TEXTRON INC - TXT Annual Report (10-K) Notes to Consolidated Financial Statements

The following is an excerpt from a 10-K SEC Filing, filed by TEXTRON INC on 2/24/2005.

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Notes to Consolidated Financial Statements

Note 1 Summary of Significant Accounting Policies

Nature of Operations Textron Inc. ("Textron") is a global, multi-industry company with manufacturing and finance operations primarily in North America, Western Europe, South America and Asia/Pacific. Textron's principal markets are summarized below by segment:

Segment Principal Markets Bell • Commercial and military helicopters and tiltrotors • Defense and aerospace
• Piston aircraft engines

Cessna • General aviation aircraft
• Business jets including fractional ownership
• Commercial transportation, humanitarian flights, tourism and freight

Fastening Systems • Aerospace
• Automotive
• Computer, electronics, electrical and industrial equipment
• Construction
• Non-automotive transportation
• Telecommunications

Industrial • Automotive original equipment manufacturers and other industrial suppliers
• Golf courses, resort communities and municipalities, and commercial and industrial users
• Original equipment manufacturers, governments, distributors and end users of fluid and power systems
• Electrical construction and maintenance, telecommunications and plumbing industries

Finance • Secured commercial loans and leases

Principles of Consolidation and Financial Statement Presentation
The consolidated financial statements include the accounts of Textron Inc. and all of its majority-owned subsidiaries (more than 50%) along with entities that are required to be consolidated in accordance with Textron's consolidation policy. This policy requires the consolidation of variable interest entities in which Textron is designated as the primary beneficiary in accordance with Financial Accounting Standards Board ("FASB") Interpretation No. 46, "Consolidation of Variable Interest Entities" ("FIN 46"), as amended. FIN 46 requires the consolidation of variable interest entities in which an enterprise absorbs a majority of the entity's expected losses, receives a majority of the entity's expected residual returns, or both, as a result of ownership, contractual or other financial interests in the entity. Variable interest entities are defined as entities with a level of invested equity insufficient to fund future activities to operate on a standalone basis, or whose equity holders lack certain characteristics of a controlling financial interest. If an entity does not meet the definition of a variable interest entity under FIN 46, Textron accounts for the entity under the provisions of Accounting Principles Board ("APB") Opinion No. 18, "The Equity Method of Accounting for Investments in Common Stock," which requires the consolidation of all majority-owned subsidiaries where the company has the ability to exercise control.

Textron's financings are conducted through two borrowing groups: Textron Manufacturing and Textron Finance. This framework is designed to enhance Textron's borrowing power by separating the Finance segment. To support creditors in evaluating the separate borrowing groups, Textron presents separate balance sheets and statements of cash flows for each borrowing group. Textron Manufacturing consists of Textron Inc., the parent company, consolidated with the entities that operate in the Bell, Cessna, Fastening Systems and Industrial business segments. Textron Finance consists of Textron's wholly owned commercial finance subsidiary, Textron Financial Corporation, consolidated with its subsidiaries, which are the entities through which Textron operates its Finance segment. Textron Finance finances its operations by borrowing from its own group of external creditors. All significant intercompany transactions are eliminated, including retail and wholesale financing activities for inventory sold by Textron Manufacturing financed by Textron Finance.

Reclassifications A portion of Textron Finance's business involves financing retail purchases and leases for new and used aircraft and equipment manufactured by Textron Manufacturing's Bell, Cessna and Industrial segments. The cash flows related to these captive financing activities are reflected as operating activities (by Textron Manufacturing) and as investing activities (by Textron Finance) based on each group's operations. For example, when product is sold to a customer and financed by Textron Finance, Textron Finance

records the origination of the finance receivable within investing activities as a cash outflow. Textron Manufacturing records the cash received from Textron Finance on the customer's behalf within operating activities. Although cash is transferred between the businesses, there is no cash transaction for the consolidated group at the time of the original financing.

Historically, Textron's consolidated statement of cash flows has presented a combination of the cash flows of both borrowing groups with no elimination of the captive financing activity. Based on recent views expressed by the staff of the Securities and Exchange Commission about this industry-wide practice followed by companies with captive finance companies, in 2004, management elected to change the consolidated classification of these cash flows. Accordingly, the captive financing transactions have been eliminated, and cash from customers and securitizations is recognized in operating activities within the consolidated statement of cash flows when received. Prior period amounts reported in the consolidated statement of cash flows have been reclassified to conform with this new presentation; however, the separate cash flow presentations of Textron Manufacturing and Textron Finance are unchanged.

The impact of the reclassification of these cash flows between investing and operating activities, on a consolidated basis, for the prior periods presented is as follows:

Year Ended Year Ended January 3, 2004 December 28, 2002 As As As As (In millions) Reported Reclassified Reported Reclassified Net cash provided by operating activities $ 858 $ 985 $ 626 $ 676 Net cash provided (used) by investing activities $ 62 $ (65 ) $ (684 ) $ (734 )

Certain other prior period amounts have been reclassified to conform with the current year presentation.

Use of Estimates

The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in these statements and accompanying notes. Some of the more significant estimates include inventory valuation, residual values of leased assets, allowance for credit losses on receivables, product liability, workers' compensation, actuarial assumptions for the pension and postretirement plans, estimates of future cash flows associated with long-lived assets, environmental and warranty reserves, and amounts reported under long-term contracts. Management's estimates are based on the facts and circumstances available at the time estimates are made, historical experience, risk of loss, general economic conditions and trends, and management's assessments of the probable future outcomes of these matters. Actual results could differ from such estimates.

Cash and Cash Equivalents

Cash and cash equivalents consist of cash and short-term, highly liquid investments with original maturities of three months or less.

Revenue Recognition

Revenue is generally recognized when products are delivered or services are performed. With respect to aircraft, delivery is upon completion of manufacturing, customer acceptance, and the transfer of the risk and rewards of ownership.

When a sale arrangement involves multiple elements, such as sales of products that include customization and other services, the deliverables in the arrangement are evaluated to determine whether they represent separate units of accounting. This evaluation occurs at inception of the arrangement and as each item in the arrangement is delivered. The total fee from the arrangement is allocated to each unit of accounting based on its relative fair value, taking into consideration any performance, cancellation, termination or refund type provisions. Fair value for each element is established generally based on the sales price charged when the same or similar element is sold separately. Revenue is recognized when revenue recognition criteria for each unit of accounting are met.

Revenue from certain qualifying noncancelable aircraft and other product lease contracts are accounted for as sales-type leases. The present value of all payments (net of executory costs and any guaranteed residual values) is recorded as revenue, and the related costs of the product are charged to cost of sales. Generally, these leases are financed through Textron Finance, and the associated interest is recorded over the term of the lease agreement using the interest method. Lease financing transactions that do not qualify as sales-type leases are accounted for under the operating method wherein revenue is recorded as earned over the lease period.

Aircraft sales with guaranteed minimum resale values are viewed as leases and are accounted for in accordance with Emerging Issues Task Force No. 95-1, "Revenue Recognition on Sales with a Guaranteed Minimum Resale Value." To determine whether the transaction should be classified as an operating lease or as a sales-type lease, the minimum lease payments generally represent the difference between the proceeds upon the equipment's initial transfer and the present value of the residual value guarantee to the purchaser as of the first exercise date of the guarantee. If residual value insurance is obtained, the present value of the residual value insurance is also included in the minimum lease payments. Textron assesses the market values of the aircraft using both industry publications as well as actual sales of used aircraft. For fixed-wing aircraft, specific information related to the individual aircraft such as hours and condition may be available, and market value assessments are appropriately adjusted accordingly. For rotor aircraft, the guarantee arrangements require certain physical condition minimums, and/or require the aircraft to be covered under an extended maintenance plan. Rotor aircraft fair value estimates are valued accordingly. Losses are recorded currently if the estimated market value of the aircraft at the exercise date is less than the guaranteed amount.

Long-Term Contracts

Long-term contracts are accounted for under American Institute of Certified Public Accountants Statement of Position No. 81-1, "Accounting for Performance of Construction-Type and Certain Production-Type Contracts." Revenue under fixed-price contracts is generally recorded as deliveries are made under the units-of-delivery method. Certain long-term fixed-price contracts provide for periodic delivery after a lengthy period of time over which significant costs are incurred or require a significant amount of development effort in relation to total contract volume. Revenues under those contracts and all cost-reimbursement-type contracts are recorded as costs are incurred under the cost-to-cost method. Certain contracts are awarded with fixed-price incentive fees. Incentive fees are considered when estimating revenues and profit rates and are recorded when these amounts are reasonably determined. Long-term contract profits are based on estimates of total sales value and costs at completion. Such estimates are reviewed and revised periodically throughout the contract life. Revisions to contract profits are recorded when the revisions to estimated sales value or costs are made. Estimated contract losses are recorded when identified.

Bell Helicopter has a joint venture with The Boeing Company ("Boeing") to provide engineering, development and test services related to the V-22 aircraft, as well as to produce the V-22 aircraft, under a number of separate contracts with the U.S. Government (the "V-22 Contracts"). The V-22 Contracts include the development contract and various production release contracts (i.e., lots) that may run concurrently with multiple earlier lots still being produced as new lots are started. The development contract and the first three production lots are under cost-reimbursement-type contracts, while subsequent lots are under fixed-price incentive contracts. The first three lots under fixed-price incentive contracts have been accounted for under the cost-to-cost method, primarily as a result of the significant engineering effort required over a lengthy period of time during the initial development phase in relation to total contract volume. The production releases on the first six production lots include separately contracted modifications to meet the additional requirements of the U.S. Government's Blue Ribbon Panel. In 2003, the development effort was considered substantially complete for the new production releases beginning in 2003 and management believed a consistent production specification had been met as these units incorporate many of these modifications on the production line. Accordingly, revenue on the new production releases that began in 2003 is recognized under the units-of-delivery method.

Finance Revenues

Finance revenues include interest on finance receivables, which is recognized using the interest method to provide a constant rate of return over the terms of the receivables. Finance revenues also include direct loan origination costs and fees received, which are deferred and amortized over the contractual lives of the respective receivables using the interest method. Unamortized amounts are recognized in revenues when receivables are sold or prepaid. Accrual of interest income is suspended for accounts that are contractually delinquent by more than three months unless collection is not doubtful. In addition, detailed reviews of loans may result in earlier suspension if collection is doubtful. Accrual of interest is resumed when the loan becomes contractually current, and suspended interest income is recognized at that time.

Losses on Finance Receivables

Provisions for losses on finance receivables are charged to income in amounts sufficient to maintain the allowance at a level considered adequate to cover losses in the existing receivable portfolio. Management evaluates the allowance by examining current delinquencies, the characteristics of the existing accounts, historical loss experience, the value of the underlying collateral and general economic conditions and trends. Finance receivables are charged off when they are deemed to be uncollectible. Finance receivables are written down to the fair value (less estimated costs to sell) of the related collateral at the earlier of the date the collateral is repossessed or when no payment has been received for six months unless management deems the receivable collectible.

Loan Impairment

Textron Finance periodically evaluates finance receivables, excluding homogeneous loan portfolios and finance leases, for impairment. A loan is considered impaired when it is probable that Textron Finance will be unable to collect all amounts due according to the contractual terms of the loan agreement. In addition, Textron Finance identifies loans that are considered impaired due to the significant modification of the original loan terms to reflect deferred principal payments generally at market interest rates but which continue to accrue finance charges since full collection of principal and interest is not doubtful. Impairment is measured by comparing the fair value of a loan with its carrying amount. Fair value is based on the present value of expected future cash flows discounted at the loan's effective interest rate, the loan's observable market price or, if the loan is collateral dependent, at the fair value of the collateral, less selling costs. If the fair value of the loan is less than its carrying amount, Textron Finance establishes a reserve based on this difference. This evaluation is inherently subjective, as it requires estimates, including the amount and timing of future cash flows expected to be received on impaired loans, that may differ from actual results.

Securitized Transactions

Textron Finance sells or securitizes loans and leases and retains servicing responsibilities and subordinated interests, including interest-only securities, subordinated certificates and cash reserves, all of which are retained interests in the securitized receivables. These retained interests are subordinate to other investors' interests in the securitizations. A gain or loss on the sale of finance receivables depends, in part, on the previous carrying amount of the finance receivables involved in the transfer, allocated between the assets sold and the retained interests based on their relative fair values at the date of transfer. Retained interests are recorded at fair value as a component of other assets.

Textron Finance estimates fair value based on the present value of future expected cash flows using management's best estimates of key assumptions: credit losses, prepayment speeds, forward interest rate yield curves and discount rates commensurate with the risks involved. Textron Finance reviews the fair values of the retained interests quarterly using updated assumptions and compares such amounts with the carrying value of the retained interests. When the carrying value exceeds the fair value of the retained interests and the decline in fair value is determined to be other than temporary, the retained interest is written down to fair value. When a change in the fair value of the retained interest is deemed temporary, any unrealized gains or losses are included in shareholders' equity as a component of accumulated other comprehensive loss.

Investments

Investments in marketable equity securities are classified as available for sale and are recorded at fair value as a component of other assets. Unrealized gains and losses on these securities, net of income taxes, are included in shareholders' equity as a component of accumulated other comprehensive loss. Investments in non-marketable equity securities are accounted for under either the cost or equity method of accounting. Textron periodically reviews investment securities for impairment based on criteria that include the duration of the market value decline, Textron's ability to hold to recovery, information regarding the market and industry trends for the investee's business, the financial strength and specific prospects of the investee, and investment analyst reports, if available. If a decline in the fair value of an investment security is judged to be other than temporary, the cost basis is written down to fair value with a charge to earnings.

In the normal course of business, Textron has entered into various joint venture agreements that are not controlled by Textron, but where Textron has the ability to exercise significant influence over the operating and financial policies. Textron's investments in these ventures are accounted for under the equity method of accounting. At January 1, 2005 and January 3, 2004, the investment in these unconsolidated joint ventures totaled $14 million and $26 million, respectively, and is included in other assets. Under the equity method, only Textron's share of the ventures' net earnings and losses is included in the consolidated statement of operations. The net loss totaled $11 million in 2004, $12 million in 2003 and $13 million in 2002. Since these losses are not considered material for separate presentation, they are included within cost of sales.

Textron's joint venture agreement with Boeing creates contractual, rather than ownership, rights related to the V-22. Accordingly, Textron does not account for this joint venture under the equity method of accounting. Textron accounts for all of Bell Helicopter's rights and obligations under the specific requirements of the V-22 Contracts allocated to Bell Helicopter under the joint venture agreement. Revenues and cost of sales reflect Bell Helicopter's performance under the V-22 Contracts. All assets used in performance of the V-22 Contracts owned by Bell Helicopter, including inventory and unpaid receivables, and all liabilities arising from Bell Helicopter's obligations under the V-22 Contracts, are included in the consolidated balance sheet.

Inventories

Inventories are carried at the lower of cost or estimated net realizable value. The cost of approximately 65% of inventories is determined using the last-in, first-out method. The cost of remaining inventories, other than those related to certain long-term contracts, is generally valued by the first-in, first-out method. Costs for commercial helicopters are determined on an average cost basis by model considering the expended and estimated costs for the current production release. Customer deposits are recorded against inventory when the right of offset exists. All other customer deposits are recorded as liabilities.

Property, Plant and Equipment

Property, plant and equipment are recorded at cost and are depreciated primarily using the straight-line method. Land improvements and buildings are depreciated primarily over estimated lives ranging from 5 to 40 years, while machinery and equipment are depreciated primarily over 3 to 15 years. Expenditures for improvements that increase asset values and extend useful lives are capitalized.

Impairment of Long-Lived Assets

Long-lived assets, including intangible assets subject to amortization, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of the asset may not be recoverable. Management assesses the recoverability of the cost of the asset based on a review of projected undiscounted cash flows. In the event an impairment loss is identified, it is recognized based on the amount by which the carrying value exceeds the estimated fair value of the long-lived asset. If an asset is held for sale, management reviews its estimated fair value less cost to sell. Fair value is determined using pertinent market information, including appraisals or brokers' estimates, and/or projected discounted cash flows.

Goodwill

Management evaluates the recoverability of goodwill annually or more frequently if events or changes in circumstances, such as declines in sales, earnings or cash flows, or material adverse changes in the business climate, indicate that the carrying value of a reporting unit or indefinite-lived intangible asset might be impaired. The reporting unit represents the operating segment unless discrete financial information is prepared and reviewed by segment management for businesses one level below that operating segment (a "component"), in which case such component is the reporting unit. In certain instances, components of an operating segment have been aggregated and deemed to be a single reporting unit based on similar economic characteristics of the components. Goodwill is considered to be impaired when the net book value of a reporting unit exceeds its estimated fair value. Fair values are established primarily using a discounted cash flow methodology. The determination of discounted cash flows is based on the businesses' strategic plans and long-range planning forecasts. When available, comparative market multiples are used to corroborate discounted cash flow results.

Derivative Financial Instruments

Textron is exposed to market risk primarily from changes in interest rates, currency exchange rates and securities pricing. To manage the volatility relating to these exposures, Textron nets the exposures on a consolidated basis to take advantage of natural offsets. For the residual portion, Textron enters into various derivative transactions pursuant to Textron's policies in areas such as counterparty exposure and hedging practices. All derivative instruments are reported on the balance sheet at fair value. Designation to support hedge accounting is performed on a specific exposure basis. Changes in fair value of financial instruments qualifying as fair value hedges are recorded in income, offset in part or in whole, by corresponding changes in the fair value of the underlying exposures being hedged. Changes in fair values of derivatives accounted for as cash flow hedges, to the extent they are effective as hedges, are recorded in other comprehensive (loss) income, net of deferred taxes. Changes in fair value of derivatives not qualifying as hedges are reported in income. Textron does not hold or issue derivative financial instruments for trading or speculative purposes.

Foreign currency denominated assets and liabilities are translated into U.S. dollars with the adjustments from the currency rate changes recorded in the cumulative translation adjustment account in shareholders' equity until the related foreign entity is sold or substantially liquidated. Foreign currency financing transactions, including currency swaps, are used to effectively hedge long-term investments in foreign operations with the same corresponding currency. Foreign currency gains and losses on the hedge of the long-term investments are recorded in the cumulative translation adjustment account in accumulated other comprehensive loss with the offset recorded as an adjustment to the non-U.S. dollar financing liability.

Fair Values of Financial Instruments

Fair values of cash and cash equivalents, accounts receivable, accounts payable and variable-rate receivables and debt approximate carrying value. The estimated fair values of other financial instruments, including debt, equity and risk management instruments, have been determined using available market information and valuation methodologies, primarily discounted cash flow analysis or independent investment bankers. The estimated fair value of nonperforming loans included in finance receivables is based on discounted cash flow analyses using risk-adjusted interest rates or the fair value of the related collateral. Because considerable judgment is required in interpreting market data, the estimates are not necessarily indicative of the amounts that could be realized in a current market.

Stock-Based Compensation

Textron's 1999 Long-Term Incentive Plan ("1999 Plan") authorizes awards to key employees. The 1999 Plan and related awards are described more fully in Note 11. Stock-based compensation awards to employees under the 1999 Plan are accounted for using the intrinsic value method prescribed in APB Opinion No. 25, "Accounting for Stock Issued to Employees" and related Interpretations. No stock-based employee compensation cost related to stock options awards is reflected in net income, as all options granted under the 1999 Plan had an exercise price equal to the market value of the underlying common stock on the date of grant. Employee compensation cost related to Textron's performance share program and restricted stock awards is reflected in net income over the awards' vesting period. Textron has entered into cash settlement forward contracts on its common stock to mitigate the impact of stock price fluctuations on compensation expense. The following table illustrates the effect on net income and earnings per share if Textron had applied the fair value recognition provisions of Statement of Financial Accounting Standards ("SFAS") No. 123, "Accounting for Stock-Based Compensation," to stock-based employee compensation:

(Dollars in millions, except per share data) 2004 2003 2002 Net income (loss), as reported $ 365 $ 259 $ (124 ) Add back: Stock-based employee compensation expense included in reported net income (loss)* 20 14 9 Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards* (26 ) (29 ) (40 ) Pro forma net income (loss) $ 359 $ 244 $ (155 ) Income (loss) per share:
Basic - as reported $ 2.66 $ 1.91 $ (0.90 ) Basic - pro forma $ 2.61 $ 1.80 $ (1.12 ) Diluted - as reported $ 2.61 $ 1.89 $ (0.88 ) Diluted - pro forma $ 2.56 $ 1.78 $ (1.10 )

* Net of related cash settlement forward income or expense and related tax effects

The compensation cost calculated under the fair value approach shown above is recognized over the vesting period of the stock options. The fair value of options granted after 1995 are estimated on the date of grant using the Black-Scholes option pricing model with the following assumptions:

2004 2003 2002 Dividend yield 2 % 3 % 3 % Expected volatility 37 % 38 % 36 % Risk-free interest rate 3 % 3 % 4 % Expected lives (years) 3.7 3.6 3.7

Under these assumptions, the weighted-average fair value of an option to purchase one share granted in 2004 was approximately $14 and approximately $10 in 2003 and in 2002.

Product and Environmental Liabilities

Product liability claims are accrued on the occurrence method based on insurance coverage and deductibles in effect at the date of the incident and management's assessment of the probability of loss when reasonably estimable.

Accruals for environmental matters are recorded on a site-by-site basis when it is probable that a liability has been incurred and the amount is reasonably estimated. Textron's environmental liabilities are undiscounted and do not take into consideration possible future insurance proceeds or significant amounts from claims against other third parties.

Research and Development Costs

Research and development costs not specifically covered by contracts and those related to Textron's share of research and development activity in connection with cost sharing arrangements are charged to expense as incurred. Research and development costs incurred under contracts with others are reported as cost of sales over the period that revenue is recognized, consistent with Textron's contract accounting policy.

Recently Issued Accounting Pronouncements

In December 2004, the FASB issued SFAS No. 123 (Revised 2004), "Share-Based Payment" ("SFAS 123-R"), which replaces SFAS No. 123, "Accounting for Stock-Based Compensation" ("SFAS 123") and supercedes APB Opinion No. 25, "Accounting for Stock Issued to Employees." SFAS 123-R requires companies to measure compensation costs for share-based payments to employees, including stock options, at fair value and expense such compensation over the service period beginning with the first interim or annual period after June 15, 2005. The pro forma disclosures previously permitted under SFAS 123 will no longer be an alternative to financial statement recognition. Textron is required to adopt SFAS 123-R in the third quarter of fiscal 2005. Under SFAS 123-R, companies must determine the appropriate fair value model to be used for valuing share-based payments, the amortization method for compensation cost and the transition method to be used at date of adoption. The transition methods include prospective and retroactive adoption options. Management is evaluating the requirements of SFAS 123-R. Management believes the impact of adopting SFAS 123-R will result in additional expense of approximately $15 million, net of income taxes, for 2005. This estimate is subject to change based on a number of factors, including the actual number of stock option awards granted, changes in assumptions underlying the option value estimates, such as the risk-free interest rate, and tax deductions for employee disqualifying dispositions, if any.

Note 2 Acquisitions and Dispositions

Acquisitions

Textron has a joint venture, CitationShares, with TAG Aviation USA, Inc. ("TAG") to sell fractional share interests in business jets. On June 30, 2004, Textron acquired an additional 25% interest in CitationShares from TAG for cash and the assumption of debt guarantees previously provided by TAG. Additional cash consideration may also be payable to TAG based on CitationShares' future operating results. TAG has the right to sell its remaining 25% interest to Textron in the years 2009 through 2011, and Textron has the right to purchase the remaining interest in 2010 or 2011, for an amount based on a multiple of earnings.

As a result of this transaction, Textron owns 75% of CitationShares and has consolidated its financial results prospectively as of June 30, 2004. Assets acquired of $47 million included $22 million of inventory, primarily Citation jets, and liabilities acquired of $59 million included $47 million of third-party debt that was immediately repaid. Additionally, CitationShares had approximately $31 million of operating lease obligations as of the acquisition date that Textron has fully guaranteed.

Discontinued Operations

During the fourth quarter of 2004, Textron reached a final decision to sell the remainder of its InteSys operations, and as a result, financial results of this business, net of income taxes, are now reported as discontinued operations. The carrying value of this business approximated fair value at the date of the decision to sell. Textron's consolidated statements of operations and related footnote disclosures have been recast to reflect the InteSys business, previously included in the Industrial segment, as a discontinued operation for the periods presented. The amounts exclude general corporate overhead previously allocated to the business for reporting purposes. Textron uses a centralized approach to the cash management and financing of its operations, and accordingly, does not allocate debt or interest expense to its discontinued businesses.

The assets and liabilities of the InteSys discontinued business are as follows:

January 1, January 3, (In millions) 2005 2004 Accounts receivable, net $ 12 $ 11 Inventories 2 9 Property, plant and equipment, net - 24 Other assets 15 28 Total assets $ 29 $ 72 Accounts payable and accrued liabilities $ 4 $ 14 Other liabilities 1 7 Total liabilities $ 5 $ 21

Discontinued operations also include the results of OmniQuip and the small business direct portfolio which were both sold in 2003. Operating results of the discontinued businesses are as follows:

(In millions) 2004 2003 2002 Revenue $ 70 $ 236 $ 386 Income (loss) from discontinued operations before special charges 12 (6 ) (66 ) Special charges (19 ) (36 ) (19 ) Loss from discontinued operations (7 ) (42 ) (85 ) Income tax (expense) benefit (1 ) 9 75 Loss from discontinued operations, net of income taxes $ (8 ) $ (33 ) $ (10 )

Discontinued operations include a second quarter 2004 pre-tax gain of $7 million from the sale of InteSys' interest in two Brazilian-based joint ventures. Prior to the disposition of these businesses, approximately $32 million and $27 million in restructuring costs related to InteSys and OmniQuip, respectively, were recorded in special charges since the inception of Textron's restructuring program.

On August 1, 2003, Textron consummated the sale of its remaining OmniQuip business to JLG Industries, Inc. for $90 million in cash and a $10 million promissory note that was paid in full in February 2004. In the second quarter of 2003, Textron recorded $30 million in special charges for the impairment of $15 million in intangible assets and $15 million in goodwill based on the fair value implied by the sale price of OmniQuip under negotiation at that time. There was no further gain or loss recorded upon the consummation of the sale.

Textron Manufacturing has retained certain non-operating assets and liabilities of the OmniQuip business. These remaining assets and liabilities are included in the consolidated balance sheet as of January 1, 2005 and are composed of assets of approximately $3 million and liabilities of approximately $27 million. The liabilities retained include $22 million in reserves related to a recourse liability to cover potential losses on approximately $52 million in finance receivables held by Textron Finance. See Note 4 for further discussion on transactions between Textron's Manufacturing and Finance borrowing groups.

Other Dispositions

During 2004, Textron sold its Energy Manufacturing and Williams Machine and Tool business in the Industrial segment. There was no gain or loss on the sale as the proceeds received approximated book value, including goodwill. During 2003, Textron sold its remaining 50% interest in an Italian joint venture to Collins & Aikman Corporation for a $12 million after-tax gain.

On December 19, 2003, Textron Finance sold its small business direct portfolio for $421 million in cash. Based upon the terms of the transaction, no gain or loss was recorded. Textron Finance entered into a loss sharing agreement related to the sale, which requires Textron Finance to reimburse the purchaser for a portion of losses incurred on the portfolio above a predetermined level. Textron Finance originally recorded a liability of $14 million representing the estimated fair value of the guarantee, which expires in 2008. At January 1, 2005, the estimated fair value of the guarantee was a $13 million liability.

Textron completed the sale of its Automotive Trim business to various operating subsidiaries of Collins & Aikman Corporation (collectively "C&A") in December 2001. The proceeds from the sale included 326,400 shares of non-marketable preferred stock of Collins & Aikman Products Company, a subsidiary of C&A, valued at $147 million. In addition to the proceeds received from C&A, prior to completing the sale, the Automotive Trim business entered into an $87 million lease agreement whereby equipment used by the business was retained by Textron and leased back to the business through Textron Finance. See Note 4 to the consolidated financial statements under the caption "Transactions between Finance and Manufacturing Groups" for more details. In addition, Textron guaranteed certain other operating lease payments transferred to C&A as described in Note 16 under the caption "Guarantees."

The purchase and sale agreement provided for an adjustment to the selling price based on an audit of the closing balance sheet in 2002. Pursuant to the audit and final settlement of the post-closing obligations under the purchase and sale agreement, Textron received $110 million from C&A. The final negotiated settlement provided C&A the ability to repurchase a portion of its preferred stock in advance of the original terms, and C&A repurchased those preferred shares in June 2002. As of January 1, 2005, Textron had 200,000 shares remaining of the original preferred stock valued at $90 million. In conjunction with this transaction and following C&A's recapitalization through a share offering, the carrying value of the C&A common stock held by Textron was revised. An additional gain of $25 million was recorded in 2002 upon the final settlement of the post-closing obligations and valuation of the common stock received from C&A. The C&A common stock was subsequently written down and sold as discussed in Note 14.

Note 3 Accounts
Receivable

Accounts receivable is composed of the following:

January 1, January 3, (In millions) 2005 2004 Commercial and customers $ 1,055 $ 966 U.S. Government contracts 220 224 1,275 1,190 Less allowance for doubtful accounts 64 66 $ 1,211 $ 1,124

Unbillable receivables on U.S. Government contracts arise when the revenues based on performance attainment, though appropriately recognized, cannot be billed yet under terms of the contract. Unbillable receivables within accounts receivable totaled $133 million at January 1, 2005 and $126 million at January 3, 2004. Long-term contract receivables due from the U.S. Government do not include significant amounts billed but unpaid due to contractual retainage provisions or subject to collection uncertainty.

Note 4 Finance Receivables and Securitizations

Finance Receivables

Textron Finance provides financial services primarily to the aircraft, golf, vacation interval resort, dealer floorplan and middle market industries under a variety of financing vehicles with various contractual maturities.

Installment contracts generally require the customer to pay a significant down payment, along with periodic scheduled principal payments that reduce the outstanding balance through the term of the loan. Finance leases include residual values expected to be realized at contractual maturity. Finance leases with no significant residual value at the end of the contractual term are classified as installment contracts, as their legal and economic substance is more equivalent to a secured borrowing than a finance lease with a significant residual value. Installment contracts and finance leases have initial terms ranging from two to 20 years and are primarily secured by the financed equipment.

Distribution finance receivables are generally secured by the inventory of the financed distributor and include floor plan financing for third party dealers for inventory sold by E-Z-GO and Jacobsen businesses. Revolving loans are secured by trade receivables, inventory, plant and equipment, pools of vacation interval notes receivables, pools of residential and recreational land loans, and the underlying property. Distribution finance and revolving loans generally mature within one to five years.

Golf course and resort mortgages are secured by real property and are generally limited to 75% or less of the property's appraised market value at loan origination. Golf course mortgages have initial terms ranging from five to seven years with amortization periods from 15 to 25 years. Resort mortgages generally represent construction and inventory loans with terms up to two years. Leveraged leases are secured by the ownership of the leased equipment and real property and have initial terms up to approximately 30 years.

The following table displays the contractual maturity of the finance receivables. It does not necessarily reflect future cash collections because of various factors, including the repayment or refinancing of receivables prior to contractual maturity:

Finance Receivables Contractual Maturities Outstanding (In
millions) 2005 2006 2007 2008 2009 Thereafter 2004 2003 Installment
contracts $ 226 $ 176 $ 159 $ 182 $ 142 $ 570 $ 1,455 $ 1,396 Distribution
finance 1,020 6 - - - - 1,026 778 Revolving
loans 754 201 169 64 70 144 1,402 1,194 Finance
leases 140 53 55 59 17 86 410 309 Golf course
and resort
mortgages 168 245 152 138 130 172 1,005 945 Leveraged
leases (5 ) 2 (9 ) 73 38 440 539 513 $ 2,303 $ 683 $ 526 $ 516 $ 397 $ 1,412 5,837 5,135 Less
allowance
for credit
losses 99 119 $ 5,738 $ 5,016

Contractual maturities for finance leases classified as installment contracts include the minimum lease payments, net of the unearned income to be recognized over the life of the lease. Total minimum lease payments and unearned income related to these finance leases were $708 million and $136 million, respectively, at January 1, 2005, and $670 million and $99 million, respectively, at January 3, 2004. Minimum lease payments due under these contracts for each of the next five years are as follows: $137 million in 2005, $120 million in 2006, $101 million in 2007, $92 million in 2008 and $92 million in 2009.

Textron Finance's net investment in finance leases, excluding leases classified as installment contracts, is provided below:

(In millions) 2004 2003 Total minimum lease payments receivable $ 383 $ 287 Estimated residual values of leased equipment 205 188
588 475 Less unearned income (178 ) (166 ) Net investment in finance leases $ 410 $ 309

Minimum lease payments due under finance leases for each of the next five years are as follows: $83 million in 2005, $54 million in 2006, $47 million in 2007, $29 million in 2008 and $10 million in 2009.

The net investment in leveraged leases was as follows:

(In millions) 2004 2003 Rental receivable, net of nonrecourse debt $ 545 $ 457 Estimated residual values on leased assets 286 389
831 846 Unearned income (292 ) (333 ) Investment in leveraged leases 539 513 Deferred income taxes (358 ) (353 ) Net investment in leveraged leases $ 181 $ 160

Excluding receivables with recourse to Textron Manufacturing, at the end of 2004 and 2003 Textron Finance had nonaccrual finance receivables totaling $119 million and $152 million, respectively, of which $85 million and $99 million, respectively, were

impaired. In addition, Textron Finance had impaired accrual finance receivables totaling $58 million at January 1, 2005 and $137 million at January 3, 2004. The allowance for losses on finance receivables related to impaired loans is determined using assumptions related to the fair market value of the underlying collateral, and totaled $16 million and $18 million at the end of 2004 and 2003, respectively. The average recorded investment in impaired loans during 2004 was $123 million, compared with $201 million in 2003. No interest income was recognized on these loans using the cash basis method.

Textron Finance manages and services finance receivables for a variety of investors, participants and third-party portfolio owners. The total managed and serviced finance receivable portfolio, including owned finance receivables, was $9.3 billion at the end of 2004 and $8.8 billion at the end of 2003. Managed receivables include owned finance receivables and finance receivables sold in securitizations and private transactions where Textron Finance has retained some element of credit risk and continues to service the portfolio.

At January 1, 2005, Textron Finance's receivables were primarily diversified geographically across the United States, along with 13% in other countries. The most significant collateral concentration was in general aviation aircraft, which accounted for 20% of managed receivables. Textron Finance also has industry concentrations in the golf and vacation interval industries, which each accounted for 18% and 14%, respectively, of managed receivables at January 1, 2005.

Transactions between Finance and Manufacturing Groups

A portion of Textron Finance's business involves financing retail purchases and leases for new and used aircraft and equipment manufactured by Textron Manufacturing's Bell, Cessna and Industrial segments. The captive finance receivables for these inventory sales included in Textron Finance's balance sheet are composed of the following:

January 1, January 3, (In millions) 2005 2004 Installment contracts $ 628 $ 627 Distribution finance 42 31 Finance leases 279 139 Total $ 949 $ 797

Operating agreements specify that Textron Finance has recourse to Textron Manufacturing for outstanding balances from some of these transactions. For those receivables for which collection has been guaranteed by Textron Manufacturing, reserves have been established for losses on Textron Manufacturing's balance sheet and are recorded in current or long-term liabilities. These reserves are established for amounts that are potentially uncollectible or if the collateral values may be insufficient to cover the outstanding receivable. If an account is deemed uncollectible and the collateral is repossessed, Textron Finance will charge Textron Manufacturing for any deficiency. In some cases, the collateral is not repossessed by Textron Finance, and the receivable is transferred to Textron Manufacturing's balance sheet for additional collection efforts. When this occurs, any related reserve previously established is reclassified from Textron Manufacturing's current or long-term liabilities and is netted against either accounts receivable or notes receivable within other assets.

In 2004, 2003 and 2002, Textron Finance paid Textron Manufacturing $0.9 billion, $0.9 billion and $1.0 billion, respectively, relating to the sale of manufactured products to third parties that were financed by Textron Finance, and $77 million, $56 million and $104 million, respectively, for the purchase of operating lease equipment. At the end of 2004 and 2003, the amounts guaranteed by Textron Manufacturing totaled $384 million and $467 million, respectively. In addition, at the end of 2004 and 2003, Textron Finance had recourse to Textron Manufacturing for a lease with C&A totaling $82 million and $87 million, respectively.

Included in the finance receivables guaranteed by Textron Manufacturing are past due loans of $31 million and $41 million at the end of 2004 and 2003, respectively, that meet the nonaccrual criteria but are not classified as nonaccrual by Textron Finance due to the guarantee. Textron Finance continues to recognize income on these loans. Concurrently, Textron Manufacturing is charged for their obligation to Textron Finance under the guarantee so that there are no net interest earnings for the loans on a consolidated basis. Textron Manufacturing has established reserves for losses related to these guarantees that are included in other current liabilities. Textron Manufacturing's reserves for these recourse liabilities to Textron Finance totaled $48 million and $64 million at the end of 2004 and 2003, respectively.

Securitizations

Textron Finance received proceeds of $0.4 billion in 2004 and $0.7 billion in 2003 from the securitization and sale (with servicing rights retained) of finance receivables. Pre-tax gains from securitized trust sales were approximately $56 million in 2004, $43 million in 2003 and $45 million in 2002. At the end of 2004, $2.3 billion in securitized loans were outstanding, with $17 million in past due loans. Textron Finance has securitized certain receivables generated by Textron Manufacturing for which it has retained full recourse to Textron Manufacturing.

Textron Manufacturing provides a guarantee to a securitization trust sponsored by a third-party financial institution that purchases timeshare note receivables from Textron Finance. The guarantee requires Textron Manufacturing to make payments to the trust should the cash flows from the timeshare notes fall below a minimum level. The maximum potential payment required under the credit enhancement agreement is $31 million. At January 1, 2005, Textron has a fair value liability recorded of approximately $0.2 million that was established upon the sale of additional timeshare note receivables into the trust. Textron has not been required to make any payments to the trust under the credit enhancement agreement, and based on historical experience with the collateral in the trust, no additional liability is considered necessary.

Textron Finance retained subordinated interests in the trusts which are approximately 2% to 10% of the total trust. Servicing fees range from 75 to 150 basis points. During 2004, key economic assumptions used in measuring the retained interests at the date of each securitization included prepayment speeds ranging from 12.4% to 23.0%, weighted-average lives ranging from 0.3 to 3.3 years, expected credit losses ranging from 0.5% to 2.8%, and residual cash flows discount rates ranging from 5.0% to 7.3%. At January 1, 2005, key economic assumptions used in measuring these retained interests were as follows:

Distribution Vacation Aircraft Finance Interval (Dollars in millions) Loans Receivables Loans Carrying amount of retained interests in securitizations, net $ 98 $ 121 $ 14 Weighted-average life (years) 2.4 0.3 2.0 Prepayment speed (annual rate) 23.0 % - 20.0 % Expected credit losses (annual rate) 0.2 % 0.7 % 3.7 % Residual cash flows discount rate 4.2 % 4.8 % 4.5 %

Hypothetical adverse changes of 10% and 20% to either the prepayment speed, expected credit losses or residual cash flows discount rates assumptions would not have a material impact on the current fair value of the residual cash flows associated with the retained interests. These hypothetical sensitivities should be used with caution, as the effect of a variation in a particular assumption on the fair value of the retained interest is calculated without changing any other assumption. In reality, a change in one factor may result in a change in another factor that may magnify or counteract the sensitivities losses. For example, increases in market interest rates may result in lower prepayments and increased credit losses.

Note 5 Inventories

January 1, January 3, (In millions) 2005 2004 Finished goods $ 643 $ 686 Work in process 1,206 681 Raw materials 231 202 2,080 1,569 Less progress/milestone payments 338 66 $ 1,742 $ 1,503

Inventories aggregating $1.1 billion and $1.0 billion at the end of 2004 and 2003, respectively, were valued by the last-in, first-out ("LIFO") method. Had such LIFO inventories been valued at current costs, their carrying values would have been approximately $238 million and $224 million higher at those respective dates. The remaining inventories, other than those related to certain long-term contracts, are valued primarily by the first-in, first-out ("FIFO") method. Inventories related to long-term contracts, net of progress/milestone payments were $259 million at the end of 2004 and $137 million at the end of 2003.

Note 6 Property, Plant and Equipment, net

Property, plant and equipment, net for Textron Manufacturing is composed of the following:

January 1, January 3, (In millions) 2005 2004 Land and buildings $ 1,210 $ 1,084 Machinery and equipment 3,364 3,256 4,574 4,340 Less accumulated depreciation and amortization 2,652 2,439 $ 1,922 $ 1,901

Note 7 Goodwill and Other Intangible Assets

On December 30, 2001, Textron adopted SFAS No. 142, "Goodwill and Other Intangible Assets," which required companies to stop amortizing goodwill and certain intangible assets with indefinite useful lives and requires an annual review for impairment. All existing goodwill as of December 30, 2001 was required to be tested for impairment on a reporting unit basis. With the implementation in 2002, an after-tax transitional impairment charge of $488 million ($561 million, a pre-tax) was taken in the second quarter and retroactively recorded in the first quarter. The after-tax charge is included in the caption "Cumulative effect of change in accounting principle, net of income taxes" and relates to the following segments: $385 million in Industrial, $88 million in Fastening Systems and $15 million in Finance. For the Industrial and Fastening Systems segments, the primary factor resulting in the impairment charge was the decline in demand in certain industries in which these segments operate, especially the telecommunications industry, due to the economic slowdown. The Finance segment's impairment charge related to the franchise finance division and was primarily the result of decreasing loan volumes and an unfavorable securitization market. No impairment charge was appropriate for these segments under the previous goodwill impairment accounting standard, which Textron applied based on undiscounted cash flows.

Textron also adopted the remaining provisions of SFAS No. 141, "Business Combinations," on December 30, 2001. These provisions broaden the criteria for recording intangible assets separate from goodwill and require that certain intangible assets that do not meet the new criteria, such as assembled workforce and customer base, be reclassified into goodwill. Upon adoption of these provisions, intangible assets totaling $37 million, net of related deferred taxes, were reclassified into goodwill within the Industrial and Finance segments.

Changes in goodwill are summarized below:

Fastening (In millions) Bell Cessna Systems Industrial Finance Total Balance at December 29, 2001 $ 101 $ 306 $ 473 $ 931 $ 192 $ 2,003 Reclassification of intangible assets - - - 36 1 37 Transitional impairment charge - - (100 ) (437 ) (24 ) (561 ) Foreign currency translation - - 17 26 - 43 Balance at December 28, 2002 $ 101 $ 306 $ 390 $ 556 $ 169 $ 1,522 Foreign currency translation - - 30 37 - 67 Balance at January 3, 2004 $ 101 $ 306 $ 420 $ 593 $ 169 $ 1,589 Acquisitions/dispositions - 16 - (20 ) - (4 ) Foreign currency translation - - 20 20 - 40 Other - - (3 ) (14 ) - (17 ) Balance at January 1, 2005 $ 101 $ 322 $ 437 $ 579 $ 169 $ 1,608

All of Textron's acquired intangible assets are subject to amortization and are composed of the following:

January 1, 2005 January 3, 2004 Weighted- Average (Dollars Amortization Gross Gross in Period Carrying Accumulated Carrying Accumulated millions) (In years) Amount Amortization Net Amount Amortization Net Trademarks 20 $ 28 $ 5 $ 23 $ 28 $ 4 $ 24 License 15 10 - 10 - - - Patents 8 12 7 5 12 5 7 Other 5 13 7 6 12 4 8 $ 63 $ 19 $ 44 $ 52 $ 13 $ 39

Amortization expense totaled $6 million in 2004 and $9 million in both 2003 and 2002. Amortization expense for fiscal years 2005, 2006, 2007, 2008 and 2009 is estimated to be approximately $5 million, $4 million, $4 million, $3 million and $3 million, respectively.

Note 8 Debt and Credit Facilities

January 1, January 3, (In millions) 2005 2004 Textron Manufacturing:
Long-term senior debt:
Medium-term notes due 2010 to 2011 (average rate of 9.85%) $ 17 $ 17 6.375% due 2004 - 300 5.625% due 2005 406 372 6.375% due 2008 300 300 4.50% due 2010 250 250 6.50% due 2012 300 300 6.625% due 2020 288 265 Other long-term debt (average rate of 6.1% and 6.5%, respectively) 230 223 Total debt $ 1,791 $ 2,027 Current portion of long-term debt (433 ) (316 ) Total long-term debt $ 1,358 $ 1,711

Textron Manufacturing maintains credit facilities with various banks for both short- and long-term borrowings. Textron Manufacturing has primary revolving credit facilities of $1.25 billion, of which $1.0 billion will expire in 2007 and $250 million will expire in March 2005. The $250 million facility includes a one-year term out option that can effectively extend its expiration into 2006. Textron Manufacturing's credit facilities permit Textron Finance to borrow under these facilities. At January 1, 2005 and January 3, 2004, none of the lines of credit were used or reserved as support for commercial paper. The weighted-average interest rates for these facilities in 2004 and 2003 were 1.7% and 1.3%, respectively.

January 1, January 3, (In millions) 2005 2004 Textron Finance:
Borrowings under or supported by credit facilities* $ 1,307 $ 520 Fixed-rate debt at average rate of 4.95% and 6.36%, respectively 2,360 2,831 Variable-rate notes at average rate of 3.04% and 2.29%, respectively 1,116 1,056 Total Textron Finance debt $ 4,783 $ 4,407

* The weighted-average interest rates on these borrowings, before the effect of interest rate exchange agreements, were 2.4% and 1.3% at year-end 2004 and 2003, respectively. Weighted-average interest rates during the years 2004 and 2003 were 1.6% and 1.5%, respectively.

Textron Finance has committed bank lines of credit of $1.5 billion of which $500 million expires in July 2005 and $1.0 billion expires in 2008. The $500 million facility includes a one-year term out option that can effectively extend its expiration into 2006. Textron Finance's lines of credit, not reserved as support for outstanding commercial paper or letters of credit at January 1, 2005, were $187 million. None of these lines of credit were used at January 1, 2005 or January 3, 2004. Lending agreements limit Textron Finance's net assets available for dividends and other payments to Textron Manufacturing to approximately $451 million of Textron Finance's net assets of $1.0 billion at the end of 2004. These lending agreements also contain various restrictive provisions regarding additional debt (not to exceed 800% of consolidated net worth and qualifying subordinated obligations), minimum net worth ($200 million), creation of liens and the maintenance of a fixed charges coverage ratio (no less than 125%).

The following table shows required payments during the next five years on debt outstanding at the end of 2004. The payment schedule excludes amounts that are payable under or supported by long-term credit facilities:

(In millions) 2005 2006 2007 2008 2009 Textron Manufacturing $ 433 $ 8 $ 37 $ 348 $ 3 Textron Finance 656 985 983 42 542 $ 1,089 $ 993 $ 1,020 $ 390 $ 545

Textron Manufacturing has agreed to cause Textron Finance to maintain certain minimum levels of financial performance. No payments from Textron Manufacturing were necessary in 2004, 2003 or 2002 for Textron Finance to meet these standards.

Cash paid for interest by Textron Manufacturing totaled $109 million, $117 million and $125 million in 2004, 2003 and 2002, respectively, and included $4 million, $5 million and $8 million in 2004, 2003 and 2002, respectively, paid to Textron Finance. Cash paid for interest by Textron Finance totaled $157 million, $182 million and $196 million in 2004, 2003 and 2002, respectively.

Note 9 Derivatives and Other Financial Instruments

Fair Value Interest Rate Hedges

Textron Manufacturing's policy is to manage interest cost using a mix of fixed- and variable-rate debt. To manage this mix in a cost efficient manner, Textron Manufacturing will enter into interest rate exchange agreements to agree to exchange, at specified intervals, the difference between fixed and variable interest amounts calculated by reference to an agreed upon notional principal amount. Since the critical terms of the debt and the interest rate exchange match and the other conditions of SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," are met, the hedge is considered perfectly effective. The mark-to-market values of both the fair value hedge instruments and underlying debt obligations are recorded as equal and offsetting unrealized gains and losses in interest expense. At January 1, 2005, Textron Manufacturing had $6 million of deferred gains related to discontinued hedges. The deferred gains are being amortized as an adjustment to interest expense over the remaining life of the underlying debt of 45 months. Textron Manufacturing has interest rate exchange agreements with a fair value liability of $2 million at January 1, 2005.

Textron Finance enters into interest rate exchange agreements in order to mitigate exposure to changes in the fair value of its fixed-rate portfolios of receivables and debt due to changes in interest rates. These agreements convert the fixed-rate cash flows to floating rates. At January 1, 2005, Textron Finance had interest exchange agreements with a fair value of $11 million designated as fair value hedges, compared with a fair value of $8 million at January 3, 2004.

Textron Finance utilizes foreign currency interest rate exchange agreements to hedge its exposure, in a Canadian dollar functional currency subsidiary, to changes in the fair value of $60 million U.S. dollar denominated fixed-rate debt as a result of changes in both foreign currency exchange rates and Canadian Banker's Acceptance rates. At January 1, 2005, these instruments had a fair value liability of $6 million, compared with $1 million at January 3, 2004. Textron Finance's fair value hedges are highly effective, resulting in an immaterial net impact to earnings due to hedge ineffectiveness.

Cash Flow Interest Rate Hedges

Textron Finance enters into interest rate exchange, cap and floor agreements to mitigate its exposure to variability in the cash flows received from its investments in interest-only securities resulting from securitizations, which is caused by fluctuations in interest rates. The combination of these instruments convert net residual floating-rate cash flows expected to be received by Textron

Finance as a result of the securitization trust's assets, liabilities and derivative instruments to fixed-rate cash flows. Changes in the fair value of these instruments are recorded net of the tax effect in other comprehensive
(loss) income. At January 1, 2005, these instruments had a fair value liability of $8 million, compared with $14 million at January 3, 2004. Textron Finance expects approximately $1 million of net tax deferred gains to be reclassified to earnings related to these hedge relationships in 2005.

Textron Finance utilizes foreign currency interest rate exchange agreements to hedge the exposure through March 2005, in a Canadian dollar functional currency subsidiary, to fluctuations in the cash flows to be received on $107 million of LIBOR based U.S. dollar variable rate notes receivable as a result of changes in both foreign currency exchange rates and LIBOR. At January 1, 2005, these instruments had a fair value of $42 million, compared with $26 million at January 3, 2004. Textron Finance expects approximately $0.3 million of net tax deferred gains to be reclassified to earnings related to these hedge relationships in 2005.

At January 1, 2005, Textron Finance had $6 million of net tax deferred losses recorded in other comprehensive (loss) income related to terminated forward starting interest rate exchange agreements. These agreements were executed to hedge the exposure to the variability in cash flows from anticipated future issuances of fixed-rate debt and were terminated upon issuance of the debt. Textron Finance is amortizing the deferred losses into interest expense over the remaining life of the hedged debt of 38 months and expects approximately $2 million, net of income taxes, in deferred losses to be reclassified to earnings in 2005.

For cash flow hedges, Textron Finance recorded an after-tax loss of $7 million in 2004, a gain of $12 million in 2003, and a loss of $4 million in 2002 to accumulated other comprehensive loss with no impact to the statement of operations. Textron Finance has not incurred or recognized any gains or losses in earnings as the result of the ineffectiveness or the exclusion from its assessment of hedge effectiveness of its cash flow hedges.

Textron had minimal exposure to loss from nonperformance by the counterparties to its interest rate exchange agreements at the end of 2004 and does not anticipate nonperformance by counterparties in the periodic settlements of amounts due. Textron currently minimizes this potential for risk by entering into contracts exclusively with major, financially sound counterparties having no less than a long-term bond rating of "A," by continuously monitoring such credit ratings and by limiting exposure to any one financial institution. The credit risk generally is limited to the amount by which the counterparties' contractual obligations exceed Textron's obligations to the counterparty.

Cash Flow Foreign Exchange Rate Hedges

Textron manufactures and sells its products in a number of countries throughout the world and, as a result, is exposed to movements in foreign currency exchange rates. The primary purpose of Textron's foreign currency hedging activities is to manage the volatility associated with foreign currency purchases of materials, foreign currency sales of its products, and other assets and liabilities created in the normal course of business. Textron primarily utilizes forward exchange contracts and purchased options with maturities of no more than 18 months that qualify as cash flow hedges. These are intended to offset the effect of exchange rate fluctuations on forecasted sales, inventory purchases and overhead expenses. The fair value of these instruments at January 1, 2005 was a $32 million asset. At year-end 2004, $21 million of after-tax gain was reported in accumulated other comprehensive loss from qualifying cash flow hedges. This gain is generally expected to be reclassified to earnings in the next 12 months as the underlying transactions occur. Textron Manufacturing also enters into certain foreign currency derivative instruments that do not meet hedge accounting criteria, and are primarily intended to protect against exposure related to intercompany financing transactions and income from international operations. The fair value of these instruments at the end of 2004 and the net impact of the related gains and losses on selling and administrative expense in 2004 were not material.

Net Investment Hedging

Textron hedges its net investment position in major currencies and generates foreign currency interest payments that offset other transactional exposures in these currencies. To accomplish this, Textron borrows directly in foreign currency and designates a portion of foreign currency debt as a hedge of net investments. In addition, certain currency forwards are designated as hedges of Textron's related foreign net investments. Currency effects of these hedges, which are reflected in the cumulative translation adjustment account within other comprehensive (loss) income, produced a $32 million after-tax loss during 2004, leaving an accumulated net loss balance of $19 million.

Stock-Based Compensation Hedging

Textron manages the expense related to stock-based compensation awards using cash settlement forward contracts on its common stock. The use of these forward contracts modifies compensation expense exposure to changes in the stock price with the intent to reduce potential variability. The fair value of these instruments at January 1, 2005 and January 3, 2004 was a receivable of

$31 million and $25 million, respectively. Gains and losses on these instruments are recorded as an adjustment to compensation expense when the award is charged to expense. These contracts impacted net income by $28 million in 2004, $23 million in 2003 and $(3) million in 2002. Cash received or paid on the contract settlement is included in cash flows from operating activities, consistent with the classification of the cash flows on the underlying hedged compensation expense.

Fair Values of Financial Instruments

The carrying amounts and estimated fair values of Textron's financial instruments that are not reflected in the financial statements at fair value are as follows:

January 1, 2005 January 3, 2004 Estimated Estimated Carrying Fair Carrying Fair (In millions) Value Value Value Value Textron Manufacturing: Debt $ (1,791 ) $ (1,902 ) $ (2,027 ) $ (2,177 ) Textron Finance: Finance receivables $ 4,888 $ 4,842 $ 4,313 $ 4,274 Debt $ (4,783 ) $ (4,864 ) $ (4,407 ) $ (4,552 )

Finance receivables exclude the fair value of finance and leveraged leases totaling $949 million at January 1, 2005 and $822 million at January 3, 2004, as these leases are recorded at fair value in the consolidated balance sheet.

Note 10 Mandatorily Redeemable Preferred Securities

Textron adopted SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity," in the third quarter of 2003. Upon adoption, Textron Finance classified its obligated mandatorily redeemable preferred securities previously classified as equity as a liability.

In June 2004, Textron Financial Corporation redeemed all of its $26 million Litchfield 10% Series A Junior Subordinated Debentures, due 2029. The debentures were held by a trust sponsored and wholly owned by Litchfield Financial Corporation, a subsidiary of Textron Financial Corporation. The proceeds from the redemption were used to redeem all of the $26 million Litchfield Capital Trust I 10% Series A Trust Preferred Securities at par value of $10 per share. There was no gain or loss on the redemption.

In July 2003, Textron redeemed its 7.92% Junior Subordinated Deferrable Interest Debentures, due 2045. The debentures were held by Textron's wholly owned trust, and the proceeds from their redemption were used to redeem all of the $500 million Textron Capital I trust preferred securities with a 7.92% dividend yield. Upon the redemption, $15 million in unamortized issuance costs were written off and recorded in special charges.

Note 11
Shareholders'
Equity

Capital Stock

Textron has authorization for 15,000,000 shares of preferred stock and 500,000,000 shares of 12.5 cent per share par value common stock. Each share of $2.08 Preferred Stock ($23.63 approximate stated value) is convertible into 4.4 shares of common stock and can be redeemed by Textron for $50 per share. Each share of $1.40 Preferred Dividend Stock ($11.82 approximate stated value) is convertible into 3.6 shares of common stock and can be redeemed by Textron for $45 per share.

Performance Share Units and Stock Options

Textron's 1999 Long-Term Incentive Plan (the "1999 Plan") authorizes awards to key employees of Textron in three forms: (a) options to purchase Textron shares,
(b) performance share units and (c) restricted stock. Options to purchase Textron shares have a maximum term of ten years and vest ratably over a three-year period, beginning with the 2003 grants. Prior grants vested ratably over two years. Restricted stock grants vest one-third each in the third, fourth and fifth year following the grant. In 2004 and 2003, Textron's shareholders approved amendments to the 1999 Plan to revise the maximum number of shares authorized to 17,500,000 options to purchase Textron shares, 2,000,000 performance units and 2,000,000 shares of restricted stock.

At the end of 2004, 5,196,760 stock options were available for future grant under the 1999 Plan, as amended. Stock option activity is summarized as follows:

2004 2003 2002 Weighted- Weighted- Weighted- Number Average Average Average (Shares in of Exercise Number of Exercise Number of Exercise thousands) Options Price Options Price Options Price Outstanding at
beginning of
year 13,158 $ 49.24 14,140 $ 49.62 10,976 $ 53.50 Granted 1,532 54.07 1,905 39.67 5,135 41.29 Exercised (4,363 ) 42.48 (1,797 ) 39.59 (696 ) 34.25 Canceled or
expired (1,066 ) 59.52 (1,090 ) 53.29 (1,275 ) 57.89 Outstanding at
end of year 9,261 $ 52.05 13,158 $ 49.24 14,140 $ 49.62 Exercisable at
end of year 7,176 $ 52.70 9,115 $ 53.02 9,043 $ 54.08

Stock options outstanding at the end of 2004 are summarized as follows:

(Shares in thousands) Options Outstanding Options Exercisable Weighted- Average Weighted- Weighted- Remaining Average Average Range of Contractual Exercise Exercise Exercise Prices Number Life Price Number Price $27 - $41 3,509 7.22 Years $ 39.89 2,745 $ 40.25 $42 - $57 3,227 6.95 Years $ 49.82 1,917 $ 45.90 $58 - $95 2,525 4.27 Years $ 71.44 2,514 $ 71.45 9,261 7,176

In 2004 and 2003, Textron granted 459,000 and 408,000 shares, respectively, of restricted stock at a weighted-average grant price of $57.30 and $40.61, respectively. There were no restricted shares granted in 2002.

Reserved Shares of Common Stock

At the end of 2004, common stock reserved for the subsequent conversion of preferred stock and shares reserved for the exercise of stock options were 2,698,000 and 9,261,000, respectively.

Preferred Stock Purchase Rights

Each outstanding share of Textron common stock has attached to it one-half of a preferred stock purchase right. One preferred stock purchase right entitles the holder to buy one one-hundredth of a share of Series C Junior Participating Preferred Stock at an exercise price of $250. The rights become exercisable only under certain circumstances related to a person or group acquiring or offering to acquire a substantial block of Textron's common stock. In certain circumstances, holders may acquire Textron stock, or in some cases the stock of an acquiring entity, with a value equal to twice the exercise price. The rights expire in September 2005 but may be redeemed earlier for $0.05 per right.

Income per Common Share

A reconciliation of income from continuing operations and basic to diluted share amounts is presented below:

2004 2003 2002 (Dollars in millions, Average Average Average shares in thousands) Income Shares Income Shares Income Shares Income from continuing operations available to common shareholders $ 373 137,337 $ 292 135,875 $ 374 138,745 Dilutive effect of convertible preferred stock and stock options - 2,832 - 1,342 - 1,507 Available to common shareholders and assumed conversions $ 373 140,169 $ 292 137,217 $ 374 140,252

Accumulated Other Comprehensive Loss

Unrealized Deferred Gains Gains Currency (Losses) Pension (Losses) Translation on Liability on Hedge (In millions) Adjustment Securities Adjustment Contracts Total Balance at December 29, 2001 $ (190 ) $ 1 $ (2 ) $ (32 ) $ (223 ) Other comprehensive income (loss), net of tax 78 2 (95 ) 13 (2 ) Net unrealized losses, net of tax - (25 ) - - (25 ) Reclassification adjustment, net of tax - 25 - - 25 Balance at December 28, 2002 $ (112 ) $ 3 $ (97 ) $ (19 ) $ (225 ) Other comprehensive income (loss), net of tax 159 - (35 ) 37 161 Balance at January 3, 2004 $ 47 $ 3 $ (132 ) $ 18 $ (64 ) Other comprehensive income (loss), net of tax 97 - (131 ) 4 (30 ) Reclassification adjustment, net of tax - (3 ) - - (3 ) Balance at January 1, 2005 $ 144 $ - $ (263 ) $ 22 $ (97 )

Included in other comprehensive income (loss) is an income tax (expense) benefit of $(22) million, $3 million and $55 million in 2004, 2003 and 2002, respectively.

Note 12 Pension Benefits and Postretirement Benefits Other Than Pensions

Textron has defined benefit and defined contribution pension plans that together cover substantially all employees. The costs of the defined contribution plans amounted to approximately $29 million in 2004, $22 million in 2003 and $44 million in 2002. Defined benefits under salaried plans are based on salary and years of service. Hourly plans generally provide benefits based on stated amounts for each year of service. Textron's funding policy is consistent with federal law and regulations. Textron also offers healthcare and life insurance benefits for certain retired employees which are included in the "Postretirement Benefits Other Than Pensions" caption.

The components of Textron's net periodic benefit costs (income) are as follows:

Postretirement Benefits Pension Benefits Other Than Pensions (In millions) 2004 2003 2002 2004 2003 2002 Service cost $ 119 $ 105 $ 99 $ 9 $ 7 $ 4 Interest cost 291 283 278 39 41 45 Expected return
on plan assets (431 ) (432 ) (454 ) - - - Amortization of
unrecognized
transition asset 1 (6 ) (17 ) - - - Amortization of
prior service
cost 17 16 15 (10 ) (8 ) (4 ) Amortization of
net loss (gain) 7 2 (16 ) 9 4 3 Curtailments - - (6 ) (1 ) - 1 Net periodic
benefit costs
(income) $ 4 $ (32 ) $ (101 ) $ 46 $ 44 $ 49 Weighted-average
assumptions used
to determine net
periodic benefit
costs (income):

Discount rate 6.14 % 6.61 % 7.06 % 6.25 % 6.75 % 7.25 % Expected long-term rate of return on plan assets 8.65 % 8.71 % 8.72 % - - - Rate of compensation increase 4.20 % 4.20 % 4.50 % - - -

Obligations and Funded Status

The following summarizes the changes in the benefit obligation and in the fair value of plan assets and provides a reconciliation of the funded status to the amounts recognized in the balance sheet for the pension and postretirement benefit plans, along with the assumptions used to determine benefit obligations:

Postretirement Benefits Pension Benefits Other Than Pensions (In millions) 2004 2003 2004 2003 Change in benefit obligation:
Beginning balance $ 4,813 $ 4,342 $ 681 $ 675 Service cost 119 105 9 7 Interest cost 291 283 39 41 Amendments 2 33 (1 ) (41 ) Plan participants' contributions 4 4 7 6 Actuarial losses 452 277 40 68 Benefits paid (296 ) (297 ) (78 ) (76 ) Foreign exchange rate changes 67 68 1 1 Curtailments - (2 ) (3 ) - Ending balance $ 5,452 $ 4,813 $ 695 $ 681 Change in fair value of plan
assets:
Beginning balance $ 4,583 $ 4,008 $ - $ - Actual return on plan assets 532 790 - - Employer contributions 45 29 - - Plan participants' contributions 4 4 - - Benefits paid (296 ) (297 ) - - Foreign exchange rate changes 50 49 - - Ending balance $ 4,918 $ 4,583 $ - $ - Reconciliation of funded status:
Funded status $ (534 ) $ (230 ) $ (695 ) $ (681 ) Unrecognized actuarial loss 1,209 839 168 137 Unrecognized prior service cost
(benefit) 148 163 (37 ) (46 )
Unrecognized transition net asset 1 2 - - Net amount recognized $ 824 $ 774 $ (564 ) $ (590 ) Amounts recognized in the balance
sheet consist of:
Prepaid benefit cost asset $ 836 $ 892 $ - $ - Accrued benefit liability (376 ) (312 ) (564 ) (590 ) Intangible assets 59 4 - - Accumulated other comprehensive
loss 305 190 - - Net amount recognized $ 824 $ 774 $ (564 ) $ (590 ) Weighted-average assumptions used
to determine benefit obligations
at year-end:
Discount rate 5.67 % 6.14 % 5.75 % 6.25 % Rate of compensation increase 4.50 % 4.20 % - -

Pension Benefits

The accumulated benefit obligation for all defined benefit pension plans was $5.0 billion at January 1, 2005 and $4.4 billion at January 3, 2004. Pension plans with accumulated benefit obligations exceeding the fair value of plan assets were as follows at year-end:

(In millions) 2004 2003 Projected benefit obligation $ 2,282 $ 798 Accumulated benefit obligation $ 2,053 $ 716 Fair value of plan assets $ 1,700 $ 417

In addition to the plans in the above table, Textron has plans with the projected benefit obligation in excess of plan assets as follows:

(In millions) 2004 2003 Projected benefit obligation $ 67 $ 1,238 Accumulated benefit obligation $ 44 $ 1,129 Fair value of plan assets $ 44 $ 1,167

Textron's pension assets are invested with the objective of achieving a total rate of return over the long term, sufficient to fund future pension obligations and to minimize future pension contributions. Textron is willing to tolerate a commensurate level of risk to achieve this objective based on the funded status of the plans and the long-term nature of Textron's pension liability. Risk is controlled by maintaining a portfolio of assets that is diversified across a variety of asset classes, investment styles and investment managers. All of the assets are managed by external investment managers, and the majority of the assets are actively managed. Where possible, investment managers are prohibited from owning Textron stock in the portfolios that they manage on behalf of Textron.

Asset allocation target ranges were established consistent with the investment objectives, and the assets are rebalanced periodically. The expected long-term rate of return on plan assets was determined based on a variety of considerations, including the established asset allocation targets and expectations for those asset classes, historical returns of the plans' assets and the advice of outside advisors. At January 1, 2005, the target allocation range is 44%-70% for equity securities, 13%-33% for debt securities and 7%-13% for both real estate and for other assets.

Textron's percentages of the fair value of total pension plan assets by major category are as follows:

January January 1, 3, Asset Category 2005 2004 Equity securities 59 % 61 % Debt securities 24 % 24 % Real estate 8 % 7 % Other 9 % 8 % Total 100 % 100 %

Other Postretirement Benefits

For measurement purposes, Textron has assumed an annual healthcare cost trend rate of 11% for covered healthcare benefits in 2005. The rate was assumed to decrease gradually to 5% in 2009 and remain at that level thereafter. Assumed healthcare cost trend rates have a significant effect on the amounts reported for the healthcare plans. A one-percentage-point change in assumed healthcare cost trend rates would have the following effects:

One- One- Percentage- Percentage- Point Point (In millions) Increase Decrease Effect on total of service and interest cost components $ 5 $ (4 ) Effect on postretirement benefit obligations other than pensions $ 59 $ (51 )

During the third quarter of 2004, Textron adopted FASB Staff Position No. 106-2, "Accounting and Disclosure Requirements related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003" (the "Act"). The Act provides for a prescription drug benefit under Medicare ("Medicare Part D") as well as a federal subsidy to sponsors of retiree healthcare benefit plans that provide benefits that are at least actuarially equivalent to Medicare Part D. Textron has determined that the benefits it provides meet the equivalency tests as defined in the Act and has included the effects of the subsidy as a reduction to the accumulated projected benefit obligation of approximately $50 million. The total impact of the subsidy on the net periodic benefit cost for postretirement benefits other than pensions in 2004 is approximately $7 million.

Estimated Future Cash Flow Impact

In 2005, Textron expects to contribute in the range of $30 million to $35 million to fund its qualified pension plans and does not expect to contribute to its other postretirement benefit plans. The benefit payments provided below reflect expected future employee service, as appropriate, that are expected to be paid, net of estimated participant contributions. The benefit payments are based on the same assumptions used to measure Textron's benefit obligation at the end of fiscal 2004. Pension benefit payments will primarily be made out of qualified pension trusts. Postretirement benefits other than pensions are paid out of Textron's assets.

Post- retirement Expected Benefits Medicare Pension Other Than Part D (In millions) Benefits Pensions Subsidy 2005 $ 292 $ 62 $ - 2006 296 66 (4 ) 2007 301 68 (4 ) 2008 307 70 (5 ) 2009 314 70 (5 ) 2010 - 2014 1,678 324 (23 )

Note 13 Income Taxes

Textron files a consolidated federal income tax return for all U.S. subsidiaries and separate returns for foreign subsidiaries. Income from continuing operations before income taxes and distributions on preferred securities of subsidiary trusts is as follows:

(In millions) 2004 2003 2002 United States $ 296 $ 253 $ 475 Foreign 232 164 101 Total $ 528 $ 417 $ 576

Income tax expense for continuing operations is summarized as follows:

(In millions) 2004 2003 2002 Federal:
Current $ 33 $ 40 $ 54 Deferred 61 8 82 State 13 15 15 Foreign 48 49 25 Income tax expense $ 155 $ 112 $ 176

The following reconciles the federal statutory income tax rate to the effective income tax rate reflected in the consolidated statements of operations:

2004 2003 2002 Federal statutory income tax rate 35.0 % 35.0 % 35.0 % Increase (decrease) in taxes resulting from: State income taxes 1.6 2.3 1.8 Special foreign dividend 2.1 - - Permanent items from Trim divestiture - - 1.2 Favorable tax settlements - (3.1 ) (2.1 ) ESOP dividends (1.6 ) (2.2 ) (3.1 ) Foreign tax rate differential (5.9 ) (2.1 ) (0.5 ) Export sales benefit (1.1 ) (1.4 ) (1.5 ) Other, net (0.7 ) (1.6 ) (0.2 ) Effective income tax rate 29.4 % 26.9 % 30.6 %

The tax effects of temporary differences that give rise to significant portions of Textron's net deferred tax assets and liabilities were as follows:

January 1, January 3, (In millions) 2005 2004 Deferred tax assets:
Deferred revenue $ 31 $ 15 Restructuring reserve 25 11 Warranty and product maintenance reserves 99 110 Self-insured liabilities, including environmental 98 90 Deferred compensation 166 156 Obligation for postretirement benefits 30 31 Investment securities - 20 Allowance for credit losses 75 77 Amortization of goodwill and other intangibles 35 52 Loss carryforwards 91 52 Other, principally timing of other expense deductions 132 59 Total deferred tax assets 782 673 Valuation allowance for deferred tax assets (155 ) (74 ) $ 627 $ 599 Deferred tax liabilities:

Textron Finance transactions, principally leasing $ (505 ) $ (442 ) Property, plant and equipment, principally depreciation (130 ) (113 ) Inventory (48 ) (24 ) Currency translation adjustment (3 ) (6 ) Total deferred tax liabilities (686 ) (585 ) Net deferred tax (liability) asset $ (59 ) $ 14

At January 1, 2005 and January 3, 2004, Textron had non-U.S. net operating loss carryforwards for income tax purposes of $165 million and $162 million, respectively, of which $148 million and $140 million, respectively, can be carried forward indefinitely. The balance expires at various dates through 2013. At January 1, 2005, Textron had U.S. federal net operating loss carryforwards for income tax purposes of $64 million that expire in 2025.

A valuation allowance at January 1, 2005 and January 3, 2004 of $155 million and $74 million, respectively, has been recognized to offset the related deferred tax assets due to the uncertainty of realizing the benefits of the deferred tax assets. The increase in the valuation allowance was primarily related to deferred tax assets resulting from minimum pension liability adjustments recorded in other comprehensive (loss) income in certain foreign jurisdictions.

The undistributed earnings of Textron's foreign subsidiaries on which tax is not provided, which approximated $910 million at the end of 2004, are considered to be indefinitely reinvested. If the earnings of foreign subsidiaries were distributed, taxes, net of foreign tax credits, would be increased by approximately $219 million in 2004.

On October 22, 2004, the American Jobs Creation Act ("AJCA") was signed into law and includes a deduction of 85% of certain foreign earnings that are repatriated, as defined in the AJCA. Textron intends to repatriate approximately $200 million in non-U.S. cash and has recognized a related tax expense of $11 million in the fourth quarter of 2004. Textron is continuing to evaluate the effects of the AJCA and expects to complete this evaluation in 2005. It is possible that Textron may repatriate an additional amount within the range of zero to $200 million in 2005, resulting in an income tax expense within the range of zero to $11 million.

Cash payments for taxes, net of tax refunds received, for Textron Manufacturing including discontinued operations totaled $(32) million in 2004, $(158) million in 2003 and $42 million in 2002. Cash payments for taxes, net of tax refunds, for Textron Finance totaled $61 million in 2004, $(6) million in