As discussed in note 1, we are restating financial statements and other financial information for the years 2004, 2003 and 2002 and financial information for the year 2001 and for each of the quarters in the years 2004 and 2003 with respect to the accounting for certain derivatives transactions. These transactions relate to treasury operations at GE Capital Corporation (GECC).
The errors identified in our internal audit related to the accounting for certain derivative instruments used in meeting our objective of managing exchange rate and interest rate risks. Because we conduct business in diverse markets around the world and local funding is not always efficient, we use derivatives including swaps to eliminate certain market and financial risks. In addition, swaps are used to adjust the debt we are issuing to match the fixed or floating nature of the assets we are acquiring. When interest rate and currency swaps are effective as accounting hedges under the technical requirements of Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended (SFAS 133), they offset the variability of expected future cash flows or changes in the fair values of assets and liabilities, both economically and for financial reporting purposes. GE has historically used such instruments to effectively mitigate financial and market risks, as evidenced by the analysis of the potential effects of changes in interest rates and currency exchange rates presented on page 43. The effect of our inability to apply hedge accounting for the swaps requiring restatement is that changes in their fair values must be recorded in earnings each reporting period. As a result, reported results of operations will be directly influenced by changes in interest rates and currency rates.
The following table sets forth the effects of the errors in accounting for debt interest rate and currency swaps with fees, asset swaps with prepayment penalties and certain other derivatives, as more fully described in the Explanatory Statement beginning on page 3, on our previously reported earnings for the years 2001 through 2004, and each of the quarters in the years 2003 and 2004. The effect of the restatement on our Statements of Financial Position at the end of each of the reported periods is immaterial and the restatement had no effect on our cash flows.
| Increase (decrease) in | |||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Earnings Before Accounting Changes | |||||||||||||||
| (In millions) | 2004 | 2003 | 2002 | 2001 | 2001 Accounting Change (a) | ||||||||||
| Debt swaps with fees | |||||||||||||||
| Interest rate | $ | 77 | $ | (35 | ) | $ | 198 | $ | (14 | ) | $ | 167 | |||
| Currency | 125 | 87 | (154 | ) | (45 | ) | (7 | ) | |||||||
| Asset swaps with prepayment penalties | 15 | 125 | – | – | – | ||||||||||
| Other, net | 9 | 57 | 5 | 9 | (3 | ) | |||||||||
| Total adjustment | $ | 226 | $ | 234 | $ | 49 | $ | (50 | ) | $ | 157 | ||||
| Previously reported earnings before accounting changes | $ | 16,593 | $ | 15,589 | $ | 15,133 | $ | 14,128 | |||||||
| Percent variation for previously reported earnings before accounting changes | 1.4 | % | 1.5 | % | 0.3 | % | (0.4 | )% | |||||||
| (a) Represents the cumulative effect on earnings as of January 1, 2001, the date we adopted SFAS 133. |
| (In millions) | Increase (decrease) in Net Earnings (a) | ||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2005 | 2004 | ||||||||||||||
| Quarter | 1st Qtr. | 4th Qtr. | 3rd Qtr. | 2nd Qtr. | 1st Qtr. | ||||||||||
| Debt swaps with fees | |||||||||||||||
| Interest rate | $ | (153 | ) | $ | 144 | $ | 142 | $ | (436 | ) | $ | 227 | |||
| Currency | 28 | 84 | (20 | ) | 69 | (8 | ) | ||||||||
| Asset swaps with prepayment penalties | 82 | 13 | (102 | ) | 198 | (94 | ) | ||||||||
| Other, net | (35 | ) | 12 | – | (4 | ) | 1 | ||||||||
| Total adjustment | $ | (78 | ) | $ | 253 | $ | 20 | $ | (173 | ) | $ | 126 | |||
| Previously reported earnings before accounting changes | $ | 5,378 | $ | 4,051 | $ | 3,924 | $ | 3,240 | |||||||
| Percent variation from previously reported earnings before accounting changes | 4.7 | % | 0.5 | % | (4.4 | )% | 3.9 | % | |||||||
| (In millions) | Increase (decrease) in Net Earnings (a) | |||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2003 | ||||||||||||
| Quarter | 4th Qtr. | 3rd Qtr. | 2nd Qtr. | 1st Qtr. | ||||||||
| Debt swaps with fees | ||||||||||||
| Interest rate | $ | (61 | ) | $ | (650 | ) | $ | 448 | $ | 228 | ||
| Currency | 8 | 74 | (1 | ) | 6 | |||||||
| Asset swaps with prepayment penalties | (5 | ) | 130 | – | – | |||||||
| Other, net | 1 | – | 3 | 53 | ||||||||
| Total adjustment | $ | (57 | ) | $ | (446 | ) | $ | 450 | $ | 287 | ||
| Previously reported earnings before accounting changes | $ | 4,560 | $ | 4,021 | $ | 3,794 | $ | 3,214 | ||||
| Percent variation from previously reported earnings before accounting changes | (1.3 | )% | (11.1 | )% | 11.9 | % | 8.9 | % | ||||
| (a) See also Note 31 to the Notes to Consolidated Financial Statements – Quarterly Information (Unaudited), as restated. |
Changes to our previously reported earnings detailed above reflect the increased volatility arising from factors outside our control – changes in interest rates and currency rates, and prepayments of fixed-rate loans by customers. We experienced such changes over the affected period of 2001 through the first quarter of 2005, with generally lower interest rates and the resultant increase in loan prepayments, and a U.S. dollar that was relatively strong in the early part of that period but weakened steadily thereafter.
We used interest rate and asset swaps to convert the economics of underlying debt and assets generally from fixed to floating interest rates. Values of swaps themselves change as interest rates change. Declines in rates generally tend to cause positive earnings effects from revaluation of associated debt swaps, the larger of our swap positions, but negative earnings effects from revaluation of asset swaps, the smaller position. Interest rates generally trended downward during the period from 2001 to the present, explaining the overall positive effect on earnings from this accounting error correction. But interest rates were sometimes volatile within the years – for example increasing sharply in the third quarter of 2003 and second quarter of 2004, resulting in a negative earnings effect in those quarters.
Those effects combined to produce a cumulative earnings increase of $0.6 billion through December 31, 2004. Of that amount, $0.4 arose from interest rate swaps, which were used throughout the affected period; $0.1 from asset swaps, which were first used in 2003 after which rates were somewhat volatile, but moved slightly higher; and no effect from currency swaps, where increases and decreases to earnings offset over the affected period. Reversal of these cumulative adjustments will affect net earnings negatively over the terms of the underlying assets and debt, but to a degree that we do not expect to be significant in any individual period given the terms of the arrangements and our plan to reduce accounting volatility by replacing volatile swaps not qualifying for hedge accounting.
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