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 subsidiaries.

Basis of presentation: All significant intercompany transactions and balances have been eliminated in consolidation.

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.

International operations: The following data relates to Polaris' international operations (in thousands of United States dollars):

             For the Years Ended December 31,
    1998   1997   1996  
Canadian Subsidiary:          
     Sales $ 142,502        $ 154,318        $ 166,471  
     Operating income   2,992   6,399   6,024  
     Identifiable assets   18,902   20,279   21,703  
Other export sales $ 61,669 $ 58,739 $ 49,134  

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):

                December 31,
    1998   1997  
Raw materials and purchased components $ 32,235        $ 17,614  
Service parts, garments and accessories   41,085   45,619  
Finished goods   34,116   76,311  
  $ 107,436 $ 139,544  

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 $11.6 million at December 31, 1998, and $10.7 million at December 31, 1997, 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 overall risk is reduced and (3) whether 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, 1998, Polaris had open Japanese yen foreign exchange contracts with notional amounts totaling U.S. $51.0 million which mature throughout 1999.

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 3), have not been material. Polaris provides for estimated sales promotion expenses at the time of sale to the dealer or distributor customer.

Major supplier: During 1998, 1997, and 1996, purchases of engines and related components totaling 12, 16 and 22 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.

New accounting pronouncements: The Financial Accounting Standards Board issued Statement of Financial Standards No. 131, "Disclosures about Segments of an Enterprise and Related Information" (SFAS No. 131) in June 1997. Polaris is a single operating segment business and is not impacted by SFAS No. 131.

The Financial Accounting Standards Board issued Statement of Financial Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities" (SFAS No. 133) in June 1998. Polaris is not required to adopt SFAS No. 133 until January 1, 2000. However, Polaris does not believe the adoption of SFAS No. 133 will have a material effect on its Financial Statements.

NOTE 1 | NOTE 2 | NOTE 3 | NOTE 4 | NOTE 5 | NOTE 6 | NOTE 7 | NOTE 8 | NOTE 9


    LITIGATION SETTLEMENT

Injection Research Specialists ("IRS") commenced an action in 1990 against Polaris and Fuji Heavy Industries, Ltd. ("Fuji") one of Polaris' engine suppliers, in Colorado Federal Court alleging various claims relating to electronic fuel injection systems for snowmobiles. In October 1998, following a judgment against Polaris for $34.0 million (before pre- and post-judgement interest) and affirmance thereof by the Federal Court of Appeals, IRS, Polaris and Fuji entered into a confidential settlement agreement to settle all outstanding claims between the parties. The resulting provision for litigation loss of $61.4 million has been reflected as non-operating expense in the accompanying statement of operations for the year ended December 31, 1998. The net income impact of the litigation loss was $39.6 million or $1.53 per diluted share. Adjusted net income excluding the IRS litigation provision was $70.6 million or $2.72 per diluted share. The related payment to IRS was made in the fourth quarter 1998 in connection with entering into the confidential settlement agreement. Polaris utilized its existing bank line of credit arrangement to fund the payment. Polaris no longer uses any of the technology in dispute.

NOTE 1 | NOTE 2 | NOTE 3 | NOTE 4 | NOTE 5 | NOTE 6 | NOTE 7 | NOTE 8 | NOTE 9


    FINANCING

Bank financing: Polaris is a party to an unsecured bank line of credit arrangement under which it may borrow up to $175 million until March 31, 1999 and up to $150 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):

    1998   1997  
Total borrowings at December 31 $ 20,500        $ 24,400  
Average outstanding borrowings
     during year $ 48,410        $ 47,950  
Maximum outstanding borrowings
     during year $ 77,000        $ 80,000  
Interest rate at december 31   5.95 % 6.76 %

Letters of credit: At December 31, 1998, Polaris had open letters of credit totaling approximately $7.8 million. The amounts outstanding are reduced as inventory purchases pertaining to the contracts are received.

Customer financing program: Certain finance companies, including Polaris Acceptance, an affiliate (Note 7), 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, 1998, was approximately $384 million. 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 1 | NOTE 2 | NOTE 3 | NOTE 4 | NOTE 5 | NOTE 6 | NOTE 7 | NOTE 8 | NOTE 9


    INCOME TAX MATTERS

Components of Polaris' provision for income taxes are as follows (in thousands):
             For the Years Ended December 31,
    1998   1997   1996  
Current
     Federal $ 10,362        $ 31,575        $ 30,063  
     State   739   2,255   2,233  
     Foreign   1,246   2,949   2,744  
Deferred   5,000   --   --  
          Total                             $ 17,347 $ 36,779 $ 35,040  

Reconciliations of the Federal statutory income tax rate to the effective tax rate are as follows:
  For the Years Ended December 31,
  1998   1997   1996  
Federal statutory rate 35.0 % 35.0 % 35.0 %
State income taxes, net of federal benefit     2.5   2.5   2.6  
Other permanent differences (1.6 ) (1.5 ) (1.6 )
     Effective income tax rate 35.9 % 36.0 % 36.0 %

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):

          December 31,
    1998   1997   1996  
Current deferred tax assets:
     Inventories $ 4,100 $ 4,000 $ 3,000  
     Accrued expenses   24,700   24,000   19,300  
     Compensation payable in
          common stock   200   1,000   2,700  
          Total current   29,000   29,000   25,000  
Noncurrent deferred tax assets:
     Cost in excess of net assets
          of business acquired   25,200   27,600   30,000  
     Property and equipment   (4,900 )      (2,000 )      (1,000 )
     Compensation payable in
          common stock   700   400   1,000  
          Total noncurrent   21,000   26,000   30,000  
          Total $ 50,000 $ 55,000 $ 55,000  

NOTE 1 | NOTE 2 | NOTE 3 | NOTE 4 | NOTE 5 | NOTE 6 | NOTE 7 | NOTE 8 | NOTE 9


    STOCK-BASED COMPENSATION

Polaris maintains a stock option plan (Option Plan) under which incentive and nonqualified stock options for a maximum of 2,350,000 shares of common stock may be issued to certain employees. Options granted to date generally 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 800,000 shares of common stock may be awarded as an incentive to certain employees with no cash payments required from the recipient. The restrictions on awards granted to date lapse after a three to four year period if Polaris achieves certain performance measures.

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 has historically maintained a plan in which rights to receive shares of common stock (First Rights) are issued to management (Management Plan) and other employees (Employee Plan). First Rights are converted to common stock with no cash payments required from the recipient. At December 31, 1998, 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:

              Restricted   Management   Employee    
  Option  Plan     Plan   Plan   Plan   ESOP
        Weighted              
        Average              
        Exercise              
  Shares     Price Shares   Shares   Shares   Shares
Outstanding as
of December 31,
1995 254,550   $ 29.00 --   317,250   153,000   --
     Granted 136,830   $ 33.75 61,795   --   171,005   --
     Converted --     -- --   (57,000 )    (153,000 ) --
     Forfeited --     -- --   --   --   --
Outstanding as
of December 31,
1996 391,830   $ 30.66 61,795   260,250   171,005   --
     Granted 142,980   $ 25.75 64,915   --   --   --
     Converted --     -- --   (147,750 ) (171,005 )    --
     Forfeited (38,617 ) $ 29.50 (2,835 )    (15,000 ) --   --
Outstanding as
of December 31,
1997 495,743   $ 29.33 123,875   97,500   --   170,000
     Granted 691,590   $ 40.15 147,765   --   --   173,206
     Exercised/
     Converted (33,425 ) $ 29.00 --   (87,750 ) --   --
     Forfeited (76,183 ) $ 30.94 (28,605 ) (1,500 ) --   --
Outstanding as
of December 31,
1998 1,077,725   $ 36.17 243,035   8,250   --   343,206
Exercisable/
Vested as
of December 31,   
1998 180,815   $ 29.00 --   --   --   343,206


Shares outstanding under the Option Plan have exercise prices ranging from $25.75 to $49.45 and a weighted average remaining contractual life of 8.6 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 has been authorized under this plan and 20,529 have been earned as of December 31, 1998.

Polaris, which accounts for all stock based compensation plans under APB Opinion No. 25, and recorded compensation costs of $7.8 million, $5.0 million, and $4.6 million in 1998, 1997 and 1996, respectively. Had compensation costs for these plans been recorded at fair value consistent with the methodology prescribed by 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:

    1998   1997   1996  
Net Income (in thousands)
     As Reported $ 31,015        $ 65,383        $ 62,293  
     Pro Forma   29,336   64,346   61,475  
Diluted Net Income Per Share
     As Reported $ 1.19        $ 2.45        $ 2.24  
     Pro Forma   1.13   2.41   2.21  

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:

    1998   1997   1996  
Risk free interest rate   5.6%   6.6%   6.8%  
Expected life   7 years   7 years   7 years  
Expected volatility   14%   23%   27%  
Expected dividend yield   2.0%   2.5%   1.8%  

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

    1998   1997   1996  
Option Plan $ 5.57 $ 7.45 $ 12.16  
Restricted Plan                      $ 34.89 $ 25.75      $ 33.75  
Employee Plan   --   -- $ 23.75  
ESOP $ 39.19      $ 30.56 $ --  

NOTE 1 | NOTE 2 | NOTE 3 | NOTE 4 | NOTE 5 | NOTE 6 | NOTE 7 | NOTE 8 | NOTE 9



    SHAREHOLDERS' EQUITY

Stock repurchase program: The Polaris Board of Directors has authorized the cumulative repurchase of up to 5,000,000 shares of the Company's common stock. During 1998, Polaris paid $37.7 million to repurchase and retire 1,090,500 shares. Cumulative repurchases through December 31, 1998 are 3,067,400 shares for $91.2 million.

Net income per share: Polaris calculates net income per share in accordance with Statement of Financial Accounting Standards 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 compute the dilutive effect of outstanding stock options. A reconciliation of these amounts is as follows (in thousands, except per share data):

    1998   1997   1996  
Net income available to common
     shareholders $ 31,015      $ 65,383      $ 62,293  
Weighted average number
     of common shares outstanding   25,709   26,403   27,338  
First Rights   21   139   458  
Director Plan   17   12   5  
ESOP   170   170   --  
Common shares outstanding - basic   25,917   26,724   27,801  
Dilutive effect of Option Plan   69   15   14  
Common and potential common
     shares outstanding - diluted   25,986   26,739   27,815  
Basic net income per share $ 1.20 $ 2.45 $ 2.24  
Diluted net income per share $ 1.19 $ 2.45 $ 2.24  


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 1 | NOTE 2 | NOTE 3 | NOTE 4 | NOTE 5 | NOTE 6 | NOTE 7 | NOTE 8 | NOTE 9


    INVESTMENTS IN AFFILIATES

In February 1996, a wholly owned subsidiary of Polaris entered into a partnership agreement with a wholly owned subsidiary of Transamerica Distribution Finance (TDF) to form Polaris Acceptance. Polaris Acceptance provides floor plan financing to Polaris' dealers and distributors and will in the future provide other financial services to dealers, distributors and retail customers of Polaris. Under the partnership agreement, Polaris' subsidiary has a 50 percent equity interest in Polaris Acceptance and guarantees 50 percent of the outstanding indebtedness of Polaris Acceptance under a credit agreement between Polaris Acceptance and TDF. At December 31, 1998, Polaris' contingent liability with respect to the guarantee was approximately $139.0 million.

In February 1995, Polaris entered into an agreement with Fuji Heavy Industries Ltd. 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 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):

                December 31,
    1998   1997  
Revenues $ 64,996        $ 67,228  
Cost of goods sold, interest and operating expenses   48,945   53,620  
Net income before income taxes $ 16,051        $ 13,608  
 
Finance Receivables, net $ 323,728        $ 231,137  
Other assets   17,288   18,424  
  $ 341,016        $ 294,561  
 
Note payable $ 278,439        $ 184,835  
Other liabilities   12,084   14,125  
Shareholders' equity and Partners' capital   50,493   50,601  
  $ 341,016        $ 294,561  

NOTE 1 | NOTE 2 | NOTE 3 | NOTE 4 | NOTE 5 | NOTE 6 | NOTE 7 | NOTE 8 | NOTE 9


    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: 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 probable 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 $2.5 million, $2.8 million and $2.9 million, for 1998, 1997 and 1996, respectively. Future minimum payments, exclusive of other costs, required under noncancelable operating leases at December 31, 1998, total $2.2 million cumulatively through 2003.

NOTE 1 | NOTE 2 | NOTE 3 | NOTE 4 | NOTE 5 | NOTE 6 | NOTE 7 | NOTE 8 | NOTE 9


    QUARTERLY FINANCIAL DATA

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

              Diluted
              Net
        Gross   Net Income
    Sales   Profit   Income       Per Share
1998:
First Quarter       $ 210,001       $ 46,804       $ 8,361       $ .32
Second Quarter   274,711   64,209   14,484   .55
Third Quarter   359,861   86,430   (14,504 ) (.56 )
Fourth Quarter   330,947   80,844   22,674   .88
Totals $   1,175,520 $   278,287 $ 31,015 $ 1.19
 
1997:
First Quarter $ 224,634 $ 49,492 $ 12,019 $ .44
Second Quarter   248,888   60,258   13,294   .49
Third Quarter   293,428   78,568   21,640   .82  
Fourth Quarter   280,346   74,220   18,430   .70
Totals $ 1,048,296 $ 262,538 $ 65,383 $ 2.45

 NOTE 1 | NOTE 2 | NOTE 3 | NOTE 4 | NOTE 5 | NOTE 6 | NOTE 7 | NOTE 8 | NOTE 9
© 1999 Polaris Industries Inc.