QWEST CORP - 10-K Annual Report

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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K

[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

FOR THE FISCAL YEAR ENDED DECEMBER 31, 2001

OR

[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 OF THE
SECURITIES EXCHANGE ACT OF 1934

FOR THE TRANSITION PERIOD FROM TO

COMMISSION FILE NO. 1-3040

QWEST CORPORATION
(formerly known as U S WEST Communications, Inc.)

COLORADO 84-0273800
(State or other jurisdiction of incorporation
or organization) (I.R.S. Employer Identification No.)

1801 CALIFORNIA STREET, DENVER, COLORADO 80202
TELEPHONE NUMBER (303) 992-1400
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SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:

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SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:

NONE

THE REGISTRANT, A WHOLLY OWNED SUBSIDIARY OF QWEST COMMUNICATIONS
INTERNATIONAL INC., MEETS THE CONDITIONS SET FORTH IN GENERAL INSTRUCTION I(1)
(a) AND (b) OF FORM 10-K AND IS THEREFORE FILING THIS FORM WITH REDUCED
DISCLOSURE FORMAT PURSUANT TO GENERAL INSTRUCTION I(2).

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

Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of the registrant's knowledge in definitive proxy or information statements
incorporated by reference in Part III of the Form 10-K or any amendment to this
Form 10-K.***

This document contains statements about expected future events and
financial results that are forward-looking and subject to risks and
uncertainties. Please refer to page 21 of this Form 10-K for a discussion of
factors that could cause actual results to differ from expectations.
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*** Not applicable in that registrant is a wholly owned subsidiary.
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QWEST CORPORATION

FORM 10-K

TABLE OF CONTENTS

1

PART I

ITEM 1. BUSINESS.

Qwest Corporation ("Qwest", "us", "we" or "our") provides local
telecommunications and related services as well as wireless services to more
than 25 million residential and business customers in the 14-state local service
area of Arizona, Colorado, Idaho, Iowa, Minnesota, Montana, Nebraska, New
Mexico, North Dakota, Oregon, South Dakota, Utah, Washington and Wyoming (our
"local service area"). We principally serve global and national business and
government customers, and small business and residential customers primarily in
our local service area.

Qwest is incorporated under the laws of the State of Colorado and its
principal offices are located at 1801 California Street, Denver, Colorado 80202,
telephone number (303) 992-1400.

On June 30, 2000, Qwest Communications International Inc. ("QCII")
completed its acquisition (the "Merger") of U S WEST, Inc. ("U S WEST"). QCII
accounted for the Merger as a reverse acquisition under the purchase method of
accounting with U S WEST being deemed the accounting acquirer and QCII the
acquired entity. As a result of the Merger, we became a wholly owned subsidiary
of QCII.

OPERATIONS

We are managed as a single business unit and do not report our results at
any lower level, such as operating segments, to our chief operating decision
maker. However, for reference purposes, this document discloses the segments as
reported by our parent, QCII. Our operations are included in QCII's consolidated
results and in the following QCII operating segments: (1) retail services, (2)
wholesale services and (3) network services. QCII intends to change its segment
reporting beginning in 2002 to reflect the way in which QCII is managing its
operations in 2002. As a result, our business will be included in the new QCII
operating segments in 2002, as follows: (1) business services, (2) consumer
services, (3) wholesale services and (4) network services. You can find
additional financial information on QCII's operating segments in Note 10 to our
consolidated financial statements.

RETAIL SERVICES

We offer a wide variety of retail products and services that help people
and businesses communicate via multiple electronic mediums. We sell these
products and services directly to residential users, businesses, educational and
governmental agencies. We also sell these products and services to other
telecommunications companies and Internet service providers ("ISPs") for resale
to end users. These companies may also use our products and services with
respect to the transport of their customers' telecommunications. The following
reflects the key categories of our retail products and services.

VOICE COMMUNICATIONS. We offer voice communications that include basic
local exchange telephone service and Centrex services.

- Local exchange telephone services. We operate our local exchange
telephone service in our local service area. The local exchange telephone
service connects our customer's home or office to our telephone network
in order to originate and terminate voice and data telecommunications. We
also offer additional voice products such as Private Branch Exchange
("PBX") and Direct Inward Dial ("DID"). PBX allows the customer to have
multiple telephone numbers carried on one large trunk between the
customer premise and the telephone exchange. DID allows the customer to
dial others within the company using only an extension. In addition to
these local telephone services, we provide a number of enhanced service
features, such as CallerID, Call Waiting, 3-Way Calling, and Voice Mail.
We also derive revenue from directory assistance and public telephone
service.

- Centrex services. Our Centrex product is offered predominantly to small
business and government customers with needs in voice communications. The
Centrex product offers the customer all of the advantages of a personal
telephone system without the expense of owning the equipment. The central
office provides all of the features directly to the business.
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ADVANCED DATA AND IP PRODUCTS. We offer a broad range of products and
services to transport voice, data and video telecommunications that use evolving
transport methods that optimize our existing network and incorporate Internet
protocol ("IP") technology. This technology lowers costs and increases
transmission speeds. We believe that these services and products will be a key
component of our overall growth. We view these products and services as data and
IP-enabled products and services.

Data. Our data products include a number of products offered primarily to
businesses, telecommunications companies, government agencies and ISPs. These
products and services are used by businesses to facilitate a variety of their
internal and external data transmissions, such as transferring files from one
location to another. Our telecommunications and ISP customers use these products
and services primarily to enable their customers to transmit large amounts of
data over broadband infrastructure. Some of these products include:

- Asynchronous Transfer Mode ("ATM"), which is a broadband, network
transport service that provides a fast, efficient way to electronically
move large quantities of information over a highly reliable, scalable,
secure fiber optic network.

- Frame Relay, which is a fast packet switching technology that allows data
to travel in individual packets of variable length. The key advantage to
this approach is that a frame relay network can accommodate data packets
of various sizes associated with virtually any data protocol.

- Private Lines, which are direct circuits or channels that are
specifically dedicated to the use of an end-user organization for the
purpose of directly connecting two or more sites in a multi-site
enterprise. Private lines offer a highly cost effective solution for
frequent communications of large amounts of data between sites is
frequent.

- Integrated Services Digital Network ("ISDN"), which is a comprehensive
digital network architecture allowing users to transmit voice, data,
video and image -- separately or simultaneously -- over standard
telephone lines or fiber optics.

- Customer Premises Equipment ("CPE"), which we resell and lease from
leading equipment manufacturers, includes equipment such as phones,
modems, routers and switches. We provide services related to the CPE for
a wide variety of customer network needs.

IP. IP-enabled products assist in the transmission of voice, data and
video using our fiber optic broadband network. These products include the
following:

- Internet Dial Access, which provides ISP customers with a comprehensive,
reliable, cost-effective dial-up network infrastructure. Our dial
products are primarily designed for established ISPs with strong
networking capabilities looking to expand their existing dial networks
quickly and cost-effectively, as well as smaller ISPs desiring to
increase their dial-up Internet access coverage.

- Digital Subscriber Line products ("DSL"), which provide residential and
business customers a digital modem technology that converts their
existing telephone lines into higher bandwidth facilities for video and
high-speed data communications to the Internet or private networks.

WIRELESS SERVICES AND PRODUCTS. We hold 10 MHz licenses to provide
Personal Communications Service (PCS) in most markets in our local service area.
We offer wireless services in 28 of these markets. Our integrated service
enables our customers to use the same telephone number for their wireless phone
as for their home or business phone. We also serve wireless customers in 20
smaller markets in our local service area through a joint venture with Touch
America, Inc. We provide digital services in the 1900 MHz band. Our PCS licenses
were issued in 1997 with 10-year terms and are renewable for successive 10-year
terms within Federal Communications Commission ("FCC") regulations.

LONG-DISTANCE SERVICES. We provide intraLATA long-distance service to our
customers within our local service area. IntraLATA long-distance service refers
to services that cross local exchange area boundaries but originate and
terminate within the same geographic local access and transport area, or LATA.
There are 27 LATAs throughout our local service area. These services include
calls that terminate outside a

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caller's local calling area but within their LATA, wide area telecommunications
service or "800" services for customers with highly concentrated demand and
special services, such as transport of data, radio and video.

We sell our retail products and services through a variety of channels
including direct-sales marketing, telemarketing and arrangements with
third-party agents.

WHOLESALE SERVICES

We provide network transport, switching and billing services in our local
service area to competitive local exchange carriers ("CLECs"), interexchange
carriers ("IXCs") and wireless carriers. CLECs are communications companies
certified by a state Public Utility Commission or similar agency ("PUC") that
provide local exchange service within a LATA, including LATAs within our local
service area. IXCs provide long-distance services to end-users by handling calls
that are made from a phone exchange in one LATA to an exchange in another LATA.
Competitive communications companies often operate as both CLECs and IXCs. We
also provide wholesale products such as conventional private line services to
other communications providers, ISPs and other data service companies and
high-volume voice services. We will be allowed to provide wholesale interLATA
network transport services within our local service area following FCC approval
of our interLATA applications.

We sell these services in our local service area (1) by means of negotiated
interconnection agreements approved by PUCs, (2) by reference to our filed
Statement of Generally Available Terms and Conditions, (3) through our tariffs
and contracts and (4) through advertising on our website.

NETWORK SERVICES

Network services provide access to our telecommunications network,
including our information technologies supporting the network, primarily to
customers of our retail services and wholesale services.

COMPETITION

RETAIL SERVICES

VOICE COMMUNICATIONS. In providing local exchange services, we compete
with CLECs, including some owned by national carriers, and increasingly with
wireless providers and cable companies. Competition is based primarily on price,
services, features, customer service, network access coverage, quality and
reliability.

Our existing infrastructure and long-standing customer relationships make
us the market leader in providing local exchange services in our local service
area. However, technology substitution, such as wireless and cable telephony
substitution of wireline and cable modem substitution of dial-up modem lines,
has led to a decrease in total access lines. Access lines are telephone lines
reaching from a central office to the customer's premises. Our competitive
position will benefit from receiving FCC approval to offer interLATA
long-distance services within our local service area. This regulatory relief
will allow us to market long-distance services to our existing local customers.

ADVANCED DATA AND IP PRODUCTS. Business customers are the primary market
for these network-related services. In providing these services, we compete with
national carriers, Regional Bell Operating Companies ("RBOCs") and CLECs.
Customers are particularly concerned with network reach, but are also sensitive
to quality, reliability, customer service and price.

WIRELESS SERVICES AND PRODUCTS. We provide mobile phone services in select
markets in our local service area, including Denver, Seattle, Phoenix,
Minneapolis, Portland, and Salt Lake City. The wireless industry continues to
grow, but is highly competitive. We compete primarily with national and regional
wireless carriers. Competition in the wireless market is based primarily on
price, services, features, coverage area, technical quality and customer
service. Increased competition combined with the lack of national coverage has
impeded our growth. Our future competitive position will depend on our ability
to offer new features and services, price competitively and respond to changing
consumer preferences and demographics.

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In addition, we hope to improve our competitive position by bundling and
integrating our wireless services with our wireline and other communications
services.

LONG-DISTANCE SERVICES. We market intraLATA long-distance services within
our local service area. We compete with national carriers as well as CLECs,
RBOCs and other resellers. Wireless providers also market in-state long-distance
services as a substitute to traditional wireline and fiber optic service.

Competition in the long-distance retail market is based primarily on price,
services, features, customer service, network coverage, quality and reliability.
We are the market share leader in providing intraLATA long-distance within our
local service area, but we face increasing competition from national carriers,
which have substantial financial and technical resources. National carriers will
continue to have a competitive advantage until we gain FCC approval to offer
interLATA long-distance services in our local service area. Upon such approval,
our competitive position will improve based on our ability to market additional
long-distance services to our existing customers.

WHOLESALE SERVICES

We primarily compete with smaller regional providers, including CLECs,
competitive access providers and independent telephone companies. We compete in
our local service area on network quality, customer service, product features,
the speed with which we can provide a customer with requested services and
price. Although our status as the incumbent local exchange carrier ("ILEC")
helps make us the leader in providing wholesale services within our local
service area, increased competition has resulted in a reduction in billable
access minutes of use. Our competitive position should improve as the FCC allows
us to offer interLATA wholesale services.

REGULATION

As a general matter, we are subject to substantial regulation, including
requirements and restrictions arising under the 1996 Telecommunications Act (the
"1996 Act") and state utility laws, and the rules and policies of the FCC, state
PUCs and other governmental entities. This regulation, among other matters,
currently prohibits us (with certain exceptions) from providing retail or
wholesale interLATA telecommunications services within our local service area,
and governs the terms and conditions under which we provide services to our
customers (including competing CLECs and IXCs in our local service area).

INTERCONNECTION. The FCC is continuing to interpret the obligations of
ILECs under the 1996 Act to interconnect their networks with, and make unbundled
network elements available to, CLECs. These decisions establish our obligations
in our local service area, and our rights when we compete outside of our local
service area. In January 2002 the FCC released its Triennial Review of Unbundled
Network Elements in which it seeks to ensure that the framework established in
the 1996 Act remains current given advances in technology and developments in
the markets for telecommunications services. The outcome of this proceeding may
affect our current obligations regarding sharing our network with our
competitors. In addition, the United States Supreme Court is now considering an
appeal from a ruling of the Eighth Circuit Court of Appeals that the FCC's rules
for the pricing of interconnection and unbundled network elements by ILECs
unlawfully preclude ILECs from recovering their actual costs as required by the
1996 Act.

ACCESS PRICING. The FCC has initiated a number of proceedings that
directly affect the rates and charges for access services that we sell or
purchase. It is expected that these proceedings and related implementation of
resulting FCC decisions will continue through 2002.

On May 31, 2000, the FCC adopted the access reform and universal service
plan developed by the Coalition for Affordable Local and Long-Distance Service
("CALLS"). The adoption of the CALLS proposal resolved a number of outstanding
issues before the FCC. The CALLS plan has a five-year life and provides for the
following: elimination of the residential presubscribed interexchange carrier
charge; increases in subscriber line charges; reductions in switched access
usage rates; the removal of certain implicit universal service support from
access charges and direct recovery from end users; and commitments from
participating IXCs to pass through access charge reductions to end users. We
have opted into the five-year CALLS plan.

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ADVANCED TELECOMMUNICATIONS SERVICES. The FCC has ruled that advanced
services provided by an ILEC are covered by those provisions of the 1996 Act
that govern telephone exchange and exchange access services. We challenged this
finding, contending that advanced services fit within neither category and are
not properly treated as exchange services. On April 20, 2001, the Court of
Appeals vacated and remanded to the FCC its classification of DSL-based advanced
services. In January 2002 the FCC released a Notice of Proposed Rulemaking
regarding the Regulatory Requirements for ILEC Broadband Telecommunications
Services. In this proceeding the FCC seeks comment on what changes should be
made in traditional regulatory requirements to reflect the competitive market
and create incentives for broadband services growth and investment.

INTERLATA LONG-DISTANCE ENTRY. Several RBOCs have filed for entry into the
interLATA long-distance business. Although many of these applications have been
supported by state PUCs, the FCC had rejected all applications until December
1999. As of March 25, 2002, the FCC has granted long-distance authority to RBOCs
operating in the states of Arkansas, Connecticut, Kansas, Massachusetts,
Missouri, New York, Oklahoma, Pennsylvania, Rhode Island and Texas. Applications
are pending that, if granted by the FCC, would permit the relevant RBOC to
provide interLATA services in the states of Georgia, Louisiana, Maine, New
Jersey and Vermont. Applications are expected to be filed with the FCC during
2002 covering numerous additional states.

We have filed applications with all of our local service area state PUCs
for support of our planned applications to the FCC for authority to enter the
interLATA long-distance business. Workshops and related proceedings are complete
in twelve of our fourteen local service area states, and hearings are underway
in the remaining two local service area states. We agreed to test operational
support systems ("OSS") on a regional basis in thirteen states, and testing of
those systems began in March 2001. Testing in Arizona was conducted separately,
and began in February 2001. OSS testing is in its final stages, and state
proceedings on our applications are in progress. We currently plan to file for
interLATA long-distance approval with the FCC for all states in our local
service area by mid-2002 and expect to receive approval of the applications
within 90 days of each filing. However, there can be no assurance that we will
be in a position to make these applications to the FCC on our current schedule,
or will obtain timely FCC approval of these applications.

RECIPROCAL COMPENSATION FOR ISPS. On April 27, 2001, the FCC issued an
Order with regard to intercarrier compensation for ISP bound traffic. The Order
required carriers serving ISP bound traffic to reduce reciprocal compensation
rates over a 36-month period beginning with an initial reduction to $0.0015 per
minute of use and ending with a rate of $0.0007 per minute of use. In addition,
a cap was placed on the number of minutes of use on which the terminating
carrier may charge such rates. This reduction will lower costs that we pay CLECs
for delivering such traffic to other carriers, although we do not expect that
this will have a material effect on our results of operations.

EMPLOYEES

As of December 31, 2001, we employed approximately 40,000 employees.
Approximately 80% were represented by collective bargaining agreements.

ITEM 2. PROPERTIES.

Our principal properties are located in our local service area. The
percentage allocation of our principal gross property, plant and equipment
consists of the following:

Communications equipment primarily consists of switches, routers and
transmission electronics. Other network equipment primarily includes conduit and
cable (both copper wire and fiber optic). We own substantially all of our
telecommunications equipment required for our business.

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ITEM 3. LEGAL PROCEEDINGS.

For a discussion of legal proceedings arising before December 31, 2001, see
Note 9 to the consolidated financial statements. The following describes certain
legal proceedings and claims that have arisen since December 31, 2001.

On February 14, 2002, the Minnesota Department of Commerce filed a formal
complaint against us with the Minnesota Public Utilities Commission alleging
that we, in contravention of federal and state law, failed to file
interconnection agreements with the Minnesota Public Utilities Commission
relating to certain of our wholesale customers, and thereby allegedly
discriminating against other CLECs. The complaint seeks civil penalties related
to such alleged violations between $50 million and $200 million. This proceeding
is at an early stage. Other states in the local service area are looking into
similar matters and further proceedings may ensue in those states.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.

Not applicable.

PART II

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.

Not applicable.

ITEM 6. SELECTED FINANCIAL DATA.

We have omitted this information pursuant to General Instruction I(2).

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.

We have omitted certain information pursuant to General Instruction I(2).

Special Note: Certain statements set forth below under this caption
constitute "forward-looking statements" within the meaning of the Private
Securities Litigation Reform Act of 1995. You can refer to "Special Note
Regarding Forward-Looking Statements" at the end of this Item 7 for additional
factors relating to such statements as well as for a discussion of certain risk
factors applicable to our financial condition and results of operations.

RESULTS OF OPERATIONS

2001 COMPARED WITH 2000

Several items of a non-recurring nature impacted net income in 2001 and
2000. Results of operations for the two years excluding the after-tax effects of
such items are as follows:

Non-recurring items in 2001 include:

- an after-tax charge of $35 million ($57 million, pre-tax) for charges
associated with Qwest Communications International Inc.'s ("QCII")
acquisition of U S WEST, Inc. ("U S WEST") (the "Merger") and other
charges;

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- an after-tax charge of $136 million ($222 million, pre-tax) for
depreciation associated with access lines returned to service;

- an after-tax gain of $30 million ($51 million, pre-tax) for the sale of
access lines; and

- an after-tax charge of $151 million ($247 million, pre-tax) for
restructuring charges.

Non-recurring items in 2000 include:

- an after-tax charge of $787 million ($1.285 billion, pre-tax) for charges
associated with the Merger; and

- an after-tax charge of $17 million ($28 million, pre-tax) for the net
loss on the sale of fixed assets.

Adjusted net income in 2001 increased $29 million or 1.5% when compared to
2000. The slight increase was primarily due to revenue growth associated with
increased demand for wireless and data services, lower employee benefit costs
such as pension and post-retirement and cost savings associated with synergies
generated by the Merger. Offsetting these items were higher operating costs as a
result of growth initiatives and higher depreciation associated with our
continued investment in our network facilities.

The following sections provide a more detailed discussion of the changes in
our revenues and expenses.

REVENUES

Total revenues. Commercial and consumer services are derived principally
from voice services. These services include local exchange telephone services
(or basic telephone service), enhanced service features (such as Caller ID, Call
Waiting, 3-Way Calling and Voice Mail), intraLATA long-distance services,
wireless products and services, directory assistance and public telephone
service. Also included in commercial and

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consumer revenues are retail and wholesale advanced data and Internet Protocol
("IP") products and services. Advanced data products and services include
asynchronous transfer mode ("ATM"), frame relay, private line, customer premise
equipment ("CPE") and integrated services digital network ("ISDN"). IP products
consist primarily of Internet dial access and digital subscriber line ("DSL").
Switched access services revenues are derived primarily from charging
interexchange carriers ("IXCs") for the use of our local network to connect
customers to their long-distance networks.

Total revenues for 2001 increased $375 million, or 3.0%, as compared to
2000, primarily due to increases in commercial and consumer services revenues
from wireless, IP and data products and services. Total wireless revenues
increased $258 million, or 53%, from $490 million in 2000 to $748 million in
2001. Revenue from data products and services such as private line, frame relay,
ATM, CPE and ISDN also contributed to the growth in 2001 compared to 2000. We
expect the data services business to become a greater portion of our overall
revenues in the future. Total DSL revenues increased $51 million, or 61%, from
$83 million in 2000 to $134 million in 2001 primarily due to an increase in
customers. The increase in revenue was partially offset by $328 million of
reductions in both commercial and consumer local voice revenues and intraLATA
toll revenues in our local service area as a result of competition and the
current economic conditions. Total access lines declined by approximately
300,000 or 2% during 2001.

Our revenue growth has been and may continue to be negatively affected by
the downturn in the economy within our local service area.

Commercial services revenues. Commercial services revenues are derived
from sales of voice, IP, data, and wireless products and services to wholesale,
large business and small business customers. The increase in commercial services
revenues of $252 million, or 4.1%, in 2001 compared to 2000, was primarily
attributable to higher revenue from sales of data and IP products and services
such as private line, frame relay, ATM, CPE, ISDN, Internet dial access and DSL.

The increase in commercial services revenues was partially offset by a $290
million decrease in local voice service revenues sold to businesses as a result
of competitive losses and the slowing economy. Access lines used by small
business customers decreased by 147,000 in 2001 over 2000. This reflects the
fact that businesses were converting their multiple single access lines to a
lower number of high-speed, high-capacity lines allowing for transport of
multiple simultaneous telephone calls and the transmission of data at higher
rates of speed. On a voice-grade equivalent basis, however, total business
access lines grew 31.9% when comparing 2001 to 2000. A voice-grade equivalent is
the amount of capacity equal to one telephone call. A voice-grade equivalent
basis is the outcome of measuring all residential and business access lines as
if they were converted to single access lines that have the ability to transmit
and receive only one voice transmission at a time.

Consumer services revenues. Consumer services revenues are derived from
sales of voice, IP, data and wireless products and services to the consumer
market. The increase in consumer services revenues for 2001 as compared to 2000
of $334 million, or 6.8%, was primarily attributable to growth in sales of
wireless and data products and services. Residential wireless revenues in 2001
increased by $224 million, or 51%, from $436 million in 2000 to $660 million in
2001. Although average revenue per wireless user decreased from $56.00 in 2000
to $54.00 in 2001, our penetration percentage (our wireless subscribers divided
by the total number of subscribers in the points-of-presence we cover) grew in
the markets we serve from 4.89% in 2000 to 5.73% in 2001. The number of net new
wireless subscribers in 2002, however, is expected to be impacted by the current
economic conditions that may slow the rate of growth in subscribers and wireless
revenues. Other factors that contributed to the growth in consumer services
revenues were improved DSL service revenues which grew by $39 million, or 74%,
from $53 million in 2000 to $92 million in 2001 and sales of bundled packages
such as Custom Choice(SM) and Total Package(SM) (which include the phone line,
calling features and/or wireless services and DSL) to our consumer customers.
Our bundled products and services are sold at prices lower than they could be
sold individually and, in exchange, the Company gains a higher level of customer
loyalty plus greater overall per customer revenue. As a result, we have added
approximately 200,000 subscribers to our CustomChoice(SM) package (which
includes a home phone line and the choice of 20 calling features) in 2001, with
total subscribers of over 2.3 million as of year-end. Total subscribers to our
other

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significant bundled offering, Total Package(SM) (bundled wireless, wireline and
Internet services package), exceeded 250,000 at December 31, 2001.

Partially offsetting these increases were declines of $115 million in local
service revenues from decreasing consumer access lines and intraLATA toll
revenues within our local service area. The declines were the result of the
slowing economy, competitive losses and technology displacement (for example,
where a wireless phone replaces the need for a land-based telephone line).

Switched access services revenues. Switched access services revenues are
derived from inter- and intrastate switched access from IXCs. The decrease in
switched access services revenues of $211 million, or 16.4%, for 2001 as
compared to 2000 was primarily attributable to federal access reform that
reduced the rates we were able to collect for switched access services. This
decrease also reflects competitive losses that have resulted in a reduction in
billable access minutes of use. These decreases were partially offset by
increased interstate subscriber line charges ("SLCs"). We believe revenues from
switched access services will continue to be negatively impacted by competition
and federal and state access reform. We believe that access reform measures will
continue to include increases in other charges, such as SLCs, to offset access
charge reductions.

EXPENSES

Employee-related expenses. Employee-related expenses include salaries and
wages, benefits, payroll taxes and fees for independent contractors.

Employee-related expenses decreased by $203 million or 6.2% in 2001 as
compared to 2000 primarily due to employee reductions as a result of the Merger
and the restructuring plan (discussed below). Another contributing factor to the
decline in employee-related expenses was an increase in the pension credit, net
of other post-retirement benefits of $6 million in 2001 versus 2000. Increased
commitments towards improving customer service, including responding to requests
for installation and repair services, have resulted in the hiring of additional
employees in these specific areas which partially offsets the decrease in
employee-related expenses associated with employee reductions.

On January 5, 2001, we announced an agreement with our major unions, the
Communications Workers of America and the International Brotherhood of
Electrical Workers, to extend the existing union contracts for another two
years, through August of 2003. The extensions include a 3.5% wage increase in
2001, a 5% wage increase in 2002, a 6% pension increase in 2002, and a 10%
pension increase in 2003. Excluding anticipated future cost synergies, these
scheduled changes will increase employee-related expenses in future years.

Other operating expenses. Other operating expenses include access charges
paid to carriers for the routing of local and long-distance traffic to their
facilities, taxes other than income taxes, uncollectible expenses and other
selling, general and administrative costs.

The increase in other operating expenses of $35 million, or 1.2%, over 2000
was primarily attributable to higher uncollectible expenses, professional fees
and costs associated with the sales of data and wireless products and services.
These higher costs were almost entirely offset by cost savings generated by the
Merger such as the closure of redundant facilities, operational synergies
derived from the consolidation of core operational units that provide common
services, using our purchasing power throughout the Company to purchase products
and services at lower costs and a decline in access charges as the result of a
one-time refund.

Depreciation expense. Depreciation expense is associated with our
property, plant, equipment, capital leases and capitalized software. The
increase in depreciation expense for 2001 of $694 million, or 28.6%, compared to
2000 was primarily attributable to higher overall property, plant and equipment
balances resulting from our capital spending program. In addition, there was an
increase in depreciation related to a "catch-up" charge for access lines
returned to service as described below. We continue to invest in our network and
service platforms to support re-entry into the long-distance business in our
local service area and to make ongoing service improvements.

10

During 1999 and 2000, we committed to sell approximately 800,000 access
lines to third-party telecommunications services providers, including
approximately 570,000 access lines to Citizens Communications Company
("Citizens") in nine states. Because these access lines were classified as "held
for sale," we discontinued recognizing depreciation expense on these assets and
recorded them at the lower of their cost or fair value, less estimated cost to
sell.

On July 20, 2001, we terminated our agreement with Citizens under which the
majority of the remaining access lines in eight states were to have been sold
and ceased actively marketing the remaining lines. As a result, the remaining
access lines in eight states were reclassified as being "held for use" as of
June 30, 2001. The access lines were measured individually at the lower of their
(a) carrying amount before they were classified as held for sale, adjusted for
any depreciation expense or impairment losses that would have been recognized
had the assets been continuously classified as held for use, or (b) their
estimated fair value at June 30, 2001. The required adjustments to the carrying
value of the individual access lines were included in operating income for 2001.
This resulted in a charge to depreciation of $222 million to "catch-up" the
depreciation on these access lines for the period they were held for sale.

Restructuring, Merger-related and other charges. We incurred
restructuring, Merger-related and other charges totaling $304 million in 2001
and Merger-related and other charges of $1.285 billion in 2000. During the
fourth quarter of 2001, we approved a restructuring plan to further reduce our
costs and as a result, the data below for restructuring and other charges
reflect costs recognized in that quarter. As we incurred substantially all of
the Merger-related charges by June 30, 2001, the 2001 data below for the
Merger-related and other charges reflects costs incurred through June 30, 2001,
subject to the adjustments described below. A breakdown of these costs is as
follows:

Restructuring and other charges. During the fourth quarter of 2001, we
approved a plan to further reduce current employee levels (in addition to the
Merger-related reductions), consolidate certain facilities and abandon certain
capital projects, terminate certain operating leases and recognize certain asset
impairments. We recorded a restructuring charge of $247 million to cover the
costs associated with these actions as more fully described below.

We occupy administrative and network operations buildings under operating
leases with varying terms. Due to the reduction in employees and consolidation
of operations, we expect to terminate eight operating lease agreements across
the country within the next 12 months. We recorded a charge of $30 million
related to the termination of these operating lease agreements.

In order to streamline the business and consolidate operations to meet
lower customer demand resulting from the current economic conditions, we
identified a further reduction in employees and contractors in various
functional areas across the country, in addition to previous reductions in
connection with the Merger. The severance charge of $188 million relates to
involuntary separation costs for approximately 5,000 employees. As of December
31, 2001, over 1,100 employees had been involuntarily separated by us and cash
severance payments totaling $9 million had been made relating to these
separations. We expect the remaining employee separations to be completed by
June 30, 2002.

11

Other restructuring charges consist of asset impairment charges. We
reviewed all internal software projects in process and determined that certain
projects should no longer be pursued. Because the projects were incomplete and
abandoned, the fair value of such software was determined to be zero.
Capitalized software costs of $29 million related to the restructuring were
written off in 2001. The abandoned projects included various billing and other
system enhancements.

Merger-related and other charges. Contractual settlements and legal
contingencies for 2001 and 2000 of ($25) million ($34 million of costs incurred
less reversals of prior year accruals of $59 million) and $658 million,
respectively, were incurred to cancel various commitments no longer deemed
necessary as a result of the Merger and to settle various claims related to the
Merger.

In connection with the Merger, we reduced employee levels by over 4,800
people primarily by eliminating duplicate functions. These employees were
terminated prior to December 31, 2001. Included in the 2001 and 2000 severance
and employee-related charges of $31 million and $202 million, respectively, were
costs associated with payments to employees who involuntarily left the business
since the consummation of the Merger and, for 2000, $59 million in payments that
were subject to the successful completion of the Merger.

Other charges were $51 million and $425 million for 2001 and 2000,
respectively. In 2001, the $51 million is comprised of $20 million related to
abandoned software (described below) and $31 million of other charges such as
professional fees, re-branding costs and other costs associated with the Merger.
In 2000, the $425 million is comprised of a $221 million asset impairment charge
for access lines (described below), $114 million relating to abandoned software
(described below), a $45 million post-retirement benefit plan curtailment gain
(described below) and $135 million of other charges such as professional fees,
re-branding costs and other costs associated with the Merger. The Company
considered only those costs that were incremental and directly related to the
Merger to be Merger-related.

After the Merger, we evaluated our assets for potential impairment and
concluded that the fair value of some of the assets was below their carrying
value. In most cases, the decline in fair value was based upon our different
intent as to the use of those assets or completion of projects after the Merger.
We also evaluated for impairment our dedicated special-purpose access lines that
we lease to Competitive Local Exchange Carriers ("CLECs"). Given current
industry conditions and regulatory changes affecting CLECs in 2000, and given
the fact that these access lines have no alternative use and cannot be sold or
re-deployed, we concluded that the net future cash flows from the assets was
negative and that sufficient cash flow would not be generated to recover the
carrying value of those assets. Therefore, we concluded that the fair value of
those assets was minimal and took a $221 million charge in 2000. Our wholesale
services segment operated the assets.

Following the Merger, we reviewed all internal software projects in
process, and determined that certain projects should no longer be pursued.
Because the projects were incomplete and abandoned, the fair value of such
incomplete software was determined to be zero. Capitalized software costs of $20
million and $114 million related to the Merger were written off in 2001 and
2000, respectively. The abandoned projects included a significant billing system
replacement and a customer database system.

Offsetting the 2000 Merger-related costs was a $45 million post-retirement
benefit plan curtailment gain. This gain resulted from the post-Merger
termination of retiree medical benefits for all former U S WEST employees who
did not have 20 years of service by December 31, 2000 or would not be service
pension eligible by December 31, 2003.

The 2001 total Merger-related and other charges of $57 million were net of
$80 million in reversals of previously recorded Merger accruals. The reversals
were recorded in the fourth quarter of 2001 and resulted from favorable
developments in the underlying matters.

As those matters identified as legal contingencies associated with contract
settlements and legal contingencies are resolved, any amounts will be paid at
that time. Any differences between amounts accrued and actual payments will be
reflected in results of operations as an adjustment to Merger-related and other
charges.

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Total other expense-net. Total other expense-net includes interest
expense-net, gains or losses on sales of rural exchanges and fixed assets,
interest income and other non-operating items. Interest expense was $612 million
for 2001 compared to $548 million for 2000. The increase was principally
attributable to increased borrowings required to fund capital improvements to
our network. In 2001, we recognized a $51 million gain on the sale of
approximately 41,000 access lines in Utah and Arizona. The remaining change was
primarily attributable to interest income on a federal income tax refund and a
reduction in regulatory interest expense. In 2000, we incurred a $39 million
loss on the sale of fixed assets, offset by a gain of $11 million on the sale of
access lines.

Provision for income taxes. The effective tax rate increased to 37.5% for
2001 from 37.2% for 2000. The increase was primarily attributable to an increase
in non-taxable income for state income tax purposes in higher rate states and a
decrease in earnings before income taxes.

NET INCOME

Net income for 2001 increased by $541 million compared to 2000. The growth
was caused principally by the year-over-year decrease in Merger-related charges
and higher revenues due to sales of data, IP and wireless services. Partially
offsetting these charges were increases in depreciation of $694 million because
of the Company's investment in its network and greater interest expense.

2000 COMPARED WITH 1999

Several items of a non-recurring nature impacted net income in 2000.
Results of operations for the two years excluding the after tax effects of such
items are as follows:

Non-recurring items in 2000 include:

- an after-tax charge of $787 million ($1.285 billion, pre-tax) for charges
associated with the merger; and

- an after-tax charge of $17 million ($28 million, pre-tax) for the net
loss on the sale of fixed assets.

Adjusted net income in 2000 increased $438 million, or 28%, when compared
to 1999. The increase was primarily due to revenue growth associated with
increased demand for services, improvements to our employee benefit costs such
as pension and post-retirement and cost savings associated with synergies
generated by the Merger. Partially offsetting these items were higher operating
costs as a result of growth initiatives and higher depreciation and property
taxes associated with our continued investment in our network facilities.

13

The following sections provide a more detailed discussion of the changes in
our revenues and expenses.

REVENUES

Total Revenues. Total revenues for 2000 increased $836 million, or 7.3%,
as compared to 1999, primarily due to increases in commercial services and
consumer services revenues driven primarily by sales of private line services,
local telephone exchange access services, enhanced service features and data
products and services including Internet dial access, frame relay, ATM and CPE.
Also contributing to the increase was growth in residential wireless
subscribers, DSL customers and sales of packages of bundled products and
services.

Commercial services revenues. Commercial services revenues for 2000 were
$6.116 billion versus $5.381 billion in 2000, an increase of $735 million or
13.7%. The major contributor to this growth was the sale of private lines that
can be attributed to our customers' increased data needs. Other factors for the
change were sales of local telephone exchange access services and increasing
sales of data products and services. Local telephone exchange access services
revenues were driven primarily by business access line growth of 5.7%
representing a year-over-year increase of over 300,000 access lines. Higher
sales of data products such as frame relay, ATM, ISDN, data and CPE also
contributed to the growth in commercial service revenues.

Consumer services revenues. In 2000, consumer services revenues grew $303
million or 6.6% from $4.597 billion in 1999 to $4.900 billion in 2000. Sales of
enhanced service features such as CallerID, Call Waiting, 3-way Calling and
Voice Mail were the major contributors to the year-over-year growth. Another
reason for the increase was the growth in wireless subscribers of 339,000 in
2000. Wireless revenues, which increased $259 million, or 110%, in 2000 as
compared to 1999, were further impacted by an increase in the

14

average revenue per wireless user from $55.00 per month to $56.00 per month. DSL
revenues grew over 150% or almost $50 million during the same period, primarily
due to an increase in customers.

To compete more effectively with other telecommunications services
providers and provide better value to our customers, we sold bundled products
and services at prices lower than they could be sold individually and, in
exchange, the Company gains a higher level of customer loyalty plus greater
overall per customer revenue. As a result, we added 730,000 subscribers to our
CustomChoice package (which includes a home phone line and the choice of 20
calling features) in 2000, with total subscribers exceeding 2,000,000 as of
year-end. Total subscribers to our other significant bundled offering, Total
Package (bundled wireless, wireline and Internet services package), exceeded
121,000 at December 31, 2000.

Switched access services revenues. Switched access revenue declined $202
million, or 13.6%, to $1.284 billion in 2000 from $1.486 billion. This change
was primarily due to rate reductions mandated by the FCC as part of access
reform, as well as rate reductions mandated by state PUCs. IntraLATA
long-distance service voice revenues also declined due to price cuts caused by
regulatory rate reductions and greater competition. We are responding to
competition through competitive pricing of intraLATA long-distance services and
increased promotional efforts to retain customers.

EXPENSES

Employee-related expenses. Employee-related expenses decreased by $439
million, or 11.9%, in 2000 as compared to 1999. The principal reason for the
decline was an improvement in our employee benefit costs such as pension and
other post-retirement benefits of $258 million in 2000 versus 1999. The change
was primarily the result of favorable returns on plan assets. We also
experienced cost savings as a result of synergies generated by the Merger as we
were able to eliminate duplicate work functions. In addition, employee-related
expenses decreased as the result of an increase in capitalized salaries and
wages associated with higher capital investment.

Partially offsetting the decrease in expense was an increase in employee
levels related to our growth businesses such as data and wireless communications
as well as our commitment towards improving customer service.

Other operating expenses. The increase in other operating expenses of $324
million, or 12.9%, over 1999 was primarily the result of increased costs
associated with the higher sales of our data and wireless products and services.
We also experienced an increase in our bad debt expense as the result of growing
revenues. Finally, our property taxes grew in 2000 as a result of our continued
investment in our network facilities.

Depreciation expense. Depreciation expense increased $134 million, or
5.8%, compared to 1999 primarily due to higher overall property, plant and
equipment resulting from continued investment in our network to meet service
demands. We continued to invest in growth areas such as data and wireless
services. Additional capital investments were also made to improve customer
service levels.

During 1999 and 2000, we committed to sell approximately 800,000 access
lines to third-party telecommunications services providers, including
approximately 570,000 access lines to Citizens Communications Company
("Citizens") in nine states. Because these access lines were classified as "held
for sale," we discontinued recognizing depreciation expense on these assets and
recorded them at the lower of their cost or fair value less estimated cost to
sell.

15

Merger-related and other charges. We incurred Merger-related and other
charges totaling $1.285 billion in 2000 and none in 1999. A breakdown of these
costs is as follows:

Contractual settlements and legal contingencies for 2000 of $658 million
were incurred to cancel various commitments no longer deemed necessary as a
result of the Merger and to settle various claims related to the Merger.

In connection with the Merger, in 2000 we reduced employee levels by over
4,800 people primarily by eliminating duplicate functions. Included in the
severance and employee-related charges of $202 million were costs associated
with payments to employees who involuntarily left the business since the
consummation of the Merger and $59 million in payments that were subject to the
successful completion of the Merger.

Other charges of $425 million include a $221 million write off of access
lines, terminated software development projects of $114 million and a
post-retirement benefit plan curtailment gain of $45 million. These charges are
discussed below. The remaining amount of $135 million included in other charges
include professional fees, re-branding costs and other costs related to the
integration of U S WEST and QCII. We considered only those costs that were
incremental and directly related to the Merger to be Merger-related.

After the Merger, we evaluated our assets for potential impairment and
concluded that the fair value of some of the assets was below their carrying
value. In most cases, the decline in fair value was based upon our different
intent as to the use of those assets or completion of projects after the Merger.
We also evaluated for impairment our dedicated special-purpose access lines that
we lease to CLECs. Given current industry conditions and regulatory changes
affecting CLECs in 2000, and given the fact that these access lines have no
alternative use and cannot be sold or re-deployed, we concluded that the net
future cash flows from the assets was negative and that sufficient cash flow
would not be generated to recover the carrying value of those assets. Therefore,
we concluded that the fair value of those assets was minimal and took a $221
million charge in 2000. Our wholesale services segment operated the assets.

Following the Merger, we reviewed all internal software projects in
process, and determined that certain projects should no longer be pursued.
Because the projects were incomplete and abandoned, the fair value of such
incomplete software was determined to be zero. Capitalized software costs of
$114 million were written off in 2000. The abandoned projects included a
significant billing system replacement and a customer database system.

Offsetting the 2000 Merger-related costs was a $45 million post-retirement
benefit plan curtailment gain. This gain resulted from the post-Merger
termination of retiree medical benefits for all former U S WEST employees who
did not have 20 years of service by December 31, 2000 or would not be service
pension eligible by December 31, 2003.

Total other expense-net. Interest expense was $548 million in 2000 and
$403 million in 1999. The increase was primarily attributable to increased
borrowings required to fund the capital improvements to our network.

Also included in other expense-net were two items. The first, various other
expenses, declined from $37 million in 1999 to $12 million in 2000 primarily due
to a reduction in the amount of regulatory interest expense. The second item was
a loss on the sale of fixed assets in 2000 of $39 million, offset by a gain of
$11 million on the sale of access lines. There were no such losses in 1999.

16

Provision for income taxes. The effective tax rate decreased to 37.2% for
2000 from 38.0% for 1999. The decrease was primarily attributable to an increase
in non-taxable income for state income tax purposes in higher rate states and a
decrease in earnings before income taxes.

NET INCOME

Net income for 2000 decreased by $366 million when compared to 1999. The
decline was caused principally by Merger-related charges partially offset by an
increase in revenues due to higher sales of data and wireless services.

SIGNIFICANT ACCOUNTING POLICIES

Revenue Recognition. Local telephone and wireless services are generally
billed in advance with revenues recognized when services are provided. Revenues
derived from exchange access, long-distance network services and wireless
airtime usage are recognized as services are provided. Payments received in
advance are deferred until the service is provided. Up-front fees received,
primarily activation fees and installation charges, are deferred and recognized
over the longer of the contractual period or the expected customer relationship,
generally 2 to 10 years. Expected customer relationship periods are generally
estimated using historical data of actual customer retention patterns. As the
telecommunications market experiences greater competition and customers shift
from traditional land-based telephony services to mobile services, our customer
relationship period will likely decline resulting in a faster recognition of the
deferred revenue and related costs.

Design, engineering and installation contracts for certain customer premise
equipment agreements are accounted for under the percentage-of-completion method
of accounting. The percentage-of-completion method is calculated using either
the ratio of total actual costs incurred to date to the estimated total project
costs or actual labor hours to total estimated labor hours for the project. This
percentage is then applied to the estimated total revenues for the project to
determine the amount of revenues to be recorded. As the estimated total costs or
total labor hours are revised up or down, the timing of the recognized revenues
can be impacted. Revenues can also be impacted by change orders negotiated
during the performance of the contract.

Software Capitalization Policy. Internally used software, whether
purchased or developed, is capitalized and amortized using the straight-line
method over an estimated useful life of 18 months to 5 years. In accordance with
Statement of Position ("SOP") 98-1, "Accounting for the Costs of Computer
Software Developed or Obtained for Internal Use", we capitalize certain costs
associated with internally developed software such as payroll costs of employees
devoting time to the projects and external direct costs for materials and
services. Costs associated with internally developed software to be used
internally are expensed until the point the project has reached the development
stage. Subsequent additions, modifications or upgrades to internal-use software
are capitalized only to the extent that they allow the software to perform a
task it previously did not perform. Software maintenance and training costs are
expensed in the period in which they are incurred. The capitalization of
software requires judgment in determining when a project has reached the
development stage. Further, the recovery of software projects is periodically
reviewed and may result in significant write-offs.

Pension and Post-retirement Benefits. Pension and post-retirement health
care and life insurance benefits earned by employees during the year as well as
interest on projected benefit obligations are accrued currently. Prior service
costs and credits resulting from changes in plan benefits are amortized over the
average remaining service period of the employees expected to receive benefits.

In computing the pension and post-retirement benefit costs, we must make
numerous assumptions about such things as employee mortality and turnover,
expected salary and wage increases, discount rates, expected return on plan
assets and expected future cost increases. Two of these items generally have the
most significant impact on the level of cost -- discount rate and expected rate
of return on plan assets.

We set the discount rate based upon the average interest rate during the
month of December for a Moody's AA rated corporate bond.

17

The expected rate of return on plan assets is the long-term rate of return
we expect to earn on the pension trust's assets. We established our expected
rate of return by reviewing the investment composition of its pension plan
assets, obtaining advice from actuaries, reviewing historical earnings on the
trust assets and evaluating current and expected market conditions.

To compute our expected return on pension plan assets, we applied its
expected rate of return to the market-related value of the pension plan assets.
The market-related asset value is a computed value that recognizes changes in
fair value of pension plan assets on a systematic and rational manner, not to
exceed five years. In accordance with Statement of Financial Accounting
Standards ("SFAS") No. 87, "Employers' Accounting for Pensions," we elected to
recognize actual returns on its pension plan assets ratably over a five year
period when computing our market-related value of pension plan assets. The
election was made in 1987 when SFAS No. 87 became effective. This method has the
effect of smoothing market volatility that may be experienced from year to year.
As a result, our expected return is not significantly impacted by the actual
return on pension plan assets experienced in the current year.

Changes in any of the assumptions made by us in computing the pension and
post-retirement benefit costs could have an impact on various components that
comprise these expenses. Factors to be considered include the strength or
weakness of the investment markets, changes in the composition of the employee
base, fluctuations in interest rates, significant employee hirings or
downsizings and medical cost trends. Changes in any of these factors could
impact employee-related expenses on the statement of operations as well as the
value of the asset or liability on the balance sheet.

Impairment of long-lived assets. Long-lived assets such as goodwill,
intangibles and property, plant and equipment are reviewed for impairment
whenever facts and circumstances warrant such a review. Under current standards,
the assets must be carried at historical cost if the projected cash flows from
their use will recover their carrying amounts on an undiscounted basis and
without considering interest. However, if projected cash flows are less than the
carrying amount, even by one dollar, the long-lived assets must be reduced to
their estimated fair value. Considerable judgment is required to project such
future cash flows and, if required, estimate the fair value of the impaired
long-lived assets. During 2001, we recorded $49 million in asset impairments
including the abandonment of software development projects. These impairments
were recorded as part of the restructuring and Merger-related charges.

Exit costs and restructuring reserves. Periodically, we commit to exit
certain business activities, eliminate office or facility locations and/or
reduce our number of employees. The charge to record such a decision depends
upon various assumptions, including future severance costs, sublease or disposal
costs, contractual termination costs and so forth. Such estimates are inherently
judgmental and may change based upon actual experience. During the fourth
quarter of 2001, we recorded a $247 million restructuring charge to reduce the
current number of employees, consolidate facilities and abandon certain capital
projects in process, terminate certain operating leases and recognize certain
asset impairments.

Due to the estimates and judgements involved in the application of each of
these policies, future changes in these estimates and market conditions could
have a material impact on the consolidated financial statements.

NEW ACCOUNTING STANDARDS

In June 1998, the Financial Accounting Standards Board ("FASB") issued SFAS
No. 133, "Accounting for Derivative Instruments and Hedging Activities." SFAS
No. 133 requires, among other things, that all derivative instruments be
recognized at fair value as assets or liabilities on the balance sheets with
changes in fair value recognized currently in earnings unless specific hedge
accounting criteria are met. The adoption of SFAS No. 133 on January 1, 2001 did
not have a material impact on our consolidated financial statements.

In September 2000, the FASB issued SFAS No. 140, "Accounting for Transfers
and Servicing of Financial Assets and Extinguishments of Liabilities." This
statement provides accounting and reporting standards for transfers and
servicing of financial assets and extinguishments of liabilities. SFAS No. 140
requires that after a transfer of financial assets, an entity continues to
recognize the financial and servicing

18

assets it controls and the liabilities it has incurred and does not recognize
those financial and servicing assets when control has been surrendered and the
liability has been extinguished. SFAS No. 140 is effective for transfers and
servicing of financial assets and extinguishments of liabilities occurring after
March 31, 2001. Adoption of SFAS No. 140 did not have a material impact on our
consolidated financial results.

In June 2001, the FASB issued SFAS No. 141, "Business Combinations." This
pronouncement eliminated the use of the "pooling of interests" method of
accounting for all mergers and acquisitions. As a result, all mergers and
acquisitions will be accounted for using the "purchase" method of accounting.
SFAS No. 141 is effective for all mergers and acquisitions initiated after June
30, 2001. Adoption of this pronouncement had no impact on our consolidated
financial statements.

In June 2001, the FASB issued SFAS No. 142, "Goodwill and Other Intangible
Assets." This statement addresses financial accounting and reporting for
intangible assets (excluding goodwill) acquired individually or with a group of
other assets at the time of their acquisition. It also addresses financial
accounting and reporting for goodwill and other intangible assets subsequent to
their acquisition. Intangible assets (excluding goodwill) acquired outside of a
business combination will be initially recorded at their estimated fair value.
If the intangible asset has a finite useful life, it will be amortized over that
life. Intangible assets with an indefinite life are not amortized. Both types of
intangible assets will be reviewed annually for impairment and a loss recorded
when the asset's carrying amount exceeds its estimated fair value. The
impairment test for intangible assets consists of comparing the fair value of
the intangible asset to its carrying value. Fair value for goodwill and
intangible assets is determined based upon discounted cash flows and appraised
values. If the carrying value of the intangible asset exceeds its fair value, an
impairment loss is recognized. Goodwill will be treated similar to an intangible
asset with an indefinite life. SFAS No. 142 is effective for fiscal years
beginning after December 15, 2001. The adoption of SFAS No. 142 will have no
impact on our consolidated financial statements.

In June 2001, the FASB issued SFAS No. 143, "Accounting for Asset
Retirement Obligations." This statement deals with the costs of closing
facilities and removing assets. SFAS No. 143 requires entities to record the
fair value of a legal liability for an asset retirement obligation in the period
it is incurred. This cost is initially capitalized and amortized over the
remaining life of the underlying asset. Once the obligation is ultimately
settled, any difference between the final cost and the recorded liability is
recognized as a gain or loss on disposition. As required, we will adopt SFAS No.
143 effective January 1, 2003. We are currently evaluating the impact this
pronouncement will have on our future consolidated financial results.

In August 2001, the FASB issued SFAS No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets." This pronouncement addresses how
to account for and report impairments or disposals of long-lived assets. Under
SFAS No. 144, an impairment loss is to be recorded on long-lived assets being
held or used when the carrying amount of the asset is not recoverable from its
undiscounted cash flows. The impairment loss is equal to the difference between
the asset's carrying amount and estimated fair value. Long-lived assets to be
disposed of by other than a sale for cash are to be accounted for and reported
like assets being held or used except the impairment loss is recognized at the
time of the disposition. Long-lived assets to be disposed of by sale are to be
recorded at the lower of their carrying amount or estimated fair value (less
costs to sell) at the time the plan of disposition has been approved and
committed to by the appropriate company management. In addition, depreciation is
to cease at the same time. As required, we will adopt SFAS No. 144 effective
January 1, 2002. We are currently evaluating the impact this pronouncement will
have on our future consolidated financial results.

RELATED PARTY TRANSACTIONS

We purchase various services from affiliated companies. We also provide
various services to affiliated companies. The amount paid and received for these
services is determined in accordance with the Federal Communications Commission
and state cost allocation rules, which prescribe various cost allocation
methodologies that are dependent upon the service provided. Management believes
that such cost allocation methods are reasonable. The total cost of services
purchased from affiliated companies was $1.5 billion,

19

$1.0 billion, and $683 million in 2001, 2000 and 1999, respectively. The total
amount of revenues derived from affiliated companies was $365 million, $327
million and $172 million in 2001, 2000 and 1999, respectively.

It is not practicable to provide a detailed estimate of the expenses that
would be recognized on a stand-alone basis. However, we believe that corporate
services, including those related to procurement, tax, legal and human
resources, are obtained more economically through affiliates than they would be
on a stand-alone basis, since we absorb only a portion of the total costs.

RISK MANAGEMENT

We are exposed to market risks arising from changes in interest rates. The
objective of our interest rate risk management program is to manage the level
and volatility of our interest expense. We may employ derivative financial
instruments to manage our interest rate risk exposure. We have also employed
financial derivatives to hedge foreign currency exposures associated with
particular debt issues. We do not hold any derivatives for other than hedging
purposes.

As of December 31, 2001 and 2000, approximately $888 million and $589
million, respectively, of floating-rate debt was exposed to changes in interest
rates. This exposure is linked to commercial paper rates. A hypothetical
increase of one percentage-point in commercial paper rates would increase annual
pre-tax interest expense by $9 million. As of December 31, 2001 and 2000, we
also had $623 million and $381 million, respectively, of long-term fixed rate
debt obligations maturing in the following 12 months. Any new debt obtained to
refinance this debt would be exposed to changes in interest rates. A
hypothetical 10% change in the interest rates on this debt would not have had a
material effect on our earnings. We had $5.781 billion and $6.247 billion of
long-term fixed rate debt at December 31, 2001 and 2000, respectively. A one
percentage-point increase in interest rates on this debt would result in a
decrease in the fair value of these instruments of $296 million and $317 million
at December 31, 2001 and 2000, respectively. A decrease of one percentage-point
in the interest rates on this debt would result in an increase in the fair value
of these instruments of $305 million and $332 million at December 31, 2001 and
2000, respectively.

CONTINGENCIES

We have certain pending regulatory and legal actions. See Part I, Item 3 to
this Form 10-K and Note 9 to the consolidated financial statements.

COMPETITION AND REGULATORY ENVIRONMENT

Our future operations and financial results will be affected by
developments in a number of federal and state regulatory matters. In addition to
our efforts to offer long-distance service in our local service area, we are
subject to a number of other regulatory matters as described in Item I, Part I
above.

FACTORS IMPACTING LIQUIDITY

We are a wholly owned subsidiary of QCII. As such, factors relating to or
affecting QCII's liquidity and capital resources could have a material impact on
us either due to perception in the market or due to provisions in certain of our
financing agreements. Because we meet the conditions set forth in General
Instruction I(1) (a) and (b) of Form 10-K, however, we have prepared this Annual
Report on Form 10-K on the basis of the reduced narrative disclosure permitted
under General Instruction I(2). As a result, we have not included information
relating to trends, demands, commitments, events or uncertainties that are
reasonably likely to materially impact our liquidity. We encourage you to review
QCII's Annual Report on Form 10-K, filed with the Securities and Exchange
Commission on April 1, 2002, as the same may be amended, for a detailed
description of issues relating to liquidity and capital resources that could
affect our business. Notwithstanding the foregoing, below is a brief description
of some recent developments and risk factors that have had or may have an impact
on our liquidity and capital resources.

20

RECENT DEVELOPMENTS

At December 31, we maintained commercial paper programs to finance the
purchase of telecommunications equipment. We also maintained with QCII and its
wholly owned subsidiary Qwest Capital Funding ("QCF") a $4.0 billion syndicated
credit facility to support the purchase of telecommunications equipment at both
Qwest and QCF. As of December 31, 2001, $1.0 billion of that credit facility was
allocated to support our program and the remainder was allocated to support the
QCF program.

As a result of reduced demand for QCF's and our commercial paper in
February 2002, we borrowed the full amount allocated to us under the syndicated
credit facility and used or will use the proceeds to repay commercial paper.
After repaying the commercial paper, we had remaining proceeds of $137 million.
After giving effect to the borrowings under the credit facility, our debt
remained approximately $9.6 billion, net of the excess unapplied cash, including
$2.3 billion in short-term borrowings from QCF.

In March 2002, we amended the syndicated credit facility and currently
expect to convert the outstanding balance of the credit facility as of May 3,
2002 into a one-year term loan that would be due in May 2003. As part of the
amendment, we increased the maximum debt-to-consolidated EBITDA ratio, measured
on a consolidated QCII basis, from 3.75-to-1 to 4.25-to-1 through the quarter
ending September 30, 2002, decreasing to 4.0-to-1 for the quarter ending
December 31, 2002 and agreed to use a portion of net proceeds from future sales
of assets and capital market transactions, including the issuance of debt and
equity securities, to prepay the bank loan until the outstanding loan is $2.0
billion or less. Consolidated EBITDA, as defined in the credit facility, is a
measure of EBITDA that starts with QCII's net income and adds back certain
items, primarily those of a non-cash or a non-operating nature.

In March 2002, we issued $1.5 billion in bonds with a ten-year maturity and
an 8.875% interest rate. Approximately $608 million of the net proceeds were
used to repay a portion of our borrowings under the syndicated credit facility.
The remaining proceeds from the sale of the bonds will be used to repay
short-term obligations and currently maturing long-term borrowings.

After applying the portion of the proceeds from our March 2002 debt
offering to repay the credit facility, our total debt outstanding remained at
$9.6 billion, net of excess unapplied cash.

Following the amendment and the $608 million payment, as permitted under
the credit facility, QCII re-distributed the amounts outstanding between QCF and
us. As of March 31, 2002 the credit facility had a total amount outstanding of
$3.39 billion, which was all assigned to QCF and none to us.

In February and March 2002, our credit ratings were lowered two levels to
BBB+ and Baa2 by Fitch and Moody's, respectively, and one level to BBB by S&P.
These ratings are investment grade. Fitch, Moody's and S&P also lowered the
ratings for our commercial paper to F-3, P-3 and A-3, respectively.

SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

This Form 10-K contains or incorporates by reference "forward-looking
statements," as that term is used in federal securities laws, about Qwest
Corporation ("Qwest" or "us," "we" or "our") financial condition, results of
operations and business. These statements include, among others:

- statements concerning the benefits that we expect will result from our
business activities and certain transactions we have completed, such as
increased revenues, decreased expenses and avoided expenses and
expenditures; and

- statements of our expectations, beliefs, future plans and strategies,
anticipated developments and other matters that are not historical facts.

These statements may be made expressly in this document or may be
incorporated by reference to other documents we will file with the Securities
and Exchange Commission ("SEC"). You can find many of these statements by
looking for words such as "believes," "expects," "anticipates," "estimates," or
similar expressions used in this report or incorporated by reference in this
report.

21

These forward-looking statements are subject to numerous assumptions, risks
and uncertainties that may cause our actual results to be materially different
from any future results expressed or implied by us in those statements.

Because these statements are subject to risks and uncertainties, actual
results may differ materially from those expressed or implied by the
forward-looking statements. We caution you not to place undue reliance on the
statements, which speak only as of the date of this report.

Further, the information contained in this document is a statement of our
present intention and is based upon, among other things, the existing regulatory
environment, industry conditions, market conditions and prices, the economy in
general and our assumptions. We may change our intentions, at any time and
without notice, based upon any changes in such factors, in our assumptions or
otherwise.

RISK FACTORS IMPACTING FORWARD-LOOKING STATEMENTS

In addition to the risk factors set forth in more detail below, the
important factors that could prevent us from achieving our stated goals include,
but are not limited to, the following:

- potential fluctuations in quarterly results;

- intense competition in the markets in which we compete;

- changes in demand for our products and services;

- adverse economic conditions in the markets served by us;

- dependence on new product development and acceleration of the deployment
of advanced new services, such as broadband data, wireless and video
services, which could require substantial expenditure of financial and
other resources in excess of contemplated levels;

- higher than anticipated employee levels, capital expenditures and
operating expenses;

- rapid and significant changes in technology and markets;

- adverse changes in the regulatory or legislative environment affecting
our business;

- adverse developments in commercial disputes or legal proceedings;

- delays in our ability to provide interLATA (services within its 14-state
local service area);

- changes in the outcome of future events from the assumed outcome included
in our significant accounting policies; and

- failure to achieve the projected synergies and financial results expected
to result from the Merger and difficulties in combining the operations of
QCII and U S WEST, which could affect our revenues, levels of expenses
and operating results.

The cautionary statements contained or referred to in this section should
be considered in connection with any subsequent written or oral forward-looking
statements that we or persons acting on our behalf may issue. We do not
undertake any obligation to review or confirm analyst's expectations or
estimates or to release publicly any revisions to any forward-looking statements
to reflect events or circumstances after the date of this report or to reflect
the occurrence of unanticipated events. In addition, we make no representation
with respect to any materials available on the Internet, including materials
available on our website.

OTHER RISK FACTORS

CONTINUED DOWNTURN IN THE ECONOMY IN OUR LOCAL SERVICE AREA COULD AFFECT
OUR OPERATING RESULTS.

Our operations in our 14-state local service area of Arizona, Colorado,
Idaho, Iowa, Minnesota, Montana, Nebraska, New Mexico, North Dakota, Oregon,
South Dakota, Utah, Washington and Wyoming have been impacted by the continuing
weakness in that region's economy. Because customers have less discretionary
income, demand for second lines or additional services has declined. This
economic downturn in our local

22

service area has also led to an increased customer disconnection rate, and has
resulted in an increase in both accounts receivable and bad debt.

We now anticipate that the economic downturn in our local service area will
be deeper and last longer than we had previously expected. Also, we believe that
this region's economy lagged the national economy in entering the downturn and
may follow the national economy in recovery by an indeterminate period. This
continued economic slowdown will affect demand for our products and services
within our local service area.

FACTORS RELATING TO QCII, OUR ULTIMATE PARENT COMPANY, COULD HAVE A
MATERIAL IMPACT ON US OR ON THE TRADING PRICE OF OUR SECURITIES.

We are a separate legal entity from QCII. Nonetheless, factors relating to
or affecting QCII could have a material impact on us or on the trading price of
our securities. These factors could include, but are not limited to the
following:

- On March 8, 2002, QCII received an informal inquiry from the Denver
regional office of the SEC requesting voluntary production of documents
related to certain of the QCII's accounting policies, practices and
procedures in 2000 and 2001. If the SEC takes any formal action against
QCII as a result of the informal inquiry, including any requirement that
QCII restate earnings for prior periods, including 2000 or 2001, investor
confidence could decline and the trading price of our securities could be
adversely affected.

- Congress, the SEC, other regulatory authorities and the media are
intensely scrutinizing a number of financial reporting issues and
practices, particularly with respect to the telecommunications industry.
Recent Congressional hearings, for example, have related to the
telecommunications industry practice of accounting for IRUs, as well as
the appropriateness and consistency of pro forma financial information
disclosure. If this heightened scrutiny impacts QCII directly, including
any requirement that QCII restate earnings, the trading price of our
securities could decline or our access to capital markets could be
limited.

- QCII's announcements of its financial results or of changes to its
financial forecasts could adversely impact the trading price of our
securities.

- Any downgrades of QCII's credit ratings; or its substantial indebtedness;
or the outcome of, or concerns regarding, material litigation matters; or
similar factors beyond our or QCII's control, could similarly impact the
trading price of our securities.

QCII'S CASH NEEDS ARE LIKELY TO CONSUME MUCH OF OUR NET INCOME IN 2002.

There are few contractual or regulatory restrictions on distributions from
us to QCII. We have customarily distributed to QCII an amount of cash equal to
our net income, and we expect to distribute much of our net income to QCII in
2002.

RAPID CHANGES IN TECHNOLOGY AND MARKETS COULD REQUIRE SUBSTANTIAL
EXPENDITURE OF FINANCIAL AND OTHER RESOURCES IN EXCESS OF CONTEMPLATED
LEVELS, AND ANY INABILITY TO RESPOND TO THOSE CHANGES COULD REDUCE OUR
MARKET SHARE.

The telecommunications industry is experiencing significant technological
changes, and our ability to compete depends upon our ability to develop new
products and accelerate the deployment of advanced new services, such as
broadband data, wireless and video services. The development and deployment of
new products could require substantial expenditure of financial and other
resources in excess of contemplated levels. If we are not able to develop new
products to keep pace with technological advances, or if such products are not
widely accepted by customers, our ability to compete could be adversely affected
and our market share could decline. Any inability to keep up with changes in
technology and markets could also adversely affect the trading price of our
securities and our ability to service our debt.

23

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK.

You can find our discussion regarding quantitative and qualitative market
risks under the heading "Risk Management" in Item 7 above.

ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.

24

REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS

To Qwest Corporation:

We have audited the accompanying consolidated balance sheets of Qwest
Corporation (a Colorado corporation) and subsidiaries as of December 31, 2001
and 2000, and the related consolidated statements of income, stockholder's
equity and cash flows for each of the three years in the period ended December
31, 2001. These consolidated financial statements are the responsibility of the
Company's management. Our responsibility is to express an opinion on these
consolidated financial statements based on our audits.

We conducted our audits in accordance with auditing standards generally
accepted in the United States. Those standards require that we plan and perform
the audit to obtain reasonable assurance about whether the financial statements
are free of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements. An
audit also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.

In our opinion, the financial statements referred to above present fairly,
in all material respects, the financial position of Qwest Corporation and
subsidiaries as of December 31, 2001 and 2000, and the results of their
operations and their cash flows for each of the three years in the period ended
December 31, 2001, in conformity with accounting principles generally accepted
in the United States.

/s/ ARTHUR ANDERSEN LLP

Denver, Colorado,
January 29, 2002 (except for the matters discussed in Note 13,
as to which the date is March 31, 2002).

25

QWEST CORPORATION

CONSOLIDATED STATEMENTS OF INCOME

The accompanying notes are an integral part of these consolidated financial
statements.
26

QWEST CORPORATION

CONSOLIDATED BALANCE SHEETS

The accompanying notes are an integral part of these consolidated financial
statements.
27

QWEST CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

The accompanying notes are an integral part of these consolidated financial
statements.
28

QWEST CORPORATION

CONSOLIDATED STATEMENTS OF STOCKHOLDER'S EQUITY

The accompanying notes are an integral part of these consolidated financial
statements.
29

QWEST CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 2001, 2000 AND 1999

NOTE 1: MERGER-RELATED AND OTHER CHARGES

Qwest Corporation ("Qwest" or "us," "we" or "our") is a wholly owned
subsidiary of Qwest Communications International Inc., a Delaware corporation
("QCII"). We provide local telecommunications and related services and wireless
services to more than 25 million residential and business customers in our 14-
state local service area of Arizona, Colorado, Idaho, Iowa, Minnesota, Montana,
Nebraska, New Mexico, North Dakota, Oregon, South Dakota, Utah, Washington and
Wyoming.

On June 30, 2000, QCII completed its acquisition (the "Merger") of U S
WEST, Inc. ("U S WEST"). U S WEST was deemed the accounting acquirer and its
historical financial statements have been carried forward as those of the newly
combined company.

We incurred Merger-related and other charges totaling $57 million and
$1.285 billion in 2001 and 2000, respectively. A breakdown of these costs is as
follows:

Contractual settlements and legal contingencies of ($25) million ($34
million of costs incurred less reversals of prior year accruals of $59 million)
and $658 million in 2001 and 2000, respectively, were incurred to cancel various
commitments no longer deemed necessary as a result of the Merger and to settle
various claims related to the Merger.

In connection with the Merger, we reduced employee levels by over 4,800
people, primarily by eliminating duplicate functions. These employees were
terminated prior to December 31, 2001. Included in the 2001 and 2000 severance
and employee-related charges of $31 million and $202 million were costs
associated with payments to employees who involuntarily left the business since
the consummation of the Merger and, for 2000, $59 million in payments that were
subject to the successful completion of the Merger.

Other charges were $51 million and $425 million for 2001 and 2000,
respectively. In 2001, the $51 million is comprised of $20 million related to
abandoned software (described below) and $31 million of other charges such as
professional fees, re-branding costs and other costs associated with the Merger.
In 2000, the $425 million is comprised of a $221 million asset impairment charge
for access lines (described below), $114 million relating to abandoned software
(described below), a $45 million post-retirement benefit plan curtailment gain
(described below) and $135 million of other charges such as professional fees,
re-branding costs and other costs associated with the Merger. The Company
considered only those costs that were incremental directly related to the Merger
to be Merger-related.

After the Merger, we evaluated our assets for potential impairment and
concluded that the fair value of some of the assets was below their carrying
value. In most cases, the decline in fair value was based upon our different
intent as to the use of those assets or completion of projects after the Merger.
We also evaluated for impairment our dedicated special-purpose access lines that
we leases to competitive local exchange carriers ("CLECs"). Given current
industry conditions and regulatory changes affecting CLECs in 2000, and given
the fact that these access lines have no alternative use and cannot be sold or
re-deployed, we concluded that the net future cash flows from the assets was
negative and that sufficient cash flow would not be generated to

30

QWEST CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

recover the carrying value of those assets. Therefore, we concluded that the
fair value of those assets was minimal and took a $221 million charge in 2000.
Our wholesale services segment operated the assets.

Following the Merger, we reviewed all internal software projects in
process, and determined that certain projects should no longer be pursued.
Because the projects were incomplete and abandoned, the fair value of such
incomplete software was determined to be zero. Capitalized software costs of $20
million and $114 million related to the Merger were written off in 2001 and
2000, respectively. The abandoned projects included a significant billing system
replacement and a customer database system.

Offsetting the Merger-related costs in 2000 was a $45 million
post-retirement benefit plan curtailment gain. This gain resulted from the
post-Merger termination of retiree medical benefits for all former U S WEST
employees who did not have 20 years of service by December 31, 2000 or would not
be service pension eligible by December 31, 2003.

The 2001 total Merger-related and other charges of $57 million were net of
$80 million in reversals of previously recorded Merger accruals. The reversals
were recorded in the fourth quarter of 2001 and resulted from favorable
developments in the underlying matters.

A summary of Merger-related and other charges follows:

As those matters identified as legal contingencies associated with contract
settlements and legal contingencies are resolved, any amounts will be paid at
that time. Any differences between amounts accrued and actual payments will be
reflected in results of operations as an adjustment to Merger-related and other
charges.

NOTE 2: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation. The consolidated financial statements include the
accounts of Qwest (formerly U S WEST Communications, Inc.) and its wholly owned
subsidiaries. We are a wholly owned subsidiary of QCII.

Use of Estimates. The preparation of financial statements in conformity
with accounting principles generally accepted in the United States requires
management to make estimates and assumptions that affect the amounts reported in
the financial statements and accompanying notes. Actual results could differ
from those estimates.

Reclassifications. Certain prior year amounts have been reclassified to
conform to the current year presentation.

Revenue Recognition. Local telephone and wireless services are generally
billed in advance with revenues recognized when the services are provided.
Revenues derived from exchange access, long-distance network services and
wireless airtime usage are recognized as services are provided. Payments
received in advance are deferred until the service is provided. Up-front fees
received, primarily activation fees and

31

QWEST CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

installation charges, are deferred and recognized over the longer of the
contractual period or the expected customer relationship, generally 2 to 10
years. Expected customer relationship periods are generally estimated using
historical data of actual customer retention patterns.

Advertising Costs. Costs related to advertising are expensed as incurred.
Advertising expense was $137 million, $347 million and $226 million in 2001,
2000 and 1999, respectively.

Income Taxes. The provision for income taxes consists of an amount for
taxes currently payable and an amount for tax consequences deferred to future
periods. Investment tax credits earned before their repeal by the Tax Reform Act
of 1986 are amortized as reductions in income tax expense over the lives of the
assets which gave rise to the credits.

We are included in the consolidated federal income tax return of QCII. We
recognize federal income tax expense based upon a pro-rata allocation agreement
with QCII. Under the agreement, we are allocated income tax consequences or
benefits based upon our pro-rata contribution to the consolidated group's
taxable income, deductions and credits. The amount of federal income tax expense
recognized by us is not significantly different than an amount computed on a
stand-alone basis.

We recognize state income tax expense based upon a stand-alone allocation
policy with QCII.

Cash and Cash Equivalents. Cash and cash equivalents include highly liquid
investments with original maturities of three months or less that are readily
convertible into cash and are not subject to significant risk from fluctuations
in interest rates. Fair values of cash, cash equivalents and current accounts
receivable and payable approximate carrying values due to their short-term
nature. Our cash balances may exceed federally insured deposit limits. However,
we seek to maintain cash and cash equivalent balances with financial
institutions we deem to be of sound financial condition. At December 31, 2001
and 2000, we had no short-term cash equivalent investments outstanding.

We account for our bank overdrafts as a liability on our consolidated
balance sheets rather than as a reduction to our cash account. The amount of
bank overdrafts included in accounts payable as of December 31, 2001 and 2000
were $83 million and $191 million, respectively.

Receivables. We have agreements with other telecommunications services
providers whereby we agree to bill and collect for certain of the other
telecommunications providers services rendered to our customers within our local
service area. We purchase these accounts receivable from the other
telecommunications service providers on a full-recourse basis and include these
amounts in our accounts receivable balance. The amount of the purchased
receivables included in our December 31, 2001 and 2000 accounts receivable
balances were $217 million and $294 million, respectively. We have not
experienced any significant losses under the recourse provisions related to
these purchased receivables.

We also have billing and collection arrangements with other
telecommunications services providers for certain services provided by us to
customers outside our local service area. While these amounts are generally
billed by the telecommunications service providers on our behalf, we continue to
include the receivables in our accounts receivable balance due to the full
recourse provisions of the billing and collection agreements.

32

QWEST CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

The following table presents a breakdown of our accounts receivable
balances:

Inventories. Inventories held for sale (primarily wireless handsets) are
carried at the lower of cost or market on a first-in, first-out basis. New and
reusable materials are carried at average cost, except for significant
individual items that are valued based on specific costs.

Property, Plant and Equipment. Property, plant and equipment is carried at
cost and is depreciated using straight-line group methods. Generally, under the
group method, when an asset is sold or retired, the cost is deducted from
property, plant and equipment and charged to accumulated depreciation without
recognition of a gain or loss. Leasehold improvements are amortized over the
shorter of the useful lives of the assets or the lease term. Expenditures for
maintenance and repairs are expensed as incurred. We capitalize interest
incurred during the construction phase of our network. Capitalized interest is
reported as a cost of the network asset and a reduction to interest expense.

Impairment of Long-Lived Assets. Long-lived assets such as property, plant
and equipment are reviewed for impairment whenever facts and circumstances
warrant such a review. Under current standards, the assets must be carried at
historical cost if the projected cash flows from their use will recover their
carrying amounts on an undiscounted basis and without considering interest.
However, if projected cash flows are less than the carrying amount, even by one
dollar, the long-lived assets must be reduced to their estimated fair value.

Customer Acquisition Costs. We defer the initial direct costs of obtaining
a customer to the extent there is sufficient revenue guaranteed under the
arrangement to ensure the realizability of the capitalized costs. Deferred
customer acquisition costs are amortized over the longer of the contract or the
expected life of the customer relationship.

Computer Software. Internally used software, whether purchased or
developed, is capitalized and amortized using the straight-line method over an
estimated useful life of 18 months to 5 years. In accordance with Statement of
Position ("SOP") 98-1, "Accounting for the Costs of Computer Software Developed
or Obtained for Internal Use", we capitalize certain costs associated with
internally developed software such as payroll costs of employees devoting time
to the projects and external direct costs for materials and services. Subsequent
additions, modifications or upgrades to internal-use software are capitalized
only to the extent that they allow the software to perform a task it previously
did not perform. Software maintenance and training costs are expensed in the
period in which they are incurred. Unamortized computer software costs of $1.269
billion and $953 million as of December 2001 and 2000, respectively, which are
net of $484 million and $448 million of accumulated amortization, respectively,
are included in property, plant and equipment.

33

QWEST CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Amortization of capitalized computer software costs totaled $356 million, $239
million and $191 million in 2001, 2000 and 1999, respectively and was included
with depreciation in the accompanying statements of income. During 2001 and
2000, a total of $49 million and $114 million, respectively, of capitalized
computer software costs were written off because several projects were
abandoned, including a significant billing system replacement project and a
customer database system project in 2000. The charges were recorded with the
Restructuring, Merger-related and other charges.

Marketable Securities. All marketable securities are classified as
available-for-sale securities. Unrealized holding gains and losses are
determined on the specific identification method and presented as a component of
accumulated other comprehensive income within stockholder's equity.

Accrued Expenses. Accrued expenses consisted of the following:

The fair value of accounts payable and accrued expenses approximates their
carrying amount because of their short-term nature.

Pension and Post-retirement Benefits. Pension and post-retirement health
care and life insurance benefits earned by employees during the year as well as
interest on projected benefit obligations are accrued currently. Prior service
costs and credits resulting from changes in plan benefits are amortized over the
average remaining service period of the employees expected to receive benefits.

In computing the pension and post-retirement benefit costs, we must make
numerous assumptions about such things as employee mortality and turnover,
expected salary and wage increases, discount rates, expected return on plan
assets and expected future cost increases. Two of these items generally have a
significant impact on the level of cost -- expected rate of return on plan
assets and discount rate.

The expected rate of return on plan assets is the long-term rate of return
we expect to earn on the pension trust's assets. We establish our expected rate
of return by reviewing the investment composition of our pension plan assets,
obtaining advice from our actuaries, reviewing historical earnings on the
pension trust assets and evaluating current and expected market conditions. We
set our discount rate primarily based upon the average interest rate during the
month of December for a Moody's AA rated corporate bond.

Grantor Trust. We have established an irrevocable grantor trust (the
"Trust") related to the payment of certain contingent obligations which are
included in our consolidated balance sheets. The assets in the Trust set aside
for payments of these contingencies are not legally restricted. During 2001,
QCII funded the Trust with a non-cash equity infusion of $286 million.

Derivative Instruments. We occasionally enter into derivative financial
instruments. The objective of our interest rate risk management program is to
manage the level and volatility of our interest expense. We also

34

QWEST CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

may employ financial derivatives to hedge foreign currency exposures associated
with particular debt. This objective was achieved in 2001 through the type of
debt issued and a cross-currency swap that converted foreign-denominated debt to
U.S. dollar-denominated debt.

Under a cross-currency swap, we agree with another party to exchange U.S.
dollars for foreign currency based on a notional amount, at specified intervals
over a defined term. We designed our cross-currency swaps as hedges of our
borrowings and these swaps were effective during 2001. The cross-currency swaps
were carried at fair value on the balance sheet with changes in fair value
included in other comprehensive income. All cross-currency swaps matured in
November 2001.

The following table summarizes the terms of outstanding cross-currency
swaps at December 31, 2000. There were none outstanding at December 31, 2001.
Cross-currency swaps were tied to the Swiss Franc and had a liability of $40
million at December 31, 2000.

We were exposed but realized no losses from non-performance by
counter-parties on these derivatives.

At December 31, 2001, deferred credits of $7 million and deferred charges
of $48 million on closed forward contracts were included as part of the carrying
value of the underlying debt. The deferred credits and charges are recognized as
yield adjustments over the life of the debt that matures at various dates
through 2043.

Comprehensive Income. Comprehensive income included the following
components:

During 2000, we transferred a marketable equity security with a cost of $8
million and a fair value of $333 million to QCII.

New Accounting Standards. In June 1998, the Financial Accounting Standards
Board ("FASB") issued SFAS No. 133. This statement establishes accounting and
reporting standards for derivative instruments and hedging activities. SFAS No.
133 requires, among other things, that all derivative instruments be recognized
at fair value as assets or liabilities in the consolidated balance sheets with
changes in fair value recognized currently in earnings unless specific hedge
accounting criteria are met. The adoption of SFAS No. 133 on January 1, 2001 did
not have a material impact on our consolidated financial statements.

In September 2000, the FASB issued SFAS No. 140, "Accounting for Transfers
and Servicing of Financial Assets and Extinguishments of Liabilities." This
statement provides accounting and reporting standards for transfers and
servicing of financial assets and extinguishments of liabilities. SFAS No. 140
requires that after a transfer of financial assets, an entity continues to
recognize the financial and servicing assets it controls and the liabilities it
has incurred and does not recognize those financial and servicing assets

35

QWEST CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

when control has been surrendered and the liability has been extinguished. SFAS
No. 140 is effective for transfers and servicing of financial assets and
extinguishments of liabilities occurring after March 31, 2001. Adoption of SFAS
No. 140 did not have a material impact on our consolidated financial statements.

In June 2001, the FASB issued SFAS No. 141, "Business Combinations." This
pronouncement eliminated the use of the "pooling of interests" method of
accounting for all mergers and acquisitions. As a result, all mergers and
acquisitions will be accounted for using the "purchase" method of accounting.
SFAS No. 141 is effective for all mergers and acquisitions initiated after June
30, 2001. Adoption of this pronouncement had no impact on our consolidated
financial statements.

In June 2001, the FASB issued SFAS No. 142, "Goodwill and Other Intangible
Assets." This statement addresses financial accounting and reporting for
intangible assets (excluding goodwill) acquired individually or with a group of
other assets at the time of their acquisition. It also addresses financial
accounting and reporting for goodwill and other intangible assets subsequent to
their acquisition. Intangible assets (excluding goodwill) acquired outside of a
business combination will be initially recorded at their estimated fair value.
If the intangible asset has a finite useful life, it will be amortized over that
life. Intangible assets with an indefinite life are not amortized. Both types of
intangible assets will be reviewed annually for impairment and a loss recorded
when the asset's carrying amount exceeds its estimated fair value. The
impairment test for intangible assets consists of comparing the fair value of
the intangible asset to its carrying value. Fair value for goodwill and
intangible assets is determined based upon discounted cash flows and appraised
values. If the carrying value of the intangible asset exceeds its fair value, an
impairment loss is recognized. Goodwill will be treated similar to an intangible
asset with an indefinite life. SFAS No. 142 is effective for fiscal years
beginning after December 15, 2001. The adoption of SFAS No. 142 will have no
impact on our consolidated financial statements.

In June 2001, the FASB issued SFAS No. 143, "Accounting for Asset
Retirement Obligations." This statement addresses the costs of closing
facilities and removing assets. SFAS No. 143 requires entities to record the
fair value of a legal liability for an asset retirement obligation in the period
it is incurred. This cost is initially capitalized and amortized over the
remaining life of the underlying asset. Once the obligation is ultimately
settled, any difference between the final cost and the recorded liability is
recognized as a gain or loss on disposition. As required, we will adopt SFAS No.
143 effective January 1, 2003. We are currently evaluating the impact this
pronouncement will have on our future consolidated financial results.

In August 2001, the FASB issued SFAS No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets." This pronouncement addresses how
to account for and report impairments or disposals of long-lived assets. Under
SFAS No. 144, an impairment loss is to be recorded on long-lived assets being
held or used when the carrying amount of the asset is not recoverable from its
undiscounted cash flows. The impairment loss is equal to the difference between
the asset's carrying amount and estimated fair value. Long-lived assets to be
disposed of by other than a sale for cash are to be accounted for and reported
like assets being held or used except the impairment loss is recognized at the
time of the disposition. Long-lived assets to be disposed of by sale are to be
recorded at the lower of their carrying amount or estimated fair value (less
costs to sell) at the time the plan of disposition has been approved and
committed to by the appropriate company management. In addition, depreciation is
to cease at the same time. As required, we will adopt SFAS No. 144 effective
January 1, 2002. We are currently evaluating the impact this pronouncement will
have on our future consolidated financial results.

36

QWEST CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

NOTE 3: PROPERTY, PLANT AND EQUIPMENT

The components of property, plant and equipment are as follows:

Capitalized Interest. Interest related to qualifying construction projects
is capitalized and included in the depreciable basis of the related asset. You
can find additional information on interest capitalized in Note 4 to our
consolidated financial statements.

Assets Held for Sale. During 1999 and 2000, we agreed to sell
approximately 800,000 access lines to third-party telecommunications services
providers, including approximately 570,000 access lines to Citizens
Communications Company ("Citizens") in nine states. Because these access lines
were "held for sale," we discontinued recognizing depreciation expense on these
assets and recorded them at the lower of their cost or fair value, less
estimated cost to sell.

On July 20, 2001, we terminated our agreement with Citizens under which the
majority of the remaining access lines in eight states were to have been sold
and ceased actively marketing the remaining lines. As a result, the remaining
access lines were reclassified as being "held for use" as of June 30, 2001. The
access lines were measured individually at the lower of their (a) carrying
amount before they were classified as held for sale, adjusted for any
depreciation (amortization) expense or impairment losses that would have been
recognized had the assets been continuously classified as held for use, or (b)
their fair value at June 30, 2001. The required adjustments to the carrying
amount of the individual access lines were included in operating income for
2001. This resulted in a charge to depreciation of $222 million to "catch-up"
the depreciation on these access lines for the period they were held for sale.

In 2001, we sold approximately 41,000 access lines in Utah and Arizona
resulting in $94 million in proceeds and a gain of $51 million. In 2000, we also
completed the sale of approximately 20,000 access lines in North Dakota and
South Dakota resulting in proceeds of $19 million and a gain of $11 million.

Asset Impairments. During 2000, we recorded a charge of $335 million ($205
million after taxes) related to the impairment of certain long-lived assets. The
majority of this non-cash charge relates to dedicated special-purpose access
lines we lease to CLECs. Given current industry conditions and regulatory
changes affecting CLECs in 2000, and given the fact that these access lines have
no alternative use and cannot be sold or re-deployed, we concluded that the net
future cash flows from the assets was negative and that sufficient cash flow
would not be generated to recover the carrying value of those assets. Therefore,
we concluded that the fair value of those assets was minimal and took a $221
million charge in 2000. These assets were used to deliver wholesale services.

As a result of the restructuring in 2001, we reviewed all internal software
projects in process and determined that certain projects should no longer be
pursued. Because the projects were incomplete and

37

QWEST CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

abandoned, the fair value of such software was determined to be zero.
Capitalized software costs of $29 million related to the restructuring were
written off in 2001. The abandoned projects included various billing and other
system enhancements.

Following the Merger, we reviewed all internal software projects in
process, and determined that certain projects should no longer be pursued.
Because the projects were incomplete and abandoned, the fair value of such
incomplete software was determined to be zero. Capitalized software costs of $20
million and $114 million related to the Merger were written off in 2001 and
2000, respectively. The abandoned projects included a significant billing system
replacement and a customer database system.

NOTE 4: BORROWINGS

CURRENT BORROWINGS

Current borrowings consisted of:

The weighted-average interest rate on commercial paper was 2.59% and 6.85%
at December 31, 2001 and 2000, respectively. The interest rate on the debt due
to Qwest Capital Funding ("QCF") was 7.5% at December 31, 2001 and 2000,
respectively.

At December 31, 2001, we maintained commercial paper programs to finance
the short-term operating cash needs of the business. We and QCII also had a $4.0
billion syndicated credit facility to support the purchase of telecommunications
equipment at both Qwest and QCF. As of December 31, 2001, $1.0 billion of that
syndicated facility was allocated to support our short-term cash needs, and the
remainder was allocated to support the QCF short-term cash needs. The syndicated
credit facility matures May 3, 2002. As of December 31, 2001, there was no
outstanding balance on the syndicated facility and we have the option to convert
any borrowed amount into a one-year term loan that would be due in May 2003. The
syndicated credit facility agreement requires us to pay a quarterly fee based
upon our long-term debt ratings. The facility fee for our portion of the credit
facility was 0.065%. The facility also contained financial covenants, measured
on a consolidated QCII basis, the most restrictive of which was a requirement to
maintain a debt-to-consolidated EBITDA ratio of not more than 3.75 to 1.
Consolidated EBITDA, as defined in the credit facility, is a measure of EBITDA
that starts with QCII's net income and then adds back certain items, primarily
those of a non-cash and non-operating nature. You can find additional
information concerning borrowings against the syndicated facility after December
31, 2001 in Note 13 to our consolidated financial statements.

38

QWEST CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

LONG-TERM BORROWINGS

Long-term borrowings consist principally of debentures and medium-term
notes with the following interest rates and maturities at December 31:

Our borrowings have a fair value of $6.9 billion and $6.5 billion at
December 31, 2001 and 2000, respectively. The fair values of our borrowings are
based on quoted market prices where available or, if not available, based on
discounting future cash flows using current interest rates.

The following table shows the amount of gross interest cost, capitalized
interest and cash interest paid during 2001, 2000 and 1999.

NOTE 5: LEASES

Operating Leases. Certain office facilities, real estate and equipment are
subject to operating leases. Rent expense, net of sublease rentals, under these
operating leases was $318 million, $323 million and $227 million during 2001,
2000 and 1999, respectively.

During 2001, we entered into operating lease arrangements ("synthetic
leases") under which we had the option to purchase the leased real estate
properties at any time during the lease term. These synthetic lease facilities
had certain financial covenants. The financial covenants included a
debt-to-EBITDA ratio of 3.75-to-1 on $238 million of the facilities and
3.50-to-1 on $26 million of the facilities. In March 2002, we paid the full
amount necessary to acquire all properties subject to the synthetic lease
agreements and terminated these agreements. You can find additional information
on subsequent events related to the synthetic lease facilities in Note 13 to our
consolidated financial statements.

Capital Leases. The Company leases certain office facilities and equipment
under various capital lease arrangements. Assets acquired through capital leases
during 2001, 2000 and 1999 were $58 million, $265 million and $118 million,
respectively. Assets recorded under capitalized lease agreements included in

39

QWEST CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

property, plant and equipment consisted of $454 million and $565 million of cost
less accumulated amortization of $260 million and $243 million at December 31,
2001 and 2000, respectively.

Future minimum payments under capital leases and non-cancelable operating
leases as of December 31, 2001 are as follows:

Minimum operating lease payments have not been reduced by minimum sublease
rentals of $30 million due in the future under non-cancelable subleases. They
also do not include contingent rentals for the synthetic leases. In 2001, 2000
and 1999, contingent rentals representing the difference between the fixed and
variable rental payments were not significant.

NOTE 6: FAIR VALUES OF EQUITY INVESTMENTS

Fair value of equity investments is based upon market prices quoted by
stock exchanges. Our equity investments in other publicly traded companies
consisted of the following (dollars in millions):

NOTE 7: EMPLOYEE BENEFITS

Pension, Post-retirement and Other Post-employment Benefits. We have a
noncontributory defined benefit pension plan (the "Pension Plan") for
substantially all management and occupational (union) employees and
post-retirement healthcare and life insurance plans for certain retirees. We
also provide post-employment benefits for certain former employees.

In conjunction with the Merger, we made the following changes to our
employee benefit plans for management employees only. Effective September 7,
2000, employees were not eligible to receive retiree medical and life benefits
unless they had either at least 20 years of service by December 31, 2000 or
would be service pension eligible by December 31, 2003. The elimination of the
retiree medical benefits decreased the other post-employment benefits expense
for 2000 by approximately $9 million. In addition, the elimination was accounted
for as a plan curtailment, resulting in a one-time gain of approximately $45
million. This gain was recorded as an offset to Merger-related costs. Employees
who retained the benefits will begin paying contributions in 2004, except for
those employees who retired before September 7, 2000.

40

QWEST CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Pension benefits for management employees before January 1, 2001 were based
upon their salary and years of service while occupational (union) employee
benefits were generally based upon job classification and years of service.

We also modified the pension plan benefits, effective January 1, 2001, for
all former U S WEST management employees who did not have 20 years of service by
December 31, 2000, or who would not be service pension eligible by December 31,
2003. For employees who did not meet these criteria, no additional years of
service will be credited under the defined lump sum formula for years worked
after December 31, 2000. These employee's pension benefits will only be adjusted
for changes in the employee's future compensation level. Future benefits will
equal 3% of pay per year, plus a return as defined in the plan. The minimum
return an employee can earn on their account in a given year is based upon the
Treasury Rate and the employee's account balance at the beginning of the year.
All management employees, other than those who remain eligible under the
previous formulas, will be eligible to participate in the 3%-of-pay plan.

Effective August 11, 2000, the Pension Plan was amended to provide
additional pension benefits to plan participants who were involuntarily
separated from Qwest as a result of the Merger between August 11, 2000, and June
30, 2001. Under the restructuring plan, this amendment was extended to cover
additional employees who involuntarily separate from Qwest. The amount of the
benefit is based on pay and years of service and ranges from a minimum of four
months up to a maximum of one year of an employee's base pay.

Pension and post-retirement costs are recognized over the period in which
the employee renders services and becomes eligible to receive benefits as
determined by using the projected unit credit method. Our funding policy is to
make contributions with the objective of accumulating sufficient assets to pay
all benefits when due. No pension funding was required in 2001, 2000 or 1999. We
did not make any contributions to the post-retirement benefit plan in 2001. In
2000 and 1999, we made contributions to the post-retirement benefit plan of $16
million and $18 million, respectively. The amount funded by us is based on
regulatory accounting requirements. Net pension credits for 2001, 2000 and 1999
were $272 million, $262 million and $116 million, respectively. Net
post-retirement benefit costs (excluding the curtailment gain of $45 million in
2000) for 2001, 2000 and 1999 were $20 million, $16 million and $128 million,
respectively.

401(k) Plan. Substantially all of our management and occupational (union)
employees are eligible to participate in a defined contribution benefit plan
sponsored by QCII. Under the plan, employees may contribute a percentage of
their annual compensation to the plan up to a certain maximum percentage as
defined by the plan and by the Internal Revenue Service. We match a percentage
of employee contributions in QCII stock. Expenses incurred in connection with
our 401(k) plan were $60 million, $79 million and $75 million for 2001, 2000 and
1999, respectively.

Deferred Compensation Plans. We sponsor three deferred compensation plans
for certain employees and for select groups of management and highly compensated
employees, certain of which are open to new participants. Depending upon the
plan, participants may, at their discretion, invest their deferred compensation
in various investment choices, including QCII stock. The value of these accounts
and our obligation are impacted by the earnings and fluctuations in the fair
value of these investment choices.

Our deferred compensation obligation is recorded on the balance sheet in
"Deferred Credits and Other." QCII shares owned inside the plan are treated as
treasury stock and are recorded at cost in Stockholder's Equity. Investment
earnings, administrative expenses and changes in investment values are
recognized in current income as non-operating income and expenses. Increases or
decreases in the deferred compensation liability resulting from changes in the
investment choice values are recorded in the non-operating income and expense
section of the consolidated statement of income. The deferred compensation
liability as of December 31, 2001 and 2000 was $13 million and $20 million,
respectively. The values of the deferred compensation plans' assets were $4
million and $14 million at the end of 2001 and 2000, respectively.

41

QWEST CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

NOTE 8: INCOME TAXES

The components of the provision for income taxes are as follows:

We paid $523 million, $395 million and $650 million to QCII for income
taxes in 2001, 2000 and 1999, respectively.

The effective tax rate differs from the statutory tax rate as follows:

The components of the net deferred tax liability are as follows:

At December 31, 2001 and 2000, we had outstanding taxes receivable from
QCII of $35 million and taxes payable to QCII of $203 million, respectively.

42

QWEST CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

NOTE 9: COMMITMENTS AND CONTINGENCIES

COMMITMENTS

Minimum Usage Requirements and Other Commitments. We have agreements with
third party vendors that require us to maintain minimum monthly and/or annual
billings based on usage. We also have certain agreements with third party
vendors that require payments that are unconditional. We believe we will meet
substantially all minimum usage commitments. Where requirements have not been
met, we have recorded appropriate charges. The financial statements reflect the
financial impact of all current, unmet minimum usage requirements. At December
31, 2001, the total amount of future cash commitments to be paid over the next
five years under minimum usage and unconditional purchase requirement agreements
is approximately $284 million.

Letters of Credit. We maintain letter of credit arrangements with various
financial institutions for up to $3.3 million. At December 31, 2001, the amount
of letters of credit outstanding was $3.3 million.

CONTINGENCIES

Litigation. On July 23, 2001, we filed a demand for arbitration against
Citizens alleging that it breached Agreements for Purchase and Sale of Telephone
Exchanges dated as of June 16, 1999, between Citizens and U S WEST
Communications, Inc., with respect to the purchase and sale of exchanges in
Arizona, Colorado, Idaho, Iowa, Minnesota, Montana, Nebraska and Wyoming. The
demand for arbitration was filed after Citizens failed to close the exchange
sales in violation of the terms of the purchase agreements. Citizens, in turn,
filed a demand for arbitration alleging counter claims against us in connection
with the sale of those same exchanges, as well as exchanges located in North
Dakota that we did sell to Citizens. In the arbitration, we seek a determination
that Citizens breached the agreements and, as a result, we are entitled to draw
down on a series of letters of credit Citizens provided in connection with the
transactions and other damages. Citizens seeks a determination that we breached
the agreements and, as a result, Citizens is entitled to damages. This
arbitration is still at a preliminary stage.

In August 2001, we filed a complaint in state court in Colorado against
Touch America, Inc. ("Touch America"). In response, also in August 2001, Touch
America filed a complaint against us in a federal district court in Montana and
removed the Colorado court complaint to federal district court in Colorado.
Touch America has also filed answers and counterclaims in the Colorado lawsuit.
Touch America's complaint in Montana was dismissed on November 5, 2001, and
Touch America's motion for reconsideration was denied on December 17, 2001. The
disputes between us and Touch America relate to various billing issues for
services provided to Touch America under Qwest tariffs or wholesale
interconnection agreements. Each party seeks damages against the other for
amounts billed and unpaid and for other disputes. The court case is in a
preliminary state, discovery has begun but no trial date has been set. Touch
America also asserts that we violated the Telecommunications Act of 1996 (the
"Act") and our tariffs, and has filed related complaints at the FCC.

Various other litigation matters have been filed against us. We intend to
vigorously defend these outstanding claims.

Intellectual Property. We frequently receive offers to take licenses for
patent and other intellectual rights, including rights held by competitors in
the telecommunications industry, in exchange for royalties or other substantial
consideration. We are also regularly the subject of allegations that our
products or services infringe upon various intellectual property rights, and
receive demands that we discontinue the alleged infringement. We normally
investigate such offers and allegations and respond appropriately, including
defending ourself vigorously when appropriate. There can be no assurance that,
if one or more of these allegations proved to have merit and involved
significant rights, damages or royalties, this would not have a material adverse
effect on us.

43

QWEST CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Regulatory Matters. We have pending regulatory actions in local regulatory
jurisdictions which call for price decreases, refunds or both. These actions are
generally routine and incidental to our business.

We have provided for certain of these matters in our consolidated financial
statements as of December 31, 2001. Although the ultimate resolution of these
claims is uncertain, we do not expect any material adverse impacts as a result
of the resolution of these matters.

NOTE 10: SEGMENT INFORMATION

Our operations are included in QCII's consolidated results and in the
following QCII operating segments: (1) retail services, (2) wholesale services
and (3) network services. The retail services segment provides local telephone
services, long-distance services, wireless services and data and IP services.
The wholesale services segment provides exchange access services that connect
customers to the facilities of interexchange carriers and interconnection to our
telecommunications network to CLECs. The network services segment provides
access to our telecommunications network, including our information
technologies, primarily to our retail services and wholesale services segments.

Following is a breakout of our segments, which we extracted from the
financial statements of QCII. Certain revenue and expenses of QCII are included
in the segment data, which we eliminated in the reconciling items column.
Additionally, because significant expenses of operating the retail services and
wholesale services segments are not allocated to such segments for QCII's
decision making purposes, QCII management does not believe the segment margins
are representative of the actual operating results of the segments. The margin
for the retail services and wholesale services segments excludes network and
corporate expenses. The margin for the network services segment excludes
corporate expenses. The "other" category includes unallocated corporate expenses
and revenues. Asset information by segment is not provided to our chief
operating decision-maker. The communications and related services column
represents the total of the retail services, wholesale services and network
services segments. The 2000 figures presented below have been adjusted to
reflect certain reclassifications to conform with the presentation of the 2001
figures. Since it was impractical to restate the 1999 information and it does
not conform to the presentation for 2000 and 2001, the Margin information may
not be comparable.

- ---------------

(1) Segment margin represents total operating revenues less employee-related and
other operating expenses. Segment margin does not include non-recurring and
non-operating items such as restructuring charges, Merger-related and other
charges, gains/losses on the sale of investments and fixed assets, legal
charges,

44

QWEST CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

regulatory accruals and sales of rural exchanges. Segment margin does not
represent cash flow for the periods presented and should not be considered
as an alternative to net earnings as an indicator of the our operating
performance or as an alternative to cash flows as a source of liquidity, and
may not be comparable with segment margin as defined by other companies.

(2) Capital expenditures reported for the retail services segment include only
expenditures for wireless services and certain data services. Additional
capital expenditures relating to these services are included in network
services capital expenditures.

A reconciliation from Segment margin to pre-tax income follows:

NOTE 11: RESTRUCTURING

During the fourth quarter of 2001, we approved a plan to further reduce
current employee levels, consolidate facilities and abandon certain capital
projects, terminate certain operating leases and recognize certain asset
impairments. We recorded a restructuring charge of $247 million to cover the
costs associated with these actions as more fully described below. A breakdown
of these costs is as follows:

In order to streamline the business and consolidate operations to meet
lower customer demand resulting from the current economic conditions, we
identified a further reduction in employees and contractors in various
functional areas across the country. The severance charge of $188 million
relates to involuntary separation costs for approximately 5,000 employees. As of
December 31, 2001, over 1,100 employees had been involuntarily separated by us
and cash severance payments totaling $9 million had been made relating to these
separations. We expect the remaining employee separations to be completed by
June 30, 2002.

We occupy administrative and network operations buildings under operating
leases with varying terms. Due to the reduction in employees and consolidation
of operations we expect to terminate eight operating lease agreements across the
country within the next 12 months. We recorded a charge of $30 million related
to the termination of these operating lease agreements.

Other restructuring charges consist of asset impairment charges. We
reviewed all internal software projects in process and determined that certain
projects should no longer be pursued. Because the projects were incomplete and
abandoned, the fair value of such software was determined to be zero.
Capitalized software costs of $29 million related to the restructuring were
written off in 2001. The abandoned projects included various billing and other
system enhancements.

45

QWEST CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

A summary of the liabilities recorded from these restructuring costs at
December 31, 2001, is as follows:

NOTE 12: RELATED PARTY TRANSACTIONS

We purchase various services from affiliated companies. We also provide
various services to affiliated companies. The amount paid and received for these
services is determined in accordance with the Federal Communications Commission
and state cost allocation rules, which prescribe various cost allocation
methodologies that are dependent upon the service provided. Management believes
that such cost allocation methods are reasonable. The total cost of services
purchased from affiliated companies was $1.5 billion, $1.0 billion, and $683
million in 2001, 2000 and 1999, respectively. The total amount of revenues
derived from affiliated companies was $365 million, $327 million and $172
million in 2001, 2000 and 1999, respectively.

It is not practicable to provide a detailed estimate of the expenses that
would be recognized on a stand-alone basis. However, we believe that corporate
services, including those related to procurement, tax, legal and human
resources, are obtained more economically through affiliates than they would be
on a stand-alone basis, since we absorb only a portion of the total costs.

NOTE 13: SUBSEQUENT EVENTS

As a result of reduced demand for QCF's and our commercial paper, in
February 2002 we borrowed the full amount allocated to us under the syndicated
credit facility and used or will use the proceeds to repay commercial paper.
After repaying the commercial paper, we had remaining proceeds of $137 million.
After giving effect to the borrowings under the credit facility, our debt
remained approximately $9.6 billion, net of the excess unapplied cash, including
$2.3 billion in short-term borrowings from QCF.

In March 2002, we amended the syndicated credit facility and currently
expect to convert the outstanding balance of the credit facility as of May 3,
2002 into a one-year term loan that would be due in May 2003. As part of the
amendment, we increased the maximum debt-to-consolidated EBITDA ratio, measured
on a consolidated QCII basis, from 3.75-to-1 to 4.25-to-1 through the quarter
ending September 30, 2002, decreasing to 4.0-to-1 for the quarter ending
December 31, 2002 and agreed to use a portion of net proceeds from future sales
of assets and capital market transactions, including the issuance of debt and
equity securities, to prepay the bank loan until the outstanding loan is $2.0
billion or less. Consolidated EBITDA, as defined in the credit facility, is a
measure of EBITDA that starts with QCII's net income and adds back certain
items, primarily those of a non-cash or a non-operating nature.

In March 2002, we issued $1.5 billion in bonds with a ten-year maturity and
an 8.875% interest rate. Approximately $608 million of the net proceeds were
used to repay a portion of our borrowings under the syndicated credit facility.
The remaining proceeds from the sale of the bonds will be used to repay
short-term obligations and currently maturing long-term borrowings. After
applying the portion of the proceeds from our March 2002 debt offering to repay
the credit facility, our total debt outstanding remained at $9.6 billion, net of
excess unapplied cash.

46

QWEST CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Following the amendment and the $608 million payment, as permitted under
the credit facility, QCII re-distributed the amounts outstanding between QCF and
us. As of March 31, 2002 the credit facility had a total amount outstanding of
$3.39 billion, which was all assigned to QCF and none to us.

In 2002, our credit ratings were lowered two levels to BBB+ and Baa2 by
Fitch and Moody's, respectively, and one level to BBB by S&P. These ratings are
investment grade. The commercial paper ratings for our commercial paper was also
lowered to F-3, P-3 and A-3 by Fitch, Moody's and S&P, respectively.

On February 14, 2002, the Minnesota Department of Commerce filed a formal
complaint against us with the Minnesota Public Utilities Commission alleging
that we, in contravention of federal and sate law, failed to file
interconnection agreements with the Minnesota Public Utilities Commission
relating to certain of our wholesale customers, and thereby allegedly
discriminating against other CLECs. The complaint seeks civil penalties related
to such alleged violations between $50 million and $200 million. This proceeding
is at an early stage. Other states in the local service area are looking into
similar matters and further proceedings may ensue in those states.

In March 2002, we paid the full amount necessary to acquire all properties
subject to the synthetic lease agreements and terminated these agreements. The
purchase price of all such properties was approximately $137 million. As a
result of the purchase, the loan commitments totaling $264 million were
terminated and we are no longer liable for our residual value guarantees of up
to $122 million, that were only applicable if the leases expired at the end of
their term.

NOTE 14: QUARTERLY FINANCIAL DATA (UNAUDITED)

- ---------------

(1) Includes an after-tax charge of $71 million for Merger-related and other
charges.

(2) Includes an after-tax charge of $154 million for restructuring and other
charges.

(3) Includes an after-tax charge of $73 million for Merger-related and other
charges.

(4) Includes an after-tax charge of $565 million for Merger-related and other
charges.

(5) Includes an after-tax charge of $167 million for Merger-related and other
charges.

47

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE.

Not applicable.

PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.

We have omitted this information pursuant to General Instruction I(2).

ITEM 11. EXECUTIVE COMPENSATION.

We have omitted this information pursuant to General Instruction I(2).

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.

We have omitted this information pursuant to General Instruction I(2).

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.

We have omitted this information pursuant to General Instruction I(2).

PART IV

ITEM 14. FINANCIAL STATEMENT SCHEDULES, REPORTS ON FORM 8-K AND EXHIBITS.

(a) Documents filed as part of this report

Financial statement schedules other than those listed above have been
omitted because the required information is contained in the consolidated
financial statements and notes thereto or because such schedules are not
required or applicable.

48

(b) Reports on Form 8-K:

We did not file any reports on Form 8-K during the fourth quarter of
2001.

(c) Exhibits:

Exhibits identified in parentheses below, on file with the United States
Securities and Exchange Commission, are incorporated herein by referenced as
exhibits hereto. All other exhibits are provided as part of this electronic
submission.

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( ) Previously filed.

50

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized, in the City of Denver,
State of Colorado, on March 31, 2002.

QWEST CORPORATION

By: /s/ BRYAN K. TREADWAY
------------------------------------
Bryan K. Treadway
Vice President and Controller
(Principal Financial and Accounting
Officer)

Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in capacities indicated on the 31st day of March, 2002.

51

EXHIBIT INDEX

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( ) Previously filed.