EX-13 2 ex_13.htm EX. 13 - 2005 GENERAL & FINANCIAL INFO. Ex. 13 - 2005 General & Financial Info.
 
EXHIBIT 13


 
CATERPILLAR INC.
GENERAL AND FINANCIAL INFORMATION
2005

 
TABLE OF CONTENTS
A-2

 
MANAGEMENT'S REPORT ON
INTERNAL CONTROL OVER FINANCIAL REPORTING
   

 
The management of Caterpillar Inc. (company) is responsible for establishing and maintaining adequate internal control over financial reporting. Our internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of our financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Our internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.
 
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
 
Management assessed the effectiveness of the company's internal control over financial reporting as of December 31, 2005. In making this assessment, we used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control—Integrated Framework. Based on our assessment we concluded that, as of December 31, 2005, the company's internal control over financial reporting was effective based on those criteria.
 
Our management's assessment of the effectiveness of the company's internal control over financial reporting as of December 31, 2005 has been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm. The report appears on page A-4.
 
 
 
 
 
             
 
 
 
 
James W. Owens
Chairman of the Board
 
   

 

 

        SIGNATURE     
       
David B. Burritt
Chief Financial Officer
   

 

 

 

 
 
February 21, 2006

 

 
 
A-3


REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 
TO THE BOARD OF DIRECTORS AND STOCKHOLDERS OF CATERPILLAR INC.:
 
We have completed integrated audits of Caterpillar Inc.'s 2005 and 2004 consolidated financial statements and of its internal control over financial reporting as of December 31, 2005, and an audit of its 2003 consolidated financial statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below.
 
Consolidated financial statements
In our opinion, the accompanying consolidated statement of financial position and the related statements of consolidated results of operations, changes in stockholders' equity, and cash flow, including pages A-5 through A-36, present fairly, in all material respects, the financial position of Caterpillar Inc. and its subsidiaries at December 31, 2005, 2004, and 2003, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2005 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (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 of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
 
Internal control over financial reporting
Also, in our opinion, management's assessment, included in Management's Report on Internal Control Over Financial Reporting appearing on page A-3, that the Company maintained effective internal control over financial reporting as of December 31, 2005 based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), is fairly stated, in all material respects, based on those criteria. Furthermore, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control—Integrated Framework issued by the COSO. The Company's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on management's assessment and on the effectiveness of the Company's internal control over financial reporting based on our audit. We conducted our audit of internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. An audit of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting, evaluating management's assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.
 
A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.
 
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
 
 
/s/ PricewaterhouseCoopers LLP
 
Peoria, Illinois
February 21, 2006, except as to the reclassifications of amounts for changes in reportable segments discussed in Note 25 and the subsequent event discussed in Note 28, as to which the date is May 31, 2006.
 
A-4

 
STATEMENT 1
Consolidated Results of Operations for the Years Ended December 31
(Dollars in millions except per share data)
 
  2005
  2004
  2003
Sales and revenues:                  
  Sales of Machinery and Engines   $ 34,006   $ 28,336   $ 21,048
  Revenues of Financial Products     2,333     1,970     1,759
   
 
 
    Total sales and revenues     36,339     30,306     22,807
Operating costs:                  
  Cost of goods sold     26,558     22,497     16,997
  Selling, general and administrative expenses     3,190     2,926     2,322
  Research and development expenses     1,084     928     669
  Interest expense of Financial Products     768     524     474
  Other operating expenses     955     747     675
   
 
 
    Total operating costs     32,555     27,622     21,137
   
 
 
Operating profit     3,784     2,684     1,670
  Interest expense excluding Financial Products     260     230     246
  Other income (expense)     377     253     53
   
 
 
Consolidated profit before taxes     3,901     2,707     1,477
  Provision for income taxes     1,120     731     398
   
 
 
  Profit of consolidated companies     2,781     1,976     1,079
  Equity in profit (loss) of unconsolidated affiliated companies     73     59     20
   
 
 
Profit   $ 2,854   $ 2,035   $ 1,099
   
 
 
Profit per common share   $ 4.21   $ 2.97   $ 1.59
Profit per common share—diluted(1)   $ 4.04   $ 2.88   $ 1.56
Weighted-average common shares outstanding (millions)                  
  —Basic     678.4     684.5     690.4
  —Diluted(1)     705.8     707.4     702.7
Cash dividends declared per common share   $ .96   $ .80   $ .72
       
(1) Diluted by assumed exercise of stock options, using the treasury stock method.
 
See accompanying Notes to Consolidated Financial Statements.
A-5

 
STATEMENT 2
Consolidated Financial Position at December 31
(Dollars in millions)
 
 
  2005
  2004
  2003
 
Assets                    
  Current assets:                    
    Cash and short-term investments   $ 1,108   $ 445   $ 342  
    Receivables—trade and other     7,526     7,463     4,030  
    Receivables—finance     6,442     5,182     5,167  
    Retained interests in securitized trade receivables             1,550  
    Deferred and refundable income taxes     344     398     707  
    Prepaid expenses     2,146     1,369     1,424  
    Inventories     5,224     4,675     3,047  
   
 
 
 
  Total current assets     22,790     19,532     16,267  
  Property, plant and equipment—net     7,988     7,682     7,251  
  Long-term receivables—trade and other     1,037     764     510  
  Long-term receivables—finance     10,301     9,903     7,735  
  Investments in unconsolidated affiliated companies     565     517     800  
  Deferred income taxes     768     674     616  
  Intangible assets     424     315     239  
  Goodwill     1,451     1,450     1,398  
  Other assets     1,745     2,258     1,895  
   
 
 
 
Total assets   $ 47,069   $ 43,095   $ 36,711  
   
 
 
 
Liabilities                    
  Current liabilities:                    
    Short-term borrowings:                    
      —Machinery and Engines   $ 871   $ 93   $ 72  
      —Financial Products     4,698     4,064     2,685  
    Accounts payable     3,471     3,580     2,259  
    Accrued expenses     2,617     2,261     1,952  
    Accrued wages, salaries and employee benefits     1,845     1,730     1,802  
    Customer advances     395     447     253  
    Dividends payable     168     141     127  
    Deferred and current income taxes payable     528     259     216  
    Long-term debt due within one year:                    
      —Machinery and Engines     340     6     32  
      —Financial Products     4,159     3,525     2,949  
   
 
 
 
  Total current liabilities     19,092     16,106     12,347  
  Long-term debt due after one year:                    
      —Machinery and Engines     2,717     3,663     3,603  
      —Financial Products     12,960     12,174     10,943  
  Liability for postemployment benefits     2,991     2,986     3,172  
  Deferred income taxes and other liabilities     877     699     568  
   
 
 
 
Total liabilities     38,637     35,628     30,633  
   
 
 
 
Stockholders' equity                    
  Common stock of $1.00 par value:                    
    Authorized shares: 900,000,000                    
    Issued shares (2005, 2004 and 2003—814,894,624) at paid-in amount     1,859     1,231     1,059  
 
Treasury stock (2005—144,027,405 shares; 2004—129,020,726 shares;
and 2003—127,370,544 shares) at cost
    (4,637 )   (3,277 )   (2,914 )
  Profit employed in the business     11,808     9,937     8,450  
  Accumulated other comprehensive income     (598 )   (424 )   (517 )
   
 
 
 
Total stockholders' equity     8,432     7,467     6,078  
   
 
 
 
Total liabilities and stockholders' equity   $ 47,069   $ 43,095   $ 36,711  
   
 
 
 
 See accompanying Notes to Consolidated Financial Statements.
 
A-6

 
STATEMENT 3
Changes in Consolidated Stockholders' Equity for the Years Ended December 31
(Dollars in millions)
 
 
  2005
  2004
  2003
 
Common stock:                                      
  Balance at beginning of year   $ 1,231         $ 1,059         $ 1,034        
  Common shares issued from treasury stock     290           172           25        
  Impact of 2-for-1 stock split     338                            
   
       
       
       
  Balance at year-end     1,859           1,231           1,059        
   
       
       
       
Treasury stock:                                      
  Balance at beginning of year     (3,277 )         (2,914 )         (2,669 )      
 
Shares issued: 2005—18,912,521;
2004—12,216,618;
2003—9,913,946
    324           176           160        
 
Shares repurchased: 2005—33,919,200;
2004—13,866,800; 2003—10,900,000
    (1,684 )         (539 )         (405 )      
   
       
       
       
  Balance at year-end     (4,637 )         (3,277 )         (2,914 )      
   
       
       
       
Profit employed in the business:                                      
  Balance at beginning of year     9,937           8,450           7,849        
  Profit     2,854   $ 2,854     2,035   $ 2,035     1,099   $ 1,099  
  Dividends declared     (645 )         (548 )         (498 )      
  Impact of 2-for-1 stock split     (338 )                          
   
       
       
       
  Balance at year-end     11,808           9,937           8,450        
   
       
       
       
Accumulated other comprehensive income:                                      
  Foreign currency translation adjustment:                                      
    Balance at beginning of year     489           348           86        
    Aggregate adjustment for year     (187 )   (187 )   141     141     262     262  
   
       
       
       
    Balance at year-end     302           489           348        
   
       
       
       
 
Minimum pension liability adjustment—consolidated companies:
                                     
   
Balance at beginning of year
(net of tax of: 2005—$485; 2004—$460; 2003—$383)
    (993 )         (934 )         (771 )      
   
Aggregate adjustment for year
(net of tax of: 2005—$36; 2004—$25; 2003—$77)
    96     96     (59 )   (59 )   (163 )   (163 )
   
       
       
       
   
Balance at year-end
(net of tax of: 2005—$449; 2004—$485; 2003—$460)
    (897 )         (993 )         (934 )      
   
       
       
       
 
Minimum pension liability adjustment—unconsolidated companies:
                                     
    Balance at beginning of year     (48 )         (48 )         (37 )      
    Aggregate adjustment for year     11     11             (11 )   (11 )
     
       
       
       
 
Balance at year-end
    (37 )         (48 )         (48 )      
   
       
       
       
  Derivative financial instruments:                                      
   
Balance at beginning of year
(net of tax of: 2005—$58; 2004—$54; 2003—$5)
    110           104           11        
   
Gains/(losses) deferred during year
(net of tax of: 2005—$0; 2004—$48; 2003—$29)
    (5 )   (5 )   90     90     53     53  
   
(Gains)/losses reclassified to earnings during year
(net of tax of: 2005—$45; 2004—$44; 2003—$20)
    (87 )   (87 )   (84 )   (84 )   40     40  
   
       
       
       
   
Balance at year-end
(net of tax of: 2005—$13; 2004—$58; 2003—$54)
    18           110           104        
   
       
       
       
  Available-for-sale securities:                                      
   
Balance at beginning of year
(net of tax of: 2005—$7; 2004—$5; 2003—$17)
    18           13           (31 )      
   
Gains/(losses) deferred during year
(net of tax of: 2005—$3; 2004—$3; 2003—$11)
    3     3     6     6     23     23  
   
(Gains)/losses reclassified to earnings during year
(net of tax of: 2005—$1; 2004—$1; 2003—$11)
    (5 )   (5 )   (1 )   (1 )   21     21  
   
 
 
 
 
 
 
   
Balance at year-end
(net of tax of: 2005—$9; 2004—$7; 2003—$5)
    16           18           13        
   
       
       
       
Total accumulated other comprehensive income     (598 )         (424 )         (517 )      
   
       
       
       
  Comprehensive income         $ 2,680         $ 2,128         $ 1,324  
         
       
       
 
Stockholders' equity at year-end   $ 8,432         $ 7,467         $ 6,078        
   
       
       
       
See accompanying Notes to Consolidated Financial Statements.
 
A-7

 
STATEMENT 4
Consolidated Statement of Cash Flow for the Years Ended December 31
(Millions of dollars)
 

  2005
  2004
  2003
 
Cash flow from operating activities:                    
  Profit   $ 2,854   $ 2,035   $ 1,099  
  Adjustments for non-cash items:                    
    Depreciation and amortization     1,477     1,397     1,347  
    Other     (20 )   (113 )   (69 )
  Changes in assets and liabilities:                    
    Receivables—trade and other (see non-cash item below)     (908 )   (7,616 )   (8,115 )
    Inventories     (568 )   (1,391 )   (286 )
    Accounts payable and accrued expenses     532     1,457     542  
    Other assets—net     (866 )   337     (277 )
    Other liabilities—net     612     (97 )   148  
   
 
 
 
Net cash provided by (used for) operating activities     3,113     (3,991 )   (5,611 )
   
 
 
 
Cash flow from investing activities:                    
  Capital expenditures—excluding equipment leased to others     (1,201 )   (926 )   (682 )
  Expenditures for equipment leased to others     (1,214 )   (1,188 )   (1,083 )
  Proceeds from disposals of property, plant and equipment     637     486     761  
  Additions to finance receivables     (10,334 )   (8,930 )   (6,868 )
  Collections of finance receivables     7,057     6,216     5,251  
  Proceeds from sale of finance receivables     900     700     661  
  Collections of retained interests in securitized trade receivables         5,722     7,129  
  Investments and acquisitions (net of cash acquired)     (13 )   (290 )   (268 )
  Proceeds from sale of partnership investment         290      
  Proceeds from release of security deposit     530          
  Proceeds from sale of available-for-sale securities     257     408     329  
  Investments in available-for-sale securities     (338 )   (609 )   (425 )
  Other—net     194     198     79  
   
 
 
 
Net cash provided by (used for) investing activities     (3,525 )   2,077     4,884  
   
 
 
 
Cash flow from financing activities:                    
  Dividends paid     (618 )   (534 )   (491 )
  Common stock issued, including treasury shares reissued     482     317     157  
  Treasury shares purchased     (1,684 )   (539 )   (405 )
  Proceeds from debt issued (original maturities greater than three months):                    
    —Machinery and Engines     574     55     164  
    —Financial Products     14,000     10,435     11,825  
  Payments on debt (original maturities greater than three months):                    
    —Machinery and Engines     (654 )   (78 )   (499 )
    —Financial Products     (10,966 )   (8,612 )   (9,562 )
  Short-term borrowings (original maturities three months or less)—net     19     830     (444 )
   
 
 
 
Net cash provided by financing activities     1,153     1,874     745  
   
 
 
 
Effect of exchange rate changes on cash     (78 )   143     15  
   
 
 
 
Increase in cash and short-term investments     663     103     33  
Cash and short-term investments at beginning of period     445     342     309  
   
 
 
 
Cash and short-term investments at end of period   $ 1,108   $ 445   $ 342  
   
 
 
 
 
All short-term investments, which consist primarily of highly liquid investments with original maturities of three months or less, are considered to be cash equivalents.
 
Non-cash activities:
Trade receivables of $6,786 million and $7,534 million were exchanged for retained interests in securitized trade receivables in 2004 and 2003, respectively. See Notes 2 and 6 on pages A-12 and A-16, respectively, for further discussion.

In 2005, $116 million of 9.375% debentures due in 2021 and $117 million of 8.00% debentures due in 2023 were exchanged for $307 million of 5.300% debentures due in 2035 and $23 million of cash. The $23 million of cash is included in payments on debt.
 
See accompanying Notes to Consolidated Financial Statements.
 
A-8

 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 
1. Operations and summary of significant accounting policies
 
A. Nature of operations
We operate in three principal lines of business:
 
(1)   Machinery—A principal line of business which includes the design, manufacture, marketing and sales of construction, mining and forestry machinery—track and wheel tractors, track and wheel loaders, pipelayers, motor graders, wheel tractor-scrapers, track and wheel excavators, backhoe loaders, log skidders, log loaders, off-highway trucks, articulated trucks, paving products, telehandlers, skid steer loaders and related parts. Also includes logistics services for other companies.
 
(2)   EnginesA principal line of business including the design, manufacture, marketing and sales of engines for Caterpillar machinery, electric power generation systems; on-highway vehicles and locomotives; marine, petroleum, construction, industrial, agricultural and other applications; and related parts. Reciprocating engines meet power needs ranging from 5 to 21,500 horsepower (4 to over 16000 kilowatts). Turbines range from 1,600 to 20,500 horsepower (1200 to 15000 kilowatts).
 
(3)   Financial Products—A principal line of business consisting primarily of Caterpillar Financial Services Corporation (Cat Financial), Caterpillar Insurance Holdings, Inc. (Cat Insurance), Caterpillar Power Ventures Corporation (Cat Power Ventures) and their subsidiaries. Cat Financial provides a wide range of financing alternatives to customers and dealers for Caterpillar machinery and engines, Solar gas turbines, as well as other equipment and marine vessels. Cat Financial also extends loans to customers and dealers. Cat Insurance provides various forms of insurance to customers and dealers to help support the purchase and lease of our equipment. Cat Power Ventures is an active investor in independent power projects using Caterpillar power generation equipment and services.
 
Our Machinery and Engines operations are highly integrated. Throughout the Notes, Machinery and Engines represents the aggregate total of these principal lines of business.
 
Our products are sold primarily under the brands "Caterpillar," "Cat," "Solar Turbines," "MaK," "Perkins," "FG Wilson" and "Olympian."
 
We conduct operations in our Machinery and Engines lines of business under highly competitive conditions, including intense price competition. We place great emphasis on the high quality and performance of our products and our dealers' service support. Although no one competitor is believed to produce all of the same types of machines and engines that we do, there are numerous companies, large and small, which compete with us in the sale of each of our products.
 
Machines are distributed principally through a worldwide organization of dealers (dealer network), 54 located in the United States and 128 located outside the United States. Worldwide, these dealers serve 182 countries and operate 3,510 places of business, including 1,587 dealer rental outlets. Reciprocating engines are sold principally through the dealer network and to other manufacturers for use in products manufactured by them. Some of the reciprocating engines manufactured by Perkins are also sold through a worldwide network of 140 distributors located in 170 countries along with 3,500 supporting dealers. Most of the electric power generation systems manufactured by FG Wilson are sold through a worldwide network of 200 dealers located in 180 countries. Our dealers do not deal exclusively with our products; however, in most cases sales and servicing of our products are the dealers' principal business. Turbines and large marine reciprocating engines are sold through sales forces employed by the company. At times, these employees are assisted by independent sales representatives.
 
Manufacturing activities of the Machinery and Engines lines of business are conducted in 41 plants in the United States; nine each in the United Kingdom and Italy; six in China; five in Mexico; three each in France, India and Northern Ireland; two each in Australia, Germany, Brazil, and Japan; and one each in Belgium, Hungary, Indonesia, The Netherlands, Poland, Russia, South Africa, Switzerland and Tunisia. Thirteen parts distribution centers are located in the United States and thirteen are located outside the United States.
 
The Financial Products line of business also conducts operations under highly competitive conditions. Financing for users of Caterpillar products is available through a variety of competitive sources, principally commercial banks and finance and leasing companies. We emphasize prompt and responsive service to meet customer requirements and offer various financing plans designed to increase the opportunity for sales of our products and generate financing income for our company. Financial Products activity is conducted primarily in the United States, with additional offices in Asia, Australia, Canada, Europe and Latin America.
 
See Note 2 for discussion of the reclassification of certain receivables and related cash flows.
 
B. Basis of consolidation
The financial statements include the accounts of Caterpillar Inc. and its subsidiaries. Investments in companies that are owned 20% to 50% or are less than 20% owned and for which we have significant influence are accounted for by the equity method (see Note 11). We consolidate all variable interest entities where Caterpillar Inc. is the primary beneficiary.
 
Certain amounts for prior years have been reclassified to conform with the current-year financial statement presentation.
 
Other operating expense primarily includes Cat Financial's depreciation of equipment leased to others, Cat Insurance underwriting expenses, gains (losses) on disposal of long-lived assets and long-lived asset impairment charges.
 
C. Sales and revenue recognition
Sales of Machinery and Engines are recognized when title transfers and the risks and rewards of ownership have passed to customers or independently owned and operated dealers.
 
Our standard invoice terms are established by marketing region. When a sale is made to a dealer, the dealer is responsible for payment even if the product is not sold to an end customer and must make payment within the standard terms to avoid interest costs. Interest at or above prevailing market rates is charged on any past due balance. Our policy is to not forgive this interest. In 2005, 2004 and 2003, terms were extended to not more than one year for $287 million, $15 million and $54 million of receivables, respectively. For 2005, 2004 and 2003, these amounts represent less than 1% of consolidated sales.
 
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Sales with payment terms of two months or more were as follows:
 
 
  2005
  2004
  2003
 
Payment Terms
(months)

  Sales
  Percent
of Sales

  Sales
  Percent
of Sales

  Sales
  Percent
of Sales

 
  (Dollars in millions)  
2  
$
261      0.8 %  
 $
96      0.3
 $
116      0.6 %
3     548   1.6 %   175   0.6 %   27   0.1 %
4     262   0.8 %   117   0.4 %   28   0.1 %
5     916   2.7 %   750   2.6 %   594   2.8 %
6     8,147   23.9 %   6,172   21.9 %   4,104   19.5 %
7-12     345   1.0 %   831   2.9 %   671   3.2 %
   
 
 
 
 
 
 
   
$
10,479   30.8 %
$
8,141   28.7 %
$
5,540   26.3 %
   
 
 
 
 
 
 
 
We establish a bad debt allowance for Machinery and Engines receivables when it becomes probable that the receivable will not be collected. Our allowance for bad debts is not significant. No significant write-offs of Machinery and Engines receivables were made during 2005, 2004 or 2003.
 
Revenues of Financial Products represent primarily finance and lease revenues of Cat Financial. Finance revenues are recognized over the term of the contract at a constant rate of return on the scheduled uncollected principal balance. Lease revenues are recognized in the period earned. Recognition of income is suspended when collection of future income is not probable. Accrual is resumed, and previously suspended income is recognized, when the receivable becomes contractually current and/or collection doubts are removed. Cat Financial provides wholesale inventory financing to dealers. Please refer to Note 7 and Note 8 for more information.
 
D. Inventories
Inventories are stated at the lower of cost or market. Cost is principally determined using the last-in, first-out (LIFO) method. The value of inventories on the LIFO basis represented about 80% of total inventories at December 31, 2005, 2004 and 2003.
 
If the FIFO (first-in, first-out) method had been in use, inventories would have been $2,345 million, $2,124 million and $1,863 million higher than reported at December 31, 2005, 2004 and 2003, respectively.
 
E. Securitized receivables
We periodically sell finance receivables in securitization transactions. When finance receivables are securitized, we retain interests in the receivables in the form of interest-only strips, servicing rights, cash reserve accounts and subordinated certificates. The retained interests are recorded in other assets at fair value. We estimate fair value based on the present value of future expected cash flows using key assumptions for credit losses, prepayment speeds and discount rates. Please refer to Note 8 for more information.
 
Prior to June 2005, we securitized trade receivables. We retained interests in the receivables in the form of certificates. The fair value of the certificated retained interests approximated carrying value due to their short-term nature. Please refer to Note 6 for more information.
 
F. Depreciation and amortization
Depreciation of plant and equipment is computed principally using accelerated methods. Depreciation on equipment leased to others, primarily for Financial Products, is computed using the straight-line method over the term of the lease. The depreciable basis is the original cost of the equipment less the estimated residual value of the equipment at the end of the lease term. In 2005, 2004 and 2003, Cat Financial depreciation on equipment leased to others was $615 million, $575 million and $527 million, respectively, and was included in "Other operating expenses" in Statement 1. In 2005, 2004 and 2003 consolidated depreciation expense was $1,444 million, $1,366 million and $1,332 million, respectively. Amortization of purchased intangibles is computed using the straight-line method, generally not to exceed a period of 20 years. Accumulated amortization was $107 million, $91 million and $44 million at December 31, 2005, 2004 and 2003, respectively.
 
G. Foreign currency translation
The functional currency for most of our Machinery and Engines consolidated companies is the U.S. dollar. The functional currency for most of our Financial Products and equity basis companies is the respective local currency. Gains and losses resulting from the translation of foreign currency amounts to the functional currency are included in "Other income (expense)" in Statement 1. Gains and losses resulting from translating assets and liabilities from the functional currency to U.S. dollars are included in "Accumulated other comprehensive income" in Statement 2.
 
H. Derivative financial instruments
Our earnings and cash flow are subject to fluctuations due to changes in foreign currency exchange rates, interest rates and commodity prices. Our Risk Management Policy (policy) allows for the use of derivative financial instruments to prudently manage foreign currency exchange rate, interest rate and commodity price exposure. Our policy specifies that derivatives are not to be used for speculative purposes. Derivatives that we use are primarily foreign currency forward and option contracts, interest rate swaps and commodity forward and option contracts. Our derivative activities are subject to the management, direction and control of our financial officers. Risk management practices, including the use of financial derivative instruments, are presented to the Audit Committee of the board of directors at least annually.
 
All derivatives are recognized on the Consolidated Financial Position at their fair value. On the date the derivative contract is entered, we designate the derivative as (1) a hedge of the fair value of a recognized liability ("fair value" hedge), (2) a hedge of a forecasted transaction or the variability of cash flow to be paid ("cash flow" hedge), or (3) an "undesignated" instrument. Changes in the fair value of a derivative that is qualified, designated and highly effective as a fair value hedge, along with the gain or loss on the hedged liability that is attributable to the hedged risk, are recorded in current earnings. Changes in the fair value of a derivative that is qualified, designated and highly effective as a cash flow hedge are recorded in other comprehensive income until earnings are affected by the forecasted transaction or the variability of cash flow and are then reported in current earnings. Changes in the fair value of undesignated derivative instruments and the ineffective portion of designated derivative instruments are reported in current earnings. Cash flows from derivative financial instruments are classified within the same category as the item being hedged on the Consolidated Statement of Cash Flow.
 
We formally document all relationships between hedging instruments and hedged items, as well as the risk-management objective and strategy for undertaking various hedge transactions.
 
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This process includes linking all derivatives that are designated as fair value hedges to specific liabilities on the Consolidated Financial Position and linking cash flow hedges to specific forecasted transactions or variability of cash flow.
 
We also formally assess, both at the hedge's inception and on an ongoing basis, whether the derivatives that are used in hedging transactions are highly effective in offsetting changes in fair values or cash flow of hedged items. When it is determined that a derivative is not highly effective as a hedge or that it has ceased to be a highly effective hedge, we discontinue hedge accounting prospectively, in accordance with Statement of Financial Accounting Standards No. 133 "Accounting for Derivative Instruments and Hedging Activities" (SFAS 133). Please refer to Note 3 for more information on derivatives.
 
I. Impairment of available-for-sale securities
Available-for-sale securities are reviewed monthly to identify market values below cost of 20% or more. If a decline for a debt security is in excess of 20% for six months, the investment is evaluated to determine if the decline is due to general declines in the marketplace or if the investment has been impaired and should be written down to market value pursuant to Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities" (SFAS 115). After the six-month period, debt securities with declines from cost in excess of 20% are evaluated monthly for impairment. For equity securities, if a decline from cost of 20% or more continues for a 12-month period, an other than temporary impairment is recognized without continued analysis.
 
J. Income taxes
The provision for income taxes is determined using the asset and liability approach for accounting for income taxes in accordance with Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS 109). Tax laws require items to be included in tax filings at different times than the items are reflected in the financial statements. A current liability is recognized for the estimated taxes payable for the current year. Deferred taxes represent the future tax consequences expected to occur when the reported amounts of assets and liabilities are recovered or paid. Deferred taxes are adjusted for enacted changes in tax rates and tax laws. Valuation allowances are recorded to reduce deferred tax assets when it is more likely than not that a tax benefit will not be realized.
 
K. Estimates in financial statements
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect reported amounts. The more significant estimates include: residual values for leased assets, fair market values for goodwill impairment tests, warranty liability, and reserves for product liability and insurance losses, postemployment benefits, post-sale discounts, credit losses and income taxes.
 
L. New accounting standards
SFAS 151—In November 2004, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 151 (SFAS 151), "Inventory Costs—an amendment of ARB No. 43, Chapter 4." SFAS 151 discusses the general principles applicable to the pricing of inventory. Paragraph 5 of ARB 43, Chapter 4 provides guidance on allocating certain costs to inventory. This Statement amends ARB 43, Chapter 4, to clarify that abnormal amounts of idle facility expense, freight, handling costs, and wasted materials (spoilage) should be recognized as current-period charges. In addition, this Statement requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of production facilities. As required by SFAS 151, we will adopt this new accounting standard on January 1, 2006. The adoption of SFAS 151 is not expected to have a material impact on our financial statements.
 
SFAS 153—In December 2004, the FASB issued Statement of Financial Accounting Standards No. 153 (SFAS 153), "Exchanges of Non-monetary Assets—an amendment of APB Opinion No. 29." SFAS 153 addresses the measurement of exchanges of non-monetary assets. It eliminates the exception from fair value measurement for non-monetary exchanges of similar productive assets in paragraph 21(b) of APB Opinion No. 29 "Accounting for Non-monetary Transactions" and replaces it with an exception for exchanges that do not have commercial substance. A non-monetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. As required by SFAS 153, we adopted this new accounting standard effective July 1, 2005. The adoption of SFAS 153 did not have a material impact on our financial statements.
 
SFAS 123R—In December 2004, the FASB issued Statement of Financial Accounting Standards No. 123R (revised 2004) "Share-Based Payment," (SFAS 123R). SFAS 123R requires that the cost resulting from all share-based payment transactions be recognized in the financial statements. SFAS 123R also establishes fair value as the measurement method in accounting for share-based payments with employees. The FASB required the provisions of SFAS 123R be adopted for interim or annual periods beginning after June 15, 2005. In April 2005, the SEC adopted a new rule amending the compliance dates for SFAS 123R. In accordance with this rule, we will adopt this new accounting standard effective January 1, 2006. We will adopt the new guidance using the modified prospective method.
 
Our stock-based compensation plans allow for immediate vesting upon retirement for employees who are 55 years old or older with more than 10 years of service and who have fulfilled the requisite service period. Prior to the adoption of SFAS 123R, compensation expense for awards associated with these employees has been recognized in the pro forma net profit over the nominal vesting period. Upon adoption of SFAS 123R, compensation expense will be recognized over the period from the grant date to the end date of the requisite service period for employees who meet the immediate vesting upon retirement requirements. For those employees who become eligible for immediate vesting upon retirement subsequent to the requisite service period and prior to the completion of the vesting period, compensation expense will be recognized over the period from grant date to the date the eligibility is achieved. Application of the nominal vesting period for these employees did not have a significant impact on the 2005, 2004 and 2003 pro forma net profit.
 
In anticipation of delaying vesting until three years after the grant date for future grants, the 2004 employee stock option grant (issued in June) fully vested on December 31, 2004. In order to
 
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better align our employee stock option program with the overall market, the number of options granted in 2005 (issued in February) was significantly reduced from the previous year. In response to this decrease, we elected to immediately vest the 2005 option grant.
 
We expect the application of the expensing provisions of SFAS 123R will result in a pretax expense of approximately $125 million in 2006. As a result of the vesting decisions discussed above, a full complement of expense related to stock-based compensation will not be recognized in our results of operations until 2009. Based on the same assumptions used to value our 2006 compensation expense, we estimate our pretax expense associated with our stock-based compensation plans will range from approximately $160 million in 2007 to approximately $210 million in 2009.
 
FIN 47—In March 2005, the FASB issued FIN 47, "Accounting for Conditional Asset Retirement Obligations, an interpretation of FASB Statement No. 143, Accounting for Asset Retirement Obligations." FIN 47 clarifies that SFAS 143 requires accrual of the fair value of legally required asset retirement obligations if sufficient information exists to reasonably estimate the fair value. We adopted this new accounting standard during the fourth quarter of 2005. The adoption of FIN 47 did not have a material impact on our financial statements.
 
SFAS 154—In June 2005, the FASB issued Statement of Financial Accounting Standards No. 154 (SFAS 154), "Accounting Changes and Error Corrections." SFAS 154 changes the requirements for the accounting for and reporting of a change in accounting principle. This Statement requires retrospective applications to prior periods' financial statements of a voluntary change in accounting principle unless it is impracticable. In addition, this Statement requires that a change in depreciation, amortization, or depletion for long-lived, non-financial assets be accounted for as a change in accounting estimate effected by a change in accounting principle. This new accounting standard is effective January 1, 2006. The adoption of SFAS 154 is not expected to have a material impact on our financial statements.
 
M. Stock-based compensation
We currently use the intrinsic value method of accounting for stock-based employee compensation in accordance with Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees." Therefore, no compensation expense is recognized in association with our options.
 
In 2004, we switched from using the Black-Scholes option pricing model to the binomial option-pricing model in order to calculate the fair value of our options. We believe this model more accurately reflects the value of the options than the Black-Scholes option-pricing model. Grants made prior to 2004 continue to be valued using the Black-Scholes model. Please refer to Note 18 for additional information on our stock-based compensation plans.
 
The following tables illustrate the effect on profit and profit per share if we had applied the fair value method of Statement of Financial Accounting Standards (SFAS 123), "Accounting for Stock-Based Compensation" for 2005 and 2004 grants using the binomial option-pricing model and 2003 using the Black-Scholes option-pricing model.
 
 
  Years ended December 31,
 
 
  2005
  2004
  2003
 
 
  (Dollars in millions except per share data)
 
Profit, as reported   $ 2,854   $ 2,035   $ 1,099  
Deduct: Total stock-based employee compensation expense determined
under fair value based method for all awards, net of related tax effects
    (135 )   (161 )   (69 )
   
 
 
 
Pro forma net profit   $ 2,719   $ 1,874   $ 1,030  
   
 
 
 
Profit per share of common stock:                    
  As reported:                    
    Basic   $ 4.21   $ 2.97   $ 1.59  
    Diluted   $ 4.04   $ 2.88   $ 1.56  
  Pro forma:                    
    Basic   $ 4.01   $ 2.74   $ 1.49  
    Diluted   $ 3.85   $ 2.65   $ 1.47  
 
 
Pro forma net profit and profit per share in 2004 using the Black-Scholes option-pricing model would have been:
 
  Year ended
December 31,
2004

 
 
  (Dollars in millions except per share data)
 
Profit, as reported   $ 2,035  
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects     (202 )
   
 
Pro forma net profit   $ 1,833  
   
 
Profit per share of common stock:        
  As reported:        
    Basic   $ 2.97  
    Diluted   $ 2.88  
  Pro forma:        
    Basic   $ 2.68  
    Diluted   $ 2.59  
 
 
2. Reclassification of certain receivables and related cash flows
 
A. Consolidated financial position
Our Machinery and Engines operations generate trade receivables from the sale of inventory to dealers and customers. Certain of these receivables are sold to Cat Financial. Cat Financial holds the receivables and prior to June 2005, securitized a portion of the dealer receivables using a revolving securitization structure. Cat Financial's portion of the securitized trade receivables was represented by certificated retained interests. Cat Financial also generates wholesale inventory receivables from its direct financing of inventory purchases by dealers. Previously, the certificated retained interests as well as the wholesale inventory receivables were classified as Finance Receivables in our Consolidated Financial Position. In the fourth quarter of 2004, we reclassified the certificated retained interests from Finance Receivables to Retained Interests in Securitized Trade Receivables and the wholesale inventory receivables from Finance Receivables to Trade and Other Receivables in our Consolidated Financial Position. These changes were made to align the financial position with the cash flow changes discussed below.
 
B. Consolidated statement of cash flow
During the fourth quarter of 2004, the staff of the Securities and Exchange Commission expressed concern regarding the classifications of certain cash flows by companies with captive finance
 
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subsidiaries. As a result of this concern, management decided to make reclassifications to the 2003 Consolidated Statement of Cash Flow as described below.
 
Securitized trade receivables
Prior to the fourth quarter of 2004, we reported an increase in cash flow from operating activities in the Consolidated Statement of Cash Flow when Machinery and Engines sold receivables to Cat Financial that were subsequently securitized. Concurrently, Cat Financial's entire purchase of these receivables was included in Additions to Finance Receivables (investing activity) in the Consolidated Statement of Cash Flow. The receivables were immediately securitized and the portion sold to a third party was included in Proceeds from Sale of Finance Receivables (investing activity) in the Consolidated Statement of Cash Flow. Subsequently, collection of the certificated retained interests was included in Collection of Finance Receivables (investing activity) in the Consolidated Statement of Cash Flow. This cash flow treatment followed our principal lines of business reporting, however, when we reported an increase in cash flow from operating activities and a corresponding outflow from investing activities there was no increase in cash on a consolidated basis from the sale of inventory to our dealers and customers.
 
In the fourth quarter of 2004, we made a reclassification to eliminate the offsetting non-cash intercompany transactions in the Consolidated Statement of Cash Flow. In addition, we reclassified the proceeds from sale of trade receivables to operating activities. The reclassification properly classifies cash receipts from the sale of inventory as operating activities and reflects that these cash flows, although held and managed by Cat Financial, arise from our sale of Machinery and Engines inventory.
 
The securitization structure mentioned above involved a securitization trust. During 2003, the trust was a qualifying special purpose entity (QSPE) and thus, in accordance with Statement of Financial Accounting Standards No. 140 (SFAS 140), "Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities," was not consolidated. (See Note 6 for discussion of the 2004 QSPE status of the trust and termination of the trust in 2005.) When receivables were placed into the trust, we received cash for the portion sold to third party purchasers and the portion retained by Cat Financial was represented by certificated retained interests. Placing receivables into a securitization trust changes their nature and the receipt of certificated retained interests is considered a non-cash transaction. We have noted this non-cash transaction on the Consolidated Statement of Cash Flow and quantified the receivables decrease resulting from this transaction and thus excluded from operating activities. This reflects that certificated retained interests, not cash, were received for these sales. The certificated retained interests are considered held-to-maturity securities as defined by SFAS 115. SFAS 115 requires that collection of held-to-maturity securities be classified as an investing activity. We have therefore reclassified the collection of the certificated retained interests from Collection of Finance Receivables to Collections of Retained Interests in Securitized Trade Receivables within the investing activities section of the Consolidated Statement of Cash Flow. The impact of these changes is a significant reduction to cash flow from operating activities and a significant increase in cash flow from investing activities. This reflects that although inventory was sold, the nature of the receivable was changed to a security. The subsequent collection of that security is shown as an investing activity.
 
Wholesale inventory receivables
Prior to the fourth quarter of 2004, we reported an increase in cash flow from operating activities when a dealer remitted payment for a trade receivable that was subsequently financed with the issuance of a wholesale inventory receivable by Cat Financial. The issuance of a wholesale inventory receivable by Cat Financial was reported as an Addition to Finance Receivables in the Consolidated Statement of Cash Flow and the subsequent collection was reported as a Collection of Finance Receivables. Similar to securitized receivables, this cash flow treatment followed our principal lines of business reporting, however, when we reported an increase in cash flow from operating activities and a corresponding outflow from investing activities there was no increase in cash on a consolidated basis from the sale of inventory to our dealers and customers. We therefore eliminated the offsetting non-cash transaction in the Consolidated Statement of Cash Flow. In addition, we reclassified the collection of wholesale inventory receivables to operating activities. The reclassification properly classifies cash receipts from the sale of inventory as operating activities and reflects that these cash flows, although held and managed by Cat Financial, arise from our sale of Machinery and Engines inventory.
 
These reclassifications had no impact on the "Increase in Cash and Short-term Investments" on the Statement of Consolidated Cash Flow.
 
Prior amounts reported have been reclassified to conform to this presentation as follows:
 
 
  2003
 
 
  Previous
classification(1)

         Change
        As
Reclassified

 
 
  (Millions of dollars)
 
Consolidated Financial Position—Statement 2                    
  Receivables—trade and other   $ 3,671   $ 359   $ 4,030  
  Receivables—finance     7,076     (1,909 )   5,167  
  Retained interests in securitized trade receivables         1,550     1,550  
  Long-term receivables—trade and other     82     428     510  
  Long-term receivables—finance     8,163     (428 )   7,735  

Consolidated Statement of Cash Flow—Statement 4

 

 

 

 

 

 

 

 

 

 
  Receivables—trade and other   $ (438 ) $ (7,677 ) $ (8,115 )
  Net cash provided by (used for) operating activities     2,066     (7,677 )   (5,611 )
  Additions to finance receivables     (17,146 )   10,278     (6,868 )
  Collections of finance receivables     13,882     (8,631 )   5,251  
  Proceeds from sale of finance receivables     1,760     (1,099 )   661  
  Collections of retained interests in securitized trade receivables         7,129     7,129  
  Net cash provided by (used for) investing activities     (2,793 )   7,677     4,884  
 
(1) Certain amounts do not agree to prior period reported amounts due to unrelated reclassifications.

 
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3. Derivative financial instruments and risk management
 
A. Foreign currency exchange rate risk
Foreign currency exchange rate movements create a degree of risk by affecting the U.S. dollar value of sales made and costs incurred in foreign currencies. Movements in foreign currency rates also affect our competitive position as these changes may affect business practices and/or pricing strategies of non-U.S.-based competitors. Additionally, we have balance sheet positions denominated in foreign currency, thereby creating exposure to movements in exchange rates.
 
Our Machinery and Engines operations purchase, manufacture and sell products in many locations around the world. As we have a diversified revenue and cost base, we manage our future foreign currency cash flow exposure on a net basis. We use foreign currency forward and option contracts to manage unmatched foreign currency cash inflow and outflow. Our objective is to minimize the risk of exchange rate movements that would reduce the U.S. dollar value of our foreign currency cash flow. Our policy allows for managing anticipated foreign currency cash flow for up to four years.
 
We generally designate as cash flow hedges at inception of the contract any Australian dollar, Brazilian real, British pound, Canadian dollar, euro, Japanese yen, Mexican peso, Singapore dollar, Chinese yuan, New Zealand dollar or Swiss franc forward or option contracts that meet the standard for hedge accounting. Designation is performed on a specific exposure basis to support hedge accounting. The remainder of Machinery and Engines foreign currency contracts are undesignated. We designate as fair value hedges specific euro forward contracts used to hedge firm commitments.
 
As of December 31, 2005, $8 million of deferred net losses included in equity ("Accumulated other comprehensive income" in Statement 2), are expected to be reclassified to current earnings ["Other income (expense)"] over the next twelve months when earnings are positively affected by the hedged transactions. As of December 31, 2004 and 2003, the projected reclassification was a gain of $102 million and $70 million, respectively. The decrease from 2004 to 2005 is due to expiration of several Machinery and Engines long-term hedges. The actual amount recorded in "Other income (expense)" will vary based on exchange rates at the time the hedged transactions impact earnings. There were no circumstances where hedge treatment was discontinued during 2005, 2004 or 2003.
 
In managing foreign currency risk for our Financial Products operations, our objective is to minimize earnings volatility resulting from conversion and the remeasurement of net foreign currency balance sheet positions. Our policy allows the use of foreign currency forward and option contracts to offset the risk of currency mismatch between our receivables and debt. All such foreign currency forward and option contracts are undesignated.
 
Gains/(losses) included in current earnings [Other income (expense)] on undesignated contracts:
 
 
  2005
  2004
  2003
 
 
  (Millions of dollars)
 
Machinery and Engines:                    
  On undesignated contracts   $ 25   $ (9 ) $ (1 )
Financial Products:                    
  On undesignated contracts   $ 58   $ (46 ) $ (121 )
   
 
 
 
    $ 83   $ (55 ) $ (122 )
   
 
 
 
 
Gains and losses on the Financial Products contracts above are substantially offset by balance sheet translation gains and losses.
 
B. Interest rate risk
Interest rate movements create a degree of risk by affecting the amount of our interest payments and the value of our fixed rate debt. Our practice is to use interest rate swap agreements to manage our exposure to interest rate changes and, in some cases, lower the cost of borrowed funds.
 
Machinery and Engines operations generally use fixed rate debt as a source of funding. Our objective is to minimize the cost of borrowed funds. Our policy allows us to enter into fixed-to-floating interest rate swaps and forward rate agreements to meet that objective with the intent to designate as fair value hedges at inception of the contract all fixed-to-floating interest rate swaps. Designation as a hedge of the fair value of our fixed rate debt is performed to support hedge accounting. During 2001, our Machinery and Engines operations liquidated all fixed-to-floating interest rate swaps. The gain ($11 million as of December 31, 2005) is being amortized to earnings ratably over the remaining life of the hedged debt.
 
Financial Products operations have a match funding policy that addresses interest rate risk by aligning the interest rate profile (fixed or floating rate) of their debt portfolio with the interest rate profile of their receivables portfolio within predetermined ranges on an on-going basis. In connection with that policy, we use interest rate derivative instruments to modify the debt structure to match assets within the receivables portfolio. This match funding reduces the volatility of margins between interest-bearing assets and interest-bearing liabilities, regardless of which direction interest rates move. This is accomplished by changing the characteristics of existing debt instruments or entering into new agreements in combination with the issuance of new debt.
 
Our policy allows us to use floating-to-fixed, fixed-to-floating and floating-to-floating interest rate swaps to meet the match funding objective. To support hedge accounting, we designate fixed-to-floating interest rate swaps as fair value hedges of the fair value of our fixed rate debt at the inception of the contract. Financial Products' practice is to designate most floating-to-fixed interest rate swaps as cash flow hedges of the variability of future cash flows at the inception of the swap contract. Designation as a hedge of the variability of cash flow is performed to support hedge accounting. Financial Products liquidated fixed-to-floating interest rate swaps during 2005, 2004 and 2002. The gains ($14 million as of December 31, 2005) are being amortized to earnings ratably over the remaining life of the hedged debt.
 
Gains/(losses) included in current earnings [Other income (expense)]:
 
 
  2005
  2004
  2003
 
 
  (Millions of dollars)
 
Fixed-to-floating interest rate swaps                    
  Machinery and Engines:                    
    Gain on liquidated swaps   $ 5   $ 5   $ 6  
  Financial Products:                    
    Loss on designated interest rate derivatives     (71 )   (28 )   (20 )
    Gain on hedged debt     71     28     20  
    Gain on liquidated swaps—included in interest expense     5     2     2  
   
 
 
 
    $ 10   $ 7   $ 8  
   
 
 
 
 
As of December 31, 2005, $12 million of deferred net gains included in equity ("Accumulated other comprehensive income" in Statement 2), related to Financial Products floating-to-fixed interest rate swaps, are expected to be reclassified to current earnings ("Interest expense of Financial Products") over the next
 
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twelve months. As of December 31, 2004, this projected reclassification was a net loss of $3 million. As of December 31, 2003, this projected reclassification was a net loss of $16 million. There were no circumstances where hedge treatment was discontinued during 2005, 2004 or 2003.
 
C. Commodity price risk
Commodity price movements create a degree of risk by affecting the price we must pay for certain raw material. Our policy is to use commodity forward and option contracts to manage the commodity risk and reduce the cost of purchased materials.
 
Our Machinery and Engines operations purchase aluminum, copper and nickel embedded in the components we purchase from suppliers. Our suppliers pass on to us price changes in the commodity portion of the component cost. In addition, we are also subjected to price changes on natural gas purchased for operational use.
 
Our objective is to minimize volatility in the price of these commodities. Our policy allows us to enter into commodity forward and option contracts to lock in the purchase price of a portion of these commodities within a four-year horizon. All such commodity forward and option contracts are undesignated. Gains on the undesignated contracts of $7 million, $15 million and $27 million were recorded in current earnings ["Other income (expense)"] in 2005, 2004 and 2003, respectively.
 
4. Other income (expense)
 
 
  Years ended December 31,
 
 
  2005
  2004
  2003
 
 
  (Millions of dollars)
 
Investment and interest income   $ 97   $ 77   $ 31  
Foreign exchange gains     148     96     3  
Charge for early retirement of debt             (55 )
License fees     59     54     40  
Miscellaneous income (loss)     73     26     34  
   
 
 
 
    $ 377   $ 253   $ 53  
   
 
 
 
 
5. Income taxes
The components of profit before taxes were:
 
  Years ended December 31,
 
  2005
  2004
  2003
 
  (Millions of dollars)
U.S.   $ 2,254   $ 1,106   $ 489
Non-U.S.     1,647     1,601     988
   
 
 
    $ 3,901   $ 2,707   $ 1,477
   
 
 
Profit before taxes, as shown above, is based on the location of the entity to which such earnings are attributable. However, since such earnings are subject to taxation in more than one country, the income tax provision shown below as U.S. or non-U.S. may not correspond to the earnings shown above.
 
The components of the provision for income taxes were:
 
  Years ended December 31,
 
 
  2005
  2004
  2003
 
 
  (Millions of dollars)
 
Current tax provision (credit):                    
  U.S. Federal   $ 683   $ 136   $ 24  
  Non-U.S.     365     308     196  
  State (U.S.)     31     13     10  
   
 
 
 
      1,079     457     230  
   
 
 
 
Deferred tax provision (credit):                    
  U.S. Federal     (5 )   301     182  
  Non-U.S.     31     (24 )   (21 )
  State (U.S.)     15     (3 )   7  
   
 
 
 
      41     274     168  
   
 
 
 
Total provision for income taxes   $ 1,120   $ 731   $ 398  
   
 
 
 
 
Reconciliation of the U.S. federal statutory rate to effective rate:
 
  Years ended December 31,
                                      
 
  2005
          2004
          2003
       
U.S. statutory rate   35.0 % 35.0 % 35.0 %
(Decreases) increases in taxes resulting from:              
     Benefit of extraterritorial income exclusion   (2.7 )% (4.9 )% (4.9 )%
     Non-U.S. subsidiaries taxed at other than 35%   (3.2 )% (3.7 )% (4.0 )%
     Other—net   0.4 % 0.6 % 0.9 %
   
 
 
 
    29.5 % 27.0 % 27.0 %
   
 
 
 
Discrete items   (0.8 )%    
   
 
 
 
Provision for income taxes   28.7 % 27.0 % 27.0 %
   
 
 
 
We paid income taxes of $731 million, $326 million and $55 million in 2005, 2004 and 2003, respectively.
 
We have recorded income tax expense at U.S. tax rates on all profits, except for undistributed profits of non-U.S. companies which are considered indefinitely reinvested. Determination of the amount of unrecognized deferred tax liability related to indefinitely reinvested profits is not feasible.
 
Deferred income tax assets and liabilities:
 
  December 31,
 
 
  2005
  2004
  2003
 
 
  (Millions of dollars)
 
Deferred income tax assets:                    
  Postemployment benefits other than pensions   $ 1,034   $ 1,092   $ 1,147  
  Warranty reserves     216     212     163  
  Unrealized profit excluded from inventories     176     153     136  
  Tax carryforwards     523     498     395  
  Deferred compensation     70     57     48  
  Allowance for credit losses     86     73     66  
  Unremitted earnings of non-U.S. subs             25  
  Post sale discounts     62     51     39  
  Other—net     106     184     156  
   
 
 
 
      2,273     2,320     2,175  
   
 
 
 
Deferred income tax liabilities:                    
  Capital assets     (787 )   (903 )   (731 )
  Pension     (359 )   (216 )   (102 )
  Unremitted earnings of non-U.S. subs     (52 )   (131 )    
   
 
 
 
      (1,198 )   (1,250 )   (833 )
   
 
 
 
Valuation allowance for deferred tax assets     (79 )   (42 )   (62 )
   
 
 
 
Deferred income taxes—net   $ 996   $ 1,028   $ 1,280  
   
 
 
 
 
SFAS 109 requires that individual tax-paying entities of the company offset all current deferred tax liabilities and assets within each particular tax jurisdiction and present them as a single amount in the Consolidated Financial Position. A similar procedure is followed for all noncurrent deferred tax liabilities and assets. Amounts in different tax jurisdictions cannot be offset against each other. The amount of deferred income taxes at December 31, included on the following lines in Statement 2, are as follows:
 
 
  2005
  2004
  2003
  (Millions of dollars)
Assets:                  
  Deferred and refundable income taxes   $ 344   $ 397   $ 702
  Deferred income taxes     768     674     616
   
 
 
    $ 1,112   $ 1,071   $ 1,318
                   
Liabilities:                  
  Deferred and current income taxes payable   $ 89   $ 20   $ 18
  Deferred income taxes and other liabilities     27     23     20
   
 
 
Deferred income taxes—net   $ 996   $ 1,028   $ 1,280
   
 
 
A-15

 
As of December 31, 2005, amounts and expiration dates of U.S. foreign tax credits available to carry forward were:
 
 2006-2011
                    
            2012
                    
            2013
                    
                
2014
                   
                   2015
                   
               Total
                   
(Millions of dollars)
 
$ 0   $ 36   $ 109   $ 74   $ 18   $ 237
 
 
 As of December 31, 2005, amounts and expiration dates of net operating loss carryforwards in various non-U.S. taxing jurisdictions were:
 
2006
                   
          2007
                   
            2008
                   
       2009
                   
        2010-2015
                   
             Unlimited
                   
             Total
                   
(Millions of dollars)
 
$ 7   $ 3   $ 0   $ 5   $ 137   $ 569   $ 721
 
A valuation allowance has been recorded at certain non-U.S. subsidiaries that have not yet demonstrated consistent and/or sustainable profitability to support the recognition of net deferred tax assets.
 
As of December 31, 2005, approximately $890 million of state tax net operating losses (NOLs) and $36 million of state tax credit carryforwards were available. Of the NOLs, 67% expire after 2015. The state tax credit carryforwards expire over the next ten years. We established a valuation allowance for those NOLs and credit carryforwards likely to expire prior to utilization.
 
In December 2004, the FASB issued FASB Staff Position No. 109-1 "Application of FASB Statement No. 109, Accounting for Income Taxes, to the Tax Deduction on Qualified Production Activities Provided by the American Jobs Creation Act of 2004" (FSP 109-1). FSP 109-1 provides accounting guidance for companies that will be eligible for a tax deduction resulting from "qualified production activities income" as defined in the American Jobs Creation Act of 2004 (the Act). FSP 109-1 requires this deduction be treated as a special deduction in accordance with SFAS 109, which does not require a revaluation of our U.S. deferred tax assets. We applied the guidance in FSP 109-1 upon recognition of this tax deduction beginning January 1, 2005. The application of FSP 109-1 did not have a material impact on our financial statements.
 
In December 2004, the FASB issued FASB Staff Position No. 109-2 "Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004" (FSP 109-2). FSP 109-2 provides accounting guidance for the one-time tax deduction of 85% of non-U.S. earnings that are repatriated in excess of a base amount as defined in the Act. SFAS 109 requires a company to reflect in the period of enactment the effect of a new tax law. Due to the lack of clarification of certain provisions within the Act, FSP 109-2 allowed companies time beyond the financial reporting period of enactment to evaluate the effect of the Act. We completed our evaluation in the second quarter and recognized a provision for income taxes of $33 million in 2005 under the provisions of the Act. We repatriated earnings of $1.4 billion in 2005, which includes approximately $500 million subject to the preferential treatment allowed by the Act. In connection with our repatriation plan, we now intend to indefinitely reinvest earnings of a few selected non-U.S. subsidiaries and have reversed the associated deferred tax liability of $38 million.
 
The 2005 provision for income taxes also includes the impact of favorable tax settlements of $26 million primarily related to non-U.S. tax jurisdictions. The net impact of repatriation planning and these favorable tax settlements was a $31 million decrease to our 2005 provision for income taxes. Excluding these discrete items, the effective tax rate for 2005 was 29.5%.
 
During the second quarter of 2005, the Internal Revenue Service (IRS) completed its field examination of our 1995 through 1999 U.S. tax returns. In connection with this examination, we received notices of certain adjustments proposed by the IRS, primarily related to foreign sales corporation (FSC) commissions, foreign tax credit calculations and R&D credits. We disagree with these proposed adjustments and are vigorously disputing this matter through applicable IRS and judicial procedures, as appropriate. Although the final resolution of the proposed adjustments is uncertain, in the opinion of our management, the ultimate disposition of these matters will not have a material adverse effect on our consolidated financial position, liquidity or results of operations.
 
6. Sales and servicing of trade receivables
Our Machinery and Engines operations generate trade receivables from the sale of inventory to dealers and customers. Certain of these receivables are sold to Cat Financial.
 
A.    Prior to June 2005, Cat Financial periodically securitized a portion of the dealer receivables using a revolving securitization structure. We used a trust which issued a collateralized trust obligation (CTO) certificate to third party purchasers for their portion of these receivables. The trust also issued a transferor certificate (certificated retained interests) to Cat Financial for the portion not represented by the CTO.
 
For 2003 and through August of 2004, the trust was a qualifying special purpose entity (QSPE) and thus, in accordance with SFAS 140, was not consolidated. The outstanding principal balance of the CTO was not included in our Consolidated Financial Position during these periods. As of December 31, 2003, the certificated retained interests of $1,550 million were included in "Retained Interests in Securitized Trade Receivables" in Statement 2.
 
From September 2004 through May 2005, because of a significant increase in Machinery and Engines' sales and subsequent sale of the receivables to Cat Financial, our certificated retained interests in the trust exceeded 90% of the fair value of trust assets. Thus, during this period, the trust did not qualify as a QSPE as defined by SFAS 140. We therefore consolidated the trust in accordance with FIN 46R, "Consolidation of Variable Interest Entities" (revised) as it represents a variable interest entity for which Cat Financial is the primary beneficiary. As of December 31, 2004, assets of the trust of $2,587 million were included in "Receivables—trade and other" in Statement 2 and the CTO of $240 million was included in "Short-term Borrowings." Please refer to Note 15.
 
Cat Financial serviced the dealer receivables and received an annual servicing fee of approximately 1% of the average outstanding principal balance of the securitized trade receivables transferred to third party purchasers. Consolidated expenses of $7 million and $6 million related to the securitized receivables were recognized during 2004 and 2003, respectively, and are included in "Other income (expense)" on Statement 1. Expected credit losses were assumed to be 0% because dealer receivables have historically had no losses and none were expected. The carrying value of the certificated retained interests approximated fair value due to their short-term nature. Other than the certificated retained interests (assets of the trust when consolidated), the investors and the securitization facilities had no recourse to Cat Financial's assets for failure of debtors to pay when due.
 
A-16

 
 
  2004
  2003
  (Millions of dollars)
Cash flow from securitizations:            
Proceeds from collections reinvested in revolving securitization(1)   $ 663   $ 1,099
Servicing fees received(1)     2     2
Characteristics of securitized receivables:            
Principal balance at December 31:            
  Certificated retained interests   $   $ 1,550
  Collateralized trust obligation         240
Average balance for the year ended December 31(1):            
  Certificated retained interests   $ 1,936   $ 1,350
  Collateralized trust obligation     240     240
 
(1) For 2004, proceeds, servicing fees and average balances include only the periods the trust was a QSPE.

 
In June 2005, Cat Financial terminated the trade receivable securitization trust and no longer securitizes trade receivables. Upon termination, receivables held by the trust were transferred back to Cat Financial.
 
B.    In June 2005, Cat Financial transferred an undivided interest of $240 million in trade receivables to third party purchasers. In accordance with SFAS 140, the transfer to third party purchasers is accounted for as a sale. Cat Financial services the transferred trade receivables and receives an annual servicing fee of approximately 1% of the average outstanding principal balance. Consolidated expense of $8 million related to the sale of trade receivables was recognized during 2005 and is included in "Other income (expense)" on Statement 1.
 
The remaining interest as of December 31, 2005 of $3,028 million is included in "Receivables—trade and other" in Statement 2. The cash collections from these receivables held by Cat Financial, including those attributable to the third party purchasers, are first applied to satisfy any obligations of Cat Financial to those purchasers. The third party purchasers have no recourse to Cat Financial's assets, other than the remaining interest, for failure of debtors to pay when due. For Cat Financial's remaining interest in trade receivables, carrying amount approximated fair value due to the short-term nature of these receivables.
 
7. Wholesale inventory receivables
Wholesale inventory receivables are receivables of Cat Financial that arise when Cat Financial provides financing for a dealer's purchase of inventory. These receivables are included in "Receivables—trade and other" and "Long-term receivables—trade and other" in Statement 2 and were $1,282 million, $991 million and $764 million at December 31, 2005, 2004 and 2003, respectively. Please refer to Note 20 on page A-28 and Table III on page A-29 for fair value information.
 
Contractual maturities of outstanding wholesale inventory receivables:
 
 
  December 31, 2005
Amounts Due In
  Wholesale
Installment
Contracts

  Wholesale
Finance
Leases

 
Wholesale
Notes

  Total
 
  (Millions of dollars)
2006   $ 37   $ 73   $ 441   $ 551
2007     13     52     254     319
2008     14     36     250     300
2009     10     19     18     47
2010     7     7     14     28
Thereafter             3     3
   
 
 
 
      81     187     980     1,248
                         
Guaranteed residual value         85         85
Less: Unearned income     4     18     29     51
   
 
 
 
Total   $ 77   $ 254   $ 951   $ 1,282
   
 
 
 
 
8. Finance receivables
Finance receivables are receivables of Cat Financial, which generally can be repaid or refinanced without penalty prior to contractual maturity. Total finance receivables reported in Statement 2 are net of an allowance for credit losses.
 
During 2005, 2004 and 2003, Cat Financial securitized retail installment sale contracts and finance leases into public asset backed securitization facilities. The securitization facilities are qualifying special purpose entities and thus, in accordance with SFAS 140, are not consolidated. These finance receivables, which are being held in securitization trusts, are secured by new and used equipment. Cat Financial retained servicing responsibilities and subordinated interests related to these securitizations. For 2005, subordinated interests included subordinated certificates with an initial fair value of $8 million, an interest in certain future cash flow (excess) with an initial fair value of $1 million and a reserve account with an initial fair value of $12 million. For 2004, subordinated interests included subordinated certificates with an initial fair value of $8 million, an interest in certain future cash flow (excess) with an initial fair value of $2 million and a reserve account with an initial fair value of $10 million. For 2003, subordinated interests included subordinated certificates with an initial fair value of $9 million, an interest in certain future cash flow (excess) with an initial fair value of $14 million and a reserve account with an initial fair value of $10 million. The company's retained interests generally are subordinate to the investors' interests. Net gains of $12 million, $13 million and $22 million were recognized on these transactions in 2005, 2004 and 2003, respectively.
 
Significant assumptions used to estimate the fair value of the retained interests and subordinated certificates at the time of the transaction were:
 
 
  2005
        2004
        2003
 
Discount rate   10.8 % 10.7 % 11.0 %
Weighted-average prepayment rate   14.0 % 14.0 % 14.0 %
Expected credit losses   1.0 % 1.0 % 1.0 %
 
These assumptions are based on our historical experience, market trends and anticipated performance relative to the particular assets securitized.
 
The company receives annual servicing fees of approximately 1% of the unpaid note value.
 
As of December 31, 2005, 2004 and 2003, the subordinated retained interests in the public securitizations totaled $72 million, $73 million and $73 million, respectively. Key assumptions used to determine the fair value of the retained interests were:
 
 
  2005
  2004
  2003
 
Cash flow discount rates on retained interests and subordinated tranches   10.7 %     10.7 %     9.1-10.8 %
Weighted-average maturity   30 months   28 months   27 months  
Average prepayment rate   14.0 % 14.0 % 14.0 %
Expected credit losses   1.0 % 1.0 % 1.0 %
 
The investors and the securitization trusts have no recourse to Cat Financial's other assets for failure of debtors to pay when due.
 
We estimated the impact of individual 10% and 20% changes to the key economic assumptions used to determine the fair value of residual cash flow in retained interests on our income. An
 
A-17

 
TABLE I—Finance Receivables Information (Millions of dollars)
 
Contractual maturities of outstanding finance receivables:
 
 
  December 31, 2005
   
Amounts Due In
  Retail
Installment
Contracts

  Retail
Finance
Leases

  Retail
Notes

  Wholesale
Notes

  Total
2006   $ 2,760   $ 2,085   $ 1,896   $ 137   $ 6,878
2007     1,988     1,465     850     15     4,318
2008     1,312     951     626     7     2,896
2009     657     516     439         1,612
2010     214     218     374         806
Thereafter     39     205     731         975
   
 
 
 
 
      6,970     5,440     4,916     159     17,485
                               
Residual value         938             938
Less: Unearned income     681     623     74         1,378
   
 
 
 
 
Total   $ 6,289   $ 5,755   $ 4,842   $ 159   $ 17,045
   
 
 
 
 
 
Impaired loans and leases:
 
  2005
  2004
  2003
Average recorded investment   $ 143   $ 265   $ 321
   
 
 
At December 31:                  
  Recorded investment   $ 106   $ 181   $ 275
  Impaired loans/finance leases for which there is a related allowance for credit losses   $ 33   $ 51   $ 98
  Impaired loans/finance leases for which there is no related allowance for credit losses   $ 73   $ 130   $ 177
 
Allowance for credit loss activity:
 
  2005
  2004
  2003
 
Balance at beginning of year   $ 278   $ 241   $ 207  
Provision for credit losses     92     105     101  
Receivables written off     (62 )   (88 )   (104 )
Recoveries on receivables previously written off     17     16     22  
Other—net     (23 )   4     15  
   
 
 
 
Balance at end of year   $ 302   $ 278   $ 241  
   
 
 
 
In estimating the allowance for credit losses, we review accounts that are past due, non-performing or in bankruptcy.
 
Cat Financial's net retail finance leases:
 
  December 31,
 
  2005
  2004
  2003
Total minimum lease payments receivable   $ 5,440   $ 4,876   $ 4,096
Estimated residual value of leased assets:                  
  Guaranteed     384     379     323
  Unguaranteed     554     540     558
   
 
 
      6,378     5,795     4,977
                   
Less: Unearned income     623     550     498
   
 
 
Net retail finance leases   $ 5,755   $ 5,245   $ 4,479
   
 
 


 

 

2005


 

2004


 

2003

Cash flow from securitizations:                              
Proceeds from initial sales of receivables   $ 829         $ 639        $ 661
Servicing fees received     11     9     8
Cash flows received on retained interests     38     34     15
Characteristics of securitized receivables:                  
At December 31:                  
  Total securitized principal balance   $ 980   $ 815   $ 813
  Loans more than 30 days past due     23     26     34
  Weighted average maturity (in months)     30     28     27
For the year ended December 31:                  
  Average securitized principal balance   $ 1,085   $ 873   $ 884
  Net credit losses     3     4     6
 

 
independent, adverse change to each key assumption had an immaterial impact on the fair value of residual cash flow.
 
We consider an account past due if any portion of an installment is due and unpaid for more than 30 days. Recognition of income is suspended when management determines that collection of future income is not probable (generally after 120 days past due). Accrual is resumed, and previously suspended income is recognized, when the receivable becomes contractually current and/or collection doubts are removed. Cash receipts on impaired loans or finance leases are recorded against the receivable and then to any unrecognized income. Investment in loans/finance leases on nonaccrual status were $175 million, $176 million and $233 million and past due over 90 days and still accruing were $31 million, $11 million and $25 million as of December 31, 2005, 2004 and 2003, respectively.
 
Cat Financial provides financing only when acceptable criteria are met. Credit decisions are based on, among other things, the customer's credit history, financial strength and intended use of equipment. Cat Financial typically maintains a security interest in retail financed equipment and requires physical damage insurance coverage on financed equipment.
 
Please refer to Table I above for additional finance receivables information and Note 20 on page A-28 and Table III on page A-29 for fair value information.
 
9. Inventories
 
  December 31,
 
  2005
  2004
  2003
 
  (Millions of dollars)
Raw materials   $ 1,689   $ 1,592   $ 1,105
Work-in-process     814     664     377
Finished goods     2,493     2,209     1,381
Supplies     228     210     184
   
 
 
Total inventories   $ 5,224   $ 4,675   $ 3,047
   
 
 
We had long-term material purchase obligations of approximately $890 million at December 31, 2005.
 
A-18

 
10. Property, plant and equipment
 
  Useful
Lives
(Years)

  2005
  December 31,
2004

  2003
 
   
  (Dollars in millions)
Land     $ 154   $ 152   $ 149
Buildings and land improvements   20-45     3,195     3,089     3,006
Machinery, equipment and other   3-10     7,829     7,361     7,039
Equipment leased to others   1-10     3,988     3,975     3,609
Construction-in-process       696     587     487
       
 
 
Total property, plant and equipment, at cost         15,862     15,164     14,290
Less: Accumulated depreciation         7,874     7,482     7,039
       
 
 
Property, plant and equipment — net       $ 7,988   $ 7,682   $ 7,251
       
 
 
 
We had commitments for the purchase or construction of capital assets of approximately $461 million at December 31, 2005. Software assets totaling $50 million, primarily related to our dealer distribution support system, were abandoned in 2005. The write-off of these assets is included in "Other Operating Expense" on Statement 1.
 
Assets recorded under capital leases(1):
 
  December 31,
 
  2005
  2004
  2003
 
  (Millions of dollars)
Gross capital leases(2)   $ 91   $ 326   $ 321
Less: Accumulated depreciation     55     220     213
   
 
 
Net capital leases   $ 36   $ 106   $ 108
   
 
 
 
(1) Included in Property, plant and equipment table above.
(2) Consists primarily of machinery and equipment.

 
The decrease in capital leases was due to termination of certain leases in the fourth quarter of 2005. See Note 16 for additional information.
 
Equipment leased to others (primarily by Financial Products):
 
  December 31,
 
  2005
  2004
  2003
 
  (Millions of dollars)
Equipment leased to others—at original cost   $ 3,988   $ 3,975   $ 3,609
Less: Accumulated depreciation     1,201     1,196     1,074
   
 
 
Equipment leased to others — net   $ 2,787   $ 2,779   $ 2,535
   
 
 
 
At December 31, 2005, scheduled minimum rental payments to be received for equipment leased to others were:
 
2006
                 
          2007
                  
         2008
                
        2009
                
   2010
               
  
After 2010 

                
(Millions of dollars)
$ 636   $ 473   $ 281   $ 136   $ 66   $ 20
 
11. Investment in unconsolidated affiliated companies
 
Our investment in affiliated companies accounted for by the equity method consists primarily of a 50% interest in Shin Caterpillar Mitsubishi Ltd. (SCM) located in Japan. Combined financial information of the unconsolidated affiliated companies accounted for by the equity method (generally on a three-month lag, e.g., SCM results reflect the periods ending September 30) was as follows:
 
 
  Years ended December 31,
 
  2005
  2004
  2003
 
  (Millions of dollars)
Results of Operations:                  
  Sales   $ 4,140   $ 3,628   $ 2,946
  Cost of sales     3,257     2,788     2,283
   
 
 
  Gross profit     883     840     663
  Profit (loss)   $ 161   $ 129   $ 48
   
 
 
  Caterpillar's profit (loss)   $ 73   $ 59   $ 20
   
 
 

 
  December 31,
 
  2005
  2004
  2003
 
  (Millions of dollars)
Financial Position:                  
  Assets:                  
    Current assets   $ 1,714   $ 1,540   $ 1,494
    Property, plant and equipment—net     1,121     1,097     961
    Other assets     193     145     202
   
 
 
      3,028     2,782     2,657
   
 
 
  Liabilities:                  
    Current liabilities   $ 1,351   $ 1,345   $ 1,247
    Long-term debt due after one year     336     276     343
    Other liabilities     188     214     257
   
 
 
          1,875     1,835     1,847
   
 
 
Ownership   $ 1,153   $ 947   $ 810
   
 
 
 
Caterpillar's investment in unconsolidated affiliated companies:
 
  December 31,
 
 
2005
 2004
2003
   
 (Millions of dollars)
 
Investment in equity method companies   $ 540   $ 487   $ 432
Plus: Investment in cost method companies     25     30     368
   
 
 
Total investments in unconsolidated affiliated companies   $ 565   $ 517   $ 800
   
 
 
 
At December 31, 2005, consolidated "Profit employed in the business" in Statement 2 included $202 million representing undistributed profit of the unconsolidated affiliated companies.
 
Certain investments in unconsolidated affiliated companies are accounted for using the cost method. During first quarter 2001, Cat Financial invested for a limited partnership interest in a venture financing structure associated with Caterpillar's rental strategy in the United Kingdom. In the fourth quarter 2004, we sold our investment in this limited partnership. This sale had no impact on earnings.
 
12. Intangible assets and goodwill
 
A. Intangible assets
 
Intangible assets are comprised of the following:
 
  Weighted
Amortizable
Life
(Years)

  December 31,
       
 2005
 
 2004
 
 2003
       
(Millions of dollars)
                       
Intellectual property  
10
  $ 206   $ 213   $ 126
Other  
16
    73     73     0
       
 
 
Total finite-lived intangible assets—gross         279     286     126
Less: Accumulated amortization         107     91     44
       
 
 
          172     195     82
Pension-related         252     120     157
       
 
 
Intangible assets—net       $ 424   $ 315   $ 239
       
 
 
During 2004 we acquired finite lived intangible assets of $130 million. (See Note 26 for details on the acquisition of these assets.) Amortization expense related to intangible assets was $22 million, $18 million and $15 million for 2005, 2004 and 2003, respectively.
 
Amortization expense related to intangible assets is expected to be:
 
2006
                
     2007
                     
     2008
                  
     2009
                   
     2010
                    
   Thereafter
                   
(Millions of dollars)
$ 21   $ 18   $ 16   $ 16   $ 18   $ 83
 
B. Goodwill
During 2004 we acquired assets with related goodwill of $55 million. (See Note 26 for details on the acquisition of these assets.) No goodwill was acquired during the years ended December 31,
 
A-19

 
2005 and 2003. During 2003 we disposed of assets reported in the Electric Power segment with related goodwill of $3 million. No goodwill was disposed of during the years ended December 31, 2005 and 2004. On an annual basis, we test goodwill for impairment in accordance with Statement of Financial Accounting Standards No. 142 "Goodwill and Other Intangible Assets." No goodwill was impaired during the years ended December 31, 2005, 2004 and 2003.
 
13. Available-for-sale securities
Financial Products, primarily Cat Insurance, has investments in certain debt and equity securities at December 31, 2005, 2004 and 2003, that have been classified as available-for-sale in accordance with SFAS 115 and recorded at fair value based upon quoted market prices. These fair values are included in "Other assets" in Statement 2. Unrealized gains and losses arising from the revaluation of available-for-sale securities are included, net of applicable deferred income taxes, in equity ("Accumulated other comprehensive income" in Statement 2). Realized gains and losses on sales of investments are generally determined using the FIFO method for debt instruments and the specific identification method for equity securities. Realized gains and losses are included in "Other income (expense)" in Statement 1.
 
 
  December 31, 2005
 
  Cost
Basis

  Unrealized
Pre-Tax Net
Gains (Losses)

  Fair
Value

 
  (Millions of dollars)
Government debt   $ 305   $ (6 ) $ 299
Corporate bonds     422     (7 )   415
Equity securities     146     38     184
   
 
 
    $ 873   $ 25   $ 898
   
 
 
 
  December 31, 2004
 
  Cost
Basis

  Unrealized
Pre-Tax Net
Gains (Losses)

  Fair
Value

 
  (Millions of dollars)
Government debt   $ 239   $ (1 ) $ 238
Corporate bonds     342         342
Equity securities     204     26     230
   
 
 
    $ 785   $ 25   $ 810
   
 
 
 
  December 31, 2003
 
  Cost
Basis

  Unrealized
Pre-Tax Net
Gains

  Fair
Value

 
  (Millions of dollars)
Government debt   $ 102   $   $ 102
Corporate bonds     288     3     291
Equity securities     191     15     206
   
 
 
    $ 581   $ 18   $ 599
   
 
 
 
Investments in an unrealized loss position that are not other-than-temporarily impaired
 
 
  December 31, 2005
 
  Less than 12 months(1)
  More than 12 months(1)
  Total
 
  Fair
Value

  Unreal-
ized
Losses

  Fair
Value

  Unreal-
ized
Losses

  Fair
Value

  Unreal-
ized
Losses

 
 
(Millions of dollars)
 
Government debt     155     2     113     3     268     5
Corporate bonds     220     3     136     4     356     7
Equity securities     31     2             31     2
   
 
 
 
 
 
  Total   $ 406   $ 7   $ 249   $ 7   $ 655   $ 14
   
 
 
 
 
 

 
  December 31, 2004
 
  Less than 12 months(1)
  More than 12 months(1)
  Total
 
  Fair
Value

  Unreal-
ized
Losses

  Fair
Value

  Unreal-
ized
Losses

  Fair
Value

  Unreal-
ized
Losses

 
  (Millions of dollars)
Government debt     166     1     9         175     1
Corporate bonds     156     2     35     1     191     3
Equity securities     46     1     2         48     1
   
 
 
 
 
 
  Total   $ 368   $ 4   $ 46   $ 1   $ 414   $ 5
   
 
 
 
 
 

 
  December 31, 2003
 
 
  Less than 12 months(1)
  More than 12 months(1)
  Total
 
 
  Fair
Value

  Unreal-
ized
Losses

  Fair
Value

  Unreal-
ized
Losses

  Fair
Value

  Unreal-
ized
Losses

 
 
 
(Millions of dollars)
 
 
Corporate bonds     93     2   13     1   106     3
Equity securities             25     1   25     1
   
 
 
 
 
 
 
  Total   $ 93   $ 2 $ 38   $ 2 $ 131   $ 4
   
 
 
 
 
 
 
(1) Indicates length of time that individual securities have been in a continuous unrealized loss position.

 
Government Debt. The unrealized losses on our investments in U.S. Treasury obligations, direct obligations of U.S. governmental agencies and federal agency mortgage-backed securities were caused by an increase in interest rates. There are no credit related events on any of these securities. We intend to and have the ability to hold these investments that are less than book value until recovery to fair value or maturity. We do not consider these investments to be other-than-temporarily impaired as of December 31, 2005.
 
Corporate Bonds. The unrealized losses on our investments in corporate bonds relate primarily to an increase in interest rates. Much of the corporate debt securities market has also been affected by an increase in risk and volatility due to the aggressiveness of private equity funds. This has caused yield spreads in general to widen which has increased the size of the unrealized losses in the portfolio. We currently believe it is probable that we will be able to collect all amounts due according to the contractual terms of our investments in corporate debt securities. We intend to and have the ability to hold these investments that are less than book value, for the aforementioned reasons, until recovery to fair value or maturity. We do not consider these investments to be other-than-temporarily impaired as of December 31, 2005.
 
Equity Securities. We maintain a well-diversified portfolio consisting of a separately managed account of individual stocks and four mutual funds. The individual securities and mutual fund investments support cash flow, asset allocation and investment objectives. In each case where unrealized losses occur in the individual stocks, company management is taking corrective action to increase shareholder value. None of the mutual funds are in a position where their market value is less than their cost. We currently believe it is probable that we will be able to recover all amounts due and do not consider these investments to be other than temporarily impaired as of December 31, 2005.
 
The fair value of available-for-sale debt securities at December 31, 2005, by contractual maturity, is shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to prepay and creditors may have the right to call obligations.
 
A-20

 
  Fair
Value

 
  (Millions of dollars)
Due in one year or less   $ 43
Due after one year through five years   $ 308
Due after five years through ten years   $ 92
Due after ten years   $ 271
 
Proceeds from sales of investments in debt and equity securities during 2005, 2004 and 2003 were $257 million, $408 million and $329 million, respectively. Gross gains of $14 million, $8 million and $3 million and gross losses of $6 million, $6 million and $2 million have been included in current earnings as a result of these sales for 2005, 2004 and 2003, respectively.
 
During 2003, we recognized pretax charges in accordance with the application of SFAS 115 for "other than temporary" declines in the market value of securities in the Cat Insurance and Caterpillar Investment Management Ltd. investment portfolios of $33 million. During 2005 and 2004, there were no charges for "other than temporary" declines in the market value of securities.
 
14. Postemployment benefit plans
We have both U.S. and non-U.S. pension plans covering substantially all of our U.S. employees and a portion of our non-U.S. employees, primarily in our European facilities. Our defined benefit plans provide a benefit based on years of service and/or the employee's average earnings near retirement. Our defined contribution plans allow employees to contribute a portion of their salary to help save for retirement, and in certain cases, we provide a matching contribution. We also have defined-benefit retirement health care and life insurance plans covering substantially all of our U.S. employees.
 
In January 2005, amendments were made to both U.S. hourly pension and other postretirement benefit plans due to the company and the United Auto Workers reaching a new six-year labor agreement that will expire on March 1, 2011. These plans were re-measured as of January 10, 2005 to account for the benefit changes. The result was a $29 million increase in pension cost, and a $69 million increase in other postretirement benefit cost for 2005. In addition, the Additional Minimum Pension Liability increased $233 million as a result of the re-measurement. The liability was offset by an increase in pension-related intangible assets of $164 million and a decrease in other comprehensive income (pre-tax) of $69 million.
 
In April 2005, amendments were made to our U.S. salaried and management other postretirement benefit plan. The plan was re-measured, resulting in a reduction of $18 million in other postretirement benefit cost for 2005.
 
We use a November 30th measurement date for our U.S. pension and other postretirement benefit plans and a September 30th measurement date for our non-U.S. pension plans. Year-end asset and obligation amounts are disclosed as of the plan measurement dates.
 
A. Benefit obligations
 
  U.S. Pension Benefits
  Non-U.S. Pension Benefits
  Other Postretirement Benefits
 
 
  2005
  2004
  2003
  2005
  2004
  2003
  2005
  2004
  2003
 
 
  (Millions of dollars)  
Change in benefit obligation:                                                        
  Benefit obligation, beginning of year   $ 9,593   $ 8,993   $ 7,844   $ 2,097   $ 1,836   $ 1,517   $ 4,926   $ 5,004   $ 4,465  
  Service cost     150     143     122     58     53     43     86     66     70  
  Interest cost     555     548     554     109     97     83     294     265     298  
  Plan amendments     204         (27 )   (8 )           412         (6 )
  Actuarial losses (gains)     863     584     1,148     254     54     118     458     (64 )   474  
  Foreign currency exchange rates                 (65 )   135     137     (2 )   2     4  
  Participant contributions                 12     11     10     28     58     25  
  Benefits paid     (686 )   (675 )   (648 )   (96 )   (89 )   (72 )   (384 )   (405 )   (326 )
   
 
 
 
 
 
 
 
 
 
  Benefit obligation, end of year   $ 10,679   $ 9,593   $ 8,993   $ 2,361   $ 2,097   $ 1,836   $ 5,818   $ 4,926   $ 5,004  
   
 
 
 
 
 
 
 
 
 
  Accumulated benefit obligation, end of year   $ 10,213   $ 9,040   $ 8,379   $ 2,069   $ 1,844   $ 1,660                    
   
 
 
 
 
 
                   
Weighted-average assumptions used to determine benefit obligations, end of year:
                                                       
  Discount rate(1)     5.6 %   5.9 %   6.2 %   4.6 %   5.2 %   5.1 %   5.6 %   5.9 %   6.1 %
  Rate of compensation increase(1)     4.0 %   4.0 %   4.0 %   3.7 %   3.5 %   3.2 %   4.0 %   4.0 %   4.0 %
 
(1) End of year rates are used to determine net periodic cost for the subsequent year.  See Note 14E.

 
Assumed health care cost trend rates have a significant effect on the amounts reported for the health care plans. A one-percentage-point change in assumed health care cost trend rates would have the following effects:
 
 
  One-percentage-
point increase

  One-percentage-
point decrease

 
 
 
(Millions of dollars)
 
 
Effect on 2005 service and interest cost components of other postretirement benefit cost   $ 34   $ (29 )
Effect on accumulated postretirement benefit obligation   $ 432   $ (376 )
 
A-21

 
B. Plan assets
 
  U.S. Pension Benefits
  Non-U.S. Pension Benefits
  Other Postretirement Benefits
 
 
  2005
  2004
  2003
  2005
  2004
  2003
  2005
  2004
  2003
 
 
  (Millions of dollars)  
Change in plan assets:                                                        
  Fair value of plan assets, beginning of year   $ 8,725   $ 7,728   $ 6,443   $ 1,503   $ 1,262   $ 1,024   $ 994   $ 867   $ 849  
  Actual return on plan assets     860     1,106     1,290     272     124     120     100     118     140  
  Foreign currency exchange rates                 (47 )   91     96              
  Company contributions     542     566     643     390     104     84     573     356     179  
  Participant contributions                 12     11     10     28     58     25  
  Benefits paid     (686 )   (675 )   (648 )   (96 )   (89 )   (72 )   (384 )   (405 )   (326 )
  Settlements                 (10 )                    
   
 
 
 
 
 
 
 
 
 
  Fair value of plan assets, end of year   $ 9,441   $ 8,725   $ 7,728   $ 2,024   $ 1,503   $ 1,262   $ 1,311   $ 994   $ 867  
   
 
 
 
 
 
 
 
 
 
 
The asset allocation for our pension and other postretirement benefit plans at the end of 2005, 2004 and 2003, and the target allocation for 2006, by asset category, are as follows:
 
  Target
Allocation

  Percentage of Plan Assets
at Year End

 
 
  2006
  2005
  2004
  2003
 
U.S. pension:                  
  Equity securities   70 % 72 % 74 % 75 %
  Debt securities   30 % 28 % 26 % 25 %