Management’s Discussion and Analysis  of Financial Condition and Results of Operations BorgWarner Inc.  and Consolidated Subsidiaries 33 32 Impairment of Long-Lived Assets Other Loss Accruals and Valuation Allowances Pension and Other Post Retirement Benefits Goodwill  Environmental Accrual Product Warranty Derivatives New Accounting Pronouncements See Note 8 to the Consolidated Financial Statements for more  information regarding costs and assumptions for employee retire- ment benefits. The Company recognizes that certain normal business transactions  generate risk. Example of risks include exposure to exchange risk  related to transactions denominated in currencies other than the  functional currency, changes in cost of major raw materials and sup- plies, and changes in interest rates. It is the objective and responsibil- ity of the Company to assess the impact of these transactions 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 transactions for  purposes other than hedging specific risks. In January 2003, the Financial Accounting Standards Board (FASB)  issued Interpretation (FIN) No. 46, “Consolidation of Variable Interest  Entities, an Interpretation of ARB No. 51,” which was revised in  December 2003. FIN No. 46R requires that the assets, liabilities and  results of the activity of variable interest entities be consolidated into  the financial statements of the entity that has the controlling financial  interest. FIN No. 46R also provides the framework for determining  whether a variable interest entity should be consolidated. For the  Company, this Interpretation, as revised, was effective January 1,  2004. The Company has no variable interest entities required to be  consolidated as a result of adopting FIN No. 46R. In November 2004, the FASB issued Statement of Financial Accounting  Standards (SFAS) No. 151, “Inventory Costs” which is an amendment  of ARB No.43, Chapter 4. This statement provides clarification of  accounting for abnormal amounts of idle facility expense, freight,  handling costs and wasted material. Generally, this statement  requires that those items be recognized as current period charges.  SFAS 151 will be effective for the Company on January 1, 2006. The  Company is currently evaluating the impact that the adoption of SFAS  151 will have on its consolidated financial position, results of opera- tions and cash flows. In December 2004, the FASB issued FSP 109-1, “Application of  FASB Statement No. 109, Accounting for Income Taxes, to the Tax  Deduction on Qualified Production Activities Provided by the American  Jobs Creation Act of 2004” (AJCA), and FSP 109-2 “Accounting and  Disclosure Guidance for the Foreign Earnings Repatriation Provision  within the AJCA.” These two FSPs provide guidance on the applica- tion of the new provisions of the AJCA, which was signed into law on  October 22, 2004. The AJCA provides a deduction for income from qualified domestic  production activities, which will be phased in from 2005 through  2010. In return, the AJCA provides for a two-year phase-out of the  existing extra-territorial income exclusion (ETI) for foreign sales that  was viewed to be inconsistent with international trade protocols by  the European Union. Under the guidance in FSP 109-1, the deduction  will be treated as a “special deduction” as described in SFAS 109.  As such, the special deduction has no effect on deferred tax assets  and liabilities existing at the enactment date. Rather, the impact of  this deduction will be reported in the period in which the deduction is  claimed on our tax return. The Company expects the net effect of the  phase out of the ETI and the phase in of this new deduction will not  have a material impact on its effective tax rate. FSP 109-2 provides guidance on the accounting for the deduction of  85% of certain foreign earnings that are repatriated, as defined in the  AJCA. The Company may elect to apply this provision to qualifying  earnings repatriations in 2005. Under the guidance set forth in FSP  109-2, the Company is allowed time beyond the financial reporting  period of enactment to evaluate the effect of the AJCA on its plan for  reinvestment or repatriation of foreign earnings. The Company has  started an evaluation of the effects of the repatriation provision; how- ever, the Company does not expect to be able to complete this evalua- tion until after the U.S. Congress or the Treasury Department provides  additional clarifying language on key elements of the provision. The  Company expects to complete its evaluation of the effects of the  repatriation provision within a reasonable period of time following the  publication of the additional clarifying language. The range of possible  amounts that the Company is considering for repatriation under this  provision is between zero and $74 million. The related range of income  tax effects of such repatriation cannot be reasonably estimated until  guidance is issued by Congress or the Treasury Department. In December 2004, the FASB issued SFAS No. 123R, “Shared-Based  Payment” which requires companies to measure and recognize com- pensation expense for all share-based payments at fair value. Share- based payments include stock option grants and certain transactions  under other Company stock plans. The Company grants options to  In December 2003, the Medicare Prescription Drug Improvement  and Modernization Act of 2003 (Medicare Act) introduced a pre- scription drug benefit under Medicare, as well as a federal subsidy  to sponsors of retiree health care benefit plans. In January 2004,  the FASB issued FASB Staff Position (FSP) No. 106-1, “Accounting  Disclosure Requirements Related to the Medicare Prescription Drug,  Improvement, and Modernization Act of 2003.” FSP 106-1 permits  a sponsor of a post retirement health care plan that provides a pre- scription drug benefit to make a one-time election to defer account- ing for the effects of the Medicare Act if there is insufficient data,  time or guidance available to ensure appropriate accounting. The  Company is a sponsor of post retirement health care plans that pro- vide prescription benefits and, in accordance with the one-time elec- tion under FSP 106-1, elected to defer accounting for the Medicare  Act. In May 2004, the FASB issued FSP 106-2, “Accounting and  Disclosure Requirements Related to the Medicare Prescription Drug,  Improvement and Modernization Act of 2003,” which supersedes  FSP 106-1, to address the accounting and disclosure requirements  related to the Medicare Act. This FSP was adopted by the Company  beginning with its third quarter ended September 30, 2004. The  effect of the adoption was to reduce the Company’s 2004 post retire- ment benefits expense by $6.8 million.  The Company determines its expected return on plan asset assump- tions by evaluating both historical returns as well as estimates of  future returns. Specifically, the Company analyzed the average his- torical broad market returns for various periods of time over the past  100 years for equities and over a 30-year period for fixed income  securities, and adjusted the computed amount for any expected  changes in the long-term outlook for the equity and fixed income  markets. The Company’s expected return on assets was based on  expected equity and fixed income returns weighted by the percent- age of assets allocated to each plan. The Company’s estimate of the  long-term rate of return on assets for its U.S. pension is 8.75% for  2004 and 2003, and 9.5% for 2002. The Company does not antici- pate a change in the long-term rate of return on assets for pension  benefits in 2005. For the U.K. plan, the expected return is based upon  the relative weight of equity and debt investments, and the recent  performance of those investments. The Company’s estimate of the  long-term rate of return on assets for its U.K. pension is 6.75% for  2004 and 2003, and 7.0% for 2002.  The Company’s approach to establishing the discount rate is based  upon corporate bond indices. In the United States, the discount rate  assumption is based upon the Moody’s Aa Corporate Bond Index as  of December 31, 2004, rounded up or down to the nearest 25 basis  points. Based on this approach, at December 31, 2004, the Company  lowered the discount rate for its U.S. pension and other benefit plans  to 5.75% from 6.00% at December 31, 2003. For the U.K. plans, the  discount rate assumption is based on the iBoxx AA rated bonds. At  December 31, 2004, the discount rate used was 5.75%. For other  locations, similar indices and methods are used. The Company provides post retirement benefits to a substantial por- tion of its employees. Costs associated with post retirement benefits  include pension and post retirement health care expenses for employ- ees, retirees and surviving spouses and dependents. The Company’s  employee pension and post retirement heath care expenses are  dependent on management’s assumptions used by actuaries in  calculating such amounts. These assumptions include discount  rates, health care cost trend rates, inflation, long-term return on plan  assets, retirement rates, mortality rates and other factors. Health  care cost trend assumptions are developed based on historical cost  data, the near-term outlook, and an assessment of likely long-term  trends. The inflation assumption is based on an evaluation of external  market indicators. Retirement and mortality rates are based primarily  on actual plan experience. The Company has numerous other loss exposures, such as customer  claims, workers’ compensation claims, litigation, and recoverability  of assets. Establishing loss accruals or valuation allowances for  these matters requires the use of estimates and judgment in regards  to the risk exposure and ultimate realization. We estimate losses  under the programs using consistent and appropriate methods;  however, changes to our assumptions could materially affect our  recorded liabilities for loss.  The Company periodically reviews the carrying value of its long-lived  assets, whether held for use or disposal, including other intangible  assets, when events and circumstances warrant such a review. This  review is performed using estimates of future cash flows. If the carry- ing value of a long-lived asset is considered impaired, an impairment  charge is recorded for the amount by which the carrying value of the  long-lived asset exceeds its fair value. Management believes that the  estimates of future cash flows and fair value assumptions are reason- able; however, changes in assumptions underlying these estimates  could affect the evaluations. The Company annually reviews its goodwill for impairment in the  fourth quarter of each year for all of its reporting units, or when  events and circumstances warrant such a review. 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 financial ratios, which require us to make certain  assumptions and estimates regarding the applicability of those mod- els 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 impair- ment test was performed in November 2004, and no impairment was  found. Amortization continues to be recorded for other intangible  assets with definite lives. We work with outside experts to determine a range of potential  liability for environmental sites. The ranges for each individual site  are then aggregated into a loss range for the total accrued liability.  Management’s estimate of the loss range for 2004 is between $21.3  million and $69.9 million. We record an accrual at the most probable  amount unless one cannot be determined; in which case we record  the accrual at the low end of the range. At the end of 2004, our total  accrued environmental liability was $25.7 million. 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 as related to the warranty provisions of our  sales agreements with customers. We actively study trends of war- ranty claims and take action to improve product quality and minimize  warranty claims. We believe that the warranty accrual is appropriate;  however, actual claims incurred could differ from the original esti- mates, requiring adjustments to the accrued liability.