Overview

The Company owns regional aircraft and engines which are leased to customers under triple net operating leases. The acquisition of such equipment is generally made using debt financing. The Company's profitability and cash flow are dependent in large part upon its ability to acquire equipment, obtain and maintain favorable lease rates on such equipment, and re-lease or sell owned equipment that comes off lease. The Company is subject to the credit risk of its lessees, both as to collection of rental payment under its operating leases and as to performance by lessees of their obligations to maintain the equipment. Since lease rates for assets in the Company's portfolio generally decline as the assets age, the Company's ability to maintain revenue and earnings is primarily dependent upon the Company's ability to grow its asset portfolio.

The Company's principal cash expenditures are for interest costs on its financing, management fees, and maintenance of its aircraft assets. Maintenance expenditures are incurred when aircraft or equipment are off lease, are being prepared for re-lease, or require maintenance in excess of lease return conditions, as well as when maintenance work is performed in connection with the release of maintenance reserves previously received by the Company from lessees. See "c. Maintenance Reserves and Accrued Costs," below, regarding the Company's accounting treatment of maintenance expenses.

The most significant non-cash expenses include aircraft and equipment depreciation, which is affected by significant estimates, and, beginning in the second quarter of 2007, amortization of costs associated with the Company's Subordinated Notes, which is included in interest expense.

Critical Accounting Policies, Judgments and Estimates

The discussion and analysis of the Company's financial condition and results of operations are based upon the consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets and liabilities, revenues and expenses, and the related disclosure of contingent assets and liabilities at the date of the financial statements. In the event that actual results differ from these estimates or the Company adjusts these estimates in future periods, the Company's operating results and financial position could be materially affected.

The Company's significant accounting policies are described in Note 1 to the consolidated financial statements. The Company believes that the most critical accounting policies include the following: Aircraft Capitalization and Depreciation; Impairment of Long-lived Assets; Maintenance Reserves and Accrued Costs; Accounting for Income Taxes; and Revenue Recognition and Accounts Receivable and Allowance for Doubtful Accounts.

a. Aircraft Capitalization and Depreciation

The Company's interests in aircraft and aircraft engines are recorded at cost, which includes acquisition costs. The Company purchases only used aircraft. It is the Company's policy to hold aircraft for approximately twelve years unless market conditions dictate otherwise. Depreciation is computed using the straight-line method over the twelve year period to an estimated residual value based on appraisal. Decreases in the market value of aircraft could not only affect the current value, discussed above, but could also affect the assumed residual value. The Company periodically obtains a residual value appraisal for its assets and, historically, has not had to write down any assets due to revised estimated residuals.

b. Impairment of Long-lived Assets

The Company periodically reviews its portfolio of assets for impairment in accordance with SFAS 144, "Accounting for the Impairment or Disposal of Long-lived Assets." Such review necessitates estimates of current market values, re-lease rents, residual values and component values. The estimates are based on currently available market data and third-party appraisals and are subject to fluctuation from time to time. The Company initiates its review periodically, whenever events or changes in circumstances indicate that the carrying amount of a long-lived asset may not be recoverable. Recoverability of an asset is measured by comparison of its carrying amount to the expected future undiscounted cash flows (without interest charges) that the asset is expected to generate. Any impairment to be recognized is measured by the amount by which the carrying amount of the asset exceeds its fair market value. Significant management judgment is required in the forecasting of future operating results which are used in the preparation of projected undiscounted cash flows and should different conditions prevail, material write downs may occur. During the year ended December 31, 2007, the Company recorded no impairment.

c. Maintenance Reserves and Accrued Costs

Maintenance costs under the Company's triple net operating leases are typically the responsibility of the lessees. Maintenance reserves and accrued costs in the accompanying consolidated balance sheet include refundable maintenance payments received from lessees, which are paid out as related maintenance is performed.

Upon adoption of FSP AUG AIR-1 on January 1, 2007, as discussed in Notes 1 and 2 to the consolidated financial statements, the Company was required to discontinue the accrue-in-advance method of accounting for planned major maintenance for financial reporting periods beginning on January 1, 2007. The Company has evaluated the impact of the adoption of this new staff position and elected to use the direct expensing method, under which maintenance costs are expensed as incurred. Under this method, non-refundable maintenance reserves for planned major maintenance are reflected as income based on reported usage. The Company accrues estimated maintenance costs at the time a reimbursement claim for incurred maintenance or sufficient information is received from its lessees.

Accrued costs also reflect accruals by the Company for maintenance work performed for off-lease aircraft and which is not related to the release of reserves received from lessees.

In the past, as a result of two situations, the Company incurred significant maintenance expense when aircraft were returned early and in a condition worse than required by the lease and for which the Company was unable to recover the costs of non-compliance from the lessees.

d. Accounting for Income Taxes

As part of the process of preparing the Company's consolidated financial statements, management is required to estimate income taxes in each of the jurisdictions in which the Company operates. This process involves estimating the Company's current tax exposure under the most recent tax laws and assessing temporary differences resulting from differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included in the consolidated balance sheet. Management must also assess the likelihood that the Company's deferred tax assets will be recovered from future taxable income, and, to the extent management believes it is more likely than not that some portion or all of the deferred tax assets will not be realized, the Company must establish a valuation allowance. To the extent the Company establishes a valuation allowance or changes the allowance in a period, the Company reflects the corresponding increase or decrease in the tax provision in the consolidated statements of operations. As discussed in Note 1 to the consolidated financial statements, the Company adopted FIN 48 on January 1, 2007, which proscribes treatment of "unrecognized tax positions" and requires measurement and disclosure of such amounts.

Significant management judgment is required in determining the Company's future taxable income for purposes of assessing the Company's ability to realize any benefit from its deferred taxes. In the event that actual results differ from these estimates or the Company adjusts these estimates in future periods, the Company's operating results and financial position could be materially affected.

e. Revenue Recognition, Accounts Receivable and Allowance for Doubtful Accounts

Revenue from leasing of aircraft assets is recognized as operating lease revenue on a straight-line basis over the terms of the applicable lease agreements. Deferred rent is recorded when the cash rent received is lower than the straight-line revenue recognized. Such receivables decrease over the term of the applicable leases. Non-refundable maintenance reserves billed to lessees are accrued as maintenance reserves income based on aircraft usage. In instances for which collectibility is not reasonably assured, the Company recognizes revenue as cash payments are received. The Company estimates and charges to income a provision for bad debts based on its experience in the business and with each specific customer, the level of past due accounts, and its analysis of the lessees' overall financial condition. If the financial condition of the Company's customers deteriorates, it could result in actual losses exceeding the estimated allowances.

Results of Operations

a. Revenues

As discussed in Notes 1 and 2 to the financial statements, in connection with the year-end audit of the 2007 consolidated financial results of the Company, the Audit Committee and the Company determined that two $450,000 non-contingent termination payments due from a lessee under two leases terminating in October 2007 and February 2008, respectively, should have been recognized as operating lease revenue ratably over the three year term of the leases. As a result of this timing difference, operating lease revenue has been understated during the previously reported periods covered by the leases. Operating lease revenue was approximately $3,601,000 higher in 2007 versus 2006, primarily because of increased operating lease revenue from aircraft purchased in the fourth quarter of 2006 and during 2007 and re-leases during 2007 at increased rental rates for several of the Company's aircraft. In addition, in 2007, the Company recorded revenue from several aircraft that had been off lease for part of 2006. The aggregate effect of these increases was partially offset by a decrease in revenue related to aircraft that were off lease for part of 2007.

As a result of the adoption of FSP AUG AIR-1 on January 1, 2007, non-refundable maintenance reserves collected from lessees are recorded as maintenance reserves income based on usage, assuming collections are reasonably assured or cash is received. Maintenance reserves income was approximately $1,319,000 higher in 2007 than in 2006 as a result of a net increase in average aircraft usage by the Company's lessees, on which the amount of reserves income is based, and the acquisition of aircraft in 2007.

Gain on sale of aircraft and aircraft engines was approximately $98,000 in 2007, which resulted from the sale of a damaged engine which the Company replaced on one of its leased aircraft. Gain on sale of aircraft was approximately $34,000 in 2006 as a result of the sale of an aircraft in April 2006.

Other income was approximately $23,000 higher in 2007 versus 2006, primarily as a result of an increase in the amount of interest income earned on the Company's cash balances, which were higher in 2007, net of accrued interest payable to lessees for certain of the Company's security deposits and maintenance reserves payable.

b. Expense items

Interest expense was approximately $1,306,000 higher in 2007 versus 2006. This is primarily the result of a draw on the Company's Subordinated Notes financing in 2007, which was used to repay a portion of the Company's senior debt, but which bears interest at a higher rate than the Credit Facility. Also contributing to the increase were increases in the average index rates upon which the Company's senior debt interest rates were based in 2007; an increase in the fees paid by the Company on its unused senior debt because of a higher unused balance of senior debt in 2007; and the expense attributed to the Company's interest swap entered into in December 2007. The effects of these increases were partially offset by a lower average senior debt balance and lower margin in 2007 compared to 2006.

Depreciation was approximately $922,000 higher in 2007 versus 2006, primarily because of purchases of aircraft in the fourth quarter of 2006 and during 2007, the effect of which was partially offset by an aircraft sale in the second quarter of 2006. Management fees, which are calculated on the net book value of the aircraft owned by the Company, were approximately $275,000 higher in 2007 compared to 2006 because of higher net book values as a result of aircraft acquisitions. The effects of these changes were partially offset by the effect of depreciation on the net book value of the Company's aircraft.

The Company's maintenance expense is dependent on the aggregate amount of the maintenance claims submitted by lessees for reimbursement and expenses incurred in connection with off-lease aircraft. As a result of lower total lessee claims and less expense incurred for off-lease aircraft in 2007, the Company incurred approximately $1,584,000 less in maintenance expense in 2007.

Total professional fees and general and administrative expenses were approximately $92,000 higher in 2007, versus 2006, primarily because of higher fees related to audit, tax and accounting consultations in 2007, an increase in directors fees which was authorized by the Board of Directors, effective January 1, 2007, and the addition of a board member during the fourth quarter of 2007. The effect of these increases was partially offset by a decrease in legal fees in 2007 as a result of legal expense incurred in connection with the early termination of two of the Company's aircraft leases in 2006 and a decrease in travel expense.

The Company records non-income based sales, use, value-added and franchise taxes as other tax expense. Such expenses were approximately $295,000 higher in 2007, versus 2006 because, in 2007, the Company accrued value-added taxes, penalties and interest in connection with an aircraft leased in Australia.

The Company's insurance expense consists primarily of directors and officers insurance, as well as product liability insurance and insurance for off-lease aircraft and aircraft engines, which varies depending on the type and length of time each off-lease asset is insured. Aircraft insurance expense was approximately $22,000 higher in 2007 versus 2006 as a result of off-lease assets. Directors and officers insurance was approximately $13,000 lower in 2007 as a result of a lower premium compared to 2006.

During 2007, the Company recorded bad debt expense of approximately $16,000 for maintenance reserves that were written off in connection with a lessee's early return of two aircraft. During 2006, the Company recorded bad debt expense of approximately $49,000 for a rent receivable that was written off in connection with a lessee's early return of an aircraft.

The Company did not record any impairment charges in 2007 or 2006.

The Company's effective tax rates for the years ended December 31, 2007 and 2006 were approximately 29% and 38%, respectively. The change in rate was primarily a result of the Company's election to amend its prior year tax returns to claim credits for foreign taxes withheld by a lessee rather than claim a deduction for the foreign taxes withheld which had not been recognized in prior years.

Liquidity and Capital Resources

The Company is currently financing its assets primarily through debt borrowings, special purpose financing and excess cash flows.

(a) Credit Facility

On April 17, 2007, the Company and the lenders under its revolving credit facility (the "Credit Facility") entered into an amended and restated credit agreement, collateralized by all of the assets of AeroCentury Corp, which provides for (i) a three-year term, (ii) a $25 million increase in the current amount available under the Credit Facility to $80 million and (iii) the ability to increase the maximum amount available under the Credit Facility to $110 million. Certain financial covenants were also modified.

During 2007, the Company borrowed $25,500,000 and repaid $16,800,000 of the outstanding principal under its Credit Facility. The balance of the principal amount owed under the Credit Facility at December 31, 2007 was $59,596,000, and interest of $144,430 was accrued.

The Company is currently in compliance with all covenants and, based on its current projections, the Company believes it will continue to be in compliance with all covenants of its Credit Facility, but there can be no assurance of such compliance in the future. See "Factors That May Affect Future Results - 'Risks of Debt Financing' and 'Credit Facility Obligations,'" below.

The Company's interest expense in connection with the Credit Facility generally moves up and down with prevailing interest rates. Because aircraft owners seeking financing generally can obtain financing through either leasing transactions or traditional secured debt financings, prevailing interest rates are a significant factor in determining market lease rates, and market lease rates generally move up or down with prevailing interest rates, assuming supply and demand of the desired equipment remain constant. However, because lease rates for the Company's assets typically are fixed under existing leases, the Company normally does not experience any positive or negative impact in revenue from changes in market lease rates due to interest rate changes until existing leases have terminated and new lease rates are set as the aircraft is re-leased. As discussed in (b) below, the Company entered into an interest rate swap in December 2007.

(b) Derivative instrument

In December 2007, the Company entered into an interest rate swap (the "Swap") with a notional amount of $20 million, under which it committed to make or receive a net settlement for the difference in interest receivable computed monthly on the basis of 30-day LIBOR and interest payable monthly on the basis of a fixed rate of 4.04% per annum. The Swap is designed to economically hedge $20 million of the Company's interest rate exposure over its term by fixing the net interest payable over the two-year term of the Swap.

Under SFAS 133, as amended, the Company is required to recognize the fair value of the Swap as an asset or liability at its fair value, which is based upon the amount the Company would receive or pay to terminate its agreements at the reporting date, taking into account market conditions and the creditworthiness of the derivative counterparties. As such, at December 31, 2007, the Company recognized a $150,040 liability for the Swap on its balance sheet in Notes Payable and Accrued Interest. The Company also recognized both a net settlement amount of $0 and a loss of $150,040 for 2007 as a component of interest expense. If short-term interest rates continue to decline, the Company will incur additional interest expense as a result of the Swap.

(c) Senior unsecured subordinated debt

On April 17, 2007, the Company entered into a Securities Purchase Agreement, whereby the Company agreed to issue 16% senior unsecured subordinated notes ("Subordinated Notes"), with an aggregate principal amount of up to $28 million to certain note purchasers ("Note Purchasers"). The Subordinated Notes were issued at 99% of the face amount and are due December 30, 2011. Principal payments which fully amortize the balance of the Subordinated Notes are due prior to December 30, 2011 in amounts necessary to cause (i) the balance of the Subordinated Notes and (ii) the ratio of total outstanding debt under the Credit Facility and Subordinated Notes compared to the discounted portfolio value to not exceed amounts specified in the Securities Purchase Agreement.

Under the Securities Purchase Agreement, the Note Purchasers also were issued warrants to purchase up to 171,473 shares of the Company's common stock at an exercise price of $8.75 per share. The warrants are exercisable for a four-year period after the earliest of (i) a change of control, or (ii) the final maturity of the related Subordinated Notes, which is December 30, 2011. Pursuant to an investors rights agreement, the warrants are subject to registration rights that require the Company to use commercially reasonable efforts to register the shares issued upon exercise of the warrants with the Securities and Exchange Commission ("SEC"). Under the terms of the Subordinated Notes, on the last day of each month, commencing on May 31, 2007 and ending on the earlier of June 30, 2008 or the final closing under the Securities Purchase Agreement, the Company pays a commitment fee on any unissued amount, of the Subordinated Notes.

In connection with the issuance of the Subordinated Notes, the Company incurred approximately $1,498,000 of costs, of which approximately $763,000 was recorded as debt discount and approximately $689,000 and $46,000 were recorded as deferred financing costs and as a reduction to additional paid-in capital, respectively. The Company allocated approximately $25.5 million of the $28 million of expected proceeds of the Subordinated Notes to debt and approximately $1.6 million to the warrants on the basis of their estimated relative fair values. The allocation of proceeds representing the fair value of the warrants was recorded as additional debt discount on the Subordinated Notes and additional paid-in capital.

The Company is amortizing the total debt discount and deferred financing costs using the interest method over the term of the Subordinated Notes. Unused commitment fees are expensed as incurred.

At the initial April 17, 2007 closing under the Securities Purchase Agreement, Subordinated Notes with a face amount of $10 million were issued. The remaining $18 million of Subordinated Notes are required to be issued on or before June 30, 2008. The Company intends to use the proceeds of the Subordinated Notes offering for acquisition of additional aircraft assets or to repay a portion of the indebtedness outstanding under the Credit Facility. As of December 31, 2007, the Company was in compliance with all covenants under the Securities Purchase Agreement, and is currently in compliance. At December 31, 2007, the carrying amount of the Subordinated Notes was approximately $7,612,060 (outstanding principal amount of $10,000,000 less unamortized debt discount of approximately $2,387,940) and accrued interest payable was $0.

(d) Special purpose financing

In September 2000, a special purpose subsidiary acquired a deHavilland DHC-8-100 aircraft using cash and bank financing separate from the Credit Facility. The related note obligation, which was due April 15, 2006, was refinanced in April 2006, using bank financing from another lender, and the subsidiary was dissolved. The aircraft was transferred to AeroCentury VI LLC, a newly formed special purpose limited liability company, which borrowed $1,650,000, due October 15, 2009. The note bears interest at an adjustable rate of one-month LIBOR plus 3%. The note is collateralized by the aircraft and the Company's interest in AeroCentury VI LLC and is non-recourse to AeroCentury Corp. Payments due under the note consist of monthly principal and interest through April 20, 2009, interest only from April 20, 2009 until the maturity date, and a balloon principal payment due on the maturity date. During 2007, $312,200 of principal was repaid on the note. The principal amount owed under the note at December 31, 2007 was $1,109,140 and interest of $2,690 was accrued. As of December 31, 2007, the Company was in compliance with all covenants of this note obligation and is currently in compliance.

In November 2005, the Company refinanced two DHC-8-300 aircraft that had been part of the collateral base for its Credit Facility. The financing, which was provided by a bank by means separate from the Credit Facility, was provided to a newly formed special purpose subsidiary, AeroCentury V LLC, to which the aircraft were transferred. The financing resulted in a note obligation in the amount of $6,400,000, due November 10, 2008, which bears interest at the rate of 7.87%. The note is collateralized by the aircraft and the Company's interest in AeroCentury V LLC and is non-recourse to AeroCentury Corp. Payments due under the note consist of monthly principal and interest through April 22, 2008, interest only from April 22, 2008 until the maturity date, and a balloon principal payment due on the maturity date. During 2007, AeroCentury V LLC repaid $965,410 of principal. The lessee has indicated that it will re-lease the aircraft for two years. The Company believes it will be able to extend the financing on similar terms with the same bank lender and if it is unable to do so, it will refinance the financing under the Credit Facility. The principal amount owed under the note at December 31, 2007 was $4,455,300 and interest of $4,870 was accrued. As of December 31, 2007, the Company was in compliance with all covenants of this note obligation and is currently in compliance.

The availability of special purpose financing in the future will depend on receiving specific prior approvals and accommodations from the Credit Facility lenders and the Subordinated Notes holders.

(e) Future maturities of notes payable

As of December 31, 2007, principal payments due under the Company's Credit Facility, Subordinated Notes and special purpose financing were as follows:

                        Less than one year   $  4,813,750
                        1-3 years              70,346,690
                        4-5 years                       -
                        After 5 years                   -
                                             $ 75,160,440

(f) Cash flow

The Company's primary source of revenue is lease rentals of its aircraft assets. It is the Company's policy to monitor each lessee's needs in periods before leases are due to expire. If it appears that a customer will not be renewing its lease, the Company immediately initiates marketing efforts to locate a potential new lessee or purchaser for the aircraft assets, in an attempt to reduce the time that an asset will be off lease. The Company's aircraft assets are subject to leases with varying expiration dates through January 2012. At December 31, 2007, the Company's two Saab 340A aircraft, one of its deHavilland DHC-8-300 aircraft and one turboprop engine were off lease. The DHC-8-300 aircraft was re-leased to an existing customer in January 2008.

Management believes that the Company will have adequate cash flow to meet its ongoing operational needs, including required repayments under its Credit Facility, Subordinated Notes financing and special purpose financings, based upon its estimates of future revenues and expenditures. The Company's expectations concerning such cash flows are based on existing lease terms and rents, as well as numerous estimates, including (i) rents on assets to be re-leased, (ii) timely use of proceeds of unused debt capacity toward additional acquisitions of income producing assets, and (iii) the cost and anticipated . . .