NOTE 1
ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES

Polaris Industries Inc. ("Polaris" or the "Company") is engaged in a single industry segment consisting of the design, engineering, manufacturing and marketing of innovative, high-quality, high-performance motorized products for recreation and utility use, including snowmobiles, all-terrain vehicles, motorcycles and personal watercraft. Polaris products, together with related parts, garments and accessories, are sold worldwide through a network of dealers, distributors and its Canadian subsidiary.

Basis of presentation: All significant intercompany transactions and balances have been eliminated in consolidation. Certain amounts previously reported in the 1996 and 1995 consolidated financial statements have been reclassified to conform to the 1997 presentation. These reclassifications had no effect on previously reported net income or shareholders’ equity.

Use of estimates: The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Ultimate results could differ from those estimates.

Foreign operations: The following data relates to Polaris’ foreign operations (in thousands of United States dollars):

Cash equivalents: Polaris considers all highly liquid investments purchased with an original maturity of 90 days or less to be cash equivalents. Such investments have consisted principally of commercial paper and money market mutual funds.

Fair value of financial instruments: Except as noted, the carrying value of all financial instruments approximates their fair value.

Inventories: Inventories are stated at the lower of cost (first-in, first-out method) or market. The major components of inventories are as follows (in thousands):

Property and equipment: Property and equipment is stated at cost. Depreciation is provided using the straight-line method over the estimated useful life of the respective assets, ranging from 10–20 years for buildings and improvements and from 1–7 years for equipment and tooling. Fully depreciated tooling is eliminated from the accounting records annually.

Intangible assets: Intangible assets are stated net of accumulated amortization totaling $10,657,000 at December 31, 1997, and $9,781,000 at December 31, 1996, and consist principally of cost in excess of the net assets of the business acquired which is amortized on a straight-line basis over 40 years. Other intangible assets are amortized using the straight-line method over their estimated useful lives ranging from 5 to 17 years.
    Polaris periodically assesses the amortization period and recoverability of the carrying amount of its intangible assets to determine potential impairment based upon expected future cash flows from the related business. To date, management has determined that no such impairment exists.

Product warranties: Polaris provides for estimated warranty costs at the time of sale to the dealer or distributor customer and for other costs associated with specific items at the time their existence and amounts are determinable.

Foreign currency: Polaris’ Canadian subsidiary uses the United States dollar as its functional currency. Canadian assets and liabilities are translated at the foreign exchange rates in effect at the balance sheet date. Revenues and expenses are translated at the average foreign exchange rate in effect. Translation and exchange gains and losses are reflected in the results of operations.
    Polaris enters into foreign exchange contracts to manage currency exposures of its purchase commitments denominated in foreign currencies and transfers of funds from its Canadian subsidiary. Polaris does not use any financial contract for trading purposes. These contracts are accounted for as hedges, thus market value gains and losses are recognized at the time of purchase or transfer of funds, respectively. The criteria to determine if hedge accounting is appropriate are (1) the designation of a hedge to an underlying exposure, (2) whether or not overall risk is reduced and (3) if there is a correlation between the value of the foreign exchange contract and the underlying exposure. Gains and losses related to purchase commitments are recorded as adjustments to cost of sales while gains and losses related to transfers of funds are recorded as other expense (income) on the accompanying statements of operations. At December 31, 1997, Polaris had open Japanese yen foreign exchange contracts with notional amounts totaling $81,543,000 United States dollars, and open Canadian dollar foreign exchange contracts with notional amounts totaling $108,420,000 United States dollars which mature throughout 1998.

Revenue recognition: Revenues are recognized at the time of shipment to the dealer or distributor. Product returns, whether in the normal course of business or resulting from repossession under its customer financing program (Note 2), have not been material. Polaris provides for estimated sales promotion expenses at the time of sale to the dealer or distributor customer.

Operating Expenses: Significant components of operating expenses are as follows (in thousands):

Major supplier: During 1997, 1996, and 1995, purchases of engines and related components totaling 16, 22 and 26 percent, respectively, of Polaris’ cost of sales were from a single Japanese supplier. Polaris has agreed with the supplier to share the impact of fluctuations in the exchange rate between the United States dollar and the Japanese yen.

NOTE 2
FINANCING

Bank financing: Polaris is a party to an unsecured bank line of credit arrangement maturing on March 31, 2000 under which it may borrow up to $150 million until March 31, 1998 and up to $125 million thereafter until maturity. Interest is charged at rates based on LIBOR or "prime" and the agreement expires on March 31, 2000, at which time the outstanding balance is due. The following summarizes activity under Polaris’ credit arrangement (in thousands):

Letters of credit: At December 31, 1997, Polaris had open letters of credit totaling approximately $7,109,000. The amounts outstanding are reduced as inventory purchases pertaining to the contracts received.

Customer financing program: Certain finance companies, including Polaris Acceptance, an affiliate (Note 6), provide floor plan financing to distributors and dealers on the purchase of Polaris products. The amount financed by distributors and dealers under these arrangements at December 31, 1997, was approximately $289,000,000. Polaris has agreed to repurchase products repossessed by the finance companies up to an annual maximum of 15 percent of the average amounts outstanding during the prior calendar year. Polaris’ financial exposure under these arrangements is limited to the difference between the amount paid to the finance companies for repurchases and the amount received on the resale of the repossessed product. No material losses have been incurred under these agreements during the periods presented. As a part of its marketing program, Polaris contributes to the cost of dealer and distributor financing up to certain limits and subject to certain conditions. Such expenditures are included with operating expenses in the accompanying statements of operations.

NOTE 3
INCOME TAXES

Polaris utilizes the liability method of accounting for income taxes whereby deferred taxes are determined based on the estimated future tax effects of differences between the financial statement and tax bases of assets and liabilities given the provisions of enacted tax laws. The net deferred tax asset consists of the following (in thousands):

Components of Polaris’ provision for income taxes are as follows (in thousands):

Reconciliations of the Federal statutory income tax rate to the effective tax rate are as follows:

NOTE 4
STOCK-BASED COMPENSATION

Polaris maintains a stock option plan (Option Plan) under which incentive and nonqualified stock options for a maximum of 1,350,000 shares of common stock may be issued to certain employees. The exercise price for shares awarded under this plan is equal to the market price of Polaris common stock at the date of the award. Options vest three years from the award date and expire after ten years.

Polaris maintains a restricted stock plan (Restricted Plan) under which a maximum of 500,000 shares of common stock may be awarded as an incentive to certain employees with no cash payments required from the recipient. The restrictions lapse after a three to four year period if certain performance measures are achieved by Polaris.

In 1997, Polaris adopted a qualified non-leveraged Employee Stock Ownership Plan (ESOP) under which a maximum of 1,250,000 shares of common stock can be awarded. Shares vest immediately and require no cash payments from the recipient. Substantially all employees are eligible to participate in the ESOP.

Polaris also maintains a plan in which rights to receive shares of common stock (First Rights) are issued to management (Management Plan) and other employees (Employee Plan). The Management Plan provides for vesting up to three years from the award date and has a maximum of 2,225,000 shares reserved, while First Rights awarded under the Employee Plan vest immediately with a maximum of 1,350,000 shares reserved. First Rights are converted to common stock with no cash payments required from the recipient. At December 31, 1997, no additional rights are available to be granted under the Management Plan or the Employee Plan.

The following summarizes share activity in the above plans, and the weighted average exercise price for the Option Plan:

Shares outstanding under the Option Plan have exercise prices ranging from $25.75 to $33.75 and a weighted average remaining contractual life of 8.1 years.

In 1995, Polaris approved a nonqualified deferred compensation plan (Director Plan) under which directors who are not Polaris officers or employees can elect to receive common stock equivalents in lieu of director’s fees, which will be converted into common stock when board service ends. A maximum of 75,000 shares of common stock have been authorized under this plan and 14,831 have been earned as of December 31, 1997.

Polaris accounts for all stock-based compensation plans under APB Opinion No. 25, under which compensation costs of $5,010,000, $4,550,000, and $4,753,000 were recorded in 1997, 1996 and 1995, respectively. Had compensation costs for these plans been recorded at fair value consistent with the methodology prescribed by the Statement of Financial Accounting Standards ("SFAS") No. 123 "Accounting for Stock-Based Compensation," Polaris’ net income and net income per share would have been reduced to the following pro forma amounts:

The fair value of each award under the Option Plan is estimated on the date of grant using the Black-Scholes option pricing model. The following assumptions were used to estimate the fair value of options:

The weighted average fair values at the grant dates of First Rights and shares awarded under the above plans are as follows:

NOTE 5
SHAREHOLDER'S EQUITY

Stock repurchase program: During 1996, the Polaris Board of Directors authorized the repurchase of up to 1,000,000 shares of Polaris’ common stock. On January 23, 1997, the Board of Directors expanded the share repurchase program, authorizing the cumulative repurchase of up to 3,000,000 shares. During 1997, Polaris paid $39,903,000 to repurchase and retire 1,455,900 shares. During 1996, Polaris paid $13,587,000 to repurchase and retire 521,000 shares. Cumulative repurchases through December 31, 1997 are 1,976,900 shares for $53,490,000.

Net income per share: Net income per share during 1997, 1996, and 1995 was calculated based on the weighted average number of common and common equivalent shares outstanding.

Polaris adopted SFAS No. 128 "Earnings per share" effective December 31, 1997. As a result, all prior periods presented have been restated to conform to the provisions of SFAS No. 128, which requires the presentation of basic and diluted earnings per share. Basic earnings per share is computed by dividing net income available to common shareholders by the weighted average number of common shares outstanding during each year, including shares earned under the First Rights plan, the Director Plan and the ESOP. Diluted earnings per share is computed under the treasury stock method and is calculated to reflect the dilutive effect of the Option Plan. A reconciliation of these amounts is as follows (in thousands, except per share data):

Polaris also has shares issued under the Restricted Plan which will not be included in the above calculations until certain performance criteria are met.

Stock Purchase Plan: In 1997, Polaris adopted an Employee Stock Purchase Plan (Purchase Plan). A total of 750,000 shares of common stock are reserved for this plan. The Purchase Plan permits eligible employees to purchase common stock at 85 percent of the average market price each month.

NOTE 6
INVESTMENTS IN AFFILIATES

In February 1996, a wholly-owned subsidiary of Polaris entered into a partnership agreement with Transamerica Distribution Finance (TDF) to form Polaris Acceptance. Polaris Acceptance provides floor plan financing to Polaris’ dealers and distributors and may in the future provide other financial services to dealers, distributors and retail customers of Polaris. Under the partnership agreement, Polaris’ subsidiary had a 25 percent equity interest in Polaris Acceptance throughout 1996. In January 1997, Polaris exercised its option to increase its equity interest in Polaris Acceptance to 50 percent for an additional investment of approximately $10,445,000. Polaris guarantees 50 percent of the outstanding indebtedness of Polaris Acceptance under a credit agreement between Polaris Acceptance and TDF. At December 31, 1997, Polaris’ contingent liability with respect to the guarantee was approximately $92,000,000.

In February, 1995, Polaris entered into an agreement with Fuji Heavy Industries Ltd. ("Fuji") to form Robin Manufacturing, U.S.A. ("Robin"). Under the agreement, Polaris has a 40 percent ownership interest in Robin, which builds engines in the United States for recreational and industrial products.

Polaris’ investments in joint ventures are accounted for under the equity method. Polaris’ allocable share of the income of Polaris Acceptance and Robin has been included as a component of nonoperating expense (income) in the accompanying consolidated statements of operations. Polaris Acceptance is a partnership and the payment of income taxes is the responsibility of each of the partners. Robin is a corporation responsible for the payment of its own income taxes.

Summarized combined financial information for the joint ventures is presented as follows (in thousands):

NOTE 7
COMMITMENTS AND CONTINGENCIES

Product liability: Polaris is subject to product liability claims in the normal course of business and prior to June 1996 elected not to purchase insurance for product liability losses. Effective June 1996, Polaris purchased excess insurance coverage for catastrophic product liability claims for incidents occurring subsequent to the policy date that exceed a self insured retention. The estimated costs resulting from any losses are charged to operating expenses when it is probable a loss has been incurred and the amount of the loss is reasonably determinable.

Litigation: Injection Research Specialists commenced an action in 1990 against Polaris in Colorado Federal Court alleging various claims relating to electronic fuel injection systems for snowmobiles. In April 1997, a judgment was entered in favor of Injection Research Specialists, before interest, for $24,000,000 in compensatory damages and $10,000,000 in punitive damages against Polaris, and $15,000,000 in compensatory damages and $8,000,000 in punitive damages against Fuji, one of Polaris’ engine suppliers. The judgment against Fuji was subsequently reduced on post trial motions to $11,600,000 in compensatory damages and no punitive damages. Polaris has appealed the judgment against Polaris and has been advised that Fuji has also appealed the judgment against it. Depending upon the conclusion of the appeal, Polaris may require additional reserves associated with this litigation on its financial statements. Polaris is a defendant in lawsuits and subject to claims arising in the normal course of business. In the opinion of management, it is not a probability that any legal proceedings pending against or involving Polaris will have a material adverse effect on Polaris’ financial position or results of operations.

Leases: Polaris leases buildings and equipment under noncancelable operating leases. Total rent expense under all lease agreements was $2,779,000, $2,889,000, and $2,212,000 for 1997, 1996 and 1995, respectively. Future minimum payments, exclusive of other costs, required under noncancelable operating leases at December 31, 1997, total $2,630,000 cumulatively through 2002.

NOTE 8
QUARTERLY FINANCIAL DATA

(Unaudited) (In thousands, except per share data)