasers, analysis of the mortgages we originated and current housing and credit market conditions, we estimate and record a loss reserve for mortgage loans held in portfolio and mortgage loans held for sale, as well as known and projected mortgage loan repurchase requests.

Inventories and Cost of Sales — Inventory includes the costs of direct land acquisition, land development and home construction, capitalized interest, real estate taxes and direct overhead costs incurred during development and home construction. Costs that we incur after development projects or homes are substantially complete, such as utilities, maintenance, and cleaning, are charged to SG&A expense as incurred. All indirect overhead costs, such as compensation of sales personnel, division and region management, and the costs of advertising and builder’s risk insurance are charged to SG&A expense as incurred.

Land and development costs are typically allocated to individual residential lots on a pro-rata basis, and the costs of residential lots are transferred to construction in progress when home construction begins. Home construction costs are specifically identified and recorded to individual homes. Cost of sales for homes closed includes the specific construction costs of each home and all applicable land acquisition, land development and related costs (both incurred and estimated to be incurred) allocated to each residential lot based upon the total number of homes expected to be closed in each community. Any changes to the estimated total development costs subsequent to the initial home closings in a community are generally allocated on a pro-rata basis to the remaining homes in the community associated with the relevant development activity.

When a home is closed, we generally have not paid all incurred costs necessary to complete the home. We record a liability and a charge to cost of sales for the amount estimated to ultimately be paid related to completed homes that have been closed. We compare our home construction budgets to actual recorded costs to determine the additional costs remaining to be paid on each closed home. We monitor the accrual by comparing actual costs incurred on closed homes in subsequent months to the amounts previously accrued. Although actual costs to be paid in the future on previously closed homes could differ from our current accruals, such differences have not been significant.

Each quarter, we review our communities and land inventories for indicators of potential impairment. We generally review our inventory for impairment indicators at the community level, and the inventory within each community is categorized as land held for development, residential land and lots developed and under development, land held for sale and construction in progress and finished homes, based on the stage of production or plans for future development or sale. A particular community often includes inventory in more than one category. In certain situations, inventory may be analyzed separately for impairment purposes based on its product type or future plans. In reviewing each of our communities, we determine if impairment indicators exist on inventory held and used by analyzing a variety of factors including, but not limited to, the following:

•gross margins on homes closed in recent months;
•projected gross margins on homes sold but not closed;
•projected gross margins based on community budgets;
•trends in gross margins, average selling prices or cost of sales;
•sales absorption rates; and
•performance of other communities in nearby locations.

If indicators of impairment are present for a community, we perform an impairment evaluation of the community, which includes an analysis to determine if the undiscounted cash flows estimated to be generated by those assets are less than their carrying amounts. If so, impairment charges are recorded to cost of sales if the fair value of such assets is less than their carrying amounts. These estimates of cash flows are significantly impacted by community specific factors including estimates of the amounts and timing of future revenues and estimates of the amount of land development, materials and labor costs which, in turn, may be impacted by the following local market conditions:

•supply and availability of new and existing homes;
•location and desirability of our communities;
•variety of product types offered in the area;
•pricing and use of incentives by us and our competitors;
•alternative uses for our land or communities such as the sale of land, finished lots or home sites to third parties;
•amount of land and lots we own or control in a particular market or sub-market; and
•local economic and demographic trends.

For those assets deemed to be impaired, the impairment to be recognized is measured as the amount by which the carrying amount of the assets exceeds the fair value of the assets. Our determination of fair value is primarily based on discounting the estimated cash flows at a rate commensurate with the inherent risks associated with the assets and related estimated cash flow streams. When an impairment charge for a community is determined, the charge is then allocated to each lot in the community in the same manner as land and development costs are allocated to each lot. Impairment charges are also recorded on finished homes in substantially completed communities when events or circumstances indicate that the carrying values are greater than the fair values less estimated costs to sell these homes.

For the inventory impairment analyses performed during fiscal 2017, we assumed that for the majority of communities, sales prices in future periods will be equal to or lower than current sales order prices in each community, or in comparable communities, in order to generate an acceptable absorption rate. The remaining lives of the communities evaluated were estimated to be in a range from six months to two years, and we utilized a range of discount rates for communities from 12% to 18%.

We rarely purchase land for resale. However, when we own land or communities under development that do not fit into our development and construction plans, and we determine that we will sell the asset, the project is accounted for as land held for sale if certain criteria are met. We record land held for sale at the lesser of its carrying value or fair value less estimated costs to sell. In performing the impairment evaluation for land held for sale, we consider several factors including, but not limited to, recent offers received to purchase the property, prices for land in recent comparable sales transactions and market analysis studies, which include the estimated price a willing buyer would pay for the land. If the estimated fair value less costs to sell an asset is less than the current carrying value, the asset is written down to its estimated fair value less costs to sell.

The key assumptions relating to inventory valuations are impacted by local market and economic conditions, and are inherently uncertain. Although our quarterly assessments reflect management’s best estimates, due to uncertainties in the estimation process, actual results could differ from such estimates.

Business Acquisitions — We account for acquisitions of businesses by allocating the purchase price of the business to the various assets acquired and liabilities assumed at their respective fair values. Any excess of the purchase price over the estimated fair values of the identifiable net assets acquired is recorded as goodwill. Significant judgment is often required in estimating the fair value of assets acquired, particularly intangible assets. These estimates and assumptions are based on historical experience, information obtained from the management of the acquired companies and our estimates of significant assumptions that a market participant would use when determining fair value. While we believe the estimates and assumptions are reasonable, they are inherently uncertain. Unanticipated market or macroeconomic events and circumstances may occur, which could affect the accuracy or validity of the estimates and assumptions.

Goodwill — We record goodwill associated with our acquisitions of businesses when the purchase price of the business exceeds the fair value of the net tangible and identifiable intangible assets acquired. We evaluate our goodwill balances for potential impairment on at least an annual basis by comparing the carrying value of each of our operating segments with goodwill to their estimated fair values. The estimated fair value is determined by discounting the future cash flows of the operating segment to their present value. If the carrying value of the operating segment exceeds its fair value, we determine if an impairment exists based on the implied fair value of the operating segment’s goodwill. As a result of the goodwill evaluation performed in fiscal 2017, no impairment charges were recorded. As a result of the goodwill evaluation performed in fiscal 2016, an impairment charge of $7.2 million was recorded to write off the remaining goodwill associated with the Huntsville operating segment in the Southeast reporting region. This operating segment experienced lower levels of profitability than anticipated primarily due to difficult market conditions. Our total goodwill balance was $80.0 million at both September 30, 2017 and 2016.

Warranty Claims — We typically provide our homebuyers with a ten-year limited warranty for major defects in structural elements such as framing components and foundation systems, a two-year limited warranty on major mechanical systems and a one-year limited warranty on other construction components. Since we subcontract our construction work to subcontractors who typically provide us with an indemnity and a certificate of insurance prior to receiving payments for their work, claims relating to workmanship and materials are generally the primary responsibility of the subcontractors. Warranty liabilities have been established by charging cost of sales for each home delivered. The amounts charged are based on management’s estimate of expected warranty-related costs under all unexpired warranty obligation periods. Our warranty liability is based upon historical warranty cost experience in each market in which we operate, and is adjusted to reflect qualitative risks associated with the types of homes we build and the geographic areas in which we build them. Actual future warranty costs could differ from our currently estimated amounts. A 10% change in the historical warranty rates used to estimate our warranty accrual would not result in a material change in our accrual.

Legal Claims and Insurance — We are named as a defendant in various claims, complaints and other legal actions in the ordinary course of business. At any point in time, we are managing several hundred individual claims related to construction defect matters, personal injury claims, employment matters, land development issues, contract disputes and other matters. We have established reserves for these contingencies based on the estimated costs of pending claims and the estimated costs of anticipated future claims related to previously closed homes. Approximately 98% and 95% of these reserves related to construction defect matters at September 30, 2017 and 2016, respectively.

Our reserves for construction defect claims include the estimated costs of both known claims and anticipated future claims. At both September 30, 2017 and 2016, we had reserves for approximately 140 pending construction defect claims, and no individual existing claim was material to our financial statements. During fiscal 2017, we established reserves for approximately 75 new construction defect claims and resolved 75 construction defect claims for a total cost of $52.6 million. We have closed a significant number of homes during recent years, and we may be subject to future construction defect claims on these homes. Although regulations vary from state to state, construction defect issues can generally be reported for up to ten years after the home has closed in many states in which we operate. Historical data and trends regarding the frequency of claims incurred and the costs to resolve claims relative to the types of products and markets where we operate are used to estimate the construction defect liabilities for both existing and anticipated future claims. These estimates are subject to ongoing revision as the circumstances of individual pending claims and historical data and trends change. Adjustments to estimated reserves are recorded in the accounting period in which the change in estimate occurs.

Historical trends in construction defect claims have been inconsistent, and we believe they may continue to fluctuate. Housing market conditions have been volatile across most of our markets over the past ten years, and we believe such conditions can affect the frequency and cost of construction defect claims. We closed a significant number of homes over the past ten years. If the ultimate resolution of construction defect claims resulting from our home closings in prior years varies from current expectations, it could significantly change our estimates regarding the frequency and timing of claims incurred and the costs to resolve existing and anticipated future claims, which would impact the construction defect reserves in the future. If the frequency of claims incurred or costs of existing and future legal claims significantly exceed our current estimates, they will have a significant negative impact on our future earnings and liquidity.

We estimate and record receivables under the applicable insurance policies related to our estimated contingencies for known claims and anticipated future construction defect claims on previously closed homes and other legal claims and lawsuits incurred in the ordinary course of business when recovery is probable. Additionally, we may have the ability to recover a portion of our losses from our subcontractors and their insurance carriers when we have been named as an additional insured on their insurance policies.

The estimation of losses related to these reserves and the related estimates of recoveries from insurance policies are subject to a high degree of variability due to uncertainties such as trends in construction defect claims relative to our markets and the types of products built, claim frequency, claim settlement costs and patterns, insurance industry practices and legal interpretations, among others. Due to the high degree of judgment required in establishing reserves for these contingencies, actual future costs and recoveries from insurance could differ significantly from current estimated amounts. A 10% increase in the claim frequency and the average cost per claim used to estimate the reserves would result in an increase of approximately $71.4 million in our reserves and a $36.1 million increase in our receivable, resulting in additional expense of $35.3 million. A 10% decrease in the claim frequency and the average cost per claim would result in a decrease of approximately $63.9 million in our reserves and a $28.6 million decrease in our receivable, resulting in a reduction in expense of $35.3 million.

Income Taxes — We calculate our income tax expense (benefit) using the asset and liability method, under which deferred tax assets and liabilities are recognized based on the future tax consequences attributable to temporary differences between the financial statement amounts of assets and liabilities and their respective tax bases and attributable to net operating losses and tax credit carryforwards. When assessing the realizability of deferred tax assets, we consider whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The realization of deferred tax assets is dependent upon the generation of sufficient taxable income in future periods and in the jurisdictions in which those temporary differences become deductible. We record a valuation allowance when we determine it is more likely than not that a portion of our deferred tax assets will not be realized. The accounting for deferred taxes is based upon estimates of future results. Differences between the anticipated and actual outcomes of these future results could have a material impact on our consolidated results of operations or financial position. Also, changes in existing federal and state tax laws and tax rates could affect future tax results and the valuation of our deferred tax assets.

Interest and penalties related to unrecognized tax benefits are recognized in the financial statements as a component of income tax expense. Significant judgment is required to evaluate uncertain tax positions. We evaluate our uncertain tax positions on a quarterly basis. Our evaluations are based upon a number of factors, including changes in facts or circumstances, changes in tax law, correspondence with tax authorities during the course of audits and effective settlement of audit issues. Changes in the recognition or measurement of uncertain tax positions could result in increases or decreases in our income tax expense in the period in which we make the change.

Stock-based Compensation — Our stockholders formally authorize shares of our common stock to be available for future grants of stock-based compensation awards. From time to time, the Compensation Committee of our Board of Directors authorizes the grant of stock-based compensation to our employees and directors from these available shares. At September 30, 2017, our outstanding stock-based compensation awards include stock options and restricted stock units. Grants of restricted stock units may vest immediately or over a certain number of years as determined by the Compensation Committee of our Board of Directors. Restricted stock units outstanding at September 30, 2017 have a remaining vesting period of 1 to 5 years. Stock options are granted at exercise prices which equal the market value of our common stock at the date of the grant. The stock options outstanding at September 30, 2017 vest over periods of 2 to 9.75 years from the initial grant date and expire 10 years after the dates on which they were granted.

The compensation expense for stock-based awards is based on the fair value of the award and is recognized on a straight-line basis over the remaining vesting period. The fair values of restricted stock units are based on our stock price at the date of grant. The fair values of stock options granted are calculated on the date of grant using a Black-Scholes option pricing model. Determining the fair value of stock options requires judgment in developing assumptions and involves a number of estimates. These estimates include, but are not limited to, the expected stock price volatility over the term of the awards, the expected dividend yield and expected stock option exercise behavior. In addition, we also use judgment in estimating the number of stock options that are expected to be forfeited. The benefits of tax deductions in excess of recognized compensation expense are reported in our consolidated statements of cash flows as a financing cash flow.

Fair Value Measurements — The Financial Accounting Standards Board’s (FASB) authoritative guidance for fair value measurements establishes a three-level hierarchy based upon the inputs to the valuation model of an asset or liability. The fair value hierarchy and its application to our assets and liabilities, is as follows:

•Level 1 — Valuation is based on quoted prices in active markets for identical assets and liabilities.
•Level 2 — Valuation is determined from quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar instruments in markets that are not active, or by model-based techniques in which all significant inputs are observable in the market.
•Level 3 — Valuation is typically derived from model-based techniques in which at least one significant input is unobservable and based on our own estimates about the assumptions that market participants would use to value the asset or liability.

When available, we use quoted market prices in active markets to determine fair value. We consider the principal market and nonperformance risk associated with our counterparties when determining the fair value measurements, if applicable. Fair value measurements are used for our mortgage loans held for sale, debt securities collateralized by residential real estate, interest rate lock commitments (IRLCs) and other derivative instruments on a recurring basis and are used for inventories, certain other mortgage loans, rental properties and real estate owned on a nonrecurring basis, when events and circumstances indicate that the carrying value may not be recoverable.

Recent Accounting Pronouncements

In May 2014, the FASB issued ASU 2014-09, “Revenue from Contracts with Customers,” which is a comprehensive new revenue recognition model that will replace most existing revenue recognition guidance. The core principle of this guidance is that an entity should recognize revenue for the transfer of goods or services equal to the amount that it expects to be entitled to receive for those goods or services. The guidance is effective for us beginning October 1, 2018 and allows for full retrospective or modified retrospective methods of adoption. We currently plan to adopt this standard using the modified retrospective method and are continuing to evaluate its effect.

In July 2015, the FASB issued ASU 2015-11, “Simplifying the Measurement of Inventory,” which simplifies the subsequent measurement of inventory, excluding inventory measured using the last-in, first-out or retail inventory methods. The guidance specifies that inventory currently measured at the lower of cost or market, where market could be determined with different methods, should now be measured at the lower of cost or net realizable value. The guidance is effective for us beginning October 1, 2017 and is not expected to have a material impact on our consolidated financial position, results of operations or cash flows.

In January 2016, the FASB issued ASU 2016-01, “Financial Instruments - Recognition and Measurement of Financial Assets and Financial Liabilities,” which addresses certain aspects of recognition, measurement, presentation and disclosure of financial instruments. The guidance is effective for us beginning October 1, 2018 and is not expected to have a material impact on our consolidated financial position, results of operations or cash flows.

In February 2016, the FASB issued ASU 2016-02, “Leases,” which requires that lease assets and liabilities be recognized on the balance sheet, and that key information about leasing arrangements be disclosed. The guidance is effective for us beginning October 1, 2019, although early adoption is permitted. We are currently evaluating the impact of this guidance on our consolidated financial position, results of operations and cash flows.

In March 2016, the FASB issued ASU 2016-09, “Compensation - Stock Compensation,” which simplifies several aspects of the accounting for share-based payment transactions, including the income tax consequences, classification of awards as either equity or liabilities, and classification on the statement of cash flows. The guidance is effective for us beginning October 1, 2017 and is not expected to have a material impact on our consolidated financial position, results of operations or cash flows.

In June 2016, the FASB issued ASU 2016-13, “Financial Instruments - Credit Losses,” which replaces the current incurred loss impairment methodology with a methodology that reflects expected credit losses and requires consideration of a broader range of reasonable and supportable information in determining credit loss estimates. The guidance is effective for us beginning October 1, 2020 and is not expected to have a material impact on our consolidated financial position, results of operations or cash flows.

In August 2016, the FASB issued ASU 2016-15, “Statement of Cash Flows - Classification of Certain Cash Receipts and Cash Payments,” which amends and clarifies the current guidance to reduce diversity in practice of the classification of certain cash receipts and payments in the statement of cash flows. The guidance is effective for us beginning October 1, 2018 and is not expected to have a material impact on our consolidated statements of cash flows.

In November 2016, the FASB issued ASU 2016-18, “Statement of Cash Flows - Restricted Cash,” which requires amounts generally described as restricted cash and restricted cash equivalents be included with cash and cash equivalents when reconciling the total beginning and ending amounts for the periods shown on the statement of cash flows. The guidance is effective for us beginning October 1, 2018 and is not expected to have a material impact on our consolidated financial position or cash flows.

In January 2017, the FASB issued ASU 2017-01, “Business Combinations - Clarifying the Definition of a Business,” which clarifies the definition of a business for determining whether transactions should be accounted for as acquisitions (or disposals) of assets or businesses. The guidance is effective for us beginning October 1, 2018 and is not expected to have a material impact on our consolidated financial position, results of operations or cash flows.

In January 2017, the FASB issued ASU 2017-04, “Intangibles - Goodwill and Other.” The guidance simplifies the measurement of goodwill impairment by removing the second step of the goodwill impairment test, which requires the determination of the fair value of individual assets and liabilities of a reporting unit. Under the new guidance, goodwill impairment is measured as the amount by which a reporting unit’s carrying amount exceeds its fair value with the loss recognized limited to the total amount of goodwill allocated to the reporting unit. The guidance is effective for us beginning October 1, 2020 and is not expected to have a material impact on our consolidated financial position, results of operations or cash flows.

In May 2017, the FASB issued ASU 2017-09, “Compensation - Stock Compensation: Scope of Modification Accounting,” which clarifies which changes to the terms or conditions of a share-based payment award require an entity to apply modification accounting. Under the new guidance, modification accounting is required if the fair value, vesting conditions or classification (equity or liability) of the new award are different from the original award immediately before the original award is modified. The guidance is effective for us beginning October 1, 2018 and is not expected to have a material impact on our consolidated financial position, results of operations or cash flows.

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