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.  On March 14, 2014, we completed the acquisition of all of the outstanding equity interests in Beech Holdings, LLC, which included Beechcraft Corporation and other subsidiaries, (collectively “Beechcraft”). The results of Beechcraft have been included in our consolidated financial statements only for the period subsequent to the completion of the acquisition. As a result, the consolidated financial results for the year ended January 3, 2015 do not reflect a full year of Beechcraft operations.

 

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 Bell, Textron Systems, Industrial segments and the Textron Aviation segment, which includes the legacy Cessna segment and the acquired Beechcraft business. 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 captive financing for retail purchases and leases for new and pre-owned aircraft manufactured by our Manufacturing group.  In the Consolidated Statements of Cash Flows, cash received from customers or from the sale of receivables 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 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.

 

During 2014, 2013 and 2012, we changed 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 in 2014, 2013 and 2012 by $95 million, $29 million and $15 million, respectively, ($60 million, $18 million and $9 million after tax, or $0.21, $0.06 and $0.03 per diluted share, respectively).  For 2014, 2013 and 2012, the gross favorable program profit adjustments totaled $132 million, $51 million and $88 million, respectively.  For 2014, 2013 and 2012, the gross unfavorable program profit adjustments totaled $37 million, $22 million and $73 million, respectively.  The increase in net program profit adjustments in 2014, compared with 2013, is largely driven by the Bell segment related to the impact of cost reduction activities in 2014 as well as unfavorable performance in 2013 related to manufacturing inefficiencies.  In addition, gross favorable program profit adjustments in 2014 included $16 million related to the settlement of the System Development and Demonstration phase of the Armed Reconnaissance Helicopter (ARH) program which was terminated in October 2008.

 

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 arrangement deliverables, typically by reference to the price charged when the same or similar items are sold separately by us, taking into consideration any performance, cancellation, termination or refund-type provisions.  We recognize revenue 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.  We resume the accrual of interest when the loan becomes contractually current through payment according to the original terms of the loan or, if a loan has been modified, following a period of performance under the terms of the modification, provided we conclude that collection of all principal and interest is no longer doubtful.  Previously suspended interest income is recognized at that time.

 

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.  Inventoried costs related to long-term contracts 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.  Such advances and payments are reflected as an offset against the related inventory balances.  Customer deposits are recorded against inventory when the right of offset exists.  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 generally is written down to fair value.

 

Goodwill and Intangible Assets

For our business acquisitions, we estimate the fair value of intangible assets primarily using discounted cash flow analysis of anticipated cash flows reflecting incremental revenues and/or cost savings resulting from the acquired intangible asset using market participant assumptions. Goodwill represents the excess of cost over the fair values assigned to intangible and other net assets of the acquired businesses.  Goodwill and intangible assets deemed to have indefinite lives are not amortized, but are subject to annual impairment testing. 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 annual 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.

 

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 intangible assets with finite lives is recognized over their estimated useful lives using a method of amortization that reflects the pattern in which the economic benefits of the intangible assets are consumed or otherwise realized.  Approximately 76% 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.  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 fair value hedges, we record changes in fair value in earnings, offset, in part or in whole, by corresponding changes in the fair value of the underlying exposures being hedged.  For 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, including parts and labor, for certain products for periods ranging from one to five years.  We estimate the costs that may be incurred under warranty programs 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 and product maintenance liabilities periodically and adjust the amounts as necessary.  Additionally, we may establish warranty liabilities 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 $694 million, $651 million, and $584 million in 2014, 2013 and 2012, respectively, and are included in cost of sales.

 

Income Taxes

Deferred income 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 income tax assets represent amounts available to reduce income taxes payable on taxable income in future years.  We evaluate the recoverability of these future tax deductions and credits 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, available tax planning strategies and estimated future taxable income.  We recognize net tax-related interest and penalties for continuing operations in income tax expense.

 

New Accounting Pronouncements

In May 2014, the Financial Accounting Standards Board issued Accounting Standards Update (ASU) No. 2014-09, “Revenue from Contracts with Customers,” that outlines a comprehensive 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.  Entities have the option of using either a full retrospective or a modified retrospective approach for the adoption. This ASU is effective for our company at the beginning of fiscal 2017; early adoption is not permitted. We are currently evaluating the new guidance to determine the impact it is expected to have on our consolidated financial statements, along with the transition method we expect to utilize.

 

Note 2. Business Acquisitions, Goodwill and Intangible Assets

 

2014 Beechcraft Acquisition

On March 14, 2014, we acquired Beechcraft for an aggregate cash payment of $1.5 billion that included a repayment of a portion of Beechcraft’s working capital credit facility at closing.  The acquisition of Beechcraft and the formation of the Textron Aviation segment provide increased scale and complementary product offerings, allowing us to strengthen our position across the aviation industry and enhance our ability to support our customers.  We financed a portion of the purchase price with the issuance of $600 million in senior notes on January 30, 2014 and by drawing $500 million under the five-year term loan agreement entered into on January 24, 2014.  The balance was paid from cash on hand.

 

The consideration paid for this business was allocated on a preliminary basis to the assets acquired and liabilities assumed based on their estimated fair values at the acquisition date. As of January 3, 2015, the valuation process is substantially complete, however, due to the size and breadth of this acquisition, additional time is necessary to complete the valuation of certain liabilities and the related income tax impact. We will finalize the purchase accounting within the one-year measurement period allowed under generally accepted accounting principles.  Our allocation of the purchase price as of January 3, 2015 is presented below.

 

 

Goodwill of $228 million was primarily related to expected synergies from combining operations and the value of the existing workforce.  Intangible assets of $581 million included unpatented technology related to original equipment manufactured parts and designs and customer relationships valued at $373 million and trade names valued at $208 million.  The unpatented technology and customer relationships assets have a life of 15 years, resulting in amortization expense in the range of approximately $17 million to $31 million annually.  Substantially all of the trade names have an indefinite life and therefore are not subject to amortization.  We acquired tax-deductible goodwill of approximately $260 million in this transaction.

 

In connection with the integration of Beechcraft, we initiated a restructuring program in our Textron Aviation segment in the first quarter of 2014 to align the Cessna and Beechcraft businesses, reduce operating redundancies and maximize efficiencies.  During 2014, we recorded charges of $41 million related to these restructuring activities that were included in the Acquisition and restructuring costs line on the Consolidated Statements of Operations.  In addition, we incurred transaction costs of $11 million in 2014 related to the acquisition that were also included in the Acquisition and restructuring costs line. We expect to incur additional restructuring costs in 2015, but do not expect these costs to be material.

 

Other Acquisitions

During 2014, we made aggregate cash payments of $149 million for seven acquisitions within our Industrial and Systems Segments, including Tug Technologies Corporation, a manufacturer of ground support equipment in the aviation industry.

 

We made aggregate cash payments of $196 million in 2013 for acquisitions of four businesses within our Textron Systems and Industrial segments and two service centers in our Textron Aviation segment.

 

Actual and Pro-Forma Impact from 2014 Acquisitions

The operating results for the 2014 acquisitions are included in the Consolidated Statement of Operations since their respective closing dates.  From the closing dates through January 3, 2015, revenues related to these acquisitions totaled $1.6 billion.  The cost structures of the Beechcraft and Cessna businesses have been significantly integrated since the acquisition of Beechcraft; therefore, it is not possible to separately report earnings for this acquisition.  The earnings related to the other 2014 acquisitions were not significant for this period.

 

The unaudited supplemental pro-forma data included in the table below presents consolidated information as if our 2014 acquisitions had been completed on December 30, 2012.  This pro-forma information should not be considered indicative of the results that would have occurred if the acquisitions and related financing had been consummated on December 30, 2012, nor are they necessarily indicative of future results as they do not reflect the potential realization of cost savings and synergies associated with the acquisitions.

 

 

Certain pro-forma adjustments were made to reflect the allocation of the preliminary purchase price to the acquired net assets, which included depreciation and intangible amortization expense resulting from the valuation of tangible and intangible assets, amortization of inventory fair value step-up adjustments and the related tax effects.  The pro-forma results for 2013 were also adjusted to include transaction and restructuring costs of $52 million, related to the Beechcraft acquisition; these costs were excluded from the 2014 pro-forma results. In addition, the pro-forma results exclude the financial impact related to Beechcraft’s emergence from bankruptcy in 2013.

 

Goodwill

The changes in the carrying amount of goodwill by segment are as follows:

 

 

Intangible Assets

Our Intangible assets are summarized below:

 

 

Trade names and trademarks in the table above include $204 million of indefinite-lived intangible assets at January 3, 2015. There were no indefinite-lived intangible assets at December 28, 2013.

 

Amortization expense totaled $62 million, $37 million and $40 million in 2014, 2013 and 2012, respectively. Amortization expense is estimated to be approximately $61 million, $62 million, $62 million, $59 million and $57 million in 2015, 2016, 2017, 2018 and 2019, respectively.

 

Note 3. Accounts Receivable and Finance Receivables

 

Accounts Receivable

Accounts receivable is composed of the following:

 

 

We have unbillable receivables primarily on U.S. Government contracts that arise when the revenues we have appropriately recognized based on performance cannot be billed yet under terms of the contract. Unbillable receivables within accounts receivable totaled $151 million at January 3, 2015 and $163 million at December 28, 2013.

 

Finance Receivables

Finance receivables are presented in the following table.

 

 

Finance receivables primarily includes loans provided to purchasers of new and pre-owned Textron Aviation aircraft and Bell helicopters.  These agreements typically have initial terms ranging from five to ten years and amortization terms ranging from eight to fifteen years.  The average balance of loans was $1 million at January 3, 2015.  Loans generally require the customer to pay a significant down payment, along with periodic scheduled principal payments that reduce the outstanding balance through the term of the loan.  Finance receivables also includes held for sale receivables of $35 million and $65 million at January 3, 2015 and December 28, 2013, respectively.  These finance receivables held for sale are recorded at fair value and are not included in the portfolio quality tables below.

 

Our finance receivables are diversified across geographic region and borrower industry.  At January 3, 2015, 37% of our finance receivables were distributed throughout the U.S. compared with 41% at the end of 2013.  At January 3, 2015 and December 28, 2013, finance receivables included $113 million and $200 million, respectively, of receivables that have been legally sold to a special purpose entity (SPE), which is a consolidated subsidiary of TFC. The assets of the SPE are pledged as collateral for its debt, which is reflected as securitized on-balance sheet debt in Note 7. Third-party investors have no legal recourse to TFC beyond the credit enhancement provided by the assets of the SPE.  In addition, at the end of 2014 and 2013, finance receivables of $565 million and $610 million, respectively, have been pledged as collateral for our debt.

 

Credit Quality Indicators and Nonaccrual Finance Receivables

We internally assess the quality of our finance receivables based on a number of key credit quality indicators and statistics such as delinquency, loan balance to estimated collateral value and the financial strength of individual borrowers and guarantors.  Because many of these indicators are difficult to apply across an entire class of receivables, we evaluate individual loans on a quarterly basis and classify these loans into three categories based on the key credit quality indicators for the individual loan.  These three categories are performing, watchlist and nonaccrual.

 

We classify finance receivables as nonaccrual if credit quality indicators suggest full collection of principal and interest is doubtful.  In addition, we automatically classify accounts as nonaccrual once they are contractually delinquent by more than three months unless collection of principal and interest is not doubtful.  Recognition of interest income is suspended for these accounts and all cash collections are used to reduce the net investment balance.  We resume the accrual of interest when the loan becomes contractually current through payment according to the original terms of the loan or, if a loan has been modified, following a period of performance under the terms of the modification, provided we conclude that collection of all principal and interest is no longer doubtful. Previously suspended interest income is recognized at that time.  Accounts are classified as watchlist when credit quality indicators have deteriorated as compared with typical underwriting criteria, and we believe collection of full principal and interest is probable but not certain.  All other finance receivables that do not meet the watchlist or nonaccrual categories are classified as performing.

 

Finance receivables categorized based on the credit quality indicators discussed above are summarized as follows:

 

 

We measure delinquency based on the contractual payment terms of our finance receivables.  In determining the delinquency aging category of an account, any/all principal and interest received is applied to the most past-due principal and/or interest amounts due.  If a significant portion of the contractually due payment is delinquent, the entire finance receivable balance is reported in accordance with the most past-due delinquency aging category.

 

Finance receivables by delinquency aging category are summarized in the table below:

 

 

Impaired Loans

On a quarterly basis, we evaluate individual finance receivables for impairment in non-homogeneous portfolios and larger balance accounts in homogeneous loan portfolios.  A finance receivable is considered impaired when it is probable that we will be unable to collect all amounts due according to the contractual terms of the loan agreement based on our review of the credit quality indicators discussed above.  Impaired finance receivables include both nonaccrual accounts and accounts for which full collection of principal and interest remains probable, but the account’s original terms have been, or are expected to be, significantly modified.  If the modification specifies an interest rate equal to or greater than a market rate for a finance receivable with comparable risk, the account is not considered impaired in years subsequent to the modification.  Interest income recognized on impaired loans was not significant in 2014 or 2013.

 

A summary of impaired finance receivables and the average recorded investment is provided below:

 

 

Allowance for Losses

A rollforward of the allowance for losses on finance receivables and a summary of its composition, based on how the underlying finance receivables are evaluated for impairment, is provided below.  The finance receivables reported in this table specifically exclude $121 million and $120 million of leveraged leases at January 3, 2015 and December 28, 2013, respectively, in accordance with generally accepted accounting principles.

 

 

Note 4. Inventories

 

Inventories are composed of the following:

 

 

Inventories valued by the LIFO method totaled $1.4 billion and $1.3 billion at January 3, 2015 and December 28, 2013, respectively, and the carrying values of these inventories would have been higher by approximately $468 million and $461 million, respectively, had our LIFO inventories been valued at current costs. Inventories related to long-term contracts, net of progress/milestone payments, were $447 million and $359 million at January 3, 2015 and December 28, 2013, respectively.

 

Note 5. Property, Plant and Equipment, Net

 

Our Manufacturing group’s property, plant and equipment, net are composed of the following:

 

 

At January 3, 2015 and December 28, 2013, assets under capital leases totaled $279 million and $247 million and had accumulated amortization of $68 million and $56 million, respectively. The Manufacturing group’s depreciation expense, which included amortization expense on capital leases, totaled $379 million, $335 million and $315 million in 2014, 2013 and 2012, respectively.

 

Note 6. Accrued Liabilities

 

The accrued liabilities of our Manufacturing group are summarized below:

 

 

Changes in our warranty and product maintenance contract liability are as follows:

 

* Adjustments include changes to prior year estimates, new issues on prior year sales and currency translation adjustments.

 

Note 7. Debt and Credit Facilities

 

Our debt is summarized in the table below:

 

* Notes amortize on a quarterly or semi-annual basis.

 

The following table shows required payments during the next five years on debt outstanding at January 3, 2015:

 

 

Textron has a senior unsecured revolving credit facility that expires in October 2018 for an aggregate principal amount of $1.0 billion, of which up to $100 million is available for the issuance of letters of credit. At January 3, 2015, there were no amounts borrowed against the facility, and there were $35 million of letters of credit issued against it.

 

6% Fixed-to-Floating Rate Junior Subordinated Notes

The Finance group’s $299 million of 6% Fixed-to-Floating Rate Junior Subordinated Notes are unsecured and rank junior to all of its existing and future senior debt.  The notes mature on February 15, 2067; however, we have the right to redeem the notes at par on or after February 15, 2017 and are obligated to redeem the notes beginning on February 15, 2042.  Interest on the notes is fixed at 6% until February 15, 2017 and floats at the three-month London Interbank Offered Rate + 1.735% thereafter.

 

Support Agreement

Under a Support Agreement, Textron Inc. is required to ensure that TFC maintains fixed charge coverage of no less than 125% and consolidated shareholder’s equity of no less than $200 million.  Cash payments of $240 million were made to TFC in 2012 to maintain compliance with the fixed charge coverage ratio.

 

Note 8. Derivative Instruments and Fair Value Measurements

 

We measure fair value at the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.  We prioritize the assumptions that market participants would use in pricing the asset or liability into a three-tier fair value hierarchy.  This fair value hierarchy gives the highest priority (Level 1) to quoted prices in active markets for identical assets or liabilities and the lowest priority (Level 3) to unobservable inputs in which little or no market data exist, requiring companies to develop their own assumptions.  Observable inputs that do not meet the criteria of Level 1, which include quoted prices for similar assets or liabilities in active markets or quoted prices for identical assets and liabilities in markets that are not active, are categorized as Level 2.  Level 3 inputs are those that reflect our estimates about the assumptions market participants would use in pricing the asset or liability based on the best information available in the circumstances.  Valuation techniques for assets and liabilities measured using Level 3 inputs may include methodologies such as the market approach, the income approach or the cost approach and may use unobservable inputs such as projections, estimates and management’s interpretation of current market data.  These unobservable inputs are utilized only to the extent that observable inputs are not available or cost effective to obtain.

 

Assets and Liabilities Recorded at Fair Value on a Recurring Basis

We manufacture and sell our products in a number of countries throughout the world, and, therefore, we are exposed to movements in foreign currency exchange rates. We utilize foreign currency exchange contracts to manage this volatility.  Our foreign currency exchange contracts are measured at fair value using the market method valuation technique.  The inputs to this technique utilize current foreign currency exchange forward market rates published by third-party leading financial news and data providers.  These are observable data that represent the rates that the financial institution uses for contracts entered into at that date; however, they are not based on actual transactions so they are classified as Level 2.  At January 3, 2015 and December 28, 2013, we had foreign currency exchange contracts with notional amounts upon which the contracts were based of $696 million and $636 million, respectively.  At January 3, 2015, the fair value amounts of our foreign currency exchange contracts were a $16 million asset and a $26 million liability.  At December 28, 2013, the fair value amounts of our foreign currency exchange contracts were a $2 million asset and a $15 million liability.

 

We primarily utilize forward exchange contracts which have maturities of no more than three years.  These contracts qualify as cash flow hedges and are intended to offset the effect of exchange rate fluctuations on forecasted sales, inventory purchases and overhead expenses.  At January 3, 2015, we had a net deferred loss of $13 million in Accumulated other comprehensive loss related to these cash flow hedges.  Net gains and losses recognized in earnings and Accumulated other comprehensive loss on cash flow hedges, including gains and losses related to hedge ineffectiveness, were not significant in the periods presented.

 

We hedge our net investment position in major currencies and generate foreign currency interest payments that offset other transactional exposures in these currencies.  To accomplish this, we borrow directly in foreign currency and designate a portion of foreign currency debt as a hedge of a net investment. We record changes in the fair value of these contracts in other comprehensive income to the extent they are effective as cash flow hedges.  Currency effects on the effective portion of these hedges, which are reflected in the foreign currency translation adjustments within Accumulated other comprehensive loss, were not significant in the periods presented.

 

Assets Recorded at Fair Value on a Nonrecurring Basis

During the years ended January 3, 2015 and December 28, 2013, the Finance group’s impaired nonaccrual finance receivable of $49 million and $45 million, respectively, were measured at fair value on a nonrecurring basis using significant unobservable inputs (Level 3). Impaired nonaccrual finance receivables represent assets recorded at fair value on a nonrecurring basis since the measurement of required reserves on our impaired finance receivables is significantly dependent on the fair value of the underlying collateral.  For impaired nonaccrual finance receivables secured by aviation assets, the fair values of collateral are determined primarily based on the use of industry pricing guides. Fair value measurements recorded on impaired finance receivables resulted in charges to provision for loan losses totaling $18 million and $7 million for 2014 and 2013, respectively.

 

Assets and Liabilities Not Recorded at Fair Value

The carrying value and estimated fair values of our financial instruments that are not reflected in the financial statements at fair value are as follows:

 

 

Fair value for the Manufacturing group debt is determined using market observable data for similar transactions (Level 2).  At January 3, 2015 and December 28, 2013, approximately 75% and 70%, respectively, of the fair value of term debt for the Finance group was determined based on discounted cash flow analyses using observable market inputs from debt with similar duration, subordination and credit default expectations (Level 2). The remaining Finance group debt was determined based on observable market transactions (Level 1). Fair value estimates for finance receivables held for investment were determined based on internally developed discounted cash flow models primarily utilizing significant unobservable inputs (Level 3), which include estimates of the rate of return, financing cost, capital structure and/or discount rate expectations of current market participants combined with estimated loan cash flows based on credit losses, payment rates and expectations of borrowers’ ability to make payments on a timely basis.

 

Note 9. Shareholders’ Equity

 

Capital Stock

We have authorization for 15 million shares of preferred stock with a par value of $0.01 and 500 million shares of common stock with a par value of $0.125.  Outstanding common stock activity for the three years ended January 3, 2015 is presented below:

 

 

Earnings per Share

In February 2014, we entered into an Accelerated Share Repurchase agreement (ASR) with a counterparty and repurchased 4.3 million shares of our outstanding common stock. The initial delivery of shares under the ASR resulted in an immediate reduction of the outstanding shares used to calculate the weighted average common shares for basic and diluted earnings per share. We settled the ASR in December 2014 for a final purchase price of $167 million.

 

We calculate basic and diluted earnings per share (EPS) based on net income, which approximates income available to common shareholders for each period.  Basic EPS is calculated using the two-class method, which includes the weighted-average number of common shares outstanding during the period and restricted stock units to be paid in stock that are deemed participating securities as they provide nonforfeitable rights to dividends.  Diluted EPS considers the dilutive effect of all potential future common stock, including stock options and, prior to the maturity of our convertible notes on May 1, 2013, the shares that could have been issued upon the conversion of the notes and upon the exercise of the related warrants.

 

The weighted-average shares outstanding for basic and diluted EPS are as follows:

 

 

In 2014, 2013 and 2012, stock options to purchase 2 million, 5 million and 7 million shares, respectively, of common stock outstanding are excluded from our calculation of diluted weighted-average shares outstanding as their effect would have been anti-dilutive.

 

Accumulated Other Comprehensive Loss

The components of Accumulated Other Comprehensive Loss are presented below:

 

 

Other Comprehensive Income (Loss)

The before and after-tax components of other comprehensive income (loss) are presented below:

*These components of other comprehensive income are included in the computation of net periodic pension cost. See Note 11 for additional information.