CUMMINS INC. AND CONSOLIDATED SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 18. DERIVATIVES AND OTHER FINANCIAL INSTRUMENTS

We are exposed to financial risk resulting from volatility in foreign exchange rates, interest rates and commodity prices. This risk is closely monitored and managed through the use of financial derivative instruments including commodity forward contracts, currency forward contracts and interest rate swaps. As stated in our policies and procedures, financial derivatives are used expressly for hedging purposes, and under no circumstances are they used for speculation purposes. Our hedging transactions are entered into with banking institutions that have strong credit ratings, and thus the credit risk associated with these contracts is not considered significant. The results and status of our hedging transactions are reported to senior management on a monthly and quarterly basis. The following table summarizes our outstanding derivatives by risk category and instrument type:

Foreign Currency Exchange Rate Risks

   As a result of our international business presence, we are exposed to foreign currency exchange risks. We transact business in foreign currencies and, as a result, our earnings experience some volatility related to movements in foreign currency exchange rates. To help manage our exposure to exchange rate volatility, we use foreign exchange forward contracts on a regular basis to hedge forecasted intercompany and third-party sales and purchases denominated in non-functional currencies. These foreign currency forward contracts are designated and qualify as foreign currency cash flow hedges under SFAS No. 133, ‘‘Accounting for Derivative Instruments and Hedging Activities’’ (SFAS 133), and are recorded in the Consolidated Balance Sheets at fair value in ‘‘Other current assets’’ and ‘‘Other accrued expenses.’’ The effective portion of the unrealized gain or loss on the forward contract is deferred and reported as a component of ‘‘Accumulated other comprehensive loss.’’ When the hedged forecasted transaction (sale or purchase) occurs, the unrealized gain or loss is reclassified into earnings in the same line item associated with the hedged transaction in the same period or periods during which the hedged transaction affects earnings. For the year ended December 31, 2007, gains of $5 million were reclassified from ‘‘Accumulated other comprehensive loss’’ to earnings. The amount of gain reclassified for the year ended December 31, 2006, was $7 million. The ineffective portion of the hedge, unrealized gain or loss, if any, is recognized in current earnings during the period of change. As of December 31, 2007, $2 million of unrealized losses, net of tax, were included in ‘‘Accumulated other comprehensive loss’’ in the Consolidated Balance Sheets and are expected to be reclassified to earnings over the next twelve months. As of December 31, 2006, $1 million of deferred gains, net of tax, were included in ‘‘Accumulated other comprehensive loss’’ in the Consolidated Balance Sheets. For the years ended December 31, 2007 and 2006, there were no circumstances that would have resulted in the discontinuance of a cash flow hedge.

   Our internal policy allows for managing anticipated foreign currency cash flow for up to one year. As of December 31, 2007, approximately 96 percent of the notional amount of the forward contracts shown in the table above was attributable to five currencies, the British Pound (61 percent), the Euro (25 percent), the Indian Rupee (4 percent), the Australian Dollar (4 percent), and the Japanese Yen (2 percent). As of December 31, 2006, approximately 99 percent of the notional amount of the forward contracts shown in the table above was attributable to five currencies, the British Pound (68 percent), the Indian Rupee (20 percent), the Mexican Peso (7 percent), the Euro (2 percent), and the Australian Dollar (2 percent).

   To minimize the earnings volatility resulting from the remeasurement of receivables and payables denominated in foreign currency, we enter into foreign currency forward contracts. The objective is to offset the gain or loss from remeasurement with the fair market valuation of the forward contract. These derivative instruments are not designated as hedges under SFAS 133.

Interest Rate Swaps

   We are exposed to market risk from fluctuations in interest rates. We manage our exposure to interest rate fluctuations through the use of interest rate swaps. The objective of the swaps is to more effectively balance our borrowing costs and interest rate risk. Currently, we have one interest rate swap outstanding.

   In November 2005, we entered into an interest rate swap to effectively convert our $250 million, due in 2028 debt from a fixed rate of 7.125% to a floating rate based on a LIBOR spread. The terms of the swap mirror those of the debt, with interest paid semi-annually. This swap qualifies as a fair value hedge under SFAS 133.

   We have equity method investees, whose financial results are not consolidated, that have entered into floating-to-fixed interest rate swap agreements. The swaps have been designated and qualify as cash flow hedges under SFAS 133. We record our share of the gain or loss on these instruments in ‘‘Accumulated other comprehensive loss.’’ As of December 31, 2007, the gains and losses related to these swaps were not material.

Commodity Forward Contracts

   We are exposed to fluctuations in commodity prices due to contractual agreements with component suppliers. In order to protect ourselves against future price volatility and, consequently, fluctuations in gross margins, we periodically enter into commodity forward contracts with designated banks to fix the cost of certain raw material purchases with the objective of minimizing changes in inventory cost due to market price fluctuations. The forward contracts are derivative contracts that are designated as cash flow hedges under SFAS 133 and are recorded in the Consolidated Balance Sheets at fair value in ‘‘Other current assets’’, ‘‘Other assets’’, and ‘‘Other accrued expenses.’’ The effective portion of the unrealized gain or loss is deferred and reported as a component of ‘‘Accumulated other comprehensive loss.’’ When the hedged forecasted transaction (purchase) occurs, the unrealized gain or loss is reclassified into earnings in the same line item associated with the hedged transaction in the same period or periods during which the hedged transaction affects earnings. For the year ended December 31, 2007, gains of $21 million were reclassified from ‘‘Accumulated other comprehensive loss’’ to earnings. For the year ended December 31, 2006, gains of $18 million were reclassified from ‘‘Accumulated other comprehensive loss’’ to earnings. The ineffective portion of the hedge, if any, is recognized in current earnings in the period in which the ineffectiveness occurs. As of December 31, 2007 and 2006, unrealized gains, net of tax, related to commodity forward contracts were $5 million and $7 million, respectively. During 2008 we expect to reclassify net gains of $6 million from ‘‘Accumulated other comprehensive loss’’ to earnings.

   Our internal policy allows for managing these cash flow hedges for up to three years. For the year ended December 31, 2007, there were no circumstances that would have resulted in the discontinuance of a cash flow hedge.

Fair Value of Financial Instruments

   Based on borrowing rates currently available to us for bank loans with similar terms and average maturities, the fair value of total debt, including current maturities, at December 31, 2007, was approximately $670 million. The carrying value at that date was $674 million. At December 31, 2006, the fair and carrying values of total debt, including current maturities, were $799 million and $811 million, respectively. The carrying values of all other receivables and liabilities approximated fair values.

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