Note 1: Basis of Presentation

Our consolidated financial statements include the accounts of Textron Inc. and its majority-owned subsidiaries. We have prepared these unaudited consolidated financial statements in accordance with accounting principles generally accepted in the U.S. for interim financial information. Accordingly, these interim financial statements do not include all of the information and footnotes required by accounting principles generally accepted in the U.S. for complete financial statements. The consolidated interim financial statements included in this quarterly report should be read in conjunction with the consolidated financial statements included in our Annual Report on Form 10-K for the year ended January 1, 2011. In the opinion of management, the interim financial statements reflect all adjustments (consisting only of normal recurring adjustments) that are necessary for the fair presentation of our consolidated financial position, results of operations and cash flows for the interim periods presented. The results of operations for the interim periods are not necessarily indicative of the results to be expected for the full year.

Our financings are conducted through two separate borrowing groups. The Manufacturing group consists of Textron Inc. consolidated with its majority-owned subsidiaries that operate in the Cessna, Bell, Textron Systems and Industrial segments. The Finance group, which also is the Finance segment, consists of Textron Financial Corporation, its consolidated subsidiaries and three other finance subsidiaries owned by Textron Inc. We designed this framework to enhance our borrowing power by separating the Finance group. Our Manufacturing group operations include the development, production and delivery of tangible goods and services, while our Finance group provides financial services. Due to the fundamental differences between each borrowing group’s activities, investors, rating agencies and analysts use different measures to evaluate each group’s performance. To support those evaluations, we present balance sheet and cash flow information for each borrowing group within the consolidated financial statements. All significant intercompany transactions are eliminated from the consolidated financial statements, including retail and wholesale financing activities for inventory sold by our Manufacturing group and financed by our Finance group.

Note 2: Special Charges

In the third quarter of 2010, we substantially liquidated the assets held by a Canadian entity within the Finance segment. Accordingly, we recorded a non-cash charge of $91 million ($74 million after-tax) within special charges to reclassify the entity’s cumulative currency translation adjustment amount within other comprehensive income to the statement of operations. The reclassification of this amount had no impact on shareholders’ equity.

In 2010, special charges also included costs incurred under a restructuring program that was completed at the end of 2010. There were no special charges in the first nine months of 2011.

Special charges by segment and type for the three and nine months ended October 2, 2010 are as follows:

		Restructuring
		Severance				Contract
(In millions)		Costs				Terminations				Other				Total
Three Months Ended October 2, 2010
Cessna		$	15			$	—			$	—			$	15
Textron Systems			4				—				—				4
Industrial			—				1				—				1
Finance			1				2				91				94
		$	20			$	3			$	91			$	114
Nine Months Ended October 2, 2010
Cessna		$	29			$	2			$	—			$	31
Bell			1				—				—				1
Textron Systems			5				—				—				5
Industrial			—				1				—				1
Finance			6				3				91				100
Corporate			(2	)			—				—				(2	)
		$	39			$	6			$	91			$	136

An analysis of our restructuring reserve activity is summarized below:

		Severance				Contract
(In millions)		Costs				Terminations				Total
Balance at January 1, 2011		$	57			$	5			$	62
Cash paid			(40	)			(1	)			(41	)
Balance at October 1, 2011		$	17			$	4			$	21

Note 3: Retirement Plans

We provide defined benefit pension plans and other postretirement benefits to eligible employees. The components of net periodic benefit cost for these plans are as follows:

										Postretirement Benefits
		Pension Benefits								Other Than Pensions
		October 1,				October 2,				October 1,				October 2,
(In millions)		2011				2010				2011				2010
Three Months Ended
Service cost		$	32			$	31			$	2			$	2
Interest cost			82				79				8				9
Expected return on plan assets			(98	)			(92	)			—				—
Amortization of prior service cost (credit)			4				4				(2	)			(2	)
Amortization of net loss			19				9				3				3
Net periodic benefit cost		$	39			$	31			$	11			$	12
Nine Months Ended
Service cost		$	96			$	93			$	6			$	6
Interest cost			246				237				24				25
Expected return on plan assets			(294	)			(276	)			—				—
Amortization of prior service cost (credit)			12				12				(5	)			(4	)
Amortization of net loss			57				27				9				9
Net periodic benefit cost		$	117			$	93			$	34			$	36

Note 4: Comprehensive Income

Our comprehensive income, net of taxes, is provided below:

		Three Months Ended								Nine Months Ended
		October 1,				October 2,				October 1,				October 2,
(In millions)		2011				2010				2011				2010
Net income (loss)		$	142			$	(48	)		$	261			$	26
Other comprehensive income (loss):
Recognition of prior service cost and unrealized losses on pension and postretirement benefits			15				11				48				31
Deferred gains (losses) on hedge contracts			(17	)			3				(9	)			10
Recognition of foreign currency translation loss upon substantial liquidation of Canadian entity, net of income tax benefit of $17			—				74				—				74
Foreign currency translation and other			(18	)			21				(3	)			(20	)
Comprehensive income		$	122			$	61			$	297			$	121

Note 5: Earnings Per Share

We calculate basic and diluted earnings per share (EPS) based on net income, which approximates income available to common shareholders for each period. Basic earnings per share is calculated using the two-class method, which includes the weighted-average number of common shares outstanding during the period and restricted stock units to be paid in stock that are deemed participating securities as they provide nonforfeitable rights to dividends. Diluted earnings per share considers the dilutive effect of all potential future common stock, including stock options, restricted stock units and the shares that could be issued upon the conversion of our convertible notes and upon the exercise of the related warrants. The convertible note call options purchased in connection with the issuance of the convertible notes are excluded from the calculation of diluted EPS as their impact is always anti-dilutive.

Upon conversion of our convertible notes, as described in our 2010 Form 10-K, the principal amount would be settled in cash and the excess of the conversion value, as defined, over the principal amount may be settled in cash and/or shares of our common stock. Therefore, only the shares of our common stock potentially issuable with respect to the excess of the notes’ conversion value over the principal amount, if any, are considered as dilutive potential common shares for purposes of calculating diluted EPS. See Note 8 regarding our cash tender offer pursuant to which we purchased a portion of our convertible notes subsequent to quarter end.

The weighted-average shares outstanding for basic and diluted earnings per share are as follows:

		Three Months Ended								Nine Months Ended
		October 1,				October 2,				October 1,				October 2,
(In thousands)		2011				2010				2011				2010
Basic weighted-average shares outstanding			278,090				274,896				277,285				274,056
Dilutive effect of convertible notes, warrants, stock options and restricted stock units			22,776				—				35,469				26,354
Diluted weighted-average shares outstanding			300,866				274,896				312,754				300,410

Stock options to purchase 8 million and 5 million shares of common stock outstanding are excluded from our calculation of diluted weighted-average shares outstanding for the three and nine months ended October 1, 2011, respectively, as the exercise prices were greater than the average market price of our common stock for the periods. Stock options to purchase 7 million shares of common stock outstanding are excluded from our calculation of diluted weighted-average shares outstanding for both the three and nine months ended October 2, 2010 as the exercise prices were greater than the average market price of our common stock for the periods. These securities could potentially dilute earnings per share in the future. For the three months ended October 2, 2010, the potential dilutive effect of 23 million weighted-average shares of stock options, restricted stock units and the shares that could be issued upon the conversion of our convertible notes and upon the exercise of the related warrants was excluded from the computation of diluted weighted-average shares outstanding as the shares would have an anti-dilutive effect on the loss from continuing operations.

Note 6: Accounts Receivable and Finance Receivables

Accounts Receivable

Accounts receivable is composed of the following:

		October 1,				January 1,
(In millions)		2011				2011
Commercial		$	578			$	496
U.S. Government contracts			368				416
			946				912
Allowance for doubtful accounts			(19	)			(20	)
		$	927			$	892

We have unbillable receivables on U.S. Government contracts that arise when the revenues we have appropriately recognized based on performance cannot be billed yet under terms of the contract. Unbillable receivables within accounts receivable totaled $172 million at October 1, 2011 and $195 million at January 1, 2011.

Finance Receivables

Finance receivables by product line, which includes both finance receivables held for investment and finance receivables held for sale, are presented in the following table:

		October 1,				January 1,
(Dollars in millions)		2011				2011
Aviation		$	1,927			$	2,120
Golf equipment			141				212
Golf mortgage			703				876
Timeshare			495				894
Structured capital			217				317
Other liquidating			64				207
Total finance receivables			3,547				4,626
Less: Allowance for losses			276				342
Less: Finance receivables held for sale			245				413
Total finance receivables held for investment, net		$	3,026			$	3,871

Credit Quality Indicators and Nonaccrual Finance Receivables

We internally assess the quality of our finance receivables held for investment portfolio based on a number of key credit quality indicators and statistics such as delinquency, loan balance to collateral value, the liquidity position of individual borrowers and guarantors, debt service coverage in the golf mortgage product line and default rates of our notes receivable collateral in the timeshare product line. Because many of these indicators are difficult to apply across an entire class of receivables, we evaluate individual loans on a quarterly basis and classify these loans into three categories based on the key credit quality indicators for the individual loan. These three categories are performing, watchlist and nonaccrual.

We classify finance receivables held for investment as nonaccrual if credit quality indicators suggest full collection is doubtful. In addition, we automatically classify accounts as nonaccrual that are contractually delinquent by more than three months unless collection is not doubtful. Cash payments on nonaccrual accounts, including finance charges, generally are applied to reduce the net investment balance. We resume the accrual of interest when the loan becomes contractually current through payment according to the original terms of the loan or, if a loan has been modified, following a period of performance under the terms of the modification, provided we conclude that collection of all principal and interest is no longer doubtful. Previously suspended interest income is recognized at that time.

Accounts are classified as watchlist when credit quality indicators have deteriorated as compared with typical underwriting criteria, and we believe collection of full principal and interest is probable but not certain. All other finance receivables held for investment that do not meet the watchlist or nonaccrual categories are classified as performing.

A summary of finance receivables held for investment categorized based on the internally assigned credit quality indicators discussed above is as follows:

		October 1, 2011																January 1, 2011
(In millions)		Performing				Watchlist				Nonaccrual				Total				Performing				Watchlist				Nonaccrual				Total
Aviation		$	1,591			$	214			$	122			$	1,927			$	1,713			$	238			$	169			$	2,120
Golf equipment			91				38				12				141				138				51				23				212
Golf mortgage			225				133				228				586				163				303				219				685
Timeshare			129				24				214				367				222				77				382				681
Structured capital			212				5				—				217				290				27				—				317
Other liquidating			34				—				30				64				130				11				57				198
Total		$	2,282			$	414			$	606			$	3,302			$	2,656			$	707			$	850			$	4,213
% of Total			69.1	%			12.5	%			18.4	%							63.0	%			16.8	%			20.2	%

We measure delinquency based on the contractual payment terms of our loans and leases. In determining the delinquency aging category of an account, any/all principal and interest received is applied to the most past-due principal and/or interest amounts due. If a significant portion of the contractually due payment is delinquent, the entire finance receivable balance is reported in accordance with the most past-due delinquency aging category.

Finance receivables held for investment by delinquency aging category is summarized in the tables below:

		Less Than												Greater Than
		31 Days				31-60 Days				61-90 Days				90 Days
(In millions)		Past Due				Past Due				Past Due				Past Due				Total
October 1, 2011
Aviation		$	1,764			$	75			$	35			$	53			$	1,927
Golf equipment			122				8				5				6				141
Golf mortgage			502				11				13				60				586
Timeshare			283				—				—				84				367
Structured capital			217				—				—				—				217
Other liquidating			45				—				—				19				64
Total		$	2,933			$	94			$	53			$	222			$	3,302
January 1, 2011
Aviation		$	1,964			$	67			$	41			$	48			$	2,120
Golf equipment			171				13				9				19				212
Golf mortgage			543				12				7				123				685
Timeshare			533				14				6				128				681
Structured capital			317				—				—				—				317
Other liquidating			166				2				1				29				198
Total		$	3,694			$	108			$	64			$	347			$	4,213

We had no accrual status loans that were greater than 90 days past due at October 1, 2011 or at January 1, 2011. At October 1, 2011, the 60+ days contractual delinquency as a percentage of finance receivables held for investment was 8.33%, compared with 9.77% at January 1, 2011.

Impaired Loans

We evaluate individual finance receivables held for investment in non-homogeneous portfolios and larger accounts in homogeneous loan portfolios for impairment on a quarterly basis. Finance receivables classified as held for sale are reflected at the lower of cost or fair value and are excluded from these evaluations. A finance receivable is considered impaired when it is probable that we will be unable to collect all amounts due according to the contractual terms of the loan agreement based on our review of the credit quality indicators discussed above. Impaired finance receivables include both nonaccrual accounts and accounts for which full collection of principal and interest remains probable, but the account’s original terms have been, or are expected to be, significantly modified. If the modification specifies an interest rate equal to or greater than a market rate for a finance receivable with comparable risk, the account is not considered impaired in years subsequent to the modification. There was no significant interest income recognized on impaired loans in the first nine months of 2011 or 2010.

The average recorded investment in impaired loans for the first nine months of 2011 and 2010 is provided below:

						Golf				Golf
(In millions)		Aviation				Equipment				Mortgage				Timeshare				Other Liquidating				Total
For the nine months ended October 1, 2011
Impaired loans with a related allowance for losses recorded		$	126			$	4			$	193			$	283			$	19			$	625
Impaired loans with no related allowance for losses recorded			21				—				96				54				15				186
Total		$	147			$	4			$	289			$	337			$	34			$	811
For the nine months ended October 2, 2010
Impaired loans with a related allowance for losses recorded		$	198			$	5			$	184			$	356			$	23			$	766
Impaired loans with no related allowance for losses recorded			14				1				112				70				60				257
Total		$	212			$	6			$	296			$	426			$	83			$	1,023

A summary of impaired finance receivables, excluding leveraged leases, and related allowance for losses is provided below:

						Golf				Golf								Other
(In millions)		Aviation				Equipment				Mortgage				Timeshare				Liquidating				Total
October 1, 2011
Impaired loans with a related allowance for losses recorded:
Recorded investment		$	94			$	2			$	196			$	206			$	23			$	521
Unpaid principal balance			95				2				205				245				30				577
Related allowance			39				—				51				76				12				178
Impaired loans with no related allowance for losses recorded:
Recorded investment			26				—				108				73				4				211
Unpaid principal balance			27				—				114				87				44				272
Total impaired loans:
Recorded investment			120				2				304				279				27				732
Unpaid principal balance			122				2				319				332				74				849
Related allowance			39				—				51				76				12				178
January 1, 2011
Impaired loans with a related allowance for losses recorded:
Recorded investment		$	147			$	4			$	175			$	355			$	16			$	697
Unpaid principal balance			144				5				178				385				15				727
Related allowance			45				2				39				102				3				191
Impaired loans with no related allowance for losses recorded:
Recorded investment			17				—				138				69				30				254
Unpaid principal balance			21				—				146				74				89				330
Total impaired loans:
Recorded investment			164				4				313				424				46				951
Unpaid principal balance			165				5				324				459				104				1,057
Related allowance			45				2				39				102				3				191

Loan Modifications

Troubled debt restructurings occur when we have either modified the contract terms of finance receivables held for investment for borrowers experiencing financial difficulties or accepted a transfer of assets in full or partial satisfaction of the loan balance. Modifications often arise in the golf mortgage and timeshare product lines as a result of the lack of financing available to borrowers in these industries. Loans in our golf mortgage product line are typically structured with amortization periods between 20 and 30 years and contractual maturities of between 5 and 10 years, resulting in a significant balloon payment. We modify a significant portion of these loans at, or near the maturity date as a result of this structure.

The types of modifications we typically make include extensions of the original maturity date of the contract, extensions of revolving borrowing periods, delays in the timing of required principal payments, deferrals of interest payments, advances to protect the value of our collateral and principal reductions contingent on full repayment prior to the maturity date.

Finance receivables held for investment that were modified during the three- and nine-month periods of 2011 and are categorized as troubled debt restructurings, excluding related allowances for doubtful accounts and transfers of assets in satisfaction of the loan balance, are summarized below.

						Pre-				Post-
						Modification				Modification				Recorded
		Number of				Recorded				Recorded				Investment at
(Dollars in millions)		Customers				Investment				Investment				October 1, 2011
For the Three Months Ended October 1, 2011
Golf mortgage			7			$	38			$	35			$	35
Timeshare			3				136				136				133
For the Nine Months Ended October 1, 2011
Golf mortgage			21			$	166			$	165			$	163
Timeshare			9				219				219				158

Due to the nature of these restructurings, the financial effect of the modifications included in the above table was insignificant. Modified finance receivables are classified as impaired loans and are evaluated on an individual basis to determine whether reserves are required. Our reserve evaluation includes an estimate of the likelihood that the borrower will be able to perform under the contractual terms of the modification. Subsequent payment defaults or delinquency trends of finance receivables modified as troubled debt restructurings are also factored into the evaluation of impaired loans for reserving purposes as a default decreases the likelihood that the borrower will be able to perform under the terms of future modifications. During the first nine months of 2011, we had four customer defaults in our timeshare product line for finance receivables that had been modified as troubled debt restructurings within the previous twelve months. The recorded investment for these customers totaled $171 million, excluding related allowances for doubtful accounts, at October 1, 2011.

We may foreclose, repossess or receive collateral when a customer no longer has the ability to make payment. These transfers of assets in full or partial satisfaction of the loan balance are also considered troubled debt restructurings if the fair value of the assets transferred is less than our recorded investment. Similar to the troubled debt restructurings described above, these loans typically have been classified as impaired loans prior to the asset transfer; therefore, reserves have already been established related to the loan. As a result, for the three and nine months ended October 1, 2011, respectively, charge-offs of $19 million and $58 million upon the transfer of such assets were largely offset by previously established reserves.

Troubled debt restructurings resulting in transfers of assets in satisfaction of the loan balance that occurred during the three and nine months of 2011 are as follows.

						Pre-
						Modification				Post-
		Number of				Recorded				Modification
(Dollars in millions)		Customers				Investment				Asset Balance
For the Three Months Ended October 1, 2011
Aviation			5			$	17			$	11
Golf mortgage			2				14				7
Timeshare			1				30				24
For the Nine Months Ended October 1, 2011
Aviation			19			$	46			$	27
Golf mortgage			3				23				14
Timeshare			2				96				60

Allowance for Losses

We maintain the allowance for losses on finance receivables held for investment at a level considered adequate to cover inherent losses in the portfolio based on management’s evaluation and analysis by product line. For larger balance accounts specifically identified as impaired, including large accounts in homogeneous portfolios, a reserve is established based on comparing the carrying value with either a) the expected future cash flows, discounted at the finance receivable’s effective interest rate; or b) the fair value, if the finance receivable is collateral dependent. The expected future cash flows consider collateral value; financial performance and liquidity of our borrower; existence and financial strength of guarantors; estimated recovery costs, including legal expenses; and costs associated with the repossession/foreclosure and eventual disposal of collateral. When there is a range of potential outcomes, we perform multiple discounted cash flow analyses and weight the potential outcomes based on their relative likelihood of occurrence using the probability-weighted approach.

The evaluation of our portfolios is inherently subjective as it requires estimates. These estimates include the amount and timing of future cash flows expected to be received on impaired finance receivables and the underlying collateral, which may differ from actual results. While our analysis is specific to each individual account, the most critical factors included in this analysis vary by product line. For the aviation product line, these factors include industry valuation guides, physical condition of the aircraft, payment history, and existence and financial strength of guarantors. For the golf equipment line, the critical factors are the age and condition of the collateral, while the factors for the golf mortgage line include historical golf course, hotel or marina cash flow performance; estimates of golf rounds and price per round or occupancy and room rates; market discount and capitalization rates; and existence and financial strength of guarantors. For the timeshare product line, the critical factors are the historical performance of consumer notes receivable collateral, real estate valuations, operating expenses of the borrower, the impact of bankruptcy court rulings on the value of the collateral, legal and other professional expenses and borrower’s access to capital.

We also establish an allowance for losses by product line to cover probable but specifically unknown losses existing in the portfolio. For homogeneous portfolios, including the aviation and golf equipment product lines, the allowance is established as a percentage of non-recourse finance receivables, which have not been identified as requiring specific reserves. The percentage is based on a combination of factors, including historical loss experience, current delinquency and default trends, collateral values, and both general economic and specific industry trends. For non-homogeneous portfolios, including the golf mortgage and timeshare product lines, the allowance is established as a percentage of watchlist balances, as defined on page 10, which represents a combination of assumed default likelihood and loss severity based on historical experience, industry trends and collateral values. In establishing our allowance for losses to cover accounts not specifically identified, the most critical factors for the aviation product line include the collateral value of the portfolio, historical default experience and delinquency trends; for golf equipment, factors considered include historical loss experience and delinquency trends; and for golf mortgage, factors include an evaluation of individual loan credit quality indicators such as delinquency, loan balance to collateral value, debt service coverage, existence and financial strength of guarantors, historical progression from watchlist to nonaccrual status and historical loss severity. For the timeshare product line, we evaluate individual loan credit quality indicators such as borrowing base shortfalls for revolving notes receivable facilities, default rates of our notes receivable collateral, borrower’s access to capital, historical progression from watchlist to nonaccrual status and estimates of loss severity based on analysis of impaired loans in the product line.

Finance receivables held for investment are written down to the fair value (less estimated costs to sell) of the related collateral at the earlier of the date when the collateral is repossessed or when no payment has been received for six months unless management deems the receivable collectable. Finance receivables are charged off when the remaining balance is deemed to be uncollectible.

A rollforward of the allowance for losses on finance receivables held for investment and a summary of its composition, based on how the underlying finance receivables are evaluated for impairment, is presented below. The finance receivables reported in the following table specifically exclude $217 million and $281 million of leveraged leases at October 1, 2011 and October 2, 2010, respectively, in accordance with authoritative accounting standards:

																		Structured
																		Capital and
						Golf				Golf								Other
(In millions)		Aviation				Equipment				Mortgage				Timeshare				Liquidating				Total
For the nine months ended October 1, 2011
Allowance for losses
Beginning balance		$	107			$	16			$	79			$	106			$	34			$	342
Provision for losses			18				(3	)			4				7				1				27
Net charge-offs and transfers			(27	)			(4	)			(11	)			(35	)			(16	)			(93	)
Ending balance		$	98			$	9			$	72			$	78			$	19			$	276
Ending balance based on individual evaluations			39				—				51				76				12				178
Ending balance based on collective evaluation			59				9				21				2				7				98
Finance receivables
Individually evaluated for impairment		$	120			$	2			$	304			$	279			$	27			$	732
Collectively evaluated for impairment			1,807				139				282				88				37				2,353
Balance at end of period		$	1,927			$	141			$	586			$	367			$	64			$	3,085
For the nine months ended October 2, 2010
Allowance for losses
Beginning balance		$	114			$	9			$	65			$	79			$	74			$	341
Provision for losses			27				12				61				37				(9	)			128
Net charge-offs			(36	)			(5	)			(48	)			(5	)			(20	)			(114	)
Ending balance		$	105			$	16			$	78			$	111			$	45			$	355
Ending balance based on individual evaluations			47				2				38				99				7				193
Ending balance based on collective evaluation			58				14				40				12				38				162
Finance receivables
Individually evaluated for impairment		$	180			$	6			$	289			$	442			$	70			$	987
Collectively evaluated for impairment			2,002				194				438				565				266				3,465
Balance at end of period		$	2,182			$	200			$	727			$	1,007			$	336			$	4,452

Note 7: Inventories

		October 1,				January 1,
(In millions)		2011				2011
Finished goods		$	1,079			$	784
Work in process			2,303				2,125
Raw materials			406				506
			3,788				3,415
Progress/milestone payments			(1,181	)			(1,138	)
		$	2,607			$	2,277

Note 8: Debt

In September 2011, we issued $250 million in 4.625% Notes due 2016 and $250 million in 5.950% Notes due 2021 for total net proceeds of $496 million. We also commenced a cash tender offer in September that expired on October 12, 2011 for any and all of our approximately $600 million in outstanding 4.50% convertible senior notes due 2013.

In accordance with the terms of the tender offer, for each $1,000 principal amount of the convertible notes purchased, a holder received a cash payment of $1,524 plus accrued and unpaid interest up to the October 13, 2011 settlement date. In the aggregate, the holders of convertible notes validly tendered $225 million principal amount, or 37.5%, of the convertible notes. Excluding accrued interest, we paid $342 million in cash for the tendered convertible notes. In accordance with the applicable authoritative accounting guidance, we have determined the fair value of the liability component of the convertible notes purchased in the tender offer to be $234 million, with the balance of $108 million representing the equity component. The carrying value of the tendered convertible notes, including unamortized issuance costs, was $200 million, so a pretax loss of $34 million will be recognized in the fourth quarter of 2011, along with a $108 million reduction to shareholders’ equity. We have classified $200 million of the convertible notes as current at October 1, 2011, based on the settlement subsequent to quarter end. Immediately following the settlement in October, we had approximately $375 million principal amount of convertible notes outstanding, which are convertible at the holder’s option, under certain circumstances described in our 2010 Form 10-K.

Note 9: Accrued Liabilities

We provide limited warranty and product maintenance programs, including parts and labor, for certain products for periods ranging from one to five years. Changes in our warranty and product maintenance liabilities are as follows:

		Nine Months Ended
		October 1,				October 2,
(In millions)		2011				2010
Accrual at the beginning of period		$	242			$	263
Provision			162				129
Settlements			(173	)			(162	)
Adjustments to prior accrual estimates			(11	)			12
Accrual at the end of period		$	220			$	242

Note 10: Commitments and Contingencies

We are subject to legal proceedings and other claims arising out of the conduct of our business, including proceedings and claims relating to commercial and financial transactions; government contracts; compliance with applicable laws and regulations; production partners; product liability; employment; and environmental, safety and health matters. Some of these legal proceedings and claims seek damages, fines or penalties in substantial amounts or remediation of environmental contamination. As a government contractor, we are subject to audits, reviews and investigations to determine whether our operations are being conducted in accordance with applicable regulatory requirements. Under federal government procurement regulations, certain claims brought by the U.S. Government could result in our being suspended or debarred from U.S. Government contracting for a period of time. On the basis of information presently available, we do not believe that existing proceedings and claims will have a material effect on our financial position or results of operations.

Note 11. Derivative Instruments and Fair Value Measurements

We measure fair value at the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. We prioritize the assumptions that market participants would use in pricing the asset or liability into a three-tier fair value hierarchy. This fair value hierarchy gives the highest priority (Level 1) to quoted prices in active markets for identical assets or liabilities and the lowest priority (Level 3) to unobservable inputs in which little or no market data exist, requiring companies to develop their own assumptions. Observable inputs that do not meet the criteria of Level 1, and include quoted prices for similar assets or liabilities in active markets or quoted prices for identical assets and liabilities in markets that are not active are categorized as Level 2. Level 3 inputs are those that reflect our estimates about the assumptions market participants would use in pricing the asset or liability based on the best information available in the circumstances. Valuation techniques for assets and liabilities measured using Level 3 inputs may include methodologies such as the market approach, the income approach or the cost approach and may use unobservable inputs such as projections, estimates and management’s interpretation of current market data. These unobservable inputs are utilized only to the extent that observable inputs are not available or cost-effective to obtain.

Assets and Liabilities Recorded at Fair Value on a Recurring Basis

The assets and liabilities that are recorded at fair value on a recurring basis consist primarily of our derivative financial instruments, which are categorized as Level 2 in the fair value hierarchy. The fair value amounts of these instruments that are designated as hedging instruments are provided below:

										Asset (Liability)
										October 1,				January 1,
(In millions)		Borrowing Group				Balance Sheet Location				2011				2011
Assets
Interest rate exchange contracts*		Finance				Other assets				$	27			$	34
Foreign currency exchange contracts		Manufacturing				Other current assets					12				39
Total										$	39			$	73
Liabilities
Interest rate exchange contracts*		Finance				Other liabilities				$	(9	)		$	(6	)
Foreign currency exchange contracts		Manufacturing				Accrued liabilities					(6	)			(2	)
Total										$	(15	)		$	(8	)