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## INTRODUCTION 

BorgWarner Inc. and Consolidated Subsidiaries (the “Company”) is a leading global supplier of highly engineered systems and components primarily for powertrain applications. These products are manufac- tured and sold worldwide, primarily to original equipment manufac- turers of passenger cars, sport-utility vehicles, trucks, commercial transportation products and industrial equipment. Our products fall into two reportable operating segments: Drivetrain and Engine. 

## NOTE 1 

## SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES 

The following paragraphs briefly describe the Company’s significant accounting policies. 

Use of estimates  The preparation of financial statements in con- formity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions. These estimates and assumptions 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. Actual results could differ from those estimates. 

Principles of consolidation The Consolidated Financial Statements include all significant majority-owned subsidiaries. All intercompany accounts and transactions have been eliminated in consolidation. 

Cash and cash equivalents Cash and cash equivalents are valued at cost, which approximates fair market value. It is the Company’s policy to classify investments with original maturities of three months or less as cash and cash equivalents. 

Accounts receivable  The Company securitizes and sells certain receivables through third party financial institutions without recourse. The amount sold can vary each month based on the amount of underly- ing receivables. In the fourth quarter of 2003, the Company reduced the maximum size of the facility from $90 million to $50 million. In the fourth quarter of 2002, the Company reduced the maximum size of the facility from $120 million to $90 million. 

During the year ended December 31, 2004, total cash proceeds from sales of accounts receivable were $600 million. The Company paid servicing fees of $0.9 million, $1.3 million, and $2.5 million in 2004, 2003, and 2002, respectively, related to these receivables. These amounts are recorded in interest expense and finance charges in the Consolidated Statements of Operations. At December 31, 2004 and 2003, the Company had sold $50 million of receivables under a Receivables Transfer Agreement for face value without recourse. 

Inventories  Inventories are valued at the lower of cost or market. Cost of U.S. inventories is determined by the last-in, first-out (LIFO) method, while the foreign operations use the first-in, first-out (FIFO) or average-cost methods. Inventory held by U.S. operations was $106.1 million in 2004 and $97.1 million in 2003. Such inventories, if valued at current cost instead of LIFO, would have been greater by $6.6 mil- lion in 2004 and $3.6 million in 2003. 

Property, plant and equipment and depreciation  Property, plant and equipment are valued at cost less accumulated depreciation. Expenditures for maintenance, repairs and renewals of relatively minor items are generally charged to expense as incurred. Renewals of significant items are capitalized. Depreciation is computed gener- ally on a straight-line basis over the estimated useful lives of the assets. Useful lives for buildings range from 15 to 40 years and useful lives for machinery and equipment range from 3 to 12 years. For income tax purposes, accelerated methods of depreciation are generally used. 

Goodwill and other intangible assets  The Company adopted Statement of Financial Accounting Standards (SFAS) No. 142, “Goodwill and Other Intangible Assets,” effective January 1, 2002. Under SFAS No. 142, goodwill is no longer amortized; however, it must be tested for impairment at least annually. Under the transi- tional provisions of this statement, the Company allocated goodwill to its reporting units and performed the two-step impairment analysis. The fair value of the Company’s businesses used in determination of the goodwill impairment was computed using the expected present value of associated future cash flows. As a result of this analysis, the Company determined that goodwill associated with its Emissions/ Thermal Systems business unit was impaired due to fundamental changes in their served markets, particularly the medium and heavy truck markets, and weakness at a major customer. A resulting pre- tax charge of $345 million, $269 million after tax, was recorded. The impairment loss was recorded in the first quarter of 2002 as a cumulative effect of change in accounting principle. The changes in the carrying amount of goodwill for the twelve months ended December 31, 2002, 2003 and 2004, are as follows: 

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In the fourth quarter of each year, or when events and circumstances warrant such a review, the Company reviews the goodwill for all of its reporting units for impairment. This review requires us to make significant assumptions and estimates about the extent and timing of future cash flows, discount rates and growth rates. The cash flows are estimated over a significant future period of time, which makes those estimates and assumptions subject to an even higher degree of uncertainty. We also utilize market valuation models and other finan- cial ratios, which require us to make certain assumptions and esti- mates regarding the applicability of those models to our assets and businesses. We believe that the assumptions and estimates used to determine the estimated fair values of each of our reporting units are reasonable. However, different assumptions could materially affect the estimated fair value. The goodwill impairment test was performed in November 2004. The results of that analysis did not indicate an impairment of the book value of the Company’s goodwill. 

The Company had intangible assets, primarily trade names, with a cost of $14.7 million, less accumulated amortization of $9.8 million and $8.7 million at December 31, 2004 and 2003, respectively. The intangible assets are being amortized on a straightline basis over their legal lives, which range from 10 to 15 years. Annual amortiza- tion expense recognized was $1.1 million in each of the years 2004, 2003, and 2002. The estimated future annual amortization expense for each of the successive years 2005 through 2008 is $1.2 million. 

Revenue recognition  The Company recognizes revenue upon ship- ment of product when title and risk of loss pass to the customer. Although the Company may enter into long-term supply agreements with its major customers, each shipment of goods is treated as a sep- arate sale and the price is not fixed over the life of the agreements. 

Financial instruments  Financial instruments consist primarily of investments in cash, short-term securities and receivables, and obli- gations under accounts payable, and debt instruments. The Company believes that the fair value of the financial instruments approximates the carrying value, except as noted in Note 6. 

The Company received corporate bonds with a face value of $30.3 million as partial consideration for the sales of Kuhlman Electric and Coleman Cable in 1999. These bonds were recorded at their estimated fair market value of $12.9 million using valuation tech- niques that considered cash flows discounted at current market rates and management’s best estimates of credit quality. In 2001, the sale agreement with Coleman Cable was renegotiated, resulting in the exchange of the corporate bonds along with a purchase price receivable, for $3 million in cash and a $2 million note, which was fully collected in 2002. During the first quarter of 2004 the Kuhlman Electric agreement was renegotiated whereby the Company received a payment of $2.5 million and a new note from Kuhlman Electric Corporation. The maturity of this new note is April 2012. The face value of the note is $4.5 million at December 31, 2004. 

Derivative financial instruments  The Company recognizes that certain normal business transactions generate risk. Examples of risks include exposure to exchange rate risk related to transactions denomi- nated in currencies other than the functional currency, changes in cost of major raw materials and supplies, and changes in interest rates. It is the objective and responsibility of the Company to assess the impact of these transaction risks, and offer protection from selected risks through various methods including financial derivatives. All derivative instruments held by the Company are designated as hedges, have high correlation with the underlying exposure and are highly effective in offsetting underlying price movements. Accordingly, gains and losses from changes in derivative fair values are matched with the underlying transactions. The Company does not engage in any derivative transac- tions for purposes other than hedging specific risks. 

Foreign currency  The financial statements of foreign subsidiaries are translated to U.S. Dollars using the period-end exchange rate for assets and liabilities and an average exchange rate for each period for revenues, expenses, and capital expenditures. The local cur- rency is the functional currency for substantially all the Company’s foreign subsidiaries. Translation adjustments for foreign subsidiaries are recorded as a component of accumulated other comprehensive income in stockholders’ equity. 

Product warranties  The Company provides warranties on some of its products. The warranty terms are typically from one to three years. Provisions for estimated expenses related to product warranty are made at the time products are sold. These estimates are established using historical information about the nature, frequency, and average cost of warranty claims. Management actively studies trends of warranty claims and takes action to improve product quality and minimize warranty claims. Management believes that the warranty accrual is appropriate; however, actual claims incurred could differ from the original estimates, requiring adjustments to the accrual. The accrual is represented in both long-term and short-term liabilities on the balance sheet. 

Below is a table that shows the activity in the warranty accrual accounts: 

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Stock based compensation SFAS No. 123, “Accounting for Stock- Based Compensation” and SFAS No. 148, “Accounting for Stock- Based Compensation – Transition and Disclosure,” encourage, but do not require, companies to record compensation cost for stock- based employee compensation plans at fair value. The Company has chosen to continue to account for stock-based compensation in accordance with Accounting Principles Board Opinion (APB) No. 25, “Accounting for Stock Issued to Employees,” and related interpreta- tions. Accordingly, no compensation cost has been recognized for fixed stock options because the exercise prices of the stock options equal the market value of the Company’s common stock at the date of grant, which is the measurement date. Further disclosure about the Company’s stock compensation plans can be found in Note 9. The following table illustrates the effect on the Company’s net earnings/ (loss) and net earnings/(loss) per share if the Company had applied the fair value recognition provision of SFAS No. 123. 

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