Notes to the Consolidated
In millions of U.S. dollars, unless otherwise stated
3. CRITICAL ACCOUNTING ESTIMATES
The preparation of the financial statements requires management to make estimates and adopt assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities and the fair value of financial instruments on the balance sheet dates and the reported amounts of revenues and expenses during the reporting period. Significant estimates for which changes in the near term are considered reasonably possible and that may have a material impact on the financial statements are disclosed. Actual results may differ from such estimates.
In order to provide an understanding about how Management forms its judgments about future events, including the variables and assumptions underlying the estimates, and the sensitivity of those judgments to different variables and conditions, the estimates and assumptions that have a significant risk of causing a material adjustment to the carrying amounts of assets and liabilities within the next financial year are addressed below.
a) Sales and other operating revenues
The Company recognizes revenues from sales made by the commercial, executive, aviation services and Defense and security business when benefits and risk of ownership is transferred to customers, which, in the case of aircraft, occurs when delivery is made, and, in the case of aviation services, when the service is provided to the customer.
The Company also recognizes rental revenue for leased aircraft, classified as operating leases on a straight-line basis over the lease term and, when presenting information by operating segment, we record such rental revenue under the "other related businesses" line item of our segment reporting.
In the Defense and security segment, a significant portion of revenues is derived from long-term development contracts with Brazilian and foreign governments, for which the Company recognize revenues on the percentage-of-completion, or POC, method. These contracts contain provisions for price escalation based on a mix of indices related to raw material and labor cost. From time to time, the Company reassesses the expected margins of certain long-term contracts, adjusting revenue recognition based upon projected costs to completion. Use of the percentage-of-completion method requires the Company to estimate the total costs to be incurred on the contracts. Were the total costs to be incurred to fall by 10% from management's estimates, the amount of revenue recognized in the year would be increased by US$77.4 and if the total costs to rise by 10%, the amount of revenue recognized in the year would be decreased by US$90.8.
Revenue under exchange pool programs is recognized monthly over the contract term and consists partly of a fixed fee and partly of a variable fee directly related to actual flight hours of the covered aircraft.
The Company enters into transactions that represent multiple-element arrangements, such as training, technical assistance, spare parts and others concessions, which are included in the aircraft purchase price. Multiple-element arrangements are assessed to determine whether they can be separated into more than one unit of accounting if all of the following criteria are met:
If these criteria are not met, the arrangement is accounted for as one unit of accounting, which results in revenue being deferred until the earlier of when such criteria are met or when the last undelivered element is delivered. If these criteria are met for each element and there is objective and reliable evidence of fair value for all units of accounting in an arrangement, the arrangement consideration is allocated to the separate units of accounting based on each unit's relative fair value.
- The delivered item has value to the client on a stand-alone basis;
- There is objective and reliable evidence of the fair value of the undelivered item; and
- If the arrangement includes a general right of return relative to the delivered item, delivery or performance of the undelivered item is considered probable and substantially under the Company's control.
b) Product warranties
Generally, aircraft sales are accompanied by a standard warranty for systems, accessories, equipment, parts and software manufactured by us and/or by the Company's risk-sharing partners and supplies. The Company recognizes warranty expense, as cost of sales and services, at the time of sale based on the estimated amounts of warranty costs anticipated to be incurred. These estimates are based on a number of factors, including historical warranty claims and cost experience, the type and duration of the warranty coverage, volume and mix of aircraft sold and in service and warranty coverage available from the related suppliers. Actual product warranty costs may have different patterns from past experience, mainly when a new family of aircraft enters service, which could require us to increase the product warranty reserve. The warranty period is three years for spare parts and five years for components that are a part of the aircraft when sold.
c) Guarantees and trade-in rights
The Company may offer financial and residual value guarantees and trade-in rights related to its aircraft. The Company reviews the value of these commitments relative to the aircraft's anticipated future fair value and, in the case of financial guarantees, the creditworthiness of the obligor. Provisions and losses are recorded when and if payments become probable and are reasonably estimable. The estimate future fair value using third-party appraisals of aircraft valuations, including information developed from the sale or lease of similar aircraft in the secondary market. The Company evaluates the creditworthiness of obligors for which it provides credit guarantees by analyzing a number of factors, including third-party credit ratings and the estimated obligors' borrowing costs.
d) Residual interests in aircraft
In structured financing arrangements, an entity purchases an aircraft from the Company, pays the full purchase price on delivery or at the conclusion of the sales financing structure, and leases the related aircraft to the ultimate customer. A third-party financial institution facilitates the financing of an aircraft, and a portion of the credit risk remains with that third party.
Although it has no equity interests, the Company controls the SPEs operations or takes a majority share of their risks and rewards. Accordingly, the SPEs owned by third parties where the Company has control are consolidated. When the Company no longer holds control, the assets and liabilities related to the aircraft are deconsolidated from the Company's balance sheet.
The Company evaluates control characteristics over the SPE principally based on a qualitative assessment. This includes a review of the SPE's capital structure, contractual relationships and terms, nature of the SPE's operations and purpose, nature of the SPE's interests issued, and their interests in the entity which either create or absorb variability. The Company evaluated the design of the SPE and the related risks the entity and the variable interest holders are exposed to in evaluating consolidation. In limited cases, when it is unclear from a qualitative standpoint who has control over the SPE, the Company uses a qualitative analysis to calculate the probability-weighted expected losses and probability-weighted expected residual returns using cash flow and statistical risk measurement modeling.
Long-lived assets held for use are subject to an impairment assessment if facts and circumstances indicate that the carrying value is no longer recoverable based upon the discounted future cash flows of the asset or its net realizable value. Assets are grouped based on families of aircraft, which are the Company's cash-generating units (CGU). The Company uses assumptions to determine the expected discounted cash flows including the forecasts of future cash flows and the net realizable values, which are based on the Company's best estimate of future sales and operating costs, primarily on existing firm orders, expected future orders, contracts with suppliers and general market conditions. Changes in these forecasts could significantly change the amount of impairment recorded, if any. The Company registered the net accounting value of the underlying assets if the sum of the expected future cash flows or the net realizable value is less than accounting value. These reviews to date have not indicated the need to recognize any impairment.
f) Fair value of financial instruments
The fair value of financial instruments that are not traded in an active market is determined by using valuation techniques. The Company uses its judgment to select a variety of methods and make assumptions that are mainly based on market conditions existing at the end of each reporting period.
g) Income taxes
The Company is subject to income taxes in numerous jurisdictions. Significant judgment is required in determining the worldwide provision for income taxes. There are many transactions and calculations for which the ultimate tax determination is uncertain. The Company recognizes liabilities based on estimates of whether additional taxes will be due. Where the final tax outcome of these matters is different from the amounts that were initially recorded, such differences will impact the current and deferred income tax assets and liabilities in the period in which such determination is made.
Because the majority of the Company's tax basis is in Reais and its functional currency is the U.S. dollar, the income tax expense line item is highly sensitive to the effects of changes in exchange rates particularly from the comparative bases of its non monetary assets. As at December 31, 2010, if the Real to depreciate or appreciate by 10% against the U.S. dollar, the deferred income tax expense would have increased by approximately US$109.0 or decreased by US$109.0, respectively.