Notes to Consolidated Financial Statements BorgWarner Inc.  and Consolidated Subsidiaries 41 40 INTRODUCTION NOTE 1  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES 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. 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. 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.  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: 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.  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. 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: 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. 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. millions of dollars, except per share data  2004 2003 2002 Net earnings/(loss), as reported  $218.3 $174.9 $(119.1)  Add: Stock-based employee  compensation expense included  in net income, net of income tax  1.6 2.7 4.5 Deduct: Total stock-based employee  compensation expense determined  under fair value based method for  all awards, net of income tax  (7.7) (7.7) (10.7) Pro forma net earnings/(loss)  $212.2 $169.9 $(125.3) Earnings/(loss) per share: Basic – as reported  $ 3.91 $ 3.23 $ (2.23) Basic – pro forma  $ 3.80 $ 3.14 $ (2.36) Diluted – as reported  $ 3.86 $ 3.20 $ (2.22) Diluted – pro forma  $ 3.75 $ 3.11 $ (2.34) millions of dollars  2004 2003 2002 Beginning balance  $28.7 $23.7 $ 19.5 Provisions   10.2  12.4   14.2 Payments  (12.5)  (7.4)  (10.0) Ending balance  $26.4 $28.7 $ 23.7 Classified in the Consolidated  Balance Sheets as: Accounts payable and accrued expenses  $16.1 $17.6 $ 14.4 Other long term liability  $10.3 $11.1  $ 9.3 millions of dollars  Drivetrain Engine Total Balance at January 1, 2002  $133.7  $1,026.9  $1,160.6 Change in accounting principle   —   (345.0)  (345.0) Translation adjustment  —   11.4   11.4 Balance at December 31, 2002  $133.7  $ 693.3  $ 827.0 Contingent valuation payment on acquired business  —  12.8  12.8 Translation adjustment  0.6  11.6  12.2 Balance at December 31, 2003  $134.3  $ 717.7   $ 852.0 Translation adjustment  0.3  8.5  8.8 Balance at December 31, 2004  $134.6 $ 726.2 $ 860.8