POLARIS AIRCRAFT INCOME FUND II, 10-K405, 1999-03-29

POLARIS AIRCRAFT INCOME FUND II
10-K405, 1999-03-29
EQUIPMENT RENTAL & LEASING, NEC

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UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

--------------------

FORM 10-K

--------------------

_X_ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 1998

___ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the transition period from ___ to ___

Commission File No.33-2794

POLARIS AIRCRAFT INCOME FUND II,
A California Limited Partnership
--------------------------------
(Exact name of registrant as specified in its charter)

California 94-2985086
------------------------------- -----------------------
(State or other jurisdiction of (IRS Employer I.D. No.)
incorporation or organization)

201 High Ridge Road, Stamford, Connecticut 06927
------------------------------------------ ----------
(Address of principal executive offices) (Zip Code)

Registrant's telephone number, including area code: (203) 357-3776

Securities registered pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section 12(g) of the Act:
Units of Limited Partnership Interest

Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes X No
--- ---

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. X
---

No formal market exists for the units of limited partnership interest and
therefore there exists no aggregate market value at December 31, 1998.

Documents incorporated by reference: None

This document consists of 49 pages.

<PAGE>
PART I

Item 1. Business

Polaris Aircraft Income Fund II, A California Limited Partnership (PAIF-II or
the Partnership), was formed primarily to purchase and lease used commercial jet
aircraft in order to provide quarterly distributions of cash from operations, to
maximize the residual values of aircraft upon sale and to protect Partnership
capital through experienced management and diversification. PAIF-II was
organized as a California Limited Partnership on June 27, 1984 and will
terminate no later than December 2010.

PAIF-II has many competitors in the aircraft leasing market, including airlines,
aircraft leasing companies, other Limited Partnerships, banks and several other
types of financial institutions. This market is highly competitive and there is
no single competitor who has a significant influence on the industry. In
addition to other competitors, the General Partner, Polaris Investment
Management Corporation (PIMC), and its affiliates, including GE Capital Aviation
Services, Inc. (GECAS), Polaris Aircraft Leasing Corporation (PALC), Polaris
Holding Company (PHC) and General Electric Capital Corporation (GE Capital),
acquire, lease, finance, sell and remarket aircraft for their own accounts and
for existing aircraft and aircraft leasing programs managed by them. Further,
GECAS provides a significant range of aircraft management services to third
parties, including without limitation, AerFi Group plc (formerly GPA Group plc),
a public limited company organized in Ireland, together with its consolidated
subsidiaries (AerFi), and Airplanes Group, together with its subsidiaries (APG),
each of which two groups leases and sells aircraft. Accordingly, in seeking to
re-lease and sell its aircraft, the Partnership may be in competition with the
General Partner, its affiliates, AerFi, APG, and other third parties to whom
GECAS provides aircraft management services from time to time.

A brief description of the aircraft owned by the Partnership is set forth in
Item 2. The following table describes certain material terms of the
Partnership's leases to Trans World Airlines, Inc. (TWA) as of December 31,
1998.
Scheduled
Number of Lease
Lessee Aircraft Type Aircraft Expiration Renewal Options
- ------ ------------- -------- ---------- ---------------
TWA McDonnell Douglas DC-9-30 11 11/04 (1) none
TWA McDonnell Douglas DC-9-30 3 2/05 (1) none

(1) These leases to TWA were modified in 1991. The leases for these
aircraft were extended for an aggregate of 75 months beyond the initial
lease expiration date in November 1991 at approximately 46% of the
original lease rates. The Partnership also agreed to share in the costs
of certain Airworthiness Directives (ADs). If such costs are incurred
by TWA, they will be credited against rental payments, subject to
annual limitations with a maximum of $500,000 per aircraft over the
lease terms. TWA may specify a lease expiration date for each aircraft
up to six months before the date shown, provided the average date for
all of the aircraft equals the dates shown.

As discussed in Item 7, in October 1994, TWA notified its creditors,
including the Partnership, of a proposed restructuring of its debt.
Subsequently, GECAS negotiated a standstill agreement with TWA which
was approved on behalf of the Partnership by PIMC. That agreement
provided for a moratorium of the rent due the Partnership in November
1994 and 75% of the rents due the Partnership from December 1994
through March 1995. The deferred rents, which aggregated $3.6 million
plus interest, were repaid in monthly installments beginning in May
1995 through October 1995. In 1995, the Partnership received as
consideration for the agreement $218,171 and warrants for 227,133
shares of TWA Common Stock (Item 7).

2
<PAGE>

In 1996, GECAS, on behalf of the Partnership, negotiated with TWA for
the acquisition of noise-suppression devices, commonly known as
"hushkits", for 14 of the Partnership's aircraft on lease to TWA at the
time, as well as other aircraft owned by affiliates of PIMC and leased
to TWA. The 14 aircraft that received hushkits were designated by TWA.
The hushkits reconditioned the aircraft so as to meet Stage 3 noise
level restrictions. Hushkits were installed on 11 of the Partnership's
aircraft during 1996 and the leases for these 11 aircraft were extended
for a period of eight years until November 2004. Hushkits were
installed on the remaining three aircraft during February 1997 and the
leases for these three aircraft were extended for a period of eight
years until February 2005.

The rent payable by TWA under the leases was increased by an amount
sufficient to cover the monthly debt service payments on the hushkits
and fully repay, during the term of the TWA leases, the amount
borrowed. The loan from the engine/hushkit manufacturer is non-recourse
to the Partnership and secured by a security interest in the lease
receivables.

At year end 1998, there were approximately 12,600 jet aircraft in the world
fleet. Approximately 1,500 aircraft were leased or sold during 1998, an increase
of 14% over 1997. Air travel has grown strongly during the past 28 years, with
the last nineteen years showing better than 5.5% annual growth, and not until
recently has it subsided after what had been a robust period from 1994 to 1997.
This strong period has mainly benefited Stage 3 narrow bodies and younger Stage
2 narrow bodies, many of which have been or are being upgraded with hushkits.
During 1998, the industry saw many alliances taking place. There was more
consolidation in the U.S. Airline Industry via alliances than had been seen in
the previous 20 years since deregulation. Booming traffic demand coupled with
reductions in the price of aviation fuel has resulted in record profits for many
airlines in North America and Europe. However, slower traffic lies ahead, the
cycle has peaked in 1998, as may have airline profits. Manufacturers continue to
produce at high levels compared to what demand will require in the future years.
Asia continues its economic turmoil which has brought about a significant
reduction in traffic growth in that region. This is resulting in a number of new
aircraft order deferrals and cancellations, mainly in the wide body sector, with
over capacity moving from Asia into the other regions around the world. Timing
of when the down cycle ends or how severe it will be is still in question, but
will be closely watched as we move into the next millennium. Several airline
accidents that occurred in 1996, involving older Stage 2 aircraft, continue to
dampen the market for such aircraft. The Partnership has been forced in the past
to adjust its estimates of the residual values realizable from its aircraft,
which resulted in an increase in depreciation expense, as discussed in Items 7
and 8. A discussion of the current market condition for the type of aircraft
owned by the Partnership follows:

McDonnell Douglas DC-9-30 - The McDonnell Douglas DC-9-30 is a short- to
medium-range twin-engine jet that was introduced in 1967. Providing reliable,
inexpensive lift, these aircraft fill thin niche markets, mostly in the United
States. Hushkits are available to bring these aircraft into compliance with
Stage 3 requirements at a cost of approximately $1.6 million per aircraft. As
noted above, hushkits have been installed on the 14 remaining fund aircraft.
Certain ADs applicable to the McDonnell Douglas DC-9 have been issued to prevent
fatigue cracks and control corrosion as discussed in the Industry Update section
of Item 7.

The General Partner believes that, in addition to the factors cited above, the
deteriorated market for the Partnership's aircraft reflects the airline
industry's reaction to the significant expenditures potentially necessary to
bring these aircraft into compliance with certain ADs issued by the FAA relating
to aging aircraft, corrosion prevention and control, and structural inspection
and modification as discussed in the Industry Update section of Item 7.

3
<PAGE>
Item 2. Properties

At December 31, 1998, PAIF-II owned 14 McDonnell Douglas DC-9-30 aircraft leased
to TWA and spare parts inventory (as discussed in Note 9) out of its original
portfolio of 30 aircraft. All leases are operating leases. Polaris Aircraft
Income Fund II (the Partnership) transferred six Boeing 727-200 aircraft,
previously leased to Pan Am, to aircraft inventory in 1992. These aircraft,
which are not included in the following table, were disassembled for sale of
their component parts, the remainder of which was sold to Soundair, Inc. in
1998. The Partnership sold one Boeing 727-200 aircraft equipped with a hushkit
in February 1995. The Partnership sold the airframe and one engine from the
Boeing 737-200 Combi aircraft in March 1996. The Partnership sold the remaining
engine along with a Boeing 737-200 in January 1997. The Partnership sold three
Boeing 727-200, one McDonnell Douglas DC-9-40 and three McDonnell Douglas
DC-9-30 aircraft to Triton Aviation Services II LLC in May 1997 and June 1997.

The following table describes the Partnership's aircraft portfolio at December
31, 1998 in greater detail:

Year of Cycles
Aircraft Type Serial Number Manufacture As of 11/30/98 (1)
- ------------- ------------- ----------- ------------------
McDonnell Douglas DC-9-30 47027 1967 84,652
McDonnell Douglas DC-9-30 47107 1968 84,779
McDonnell Douglas DC-9-30 47108 1968 81,594
McDonnell Douglas DC-9-30 47135 1968 81,114
McDonnell Douglas DC-9-30 47137 1968 80,309
McDonnell Douglas DC-9-30 47174 1968 82,371
McDonnell Douglas DC-9-30 47249 1968 86,488
McDonnell Douglas DC-9-30 47251 1968 84,738
McDonnell Douglas DC-9-30 47324 1969 78,976
McDonnell Douglas DC-9-30 47343 1969 83,574
McDonnell Douglas DC-9-30 47345 1969 81,905
McDonnell Douglas DC-9-30 47357 1969 78,797
McDonnell Douglas DC-9-30 47411 1969 79,321
McDonnell Douglas DC-9-30 47412 1969 79,366

(1) Cycle information as of 12/31/98 was not available.

Item 3. Legal Proceedings

Braniff, Inc. (Braniff) Bankruptcy - As previously reported in the Partnership's
1997 Form 10-K, the Bankruptcy Court disposed of the Partnership's claim in this
Bankruptcy proceeding by permitting the Partnership to exchange a portion of its
unsecured claim for Braniff's right (commonly referred to as a "Stage 2 Base
Level right") under the FAA noise regulations to operate one Stage 2 aircraft
and by allowing the Partnership a net remaining unsecured claim of $769,231 in
the proceedings.

Braniff's bankrupt estate made a payment in the amount of $200,000 in respect of
the unsecured claims of the Partnership and other affiliates of Polaris
Investment Management Corporation. Of this amount, $15,385 was allocated to the
Partnership based on its pro rata share of the total claims and was recognized
as revenue during the quarter ended March 31, 1998. On January 20, 1999,
Braniff's bankrupt estate made an additional payment in the amount of $84,000 in
respect of the unsecured claims of the Partnership and other affiliates of
Polaris Investment Management Corporation. Of this amount $6,462 was allocated
to the Partnership based on its pro rata share of the total claims.

4
<PAGE>

Viscount Air Services, Inc. (Viscount) Bankruptcy - As previously reported in
the Partnership's 1997 Form 10-K, all disputes between the Partnership and
Viscount have been resolved, and there is no further pending litigation with
Viscount. However, when Viscount rejected its lease of one of the Partnership's
aircraft ("306 Aircraft"), as authorized by the Bankruptcy Court, the 306
Aircraft was located at a maintenance facility called BAE Aviation, Inc. dba
Tucson Aerospace (BAE). BAE and its subcontractors STS Services, Inc. and Piping
Design Services, Inc., dba PDS Technical Services asserted mechanics' liens over
the 306 Aircraft.

On May 22, 1996, First Security Bank, National Association (FSB), as owner
trustee, filed suit in the Superior Court of Arizona in Pima County to recover
the 306 Aircraft. After FSB filed a bond in the penal amount of $1,371,000, the
claimants in the action released the 306 Aircraft and filed a claim against the
bond. FSB filed a motion for summary judgment on all claims raised by the
claimants in the counterclaim. The Superior Court granted the motion and entered
judgment on October 30, 1998 dismissing the counterclaim and exonerating the
bond. The Court has stayed exoneration of the bond pending appeal by the
claimants. The Court has denied the claimants' subsequent motion for a new trial
seeking reconsideration. FSB filed a motion seeking recovery of its attorneys'
fees and costs incurred in defending the litigation, and the Court set a hearing
on the motion for March 8, 1999. Subsequently, FSB and the claimants agreed to
settle this claim for an agreed judgement of $159,374.51 in attorney's fees to
be paid to FSB. The settlement agreement is subject to approval by the Court.
The claimants are appealing the Court's rulings.

After recovering the 306 Aircraft, the Partnership sold the airframe and certain
engines in January of 1997. In the course of delivering the airframe, GE Capital
Aviation Services, Inc. (GECAS) determined that a painter, Thomas Cook, was
holding the right elevator at his shop due to an unpaid bill incurred in
connection with work on the 306 Aircraft by BAE under contract to Viscount,
which at that time was leasing the 306 Aircraft. On March 20, 1997, FSB, as
owner trustee, filed a lawsuit in the Superior Court of Arizona in Pima County,
Case No. 318585 against Mr. Cook and Hamilton Aviation, Inc., where his shop is
located, to recover possession. The parties have stipulated to dismissal of the
lawsuit, with Mr. Cook agreeing to release the Partnership's elevator in
exchange for a settlement payment of $3,000 by the Partnership.

Kepford, et al. v. Prudential Securities, et al. - On April 13, 1994, this
action was filed in the District Court of Harris County, Texas against Polaris
Investment Management Corporation, Polaris Securities Corporation, Polaris
Holding Company, Polaris Aircraft Leasing Corporation, the Partnership, Polaris
Aircraft Income Fund I, Polaris Aircraft Income Fund III, Polaris Aircraft
Income Fund IV, Polaris Aircraft Income Fund V, Polaris Aircraft Income Fund VI,
General Electric Capital Corporation, Prudential Securities, Inc., Prudential
Insurance Company of America and James J. Darr. The complaint alleges violations
of the Texas Securities Act, the Texas Deceptive Trade Practices Act, sections
11 and 12 of the Securities Act of 1933, common law fraud, fraud in the
inducement, negligent misrepresentation, negligence, breach of fiduciary duty
and civil conspiracy arising from the defendants' alleged misrepresentation and
failure to disclose material facts in connection with the sale of Limited
Partnership units in the Partnership and the other Polaris Aircraft Income
Funds. Plaintiffs seek, among other things, an award of compensatory damages in
an unspecified amount plus interest, and double and treble damages under the
Texas Deceptive Trade Practices Act. The trial court has issued a revised
scheduling order setting the trial date for this action for September 7, 1999.

5
<PAGE>

State of California, County of San Francisco. The complaint names each of
Polaris Investment Management Corporation (PIMC), GE Capital Aviation Services,
Inc. (GECAS), Polaris Aircraft Leasing Corporation, Polaris Holding Company,
General Electric Capital Corporation, certain executives of PIMC and GECAS and
John E. Flynn, a former PIMC executive, as defendants. The complaint alleges
that defendants committed a breach of their fiduciary duties with respect to the
Sale Transaction involving the Partnership as described in Item 7, under the
caption "Sale of Aircraft -- Sale of Aircraft to Triton." On September 2, 1997,
an amended complaint was filed adding additional plaintiffs, and on December 18,
1997, the plaintiffs filed a second amended complaint asserting their claims
derivatively.

On November 9, 1998, defendants, acting through their counsel, entered into a
settlement agreement with plaintiffs and with the plaintiff in a related action,
"Accelerated" High Yield Income Fund II, Ltd., L.P. v. Polaris Investment
Management Corporation, et al. The settlement agreement does not provide for any
payments to be made to the Partnership. Plaintiff's counsel sought reimbursement
from the Partnership for its attorneys' fees and expenses. A settlement notice
setting forth the terms of the settlement was mailed to the last known address
of each unitholder of the Partnership on November 20, 1998. On December 24,
1998, the Court approved the terms of the settlement and approved plaintiffs'
attorney's fees and expenses in the amount of $438,766.

Other Proceedings - Part III, Item 10 discusses certain other actions which have
been filed against the General Partner in connection with certain public
offerings, including that of the Partnership. The Partnership is not a party to
these actions.

Item 4. Submission of Matters to a Vote of Security Holders

None.

6
<PAGE>
PART II

Item 5. Market for the Registrant's Common Equity and Related Stockholder
Matters

a) Polaris Aircraft Income Fund II's (PAIF-II or the Partnership) Limited
Partnership interests (Units) are not publicly traded. Currently there
is no market for PAIF-II's Units and it is unlikely that any market
will develop.

b) Number of Security Holders:

Number of Record Holders
Title of Class as of December 31, 1998
---------------- ------------------------

Limited Partnership Interest: 14,620

General Partnership Interest: 1

c) Dividends:

The Partnership distributed cash to partners on a quarterly basis
beginning July 1986. Cash distributions to Limited Partners during 1998
and 1997 totaled $18,673,991 and $14,349,914, respectively. Cash
distributions per Limited Partnership unit were $37.35 and $28.70 in
1998 and 1997, respectively.

7
<PAGE>

Item 6. Selected Financial Data

<TABLE>
<CAPTION>
For the years ended December 31,
--------------------------------

1998 1997 1996 1995 1994
---- ---- ---- ---- ----
<S> <C> <C> <C> <C> <C>

Revenues $ 13,901,118 $ 17,609,635 $ 16,304,608 $ 21,093,341 $ 14,443,902

Net Income (Loss) 3,456,655 4,469,336 (14,708,486) 5,717,065 (3,217,172)

Net Income (Loss)
Allocated to Limited
Partners 1,607,397 4,424,643 (16,311,216) 4,972,468 (4,434,868)

Net Income (Loss) per
Limited Partnership Unit 3.22 8.85 (32.62) 9.94 (8.87)

Cash Distributions per
Limited Partnership
Unit 37.35 28.70 35.00 13.75 25.00

Amount of Cash
Distributions Included
Above Representing
a Return of Capital on
a Generally Accepted
Accounting Principle
Basis per Limited
Partnership Unit* 37.35 28.70 35.00 13.75 25.00

Total Assets 57,461,885 77,546,425 87,622,742 107,820,317 110,568,377

Partners' Capital 43,445,400 60,740,696 72,215,709 106,368,523 108,290,301
<FN>

* The portion of such distributions which represents a return of capital on an
economic basis will depend in part on the residual sale value of the
Partnership's aircraft and thus will not be ultimately determinable until the
Partnership disposes of its aircraft. However, such portion may be significant
and may equal, exceed or be smaller than the amount shown in the above table.
</FN>
</TABLE>

8
<PAGE>

Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations

At December 31, 1998, Polaris Aircraft Income Fund II (the Partnership) owned a
portfolio of 14 used commercial jet aircraft and spare parts inventory (as
discussed in Note 9) out of its original portfolio of 30 aircraft. The portfolio
consists of 14 McDonnell Douglas DC-9-30 aircraft leased to Trans World
Airlines, Inc. (TWA). The Partnership transferred six Boeing 727-200 aircraft,
previously leased to Pan American World Airways, Inc., to aircraft inventory in
1992. These aircraft were disassembled for sale of their component parts. The
Partnership sold its remaining inventory of aircraft parts from the six
disassembled aircraft, to Soundair, Inc., in 1998. The Partnership sold one
Boeing 727-200 aircraft in February 1995, one Boeing 737-200 Combi aircraft in
March 1996, and one Boeing 737-200 aircraft in January 1997. During the second
quarter of 1997, the Partnership sold three McDonnell Douglas DC-9-30 aircraft
and one McDonnell Douglas DC-9-40 aircraft leased to TWA, two Boeing 727-200
Advanced aircraft leased to Continental Micronesia, Inc. (Continental
Micronesia), and one Boeing 727-200 Advanced aircraft leased to Continental
Airlines, Inc. (Continental), to Triton Aviation Services II LLC.

Remarketing Update

General - Polaris Investment Management Corporation (the General Partner or
PIMC) evaluates, from time to time, whether the investment objectives of the
Partnership are better served by continuing to hold the Partnership's remaining
portfolio of Aircraft or marketing such Aircraft for sale. This evaluation takes
into account the current and potential earnings of the Aircraft, the conditions
in the markets for lease and sale and future outlook for such markets, and the
tax consequences of selling rather than continuing to lease the Aircraft.

Sale of Aircraft Inventory to Soundair, Inc. - The Partnership sold its
remaining inventory of aircraft parts from the six disassembled aircraft, to
Soundair, Inc. The remaining inventory, with a net carrying value of $-0-, was
sold effective February 1, 1998 for $90,000, less amounts previously received
for sales as of that date. The net purchase price of $85,080 was paid in
September 1998, and is included in gain on sale of aircraft inventory.

Partnership Operations

The Partnership reported net income of $3,456,655, or $3.22 per Limited
Partnership unit for the year ended December 31, 1998, compared to net income of
$4,469,336, or $8.85 per Limited Partnership unit and a net loss of $14,708,486,
or $32.62 per Limited Partnership unit, for the years ended December 31, 1997
and 1996, respectively. Variances in net income may not correspond to variances
in net income per Limited Partnership unit due to the allocation of components
of income and loss in accordance with the Partnership agreement. The decrease in
net income in 1998, as compared to 1997, is primarily due to decreases in
interest and other income. Interest income decreased during 1998, as compared to
1997, primarily due to the December 1997 payoff of the Promissory note related
to the aircraft sold to Triton Aviation Services II LLC in 1997. The Partnership
recorded other income of $50,000 in 1998, compared to $802,443 during 1997.
Other income in 1997 was comprised of the receipt of amounts due under a TWA
maintenance credit and rent deferral agreement.

The improved income from operations during 1997, as compared to 1996, is due to
a substantial decrease in depreciation expense related to the sale of aircraft.
A substantial increase in depreciation expense contributed to the net loss
during 1996.

Rental revenues, management fees and depreciation declined during 1998, as
compared to 1997. This decline was the result of the sale of aircraft to Triton
Aviation Services II LLC in 1997. Rental revenues, net of related management

9
<PAGE>

fees, increased during 1997, compared to the same period in 1996. This increase
was primarily the result of an increase in rental revenues from TWA. In November
1996 and February 1997, installation of hushkits was completed on the 14
aircraft leased to TWA and the leases were extended for eight years. The rent
payable by TWA under the leases has been increased by an amount sufficient to
cover the monthly debt service payments on the hushkits and fully repay, during
the term of the TWA leases, the amount borrowed.

The increase in interest income during 1997, as compared to the same period in
1996, was attributable to interest earned on the Promissory Note related to the
Triton sale that occurred during the second quarter of 1997.

Operating expense increased due to legal expense related to the Ron Wallace
Litigation Settlement as more fully described below.

The Partnership had been holding a security deposit, received from Jet Fleet in
1992, pending the outcome of bankruptcy proceedings. The bankruptcy proceeding
of Jet Fleet Corporation was closed on August 6, 1997, and the bankruptcy
proceeding of Jet Fleet International Airlines, Inc. was closed on February 10,
1998. Consequently, the Partnership recognized, during the quarter ended March
31, 1998, revenue of $50,000 that had been held as a deposit.

The Partnership recorded an increase in other revenue during 1997. This increase
in other income was the result of the receipt of $802,443 related to amounts due
under the TWA maintenance credit and rent deferral agreement as discussed above.

On July 10, 1996, the Partnership entered into a proposed Stipulation and Order
in which Pan Am agreed to allow the Partnership $2.5 million as an
administrative expense priority claim and $56 million as a general unsecured
claim. In May 1996, the Partnership received from Pan Am a payment of $567,500
on the administrative expense priority claim. In November 1996, the Partnership
received an additional $9,000 payment on the administrative expense priority
claim. The Partnership has recorded these payments as other revenue in claims
related to lessee defaults in the 1996 statement of operations. It is unlikely
that the Partnership will receive additional payments on the administrative
expense priority claim. It cannot be estimated at this time when and if the
general unsecured claim will be paid.

In consideration for the rent deferral as discussed later under TWA
Restructuring, the Partnership received $218,171 in January 1995 as its share of
such payment by TWA. This amount was recognized as other revenue in 1995. In
addition, TWA agreed to issue warrants to the Partnership for TWA Common Stock.
The Partnership received warrants to purchase 227,133 shares of TWA Common Stock
from TWA in November 1995 and recognized the net warrant value as of the date of
receipt of $1,772,206 as revenue in 1995. The Partnership exercised the warrants
on December 29, 1995 for the strike price of $0.01 per share and recognized a
gain on the value of the warrants of $582,028 in 1995. The Partnership sold its
TWA Common Stock in 1996.

The Partnership incurred interest expense during 1998, 1997 and 1996 as the
result of the Partnership installing hushkits on 11 of its aircraft in November
1996 and 3 of its aircraft in February 1997. The aggregate cost of the hushkit
reconditioning for the 11 and 3 aircraft was $17,516,722 and $4,784,633,
respectively, or approximately $1.6 million per aircraft, which was capitalized
by the Partnership during 1996 and 1997. The Partnership paid $3.3 million and
$900,000 in 1996 and 1997, respectively, of the aggregate hushkit cost, and the
balance of $14,216,722 and $3,884,633 in 1996 and 1997, respectively, was
financed by the engine/hushkit manufacturer over 50 months at an interest rate
of 10% per annum.

As discussed later in the Industry Update section, if the projected net cash
flow for each aircraft (projected rental revenue, net of management fees, less
projected maintenance costs, if any, plus the adjusted estimated residual value)

10
<PAGE>

is less than the carrying value of the aircraft, the Partnership recognizes the
deficiency currently as increased depreciation expense.

The Partnership recognized approximately $17.0 million of this deficiency as
increased depreciation expense in 1996. In 1996, the impairment loss was the
result of several significant factors. As a result of industry and market
changes, a more extensive review of the Partnership's aircraft was completed in
the fourth quarter of 1996 which resulted in revised assumptions of future cash
flows including reassessment of projected re-lease terms and potential future
maintenance costs. As discussed in Note 4, the Partnership accepted an offer to
purchase 7 of the Partnership's remaining aircraft subject to each aircraft's
existing lease and certain notes receivable. This offer constituted an event
that required the Partnership to review the aircraft carrying value pursuant to
SFAS 121. In determining this additional impairment loss, the Partnership
estimated the fair value of the aircraft based on the proposed purchase price
reflected in the offer, less the estimated costs and expenses of the proposed
sale. The Partnership is deemed to have an impairment loss to the extent that
the carrying value exceeded the fair value. Management believes the assumptions
related to fair value of impaired assets represents the best estimates based on
reasonable and supportable assumptions and projections.

The increased depreciation expense reduces the aircraft's carrying value and
reduces the amount of future depreciation expense that the Partnership will
recognize over the projected remaining economic life of the aircraft. For any
downward adjustment to the estimated residual values, future depreciation
expense over the projected remaining economic life of the aircraft is increased.
The Partnership's earnings are impacted by the net effect of the adjustments to
the aircraft carrying values recorded in 1996.

Liquidity and Cash Distributions

Liquidity - The Partnership received prepayment in full of all amounts due from
Triton and all payments due from lessees during 1998, except for the December
1998 lease payment from TWA. On January 4, 1999, the Partnership received its
$935,000 rental payment from TWA that was due on December 27, 1998. This amount
was included in rent and other receivables on the balance sheet at December 31,
1998.

As further discussed in Note 9 to the financial statements, the Partnership
recorded an allowance for credit losses of $100,409 in 1996 for the aggregate
unsecured receivables from Viscount. The line of credit, which was advanced to
Viscount in 1994, was, in accordance with the Compromise and Stipulation,
secured by certain of Viscount's trade receivables and spare parts. The
Stipulation and Agreement releases the Partnership's claim against Viscount's
trade receivables. As a result, the Partnership recorded an additional allowance
for credit losses of $92,508 during 1996, representing Viscount's outstanding
balance of the line of credit and accrued interest. Payments received by the
Partnership from the sale of the spare aircraft parts (as discussed above), if
any, will be recorded as revenue when received. The Stipulation and Agreement
provides that, upon entry of a final non-appealable court order approving it,
the Partnership would waive its pre- and post-petition claims against Viscount
for all amounts due and unpaid. As a result, the Partnership considers all
receivables from Viscount to be uncollectible and has written-off, during 1996,
all notes, rents and interest receivable balances from Viscount.

As discussed above, the Partnership agreed to share in the cost of meeting
certain Airworthiness Directives (ADs) with TWA. In accordance with the
cost-sharing agreement, TWA may offset up to an additional $1.7 million against
rental payments, subject to annual limitations, over the remaining lease terms.

The Partnership sold one Boeing 727-200 aircraft equipped with a hushkit to AIA
in February 1995 as previously discussed. The agreement with AIA specified
payment of the sales price in 36 monthly installments of $55,000 beginning in

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March 1995. The Partnership received all scheduled payments due from AIA. This
note was sold to Triton during 1997 as part of the transaction discussed later
under Sale of Aircraft.

In March 1996, the Partnership sold its Boeing 737-200 Combi aircraft to Westjet
for cash and a note due in 22 monthly installments, with interest at a rate of
10% per annum beginning in March 1996. The Partnership has received all
scheduled payments from Westjet. This note was sold to Triton during 1997 as
part of the transaction discussed previously under the Remarketing Update
section.

Payments of $133,285, $214,749, and $260,234 were received during 1998, 1997 and
1996, respectively, from the sale of inventoried parts from the six disassembled
aircraft. This includes the sale of remaining inventory of aircraft parts from
the six disassembled aircraft to Soundair, Inc. in 1998 for $90,000.

PIMC has determined that the Partnership maintain cash reserves as a prudent
measure to ensure that the Partnership has available funds in the event that the
aircraft presently on lease to TWA require remarketing, and for other
contingencies including expenses of the Partnership. The Partnership's cash
reserves will be monitored and may be revised from time to time as further
information becomes available in the future.

Cash Distributions - Cash distributions to Limited Partners were $18,673,991,
$14,349,914, and $17,499,895 in 1998, 1997 and 1996, respectively. Cash
distributions per Limited Partnership unit were $37.35, $28.70, and $35.00 per
Limited Partnership unit in 1998, 1997 and 1996, respectively. The increase in
1998, as compared to 1997 is due to the distribution of the proceeds received
from the prepayment of a note due from Triton Aviation Services II, LLC on
December 30, 1997. The timing and amount of future cash distributions are not
yet known and will depend on the Partnership's future cash requirements
(including expenses of the Partnership) and need to retain cash reserves as
previously discussed in the Liquidity section; the receipt of rental payments
from TWA; and payments generated from the aircraft disassembly process.

Impact of the Year 2000 Issue

The inability of business processes to continue to function correctly after the
beginning of the Year 2000 could have serious adverse effects on companies and
entities throughout the world. As discussed in prior filings with the Securities
and Exchange Commission, the General Partner has engaged GE Capital Aviation
Services, Inc. ("GECAS") to provide certain management services to the
Partnership. Both the General Partner and GECAS are wholly-owned subsidiaries
(either direct or indirect) of General Electric Capital Corporation ("GECC").
All of the Partnership's operational functions are handled either by the General
Partner and GECAS or by third parties (as discussed in the following
paragraphs), and the Partnership has no information systems of its own.

GECC and GECAS have undertaken a global effort to identify and mitigate Year
2000 issues in their information systems, products and services, facilities and
suppliers as well as to assess the extent to which Year 2000 issues will impact
their customers. Each business has a Year 2000 leader who oversees a
multi-functional remediation project team responsible for applying a Six Sigma
quality approach in four phases: (1) define/measure -- identify and inventory
possible sources of Year 2000 issues; (2) analyze -- determine the nature and
extent of Year 2000 issues and develop project plans to address those issues;
(3) improve -- execute project plans and perform a majority of the testing; and
(4) control -- complete testing, continue monitoring readiness and complete
necessary contingency plans. The progress of this program is monitored at each
business, and company-wide reviews with senior management are conducted monthly.
GECC and GECAS management plan to have completed the first three phases of the
program for a substantial majority of mission-critical systems by the end of
1998 and to have nearly all significant information systems, products and

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services, facilities and suppliers in the control phase of the program by
mid-1999.

As noted elsewhere, the Partnership has fourteen aircraft and spare parts
inventory remaining in its portfolio at this time. All of these remaining
aircraft are on lease with Trans World Airlines, Inc. ("TWA"). TWA has advised
GECAS that it has adopted procedures to identify and address Year 2000 issues
and that it has developed a plan to implement required changes in its equipment,
operations and systems. To the extent, however, that TWA suffers any material
disruption of its business and operations due to Year 2000 failure of equipment
or information systems, such disruption would likely have a material adverse
effect on the Partnership's operations and financial condition.

Aside from maintenance and other matters relating to the Partnership's
aircraft-related assets discussed above, the principal third-party vendors to
the Partnership are those providing the Partnership with services such as
accounting, auditing, banking and investor services. GECAS intends to apply the
same standards in determining the Year 2000 capabilities of the Partnership's
third-party vendors as GECAS will apply with respect to its outside vendors
pursuant to its internal Year 2000 program.

The scope of the global Year 2000 effort encompasses many thousands of
applications and computer programs; products and services; facilities and
facilities-related equipment; suppliers; and, customers. The Partnership, like
all business operations, is also dependent on the Year 2000 readiness of
infrastructure suppliers in areas such as utility, communications,
transportation and other services. In this environment, there will likely be
instances of failure that could cause disruptions in business processes or that
could affect customers' ability to repay amounts owed to the Partnership or
vendors' ability to provide services without interruption. The likelihood and
effects of failures in infrastructure systems, over which the Partnership has no
control, cannot be estimated. However, aside from the impact of any such
possible failures or the possibility of a disruption of TWA's business caused by
Year 2000 failures, the General Partner does not believe that occurrences of
Year 2000 failures will have a material adverse effect on the financial
position, results of operations or liquidity of the Partnership.

To date, the Partnership has not incurred any Year 2000 expenditures nor does it
expect to incur any material costs in the future. However, the activities
involved in the Year 2000 effort necessarily involve estimates and projections
of activities and resources that will be required in the future. These estimates
and projections could change as work progresses.

Sale of Aircraft

Sale of Boeing 737-200 Aircraft - On January 30, 1997, one Boeing 737-200
formerly on lease to Viscount, was sold to American Aircarriers Support,
Inc.(American Aircarriers) on an "as-is, where-is" basis for $660,000 cash. In
addition, the Partnership retained maintenance reserves from the previous lessee
of $217,075, that had been held by the Partnership, which were recognized as
additional sale proceeds. A net loss of $26,079 was recorded on the sale of the
aircraft.

Sale of Aircraft to Triton - On May 28, 1997, PIMC, on behalf of the
Partnership, executed definitive documentation for the purchase of 7 of the
Partnership's 21 remaining aircraft (the "Aircraft") and certain of its notes
receivables by Triton Aviation Services II LLC, a special purpose company (the
"Purchaser" or "Triton"). The closings for the purchase of the 7 Aircraft
occurred from May 28, 1997 to June 16, 1997. The Purchaser is managed by Triton
Aviation Services, Ltd. ("Triton Aviation" or the "Manager"), a privately held
aircraft leasing company which was formed in 1996 by Triton Investments, Ltd., a
company which has been in the marine cargo container leasing business for 17
years and is diversifying its portfolio by leasing commercial aircraft. Each
Aircraft was sold subject to the existing leases.

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<PAGE>

The General Partner's Decision to Approve the Transaction - In determining
whether the transaction was in the best interests of the Partnership and its
unitholders, PIMC evaluated, among other things, the risks and significant
expenses associated with continuing to own and remarket the Aircraft (many of
which were subject to leases that were nearing expiration). The General Partner
determined that such a strategy could require the Partnership to expend a
significant portion of its cash reserves for remarketing and that there was a
substantial risk that this strategy could result in the Partnership having to
reduce or even suspend future cash distributions to Limited Partners. The
General Partner concluded that the opportunity to sell the Aircraft at an
attractive price would be beneficial in the present market where demand for
Stage II aircraft is relatively strong rather than attempting to sell the
aircraft "one-by-one" over the coming years when the demand for such Aircraft
might be weaker. GE Capital Aviation Services, Inc. ("GECAS"), which provides
aircraft marketing and management services to the General Partner, sought to
obtain the best price and terms available for these Stage II aircraft given the
aircraft market and the conditions and types of planes owned by the Partnership.
Both the General Partner and GECAS approved the sale terms of the Aircraft as
being in the best interest of the Partnership and its unit holders because both
believe that this transaction will optimize the potential cash distributions to
be paid to Limited Partners. To ensure that no better offer could be obtained,
the terms of the transaction negotiated by GECAS included a "market-out"
provision that permitted the Partnership to elect to accept an offer for all
(but not less than all) of the assets to be sold by it to the Purchaser on terms
which it deemed more favorable, with the ability of the Purchaser to match the
offer or decline to match the offer and be entitled to be compensated in an
amount equal to 1.5% of the Purchaser's proposed purchase price. The Partnership
did not receive any other offers and, accordingly, the General Partner believes
that a valid market check had occurred confirming that the terms of this
transaction were the most beneficial that could have been obtained.

The Terms of the Transaction - The total contract purchase price (the "Purchase
Price") to the Purchaser was $13,988,000 which was allocated to the Aircraft and
to certain notes receivable by the Partnership. The Purchaser paid into an
escrow account $1,575,888 of the Purchase Price in cash upon the closing of the
first aircraft and delivered a promissory note (the "Promissory Note") for the
balance of $12,412,112. The Partnership received payment of $1,575,888 from the
escrow account on June 24, 1997. On December 30, 1997, the Partnership received
prepayment in full of the outstanding note receivable and interest earned by the
Partnership to that date.

Under the purchase agreement, the Purchaser purchased the Aircraft effective as
of April 1, 1997 notwithstanding the actual closing dates. The utilization of an
effective date facilitated the determination of rent and other allocations
between the parties. The Purchaser had the right to receive all income and
proceeds, including rents and receivables, from the Aircraft accruing from and
after April 1, 1997, and the Promissory Note commenced bearing interest as of
April 1, 1997 subject to the closing of the Aircraft. Each Aircraft was sold
subject to the existing leases.

Neither PIMC nor GECAS received a sales commission in connection with the
transaction. In addition, PIMC was not paid a management fee with respect to the
collection of the Promissory Note or on any rents accruing from or after April
1, 1997 with respect to the 7 Aircraft. Neither PIMC nor GECAS or any of its
affiliates holds any interest in Triton Aviation or any of Triton Aviation's
affiliates. John Flynn, the current President of Triton Aviation, was a Polaris
executive until May 1996 and has over 15 years experience in the commercial
aviation industry. At the time Mr. Flynn was employed at PIMC, he had no
affiliation with Triton Aviation or its affiliates.

Polaris Aircraft Income Fund III, Polaris Aircraft Income Fund IV, Polaris
Aircraft Income Fund V and Polaris Aircraft Income Fund VI have also sold
certain aircraft assets to separate special purpose companies under common
management with the Purchaser (collectively, together with the Purchaser, the
"SPC's") on terms similar to those set forth above, with the exception of the
Polaris Aircraft Income Fund VI aircraft, which were sold on an all cash basis.

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<PAGE>

The Accounting Treatment of the Transaction - In accordance with GAAP, the
Partnership recognized rental income up until the closing date for each aircraft
which occurred from May 28, 1997 to June 16, 1997. However, under the terms of
the transaction, the Purchaser was entitled to receive payment of the rents,
receivables and other income accruing from April 1, 1997. As a result, the
Partnership made payments to the Purchaser in the amount of the rents,
receivables and other income due and received from April 1, 1997 to the closing
date of $1,001,067, which is included in rent from operating leases and interest
income. For financial reporting purposes, the cash down payment portion of the
sales proceeds of $1,575,888 has been adjusted by the following: income and
proceeds, including rents and receivables from the effective date of April 1,
1997 to the closing date, interest due on the cash portion of the purchase
price, interest on the Promissory Note from the effective date of April 1, 1997
to the closing date and estimated selling costs. As a result of these GAAP
adjustments, the net adjusted sales price recorded by the Partnership, including
the Promissory Note, was $13,205,140.

The Aircraft sold pursuant to the definitive documentation executed on May 28,
1997 had been classified as aircraft held for sale from that date until the
actual closing date. Under GAAP, aircraft held for sale are carried at their
fair market value less estimated costs to sell. The adjustment to the sales
proceeds described above and revisions to estimated costs to sell the Aircraft
required the Partnership to record an adjustment to the net carrying value of
the aircraft held for sale of $749,373 during the three months ended June 30,
1997. This adjustment to the net carrying value of the aircraft held for sale is
included in depreciation expense on the statement of operations.

Ron Wallace Litigation Settlement

Ron Wallace v. Polaris Investment Management Corporation, et al. - On or about
June 18, 1997, a purported class action entitled Ron Wallace v. Polaris
Investment Management Corporation, et al. was filed on behalf of the unitholders
of Polaris Aircraft Income Funds II through VI in the Superior Court of the
State of California, County of San Francisco. The complaint names each of
Polaris Investment Management Corporation (PIMC), GE Capital Aviation Services,
Inc. (GECAS), Polaris Aircraft Leasing Corporation, Polaris Holding Company,
General Electric Capital Corporation, certain executives of PIMC and GECAS and
John E. Flynn, a former PIMC executive, as defendants. The complaint alleges
that defendants committed a breach of their fiduciary duties with respect to the
Sale Transaction involving the Partnership as described in Item 7, under the
caption "Sale of Aircraft -- Sale of Aircraft to Triton." On September 2, 1997,
an amended complaint was filed adding additional plaintiffs, and on December 18,
1997, the plaintiffs filed a second amended complaint asserting their claims
derivatively.

TWA Restructuring

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<PAGE>

GECAS, 18 of which were owned by the Partnership. As required by its terms, the
Deferral Agreement (which has since been amended as discussed below) was
approved by PIMC on behalf of the Partnership with respect to the Partnership's
aircraft.

The Deferral Agreement provided for (i) a moratorium on all the rent due to the
Partnership in November 1994 and on 75% of the rents due to the Partnership from
December 1994 through March 1995, and (ii) all of the deferred rents, together
with interest thereon, to be repaid in monthly installments beginning in May
1995 and ending in December 1995. The repayment schedule was subsequently
accelerated upon confirmation of TWA's bankruptcy plan. The Partnership recorded
a note receivable and corresponding allowance for credit losses equal to the
total of the 1994 deferred rents of $1.575 million. The Partnership did not
recognize either the $1.575 million rental amount deferred in 1994 or the $2.025
million rental amount deferred during the first quarter of 1995 as rental
revenue until the deferred rents were received. The note receivable and
corresponding allowance for credit losses were reduced by the principal portion
of the payments received. The Partnership received all scheduled rent payments
beginning in April 1995 and all scheduled deferred rental payments beginning in
May 1995, including interest at a rate of 12% per annum, from TWA and has
recognized the $3.6 million deferred rents as rental revenue during 1995. The
deferred rents were paid in full by October 1995.

In consideration for the partial rent moratorium described above, TWA agreed to
make a lump sum payment of $1,000,000 to GECAS for the TWA lessors for whom
GECAS provides management services and who agreed to the Deferral Agreement. The
Partnership received $218,171 in January 1995 as its pro rata share of such
payment by TWA. In addition, TWA agreed to issue warrants to the Partnership for
TWA Common Stock.

In order to resolve certain issues that arose after the execution of the
Deferral Agreement, TWA and GECAS entered into a letter agreement dated June 27,
1995, pursuant to which they agreed to amend certain provisions of the Deferral
Agreement (as so amended, the Amended Deferral Agreement). The effect of the
Amended Deferral Agreement, which was approved by PIMC with respect to the
Partnership's aircraft, is that TWA, in addition to agreeing to repay the
deferred rents to the Partnership, agreed (i) to a fixed payment amount (payable
in warrants, the number of which was determined by a formula) in consideration
for the aircraft owners' agreement to defer rent under the Deferral Agreement,
and, (ii) to the extent the market value of the warrants is less than the
payment amount, to supply maintenance services to the aircraft owners having a
value equal to such deficiency. The payment amount was determined by subtracting
certain maintenance reimbursements owed to TWA by certain aircraft owners,
including the Partnership, from the aggregate amount of deferred rents.

On June 30, 1995, TWA filed its prepackaged Chapter 11 bankruptcy in the United
States Bankruptcy Court for the Eastern District of Missouri. On August 4, 1995,
the Bankruptcy Court confirmed TWA's plan of reorganization, which became
effective on August 23, 1995. Pursuant to the Amended Deferral Agreement, on the
confirmation date of the plan, August 4, 1995, the Partnership received a
payment of $1,217,989 from TWA which represented fifty percent (50%) of the
deferred rent outstanding plus interest as of such date. The remaining balance
of deferred rent plus interest was paid in full to the Partnership on October 2,
1995. TWA has been current with its obligation to the Partnership since August
1995. While TWA has committed to an uninterrupted flow of lease payments, there
can be no assurance that TWA will continue to honor its obligations in the
future.

The Partnership received warrants to purchase 227,133 shares of TWA Common Stock
from TWA in November 1995. The Partnership exercised the warrants on December
29, 1995 for the strike price of $0.01 per share. The fair market value of the
TWA stock at December 31, 1995 was $2,356,505, which was determined based on
quoted market prices. The Partnership sold the TWA Common Stock in February
1996, net of broker commissions, for $2,406,479 and recognized a gain on trading
securities of $49,974 in 1996.

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<PAGE>

Viscount Default and Bankruptcy Filing

On January 24, 1996, Viscount filed a petition for protection under Chapter 11
of the United States Bankruptcy Code in the United States Bankruptcy Court in
Tucson, Arizona. In April 1996, GECAS, on behalf of the Partnership, First
Security Bank, National Association (formerly known as First Security Bank of
Utah, National Association) (FSB), the owner/trustee under the Partnership's
leases with Viscount (the Leases), Viscount, certain guarantors of Viscount's
indebtedness and others executed in April 1996 a Compromise of Claims and
Stipulation under Section 1110 of the Bankruptcy Code (the Compromise and
Stipulation), which was subsequently approved by the Bankruptcy Court. The
Compromise and Stipulation provided, among other things, that Viscount rejected
the lease of the Partnership's aircraft. The rejection of the lease gave rise to
a pre-petition unsecured claim in Viscount's bankruptcy for breach of contract
damages. Notwithstanding Viscount's rejection of the Partnership's aircraft
lease, Viscount continued to possess and use the Partnership's engine and
refused to return various aircraft parts removed from the Partnership's
aircraft.

During 1995, Viscount delivered the Partnership's Boeing 737-200 aircraft to a
repair facility operated by BAE Aviation, Inc., d/b/a Tucson Aerospace, located
in Arizona, to perform a heavy maintenance check on the aircraft. The
Partnership has paid to Tucson Aerospace approximately $565,000 from maintenance
reserves and cash reserves for this aircraft as progress payments on this
maintenance check. Work on the maintenance check was suspended prior to the
filing of the Chapter 11 petition by Viscount. Tucson Aerospace asserts that
Viscount owes it approximately $866,000 for work done on the aircraft, which is
in addition to the approximately $565,000 already paid by the Partnership from
maintenance reserves. In addition, a third party vendor, who claims it provided
personnel to work on the aircraft, is asserting a claim against Tucson Aerospace
and a lien against the aircraft in the amount of $720,000. Another third-party
vendor, who claims it provided inspectors, is claiming $185,000 from Tucson
Aerospace. On May 22, 1996, First Security Bank, National Association (formerly
known as First Security Bank of Utah, National Association) (FSB), as
owner/trustee, filed suit in the Superior Court of Arizona in Pima County, to
recover the airframe from BAE Aviation, Inc. and certain creditors alleging
mechanics liens and to determine the validity of the claimed liens.

Pursuant to a stipulated order of the Superior Court entered on July 9, 1996,
FSB filed a bond in the penal sum of $1,371,000 for the benefit of the
lienholders, who subsequently released the aircraft to the Partnership on July
11, 1996 and filed a claim against the bond. FSB filed a motion for summary
judgment on all claims raised by the claimants in the counterclaim. The Superior
Court granted the motion and entered judgment on October 30,1998 dismissing the
counterclaim and exonerating the bond. The Court has stayed exoneration of the
bond pending appeal by the claimants. The Court has denied the claimants'
subsequent motion for a new trial seeking reconsideration. FSB filed a motion
seeking recovery of its attorneys' fees and costs incurred in defending the
litigation, and the Court set a hearing on the motion for March 8, 1999.
Subsequently, FSB and the claimants agreed to settle this claim for an agreed
judgement of $159,374.51 in attorney's fees to be paid to FSB. The settlement
agreement is subject to approval by the Court. The claimants are appealing the
Court's rulings.

On July 12, 1996, GECAS and FSB filed a motion in Viscount's bankruptcy case to
recover the engines and parts leased in connection with the Partnership's
aircraft. GECAS and FSB assert that these engines and parts should have been
delivered to FSB pursuant to the Compromise and Stipulation. Viscount paid to
the Partnership $10,000 for the use of the engine during the month of August
1996, and continued through August 1996 to pay maintenance reserves pursuant to
the lease terms.

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<PAGE>

Entities' aircraft and engines, turn over possession of the majority of its
aircraft parts inventory, and cooperate with GECAS in the transition of aircraft
equipment and maintenance, in exchange for which, upon Bankruptcy Court approval
of the Stipulation and Agreement, the Polaris Entities would waive their pre-
and post-petition claims against Viscount for amounts due and unpaid.

A consignment agreement has been entered into with a sales agent for the
disposal of the spare parts inventory recovered from Viscount. Given that many
of the parts require repair/overhaul, the cost of which is not accurately
determinable in advance, and the inherent uncertainty of sales prices for used
spare parts, there remains uncertainty as to whether the Partnership will derive
further proceeds from the sale of this inventory.

The Stipulation and Agreement also provides that the Polaris Entities, GECAS and
FSB would release any and all claims against Viscount, Viscount's bankruptcy
estate, and the property of Viscount's bankruptcy estate, effective upon entry
of a final non-appealable court order approving the Stipulation and Agreement.
The Bankruptcy Court entered such an order approving the Stipulation and
Agreement on October 23, 1996.

The Partnership recorded a provision for credit losses of $100,409 in 1996, for
the aggregate unsecured receivables from Viscount. The line of credit, which was
advanced to Viscount in 1994, was, in accordance with the Compromise and
Stipulation, secured by certain of Viscount's trade receivables and spare parts.
The Stipulation and Agreement releases the Partnership's claim against
Viscount's trade receivables. As a result, the Partnership recorded an
additional provision for credit losses of $92,508 during 1996, representing
Viscount's outstanding balance of the line of credit and accrued interest.
Payments received by the Partnership from the sale of the spare aircraft parts
(as discussed above), if any, will be recorded as revenue when received. The
Stipulation and Agreement provides that, upon entry of a final non-appealable
court order approving it, the Partnership would waive its pre- and post-petition
claims against Viscount for all amounts due and unpaid. As a result, the
Partnership considers all receivables from Viscount to be uncollectible and has
written-off, during 1996, all notes, rents and interest receivable balances from
Viscount.

The Partnership evaluated the airframe and engines previously leased to Viscount
for potential re-lease or sale and estimated that maintenance and refurbishment
costs aggregating approximately $1.6 million would be required to re-lease the
airframe and engines. Alternatively, a sale of the airframe and engines would
likely be made on an "as is, where is" basis, without the Partnership incurring
substantial maintenance costs. The aircraft was sold in January 1997 for
$660,000. As discussed in Note 4, the Partnership recognized an impairment loss
of $300,000 on this aircraft which was recorded as additional depreciation
expense during 1996.

Viscount's failure to perform its financial obligations to the Partnership had a
material adverse effect on the Partnership's financial position. As a result of
Viscount's defaults and Chapter 11 bankruptcy filing, the Partnership had
accrued legal costs of approximately $116,000, $107,000 and $147,000, which are
reflected in operating expense in the Partnership's 1998, 1997 and 1996
statement of operations, respectively. In 1998, the Partnership revised its
estimate of legal costs and reduced the accrual for legal costs by $68,753.

Claims Related to Lessee Defaults

Pan Am - The Partnership entered into a proposed Stipulation and Order in which
Pan Am agreed to allow the Partnership $2.5 million as an administrative expense
priority claim and $56 million as a general unsecured claim. In May 1996, the
Partnership received from Pan Am a payment of $567,500 on the administrative
expense priority claim. In November 1996, the Partnership received an additional
$9,000 payment on the administrative expense priority claim. The Partnership has
recorded these payments as revenue in claims related to lessee defaults in the
1996 statement of operations. It is unlikely that the Partnership will receive

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<PAGE>

additional payments on the administrative expense priority claim. It cannot be
estimated at this time when and if the general unsecured claim will be paid.

Braniff, Inc. (Braniff) Bankruptcy - As previously reported, the Bankruptcy
Court disposed of the Partnership's claim in this Bankruptcy proceeding by
permitting the Partnership to exchange a portion of its unsecured claim for
Braniff's right (commonly referred to as a "Stage 2 Base Level right") under the
Federal Aviation Administration noise regulations to operate one Stage 2
aircraft and by allowing the Partnership a net remaining unsecured claim of
$769,231 in the proceedings.

Industry Update

Maintenance of Aging Aircraft - The process of aircraft maintenance begins at
the aircraft design stage. For aircraft operating under Federal Aviation
Administration (FAA) regulations, a review board consisting of representatives
of the manufacturer, FAA representatives and operating airline representatives
is responsible for specifying the aircraft's initial maintenance program. The
General Partner understands that this program is constantly reviewed and
modified throughout the aircraft's operational life.

Since 1988, the FAA, working with the aircraft manufacturers and operators, has
issued a series of ADs which mandate that operators conduct more intensive
inspections, primarily of the aircraft fuselages. The results of these mandatory
inspections may result in the need for repairs or structural modifications that
may not have been required under pre-existing maintenance programs.

In addition, an AD adopted in 1990, applicable to McDonnell Douglas aircraft,
requires replacement or modification of certain structural items on a specific
timetable. These structural items were formerly subject to periodic inspection,
with replacement when necessary. The AD requires specific work to be performed
at various cycle thresholds between 40,000 and 100,000 cycles, and on specific
date or age thresholds. The estimated cost of compliance with all of the
components of this AD is approximately $850,000 per aircraft. The extent of
modifications required to an aircraft varies according to the level of
incorporation of design improvements at manufacture.

In January 1993, the FAA adopted another AD intended to mitigate corrosion of
structural components, which would require repeated inspections from 5 years of
age throughout the life of an aircraft, with replacement of corroded components
as needed. Integration of the new inspections into each aircraft operator's
maintenance program was required by January 31, 1994.

The Partnership's existing leases require the lessees to maintain the
Partnership's aircraft in accordance with an FAA-approved maintenance program
during the lease term. At the end of the leases, each lessee is generally
required to return the aircraft in airworthy condition including compliance with
all ADs for which action is mandated by the FAA during the lease term. An
aircraft returned to the Partnership as a result of a lease default would most
likely not be returned to the Partnership in compliance with all return
conditions required by the lease. The Partnership has agreed to bear a portion

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of the costs of compliance with certain ADs with respect to the aircraft leased
to TWA, as described in Item 1. In negotiating subsequent leases, market
conditions may require that the Partnership bear some or all of the costs of
compliance with future ADs or ADs that have been issued, but which did not
require action during the previous lease term. The ultimate effect on the
Partnership of compliance with the FAA maintenance standards is not determinable
at this time and will depend on a variety of factors, including the state of the
commercial aircraft industry, the timing of the issuance of ADs, and the status
of compliance therewith at the expiration of the current leases.

Aircraft Noise - Another issue which has affected the airline industry is that
of aircraft noise levels. The FAA has categorized aircraft according to their
noise levels. Stage 1 aircraft, which have the highest noise level, are no
longer allowed to operate from civil airports in the United States. Stage 2
aircraft meet current FAA requirements, subject to the phase-out rules discussed
below. Stage 3 aircraft are the most quiet and Stage 3 is the standard for all
new aircraft.

On September 24, 1991, the FAA issued final rules on the phase-out of Stage 2
aircraft by the end of this decade. The key features of the rule include:

- Compliance can be accomplished through a gradual process of
phase-in or phase-out (see below) on each of three interim
compliance dates: December 31, 1994, 1996, and 1998. All Stage
2 aircraft must be phased out of operations in the contiguous
United States by December 31, 1999, with waivers available in
certain specific cases to December 31, 2003.

- All operators have the option of achieving compliance through
a gradual phase-out of Stage 2 aircraft (i.e., eliminate 25%
of its Stage 2 fleet on each of the compliance dates noted
above), or a gradual phase-in of Stage 3 aircraft (i.e., 55%,
65% and 75% of an operator's fleet must consist of Stage 3
aircraft by the respective interim compliance dates noted
above).

The federal rule does not prohibit local airports from issuing more stringent
phase-out rules. In fact, several local airports have adopted more stringent
noise requirements which restrict the operation of Stage 2 and certain Stage 3
aircraft.

Other countries have also adopted noise policies. The European Union (EU)
adopted a non-addition rule in 1989, which directed each member country to pass
the necessary legislation to prohibit airlines from adding Stage 2 aircraft to
their fleets after November 1, 1990, with all Stage 2 aircraft phased-out by the
year 2002. The International Civil Aviation Organization has also endorsed the
phase-out of Stage 2 aircraft on a world-wide basis by the year 2002.

Hushkit modifications, which allow Stage 2 aircraft to meet Stage 3
requirements, are currently available for the Partnership's aircraft and have
been added to eleven of the Partnership's aircraft in 1996 and to three of their
aircraft in 1997.

Currently legislation has been drafted and is under review by the EU to adopt
anti-hushkitting regulations within member states. The legislation seeks to ban
hushkitted aircraft from being added to member states registers after April 1,
1999 and will preclude all operation of hushkitted aircraft within the EU by
April 1, 2002. The effect of this proposal has been to reduce the demand for
hushkitted aircraft within the EU and its neighboring states, including the
former Eastern Block states.

Demand for Aircraft - At year end 1998, there were approximately 12,600 jet
aircraft in the world fleet. Approximately 1,500 aircraft were leased or sold
during 1998, an increase of 14% over 1997. Air travel has grown strongly during
the past 28 years, with the last nineteen years showing better than 5.5% annual
growth, and not until recently has it subsided after what had been a robust

20
<PAGE>

period from 1994 to 1997. This strong period has mainly benefited Stage 3 narrow
bodies and younger Stage 2 narrow bodies, many of which have been or are being
upgraded with hushkits. During 1998, the industry saw many alliances taking
place. There was more consolidation in the U.S. Airline Industry via alliances
than had been seen in the previous 20 years since deregulation. Booming traffic
demand coupled with reductions in the price of aviation fuel has resulted in
record profits for many airlines in North America and Europe. However, slower
traffic lies ahead, the cycle has peaked in 1998, as may have airline profits.
Manufacturers continue to produce at high levels compared to what demand will
require in the future years. Asia continues its economic turmoil which has
brought about a significant reduction in traffic growth in that region. This is
resulting in a number of new aircraft order deferrals and cancellations, mainly
in the wide body sector, with over capacity moving from Asia into the other
regions around the world. Timing of when the down cycle ends or how severe it
will be is still in question, but will be closely watched as we move into the
next millennium.

Effects on the Partnership's Aircraft - The Partnership periodically reviews the
estimated realizability of the residual values at the projected end of each
aircraft's economic life based on estimated residual values obtained from
independent parties which provide current and future estimated aircraft values
by aircraft type. The Partnership made downward adjustments to the estimated
residual value of certain of its on-lease aircraft as of December 31, 1995. For
any downward adjustment in estimated residual value or decrease in the projected
remaining economic life, the depreciation expense over the projected remaining
economic life of the aircraft is increased.

If the projected net cash flow for each aircraft (projected rental revenue, net
of management fees, less projected maintenance costs, if any, plus the estimated
residual value) is less than the carrying value of the aircraft, the Partnership
recognizes the deficiency currently as increased depreciation expense. The
Partnership recognized impairments on aircraft to be held and used by the
Partnership of approximately $17.0 million, or $33.97 per Limited Partnership
unit, in 1996. The impairment loss was the result of several significant
factors. As a result of industry and market changes, a more extensive review of
the Partnership's aircraft was completed in the fourth quarter of 1996 which
resulted in revised assumptions of future cash flows including reassessment of
projected re-lease terms and potential future maintenance costs. As discussed in
Note 4, the Partnership accepted an offer to purchase seven of the Partnership's
remaining aircraft subject to each aircraft's existing lease and certain notes
receivable. This offer constituted an event that required the Partnership to
review the aircraft carrying value pursuant to SFAS 121. In determining this
additional impairment loss, the Partnership estimated the fair value of the
aircraft based on the proposed purchase price reflected in the offer, less the
estimated costs and expenses of the proposed sale. The Partnership recorded an
impairment loss to the extent that the carrying value exceeded the fair value.
Management believes the assumptions related to fair value of impaired assets
represents the best estimates based on reasonable and supportable assumptions
and projections.

The Partnership periodically reviews its aircraft for impairment in accordance
with SFAS No. 121. The Partnership uses information obtained from third party
valuation services in arriving at its estimate of fair value for purposes of
determining residual values. The Partnership will use similar information, plus
available information and estimates related to the Partnership's aircraft, to
determine an estimate of fair value to measure impairment as required by the
statement. The estimates of fair value can vary dramatically depending on the
condition of the specific aircraft and the actual marketplace conditions at the
time of the actual disposition of the asset. If assets are deemed impaired,
there could be substantial write-downs in the future.

21
<PAGE>

Item 8. Financial Statements and Supplementary Data

POLARIS AIRCRAFT INCOME FUND II,
A California Limited Partnership

FINANCIAL STATEMENTS AS OF DECEMBER 31, 1998 AND 1997

AND FOR THE YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996

TOGETHER WITH THE

REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS

22
<PAGE>

REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS

To the Partners of
Polaris Aircraft Income Fund II,
A California Limited Partnership:

We have audited the accompanying balance sheets of Polaris Aircraft Income Fund
II, A California Limited Partnership as of December 31, 1998 and 1997, and the
related statements of operations, changes in partners' capital (deficit) and
cash flows for each of the three years in the period ended December 31, 1998.
These financial statements are the responsibility of the General Partner. Our
responsibility is to express an opinion on these financial statements based on
our audits.

We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by the
General Partner, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our
opinion.

In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of Polaris Aircraft Income Fund
II, A California Limited Partnership as of December 31, 1998 and 1997, and the
results of its operations and its cash flows for each of the three years in the
period ended December 31, 1998, in conformity with generally accepted accounting
principles.

ARTHUR ANDERSEN LLP

San Francisco, California,
January 25, 1999

23
<PAGE>

POLARIS AIRCRAFT INCOME FUND II,
A California Limited Partnership

BALANCE SHEETS

DECEMBER 31, 1998 AND 1997

1998 1997
---- ----
ASSETS:

CASH AND CASH EQUIVALENTS $ 19,228,093 $ 31,587,494

RENT AND OTHER RECEIVABLES 941,563 935,629

AIRCRAFT, net of accumulated depreciation of
$78,075,872 in 1998 and $70,346,578 in 1997 37,287,437 45,016,731

OTHER ASSETS 4,792 6,571
------------ ------------

$ 57,461,885 $ 77,546,425
============ ============

LIABILITIES AND PARTNERS' CAPITAL (DEFICIT):

PAYABLE TO AFFILIATES $ 155,123 $ 142,761

ACCOUNTS PAYABLE AND ACCRUED
LIABILITIES 456,414 317,799

SECURITY DEPOSITS -- 50,000

DEFERRED INCOME 2,324,958 627,660

NOTES PAYABLE 11,079,990 15,667,509
------------ ------------

Total Liabilities 14,016,485 16,805,729
------------ ------------

PARTNERS' CAPITAL (DEFICIT):
General Partner (3,256,230) (3,030,600)
Limited Partners, 499,973 and 499,997 units
outstanding in 1998 and 1997 46,701,630 63,771,296
------------ ------------

Total Partners' Capital 43,445,400 60,740,696
------------ ------------

$ 57,461,885 $ 77,546,425
============ ============

The accompanying notes are an integral part of these statements.

24
<PAGE>

POLARIS AIRCRAFT INCOME FUND II,
A California Limited Partnership

STATEMENTS OF OPERATIONS

FOR THE YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996

1998 1997 1996
---- ---- ----
REVENUES:
Rent from operating leases $ 12,582,702 $ 14,792,071 $ 14,172,153
Gain on trading securities -- -- 49,974
Interest 1,113,284 1,939,699 1,505,981
Claims related to lessee
defaults 21,847 -- 576,500
Loss on sale of aircraft -- (26,079) --
Gain on sale of aircraft
inventory 133,285 101,501 --
Other 50,000 802,443 --
------------ ------------ ------------

Total Revenues 13,901,118 17,609,635 16,304,608
------------ ------------ ------------

EXPENSES:
Depreciation 7,729,294 10,435,053 29,470,353
Management fees to General
Partner 486,468 531,135 667,678
Provision for credit losses -- -- 192,917
Operating 581,127 145,905 244,494
Interest 1,290,441 1,659,897 134,341
Administration and other 357,133 368,309 303,311
------------ ------------ ------------

Total Expenses 10,444,463 13,140,299 31,031,094
------------ ------------ ------------

NET INCOME (LOSS) $ 3,456,655 $ 4,469,336 $(14,708,486)
============ ============ ============

NET INCOME ALLOCATED TO
THE GENERAL PARTNER $ 1,849,258 $ 44,693 $ 1,602,730
============ ============ ============

NET INCOME (LOSS) ALLOCATED
TO LIMITED PARTNERS $ 1,607,397 $ 4,424,643 $(16,311,216)
============ ============ ============

NET INCOME (LOSS) PER LIMITED
PARTNERSHIP UNIT $ 3.22 $ 8.85 $ (32.62)
============ ============ ============

The accompanying notes are an integral part of these statements.

25
<PAGE>

POLARIS AIRCRAFT INCOME FUND II,
A California Limited Partnership

STATEMENTS OF CHANGES IN PARTNERS' CAPITAL (DEFICIT)

FOR THE YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996

General Limited
Partner Partners Total
------- -------- -----

Balance, December 31, 1995 $ (1,139,155) $ 107,507,678 $ 106,368,523

Net income (loss) 1,602,730 (16,311,216) (14,708,486)

Cash distributions to partners (1,944,433) (17,499,895) (19,444,328)
------------- ------------- -------------

Balance, December 31, 1996 (1,480,858) 73,696,567 72,215,709

Net income 44,693 4,424,643 4,469,336

Cash distributions to partners (1,594,435) (14,349,914) (15,944,349)
------------- ------------- -------------

Balance, December 31, 1997 $ (3,030,600) $ 63,771,296 $ 60,740,696

Net income 1,849,258 1,607,397 3,456,655

Capital redemptions -- (3,072) (3,072)

Cash distributions to partners (2,074,888) (18,673,991) (20,748,879)
------------- ------------- -------------

Balance, December 31, 1998 $ (3,256,230) $ 46,701,630 $ 43,445,400
============= ============= =============

The accompanying notes are an integral part of these statements.

26
<PAGE>

POLARIS AIRCRAFT INCOME FUND II,
A California Limited Partnership

STATEMENTS OF CASH FLOWS

FOR THE YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996

1998 1997 1996
---- ---- ----
<S> <C> <C> <C>
OPERATING ACTIVITIES:
Net income (loss) $ 3,456,655 $ 4,469,336 $(14,708,486)
Adjustments to reconcile net income (loss) to
net cash provided by operating activities:
Depreciation 7,729,294 10,435,053 29,470,353
Provision for credit losses -- -- 192,917
Loss on sale of aircraft -- 26,079 --
Gain on sale of aircraft inventory (133,285) (101,501) --
Changes in operating assets and liabilities:
Decrease in marketable securities, trading -- -- 2,356,506
Increase in rent and other receivables (5,934) (929,403) (101,959)
Decrease (increase) in other assets 1,779 110,444 (87,245)
Increase (decrease) in payable to affiliates 12,362 76,130 (25,880)
Increase in accounts payable and
accrued liabilities 138,615 42,619 122,425
Decrease in security deposits (50,000) (66,000) (334,000)
Increase (decrease) in maintenance reserves -- (6,453) 44,343
Increase (decrease) in deferred income 1,697,298 29,745 (44,827)
------------ ------------ ------------

Net cash provided by operating activities 12,846,784 14,086,049 16,884,147
------------ ------------ ------------

INVESTING ACTIVITIES:
Proceeds from sale of aircraft -- 2,519,495 --
Increase in aircraft capitalized costs -- (4,784,633) (17,516,722)
Principal payments on notes receivable -- 12,798,106 1,963,561
Payments to Purchaser related to sale of aircraft -- (1,001,067) --
Net proceeds from sale of aircraft inventory 133,285 214,749 260,235
------------ ------------ ------------

Net cash provided by (used in)
investing activities 133,285 9,746,650 (15,292,926)
------------ ------------ ------------

FINANCING ACTIVITIES:
Increase in note payable -- 3,884,633 14,216,722
Principal payments on notes payable (4,587,519) (2,410,302) (23,544)
Capital redemptions (3,072) -- --
Cash distributions to partners (20,748,879) (15,944,349) (19,444,328)
------------ ------------ ------------

Net cash used in financing activities (25,339,470) (14,470,018) (5,251,150)
------------ ------------ ------------

CHANGES IN CASH AND CASH
EQUIVALENTS (12,359,401) 9,362,681 (3,659,929)

CASH AND CASH EQUIVALENTS AT
BEGINNING OF YEAR 31,587,494 22,224,813 25,884,742
------------ ------------ ------------

CASH AND CASH EQUIVALENTS AT
END OF YEAR $ 19,228,093 $ 31,587,494 $ 22,224,813
============ ============ ============
</TABLE>
The accompanying notes are an integral part of these statements.

27
<PAGE>

POLARIS AIRCRAFT INCOME FUND II,
A California Limited Partnership

NOTES TO FINANCIAL STATEMENTS

DECEMBER 31, 1998

1. Accounting Principles and Policies

Accounting Method - Polaris Aircraft Income Fund II, A California Limited
Partnership (PAIF-II or the Partnership), maintains its accounting records,
prepares its financial statements and files its tax returns on the accrual basis
of accounting. The preparation of financial statements in conformity with
generally accepted accounting principles (GAAP) requires management to make
estimates and assumptions that affect reported amounts and related disclosures.
Actual results could differ from those estimates. The most significant estimates
with regard to these financial statements are related to the projected cash
flows analysis in determining the fair value of assets.

Cash and Cash Equivalents - This includes deposits at banks and investments in
money market funds. Cash and Cash Equivalents are stated at cost, which
approximates fair value.

Marketable Securities, trading - Marketable Securities, trading, were carried at
fair value, which was determined based on quoted market prices. These securities
were held for sale in the near term (Note 7).

Aircraft and Depreciation - The aircraft are recorded at cost, which includes
acquisition costs. Depreciation to an estimated residual value is computed using
the straight-line method over the estimated economic life of the aircraft which
was originally estimated to be 30 years from the date of manufacture.
Depreciation in the year of acquisition was calculated based upon the number of
days that the aircraft were in service.

The Partnership periodically reviews the estimated realizability of the residual
values at the projected end of each aircraft's economic life. For any downward
adjustment in estimated residual value or decrease in the projected remaining
economic life, the depreciation expense over the projected remaining economic
life of the aircraft will be increased.

If the projected net cash flow for each aircraft (projected rental revenue, net
of management fees, less projected maintenance costs, if any, plus the estimated
residual value) is less than the carrying value of the aircraft, an impairment
loss is recognized. Pursuant to Statement of Financial Accounting Standards
(SFAS) No. 121, as discussed in Note 3, measurement of an impairment loss will
be based on the "fair value" of the asset as defined in the statement.

Capitalized Costs - Aircraft modification and maintenance costs which are
determined to increase the value or extend the useful life of the aircraft are
capitalized and amortized using the straight-line method over the estimated
useful life of the improvement. These costs are also subject to periodic
evaluation as discussed above.

Aircraft Inventory - Aircraft held in inventory for sale are reflected at the
lower of depreciated cost or estimated net realizable value. Proceeds from sales
are applied against inventory until the book value is fully recovered. The
remaining book value of the inventory was recovered in 1997. Proceeds in excess
of inventory net book value were recorded as revenue when received.

Operating Leases - The aircraft leases are accounted for as operating leases.
Lease revenues are recognized in equal installments over the terms of the
leases.

28
<PAGE>

Maintenance Reserves - The Partnership received maintenance reserve payments
from certain of its lessees that were to be reimbursed to the lessee or applied
against certain costs incurred by the Partnership or lessee for maintenance work
performed on the Partnership's aircraft or engines, as specified in the leases.
Maintenance reserve payments were recognized when received and balances
remaining at the termination of the lease, if any, were used by the Partnership
to offset future maintenance expenses or recognized as revenue.

Operating Expenses - Operating expenses include costs incurred to maintain,
insure, lease and sell the Partnership's aircraft, including costs related to
lessee defaults and costs of disassembling aircraft inventory.

Net Income (Loss) Per Limited Partnership Unit - Net income (loss) per Limited
Partnership unit is based on the Limited Partners' share of net income or
(loss), allocated in accordance with the Partnership Agreement, and the number
of units outstanding of 499,973, 499,997 and 499,997 for the years ended
December 31, 1998, 1997 and 1996, respectively.

Income Taxes - The Partnership files federal and state information income tax
returns only. Taxable income or loss is reportable by the individual partners.

Receivables - The Partnership recorded an allowance for credit losses for
certain impaired note and rents receivable as a result of uncertainties
regarding their collection as discussed in Note 9. The Partnership recognizes
revenue on impaired notes and receivables only as payments are received.

2. Organization and the Partnership

The Partnership was formed on June 27, 1984 for the purpose of acquiring and
leasing aircraft. The Partnership will terminate no later than December 2010.
Upon organization, both the General Partner and the initial Limited Partner
contributed $500. The Partnership recognized no profits or losses during the
periods ended December 31, 1985 and 1984. The offering of Limited Partnership
units terminated on December 31, 1986, at which time the Partnership had sold
499,997 units of $500, representing $249,998,500. All partners were admitted to
the Partnership on or before December 1, 1986. During January 1998, 24 units
were redeemed by the Partnership in accordance with section 18 of the Limited
Partnership agreement. At December 31, 1998, there were 499,973 units
outstanding, net of redemptions.

Polaris Investment Management Corporation (PIMC), the sole General Partner of
the Partnership, supervises the day-to-day operations of the Partnership. PIMC
is a wholly-owned subsidiary of Polaris Aircraft Leasing Corporation (PALC).
Polaris Holding Company (PHC) is the parent company of PALC. General Electric
Capital Corporation (GE Capital), an affiliate of General Electric Company, owns
100% of PHC's outstanding common stock. PIMC has entered into a services
agreement dated as of July 1, 1994 with GE Capital Aviation Services, Inc.
(GECAS). Allocations to related parties are described in Notes 12 and 13.

3. Aircraft

At December 31, 1998, Polaris Aircraft Income Fund II (the Partnership) owned a
portfolio of 14 used commercial jet aircraft and spare parts inventory (as
discussed in Note 9) out of its original portfolio of 30 aircraft, which were
acquired, leased or sold as discussed below. All aircraft acquired from an
affiliate were purchased within one year of the affiliate's acquisition at the
affiliate's original price paid. The aircraft leases are net operating leases,
requiring the lessees to pay all operating expenses associated with the aircraft
during the lease term. While the leases require the lessees to comply with
Airworthiness Directives (ADs) which have been or may be issued by the Federal
Aviation Administration and require compliance during the lease term, in certain
of the leases the Partnership has agreed to share in the cost of compliance with
ADs. In addition to basic rent, one lessee was required to pay supplemental

29
<PAGE>

amounts based on flight hours or cycles into a maintenance reserve account, to
be used for heavy maintenance of the engines or airframe. The leases generally
state a minimum acceptable return condition for which the lessee is liable under
the terms of the lease agreement. In the event of a lessee default, these return
conditions are not likely to be met. Certain leases also provide that, if the
aircraft are returned at a level above the minimum acceptable level, the
Partnership must reimburse the lessee for the related excess, subject to certain
limitations. The related liability to these lessees, if any, cannot currently be
estimated and therefore is not reflected in the financial statements.

The following table describes the Partnership's aircraft portfolio at December
31, 1998 in greater detail:

Year of
Aircraft Type Serial Number Manufacture
- ------------- ------------- -----------
McDonnell Douglas DC-9-30 47027 1967
McDonnell Douglas DC-9-30 47107 1968
McDonnell Douglas DC-9-30 47108 1968
McDonnell Douglas DC-9-30 47135 1968
McDonnell Douglas DC-9-30 47137 1968
McDonnell Douglas DC-9-30 47174 1968
McDonnell Douglas DC-9-30 47249 1968
McDonnell Douglas DC-9-30 47251 1968
McDonnell Douglas DC-9-30 47324 1969
McDonnell Douglas DC-9-30 47343 1969
McDonnell Douglas DC-9-30 47345 1969
McDonnell Douglas DC-9-30 47357 1969
McDonnell Douglas DC-9-30 47411 1969
McDonnell Douglas DC-9-30 47412 1969

14 McDonnell Douglas DC-9-30 - Initially there were 17 McDonnell Douglas DC-9-30
and one McDonnell Douglas DC-9-40 which were acquired for $122,222,040 during
1986 and leased to Ozark Air Lines, Inc. (Ozark). In 1987, Trans World Airlines,
Inc. (TWA) merged with Ozark and assumed the leases. The leases were modified
and extended in 1991 prior to TWA's bankruptcy filing as discussed in Note 7.
Two of the aircraft had a lease expiration date of February 1998 and two other
aircraft had a lease expiration date of November 1998. These four aircraft were
sold to Triton Aviation Services II LLC in June 1997, as discussed in Note 4.
The leases for 11 of the aircraft that previously had lease expiration dates in
1998 were extended for eight years until November 2004. The leases for three of
the aircraft that previously had lease expiration dates in 1998 were extended in
February 1997 for eight years until February 2005.

The following is a schedule by year of future minimum rental revenue under the
existing leases:

Year Amount
---- ------
1999 $14,280,000
2000 14,280,000
2001 14,280,000
2002 10,655,000
2003 and thereafter 19,020,000
-----------

Total $72,515,000
===========

Future minimum rental payments may be offset or reduced by future costs as
described above and in Note 7.

As discussed in Note 1, the Partnership periodically reviews the estimated
realizability of the residual values at the projected end of each aircraft's
economic life based on estimated residual values obtained from independent
parties which provide current and future estimated aircraft values by aircraft
type.

30
<PAGE>

The Partnership's future earnings are impacted by the net effect of the
adjustments to the carrying values of the aircraft (which has the effect of
decreasing future depreciation expense) and the downward adjustments to the
estimated residual values (which has the effect of increasing future
depreciation expense).

As discussed above, the Partnership uses information obtained from third party
valuation services in arriving at its estimate of fair value for purposes of
determining residual values. The Partnership will use similar information, plus
available information and estimates related to the Partnership's aircraft, to
determine an estimate of fair value to measure impairment as required by the
statement. The estimates of fair value can vary dramatically depending on the
condition of the specific aircraft and the actual marketplace conditions at the
time of the actual disposition of the asset. If assets are deemed impaired,
there could be substantial write-downs in the future.

The Partnership recognized an impairment loss on aircraft to be held and used by
the Partnership aggregating approximately $17.0 million, or $33.97 per Limited
Partnership unit, as increased depreciation expense in 1996. The impairment loss
was the result of several significant factors. As a result of industry and
market changes, a more extensive review of the Partnership's aircraft was
completed in the fourth quarter of 1996 which resulted in revised assumptions of
future cash flows including reassessment of projected re-lease terms and
potential future maintenance costs. As discussed in Note 4, the Partnership
accepted an offer to purchase seven of the Partnership's remaining aircraft
subject to each aircraft's existing lease. This offer constitutes an event that
required the Partnership to review the aircraft carrying value pursuant to SFAS
121. In determining this additional impairment loss, the Partnership estimated
the fair value of the aircraft based on the proposed purchase price reflected in
the offer, less the estimated costs and expenses of the proposed sale. The
Partnership recorded an impairment loss to the extent that the carrying value
exceeded the fair value. Management believes the assumptions related to fair
value of impaired assets represents the best estimates based on reasonable and
supportable assumptions and projections. The increased depreciation expense
reduces the aircraft's carrying value and reduces the amount of future
depreciation expense that the Partnership will recognize over the projected
remaining economic life of the aircraft.

The General Partner evaluates, from time to time, whether the investment
objectives of the Partnership are better served by continuing to hold the
Partnership's remaining portfolio of Aircraft or marketing such Aircraft for
sale. This evaluation takes into account the current and potential earnings of
the Aircraft, the conditions in the markets for lease and sale and future
outlook for such markets, and the tax consequences of selling rather than
continuing to lease the Aircraft. The General Partner has had discussions with
third parties regarding the possibility of selling some or all of these
Aircraft. While such discussions may continue, and similar discussions may occur
again in the future, there is no assurance that such discussions will result in
the Partnership receiving a purchase offer for all or any of the Aircraft which
the General Partner would regard as acceptable.

4. Sale of Aircraft

31
<PAGE>

aircraft leasing company which was formed in 1996 by Triton Investments, Ltd., a
company which has been in the marine cargo container leasing business for 17
years and is diversifying its portfolio by leasing commercial aircraft. Each
Aircraft was sold subject to the existing leases.

32
<PAGE>

5. Ron Wallace Litigation Settlement

Ron Wallace v. Polaris Investment Management Corporation, et al. - On or about
June 18, 1997, a purported class action entitled Ron Wallace v. Polaris
Investment Management Corporation, et al. was filed on behalf of the unitholders
of Polaris Aircraft Income Funds II through VI in the Superior Court of the
State of California, County of San Francisco. The complaint names each of
Polaris Investment Management Corporation (PIMC), GE Capital Aviation Services,
Inc. (GECAS), Polaris Aircraft Leasing Corporation, Polaris Holding Company,
General Electric Capital Corporation, certain executives of PIMC and GECAS and
John E. Flynn, a former PIMC executive, as defendants. The complaint alleges
that defendants committed a breach of their fiduciary duties with respect to the
Sale Transaction involving the Partnership as described in Note 4, under the
caption "Sale of Aircraft -- Sale of Aircraft to Triton." On September 2, 1997,
an amended complaint was filed adding additional plaintiffs, and on December 18,
1997, the plaintiffs filed a second amended complaint asserting their claims
derivatively.

6. Disassembly of Aircraft

In an attempt to maximize the economic return from the remaining six aircraft
formerly leased to Pan Am, the Partnership entered into an agreement with
Soundair, Inc. (Soundair) in October 1992, for the disassembly and sale of
certain of the Partnership's aircraft. The Partnership has incurred the cost of
disassembly and received the proceeds from the sale of such parts, net of
necessary overhaul expenses, and commissions paid to Soundair. The Partnership
received net proceeds from the sale of aircraft inventory of $133,285 (including
the proceeds discussed below), $214,749 and $260,234 during 1998, 1997 and 1996,
respectively. The net book value of the Partnership's aircraft inventory was
reduced to zero during 1997. Payments received by the Partnership of $101,501 in
excess of the aircraft inventory net book value were recorded as gain on sale of
aircraft inventory during 1997.

The Partnership sold its remaining inventory of aircraft parts from the six
disassembled aircraft, to Soundair, Inc. The remaining inventory, with a net
carrying value of $-0-, was sold effective February 1, 1998 for $90,000, less
amounts previously received for sales as of that date. The net purchase price of
$85,080, was paid in September 1998, and is included in gain on sale of aircraft
inventory.

7. TWA Reorganization

The Partnership renegotiated the TWA leases after TWA defaulted under its leases
with the Partnership during 1991. The renegotiated agreement stipulated that the
Partnership share in the cost of certain ADs after TWA successfully reorganized.
Pursuant to this cost-sharing agreement, since TWA emerged from its
reorganization proceedings in 1993, expenses totaling $6.6 million have been
offset against rental payments or credited to other amounts due from TWA. Under
the terms of this agreement, TWA may offset up to an additional $1.7 million
against rental payments, subject to annual limitations, over the remaining lease
terms.

33
<PAGE>

In October 1994, TWA notified its creditors, including the Partnership, of
another proposed restructuring of its debt. Subsequently, GECAS negotiated a
standstill arrangement, as set forth in a letter agreement dated December 16,
1994 (the Deferral Agreement), with TWA for the 46 aircraft that are managed by
GECAS, 18 of which were owned by the Partnership. As required by its terms, the
Deferral Agreement (which has since been amended as discussed below) was
approved by PIMC on behalf of the Partnership with respect to the Partnership's
aircraft.

The Deferral Agreement provided for (i) a moratorium on the rents due to the
Partnership in November 1994 and on 75% of the rents due to the Partnership from
December 1994 through March 1995, and (ii) all of the deferred rents, together
with interest thereon, to be repaid in monthly installments beginning in May
1995 and ending in December 1995. The repayment schedule was subsequently
accelerated upon confirmation of TWA's bankruptcy plan. The Partnership did not
recognize either the $1.575 million rental amount deferred in 1994 or the $2.025
million rental amount deferred during the first quarter of 1995 as rental
revenue until the deferred rents were received. The deferred rents were paid in
full by October 1995. While TWA has committed to an uninterrupted flow of lease
payments, there can be no assurance that TWA will continue to honor its
obligations in the future.

In consideration for the partial rent moratorium described above, TWA agreed to
make a lump sum payment of $1,000,000 to GECAS for the TWA lessors for whom
GECAS provides management services and who agreed to the Deferral Agreement. The
Partnership received $218,171, in January 1995, as its pro rata share of such
payment by TWA.

In order to resolve certain issues that arose after the execution of the
Deferral Agreement, TWA and GECAS entered into a letter agreement dated June 27,
1995, pursuant to which they agreed to amend certain provisions of the Deferral
Agreement (as so amended, the Amended Deferral Agreement). The effect of the
Amended Deferral Agreement, which was approved by PIMC with respect to the
Partnership's aircraft, is that TWA, in addition to agreeing to repay the
deferred rents to the Partnership, agreed (i) to a fixed payment amount (payable
in warrants, the number of which was determined by formula) in consideration for
the aircraft owners' agreement to defer rent under the Deferral Agreement, and,
(ii) to the extent the market value of the warrants is less than the payment
amount, to supply maintenance services to the aircraft owners having a value
equal to such deficiency. The payment amount was determined by subtracting
certain maintenance reimbursements owed to TWA by certain aircraft owners,
including the Partnership, from the aggregate amount of deferred rents.

8. TWA Lease Extension

GECAS, on behalf of the Partnership, negotiated with TWA for the acquisition of
noise-suppression devices, commonly known as "hushkits", for the 14 Partnership
aircraft currently on lease to TWA, as well as other aircraft owned by
affiliates of PIMC and leased to TWA. The 14 aircraft that received hushkits
were designated by TWA. The hushkits recondition the aircraft so as to meet
Stage 3 noise level restrictions. Hushkits were installed on 11 of the
Partnership's aircraft during 1996 and the leases for these 11 aircraft were
extended for a period of eight years until November 2004. Hushkits were
installed on 3 of the Partnership's aircraft during 1997 and the leases for
these 3 aircraft were extended for a period of eight years until February 2005.

The aggregate cost of the hushkit reconditioning for the 11 aircraft was
$17,516,722, or approximately $1.6 million per aircraft, which was capitalized
by the Partnership during 1996. The Partnership paid $3.3 million of the

34
<PAGE>

aggregate hushkit cost and the balance of $14,216,722 was financed by the
hushkit manufacturer over 50 months at an interest rate of approximately 10% per
annum.

The aggregate cost of the hushkit reconditioning completed in February 1997 for
the 3 remaining aircraft was $4,784,633, or approximately $1.6 million per
aircraft, which was capitalized by the Partnership during 1997. The Partnership
paid $900,000 of the aggregate hushkit cost and the balance of $3,884,633 was
financed by UT Finance Corporation (UT Finance), a wholly owned subsidiary of
United Technologies Corporation, of which a division is Pratt and Whitney Group,
the hushkit manufacturer, over 50 months at an interest rate of approximately
10% per annum.

The rent payable by TWA under the leases was increased by an amount sufficient
to cover the monthly debt service payments on the hushkits and fully repay,
during the term of the TWA leases, the amount borrowed. The loans from the
hushkit manufacturer are non-recourse to the Partnership and secured by a
security interest in the lease receivables. Cash paid for interest expense on
the loans was $1,292,480, $1,551,093 and $236,848 in 1998, 1997 and 1996,
respectively.

9. Viscount Restructuring Agreement and Default

35
<PAGE>

litigation, and the Court set a hearing on the motion for March 8, 1999.
Subsequently, FSB and the claimants agreed to settle this claim for an agreed
judgement of $159,374.51 in attorney's fees to be paid to FSB. The settlement
agreement is subject to approval by the Court. The claimants are appealing the
Court's rulings.

On July 12, 1996, GECAS and FSB filed a motion in Viscount's bankruptcy case to
recover the engines and parts leased in connection with the Partnership's
aircraft. GECAS and FSB asserted that these engines and parts should have been
delivered to FSB pursuant to the Compromise and Stipulation. Viscount paid to
the Partnership $10,000 for the use of the engine during the month of August
1996, and continued through August 1996 to pay maintenance reserves pursuant to
the lease terms.

On September 18, 1996, GECAS (on behalf of the Partnership, Polaris Holding
Company, Polaris Aircraft Income Fund I, Polaris Aircraft Income Fund IV and
Polaris Aircraft Investors XVIII) (collectively, the Polaris Entities) and
Viscount entered into a Stipulation and Agreement (the Stipulation and
Agreement) by which Viscount agreed to voluntarily return all of the Polaris
Entities' aircraft and engines, turn over possession of the majority of its
aircraft parts inventory, and cooperate with GECAS in the transition of aircraft
equipment and maintenance, in exchange for which, upon Bankruptcy Court approval
of the Stipulation and Agreement, the Polaris Entities would waive their pre-
and post-petition claims against Viscount for amounts due and unpaid.

The Partnership recorded an allowance for credit losses of $100,409 in 1996, for
the aggregate unsecured receivables from Viscount. The line of credit, which was
advanced to Viscount in 1994, was, in accordance with the Compromise and
Stipulation, secured by certain of Viscount's trade receivables and spare parts.
The Stipulation and Agreement releases the Partnership's claim against
Viscount's trade receivables. As a result, the Partnership recorded an
additional allowance for credit losses of $92,508 during 1996, representing
Viscount's outstanding balance of the line of credit and accrued interest.
Payments received by the Partnership from the sale of the spare aircraft parts
(as discussed above), if any, will be recorded as revenue when received. The
Stipulation and Agreement provides that, upon entry of a final non-appealable
court order approving it, the Partnership would waive its pre- and post-petition
claims against Viscount for all amounts due and unpaid. As a result, the
Partnership considers all receivables from Viscount to be uncollectible and has
written-off, during 1996, all notes, rents and interest receivable balances from
Viscount.

The Partnership evaluated the airframe and engines previously leased to Viscount
for potential re-lease or sale and estimated that maintenance and refurbishment
costs aggregating approximately $1.6 million will be required to re-lease the
airframe and engines. Alternatively, a sale of the airframe and engines would
likely be made on an "as is, where is" basis, without the Partnership incurring
substantial maintenance costs. The aircraft was sold in January 1997 for
$660,000. As discussed in Note 4, in accordance with SFAS No. 121, the
Partnership recognized an impairment loss of $300,000 on this aircraft which was
recorded as additional depreciation expense during 1996.

36
<PAGE>

accrued legal costs of approximately $116,000, $107,000 and $147,000, which are
reflected in operating expense in the Partnership's 1998, 1997 and 1996
statement of operations, respectively. In 1998, the Partnership revised its
estimate of legal costs and reduced the accrual for legal costs by $68,753.

10. ALG Default and Restructuring

In 1995, ALG paid to the Partnership $19,138 of the $897,932 balloon payment due
in January 1995, originating an event of default under the note. The Partnership
and ALG subsequently restructured the terms of the promissory note. The
renegotiated terms specify payment by ALG of the note balance with interest at a
rate of 13% per annum with one lump sum payment in January 1995 of $254,733,
eleven monthly payments of $25,600 beginning in February 1995, and a balloon
payment in January 1996 of $416,631. In January 1996, the Partnership and ALG
once again restructured the terms of the promissory note. The renegotiated terms
specify payment by ALG of the note balance with interest at a rate of 13% per
annum with a lump sum payment in January 1996 of $135,258 and eleven payments of
$27,272 beginning in February 1996 through December 1996. ALG paid the note in
full during 1996.

11. Claims Related to Lessee Defaults

12. Related Parties

Under the Limited Partnership Agreement (Partnership Agreement), the Partnership
paid or agreed to pay the following amounts to PIMC and/or its affiliates in
connection with services rendered:

37
<PAGE>

a. An aircraft management fee equal to 5% of gross rental revenues with
respect to operating leases or 2% of gross rental revenues with respect
to full payout leases of the Partnership, payable upon receipt of the
rent. In 1998, 1997 and 1996, the Partnership paid management fees to
PIMC of $420,000, $440,295, and $652,417, respectively. Management fees
payable to PIMC at December 31, 1998 and 1997 were $142,798 and $76,330
respectively.

b. Reimbursement of certain out-of-pocket expenses incurred in connection
with the management of the Partnership and supervision of its assets.
In 1998, 1997 and 1996, $377,665, $375,486, and $316,061, respectively,
were reimbursed by the Partnership to PIMC for administrative expenses.
Administrative reimbursements of $10,874 and $50,286 were payable at
December 31, 1998 and 1997, respectively. Reimbursements for
maintenance and remarketing costs of $483,221, $82,633, and $153,699
were paid by the Partnership in 1998, 1997 and 1996, respectively.
Maintenance and remarketing reimbursements of $1,451 and $16,145 were
payable at December 31, 1998 and 1997, respectively.

c. A 10% interest to PIMC in all cash distributions and sales proceeds,
gross income in an amount equal to 9.09% of distributed cash available
from operations and 1% of net income or loss and taxable income or
loss, as such terms are defined in the Partnership Agreement. After the
Partnership has sold or disposed of aircraft representing 50% of the
total aircraft cost, gains from the sale or other disposition of
aircraft are generally allocated first to the General Partner until
such time that the General Partner's capital account is equal to the
amount to be distributed to the General Partner from the proceeds of
such sale or disposition.

d. A subordinated sales commission to PIMC of 3% of the gross sales price
of each aircraft for services performed upon disposition and
reimbursement of out-of-pocket and other disposition expenses.
Subordinated sales commissions will be paid only after Limited Partners
have received distributions in an aggregate amount equal to their
capital contributions plus a cumulative non-compounded 8% per annum
return on their adjusted capital contributions, as defined in the
Partnership Agreement. The Partnership did not pay or accrue a sales
commission on any aircraft sales to date as the above subordination
threshold has not been met.

e. In the event that, immediately prior to the dissolution and termination
of the Partnership, the General Partner shall have a deficit balance in
its tax basis capital account, then the General Partner shall
contribute in cash to the capital of the Partnership an amount which is
equal to such deficit (see Note 13).

13. Partners' Capital

The Partnership Agreement (the Agreement) stipulates different methods by which
revenue, income and loss from operations and gain or loss on the sale of
aircraft are to be allocated to the General Partner and the Limited Partners
(see Note 12). Such allocations are made using income or loss calculated under
GAAP for book purposes, which, as more fully described in Note 15, varies from
income or loss calculated for tax purposes.

Cash available for distributions, including the proceeds from the sale of
aircraft, is distributed 10% to the General Partner and 90% to the Limited
Partners.

The different methods of allocating items of income, loss and cash available for
distribution combined with the calculation of items of income and loss for book
and tax purposes result in book basis capital accounts that may vary
significantly from tax basis capital accounts. The ultimate liquidation and
distribution of remaining cash will be based on the tax basis capital accounts
following liquidation, in accordance with the Agreement.

38
<PAGE>

Had all the assets of the Partnership been liquidated at December 31, 1998 at
the current carrying value, the tax basis capital (deficit) accounts of the
General Partner and the Limited Partners is estimated to be $4,344,540 and
$39,100,860, respectively.

14. Income Taxes

Federal and state income tax regulations provide that taxes on the income or
loss of the Partnership are reportable by the partners in their individual
income tax returns. Accordingly, no provision for such taxes has been made in
the financial statements.

The net differences between the tax basis and the reported amounts of the
Partnership's assets and liabilities at December 31, 1998 and 1997 are as
follows:

Reported Amounts Tax Basis Net Difference
---------------- --------- --------------

1998: Assets $57,461,885 $63,662,817 $(6,200,932)
Liabilities 14,016,485 11,841,104 2,175,381

1997: Assets $77,546,425 $84,836,496 $(7,290,071)
Liabilities 16,805,729 16,232,563 573,166

15. Reconciliation of Net Book Income (Loss) to Taxable Net Income (Loss)

The following is a reconciliation between net income (loss) per Limited
Partnership unit reflected in the financial statements and the information
provided to Limited Partners for federal income tax purposes:

For the years ended December 31,

1998 1997 1996
---- ---- ----

Book net income (loss) per Limited Partnership
unit $ 3.22 $ 8.85 $(32.62)
Adjustments for tax purposes represent
differences between book and tax revenue
and expenses:
Rental and maintenance reserve revenue
recognition 3.36 (1.18) 0.03
Management fee expense (.19) 0.06 0.03
Depreciation (2.16) (11.31) 30.16
Gain or loss on sale of aircraft -- (0.02) (0.19)
Basis in inventory -- (0.07) (0.08)
Other revenue and expense items (0.04) (0.01) (0.16)
------ ------- -------

Taxable net income (loss) per Limited
Partnership unit $ 4.19 $ (3.68) $ (2.83)
====== ======= =======

The differences between net income and loss for book purposes and net income and
loss for tax purposes result from the temporary differences of certain revenue
and deductions.

For book purposes, rental revenue is generally recorded as it is earned. For tax
purposes, certain temporary differences exist in the recognition of revenue. For
tax purposes, management fee expense is accrued in the same year as the tax
basis rental revenue. Increases in the Partnership's book maintenance reserve
liability were recognized as rental revenue for tax purposes. Disbursements from
the Partnership's book maintenance reserves are capitalized or expensed for tax
purposes, as appropriate.

39
<PAGE>

The Partnership computes depreciation using the straight-line method for
financial reporting purposes and generally an accelerated method for tax
purposes. The Partnership also periodically evaluates the ultimate
recoverability of the carrying values and the economic lives of its aircraft for
book purposes and, accordingly, recognized adjustments which increased book
depreciation expense. As a result, the current year tax depreciation expense is
greater than the book depreciation expense. These differences in depreciation
methods result in book to tax differences on the sale of aircraft. In addition,
certain costs were capitalized for tax purposes and expensed for book purposes.

16. Subsequent Events

The Partnership made a cash distribution, to Limited Partners, of $2,574,861 or
$5.15 per Limited Partnership unit, and $286,096 to the General Partner on
January 15, 1999.

40
<PAGE>

Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure

None.

41
<PAGE>

PART III

Item 10. Directors and Executive Officers of the Registrant

Polaris Aircraft Income Fund II, A California Limited Partnership (PAIF-II or
the Partnership) has no directors or officers. Polaris Holding Company (PHC) and
its subsidiaries, including Polaris Aircraft Leasing Corporation (PALC) and
Polaris Investment Management Corporation (PIMC), the General Partner of the
Partnership (collectively Polaris), restructured their operations and businesses
(the Polaris Restructuring) in 1994. In connection therewith, PIMC entered into
a services agreement dated as of July 1, 1994 (the Services Agreement) with GE
Capital Aviation Services, Inc. (GECAS), a Delaware corporation which is a
wholly owned subsidiary of General Electric Capital Corporation, a New York
corporation (GE Capital). GE Capital has been PHC's parent company since 1986.
As subsidiaries of GE Capital, GECAS and PIMC are affiliates.

The officers and directors of PIMC are:

Name PIMC Title
----------- -------------------

Eric M. Dull President; Director
Marc A. Meiches Chief Financial Officer
Barbara Macholl Director
Norman C. T. Liu Vice President; Director
Ray Warman Secretary
Robert W. Dillon Assistant Secretary

Substantially all of these management personnel will devote only such portion of
their time to the business and affairs of PIMC as deemed necessary or
appropriate.

Mr. Dull, 38, assumed the position of President and Director of PIMC effective
January 1, 1997. Mr. Dull previously was a Director of PIMC from March 31, 1995
to July 31, 1995. Mr. Dull holds the position of Executive Vice President - Risk
and Portfolio Management of GECAS, having previously held the positions of
Executive Vice President - Portfolio Management and Senior Vice President -
Underwriting Risk Management of GECAS. Prior to joining GECAS, Mr. Dull held
various positions with Transportation and Industrial Funding Corporation (TIFC).

Mr. Meiches, 46, assumed the position of Chief Financial Officer of PIMC
effective October 9, 1995. Previously, he held the position of Vice President of
PIMC from October 1995 to October 1997. Mr. Meiches presently holds the
positions of Executive Vice President and Chief Financial and Operating Officer
of GECAS. Prior to joining GECAS, Mr. Meiches has been with General Electric
Company (GE) and its subsidiaries since 1978. Since 1992, Mr. Meiches held the
position of Vice President of the General Electric Capital Corporation Audit
Staff. Between 1987 and 1992, Mr. Meiches held Manager of Finance positions for
GE Re-entry Systems, GE Government Communications Systems and the GE Astro-Space
Division.

Ms. Macholl, 45, assumed the position of Director of PIMC effective February 27,
1999. Ms. Macholl presently holds the position of Senior Vice President,
Marketing Finance for GECAS. Prior to joining GECAS, Ms. Macholl has been with
the General Electric Company (GE) and its subsidiaries since 1977. Ms. Macholl
previously held the position of Vice President Finance for CBSI Inc., a wholly
owned subsidiary of the General Electric Company. Ms. Macholl has also held
various financial management positions for the GE Lighting business.

42
<PAGE>

Mr. Liu, 41, assumed the position of Vice President of PIMC effective May 1,
1995 and Director of PIMC effective July 31, 1995. Mr. Liu presently holds the
position of Executive Vice President - Marketing and Structured Finance of
GECAS, having previously held the position of Executive Vice President - Capital
Funding and Portfolio Management of GECAS. Prior to joining GECAS, Mr. Liu was
with General Electric Capital Corporation for nine years. He has held management
positions in corporate Business Development and in Syndications and Leasing for
TIFC. Mr. Liu previously held the position of managing director of Kidder,
Peabody & Co., Incorporated.

Mr. Warman, 50, assumed the position of Secretary of PIMC effective March 23,
1998. Mr. Warman has served as a GECAS Senior Vice President and Associate
General Counsel since March 1996, and for 13 years theretofore was a partner,
with an air-finance and corporate practice of the national law firm of Morgan,
Lewis & Bockius LLP.

Mr. Dillon, 57, held the position of Vice President - Aviation Legal and
Insurance Affairs, from April 1989 to October 1997. Previously, he served as
General Counsel of PIMC and PALC effective January 1986. Effective July 1, 1994,
Mr. Dillon assumed the position of Assistant Secretary of PIMC. Mr. Dillon
presently holds the position of Senior Vice President and Managing Counsel of
GECAS.

Certain Legal Proceedings:

On or around February 17, 1993, a civil action entitled Einhorn, et al. v.
Polaris Public Income Funds, et al. was filed in the Circuit Court of the 11th
Judicial Circuit in and for Dade County, Florida against, among others, Polaris
Investment Management Corporation and Polaris Depositary Company. The
Partnership is not named as a defendant in this action. Plaintiffs seek class
action certification on behalf of a class of investors in Polaris Aircraft
Income Fund IV, Polaris Aircraft Income Fund V and Polaris Aircraft Income Fund
VI who purchased their interests while residing in Florida. Plaintiffs allege
the violation of Section 517.301, Florida Statutes, in connection with the
offering and sale of units in such Polaris Aircraft Income Funds. Plaintiffs
seek rescission or damages, in addition to interest, costs, and attorneys' fees.
On May 7, 1993, the court granted the defendants' motion to stay this action,
and subsequently this suit was dismissed.

On or around September 27, 1995, a complaint entitled Martha J. Harrison v.
General Electric Company, et al. was filed in the Civil District Court for the
Parish of Orleans, State of Louisiana. The complaint names as defendants General
Electric Company and Prudential Securities Incorporated. The Partnership is not
named as a defendant in this action. Plaintiff alleges claims of tort, breach of
fiduciary duty in tort, contract and quasi-contract, violation of sections of
the Louisiana Blue Sky Law and violation of the Louisiana Civil Code concerning
the inducement and solicitation of purchases arising out of the public offering
of Polaris Aircraft Income Fund IV. Plaintiff seeks compensatory damages,
attorney's fees, interest, costs and general relief.

On or around December 8, 1995, a complaint entitled Overby, et al. v. General
Electric Company, et al. was filed in the Civil District Court for the Parish of
Orleans, State of Louisiana. The complaint names as defendants General Electric
Company and General Electric Capital Corporation. The Partnership is not named
as a defendant in this action. Plaintiffs allege claims of tort, breach of
fiduciary duty, in tort, contract and quasi-contract, violation of sections of
the Louisiana Blue Sky Law and violation of the Louisiana Civil Code in
connection with the public offering of Polaris Aircraft Income Funds III and IV.
Plaintiffs seek compensatory damages, attorneys' fees, interest, costs and
general relief.

In or around November 1994, a complaint entitled Lucy R. Neeb, et al. v.
Prudential Securities Incorporated et al. was filed in the Civil District Court
for the Parish of Orleans, State of Louisiana. The complaint named as defendants
Prudential Securities, Incorporated and Stephen Derby Gisclair. On or about

43
<PAGE>

December 20, 1995, plaintiffs filed a First Supplemental and Amending Petition
adding as additional defendants General Electric Company, General Electric
Capital Corporation and Smith Barney, Inc. The Partnership is not named as a
defendant in this action. Plaintiffs allege claims of tort, breach of fiduciary
duty, in tort, contract and quasi-contract, violation of sections of the
Louisiana Blue Sky Law and violation of the Louisiana Civil Code in connection
with the public offering of Polaris Aircraft Income Funds III and IV. Plaintiffs
seek compensatory damages, attorneys' fees, interest, costs and general relief.

In or about January of 1995, a complaint entitled Albert B. Murphy, Jr. v.
Prudential Securities, Incorporated et al. was filed in the Civil District Court
for the Parish of Orleans, State of Louisiana. The complaint named as defendants
Prudential Securities Incorporated and Stephen Derby Gisclair. On or about
January 18, 1996, plaintiff filed a First Supplemental and Amending Petition
adding defendants General Electric Company and General Electric Capital
Corporation. The Partnership is not named as a defendant in this action.
Plaintiff alleges claims of tort, breach of fiduciary duty in tort, contract and
quasi-contract, violation of sections of the Louisiana Blue Sky Law and
violation of the Louisiana Civil Code in connection with the public offering of
Polaris Aircraft Income Funds III and IV. Plaintiffs seek compensatory damages,
attorneys' fees, interest, costs and general relief.

On or about January 22, 1996, a complaint entitled Mrs. Rita Chambers, et al. v.
General Electric Co., et al. was filed in the Civil District Court for the
Parish of Orleans, State of Louisiana. The complaint names as defendants General
Electric Company and General Electric Capital Corporation. The Partnership is
not named as a defendant in this action. Plaintiffs allege claims of tort,
breach of fiduciary duty in tort, contract and quasi-contract, violation of
sections of the Louisiana Blue Sky Law and violation of the Louisiana Civil Code
in connection with the public offering of Polaris Aircraft Income Fund IV.
Plaintiffs seek compensatory damages, attorneys' fees, interest, costs and
general relief.

In or around December 1994, a complaint entitled John J. Jones, Jr. v.
Prudential Securities Incorporated et al. was filed in the Civil District Court
for the Parish of Orleans, State of Louisiana. The complaint named as defendants
Prudential Securities, Incorporated and Stephen Derby Gisclair. On or about
March 29, 1996, plaintiffs filed a First Supplemental and Amending Petition
adding as additional defendants General Electric Company and General Electric
Capital Corporation. The Partnership is not named as a defendant in this action.
Plaintiff alleges claims of tort, breach of fiduciary duty in tort, contract and
quasi-contract, violation of section of the Louisiana Blue Sky Law and violation
of the Louisiana Civil Code concerning the inducement and solicitation of
purchases arising out of the public offering of Polaris Aircraft Income Fund
III. Plaintiff seeks compensatory damages, attorneys' fees, interest, costs and
general relief.

On or around February 16, 1996, a complaint entitled Henry Arwe, et al. v.
General Electric Company, et al. was filed in the Civil District Court for the
Parish of Orleans, State of Louisiana. The complaint named as defendants General
Electric Company and General Electric Capital Corporation. The Partnership is
not named as a defendant in this action. Plaintiffs allege claims of tort,
breach of fiduciary duty in tort, contract and quasi-contract, violation of
sections of the Louisiana Blue Sky Law and violation of the Louisiana Civil Code
concerning the inducement and solicitation of purchases arising out of the
public offering of Polaris Aircraft Income Funds III and IV. Plaintiffs seek
compensatory damages, attorneys' fees, interest, costs and general relief.

On or about May 7, 1996, a petition entitled Charles Rich, et al. v. General
Electric Company and General Electric Capital Corporation was filed in the Civil
District Court for the Parish of Orleans, State of Louisiana. The complaint
names as defendants General Electric Company and General Electric Capital
Corporation. The Partnership is not named as a defendant in this action.

44
<PAGE>

Plaintiffs allege claims of tort concerning the inducement and solicitation of
purchases arising out of the public offering of Polaris Aircraft Income Funds
III and IV. Plaintiffs seek compensatory damages, attorneys' fees, interest,
costs and general relief.

On or about March 4, 1996, a petition entitled Richard J. McGiven v. General
Electric Company and General Electric Capital Corporation was filed in the Civil
District Court for the Parish of Orleans, State of Louisiana. The complaint
names as defendants General Electric Company and General Electric Capital
Corporation. The Partnership is not named as a defendant in this action.
Plaintiff alleges claims of tort concerning the inducement and solicitation of
purchases arising out of the public offering of Polaris Aircraft Income Fund V.
Plaintiff seeks compensatory damages, attorneys' fees, interest, costs and
general relief.

On or about March 4, 1996, a petition entitled Alex M. Wade v. General Electric
Company and General Electric Capital Corporation was filed in the Civil District
Court for the Parish of Orleans, State of Louisiana. The complaint names as
defendants General Electric Company and General Electric Capital Corporation.
The Partnership is not named as a defendant in this action. Plaintiff alleges
claims of tort concerning the inducement and solicitation of purchases arising
out of the public offering of Polaris Aircraft Income Fund V. Plaintiff seeks
compensatory damages, attorneys' fees, interest, costs and general relief.

Other Proceedings - Part I, Item 3 discusses certain other actions arising out
of certain public offerings, including that of the Partnership, to which both
the Partnership and its General Partner are parties.

Item 11. Executive Compensation

PAIF-II has no directors or officers. PAIF-II is managed by PIMC, the General
Partner. In connection with management services provided, management and
advisory fees of $420,000 were paid to PIMC in 1998 in addition to a 10%
interest in all cash distributions as described in Note 12 to the financial
statements (Item 8).

Item 12. Security Ownership of Certain Beneficial Owners and Management

a) No person owns of record, or is known by PAIF-II to own beneficially,
more than five percent of any class of voting securities of PAIF-II.

b) The General Partner of PAIF-II owns the equity securities of PAIF-II as
set forth in the following table:

Title Name of Amount and Nature of Percent
of Class Beneficial Owner Beneficial Ownership of Class
-------- ---------------- -------------------- --------

General Polaris Investment Represents a 10.0% interest 100%
Partner Management of all cash distributions,
Interest Corporation gross income in an amount
equal to 9.09% of distributed
cash available from operations,
and a 1% interest in net
income or loss

c) There are no arrangements known to PAIF-II, including any pledge by any
person of securities of PAIF-II, the operation of which may at a
subsequent date result in a change in control of PAIF-II.

45
<PAGE>

Item 13. Certain Relationships and Related Transactions

None.

46
<PAGE>

PART IV

Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K

1. Financial Statements.

The following are included in Part II of this report:
Page No.

Report of Independent Public Accountants 23
Balance Sheets 24
Statements of Operations 25
Statements of Changes in Partners' Capital (Deficit) 26
Statements of Cash Flows 27
Notes to Financial Statements 28

2. Reports on Form 8-K.

No reports on Form 8-K were filed during the quarter ended December 31,
1998.

3. Exhibits required to be filed by Item 601 of Regulation S-K.

27. Financial Data Schedule (in electronic format only).

4. Financial Statement Schedules.

All financial statement schedules are omitted because they are not
applicable, not required or because the required information is
included in the financial statements or notes thereto.

47
<PAGE>

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the registrant has duly caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized.

POLARIS AIRCRAFT INCOME FUND II,
A California Limited Partnership
(REGISTRANT)
By: Polaris Investment
Management Corporation
General Partner

March 24, 1999 By: /S/ Eric M. Dull
-------------- -------------------------
Date Eric M. Dull, President

Pursuant to the requirements of the Securities Exchange Act of 1934, this report
has been signed below by the following persons on behalf of the registrant and
in the capacities and on the dates indicated.

Signature Title Date
--------- ----- ----

/S/Eric M. Dull President and Director of Polaris March 24, 1999
--------------- Investment Management Corporation, --------------
(Eric M. Dull) General Partner of the Registrant

/S/Marc A. Meiches Chief Financial Officer of Polaris March 24, 1999
------------------ Investment Management Corporation, --------------
(Marc A. Meiches) General Partner of the Registrant

/S/Barbara Macholl Director of Polaris Investment March 24, 1999
------------------- Management Corporation, General --------------
(Barbara Macholl) Partner of the Registrant

/S/Norman C. T. Liu Vice President and Director of March 24, 1999
------------------- Polaris Investment Management --------------
(Norman C. T. Liu) Corporation, General Partner
of the Registrant

<ARTICLE>5

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