Annual Report 2018 www.avcorp.com Avcorp Industries Inc. annual report 2018 ABOUT AVCORP INDUSTRIES INC. The Avcorp Group designs and builds major airframe structures for some of the world’s leading aircraft companies, including BAE Systems, Boeing, Bombardier, Lockheed Martin and Subaru Corporation. The Avcorp Group has more than 60 years of experience, over 650 skilled employees and 636,000 square feet of facilities. Avcorp Structures & Integration located in Delta British Columbia, Canada is dedicated to metallic and composite aerostructures assembly and integration; Avcorp Engineered Composites located in Burlington Ontario, Canada is dedicated to design and manufacture of composite aerostructures, and Avcorp Composite Fabrication located in Gardena California, USA has advanced composite aerostructures fabrication capabilities for composite aerostructures. The Avcorp Group offers integrated composite and metallic aircraft structures to aircraft manufacturers, a distinct advantage in the pursuit of contracts for new aircraft designs, which require lower-cost, light-weight, strong, reliable structures. Comtek Advanced Structures Ltd., at our Burlington, Ontario, Canada location also provides aircraft operators with aircraft structural component repair services for commercial aircraft. Avcorp Composite Fabrication Inc. is wholly owned by Avcorp US Holdings Inc. Both companies are incorporated in the State of Delaware, USA, and are wholly owned subsidiaries of Avcorp Industries Inc. Comtek Advanced Structures Ltd., incorporated in the Province of Ontario, Canada, is a wholly owned subsidiary of Avcorp Industries Inc. Avcorp Industries Inc. is a federally incorporated reporting company in Canada and traded on the Toronto Stock Exchange (TSX:AVP). Page 1 Avcorp Industries Inc. annual report 2018 management discussion & analysis This Management Discussion and Analysis has been prepared as of March 29, 2019, and should be read in conjunction with the Company’s consolidated financial statements and notes thereto for the year ended December 31, 2018. Description of Business Avcorp Industries Inc. (the “Company”, “Avcorp” or the “Avcorp Group”) supplies major airframe structures to aircraft manufacturers and to their suppliers. Our capabilities are product design, tool design, metal and composite parts fabrication, assembly and repair, all of which are governed by strong program management. The Company currently operates from two locations in Canada and one location in the United States. Located in Delta, British Columbia, Avcorp Industries Inc., named as Avcorp Structures & Integration (“ASI”), is dedicated to metallic and composite aerostructures assembly and integration. Within Comtek Advanced Structures Ltd., located in Burlington, Ontario, exists two named divisions, one (“Comtek”) dedicated to aircraft structural component repair services, and the second Avcorp Engineered Composites (“AEC”) dedicated to design and manufacture of composite aerostructures. Located in Gardena, California, Avcorp Composite Fabrication Inc. (“ACF”) is dedicated to advanced composite aerostructures fabrication. Avcorp Industries Inc. is a federally incorporated reporting company in Canada and traded on the Toronto Stock Exchange (TSX:AVP). Avcorp Composite Fabrication Inc. is wholly owned by Avcorp US Holdings Inc. Both companies are incorporated in The State of Delaware and are subsidiaries of Avcorp Industries Inc. Comtek Advanced Structures Ltd., incorporated in the Province of Ontario is a wholly owned subsidiary of Avcorp Industries Inc. Avcorp is in compliance with industry standard quality certifications. 2018 Highlights Key financial results include: 2018 operating loss was reduced by $26,364,000, in comparison to 2017, primarily as a result of increased revenues, consolidation of costs and improved operating effectiveness; after the benefit of amortization to income of unfavourable contracts liability and onerous contracts provisions, and the income impact of a net claim position and contract modification, have been removed. During the third quarter 2018 production requirements associated with a certain unfavourable contract were redirected to another supplier, giving rise to the full amortization of the unfavourable contracts liability and related onerous contract provision into income. This has been recorded in the Consolidated Statements of Income (Loss) and Comprehensive Income (Loss) as a contract modification in the amount of $41,470,000. On August 20, 2018, the Company entered into a settlement agreement with a customer, in the amount of $2,219,000, which provided the Company a Net claim settlement in satisfaction of existing and potential claims, causes of action, and disputes between the Company and its customer. 2018 cash flows used in operating activities were reduced by $26,575,000, relative to 2017. On March 28, 2018, the Company signed a loan agreement to expand the current agreement with a Canadian Chartered Bank, supported by a major and material customer, to access an additional USD$10,000,000 operating line of credit. On August 24, 2018, the Company signed a non-revolving term loan agreement with its majority shareholder in the principal amount of USD$3,500,000. On April 19, 2018 Avcorp’s Board appointed Amandeep Kaler, formerly the General Manager of Avcorp’s Delta operations, as the new CEO of Avcorp Group. Avcorp is a member of Canada’s Digital Technology Supercluster (“CDTS”) which was awarded funding under the Federal Government’s Innovation Supercluster Initiative (“ISI”). In Comtek’s continuing effort to reduce airline operator’s key metric of turnaround time for repaired aircraft components, while still providing premium quality, Comtek has embarked on deploying a forward base of operations located in the United Kingdom. EASA certification has now been granted and the team is actively engaged on its’ first repair orders, providing much needed support for the growing Q400 fleet in Europe. Highlights Subsequent to Year-End Since December 31, 2018 key developments include: On January 25, 2019, the Company announced that it reached a settlement with HITCO Carbon Composites, Inc. (“HITCO”), SGL Carbon, LLC, and SGL Carbon SE (collectively the “SGL Parties”) of all claims related to alleged deficiencies in HITCO’s non- destructive inspection processes. Page 2 Avcorp Industries Inc. annual report 2018 On March 28, 2019, the Company entered into an amendment to its existing credit facility with a Canadian chartered bank whereby the following amendments were made: Maximum availability under the Revolving Loan cannot exceed USD$68,000,000 less USD$4,300,000, until April 30, 2019, at which time the agreement reverts back to existing terms. Availability under the Revolving Loan was increased on March 28, 2018, by USD$10,000,000 (“Expanded Loan”), subject to existing drawdown provisions, interest rates and bonus fees. Drawdowns under the Expanded Loan are supported by a major and material customer of the Company by way of a guarantee. The maturity of the Expanded Loan has been extended from March 31, 2019 to April 30, 2019. Financial Overview Three-Year Results The following table provides selected financial information for the three years to December 31, 2018. THREE-YEAR RESULTS (prepared in accordance with IFRS, expressed in thousands of Canadian dollars except per share amounts) FOR THE YEAR ENDED DECEMBER 31 20183 2017 2016 OPERATIONS Revenue EBITDA1 Operating income (loss) Net income (loss) Basic and diluted income (loss) per share FINANCIAL POSITION Capital expenditures Total assets Bank indebtedness and term debt Shareholders’ (deficit) equity Net book value per share2 Ratio: current assets/current liabilities Shares outstanding at period end $170,710 $149,444 $183,707 35,338 26,917 20,373 0.06 1,809 116,068 94,150 (36,144) (0.10) 0.50 (48,342) (53,773) (58,538) (0.18) 3,054 113,276 64,453 (57,405) (0.17) 0.53 (13,762) (16,405) (19,959) (0.07) 6,836 133,076 25,040 (6,883) (0.02) 0.94 368,118,620 337,404,502 307,141,184 1. 2. 3. EBITDA = earnings before interest, taxes, depreciation and amortization. This is not a recognized term under International Financial Reporting Standards (“IFRS”), refer to page 10. Net book value per share is not a recognized term under IFRS, refer to page 14. Included within 2018 revenues is additional $1,121,000 revenue recognized during the current year as a result of a change in revenue recognition policy under IFRS 15 – Revenue from Contracts with Customers effective January 1, 2018 (December 31, 2017: $Nil; December 31, 2016: $Nil). Avcorp’s recurring contracted revenue base remains strong as customers continue to place orders within existing long-term supply agreements. 2018 production revenues have increased by $23,008,000 from 2017, exclusive of a $4,617,000 amortization of the unfavourable contract liability into revenue (December 31, 2017: $9,058,000). Recent customer contract awards contributed $18,133,000 to 2018 revenues in comparison to $5,395,000 for 2017. Included within 2018 revenues is additional $1,121,000 revenue recognized during the current year as a result of a change in revenue recognition policy under IFRS 15 – Revenue from Contracts with Customers effective January 1, 2018 (December 31, 2017: $Nil; December 31, 2016: $Nil). The three primary factors underlying the year on year change in revenues are: 2016 revenues include amortization for the unfavourable contract liability, which amounted to $33,019,000; wind-down of certain loss-making contracts acquired in the Hitco acquisition occurred primarily in 2017 and 2018; offset by revenues arising from recent contract awards, primarily in the Delta facility. The Company continued with its strategic approach for securing business growth in the composite aircraft structures assembly market, to further diversify its aerostructures market position, leveraging its 2015 acquisition of Hitco. The Hitco acquisition, which required significant turn-around expenditures and was severely burdened with operational inefficiencies and extensive legacy product warranty obligations, reduced Earnings Before Interest, Taxes, Depreciation & Amortization (“EBITDA”) for the Group. Although expenditures have now been reduced, the Company continues to consume significant resources for the Hitco turn-around. Page 3 Avcorp Industries Inc. annual report 2018 The 2016 $16,405,000 operating loss contains a $38,937,000 amortization of an unfavourable contract liability into income; without which the operating loss for 2016 was $55,342,000. On a comparative basis, the 2017 $53,773,000 operating loss contains a $9,058,000 amortization of an unfavourable contracts liability into income; without which the operating loss was $62,831,000. Additional provisions for onerous contracts amounting to $13,603,000 during 2017 caused operating results to deteriorate in 2017; certain of those contracts were wound down in 2018. The 2018 $26,917,000 operating income contains a $4,617,000 amortization of an unfavourable contracts liability and a $9,115,000 amortization of onerous contracts provision into income, as well as a $41,470,000 net contract modification gain and a $5,421,000 net claim position. Capital expenditures during the three year period presented have been limited to upgrading manufacturing equipment and capabilities, in particular for new program introductions, as well as information technology assets. Bank indebtedness and term debt increased by $29,697,000 in 2018 over 2017. Cash flows from operating activities, before consideration of changes in non-cash working capital, decreased by $11,632,000 during the year ended December 31, 2018 as compared to a $42,257,000 decrease of cash during the year ended December 31, 2017. Cash flows from operating activities were most significantly impacted as a result of operating losses incurred from the integration and production costs expended for the acquired Hitco operations; losses arising from unfavourable customer contracts assumed; and operational, administrative, and legal expenditures, incurred at Avcorp’s Gardena facility; as well as new program introduction and start-up costs at the Delta facility. 2016 bank debt and 2017 bank debt were reduced by $22,429,000 and $12,378,000 respectively as a result of cash consideration received from the December 18, 2015 Hitco acquisition (December 31, 2018: $Nil). Quarterly Results The following table provides selected unaudited quarterly consolidated financial information for the eight most recent fiscal quarters to December 31, 2018 prepared in accordance with IAS 34 – Interim Financial Reporting (“IAS 34”) as issued by the International Accounting Standards Board (“IASB”). QUARTERLY RESULTS (prepared in accordance with IFRS, expressed in thousands of Canadian dollars except per share amounts) FOR THE THREE MONTHS ENDED Dec 31 Sep 30 Jun 30 Mar 31 Dec 31 Sep 30 Jun 30 Mar 31 20182 2017 Revenue $39,280 $44,862 $43,292 $43,276 $37,923 $36,267 $36,686 $38,568 Operating (loss) income (9,833) 41,070 286 (4,606) (27,342) (6,644) (11,170) (8,617) EBITDA1 Net (loss) income EBITDA per share1 Basic Diluted Net (loss) income per share Basic Diluted Long-term debt (8,575) 43,682 2,139 (1,908) (24,493) (6,253) (10,003) (7,593) (13,299) 40,234 (961) (5,601) (27,469) (8,444) (12,512) (10,113) (0.02) (0.02) (0.04) (0.04) 2,800 0.13 0.13 0.12 0.12 7,651 0.00 0.00 (0.01) (0.01) (0.07) (0.07) (0.02) (0.02) (0.03) (0.03) (0.02) (0.02) (0.00) (0.00) 2,180 (0.02) (0.02) 2,187 (0.08) (0.08) 1,885 (0.03) (0.03) 1,919 (0.04) (0.04) 1,588 (0.03) (0.03) 1,617 1. EBITDA = earnings before interest, taxes, depreciation and amortization. This is not a recognized term under International Financial Reporting Standards (“IFRS”), refer to page 10. 2. Includes revenues recognized as a result of a change in revenue recognition policy under IFRS 15. IFRS 15 was adopted on a modified retrospective basis, and therefore comparative figures have not been restated. During 2018 certain production contracts for commercial aircraft continued to be wound down at Avcorp Composite Fabrication Inc., as planned during the Hitco acquisition; however, operating inefficiencies contributed to quarterly operational losses. The Company continues to focus on reducing the cost structure in Gardena by consolidating facility usage and staffing levels via lean production techniques. Year ended December 31, 2018 operating income totalled $26,917,000; a $80,690,000 improvement over the December 31, 2017 $53,773,000 operating loss. Current year operating income benefited from the amortization into income of an unfavourable contracts liability and onerous contracts provision in the amount of $13,732,000 (December 31, 2017: $4,545,000 reduction to operating income) as well as the negative income impact of a $5,421,000 net claim position and net positive income impact of $41,470,000 contract modification. Increased revenues, consolidation of costs and improved operating effectiveness were also factors contributing to the reduction in 2018 operating losses in comparison to 2017. Exclusive of the above-mentioned items included in reported operating income for 2018 and 2017, the 2018 operating income improved by $26,364,000 over 2017. Page 4 Avcorp Industries Inc. annual report 2018 2018 and 2017 Results Overview During the year ended December 31, 2018 Avcorp Group revenues totalled $170,710,000 compared with $149,444,000 for the previous year. Included within 2018 revenues is additional $1,121,000 revenue recognized during the year as a result of a change in revenue recognition policy under IFRS 15 – Revenue from Contracts with Customers effective January 1, 2018 (December 31, 2017: $Nil). The Company operates within “general terms agreements” with its customers. These agreements are typically for five years or longer. The contracts provide for long lead-time orders; the civil aerospace business is also slightly seasonal as some aircraft manufacturers reduce or suspend production in December and for a period of time during the summer months. Manufacturing of composite parts occurs in Avcorp Group’s Gardena facility. 2018 revenues arising from the assignment by customers of commercial aerospace contracts to Avcorp Industries Inc. in conjunction with the December 18, 2015 Hitco acquisition have generated $38,109,000 in revenue (December 31, 2017: $50,999,000). These contracts, whose production occurs in the Gardena facility, support customer production of commercial aircraft. The planned wind-down of certain commercial contracts assigned from the Hitco acquisition have reduced revenues for the current year relative to 2018. The majority of the loss making production contracts for the Gardena facility, which were assumed with the Hitco acquisition, have been wound-down. The Gardena facility was assigned defence aerospace contracts by Hitco’s customers upon the finalization of the acquisition. These contracts generated $24,494,000 of revenue during the year ended December 31, 2018 for ACF (December 31, 2017: $19,826,000). Further manufacturing focus on meeting defence contract demand has increased this market segment revenue in 2018 relative to 2017. The Burlington facility continued through 2018 with increased delivery of composite panels in supply to original equipment manufacturer (OEM) production demand, and spares and after market demand (a $2,375,000 revenue increase in 2018 over 2017). Composite aircraft repair revenues out of Comtek were $263,000 greater in 2018 in comparison to 2017; it is anticipated that new market penetration and a backup of regional airline repairs will augment the 2019 revenue base. Non- panel OEM composite components generated revenue during the current year which were $1,009,000 less than the previous year. Increased revenues and a strong cost control process have enabled the Burlington facility to improve its operating income in 2018 by $910,000. Delta facility revenues, for all programs generated by production contracts, have increased by $29,608,000 during the current year relative to the year ended December 31, 2017. On a market segment basis, Delta revenues from the production and delivery of business and commercial jet programs has increased by approximately $15,105,000 in 2018 relative to 2017 primarily due to the production of higher complexity assembled commercial structures; while defence programs’ production has increased by $14,503,000 from both existing and new defence production programs. Avcorp’s Delta location continues to actively pursue production contracts on aerospace programs throughout North America, Asia, and Europe both in the commercial and defence aerospace sectors. These production contracts consist of complex metal bond and multi-material structural assemblies that complement Avcorp’s capability as a strategic integrated supplier within the aerospace industry. For the year ended December 31, 2018, the Avcorp Group recorded income from operations totaling $26,917,000 from $170,710,000 revenue, as compared to $53,773,000 operating losses from $149,444,000 revenue for the previous year. It should be noted that 2018 operating income benefited by $13,732,000 income from amortization of an unfavourable contract liability and onerous contracts provision into income (December 31, 2017: $4,545,000 reduction in operating income). During the third quarter 2018 production of a certain unfavourable contract was modified after the customer stopped issuing purchase orders to the Company and redirected production requirements to another supplier, giving rise to the full amortization of the unfavourable contracts liability and related onerous contract provision into income. This has been recorded in Consolidated Statements of Income (Loss) and Comprehensive Income (Loss) as a contract modification in the amount of $41,470,000. On August 20, 2018, the Company entered into a settlement agreement with a customer, in the amount of $2,219,000, which provided the Company a net settlement in satisfaction of existing and potential claims, causes of action, and disputes between the Company and its customer. Increased sales and continued consolidation of operating costs have resulted in reduced current year operating losses, in comparison to 2017 after the benefit of amortization to income of unfavourable contracts liability and onerous contracts provisions, and the income impact of a claim settlement and contract modification, have been removed. An unfavourable contract liability accruing for certain customer contracts, for which unavoidable costs were expected to exceed the corresponding revenue earned, amounted to $100,582,000 upon the December 18, 2015 Hitco acquisition; of which $Nil remains unamortized as at December 31, 2018 due to a contract modification to production of a certain customer contract (December 31, 2017: $44,460,000). The unfavourable contract liability was amortized into income on a units-of-production basis over the expected life of the contract and as costs were incurred. The amount of unfavourable contract liability amortized into income during the year ended December 31, 2018 on a units-of-production basis was $4,617,000 (December 31, 2017: $9,058,000). The unamortized unfavourable contract liability was accrued in US dollars and therefore the unamortized balance varied as the estimated provision was adjusted for foreign currency fluctuations. The ACF commercial operations in Gardena faced several significant unanticipated challenges during 2016, immediately post-acquisition which continued to have an adverse financial impact into 2017 as the Company’s operational turn around initiatives were significantly delayed. Operational losses, incurred at the Gardena facility amounted to $4,948,000 for the year ended December 31, 2018 as compared to $33,035,000 operating losses for the year ended December 31, 2017. Gardena 2018 operating losses benefited by $4,617,000 income from amortization of an unfavourable contract liability into income (2017: $9,058,000). Page 5 Avcorp Industries Inc. annual report 2018 The complexity and challenge of executing the production start-up and improvement plans for the Gardena operations increased from pre-acquisition estimates. Avcorp continues to work successfully with its commercial and defence aerospace customers to update plans and commitments to ensure support for their programs and maintain purchase order schedules. Over the course of 2016 and through 2018 certain of the smaller loss making contracts at the Gardena facility were being wound down eliminating the associated losses; as well, production for the most significant loss making contract was wound down during the third quarter 2018. Contract revisions are in place which will help improve Avcorp’s financial performance. Although recent customer contract awards in Canadian operations will continue to increase facility utilization, there remains unutilized plant capacity within the Company’s Delta, British Columbia facility, and also within the Gardena, California facility due to the recent transition out of certain loss making production contracts. The Company has expensed $6,469,000 of overhead costs during the year as compared to $4,309,000 for December 31, 2017 in respect of unutilized plant capacity. The amount of overhead costs expensed, as a result of unutilized capacity, will fluctuate from quarter to quarter as production in support of deliveries varies. Revenue growth in these facilities would benefit Company profitability via a contribution to the recovery of fixed overhead expenditures. Avcorp is engaged with aerospace OEM’s as well as industry tier 1 suppliers in North America, Asia and Europe in collaborative production initiatives that support the Company’s recent transition to composite manufacturing capabilities, further leveraging existing production capacity and investments. During the year ended December 31, 2018, cash flows from operating activities, excluding the impact of changes in non-cash working capital, utilized $11,632,000 of cash as compared with utilization of $42,257,000 of cash during the year ended December 31, 2017; a significant improvement, primarily attributable to a reduction in operating losses during 2018 in comparison to 2017. Changes in non-cash working capital during the current year utilized $4,397,000 as compared to the previous year during which non-cash working capital utilized $347,000; primarily as a result of a change in revenue recognition policy under IFRS 15 – Revenue from Contracts with Customers effective January 1, 2018. On December 18, 2015, in conjunction with the acquisition of Hitco, the Company assumed a customer advance for pre-funded product deliveries. The customer advance is re-paid as the Company delivers to the customer. In the event that cancellation, termination, or assignment of the statement of work occurs earlier than December 31, 2019, the customer shall have the right to recover from the Company within 120 days of such an event the unamortized portion of the cash advance; such event occurred during the third quarter 2018. The customer advance is subject to an access and security agreement along with a general security agreement entered into with the Company’s bank and a customer. The customer advance was recorded at its fair value on December 18, 2015 in the amount of $18,953,000 (December 31, 2017: $7,227,000). The Company amortized into revenue $2,660,000 of the customer advance during the year ended December 31, 2018 (December 31, 2017: $3,702,000). The remaining unamortized customer advance has been recorded at its face value to reflect the amount due. The face value of the unamortized portion of the cash advance as at December 31, 2018 is USD$4,643,000 (December 31, 2017: USD$7,219,000). As at December 31, 2018, the Company had $2,051,000 cash on hand (December 31, 2017: $5,212,000) and had utilized $85,840,000 of its operating line of credit (December 31, 2017: $61,283,000). The Company has a working capital deficit of $71,503,000 as at December 31, 2018 which has increased from the December 31, 2017 $63,038,000 deficit. Working capital surplus/deficit is defined as the difference between current assets and current liabilities. However, the Company’s accounts receivable, contract assets, and inventories net of accounts payable, amount to a $22,000,000 surplus as at December 31, 2018 (December 31, 2017: $38,464,000 surplus). The Company’s accumulated deficit as at December 31, 2018 is $132,878,000 (December 31, 2017: $157,185,000). Revenue For the year ended December 31, 2018 revenues totalled $170,710,000, a $21,266,000 increase in revenues relative to 2017 (December 31, 2017; $149,444,000). Included within 2018 revenues is additional $1,121,000 revenue recognized during the current year as a result of a change in revenue recognition policy under IFRS 15 – Revenue from Contracts with Customers effective January 1, 2018 (December 31, 2017: $Nil). The amount of unfavourable contract liability amortized into revenue during the year ended December 31, 2018 on a units-of- production basis was $4,617,000 (December 31, 2017: $9,058,000). The unamortized unfavourable contract liability is accrued in US dollars and therefore the unamortized balance will vary from quarter to quarter as the estimated provision is adjusted for foreign currency fluctuations. Exclusive of the impact of IFRS 15 and the amortization into revenue of an unfavourable contract liability, the Company’s revenues attributable to production deliveries to customers amounted to $163,394,000 in 2018, a $23,008,000 increase over the $140,386,000 comparable revenues for 2017. Page 6 Avcorp Industries Inc. annual report 2018 Operating segment revenues are as follows: REVENUE DISTRIBUTION (prepared in accordance with IFRS, expressed in thousands of Canadian dollars) FOR THE YEAR ENDED DECEMBER 31 20182 2017 Avcorp Industries Inc. (ASI) Comtek Advanced Structures Ltd. (AEC) Avcorp Composite Fabrication Inc.1 (ACF) Revenue % of Total Revenue % of Total $83,589 19,916 67,205 49.0 11.6 39.4 $51,485 18,076 79,883 34.4 12.1 53.5 Total 170,710 100.0 149,444 100.0 1. ACF revenue includes amortization of a portion of the unfavourable contract liability of $4,617,000 in 2018 (2017: $9,058,000). 2. Includes revenue recognized as a result of a change in revenue recognition policy under IFRS 15. The Company operates within “general terms agreements” with its customers. These agreements are typically for five years or longer. The contracts provide for long lead-time orders; the civil aerospace business is also slightly seasonal as some aircraft manufacturers reduce or suspend production in December and for a period of time during the summer months. Delta facility revenues for 2018 totalled $83,589,000 (December 31, 2017: $51,485,000), which included $2,497,000 revenue recognized as a result of change in revenue recognition policy under IFRS 15 – Revenue from Contracts with Customers effective January 1, 2018 (December 31, 2017: $Nil) leaving $81,092,000 of production related revenue billings. Delta facility commercial aircraft programs production revenues have increased by $15,105,000 of which recently introduced commercial aircraft production contract revenues have contributed $12,738,000 of revenue growth in 2018 over 2017. Production for defence programs has increased significantly by $14,503,000 in 2018 relative to 2017. Avcorp’s Delta location continues to actively pursue production contracts on aerospace programs throughout North America, Asia, and Europe both in the commercial and defence aerospace sectors. These production contracts consist of complex metal bond and multi-material structural assemblies that complement Avcorp’s capability as a strategic integrated supplier within the aerospace industry. Production and deliveries for recent contract awards commenced during 2017 and have continued to grow in 2018 for the Delta facility. Burlington facility revenues for 2018 totalled $19,916,000 (December 31, 2017: $18,076,000), which included $217,000 revenue recognized as a result of change in revenue recognition policy under IFRS 15 – Revenue from Contracts with Customers effective January 1, 2018 (December 31, 2017: $Nil) leaving $19,699,000 of production related revenue billings. The Burlington facility had an increase in the delivery of composite floor panels and racks in supply to OEM production lines during the current year of 43% relative to 2017. Full rate production for these programs establishes the wholly owned subsidiary as a leading manufacturer of composite floor panels. Composite floor panel revenues arising from aftermarket or OEM spares composite floor panel sales decreased by $1,023,000 during the current year relative to 2017. Sales for other composite component deliveries to OEMs decreased by $1,009,000 in 2018 relative to 2017. Composite aircraft repair revenues out of Comtek increased by 7% in 2018 in comparison to 2017; it is anticipated that new market penetration and a backup of regional airline repairs will augment the 2019 revenue base. Effective December 18, 2015, Avcorp completed the acquisition of the US-based composite Aerostructures division of Hitco, a subsidiary of Frankfurt-listed SGL. The Acquisition was completed pursuant to the terms of an asset purchase agreement that was entered into on July 20, 2015, and subsequent amendments to December 18, 2015. Pursuant to the Agreement Avcorp’s subsidiary, Avcorp Composite Fabrication Inc., (the Group’s Gardena facility) purchased the assets of the division of Hitco which produces composite structural parts for commercial and military aerostructures. Gardena facility revenues for 2018 totalled $67,205,000 (December 31, 2017: $79,883,000), which included a $15,000 revenue reduction as a result of change in revenue recognition policy under IFRS 15 – Revenue from Contracts with Customers effective January 1, 2018 (December 31, 2017: $Nil) leaving $67,220,000 of production related revenue billings as well as $4,617,000 amortization into revenue of an unfavourable contract liability in 2018 (December 31, 2017: $9,058,000). The acquisition of Hitco’s Aerostructures composite division provided Avcorp the unique opportunity to transform the Avcorp Group’s existing metal fabrication and integrated assembly business by broadening the product range and strengthening Avcorp’s composite capabilities. Advanced composite fabrication capabilities, provided by this acquisition, will enhance Avcorp Group’s ability to participate in large aerospace assembly programs which combine mixed material components. Year ended December 31, 2018 revenues arising from the assignment by customers of commercial aerospace contracts to Avcorp Industries Inc. in conjunction with the December 18, 2015 Hitco acquisition have generated $38,109,000 in production revenue (December 31, 2017: $50,999,000). Wind-down of certain loss-making contracts and a reduction in deliveries for an ongoing customer program have resulted in a $12,891,000 reduction in commercial aircraft production revenues from this facility for 2018 relative to 2017. These contracts support customer production of commercial aircraft. Manufacturing of the composite parts occurs in Avcorp Group’s Gardena facility. The Gardena facility was assigned defence aerospace contracts by Hitco’s customers upon the finalization of the acquisition. These contracts generated $24,494,000 of production revenue during the year ended December 31, 2018 for ACF (December 31, 2017: $19,826,000) as facility resources are further operationalized to meet customer delivery requirements. Page 7 Avcorp Industries Inc. annual report 2018 Deliveries and quality performance as at December 31, 2017 for Avcorp manufacturing operations were at customer required levels. The manufacturing operations have achieved, and continue to maintain, top quality and delivery ratings for the majority of their programs. Revenues from Avcorp Group customers are as follows: REVENUE DISTRIBUTION (prepared in accordance with IFRS, expressed in thousands of Canadian dollars) FOR THE YEAR ENDED DECEMBER 31 20182 2017 BAE Systems Boeing1 Bombardier Lockheed Martin Subaru Corporation Other Amortization of the unfavourable contract liability Revenue % of Total Revenue % of Total $15,789 67,606 20,860 24,527 22,970 14,341 4,617 9.3 39.6 12.2 14.4 13.5 8.3 2.7 $5,413 59,089 19,134 15,735 24,566 16,449 9,058 3.6 39.5 12.8 10.5 16.4 11.0 6.2 Total 170,710 100.0 149,444 100.0 1. Includes Boeing program partner revenue consisting of industry tier-one suppliers to Boeing. 2. Includes revenue recognized as a result of a change in revenue recognition policy under IFRS 15. The Avcorp Delta BC facility is the single source supplier for the F-35 CV-OBW assembly under contract with BAE Systems (“BAES”), and delivers directly to Lockheed Martin. The Outboard Wing is the foldable portion of the wing on the carrier version of the F-35 aircraft which allows for handling and storage of the aircraft on the aircraft-carrier’s deck and hangers, while keeping its long-range and low-landing-speed flight characteristics. The CV-OBW is regarded as one of the more complex assemblies that the Canadian aerospace industry contributes to the F-35 program. Production demand for the F-35 CV-OBW increased significantly in 2018 relative to 2017; a $13,014,000 increase. Production contracts have been secured through to end of 2019, with discussions underway with the customer to secure constant production through to mid-2022. The Company announced that further to the contract award from Lockheed Martin announced on October 15, 2015 for the expanded scope on the F-35 CV-OBW, Avcorp has received a firm order for the production phase, referred to as Low Rate Initial Production (“LRIP”) eleven; and are in discussions with the customer for production under LRIP twelve through fourteen. The delivery of the first shipset to Lockheed Martin’s Final Assembly and Check Out facility in Fort Worth, Texas, USA was in August 2016, with subsequent confirmed orders extending out to 2019, and discussions underway with the customer to secure constant production through to mid-2022. Avcorp’s Gardena California facility provides content for all three models of the F-35 fighter aircraft. Fabricated components include: wing skins, upper and lower, nacelles, access panels, and a strap component that serves as a structural backbone to the aircraft. Avcorp fabricates these complex structures through a combination of both automated robotic fiber placement and hand laid graphic fabric methods. Avcorp is under a multi-year contract with Lockheed Martin Corporation, who release order quantity and schedule requirements that coincide with their fiscal year. The current period of performance extends through mid-2020. Follow on contract value is anticipated, assuming acceptable quality and delivery performance. Total revenues for this long-term defence program totalled $20,318,000 for the year ended December 31, 2018 (December 31, 2017: $15,141,000). Shipments of large complex metal assemblies out of the Delta facility to Boeing Commercial Airplane Group (“Boeing”), primarily for the 737 commercial jet program, increased by 74% during 2018 relative to 2017, primarily as a result of recently awarded program start-ups. Concurrently, deliveries of fabricated parts and components to Boeing decreased by $702,000 as customer demand for discrete and lower complexity assembled structures has decreased slightly. These products were manufactured at Avcorp’s Delta facility. During 2016, Avcorp delivered its first significant quantity of shipsets of composite fabricated aerostructures parts for Boeing programs from its acquired Gardena production facility. 2018 revenues for these composite parts totalled $10,945,000 (December 31, 2017: $21,625,000), a reduction from 2017 as the planned wind-down of certain Hitco acquired customer contracts takes place. Total production deliveries generated for the Company from various Boeing Commercial aircraft programs amounted to $56,485,000 for the year ended December 31, 2018 (December 31, 2017: $51,058,000). The Company also delivers components to Boeing Defense, Space & Security (“Boeing DSS”) for the Chinook CH47 helicopter and KC135 aircraft. During the year ended December 31, 2018 the Company generated $4,149,000 of revenues in supply to Boeing DSS, a slight increase in revenues recorded for the same period in 2017 (December 31, 2017: $3,697,000). Production deliveries for Bombardier Aerospace (“Bombardier”) programs increased by 11% during the current year relative to the year ended December 31, 2017. Shipments of large assemblies for the CL605 business jet program decreased by $616,000 during the current year as demand for these products decreased slightly relative to 2017; while the Company experienced a $2,488,000 increase in its deliveries of composite panels and related products to Bombardier primarily as a result in the growth of Global 5000/6000 and Global 7000/8000 program deliveries. Avcorp Group’s primary source of revenues from Bombardier in 2019 will continue to be from components for the CL605 and CL850 business jets, composite floor panels for the CRJ and Q400 aircraft programs, as well as a sustained rate of production of composite floor panels for Bombardier’s Global 5000/6000 and Global 7000/8000 programs. Page 8 Avcorp Industries Inc. annual report 2018 Avcorp’s deliveries to Subaru Corporation (“Subaru”) of large complex composite structural components which are integrated into the centre wing box in support of the Boeing 787 commercial jet program totalled $22,970,000 for the current year (December 31, 2017: $24,627,000). This is a significant commercial production contract being manufactured in the Gardena facility. This long term agreement represents an important relationship with a long-standing industry tier one supplier. Composite aircraft structure repair revenues out of Comtek were increased by 7% relative to revenues in the previous year; it is anticipated that new market penetration and a backup of regional airline repairs will augment the 2018 revenue base. The Group also supplies Canadian aircraft retro-fit programs out of its Delta facility, and large composite structures in support of various US defense programs out of its Gardena facility, whose revenues decreased relative to 2017. These Other revenues are of significant importance to the Group’s operations as they generated $14,340,000 in revenue during the year ended December 31, 2018 (December 31, 2017: $16,449,000). Defence program revenues for Avcorp during 2018 totalled $51,296,000 (December 31, 2017: $30,297,000); 30% of total production sales (December 31, 2017: 20%). Commercial program sales continue to provide the majority of the Company’s sales (December 31, 2018: 70%; December 31, 2017: 80%) amounting to $119,414,000 for 2018 and $119,147,000 for 2017. The Group continues to move forward with its revenue diversification between commercial and defence aerospace programs. Included in total revenues for the Company is the amortization of the unfavourable contract liability of $4,617,000 in 2018 (December 31, 2017: $9,058,000). Gross Profit Gross profit (revenue less cost of sales) for the year ended December 31, 2018 was positive 8.8% of revenue compared to negative 21.3% of revenue for the year ended December 31, 2017. Included in the calculation of gross profit is the amortization of the unfavourable contract liability of $4,617,000 into revenue in 2018 (December 31, 2017: $9,058,000) as well as a $9,115,000 amortization into income of an onerous contracts provision (December 31, 2017: $13,603,000 provision). The $46,809,000 improvement in 2018 gross profit over 2017 gross profit is primarily due to increased revenues in 2018 providing recovery of fixed costs, consolidation of costs, increased utilization of idle capacity in the Delta facility as new programs ramp up in production, as well as strong delivery performance of composite floor panels from the Burlington facility; in addition to the non-cash amortization into income and provisions noted above. Key turn around initiatives were delayed, significantly delaying gross margin improvements on production contracts manufactured out of the Gardena facility. The Gardena facility gross margin for the current year was positive $3,156,000 (December 31, 2017: $27,588,000 negative gross margin). 2018 Gardena facility gross margin, exclusive of the $4,617,000 amortization of the unfavourable contract liability into revenue was negative $1,461,000. On a comparative basis exclusive of the 2017 $9,058,000 amortization of the unfavourable contract liability into revenue, the 2017 Gardena facility gross margin was negative $36,646,000. The Gardena facility gross margin improved by $35,185,000 in 2018 relative to 2017 exclusive of the positive impact of amortization of the unfavourable contact liability into revenue. Many corrective actions have been implemented. Turnaround activities focused on cost reduction initiatives as well as operational process flow improvements are contributing to the financial improvement in comparison to 2017. Avcorp’s key commercial customers have worked collaboratively with Avcorp to mitigate production schedule risks and support the earliest resolution of the outstanding process and product issues. Over the course of 2016 and through 2018 certain of the smaller loss making contracts at the Gardena facility are being wound down eliminating the associated losses; as well, production for the most significant loss making contract was wound down during the third quarter 2018. Contract revisions are in place which will help improve Avcorp’s financial performance. The Delta facility gross margin for the current year was positive $8,302,000 (December 31, 2017: $6,868,000 negative gross margin). 2018 Delta facility gross margin improved by $15,170,000 over the 2017 gross margin; increased revenues are the primary contributor to this facility’s improved gross margin. Burlington production contracts produced a positive gross margin for the year ended December 31, 2018 of $3,499,000 as compared to a gross margin of $2,604,000 for 2017. Although recent customer contract awards in Canadian operations will continue to increase facility utilization, there remains unutilized plant capacity within the Company’s Delta, British Columbia facility, and also within the Gardena, California facility due to the recent transition out of certain loss making production contracts. The Company has expensed $6,469,000 of overhead costs during the year as compared to $4,309,000 for December 31, 2017 in respect of unutilized plant capacity. Administration and General Expenses As a percentage of revenue, administration and general expenses decreased to 13.7% for the year ended December 31, 2018 from 14.4% for the year ended December 31, 2017. In absolute terms, administration and general costs increased by $1,886,000 during the current year relative to the previous year. Legal and professional services incurred during the current year were substantial and continue as the Company administers various contracts and agreements assigned from and ancillary to its asset purchase agreement with Hitco and Frankfurt-listed SGL, which became effective on December 18, 2015. Audit fees, as well as additional legal costs and fees associated with financing arrangements, were also very significant during the current year. Page 9 Avcorp Industries Inc. annual report 2018 Foreign Exchange Gain or Loss Avcorp Group recorded a $770,000 foreign exchange loss during the year ended December 31, 2018 (December 31, 2017: $1,944,000 loss) as a result of holding US dollar-denominated cash, receivables, payables and debt. Earnings Before Interest, Taxes, Depreciation & Amortization Avcorp Group presents earnings before interest, taxes, depreciation and amortization (“EBITDA”) to assist the Company’s stakeholders with their assessment of its financial performance. EBITDA is a financial measure not recognized as a term under IFRS. However, the Company’s management believes that the Company’s stakeholders consider this metric to be useful information to assist them in evaluating profitability. EBITDA was positive $35,338,000 for the year ended December 31, 2018 compared to EBITDA of negative $48,342,000 for the year ended December 31, 2017. During the third quarter 2018 production of a certain unfavourable contract was modified after the customer stopped issuing purchase orders to the Company and redirected production requirements to another supplier, giving rise to the full amortization of the unfavourable contracts liability and related onerous contract provision into income. This has been recorded in Consolidated Statements of Income (Loss) and Comprehensive Income (Loss) as a contract modification in the amount of $41,470,000. On August 20, 2018, the Company entered into a settlement agreement with a customer, in the amount of $2,219,000, which provided the Company a net settlement in satisfaction of existing and potential claims, causes of action, and disputes between the Company and its customer. The Company has provisioned for a claim asserted by a customer in the amount of $7,640,000. Also, included in the calculation of EBITDA is the amortization of the unfavourable contract liability of $4,617,000 into income in 2018 (December 31, 2017: $9,058,000) as well as a $9,115,000 amortization into income of an onerous contracts provision (December 31, 2017: $13,603,000 provision). EBITDA for 2018 has improved by $29,354,000 after the benefit of amortization to income of unfavourable contracts liability and onerous contracts provisions, and the income impact of the net claim position and contract modification, have been removed. Turnaround activities focused on cost reduction initiatives as well as operational process flow improvements contributed to the financial improvement. Significant pre-existing operational deficiencies and excessive cost structure within the acquired Hitco operations resulted in poor production contract performance and adversely affected Group earnings for 2016 and continued through into 2017 as turnaround initiatives for the Gardena facility were significantly deferred. As legacy operational deficiencies were identified, operational improvements were made, thereby allowing the Gardena operations to achieve customer required output levels. Avcorp’s key commercial customers have worked collaboratively with Avcorp to mitigate production schedule risks and support the earliest resolution of the outstanding process and product issues. Over the course of 2016 and through 2018 certain of the smaller loss making contracts at the Gardena facility are being wound down eliminating the associated losses; as well, production for the most significant loss making contract was wound down during the fourth quarter 2018. Contract revisions are in place which will help improve Avcorp’s financial performance. EBITDA1 (expressed in thousands of Canadian dollars) FOR THE YEAR ENDED DECEMBER 31 2018 2017 2016 Income loss for the year Interest expense and financing charges Income tax expense Depreciation Amortization of development costs and intangibles $20,373 $(58,538) $(19,959) 5,813 - 4,482 4,670 2,820 - 4,153 3,223 353 - 3,915 1,929 35,338 (48,342) (13,762) 1. This is not a recognized term under International Financial Reporting Standards Finance Costs Total interest and financing charges on both short- and long-term debt for the year ended December 31, 2018 were $5,774,000, which is net of $39,000 interest income as compared with to $2,806,000 expense, net of $14,000 interest income for the year ended December 31, 2017. Interest expenditures have increased during the current year relative the previous year as bank indebtedness has increased substantially. Income Taxes Avcorp Group has not incurred a tax expense during the year ended December 31, 2018 (December 31, 2017: $Nil) nor recorded a tax benefit as it is not more likely than not that the benefit would be recognized. Page 10 Avcorp Industries Inc. annual report 2018 Income or Loss Income for the year ended December 31, 2018 was $20,373,000 compared to a loss of $58,538,000 for the year ended December 31, 2017. Significant pre-existing operational deficiencies and excessive cost structure within the acquired Hitco operations have resulted in poor production contract performance and significantly adversely affected Group earnings, operational turn around initiatives, although delayed, continue. The December 31, 2018 net income contains a $13,732,000 amortization of an unfavourable contract liability and onerous contracts provision into income, as well as $41,470,000 contract modification and $5,421,000 net claim position; without which the net loss for 2018 was $29,408,000. On a comparative basis, the 2017 $58,538,000 net loss contains a net $4,545,000 amoritization of an unfavourable contracts liability and onerous contracts provision; without which the net loss was $53,993,000. The significant reduction in net loss during the year ended December 31, 2018 relative to the year ended December 31, 2017 is primarily due to the $28,532,000 improvement in 2018 gross profit over 2017 gross profit; which was primarily due to increased revenues in 2018 providing recovery of fixed costs, consolidation of costs, increased utilization of idle capacity in the Delta facility as new programs ramp up in production, as well as strong delivery performance of composite floor panels from the Burlington facility. Administration and general costs increased by $1,886,000 during the current year relative to the previous year. Turnaround activities focused on cost reduction initiatives as well as operational process flow improvements are contributing to the financial improvement in comparison to 2017. Liquidity and Capital Resources On May 26, 2017, the Company entered into a loan agreement to expand its operating credit facility with a Canadian Chartered bank. This loan agreement amends, restates and replaces the loan agreement entered into on September 27, 2012. This loan amendment provides an additional borrowing capacity of up to USD$35,000,000 increasing its existing, as at December 31, 2017, USD$23,000,000 revolving loan in total up to USD$58,000,000. The loan matures on June 30, 2020. Interest rate for advances made up to the maximum of the allowable borrowing base on the existing USD$23,000,000 revolving loan: RBP plus 0.75% per annum RBUSBR plus 0.75% per annum BA Equivalent Rate plus 2.25% per annum LIBOR Rate plus 2.25% per annum Interest rate for advances made on the additional USD$35,000,000 borrowing capacity up to USD$58,000,000. RBP plus 0.00% per annum RBUSBR plus 0.00% per annum BA Equivalent Rate plus 0.875% per annum LIBOR Rate plus 0.875% per annum Drawdown under the USD$35,000,000 additional borrowing capacity is supported by a major and material customer of the Company by way of a guarantee. The Company will provide the guarantor, as consideration for the guarantee, a fee equal to 5.375% of the weighted average outstanding balance of the guaranteed portion over each full twelve (12) month period commencing on the funding date plus, for the partial year thereafter, 5.375% of the weighted average outstanding balance of the guaranteed portion multiplied by the number of days in the partial year divided by three hundred sixty (360). The fee will be payable on the maturity date. On March 28, 2018, the Company entered into an amendment to its existing credit facility with a Canadian chartered bank whereby the following amendments were made: Availability under the Revolving Loan is increased by USD$10,000,000 (“Expanded Loan”) subject to existing drawdown provisions, interest rates and bonus fees; Drawdowns under the Expanded Loan are supported by a major and material customer of the Company by way of a guarantee; and The Expanded Loan matures on March 31, 2019. On May 25, 2018, the Company entered into an amendment to its existing credit facility with a Canadian chartered bank whereby the following amendment was made: Maximum availability under the Revolving Loan cannot exceed USD$68,000,000 less USD$4,300,000, until August 31, 2018, at which time the agreement reverts back to existing terms. On September 5, 2018, the Company entered into an amendment to its existing credit facility with a Canadian chartered bank whereby the following amendment was made: Maximum availability under the Revolving Loan cannot exceed USD$68,000,000 less USD$4,300,000, until September 30, 2018, at which time the agreement reverts back to existing terms. On September 28, 2018, the Company entered into an amendment to its existing credit facility with a Canadian chartered bank whereby the following amendment was made: Maximum availability under the Revolving Loan cannot exceed USD$68,000,000 less USD$4,300,000, until December 30, 2018, at which time the agreement reverts back to existing terms; and Page 11 Avcorp Industries Inc. annual report 2018 On November 27, 2018, the Company entered into an amendment to its existing credit facility with a Canadian chartered bank whereby the following amendment was made: Maximum availability under the Revolving Loan cannot exceed USD$68,000,000 less USD$4,300,000, until January 31, 2019, at which time the agreement reverts back to existing terms. On January 31, 2019, the Company entered into an amendment to its existing credit facility with a Canadian chartered bank whereby the following amendment was made: Maximum availability under the Revolving Loan cannot exceed USD$68,000,000 less USD$4,300,000, until March 31, 2019, at which time the agreement reverts back to existing terms. On March 28, 2019, the Company entered into an amendment to its existing credit facility with a Canadian chartered bank whereby the following amendments were made: Maximum availability under the Revolving Loan cannot exceed USD$68,000,000 less USD$4,300,000, until April 30, 2019, at which time the agreement reverts back to existing terms. Availability under the Revolving Loan was increased on March 28, 2018, by USD$10,000,000 (“Expanded Loan”), subject to existing drawdown provisions, interest rates and bonus fees. Drawdowns under the Expanded Loan are supported by a major and material customer of the Company by way of a guarantee. The maturity of the Expanded Loan has been extended from March 31, 2019 to April 30, 2019. At December 31, 2018 Avcorp Group’s operating line of credit provides for a total utilization of USD$68,000,000 (providing approximately CAD$92,766,000 of liquidity). Avcorp Group ended 2018 with bank operating line utilization of $85,840,000 offset by $2,051,000 cash compared to utilization of $61,283,000 and $5,212,000 cash on hand at December 31, 2017. Based on net collateral provided to its bank, Avcorp Group is able to draw up to an additional USD$776,000 on its operating line of credit as at December 31, 2018 (December 31, 2017: USD$9,149,000). As at the date of this report the Company is able to draw up to an additional USD$9,659,000 on its operating line of credit. On December 18, 2015, in conjunction with the acquisition of Hitco, the Company assumed a customer advance for pre-funded product deliveries. The customer advance is re-paid as the Company delivers to the customer. In the event that cancellation, termination, or assignment of the statement of work occurs earlier than December 31, 2019, the customer shall have the right to recover from the Company within 120 days of such an event the unamortized portion of the cash advance; such event occurred during the third quarter 2018. The customer advance is subject to an access and security agreement along with a general security agreement entered into with the Company’s bank and a customer. The customer advance was recorded at its fair value on December 18, 2015 in the amount of $18,953,000 (December 31, 2017: $7,227,000). The Company amortized into revenue $2,660,000 of the customer advance during the year ended December 31, 2018 (December 31, 2017: $3,702,000). The remaining unamortized customer advance has been recorded at its face value to reflect the amount due. The face value of the unamortized portion of the cash advance as at December 31, 2018 is USD$4,643,000 (December 31, 2017: USD$7,219,000). During 2018 production requirements associated with a certain unfavourable contract were redirected to another supplier, giving rise to the full amortization of the unfavourable contract liability and related onerous contract provision into income. This has been recorded in Consolidated Statements of Income (Loss) and Comprehensive Income (Loss) as a contract modification in the amount of $41,470,000.On August 20, 2018, the Company entered into a settlement agreement with a customer, in the amount of $2,219,000, which provided the Company a net settlement in satisfaction of existing and potential claims, causes of action, and disputes between the Company and its customer. During the year ended December 31, 2018, the Company had a net income of $20,373,000 (December 31, 2017: net loss of $58,838,000), had negative operating cash flows of $16,029,000 (December 31, 2017: negative $42,604,000) and a shareholders’ deficiency of $36,144,000 as of December 31, 2018 (December 31, 2017: $57,405,000 deficiency) and an accumulated deficit of $132,878,000 (December 31, 2017: $157,185,000). Management assesses the Company’s ability to continue as a going concern at each reporting date, using quantitative and qualitative information available including contract modification associated to an unfavourable contract, and the past due date of its customer advance. Material uncertainties have been identified which may cast significant doubt upon the Company’s ability to continue as a going concern. This assessment, by its nature, relies on estimates of future cash flows and other future events, whose subsequent changes would materially impact the validity of such an assessment. The Company’s ability to continue as a going concern is dependent upon its ability to successfully negotiate extended terms with its creditors to continue to raise adequate financing and achieve significant improvements in operating results in the future. In assessing whether the going concern assumption was appropriate, management took into account all relevant information available about the future, which was at least, but not limited to, the 12 month period from the date of this report. The Company, in conjunction with its Board of Directors, is currently implementing various financing strategies which include the aforementioned banking arrangements. The Company, in conjunction with is Board of Directors continue to carry out various operational strategies which include: Operating and warranty issues at ACF were the largest cause of the Company’s 2016 losses. Technical quality issues which were discovered by the Company soon after the Hitco acquisition created additional compliance costs during 2016. Management has resolved these technical quality issues such that they did not re-occur in 2017 and going forward. Furthermore, the Company has received notification from its customers that these quality issues have been appropriately resolved. All personnel resources and support service provider costs incurred during 2016 as a result of these issues have been terminated. The significant product scrap and re-work costs have been processed and expensed and one-time expenditures for equipment upgrades have been completed. Page 12 Avcorp Industries Inc. annual report 2018 Numerous process improvements initiatives, restructuring activities and supplier contract renegotiations have significantly reduced production costs on a go forward basis. These cost reduction initiatives have included headcount reductions which continue into 2018. Contract renegotiations with customers and new customer contracts have provided an improved basis for operations in the future. Close collaboration with customers has resulted in both financial and operational support for continued operations. The assessment of the Company’s ability to execute its strategy of reducing operating costs and funding future working capital requirements involves significant judgement. Estimates and assumptions regarding future operating costs, revenue and profitability levels and general business and customer conditions are continually evaluated and are based on historical experience and other factors, including expectations of future events that are believed to be reasonable under the circumstances. Management is actively working to secure additional production orders, extension to its banking agreements, will continue to work with existing common shareholders, and will seek additional financing as necessary. The Company cannot provide assurance that, if it needs to raise additional funds, such funds will be available on favourable terms, or at all. If the Company cannot raise adequate funds on acceptable terms, its business could be materially harmed. Cash Flows from Operating Activities Cash flows from operating activities, before consideration of changes in non-cash working capital, decreased by $11,632,000 during the year ended December 31, 2018 as compared to a $42,257,000 decrease of cash during the year ended December 31, 2017; a significant improvement, primarily attributable to a reduction in operating losses during 2018 in comparison to 2017. Non-cash operating assets and liabilities utilized $4,397,000 of cash during the current year, compared to utilizing $347,000 of cash during the previous year; primarily as a result of a change in revenue recognition policy under IFRS 15 – Revenue from Contracts with Customers effective January 1, 2018. Avcorp Group continues to closely monitor accounts receivable and work with its customers in order to ensure cash is collected on a timely basis. Cash Flows from Investing Activities During the year ended December 31, 2018, the Avcorp Group purchased equipment totalling $1,429,000 compared with $2,744,000 during the year ended December 31, 2017. Avcorp Group continues to minimize its capital expenditures in order to conserve cash, with only operation critical expenditures being made. The Company also continued into 2018 with its upgrade to the IT infrastructure and systems with investments in 2018 totalling $371,000 (December 31, 2017: $571,000). During 2017 and 2018, the Company commenced the new program introduction process in support of the recently awarded production contracts. The start-up of new production contracts requires significant investments in hard and soft tooling. Such tooling investments amounted to $6,410,000 for the year ended December 31, 2018 (December 31, 2017: $5,347,000). Cash Flows from Financing Activities Avcorp Group finances working capital through a combination of bank debt and equity financings. Cash flows from financing activities provided $21,406,000 of cash during the current year compared with providing $40,739,000 of cash in 2017. The Company’s operating line was $85,840,000 drawn as at December 31, 2018 (December 31, 2017: $61,283,000) providing $17,961,000 in cash during the year (December 31, 2017: $46,872,000). Repayment of term debt during the current year amounted to $294,000 (December 31, 2017: $6,275,000); which was used to fund equipment and development costs and tooling. Proceeds from term debt during the current year amounted to $6,601,000 (December 31, 2017: $1,473,000) primarily from the Company signing a non-revolving term loan agreement with Panta in the principal amount of USD$3,500,000 on August 24, 2018. Payment of interest during the current year amounted to $2,862,000 (December 31, 2017: $1,331,000); with the increase in 2018 over 2017 primarily attributable to the Company having increased debt. On December 31, 2018, the ratio of the Company's current assets to current liabilities was 0.50:1 (December 31, 2017: 0.53:1). Page 13 Avcorp Industries Inc. annual report 2018 Contractual Obligations PAYMENTS DUE BY PERIOD (expressed in thousands of Canadian dollars) Finance lease obligations Term loan Other long-term obligations1 Purchase obligations2 Total contractual obligations Total 2019 2020 – 2022 2023 - 2024 Post 2024 $422 4,986 2,902 83,883 92,193 $159 30 365 55,784 56,338 $263 4,956 400 13,626 19,245 $- - 327 5,488 5,815 $- - 1,810 8,985 10,795 1. This amount represents obligations the Company has with Industrial Technologies Office. 2. Purchase obligations include payments for the Company’s operating and property leases, as well as committed contractual operational purchase order obligations outstanding. The Company expects that payment of contractual obligations will come from funds generated by operations, utilization of the bank operating line of credit, cash on hand and proceeds from debt and equity financings. The Company does not have any off-balance sheet liabilities or transactions that are not recorded or disclosed in the consolidated financial statements. Capital Stock As at December 31, 2018, there were 368,118,620 common shares, no common share purchase warrants, and 11,443,000 stock options issued and outstanding. Common Shares During the third quarter 2018 holders of the Company’s warrants exercised 30,714,118 warrants at a price of $0.07 resulting in the issuance of 30,714,118 common shares with a value of $2,150,000. During the third quarter 2017 holders of the Company’s warrants exercised 30,263,318 warrants at a price of $0.07 resulting in the issuance of 30,263,318 common shares with a value of $2,118,000. Panta Canada B.V., is 100% owned by Panta Holdings B.V. and is Avcorp’s majority shareholder owning approximately 71.2% of issued and outstanding common shares as of December 31, 2018. The Company is authorized to issue an unlimited number of common shares as well as an unlimited number of first preferred and second preferred shares, issuable in series, the terms of which will be determined by the Company’s directors at the time of creation of each series. There were 368,118,620 common shares issued at December 31, 2018. The book value of common shares issued and outstanding as at December 31, 2018 was $86,219,000 (December 31, 2017: $82,905,000), and a shareholders’ deficiency of $36,144,000 (December 31, 2017: $57,405,000 deficiency). Accounting standards The following is a brief summary of the new standard issued but not yet effective: IFRS 16 - Leases In January 2016, the IASB issued IFRS 16 – Leases (“IFRS 16”) which replaces IAS 17 – Leases and its associated interpretative guidance. IFRS 16 applies a control model to the identification of leases, distinguishing between a lease and a service contract on the basis of whether the customer controls the asset being leased. For those assets determined to meet the definition of a lease, IFRS 16 introduces significant changes to the accounting by lessees, introducing a single, on-balance sheet accounting model that is similar to current finance lease accounting, with limited exceptions for short-term leases or leases of low value assets. Lessor accounting remains similar to current accounting practice. The standard is effective for annual periods beginning on or after January 1, 2019, with early application permitted for entities that apply IFRS 15. The Company plans to adopt the new standard on the required effective date. The Company is in the process of assessing the impact the final standard is expected to have on its consolidated financial statements. The following is a brief summary of the new standard adopted: Adoption of IFRS 9 – Financial instruments In July 2014, the IASB completed the three-part project to replace IAS 39, Financial instruments: recognition and measurement by issuing IFRS 9, Financial instruments. IFRS 9 includes classification and measurement of financial assets and financial liabilities, and a forward-looking expected credit loss impairment model. Page 14 Avcorp Industries Inc. annual report 2018 IFRS 9 uses a new approach to determine whether a financial asset is measured at amortized cost or fair value, replacing the multiple rules in IAS 39. The approach in IFRS 9 is based on how an entity manages its financial instruments and the contractual cash flow characteristics of the financial assets. IFRS 9 also introduced a new expected credit loss impairment model that requires more timely recognition of expected credit losses. Specifically, the new standard requires entities to account for expected credit losses from when financial instruments are first recognized and to recognize full lifetime expected losses on a timelier basis. The Company adopted the new standard on the required effective date on January 1, 2018. Any difference between previous carrying amounts recognized under IAS 39 and those determined under IFRS 9 at the date of initial application would be included in opening accumulated losses on January 1, 2018. The adoption of IFRS 9 resulted in no adjustments. Adoption of IFRS 15 – Revenue from contracts with customers In May 2014, the IASB released IFRS 15 “Revenue from contracts with customers” which supersedes IAS 11 “Construction Contracts”, IAS 18 “Revenue”, and other related interpretations. The new standard establishes a control-based revenue recognition model and provides additional guidance in many areas not covered in detail under previous IFRSs. The core principle of IFRS 15 is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods and services. Revenue is recognized when, or as, the customer obtains control of the goods and services. The Company has adopted IFRS 15 effective January 1, 2018 and the changes have been accounted for using the retrospective with cumulative effect method only to contracts that are not completed contracts at the date of initial application in accordance with the transition rules of IFRS 15. This method does not require the restatement of comparative information. The following table shows the adjustments for each individual line item and do not include those line items that were not affected. As Previously Reported Adjustment Restated January 1, 2018 Consolidated Statement of Financial Position Contract asset Accounts receivable Inventory Contract liability Unfavourable contract liability Accumulated deficit $- 18,942 42,781 17,241 44,460 157,185 $18,142 1,211 (26,338) (9,341) (1,578) (3,934) $18,142 20,153 16,443 7,900 42,882 153,251 The Company reviewed its revenue contracts to evaluate the effect of the new standard on the Company’s revenue recognition policy. Contracts identified to be recognized over-time under Current IFRS resulted in the recognition of revenue on inventory as completed. Revenue was recognized, contract assets recorded, inventory released, and cost of goods sold was recorded in comparison to these contract’s recognizing at the time of shipment under Previous IFRS. Contract liabilities are recognized into revenue. The following table shows the adjustments for each individual financial statement line item in the current reporting period by the application of this Standard as compared to IAS 11, IAS 18 and related interpretations that were in effect before the change. Consolidated Statement of Financial Position Contract asset Inventory Contract liability Accumulated deficit Accumulated other comprehensive income Consolidated Statement of Loss Revenue Cost of Sales Other comprehensive loss Previous IFRS Adjustment Current IFRS December 31, 2018 $- 41,223 12,142 139,176 5,160 169,589 156,996 4,766 $24,762 (25,622) (7,143) (6,298) (15) 1,121 (1,243) (15) $24,762 15,601 4,999 132,878 5,145 170,710 155,753 4,751 As required for the consolidated financial statements, the Corporation disaggregated revenue recognized from contracts with customers into categories that depict how the nature and amount are affected by economic factors, refer to note 33 for the disclosure on disaggregated revenue. Page 15 Avcorp Industries Inc. annual report 2018 Operations Overview Delivery and Quality Performance Deliveries and quality performance as at December 31, 2018 for Canadian and US manufacturing operations were at customer required levels. The manufacturing operations have achieved, and continue to maintain, top quality and delivery ratings for the majority of their programs. Order Backlog Avcorp Group operates within “general terms agreements” with its customers. These agreements are typically for five years or longer. The Company’s agreements with Boeing Commercial Airplane Group extend from January 2018 to December 2022; additional production contracts entered into during 2015 and 2016 extend to 2025. Agreements with Boeing Defense, Space and Security extend from 2013 into 2020 with established minimum base delivery quantity requirements. The Bombardier and Subaru agreements extend for the life of the individual aircraft programs. Agreements with Lockheed Martin extend into 2020. Agreements with BAE Systems (Operations) Limited extend into 2019 and continue to generate additional sales order backlog. The Company defines order backlog as the value of purchase orders it expects to receive from these agreements based on manufacturers’ projections and current degrees of exclusivity. Order backlog is a financial measure not recognized as a term under IFRS. However, the Avcorp’s management believes that the Company’s stakeholders consider this metric to be useful information to assist them in evaluating profitability. The order backlog, as at December 31, 2018, is $839 million in consideration of attaining full award values, compared to $879 million as at December 31, 2017. The changes in order backlog are as follows: $171 million decrease in order backlog resulting from revenues recorded during the year ended December 31, 2018; $69 million increase in order backlog due to increases in the production rates, contract renewals for various existing programs, and contract awards; and $62 million increase in order backlog resulting from change in the value of the Canadian dollar relative to the US dollar for the Company’s US dollar denominated sales. Refer to comments on currency risk. Supply Chain Supplier quality and delivery performance continued to meet targeted levels during the year; the Company continues to monitor supplier performance in all aspects of quality, delivery and price. The Company works closely with its supply chain to ensure a stable, uninterrupted delivery of compliant products and is making changes in product sourcing processes where necessary. The capacity and delivery performance of a limited number of critical vendors continues to be closely monitored to mitigate risks to assembly start dates. Risk mitigation plans have been implemented. The securing of additional long term contracts with key suppliers continues. Critical supplier cost reduction initiatives are in process, and continuing into the future. Working Capital Utilization Total current assets less total current liabilities were in a deficit position of $71,503,000 at December 31, 2018 and a $63,038,000 deficit position at December 31, 2017. However, the Company’s accounts receivable, contract assets, and inventories net of accounts payable, amount to a $22,000,000 surplus as at December 31, 2018 (December 31, 2017: $38,464,000 surplus). Financial Resources Avcorp Group has invested in its chosen strategies of organic growth, capabilities acquisition, lean manufacturing and strategic outsourcing. Management believes that significant investments necessary to better position Avcorp Group in the aerospace industry have and continue to be made, and that those investments along with the expected continued financial support of shareholders and lenders position the Company to be able to face and mitigate risks associated with the business. Non-Financial Resources The Company’s non-financial resources relate to the Company’s human resources, operating equipment, business systems, technologies, processes and qualifications. The Company does not have any extended enterprise relationships such as special purpose entities or joint ventures. Human Resources The number of employees at December 31, 2018 was 674 (December 31, 2017: 728). The reduction in the number of employees during 2018 occurred primarily as a result of certain production programs being wound down in the Gardena facility. Page 16 Avcorp Industries Inc. annual report 2018 Equipment, Systems, Technologies and Processes Manufacturing equipment and information technology assets have been consistently upgraded and further deployed, increasing reliability and utility. Risk Assessment The principal risks that Avcorp Group faces are summarized as follows: additional financing is required to maintain and grow its business; no agreement on extension of customer contracts, or terminated customer programs are not replaced; increases in material costs, primarily aluminum plate, composite materials, titanium, sandwich panels and assembly hardware, and subcontractor costs, without equivalent price protection in customer contracts; reduction in production rates of aircraft manufacturers and delays in program introduction; consolidation and globalization by competitors; potential failure to achieve cost-reduction objectives relative to changes in revenue levels; and increase in the value of the Canadian dollar, relative to the US dollar, has an adverse effect on the US dollar equivalent value of those Company procured goods and services which are denominated in Canadian dollars. The Company’s view is that with its strategic plan in place and the continued integration of composite design and manufacturing capabilities, the Company should be in a position to face and mitigate these risks. However, there can be no assurance that the Company will be successful with all initiatives. Additional Financing Avcorp Group’s growth strategy requires continued access to capital. From time to time, the Company may require additional financing to enable it to: finance unanticipated working capital requirements; finance transitional operating losses incurred upon integration of acquired entities; finance new program development and introduction; develop or enhance existing services and capabilities; respond to competitive pressures; or finance business acquisitions. On May 26, 2017, the Company entered into a loan agreement to expand its existing credit facility by an additional borrowing capacity of up to USD$35,000,000; providing a total borrowing capacity of USD$58,000,000 until June 30, 2020. On March 28, 2018, the Company entered into an amendment to its existing credit facility, which provides an additional borrowing capacity of up to USD$10,000,000 and is due on March 31, 2019. On May 25, 2018, the Company entered into an amendment to its existing credit facility with a Canadian chartered bank whereby the maximum availability under the Revolving Loan cannot exceed USD$68,000,000 less USD$4,300,000, until August 31, 2018, at which time the agreement reverts back to existing terms. On September 5, 2018, the Company entered into an amendment to its existing credit facility with a Canadian chartered bank whereby the following amendment was made: Maximum availability under the Revolving Loan cannot exceed USD$68,000,000 less USD$4,300,000, until September 30, 2018, at which time the agreement reverts back to existing terms. On September 28, 2018, the Company entered into an amendment to its existing credit facility with a Canadian chartered bank whereby the following amendment was made: Maximum availability under the Revolving Loan cannot exceed USD$68,000,000 less USD$4,300,000, until December 30, 2018, at which time the agreement reverts back to existing terms. On November 27, 2018, the Company entered into an amendment to its existing credit facility with a Canadian chartered bank whereby the following amendment was made: Maximum availability under the Revolving Loan cannot exceed USD$68,000,000 less USD$4,300,000, until January 31, 2019, at which time the agreement reverts back to existing terms. On January 31, 2019, the Company entered into an amendment to its existing credit facility with a Canadian chartered bank whereby the following amendment was made: Maximum availability under the Revolving Loan cannot exceed USD$68,000,000 less USD$4,300,000, until March 31, 2019, at which time the agreement reverts back to existing terms. Page 17 Avcorp Industries Inc. annual report 2018 On March 28, 2019, the Company entered into an amendment to its existing credit facility with a Canadian chartered bank whereby the following amendments were made: Maximum availability under the Revolving Loan cannot exceed USD$68,000,000 less USD$4,300,000, until April 30, 2019, at which time the agreement reverts back to existing terms. Availability under the Revolving Loan was increased on March 28, 2018, by USD$10,000,000 (“Expanded Loan”), subject to existing drawdown provisions, interest rates and bonus fees. Drawdowns under the Expanded Loan are supported by a major and material customer of the Company by way of a guarantee. The maturity of the Expanded Loan has been extended from March 31, 2019 to April 30, 2019. The Company ended the year with bank operating line utilization of $85,840,000 offset by $2,051,000 cash compared to utilization of $61,283,000 with $5,212,000 cash on hand as at December 31, 2017. Based on net collateral provided to its bank, the Company was able to draw up to an additional USD$776,000 on its operating line of credit as at December 31, 2018 (December 31, 2017: USD$9,149,000). As at the date of this report the Company is able to draw up to an additional USD$9,659,000 on its operating line of credit. The Company cannot provide assurance that, if it needs to raise additional funds, such funds will be available on favourable terms, or at all. If the Company cannot raise adequate funds on acceptable terms, its business could be materially harmed. Customer Contracts The Company is exposed to the risk that existing customer fixed-term contracts are not renewed at expiration date. Avcorp Group operates within “general terms agreements” with its customers. These agreements are typically for five years or longer. The Company’s agreements with Boeing CA extend from current date, with various expiry timelines, through to the end of 2028. Agreements with Boeing DSS have been renewed and established which extend from 2013 into 2020 with minimum base quantity requirements. It is the Company’s objective to successfully renew Boeing production contracts in advance of expiry dates. The Bombardier and Subaru agreements extend for the life of the individual aircraft programs. BAE and Lockheed Martin customer contracts extend into 2020. The Company is currently negotiating the extension of follow-on contracts. The Company continues to face the financial risk that the wind-down in previous years of certain program contracts have not been replaced on a timely basis thereby causing the Company to continue to bear significant levels of expenses related to under-utilized operational capacity. The Company has restructured its business development strategy in order to best mitigate this risk and is now commencing to be awarded new customer production contracts. Procured Materials and Parts The Company is engaging suppliers and customers to properly align production requirements and pricing, ensuring uninterrupted delivery of compliant products with a cost structure closely matching product pricing. Changes in forecasts are closely monitored in order to promptly adjust procured materials and parts quantities with the objective of limiting unwanted inventory build-up. Aircraft Production Rates The following industry and program trends impact the Company: Company research indicates that the aerostructures markets for commercial aircraft and larger business jets would continue to grow beyond 2018. Growth in air travel rates has and will further increase production rates on the Boeing 737 and Airbus A320 platforms in the coming years. Bombardier Challenger CL650 aircraft production requirements increased in 2017 relative to 2016, and are forecasted to remain substantially flat through 2020. The global market for defence aircraft has continued growth expected for 2019. The F-35 remains, on a global scale, one of the largest Defence Airplane programs for the foreseeable future. Offset opportunities created by Canadian Government procurement within military aerospace programs such as the Boeing F-18 and Airbus C295 FWSAR could lead to additional revenue opportunities from this aerospace sector. Competitors The long-term trend continues towards more intense competition from larger entities having operations in Asia, Mexico and Europe, while original equipment manufacturers continue to increase the size and amount of outsourced components. It can be expected that consolidation on Tier 1 and Tier 2 levels will continue to take place. The Company continues to examine opportunities for mergers or acquisitions, on a global basis, that would improve competitiveness and acquire vertical strengths or additional strategic capabilities. Page 18 Avcorp Industries Inc. annual report 2018 Cost Reductions Approximately 52% of Avcorp Group’s cost of sales is related to labour and overhead and 48% related to procurement of raw materials and finished parts. The Company’s wage rates are generally lower than its western European and north western United States competitors and higher than those in the south eastern United States, Asia, Eastern Europe and Mexico. On July 30, 2013 the labour force, at the Delta facility ratified a six year collective agreement. The Company’s current six year collective agreement with its labour force expires on March 31, 2019. The parties have commenced bargaining. The collective agreement contains bridging language that extends the terms of the contract while the parties are bargaining the renewal. Subsequent to the Hitco acquisition the Company and the labour force, in Gardena, agreed to a four month extension of the current collective agreement, which was to expire February 29, 2016. On June 29, 2016 the labour force at the Gardena facility ratified a six-year collective agreement, adding language that allows for High Performance Work Teams and incentive bonus payments for accomplishing annual targets regarding operational and quality performance. The Company continues to focus on cost reductions for direct labour, material and overhead costs. These cost reductions will be achieved through continuous improvements in the internal and external parts supply chain using lean manufacturing technology, through continued negotiation of long-term agreements with the majority of key suppliers, through increased efficiency of plant capacity augmented by technological improvements, and through continued focus on cost targets at all levels of the organization. All discretionary spending is reviewed and controlled by senior management, with expenditures focused on expediting new commercial program business growth and launching of long-term defence programs. However, fixed overhead costs continue to have an adverse impact on the Company’s cost structure during this period of reduced revenues. This will be mitigated by increased revenue and facility utilization. US Dollar Revenues Avcorp Group sells a significant proportion of its products in US dollars, partially from its Canadian operations and entirely within its United States operations, at prices which are often established well in advance of manufacture and shipment dates. As the value of the Canadian dollar decreases, the equivalent value of US dollar denominated revenues increases; conversely, the cost of US dollar denominated purchases will increase. The Company is continuing to structure new agreements with customers which mitigate the risk associated with currency fluctuations. It should be noted that a significant portion of the Company’s purchases of raw materials, supplier fabricated parts, as well as equipment purchases, are denominated in US dollars. Outlook Variability of the Canadian dollar relative to the US dollar continues to cause the value of the Company’s current order backlog to fluctuate. Also, the Company continues to work towards securing additional defence and commercial program production contracts in order to augment and diversify its backlog. The Company began delivering products under its defence contracts in 2009 and continues to negotiate long-term supply agreements. Both defence and commercial production contracts are being renewed, with select new customer agreements extending into 2028. The Company expects to finance investment in the start-up of new production programs primarily by milestone payments from customers, though this cannot be assured. Avcorp Group may require financing for capital expenditures and start-up costs required for new programs. Boeing is the Company’s largest customer during 2018, followed by Lockheed Martin, Subaru, Bombardier, and BAE Systems. The Company forecasts its 2019 revenues to increase due to orders received for defence related program deliveries, and Delta production ramp-up for recently awarded contracts (exclusive of the amortization into revenue of the unfavourable contract liability). The Company forecasts its working capital financing requirements for 2019 to be met by the operating line of credit, and working capital surplus (exclusive of bank indebtedness). Working capital financing has been supplemented, at times, by shareholder loans and consideration received as a result of the Hitco acquisition. However, further debt and equity financing may be required. On March 28, 2018, the Company entered into an amendment to its existing credit facility (“Revolving Loan”) with a Canadian chartered bank whereby the following amendments were made: Availability under the Revolving Loan is increased by USD$10,000,000 (“Expanded Loan”) subject to existing drawdown provisions, interest rates and bonus fees; Drawdowns under the Expanded Loan are supported by a major and material customer of the Company by way of a guarantee; and The Expanded Loan matures on March 31, 2019. On May 25, 2018, the Company entered into an amendment to its existing credit facility with a Canadian chartered bank whereby the following amendment was made: Maximum availability under the Revolving Loan cannot exceed USD$68,000,000 less USD$4,300,000, until August 31, 2018, at which time the agreement reverts back to existing terms. Pursuant to the terms of the loan agreement, the Company is required to meet certain covenants. The Company is in breach of certain covenants pursuant to the terms of the loan agreement and accordingly an event of default had occurred that requires remediation. On September 5, 2018, the Company entered into an amendment to its existing credit facility with a Canadian chartered bank whereby the following amendment was made: Maximum availability under the Revolving Loan cannot exceed USD$68,000,000 less USD$4,300,000, until September 30, 2018, at which time the agreement reverts back to existing terms. Page 19 Avcorp Industries Inc. annual report 2018 On September 28, 2018, the Company entered into an amendment to its existing credit facility with a Canadian chartered bank whereby the following amendment was made: Maximum availability under the Revolving Loan cannot exceed USD$68,000,000 less USD$4,300,000, until December 30, 2018, at which time the agreement reverts back to existing terms. On November 27, 2018, the Company entered into an amendment to its existing credit facility with a Canadian chartered bank whereby the following amendment was made: Maximum availability under the Revolving Loan cannot exceed USD$68,000,000 less USD$4,300,000, until January 31, 2019, at which time the agreement reverts back to existing terms. On January 31, 2019, the Company entered into an amendment to its existing credit facility with a Canadian chartered bank whereby the following amendment was made: Maximum availability under the Revolving Loan cannot exceed USD$68,000,000 less USD$4,300,000, until March 31, 2019, at which time the agreement reverts back to existing terms. On March 28, 2019, the Company entered into an amendment to its existing credit facility with a Canadian chartered bank whereby the following amendments were made: Maximum availability under the Revolving Loan cannot exceed USD$68,000,000 less USD$4,300,000, until April 30, 2019, at which time the agreement reverts back to existing terms. Availability under the Revolving Loan was increased on March 28, 2018, by USD$10,000,000 (“Expanded Loan”), subject to existing drawdown provisions, interest rates and bonus fees. Drawdowns under the Expanded Loan are supported by a major and material customer of the Company by way of a guarantee. The maturity of the Expanded Loan has been extended from March 31, 2019 to April 30, 2019. The Company cannot provide assurance that, if it needs to raise additional funds, such funds will be available on favourable terms, or at all. If the Company cannot raise adequate funds on acceptable terms, its business could be materially harmed. Transactions with Related Parties Periodically, consulting services are provided by certain directors. Fees paid to certain directors, or companies with which they have beneficial ownership, during the year ended December 31, 2018 amounted to $Nil (December 31, 2017: $437,000). Fees payable to certain directors or Companies with which they have beneficial ownership, as at December 31, 2018 are $Nil (December 31, 2017: $Nil). These fees are included in the Consolidated Statements of Income (Loss) and Comprehensive Income (Loss) as administrative and general expenses and amount to $Nil for the year ended December 31, 2018 (December 31, 2017: $61,000). Key management includes Executive Officers for all operating facilities. The compensation paid or payable to key management for employee services is shown below. KEY MANAGEMENT COMPENSATION (expressed in thousands of Canadian dollars) Salaries and other short-term employee benefits Contributions to defined contribution plan Option-based awards 2018 $2,150 67 164 2,381 2017 $2,285 75 659 3,019 The balance of loans receivable from key management as at December 31, 2018 is $15,000 (December 31, 2017: $15,000). These loans are unsecured and payable on demand. Other related party transactions are disclosed elsewhere in these consolidated financial statements. These transactions were conducted in the normal course of business and were accounted for at the exchange amount. Business Acquisition As at the date of this report, no agreements to merge with or acquire another entity have been entered into. Fourth Quarter The following summarizes unaudited financial results for the fourth quarter 2018. Operating loss for the fourth quarter of 2018 was $9,833,000 from $39,280,000 in revenues, as compared to operating loss of $27,342,000 from $37,923,000 in revenues for the quarter ended December 31, 2017. The Company expensed $3,602,000 of overhead costs during the fourth quarter 2018 (2017: $1,013,000) in respect of unutilized plant capacity. Provision amortization for onerous contracts accrued during the fourth quarter 2018 totalled $3,739,000 (December 31, 2017: $13,603,000 provision). The Company has provisioned for a claim asserted by a customer in the amount of $7,640,000. Page 20 Avcorp Industries Inc. annual report 2018 Critical Accounting Estimates and Judgment The preparation of consolidated financial statements in conformity with IFRS requires management to make estimates and judgments that affect the amounts which are reported in the consolidated financial statements during the reporting period. Estimates and other judgments are evaluated at each reporting date and are based on management’s experience and other factors, including expectations about future events that are believed to be reasonable under the circumstances. The critical estimates and judgements utilized in preparing the Company’s consolidated financial statements affect the assessment of net recoverable amounts, net realizable values and fair values, and the determination of functional currency of the Canadian operations of the group. Any changes in estimates and assumptions could have a material impact on the assets and liabilities at the date of the statement of financial position. The Company reviews its estimates and assumptions on an ongoing basis and uses the most current information available and exercises careful judgement in making these estimates and assumptions. Functional currency: The functional currency for the Company and its subsidiaries is the currency of the primary economic environment in which each operates. The Company has determined that the functional currency for the Company and all its subsidiaries except for Avcorp US Holdings Inc. and ACF is the Canadian dollar. The functional currency for Avcorp US Holdings Inc. and ACF is the US dollar. The determination of functional currency may require certain judgements to determine the primary economic environment. The Company reconsiders the functional currency used when there is a change in events and conditions which determined the primary economic environment. Impairments: The recoverable amount of intangible assets, development costs and property, plant and equipment is based on estimates and assumptions regarding the expected market outlook and cash flows from each CGU or group of CGUs. In order to estimate the fair value of indefinite-lived intangible assets and goodwill resulting from business combinations, the Company typically estimates future revenue, considers market factors and estimates future cash flows. Based on these key assumptions, judgments and estimates, the Company determines whether to record an impairment charge to reduce the value of the asset carried on the consolidated statement of financial position to its estimated fair value. Assumptions, judgments and estimates about future values are complex and often subjective. They can be affected by a variety of factors, including external factors such as industry and economic trends, and internal factors such as changes in the Company’s business strategy or internal forecasts. Although the Company believes the assumptions, judgments and estimates made in the past have been reasonable and appropriate, different assumptions, judgments and estimates could materially affect the Company’s reported financial results. Going concern: Management assesses the Company’s ability to continue as a going concern at each reporting date, using quantitative and qualitative information available. This assessment, by its nature, relies on estimates of future cash flows and other future events, whose subsequent changes would materially impact the validity of such an assessment. Capitalization of development costs: When capitalizing development costs the Company must assess the technical and commercial feasibility of the projects and estimate the useful lives of resulting products. Determining whether future economic benefits will flow from the assets and therefore the estimates and assumptions associated with these calculations are instrumental in (i) deciding whether project costs can be capitalized, and (ii) accurately calculating the useful life of the projects for the Company. Unfavourable contracts liability: At the acquisition date valued the unfavourable contracts liability at fair value using certain assumptions that would arise in a market participant view. The Company estimates the expected shipsets or production when assessing the liability, together with the discounts rate and period of performance under the varying contracts and service agreements. The cash flows are discounted over the period of performance using a discount rate commensurate with the risk associated with the liability. During 2018 production requirements associated with the unfavourable contract were redirected to another supplier, giving rise to the full amortization of the unfavourable contract liability and the onerous contract provision into income. In addition, the customer advance was adjusted to its face value through income. This has been recorded in Consolidated Statements of Income (Loss) and Comprehensive Income (Loss) as a contract modification in the amount of $41,470,000. Uncertainties exist as to ultimate outcome of a formal contract termination. While the Company believes that it has fulfilled all of its obligations under the contract, it is possible claims may be levied against the Company. The Company has assessed such possible claims as not probable. Inventories are valued at the lower of cost and net realizable value. The costs of inventory involve estimates in determining the allocation of fixed and variable production overhead. These estimates involved include determination of normal production capacity and nature of expenses to be allocated. Additionally inventory is reviewed monthly to ensure the carrying value does not exceed net realizable value. If so, a write-down is recognized. The write-down may be reversed if the circumstances which caused it no longer exist. On a periodic basis the Company reviews its plant capacity and estimates the portion of its under-utilized overhead expenditures. The Company has expensed $6,469,000 of overhead costs during the current year (December 31, 2017: $4,309,000) in respect of unutilized plant capacity. These amounts are included in the Consolidated Statements of Loss and Comprehensive Loss as costs of sales. The Company has entered into production contracts in the ordinary course of its business. The unavoidable cost of meeting the obligations under certain of these contracts exceeds the associated expected future net benefits; consequently, an onerous contract provision has been recognized. The calculation of this provision involves the use of estimates including, but not limited to, program gross margin, and the effect of learning curves of production and the timing of achieving certain operational efficiencies. These actual results can vary significantly from these estimates with consequent variability in the amounts of the provision recorded. The onerous contract provision is calculated by taking the expected future costs that will be incurred under the contract and deducting any estimated revenues. The onerous contract provision is primarily due to a high cost structure and learning curves of production that cannot be recovered through current pricing of the associated contracts. The current portion of the onerous contract provision for the year ended December 31, 2018 is $1,809,000 (December 31, 2017: $7,297,000). The onerous contract provision for the year ended December 31, 2018 is $1,930,000 (December 31, 2017: $13,366,000). Page 21 Avcorp Industries Inc. annual report 2018 While a formal claim has yet to be levied by the customer, the Company has provisioned for a claim asserted by a customer in the amount of $7,640,000. Financial Instruments and Other Instruments Market Risk Market risk is the risk that changes in the market prices, such as foreign exchange rates and interest rates, will affect the Company’s income or the value of its holdings of financial instruments. The Company’s policy is not to utilize derivative financial instruments for trading or speculative purposes. The Company may utilize derivative instruments in the management of its foreign currency and interest rate exposures. Currency Risk Currency risk arises because the amount of the local currency receivable or payable for transactions denominated in foreign currencies may vary due to changes in exchange rate (“transaction exposures”) and because the non-Canadian dollar denominated financial statements of the Company’s subsidiaries may vary on consolidation into the reporting currency of Canadian dollars (“translation exposures”). The Company sells a significant proportion of its products in US dollars at prices which are often established well in advance of manufacture and shipment dates. In addition, the Company purchases a significant proportion of its raw materials and components in US dollars at prices that are usually established at the order date. The Company’s operations are based in Canada and in the US. As a result of this, the Company is exposed to currency risk to the extent that fluctuations in exchange rates are experienced. The amount of foreign exchange loss recorded for the year ended December 31, 2018 is $770,000 (December 31, 2017: $1,944,000 loss). The Company had the following US dollar denominated balances: CURRENCY RISK (expressed in thousands of dollars) FOR THE QUARTER ENDED DECEMBER 31 2018 (expressed in USD) 2017 (expressed in USD) Bank cash position Accounts receivable Accounts payable Customer advance Bank indebtedness Term debt $1,050 12,996 8,838 4,643 62,924 3,633 $2,929 9,749 2,111 - 48,851 868 With other variables unchanged, each $0.10 strengthening (weakening) of the CAD against the USD would result in an increase (decrease) of approximately $6,135,000 in net income for the year ended December 31, 2018 as a result of holding a net liability position in USD as at December 31, 2018. As at December 31, 2017, a $0.10 strengthening (weakening) of the CAD against the USD would result in a (decrease) increase of approximately $3,915,000 in net income for the year ended December 31, 2017 as a result of holding a net USD asset position in as at December 31, 2017. Credit Risk Credit risk is the risk of a financial loss to the Company if a customer or counterparty to a financial instrument fails to meet its contractual obligation. The Company manages credit risk for trade and other receivables through a financial review of the credit worthiness of the prospective customer along with credit monitoring activities. The majority of the Company’s trade receivables reside with Boeing Commercial Airplane Group (“Boeing”), Boeing Defense, Space & Security (“BDS”), Bombardier Aerospace (“Bombardier”), BAE Systems (Operations) Limited (“BAE”), Lockheed Martin (“LM”), and Subaru Corporation (“Subaru”). The maximum exposure to credit risk is represented by the amount of accounts receivable in the consolidated statements of financial position. As at the consolidated statements of financial position date 90.8% (December 31, 2017: 86.6%) of the Company’s trade accounts receivable are attributable to these customers. The Company is exposed to credit risk if counterparties to its trade receivables are unable to meet their obligations. The concentration of credit risk from its customers is minimized because the Company has an original equipment manufacturer and tier one aerospace customer base as at December 31, 2018. The customers are predominately large, well-capitalized, and long established entities with a low risk of non-payment. The Company regularly monitors its credit risk and credit exposure. Page 22 Avcorp Industries Inc. annual report 2018 Liquidity Risk Liquidity risk is the risk that the Company will not be able to meet its financial obligations as they fall due. The Company seeks to manage liquidity risk through the management of its capital structure and financial leverage. Accounts payable and accrued liabilities are all due within the next twelve months. The Company’s operating line of credit is due on demand. During the year ended December 31, 2018, the Company had a net income of $20,373,000 (December 31, 2017: net loss of $58,838,000), had negative operating cash flows of $16,029,000 (December 31, 2017: negative $42,604,000) and a shareholders’ deficiency of $36,144,000 as of December 31, 2018 (December 31, 2017: $57,405,000 deficiency) and an accumulated deficit of $132,878,000 (December 31, 2017: $157,185,000). Management assesses the Company’s ability to continue as a going concern at each reporting date, using quantitative and qualitative information available including contract modification associated to an unfavourable contract, and the past due date of its customer advance. Material uncertainties have been identified which may cast significant doubt upon the Company’s ability to continue as a going concern. This assessment, by its nature, relies on estimates of future cash flows and other future events, whose subsequent changes would materially impact the validity of such an assessment. During 2018 production requirements associated with a certain unfavourable contract were redirected to another supplier, giving rise to the full amortization of the unfavourable contract liability and related onerous contract provision into income. This has been recorded in Consolidated Statements of Income (Loss) and Comprehensive Income (Loss) as a contract modification in the amount of $41,470,000. On August 20, 2018, the Company entered into a settlement agreement with a customer, in the amount of $2,219,000, which provided the Company a net settlement in satisfaction of existing and potential claims, causes of action, and disputes between the Company and its customer. The Company’s ability to continue as a going concern is dependent upon its ability to successfully negotiate extended terms with its creditors to continue to raise adequate financing and achieve significant improvements in operating results in the future. In assessing whether the going concern assumption was appropriate, management took into account all relevant information available about the future, which was at least, but not limited to, the 12 month period from the date of this report. The Company, in conjunction with its Board of Directors, is currently implementing various financing strategies which include: On May 26, 2017, the Company entered into a loan agreement to expand its loan facility with a Canadian Chartered bank. This loan agreement amends, restates and replaces the loan agreement entered into on September 27, 2012. This Revolving Loan provides an additional borrowing capacity of up to USD$35,000,000 increasing its existing, as at March 30, 2017, USD$23,000,000 revolving loan in total up to USD$58,000,000. The loan agreement matures on June 30, 2020. On March 28, 2018, the Company entered into an amendment to its existing credit facility with a Canadian chartered bank whereby the following amendments were made: Availability under the Revolving Loan is increased by USD$10,000,000 (“Expanded Loan”) subject to existing drawdown provisions, interest rates and bonus fees; Drawdowns under the Expanded Loan are supported by a major and material customer of the Company by way of a guarantee; and The Expanded Loan matures on March 31, 2019. On May 25, 2018, the Company entered into an amendment to its existing credit facility with a Canadian chartered bank whereby the following amendment was made: Maximum availability under the Revolving Loan cannot exceed USD$68,000,000 less USD$4,300,000, until August 31, 2018, at which time the agreement reverts back to existing terms. On September 5, 2018, the Company entered into an amendment to its existing credit facility with a Canadian chartered bank whereby the following amendment was made: Maximum availability under the Revolving Loan cannot exceed USD$68,000,000 less USD$4,300,000, until September 30, 2018, at which time the agreement reverts back to existing terms. On September 28, 2018, the Company entered into an amendment to its existing credit facility with a Canadian chartered bank whereby the following amendment was made: Maximum availability under the Revolving Loan cannot exceed USD$68,000,000 less USD$4,300,000, until December 30, 2018, at which time the agreement reverts back to existing terms. On November 27, 2018, the Company entered into an amendment to its existing credit facility with a Canadian chartered bank whereby the following amendment was made: Maximum availability under the Revolving Loan cannot exceed USD$68,000,000 less USD$4,300,000, until January 31, 2019, at which time the agreement reverts back to existing terms. On January 31, 2019, the Company entered into an amendment to its existing credit facility with a Canadian chartered bank whereby the following amendment was made: Maximum availability under the Revolving Loan cannot exceed USD$68,000,000 less USD$4,300,000, until March 31, 2019, at which time the agreement reverts back to existing terms. Page 23 Avcorp Industries Inc. annual report 2018 On March 28, 2019, the Company entered into an amendment to its existing credit facility with a Canadian chartered bank whereby the following amendments were made: Maximum availability under the Revolving Loan cannot exceed USD$68,000,000 less USD$4,300,000, until April 30, 2019, at which time the agreement reverts back to existing terms. Availability under the Revolving Loan was increased on March 28, 2018, by USD$10,000,000 (“Expanded Loan”), subject to existing drawdown provisions, interest rates and bonus fees. Drawdowns under the Expanded Loan are supported by a major and material customer of the Company by way of a guarantee. The maturity of the Expanded Loan has been extended from March 31, 2019 to April 30, 2019. The Company ended the year with bank operating line utilization of $85,840,000 offset by $2,051,000 cash compared to utilization of $61,283,000 with $5,212,000 cash on hand as at December 31, 2017. Based on net collateral provided to its bank, the Company was able to draw up to an additional USD$776,000 on its operating line of credit as at December 31, 2018 (December 31, 2017: USD$9,149,000). As at the date of this report the Company is able to draw up to an additional USD$9,659,000 on its operating line of credit. Pursuant to the Hitco acquisition, the Company assumed a customer advance for pre-funding of product deliveries. The customer advance is re-paid as the Company delivers to its customer ordered products for a specific program. In the event that cancellation, termination, or assignment of the statement of work occurs earlier than December 31, 2018, the customer shall have the right to recover from the Company, within 120 days of such an event, the unamortized portion of the cash advance; such event occurred during the third quarter 2018. The customer advance is subject to an access and security agreement along with a general security agreement entered into with the Company’s bank and the customer. The face value of the unamortized portion of the cash advance as at December 31, 2018 is USD$4,643,000 (December 31, 2017: USD$7,219,000). The Company, in conjunction with is Board of Directors continue to carry out various operational strategies which include: Operating and warranty issues at ACF were the largest cause of the Company’s 2016 losses. Technical quality issues which were discovered by the Company soon after the Hitco acquisition created additional compliance costs during 2016. Management has resolved these technical quality issues such that they did not re-occur in 2017 and going forward. Furthermore, the Company has received notification from its customers that these quality issues have been appropriately resolved. All personnel resources and support service provider costs incurred during 2016 as a result of these issues have been terminated. The significant product scrap and re-work costs have been processed and expensed and one-time expenditures for equipment upgrades have been completed. Numerous process improvements initiatives, restructuring activities and supplier contract renegotiations have significantly reduced production costs on a go forward basis. These cost reduction initiatives have included significant headcount reductions the latest of which were announced in April 2017 and continued through the second half of 2017 and into 2018. Contract renegotiations with customers and new customer contracts have provided an improved basis for operations in the future. Close collaboration with customers has resulted in both financial and operational support for continued operations. The assessment of the Company’s ability to execute its strategy of reducing operating costs and funding future working capital requirements involves significant judgement. Estimates and assumptions regarding future operating costs, revenue and profitability levels and general business and customer conditions are continually evaluated and are based on historical experience and other factors, including expectations of future events that are believed to be reasonable under the circumstances. Management is actively working to secure additional production orders, extension to its banking agreements, will continue to work with existing common shareholders, and will seek additional financing as necessary. The Company cannot provide assurance that, if it needs to raise additional funds, such funds will be available on favourable terms, or at all. If the Company cannot raise adequate funds on acceptable terms, its business could be materially harmed. Interest Rate Risk The Company is exposed to interest rate risk on the utilized portion of its operating line of credit. Interest rate for advances made up to the maximum of the allowable borrowing base on the existing USD$23,000,000 revolving loan: RBP plus 0.75% per annum RBUSBR plus 0.75% per annum BA Equivalent Rate plus 2.25% per annum LIBOR Rate plus 2.25% per annum Interest rate for advances made on the additional borrowing capacity up to USD$58,000,000. RBP plus 0.00% per annum RBUSBR plus 0.00% per annum BA Equivalent Rate plus 0.875% per annum LIBOR Rate plus 0.875% per annum Page 24 Avcorp Industries Inc. annual report 2018 There is uncertainty as to the continued use of LIBOR in the future. LIBOR is the subject of recent national, international and other regulatory guidance and proposals for reform. These reforms and other pressures may cause LIBOR to be eliminated or to perform differently than in the past. The consequences of these developments cannot be entirely predicted, but could include an increase in the cost of our variable rate indebtedness and obligations. Drawdown under the USD$35,000,000 additional borrowing capacity is supported by a major and material customer of the Company by way of a guarantee. The Company will provide the guarantor, as consideration for the guarantee, a fee equal to 5.375% of the weighted average outstanding balance of the guaranteed portion over each full twelve (12) month period commencing on the funding date plus, for the partial year thereafter, 5.375% of the weighted average outstanding balance of the guaranteed portion multiplied by the number of days in the partial year divided by three hundred sixty (360). The fee will be payable on the maturity date. The maximum operating line of credit availability is USD$68,000,000 (providing approximately CDN$92,766,000 of liquidity) of which $85,840,000 is utilized as at December 31, 2018 (December 31, 2017: $61,283,000). Based on net collateral provided to its bank, the Company was able to draw up to an additional USD$776,000 on its operating line of credit as at December 31, 2018 (December 31, 2017: USD$9,149,000). The Company lowers interest rate costs by managing utilization of the operating lines of credit to the lowest amount practical. For the year ended December 31, 2018, with other variables unchanged, a 1% change in the base borrowing rate would have an $858,000 (December 31, 2017: $613,000) impact on net earnings and cash flow. The Company primarily finances the purchase of long-lived assets at fixed interest rates. Capital Risk The Company’s objectives when managing capital are to safeguard its ability to continue as a going concern and to provide an adequate return to shareholders, while satisfying other stakeholders. The Company includes long-term debt and capital stock in its definition of capital, as shown in the Company’s consolidated statements of financial position. The Company’s primary objective in its management of capital is to ensure that it has sufficient financial resources to fund ongoing operations and new program investment. In order to secure this capital the Company may attempt to raise funds via issuance of debt and equity, or by securing strategic partners. Other Items Disclosure Controls and Procedures, and Internal Controls over Financial Reporting In accordance with the Canadian Securities Administrators Multilateral Instrument 52-109, the Company has filed certificates signed by the Chief Executive Officer and the Chief Financial Officer that, among other things, report on the design of disclosure controls and procedures and the design of internal control over financial reporting. These certificates can be found on www.sedar.com. The Company has continued to undertake to engage additional, qualified financial reporting expertise to assist with complex accounting matters, as well as develop the expertise of in-house staff ensuring that the Company’s tax accounting resources, processes and controls are designed and operating effectively. Furthermore, the Company is aligning its business systems within its two largest facilities in order to simplify and increase consistency of internal controls over financial reporting. Internal Controls over Financial Reporting The Chief Executive Officer (“CEO”) and the Chief Financial Officer (“CFO”) have designed internal controls over financial reporting, or have caused them to be designed under their supervision, in order to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with IFRS. An evaluation was carried out, under the supervision of the CEO and the CFO, of the design and effectiveness of our internal controls over financial reporting. Based on this evaluation, the CEO and the CFO concluded that the internal controls over financial reporting are effective, using the criteria set forth by the Committee of Sponsoring. Organizations of the Treadway Commission (COSO) on Internal Control – Integrated Framework (2013 Framework). Disclosure Controls and Procedures (“DCP”) The CEO and the CFO have designed disclosure controls and procedures, or have caused them to be designed under their supervision, in order to provide reasonable assurance that: material information relating to the Corporation has been made known to them; and information required to be disclosed in the Corporation’s filings is recorded, processed, summarized and reported within the time periods specified in securities legislation. An evaluation was carried out, under the supervision of the CEO and the CFO, of the design and effectiveness of our disclosure controls and procedures. Based on this evaluation, the CEO and the CFO concluded that the disclosure controls and procedures are effective. Page 25 Avcorp Industries Inc. annual report 2018 Forward Looking Statements This management discussion and analysis should be read in conjunction with the Company’s audited consolidated financial statements. Certain statements in this report and other oral and written statements made by the Company from time to time are forward-looking statements, including those that discuss strategies, goals, outlook or other non-historical matters; or projected revenues, income, returns or other financial measures. These forward-looking statements are subject to risks and uncertainties that may cause actual results to differ materially from those contained in the statements, including the following: (a) the ability of the Company to renegotiate its debt agreements under which it is in default; (b) the extent to which the Company is able to achieve savings from its restructuring plans; (c) uncertainty in estimating the amount and timing of restructuring charges and related costs; (d) changes in worldwide economic and political conditions that impact interest and foreign exchange rates; (e) the occurrence of work stoppages and strikes at key facilities of the Company or the Company’s customers or suppliers; (f) government funding and program approvals affecting products being developed or sold under government programs; (g) cost and delivery performance under various program and development contracts; (h) the adequacy of cost estimates for various customer care programs including servicing warranties; (i) the ability to control costs and successful implementation of various cost reduction programs; (j) the timing of certifications of new aircraft products; (k) the occurrence of further downturns in customer markets to which the Company products are sold or supplied or where the Company offers financing; (l) changes in aircraft delivery schedules, cancellation of orders or changes in production scheduling; (m) the Company’s ability to offset, through cost reductions, raw material price increases and pricing pressure brought by original equipment manufacturer customers; (n) the availability and cost of insurance; (o) the Company’s ability to maintain portfolio credit quality; (p) the Company’s access to debt financing at competitive rates; and (q) uncertainty in estimating contingent liabilities and establishing reserves tailored to address such contingencies. Page 26 Avcorp Industries Inc. annual report 2018 report of management The accompanying consolidated financial statements of Avcorp Industries Inc. and all other information contained in the Management Discussion and Analysis are the responsibility of management. The consolidated financial statements were prepared in conformity with International Financial Reporting Standards (“IFRS”) as issued by the International Accounting Standards Board (“IASB”) appropriate in the circumstances, and include some amounts based on management's best judgments and estimates. The financial information contained elsewhere in this Management Discussion and Analysis is consistent with that in the consolidated financial statements. Management is responsible for maintaining a system of internal accounting controls and procedures to provide reasonable assurance. As at the end of the period covered by this report, management identified material weaknesses as described in the Management Discussion and Analysis under the heading “Other Items”. During the period covered by this report, there has been no change in internal control over financial reporting that has materially affected, or is reasonably likely to materially affect, the issuer’s internal control over financial reporting. EDWARD MERLO Chief Financial Officer and Corporate Secretary AMANDEEP KALER Executive Officer and Group Chief Executive Officer Page 27 Avcorp Industries Inc. annual report 2018 independent auditor’s report To the Shareholders of Avcorp Industries Inc. Opinion We have audited the consolidated financial statements of Avcorp Industries Inc. and its subsidiaries (the “Group”), which comprise the consolidated statement of financial position as at December 31, 2018 and December 31, 2017, and the consolidated statements of income (loss) and comprehensive income (loss), the consolidated statement of changes in equity and the consolidated statement of cash flows for the years then ended, and notes to the consolidated financial statements, including a summary of significant accounting policies. In our opinion, the accompanying consolidated financial statements present fairly, in all material respects the consolidated financial position of the Group as at December 31, 2018 and December 31, 2017, and its consolidated financial performance and its consolidated cash flows for the years then ended in accordance with International Financial Reporting Standards (IFRSs). Basis for opinion We conducted our audit in accordance with Canadian generally accepted auditing standards. Our responsibilities under those standards are further described in the Auditor’s Responsibilities for the Audit of the Consolidated Financial Statements section of our report. We are independent of the Group in accordance with the ethical requirements that are relevant to our audit of the consolidated financial statements in Canada, and we have fulfilled our other ethical responsibilities in accordance with these requirements. We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our opinion. Material Uncertainty related to Going Concern We draw attention to Note 1 in the consolidated financial statements, which indicates the Group had a net income of $20,373,000 inclusive of a net gain on contract modification of $41,470,000, negative cash flows of $16,029,000, shareholders’ deficiency of $36,144,000, and an accumulated deficit of $132,878,000. In addition to the quantitative aspects noted, management considered qualitative information including contract modification associated to an unfavourable contract and the past due date of its customer advance. As stated in Note 1, these events or conditions indicate that a material uncertainty exists that may cast significant doubt on the Group’s ability to continue as a going concern. Our opinion is not modified in respect of this matter. Other information included in the Group’s 2018 Annual Report Management is responsible for the other information. The other information comprises: • Management’s Discussion and Analysis • The information, other than the consolidated financial statements and our auditor’s report thereon, in the Annual Report Our opinion on the consolidated financial statements does not cover the other information and we do not express any form of assurance conclusion thereon. In connection with our audit of the financial statements, our responsibility is to read the other information, and in doing so, consider whether the other information is materially inconsistent with the consolidated financial statements or our knowledge obtained in the audit or otherwise appears to be materially misstated. We obtained Management’s Discussion & Analysis and Annual Report prior to the date of this auditor’s report. If, based on the work we have performed, we conclude that there is a material misstatement of this other information, we are required to report that fact. We have nothing to report in this regard. Responsibilities of Management and Those Charged with Governance for the Consolidated Financial Statements Management is responsible for the preparation and fair presentation of the consolidated financial statements in accordance with IFRSs, and for such internal control as management determines is necessary to enable the preparation of consolidated financial statements that are free from material misstatement, whether due to fraud or error. In preparing the consolidated financial statements, management is responsible for assessing the Group’s ability to continue as a going concern, disclosing, as applicable, matters related to going concern and using the going concern basis of accounting unless management either intends to liquidate the Group or to cease operations, or has no realistic alternative but to do so. Those charged with governance are responsible for overseeing the Group’s financial reporting process. Page 28 Avcorp Industries Inc. annual report 2018 Auditor’s Responsibilities for the Audit of the Consolidated Financial Statements Our objectives are to obtain reasonable assurance about whether the consolidated financial statements as a whole are free from material misstatement, whether due to fraud or error, and to issue an auditor’s report that includes our opinion. Reasonable assurance is a high level of assurance, but is not a guarantee that an audit conducted in accordance with Canadian generally accepted auditing standards will always detect a material misstatement when it exists. Misstatements can arise from fraud or error and are considered material if, individually or in the aggregate, they could reasonably be expected to influence the economic decisions of users taken on the basis of these consolidated financial statements. As part of an audit in accordance with Canadian generally accepted auditing standards, we exercise professional judgment and maintain professional scepticism throughout the audit. We also: • Identify and assess the risks of material misstatement of the consolidated financial statements, whether due to fraud or error, design and perform audit procedures responsive to those risks, and obtain audit evidence that is sufficient and appropriate to provide a basis for our opinion. The risk of not detecting a material misstatement resulting from fraud is higher than for one resulting from error, as fraud may involve collusion, forgery, intentional omissions, misrepresentations, or the override of internal control. • Obtain an understanding of internal control relevant to the audit 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 Group’s internal control. • • • Evaluate the appropriateness of accounting policies used and the reasonableness of accounting estimates and related disclosures made by management. Conclude on the appropriateness of management’s use of the going concern basis of accounting and, based on the audit evidence obtained, whether a material uncertainty exists related to events or conditions that may cast significant doubt on the Group’s ability to continue as a going concern. If we conclude that a material uncertainty exists, we are required to draw attention in our auditor’s report to the related disclosures in the consolidated financial statements or, if such disclosures are inadequate, to modify our opinion. Our conclusions are based on the audit evidence obtained up to the date of our auditor’s report. However, future events or conditions may cause the Group to cease to continue as a going concern. Evaluate the overall presentation, structure, and content of the consolidated financial statements, including the disclosures, and whether the consolidated financial statements represent the underlying transactions and events in a manner that achieves fair presentation. • Obtain sufficient appropriate audit evidence regarding the financial information of the entities or business activities within the Group to express an opinion on the consolidated financial statements. We are responsible for the direction, supervision and performance of the group audit. We remain solely responsible for our audit opinion. We communicate with those charged with governance regarding, among other matters, the planned scope and timing of the audit and significant audit findings, including any significant deficiencies in internal control that we identify during our audit. We also provide those charged with governance with a statement that we have complied with relevant ethical requirements regarding independence, and to communicate with them all relationships and other matters that may reasonably be thought to bear on our independence, and where applicable, related safeguards. The engagement partner on the audit resulting in this independent auditor’s report is Nicole Poirier. Ernst & Young LLP Vancouver, Canada 29 March 2019 Page 29 Avcorp Industries Inc. annual report 2018 CONSOLIDATED STATEMENTS OF FINANCIAL POSITION (expressed in thousands of Canadian dollars) AS AT DECEMBER 31 ASSETS Current assets Cash (note 16) Accounts receivable (note 9) Contract assets (notes 3 and 10) Inventories (notes 3 and 11) Prepayments and other assets (note 12) Non-current assets Prepaid rent and security Development costs (note 13) Property, plant and equipment (note 14) Intangibles (note 15) Investment in AVS-SYS (note 34) Total assets LIABILITIES AND EQUITY Current liabilities Bank indebtedness (note 16) Accounts payable and accrued liabilities (note 18) Current portion of term debt (note 21) Customer advance (note 17) Contract liability (notes 3 and 19) Unfavourable contracts liability (note 20) Onerous contract provision (note 22) Non-current liabilities Guarantee fee (note 16) Deferred gain and lease inducement Term debt (note 21) Contract liability (notes 3 and 19) Unfavourable contracts liability (note 20) Onerous contract provision (note 22) (Deficiency) Equity Capital stock (note 24) Contributed surplus Accumulated other comprehensive income (note 3) Accumulated deficit (note 3) Total liabilities and (deficiency) equity Nature of operations and going concern (note 1) Subsequent events (note 35) 2018 2017 $2,051 23,442 24,762 15,601 6,076 71,932 146 11,755 28,416 3,137 682 $5,212 18,942 - 42,781 4,390 71,325 146 8,623 29,318 3,864 - 116,068 113,276 85,840 41,805 5,510 6,334 2,137 - 1,809 61,283 23,259 1,285 7,227 17,131 16,881 7,297 143,435 134,363 2,994 - 2,800 2,862 - 121 575 100 1,885 110 27,579 6,069 152,212 170,681 86,219 5,370 5,145 82,905 6,979 9,896 (132,878) (157,185) (36,144) (57,405) 116,068 113,276 The accompanying notes are an integral part of these consolidated financial statements. Approved by the Board of Directors on March 29, 2019 David Levi Chairman Ken Robertson Committee Chair, Audit & Corporate Governance Committee Page 30 Avcorp Industries Inc. annual report 2018 CONSOLIDATED STATEMENTS OF INCOME (LOSS) AND COMPREHENSIVE INCOME (LOSS) (expressed in thousands of Canadian dollars, except number of shares and per share amounts) AS AT DECEMBER 31 Revenues (notes 3, 17, 20 and 33) Cost of sales (notes 3, 22 and 33) 2018 2017 $170,710 $149,444 155,753 181,296 Gross profit (loss) 14,957 (31,852) Administrative and general expenses Office equipment depreciation Net contract modification (notes 17, 20 and 22) Net claim position (note 27) Operating income (loss) Finance costs – net (note 28) Foreign exchange loss Net loss on sale of equipment Income (loss) before income tax Income tax expense Income (loss) for the period Other comprehensive (loss) income 23,466 623 (41,470) 5,421 21,580 341 - - 26,917 (53,773) 5,774 770 - 2,806 1,944 15 20,373 (58,538) - - 20,373 (58,538) (4,751) 5,178 Net income (loss) and total comprehensive income (loss) for the period 15,622 (53,360) Income (loss) per share: Basic income (loss) per common share (note 32) Diluted income (loss) per common share (note 32) 0.06 0.06 (0.18) (0.18) Basic weighted average number of shares outstanding (000’s) (note 32) 345,651 318,019 Diluted weighted average number of shares outstanding (000’s) (note 32) 345,993 318,019 The accompanying notes are an integral part of these consolidated financial statements. Page 31 Avcorp Industries Inc. annual report 2018 CONSOLIDATED STATEMENTS OF CASH FLOWS (expressed in thousands of Canadian dollars) AS AT DECEMBER 31 Cash flows (used in) operating activities Net income (loss) for the year Adjustment for items not affecting cash: Interest expense Depreciation Development cost amortization Intangible assets amortization Non-cash financing cost accretion Loss on disposal of equipment Provision for unfavourable contracts Provision for onerous contracts Provision for doubtful accounts Provision for obsolete inventory Stock based compensation Net contract modification Provision for claim Unrealized foreign exchange Other items 2018 2017 $20,373 $(58,538) 5,765 4,482 3,291 1,379 9 - (4,617) (9,115) 543 (928) (445) (41,470) 7,640 1,558 (97) 2,216 4,153 1,924 1,299 589 15 (9,058) 13,603 921 (678) 720 - - 712 (135) Cash flows (used in) operating activities before changes in non-cash working capital (11,632) (42,257) Changes in non-cash working capital Accounts receivable Contract assets Inventories Prepayments and other assets Accounts payable and accrued liabilities Customer advance payable Contract liability (2,922) (6,108) 2,509 (805) 9,820 (2,660) (4,231) 6,546 - 869 (693) (6,636) (3,702) 3,269 Net cash (used in) operating activities (16,029) (42,604) Cash flows (used in) from investing activities Proceeds from consideration receivable Proceeds from sale of equipment Purchase of equipment Addition of developed software Payments relating to development costs and tooling Investment in AVS-SYS Net cash (used in) from investing activities Cash flows from (used in) financing activities Increase in bank indebtedness Payment of interest Proceeds from term debt Repayment of term debt Net cash from financing activities Net (decrease) increase in cash Net foreign exchange difference Cash - Beginning of the period Cash - End of the period Supplementary Cash Flow Information (note 29) The accompanying notes are an integral part of these consolidated financial statements. Page 32 - - (1,429) (371) (6,410) (551) (8,761) 17,961 (2,862) 6,601 (294) 21,406 (3,384) 223 5,212 2,051 12,378 20 (2,744) (571) (5,347) - 3,736 46,872 (1,331) 1,473 (6,275) 40,739 1,871 (619) 3,960 5,212 Avcorp Industries Inc. annual report 2018 CONSOLIDATED STATEMENTS OF CHANGES IN EQUITY (expressed in thousands of Canadian dollars, except number of shares) Capital Stock Number of Shares Amount Contributed Surplus Accumulated Deficit Accumulated Other Comprehensive Income Total Deficiency Balance at December 31, 2016 307,141,184 80,302 6,744 (98,647) 4,718 (6,883) Issue of common shares 30,263,318 2,118 - Transfer to share capital on exercise of warrants Stock-based compensation expense Cancellation of issued stock options Unrealized currency gain on translation for the period Net loss for the year - - - - - 485 (485) - - - - 718 2 - - - - - - - - - - - 2,118 - 718 2 5,178 5,178 (58,538) - (58,538) Balance at December 31, 2017 337,404,502 82,905 6.979 (157,185) 9,896 (57,405) Restated balance at January 1, 20181 337,404,502 82,905 6,979 (153,251) 9,896 (53,471) Issue of common shares 30,714,118 2,150 - Transfer to share capital on exercise of warrants Stock-based compensation expense Forfeiture of issued stock options Unrealized currency loss on translation for the year Net income for the year - - - - - 1,164 (1,164) - - - - 195 (640) - - - - - - - - - - - 2,150 - 195 (640) (4,751) (4,751) 20,373 - 20,373 Balance at December 31, 2018 368,118,620 86,219 5,370 (132,878) 5,145 (36,144) 1. The Company has initially applied IFRS 15 using the retrospective with cumulative effect method. Under this method, the comparative information is not restated (note 3). The accompanying notes are an integral part of these consolidated financial statements. Page 33 Avcorp Industries Inc. Notes to Consolidated Financial Statements For the year ended December 31, 2018 (all figures in tables are expressed in thousands of Canadian dollars, except per share amounts) annual report 2018 1. Nature of Operations and Going Concern Avcorp Industries Inc. (the “Company” or “Avcorp”) is a Canadian-based manufacturer within the aerospace industry, and a single source supplier for engineering design, manufacture and assembly of subassemblies and complete major structures for aircraft manufacturers. The Company currently operates from two locations in Canada and one location in the United States. Located in Delta, British Columbia, Avcorp Industries Inc., named as Avcorp Structures & Integration (“ASI”), is dedicated to metallic and composite aerostructures assembly and integration. Within Comtek Advanced Structures Ltd. (“Comtek”) located in Burlington, Ontario, exists two named divisions: Comtek, dedicated to aircraft structural component repair services, and Avcorp Engineered Composites (“AEC”) dedicated to design and manufacture of composite aerostructures. Located in Gardena, California, Avcorp Composite Fabrication Inc. (“ACF”) is dedicated to advanced composite aerostructures fabrication. Avcorp Composite Fabrication Inc. is wholly owned by Avcorp US Holdings Inc. Both companies are incorporated in the State of Delaware and are wholly owned subsidiaries of Avcorp Industries Inc. Comtek Advanced Structures Ltd., incorporated in the Province of Ontario is a wholly owned subsidiary of Avcorp Industries Inc. The Company’s governing corporate statute is the Canada Business Corporations Act (the “CBCA”). The consolidated financial statements of the Company for the year ended December 31, 2018 were authorized for issue in accordance with a resolution of its Board of Directors on March 29, 2019. During the year ended December 31, 2018, the Company had a net income of $20,373,000 (December 31, 2017: net loss of $58,838,000) inclusive of a net gain on contract modification of $41,470,000 (December 31, 2017: $Nil), had negative operating cash flows of $16,029,000 (December 31, 2017: negative $42,604,000) and a shareholders’ deficiency of $36,144,000 as of December 31, 2018 (December 31, 2017: $57,405,000 deficiency) and an accumulated deficit of $132,878,000 (December 31, 2017: $157,185,000). Management assesses the Company’s ability to continue as a going concern at each reporting date, using quantitative and qualitative information available including contract modification associated to an unfavourable contract (notes 17, 20 and 22), and the past due date of its customer advance (note 17). Material uncertainties have been identified which may cast significant doubt upon the Company’s ability to continue as a going concern. This assessment, by its nature, relies on estimates of future cash flows and other future events, whose subsequent changes would materially impact the validity of such an assessment. The Company’s ability to continue as a going concern is dependent upon its ability to successfully negotiate extended terms with its creditors to continue to raise adequate financing and achieve significant improvements in operating results in the future. In assessing whether the going concern assumption was appropriate, management took into account all relevant information available about the future, which was at least, but not limited to, the 12 month period from the date of this report. The Company, in conjunction with its Board of Directors, is currently implementing various financing strategies which include: On May 26, 2017, the Company entered into a loan agreement to expand its loan facility with a Canadian Chartered bank. This loan agreement amends, restates and replaces the loan agreement entered into on September 27, 2012. This Revolving Loan provided an additional borrowing capacity of up to USD$35,000,000 increasing its existing, as at March 30, 2017, USD$23,000,000 revolving loan in total up to USD$58,000,000. The loan agreement matures on June 30, 2020 (note 16). On March 28, 2018, the Company entered into an amendment to its existing credit facility with a Canadian chartered bank whereby the following amendments were made: Availability under the Revolving Loan is increased by USD$10,000,000 (“Expanded Loan”) subject to existing drawdown provisions, interest rates and bonus fees; Drawdowns under the Expanded Loan are supported by a major and material customer of the Company by way of a guarantee; and The Expanded Loan matures on March 31, 2019. On September 5, 2018, the Company entered into an amendment to its existing credit facility with a Canadian chartered bank whereby the following amendment was made: Maximum availability under the Revolving Loan cannot exceed USD$68,000,000 less USD$4,300,000, until September 30, 2018, at which time the agreement reverts back to existing terms. On September 28, 2018, the Company entered into an amendment to its existing credit facility with a Canadian chartered bank whereby the following amendment was made: Maximum availability under the Revolving Loan cannot exceed USD$68,000,000 less USD$4,300,000, until December 31, 2018, at which time the agreement reverts back to existing terms. On November 27, 2018, the Company entered into an amendment to its existing credit facility with a Canadian chartered bank whereby the following amendment was made: Maximum availability under the Revolving Loan cannot exceed USD$68,000,000 less USD$4,300,000, until January 31, 2019, at which time the agreement reverts back to existing terms. Page 34 Avcorp Industries Inc. Notes to Consolidated Financial Statements For the year ended December 31, 2018 (all figures in tables are expressed in thousands of Canadian dollars, except per share amounts) annual report 2018 On January 31, 2019, the Company entered into an amendment to its existing credit facility with a Canadian chartered bank whereby the following amendment was made (note 35a): Maximum availability under the Revolving Loan cannot exceed USD$68,000,000 less USD$4,300,000, until March 31, 2019, at which time the agreement reverts back to existing terms. On March 28, 2019, the Company entered into an amendment to its existing credit facility with a Canadian chartered bank whereby the following amendments were made: Maximum availability under the Revolving Loan cannot exceed USD$68,000,000 less USD$4,300,000, until April 30, 2019, at which time the agreement reverts back to existing terms. Availability under the Revolving Loan was increased on March 28, 2018, by USD$10,000,000 (“Expanded Loan”), subject to existing drawdown provisions, interest rates and bonus fees. Drawdowns under the Expanded Loan are supported by a major and material customer of the Company by way of a guarantee. The maturity of the Expanded Loan has been extended from March 31, 2019 to April 30, 2019. The Company ended the year with bank operating line utilization of $85,840,000 offset by $2,051,000 cash compared to utilization of $61,283,000 with $5,212,000 cash on hand as at December 31, 2017. Based on net collateral provided to its bank, the Company is able to draw up to an additional USD$776,000 on its operating line of credit as at December 31, 2018 (December 31, 2017: USD$9,149,000). As at the date of this report the Company is able to draw up to an additional USD$9,659,000 (note 35b) on its operating line of credit. Pursuant to the Hitco acquisition, the Company assumed a customer advance for pre-funding of product deliveries. The customer advance is re-paid as the Company delivers to its customer ordered products for a specific program. In the event that cancellation, termination, or assignment of the statement of work occurs earlier than December 31, 2018, the customer shall have the right to recover from the Company, within 120 days of such an event, the unamortized portion of the cash advance; such event occurred during the third quarter 2018. The customer advance is subject to an access and security agreement along with a general security agreement entered into with the Company’s bank and the customer. The face value of the unamortized portion of the cash advance as at December 31, 2018 is USD$4,643,000 (December 31, 2017: USD$7,219,000) (note 17). The Company, in conjunction with is Board of Directors continue to carry out various operational strategies which include: Contract renegotiations with customers and new customer contracts have provided an improved basis for operations in the future. Close collaboration with customers has resulted in both financial and operational support for continued operations. The assessment of the Company’s ability to execute its strategy of reducing operating costs and funding future working capital requirements involves significant judgement. Estimates and assumptions regarding future operating costs, revenue and profitability levels and general business and customer conditions are continually evaluated and are based on historical experience and other factors, including expectations of future events that are believed to be reasonable under the circumstances. Management is actively working to secure additional production orders, extension to its banking agreements, will continue to work with existing common shareholders, and will seek additional financing as necessary. The Company cannot provide assurance that, if it needs to raise additional funds, such funds will be available on favourable terms, or at all. If the Company cannot raise adequate funds on acceptable terms, its business could be materially harmed. 2. Basis of Preparation and Measurement The consolidated financial statements of the Company have been prepared in accordance with International Financial Reporting Standards (“IFRS”). The consolidated financial statements have been prepared on a historical cost basis, except for derivative financial instruments and financial equity investments that have been measured at fair value. The consolidated financial statements are presented in Canadian dollars and all values are rounded to the nearest thousand (000), except where otherwise indicated. Accounting standards issued but not yet effective The following is a brief summary of the new standards issued but not yet effective: IFRS 16 - Leases In January 2016, the IASB issued IFRS 16 – Leases (“IFRS 16”) which replaces IAS 17 – Leases and its associated interpretative guidance. IFRS 16 applies a control model to the identification of leases, distinguishing between a lease and a service contract on the basis of whether the customer controls the asset being leased. For those assets determined to meet the definition of a lease, IFRS 16 introduces significant changes to the accounting by lessees, introducing a single, on-balance sheet accounting model that is similar to current finance lease accounting, with limited exceptions for short-term leases or leases of low value assets. Lessor accounting remains similar to current accounting practice. The standard is effective for annual periods beginning on or after January 1, 2019, with early application permitted for entities that apply IFRS 15. The Company plans to adopt the new standard on the required effective date. The Company is in the process of assessing the impact the final standard is expected to have on its consolidated financial statements. Page 35 Avcorp Industries Inc. Notes to Consolidated Financial Statements For the year ended December 31, 2018 (all figures in tables are expressed in thousands of Canadian dollars, except per share amounts) annual report 2018 3. Significant Accounting Policies The significant accounting policies and methods of computation used in the preparation of these consolidated financial statements are described below. The policies have been consistently applied to all periods presented, unless otherwise stated. Basis of consolidation The financial statements of the Company consolidate the accounts of Avcorp Industries Inc. and its subsidiaries Comtek Advanced Structures Ltd., Avcorp US Holdings Inc., and Avcorp Composite Fabrication Inc. (the “Group”). All material intercompany transactions, balances and unrealized gains and losses from intercompany transactions are eliminated on consolidation. The consolidated financial statements comprise the financial statements of the Group and its subsidiaries as at December 31, 2018. Control is achieved when the Group is exposed, or has rights, to variable returns from its involvement with the investee and has the ability to affect those returns through its power over the investee. Specifically, the Group controls an investee if, and only if, the Group has: Power over the investee (i.e. existing rights that give it the current ability to direct the relevant activities of the investee); Exposure, or rights, to variable returns from its involvement with the investee; and The ability to use its power over the investee to affect its returns. Generally, there is a presumption that a majority of voting rights result in control. Consolidation of a subsidiary begins when the Group obtains control over the subsidiary and ceases when the Group loses control of the subsidiary. Assets, liabilities, income and expenses of a subsidiary acquired or disposed of during the year are included in the consolidated financial statements from the date the Group gains control until the date the Group ceases to control the subsidiary. When necessary, adjustments are made to the financial statements of subsidiaries to bring their accounting policies into line with the Group’s accounting policies. All intra-group assets and liabilities, equity, income, expenses and cash flows relating to transactions between members of the Group are eliminated in full on consolidation. Business combinations Business combinations are accounted for using the acquisition method. The cost of an acquisition is measured as the aggregate of the consideration transferred, which is measured at acquisition date fair value. Acquisition-related costs are expensed as incurred and included in administrative expenses. Foreign currency translation Functional and presentation currency: Foreign currency items included in the consolidated financial statements of each consolidated entity in the Avcorp Industries Inc. group are measured using the currency of the primary economic environment in which the entity operates (the “functional currency”). The consolidated financial statements are presented in Canadian dollars, which is the Company’s functional currency. The functional currency of the Company’s subsidiary, Comtek, is also determined to be Canadian dollars. The functional currency of the Company’s subsidiary, Avcorp US Holdings Inc., and ACF is determined to be US dollars. On consolidation, the assets and liabilities of foreign operations are translated into Canadian dollars at the rate of exchange prevailing at the reporting date and their statements of income are translated at average exchange rates prevailing during the period. The exchange differences arising on translation for consolidation are recognized in other comprehensive income (“OCI”). On disposal of a foreign operation, the component of OCI relating to that particular foreign operation is reclassified to consolidated income. Any goodwill arising on the acquisition of a foreign operation and any fair value adjustments to the carrying amounts of assets and liabilities arising on the acquisition are treated as assets and liabilities of the foreign operation and translated at the spot rate of exchange at the reporting date. Transactions and balances: Foreign currency transactions are translated into the functional currency using the exchange rates prevailing at the dates of the transactions. Generally, foreign exchange gains and losses resulting from the settlement of foreign currency transactions and from the translation at period-end exchange rates of monetary assets and liabilities denominated in currencies other than an operation’s functional currency are recognized in the consolidated statements of income. Fair value measurement Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. When determining fair value measurements for assets and liabilities required to be recorded at fair value, the Company considers the principal or most advantageous market in which it would transact and also considers assumptions that market participants would use when pricing an asset or liability. The fair value hierarchy has three levels of inputs that may be used to measure fair value: Level 1—Unadjusted quoted prices in active markets for identical assets or liabilities; Level 2—Unadjusted quoted prices in active markets for similar assets or liabilities, or unadjusted quoted prices for identical or similar assets or liabilities in markets that are not active, or inputs other than quoted prices that are observable for the asset or liability; and Level 3—Unobservable inputs for the asset or liability. Page 36 Avcorp Industries Inc. Notes to Consolidated Financial Statements For the year ended December 31, 2018 (all figures in tables are expressed in thousands of Canadian dollars, except per share amounts) annual report 2018 Financial instruments a) Financial assets Financial assets include, in particular, cash, accounts receivables and equity investments. Financial assets are classified, at initial recognition, as subsequently measured at amortized cost, fair value through other comprehensive income, and fair value through profit or loss. The classification of financial assets at initial recognition depends on the financial asset’s contractual cash flow characteristics. With the exception of accounts receivables that do not contain a significant financing component or for which the Company has applied the practical expedient, the Company initially measures a financial asset at its fair value plus, in the case of a financial asset not at fair value through profit or loss, transaction costs. Accounts receivables that do not contain a significant financing component or for which the Company has applied the practical expedient are measured at the transaction price determined under IFRS 15. Refer to the accounting policies for Revenue from contracts with customers. The Company measures financial assets at amortized cost if the financial asset is held within a business model with the objective to hold financial assets in order to collect contractual cash flows and the contractual terms of the financial asset give rise on specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding. Financial assets at amortized cost are subsequently measured using the effective interest method and are subject to impairment. Gains and losses are recognized in profit or loss when the asset is derecognized, modified or impaired. The Company’s financial assets at amortized cost includes accounts receivables. The Company recognizes an allowance for expected credit losses (ECLs) for all debt instruments not held at fair value through profit or loss. ECLs are based on the difference between the contractual cash flows due in accordance with the contract and all the cash flows that the Company expects to receive, discounted at an approximation of the original effective interest rate. The expected cash flows will include cash flows from the sale of collateral held or other credit enhancements that are integral to the contractual terms. For accounts receivables and contract assets, the Company applies a simplified approach in calculating ECLs. Therefore, the Company does not track changes in credit risk, but instead recognizes a loss allowance based on lifetime ECLs at each reporting date. The Company has established a provision matrix that is based on its historical credit loss experience, adjusted for forward-looking factors specific to the debtors and the economic environment. The provision for ECL rates is based on days past due for groupings of various customer segments that have similar loss patterns (i.e., by customer type and rating). The assessment of the correlation between historical credit loss pattern, forecast economic conditions and ECLs is a significant estimate. The amount of ECLs is sensitive to changes in circumstances and of forecast economic conditions. The Company’s historical credit loss experience and forecast of economic conditions may also not be representative of customer’s actual default in the future. Equity investments in non-listed companies are classified and measured as equity instruments at fair value through profit or loss. There were no impairment losses recognized in profit and loss for these investments in the current year. b) Financial liabilities Financial liabilities often entitle the holder to return the instrument to the issuer in return for cash or another financial asset. These include, in particular, bank indebtedness, accounts payables, finance lease liabilities, customer advance guarantee fee, and term debt. Financial liabilities are measured at their fair value at the time of acquisition, which is normally equivalent to the net loan proceeds. Transaction costs directly attributable to the acquisition are deducted from the amount of all financial liabilities that are not measured at fair value through profit or loss subsequent to initial recognition. If a financial liability is interest free or bears interest at below the market rate, it is recognized at an amount below the settlement price or nominal value. The financial liability initially recognized at fair value is amortized subsequent to initial recognition using the effective interest method. Inventories Inventories are stated at the lower of cost and net realizable value. Cost is determined using the first-in, first-out (“FIFO”) method. The cost of finished goods and work-in-progress comprises raw materials, direct labour, other direct costs and related production overheads (based on normal operating capacity) including applicable depreciation on property, plant and equipment and amortization of intangible assets. Net realizable value is the estimated selling price less applicable selling expenses. Property, plant and equipment Property, plant and equipment are stated at cost less accumulated depreciation and accumulated impairment losses. Cost includes expenditures that are directly attributable to the acquisition of the asset. Subsequent costs are included in the asset’s carrying amount or recognized as a separate asset, as appropriate, only when it is probable that future economic benefits associated with the item will flow to the Company and the cost can be measured reliably. The carrying amount of a replaced asset is derecognized when replaced. Repairs and maintenance costs are charged to the consolidated statement of loss during the period in which they are incurred. Page 37 Avcorp Industries Inc. Notes to Consolidated Financial Statements For the year ended December 31, 2018 (all figures in tables are expressed in thousands of Canadian dollars, except per share amounts) annual report 2018 An estimation is made of the useful life of property, plant and equipment. The useful life is measured in terms of years of production, and depreciated on a straight line basis. Computer hardware and software Machinery and equipment Leasehold improvements 2 - 10 years 5 - 15 years end of leases up to 2028 The Company allocates the amount initially recognized in respect of an item of property, plant and equipment to its significant parts and depreciates separately each such part. The useful lives of the assets are reviewed annually and adjusted if appropriate. The amortization expense in property, plant and equipment is recognized in the consolidated statement of loss in the expense category that is consistent with the function of the property, plant and equipment. Intangible Assets Intangible assets acquired separately are measured on initial recognition at cost. The cost of intangible assets acquired in a business combination is their fair value at the date of acquisition. Following initial recognition, intangible assets are carried at cost less any accumulated amortization and accumulated impairment losses. Internally generated intangibles, excluding capitalized development costs, are not capitalized and the related expenditure is reflected in profit or loss in the period in which the expenditure is incurred. Intangible assets with finite lives are amortized over the useful economic life and assessed for impairment whenever there is an indication that the intangible asset may be impaired. The amortization period and the amortization method for an intangible asset with a finite useful life are reviewed at least at the end of each reporting period. Changes in the expected useful life or the expected pattern of consumption of future economic benefits embodied in the asset are considered to modify the amortization period or method, as appropriate, and are treated as changes in accounting estimates. The amortization expense on intangible assets with finite lives is recognized in the profit or loss in the expense category that is consistent with the function of the intangible assets. Research and development costs Research costs are expensed as incurred. Development costs, which are currently all tooling and new program introduction costs incurred on long-term programs that meet the criteria for deferral, are capitalized and amortized straight-line over the number of shipsets management believes is a reasonable estimate of units to be sold for the program. Segment Reporting Management has determined the operating segments based on information regularly reviewed for the purposes of decision making, allocating resources and assessing performance by the Company’s chief operating decision maker; the Chief Executive Officer (CEO). The Company evaluates the financial performance of its operating segments primarily based on operating income or loss. Impairment of non-financial assets The Company assesses, at each reporting date, whether there is an indication that an asset may be impaired. If any indication exists, or when annual impairment testing for an asset is required, the Company estimates the asset’s recoverable amount. An asset’s recoverable amount is the higher of an asset’s or cash generating units (“CGU”) fair value less costs of disposal and its value in use. The Company’s CGUs are ASI, Comtek, and ACF. The recoverable amount is determined for an individual asset, unless the asset does not generate cash inflows that are largely independent of those from other assets or groups of assets. When the carrying amount of an asset or CGU exceeds its recoverable amount, the asset is considered impaired and is written down to its recoverable amount. In assessing value in use, the estimated future cash flows are discounted to their present value using a pre-tax discount rate that reflects current market assessments of the time value of money and the risks specific to the asset. In determining fair value less costs of disposal, recent market transactions are taken into account. If no such transactions can be identified, an appropriate valuation model is used. These calculations are corroborated by valuation multiples, quoted share prices for publicly traded companies or other available fair value indicators. The Company bases its impairment calculation on detailed budgets and forecast calculations, which are prepared separately for each of the Company’s CGUs to which the individual assets are allocated. These budgets and forecast calculations generally cover a period of five years. A long-term growth rate is calculated and applied to project future cash flows after the fifth year. An assessment is made at each reporting date to determine whether there is an indication that previously recognized impairment losses no longer exist or have decreased. If such indication exists, the Company estimates the asset’s or CGU’s recoverable amount. A previously recognized impairment loss is reversed only if there has been a change in the assumptions used to determine the asset’s recoverable amount since the last impairment loss was recognized. The reversal is limited so that the carrying amount of the asset does not exceed its recoverable amount, nor exceed the carrying amount that would have been determined, net of depreciation, had no impairment loss been recognized for the asset in prior years. Such reversal is recognized in the statement of profit or loss unless the asset is carried at a revalued amount, in which case, the reversal is treated as a revaluation increase. Page 38 Avcorp Industries Inc. Notes to Consolidated Financial Statements For the year ended December 31, 2018 (all figures in tables are expressed in thousands of Canadian dollars, except per share amounts) annual report 2018 Employee benefits Post-employment benefit obligations: Employees of companies included in these consolidated financial statements have entitlements under Company pension plans which are defined contribution pension plans. The cost of defined contribution pension plans is charged to expense as the contributions become payable. Stock based compensation: The Company grants stock options to certain employees. Stock options vest over three to ten years and all expire over five to ten years after grant date. Each tranche in an award is considered a separate award with its own vesting period and grant date fair value. Fair value of each tranche is measured at the date of grant using the Black-Scholes option pricing model. Compensation expense is recognized over the tranche’s vesting period based on the number of awards expected to vest, by increasing contributed surplus. The number of awards expected to vest is reviewed at least quarterly, with any impact being recognized immediately. Termination benefits: The Company recognizes termination benefits when it is demonstrably committed to either terminating the employment of current employees according to a detailed formal plan without possibility of withdrawal, or providing benefits as a result of an offer made to encourage voluntary termination. Benefits falling due more than twelve months after the end of the reporting period are discounted to their present value where the effect is material. Unfavourable contracts liability In connection with the acquisition of the US-based composite Aerostructures division of Hitco Carbon Composites Inc. (“Hitco”), a subsidiary of Frankfurt-listed SGL Carbon SE (“SGL”) the Company assumed existing long-term and short-term customer contracts. Based on our review of these contracts, the Company concluded that the terms of the contracts to be unfavourable, compared to what could be realized in market transactions, as of the date of the acquisition. As a result, the Company recognized contract liabilities, assumed, based on the present value of the difference between the contractual cash flows of the unfavourable contracts and the estimated cash flows to fulfil the obligation under the terms of the existing contracts from the acquisition date. The liabilities principally relate to long-term life of program contracts that were initially executed in the years prior to the acquisition. The Company measured these liabilities under the measurement provisions of IFRS 13, Fair Value Measurements, which is based on the price to transfer the obligation to a market participant at the measurement date, assuming that the liabilities will remain outstanding in the marketplace. Fair value estimates are based on a complex series of judgments about future events and uncertainties and rely heavily on estimates and assumptions. The judgments used to determine the estimated fair value assigned to each long-term contracts can materially impact our results of operations. Included in income is the non-cash amortization of acquired contract liabilities recognized as fair value adjustments through purchase accounting from the acquisition of ACF. For the year ended December 31, 2018, the Company recognized net amortization of unfavourable contract liabilities of $4,617,000 (December 31, 2017: $9,058,000) and $1,578,000 on transition to IFRS 15 as at January 1, 2018. The balance of the liability as of December 31, 2018 is $Nil (December 31, 2017: $44,460,000) and, is based on a units of production basis over the expected life of the contracts. The unfavourable contract liability was amortized on a units-of-production basis over the expected lives of the contracts. During 2018, production requirements associated with the unfavourable contract were redirected to another supplier, giving rise to the full amortization of the unfavourable contract liability into income. This has been recorded in Consolidation Statements of Income and Comprehensive Income as a contract modification in the amount of $39,982,000 (note 20). Revenue The Company’s major revenue streams arise from the production and supply of major airframe structures and aircraft parts to aircraft manufacturers, the repair of aircraft components, aircraft product design and production tooling design and manufacture. Revenue is recognized either at a point in time or over time, as the Company satisfies performance obligations by transferring the promised goods or services to its customers. An asset is transferred as the customer obtains control of the asset. If a performance obligation is not satisfied over time, the Company satisfies the performance obligation at a point in time. The Company transfers control of a good or service over time and, therefore, satisfies a performance obligation and recognizes revenue over time, if one of the following criteria is met: the customer simultaneously receives and consumes the benefits provided by the Company's performance as the Company performs; the Company's performance creates or enhances an asset (for example, work in progress) that the customer controls as the asset is created or enhanced; or the Company's performance does not create an asset with an alternative use to the Company and the Company has an enforceable right to payment for performance completed to date. The Company transfers control of the goods over time as evidenced either by contractual termination clauses or by our rights to payment for work performed to date plus a reasonable profit to deliver products that do not have an alternative use to the Company. The Company uses the input method to measure the satisfaction of performance obligations over time. The inputs are labour hours expended and cost of materials consumed relative to the total expected inputs to the satisfaction of that performance obligation. Page 39 Avcorp Industries Inc. Notes to Consolidated Financial Statements For the year ended December 31, 2018 (all figures in tables are expressed in thousands of Canadian dollars, except per share amounts) annual report 2018 Determining whether a contract transfers control of the goods over time requires management to consider the terms of the contract, as well as any laws that apply to the contract, and make judgements as to (1) whether the asset created by the Company's performance does not have an alternative use to the Company if the Company is either restricted contractually from readily directing the asset for another use during the creation or enhancement of that asset or limited practically from readily directing the asset in its completed state for another use and (2) evaluating whether it has an enforceable right to payment for performance completed to date. The Company transfers control of the goods at a point in time evidenced when the delivery has occurred. Revenue is measured based on the price specified in the sales contract. Contract Assets include unbilled amounts typically resulting from sales under long-term contracts when over time method of revenue recognition is utilized and revenue recognized exceeds the amount billed to the customer, and right to payment is not just subject to passage of time. Amounts may not exceed their net realizable value. Contract assets are current in nature. Contract liabilities consist of advance payments and billings in excess of revenue recognized. Advance payments and billings in excess of revenue recognized are classified as current or non-current based on the timing of when revenue is expected to be recognized. This period of contract liabilities realization can extend, dependent on the amortization of the related costs, over one or more fiscal years. Certain program inventories have been funded by a customer, whereby the associated contract liability will be recorded as revenue upon delivery of units of production. The Company has adopted IFRS 15 effective January 1, 2018 and the changes have been accounted for using the retrospective with cumulative effect method only to contracts that are not completed contracts at the date of initial application in accordance with the transition rules of IFRS 15. This method does not require the restatement of comparative information. As a result, the 2017 comparative information follows the following method of revenue recognition policy: Revenue is recognized when it is probable that the economic benefits will flow to the Company and delivery has occurred, the sales price is fixed or determinable, and collectability is reasonably assured. These criteria are generally met at the time the product is shipped and delivered to the customer and, depending on the delivery conditions, title and risk of the product have passed to the customer. The term ‘bill and hold’ sale is used to describe a transaction where delivery is delayed at the customer’s request, but the customer takes title and accepts billing. Revenue is recognized when the customer takes title, provided it is probable that delivery will be made, the item is on hand, identified and ready for delivery to the customer at the time the sale is recognized, the customer specifically acknowledges the deferred delivery instructions, and the usual payment terms apply. Revenue is measured based on the price specified in the sales contract. The Company’s major revenue streams arise from the production and supply of major airframe structures and aircraft parts to aircraft manufacturers, the repair of aircraft components, aircraft product design and production tooling design and manufacture. The nature of the Company’s operating cycle for the manufacture and delivery of highly engineered aerospace parts and components is one in which significant order and production lead-times exist. There exists a high degree of variability within the length of operating cycles for the various manufactured components, aircraft programs, and customers. The Company’s operating cycle commences with receipt, from its customers, of a purchase order for production of a component and culminates when the Company has received full payment from the customer for the product it has delivered. The individual product component operating cycles can range from twelve weeks to greater than sixty weeks. Costs incurred for proto-type design, as well as hard and soft tooling expenditures for new program introduction can occur over a two year period. Given this variability, since no single operating cycle is clearly identifiable, the Company has concluded that the operating cycle is twelve months. Certain program inventories have been funded by a customer, whereby the associated contract liability will be recorded as revenue upon delivery of units of production. Additionally, customers have funded non-recurring costs incurred during the introduction of new production programs. These costs are deferred as development costs and will be amortized to the consolidated statement of loss straight- line on a units-of production basis over the expected life of the programs, in conjunction with the associated deferred revenue upon commencement of production. Contract liabilities are classified as current or non-current based on the estimated timing of when the related revenues are realized. This period of contract liability realization can extend, dependent on the amortization of the related costs, over one or more fiscal years. Cost of sales Cost of sales includes the cost of production, including materials, direct labour, overhead expenses as well as applicable depreciation and amortization. Income tax a) Current income tax Current income tax assets and liabilities for the current year are measured at the amount expected to be recovered from or paid to the taxation authorities. The tax rates and tax laws used to compute the amount are those that are enacted or substantively enacted, at the reporting date in the countries where the Company operates and generates taxable income. Page 40 Avcorp Industries Inc. Notes to Consolidated Financial Statements For the year ended December 31, 2018 (all figures in tables are expressed in thousands of Canadian dollars, except per share amounts) annual report 2018 Current income tax relating to items recognized directly in equity is recognized in equity and not in the consolidated statement of loss. Management periodically evaluates positions taken in the tax returns with respect to situations in which applicable tax regulations are subject to interpretation and establishes provisions where appropriate. b) Deferred income tax Deferred income tax is provided using the liability method on deductible temporary differences between the tax bases of assets and liabilities and their carrying amounts for financial reporting purposes at the reporting date. Deferred income tax liabilities are recognized for all taxable temporary differences, except: taxable temporary differences associated with investments in subsidiaries, when the timing of the reversal of the temporary differences can be controlled and it is probable that the temporary differences will not reverse in the foreseeable future. Deferred income tax assets are recognized for all deductible temporary differences, the carry forward of unused tax credits and any unused tax losses to the extent that it is probable that taxable profit will be available against which the deductible temporary differences and the carry forward of unused tax credits and unused tax losses can be utilized. The carrying amount of deferred income tax assets is reviewed at each reporting date and reduced to the extent that it is no longer probable that sufficient taxable profit will be available to allow all or part of the deferred income tax asset to be utilized. Unrecognized deferred income tax assets are reassessed at each reporting date and are recognized to the extent that it has become probable that future taxable profits will allow the deferred income tax asset to be recovered. Deferred income tax assets and liabilities are measured at the tax rates that are expected to apply in the year when the asset is realized or the liability is settled, based on tax rates (and tax laws) that have been enacted or substantively enacted at the reporting date. Deferred income tax relating to items recognized outside profit or loss is recognized outside profit or loss. Deferred income tax items are recognized in correlation to the underlying transaction either in other comprehensive income or directly in equity. Deferred income tax assets and deferred income tax liabilities are offset if a legally enforceable right exists to set off current tax assets against current income tax liabilities and the deferred income taxes relate to the same taxable entity and the same taxation authority. Capital Stock Common shares are classified as equity. Incremental costs directly attributable to the issuance of shares are recognized as a deduction from equity. Earnings per share Basic earnings per share (“EPS”) is calculated by dividing the net income (loss) for the year by the weighted average number of common shares outstanding during the year. Diluted EPS is calculated by adjusting the weighted average number of common shares outstanding for dilutive instruments. The number of shares included with respect to options, warrants and similar instruments is computed using the treasury stock method. The Company’s potentially dilutive common shares comprise stock options granted to employees and warrants. Leases Leases are classified as finance or operating leases. A lease that transfers substantially all the benefits and risks incidental to the ownership of property is classified as a finance lease. All other leases are accounted for as operating leases whereby lease payments are expensed on a straight-line basis over the term of the lease. Gains and losses arising on sale and leaseback transactions, when the leaseback is classified as a finance lease, are deferred and amortized in proportion to the amortization of the leased asset when material. Lease inducements received are recorded as a deferred credit and amortized as a reduction of lease expense over the term of the lease. Adoption of IFRS 9 – Financial instruments In July 2014, the IASB completed the three-part project to replace IAS 39, Financial instruments: recognition and measurement by issuing IFRS 9, Financial instruments. IFRS 9 includes classification and measurement of financial assets and financial liabilities, and a forward-looking expected credit loss impairment model. IFRS 9 uses a new approach to determine whether a financial asset is measured at amortized cost or fair value, replacing the multiple rules in IAS 39. The approach in IFRS 9 is based on how an entity manages its financial instruments and the contractual cash flow characteristics of the financial assets. IFRS 9 also introduced a new expected credit loss impairment model that requires more timely recognition of expected credit losses. Specifically, the new standard requires entities to account for expected credit losses from when financial instruments are first recognized and to recognize full lifetime expected losses on a timelier basis. The Company adopted the new standard on the required effective date on January 1, 2018. Any difference between previous carrying amounts recognized under IAS 39 and those determined under IFRS 9 at the date of initial application would be included in opening accumulated losses on January 1, 2018. The adoption of IFRS 9 resulted in no adjustments. Page 41 Avcorp Industries Inc. Notes to Consolidated Financial Statements For the year ended December 31, 2018 (all figures in tables are expressed in thousands of Canadian dollars, except per share amounts) annual report 2018 Adoption of IFRS 15 – Revenue from contracts with customers In May 2014, the IASB released IFRS 15 “Revenue from contracts with customers” which supersedes IAS 11 “Construction Contracts”, IAS 18 “Revenue”, and other related interpretations. The new standard establishes a control-based revenue recognition model and provides additional guidance in many areas not covered in detail under previous IFRSs. The core principle of IFRS 15 is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods and services. Revenue is recognized when, or as, the customer obtains control of the goods and services. The Company has adopted IFRS 15 effective January 1, 2018 and the changes have been accounted for using the retrospective with cumulative effect method only to contracts that are not completed contracts at the date of initial application in accordance with the transition rules of IFRS 15. This method does not require the restatement of comparative information. The following table shows the adjustments for each individual line item and do not include those line items that were not affected. As Previously Reported Adjustment Restated January 1, 2018 Consolidated Statement of Financial Position Contract asset Accounts receivable Inventory Contract liability Unfavourable contract liability Accumulated deficit $- 18,942 42,781 17,241 44,460 157,185 $18,142 1,211 (26,338) (9,341) (1,578) (3,934) $18,142 20,153 16,443 7,900 42,882 153,251 The Company reviewed its revenue contracts to evaluate the effect of the new standard on the Company’s revenue recognition policy. Contracts identified to be recognized over-time under Current IFRS resulted in the recognition of revenue on inventory as completed. Revenue was recognized, contract assets recorded, inventory released, and cost of goods sold was recorded in comparison to these contract’s recognizing at the time of shipment under Previous IFRS. Contract liabilities are recognized into revenue. The following table shows the adjustments for each individual financial statement line item in the current reporting period by the application of this Standard as compared to IAS 11, IAS 18 and related interpretations that were in effect before the change. Consolidated Statement of Financial Position Contract asset Inventory Contract liability Accumulated deficit Accumulated other comprehensive income Consolidated Statement of Loss Revenue Cost of Sales Other comprehensive loss Previous IFRS Adjustment Current IFRS December 31, 2018 $- 41,223 12,142 139,176 5,160 169,589 156,996 4,766 $24,762 (25,622) (7,143) (6,298) (15) 1,121 (1,243) (15) $24,762 15,601 4,999 132,878 5,145 170,710 155,753 4,751 As required for the consolidated financial statements, the Corporation disaggregated revenue recognized from contracts with customers into categories that depict how the nature and amount are affected by economic factors, refer to note 33 for the disclosure on disaggregated revenue. 4. Critical Accounting Estimates and Judgements The preparation of consolidated financial statements in conformity with IFRS requires management to make estimates and judgments that affect the amounts which are reported in the consolidated financial statements during the reporting period. Estimates and other judgments are evaluated at each reporting date and are based on management’s experience and other factors, including expectations about future events that are believed to be reasonable under the circumstances. The critical estimates and judgements utilized in preparing the Company’s consolidated financial statements affect the assessment of net recoverable amounts, net realizable values and fair values, and the determination of functional currency of the Canadian operations of the group. Any changes in estimates and assumptions could have a material impact on the assets and liabilities at the date of the statement of financial position. The Company reviews its estimates and assumptions on an ongoing basis and uses the most current information available and exercises careful judgement in making these estimates and assumptions. Page 42 Avcorp Industries Inc. Notes to Consolidated Financial Statements For the year ended December 31, 2018 (all figures in tables are expressed in thousands of Canadian dollars, except per share amounts) annual report 2018 Functional currency: The functional currency for the Company and its subsidiaries is the currency of the primary economic environment in which each operates. The Company has determined that the functional currency for the Company and all its subsidiaries except for Avcorp US Holdings Inc. and ACF is the Canadian dollar. The functional currency for Avcorp US Holdings Inc. and ACF is the US dollar. The determination of functional currency may require certain judgements to determine the primary economic environment. The Company reconsiders the functional currency used when there is a change in events and conditions which determined the primary economic environment. Impairments: The recoverable amount of intangible assets, development costs and property, plant and equipment is based on estimates and assumptions regarding the expected market outlook and cash flows from each CGU or group of CGUs. In order to estimate the fair value of indefinite-lived intangible assets and goodwill resulting from business combinations, the Company typically estimates future revenue, considers market factors and estimates future cash flows. Based on these key assumptions, judgments and estimates, the Company determines whether to record an impairment charge to reduce the value of the asset carried on the consolidated statement of financial position to its estimated fair value. Assumptions, judgments and estimates about future values are complex and often subjective. They can be affected by a variety of factors, including external factors such as industry and economic trends, and internal factors such as changes in the Company’s business strategy or internal forecasts. Although the Company believes the assumptions, judgments and estimates made in the past have been reasonable and appropriate, different assumptions, judgments and estimates could materially affect the Company’s reported financial results. Going concern: Management assesses the Company’s ability to continue as a going concern at each reporting date, using quantitative and qualitative information available. This assessment, by its nature, relies on estimates of future cash flows and other future events, whose subsequent changes would materially impact the validity of such an assessment. Capitalization of development costs: When capitalizing development costs the Company must assess the technical and commercial feasibility of the projects and estimate the useful lives of resulting products. Determining whether future economic benefits will flow from the assets and therefore the estimates and assumptions associated with these calculations are instrumental in (i) deciding whether project costs can be capitalized, and (ii) accurately calculating the useful life of the projects for the Company. Unfavourable contracts liability: At the acquisition date valued the unfavourable contracts liability at fair value using certain assumptions that would arise in a market participant view. The Company estimates the expected shipsets or production when assessing the liability, together with the discounts rate and period of performance under the varying contracts and service agreements. The cash flows are discounted over the period of performance using a discount rate commensurate with the risk associated with the liability. During 2018 production requirements associated with the unfavourable contract were redirected to another supplier, giving rise to the full amortization of the unfavourable contract liability and the onerous contract provision into income. In addition, the customer advance was adjusted to its face value through income. This has been recorded in Consolidated Statements of Income (Loss) and Comprehensive Income (Loss) as a contract modification in the amount of $41,470,000. Uncertainties exist as to ultimate outcome of a formal contract termination. While the Company believes that it has fulfilled all of its obligations under the contract, it is possible claims may be levied against the Company. The Company has assessed such possible claims as not probable. Inventories are valued at the lower of cost and net realizable value. The costs of inventory involve estimates in determining the allocation of fixed and variable production overhead. These estimates involved include determination of normal production capacity and nature of expenses to be allocated. Additionally inventory is reviewed monthly to ensure the carrying value does not exceed net realizable value. If so, a write-down is recognized. The write-down may be reversed if the circumstances which caused it no longer exist. On a periodic basis the Company reviews its plant capacity and estimates the portion of its under-utilized overhead expenditures. The Company has expensed $6,469,000 of overhead costs during the current year (December 31, 2017: $4,309,000) in respect of unutilized plant capacity. These amounts are included in the Consolidated Statements of Loss and Comprehensive Loss as costs of sales. The Company has entered into production contracts in the ordinary course of its business. The unavoidable cost of meeting the obligations under certain of these contracts exceeds the associated expected future net benefits; consequently, an onerous contract provision has been recognized. The calculation of this provision involves the use of estimates including, but not limited to, program gross margin, and the effect of learning curves of production and the timing of achieving certain operational efficiencies. These actual results can vary significantly from these estimates with consequent variability in the amounts of the provision recorded. The onerous contract provision is calculated by taking the expected future costs that will be incurred under the contract and deducting any estimated revenues. The onerous contract provision is primarily due to a high cost structure and learning curves of production that cannot be recovered through current pricing of the associated contracts. The current portion of the onerous contract provision for the year ended December 31, 2018 is $1,809,000 (December 31, 2017: $7,297,000). The onerous contract provision for the year ended December 31, 2018 is $1,930,000 (December 31, 2017: $13,366,000). While a formal claim has yet to be levied by the customer, the Company has provisioned for a claim asserted by a customer in the amount of $7,640,000. Page 43 Avcorp Industries Inc. Notes to Consolidated Financial Statements For the year ended December 31, 2018 (all figures in tables are expressed in thousands of Canadian dollars, except per share amounts) annual report 2018 5. Expenses by Nature The Consolidated Statements of Income (Loss) and Comprehensive Income (Loss) presents expenses by function. Accordingly, amortization and depreciation is not presented as a separate line on the statement, but is included within cost of sales to the extent that it relates to manufacturing machinery and equipment, or leasehold improvements. Expenses by nature: Raw materials, purchased parts and consumables Salary, wages and benefits Contracted services and consulting Rent Depreciation Utilities Amortization of development costs Legal and audit fees Transportation Office equipment rental/maintenance Plant equipment rental and maintenance Amortization of intangible assets Travel costs Insurance Bad debt expense Office supplies Royalties Other expenses and conversion of costs into inventory Change in onerous contracts provision 2018 $83,142 74,707 4,862 4,499 4,482 3,713 3,291 2,774 2,501 2,346 1,652 1,379 1,178 795 292 291 179 (3,126) (9,115) 179,842 2017 $78,961 70,891 6,266 3,695 4,153 3,143 1,924 2,981 2,240 1,071 4,333 1,299 1,488 623 1,030 384 223 4,909 13,603 203,217 6. Capital Risk Management The Company’s objectives when managing capital are to safeguard its ability to continue as a going concern and to provide an adequate return to shareholders, while satisfying other stakeholders. The Company includes long-term debt and capital stock in its definition of capital, as shown in the Company’s consolidated statements of financial position. The Company’s primary objective in its management of capital is to ensure that it has sufficient financial resources to fund ongoing operations and new program investment. In order to secure this capital the Company may attempt to raise funds via issuance of debt and equity, or by securing strategic partners. The Company’s loan agreement with a Canadian chartered bank restricts the declaration or payment of any dividend. 7. Financial Risk Management The Company is exposed to certain financial risks including market risk, currency risk, credit risk, liquidity risk, interest rate risk and price risk. The note presents information about the Company’s risk to each of these risks; its objectives, policies and processes for measuring and managing risk. a) Market Risk Market risk is the risk that changes in the market prices, such as foreign exchange rates and interest rates, will affect the Company’s income or the value of its holdings of financial instruments. The Company’s policy is not to utilize derivative financial instruments for trading or speculative purposes. The Company may utilize derivative instruments in the management of its foreign currency and interest rate exposures. b) Currency Risk Currency risk arises because the amount of the local currency receivable or payable for transactions denominated in foreign currencies may vary due to changes in exchange rate (“transaction exposures”) and because the non-Canadian dollar denominated financial statements of the Company’s subsidiaries may vary on consolidation into the reporting currency of Canadian dollars (“translation exposures”). Page 44 Avcorp Industries Inc. Notes to Consolidated Financial Statements For the year ended December 31, 2018 (all figures in tables are expressed in thousands of Canadian dollars, except per share amounts) annual report 2018 The Company sells a significant proportion of its products in US dollars at prices which are often established well in advance of manufacture and shipment dates. In addition, the Company purchases a significant proportion of its raw materials and components in US dollars at prices that are usually established at the order date. The Company’s operations are based in Canada and in the US. As a result of this, the Company is exposed to currency risk to the extent that fluctuations in exchange rates are experienced. The amount of foreign exchange loss recorded for the year ended December 31, 2018 is $770,000 (December 31, 2017: $1,944,000 loss). The Company had the following US dollar denominated balances: FOR THE YEAR ENDED DECEMBER 31 Bank cash position Accounts receivable Accounts payable Customer advance Bank indebtedness Term debt 2018 2017 US$1,050 US$2,929 12,996 8,838 4,643 62,924 3,633 9,749 2,111 - 48,851 868 With other variables unchanged, each $0.10 strengthening (weakening) of the CAD against the USD would result in an increase (decrease) of approximately $6,135,000 in net income for the year ended December 31, 2018 as a result of holding a net liability position in USD as at December 31, 2018. As at December 31, 2017, a $0.10 strengthening (weakening) of the CAD against the USD would result in a (decrease) increase of approximately $3,915,000 in net income for the year ended December 31, 2017 as a result of holding a net USD asset position in as at December 31, 2017. c) Credit Risk Credit risk is the risk of a financial loss to the Company if a customer or counterparty to a financial instrument fails to meet its contractual obligation. The Company manages credit risk for trade and other receivables through a financial review of the credit worthiness of the prospective customer along with credit monitoring activities. The majority of the Company’s trade receivables reside with Boeing Commercial Airplane Group (“Boeing”), Boeing Defense, Space & Security (“BDS”), Bombardier Aerospace (“Bombardier”), BAE Systems (Operations) Limited (“BAE”), Lockheed Martin (“LM”), and Subaru Corporation (“Subaru”). The maximum exposure to credit risk is represented by the amount of accounts receivable in the consolidated statements of financial position. As at the consolidated statements of financial position date 90.8% (December 31, 2017: 86.6%) of the Company’s trade accounts receivable are attributable to these customers. The Company is exposed to credit risk if counterparties to its trade receivables are unable to meet their obligations. The concentration of credit risk from its customers is minimized because the Company has an original equipment manufacturer and tier one aerospace customer base as at December 31, 2018. The customers are predominately large, well-capitalized, and long established entities with a low risk of non-payment. The Company regularly monitors its credit risk and credit exposure. The following table provides the change in allowance for doubtful accounts for trade receivables: FOR THE YEAR ENDED DECEMBER 31 Balance as at January 1 Additions Use Collection Balance as at December 31 The following table provides aged trade receivables: FOR THE YEAR ENDED DECEMBER 31 Current 31 – 60 days 61 – 90 days Over 90 days Total Page 45 2018 $1,237 630 (87) - 1,780 2018 $10,193 6,540 3,743 1,232 21,708 2017 $326 1,168 (129) (128) 1,237 2017 $8,587 5,895 1,841 379 16,702 Avcorp Industries Inc. Notes to Consolidated Financial Statements For the year ended December 31, 2018 (all figures in tables are expressed in thousands of Canadian dollars, except per share amounts) annual report 2018 d) Liquidity Risk Liquidity risk is the risk that the Company will not be able to meet its financial obligations as they fall due. The Company seeks to manage liquidity risk through the management of its capital structure and financial leverage. Accounts payable and accrued liabilities are all due within the next twelve months. The Company’s operating line of credit is due on demand (note 16). Term debt repayments are as outlined in note 21. The table below categorizes the Company’s non-derivative financial liabilities into relevant maturity periods based on the remaining period from the consolidated statements of financial position date to the contractual maturity date. The amounts disclosed in the table are the contractual undiscounted cash flows. Bank indebtedness (note 16) Term debt (note 21) Trade payables (note 18) Payroll related liabilities (note 18) Boeing advance (note 17) Guarantee fee (note 16) Accrued interest (note 18) Restructuring provision (note 18) Other accruals (note 18) Bank indebtedness (note 16) Term debt (note 22) Trade payables (note 18) Payroll related liabilities (note 18) Guarantee fee (note 16) Accrued interest (note 18) Restructuring provision (note 18) Other accruals (note 18) e) Interest Rate Risk Less than 3 months 3 months to 1 year December 31, 2018 2 – 5 years Over 5 years $85,840 69 28,225 4,707 6,334 - 423 17 337 $- 385 - - - - - - - $- 5,779 - - - 2,994 - - - $- 2,077 - - - - - - - Less than 3 months 3 months to 1 year 2 – 5 years Over 5 years December 31, 2017 $61,283 1,136 17,263 5,150 - 264 - - $- 149 - - - - 103 33 $- 1,883 - - 575 - - - $- 2 - - - - - - The Company is exposed to interest rate risk on the utilized portion of its operating line of credit. Interest rate for advances made up to the maximum of the allowable borrowing base on the existing USD$23,000,000 revolving loan: RBP plus 0.75% per annum RBUSBR plus 0.75% per annum BA Equivalent Rate plus 2.25% per annum LIBOR Rate plus 2.25% per annum Interest rate for advances made on the additional borrowing capacity up to USD$58,000,000. RBP plus 0.00% per annum RBUSBR plus 0.00% per annum BA Equivalent Rate plus 0.875% per annum LIBOR Rate plus 0.875% per annum There is uncertainty as to the continued use of LIBOR in the future. LIBOR is the subject of recent national, international and other regulatory guidance and proposals for reform. These reforms and other pressures may cause LIBOR to be eliminated or to perform differently than in the past. The consequences of these developments cannot be entirely predicted, but could include an increase in the cost of our variable rate indebtedness and obligations. Drawdown under the USD$35,000,000 additional borrowing capacity is supported by a major and material customer of the Company by way of a guarantee. Page 46 Avcorp Industries Inc. Notes to Consolidated Financial Statements For the year ended December 31, 2018 (all figures in tables are expressed in thousands of Canadian dollars, except per share amounts) annual report 2018 The Company will provide the guarantor, as consideration for the guarantee, a fee equal to 5.375% of the weighted average outstanding balance of the guaranteed portion over each full twelve (12) month period commencing on the funding date plus, for the partial year thereafter, 5.375% of the weighted average outstanding balance of the guaranteed portion multiplied by the number of days in the partial year divided by three hundred sixty (360). The fee will be payable on the maturity date. On March 28, 2018, the Company entered into an amendment to its existing credit facility (“Revolving Loan”) with a Canadian chartered bank whereby the following amendments were made: Availability under the Revolving Loan is increased by USD$10,000,000 (“Expanded Loan”) subject to existing drawdown provisions, interest rates and bonus fees; Drawdowns under the Expanded Loan are supported by a major and material customer of the Company by way of a guarantee; and The Expanded Loan matures on March 31, 2019. The maximum operating line of credit availability is $92,766,000 (USD$68,000,000) of which $85,840,000 is utilized as at December 31, 2018 (December 31, 2017: $61,283,000). The Company lowers interest rate costs by managing utilization of the operating lines of credit to the lowest amount practical. For the year ended December 31, 2018, with other variables unchanged, a 1% change in the base borrowing rate would have an $858,000 (December 31, 2017: $613,000) impact on net earnings and cash flow. Based on net collateral provided to its bank, the Company is able to draw up to an additional USD$776,000 on its operating line of credit as at December 31, 2018 (December 31, 2017: $9,149,000). As at the date of this report the Company is able to draw up to an additional USD$9,659,000 (note 35b) on its operating line of credit. The Company primarily finances the purchase of long-lived assets at fixed interest rates. f) Price Risk Certain of the Company’s sales contracts contain derivative financial instruments to reduce exposure to price risk associated with its revenues. The price adjustment clause within these sales contracts was not recorded as it does not produce a significant amount to be recorded. g) Financial Assets and Liabilities by Category Categories of financial instruments Under IFRS, financial instruments are classified into one of the following categories: financial assets at fair value through other comprehensive income and fair value through profit and loss, financial liabilities at fair value through profit or loss, and other financial liabilities and financial assets at amortized cost. As at December 31, 2018 and 2017, the Company’s financial assets and liabilities are categorized as follows: FOR THE YEAR ENDED DECEMBER 31 Amortized cost 2018 Fair value through profit or loss 2017 Total Amortized cost Financial Assets Cash Accounts receivable Investment in AVS-SYS Financial Liabilities Bank indebtedness Accounts payable Term debt Customer advance Guarantee fee $2,051 23,442 - 85,840 41,805 8,310 6,334 2,994 $- - 682 - - - - - $2,051 23,442 682 85,840 41,805 8,310 6,334 2,994 $5,212 18,942 61,283 23,259 3,170 - 575 Page 47 Avcorp Industries Inc. Notes to Consolidated Financial Statements For the year ended December 31, 2018 (all figures in tables are expressed in thousands of Canadian dollars, except per share amounts) annual report 2018 8. Fair Value Measurement At December 31, 2018 and December 31, 2017, the fair values of cash, accounts receivable, accounts payable, and bank indebtedness approximated their carrying values because of the short-term nature of these instruments. FOR THE YEAR ENDED DECEMBER 31 2018 2017 Carrying value Fair value Carrying value Fair value Financial asset Investment in AVS-SYS (level 3) $682 $682 $- $- Financial liabilities Term debt (level 2) Customer advance (level 2) Guarantee fee (level 2) Fair value hierarchy 8,310 6,334 2,994 8,310 6,334 2,994 3,170 - 575 3,170 - 575 The Company’s financial assets and liabilities recorded at fair value on the consolidated statements of financial position have been categorized into three categories based on a fair value hierarchy. Fair value of assets and liabilities included in Level 1 are determined by reference to quoted prices in active markets for identical assets and liabilities. Assets and liabilities in Level 2 include valuations using inputs other than the quoted prices for which all significant inputs are based on observable market data, either directly or indirectly. Level 3 valuations are based on inputs that are not based on observable market data. The fair value hierarchy requires the use of observable market inputs whenever such inputs exist. A financial instrument is classified to the lowest level of the hierarchy for which a significant input has been considered in measuring fair value. The Company does not have any financial assets or financial liabilities carried at fair value as at December 31, 2017. 9. Accounts Receivable FOR THE YEAR ENDED DECEMBER 31 Trade receivables Input tax credits Accrued receivables 2018 $21,708 1,659 75 23,442 2017 $16,702 2,176 64 18,942 The average trade receivables days outstanding is 46 days as at December 31, 2018 (December 31, 2017: 54 days). The carrying amount of accounts receivable pledged as security under the Company’s operating line of credit as at December 31, 2018 is $21,708,000 (December 31, 2017: $16,702,000) (note 16). Upon transition to IFRS 15 on January 1, 2018, the Company carried $20,153,000 in accounts receivable (note 3). The carrying amounts of the Company’s trade and accrued receivables are denominated in the following currencies: FOR THE YEAR ENDED DECEMBER 31 US dollar Canadian dollar 10. Contract Assets 2018 2017 US$14,592 US$10,649 3,536 5,600 Contract assets include unbilled amounts typically resulting from sales under long-term contracts when over time method of revenue recognition is utilized and revenue recognized exceeds the amount billed to the customer, and right to payment is not just subject to the passage of time. Amounts may not exceed their net realizable value. Contract Assets are released when the customer is invoiced and is recorded to accounts receivable. Contract assets are current in nature. Upon transition to IFRS 15 on January 1, 2018, the Company carried $18,142,000 in relation to contracts that are recognized under percentage of completion input method based on costs incurred for those contracts not completed at the date of initial application. FOR THE YEAR ENDED DECEMBER 31 Contract asset 2018 $24,762 2017 $- Page 48 Avcorp Industries Inc. Notes to Consolidated Financial Statements For the year ended December 31, 2018 (all figures in tables are expressed in thousands of Canadian dollars, except per share amounts) annual report 2018 11. Inventories FOR THE YEAR ENDED DECEMBER 31 Raw materials Work-in-progress Finished products Inventory obsolescence 2018 $11,164 9,231 890 (5,684) 15,601 2017 $24,762 22,156 2,238 (6,375) 42,781 The amount of inventory expensed in cost of sales during the year ended December 31, 2018 amounted to $147,038,000 (December 31, 2017: $162,217,000). The carrying value of inventory pledged as security under the Company’s operating line of credit (note 16) as at December 31, 2018 is $41,223,000 (note 3) (December 31, 2017: $42,781,000). During the year ended December 31, 2018, $466,000 (December 31, 2017: $1,698,000) was recognized as an expense for inventories carried at net realizable value. This is recognized in cost of sales. Upon transition to IFRS 15 on January 1, 2018, the Company carried $16,443,000 in inventory (note 3). Certain program inventories have been funded by a customer, whereby the associated contract liabilities will be recorded as revenue upon delivery of units of production. 12. Prepayments and Other Assets FOR THE YEAR ENDED DECEMBER 31 Deposits on material purchases Prepaid insurance Prepaid IT security maintenance and licenses Prepaid property tax Prepaid other 13. Development Costs 2018 $934 3,351 641 645 505 6,076 2017 $1,126 1,763 625 425 451 4,390 Development costs represent hard and soft tooling, and prototype design costs incurred for various customer programs. FOR THE YEAR ENDED DECEMBER 31 Opening balance Additions Amortization Foreign exchange FOR THE YEAR ENDED DECEMBER 31 Cost Accumulated amortization Net book amount 2018 $8,623 6,410 (3,291) 13 11,755 2018 $22,951 (11,196) 11,755 2017 $5,200 5,347 (1,924) - 8,623 2017 $16,528 (7,905) 8,623 Customers have funded non-recurring costs incurred during the introduction of new production programs. These costs are deferred as development costs and are amortized to income in conjunction with the associated production activities, upon commencement of production, on a units-of-production basis over the expected life of the programs. Page 49 Avcorp Industries Inc. Notes to Consolidated Financial Statements For the year ended December 31, 2018 (all figures in tables are expressed in thousands of Canadian dollars, except per share amounts) annual report 2018 14. Property, Plant and Equipment Machinery and equipment Computer hardware and software Leasehold improvements Year ended December 31, 2017 Opening net book amount Additions Disposals – cost Disposals – accumulated depreciation Depreciation charge Currency translation adjustment Closing net book amount At December 31, 2017 Cost Accumulated depreciation Net book amount Year ended December 31, 2018 Opening net book amount Additions Disposals – cost Disposals – accumulated depreciation Depreciation charge Currency translation adjustment Closing net book amount At December 31, 2018 Cost Accumulated depreciation Net book amount $30,024 967 (39) 4 (3,611) (1,380) 25,965 56,395 (30,430) 25,965 25,965 1,443 - - (3,667) 1,550 25,291 59,907 (34,616) 25,291 $953 1,315 - - (183) (57) 2,028 9,314 (7,286) 2,028 2,028 227 - - (473) 113 1,895 9,676 (7,781) 1,895 $953 772 - - (359) (41) 1,325 2,690 (1,365) 1,325 1,325 139 - - (342) 108 1,230 2,962 (1,732) 1,230 Total $31,930 3,054 (39) 4 (4,153) (1,478) 29,318 68,399 (39,081) 29,318 29,318 1,809 - - (4,482) 1,771 28,416 72,545 (44,129) 28,416 The Company has $580,000 in commitments at December 31, 2018 (December 31, 2017: $1,012,000) to purchase property, plant and equipment in 2019 (note 23). Included in computer hardware and software are assets held under finance leases at a cost of $190,000 (December 31, 2017: $24,000) having accumulated depreciation of $31,000 (December 31, 2017: $14,000). Included in machinery and equipment are assets held under finance leases at a cost of $630,000 (December 31, 2017: $416,000) having accumulated depreciation of $123,000 (December 31, 2017: $66,000). Page 50 Avcorp Industries Inc. Notes to Consolidated Financial Statements For the year ended December 31, 2018 (all figures in tables are expressed in thousands of Canadian dollars, except per share amounts) annual report 2018 15. Intangibles Year ended December 31, 2017 Opening net book amount Additions Amortization charge Currency translation adjustment Closing net book amount At December 31, 2017 Cost Accumulated depreciation Net book amount Year ended December 31, 2018 Opening net book amount Additions Amortization charge Currency translation adjustment Closing net book amount At December 31, 2018 Cost Accumulated depreciation Net book amount 16. Bank Indebtedness Lease Customer contract – re-compete Developed Software $483 - (234) (24) 225 677 (452) 225 225 - (233) 8 - 737 (737) - $4,404 - (1,065) (253) 3,086 5,143 (2,057) 3,086 3,086 - (1,062) 214 2,238 5,593 (3,355) 2,238 $- 571 - (18) 553 553 - 553 553 371 (84) 59 899 988 (89) 899 Total $4,887 571 (1,299) (295) 3,864 6,373 (2,509) 3,864 3,864 371 (1,379) 281 3,137 7,318 (4,181) 3,137 On September 27, 2012 the Company entered into a loan agreement with a Canadian chartered bank for a $12,000,000 principal amount secured debt facility. On May 26, 2017, the Company entered into a loan agreement to expand its loan facility with a Canadian Chartered bank. This loan agreement amends, restates and replaces the loan agreement entered into on September 27, 2012. This revolving loan provides an additional borrowing capacity of up to USD$35,000,000 increasing its existing, as at March 30, 2017, USD$23,000,000 revolving loan in total up to USD$58,000,000. The loan agreement matures on June 30, 2020. Interest rate for advances made up to the maximum of the allowable borrowing base on the existing USD$23,000,000 revolving loan: RBP plus 0.75% per annum RBUSBR plus 0.75% per annum BA Equivalent Rate plus 2.25% per annum LIBOR Rate plus 2.25% per annum Interest rate for advances made on the additional borrowing capacity up to USD$58,000,000. RBP plus 0.00% per annum RBUSBR plus 0.00% per annum BA Equivalent Rate plus 0.875% per annum LIBOR Rate plus 0.875% per annum Drawdown under the USD$35,000,000 additional borrowing capacity is supported by a major and material customer of the Company by way of a guarantee. The Company will provide the guarantor, as consideration for the guarantee, a fee equal to 5.375% of the weighted average outstanding balance of the guaranteed portion over each full twelve (12) month period commencing on the funding date plus, for the partial year thereafter, 5.375% of the weighted average outstanding balance of the guaranteed portion multiplied by the number of days in the partial year divided by three hundred sixty (360). The fee will be payable on the maturity date. Page 51 Avcorp Industries Inc. Notes to Consolidated Financial Statements For the year ended December 31, 2018 (all figures in tables are expressed in thousands of Canadian dollars, except per share amounts) annual report 2018 On March 28, 2018, the Company entered into an amendment to its existing credit facility (“Revolving Loan”) with a Canadian chartered bank whereby the following amendments were made: Availability under the Revolving Loan is increased by USD$10,000,000 (“Expanded Loan”) subject to existing drawdown provisions, interest rates and bonus fees; Drawdowns under the Expanded Loan are supported by a major and material customer of the Company by way of a guarantee; and The Expanded Loan matures on March 31, 2019. On May 25, 2018, the Company entered into an amendment to its existing credit facility with a Canadian chartered bank whereby the following amendment was made: Maximum availability under the Revolving Loan cannot exceed USD$68,000,000 less USD$4,300,000, until August 31, 2018, at which time the agreement reverts back to existing terms. On September 5, 2018, the Company entered into an amendment to its existing credit facility with a Canadian chartered bank whereby the following amendment was made: Maximum availability under the Revolving Loan cannot exceed USD$68,000,000 less USD$4,300,000, until September 30, 2018, at which time the agreement reverts back to existing terms. On September 28, 2018, the Company entered into an amendment to its existing credit facility with a Canadian chartered bank whereby the following amendment was made: Maximum availability under the Revolving Loan cannot exceed USD$68,000,000 less USD$4,300,000, until December 30, 2018, at which time the agreement reverts back to existing terms. On November 27, 2018, the Company entered into an amendment to its existing credit facility with a Canadian chartered bank whereby the following amendment was made: Maximum availability under the Revolving Loan cannot exceed USD$68,000,000 less USD$4,300,000, until January 31, 2019, at which time the agreement reverts back to existing terms (notes 35a and c). The loan agreement is subject to the existing security agreements with a Canadian Chartered bank and with its guarantor. This debt facility is secured by a charge and specific registration over all of the assets of the Company. The Company ended the year with bank operating line utilization of $85,840,000 offset by $2,051,000 cash compared to utilization of $61,283,000 with $5,212,000 cash on hand as at December 31, 2017. Based on net collateral provided to its bank, the Company is able to draw up to an additional USD$776,000 on its operating line of credit as at December 31, 2018 (December 31, 2017: USD$9,149,000). As at the date of this report the Company is able to draw up to an additional USD$9,659,000 (note 35b) on its operating line of credit. FOR THE YEAR ENDED DECEMBER 31 Opening balance Add: Drawdowns on bank indebtedness Less: Repayment of loans Less: Foreign exchange loss (gain) Ending balance 17. Customer advance 2018 $61,283 17,961 - 6,596 85,840 2017 $17,111 102,045 (55,173) (2,700) 61,283 On December 18, 2015, in conjunction with the acquisition of Hitco, the Company assumed a customer advance for pre-funded product deliveries. The customer advance is re-paid as the Company delivers to the customer. In the event that cancellation, termination, or assignment of the statement of work occurs earlier than December 31, 2019, the customer shall have the right to recover from the Company within 120 days of such an event the unamortized portion of the cash advance; such event occurred during the third quarter 2018 (note 20). The customer advance is subject to an access and security agreement along with a general security agreement entered into with the Company’s bank and a customer. The customer advance was recorded at its fair value on December 18, 2015 in the amount of $18,953,000 (December 31, 2017: $7,227,000). The Company amortized into revenue $2,660,000 of the customer advance during the year ended December 31, 2018 (December 31, 2017: $3,702,000). The remaining unamortized customer advance has been recorded at its face value to reflect the amount due and is non-interest bearing. The face value of the unamortized portion of the cash advance as at December 31, 2018 is USD$4,643,000 (December 31, 2017: USD$7,219,000). Page 52 Avcorp Industries Inc. Notes to Consolidated Financial Statements For the year ended December 31, 2018 (all figures in tables are expressed in thousands of Canadian dollars, except per share amounts) annual report 2018 FOR THE YEAR ENDED DECEMBER 31 Opening balance Amortization Contract modification (note 20) Foreign exchange 18. Accounts Payable and Accrued Liabilities FOR THE YEAR ENDED DECEMBER 31 Trade payables Claims provision (note 27) Payroll-related liabilities Accrued interest Restoration provision Restructuring provision Other 19. Contract Liability FOR THE YEAR ENDED DECEMBER 31 Opening balance IFRS 15 opening adjustment Additions Realized Less: Current portion Non-current portion 2018 $7,227 (2,660) 1,240 (527) 6,334 2018 $28,225 7,640 4,707 423 456 17 337 2017 $11,573 (3,702) - (644) 7,227 2017 $17,263 - 5,150 264 446 103 33 41,805 23,259 2018 $17,241 (9,341) 13,125 (16,026) 4,999 2,137 2,862 2017 $13,972 - 10,502 (7,233) 17,241 17,131 110 Certain program inventories have been funded by a customer, whereby the associated deferred program revenues will be recognized as revenue upon delivery of units of production. Additionally, customers have funded non-recurring costs incurred during the introduction of new production programs. These costs are deferred as development costs and will be amortized to income, on a units-of-production basis over the expected life of the programs, in conjunction with the associated deferred revenue upon commencement of production. Upon transition to IFRS 15 on January 1, 2018, the Company carried $7,900,000 in contract liability (note 3). 20. Unfavourable Contracts Liability On December 18, 2015, in conjunction with the acquisition of Hitco, the Company assumed an unfavourable contract liability on certain long term revenue contracts for which unavoidable costs are expected to exceed the corresponding revenues earned. The unfavourable contract liability is amortized into income on a units-of-production basis over the expected life of the contracts which are contracted up to December 31, 2019 and as costs are incurred. During 2018 production requirements associated with the unfavourable contract were redirected to another supplier, giving rise to the full amortization of the unfavourable contract liability into income. This has been recorded in Consolidated Statements of Income and Comprehensive Income as a contract modification in the amount of $39,982,000. Uncertainties exist as to the ultimate outcome of a formal contract termination. While the Company believes that it has fulfilled all of its obligations under the contract, it is possible claims may be levied against the Company. The Company has assessed such possible claims as not probable. As at December 31, 2018, the remaining unamortized unfavourable contract liability amounted to $Nil (December 31, 2017: $44,460,000). Upon transition to IFRS 15 on January 1, 2019, the Company carried $42,882,000 in unfavourable contract liability. Page 53 Avcorp Industries Inc. Notes to Consolidated Financial Statements For the year ended December 31, 2018 (all figures in tables are expressed in thousands of Canadian dollars, except per share amounts) annual report 2018 FOR THE YEAR ENDED DECEMBER 31 Opening net book amount IFRS 15 opening adjustment Amortization Contract modification Foreign exchange Closing net book amount Less: Current portion Non-current portion 21. Term Debt FOR THE YEAR ENDED DECEMBER 31 Finance leases (a) Term loans (b) (c) (d) SADI (e) Less: Current portion Non-current portion a) Finance Leases 2018 $44,460 (1,578) (4,617) (39,982) 1,717 - - - 2018 $422 4,986 2,902 8,310 5,510 2,800 2017 $56,969 - (9,058) - (3,451) 44,460 16,881 27,579 2017 $218 1,237 1,715 3,170 1,285 1,885 There are various equipment leases that have a weighted average interest rate of 8.98% per annum (2017: 8.01%). The leases are secured by way of a charge against specific assets. The leases are repayable in equal installments over periods up to 60 months. b) Term Loan On September 19, 2016, Avcorp entered into a non-revolving term loan agreement (“loan”) with Panta Canada B.V. (“Panta”) to fund the Company to a maximum aggregate principal amount of USD$5,000,000 due on April 7, 2017. The Company received its first advance on September 23, 2016 of USD$2,000,000 ($2,612,000). On October 25, 2016, Panta provided a second advance in the amount of USD$1,500,000 ($1,983,000) and a third advance on November 15, 2016 in the amount of USD$1,500,000 ($2,020,000). Panta Canada B.V. is Avcorp’s majority shareholder owning approximately 71.2% of the issued and outstanding common shares on December 31, 2018. Panta Canada B.V. is wholly owned by Panta Holdings B.V. Both companies are incorporated in The Netherlands and Mr. Jaap Rosen Jacobson, a director of the Company, is the sole shareholder of Panta Holdings B.V. The Company’s acceptance of this loan was subject to a 3% commitment fee (USD$150,000) paid by the Company to Panta Canada B.V. from proceeds of the first advance. In conjunction with receiving advances under the term loan, the Company issued Panta 30,714,118 common share purchase warrants (“warrants”) on a pro-rata basis, each warrant is exercisable for a period of 24 months following the date of issuance with respect to one common share at an exercise price of $0.07 per common share. The Company issued 12,285,647 such warrants on September 19, 2016, 9,214,235 such warrants on October 24, 2016, and 9,214,236 such warrants on November 10, 2016. The warrants were valued at fair value on date of issue using the Black Scholes option pricing model. The loan bears interest at 8% per year, is subordinated to existing security agreements and could be prepaid without interest and penalties. The interest rate will increase to 15% per year, and all outstanding indebtedness including unpaid interest, will continue to accrue such interest, after the loan maturity date until paid in full. The loan and all accrued interest was due and payable on April 7, 2017. As at that date the Company and Panta amended the term loan to provide for a maturity date which is the earlier of the date on which credit is available to be drawn by the Company under the revolving loan with a Canadian Chartered bank, and July 6, 2017, with interest continuing at 8% per year. The Company incurred a USD$100,000 amendment fee in this regard. Effective July 6, 2017 the Company and Panta amended the term loan to provide for a maturity date which is the earlier of (i) the date upon which, for any reason, the outstanding principal balance of the revolving loan with a Canadian Chartered bank becomes due and owing and (ii) the date on which all or substantially all the assets of Comtek are sold by the Borrower or a controlling interest in the shares of Comtek is sold by the Borrower in each case by a transaction or series of transactions, and (iii) July 6, 2021. Page 54 Avcorp Industries Inc. Notes to Consolidated Financial Statements For the year ended December 31, 2018 (all figures in tables are expressed in thousands of Canadian dollars, except per share amounts) annual report 2018 As at July 7, 2017 the loan bears interest at the aggregate rate of interest, expressed as an annual rate, of the U.S. Base Rate of Royal Bank of Canada (RBUSBR) plus a margin of 5.375% per annum which shall accrue and not be compounded until the maturity date. On July 31, 2017 the Company repaid a principal amount of USD$2,500,000 plus interest accrued in the amount of USD$285,000 of the Panta term loan. On August 3, 2017 Panta exercised 12,105,327 warrants expiring August 17, 2017 at $0.07 whose aggregate price of $847,000 was deemed to be made by way of set-off against the Panta loan obligation (note 24). On August 25, 2017 Panta exercised 6,052,664 warrants expiring September 9, 2017 at $0.07 whose aggregate price of $424,000 was deemed to be made by way of set-off against the Panta loan obligation (note 24). On September 8, 2017 Panta exercised 12,105,327 warrants expiring September 23, 2017 at $0.07 whose aggregate price of $847,000 was deemed to be made by way of set-off against the Panta loan obligation (note 24). On September 19, 2018, Panta exercised 30,714,118 warrants at $0.07 whose aggregate price of $2,150,000 was deemed to be made by way of set-off in the amount of $1,212,000 against the Panta loan obligation, with the remaining $938,000 as funds received by the Company (note 24). FOR THE YEAR ENDED DECEMBER 31 Opening balance Accrued interest Less: Repayment Less: Exercise of warrants Add: Foreign exchange gain Accretion c) Term Loan 2018 $1,088 77 - (1,212) 47 - - 2017 $6,123 348 (3,478) (2,118) (502) 715 1,088 On August 24, 2018, Avcorp entered into a non-revolving term loan agreement (“loan”) with Panta Canada B.V. (“Panta”) in the principal amount of USD$3,500,000. Panta Canada B.V. is Avcorp’s majority shareholder owning approximately 71.2% of the issued and outstanding common shares. Panta Canada B.V. is wholly owned by Panta Holdings B.V. Both companies are incorporated in The Netherlands and Mr. Jaap Rosen Jacobson, a director of Avcorp, is the sole shareholder of Panta Holdings B.V. The loan is subordinated to existing security agreements, except that in the event that Avcorp sells its wholly-owned subsidiary, Comtek Advanced Structures Ltd., Avcorp shall pay to Panta an amount up to the indebtedness then outstanding under the loan, subject to any priority payment required by the bank indebtedness and provided there does not then exist an event of default under the Senior Loan Agreement. The loan bears interest at the aggregate rate of interest, expressed as an annual rate, of the U.S. Base Rate of Royal Bank of Canada (“RBUSBR”) plus a margin of 5.375% per annum which shall accrue and not be compounded until the maturity date. If either an event of default occurs and is continuing or the indebtedness is not repaid in full on the maturity date, the interest rate in such period shall increase to the rate of 15% per annum and all outstanding indebtedness, including unpaid interest, shall continue to accrue interest at such increased rate of interest from and after the maturity date until paid in full. The maturity date is the earlier of: (i) the date upon which, for any reason, the outstanding principal balance of the operating credit facility established under the Senior Loan Agreement becomes due and owing; (ii) June 30, 2020; and (iii) the date on which there is an acceleration of the loan as a result of a written demand by Panta following the occurrence and during the continuance of an uncured event of default. Upon the happening of any event of default, Panta may at its option: (i) declare that the indebtedness has become immediately due and payable; and (ii) declare that the indebtedness has become immediately due and payable and elect to convert all or part of the indebtedness into common shares of Avcorp at an exercise price equivalent to the then market price at the time of conversion which shall not exceed $0.15 per common share. FOR THE YEAR ENDED DECEMBER 31 Opening balance Accrued interest Add: Foreign exchange gain 2018 $4,572 175 209 4,956 Page 55 Avcorp Industries Inc. Notes to Consolidated Financial Statements For the year ended December 31, 2018 (all figures in tables are expressed in thousands of Canadian dollars, except per share amounts) annual report 2018 d) Term Loan On March 13, 2015, the Company completed a secured term loan with a principal amount of $450,000. The Company received full funding from the loan on March 26, 2015. The purpose of the loan was to finance machinery and equipment required for new production programs at its Burlington ON facility. The term loan has been provided by a Canadian chartered bank. The loan has a four year term; it is secured by a general security agreement constituting a first ranking security interest in all personal property of the Company and a first ranking and specific interest in the equipment financed. Export Development Canada (“EDC”) has guaranteed 50% of the aggregate borrowings outstanding under the loan. The fee associated to the guarantee provided by EDC is equal to 3% of 50% of the outstanding loan amount. Interest is calculated and paid monthly at a rate of bank prime plus 1%. The loan will be repaid over 48 months by way of blended principal and interest payments. The balance outstanding for this term loan as at December 31, 2018 is $30,000 (December 31, 2017: $149,000). e) SADI On April 23, 2014, the Company secured funding for certain non-recurring expenditures and manufacturing equipment. The Government of Canada under the Strategic Aerospace and Defence Initiative (“SADI”) program has committed up to $4.4 million for funding of program eligible costs. The contribution amount represents 40% funding for eligible costs. The contribution agreement has the following terms: The maximum amount to be repaid by the Company is 1.5 times the amount contributed by the Government of Canada; Annual repayments are to occur over a 15 year term, commencing four months following the 2018 fiscal year end with subsequent annual repayments to be paid within four months following the Company’s then fiscal year ends; and Amounts repayable are unsecured. $2,902,000 was drawn on this facility as at December 31, 2018 (December 31, 2017: $1,715,000). The amounts owing, when due, are repayable to the Industrial Technologies Office. FOR THE YEAR ENDED DECEMBER 31 Opening balance Add: Accrued interest Add: Contributions Ending Balance 22. Onerous Contract Provision 2018 $1,715 95 1,092 2,902 2017 $1,398 57 260 1,715 The Company entered into production contracts in the ordinary course of business. The unavoidable costs of meeting the obligations under certain of these contracts exceed the associated expected future net benefits; consequently, an onerous contract provision has been recognized. The calculation of this provision involves the use of estimates. The onerous contract provision is calculated by taking the expected future costs that will be incurred under the contracts and deducting any estimated revenues. The onerous contract provision for the period ended December 31, 2018 is $1,930,000 (December 31, 2017: $13,366,000). FOR THE YEAR ENDED DECEMBER 31 Opening balance Additions Amortization Contract modification (note 20) Foreign exchange Balance Less: Current portion Non-current portion 2018 $13,366 - (9,115) (2,728) 409 1,930 1,809 121 2017 $37 13,603 - - (274) 13,366 7,297 6,069 Page 56 Avcorp Industries Inc. Notes to Consolidated Financial Statements For the year ended December 31, 2018 (all figures in tables are expressed in thousands of Canadian dollars, except per share amounts) annual report 2018 23. Obligations and Commitments Under Finance and Operating Leases, and Contingent Liabilities The Company has committed to payments under certain capital and operating leases relating to manufacturing machinery and equipment, and building lease costs. Future minimum lease payments required in each of the next five fiscal years and thereafter are: FOR THE YEAR ENDED DECEMBER 31 2018 2017 2018 2019 2020 2021 2022 2023 Thereafter Total future minimum lease payments Less: Imputed interest Balance of obligation under finance leases included in term debt (note 22) Operating Finance Operating Finance $- 4,552 4,391 4,432 4,421 2,749 11,724 32,269 n/a n/a $- 190 151 100 40 - - 481 (59) 422 $4,416 2,500 2,301 2,164 2,287 2,419 11,152 27,239 n/a n/a $94 84 44 25 - - - 246 (28) 218 For the year ended December 31, 2018, an amount of $4,667,000 representing payments under operating leases was expensed (December 31, 2017: $2,865,000). The Company has $580,000 in commitments at December 31, 2018 (December 31, 2017: $1,012,000) to purchase property, plant and equipment in 2019. Under a settlement entered into with SGL (note 35), the Company entered into a First Amendment to an Industrial Lease, extending the current lease expiry date of December 17, 2019 to December 31, 2022. The lease amendment additionally provides an option for the Company to extend the lease term from the last day of the initial term to December 31, 2023, and a subsequent further option to extend the lease term to December 31, 2024. As at December 31, 2018 the Company had $51,613,000 of committed contractual operational purchase order obligations outstanding (December 31, 2017: $38,811,000). Prior to 2018, two of the Company’s customers have made certain claims against the Company; one in the amount of €2,864,000 which represents a claim against the Company for untimely delivery of product to that customer; the second claim in the amount of $700,000USD which represents a claim for certain services performed by the second customer on behalf of the Company. The Company had a claim, in excess of the amounts claimed, against one of the customers. The Company and its two customers have negotiated a three-way settlement (note 27). 24. Capital Stock The Company is authorized to issue an unlimited number of common shares as well as an unlimited number of first preferred and second preferred shares, issuable in series, the terms of which will be determined by the Company’s directors at the time of creation of each series. There were 368,118,620 common shares issued at December 31, 2018. Common shares issued or reserved: December 31, 2016 Share issue Exercise of stock warrants (b) Transfer from contributed surplus on exercise of stock warrants (b) December 31, 2017 Share issue Exercise of stock warrants (a) Transfer from contributed surplus on exercise of stock warrants (a) December 31, 2018 Number of shares 307,141,184 Amount 80,302 30,263,318 - 337,404,502 30,714,118 - 368,118,620 2,118 485 82,905 2,150 1,164 86,219 Page 57 Avcorp Industries Inc. Notes to Consolidated Financial Statements For the year ended December 31, 2018 (all figures in tables are expressed in thousands of Canadian dollars, except per share amounts) annual report 2018 a) During the third quarter 2018 holders of the Company’s warrants exercised 30,714,118 warrants at a price of $0.07 resulting in the issuance of 30,714,118 common shares with a value of $2,150,000. b) During the third quarter 2017 holders of the Company’s warrants exercised 30,263,318 warrants at a price of $0.07 resulting in the issuance of 30,263,318 common shares with a value of $2,118,000. c) The Company’s incentive stock option plan is administered by the Board of Directors. It is a rolling share option plan wherein 10% of the issued and outstanding common shares at the time an option is granted are reserved for issuance. A summary of the Company’s stock options issued as of December 31, 2018 and December 31, 2017, and changes during the periods ending on those dates, are presented below. FOR THE YEAR ENDED DECEMBER 31 2018 Weighted average exercise price Options 2017 Options Weighted average exercise price Outstanding – Beginning of year 49,532,500 $0.092 52,225,500 $0.092 Granted Expired Exercised Forfeited 4,710,500 (29,390,000) - 0.042 0.094 - - - - (13,410,000) 0.090 (2,693,000) Outstanding – End of year 11,443,000 0.067 49,532,500 - - - 0.095 0.092 The options granted during the current year vest over a period of one to four years and have a weighted average remaining life of 7.23 years. The following table summarizes stock options which are exercisable as at December 31, 2018: $0.085 d) The Company’s contributed surplus is comprised as follows: FOR THE YEAR ENDED DECEMBER 31 Beginning of year Stock-based compensation expense Forfeiture of issued stock options Transfer to share capital on exercise of warrants End of year Weighted average remaining contractual life (years) Weighted average exercise price 1.94 $0.085 Number 6,732,500 2018 $6,979 195 (640) (1,164) 5,370 2017 $6,744 718 2 (485) 6,979 The stock-based compensation expense is included in the Consolidated Statements of Income and Comprehensive Income as administrative and general expenses and amounts to $195,000 (December 31, 2017: $718,000). The forfeiture of issued stock options was included in the Consolidated Statements of Income and Comprehensive Income as administrative and general expense of $640,000 as a recovery of expense. Panta exercised 30,714,118 common share purchase warrants (“warrants”) at a price of $0.07 resulting in the issuance of 30,714,118 common shares on September 19, 2018. Page 58 Avcorp Industries Inc. Notes to Consolidated Financial Statements For the year ended December 31, 2018 (all figures in tables are expressed in thousands of Canadian dollars, except per share amounts) annual report 2018 e) A summary of the Company’s warrants issued as of December 31, 2018 and December 31, 2017, and changes during the periods ending on those dates, are presented below. FOR THE YEAR ENDED DECEMBER 31 Outstanding – Beginning of year Granted Expired Exercised (i) Outstanding – End of year 2018 2017 30,714,118 60,977,436 - - - - (30,714,118) (30,263,318) - 30,714,118 i. September 19, 2018: Exercise of 30,714,118 Warrants expiring September 19, 2018 at $0.07 to Panta. August 3, 2017: Exercise of 12,105,327 Warrants expiring August 17, 2017 at $0.07 to Panta. August 25, 2017: Exercise of 6,052,664 Warrants expiring September 9, 2017 at $0.07 to Panta. September 8, 2017: Exercise of 12,105,327 Warrants expiring September 27, 2017 at $0.07 to Panta. 25. Stock Based Compensation The Company records compensation expense for the fair value of the stock options granted under its incentive stock option plan using the Black-Scholes option-pricing model. This model determines the fair value of stock options granted and amortizes it to earnings over the vesting period. The fair value of 4,710,500 options granted during the year ended December 31, 2018 was $204,000 (December 31, 2017: $Nil). The assumptions used in the valuation of stock options were as follows: Number of options Risk-free rate (%) Dividend yield (%) Expected Lives (years) Volatility (%) 2018 4,710,500 Options 2.35 - 7.65 103.11 The amount of stock-based compensation expense, for options granted in current and prior periods, amortized to earnings during the year ended December 31, 2018 was $195,000 (2017: $718,000). Stock-based compensation expense has been included in the Consolidated Statements of Loss and Comprehensive Loss as administrative and general expenses. During the year ended, 13,410,000 stock options were forfeited. The Black-Scholes option-pricing model used by the Company to calculate option values was developed to estimate the fair value of freely tradeable, fully transferable options without vesting restrictions, which significantly differ from the Company’s stock option awards. Changes in the subjective input assumptions can materially affect the fair value estimate, and therefore, the existing models do not necessarily provide a reliable, single measure of the fair value of options granted by the Company. 26. Defined Contribution Plan The total cost recognized and paid for the Company’s defined contribution plans is as follows. FOR THE YEAR ENDED DECEMBER 31 Defined contribution plan 2018 $1,376 2017 $1,341 The Company’s contribution to the plan is calculated on a percentage of employee wages. The range of percentages is 1.5% to 9.5%. The plan is available to all employees. Defined contribution plan expenses have been included in the Consolidated Statements of Loss and Comprehensive Loss as administrative and general expenses and cost of sales. 27. Claim Position On August 20, 2018, the Company entered into a settlement agreement with a customer, in the amount of $2,219,000, which provided the Company a net claim settlement in satisfaction of existing and potential claims, causes of action, and disputes between the Company and its customer. The Company has provisioned for a claim asserted by a customer in the amount of $7,640,000. Page 59 Avcorp Industries Inc. Notes to Consolidated Financial Statements For the year ended December 31, 2018 (all figures in tables are expressed in thousands of Canadian dollars, except per share amounts) annual report 2018 28. Finance Costs FOR THE YEAR ENDED DECEMBER 31 Interest on finance leases Interest on other term debt Interest on bank indebtedness Interest on related party debt Non-cash financing cost accretion Interest expense Interest income Net interest expense 29. Supplementary Cash Flow Information FOR THE YEAR ENDED DECEMBER 31 Equipment acquired under capital lease Panta loan settled with exercise of warrants Restoration provision revaluation Transfer to share capital on exercise of warrants 30. Income Tax 2018 $35 112 5,405 252 9 5,813 (39) 5,774 2018 $380 1,212 - 1,164 2017 $12 173 1,711 335 589 2,820 (14) 2,806 2017 $125 2,118 185 485 The provision for income tax (recovery) expense is based on the combined Canadian federal and provincial annual income tax rate expected for the full financial year of 27%. On December 22, 2017, the U.S. enacted the Tax Cuts and Job Act (TCJA). Substantially all the provisions of the TCJA are effective for taxable years beginning after December 31, 2017. The most significant provisions of Tax Reform that impact the Company is the reduction in the federal corporate tax rate from 35% to 21%. IAS 12, Income Taxes, states that the tax effects of changes in tax laws must be recognized in the period in which the law is enacted or substantively enacted. IAS 12 further requires deferred income tax assets and liabilities to be measured at the enacted or substantively enacted tax rate expected to apply when temporary differences are to be realized or settled. Thus, at the date of enactment, the Company’s deferred income taxes were re-measured based upon the new tax rate. The change in deferred income taxes is generally recorded as a non-cash re-measurement adjustment to earnings. The Company has made a reasonable estimate for the measurement of certain effects of the TCJA. However, considered in net, no deferred tax assets/liabilities were booked. As the Company has not recognized any net deferred tax assets, historically or currently, the TCJA has no tax impact on the Company as of December 31, 2018 (2017: $Nil). Deferred income tax assets are recognized for deductible temporary differences, unused tax losses, and unused tax credits to the extent that the realization of the related tax benefit through future taxable profits is probable. The Company did not recognize deferred income tax assets of $28,897,000 (2017: $35,727,000) in respect of losses amounting to $59,362,000 (2017: $107,532,000) which include foreign losses of $30,830,000 (2017: $29,260,000) that will expire beginning in 2035 through 2037 (except current year U.S. Net Operating Losses of $13,443,000 that carryforward indefinitely), unclaimed research and development costs of $11,173,000 (2017: $10,830,000) and capital losses of $830,000 (2017: $Nil) with no expiry, investment tax credits of $1,814,000 (2017: $1,726,000) which expire beginning in 2019 through 2037, and deductible temporary differences of $30,829,000 (2017: $35,058,000). The company has recognized $Nil (2017: $Nil) in deferred income tax liabilities in relation to the fair value of the intangible lease. Income tax expense reported differs from the amount computed by applying the combined Canadian federal and provincial income tax rates, applicable to Avcorp Industries Inc., to the income (loss) before taxes due to the following: FOR THE YEAR ENDED DECEMBER 31 Canadian federal and provincial income tax rates Income tax expense (recovery) at statutory rate Change in unrecognized temporary differences Tax rate differences Permanent differences Tax expense (recovery) 2018 27.00% $5,501 (4,778) (45) (678) - 2017 26.00% $(15,205) 15,964 (959) 200 - Page 60 Avcorp Industries Inc. Notes to Consolidated Financial Statements For the year ended December 31, 2018 (all figures in tables are expressed in thousands of Canadian dollars, except per share amounts) annual report 2018 31. Related Party Transactions a) Periodically, consulting services are provided by certain directors. Fees paid to certain directors, or companies with which they have beneficial ownership, during the year ended December 31, 2018 amounted to $Nil (December 31, 2017: $437,000). Fees payable to certain directors or Companies with which they have beneficial ownership, as at December 31, 2018 are $Nil (December 31, 2017: $Nil). These fees are included in the Consolidated Statements of Income and Comprehensive Income as administrative and general expenses and amount to $Nil for the year ended December 31, 2018 (December 31, 2017: $61,000). b) Key management compensation Key management includes Executive Officers for all operating facilities. The compensation paid or payable to key management for employee services is shown below. FOR THE YEAR ENDED DECEMBER 31 Salaries and other short-term employee benefits Contributions to defined contribution plan Option-based awards c) Loans to related parties 2018 $2,150 67 164 2,381 2017 $2,285 75 659 3,019 The balance of loans receivable from key management as at December 31, 2018 is $15,000 (December 31, 2017: $15,000). These loans are unsecured and payable on demand. Other related party transactions are disclosed elsewhere in these consolidated financial statements (note 21). These transactions were conducted in the normal course of business and were accounted for at the exchange amount. 32. Earnings per share The following reflects the share data used in the basic and diluted earnings per share computations: FOR THE YEAR ENDED DECEMBER 31 2018 2017 Weighted average number of common shares for basic earnings per share 345,651,033 318,019,396 Effect of dilution: Warrants 342,428 - Weighted average number of ordinary shares adjusted for the effect of dilution 345,993,461 318,019,396 There have been no other transactions involving common shares or potential common shares between the reporting date and the date of authorization of these consolidated financial statements. 33. Economic Dependence and Segmented Information The Company reports financial performance based on three reportable segments as detailed below. The Company's Chief Operating Decision Maker (“CODM”) utilizes Operating Income Loss as a primary measure of profitability to evaluate performance of its segments and allocate resources: The Avcorp Structures & Integration (“ASI”) segment, which is dedicated to metallic and composite aerostructures assembly and integration. The Comtek Advanced Structures Ltd. (“Comtek”) segment, within which exists two divisions dedicated to aircraft structural component repair services, and Avcorp Engineered Composites (“AEC”) dedicated to design and manufacture of composite aerostructures. The Avcorp Composite Fabrication Inc. (“ACF”) segment is dedicated to advanced composite aerostructures fabrication. No operating segments have been aggregated to form the above reportable operating segments. Corporate includes general corporate administrative costs and any other costs not identifiable with one of the Company’s segments. The Company’s Board of Directors monitors the operating results of its business units separately for the purpose of making decisions about resource allocation and performance assessment. Segment performance is evaluated based on operating profit or loss and is measured consistently with operating profit or loss in the Consolidated Statements of Income and Comprehensive Income. Page 61 Avcorp Industries Inc. Notes to Consolidated Financial Statements For the year ended December 31, 2018 (all figures in tables are expressed in thousands of Canadian dollars, except per share amounts) annual report 2018 a) Sales to five major customers for the year ended December 31, 2018, which comprise several programs and contracts, accounted for approximately 89.0% (December 31, 2017: 82.8%) of sales. FOR THE YEAR ENDED DECEMBER 31 20182 2017 BAE Systems Boeing1 Bombardier Lockheed Martin Subaru Corporation Other Amortization of the unfavourable contract liability Revenue % of Total Revenue % of Total $15,789 67,606 20,860 24,527 22,970 14,341 4,617 9.3 39.6 12.2 14.4 13.5 8.3 2.7 $5,413 59,089 19,134 15,735 24,566 16,449 9,058 3.6 39.5 12.8 10.5 16.4 11.0 6.2 Total 170,710 100.0 149,444 100.0 1. 2. Includes Boeing program partner revenue consisting of industry tier-one suppliers to Boeing Includes revenue recognized as a result of a change in revenue recognition policy under IFRS 15 b) The Company’s sales are distributed amongst the following geographical locations based on location of customers: FOR THE YEAR ENDED DECEMBER 31 2018 2017 Canada USA Europe Asia Australia Other Amortization of the unfavourable contract liability Revenue % of Total Revenue % of Total $27,165 91,302 21,961 25,400 238 27 4,617 15.9 53.6 12.8 14.9 0.1 0.0 2.7 $26,498 80,976 6,375 26,016 358 163 9,058 17.7 54.2 4.3 17.3 0.2 0.1 6.2 Total 170,710 100.0 149,444 100.0 c) The Company operates in one industry that involves the manufacture and sale of aerospace products. All of the Company’s operations and assets are in Canada and in the United States. FOR THE YEAR ENDED DECEMBER 31 Canada USA Total 2018 $62,378 53,690 116,068 2017 $61,154 52,122 113,276 The Company operates from two locations in Canada and one in the United States. Located in Delta, British Columbia, Avcorp Industries Inc., named as Avcorp Structures & Integration (“ASI”), is dedicated to metallic and composite aerostructures assembly and integration. Within Comtek Advanced Structures Ltd. (“Comtek”), located in Burlington, Ontario, exists two divisions dedicated to aircraft structural component repair services, and Avcorp Engineered Composites (“AEC”) dedicated to design and manufacture of composite aerostructures. Located in Gardena, California, Avcorp Composite Fabrication Inc. (“ACF”) is dedicated to advanced composite aerostructures fabrication. d) The Company’s sales are distributed amongst commercial and defence markets: FOR THE YEAR ENDED DECEMBER 31 2018 2017 Commercial Defence Total Revenue % of Total Revenue % of Total $119,414 51,296 70.0 30.0 $119,147 30,297 79.7 20.3 170,710 100.0 149,444 100.0 e) The Company’s revenue is recognized either at a point in time or over time. For the year ended December 31, 2018, revenue earned at a point in time is $42,979,000 (December 31, 2017: $149,444,000). Revenue earned over time is $127,731,000 for the year ended December 31, 2018 (December 31, 2017: $Nil). Page 62 Avcorp Industries Inc. Notes to Consolidated Financial Statements For the year ended December 31, 2018 (all figures in tables are expressed in thousands of Canadian dollars, except per share amounts) annual report 2018 f) Revenues, income loss and total assets are distributed by operating segment as noted in the tables below. Intercompany revenues and cost of sales are eliminated from the operating results presented. FOR THE YEAR ENDED DECEMBER 31, 2018 Total ASI Comtek ACF1 Corporate Revenue Cost of sales Gross profit Administrative and general expenses Depreciation and amortization Net contract modification Net claim position Operating gain (loss) $170,710 $83,589 $19,916 $67,205 155,753 75,287 16,417 64,049 14,957 23,466 623 (41,470) 5,421 8,302 5,360 217 - - 3,499 2,453 64 - - 3,156 7,762 342 - - $- - - 7,891 - (41,470) 5,421 26,917 2,725 982 (4,948) 28,128 1. ACF revenue includes $4,617,000 amortization of unfavourable contract liability FOR THE YEAR ENDED DECEMBER 31, 2017 Total ASI Comtek ACF1 Corporate Revenue Cost of sales Gross (loss) profit Administrative and general expenses Depreciation and amortization $149,444 $51,485 $18,076 181,296 (31,852) 21,580 341 58,353 (6,868) 5,124 213 15,472 2,604 2,472 60 72 $79,883 107,471 (27,588) 5,379 68 $- - - 8,605 - (33,035) (8,605) Operating (loss) gain (53,773) (12,205) 1. ACF revenue includes $9,058,000 amortization of the unfavourable contract liability. FOR THE YEAR ENDED DECEMBER 31 2018 2017 Avcorp Industries Inc. Comtek Advanced Structures Ltd. Avcorp Composite Fabrication Inc. Corporate Total Total Assets % of Total Total Assets % of Total $50,748 10,695 53,690 935 43.7 9.2 46.3 0.8 $50,814 10,197 52,122 143 44.9 9.0 46.0 0.1 116,068 100.0 113,276 100.0 FOR THE YEAR ENDED DECEMBER 31 2018 Development Cost Additions Property, Plant and Equipment Intangible Asset Additions Development Cost Additions 2017 Property, Plant and Equipment Intangible Asset Additions Avcorp Industries Inc. $5,962 $1,422 Comtek Advanced Structures Ltd. Avcorp Composite Fabrication Inc. Total 201 247 387 - 6,410 1,809 $- - 371 371 $4,929 $1,325 418 - 5,347 408 1,321 3,054 $- - 571 571 FOR THE YEAR ENDED DECEMBER 31 Avcorp Industries Inc. Comtek Advanced Structures Ltd. Avcorp Composite Fabrication Inc. Corporate Total 2018 Total Liabilities % of Total $27,339 2,673 18,193 104,007 18.0 1.8 12.0 68.2 2017 Total Liabilities $31,946 3,545 71,116 64,074 % of Total 18.7 2.1 41.7 37.5 152,212 100.0 170,681 100.0 Page 63 Avcorp Industries Inc. Notes to Consolidated Financial Statements For the year ended December 31, 2018 (all figures in tables are expressed in thousands of Canadian dollars, except per share amounts) annual report 2018 34. Investment in AVS-SYS On November 29, 2018, the Company entered into an investment agreement with AVS-SYS Ltd., a private company which specialized in providing aircraft operators with aircraft structural component repair services for commercial aircrafts. 35. Subsequent Events a) On January 31, 2019, the Company entered into an amendment to its existing credit facility with a Canadian chartered bank whereby the following amendment was made: Maximum availability under the Revolving Loan cannot exceed USD$68,000,000 less USD$4,300,000, until March 31, 2019, at which time the agreement reverts back to existing terms. b) On January 25, 2019, the Company and its subsidiary Avcorp Composite Fabrication Inc. (the “Avcorp Parties”) entered into an agreement with HITCO Carbon Composites, Inc., SGL Carbon, LLC, and SGL Carbon SE (the “SGL parties”) and a customer to settle all claims related to alleged deficiencies in HITCO’s non-destructive inspection processes and other business matters including a lease renewal in exchange for gross consideration of USD$12,000,000 from the SGL parties to Avcorp and mutual releases among the Avcorp Parties, SGL Parties and a customer. The net cash payment received totalled USD$10,810,000. c) On March 28, 2019, the Company entered into an amendment to its existing credit facility with a Canadian chartered bank whereby the following amendments were made: Maximum availability under the Revolving Loan cannot exceed USD$68,000,000 less USD$4,300,000, until April 30, 2019, at which time the agreement reverts back to existing terms. Availability under the Revolving Loan was increased on March 28, 2018, by USD$10,000,000 (“Expanded Loan”), subject to existing drawdown provisions, interest rates and bonus fees. Drawdowns under the Expanded Loan are supported by a major and material customer of the Company by way of a guarantee. The maturity of the Expanded Loan has been extended from March 31, 2019 to April 30, 2019. Page 64 notes AVCORP INDUSTRIES INC. BOARD OF DIRECTORS AND OFFICERS MANAGEMENT David Levi (1)(2) CHAIRMAN OF THE BOARD Executive Chairman GrowthWorks Capital Ltd. Vancouver, British Columbia Elizabeth Otis (1)(2) DIRECTOR Palm Springs, California Jaap Rosen Jacobson (2*) DIRECTOR President Panta Holdings B.V. Mijdrecht, The Netherlands Ken Robertson (1*) DIRECTOR Vancouver, British Columbia (1) Member of the Audit and Corporate Governance Committee (2) Member of the Compensation and Nominating Committee * Designates the Committee Chair DIRECTORY Amandeep Kaler Group Chief Executive Officer Surrey, British Columbia Edward Merlo CORPORATE SECRETARY Group Chief Financial Officer Richmond, British Columbia Robin Lovell President Comtek Advanced Structures Ltd. Oakville, Ontario Tony Kelsey General Manager Avcorp Composite Fabrication Inc. Jurupa Valley, California Cedric Savineau General Manager Avcorp Industries Inc. Surrey, British Columbia Legal Counsel Registrar and Transfer Agent Avcorp Industries Inc. McMillan LLP Barristers & Solicitors Vancouver, British Columbia AST Trust Company (Canada) Vancouver, British Columbia Auditors Bank Ernst & Young LLP Chartered Professional Accountants Vancouver, British Columbia Royal Bank of Canada Richmond, British Columbia 10025 River Way Delta, British Columbia Canada V4G 1M7 Telephone: Facsimile: Email: Website: 604-582-6677 604-582-2620 info@avcorp.com www.avcorp.com Shares Listed Toronto Stock Exchange Symbol AVP www.avcorp.com