2. PRESENTATION OF THE FINANCIAL STATEMENTS AND ACCOUNTING PRACTICES
2.1 Presentation of the financial statements
The financial statements presented were approved for issue by the Board of Directors at March 17, 2011.
a) Basis of preparation
The consolidated financial statements have been prepared in accordance with International Financial Reporting Standards (IFRS) issued by the International Accounting Standards Board (IASB). These standards comprise (i) IFRS; (ii) the International Accounting Standard (IAS); and (iii) Interpretations originated by the International Financial Reporting Interpretations Committee (IFRIC), or its predecessor, the Standing Interpretations Committee (SIC). For the purposes of these consolidated financial statements presented in accordance with IFRS there are no differences in relation to the current accounting practices adopted in Brazil ("Brazilian GAAP") for the periods presented.
These are the first IFRS compliant financial statements prepared and presented by the Company. A summary of the main differences between the accounting practices previously adopted by the Company ("Prior Brazilian GAAP") and IFRS and the reconciliations between these comprehensive bodies of GAAP for shareholders' equity and comprehensive income, are presented in Note 5.
The preparation of financial statements in conformity with IFRS requires the use of certain critical accounting estimates. It also requires Management to exercise its judgment in the process of applying the Company's accounting policies.
The areas involving a higher degree of judgment or complexity, or areas where assumptions and estimates are significant to the consolidated financial statements are disclosed in Note 3. The actual results may differ from these estimates.
These consolidated financial statements were prepared under the historical cost convention and adjusted to reflect financial assets and liabilities (including derivative instruments) measured at fair value through profit or loss.
2.2 Summary of significant accounting policies
The consolidated financial statements include the accounts of (i) the Company and all majority-owned subsidiaries in which the Company, directly or indirectly, has a majority of the equity of the subsidiary and has the power to direct the subsidiary's finance and operating policies; (ii) special purpose entities ("SPEs"), for which the Company has control, and (iii) exclusive investment funds, as follows:
ELEB – Equipamentos Ltda. – "ELEB" – subsidiary with 99.9% of its capital is held by Embraer, located in São José dos Campos – São Paulo, Brazil. ELEB produces and sells precision hydraulic and mechanical equipment for the aviation industry, mainly for Embraer aircraft. Its wholly-owned subsidiary, ELEB Aerospace, Inc., domiciled in Delaware, United States, with an operational base in the State of Kansas, United States, is currently closing down its operations.
Embraer Aircraft Holding Inc. – "EAH" – subsidiary with 99.9% of its capital is held by Embraer, located in São José dos Campos – São Paulo, Brazil. ELEB produces and sells precision hydraulic and mechanical equipment for the aviation industry, mainly for Embraer aircraft. Its wholly-owned subsidiary, ELEB Aerospace, Inc., domiciled in Delaware, United States, with an operational base in the State of Kansas, United States, is currently closing down its operations:
- Embraer Aircraft Customer Services, Inc. – "EACS" – sells spare parts, product support and customer training to customers in the United States, Canada and the Caribbean.
- Embraer Aircraft Maintenance Services Inc. – "EAMS" – provides maintenance services for aircraft and components.
- Embraer Training Services – "ETS" – located in Delaware, United States, responsible for corporate and institutional activities, and has a 51% subsidiary, Embraer CAE Training Services – "ECTS", also located in Delaware – United States, which provides training for pilots, mechanics and crew.
- Embraer Executive Jet Services, LLC – "EEJS" – located in Delaware – United States. EEJS provides after-sales support services and maintenance services for executive aircraft.
- Embraer Services Inc. – "ESI" – provides support in the United States for the defense and commercial market programs
- Embraer Executive Aircraft, Inc. – created in 2008, is located in Delaware and has its operational base in Melbourne, Florida. Its objective is the final assembly and delivery of the Phenom executive jet
Embraer Asia Pacific PTE. Ltd. – "EAP" – a wholly-owned subsidiary, located in Singapore, created in 2006 with the objective of providing after-sales support services in Asia.
Embraer Australia PTY Ltd. – "EAL" – a wholly-owned subsidiary, located in Melbourne, Australia, with the objective of providing after-sales support services to customers in the Australasian and Asian regions. The company is currently inactive.
Embraer Aviation Europe SAS – "EAE" – a wholly-owned subsidiary, located in Villepinte, France, responsible for corporate and institutional activities, and has the following subsidiaries:
- Embraer Aviation International SAS – "EAI" – located in Villepinte, France, sells parts and provides after-sales support services in Europe, Africa and the Middle East.
- Embraer Aviation International SAS – "EAI" – located in Villepinte, France, sells parts and provides after-sales support services in Europe, Africa and the Middle East.
Embraer Credit Ltd. – "ECL" – a wholly-owned subsidiary, located in Delaware, United States, provides support for sales operations.
Embraer GPX Ltda – "GPX" – subsidiary with 99,9% of its capital is held by Embraer, created in 2006 and located in Gavião Peixoto, State of São Paulo, Brazil to provide specialized aircraft maintenance services, started operations in October 2009.
Embraer Overseas Limited – "EOS" – a wholly-owned subsidiary, located in the Cayman Islands, B.W.I., created in September 2006 with the sole objective of carrying out financial transactions, including rising and investing funds, intercompany loans for Embraer companies.
Embraer Representation LLC – "ERL" – a wholly-owned subsidiary, located in Delaware, United States, provides commercial and institutional representation for the Company.
Embraer Spain Holding Co. SL – "ESH" – a wholly-owned subsidiary, located in Spain. Its objective is to coordinate investments in subsidiaries abroad, including those focused on activities that support the sale of aircraft and Management of assets derived from these operations. ESH's operations are carried out by its subsidiaries, as follows:
- Airholding SGPS, S.A. – is located in Portugal and 70% of its capital is held by ESH. Its main activity is its 65% participation in the voting capital of OGMA – Indústria Aeronáutica de Portugal S.A., a Portuguese aviation maintenance and production company. The remaining 35% of the voting capital is held by Empresa Portuguesa de Defesa – EMPORDEF.
- ECC Investment Switzerland AG – located in Switzerland, holds 100% of the capital of the subsidiaries ECC Insurance & Financial Co. Ltd. and Embraer Finance Ltd. – EFL.
- ECC Insurance & Financial Co. Ltd. – located in the Cayman Islands, is an in-house insurance company providing cover for the financial guarantees offered to customers and/or financing agents involved in structuring the sales of Embraer aircraft.
- Embraer Finance Ltd. – "EFL" – located in the Cayman Islands, assists customers in obtaining third-party financing, as well as providing support for some of the Company's purchase and sale transactions.
- ECC Leasing Co. Ltd. – located in Ireland, its objective is the lease and sale of used aircraft.
- Harbin Embraer Aircraft Industry Company Ltd. – "HEAI" – based in Harbin, in China, its purpose is to manufacture aircraft in order to meet the air transportation market demand in China.
- Embraer CAE Training Services (UK) Ltd. – "ECUK" – created in 2009, is located in London, United Kingdom, and provides training for pilots, mechanics and crew. EMBRAER holds 51% of its capital.
- Embraer Portugal – SGPS S.A. – a wholly-owned subsidiary created in 2008, is located in Ever, Portugal, and its objective is to coordinate investments and economic activity in its subsidiaries in Portugal.
- Embraer-Portugal Estruturas Metálicas S.A. – created in 2008 and located in Portugal, in the city of Évora, its objective is the manufacture, assembly, maintenance and sale of parts, components and metal sets and carrying out other technical, industrial, commercial and service activities related to the metal products industry.
- Embraer-Portugal Estruturas em Compósitos S.A. – constituída em 2008, está domiciliada em Portugal, na cidade de Évora, tem como objeto social a fabricação, montagem e comercialização de estruturas a partir de peças e conjuntos em materiais compostos e a execução de outras atividades tecnológicas, industriais, comerciais e de serviços relacionados à indústria de produtos fabricados com materiais compostos e não metálicos.
- Embraer (China) Aircraft Techinical Services Co., Ltd – "ECA" – based in Beijing, its objective is to provide after-sales support services, maintenance services and sell parts to customers in China.
ECC do Brasil Cia. de Seguros – "ECC" – a wholly-owned subsidiary, located in Rio de Janeiro, State of Rio de Janeiro, Brazil, was created in 2004 and approved by the Private Insurance Agency – SUSEP. Its objective is to operate solely with export credit insurance. On December 7, 2007, Embraer's Board of Directors approved the proposal to sell all of its shares in ECC do Brasil Cia. de Seguros, and on April 7, 2009, Embraer signed a contract to this effect, subject to approval by the Private Insurance Agency – SUSEP, which has not yet been granted.
Indústria Aeronáutica Neiva Ltda. – "Neiva" – subsidiary with 99,9% of its capital is held by Embraer, located in Botucatu, State of São Paulo, Brazil, which currently sells agricultural aircraft and parts and components for this model of aircraft.
Special Purpose Companies – "SPEs" – the Company organizes some of its aircraft sale financing transactions through SPEs, in which the Company has no direct or indirect interest. Although it has no equity interests, the Company controls their operations or takes a majority share of their risks and rewards, and the SPEs are therefore consolidated in the financial statements of the parent company. The consolidated SPEs are: Table Inc., PM Limited, Refine Inc., RS Limited, River One Ltd. and Port One Ltd. Other SPEs in which Embraer has not control and has no continuous involvement were not consolidated, based on technical analyses made by Management.
Exclusive Investment Funds – in connection with its business strategies, the Company has investments in exclusive funds, which are consolidated in the financial statements. The balances of marketable securities and investments maintained through these Funds are recorded in the Cash and cash equivalents or Financial assets accounts, taking into consideration the original maturities of the securities and the fund investment strategies, which provide for negotiation of these securities in periods that reflect the immediate liquidity of the amounts (Note 7 and 8).
All intercompany accounts and transactions arising from consolidated entities have been eliminated.
Subsidiaries are all entities (including special purpose entities) whose financial and operational policies may be directed by the Company and in which it normally holds more than half the voting shares. The existence and effect of potential voting rights that are currently exercisable or convertible are considered when assessing whether the Company controls another entity. Subsidiaries are fully consolidated from the date on which control is transferred to the Company. They are de-consolidated from the date that control ceases.
The purchase method of accounting is used to account for the acquisition of subsidiaries by the Company. The cost of an acquisition is measured as the fair value of the assets given, equity instruments issued and liabilities incurred or assumed at the acquisition date. The acquition-related costs are recognizes as expenses in the period which the costs are incurred and the services received. Identifiable assets acquired and liabilities and contingent liabilities assumed in a business combination are measured initially at their fair values at the acquisition date, irrespective of the extent of any minority interest. The excess of the cost of acquisition over the fair value of the Company's share of the identifiable net assets acquired is recorded as goodwill. If the cost of acquisition is less than the fair value of the net assets of the subsidiary acquired, the difference is recognized directly in the statement of income.
c) Functional and presentation currency
After analyzing Embraer's operations and businesses with regard to the applicability of IAS 21 – The Effects of Changes in Foreign Exchange Rates, particularly in relation to the factors involved in determining its functional currency, Management concluded that the Company's functional currency is the U.S. dollar ("US$" or "dollar"). This conclusion was based on analysis of the following indicators, as set out in IAS 21:
- Currency that mainly influences sales prices of goods and services;
- Currency of the country whose competitive forces and regulations mainly determine the sales price of its goods and services;
- Currency that mainly influences labor, materials and other costs of providing goods or services;
- Currency in which the funds for financial operations are largely obtained; and
- Currency in which revenue from operations is usually received.
Items included in the financial statements of each of the Company's entities are measured using the currency of the primary economic environment in which the entity operates ('the functional currency'). The consolidated financial statements are presented in U.S. dollars, which is the Company's presentation currency.
d) Transactions in foreign currenciess
Transactions in other currencies (different to the functional currency) are translated to the functional currency, using the exchange rates in effect on the date of the transactions or measurement, on which the items are re-measured. Foreign exchange gains and losses resulting from translation using the closing rate at the end of the year, relating to monetary assets and liabilities in foreign currencies, are recognized in the statement of income.
Foreign exchange gains and losses relating to monetary assets and liabilities are presented in the statement of income as Foreign exchange gain (loss), net.
e) Translation of subsidiary´s financial statements
For subsidiaries whose functional currency is a currency other than the U.S. dollar, asset and liability accounts are translated into the Company's reporting currency using exchange rates in effect at the date of the balance sheet, and income and expense items are translated using average exchange rates. The resulting translation adjustments are reported in a separate component of shareholders' equity, in Cumulative Translation Adjustment.
f) Financial Instruments
Financial Assets – Classification and measurement
The Company classifies its financial assets among the following categories: (i) measured at fair value through profit or loss; (ii) available for sale; (iii) held to maturity; and (iv) loans and receivables. The classification depends on the purpose for which the financial assets were acquired. Management decides on the classification of its financial assets at initial recognition.
Regular purchases and sales of financial assets are recognized on the trade-date – the date on which the Company commits to purchase or sell the asset.
Investments are initially recognized at fair value plus transaction costs for all financial assets not carried at fair value through profit or loss. Financial assets carried at fair value through profit or loss is initially recognized at fair value, and transaction costs are expensed in the statement of income.
Financial assets are de-recognized when the rights to receive cash flows from the investments have expired or have been transferred, and the Company has transferred substantially all risks and rewards of ownership. Available-for-sale financial assets and financial assets at fair value through profit or loss are subsequently carried at fair value. Loans and receivables are subsequently carried at amortized cost, using the effective interest method.
(i) Financial assets measured at fair value through profit or loss
Financial assets measured at fair value through profit or loss is those held for active and frequent trading. The assets in this category are classified as current assets. Gains and losses resulting from differences in the fair value of financial assets measured at fair value through profit or loss are presented in the statement of income in financial income in the period in which they occur. In this case, the differences are recorded under the same heading as the income affected by the transaction.
The fair values of publicly quoted investments are based on the current purchase and sale prices. In the case of financial assets without an active market or not publicly quoted, the Company uses valuation techniques to calculate the fair value. These methods include comparison with recent transactions with third parties, reference to other substantially similar instruments, analysis of discounted cash flows and options pricing models that prioritize market information and minimize information generated by Management.
(ii) Available for sale financial assets
Financial assets available for sale are non derivatives classified in this category or that are not classified in any other category. They are included in noncurrent assets, unless Management intends to dispose of the investment within 12 months after the balance sheet date. Financial assets available for sale are recorded at fair value. The interest on securities available for sale, calculating by the effective interest rate method, is recorded in the statement of income as financial income. The portion corresponding to the change in fair value is posted directly to shareholders' equity, in the Equity Adjustments Account, and realized through profit or loss on settlement when the loss is considered permanent (impairment).
(iii) Held to maturity
The investments in derivative instruments that the Company has the ability and intention to hold until maturity are classified as investments held to maturity, and are measured at amortized cost.
The Company evaluates if there is objective evidence that a financial asset or a group of financial assets are registered above their recovery value. When applicable, a provision for devaluation is recognized.
(iv) Loans and receivables
This category includes loans granted and receivables that are non derivative financial assets with fixed or determinable payments, not quoted in an active market. They are included in current assets, except for maturities greater than 12 months after the end of the reporting period. These are classified as non current assets.
The Company's loans and receivables comprise loans to subsidiaries, trade accounts receivable, other accounts receivable. Loans and receivables are recorded at the amortized cost, by the effective interest rate method.
The Company assesses, at the end of each reporting period, whether there is objective evidence that a financial asset or group of financial assets is impaired. A financial asset or a group of financial assets is impaired, and impairment losses are incurred only if there is objective evidence of impairment as a result of one or more events that occurred after the initial recognition of the asset (a "loss event") and that loss event (or events) has an impact on the estimated future cash flows of the financial asset or group of financial assets that can be reliably estimated.
g) Cash and cash equivalents
Cash and cash equivalents include cash on hand, bank deposits and highly liquid short-term investments, usually maturing within 90 days of the investment date, readily convertible into a known amount of cash and subject to an insignificant risk of change in value. This classification includes repurchase agreements and Bank Deposit Certificates – CDBs, with a daily liquidity index in the Clearing House for the Custody and Financial Settlement of Securities – CETIP
h) Financial assets measured at fair value through profit or loss
Financial instrument assets measured through profit or loss are financial assets acquired by the Company, principally for the purpose of selling or repurchasing in the short-term. Usually, this classification includes securities with original maturities over 90 days from the date of application.
i) Derivatives and hedge operations
Derivatives are initially recognized at fair value on the date on which a derivatives contract is signed and are, subsequently, re-measured at fair value, the differences in fair value are recorded in the statement of income as Financial Expenses, except when the derivative is designated as a hedge instrument.
Although the Company uses derivatives for protection, no derivative instrument has been designated as hedge accounting.
j) Trade accounts receivable
Trade accounts receivable are recognized initially at present value and include revenues recorded using the percentage-of-completion method. They are subsequently recorded at amortized cost using the effective interest rate method, less provision for impairment.
A provision for impairment of trade receivable is recorded when there is objective evidence that the Company will not be able to recover all the amounts owed by its customers. Significant financial difficulties of the debtor, probability of the debtor filing for bankruptcy or reorganization proceedings and failure to pay or default (overdue 180 days or more) are considered indicators that the trade receivables are impaired. The amount of the provision is the difference between the book value and the recoverable value. The book value of the asset is reduced by the amount of the provision, and the amount of the loss is recorded in the statement of income as Selling expenses. When a trade receivable is deemed totally unrecoverable, it is written off against a provision for trade receivables. Subsequent recovery of amounts previously written off is registered in Selling expenses.
k) Customer and commercial financing
These relate to financing granted on the sale of certain aircraft and are measured at the amortized cost, by the effective interest rate method.
The Company assesses at the end of each reporting period if there is objective evidence that the assets are recorded at an amount higher than their recoverable value (impairment). When applicable, a provision is recorded to reduce the value of this asset.
l) Collateralized accounts receivable and recourse and non recourse debt
Certain of the Company's sales are made under structured financing arrangements whereby a Special Purpose Entity – SPE purchases the aircraft, pays the Company the purchase price on delivery or at the end of the structured sales financing period, and transfers the purchased aircraft to the final customer. A financial institution finances the purchase of the aircraft from an SPE and bears part of the credit risk; the Company offers financial guarantees and/or residual value guarantees in favor of the institution.
The Company classifies the risks of this transaction as non recourse when the financing institution bears the risk, and as recourse when the Company bears the risk (Note 11).
Inventories are stated at the lower of average production cost or acquisition cost or market value. Inventories of work in process and finished goods are reduced, when applicable, to net realizable value after deduction for costs, taxes and selling expenses.
The Company records a valuation allowance when items are determined to be obsolete or are held in quantities that are in excess of projected usage based on Management's estimate of net realizable values. Allowances are utilized if inventories are sold or written off. Inventories in transit are stated at Accumulated cost of each item.
n) Property, plant and equipment
Property, plant and equipment are recorded at purchase, formation or construction cost, less accumulated depreciation and impairment losses.
Depreciation is calculated on the straight-line method (except spare parts pool). Land is not depreciated (Note 16).
The Company determines residual value for certain aircraft and spare parts included in the Exchange Pool Program. Others items of property, plant and equipment does not have residual value attributed as the Company does not intend to sell or dispose of these assets, other than for scrap. The assets' residual values and useful lives are reviewed, and adjusted if appropriate, at the end of each reporting period. The Company reviewed useful lives of certain assets during 2010 (Note 16).
Subsequent costs are included in the book value of the asset or recorded as a separate asset, as appropriate, only when it is likely that the item will yield future economic benefits and the cost of the item can be reliably measured. The book value of replacement items or parts is written off. All other repairs and maintenance costs incurred are recorded in the statement of income.
Materials allocated to specific projects are capitalized in property, plant and equipment in progress and subsequently transferred to the final property, plant and equipment accounts.
The cost of charges on loans obtained to finance construction of property, plant and equipment are capitalized during the period required to build and prepare the asset for its intended use. The gains and losses on disposals are determined by comparing the amount received with the book value and are reported under Other operating income (expenses), net in the statement of income.
The items comprising property, plant and equipment are summarized below:
- Land – mainly comprise areas on which the industrial, engineering and administrative buildings are located.
- Buildings and land improvements – buildings are mainly plants, engineering departments and offices, and land improvements include parking lots, road systems and water and sewage networks.
- Facilities – comprise auxiliary industrial facilities that directly or indirectly support the Company's industrial operations, as well as facilities of the engineering and administrative departments.
- Machinery and equipment – comprise the machinery and other equipment directly or indirectly used in the manufacturing process.
- Furniture and fixtures – comprise furniture and fixtures used in the production, engineering and administrative departments.
- Vehicles – comprise mainly industrial vehicles and automobiles.
- Aircraft – comprise mainly aircraft leased to airlines, and those used by the parent company to assist in testing new projects.
- Computers and peripherals – comprise technology equipment used mainly in the production process, engineering and administration.
- Property, plant and equipment in progress – comprise construction works to expand the manufacturing plants and aircraft maintenance centers.
- Spare parts pool – comprises a spare parts pool for the exclusive use of customers who are included in the Exchange Pool Program. This program allows these customers to exchange a damaged component for one in working condition, as defined in the Program. These items are depreciated based on estimated useful lives of seven to ten years and an average residual value of 35%, which the Company believes to be the approximate utilization time and realizable amount, respectively.
o) Intangible assets
(i) Research and development
Research costs are recorded as expense when they are incurred. Cost on project development, mainly product development, including drawings, engineering designs and construction of prototypes are recorded as intangible assets when it is probable that the projects will generate future benefits, taking into account their commercial and technological feasibility, availability of technological and financial resources and only if the cost can be reliably measured.
Capitalized development costs are amortized when the related asset is available for use, based on the number of estimated aircraft sales for each project, and the amortized amounts are appropriated to production cost. These estimates are reviewed as required.
In the case of inactive projects or those that are unlikely to be completed, the deferred costs are written off or reduced to the recoverable amount. Other development costs that do not meet these criteria are recorded as an expense as they are occurred. Development costs previously recorded as an expense are not subsequently capitalized as an asset.
(ii) Computer software
Software licenses are capitalized and amortized over their estimated useful lives.
Costs associated with maintaining computer software programs are recognized as an expense as incurred. Development costs that are directly attributable to identifiable and unique software, controlled by the Company and that are expected to generate benefits greater that exceed costs for more than one year, are recorded in intangible assets.
Property, plant and equipment and other non current assets, including intangible assets, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. In such cases, the recoverable value is determined. An impairment loss is recognized for the amount by which the asset's carrying amount exceeds its recoverable amount. The recoverable amount is the higher of an asset's fair value less costs to sell and value in use.
For the purposes of assessing impairment, assets are grouped at the lowest levels for which there are separately identifiable cash flows (cash-generating units). Non financial assets other than goodwill that suffered an impairment charge are reviewed for possible reversal of the impairment charge at each reporting date. For intangible assets arising in the process of development, impairment tests are carried out irrespective of evidence of loss.
q) Others current and non current assets
Other current and non current assets are stated at cost or realizable value including, when applicable accrued income
r) Loans and financing
Loans and financing are recognized initially at fair value. Loans and financing are subsequently carried at amortized cost; any difference between the proceeds (net of transaction costs) and the redemption value is recognized in the statement of income over the period of the contract using the effective interest method.
Fees paid on the establishment of loan facilities are recognized as transaction costs of the loan to the extent that it is probable that some or all of the facility will be drawn down. In this case, the fee is deferred until the draw-down occurs. To the extent there is no evidence that it is probable that some or all of the facility will be drawn down, the fee is capitalized as a pre-payment for liquidity services and amortized over the period of the facility to which it relates.
Loans and financing are registered as current liabilities, unless the Company has an unconditional right to defer the settlement of the liability to 12 months after the date of the balance sheet, at least.
The classification of a lease depends on whether an agreement is or contains a lease, is based on the essence of the agreement and includes a determination as to if (i) the fulfillment of the agreement depends on the use of one or more specific assets; and (ii) the agreement assigns the right to use the asset
(i) Aircraft leases
Aircraft classified as operating leases are reported in the Company's balance sheet as property, plant and equipment, and depreciated over their estimated useful lives. The rental income (net of any subsidy granted to the lessee) is recorded by the straight-line method over the lease period. Aircraft classified as finance leases are not recorded in the Company's assets after the lease commences; the income and respective cost of sales are recorded on the date of the leasing transaction.
(ii) Other leases
Leases in which the Company holds substantially all the risks and benefits of ownership are classified as finance leases. Finance leases are recorded as a financed purchase, initially by recording a property, plant and equipment asset and a financial liability (lease). Property, plant and equipment assets purchased classified as finance leases are depreciated at the rates in Note 16.
Leases in which a significant part of the risks and benefits of ownership are assumed by the lessor are classified as operating leases. Payments made for operating leases are appropriated to the statement of income on the straight-line method over the contract period.
t) Borrowing costs
u) Advances from customers
Borrowing costs attributable to acquisitions, buildings, or production of qualifying assets that need a substantial period of time to be ready for use or sale are capitalized as part of the cost of the asset. The additional borrowing costs are recognized as expenses in the period when they occur. Borrowing costs include interest and other costs that the Company incurs in connection with funds raising.
These refer basically to advances received from customers prior to the delivery of the aircraft.
v) Contingent assets and liabilities, legal obligations and court-mandated escrow deposits
Contingent assets – are not recognized except when the Company concludes that the gain is virtually certain or in the case of real guarantees or favorable legal decisions which no further appeals can be made.
Provision for contingencies – are recorded considering the advice of the Company's legal counsel, the nature of the lawsuits, similarity with previous cases, complexity and court interpretations, whenever the loss is considered probable, would result in a probable outflow of resources to settle the obligations and also when the amounts involved can be measured with a reasonable degree of certainty. Contingent liabilities classified as possible losses are not recorded, but disclosed in the financial statements, and where the probability of loss is classified as remote, no provision or disclosure is made.
Court-mandated escrow deposits are recorded as other assets.
The amount recorded in the provisions is considered sufficient to cover the estimates of probable losses.
w) Employee benefits
(i) Defined contribution
The Company and its subsidiaries provide defined contribution pension plans for their employees. For the companies headquartered in Brazil, the administration of the plan was transferred from Banco do Brasil S.A. – BB Previdência to EMBRAER PREV – Sociedade de Previdência Complementar in 2010.
(ii) Post-retirement healthcare benefits
The Company provides healthcare benefits including medical treatment, reimbursement of costs of medications, dental treatment and other benefits for certain retirees who retired in the past and for certain retirees who will retire in the future.
The planned costs of offering post-retirement healthcare benefits and coverage for dependents are recorded as a provision during the period of employment.
The Company accounts for such benefits recognizing in its balance sheet the over or underfunded status of its defined benefit post-retirement plans, measured as the difference between the fair value of the plan assets and the benefit obligation. The Company also recognizes changes in the funded status of defined benefit post-retirement plans within other comprehensive income, net of tax, to the extent such changes are not recognized in earnings as components of periodic net benefit cost.
The funded status of the defined benefit pension and post-retirement medical benefit plans are recorded by the Company based on the funded status of each plan as of the balance sheet dates. The net periodic cost of the Company's post-retirement medical benefit plan and the terminated defined benefit pension was determined using the projected unit credit method and several actuarial assumptions, the most significant of which are the discount rate, the long-term rate of return on plan assets and the medical cost trend rate.
x) Earnings per share
Basic earnings per common share was computed by dividing net income attributable to owners of Embraer available to common shareholders by the weighted average number of common shares outstanding during the period.
Undistributed net income attributable to owners of Embraer is computed by deducting total dividends from net income attributable to owners of Embraer.
Diluted earnings per share is computed similarly to basic earnings per share except that the outstanding shares are increased to include the number of additional shares that would have been outstanding had the potentially dilutive shares attributable to stock options been issued during the respective periods, utilizing the treasury stock method.
y) Share-based payment
The Company operates an equity-settled, share-based compensation plan, under which the entity receives services from employees as consideration for equity instruments (options) of the Company. The fair value of the employee services received in exchange for the grant of the options is recognized as an expense. The total amount to be expensed is determined by reference to the fair value of the options granted.
The total expense is recognized over the vesting period, which is the period over which all of the specified vesting conditions are to be satisfied. At the end of each reporting period, the Company revises its estimates of the number of options that are expected to vest. It recognizes the impact of revisions to original estimates, if any, in the statement of income, with a corresponding adjustment to equity.
z) Employee profit-sharing plan
The employee profit-sharing program is linked to the Company's net income and to performance targets. Provisions are recorded monthly for the amounts determined proportionally to the salaries payable. The policies established for company profit-sharing are set forth in Note 31.
aa) Dividends and interest on own capital
Proposed distribution of dividends to shareholders is recorded as a liability in the Company's financial statements at the end of the tax year, based on the corporate bylaws. Any amount over and above the minimum mandatory dividends according to Brazilian Law is only provisioned when declared by the shareholders' meeting.
Interest on own capital, paid out or registered as a provision, is recorded in the accounts as a financial expense for tax purposes. However, for purposes of these financial statements, the amount is disclosed as a part of the net income for the year, and reclassified to shareholders' equity; the tax benefits arising from the distributions are included the net income for the year.
bb) Income tax and social contribution
Tax expenses for the period comprise current and deferred income tax. Tax is recorded in the statement of income, except to the extent that it relates to items recognized in Other comprehensive income or directly in Shareholders' equity. In this case, the tax is also recognized in Shareholders' equity.
The current income tax charge is calculated at the nominal rates applicable in each country, which on a composite, in the case of the Brazilian operations, approximate 34%, comprising income tax of 25% and social contribution on net income of 9%.
Deferred income tax is recognized using the liability method on temporary differences arising between the tax bases of assets and liabilities and their accounting values in the consolidated financial statements.
Deferred tax assets are recorded on income tax and social contribution losses, and on temporary differences between the book and tax bases of assets and liabilities, when it is probable that future taxable income will be sufficient to recover these tax credits. This assessment is based on projections of future results of operations prepared and supported by internal assumptions and on future economic scenarios and are, accordingly, subject to change.
There is no prescriptive period of the tax losses carryforwards from the Brazilian operations; however, their compensation is limited in future years to 30% of the tax payable in each year.
cc) Product warranties
Warranty expenses relating to aircraft and spare parts are recognized at the time of delivery, based on the estimated amounts to be incurred. These estimates are based on historical factors that include warranty claims and the corresponding repair and replacement costs, the warranty given by the suppliers and the contractual coverage period. The warranty coverage period is usually between 36 and 60 months. In some cases, the Company might be required by the aviation certification authorities to modify the product after delivery, due to upgrades or performance improvements. A provision is recorded for the estimated costs of these modifications when the new requirements or improvements are demanded and known.
Certain sales contracts may contain clauses guaranteeing minimum aircraft performance levels subsequent to delivery, based on predetermined operating targets. If the aircraft which is subject to such guarantees does not achieve the minimum performance indices after delivery, the Company may be obliged to reimburse its customers for the increase in operating costs and services incurred, based on the criteria defined in the agreements. Losses relating to such performance guarantees are recognized when known or when, in Management's opinion, circumstances indicate that the aircraft is unlikely to meet the minimum expected performance requirement.
dd) Financial guarantees and residual value guarantees
Based on its analysis of the market and economic scenario, the Company may, in some cases, grant financial or residual value guarantees as part of the structured financing at the time of delivery of its aircraft. The guaranteed amount is based on the expected future value of these aircraft at a certain moment in time during the period of effectiveness of the financing and is subject to a guarantee ceiling. If the guarantees are executed, the Company must bear the difference, if any, between the guaranteed amount and the fair market value of the respective aircraft.
The provision for guarantees is based on statistical information or appraisals by third parties that take into consideration, among other factors, the future value of the aircraft on the maturity and within the limits guaranteed by the Company. The Company records a provision to cover the risk of loss on these guarantees, and the estimates are reviewed upon the occurrence of events that justify such reviews, when an additional provision may be recorded based on the estimated losses (Note 38).
Residual value guarantees (RVG) are recorded as financial derivative instruments (Note 38).
In some cases, the Company holds guarantee deposits in favor of third parties to whom financial and residual value guarantees have been given related to aircraft financing structures (Note 14).
ee) Unearned income
This refers to commitments to supply spare parts, training, technical representatives and other commitments established in sales contracts for aircraft already delivered, the income from which will be appropriated when the service or product is delivered to the customer.
This account also includes the unearned income on certain aircraft sales that, because of contractual obligations, are accounted for as operating leases.
ff) Other current and non current liabilities
These are stated at known or estimated amounts including, when applicable, accrued charges and foreign exchange differences.
gg) Revenue recognition
Revenue comprises the fair value of the remuneration received or to be received for the sale of products and services in the normal course of business. Revenue is presented net of taxes, returns, reductions and discounts, and in the consolidated financial statements, after eliminating intercompany sales.
(i) Revenue from aircrafts and spare parts
Revenues from sales of commercial, executive and other aircraft, spare parts and services are generally recognized at the time of delivery or shipment, when the risks and benefits are transferred to the customer.
(ii) Revenue from after-sales support
Revenue from aircraft sales contracts involving the supply of spare parts, training and technical representation is recognized when effectively realized;
(iii) Revenue from Exchange Pool Program
Revenue from the spare parts pool programs is recognized during the period of the contract and consists of a fixed charge and a variable charge directly related to the hours effectively flown by the aircraft covered by this program;
(iv) Revenue from construction contracts
In the Defense and security business, includes long-term contracts the revenue from which is recognized according to the percentage-of-completion method, considering the percentage of costs incurred in relation to the estimated total costs. Some contracts contain clauses for price increases based on pre-established price indices which are recognized on an accrual basis. Adjustments of recognition of revenues from sales contracts in the Defense and security business sector are recorded when there is evidence that they will occur, based on Management's best estimates;
(v) Revenue from operating leases
The Company also recognizes the revenue from aircraft rental as operating leases, proportional to the lease period, and records such revenues as income under the "Other related businesses" line item of our segment reporting;
(vi) Sales deductions
Sales deductions comprise indirect sales taxes and contractual concessions. The Company may offer contractual concessions that provide customers with a reduction in the amount paid for the aircraft. The concessions are recorded as sales deductions, because the concessions represent a reduction of the sales price.
hh) Cost of sales and services
Cost of sales and services consist of the cost of the aircraft, spare parts and services rendered, comprising:
(i) Material – substantially all material cost are covered by contracts with suppliers. Prices under these contracts are generally adjusted based on escalation formula which reflect, in part, inflation in the United States;
(ii) Labor – these costs are primarily Real-denominated;
(iii) Depreciation – property, plant and equipment is depreciated over the useful lives, on a straight-line basis. Depreciation of aircraft classified as operating leases and exchange pool programs is recorded in Cost of sales and services, from the beginning of the lease term using the straight-line method over the estimated useful life and considering a residual value at the end of the lease term;
(iv) Amortization – Internally generated intangible assets are amortized in accordance with the estimated sales of the series of aircraft and intangible assets acquired from third parties are amortized on straight-line bases over the estimated useful lives of the assets.
The Company accrues a liability for obligations associated with product warranties at the aircraft delivery date estimated based on historical experience and recorded in Cost of sales and services, pursuant to the accounting standard for contingencies.
The Company enters into transactions that represent multiple-element arrangements, such as training, technical assistance, spare parts and others concessions. These costs are recognized when the product or service is provided to the customer.
ii) Operating expenses and other income
Operating expenses are basically made up of sales and marketing, administration, research and other operating expenses.
jj) Government grants
Refers to investment subsidies received from FINEP (Research and Projects Financing Agency) for joint development of technologically innovative projects, in accordance with Law No. 10,973/04, relating to subsidies for technological research and development. These amounts are recorded in the statement of income to the extent that the recourses are invested and the contractual milestones are met.
Government grants received for investments in research that is in accordance with pre determined conditions are recorded in the statement of income as a reduction of research expenses.
kk) Financial income and expenses
Financial income and expenses primarily comprise earnings on short-term investments, financial charges on loans, interest on contested taxes and contingencies (Note 34), as well as foreign exchange differences on assets and liabilities expressed in currencies other than the functional currency (U.S. dollars). Financial income and expenses exclude borrowing costs attributable to acquisitions, buildings or production of qualifying assets that need a substantial period of time to be ready for use or sale which are capitalized as part of the cost of the asset.
ll) Transitional tax regime
The transitional tax regime (Regime Tributário de Transição – RTT) will be in force until a law regulating the tax effects of the new accounting methods comes into effect, while seeking to maintain tax neutrality.
The regime was optional for tax-years 2008 and 2009 and is mandatory for 2010, as follows:
(i) Application to the two-year period 2008-2009, and not only to a single year; and
(ii) Declaration of the election in the corporate income tax return (DIPJ).
The Company decided to adopt the RTT in 2008. Accordingly, for purposes of determining income tax and social contribution for the years ended December 31, 2010 and 2009, the Company adopted the prerogatives set forth in the RTT.
mm) Statement of Cash Flows
The statement of cash flows was prepared on the indirect method in accordance with IAS 7 – Statement of Cash Flows.
nn) Segment reporting
Operating segments are reported in a manner consistent with the internal reporting provided to the chief operating decision-maker. The chief operating decision-maker, who is responsible for allocating resources and assessing performance of the operating segments and making strategic decisions, is the Chief Executive Officer.