AAR CORP (AIR) FY 2022 MD&A

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

(Dollars in millions)

Background and Forward-Looking Statements

The following discussion and analysis of our financial condition and results of operations, and quantitative and qualitative disclosures about market risk should be read in conjunction with our consolidated financial statements and the related notes included in this Form 10-K.  For a discussion of the comparison of fiscal 2021 and 2020, refer to Part II, Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations of our Annual Report on Form 10-K for the year ended May 31, 2021 (filed July 21, 2021).

Management’s Discussion and Analysis of Financial Condition and Results of Operations contain certain statements relating to future results, which are forward-looking statements as that term is defined in the Private Securities Litigation Reform Act of 1995.  Forward-looking statements may also be identified because they contain words such as ‘‘anticipate,’’ ‘‘believe,’’ ‘‘continue,’’ ‘‘could,’’ ‘‘estimate,’’ ‘‘expect,’’ ‘‘intend,’’ ‘‘likely,’’ ‘‘may,’’ ‘‘might,’’ ‘‘plan,’’ ‘‘potential,’’ ‘‘predict,’’ ‘‘project,’’ ‘‘seek,’’ ‘‘should,’’ ‘‘target,’’ ‘‘will,’’ ‘‘would,’’ or similar expressions and the negatives of those terms.  These forward-looking statements are based on the beliefs of management, as well as assumptions and estimates based on information available to us as of the dates such assumptions and estimates are made, and are subject to certain risks and uncertainties, including those factors discussed under Item 1A, “Risk Factors,” that could cause actual results to differ materially from those anticipated. Should one or more of those risks or uncertainties materialize adversely, or should underlying assumptions or estimates prove incorrect, actual results may vary materially from those described. Those events and uncertainties are difficult or impossible to predict accurately and many are beyond our control. We assume no obligation to update any forward-looking statements to reflect events or circumstances after the date of such statements or to reflect the occurrence of anticipated or unanticipated events.

General Overview

We report our activities in two business segments: Aviation Services comprised of supply chain and maintenance, repair and overhaul (“MRO”) activities and Expeditionary Services comprised of manufacturing activities.

The Aviation Services segment consists of aftermarket support and services offerings that provide spare parts and maintenance support for aircraft operated by our commercial and government/defense customers. Sales in the Aviation Services segment are derived from the sale and lease of a wide variety of new, overhauled and repaired engine and airframe parts and components to the commercial aviation and government and defense markets. We provide customized inventory supply chain management, performance-based logistics programs, customer fleet management and operations, and aircraft component repair management services. The segment also includes repair, maintenance and overhaul of aircraft, landing gear and components. Cost of sales consists principally of the cost of product, direct labor, and overhead.

The Expeditionary Services segment consists of primarily manufacturing operations with sales derived from the design and manufacture of pallets, shelters, and containers used to support the U.S. military’s requirements for a mobile and agile force including engineering, design, and system integration services for specialized command and control systems. Cost of sales consists principally of the cost of material to manufacture products, direct labor and overhead.

Our chief operating decision making officer (Chief Executive Officer) evaluates performance based on the reportable segments and utilizes gross profit as a primary profitability measure.  Gross profit is calculated by subtracting cost of sales from sales. The assets and certain expenses related to corporate activities are not allocated to the segments. Our reportable segments are aligned principally around differences in products and services.

Business Trends and Outlook

Fiscal 2022 began with our focus centered on continuing to navigate the unprecedented decline in commercial passenger flight hours.  We maintained our strategy of leveraging our efficiency gains, optimized portfolio and strong balance sheet to drive growth and margin expansion through the recovery in our commercial markets from the impact of COVID-19.  Our sales to commercial customers in fiscal 2022 increased by $277.4 million, or 34.4%, over the prior year as we were successful in driving sales growth through the uneven recovery from COVID-19.

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We were also successful in winning new long-term agreements in both our commercial and government markets.  We were awarded an exclusive distribution agreement with Collins Aerospace’s Goodrich De-Icing & Specialty Heating Systems business.  Under the agreement, we provide airlines, business jet and other aircraft operators as well as MROs globally with de-icers and supporting products.  We also were awarded a five-year renewal of our power-by-the-hour component pool and repair support program for flydubai’s fleet of 33 Boeing 737NG aircraft.

Our sales to government customers in fiscal 2022 decreased by $109.7 million, or 13.0%, from the prior year as we were impacted by the U.S. exit from Afghanistan and certain programs coming to a natural completion.  The operations related to our activities in Afghanistan contributed revenue of $67 million and $43 million in fiscal 2021 and fiscal 2022, respectively.  During fiscal 2022, we were awarded a firm fixed price, indefinite delivery/indefinite quantity contract from the Air Force to support United States Air Forces in Europe (“USAFE”) F-16 aircraft. This $365 million, ten-year contract provides for F-16 depot work as well as Service Life Extension Program modifications and maintenance.

During fiscal 2022, we continued our strong focus on working capital management with cash flows from operating activities from continuing operations of $89.8 million.  Borrowings outstanding under the Revolving Credit Facility were $100.0 million at May 31, 2022 with an availability on the facility of $488.6 million.

Our long-term strategy also emphasizes the return of capital to shareholders.  In December 2021, our Board of Directors authorized a renewal of our stock repurchase program.  The authorization has no expiration date and permits the Company to repurchase up to $150 million of our common stock. We were able to return capital to shareholders through common stock repurchases of $42.4 million during fiscal 2022 and expect to fully utilize the authorization by the end of calendar 2023.

Over the long-term, we expect to see strength in our Aviation Services segment given its offerings of value-added services to both commercial and government and defense customers.  We believe long-term commercial aftermarket growth trends are favorable.  As we continue to invest in the pipeline of opportunities in the government market and maintain our focus on the commercial market recovery, our long-term strategy continues to emphasize investing in the business and capitalizing on opportunities in those markets.

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Results of Operations – Fiscal 2022 Compared with Fiscal 2021

Sales and gross profit for our two business segments for the years ended May 31, 2022 and 2021 were as follows:

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nm – Percentage change is not meaningful.

Aviation Services Segment

Sales in the Aviation Services segment increased $192.1 million, or 12.4%, over the prior year due to a $287.7 million, or 36.2%, increase in sales to commercial customers.  The increase in sales to commercial customers was primarily attributable to increased sales of $99.4 million in our MRO activities and $81.5 million related to new parts distribution activities as commercial passenger air traffic continues to recover from the impact of COVID-19. In addition, sales increased $74.0 million in our aftermarket trading activities which included whole asset sales of $66.6 million in fiscal 2022 compared to $20.3 million in the prior year.

During fiscal 2022, sales in this segment to government and defense customers decreased $95.6 million, or 12.6%, from the prior year. The decrease in sales to government and defense customers was primarily attributable to the timing of activities for the C-40 aircraft we are delivering to the Naval Air Systems Command in support of the U.S. Marine Corps. The prior year included sales of $39.5 million related to the installation of engines on the aircraft while no engine installation activities occurred in fiscal 2022. The remainder of the decrease in sales from the prior year relates to the natural completion of certain programs, including Afghanistan contracts, partially offset by growth from new programs.

Changes in estimates and assumptions related to our programs accounted for using the cost-to-cost method are recorded using the cumulative catch-up method of accounting. In fiscal 2022, we recognized favorable and unfavorable cumulative catch-up adjustments of $15.0 million and $5.0 million, respectively, compared to favorable and unfavorable cumulative catch-up adjustments of $16.1 million and $4.1 million, respectively, in fiscal 2021.  When considering these adjustments on a net basis, we recognized favorable cumulative catch-up adjustments of $10.0 million and $12.0 million for fiscal 2022 and 2021, respectively. These adjustments primarily relate to our long-term programs where we provide component inventory management, supply chain logistics programs and/or repair services.

Cost of sales in Aviation Services increased $157.8 million, or 12.2%, over the prior year which was largely in line with the sales increase of 12.4% discussed above.

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Gross profit in the Aviation Services segment increased $34.3 million, or 13.0%, over the prior year. Gross profit in this segment on sales to commercial customers increased $44.1 million, or 32.4%, over the prior year primarily due to the COVID-19 impact discussed above.

In addition, gross profit was unfavorably impacted in fiscal 2021 by contract termination, restructuring and loss provision charges of $9.3 million and asset impairment charges of $8.4 million.  These items were more than offset by a benefit in fiscal 2021 of $53.8 million in government workforce subsidies from the Payroll Support Program in the CARES Act and other subsidies provided by foreign governments.

Gross profit margin on sales to commercial customers decreased to 16.7% from 17.2% in the prior year period primarily due to the impact of the subsidies in the prior year period more than offsetting the volume recovery in fiscal 2022.

Gross profit on sales to government and defense customers decreased $9.8 million, or 7.7%, from the prior year primarily driven by the mix of products and services provided on long-term government programs. Gross profit margin on sales to government and defense customers increased to 17.6% from 16.7% in the prior year period primarily as a result of the mix of sales.

Expeditionary Services Segment

Sales in the Expeditionary Services segment decreased $24.4 million, or 24.7%, from the prior year primarily due to reduced volume for our mobility products. In addition, we divested our composites manufacturing business in the first quarter of fiscal 2021 and the business contributed sales of $6.7 million in fiscal 2021 prior to the sale.

Gross profit in the Expeditionary Services segment increased $3.0 million, or 23.6%, over the prior year primarily due to the divestiture of our composites manufacturing business which was not profitable prior to its divestiture on August 31, 2020. Gross profit margin increased to 21.2% from 12.9% in the prior year primarily as a result of the divestiture.

Provision for Credit Losses

Provision for credit losses decreased $7.3 million from the prior year primarily related to lower customer credit charges in fiscal 2022.  The impact of COVID-19 on the recoverability of our accounts receivable was largely concentrated to fiscal 2021 as most commercial airlines are experiencing more favorable market conditions in our fiscal 2022.

Selling, General and Administrative Expenses

Selling, general and administrative expenses increased $19.8 million, or 10.9%, over the prior year primarily due to investments to support the sales growth as our commercial activities continue the recovery from the impact of COVID-19. As a percent of sales, selling, general and administrative expenses increased slightly to 11.1% from 11.0% in the prior year as the benefit from our actions over the last two years to reduce both our fixed and variable cost structure largely offset the investments to support sales growth.

Losses Related to Sale and Exit of Business

Losses related to sale and exit of business were $1.7 million in fiscal 2022 compared to losses of $20.2 million in fiscal 2021.  In the first quarter of fiscal 2021, we completed the sale of our composites manufacturing business and recognized a loss on the sale of $19.5 million.  We recognized additional losses in fiscal 2021 related to the finalization of the post-closing working capital adjustment.   Losses in fiscal 2022 relate to the re-valuation of the contingent consideration to zero as it was unlikely the sales targets will be achieved and the recognition of reserves against outstanding accounts receivable from the buyer in conjunction with their bankruptcy filing in the fourth quarter of fiscal 2022.

Interest Expense

Interest expense decreased $2.6 million in fiscal 2022 reflecting the impact of lower average borrowings partially offset by higher average borrowing rates on our Revolving Credit Facility during fiscal 2022.

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Income Taxes

Our fiscal 2022 effective income tax rate for continuing operations was 25.3% compared to 28.2% in the prior year.  In fiscal 2022, we recognized favorable excess tax benefits of $2.1 million related to stock compensation while we recognized additional tax expense of $0.7 million for stock compensation fiscal 2021.

Discontinued Operations

Income from discontinued operations was $0.2 million in fiscal 2022 compared to a loss of $10.5 million in the prior year. The fiscal 2021 loss was primarily attributable to an $11.0 million increase in our legal reserve to reflect the agreement with the U.S. Department of Justice to settle their investigation of our COCO business under the federal civil False Claims Act.

Liquidity, Capital Resources and Financial Position

Our operating activities are funded and commitments met through the generation of cash from operations.  In addition to operations, our current capital resources include an unsecured Revolving Credit Facility and an accounts receivable financing program.  Periodically, we may also raise capital through common stock and debt financings in the public or private markets.  We continually evaluate various financing arrangements, including the issuance of common stock or debt, which would allow us to improve our liquidity position and finance future growth on commercially reasonable terms. Our continuing ability to borrow from our lenders and issue debt and equity securities to the public and private markets in the future may be negatively affected by a number of factors, including the overall health of the credit markets, general economic conditions, airline industry conditions, geo-political events, and our operating performance.  Our ability to generate cash from operations is influenced primarily by our operating performance and changes in working capital.

At May 31, 2022, our liquidity and capital resources included working capital of $659.0 million inclusive of cash of $53.5 million.

We maintain a Revolving Credit Facility with various financial institutions, as lenders, and Bank of America, N.A., as administrative agent for the lenders, which provides the Company an aggregate revolving credit commitment of $600 million that matures September 25, 2024. Under certain circumstances, we have the ability to request, but our lenders are not required to grant, an increase to the revolving credit commitment by an aggregate amount of up to $300 million, not to exceed $900 million in total.

Borrowings under the Revolving Credit Facility bear interest at the offered Eurodollar Rate plus 87.5 to 175 basis points based on certain financial measurements if a Eurodollar Rate loan, or at the offered fluctuating Base Rate plus 0 to 75 basis points based on certain financial measurements if a Base Rate loan.

Borrowings outstanding under the Revolving Credit Facility at May 31, 2022 were $100.0 million and there were approximately $11.4 million of outstanding letters of credit, which reduced the availability of this facility to $488.6 million. There are no other terms or covenants limiting the availability of this facility.

In the first quarter of fiscal 2021, we received $57.2 million from the U.S. Treasury Department through the Payroll Support Program under the CARES Act.  This funding included a $48.5 million cash grant, which was to be used exclusively for the continuation of payment of employee wages, salaries and benefits for employees of certain MRO facilities, and a low interest 10-year senior unsecured promissory note of $8.7 million. In fiscal 2021, we recognized the full amount of the grant as contra-expense within Cost of sales and Selling, general and administrative expenses. The Promissory Note was re-paid in full during the fourth quarter of fiscal 2021.

As of May 31, 2022, we also had other financing arrangements that did not limit availability on our Revolving Credit Facility including outstanding letters of credit of $11.6 million and foreign lines of credit of $9.3 million.

On October 18, 2017, we entered into a Credit Agreement with the Canadian Imperial Bank of Commerce, as lender (the “Credit Agreement”). The Credit Agreement provided a Canadian $31 million term loan with the proceeds used to fund the acquisition of two MRO facilities in Canada from Premier Aviation. The term loan was paid in full at the expiration of the Credit Agreement on November 1, 2021.

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We maintain a Purchase Agreement with Citibank N.A. (“Purchaser”) for the sale, from time to time, of certain accounts receivable due from certain customers (the “Purchase Agreement”). Under the Purchase Agreement, the maximum amount of receivables sold is limited to $150 million and Purchaser may, but is not required to, purchase the eligible receivables we offer to sell. The term of the Purchase Agreement runs through February 22, 2023, however, the Purchase Agreement may also be terminated earlier under certain circumstances. The term of the Purchase Agreement shall be automatically extended for annual terms unless either party provides advance notice that they do not intend to extend the term.

We have no retained interests in the sold receivables, other than limited recourse obligations in certain circumstances, and only perform collection and administrative functions for the Purchaser. We account for these receivable transfers as sales under ASC 860, Transfers and Servicing, and de-recognize the sold receivables from our Consolidated Balance Sheet.

Receivables sold under the Purchase Agreement during fiscal 2022, 2021, and 2020 were $283.3 million, $440.6 million, and $746.4 million, respectively. Amounts remitted to the Purchaser on their behalf during fiscal 2022, 2021, and 2020 were $306.9 million, $476.3 million, and $758.3 million, respectively. As of May 31, 2022 and May 31, 2021, we had collected cash of $5.4 million and $8.4 million, respectively, which was not yet remitted to the Purchaser as of those dates and was classified as Restricted cash on our Consolidated Balance Sheets.

At May 31, 2022, we complied with all financial and other covenants under each of our financing arrangements.

On December 16, 2021, our Board of Directors authorized a renewal of our stock repurchase program in which we may repurchase up to $150 million of our common stock with no expiration date. The timing and amount of repurchases are subject to prevailing market conditions and other considerations, including our liquidity and acquisition and other investment opportunities.  During fiscal 2022, we repurchased 1.0 million shares for $42.4 million.  We plan to fully utilize the authorization by December 31, 2023.

Cash Flows – Fiscal 2022 Compared with Fiscal 2021

Cash Flows from Operating Activities

Net cash provided from operating activities–continuing operations was $89.8 million in fiscal 2022 compared to $108.5 million in fiscal 2021.  The decrease from the prior period of $18.7 million was primarily attributable to a greater reduction in inventory levels in the prior year and the proceeds of a $48.5 million grant from the Payroll Support Program of the CARES Act received in fiscal 2021.  These items were partially offset by a $25 million license fee paid to Unison Industries in the prior year for our expanded and extended exclusive distribution agreement.

Cash Flows from Investing Activities

Net cash used in investing activities–continuing operations was $16.5 million in fiscal 2022 compared to $0.5 million in fiscal 2021. The increase in cash used from the prior period was primarily related to proceeds of $10.0 million from the termination of split-dollar life insurance policies in the prior year.

Cash Flows from Financing Activities

Net cash used in financing activities–continuing operations was $59.8 million in fiscal 2022 compared to $469.5 million in fiscal 2021. The decrease in cash used was primarily related to the repayment in fiscal 2021 of the additional draw down on our Revolving Credit Facility from late fiscal 2020.  These funds were originally drawn in late fiscal 2020 as a precautionary measure in light of the economic and market uncertainty presented by COVID-19. The current year also included $42.4 million for the repurchase of 1.0 million shares in conjunction with our stock repurchase program announced in fiscal 2022.

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Contractual Obligations and Off-Balance Sheet Arrangements

A summary of contractual cash obligations and off-balance sheet arrangements as of May 31, 2022 is as follows:

Notes:

We routinely issue letters of credit and performance bonds in the ordinary course of business.  These instruments are typically issued in conjunction with insurance contracts or other business requirements.  The total of these instruments outstanding at May 31, 2022 was $23.0 million.

Critical Accounting Policies and Significant Estimates

Our Consolidated Financial Statements are prepared in conformity with accounting principles generally accepted in the United States.  Management has made estimates and assumptions relating to the reporting of assets and liabilities and the disclosure of contingent liabilities to prepare the Consolidated Financial Statements.  The most significant estimates made by management include those related to assumptions used in assessing goodwill impairment, adjustments to reduce the value of inventories and certain rotable assets, revenue recognition, allowance for credit losses, and assumptions used in determining pension plan obligations.  Accordingly, actual results could differ materially from those estimates.  The following is a summary of the accounting policies considered critical by management.

Goodwill

Under accounting standards for goodwill and other intangible assets, goodwill and other intangible assets deemed to have indefinite lives are not amortized, but are subject to annual impairment tests. We review and evaluate our goodwill and indefinite life intangible assets for potential impairment at a minimum annually, on May 31, or more frequently if circumstances indicate that impairment is possible.

The accounting standards for goodwill allow for either a qualitative or quantitative approach for the annual impairment test.  Under the qualitative approach, factors such as macroeconomic conditions, industry and market conditions and company-specific events or circumstances are assessed to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount.  When the quantitative approach is utilized, we compare the fair value of each reporting unit with the carrying value of the reporting unit, including goodwill.  If the estimated fair value of the reporting unit is less than the carrying value of the reporting unit, we would be required to recognize an impairment loss for the excess carrying value of the reporting unit’s assets.

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As of May 31, 2022, we had three reporting units, which included two in our Aviation Services segment (Aviation Supply Chain and MRO) and one comprised of our Expeditionary Services segment.  In fiscal 2022 and 2021, we utilized the qualitative assessment approach for all reporting units.  Under this approach, we considered the overall industry and market conditions related to the aerospace and government/defense markets as well as conditions in the global capital markets.  We also considered the long-term forecasts for each reporting unit, which incorporated specific opportunities and risks, working capital requirements, and capital expenditure needs.  We concluded it was more likely than not that the fair value of each reporting unit exceeded its carrying value at the respective measurement dates, and thus no impairment charges were recorded in those fiscal years.

In fiscal 2020, we elected to forego the qualitative assessment due to the unprecedented impact of COVID-19 and utilized a quantitative assessment approach for all reporting units.  We estimated the fair value of each reporting unit using primarily an income approach based on discounted cash flows.  The assumptions we used to estimate the fair value of our reporting units are based on historical performance, as well as forecasts used in our business plan, and required considerable management judgment in light of the impact of COVID-19.  Our Aviation Services reporting units were impacted by the reduced numbers of commercial aircraft flying and the overall decline in flight hours.  We incorporated the decline in demand from commercial airline customers followed by a multiple year recovery as passenger miles and flight hours progressively increase.

We used discount rates based on our consolidated weighted average cost of capital which was adjusted for each of our reporting units based on their specific risk, size, and industry characteristics.  The fair value measurements used for our goodwill impairment testing used significant unobservable inputs, which reflected our own assumptions about the inputs that market participants would use in measuring fair value.  The fair value of our reporting units is also impacted by our overall market capitalization and may be impacted by volatility in our stock price and assumed control premium, among other items.

Upon completion of the annual quantitative goodwill impairment analysis as of May 31, 2020 for our reporting units, we concluded the fair value of each reporting unit exceeded its carrying values, and thus no impairment charges were recorded.

We also evaluate the sensitivity of the discounted cash flow valuations by assessing the impact of changes in certain assumptions on the estimated fair value of each reporting unit by increasing the discount rates and/or adjusting our business plan assumptions including slower recovery of sales from COVID-19 and reduced profitability.  All of our reporting units would have had fair values substantially in excess of their carrying values under all our sensitivity scenarios.

Inventories

Inventories are valued at the lower of cost or net realizable value.  Cost is determined by the specific identification, average cost or first-in, first-out methods.  Write-downs are made for excess and obsolete inventories and inventories that have been impaired as a result of industry conditions.  We have utilized certain assumptions when determining the market value of inventories, such as inventory quantities and aging, historical sales of inventory, current and expected future aviation usage trends, replacement values, expected future demand, and historical scrap recovery rates.  Reductions in demand for certain of our inventories or declining market values, as well as differences between actual results and the assumptions utilized by us when determining the market value of our inventories, could result in the recognition of impairment charges in future periods.

In conjunction with the decision to exit certain product lines and facilities, we recognized inventory impairment charges of $3.9 million in fiscal 2020.  We also recognized rotable asset impairment charges of $1.9 million in fiscal 2020 in conjunction with reclassifying the rotable assets as inventory held for sale.  In fiscal 2022 and 2021, we recognized additional impairment charges of $1.0 million and $1.4 million, respectively, on these assets.

Revenue Recognition

Revenue is measured based on consideration specified in a contract with a customer, and excludes any sales incentives and amounts collected on behalf of third parties. We recognize revenue when we satisfy a performance obligation by transferring control over a product or service to a customer.

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Our unit of accounting for revenue recognition is a performance obligation included in our customer contracts.  A performance obligation reflects the distinct good or service that we must transfer to a customer.  At contract inception, we evaluate if the contract should be accounted for as a single performance obligation or if the contract contains multiple performance obligations.  In some cases, our contract with the customer is considered one performance obligation as it includes factors such as whether the good or service being provided is significantly integrated with other promises in the contract, whether the service provided significantly modifies or customizes another good or service or whether the good or service is highly interdependent or interrelated.  If the contract has more than one performance obligation, we determine the standalone price of each distinct good or service underlying each performance obligation and allocate the transaction price based on their relative standalone selling prices.

The transaction price of a contract, which can include both fixed and variable amounts, is allocated to each performance obligation identified.  Some contracts contain variable consideration, which could include incremental fees or penalty provisions related to performance.  Variable consideration that can be reasonably estimated based on current assumptions and historical information is included in the transaction price at the inception of the contract but limited to the amount that is probable that a significant reversal in the amount of cumulative revenue recognized will not occur.  Variable consideration that cannot be reasonably estimated is recorded when known.

Our performance obligations are satisfied over time as work progresses or at a point in time based on transfer of control of products and services to our customers.  The majority of our sales from products are recognized at a point in time upon transfer of control to the customer, which generally occurs upon shipment.  In connection with certain sales of products, we also provide logistics services, which include inventory management, replenishment, and other related services.  The price of such services is generally included in the price of the products delivered to the customer, and revenues are recognized upon delivery of the product, at which point the customer has obtained control of the product.  We do not account for these services separate from the related product sales as the services are inputs required to fulfill part orders received from customers.

For our performance obligations that are satisfied over time, we measure progress in a manner that depicts the performance of transferring control to the customer. As such, we utilize the input method of cost-to-cost to recognize revenue over time as this depicts when control of the promised goods or services are transferred to the customer.  Revenue is recognized based on the relationship of actual costs incurred to date to the estimated total cost at completion of the performance obligation.  We are required to make certain judgments and estimates, including estimated revenues and costs, as well as inflation and the overall profitability of the arrangement.  Key assumptions involved include future labor costs and efficiencies, overhead costs, and ultimate timing of product delivery.  Differences may occur between the judgments and estimates made by management and actual program results.

Changes in estimates and assumptions related to our arrangements accounted for using the cost-to-cost method are recorded using the cumulative catch-up method of accounting.  These changes are primarily adjustments to the estimated profitability for our long-term programs where we provide component inventory management and/or repair services.

When contracts are modified, we consider whether the modification either creates new or changes the existing enforceable rights and obligations. Contract modifications that are for goods or services that are not distinct from the existing contract, due to the significant integration with the original goods or services provided, are accounted for as if they were part of that existing contract with the effect of the contract modification recognized as an adjustment to revenue on a cumulative catch-up basis. When the modifications include additional performance obligations that are distinct, they are accounted for as a new contract and performance obligation, which are recognized prospectively.

Under most of our U.S. government contracts, if the contract is terminated for convenience, we are entitled to payment for items delivered and fair compensation for work performed, the costs of settling and paying other claims, and a reasonable profit on the costs incurred or committed.

Shipping and handling fees and costs incurred associated with outbound freight after control over a product has transferred to a customer are accounted for as a fulfillment cost and are included in Cost of sales on our Consolidated Statements of Income, and are not considered a performance obligation to our customers.  Our reported sales on our Consolidated Statements of Income are net of any sales or related non-income taxes.  We also utilize the “as invoiced” practical expedient in certain cases where performance obligations are satisfied over time and the invoiced amount corresponds directly with the value we are providing to the customer.

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The timing of revenue recognition, customer billings, and cash collections results in a contract asset or contract liability at the end of each reporting period.  Contract assets consist of unbilled receivables or costs incurred where revenue recognized over time using the cost-to-cost model exceeds the amounts billed to customers.  Contract liabilities include advance payments and billings in excess of revenue recognized. Certain customers make advance payments prior to the satisfaction of our performance obligations on the contract.  These amounts are recorded as contract liabilities until such performance obligations are satisfied, either over time as costs are incurred or at a point in time when deliveries are made. Contract assets and contract liabilities are determined on a contract-by-contract basis.

Allowance for Credit Losses

We maintain an allowance for credit losses to reflect the expected uncollectibility of accounts receivable based on past collection history and specific risks identified among uncollected accounts.  In determining the required allowance, we consider factors such as general and industry-specific economic conditions, customer credit history, and our customers’ current and expected future financial performance. The majority of our customers are recurring customers with an established payment history. Certain customers are required to undergo an extensive credit check prior to delivery of products or services.

We perform regular evaluations of customer payment experience, current financial condition, and risk analysis. We may require collateral in the form of security interests in assets, letters of credit, and/or obligation guarantees from financial institutions for transactions executed on other than normal trade terms. We also maintain trade credit insurance for certain customers to provide coverage, up to a certain limit, in the event of insolvency of some customers.

Impairment of Long-Lived Assets

We are required to test for impairment of long-lived assets whenever events or changes in circumstances indicate the carrying value of an asset may not be recoverable from its undiscounted cash flows. When applying accounting standards addressing impairment of long-lived assets, we have utilized certain assumptions to estimate future undiscounted cash flows, including current and future sales volumes or lease rates, expected changes to cost structures, lease terms, residual values, market conditions, and trends impacting future demand. Differences between actual results and the assumptions utilized by us when determining undiscounted cash flows could result in future impairments of long-lived assets. We recognized a pre-tax asset impairment charge of $11.8 million in fiscal 2020 related to assets included in our COCO business, which is classified as a discontinued operation.  In our Expeditionary Services segment, we consolidated manufacturing facilities and recognized impairment and related charges of $2.6 million during fiscal 2021.

We maintain a significant inventory of rotable parts and equipment to service customer aircraft and components.  Portions of that inventory are used parts that are often exchanged with parts removed from aircraft or components, and are reworked to a useable condition.  We may have to recognize an impairment of our rotable parts and equipment if we discontinue using or servicing certain aircraft models or if an older aircraft model is phased-out in the industry.  In light of declines in commercial airline volumes and commercial program contract terminations, we evaluated future cash flows related to certain rotable assets supporting long-term programs and recognized asset impairment charges of $2.3 million, $5.8 million, and $1.9 million in fiscal 2022, 2021, and 2020, respectively.

Pension Plans

Our pension plan assets exceed our total projected benefit obligation by $6.0 million as of May 31, 2022. This overfunded position is driven by our U.S. plans where their plan assets exceed their obligations by $5.2 million.

Effective May 31, 2022, our Union and U.S. Retirement Plans were merged (collectively, the “Merged U.S. Plan”). We are expecting to terminate the Merged U.S. Plan in the next 12-18 months upon the completion of regulatory approvals and the anticipated transfer of the Merged U.S. Plan’s obligations and assets to a third-party.  The Merged U.S. Plan is in an overfunded position of $8.9 million and we do not anticipate making any contributions to the Merged U.S. Plan in conjunction with the termination.

The liabilities and net periodic cost of our pension plans are determined utilizing several actuarial assumptions, the most significant of which are the discount rate and the expected long-term rate of return on plan assets.

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We use discount rates to measure our benefit obligation and net periodic benefit cost for our pension plans.  We used a broad population of Aa-rated corporate bonds as of May 31, 2022 to determine the discount rate assumption.  All bonds were denominated in U.S. Dollars, with a minimum outstanding of $50.0 million.  This population of bonds was narrowed from a broader universe of over 500 Moody’s Aa-rated, non-callable (or callable with make-whole provisions) bonds by eliminating the top 10th percentile and the bottom 40th percentile to adjust for any pricing anomalies and to represent the bonds we would most likely select if we were to actually annuitize our pension plan liabilities.  This portfolio of bonds was used to generate a yield curve and associated spot rate curve to discount the projected benefit payments and settlements for the Merged U.S. Plan.  The discount rate is the single level rate that produces the same result as the spot rate curve.

We establish the long-term asset return assumption based on a review of historical compound average asset returns, both company-specific and relating to the broad market, as well as analysis of current market and economic information and future expectations. For our Merged U.S. Plan, we have invested the majority of the plan assets in fixed income investments in anticipation of the upcoming termination of the Merged U.S. Plan. The asset return is expected to correspond to the changes in the discount rate and the valuation of the pension obligation to mitigate the risk of a significant reduction in the current overfunded position.

In calculating the net pension cost, the expected return on assets is applied to a calculated value on plan assets, which recognizes changes in the fair value of plan assets in a systematic manner over five years.  The difference between this expected return and the actual return on plan assets is a component of the total net unrecognized gain or loss and is subject to amortization in the future.

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