Table of Contents

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

 

For the Quarterly Period Ended June 30, 2013

 

Commission File Number 1-4949

 

GRAPHIC

 


 

CUMMINS INC.

(Exact name of registrant as specified in its charter)

 

Indiana
(State of Incorporation)

 

35-0257090
(IRS Employer Identification No.)

 

500 Jackson Street

Box 3005

Columbus, Indiana 47202-3005

(Address of principal executive offices)

 

Telephone (812) 377-5000

(Registrant’s telephone number, including area code)

 

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes x  No o

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that registrant was required to submit and post such files).  Yes x  No o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.  (Check one):

 

Large accelerated filer x

 

Accelerated filer o

 

Non-accelerated filer o

 

Smaller reporting company o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o   No x

 

As of June 30, 2013, there were 187,229,083 shares of common stock outstanding with a par value of $2.50 per share.

 

Website Access to Company’s Reports

 

Cummins maintains an internet website at www.cummins.com.  Investors can obtain copies of our filings from this website free of charge as soon as reasonably practicable after they are electronically filed with, or furnished to the Securities and Exchange Commission.

 

 

 



Table of Contents

 

CUMMINS INC. AND SUBSIDIARIES

TABLE OF CONTENTS

QUARTERLY REPORT ON FORM 10-Q

 

 

 

Page

 

PART I. FINANCIAL INFORMATION

 

 

 

 

ITEM 1.

Condensed Consolidated Financial Statements (Unaudited)

3

 

 

 

 

Condensed Consolidated Statements of Income for the three and six months ended June 30, 2013 and July 1, 2012

3

 

 

 

 

Condensed Consolidated Statements of Comprehensive Income for the three and six months ended June 30, 2013 and July 1, 2012

4

 

 

 

 

Condensed Consolidated Balance Sheets at June 30, 2013 and December 31, 2012

5

 

 

 

 

Condensed Consolidated Statements of Cash Flows for the six months ended June 30, 2013 and July 1, 2012

6

 

 

 

 

Condensed Consolidated Statements of Changes in Equity for the six months ended June 30, 2013 and July 1, 2012

7

 

 

 

 

Notes to Condensed Consolidated Financial Statements

8

 

 

 

ITEM 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

26

 

 

 

ITEM 3.

Quantitative and Qualitative Disclosures About Market Risk

48

 

 

 

ITEM 4.

Controls and Procedures

48

 

 

 

 

PART II. OTHER INFORMATION

 

 

 

 

ITEM 1.

Legal Proceedings

48

 

 

 

ITEM 1A.

Risk Factors

49

 

 

 

ITEM 2.

Unregistered Sales of Equity Securities and Use of Proceeds

49

 

 

 

ITEM 3.

Defaults Upon Senior Securities

49

 

 

 

ITEM 4.

Mine Safety Disclosures

49

 

 

 

ITEM 5.

Other Information

49

 

 

 

ITEM 6.

Exhibits

49

 

 

 

 

Signatures

50

 

 

 

 

Cummins Inc. Exhibit Index

51

 

2



Table of Contents

 

PART I.  FINANCIAL INFORMATION

 

ITEM 1.  Condensed Consolidated Financial Statements

 

CUMMINS INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(Unaudited)

 

 

 

Three months ended

 

Six months ended

 

In millions, except per share amounts 

 

June 30, 2013

 

July 1, 2012

 

June 30, 2013

 

July 1, 2012

 

NET SALES (a)

 

$

4,525

 

$

4,452

 

$

8,447

 

$

8,924

 

Cost of sales

 

3,372

 

3,242

 

6,337

 

6,516

 

GROSS MARGIN

 

1,153

 

1,210

 

2,110

 

2,408

 

 

 

 

 

 

 

 

 

 

 

OPERATING EXPENSES AND INCOME

 

 

 

 

 

 

 

 

 

Selling, general and administrative expenses

 

484

 

487

 

928

 

962

 

Research, development and engineering expenses

 

177

 

187

 

359

 

368

 

Equity, royalty and interest income from investees (Note 5)

 

108

 

104

 

190

 

208

 

Other operating income (expense), net

 

10

 

8

 

11

 

10

 

OPERATING INCOME

 

610

 

648

 

1,024

 

1,296

 

 

 

 

 

 

 

 

 

 

 

Interest income

 

10

 

7

 

15

 

15

 

Interest expense

 

8

 

8

 

14

 

16

 

Other income (expense), net

 

1

 

14

 

19

 

16

 

INCOME BEFORE INCOME TAXES

 

613

 

661

 

1,044

 

1,311

 

 

 

 

 

 

 

 

 

 

 

Income tax expense (Note 6)

 

172

 

166

 

291

 

341

 

CONSOLIDATED NET INCOME

 

441

 

495

 

753

 

970

 

 

 

 

 

 

 

 

 

 

 

Less: Net income attributable to noncontrolling interests

 

27

 

26

 

57

 

46

 

NET INCOME ATTRIBUTABLE TO CUMMINS INC.

 

$

414

 

$

469

 

$

696

 

$

924

 

 

 

 

 

 

 

 

 

 

 

EARNINGS PER COMMON SHARE ATTRIBUTABLE TO CUMMINS INC.

 

 

 

 

 

 

 

 

 

Basic

 

$

2.20

 

$

2.47

 

$

3.70

 

$

4.86

 

Diluted

 

$

2.20

 

$

2.47

 

$

3.69

 

$

4.85

 

 

 

 

 

 

 

 

 

 

 

WEIGHTED AVERAGE SHARES OUTSTANDING

 

 

 

 

 

 

 

 

 

Basic

 

187.8

 

189.8

 

188.1

 

190.1

 

Dilutive effect of stock compensation awards

 

0.4

 

0.3

 

0.4

 

0.4

 

Diluted

 

188.2

 

190.1

 

188.5

 

190.5

 

 

 

 

 

 

 

 

 

 

 

CASH DIVIDENDS DECLARED PER COMMON SHARE

 

$

0.50

 

$

0.40

 

$

1.00

 

$

0.80

 

 


(a)   Includes sales to nonconsolidated equity investees of $576 million and $1,128 million and $622 million and $1,291 million for the three and six months ended June 30, 2013 and July 1, 2012, respectively.

 

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

 

3



Table of Contents

 

 

CUMMINS INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(Unaudited)

 

 

 

Three months ended

 

Six months ended

 

 

 

June 30,

 

July 1,

 

June 30,

 

July 1,

 

In millions 

 

2013

 

2012

 

2013

 

2012

 

CONSOLIDATED NET INCOME

 

$

441

 

$

495

 

$

753

 

$

970

 

Other comprehensive income (loss), net of tax (Note 14)

 

 

 

 

 

 

 

 

 

Foreign currency translation adjustments

 

(46

)

(159

)

(196

)

(53

)

Unrealized gain (loss) on derivatives

 

(6

)

(8

)

(12

)

11

 

Change in pension and other postretirement defined benefit plans

 

21

 

10

 

40

 

21

 

Unrealized gain (loss) on marketable securities

 

7

 

 

(3

)

(1

)

Total other comprehensive income (loss), net of tax

 

(24

)

(157

)

(171

)

(22

)

COMPREHENSIVE INCOME

 

417

 

338

 

582

 

948

 

Less: Comprehensive income attributable to noncontrolling interest

 

7

 

2

 

35

 

32

 

COMPREHENSIVE INCOME ATTRIBUTABLE TO CUMMINS INC.

 

$

410

 

$

336

 

$

547

 

$

916

 

 

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

 

4



Table of Contents

 

CUMMINS INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited)

 

In millions, except par value 

 

June 30, 2013

 

December 31, 2012

 

ASSETS

 

 

 

 

 

Current assets

 

 

 

 

 

Cash and cash equivalents

 

$

1,382

 

$

1,369

 

Marketable securities (Note 7)

 

205

 

247

 

Total cash, cash equivalents and marketable securities

 

1,587

 

1,616

 

Accounts and notes receivable, net

 

 

 

 

 

Trade and other

 

2,479

 

2,235

 

Nonconsolidated equity investees

 

266

 

240

 

Inventories (Note 9)

 

2,475

 

2,221

 

Prepaid expenses and other current assets

 

597

 

855

 

Total current assets

 

7,404

 

7,167

 

Long-term assets

 

 

 

 

 

Property, plant and equipment

 

6,077

 

5,876

 

Accumulated depreciation

 

(3,195

)

(3,152

)

Property, plant and equipment, net

 

2,882

 

2,724

 

Investments and advances related to equity method investees

 

924

 

897

 

Goodwill

 

450

 

445

 

Other intangible assets, net

 

360

 

369

 

Other assets

 

1,028

 

946

 

Total assets

 

$

13,048

 

$

12,548

 

 

 

 

 

 

 

LIABILITIES

 

 

 

 

 

Current liabilities

 

 

 

 

 

Loans payable

 

$

40

 

$

16

 

Accounts payable (principally trade)

 

1,669

 

1,339

 

Current maturities of long-term debt (Note 10)

 

43

 

61

 

Current portion of accrued product warranty (Note 11)

 

393

 

386

 

Accrued compensation, benefits and retirement costs

 

348

 

400

 

Deferred revenue

 

243

 

215

 

Taxes payable (including taxes on income)

 

159

 

173

 

Other accrued expenses

 

567

 

546

 

Total current liabilities

 

3,462

 

3,136

 

Long-term liabilities

 

 

 

 

 

Long-term debt (Note 10)

 

754

 

698

 

Postretirement benefits other than pensions

 

414

 

432

 

Other liabilities and deferred revenue

 

1,325

 

1,308

 

Total liabilities

 

5,955

 

5,574

 

 

 

 

 

 

 

Commitments and contingencies (Note 12)

 

 

 

 

 

 

 

 

 

EQUITY

 

 

 

 

 

Cummins Inc. shareholders’ equity

 

 

 

 

 

Common stock, $2.50 par value, 500 shares authorized, 222.3 and 222.4 shares issued

 

2,082

 

2,058

 

Retained earnings

 

7,850

 

7,343

 

Treasury stock, at cost, 35.0 and 32.6 shares

 

(2,112

)

(1,830

)

Common stock held by employee benefits trust, at cost, 1.4 and 1.5 shares

 

(17

)

(18

)

Accumulated other comprehensive loss (Note 14)

 

 

 

 

 

Defined benefit postretirement plans

 

(754

)

(794

)

Other

 

(345

)

(156

)

Total accumulated other comprehensive loss

 

(1,099

)

(950

)

Total Cummins Inc. shareholders’ equity

 

6,704

 

6,603

 

Noncontrolling interests

 

389

 

371

 

Total equity

 

7,093

 

6,974

 

Total liabilities and equity

 

$

13,048

 

$

12,548

 

 

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

 

5



Table of Contents

 

CUMMINS INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

 

 

 

Six months ended

 

In millions

 

June 30, 2013

 

July 1, 2012

 

CASH FLOWS FROM OPERATING ACTIVITIES

 

 

 

 

 

Consolidated net income

 

$

753

 

$

970

 

Adjustments to reconcile consolidated net income to net cash provided by operating activities

 

 

 

 

 

Restructuring payments, net(Note 15)

 

(23

)

 

Depreciation and amortization

 

200

 

171

 

Gain on sale of businesses

 

 

(6

)

Gain on fair value adjustment for consolidated investees (Note 3)

 

(12

)

 

Deferred income taxes

 

20

 

(39

)

Equity in income of investees, net of dividends

 

(57

)

(25

)

Pension contributions in excess of expense (Note 4)

 

(78

)

(52

)

Other post-retirement benefits payments in excess of expense (Note 4)

 

(15

)

(7

)

Stock-based compensation expense

 

19

 

21

 

Excess tax benefits on stock-based awards

 

(8

)

(11

)

Translation and hedging activities

 

3

 

7

 

Changes in current assets and liabilities, net of acquisitions:

 

 

 

 

 

Accounts and notes receivable

 

(265

)

(116

)

Inventories

 

(184

)

(439

)

Other current assets

 

214

 

(47

)

Accounts payable

 

310

 

61

 

Accrued expenses

 

(87

)

(173

)

Changes in other liabilities and deferred revenue

 

100

 

103

 

Other, net

 

70

 

(21

)

Net cash provided by operating activities

 

960

 

397

 

 

 

 

 

 

 

CASH FLOWS FROM INVESTING ACTIVITIES

 

 

 

 

 

Capital expenditures

 

(275

)

(266

)

Investments in internal use software

 

(24

)

(40

)

Investments in and advances to equity investees

 

(4

)

(40

)

Acquisition of businesses, net of cash acquired (Note 3)

 

(134

)

(12

)

Investments in marketable securities—acquisitions (Note 7)

 

(243

)

(276

)

Investments in marketable securities—liquidations (Note 7)

 

280

 

280

 

Cash flows from derivatives not designated as hedges

 

(23

)

1

 

Other, net

 

12

 

3

 

Net cash used in investing activities

 

(411

)

(350

)

 

 

 

 

 

 

CASH FLOWS FROM FINANCING ACTIVITIES

 

 

 

 

 

Proceeds from borrowings

 

2

 

46

 

Payments on borrowings and capital lease obligations

 

(51

)

(75

)

Net borrowings under short-term credit agreements

 

56

 

3

 

Distributions to noncontrolling interests

 

(28

)

(32

)

Dividend payments on common stock

 

(189

)

(152

)

Repurchases of common stock

 

(289

)

(196

)

Excess tax benefits on stock-based awards

 

8

 

11

 

Other, net

 

18

 

9

 

Net cash used in financing activities

 

(473

)

(386

)

EFFECT OF EXCHANGE RATE CHANGES ON CASH AND CASH EQUIVALENTS

 

(63

)

 

Net increase (decrease) in cash and cash equivalents

 

13

 

(339

)

Cash and cash equivalents at beginning of year

 

1,369

 

1,484

 

CASH AND CASH EQUIVALENTS AT END OF PERIOD

 

$

1,382

 

$

1,145

 

 

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

 

6



Table of Contents

 

CUMMINS INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN EQUITY

(Unaudited)

 

 

 

 

 

 

 

 

 

Accumulated

 

 

 

Common

 

Total

 

 

 

 

 

 

 

 

 

Additional

 

 

 

Other

 

 

 

Stock

 

Cummins Inc.

 

 

 

 

 

 

 

Common

 

paid-in

 

Retained

 

Comprehensive

 

Treasury

 

Held in

 

Shareholders’

 

Noncontrolling

 

Total

 

In millions

 

Stock

 

Capital

 

Earnings

 

Loss

 

Stock

 

Trust

 

Equity

 

Interests

 

Equity

 

BALANCE AT DECEMBER 31, 2011

 

$

555

 

$

1,446

 

$

6,038

 

$

(938

)

$

(1,587

)

$

(22

)

$

5,492

 

$

339

 

$

5,831

 

Net income

 

 

 

 

 

924

 

 

 

 

 

 

 

924

 

46

 

970

 

Other comprehensive income (loss)

 

 

 

 

 

 

 

(8

)

 

 

 

 

(8

)

(14

)

(22

)

Issuance of shares

 

1

 

3

 

 

 

 

 

 

 

 

 

4

 

 

4

 

Employee benefits trust activity

 

 

 

17

 

 

 

 

 

 

 

2

 

19

 

 

19

 

Acquisition of shares

 

 

 

 

 

 

 

 

 

(196

)

 

 

(196

)

 

(196

)

Cash dividends on common stock

 

 

 

 

 

(152

)

 

 

 

 

 

 

(152

)

 

(152

)

Distribution to noncontrolling interests

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(52

)

(52

)

Stock option exercises

 

 

 

 

 

 

 

 

 

6

 

 

 

6

 

 

6

 

Other shareholder transactions

 

 

 

14

 

 

 

 

 

 

 

 

 

14

 

15

 

29

 

BALANCE AT JULY 1, 2012

 

$

556

 

$

1,480

 

$

6,810

 

$

(946

)

$

(1,777

)

$

(20

)

$

6,103

 

$

334

 

$

6,437

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

BALANCE AT DECEMBER 31, 2012

 

$

556

 

$

1,502

 

$

7,343

 

$

(950

)

$

(1,830

)

$

(18

)

$

6,603

 

$

371

 

$

6,974

 

Net income

 

 

 

 

 

696

 

 

 

 

 

 

 

696

 

57

 

753

 

Other comprehensive income (loss)

 

 

 

 

 

 

 

(149

)

 

 

 

 

(149

)

(22

)

(171

)

Issuance of shares

 

 

 

3

 

 

 

 

 

 

 

 

 

3

 

 

3

 

Employee benefits trust activity

 

 

 

13

 

 

 

 

 

 

 

1

 

14

 

 

14

 

Acquisition of shares

 

 

 

 

 

 

 

 

 

(289

)

 

 

(289

)

 

(289

)

Cash dividends on common stock

 

 

 

 

 

(189

)

 

 

 

 

 

 

(189

)

 

(189

)

Distribution to noncontrolling interests

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(28

)

(28

)

Stock option exercises

 

 

 

1

 

 

 

 

 

7

 

 

 

8

 

 

8

 

Other shareholder transactions

 

 

 

7

 

 

 

 

 

 

 

 

 

7

 

11

 

18

 

BALANCE AT JUNE 30, 2013

 

$

556

 

$

1,526

 

$

7,850

 

$

(1,099

)

$

(2,112

)

$

(17

)

$

6,704

 

$

389

 

$

7,093

 

 

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

 

7



Table of Contents

 

CUMMINS INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

NOTE 1NATURE OF OPERATIONS

 

Cummins Inc. (“Cummins,” “we,” “our” or “us”) was founded in 1919 as a corporation in Columbus, Indiana, as one of the first diesel engine manufacturers.  We are a global power leader that designs, manufactures, distributes and services diesel and natural gas engines and engine-related component products, including filtration, aftertreatment, turbochargers, fuel systems, controls systems, air handling systems and electric power generation systems.  We sell our products to original equipment manufacturers (OEMs), distributors and other customers worldwide.  We serve our customers through a network of approximately 600 company-owned and independent distributor locations and approximately 6,500 dealer locations in more than 190 countries and territories.

 

NOTE 2.  BASIS OF PRESENTATION

 

The unaudited Condensed Consolidated Financial Statements reflect all adjustments which, in the opinion of management, are necessary for a fair statement of the results of operations, financial position and cash flows.  All such adjustments are of a normal recurring nature.  The Condensed Consolidated Financial Statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (SEC) and in accordance with accounting principles generally accepted in the United States of America (GAAP) for interim financial information.  Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with GAAP have been condensed or omitted as permitted by such rules and regulations.  Certain reclassifications have been made to prior period amounts to conform to the presentation of the current period condensed financial statements.

 

Our reporting period usually ends on the Sunday closest to the last day of the quarterly calendar period.  The second quarters of 2013 and 2012 ended on June 30 and July 1, respectively.  The interim period for both 2013 and 2012 contained 13 weeks, while the six month periods both contained 26 weeks.  Our fiscal year ends on December 31, regardless of the day of the week on which December 31 falls.

 

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect reported amounts in the Condensed Consolidated Financial Statements.  Significant estimates and assumptions in these Condensed Consolidated Financial Statements require the exercise of judgment and are used for, but not limited to, allowance for doubtful accounts, estimates of future cash flows and other assumptions associated with goodwill and long-lived asset impairment tests, useful lives for depreciation and amortization, warranty programs, determination of discount and other rate assumptions for pension and other postretirement benefit expenses, income taxes and deferred tax valuation allowances, lease classifications and contingencies.  Due to the inherent uncertainty involved in making estimates, actual results reported in future periods may be different from these estimates.

 

The weighted-average diluted common shares outstanding exclude the anti-dilutive effect of certain stock options since such options had an exercise price in excess of the monthly average market value of our common stock.  The options excluded from diluted earnings per share for the three and six month periods ended June 30, 2013 and July 1, 2012, were as follows:

 

 

 

Three months ended

 

Six months ended

 

 

 

June 30, 2013

 

July 1, 2012

 

June 30, 2013

 

July 1, 2012

 

Options excluded

 

693,550

 

439,328

 

626,527

 

332,802

 

 

You should read these interim condensed financial statements in conjunction with the Consolidated Financial Statements included in our Annual Report on Form 10-K for the year ended December 31, 2012.  Our interim period financial results for the three and six month interim periods presented are not necessarily indicative of results to be expected for any other interim period or for the entire year.  The year-end Condensed Consolidated Balance Sheet data was derived from audited financial statements, but does not include all disclosures required by GAAP.

 

NOTE 3.  ACQUISITIONS

 

Cummins Rocky Mountain LLC

 

In May 2013, we acquired the remaining 67 percent interest in Cummins Rocky Mountain LLC (Rocky Mountain) from the former principal for consideration of approximately $62 million in cash and an additional $74 million in cash paid to creditors to eliminate all debt related to the entity.  The purchase price was approximately $136 million as presented below.  The intangible assets are primarily

 

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customer related and are being amortized over periods ranging from 1 to 4 years.  The acquisition was accounted for as a business combination, with the results of the acquired entity included in the Distribution operating segment in the second quarter of 2013.

 

Distribution segment results also included a $5 million gain, as we were required to re-measure our pre-existing 33 percent ownership interest in Rocky Mountain to fair value in accordance with GAAP.  Net sales for Rocky Mountain were $384 million for the 12 months ended December 31, 2012.  This amount is not fully incremental to Cummins Inc. as the amount would be reduced by the elimination of sales to the previously unconsolidated entity.  Approximately $14 million of the purchase price will be distributed in future quarters.

 

The preliminary purchase price allocation, subject to finalization, was as follows:

 

In millions

 

 

 

Accounts receivable

 

$

48

 

Inventory

 

99

 

Fixed assets

 

34

 

Intangible assets

 

7

 

Goodwill

 

6

 

Other assets

 

9

 

Current liabilities

 

(36

)

Total business valuation

 

167

 

Fair value of pre-existing 33 percent interest

 

(31

)

Purchase price

 

$

136

 

 

Cummins Northwest LLC

 

In January 2013, we acquired an additional 50 percent interest in Cummins Northwest LLC (Northwest) from the former principal for consideration of approximately $18 million.   We formed a new partnership with a new distributor principal.  We own 79.99 percent of Northwest and the new distributor principal owns 20.01 percent. The acquisition was accounted for as a business combination, with the results of the acquired entity included in the Distribution operating segment in the first quarter of 2013.  Distribution segment results also included a $7 million gain, as we were required to re-measure our pre-existing 50 percent ownership interest in Northwest to fair value in accordance with GAAP.  The transaction generated $3 million of goodwill.  Net sales for Northwest were $137 million for the 12 months ended December 31, 2012.  This amount is not fully incremental to Cummins Inc. as the amount would be reduced by the elimination of sales to the previously unconsolidated entity.

 

NOTE 4. PENSION AND OTHER POSTRETIREMENT BENEFITS

 

We sponsor funded and unfunded domestic and foreign defined benefit pension and other postretirement plans. Contributions to these plans were as follows:

 

 

 

Three months ended

 

Six months ended

 

 

 

June 30,

 

July 1,

 

June 30,

 

July 1,

 

In millions

 

2013

 

2012

 

2013

 

2012

 

Defined benefit pension and other postretirement plans

 

 

 

 

 

 

 

 

 

Voluntary contribution

 

$

38

 

$

35

 

$

77

 

$

73

 

Mandatory contribution

 

7

 

6

 

44

 

11

 

Defined benefit pension contributions

 

45

 

41

 

121

 

84

 

Other postretirement plans

 

12

 

8

 

26

 

17

 

Total defined benefit plans

 

$

57

 

$

49

 

$

147

 

$

101

 

 

 

 

 

 

 

 

 

 

 

Defined contribution pension plans

 

$

14

 

$

17

 

$

36

 

$

44

 

 

We made $121 million of pension contributions in the six months ended June 30, 2013 and we anticipate making an additional $49 million of contributions during the remainder of 2013.  We paid $26 million of claims and premiums for other postretirement benefits in the six months ended June 30, 2013; payments for the remainder of 2013 are expected to be $21 million.  The $170 million of pension contributions for the full year include voluntary contributions of approximately $115 million.  These contributions and payments may be made from trusts or company funds either to increase pension assets or to make direct benefit payments to plan

 

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participants.  Our expected pension expense for 2013 has been reduced $10 million, to $87 million, from the amount we had expected at December 31, 2012, due to a remeasurement of the U.S. plan for changes in employee census data in the first quarter of 2013.

 

The components of net periodic pension and other postretirement benefit cost under our plans consisted of the following:

 

 

 

Pension

 

 

 

 

 

 

 

U.S. Plans

 

U.K. Plans

 

Other Postretirement Benefits

 

 

 

Three months ended

 

 

 

June 30,

 

July 1,

 

June 30,

 

July 1,

 

June 30,

 

July 1,

 

In millions

 

2013

 

2012

 

2013

 

2012

 

2013

 

2012

 

Service cost

 

$

18

 

$

15

 

$

5

 

$

5

 

$

 

$

 

Interest cost

 

23

 

26

 

14

 

15

 

4

 

5

 

Expected return on plan assets

 

(42

)

(39

)

(18

)

(21

)

 

 

Amortization of prior service credit

 

 

 

 

 

 

(1

)

Recognized net actuarial loss

 

15

 

11

 

6

 

4

 

1

 

1

 

Net periodic benefit cost

 

$

14

 

$

13

 

$

7

 

$

3

 

$

5

 

$

5

 

 

 

 

Pension

 

 

 

 

 

 

 

U.S. Plans

 

U.K. Plans

 

Other Postretirement Benefits

 

 

 

Six months ended

 

 

 

June 30,

 

July 1,

 

June 30,

 

July 1,

 

June 30,

 

July 1,

 

In millions

 

2013

 

2012

 

2013

 

2012

 

2013

 

2012

 

Service cost

 

$

35

 

$

29

 

$

10

 

$

11

 

$

 

$

 

Interest cost

 

47

 

52

 

28

 

29

 

8

 

10

 

Expected return on plan assets

 

(84

)

(78

)

(36

)

(41

)

 

 

Amortization of prior service credit

 

 

 

 

 

 

(2

)

Recognized net actuarial loss

 

31

 

23

 

12

 

7

 

3

 

2

 

Net periodic benefit cost

 

$

29

 

$

26

 

$

14

 

$

6

 

$

11

 

$

10

 

 

NOTE 5.  EQUITY, ROYALTY AND INTEREST INCOME FROM INVESTEES

 

Equity, royalty and interest income from investees included in our Condensed Consolidated Statements of Income for the interim reporting periods was as follows:

 

 

 

Three months ended

 

Six months ended

 

 

 

June 30,

 

July 1,

 

June 30,

 

July 1,

 

In millions

 

2013

 

2012

 

2013

 

2012

 

Distribution Entities

 

 

 

 

 

 

 

 

 

North American distributors

 

$

29

 

$

38

 

$

64

 

$

78

 

Komatsu Cummins Chile, Ltda.

 

6

 

6

 

11

 

11

 

All other distributors

 

 

2

 

 

3

 

Manufacturing Entities

 

 

 

 

 

 

 

 

 

Dongfeng Cummins Engine Company, Ltd.

 

20

 

17

 

32

 

33

 

Chongqing Cummins Engine Company, Ltd.

 

17

 

17

 

29

 

35

 

Beijing Foton Cummins Engine Co., Ltd.

 

9

 

2

 

10

 

 

Shanghai Fleetguard Filter Co., Ltd.

 

4

 

4

 

7

 

7

 

Komatsu manufacturing alliances

 

4

 

1

 

3

 

 

Cummins Westport, Inc.

 

3

 

4

 

3

 

9

 

Valvoline Cummins, Ltd.

 

2

 

2

 

5

 

4

 

Tata Cummins, Ltd.

 

2

 

3

 

3

 

7

 

Xian Cummins Engine Company Ltd.

 

1

 

(5

)

1

 

(6

)

All other manufacturers

 

1

 

4

 

3

 

6

 

Cummins share of net income

 

98

 

95

 

171

 

187

 

Royalty and interest income

 

10

 

9

 

19

 

21

 

Equity, royalty and interest income from investees

 

$

108

 

$

104

 

$

190

 

$

208

 

 

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NOTE 6.  INCOME TAXES

 

Our effective tax rate for the year is expected to approximate 29.1 percent, excluding any one-time items that may arise.  Our tax rate is generally less than the 35 percent U.S. statutory income tax rate primarily due to lower tax rates on foreign income and research tax credits.  The tax rates for the three and six month periods ended June 30, 2013, were 28.1 percent and 27.9 percent, respectively.  These tax rates include a discrete tax benefit in the first quarter of 2013 of $28 million attributable to the reinstatement of the research credit back to 2012 as well as a discrete tax expense in the first quarter of 2013 of $17 million, which primarily relates to the write-off of a deferred tax asset deemed unrecoverable.  On January 2, 2013, the American Taxpayer Relief Act of 2012 was signed into law and reinstated the research tax credit.  As tax law changes are accounted for in the period of enactment, we recognized the discrete tax benefit in the first quarter of 2013.

 

Our tax rates for the three and six month periods ended July 1, 2012, were 25.1 percent and 26.0 percent, respectively.  The increase in the 2013 effective tax rates compared to 2012 is due primarily to an unfavorable change in the pre-tax mix of income taxed in higher rate jurisdictions, partially offset by $11 million of net discrete tax benefits in the first quarter of 2013.

 

NOTE 7.  MARKETABLE SECURITIES

 

A summary of marketable securities, all of which are classified as current, was as follows:

 

 

 

June 30, 2013

 

December 31, 2012

 

In millions

 

Cost

 

Gross unrealized
gains/(losses)

 

Estimated
fair value

 

Cost

 

Gross unrealized
gains/(losses)

 

Estimated
fair value

 

Available-for-sale

 

 

 

 

 

 

 

 

 

 

 

 

 

Debt mutual funds(1)

 

$

116

 

$

1

 

$

117

 

$

139

 

$

3

 

$

142

 

Bank debentures

 

12

 

 

12

 

45

 

 

45

 

Certificates of deposit

 

51

 

 

51

 

47

 

 

47

 

Government debt securities-non-U.S.

 

3

 

 

3

 

3

 

 

3

 

Corporate debt securities

 

1

 

 

1

 

1

 

 

1

 

Equity securities and other(2)

 

12

 

9

 

21

 

 

9

 

9

 

Total marketable securities

 

$

195

 

$

10

 

$

205

 

$

235

 

$

12

 

$

247

 

 


(1) Contractual maturities are only applicable to debt mutual funds that utilize a Level 2 fair value.

(2) In the first quarter of 2013 we realized a $9 million gain on the sale of equity securities.

 

At June 30, 2013, the fair value of available-for-sale investments with contractual maturities was as follows:

 

Maturity date

 

 

 

In millions

 

Fair value

 

1 year or less

 

$

82

 

1-5 years

 

5

 

5-10 years

 

1

 

Total

 

$

88

 

 

NOTE 8.  FAIR VALUE OF FINANCIAL INSTRUMENTS

 

The majority of the assets and liabilities we carry at fair value are available-for-sale (AFS) securities and derivatives.  AFS securities are derived from Level 1 or Level 2 inputs.  Derivative assets and liabilities are derived from Level 2 inputs.  The predominance of market inputs are actively quoted and can be validated through external sources, including brokers, market transactions and third-party pricing services.  When material, we adjust the values of our derivative contracts for counter-party or our credit risk.  There were no transfers into or out of Levels 2 or 3 in the first six months of 2013 and 2012.

 

The following table summarizes our financial instruments recorded at fair value in our Condensed Consolidated Balance Sheets at June 30, 2013:

 

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Fair Value Measurements Using

 

 

 

Quoted prices in
active markets for
identical assets

 

Significant other
observable inputs

 

Significant
unobservable inputs

 

 

 

In millions

 

(Level 1)

 

(Level 2)

 

(Level 3)

 

Total

 

Available-for-sale debt securities

 

 

 

 

 

 

 

 

 

Debt mutual funds

 

$

96

 

$

21

 

$

 

$

117

 

Bank debentures

 

 

12

 

 

12

 

Certificates of deposit

 

 

51

 

 

51

 

Government debt securities-non-U.S.

 

 

3

 

 

3

 

Corporate debt securities

 

 

1

 

 

1

 

 

 

 

 

 

 

 

 

 

 

Available-for-sale equity securities

 

 

 

 

 

 

 

 

 

Information technology industry

 

21

 

 

 

21

 

 

 

 

 

 

 

 

 

 

 

Derivative assets

 

 

 

 

 

 

 

 

 

Interest rate contracts

 

 

60

 

 

60

 

Foreign currency forward contracts

 

 

1

 

 

1

 

Commodity call option contracts

 

 

1

 

 

1

 

Total assets

 

$

117

 

$

150

 

$

 

$

267

 

 

 

 

 

 

 

 

 

 

 

Derivative liabilities

 

 

 

 

 

 

 

 

 

Commodity swap contracts

 

 

11

 

 

11

 

Foreign currency forward contracts

 

 

7

 

 

7

 

Commodity put option contracts

 

 

4

 

 

4

 

Total liabilities

 

$

 

$

22

 

$

 

$

22

 

 

The following table summarizes our financial instruments recorded at fair value in our Condensed Consolidated Balance Sheets at December 31, 2012:

 

 

 

Fair Value Measurements Using

 

 

 

Quoted prices in
active markets for
identical assets

 

Significant other
observable inputs

 

Significant
unobservable inputs

 

 

 

In millions

 

(Level 1)

 

(Level 2)

 

(Level 3)

 

Total

 

Available-for-sale debt securities

 

 

 

 

 

 

 

 

 

Debt mutual funds

 

$

100

 

$

42

 

$

 

$

142

 

Bank debentures

 

 

45

 

 

45

 

Certificates of deposit

 

 

47

 

 

47

 

Government debt securities-non-U.S.

 

 

3

 

 

3

 

Corporate debt securities

 

 

1

 

 

1

 

 

 

 

 

 

 

 

 

 

 

Available-for-sale equity securities

 

 

 

 

 

 

 

 

 

Financial services industry

 

9

 

 

 

9

 

 

 

 

 

 

 

 

 

 

 

Derivative assets

 

 

 

 

 

 

 

 

 

Interest rate contracts

 

 

88

 

 

88

 

Foreign currency forward contracts

 

 

3

 

 

3

 

Commodity swap contracts

 

 

1

 

 

1

 

Commodity call option contracts

 

 

1

 

 

1

 

Total assets

 

$

109

 

$

231

 

$

 

$

340

 

 

 

 

 

 

 

 

 

 

 

Derivative liabilities

 

 

 

 

 

 

 

 

 

Commodity swap contracts

 

 

2

 

 

2

 

Commodity put option contracts

 

 

1

 

 

1

 

Total liabilities

 

$

 

$

3

 

$

 

$

3

 

 

The substantial majority of our assets were valued utilizing a market approach.  A description of the valuation techniques and inputs used for our level 2 fair value measures are as follows:

 

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Table of Contents

 

·                  Debt mutual funds — Assets in Level 2 consist of exchange traded mutual funds that lack sufficient trading volume to be classified at Level 1.  The fair value measure for these investments is the daily net asset value published on a regulated governmental website.  Daily quoted prices are available from the issuing brokerage and are used on a test basis to corroborate this Level 2 input.

 

·                  Bank debentures and Certificates of deposit — These investments provide us with a fixed rate of return and generally range in maturity from six months to five years.  The counter-parties to these investments are reputable financial institutions with investment grade credit ratings.  Since these instruments are not tradable and must be settled directly by us with the respective financial institution, our fair value measure is the financial institutions’ month-end statement.

 

·                  Government debt securities-non-U.S. and Corporate debt securities — The fair value measure for these securities are broker quotes received from reputable firms.  These securities are infrequently traded on a national stock exchange and these values are used on a test basis to corroborate our Level 2 input measure.

 

·                  Foreign currency forward contracts — The fair value measure for these contracts are determined based on forward foreign exchange rates received from third-party pricing services.  These rates are based upon market transactions and are periodically corroborated by comparing to third-party broker quotes.

 

·                  Commodity swap contracts — The fair value measure for these contracts are current spot market data adjusted for the appropriate current forward curves provided by external financial institutions.  The current spot price is the most significant component of this valuation and is based upon market transactions.  We use third-party pricing services for the spot price component of this valuation which is periodically corroborated by market data from broker quotes.

 

·                  Commodity call and put option contracts — We utilize the month-end statement from the issuing financial institution as our fair value measure for this investment.  We corroborate this valuation through the use of a third-party pricing service for similar assets and liabilities.

 

·                  Interest rate contracts — We currently have only one interest rate contract.  We utilize the month-end statement from the issuing financial institution as our fair value measure for this investment.  We corroborate this valuation through the use of a third-party pricing service for similar assets and liabilities.

 

Fair Value of Other Financial Instruments

 

Based on borrowing rates currently available to us for bank loans with similar terms and average maturities, considering our risk premium, the fair value and carrying value of total debt, including current maturities, at June 30, 2013 and December 31, 2012, are set forth in the table below.  The carrying values of all other receivables and liabilities approximated fair values.  The fair value of financial instruments is derived from Level 2 inputs.

 

 

 

June 30,

 

December 31,

 

In millions

 

2013

 

2012

 

Fair value of total debt

 

$

947

 

$

926

 

Carrying value of total debt

 

837

 

775

 

 

NOTE 9.  INVENTORIES

 

Inventories are stated at the lower of cost or market.  Inventories included the following:

 

 

 

June 30,

 

December 31,

 

In millions

 

2013

 

2012

 

Finished products

 

$

1,561

 

$

1,393

 

Work-in-process and raw materials

 

1,026

 

939

 

Inventories at FIFO cost

 

2,587

 

2,332

 

Excess of FIFO over LIFO

 

(112

)

(111

)

Total inventories

 

$

2,475

 

$

2,221

 

 

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Table of Contents

 

NOTE 10.  DEBT

 

A summary of long-term debt was as follows:

 

 

 

June 30,

 

December 31,

 

In millions

 

2013

 

2012

 

Long-term debt

 

 

 

 

 

Export financing loan, 4.5%, due 2013

 

 

23

 

Debentures, 6.75%, due 2027

 

58

 

58

 

Debentures, 7.125%, due 2028

 

250

 

250

 

Debentures, 5.65%, due 2098 (effective interest rate 7.48%)

 

165

 

165

 

Credit facilities related to consolidated joint ventures

 

125

 

88

 

Other

 

75

 

69

 

 

 

673

 

653

 

Unamortized discount

 

(35

)

(35

)

Fair value adjustments due to hedge on indebtedness

 

60

 

88

 

Capital leases

 

99

 

53

 

Total long-term debt

 

797

 

759

 

Less: Current maturities of long-term debt

 

(43

)

(61

)

Long-term debt

 

$

754

 

$

698

 

 

Principal payments required on long-term debt during the next five years are the following:

 

 

 

Required Principal Payments

 

In millions

 

2013

 

2014

 

2015

 

2016

 

2017

 

Payment

 

$

23

 

$

46

 

$

76

 

$

82

 

$

14

 

 

NOTE 11.  PRODUCT WARRANTY LIABILITY

 

We charge the estimated costs of warranty programs, other than product recalls, to income at the time products are shipped to customers.  We use historical claims experience to develop the estimated liability.  We review product recall programs on a quarterly basis and, if necessary, record a liability when we commit to an action, or when they become probable and estimable, which is reflected in the provision for warranties issued line.  We also sell extended warranty coverage on several engines.  The following is a tabular reconciliation of the product warranty liability, including the deferred revenue related to our extended warranty coverage and accrued recall programs:

 

 

 

Six months ended

 

 

 

June 30,

 

July 1,

 

In millions 

 

2013

 

2012

 

Balance, beginning of year

 

$

1,088

 

$

1,014

 

Provision for warranties issued

 

227

 

227

 

Deferred revenue on extended warranty contracts sold

 

93

 

98

 

Payments

 

(210

)

(196

)

Amortization of deferred revenue on extended warranty contracts

 

(56

)

(51

)

Changes in estimates for pre-existing warranties

 

(13

)

(27

)

Foreign currency translation

 

(6

)

(3

)

Balance, end of period

 

$

1,123

 

$

1,062

 

 

Warranty related deferred revenue, supplier recovery receivables and the long-term portion of the warranty liability on our June 30, 2013, balance sheet were as follows:

 

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Table of Contents

 

 

 

June 30,

 

 

 

In millions

 

2013

 

Balance Sheet Location

 

Deferred revenue related to extended coverage programs

 

 

 

 

 

Current portion

 

$

124

 

Deferred revenue

 

Long-term portion

 

333

 

Other liabilities and deferred revenue

 

Total

 

$

457

 

 

 

 

 

 

 

 

 

Receivables related to estimated supplier recoveries

 

 

 

 

 

Current portion

 

$

5

 

Trade and other receivables

 

Long-term portion

 

5

 

Other assets

 

Total

 

$

10

 

 

 

 

 

 

 

 

 

Long-term portion of warranty liability

 

$

273

 

Other liabilities and deferred revenue

 

 

NOTE 12.  COMMITMENTS AND CONTINGENCIES

 

We are subject to numerous lawsuits and claims arising out of the ordinary course of our business, including actions related to product liability; personal injury; the use and performance of our products; warranty matters; patent, trademark or other intellectual property infringement; contractual liability; the conduct of our business; tax reporting in foreign jurisdictions; distributor termination; workplace safety; and environmental matters. We also have been identified as a potentially responsible party at multiple waste disposal sites under U.S. federal and related state environmental statutes and regulations and may have joint and several liability for any investigation and remediation costs incurred with respect to such sites.  We have denied liability with respect to many of these lawsuits, claims and proceedings and are vigorously defending such lawsuits, claims and proceedings.  We carry various forms of commercial, property and casualty, product liability and other forms of insurance; however, such insurance may not be applicable or adequate to cover the costs associated with a judgment against us with respect to these lawsuits, claims and proceedings.  We do not believe that these lawsuits are material individually or in the aggregate.  While we believe we have also established adequate accruals for our expected future liability with respect to pending lawsuits, claims and proceedings, where the nature and extent of any such liability can be reasonably estimated based upon then presently available information, there can be no assurance that the final resolution of any existing or future lawsuits, claims or proceedings will not have a material adverse effect on our business, results of operations, financial condition or cash flows.

 

We conduct significant business operations in Brazil that are subject to the Brazilian federal, state and local labor, social security, tax and customs laws.  While we believe we comply with such laws, they are complex, subject to varying interpretations and we are often engaged in litigation regarding the application of these laws to particular circumstances.

 

U.S. Distributor Commitments

 

Our distribution agreements with independent and partially-owned distributors generally have a renewable three-year term and are restricted to specified territories.  Our distributors develop and maintain a network of dealers with which we have no direct relationship.  Our distributors are permitted to sell other, noncompetitive products only with our consent.  We license all of our distributors to use our name and logo in connection with the sale and service of our products, with no right to assign or sublicense the trademarks, except to authorized dealers, without our consent.  Products are sold to the distributors at standard domestic or international distributor net prices, as applicable.  Net prices are wholesale prices we establish to permit our distributors an adequate margin on their sales.  Subject to local laws, we can generally refuse to renew these agreements upon expiration or terminate them upon written notice for inadequate sales, change in principal ownership and certain other reasons.  Distributors also have the right to terminate the agreements upon 60-day notice without cause, or 30-day notice for cause.  Upon termination or failure to renew, we are required to purchase the distributor’s current inventory, signage and special tools and may, at our option purchase other assets of the distributor, but are under no obligation to do so.

 

Other Guarantees and Commitments

 

In addition to the matters discussed above, from time to time we periodically enter into other guarantee arrangements, including guarantees of non-U.S. distributor financing, residual value guarantees on equipment under operating leases and other miscellaneous guarantees of third-party obligations.  As of June 30, 2013, the maximum potential loss related to these other guarantees is summarized as follows (where the guarantee is in a foreign currency the amount below represents the amount in U.S. dollars at current exchange rates):

 

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In millions

 

 

 

Cummins Olayan Energy Limited debt guarantee

 

$

8

 

Residual value guarantees

 

1

 

Other debt guarantees

 

3

 

Maximum potential loss

 

$

12

 

 

The amount of liabilities related to the above guarantees was less than $1 million.

 

We have arrangements with certain suppliers that require us to purchase minimum volumes or be subject to monetary penalties.  The penalty amounts are less than our purchase commitments and essentially allow the supplier to recover their tooling costs in most instances.  As of June 30, 2013, if we were to stop purchasing from each of these suppliers, the aggregate amount of the penalty would be approximately $118 million, of which $80 million relates to a contract with an engine parts supplier that extends to 2016.  These arrangements enable us to secure critical components.  We do not currently anticipate paying any penalties under these contracts.

 

We have guarantees with certain customers that require us to satisfactorily honor contractual or regulatory obligations, or compensate for monetary losses related to nonperformance.  These performance bonds and other performance-related guarantees were $68 million at June 30, 2013 and $70 million at December 31, 2012.

 

Indemnifications

 

Periodically, we enter into various contractual arrangements where we agree to indemnify a third-party against certain types of losses.  Common types of indemnities include:

 

·                  product liability and license, patent or trademark indemnifications,

 

·                  asset sale agreements where we agree to indemnify the purchaser against future environmental exposures related to the asset sold and

 

·                  any contractual agreement where we agree to indemnify the counter-party for losses suffered as a result of a misrepresentation in the contract.

 

We regularly evaluate the probability of having to incur costs associated with these indemnities and accrue for expected losses that are probable.  Because the indemnifications are not related to specified known liabilities and due to their uncertain nature, we are unable to estimate the maximum amount of the potential loss associated with these indemnifications.

 

Joint Venture Commitments

 

As of June 30, 2013, we have committed to invest an additional $64 million into existing joint ventures, of which $19 million is expected to be funded in 2013.

 

NOTE 13.  DERIVATIVES

 

We are exposed to financial risk resulting from volatility in foreign exchange rates, commodity prices and interest rates.  This risk is closely monitored and managed through the use of financial derivative instruments including foreign currency forward contracts, commodity swap contracts, commodity zero-cost collars 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 speculative purposes.  When material, we adjust the value of our derivative contracts for counter-party or our credit risk.  None of our derivative instruments are subject to collateral requirements.  Substantially all of our derivative contracts are subject to master netting arrangements which provide us with the option to settle certain contracts on a net basis when they settle on the same day with the same currency.  In addition, these arrangements provide for a net settlement of all contracts with a given counterparty in the event that the arrangement is terminated due to the occurrence of default or a termination event.

 

Foreign Exchange Rates

 

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 income experiences some volatility related to movements in foreign currency exchange rates.  To help manage our exposure to exchange rate volatility, we use foreign currency forward contracts on a regular basis to hedge forecasted

 

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intercompany and third-party sales and purchases denominated in non-functional currencies.  Our internal policy allows for managing

anticipated foreign currency cash flows for up to one year.  These foreign currency forward contracts are designated and qualify as foreign currency cash flow hedges under GAAP.  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” (AOCL).  When the hedged forecasted transaction (sale or purchase) occurs, the unrealized gain or loss is reclassified into income in the same line item associated with the hedged transaction in the same period or periods during which the hedged transaction affects income.  The ineffective portion of the hedge, if any, is recognized in current income during the period of change.  As of June 30, 2013, the amount we expect to reclassify from AOCL to income over the next year is an unrealized net loss of $3 million.  For the six month periods ended June 30, 2013 and July 1, 2012, there were no circumstances that would have resulted in the discontinuance of a foreign currency cash flow hedge.

 

To minimize the income volatility resulting from the remeasurement of net monetary assets and payables denominated in a currency other than the functional currency, we enter into foreign currency forward contracts, which are considered economic hedges.  The objective is to offset the gain or loss from remeasurement with the gain or loss from the fair market valuation of the forward contract.  These derivative instruments are not designated as hedges under GAAP.

 

The table below summarizes our outstanding foreign currency forward contracts. Only the U.S. dollar forward contracts are designated and qualify for hedge accounting as of each period presented below. The currencies in this table represent 92 percent and 95 percent of the notional amounts of contracts outstanding as of June 30, 2013 and December 31, 2012, respectively.

 

 

 

Notional amount in millions

 

 

 

June 30,

 

December 31,

 

Currency denomination

 

2013

 

2012

 

United States Dollar (USD)

 

109

 

110

 

British Pound Sterling (GBP)

 

207

 

227

 

Euro (EUR)

 

18

 

28

 

Indian Rupee (INR)

 

2,401

 

1,943

 

Japanese Yen (JPY)

 

1,151

 

384

 

Canadian Dollar (CAD)

 

59

 

59

 

South Korea Won (KRW)

 

31,938

 

35,266

 

Chinese Renmimbi (CNY)

 

66

 

45

 

Singapore Dollar (SGD)

 

 

3

 

 

Commodity Price Risk

 

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 swap 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.  Certain commodity swap contracts are derivative contracts that are designated as cash flow hedges under GAAP.  We also have commodity swap contracts that represent an economic hedge, but are not designated for hedge accounting and are marked to market through earnings.  For those contracts that qualify for hedge accounting, the effective portion of the unrealized gain or loss is deferred and reported as a component of AOCL.  When the hedged forecasted transaction (purchase) occurs, the unrealized gain or loss is reclassified into income in the same line item associated with the hedged transaction in the same period or periods during which the hedged transaction affects income.  The ineffective portion of the hedge, if any, is recognized in current income in the period in which the ineffectiveness occurs.  As of June 30, 2013, we expect to reclassify an unrealized net loss of $6 million from AOCL to income over the next year.  Our internal policy allows for managing these cash flow hedges for up to three years.

 

The following table summarizes our outstanding commodity swap contracts that were entered into to hedge the cost of certain raw material purchases:

 

Dollars in millions

 

June 30, 2013

 

December 31, 2012

 

Commodity

 

Notional Amount

 

Quantity

 

Notional Amount

 

Quantity