Note 1. Accounting Policies:

Principles of Consolidation:

The consolidated financial statements include all significant majority-owned subsidiaries. Affiliated companies in which Cummins does not have a controlling interest, or for which control is expected to be temporary, are accounted for using the equity method. Use of estimates and assumptions, as determined by management, is required in the preparation of consolidated financial statements in conformity with generally accepted accounting principles. Actual results could differ from these estimates and assumptions.

Revenue Recognition:

The Company recognizes revenues on the sale of its products, net of estimated costs of returns, allowances and sales incentives, when the products are shipped to customers. The Company generally sells its products on open account under credit terms customary to the region of distribution. The Company performs ongoing credit evaluations of its customers and generally does not require collateral to secure its customers' receivables.

Foreign Currency:

Assets and liabilities of foreign entities, where the local currency is the functional currency, have been translated at year-end exchange rates, and income and expenses have been translated to US dollars at average-period rates. Adjustments resulting from translation have been recorded in shareholders' investment and are included in net earnings only upon sale or liquidation of the underlying foreign investment.

For foreign entities where the US dollar is the functional currency, including those operating in highly inflationary economies, inventory, property, plant and equipment balances and related income statement accounts have been translated using historical exchange rates. The resulting gains and losses have been credited or charged to net earnings and were net losses of $14 million in 2000, $2 million in 1999 and $5 million in 1998.

Derivative Instruments:

The Company makes use of derivative instruments in its foreign exchange, commodity price and interest rate hedging programs. Derivatives currently in use are commodity and interest rate swaps, as well as foreign currency forward contracts. These contracts are used strictly for hedging and not for speculative purposes. Refer to Note 10 for more information on derivative financial instruments.

The Company enters into commodity swaps to offset the Company's exposure to price volatility for certain raw materials used in the manufacturing process. As the Company has the discretion to settle these transactions either in cash or by taking physical delivery, these contracts are not considered financial instruments for accounting purposes. These commodity swaps are accounted for as hedges.

In June 1998, the Financial Accounting Standards Board issued SFAS No. 133 on accounting for derivative instruments and hedging activities. The statement is effective for fiscal years beginning after June 15, 2000.The Company will adopt this statement at the beginning of fiscal 2001 and has evaluated and modified its hedging strategy as it applies to the new statement. The statement will not have a material effect on the Company's results of operations.

Other Costs:

Estimated costs of commitments for product coverage programs are charged to earnings at the time the Company sells its products.

Research & development expenditures, net of contract reimbursements, are expensed when incurred and were $224 million in 2000, $218 million in 1999 and $228 million in 1998. Maintenance and repair costs are charged to earnings as incurred.

Cash Equivalents:

Cash equivalents include all highly liquid investments with an original maturity of three months or less at the time of purchase.

Accounts Receivable:

During 2000, the Company entered into a receivables securitization program and sold trade receivables in securitization transactions to a special purpose subsidiary with principal aggregating $741 million. The subsidiary transfers positions in these receivables to conduits as the basis for issuing commercial paper. The subsidiary obtains receivables from the conduit for approximately 15 percent of a transferred position and receives cash for the remainder of the position. The Company receives annual servicing fees approximating .5 percent of the sold accounts receivable. The conduit investors and the special purpose subsidiary have no recourse to the Company's other assets for failure of debtors to pay when due. For the marketed receivables, the Company's retained interests are subordinated to the conduit's interests. The sold receivables servicing portfolio amounted to $355 million at December 31, 2000.

The table below summarizes certain cash flows received from and paid to the special purpose subsidiary for the year ended December 31, 2000:

Inventories:

Inventories are stated at the lower of cost or net realizable value. Approximately 22 percent of domestic inventories (primarily heavy-duty and high horsepower engines and engine parts) are valued using the last-in, first-out (LIFO) cost method. All other inventories are valued using the first-in, first-out (FIFO) method. Inventories at December 31 were as follows:

Property, Plant and Equipment:

Property, plant and equipment are stated at cost. A modified units-of-production method, which is based upon units produced subject to a minimum level, is used to depreciate substantially all engine production equipment. The straight-line depreciation method is used for all other equipment. The estimated depreciable lives range from 20 to 40 years for buildings and 3 to 20 years for machinery, equipment and fixtures.

Long-Lived Assets:

The Company evaluates the carrying value of its long-lived assets for impairment whenever adverse events or changes in circumstances indicate that the carrying value of an asset may be impaired. In accordance with SFAS No. 121, if the quoted market price or, if not available, the undiscounted cash flows are not sufficient to support the recorded asset value, an impairment loss is recorded to reduce the carrying value of the asset to the amount of expected discounted cash flows. This same policy is followed for goodwill.

Software:

Internal and external software costs (excluding research, reengineering and training) are capitalized and amortized generally over 5 years. Capitalized software, net of amortization, was $110 million at December 31, 2000, $110 million at December 31, 1999 and $75 million at December 31, 1998. Total software amortization expense was $27 million in 2000, $18 million in 1999 and $8 million in 1998.

Earnings Per Share:

Basic earnings per share of common stock are computed by dividing net earnings by the weighted-average number of shares outstanding for the period. Diluted earnings per share are computed by dividing net earnings by the weighted-average number of shares, assuming the exercise of stock options when the effect of their exercise is dilutive. Shares of stock held by the employee benefits trust are not included in outstanding shares for EPS until distributed from the trust.

Note 2. Acquisition:

In January 1998, the Company completed the acquisition of Nelson Industries, Inc., for $453 million. Nelson, a filtration and exhaust manufacturer, was consolidated on the date of acquisition. In accordance with APB No. 16, Nelson's net assets were recorded at fair value, and the purchase price in excess of net assets is amortized over 40 years.

Note 3. Special Charges:

In 1998, the Company recorded special charges of $92 million for product coverage costs and inventory write-downs. The product coverage special charges of $78 million included $43 million primarily attributable to the recent experience of higher than anticipated base warranty costs to repair certain automotive engines manufactured in previous years, and $35 million related to a revised estimate of product coverage cost liability primarily for extended warranty programs. The special charges also included $14 million for inventory write-downs associated with the Company's restructuring and exit activities. These write-downs related to amounts of inventory rendered excess or unusable due to the closing or consolidation of facilities.

Note 4. Restructuring, Asset Impairment and Other Special Charges:

The 2000 financial results included charges of $160 million ($103 million after tax, or $2.71 per share) reflecting restructuring actions, asset impairments and other activities largely focused in the Engine Business. These actions were taken in response to the downturn in the North American heavy-duty truck market and related conditions. The charges included $42 million attributable to employee severance actions, $72 million for impairment of equipment and other assets, $30 million for impairment of software developed for internal use where the programs were cancelled prior to implementation and $16 million associated with exit costs to close or consolidate a number of smaller business operations.

Of the $160 million charge, $131 million was assigned to the Engine Business, $19 million to the Power Generation Business and $10 million to the Filtration Business and Other.

Workforce reduction actions included overall cutbacks in staffing levels plus the impacts of closing and consolidating operations. Restructuring charges for workforce reductions included the severance costs and related benefits of terminating 600 salaried employees and 830 hourly employees. Costs for workforce reductions were based on amounts pursuant to benefit programs or statutory requirements of the affected operations.

The asset impairment loss of $72 million was calculated in accordance with the provisions of SFAS 121. Asset impairment of equipment from discontinuing operations was primarily for engine assembly and fuel system manufacturing equipment to be disposed of upon the closure or consolidation of production operations. The asset impairment charge included a write-down of $38 million for manufacturing equipment that will continue to be used for approximately two years. Depreciation will continue on these assets over that period of time. The expected recovery value of equipment to be disposed of was based on estimated salvage value and was excluded from the write-down. The charge also included $11 million for equipment available for disposal, $6 million for properties available for disposal, $10 million for investments and $7 million for intangibles and minority interest positions related to divesting smaller operations and investments. The carrying value of assets held for disposal and the effect from suspending depreciation on such assets is immaterial.

The asset impairment charge of $30 million consisted of capitalized software-in-process being developed for internal use. The charge was related to manufacturing, financial and administrative information technology programs cancelled during program development and prior to implementation.

Exit costs of $16 million to close or consolidate a number of small businesses and operations included $6 million for equipment removal costs, $5 million to satisfy contractual obligations and $5 million for other exit costs. As the restructuring actions consist primarily of the closing or consolidation of smaller operations, the Company does not expect these actions to have a material effect on future revenues.

Approximately $73 million, primarily related to the write-down of impaired equipment and software and employee severance payments, has been charged to the restructuring liabilities as of December 31, 2000. Of the total charges associated with the restructuring activities, cash outlays will approximate $54 million. The actions will be completed in 2001 and 2002 with the majority of the cash outlays in 2001. The associated annual savings are estimated at $55 million upon completion of the actions.

Activities in the major components of these charges were as follows:

In December 1999, the Company recorded a charge of $60 million in connection with the dissolution of the Cummins WŠrtsilŠ joint venture. The charge included $17 million to write off the Company's remaining investment in the joint venture, $29 million for impairment of assets transferred from the joint venture and $14 million for additional warranty and other liabilities assumed by the Company. The joint venture termination was effective December 31, 1999, with the Company taking over the operations and assets of the product line manufactured in Daventry, England.

Activity in the major components of these charges is as follows:

The asset impairment loss was calculated according to the provisions of SFAS No. 121, using expected discounted cash flows as the estimate of fair value. The majority of the impaired assets are to be held and used in the Company's Power Generation Business, with depreciation continuing on such assets.

In the third quarter of 1998, the Company recorded charges of $125 million, comprised of $100 million for costs to reduce the worldwide workforce by approximately 1,100 people, as well as costs associated with streamlining certain majority-owned and international joint venture operations and $25 million for a civil penalty to be paid by the Company as a result of an agreement reached with the U.S. Environmental Protection Agency (EPA) regarding diesel engine emissions. In addition, the Company recorded special charges of $14 million for inventory write-downs associated with restructuring actions.

The Company is concluding the restructuring plan implemented in the third quarter of 1998. In the third quarter of 2000, the Company reversed excess accruals from 1998 of $7 million and recorded $7 million of charges related to new actions committed to during the quarter. As of December 31, 2000, approximately $127 million has been charged against the liabilities associated with these actions. The Company has funded the restructuring actions using cash generated from operations. The remaining actions to be completed consist primarily of the payment of severance commitments to terminated employees in early 2001 and the remaining payment to the EPA in July 2001.

Note 5. Other (Income) Expense:

The major components of other (income) expense included the following:

Note 6. Investments in Joint Ventures and Alliances:

Investments in joint ventures and alliances at December 31 were as follows:

Summary financial information for the joint ventures and alliances was as follows:

In connection with various joint venture agreements, Cummins is required to purchase products from the joint ventures in amounts to provide for the recovery of specified costs of the ventures. Under the agreement with Consolidated Diesel, Cummins' purchases were $541 million in 2000 and $513 million in 1999.

Note 7. Borrowings:

Long-term debt at December 31 was:

Maturities of long-term debt for the five years subsequent to December 31, 2000 are $8 million, $10 million, $133 million, $7 million, and $232 million. At December 31, 2000 and 1999, the weighted-average interest rate on loans payable and current maturities of long-term debt approximated 7 percent and 6 percent, respectively.

The Company maintains a $500 million revolving credit agreement, maturing in 2003, under which there were no outstanding borrowings at December 31, 2000 or 1999. The revolving credit agreement supports the Company's commercial paper borrowings of $112 million at December 31, 2000 and $168 million at December 31, 1999. In February 1998, the Company issued $765 million face amount of notes and debentures under a $1 billion Registration Statement filed with the Securities and Exchange Commission in 1997. Net proceeds were used to finance the acquisition of Nelson and to pay down other indebtedness outstanding at December 31, 1997. The Company also has other domestic and international credit lines with approximately $135 million available at December 31, 2000.

The Company's debt agreements have several covenants which, among other restrictions, require maintenance of a certain level of net worth, place restrictions on the amount of additional debt the Company may incur and require maintenance of minimum leverage ratios.

In December 2000, the Company paid down certain borrowings with the proceeds from the sale of receivables in a securitization program.

At December 31, 2000 and 1999, loans payable included $139 million and $100 million, respectively, of notes payable to banks and $17 million and $13 million, respectively, of bank overdrafts.

The Company has guaranteed the outstanding borrowings of its ESOP Trust. Cash contributions to the Trust, together with the dividends accumulated on the common stock held by the Trust, are used to pay interest and principal. Cash contributions and dividends to the Trust approximated $9 million in each year. The unearned compensation, which is reflected as a reduction to shareholders' investment, represents the historical cost of the shares of common stock that have not yet been allocated by the Trust to participants.

Note 8. Other Liabilities:

Other liabilities at December 31 included the following:

Note 9. Income Taxes:

The provision (benefit) for income taxes was as follows:

Significant components of net deferred tax assets related to the following tax effects of differences between financial and tax reporting at December 31:

The Company expects to realize all of its tax assets, including the use of all carryforwards, before any expiration.

Earnings before income taxes and differences between the effective tax rate and U.S. Federal income tax rate were:

Note 10. Financial Instruments and Risk Management:

The Company is exposed to financial risk resulting from volatility in foreign exchange rates and interest rates. This risk is closely monitored and managed through the use of financial derivative contracts. As clearly stated in the Company's policies and procedures, financial derivatives are used expressly for hedging purposes, and under no circumstances are they used for speculating or trading. Transactions are entered into only with banking institutions with strong credit ratings, and thus the credit risk associated with these contracts is considered immaterial. Hedging program results and status are reported to senior management on a periodic basis.

Foreign Exchange Rates

Due to its international business presence, the Company uses foreign exchange forward contracts to manage its exposure to exchange rate volatility. Foreign exchange balance sheet exposures are aggregated and hedged at the corporate level. Maturities on these instruments generally fall within the one-month and six-month range. The objective of the hedging program is to reduce earnings volatility resulting from the translation of net foreign exchange balance sheet positions. The total notional amount of these forward contracts outstanding at December 31 was as follows:

Interest Rates

The Company manages its exposure to interest rate fluctuations through the use of interest rate swaps. Currently the Company has in place three interest rate swaps that effectively convert fixed-rate debt into floating-rate debt. The objective of the swaps is to more efficiently balance borrowing costs and interest rate risk. The contracts were established during 1998 and 1999 and have a total notional value of $350 million.

Fair Value of Financial Instruments

Based on borrowing rates currently available to the Company for bank loans with similar terms and average maturities, the fair value of total debt, including current maturities, at December 31, 2000, approximated $1,138 million. The carrying value at that date was $1,196 million. At December 31, 1999, the fair and carrying values of total debt, including current maturities, were $1,104 million and $1,215 million, respectively. The carrying values of all other receivables and liabilities approximated fair values.

Note 11. Retirement Plans:

The Company has various contributory and noncontributory pension plans covering substantially all employees. Cummins common stock represented 9 percent of pension plan assets at December 31, 2000.

Cummins also provides various health care and life insurance benefits to eligible retirees and their dependents but reserves the right to change benefits covered under these plans. The plans are contributory with retirees' contributions adjusted annually, and they contain other cost-sharing features, such as deductibles, coinsurance and spousal contributions. The general policy is to fund benefits as claims and premiums are incurred.

The projected benefit obligation, accumulated benefit obligation and fair value of plan assets for plans with accumulated benefit obligations in excess of plan assets were $697 million, $682 million and $558 million, respectively, as of December 31, 2000, and $651 million, $636 million and $513 million, respectively, as of December 31, 1999. The assumed long-term rate of compensation increase for salaried plans was 5.25 percent in 2000 and 1999. Other significant assumptions for the Company's principal plans were:

For measurement purposes a 7 percent annual increase in health care costs was assumed for 2001, decreasing gradually to 5.5 percent in five years and remaining constant thereafter.

Increasing the health care cost trend rate by 1 percent would increase the obligation by $48 million and annual expense by $4 million. Decreasing the health care cost trend rate by 1 percent would decrease the obligation by $43 million and annual expense by $3 million.

The Company's net periodic benefit cost under these plans was as follows:

(a) The net deferred (gain) loss resulting from investments, other experience and changes in assumptions.

(b) The prior service effect of plan amendments deferred for recognition over remaining service.

(c) The balance of the initial difference between assets and obligations deferred for recognition over a 15-year period.

Note 12. Common Stock:

The Company increased its quarterly common stock dividend from 27.5 cents per share to 30.0 cents, effective with the dividend payment in December 1999.

The Company repurchased 0.4 million shares on the open market at an aggregate purchase price of $16 million in 2000, 0.7 million shares on the open market at an aggregate purchase price of $34 million in 1999 and 0.4 million shares on the open market at an aggregate purchase price of $14 million in 1998. All of the acquired shares are held as common stock in treasury.

Note 13. Shareholders' Rights Plan:

The Company has a Shareholders' Rights Plan which it first adopted in 1986. The Rights Plan provides that each share of the Company's common stock has associated with it a stock purchase right. The Rights Plan becomes operative when a person or entity acquires 15 percent of the Company's common stock or commences a tender offer to purchase 20 percent or more of the Company's common stock without the approval of the Board of Directors.

Note 14. Employee Stock Plans:

Under the Company's stock incentive and option plans, officers and other eligible employees may be awarded stock options, stock appreciation rights and restricted stock. Under the provisions of the stock incentive plan, up to one percent of the Company's outstanding shares of common stock at the end of the preceding year is available for issuance under the plan each year. At December 31, 2000, there were no shares of common stock available for grant and 2,319,080 options exercisable under the plans.

The Company accounts for stock options in accordance with APB Opinion No. 25 and related interpretations. No compensation expense has been recognized for stock options since the options have exercise prices equal to the market price of the Company's common stock at the date of grant.

Options outstanding at December 31, 2000, have exercise prices between $19.38 and $79.81 and a weighted-average remaining life of 6.8 years. The weighted-average fair value of options granted was $12.58 per share in 2000 and $13.76 per share in 1999. The fair value of each option was estimated on the date of grant using a risk-free interest rate of 6.5 percent in 2000 and 5.6 percent in 1999 and 1998, current annual dividends, expected lives of 10 years and expected volatility of 41 percent. A fair-value method of accounting for awards subsequent to January 1, 1998, would have resulted in an increase in compensation expense of $8 million, net of tax ($.20 per share) in 2000. $8 million, net of tax ($.20 per share) in 1999 and $8 million, net of tax ($.20 per share) in 1998.

Note 15. Comprehensive Income:

Comprehensive income includes net income and all other nonowner changes in equity during a period.

The tax effect on other comprehensive income is as follows:

The components of accumulated other comprehensive income are as follows:

Note 16. Segments of the Business:

The Company has three operating segments: Engine, Power Generation, and Filtration and Other. The Engine segment produces engines and parts for sale to customers in automotive and industrial markets. The engines are used in trucks of all sizes, buses and recreational vehicles, as well as various industrial applications including construction, mining, agriculture, marine, rail and military. The Power Generation segment is the Company's power systems supplier, selling engines, generator sets and alternators and providing temporary power through rentals of generator sets. The Filtration and Other segment includes sales of filtration products, exhaust systems and turbochargers and sales from company-owned distributors.

The Company's operating segments are organized according to products and the markets they each serve. This business structure was designed to focus efforts on providing enhanced service to a wide range of customers.

The accounting policies of the segments are the same as those described in the summary of significant accounting policies except that the Company evaluates performance based on earnings before interest and income taxes and on net assets; therefore, no allocation of debt-related items and income taxes is made to the individual segments.

Operating segment information is as follows:

Reconciliation to Consolidated Financial Statements:

Summary geographic information is listed below:

(a) Net sales are attributed to countries based on location of customer.

Revenues from the Company's largest customer represent approximately $1.2 billion of the Company's net sales in 2000. These sales are included in the Engine and Filtration and Other segments.

Note 17. Guarantees, Commitments and Other Contingencies:

At December 31, 2000, the Company had the following minimum rental commitments for noncancelable operating leases: $45 million in 2001, $37 million in 2002, $31 million in 2003, $22 million in 2004, $13 million in 2005 and $63 million thereafter. Rental expense under these leases approximated $79 million in 2000, $75 million in 1999 and $70 million in 1998.

Commitments under outstanding letters of credit, guarantees and contingencies at December 31, 2000, approximated $89 million.

Cummins and its subsidiaries are defendants in a number of pending legal actions, including actions related to use and performance of the Company's products. The Company carries product liability insurance covering significant claims for damages involving personal injury and property damage.

In the event the Company is determined to be liable for damages in connection with actions and proceedings, the unreserved portion of such liability is not expected to be material. The Company also has been identified as a potentially responsible party at several waste disposal sites under U.S. and related state environmental statutes and regulations and has joint and several liability for any investigation and remediation costs incurred with respect to such sites. The Company denies liability with respect to many of these legal actions and environmental proceedings and is vigorously defending such actions or proceedings. The Company has established reserves that it believes are adequate for its expected future liability in such actions and proceedings where the nature and extent of such liability can be estimated reasonably based upon presently available information. The Company is working to comply with U.S. EPA regulations with respect to emissions which are scheduled to become more restrictive in 2002 and beyond.

Note 18. Quarterly Financial Data (unaudited):

Fourth quarter 2000 net earnings included restructuring, asset impairment and other special charges of $103 million, net of tax ($160 million pretax), or $2.71 per share.

Fourth quarter 1999 net earnings included a charge of $45 million, net of tax ($60 million pretax), or $1.17 per share, for the termination of the Cummins WŠrtsilŠ joint venture.