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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
APPLICATION OF CRITICAL ACCOUNTING ESTIMATES
A summary of our significant accounting policies is included in Note 1 to the Consolidated Financial Statements of this annual report which discusses accounting policies that we have selected from acceptable alternatives. There were no accounting policies adopted during 2007 that had a material impact on our financial condition or results of operations.
Our Consolidated Financial Statements are prepared in accordance with GAAP which often requires management to make judgments, estimates and assumptions regarding uncertainties that affect the reported amounts presented and disclosed in the financial statements. Our management reviews these estimates and assumptions based on historical experience, changes in business conditions and other relevant factors they believe to be reasonable under the circumstances. In any given reporting period, our actual results may differ from the estimates and assumptions used in preparing our Consolidated Financial Statements.
Critical accounting estimates are defined as follows: the estimate requires management to make assumptions about matters that were highly uncertain at the time the estimate was made; different estimates reasonably could have been used; or if changes in the estimate are reasonably likely to occur from period to period and the change would have a material impact on our financial condition or results of operations. Our senior management has discussed the development and selection of our accounting policies, related accounting estimates and the disclosures set forth below with the Audit Committee of our Board of Directors. We believe our critical accounting estimates include those addressing the estimation of liabilities for warranty programs, accounting for income taxes, pension benefits and annual assessment of recoverability of goodwill.
Warranty Programs
We estimate and record a liability for warranty programs, primarily base warranty and other than product recalls, at the time our products are sold. Our estimates are based on historical experience and reflect management’s best estimates of expected costs at the time products are sold and subsequent adjustment to those expected costs when actual costs differ. As a result of the uncertainty surrounding the nature and frequency of product recall programs, the liability for such programs is recorded when we commit to a recall action, which generally occurs when it is announced. Our warranty liability is generally affected by component failure rates, repair costs and the time of failure. Future events and circumstances related to these factors could materially change our estimates and require adjustments to our liability. New product launches require a greater use of judgment in developing estimates until historical experience becomes available. Product specific experience is typically available four or five quarters after product launch, with a clear experience trend evident eight quarters after launch. We generally record warranty expense for new products upon shipment using a factor based upon historical experience only in the first year, a blend of actual product and historical experience in the second year and product specific experience thereafter. Note 12 to the Consolidated Financial Statements contains a summary of the activity in our warranty liability account for 2007 and 2006 including adjustments to pre-existing warranties.
Accounting for Income Taxes
We determine our provision for income taxes using the asset and liability method. Under this method, deferred tax assets and liabilities are recognized for the future tax effects of temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Future tax benefits of tax loss and credit carryforwards are also recognized as deferred tax assets. We evaluate the recoverability of our deferred tax assets each quarter by assessing the likelihood of future profitability and available tax planning strategies that could be implemented to realize our net deferred tax assets. At December 31, 2007, we recorded net deferred tax assets of $543 million. These assets include $39 million for the value of tax loss and credit carryforwards. A valuation allowance of $24 million has been recorded to reduce the tax assets to the net value management believes is more likely than not to be realized. In the event our operating performance deteriorates, future assessments could conclude that a larger valuation allowance will be needed to further reduce the deferred tax assets. In addition, we operate within multiple taxing jurisdictions and are subject to tax audits in these jurisdictions. These audits can involve complex issues, which may require an extended period of time to resolve. We reduce our net tax assets for the estimated additional tax and interest that may result from tax authorities disputing uncertain tax positions we have taken and we believe we have made adequate provision for income taxes for all years that are subject to audit based upon the latest information available. A more complete description of our income taxes and the future benefits of our tax loss and credit carryforwards is disclosed in Note 4 to the Consolidated Financial Statements.
Pension Benefits
We sponsor a number of pension plans primarily in the U.S. and the U.K. and to a lesser degree in various other countries. In the U.S. and the U.K. we have several major defined benefit plans that are separately funded. We account for our pension programs in accordance with Statement of Financial Accounting Standards (SFAS) No. 87, ‘‘Employers’ Accounting for Pensions,’’ (SFAS 87) and SFAS No. 158, ‘‘Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans—an amendment of FASB Statements No. 87, 88, 106 and 132 (R)’’ (SFAS 158). SFAS 87 requires that amounts recognized in financial statements be determined using an actuarial basis. As a result, our pension benefit programs are based on a number of statistical and judgmental assumptions that attempt to anticipate future events and are used in calculating the expense and liability related to our plans. These assumptions include discount rates used to value liabilities, assumed rates of return on plan assets, future compensation increases, employee turnover rates, actuarial assumptions relating to retirement age, mortality rates and participant withdrawals. The actuarial assumptions we use may differ significantly from actual results due to changing economic conditions, participant life span and withdrawal rates. These differences may result in a material impact to the amount of net periodic pension expense to be recorded in our Consolidated Financial Statements in the future. SFAS 158 requires an employer to recognize the overfunded or underfunded status of a defined benefit postretirement plan as an asset or liability in its statement of financial position and to recognize changes in that funded status in the year in which the changes occur through comprehensive income. The Statement also requires an employer to measure the funded status of a plan as of the date of its year-end statement of financial position. We adopted SFAS 158, except for the measurement date change, as required on December 31, 2006. We will adopt the measurement date change effective January 1, 2008.
The expected long-term return on plan assets is used in calculating the net periodic pension expense. We considered several factors in developing our expected rate of return on plan assets. The long-term rate of return considers historical returns and expected returns on current and projected asset allocations and is generally applied to a 5-year average market value of return. The long-term rate of return on plan assets represents an estimate of long-term returns on an investment portfolio consisting of a mixture of equities, fixed income, real estate and other miscellaneous investments. The differences between the actual return on plan assets and expected long-term return on plan assets are recognized in the asset value used to calculate net periodic expense over five years. The table below sets forth the expected return assumptions used to develop our pension expense for the period 2005-2007 and our expected rate for 2008.
Long-Term Expected Return Assumptions
| 2008 | 2007 | 2006 | 2005 | ||||||||
| U.S. Plans | 8.25 | % | 8.50 | % | 8.50 | % | 8.50 | % | |||
| Non-U.S. Plans | 7.25 | % | 7.24 | % | 7.24 | % | 7.56 | % |
A lower expected rate of return will increase our net periodic pension expense and reduce profitability.
The difference between the expected return and the actual return on plan assets is deferred from recognition in our results of operations and, under certain circumstances such as when the difference exceeds 10 percent of the market value of plan assets or the projected benefit obligation (PBO), amortized over future years of service. This is also true of changes to actuarial assumptions. As of December 31, 2007, we had net pension actuarial losses of $341 million and $226 million for the U.S. and non-U.S. pension plans, respectively. Under SFAS 158, the actuarial gains and losses are recognized and recorded in accumulated other comprehensive loss. As these amounts exceed 10 percent of our PBO, the excess is amortized over the average remaining service lives of participating employees.
The table below sets forth the net periodic pension expense for the period 2005-2007 and our expected expense for 2008.
| 2008 | 2007 | 2006 | 2005 | ||||
| Pension Expense (in millions) | $72 | $98 | $120 | $103 |
The decrease in periodic pension expense in 2007 and 2008 is due to higher expected returns on assets driven by the significant pension contributions we made in 2006 and 2007. In addition, our expense is expected to decline as the amortization of prior investment losses begins to be replaced with the amortization of prior investment gains. Another key assumption used in the development of the net periodic pension expense is the discount rate. The discount rates used to develop our net periodic pension expense are set forth in the table below.
Discount Rates
| 2008 | 2007 | 2006 | 2005 | ||||||||
| U.S. Plans | 6.10 | % | 5.60 | % | 5.60 | % | 5.75 | % | |||
| Non-U.S. Plans | 5.80 | % | 4.96 | % | 4.95 | % | 5.30 | % |
Changes in the discount rate assumptions will impact the interest cost component of the net periodic pension expense calculation.
The discount rate enables us to state expected future cash payments for benefits as a present value on the measurement date. The guidelines for setting this rate are discussed in EITF D-36 which suggests a high-quality corporate bond rate. We used bond information provided by Standard & Poors for the U.S. and iBoxx for the U.K. All bonds used to develop our hypothetical portfolio in the U.S. and U.K. were high-quality, non-callable bonds (AA- or better) as of November 30, 2007. The average yield of this hypothetical bond portfolio was used as the benchmark for determining the discount rate to be used to value the obligations of the plans subject to SFAS 87 and SFAS No. 106, ‘‘Employer’s Accounting for Postretirement Benefits Other Than Pensions.’’
Our model called for 60 years of benefit payments. For the U.S. plans, the sum of the cash flows from the 60 bonds matched the cash flow from the benefit payment stream upon completion of the process. The number of bonds purchased for each issue was used to determine the price of the entire portfolio. The discount rate benchmark was set to the internal rate of return needed to discount the cash flows to arrive at the portfolio price.
In developing the U.K. discount rate, excess cash flows resulted in the early years of the 60 year period when the sum of the cash flow from the bonds maturing in later years exceeded the benefit payments in early years, thus no bonds maturing in early years are needed. As a result, the price of the entire portfolio of bonds was too high because all benefit payments were covered with excess cash flow remaining. We made no adjustment to the cash flow and the discount rate was determined as the internal rate of return needed to discount the cash flows to arrive at the portfolio price. Due to the flat shape of the yield curve, this methodology choice impacted the discount rate by less than two basis percentage points. The discount rate would have been slightly higher had the cash flows been allowed to reinvest.
The table below sets forth the estimated impact on our 2008 net periodic pension expense relative to a change in the discount rate and a change in the expected rate of return on plan assets.
| Impact on Pension Expense Increase (Decrease) |
|||
| Millions | |||
| Discount rate used to value liabilities: 0.25 percent increase |
$ (7.5 | ) | |
| 0.25 percent decrease | 7.6 | ||
| Expected rate of return on assets: 1 percent increase |
(28.4 | ) | |
| 1 percent decrease | 28.2 | ||
The above sensitivities reflect the impact of changing one assumption at a time. A higher discount rate decreases the plan obligations and decreases our net periodic pension expense. A lower discount rate increases the plan obligations and increases our net periodic pension expense. It should be noted that economic factors and conditions often affect multiple assumptions simultaneously and the effects of changes in key assumptions are not necessarily linear.
Based upon our target asset allocations it is anticipated that our U.S. investment policy will generate an average annual return over the 20-year projection period equal to or in excess of 7.9 percent approximately 50 percent of the time while returns of 9.5 percent or greater are anticipated 25 percent of the time. Our three-year average rate of return has exceeded 10.0 percent in each of the last three years. As a result, based on the historical returns and forward-looking return expectations, we believe an investment return assumption of 8.25 percent per year for U.S. pension assets is reasonable. The methodology used to determine the rate of return on pension plan assets in the U.K. was based on establishing an equity-risk premium over current long-term bond yields adjusted based on target asset allocations. Our strategy with respect to our investments in pension plan assets is to be invested with a long-term outlook. Therefore, the risk and return balance of our asset portfolio should reflect a long-term horizon. Our pension plan asset allocation at December 31, 2007 and 2006 and target allocation for 2008 are as follows:
| Target Allocation | Percentage of Plan Assets at December 31, |
||||||||
| Investment description | 2008 | 2007 | 2006 | ||||||
| Equity securities | 60-80 | % | 63.5 | % | 62.7 | % | |||
| Fixed income | 23-33 | % | 32.3 | % | 33.4 | % | |||
| Real estate/Other | 3-7 | % | 4.2 | % | 3.9 | % | |||
| Total | 100.0 | % | 100.0 | % | |||||
Actual cash funding for our pension plans is governed by employee benefit and tax laws and the Pension Protection Act of 2006 (‘‘the Act’’). The Act extends the use of an average corporate bond rate for determining current liabilities for funding purposes. Among its many provisions, the Act establishes a 100 percent funding target for plan years beginning after December 31, 2007. Our funding strategy is to make contributions to our various qualified plans in accordance with statutory funding requirements and any additional contributions we determine are appropriate. The table below sets forth our pension contributions for the period 2006-2007 and our expected range of contributions for 2008.
| 2008 | 2007 | 2006 | |||
| Contributions (in millions) | $95-105 | $250 | $266 |
Contributions beyond 2008 will depend on the funded status of our plans at that time in relation to the targeted funding established under the Act.
Our qualified pension plans in the U.S. and outside the U.S. were over-funded at December 31, 2007, by a total of $205 million due to our funding strategy and pension trust asset performance. We have under-funded plans of $146 million at December 31, 2007, which are primarily non-qualified plans in the U.S.
Under SFAS 158, the actuarial gains and losses and prior service costs (credits) are recognized and recorded in accumulated other comprehensive loss. Reductions in these amounts increased our shareholders’ equity by $132 million (after tax and minority interest) in 2007. The reductions resulted from strong plan asset performance and significant pension contributions in 2007 and the past several years.
Note 11 to the Consolidated Financial Statements provides a summary of our pension benefit plan activity, the funded status of our plans and the amounts recognized in our Consolidated Financial Statements.
Annual Assessment for Recoverability of Goodwill
Under the provisions of SFAS No. 142, ‘‘Goodwill and Other Intangible Assets’’ (SFAS 142), the carrying value of goodwill is reviewed annually. The fair value of each reporting unit was estimated by discounting the future cash flows less requirements for working capital and fixed asset additions. Our valuation method requires us to make projections of revenue, operating expenses, working capital investment and fixed asset additions for the reporting units over a multi-year period. Additionally, management must estimate its weighted-average cost of capital for each reporting unit for use as a discount rate. The discounted cash flows are compared to the carrying value of the reporting unit and, if less than the carrying value, a separate valuation of the goodwill is required to determine if an impairment loss has occurred. As of the end of the third quarter in 2007, we performed the annual impairment assessment required by SFAS 142 and determined that our goodwill was not impaired. At December 31, 2007, our recorded goodwill was $365 million. Changes in our projections or estimates, a deterioration of our operating results and the related cash flow effect or a significant increase in the discount rate could decrease the estimated fair value of our reporting units and result in a future impairment of goodwill.