Note 1. Summary of Significant Accounting Policies

 

Principles of Consolidation and Financial Statement Presentation

Our Consolidated Financial Statements include the accounts of Textron Inc. and its majority-owned subsidiaries.  Our financings are conducted through two separate borrowing groups. The Manufacturing group consists of Textron Inc. consolidated with its majority-owned subsidiaries that operate in the Textron Aviation, Bell, Textron Systems and Industrial segments. The Finance group, which also is the Finance segment, consists of Textron Financial Corporation (TFC) and its consolidated subsidiaries. We designed this framework to enhance our borrowing power by separating the Finance group. Our Manufacturing group operations include the development, production and delivery of tangible goods and services, while our Finance group provides financial services.  Due to the fundamental differences between each borrowing group’s activities, investors, rating agencies and analysts use different measures to evaluate each group’s performance.  To support those evaluations, we present balance sheet and cash flow information for each borrowing group within the Consolidated Financial Statements.

 

Our Finance group provides financing primarily to purchasers of new and pre-owned Textron Aviation aircraft and Bell helicopters manufactured by our Manufacturing group, otherwise known as captive financing.  In the Consolidated Statements of Cash Flows, cash received from customers is reflected as operating activities when received from third parties.  However, in the cash flow information provided for the separate borrowing groups, cash flows related to captive financing activities are reflected based on the operations of each group.  For example, when product is sold by our Manufacturing group to a customer and is financed by the Finance group, the origination of the finance receivable is recorded within investing activities as a cash outflow in the Finance group’s statement of cash flows.  Meanwhile, in the Manufacturing group’s statement of cash flows, the cash received from the Finance group on the customer’s behalf is recorded within operating cash flows as a cash inflow.  Although cash is transferred between the two borrowing groups, there is no cash transaction reported in the consolidated cash flows at the time of the original financing.  These captive financing activities, along with all significant intercompany transactions, are reclassified or eliminated in consolidation.

 

Collaborative Arrangements

Our Bell segment has a strategic alliance agreement with The Boeing Company (Boeing) to provide engineering, development and test services related to the V-22 aircraft, as well as to produce the V-22 aircraft, under a number of separate contracts with the U.S. Government (V-22 Contracts).  The alliance created by this agreement is not a legal entity and has no employees, no assets and no true operations.  This agreement creates contractual rights and does not represent an entity in which we have an equity interest.  We account for this alliance as a collaborative arrangement with Bell and Boeing reporting costs incurred and revenues generated from transactions with the U.S. Government in each company’s respective income statement. Neither Bell nor Boeing is considered to be the principal participant for the transactions recorded under this agreement.  Profits on cost-plus contracts are allocated between Bell and Boeing on a 50%-50% basis.  Negotiated profits on fixed-price contracts are also allocated 50%-50%; however, Bell and Boeing are each responsible for their own cost overruns and are entitled to retain any cost underruns.  Based on the contractual arrangement established under the alliance, Bell accounts for its rights and obligations under the specific requirements of the V-22 Contracts allocated to Bell under the work breakdown structure.  We account for all of our rights and obligations, including warranty, product and any contingent liabilities, under the specific requirements of the V-22 Contracts allocated to us under the agreement.  Revenues and cost of sales reflect our performance under the V-22 Contracts with revenues currently recognized using the units-of-delivery method.  We include all assets used in performance of the V-22 Contracts that we own, including inventory and unpaid receivables and all liabilities arising from our obligations under the V-22 Contracts in our Consolidated Balance Sheets.

 

Use of Estimates

We prepare our financial statements in conformity with generally accepted accounting principles, which require us to make estimates and assumptions that affect the amounts reported in the financial statements.  Actual results could differ from those estimates. Our estimates and assumptions are reviewed periodically, and the effects of changes, if any, are reflected in the Consolidated Statements of Operations in the period that they are determined.

 

We periodically change our estimates of revenues and costs on certain long-term contracts that are accounted for under the percentage-of-completion method of accounting. These changes in estimates increased income from continuing operations before income taxes by $5 million, $83 million and $78 million in 2017, 2016 and 2015, respectively, ($3 million, $52 million and $49 million after tax, respectively, or $0.01, $0.19 and $0.18 per diluted share, respectively).  For 2017, 2016 and 2015, the gross favorable program profit adjustments totaled $92 million, $106 million and $111 million, respectively, and the gross unfavorable program profit adjustments totaled $87 million, $23 million and $33 million, respectively. Gross unfavorable program adjustments for 2017 included $44 million related to the Tactical Armoured Patrol Vehicle program. In 2017, this program experienced inefficiencies resulting from various production issues during the ramp up and subsequent production.

 

Revenue Recognition

We generally recognize revenue for the sale of products, which are not under long-term contracts, upon delivery.  For commercial aircraft, delivery is upon completion of manufacturing, customer acceptance, and the transfer of the risk and rewards of ownership.  Taxes collected from customers and remitted to government authorities are recorded on a net basis.

 

When a sale arrangement involves multiple deliverables, such as sales of products that include customization and other services, we evaluate the arrangement to determine whether there are separate items that are required to be delivered under the arrangement that qualify as separate units of accounting.  These arrangements typically involve the customization services we offer to customers who purchase Bell helicopters, and the services generally are provided within the first six months after the customer accepts the aircraft and assumes risk of loss.  We consider the aircraft and the customization services to be separate units of accounting and allocate contract price between the two on a relative selling price basis using the best evidence of selling price for each of the deliverables, typically by reference to the price charged when the same or similar items are sold separately by us.  We also consider any performance, cancellation, termination or refund-type provisions.  Revenue is recognized when the recognition criteria for each unit of accounting are met.

 

Long-Term Contracts

Revenues under long-term contracts are accounted for under the percentage-of-completion method of accounting.  Under this method, we estimate profit as the difference between the total estimated revenues and cost of a contract.  We then recognize that estimated profit over the contract term based on either the units-of-delivery method or the cost-to-cost method (which typically is used for development effort as costs are incurred), as appropriate under the circumstances.  Revenues under fixed-price contracts generally are recorded using the units-of-delivery method.  Revenues under cost-reimbursement contracts are recorded using the cost-to-cost method.

 

Long-term contract profits are based on estimates of total contract cost and revenues utilizing current contract specifications, expected engineering requirements, the achievement of contract milestones and product deliveries.  Certain contracts are awarded with fixed-price incentive fees that also are considered when estimating revenues and profit rates.  Contract costs typically are incurred over a period of several years, and the estimation of these costs requires substantial judgment.  Our cost estimation process is based on the professional knowledge and experience of engineers and program managers along with finance professionals.  We update our projections of costs at least semiannually or when circumstances significantly change.  When adjustments are required, any changes from prior estimates are recognized using the cumulative catch-up method with the impact of the change from inception-to-date recorded in the current period.  Anticipated losses on contracts are recognized in full in the period in which the losses become probable and estimable.

 

Finance Revenues

Finance revenues primarily include interest on finance receivables, capital lease earnings and portfolio gains/losses.  Portfolio gains/losses include impairment charges related to repossessed assets and properties and gains/losses on the sale or early termination of finance assets.  We recognize interest using the interest method, which provides a constant rate of return over the terms of the receivables.  Accrual of interest income is suspended if credit quality indicators suggest full collection of principal and interest is doubtful.  In addition, we automatically suspend the accrual of interest income for accounts that are contractually delinquent by more than three months unless collection is not doubtful. Cash payments on nonaccrual accounts, including finance charges, generally are applied to reduce the net investment balance. Once we conclude that the collection of all principal and interest is no longer doubtful, we resume the accrual of interest and recognize previously suspended interest income at the time either a) the loan becomes contractually current through payment according to the original terms of the loan, or b) if the loan has been modified, following a period of performance under the terms of the modification.

 

Cash and Equivalents

Cash and equivalents consist of cash and short-term, highly liquid investments with original maturities of three months or less.

 

Inventories

Inventories are stated at the lower of cost or estimated net realizable value.  We value our inventories generally using the first-in, first-out (FIFO) method or the last-in, first-out (LIFO) method for certain qualifying inventories where LIFO provides a better matching of costs and revenues. We determine costs for our commercial helicopters on an average cost basis by model considering the expended and estimated costs for the current production release.  Inventories include costs related to long-term contracts, which are stated at actual production costs, including allocable operating overhead, advances to suppliers, and, in the case of contracts with the U.S. Government, allocable research and development and general and administrative expenses.  Since our inventoried costs include amounts related to contracts with long production cycles, a portion of these costs is not expected to be realized within one year.  Pursuant to contract provisions, agencies of the U.S. Government have title to, or security interest in, inventories related to such contracts as a result of advances, performance-based payments and progress payments.  Accordingly, these advances and payments are reflected as an offset against the related inventory balances with any remaining amounts recorded as a liability in customer deposits.  Customer deposits are recorded against inventory only when the right of offset exists, while all other customer deposits are recorded in Accrued liabilities.

 

Property, Plant and Equipment

Property, plant and equipment are recorded at cost and are depreciated primarily using the straight-line method.  We capitalize expenditures for improvements that increase asset values and extend useful lives.  Property, plant and equipment are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of the asset may not be recoverable.  If the carrying value of the asset exceeds the sum of the undiscounted expected future cash flows, the asset is written down to fair value.

 

Goodwill and Intangible Assets

Goodwill represents the excess of the consideration paid for the acquisition of a business over the fair values assigned to intangible and other net assets of the acquired business.  Goodwill and intangible assets deemed to have indefinite lives are not amortized, but are subject to an annual impairment test. We evaluate the recoverability of these assets in the fourth quarter of each year or more frequently if events or changes in circumstances, such as declines in sales, earnings or cash flows, or material adverse changes in the business climate, indicate a potential impairment.

 

For our impairment test, we calculate the fair value of each reporting unit and indefinite-lived intangible asset primarily using discounted cash flows.  A reporting unit represents the operating segment unless discrete financial information is prepared and reviewed by segment management for businesses one level below that operating segment, in which case such component is the reporting unit.  In certain instances, we have aggregated components of an operating segment into a single reporting unit based on similar economic characteristics.  For the goodwill impairment test, the discounted cash flows incorporate assumptions for revenue growth, operating margins and discount rates that represent our best estimates of current and forecasted market conditions, cost structure, anticipated net cost reductions, and the implied rate of return that we believe a market participant would require for an investment in a business having similar risks and characteristics to the reporting unit being assessed.  If the reporting unit’s estimated fair value exceeds its carrying value, there is no impairment. Otherwise, the amount of the impairment is determined by comparing the carrying amount of the reporting unit’s goodwill to the implied fair value of that goodwill.  The implied fair value of goodwill is determined by assigning a fair value to all of the reporting unit’s assets and liabilities as if the reporting unit had been acquired in a business combination.  If the carrying amount of the goodwill exceeds the implied fair value, an impairment loss is recognized in an amount equal to that excess. For indefinite-lived intangible assets, if the carrying amount of an intangible asset exceeds its fair value, an impairment loss is recognized in an amount equal to that excess.

 

Acquired intangible assets with finite lives are subject to amortization. These assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of the asset may not be recoverable.  Amortization of these intangible assets is recognized over their estimated useful lives using a method that reflects the pattern in which the economic benefits of the intangible assets are consumed or otherwise realized.  Approximately 78% of our gross intangible assets are amortized based on the cash flow streams used to value the assets, with the remaining assets amortized using the straight-line method.

 

Finance Receivables

Finance receivables primarily include loans provided to purchasers of new and pre-owned Textron Aviation aircraft and Bell helicopters. Finance receivables are generally recorded at the amount of outstanding principal less allowance for losses.

 

We maintain an allowance for losses on finance receivables at a level considered adequate to cover inherent losses in the portfolio based on management’s evaluation.  For larger balance accounts specifically identified as impaired, a reserve is established based on comparing the expected future cash flows, discounted at the finance receivable’s effective interest rate, or the fair value of the underlying collateral if the finance receivable is collateral dependent, to its carrying amount. The expected future cash flows consider collateral value; financial performance and liquidity of our borrower; existence and financial strength of guarantors; estimated recovery costs, including legal expenses; and costs associated with the repossession and eventual disposal of collateral. When there is a range of potential outcomes, we perform multiple discounted cash flow analyses and weight the potential outcomes based on their relative likelihood of occurrence. The evaluation of our portfolio is inherently subjective, as it requires estimates, including the amount and timing of future cash flows expected to be received on impaired finance receivables and the estimated fair value of the underlying collateral, which may differ from actual results. While our analysis is specific to each individual account, critical factors included in this analysis include industry valuation guides, age and physical condition of the collateral, payment history and existence and financial strength of guarantors.

 

We also establish an allowance for losses to cover probable but specifically unknown losses existing in the portfolio.  This allowance is established as a percentage of non-recourse finance receivables, which have not been identified as requiring specific reserves. The percentage is based on a combination of factors, including historical loss experience, current delinquency and default trends, collateral values and both general economic and specific industry trends.

 

Finance receivables are charged off at the earlier of the date the collateral is repossessed or when no payment has been received for six months, unless management deems the receivable collectible.  Repossessed assets are recorded at their fair value, less estimated cost to sell.

 

Pension and Postretirement Benefit Obligations

We maintain various pension and postretirement plans for our employees globally.  These plans include significant pension and postretirement benefit obligations, which are calculated based on actuarial valuations.  Key assumptions used in determining these obligations and related expenses include expected long-term rates of return on plan assets, discount rates and healthcare cost projections.  We evaluate and update these assumptions annually in consultation with third-party actuaries and investment advisors.  We also make assumptions regarding employee demographic factors such as retirement patterns, mortality, turnover and rate of compensation increases.

 

For our year-end measurement, our defined benefit plan assets and obligations are measured as of the month-end date closest to our fiscal year-end.  We recognize the overfunded or underfunded status of our pension and postretirement plans in the Consolidated Balance Sheets and recognize changes in the funded status of our defined benefit plans in comprehensive income in the year in which they occur. Actuarial gains and losses that are not immediately recognized as net periodic pension cost are recognized as a component of other comprehensive income (loss) (OCI) and are amortized into net periodic pension cost in future periods.

 

Derivatives and Hedging Activities

We are exposed to market risk primarily from changes in currency exchange rates and interest rates.  We do not hold or issue derivative financial instruments for trading or speculative purposes.  To manage the volatility relating to our exposures, we net these exposures on a consolidated basis to take advantage of natural offsets.  For the residual portion, we enter into various derivative transactions pursuant to our policies in areas such as counterparty exposure and hedging practices.  Credit risk related to derivative financial instruments is considered minimal and is managed by requiring high credit standards for counterparties and through periodic settlements of positions.

 

All derivative instruments are reported at fair value in the Consolidated Balance Sheets.  Designation to support hedge accounting is performed on a specific exposure basis.  For financial instruments qualifying as cash flow hedges, we record changes in the fair value of derivatives (to the extent they are effective as hedges) in OCI, net of deferred taxes.  Changes in fair value of derivatives not qualifying as hedges are recorded in earnings.

 

Foreign currency denominated assets and liabilities are translated into U.S. dollars.  Adjustments from currency rate changes are recorded in the cumulative translation adjustment account in shareholders’ equity until the related foreign entity is sold or substantially liquidated.  We use foreign currency financing transactions to effectively hedge long-term investments in foreign operations with the same corresponding currency.  Foreign currency gains and losses on the hedge of the long-term investments are recorded in the cumulative translation adjustment account.

 

Product Liabilities

We accrue for product liability claims and related defense costs when a loss is probable and reasonably estimable.  Our estimates are generally based on the specifics of each claim or incident and our best estimate of the probable loss using historical experience.

 

Environmental Liabilities and Asset Retirement Obligations

Liabilities for environmental matters are recorded on a site-by-site basis when it is probable that an obligation has been incurred and the cost can be reasonably estimated.  We estimate our accrued environmental liabilities using currently available facts, existing technology, and presently enacted laws and regulations, all of which are subject to a number of factors and uncertainties.  Our environmental liabilities are not discounted and do not take into consideration possible future insurance proceeds or significant amounts from claims against other third parties.

 

We have incurred asset retirement obligations primarily related to costs to remove and dispose of underground storage tanks and asbestos materials used in insulation, adhesive fillers and floor tiles.  There is no legal requirement to remove these items, and there currently is no plan to remodel the related facilities or otherwise cause the impacted items to require disposal.  Since these asset retirement obligations are not estimable, there is no related liability recorded in the Consolidated Balance Sheets.

 

Warranty and Product Maintenance Liabilities

We provide limited warranty and product maintenance programs for certain products for periods ranging from one to five years.  A significant portion of these liabilities arises from our commercial aircraft businesses.  For our product maintenance contracts, revenue is recognized on a straight-line basis over the contract period, unless sufficient historical evidence indicates that the cost of providing these services is incurred on a basis other than straight-line.  In those circumstances, revenue is recognized over the contract period in proportion to the costs expected to be incurred in performing the service.

 

For our warranty programs, we estimate the costs that may be incurred and record a liability in the amount of such costs at the time product revenues are recognized.  Factors that affect this liability include the number of products sold, historical costs per claim, contractual recoveries from vendors and historical and anticipated rates of warranty claims, including production and warranty patterns for new models.  We assess the adequacy of our recorded warranty liability periodically and adjust the amounts as necessary.  Additionally, we may establish a warranty liability related to the issuance of aircraft service bulletins for aircraft no longer covered under the limited warranty programs.

 

Research and Development Costs

Our customer-funded research and development costs are charged directly to the related contracts, which primarily consist of U.S. Government contracts. In accordance with government regulations, we recover a portion of company-funded research and development costs through overhead rate charges on our U.S. Government contracts.  Research and development costs that are not reimbursable under a contract with the U.S. Government or another customer are charged to expense as incurred.  Company-funded research and development costs were $634 million, $677 million and $778 million in 2017, 2016 and 2015, respectively, and are included in cost of sales.

 

Income Taxes

The provision for income tax expense is calculated on reported Income from continuing operations before income taxes based on current tax law and includes, in the current period, the cumulative effect of any changes in tax rates from those used previously in determining deferred tax assets and liabilities. Tax laws may require items to be included in the determination of taxable income at different times from when the items are reflected in the financial statements. Deferred tax balances reflect the effects of temporary differences between the financial reporting carrying amounts of assets and liabilities and their tax bases, as well as from net operating losses and tax credit carryforwards, and are stated at enacted tax rates in effect for the year taxes are expected to be paid or recovered.  Deferred tax assets represent tax benefits for tax deductions or credits available in future years and require certain estimates and assumptions to determine whether it is more likely than not that all or a portion of the benefit will not be realized.  The recoverability of these future tax deductions and credits is determined by assessing the adequacy of future expected taxable income from all sources, including the future reversal of existing taxable temporary differences, taxable income in carryback years, estimated future taxable income and available tax planning strategies. Should a change in facts or circumstances lead to a change in judgment about the ultimate recoverability of a deferred tax asset, we record or adjust the related valuation allowance in the period that the change in facts and circumstances occurs, along with a corresponding increase or decrease in income tax expense.

 

We record tax benefits for uncertain tax positions based upon management’s evaluation of the information available at the reporting date.  To be recognized in the financial statements, the tax position must meet the more-likely-than-not threshold that the position will be sustained upon examination by the tax authority based on technical merits assuming the tax authority has full knowledge of all relevant information.  For positions meeting this recognition threshold, the benefit is measured as the largest amount of benefit that meets the more-likely-than-not threshold to be sustained. We periodically evaluate these tax positions based on the latest available information.  For tax positions that do not meet the threshold requirement, we recognize net tax-related interest and penalties for continuing operations in income tax expense.

 

New Accounting Standards

 

Revenue Recognition

In May 2014, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers, that outlines a five-step revenue recognition model based on the principle that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods and services. This new standard became effective for us at the beginning of 2018, and will be adopted using the modified retrospective transition method. Under this method, we will record the cumulative effect of adopting the new standard in the first quarter of 2018.

 

Based on review and analysis of our contracts, the standard primarily impacts our Bell and Textron Systems segments, which have long-term production contracts with the U.S. Government.  Prior to adoption of the new standard, revenue was generally recognized for these contracts as units were delivered, while under the new standard, revenue will be recognized over time, principally as costs are incurred.  This change will generally result in an acceleration of revenue for these contracts.  At the adoption date, the impact of recognizing these revenues under the new standard for historical periods ending prior to December 31, 2017 will result in a cumulative after-tax transition adjustment to increase retained earnings by approximately $90 million, largely related to the Bell segment.  In addition, the transition adjustment will establish contract assets of approximately $350 million, with corresponding decreases in inventory of approximately $200 million and in contract liabilities (deferred revenue and customer deposits) and accounts receivables, primarily reflecting the conversion of contracts to the cost-to-cost method.  This change is not expected to have a significant impact on our future operating results as the revenues that would have been recognized under the units-of-delivery method in future years, will essentially be replaced by the acceleration of revenue on other contracts into earlier periods using the cost-to-cost method. The new standard will have no impact on cash flows and does not affect the economics of our underlying customer contracts.  The standard does not have a significant impact on revenue recognition for our Textron Aviation and Industrial segments, which will continue to primarily recognize revenue at the point in time when the customer accepts delivery of the goods provided.

 

At the end of 2017, our backlog excluded amounts where funding from the U.S. Government had not been formally appropriated.  Under the new standard, backlog will generally include these unfunded amounts as backlog will be the equivalent of the transaction price allocated to our remaining performance obligations, which represents the revenue we expect to recognize under our contracts in future periods for which work has not yet been performed.  At adoption, the increase in our backlog for the unfunded amounts will be fully offset by the decrease due to the acceleration of revenues in the transition adjustment.  We expect backlog at the Bell segment to decrease by approximately 15% at the adoption date, which will partially be offset by an increase of approximately 7% at the Textron Systems segment.

 

We have updated the accounting policies affected by this standard, redesigned our related internal controls over financial reporting and are expanding the disclosures to be included in our first quarter Form 10-Q to meet the new requirements.

 

Other Standards

In March 2017, the FASB issued ASU No. 2017-07, Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost.  This standard requires companies to present only the service cost component of net periodic benefit costs in operating income in the same line as other employee compensation costs, while the other components of net periodic benefit costs must be excluded from operating income. In addition, only the service cost component will be eligible for capitalization into inventory.  This standard is effective for our company at the beginning of 2018.  The reclassification of the other components of net periodic benefit cost out of operating income must be applied retrospectively, while the change in the amount companies may capitalize into inventory can be applied prospectively.  This standard will not have a material impact on our consolidated financial statements and will not change our segment reporting.

 

In February 2016, the FASB issued ASU No. 2016-02, Leases, that requires lessees to recognize all leases with a term greater than 12 months on the balance sheet as right-to-use assets and lease liabilities, while lease expenses would continue to be recognized in the statement of operations in a manner similar to current accounting guidance.  Under the current accounting guidance, we are not required to recognize assets and liabilities arising from operating leases on the balance sheet.  The new standard is effective for our company at the beginning of 2019 and early adoption is permitted.  Entities must adopt the standard on a modified retrospective basis whereby it would be applied at the beginning of the earliest comparative year.  While we continue to evaluate the impact of the standard on our consolidated financial statements, we expect that it will materially increase the assets and liabilities on our consolidated balance sheet as we recognize the rights and corresponding obligations related to operating leases.

 

In June 2016, the FASB issued ASU No. 2016-13, Financial Instruments – Credit Losses. For most financial assets, such as trade and other receivables, loans and other instruments, this standard changes the current incurred loss model to a forward-looking expected credit loss model, which generally will result in the earlier recognition of allowances for losses.  The new standard is effective for our company at the beginning of 2020 with early adoption permitted beginning in 2019.  Entities are required to apply the provisions of the standard through a cumulative-effect adjustment to retained earnings as of the effective date.  We are currently evaluating the impact of the standard on our consolidated financial statements.