CUMMINS INC. AND CONSOLIDATED SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES    (Continued)

Long-Lived Assets

   We review our long-lived assets for possible impairment whenever events or circumstances indicate that the carrying value of an asset or asset group may not be recoverable. We assess the recoverability of the carrying value of the long-lived assets at the lowest level for which identifiable cash flows are largely independent of the cash flows of other assets and liabilities. An impairment of a long-lived asset or asset group exists when the expected future pre-tax cash flows (undiscounted and without interest charges) estimated to be generated by the asset or asset group is less than its carrying value. If these cash flows are less than the carrying value of such asset or asset group, an impairment loss is measured based on the difference between the estimated fair value and carrying value of the asset or asset group. Assumptions and estimates used to estimate cash flows in the evaluation of impairment and the fair values used to determine the impairment are subject to a degree of judgment and complexity. Any changes to the assumptions and estimates resulting from changes in actual results or market conditions from those anticipated may affect the carrying value of long-lived assets and could result in an impairment charge.

Goodwill

   Goodwill represents the excess of purchase price paid over the fair value of net assets acquired in a business combination accounted for as a purchase. As required by SFAS No. 142, ‘‘Goodwill and Other Intangibles’’ (SFAS 142), we no longer amortize goodwill but rather evaluate it for impairment on an annual basis, or more often if events or circumstances change that could cause goodwill to become impaired. We have allocated our goodwill to reporting units for purposes of performing annual impairment tests. See Note 8 for a further discussion about goodwill.

Software

   We capitalize certain costs for software that is developed or obtained for internal use. Software costs are amortized on a straight-line basis over their estimated useful lives generally ranging from three to five years. Software assets are reviewed for impairment when events or circumstances indicate that the carrying value may not be recoverable over the remaining lives of the assets. Upgrades and enhancements are capitalized if they result in added functionality which enables the software to perform tasks it was previously incapable of performing. Software maintenance, training, data conversion and business process reengineering costs are expensed in the period in which they are incurred.

Warranty

   We charge the estimated costs of warranty programs, other than product recalls, to earnings at the time products are shipped to customers. We use historical experience of warranty programs to estimate the remaining liability for our various warranty programs. As a result of the uncertainty surrounding the nature and frequency of product recall programs, the liability for such programs is recorded when we commit to a recall action, which generally occurs when it is announced. We review and assess the liability for these programs on a quarterly basis. We also assess our ability to recover certain costs from our suppliers and record a receivable from the supplier when we believe a recovery is probable. At December 31, 2007, we had $19 million of receivables related to estimated supplier recoveries of which $9 million was included in ‘‘Receivables, net’’ and $10 million was included in ‘‘Other assets’’ on our Consolidated Balance Sheets. At December 31, 2006, we had $23 million of receivables related to estimated supplier recoveries of which $16 million was included in ‘‘Receivables, net’’ and $7 million was included in ‘‘Other assets’’ on our Consolidated Balance Sheets.

   In addition, we sell extended warranty coverage on most of our engines. The revenue collected is initially deferred and is recognized as revenue in proportion to the costs expected to be incurred in performing services over the contract period. We compare the remaining deferred revenue balance quarterly to the estimated amount of future claims under extended warranty programs and provide an additional accrual when the deferred revenue balance is less than expected future costs.

Shipping and Handling Costs

   Our shipping and handling costs are expensed as incurred. Those shipping and handling costs associated with operations of our inventory distribution centers and warehouse facilities were previously classified as ‘‘Selling and administrative expenses’’ in our Consolidated Statements of Earnings. In accordance with Emerging Issues Task Force (EITF) Issue No. 00-10 ‘‘Accounting for Shipping and Handling Fees and Costs,’’ we previously disclosed the amount of these shipping and handling costs that were included as ‘‘Selling and administrative expenses’’ in the notes to our Consolidated Financial Statements. Beginning January 1, 2007, we revised our accounting policy and all shipping and handling costs are now classified as ‘‘Cost of sales.’’ This presentation is more consistent with current industry practice. For purposes of comparability, the $130 million and $142 million previously classified as ‘‘Selling and administrative expenses’’ for the years ended 2006 and 2005 have been adjusted retrospectively to apply the new method. This change had no impact on operating earnings, net earnings, or earnings per share.

Research and Development

   Our research and engineering program is focused on product improvements, innovations and cost reductions for our customers. We expense research and development expenditures, net of contract reimbursements, when incurred. Research and development expenses, net of contract reimbursements, were $318 million in 2007, $312 million in 2006 and $271 million in 2005. Contract reimbursements were $52 million in 2007, $40 million in 2006 and $55 million in 2005.

RECENTLY ADOPTED ACCOUNTING PRONOUNCEMENTS

   In December 2004, the Financial Accounting Standards Board (FASB) issued SFAS No. 123 (Revised 2004), ‘‘Share-Based Payment’’ (SFAS 123R). This standard requires financial statement recognition of compensation cost related to share-based payment transactions. Share-based payment transactions within the scope of SFAS 123R include stock options, restricted stock plans, performance-based awards, stock appreciation rights and employee share purchase plans. We implemented the revised standard in the first quarter of 2006. Prior to January 1, 2006, we accounted for stock-based employee awards issued after December 31, 2002, using the fair value method preferred by SFAS No. 123, ‘‘Accounting for Stock-Based Compensation.’’ SFAS 123R requires us to estimate forfeitures in calculating the expense relating to stock-based compensation as opposed to recognizing these forfeitures and the corresponding reduction in expense as they occur. SFAS 123R also requires prospective presentation of the ‘‘Excess tax benefits on stock-based awards’’ as a financing activity rather than an operating activity in our Consolidated Statements of Cash Flows. See Note 16 for the impact that the adoption of this standard had on our Consolidated Financial Statements.

   In September 2006, the FASB issued SFAS No. 158, ‘‘Employers’ Accounting for Defined Benefit Plans and Other Postretirement Plans—an amendment of FASB Statements No. 87, 88, 106, and 132(R)’’ (SFAS 158), which requires employers to fully recognize the obligations associated with single-employer defined benefit pension, retiree healthcare and other postretirement plans in their financial statements. In addition, SFAS 158 requires companies to measure plan assets and liabilities as of the end of a fiscal year rather than a date within 90 days of the end of the fiscal year. We adopted SFAS 158 effective December 31, 2006, except for the change in measurement date provisions which are not effective until 2008. Total assets, total liabilities, minority interests and total shareholders’ equity were impacted in the following manner. Total assets increased by approximately $11 million, total liabilities increased by approximately $106 million, minority interests decreased by approximately $1 million and shareholders’ equity decreased by approximately $94 million. The adoption of SFAS 158 did not impact compliance with any of our financial covenants. See Note 11 for further information regarding the impact that the adoption of this standard had on our Consolidated Financial Statements.

   In July 2006, the FASB issued FASB Interpretation (FIN) No. 48, ‘‘Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109’’ (FIN 48), which prescribes a recognition threshold and measurement process for recording in the financial statements, uncertain tax positions taken or expected to be taken in a tax return. In addition, FIN 48 provides guidance on the derecognition, classification, accounting in interim periods and disclosure requirements for uncertain tax positions. The adoption of FIN 48, effective January 1, 2007, did not have a material effect on our Consolidated Financial Statements. See Note 4 for further information regarding the adoption of this standard.

ACCOUNTING PRONOUNCEMENTS ISSUED BUT NOT YET EFFECTIVE

   In September 2006, the FASB issued SFAS No. 157, ‘‘Fair Value Measurements’’ (SFAS 157), which defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. We will adopt SFAS 157 effective January 1, 2008. We do not expect the adoption of SFAS 157 to have a material impact on our Consolidated Financial Statements.

   In February 2007, the FASB issued SFAS No. 159, ‘‘The Fair Value Option for Financial Assets and Financial Liabilities—Including an Amendment of FASB Statement No. 115’’ (SFAS 159), which is effective for fiscal years beginning after November 15, 2007. SFAS 159 permits an entity to choose to measure many financial instruments and certain other items at fair value at specified election dates. Subsequently unrealized gains and losses on items for which the fair value option has been elected will be reported in earnings. We do not expect to elect the fair value methodology under SFAS 159 for any of our financial instruments, thus the adoption of SFAS 159 will not impact our Consolidated Financial Statements.

   In December 2007, the FASB issued SFAS No. 141 (revised 2007), ‘‘Business Combinations’’ (SFAS 141R), which is effective for fiscal years beginning after December 15, 2008. SFAS 141R makes significant changes to both the accounting and disclosures related to the acquisition of a business and could materially impact how we account for future business combination transactions. Because the standard will only impact transactions entered into after January 1, 2009, SFAS 141R will not impact our consolidated financial statements upon adoption

   In December 2007, the FASB issued SFAS No. 160, ‘‘Noncontrolling Interests in Consolidated Financial Statements’’ (SFAS 160), which is effective for fiscal years beginning after December 15, 2008. SFAS 160 amends Accounting Research Bulletin No. 51, ‘‘Consolidated Financial Statements’’ (ARB 51) and establishes accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. For Cummins, the most significant impact of the standard, at adoption, will be to reclass our minority interests ($293 million at December 31, 2007) to be included as a part of equity, which may affect certain performance and equity ratios. We are currently evaluating the potential additional impact that SFAS 160 may have on our Consolidated Financial Statements.

The accompanying notes are an integral part of the Consolidated Financial Statements.