Bombardier Inc. – Annual report – 31 December 2017
- USE OF ESTIMATES AND JUDGMENT
The application of the Corporation’s accounting policies requires management to use estimates and judgments that can have a significant effect on the revenues, expenses, comprehensive income, assets and liabilities recognized and disclosures made in the consolidated financial statements. Estimates and judgments are significant when:
- the outcome is highly uncertain at the time the estimates and judgments are made; and
- if different estimates or judgments could reasonably have been used that would have had a material impact on the consolidated financial statements.
Management’s best estimates regarding the future are based on the facts and circumstances available at the time estimates are made. Management uses historical experience, general economic conditions and trends, as well as assumptions regarding probable future outcomes as the basis for determining estimates. Estimates and their underlying assumptions are reviewed periodically and the effects of any changes are recognized immediately. Actual results will differ from the estimates used, and such differences could be material.
Management’s budget and strategic plan cover a five-year period and are fundamental information used as a basis for many estimates necessary to prepare financial information. Management prepares a budget and a strategic plan covering a five-year period, on an annual basis, using a process whereby a detailed one-year budget and four-year strategic plan are prepared by each reportable segment and then consolidated. Cash flows and profitability included in the budget and strategic plan are based on existing and future contracts and orders, general market conditions, current cost structures, anticipated cost variations and in-force collective agreements. The budget and strategic plan are subject to approval at various levels, including senior management and the Board of Directors. Management uses the budget and strategic plan, as well as additional projections or assumptions, to derive the expected results for periods thereafter. Management then tracks performance as compared to the budget and strategic plan at various levels within the Corporation. Significant variances in actual performance are a key trigger to assess whether certain estimates used in the preparation of financial information must be revised.
The following areas require management’s most critical estimates and judgments. The sensitivity analyses below should be used with caution as the changes are hypothetical and the impact of changes in each key assumption may not be linear.
Long-term contracts – Transportation conducts most of its business under long-term manufacturing and service contracts and the aerospace segments have some long-term maintenance service contracts, as well as design and development contracts for third parties. Revenues and margins from long-term contracts relating to the designing, engineering or manufacturing of specially designed products (including rail vehicles, vehicle overhaul and signaling contracts) and service contracts are recognized using the percentage-of-completion method of accounting. The long-term nature of these contracts requires estimates of total contract costs and revenues at completion.
Estimated revenues at completion are adjusted for change orders, anticipated options for additional assets, claims, performance incentives, price escalation clauses and other contract terms that provide for the adjustment of prices. If it is probable that changes in revenues will occur, and the amount can be measured reliably, they are included in estimated revenues at completion.
Contract costs include material, direct labour, manufacturing overhead and other costs, such as warranty and freight. Estimated contract costs at completion incorporate forecasts for material usage and costs, including escalation clauses, labour hours and costs, foreign exchange rates (including the effect of hedges) and labour productivity. These costs are influenced by the nature and complexity of the work to be performed, as well as the impact of change orders and potential delays in delivery. Cost estimates are based mainly on historical performance trends, economic trends, collective agreements and contracts signed with suppliers. Management applies judgment to determine the probability that the Corporation will incur additional costs from delays or other penalties and such costs, if probable, are included in estimated costs at completion.
Recognized revenues and margins are subject to revisions as contracts progress towards completion. Management conducts quarterly reviews of estimated costs and revenues to completion on a contract-by-contract basis, including a review of escalation assumptions. In addition, a detailed annual review is performed on a contract-by-contract basis as part of the budget and strategic plan process. The effect of any revision may be significant and is recorded by way of a cumulative catch-up adjustment in the period in which the estimates are revised.
A 1% increase in the estimated future costs to complete all ongoing long-term contracts would have decreased Transportation’s gross margin for fiscal year 2017 by approximately $84 million.
Assets held for sale – On October 16, 2017, the Corporation entered into an agreement with Airbus SE (Airbus) whereby Airbus will acquire 50.01% of CSALP, the entity that manufactures and sells the C Series aircraft. Airbus will provide procurement, sales and marketing, and customer support expertise to CSALP. At closing of the transaction, since Bombardier will no longer control CSALP, the transaction will be accounted for as a disposal of CSALP in exchange for an equity interest in the new partnership. At the transaction date, the Corporation’s interest in the new partnership will be measured at fair value based on the expected cash flows to be generated by the partnership. Thereafter, the Corporation’s investment will be accounted for using the equity method of accounting. Completion of the transaction is expected in 2018, subject to regulatory approvals and usual closing conditions.
In the consolidated financial statements the CSALP net assets are classified as a disposal group that is held for sale since management believes closing of the transaction is highly probable (e.g. the agreement was signed and the transaction is expected to be completed in 2018).
As an asset held for sale, the CSALP disposal group is measured at the lower of cost and fair value less costs to sell. PP&E and Intangible assets are not depreciated or amortized once classified as held for sale. In Q4 2017, the fair value less costs to sell of CSALP was estimated based on the Corporation’s interest in the discounted cash flows of the partnership subsequent to closing of the transaction. The Corporation’s impairment methodology described in the aerospace program tooling section below was used to determine discounted cash flows. Judgment was applied in considering potential synergies from Airbus procurement, sales and marketing and customer support expertise in the discounted cash flows. Based on this assessment, the Corporation does not expect a loss on the transaction and therefore the disposal group is measured at cost.
See Note 28 – Assets held for sale for more information.
Aerospace program tooling – Aerospace program tooling amortization and the calculation of recoverable amounts used in impairment testing require estimates of the expected number of aircraft to be delivered over the life of each program. The expected number of aircraft is based on management’s aircraft market forecasts and the Corporation’s expected share of each market. Such estimates are reviewed in detail as part of the budget and strategic plan process. For purposes of impairment testing, management exercises judgment to identify independent cash inflows to identify CGUs by family of aircraft. Other key estimates used to determine the recoverable amount include the applicable discount rate, the expected future cash flows over the remaining life of each program, which include costs to complete the development activities, if any, as well as potential upgrades, and derivatives expected over the life of the program. The estimated cost of potential upgrades and derivatives is based on past experience with previous programs. The expected future cash flows also include cash flows from aftermarket activities, as well as expected cost savings due to synergies from the perspective of a market participant. The inputs used in the discounted cash flow model are Level 3 inputs (inputs that are not based on observable market data).
The recoverable amounts of aerospace assets or CGUs are based on fair value less costs of disposal. The recoverable amounts were established during the fourth quarter of 2017. The fair value measurements are categorized within Level 3 of the fair value hierarchy. The estimate of the fair value less costs of disposal was determined using forecast future cash flows. The estimated future cash flows for the first five years are based on the budget and strategic plan. After the initial five years, long-range forecasts prepared by management are used. Forecast future cash flows are based on management’s best estimate of future sales under existing firm orders, expected future orders, timing of payments based on expected delivery schedules, revenues from related services, procurement costs based on existing contracts with suppliers, future labour costs, general market conditions, foreign exchange rates and applicable long-range forecast income tax rates and a post-tax discount rate of 10% based on a weighted average cost of capital calculated using market-based inputs, available directly from financial markets or based on a benchmark sampling of representative publicly-traded companies in the aerospace sector.
Since an annual impairment test is required for aircraft programs under development, an assessment was prepared for the Global 7000 and Global 8000 aircraft program and the Corporation concluded there was no impairment.
Since the C Series aircraft program recently entered into service and given that a significant impairment charge was recorded in 2015, an assessment was prepared again this year and the Corporation concluded there was no impairment.
The following analyses are presented in isolation from one another, i.e. all other estimates left unchanged:
A 10% decrease, evenly distributed over future periods, in the expected future net cash inflows for the Global 7000 and Global 8000 aircraft program and the C Series aircraft program would not have resulted in an impairment charge in fiscal year 2017.
An increase of 100-basis points in the discount rate used to perform the impairment tests would not have resulted in an impairment charge in fiscal year 2017 for the Global 7000 and Global 8000 aircraft program and the C Series aircraft program.
Goodwill – The recoverable amount of the Transportation operating segment, the group of CGUs at which level goodwill is monitored by management, is based on fair value less costs of disposal using a discounted cash flow model. During the fourth quarter of 2017, the Corporation completed its annual goodwill impairment test for the Transportation segment and did not identify any impairment. The fair value measurement is categorized within Level 3 of the fair value hierarchy.
Estimated future cash flows were based on the budget and strategic plan for the first 5 years and a growth rate of 1% was applied to derive a terminal value beyond the initial 5-year period. The post-tax discount rate is also a key estimate in the discounted cash flow model and was based on a representative weighted average cost of capital. The post-tax discount rate used to calculate the recoverable amount in fiscal year 2017 was 8.5%. A 100-basis point change in the post-tax discount rate would not have resulted in an impairment charge in 2017.
Valuation of deferred income tax assets – To determine the extent to which deferred income tax assets can be recognized, management estimates the amount of probable future taxable profits that will be available against which deductible temporary differences and unused tax losses can be utilized. Such estimates are made as part of the budget and strategic plan by tax jurisdiction on an undiscounted basis and are reviewed on a quarterly basis. Management exercises judgment to determine the extent to which realization of future taxable benefits is probable, considering factors such as the number of years to include in the forecast period, the history of taxable profits and availability of prudent tax planning strategies. See Note 12 – Income taxes for more details.
Tax contingencies – Uncertainties exist with respect to the interpretation of complex tax regulations, changes in tax laws, and the amount and timing of future taxable income. Given the wide range of international business relationships and the long-term nature and complexity of existing contractual agreements, differences arising between the actual results and the assumptions made, or future changes to such assumptions, could necessitate future adjustments to tax expense or recovery already recorded. The Corporation establishes tax provisions for possible consequences of audits by the tax authorities of each country in which it operates. The amount of such provisions is based on various factors, such as experience from previous tax audits and differing interpretations of tax regulations by the taxable entity and the relevant tax authority. Such differences in interpretation may arise for a wide variety of issues depending on the conditions prevailing in the domicile of each legal entity.
Credit and residual value guarantees – The Corporation uses an internal valuation model based on stochastic simulations. The amounts expected to be paid under the guarantees may depend on whether credit defaults occur during the term of the original financing. When a credit default occurs, the credit guarantee may be called upon. In the absence of a credit default the residual value guarantee may be triggered. In both cases, the guarantees can only be called upon if there is a loss upon the sale of the aircraft. Therefore, the value of the guarantee is in large part impacted by the future value of the underlying aircraft, as well as on the likelihood that credit or residual value guarantees will be called upon at the expiry of the financing arrangements. Aircraft residual value curves, prepared by management based on information from external appraisals and adjusted to reflect specific factors of the current aircraft market and a balanced market in the medium and long term, are used to estimate the underlying aircraft future value. The amount of the liability is also significantly impacted by the current market assumption for interest rates since payments under these guarantees are mostly expected to be made in the medium to long term. Other key estimates in calculating the value of the guarantees include default probabilities, estimated based on published credit ratings when available or, when not available, on internal assumptions regarding the credit risk of customers. The estimates are reviewed on a quarterly basis.
The following analyses are presented in isolation from one another, i.e. all other estimates left unchanged:
Assuming a decrease of 10% in the residual value curves of all commercial aircraft as at December 31, 2017, Commercial Aircraft’s EBIT for 2017 would have been negatively impacted by $24 million.
Assuming an increase of 10% in the likelihood that residual value guarantees will be called upon at the expiry of the financing arrangements as at December 31, 2017, Commercial Aircraft’s EBIT for 2017 would have been negatively impacted by $41 million.
Assuming a 100-basis point decrease in interest rates as at December 31, 2017, Commercial Aircraft’s EBT for 2017 would have been negatively impacted by $12 million. Assuming a 100-basis point increase in interest rates as at December 31, 2017, Commercial Aircraft’s EBT for 2017 would have been positively impacted by $9 million.
Retirement and other long-term employee benefits – The actuarial valuation process used to measure pension and other post-employment benefit costs, assets and obligations is dependent on assumptions regarding discount rates, compensation and pre-retirement benefit increases, inflation rates, health-care cost trends, as well as demographic factors such as employee turnover, retirement and mortality rates. The impacts from changes in discount rates and, when significant, from key events and other circumstances, are recorded quarterly.
Discount rates are used to determine the present value of the expected future benefit payments and represent the market rates for high-quality corporate fixed-income investments consistent with the currency and the estimated term of the retirement benefit liabilities. As the Canadian high-quality corporate bond market, as defined under IFRS, includes relatively few medium- and long- term maturity bonds, the discount rate for the Corporation’s Canadian pension and other post-employment plans is established by constructing a yield curve using three maturity ranges. The first maturity range of the curve is based on observed market rates for AA-rated corporate bonds with maturities of less than six years. In the longer maturity ranges, due to the smaller number of high-quality bonds available, the curve is derived using market observations and extrapolated data. The extrapolated data points were created by adding a term-based yield spread over long-term provincial bond yields. This term-based spread is extrapolated between a base spread and a long spread. The base spread is based on the observed spreads between AA-rated corporate bonds and AA-rated provincial bonds for the 5 to 10 years to maturity range. The long spread is determined as the spread required at the point of average maturity of AA-rated provincial bonds in the 11 to 30 years to maturity range such that the average AA-rated corporate bond spread above AA-rated provincial bonds is equal to the extrapolated spread derived by applying the ratio of the observed spreads between A-rated corporate bonds and AA-rated provincial bonds for the 11 to 30 years to maturity range over the 5 to 10 years to maturity range, to the base spread. For maturities longer than the average maturity of AA-rated provincial bonds in the 11 to 30 years to maturity range, the spread is assumed to remain constant at the level of the long spread.
As the U.K. high-quality corporate bond market, as defined under IFRS, includes relatively few long-term maturity bonds, the discount rate for the Corporation’s U.K. pension and other post-employment plans is established by constructing an hypothetical yield curve. The hypothetical yield curve is developed from Sterling corporate bond yield information for corporate bonds rated AA or equivalent quality. Target yields are developed from bonds across a range of maturity points, and a curve is fitted to those targets. Spot rates (zero coupon bond yields) are developed from the yield curve and used to discount benefit payment amounts associated with each future year. Since corporate bonds are generally not available for very long maturities, an assumption is made that spot rates remain level beyond the term of the longest data target point. The term of the longest data target point as at December 31, 2017 was 22 years.
Expected rates of compensation increases are determined considering the current salary structure, as well as historical and anticipated wage increases, in the context of current economic conditions.
See Note 22 – Retirement benefits for further details regarding assumptions used and sensitivity analysis to changes in critical actuarial assumptions.
Onerous contract provision – An onerous contract provision is recorded if it is more likely than not that the unavoidable costs of meeting the obligations under a firm contract, other than long-term contracts related to designing, engineering or manufacturing specifically designed products and service contracts for which revenue is recognized using the percentage of completion method of accounting, exceed the economic benefits expected to be received under the contract. Judgment is used to determine which costs are considered unavoidable and the calculation of the unavoidable costs require estimates of expected future costs, including anticipated future cost reductions related to performance improvements and transformation initiatives. Unavoidable costs exclude the allocation of certain indirect overheads which are included in the cost of inventories, such as amortization. As early production units in a new aircraft program require higher costs than units produced later in the program, cost estimates also depend on expected delivery schedules. The estimates are reviewed on a quarterly basis.
CDPQ equity and derivative liability components – The convertibles shares issued to the CDPQ contain no obligation for the Corporation to deliver cash or other financial assets to the CDPQ. Judgment was used to conclude that the CDPQ’s convertible share investment in BT Holdco is considered a compound instrument comprised of an equity component, representing the discretionary dividends and liquidation preference, and a liability component that reflects a derivative to settle the instrument by delivering a variable number of common shares of BT Holdco, as opposed to the entire instrument being characterized as a liability. The Corporation presents convertible shares in its equity (NCI) and derivative component as a liability.
The fair value of the convertible shares at issuance was assigned to its respective equity and derivative liability components so that no gain or loss arose from recognizing each component separately, the fair value of the derivative liability being established first and the residual amount allocated to the equity component. The liability component is remeasured quarterly using the Corporation’s best estimate of the present value of the settlement amount. The Corporation uses an internal valuation model based on stochastic simulations to estimate the fair value of the conversion option embedded in the BT Holdco convertible shares. The fair value of the embedded conversion option is based on the difference in the present value between: the convertible shares’ accrued liquidation preference based on the minimum return entitlement; and the fair value of the common shares on an as converted basis. This value is dependent on Transportation meeting the performance incentives agreed upon with the CDPQ, the timing of exercise of the conversion rights and the applicable conversion rate. The simulation model generates multiple Transportation performance scenarios over the expected term of the option, using the best estimate of Transportation’s expected results over the remaining term of the instrument and a standard deviation derived from historic results. Fair value of the shares on an as-converted basis is calculated using an EBIT multiple, which is based on market data, to determine the enterprise value. The discount rate used is also determined using market data. The Corporation uses internal assumptions to determine the term of the instrument and the future performance of Transportation, derived from the budget and strategic plan.
See Note 35 – Fair value of financial instruments for a sensitivity analysis on the variability in the fair value of the conversion option as a result of a reasonably likely change in the expected future performance of Transportation.
Consolidation – From time to time, the Corporation participates in structured entities where voting rights are not the dominant factor in determining control. In these situations, management may use a variety of complex estimation processes involving both qualitative and quantitative factors to determine whether the Corporation is exposed to, or has rights to, significant variable returns. The quantitative analyses involve estimating the future cash flows and performance of the investee and analyzing the variability in those cash flows. The qualitative analyses involve consideration of factors such as the purpose and design of the investee and whether the Corporation is acting as an agent or principal. There is a significant amount of judgment exercised in evaluating the results of these analyses as well as in determining if the Corporation has power to affect the investee’s returns, including an assessment of the impact of potential voting rights, contractual agreements and de facto control.
Also, the Corporation uses judgment to determine whether rights held by NCI, such as the CDPQ’s rights in respect of Transportation and Investissement Québec’s rights in respect of CSALP, are protective in nature as opposed to substantive. The Corporation reassesses the initial determination of control if facts or circumstances indicate that there may be changes to one or more elements of control.