TEXTRON FINANCIAL CORPORATION Annual Financial Statements For the year ended Textron Financial Corporation is a wholly-owned subsidiary of Textron Inc. Beginning with the quarter ended March 31, 2011, Textron Financial Corporation is no longer required to file periodic reports with the Securities Exchange Commission (SEC). Reports and other information previously filed with the SEC may be obtained through the SEC s Internet website at http://www.sec.gov, at http://www.textronfinancial.com or upon request of the Company.
Report of Independent Auditors The Board of Directors Textron Financial Corporation We have audited the accompanying Consolidated Financial Statements of Textron Financial Corporation, which comprise the Consolidated Balance Sheets as of and, and the related Consolidated Statements of Operations, Comprehensive Income, Cash Flows and Changes in Shareholder s Equity for the years then ended, and the related notes to the financial statements. Management s Responsibility for the Financial Statements Management is responsible for the preparation and fair presentation of these consolidated financial statements in conformity with U.S. generally accepted accounting principles; this includes the design, implementation, and maintenance of internal control relevant to the preparation and fair presentation of consolidated financial statements that are free of material misstatement, whether due to fraud or error. Auditor s Responsibility Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the consolidated financial statements. The procedures selected depend on the auditor s judgment, including the assessment of the risks of material misstatement of the consolidated financial statements, whether due to fraud or error. In making those risk assessments, the auditor considers internal control relevant to the entity s preparation and fair presentation of the consolidated financial statements in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the entity s internal control. Accordingly, we express no such opinion. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of significant accounting estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our audit opinion. Opinion In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Textron Financial Corporation at and and the results of its operations and its cash flows for the years then ended in conformity with U.S. generally accepted accounting principles. /s/ Ernst & Young LLP Boston, Massachusetts March 14, 2014 1
CONSOLIDATED STATEMENTS OF OPERATIONS For each of the years in the two-year period ended Finance charges $ 51 $ 125 Valuation allowance adjustment 31 76 Rental revenues on operating lease assets 18 21 Portfolio losses, net of gains (18) (50) Other income 25 20 Total revenues 107 192 Interest expense 35 56 Depreciation of operating lease assets 13 17 Net interest margin 59 119 Operating and administrative expenses 45 69 Provision for losses (22) (12) Income before income taxes 36 62 Income tax expense 17 16 Net income $ 19 $ 46 See Notes to the Consolidated Financial Statements. 2
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME For each of the years in the two-year period ended Net income $ 19 $ 46 Other comprehensive (loss) income, net of tax: Unrealized net (loss) gain on marketable securities (1) 1 Comprehensive income 18 47 See Notes to the Consolidated Financial Statements. 3
CONSOLIDATED BALANCE SHEETS Assets Cash and equivalents $ 48 $ 35 Finance receivables held for investment, net of unearned income: Loans 1,282 1,083 Leveraged leases 120 122 Finance leases 81 96 Total finance receivables held for investment 1,483 1,301 Allowance for losses on finance receivables held for investment (55) (71) Finance receivables held for investment net 1,428 1,230 Finance receivables held for sale 65 140 Operating lease assets net 86 144 Amounts due from Textron 53 Other assets 98 126 Total assets $ 1,725 $ 1,728 Liabilities and Shareholder s equity Liabilities Accrued interest and other liabilities 260 267 Debt 1,256 1,240 Total liabilities 1,516 1,507 Shareholder s Equity Capital surplus 2,437 2,292 Investment in parent preferred stock (25) (25) Subsidiary preferred stock 1 1 Accumulated other comprehensive income 1 Retained deficit (2,204) (2,048) Total shareholder's equity 209 221 Total liabilities and shareholder s equity $ 1,725 $ 1,728 See Notes to the Consolidated Financial Statements. 4
CONSOLIDATED STATEMENTS OF CASH FLOWS For each of the years in the two-year period ended Cash flows from operating activities: Net income $ 19 $ 46 Adjustments to reconcile net income to net cash provided by operating activities: Increase (decrease) in income taxes payable 32 (95) Valuation allowance on finance receivables held for sale (31) (76) Deferred income taxes 37 72 Portfolio losses 28 68 Depreciation and amortization 15 22 Decrease in accrued interest and other liabilities (22) (21) Provision for losses (22) (12) Other, net 1 (2) Net cash provided by operating activities 57 2 Cash flows from investing activities: Finance receivables repaid 496 909 Finance receivables originated or purchased (98) (109) Proceeds from receivable sales 103 116 Proceeds from disposition of other assets, including repossessed assets and properties and operating lease assets 92 138 Other investments 13 6 Net cash provided by investing activities 606 1,060 Cash flows from financing activities: Principal payments on long-term debt (502) (115) Principal payments on secured debt (111) (158) Principal payments on nonrecourse debt (28) (67) Proceeds from issuance of long-term debt 200 Net decrease in intercompany borrowings with Textron Inc. (35) (596) Capital contributions from Textron Inc. 10 249 Dividends paid to Textron Inc. (184) (354) Net cash used by financing activities (650) (1,041) Net increase in cash and equivalents 13 21 Cash and equivalents at beginning of year 35 14 Cash and equivalents at end of year $ 48 $ 35 See Notes to the Consolidated Financial Statements. 5
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDER S EQUITY For each of the years in the two-year period ended Investment In Parent Company Preferred Stock Subsidiary Preferred Stock Accumulated Other Comprehensive Income Total Shareholder s Equity Capital Surplus Retained Deficit Balance December 31, 2011 $ 2,052 $ (25) $ 1 $ $ (1,749) $ 279 Net income 46 46 Capital contributions from Textron Inc. 249 249 Dividends to Textron Inc. (9) (345) (354) Other comprehensive income 1 1 Balance $ 2,292 $ (25) $ 1 $ 1 $ (2,048) $ 221 Net income 19 19 Capital contributions from Textron Inc. 10 10 Dividends to Textron Inc. (9) (175) (184) Other comprehensive loss (1) (1) Share assignment * 144 144 Balance $ 2,437 $ (25) $ 1 $ $ (2,204) $ 209 See Notes to the Consolidated Financial Statements. * On December 27,, Textron Inc. assigned the shares of one of its finance subsidiaries to Textron Financial. See Note 1, Summary of Significant Accounting Policies, for additional information. 6
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS Note 1: Summary of Significant Accounting Policies Principles of Consolidation and Nature of Operations Textron Financial Corporation (Textron Financial or the Company) is a commercial finance business and wholly-owned subsidiary of Textron Inc. (Textron). Textron is a global multi-industry company with operations in five business segments: Cessna, Bell, Textron Systems, Industrial and Finance. The accompanying Consolidated Financial Statements include the accounts of Textron Financial and its majority-owned subsidiaries. All significant intercompany transactions have been eliminated. On December 27,, Textron assigned the shares of one of its finance subsidiaries to Textron Financial and as a result, all finance subsidiaries owned by Textron are now consolidated subsidiaries of Textron Financial. This transfer of net assets did not result in a change in reporting entity and is accounted for prospectively. In the fourth quarter of 2008, Textron announced a plan to exit the non-captive portion of our commercial finance business, while retaining the captive portion of the business that supports customer purchases of products which Textron manufactures. During 2009, we transitioned to operating our business in two segments, the Captive Finance segment and the Non-Captive Finance segment. The Captive Finance segment provides financing primarily to purchasers of new Cessna aircraft and Bell helicopters as well as preowned Cessna aircraft and Bell helicopters on a limited basis. The majority of new finance receivables are cross-border transactions for aircraft sold outside of the U.S. New originations in the U.S. are primarily for purchasers who had difficulty in accessing other sources of financing for the purchase of Textron-manufactured products. The Non-captive Finance segment has historically included the Golf Mortgage, Timeshare, Structured Capital and Other Liquidating product lines. At, the Non-captive portfolio has been substantially liquidated. Therefore, the Non-captive Finance segment will be consolidated with the Captive Finance segment for reporting periods beginning in 2014. Textron Financial s year-end dates conform with Textron s year-end, which falls on the nearest Saturday to December 31. Use of Estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in those financial statements. Actual results may differ from such estimates. Finance Charges Finance charges include interest on loans, capital lease earnings and leveraged lease earnings. Finance charges are recognized in revenues using the interest method to provide a constant rate of return over the terms of the finance assets. 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 for interest income on accounts that are contractually delinquent by more than three months, unless collection of principal and interest is not doubtful. Cash payments on nonaccrual accounts, including finance charges, generally are applied to reduce the net investment balance. Accrual of interest is resumed 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. In addition, loan origination fees received and direct costs are deferred and amortized to finance charges over the contractual lives of the respective finance receivables using the interest method. Unamortized amounts are recognized in revenues when finance receivables are paid in full. Allowance for Losses on Finance Receivables Held for Investment 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, including large accounts in homogeneous portfolios, 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 7
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. Finance Receivables Held for Sale Finance receivables are classified as held for sale based on the determination that we no longer intend to hold the receivables for the foreseeable future, until maturity or payoff, or we no longer have the ability to hold to maturity. Our decision to classify certain finance receivables as held for sale is based on a number of factors, including, but not limited to, contractual duration, type of collateral, credit strength of the borrowers, interest rates and perceived marketability of the receivables. These receivables are carried at the lower of cost or fair value. At the time of transfer to the held for sale classification, we establish a valuation allowance for any shortfall between the carrying value and fair value. In addition, any allowance for loan losses previously allocated to these finance receivables is transferred to the valuation allowance account. Fair value changes can occur based on market interest rates, market liquidity, and changes in the credit quality of the borrower and value of underlying loan collateral. Portfolio Losses, net of gains Portfolio losses, net of gains include impairment charges related to repossessed assets and properties, other long-term investments and (losses) gains incurred on the sale or early termination of finance assets. Other Income Other income primarily includes servicing fees, investment income, late charges and other miscellaneous fees, which are primarily recognized as income when received. Operating Lease Assets Income from operating leases is recognized in equal amounts over the lease terms. The costs of such assets are capitalized and depreciated to estimated residual values using the straight-line method over the estimated useful life of the asset or the lease term. Pension Benefits and Postretirement Benefits Other than Pensions Textron Financial participates in Textron s defined contribution and defined benefit pension plans. In, the recorded amount related to participation in the defined contribution plan was insignificant. We recorded $1.0 million in, related to participation in the defined contribution plan. We recorded $5.3 million in and, related to participation in the defined benefit pension plan. Defined benefits under salaried plans are based on salary and years of service. Textron s funding policy is consistent with federal law and regulations. In December, we paid Textron $57 million to settle our intercompany liability related to our accumulated unpaid pension expense, net of deferred taxes. Income Taxes Textron Financial s revenues and expenses are included in Textron s consolidated federal and unitary state tax returns. Textron Financial s current tax expense reflects statutory U.S. tax rates applied to taxable income or loss included in Textron s consolidated and unitary tax returns. In accordance with the Tax Sharing agreement with Textron, Textron Financial is paid for tax benefits generated and utilized in Textron s consolidated federal and unitary state tax returns, whether or not the Company would have been able to utilize those benefits on a separate tax return. 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 in conjunction with Textron s consolidated tax position. We recognize net tax-related interest and penalties in income tax expense in the Consolidated Statements of Operations. 8
Derivative Financial Instruments Textron Financial has entered into various interest rate and foreign exchange agreements to mitigate its exposure to changes in interest and foreign exchange rates. We record our derivative financial instruments at fair value in the Consolidated Balance Sheets. For derivative financial instruments qualifying as fair value hedges, we record changes in fair value in finance charges or interest expense, offset in part or in whole, by corresponding changes in the fair value of the underlying exposures being hedged. Changes in fair value of derivatives not qualifying as hedges are recorded in earnings. Fair Value of Financial Instruments Fair values of financial instruments are based upon estimates at the balance sheet date of the price that would be received in an orderly transaction between market participants. We use quoted market prices and observable inputs when available. However, these inputs are often not available in the markets for many of our assets. In these cases management typically performs discounted cash flow analysis using our best estimates of key assumptions such as credit losses, prepayment speeds and discount rates based on both historical experience and our interpretation of how comparable market data in more active markets should be utilized. These estimates are subjective in nature and involve uncertainties and significant judgment in the interpretation of current market data. Therefore, the fair values presented may differ from amounts Textron Financial could realize or settle currently. Subsequent Events The Company evaluates subsequent events through the date on which financial statements are issued. Cash and Equivalents Cash and equivalents consist of cash in banks and overnight interest-bearing deposits in banks. Note 2: Relationship with Textron Inc. Textron Financial paid Textron $89 million in and $90 million in relating to the sale of manufactured products to third parties that were financed by us. Textron Financial recognized finance charge revenues from Textron affiliates (net of payments or reimbursements for interest charged at more or less than market rates on Textron manufactured products) of $1 million in and, and operating lease revenues of $10 million in and $14 million in. Textron Financial and Textron are parties to several agreements, collectively referred to as operating agreements, which govern many areas of this relationship. It is the intention of these parties to execute transactions at market terms. Under operating agreements with Textron, Textron Financial has recourse to Textron with respect to certain uncollectible amounts related to finance receivables and operating leases. Finance receivables of $41 million at and $32 million at, and operating leases of $7 million at and $18 million, were subject to recourse to Textron. Pursuant to the terms of an Intercompany Loan Facility Agreement, Textron may lend funds to Textron Financial, with interest. In, the weighted average interest rate on these borrowings was 4.3% and we paid interest of $11 million to Textron. At December 29,, there was no outstanding balance due to Textron under this arrangement. Prior to the consolidation of Textron s other wholly-owned finance subsidiaries under Textron Financial as described in Note 1, Summary of Significant Accounting Policies, Textron Financial originated and serviced loans and finance leases as servicer for these finance subsidiaries. Textron Financial recorded servicing fees of $14 million in both and, which are included in Other income in the Consolidated Statements of Operations. Under a Support Agreement between Textron Financial and Textron, Textron is required to maintain a controlling interest in Textron Financial. The agreement also requires Textron to ensure that Textron Financial maintains fixed charge coverage of no less than 125% and consolidated shareholder s equity of no less than $200 million. In 2011, Textron Financial s fixed charge coverage ratio dropped below the required 125%. As a result, Textron made a cash payment of $240 million on January 17, related to 2011. This cash payment was reflected as capital contributions to maintain compliance with the fixed charge coverage ratio required by the Support Agreement. There were no cash payments made during. For the years ended and, we declared and paid dividends to Textron of $184 million and $354 million, respectively. We had income taxes payable of $61 million and $24 million at and, respectively. These accounts are settled with Textron as its consolidated federal and state tax positions are managed. 9
Note 3: Finance Receivables and Allowance for Losses on Finance Receivables Held for Investment Finance Receivables Finance receivables by classification are presented in the following table. Finance receivables held for investment $ 1,483 $ 1,301 Allowance for losses (55) (71) Total finance receivables held for investment, net 1,428 1,230 Finance receivables held for sale 65 140 Total finance receivables, net $ 1,493 $ 1,370 As discussed in Note 1, Summary of Significant Accounting Policies, effective December 27,, Textron assigned the shares of one of its finance subsidiaries to Textron Financial and as a result, all finance subsidiaries owned by Textron are now consolidated subsidiaries of Textron Financial. The total finance receivables held for investment and allowance for losses resulting from this transfer were $611 million and $12 million, respectively, at. Finance receivables held for investment primarily includes loans and finance leases provided to purchasers of new and used Cessna aircraft and Bell helicopters and also includes loans and finance leases secured by used aircraft produced by other manufacturers. 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 and finance leases in Captive was $1 million at. 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 leases with no significant residual value at the end of the contractual term are classified as loans, as their legal and economic substance is more equivalent to a secured borrowing than a finance lease with a significant residual value. Finance receivables held for investment also includes leveraged leases secured by the ownership of the leased equipment and real property. Finance receivables held for sale includes the Non-captive loan portfolio at. The finance receivables are carried at the lower of cost or fair value and are not included in the credit performance tables below. During, we determined that we no longer had the intent to hold the remaining Non-captive loan portfolio for the foreseeable future and, accordingly, transferred $34 million of the remaining Non-captive loans, net of a $1 million allowance for loan losses, from the held for investment classification to the held for sale classification. We received proceeds of $64 million and $109 million in and, respectively, from the sale of finance receivables held for sale and $76 million and $207 million, respectively, from payoffs and collections. At and finance receivables included $200 million and $341 million, respectively, of receivables that have been legally sold to a special purpose entity (SPE) which is a consolidated subsidiary of Textron Financial. The assets of the SPE are pledged as collateral for its debt which is reflected as securitized on-balance sheet debt in Note 6, Debt and Credit Facilities. Third-party investors have no legal recourse to Textron Financial beyond the credit enhancement provided by the assets of the SPE. Our finance receivables are diversified across geographic region and borrower industry. Textron Financial's geographic concentrations (which include finance receivables held for investment and finance receivables held for sale) are as follows: United States $ 630 41% $ 853 59% South America 248 16% 158 11% Mexico 183 12% 140 10% Other international 487 31% 290 20% Total finance receivables $ 1,548 100% $ 1,441 100% 10
Leveraged Leases Rental receivable $ 273 $ 302 Nonrecourse debt (218) (246) Estimated residual values of leased assets 105 111 160 167 Less unearned income (40) (45) Investment in leveraged leases 120 122 Deferred income taxes (121) (132) Net investment in leveraged leases $ (1) $ (10) At and, approximately 16% and 15% of Textron Financial s investment in leveraged leases was collateralized by real estate, respectively. The components of income from leveraged leases were as follows: Income recognized $ (1) $ Income tax benefit 8 Net income from leveraged leases * $ (1) $ 8 *In, net income from leveraged leases included the impact from the termination of certain leveraged leases prior to maturity. Credit Quality Indicators and Nonaccrual Finance Receivables We internally assess the quality of our finance receivables held for investment portfolio 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/portfolios into three basic 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 full 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 to 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. A summary of finance receivables categorized based on the credit quality indicators discussed above is as follows: Performing $ 1,285 $ 1,083 Watchlist 93 84 Nonaccrual 105 134 Total $ 1,483 $ 1,301 Nonaccrual as a percentage of total finance receivables 7.08% 10.30% We measure delinquency based on the contractual payment terms of our loans and leases. 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. 11
Finance receivables by delinquency aging category are summarized in the table below: Less than 31 days past due $ 1,295 $ 1,182 31-60 days past due 108 54 61-90 days past due 37 32 Over 90 days past due 43 33 Total $ 1,483 $ 1,301 Accrual status loans that were greater than 90 days past due totaled $5 million at. There were no accrual status loans that were greater than 90 days past due at. At and, 60+ days contractual delinquency as a percentage of finance receivables was 5.39% and 5.00%, respectively. Impaired Loans On a quarterly basis, we evaluate individual finance receivables for impairment in non-homogeneous portfolios and larger 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. There was no significant interest income recognized on impaired loans in or. A summary of impaired finance receivables, excluding leveraged leases, at year-end and the average recorded investment for the year is provided below: Recorded investment: Impaired loans with no related allowance for credit losses $ 78 $ 56 Impaired loans with related allowance for credit losses 59 97 Total $ 137 $ 153 Unpaid principal balance $ 141 $ 169 Allowance for losses on impaired loans 14 27 Average recorded investment 155 261 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 leveraged leases based on authoritative accounting standards. Balance at beginning of period $ 71 $ 151 Provision for losses (22) (12) Charge-offs (17) (83) Recoveries 12 15 Transfers 11 Balance at end of period $ 55 $ 71 Allowance based on collective evaluation $ 41 $ 44 Allowance based on individual evaluation 14 27 Finance receivables evaluated collectively $ 1,226 $ 1,026 Finance receivables evaluated individually 137 153 12
Loan Modifications Troubled debt restructurings occur when we have either modified the contract terms of finance receivables for borrowers experiencing financial difficulties or accepted a transfer of assets in full or partial satisfaction of the loan balance. The types of modifications we typically make include extensions of the original maturity date of the contract, extensions of revolving borrowing periods, delays in the timing of required principal payments, deferrals of interest payments, advances to protect the value of our collateral and principal reductions contingent on full repayment prior to the maturity date. During, loans for sixteen of our customers had been modified and are categorized as troubled debt restructurings, excluding related allowance for loan losses. The recorded investment related to these loans totaled $40 million at. The premodification and post-modification recorded investment amounts were $41 million and $40 million, respectively. The changes effected by these modifications were not material. Modified finance receivables are classified as impaired loans and are evaluated on an individual basis to determine whether reserves are required. Our reserve evaluation includes an estimate of the likelihood that the borrower will be able to perform under the contractual terms of the modification. Subsequent payment defaults or delinquency trends of finance receivables modified as troubled debt restructurings are also factored into the evaluation of impaired loans for reserving purposes as a default decreases the likelihood that the borrower will be able to perform under the terms of future modifications. During, we had four customer defaults related to finance receivables that had been modified as troubled debt restructurings within the previous twelve months. The recorded investment for these customers totaled $15 million, excluding the related allowance for losses, at. We may repossess or receive collateral when a customer no longer has the ability to make payment. These transfers of assets in full or partial satisfaction of the loan balance are also considered troubled debt restructurings if the fair value of the assets transferred is less than our recorded investment. Similar to the troubled debt restructurings described above, these loans typically have been classified as impaired loans prior to the asset transfer; therefore, reserves have already been established related to the loan. For the year ended and, respectively, charge-offs upon the transfer of such assets were largely offset by previously established reserves. Note 4: Operating Lease Assets Operating lease assets, at cost: Aircraft $ 131 $ 182 Other 12 40 Accumulated depreciation: Aircraft (53) (72) Other (4) (6) Operating lease assets net $ 86 $ 144 Initial lease terms of operating leases range from 1 year to 10 years. Future minimum rentals at are $13 million in 2014, $8 million in 2015, $8 million in 2016, $6 million in 2017, $5 million in 2018 and $6 million thereafter. At, Other included an $18 million operating lease asset that was subsequently sold resulting from the modification of the terms of an existing lease that no longer met the criteria to be accounted for as a leveraged lease. The modified lease is reflected as an operating lease asset and the associated $8 million non-recourse debt is included in Debt on the Consolidated Balance Sheets at. The income statement impact from the change in classification was not significant during. Note 5: Other Assets Textron Financial s other assets are summarized below: Repossessed assets and properties $ 47 $ 76 Investments in other marketable securities 13 17 Other 38 33 Total other assets $ 98 $ 126 13
Repossessed assets and properties are assets we intend to sell in a relatively short period of time and are initially recorded at the lower of net realizable value or the previous carrying value of the related finance receivable. Subsequent declines in fair value are recorded in Portfolio losses, net of gains. Note 6: Debt and Credit Facilities Fixed-rate notes due (weighted-average rate of 5.28%) $ $ 400 Variable-rate note due (weighted-average rate of 1.21%) 48 Fixed-rate note due 2014 (5.13%) 100 100 Fixed-rate notes due -2017* (weighted-average rate of 4.59% and 4.88%, respectively) 42 102 Variable-rate notes due 2016 (weighted-average rate of 1.78%) 200 Fixed-rate notes, secured due 2017-2023* (weighted-average rate of 2.67%) 378 Variable-rate notes, secured due 2015-2020* (weighted-average rate of 1.19%) 63 Securitized debt (weighted-average rate of 1.50% and 1.55%, respectively) 172 282 6% Fixed-to-Floating Rate Junior Subordinated Notes 299 300 Fair value adjustments and unamortized discount 2 8 Total debt $ 1,256 $ 1,240 *Notes amortized on a quarterly or semi-annual basis. As discussed in Note 1, Summary of Significant Accounting Policies, effective December 27,, Textron assigned the shares of one of its finance subsidiaries to Textron Financial and as a result, all finance subsidiaries owned by Textron are now consolidated subsidiaries of Textron Financial. The outstanding debt transferred totaled $378 million of secured fixed-rate notes due 2017-2023 and $63 million of secured variable-rate notes due 2015-2020. Our 6% Fixed-to-Floating Rate Junior Subordinated Notes are unsecured and rank junior to all of our 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. Pursuant to the terms of the notes or the replacement capital covenant described below, any redemption of the notes must be made from the sale of certain replacement capital securities or a capital contribution from Textron. During, we received a capital contribution from Textron for the repurchase of $1 million of these notes. Interest on the notes is fixed at 6% until February 15, 2017, and floats at three-month LIBOR + 1.735% thereafter. We may defer payment of interest on one or more occasions, in each case, for a period of up to 10 years. In a replacement capital covenant for the benefit of the holders of a specified class of covered debt, we agreed that we will not redeem the 6% Fixed-to-Floating Rate Junior Subordinated Notes on or before February 15, 2047, unless we have received a capital contribution from Textron and/or net proceeds from the sale of certain replacement capital securities in certain specified amounts. The initial class of covered debtholders under the replacement capital covenant are the holders of our 5.125% Medium Term Notes, Series E, due August 15, 2014 (the Initial Covered Notes ). On or during the 30-day period preceding the date that is two years prior to the maturity of the Initial Covered Notes, such date being the Redesignation Date, we are required to identify the series of eligible debt that will become the covered debt on and after such Redesignation Date. The Initial Covered Notes mature on August 15, 2014; therefore, the Redesignation Date was August 15,. At this time, we have no other debt that qualifies as eligible debt under the replacement capital covenant. Therefore, no series of debt will succeed the Initial Covered Debt as covered debt for purposes of the replacement capital covenant. We had interest rate exchange agreements related to the conversion of fixed-rate debt to variable-rate debt of $42 million and $384 million at and, respectively, whereby we make periodic floating-rate payments in exchange for periodic fixed-rate receipts. The weighted-average rate of these borrowings considering the impact of interest rate exchange agreements, including fees was 1.60% and 1.45% for the years ended and, respectively. We made cash payments for interest of $46 million in and $52 million in, which includes interest paid to Textron. 14
Note 7: Fair Value of Financial Instruments 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. We measure our derivative instruments, net at fair value on a recurring basis using Level 2 inputs. Assets Recorded at Fair Value on a Recurring Basis We entered into interest rate exchange agreements to mitigate our exposure to changes in the fair value of its fixed-rate receivables and debt due to fluctuations in interest rates. These interest rate exchange contracts are not exchange traded and are measured at fair value utilizing widely accepted, third-party developed valuation models. The actual terms of each individual contract are entered into a valuation model, along with interest rate data, which is based on readily observable market data published by third-party leading financial news and data providers. At and we had interest rate exchange contracts with notional amounts upon which the contracts were based of $229 and $671 million, respectively. The fair value amounts of our interest rate exchange contracts recorded at, were a $2 million asset and a $5 million liability. At, the fair value amounts of our interest rate exchange contracts were an $8 million asset and an $8 million liability. A net loss of $8 million was recorded in finance charges related to these interest rate exchange agreements in. There was no significant net gain or loss recorded in earnings in. Credit risk is factored into the fair value of derivative assets and liabilities based on the differential between both the Company s credit default swap spread for liabilities and the counterparty s credit default swap spread for assets as compared to a standard AArated counterparty, however, this had no significant impact on the valuation as of and. Investments in Other Marketable Securities As of and, our investments in other marketable securities of $13 million and $17 million, respectively, were classified as available for sale and measured at fair value using Level 2 inputs. The estimate of fair value was based on observable market inputs for similar securitization interests in markets that are relatively inactive compared to the market environment in which they were originally issued and bids received from prospective purchasers. Assets Recorded at Fair Value on a Nonrecurring Basis During and, certain assets were measured at fair value on a nonrecurring basis using significant unobservable inputs (Level 3). The table below sets forth the balance of those assets at the end of the year in which a fair value adjustment was taken. Balance at Finance receivables held for sale $ 65 $ 140 Impaired finance receivables 45 70 Repossessed assets and properties 29 73 Other assets 6 15
The following table provides the fair value adjustments recorded for the assets measured at fair value on a non-recurring basis during and. Gain (Loss) Finance receivables held for sale $ 31 $ 76 Repossessed assets and properties (11) (51) Impaired finance receivables (7) (10) Other assets (2) Finance receivables held for sale are recorded at fair value on a nonrecurring basis during periods in which the fair value is lower than cost. There are no active, quoted market prices for these finance receivables. At, our finance receivables held for sale included the Non-captive loan portfolio. Fair values of each loan in this portfolio were determined based on a combination of discounted cash flow models and recent third-party offers to estimate the price we expect to receive in the principal market for each loan, in an orderly transaction. The cash flow models include the use of qualitative assumptions regarding the borrower s ability to pay and the period of time that will likely be required to restructure and/or exit the account through acquisition of the underlying collateral, as well as quantitative assumptions, including discount rates and revenue and earnings multiples, which are used to estimate the value of the underlying collateral. The gains on finance receivables held for sale during and were primarily the result of the payoff of loans in amounts, and sale of loans at prices, in excess of the values established in previous periods. 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 and primarily related to initial fair value adjustments. Other assets in the table above primarily include aviation assets and repossessed golf and hotel properties. The fair value of our aviation assets was largely determined based on the use of industry pricing guides. The fair value of our golf and hotel properties was determined based on the use of discounted cash flow models, bids from prospective buyers or inputs from market participants. If the carrying amount of these assets is higher than their estimated fair value, we record a corresponding charge to portfolio losses, net of gain for the difference. Assets and Liabilities Not Recorded at Fair Value The carrying values and estimated fair values of Textron Financial s financial instruments which are not recorded at fair value are as follows: Carrying Value Estimated Fair Value Carrying Value Estimated Fair Value Finance receivables held for investment, net of allowance for losses $ 1,231 $ 1,290 $ 1,017 $ 1,010 Debt 1,256 1,244 1,240 1,207 Finance Receivables Held for Investment There are no active, quoted market prices for these finance receivables. The estimate of fair value was 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. Where available, the assumptions related to the expectations of current market participants are compared to observable market inputs, including bids from prospective purchasers of similar loans and certain bond market indices for loans of similar perceived credit quality. Although we utilize and prioritize these market observable inputs in our discounted cash flow models, these inputs are rarely derived from markets with directly comparable loan structures, industries and collateral types. Therefore, all valuations of finance receivables involve significant management judgment, which can result in differences between our fair value estimates and those of other market participants. 16
Debt At and, 70% and 36%, respectively, of the estimated fair value of debt was determined based on discounted cash flow analyses using observable market inputs from debt with similar duration, subordination and credit default expectations. The remaining estimated fair values were determined based on observable market transactions. Note 8: Investment in Parent Company Preferred Stock On April 12, 2000, Textron made a $25 million noncash capital contribution to Textron Financial consisting of all of the outstanding shares of Textron Funding Corporation (Textron Funding), a related corporate holding company. Textron Funding s only asset is 1,522 shares of Textron Inc. Series D cumulative preferred stock, bearing an annual dividend yield of 5.92%. The preferred stock, which has a face value of $152 million, is carried at its original cost of $25 million and is presented in a manner similar to treasury stock for financial reporting purposes. Dividends on the preferred stock are treated as additional capital contributions from Textron. Note 9: Income Taxes Income before income taxes: United States $ 35 $ 60 Foreign 1 2 Total $ 36 $ 62 The components of income tax expense are as follows: Current: Federal $ (21) $ (54) State 2 Foreign (1) (2) Total current income tax expense (benefit) $ (20) $ (56) Deferred: Federal $ 32 $ 70 State 5 2 Total deferred income tax expense 37 72 Total income tax expense $ 17 $ 16 The current federal and state provisions for includes $25 million of tax related to the sale of certain leverage leases to which we had previously recorded significant deferred tax liabilities, the majority of which was paid to the Internal Revenue Service (IRS) during. Cash (refunded) paid for income taxes was $(54) million in and $38 million in. During and, Textron Financial paid $16 million and $111 million in taxes and interest to the IRS primarily related to a partial payment for the 2008 settlement reached with the IRS with respect to the challenge of tax deductions taken by the Company in prior years for certain leveraged lease transactions. 17