CUMMINS INC. AND CONSOLIDATED SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 3. VARIABLE INTEREST ENTITIES

   We consolidate certain VIEs if we are deemed to be the primary beneficiary, defined in FASB Interpretation No. 46R, ‘‘Consolidation of Variable Interest Entities,’’ (FIN 46R) as the entity that absorbs a majority of the VIEs’ expected losses, receives a majority of the VIEs’ expected residual returns, or both. We have variable interests in businesses accounted for under the equity method of accounting and certain North American distributors that are deemed VIEs and are subject to the provisions of FIN 46R.

   During 2001, we entered into a sale-leaseback transaction with a financial institution with regard to certain heavy-duty engine manufacturing equipment. The accounting for the original sale-leaseback transaction is discussed in Note 19. The financial institution created a grantor trust to act as the lessor in the arrangement. The financial institution owns 100 percent of the equity in the trust. The grantor trust has no assets other than the equipment and its rights to the lease agreement with us. On the initial sale, we received $125 million from the financial institution which was financed with $99 million of non-recourse debt and $26 million of equity. Our obligations to the grantor trust consist of the payments due under the lease and a $9 million guarantee of the residual value of the equipment. In addition, we have a fixed price purchase option that is exercisable on January 14, 2009, for approximately $35 million. We have determined that the grantor trust is a VIE under FIN 46R and due primarily to the existence of the residual value guarantee, we determined that we are the primary beneficiary of the VIE. As a result, we began consolidating the grantor trust as of December 31, 2003, even though we own none of its equity. As of December 31, 2007, the non-recourse debt had an outstanding balance of $49 million, the assets serving as collateral on this debt had a carrying amount of $38 million and the related noncontrolling interest in the VIE was $33 million.

   Consolidated Diesel Corporation (CDC) and Cummins Komatsu Engine Corporation (CKEC), are engine manufacturing entities jointly owned and operated by us and our equity partners. We were deemed the primary beneficiary of these VIEs due to the pricing arrangements of purchases and the substantial volume of purchases we made from these VIEs. Our arrangements with CDC are more fully described in Note 2. As of December 31, 2007, CDC has approximately $25 million of debt which is collateralized by substantially all of its inventory and fixed assets with a current book value of $48 million and $135 million, respectively. CKEC has no unsecured debt as of December 31, 2007. Creditors of these entities have no recourse to the general credit of Cummins.

   Results of these entities for the year ended December 31, 2007, are included in our Consolidated Statements of Earnings and a significant amount of their sales are eliminated in consolidation. The table below shows the increase in our assets and liabilities from consolidating these entities, after eliminating intercompany items, as of December 31, 2007:

   We also have variable interests in three North American distributors that were deemed to be VIEs in accordance with FIN 46R, but we were not deemed to be the primary beneficiary since we do not absorb a majority of the entity’s expected losses. Our ownership percentage in these entities ranges from zero percent to 50 percent. For all three of the entities, our equity ownership represents our only variable interest in the entity and thus we would not be deemed the primary beneficiary.

   The principal business of the distributors is to sell Cummins engines and related service parts as well as provide repair and maintenance services on engines, including warranty repairs. Our maximum potential loss related to these three distributors as of December 31, 2007, consisted of our ownership interest totaling $24 million. Our involvement with these distributors as equity holders began in 2005, 2003 and 2002. Selected financial information for these distributors as of and for the year ended December 31, 2007, is as follows:

   In June 2001, Cummins Capital Trust I (the ‘‘Trust’’), a Delaware business trust and our wholly-owned subsidiary, issued 6 million shares of 7 percent convertible quarterly income preferred securities (‘‘preferred securities’’). The total proceeds from the issuance of the preferred securities by the Trust were invested in $309 million aggregate principal amount of 7 percent convertible subordinated debentures (the ‘‘debentures’’) that we issued. The debentures were the sole assets of the Trust. The Trust qualified as a VIE under FIN 46R. We were not the primary beneficiary of the Trust and thus reported the debentures rather than the preferred securities as an obligation. On May 8, 2006, the Board of Directors approved our plan to redeem all of the 7 percent convertible quarterly income preferred securities. See Note 10 for information relating to this redemption.

   AVK/SEG is a German holding company that directly owned shares of AVK and SEG and was jointly owned by Cummins (50 percent) and other equity partners. AVK manufactures alternators and SEG manufactures power electronic components. We were deemed the primary beneficiary of this VIE due to the existence of a call/guarantee arrangement on an additional 13 percent ownership interest in the entity and our guarantee on portions of the entity’s subordinated debt. During the second quarter of 2004, AVK/SEG was liquidated and its shares in AVK and SEG were distributed directly to us and the other equity partners. As a result of the liquidation, we owned 100 percent of AVK, 25 percent of SEG and our call/guarantee arrangement to obtain an additional ownership interest in SEG increased from 13 percent to 19 percent. This transaction was accounted for as an acquisition of a noncontrolling interest in AVK (via a nonmonetary exchange of shares) and was recorded at fair value, resulting in a nominal gain (less than $1 million after-tax). During 2005, we exercised our call option to purchase an additional 19 percent ownership in SEG. In addition, SEG failed to timely repay certain intercompany loans due to us which increased our ownership percentage by an additional 7 percent. As a result of these transactions, we owned 51 percent of SEG. During the fourth quarter of 2006, we sold our interest in SEG, therefore it is no longer consolidated in our Consolidated Financial Statements. The sale resulted in a pre-tax gain of approximately $9 million. Total assets of SEG were approximately $42 million at the date of the transaction and $39 million at December 31, 2005, which is less than 1 percent of our total assets at those dates. Total sales of SEG were approximately $51 million and $72 million, for the ten months ended October 31, 2006 and for the year ended December 31, 2005, respectively, which is less than 1 percent of our total net sales for these periods.

   In April 2004, Cummins Eastern Canada (CEC) acquired another Cummins distributor in Canada. The acquisition price of the distributor was $19 million ($18 million, net of cash acquired), which was funded by the addition of $15 million of debt and our additional $4 million equity investment. The additional equity contribution increased our ownership percentage in CEC to 67 percent (50 percent prior to the acquisition.) During the third quarter of 2004, we sold a 16 percent ownership interest in CEC to another equity holder by accepting a note. As a result of this sale, our ownership percentage in CEC was reduced from 67 percent to 51 percent. Immediately upon repayment of the loan, the equity holder had an option agreement to purchase an additional 1 percent ownership share from us. We also agreed with the other shareholders to maintain our voting interest at 50 percent. We do not have management or voting control over CEC. In accordance with FIN 46R, CEC was consolidated in our Consolidated Financial Statements due to our former 51 percent economic interest and deemed interest of 16 percent resulting from our financing of the other equity holder’s purchase. As of December 31, 2006, CEC had approximately $23 million of debt which was collateralized by various current and fixed assets with a current book value of $62 million. Creditors of CEC have no recourse to the general credit of Cummins. On January 3, 2007, the equity holder repaid the balance due on the outstanding note of $3.3 million and exercised the purchase option on the additional 1 percent share for $0.3 million. The repayment of the loan and the exercise of the purchase option triggered a reassessment under FIN 46R, resulting in the deconsolidation of CEC. The results of CEC are no longer included in our Consolidated Financial Statements.

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