The accompanying management's discussion and analysis of financial condition and results of operations set forth in this Item 7 is restated to reflect the correction of errors that were contained in the Company's consolidated financial statements and other financial information for the years ended December 31, 2002 through 2005 as discussed below and in Note 1 of the Consolidated Financial Statements. In addition, the prior period financial statements have been restated to reflect the change in the Company's segments as discussed below and in Note 22 of the Consolidated Financial Statements. The following management's discussion and analysis of financial condition and results of operations should be read in conjunction with our restated consolidated financial statements and the related notes.

Restatement Of Consolidated Financial Statements

Background

The Company has previously identified certain material weaknesses related to its system of internal control over financial reporting. These material weaknesses, as described in the Company's previously filed Form 10-K for the year ended December 31, 2005 included the following general areas:

† Aggregation of control deficiencies at our Cameroonian subsidiary;

† Lack of U.S. GAAP expertise in Brazilian businesses;

† Treatment of intercompany loans denominated in other than the functional currency;

† Derivative accounting; and

† Income taxes.

In part, the continuing remediation of these material weaknesses resulted in the identification of certain material financial statement errors. The Company has restated its financial statements for years ended prior to December 31, 2005 on March 30, 2005, January 19, 2006 and April 4, 2006 largely as a result of material weaknesses. As part of the Company's plan to eliminate these material weaknesses in internal control over financial reporting, the Company has embarked on a program, over a several year period, to improve the quality of its people, processes and financial systems. This has included a broad restructuring of the global finance organization to operate on a more centralized basis and the recruitment of additional accounting, financial reporting, income tax, internal control and internal audit staff around the world.

During the fourth quarter of 2006, in conjunction with these improvements, continued remediation of some of our material weaknesses and overall strengthening of controls across our businesses, the Company identified certain additional errors which required the restatement of previously issued consolidated financial statements for the years ended December 31, 2004 and 2005; and for the previously issued interim periods ending March 31, June 30 and September 30, 2005 and 2006.

The Company's remediation efforts for certain material weaknesses reported as of December 31, 2005, as well as improvements to controls across the Company, resulted in the identification of errors included in the current restatement. In addition, a number of immaterial errors were identified as a result of the continued strengthening of the global finance organization. The Company believes that the increase in technical tax and accounting expertise, increased staffing levels at certain of our businesses and at our corporate office, and a focused effort on increasing the number of financial audit activities have contributed to the overall improvement of the accuracy of our financial statements. It also resulted in the identification of material weaknesses in areas not previously reported, although not all weaknesses contributed to the need to restate the consolidated financial statements. For further discussion of our material weaknesses, see Item 9A of this Annual Report on Form 10-K.

The restatement adjustments resulted in a decrease to previously reported income from continuing operations and net income of $24 million for the year ended December 31, 2005 and an increase of $2 million for the year ended December 31, 2004. It also resulted in a decrease to previously reported income from continuing operations and net income of $3 million for the three months ending March 31, 2006, an increase to net income of $10 million for the six months ending June 30, 2006 and an increase to net income of $30 million for the nine months ending September 30, 2006. These interim period adjustments for the first three quarters of 2006 were largely the result of reversing errors previously corrected in these periods, which were not previously considered material either to the period in which they were corrected or the prior period to which they actually arose. Additionally, the cumulative adjustment for all periods prior to 2004 resulted in an increase to retained deficit of $50 million.

The following table quantifies the net impact of the restatement corrections by key income statement line items for the years ended December 31, 2005 and 2004 and includes the resulting impact on diluted earnings per share from continuing operations. The primary line items affected include revenue, cost of sales, gain
(loss) on foreign currency transactions, income tax expense and the related impacts on minority interest expense.

                                                                   Year Ended
                                                                  December 31,
                                                               2005           2004
                                                              (in millions, except
                                                               per share amounts)
Income from continuing operations as previously reported   $        598    $      266
Changes in income from continuing operations from
restatement due to:
Increase in revenue                                                  25             1
Decrease in cost of sales                                             5            18
(Increase) decrease in general and administrative
expense                                                              (4 )           1
Increase in other income                                             11             1
(Increase) in goodwill and asset impairment expense                  (6 )          (1 )
(Increase) decrease in foreign currency transaction
losses                                                              (13 )          27
Decrease in equity earnings of affiliates                            (6 )          (7 )
(Increase) in income tax expense                                    (27 )         (24 )
(Increase) in minority interest and other(1)                         (9 )         (14 )
(Decrease) increase in income from continuing operations            (24 )           2
Income from continuing operations as restated              $        574    $      268
Diluted earnings per share from continuing operations as
previously reported                                        $       0.90    $     0.41
Changes due to restatement effects                               (0.03)             -
Diluted earnings per share from continuing operations as
restated                                                   $       0.87    $     0.41
Diluted shares outstanding                                        664.6         648.1

The Company has been cooperating with an informal inquiry by the SEC Staff concerning the Company's restatements and related matters, and has been providing information and documents to the SEC Staff on a voluntary basis. Because the Company is unable to predict the outcome of this inquiry and the SEC Staff may disagree with the manner in which the Company has accounted for and reported the financial impact of the adjustments to previously filed financial statements, there may be a risk that the inquiry by the SEC could lead to circumstances in which the Company may have to further restate previously filed financial statements, amend prior filings or take other actions not currently contemplated.

The restatement adjustments include several key categories as described below:

Brazil Adjustments

Prior year errors related to certain subsidiaries in Brazil include the following:

† decrease of the U.S. GAAP fixed asset basis and related depreciation at Eletropaulo of $21 million in 2005 and $16 million in 2004 (the impact net of tax and minority interest is $4 million in 2005 and $4 million in 2004); and

† other errors identified through account reconciliation or review procedures.

The cumulative impact on net income was an increase of $6 million and $3 million for the years ended December 31, 2005 and 2004, respectively.

EDC

Prior year errors related to the Company's Venezuelan subsidiary, EDC, include the following:

† $22 million revenue increase predominantly related to an error in updating the current tariff rates in the unbilled revenue calculation for 2005,

† $10 million increase in foreign currency transaction expense posted incorrectly to the balance sheet in 2005, and

† other errors identified through account reconciliation or review procedures.

The cumulative impact of all EDC adjustments on net income was an increase of $2 million for each of the years ended December 31, 2005 and 2004.

Capitalization of Certain Costs

Certain errors were discovered with fixed asset balances at several of the Company's facilities related to capitalization of development costs, overhead and capitalized interest. The cumulative impact on net income for capitalization errors was a decrease of $4 million for the year ended December 31, 2005 and a decrease of $2 million for the year ended December 31, 2004.

Derivatives

Adjustments were identified resulting from the detailed review of certain prior year contracts and include the following:

† the evaluation of hedge effectiveness; and

† the identification and evaluation of derivatives.

The most significant adjustment involved a power sales agreement signed in 2002 between the Company's generation facility in Cartagena, Spain, an unconsolidated subsidiary accounted for using the equity method of accounting, and its power offtaker. The power sales agreement had a pricing component that was tied to the U.S. dollar, although the entity's own functional currency was the Euro and that of the offtaker was the Euro. In addition, a maintenance service agreement related to the Cartagena facility included a pricing mechanism that was tied to changes in the U.S. dollar, when the entity's functional currency was the Euro and the service provider's functional currency was the Yen.

Under the guidance of Statement of Financial Accounting Standard ("SFAS") No. 133, "Accounting for Derivative Instruments and Hedging Activities," these contracts contained embedded derivatives that are required to be bifurcated from the contract and recorded at fair value with changes in fair value recognized in the results of operations. The net result of these adjustments was a decrease of $3 million and an increase of $4 million in equity in earnings of affiliates for the years ended December 31, 2005 and 2004, respectively.

The cumulative impact of all derivative adjustments on net income was a decrease of $4 million in 2005 and an increase of $5 million in 2004.

Income Tax Adjustments

Income tax adjustments relate primarily to the following:

† A $20 million adjustment to correct income tax expense in the fourth quarter of 2005 as a result of an incorrect 2004 tax return to accrual adjustment, previously disclosed in the Company's Form 10-Q for September 30, 2006; and

† A $21 million adjustment to record income tax benefit in 2004 as a result of a change in local income tax reporting for leases in Qatar, offset by adjustments to correct income tax expense for certain state deferred tax assets and other miscellaneous items.

The net impact of individual income tax adjustments resulted in an increase to income tax expense of approximately $18 million in 2005 and $7 million in 2004. The cumulative impact on income tax expense as a result of all restatement adjustments was an increase of approximately $27 million for the year ended December 31, 2005 and an increase of approximately $24 million for the year ended December 31, 2004.

Other Adjustments

As a result of work performed in the course of our year end closing process, certain other adjustments were identified which decreased net income by $6 million for the year ended December 31, 2005 and increased net income by $1 million for the year ended December 31, 2004.

Balance Sheet Adjustments

Adjustments at certain businesses in Brazil

The Company's Brazilian business, Sul, records customer receipts used to provide line extensions as an offset against property, plant and equipment. However, the regulatory body of Brazil never issued any guidance with respect to the treatment of these customer receipts. As such, we believe that a more appropriate classification of these customer receipts would have been as a regulatory liability given that the actual treatment as an offset against property, plant and equipment was never approved by the regulatory body of Brazil. Additionally, the regulatory liability treatment provides for the possibility of a future obligation back to the customers, which was confirmed by a recent regulatory ruling. The increase to property, plant and equipment and increase to long-term regulatory liabilities was $93 million and $62 million at December 31, 2005 and 2004, respectively.

Cartagena Deconsolidation

Upon the Company's adoption of Financial Interpretation No.46, Variable Interest Entities ("FIN No. 46R"), as of January 1, 2004, the Company incorrectly continued to consolidate our business in Cartagena, Spain. An adjustment was made to deconsolidate the Cartagena balance sheet and statement of operations and to reflect AES' share of the results of its operations using the equity method of accounting. This resulted in a decrease to investments in affiliates of $55 and $39 million; a decrease in net property, plant and equipment of $570 and $387 million; and a decrease in non-recource debt of $579 and $497 million at December 31, 2005 and 2004, respectively.

Restricted Cash

Certain balance sheet reclassifications were recorded at December 31, 2005 and December 31, 2004 that were the result of errors in the presentation of restricted cash. These reclasses resulted in a reduction in cash and cash equivalents and an increase in restricted cash by $63 million and $97 million, in 2005 and 2004, respectively

Share-based Compensation

The Company recently concluded an internal review of accounting for share-based compensation (the "LTC Review"), which originally was disclosed in the Company's Form 8-K filed on February 26, 2007. As a result of the LTC Review, the Company identified certain errors in its previous accounting for share-based compensation. These errors required adjustments to the Company's previous accounting for these awards under the guidance of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees ("APB No. 25"), Financial Accounting Standards Board ("FASB") Statement No. 123, Accounting for Stock-Based Compensation ("FAS No. 123") and FASB Statement No. 123R (revised 2004),

Share-Based Payment ("FAS No. 123R"). As described below, the Company is recording adjustments to its prior financial statements resulting in additional cumulative pre-tax compensation expense for the years 2000-2005 of $36 million ($26 million net of taxes). None of these adjustments, individually or in the aggregate, is quantitatively material to any period presented.

In addition, the Company has identified accounting for share-based compensation as a material weakness and has prepared a remediation plan to strengthen further its granting and accounting practices to avoid similar errors in the future. See Item 9A-Disclosure Controls and Procedures of this Form 10-K for further explanation of the material weakness and the Company's remediation plans.

Background of the LTC Review

Beginning in mid-2006 the Company conducted limited assessments of its share-based compensation practices. Based on those assessments, it did not appear likely that the potential accounting adjustments relating to share-based compensation issues identified as of that time would be material to the Company's prior period financial statements. However, information subsequently developed by the Company's Internal Audit group indicated that there had been control deficiencies and inadequate oversight related to historical granting practices and accounting for share-based compensation.

Following consideration of this information, the Company determined that a more comprehensive review of prior period awards was warranted. Accordingly, in early February 2007, the Company requested that an outside consulting firm assist with the collection and processing of data relating to the Company's share-based compensation awards. The outside consulting firm also provided a team of forensic accountants to assist the Company with its: (i) evaluation of relevant Securities and Exchange Commission ("SEC") and FASB guidance relating to share-based compensation; (ii) implementation of procedures for review of electronic data, including e-mails; and (iii) analysis of the information used to determine measurement dates, strike prices and valuations required to reach the resulting accounting adjustments. The Company also asked an outside law firm to assist the Company with the LTC Review. This law firm had already been assisting the Company in responding to requests for documents and information from the SEC Staff principally relating to the Company's restatements for the years 2002-2005. As disclosed in a Form 8-K filed on March 19, 2007, the Financial Audit Committee of the Company's Board of Directors formed an Ad Hoc Committee of three independent directors to review the Company's procedures, conclusions and recommendations regarding the LTC Review, as described herein.

Purposes and Scope of the LTC Review

The LTC Review was designed and conducted principally to determine whether any adjustments to the Company's prior period financial statements were required as a result of incorrect accounting for share-based compensation, which includes stock options and restricted stock units. A secondary purpose of the LTC Review was to evaluate the Company's historical practices and procedures for making share-based compensation awards, including the conduct of individuals involved in the granting process.

The Company determined that a ten-year review period covering the years 1997-2006 (the "Review Period") was appropriate. Supporting documentation was more readily available in more recent years and, in many instances, the Company experienced difficulty locating and/or gathering documentation for the years 1997-1999. Therefore, the Company determined that a review of years preceding 1997 was unlikely to result in information susceptible to meaningful analysis.

A significant accounting issue identified in the LTC Review related to the determination of the "measurement date" with respect to share-based compensation awards. During the Review Period, the Company had generally used the indicated grant date as the measurement date for accounting purposes, when in many cases the indicated grant date actually preceded the measurement date as correctly defined under Generally Accepted Accounting Principles ("GAAP"). The U.S. GAAP technical accounting

literature in effect during the accounting periods under review defined the measurement date for purposes of determining share-based compensation expense as the date on which the Company finalized an individual's share-based award, to include the number of units awarded at a determinable strike price.

The Company gathered documentation and conducted analysis related to measurement dates with respect to all of the grants awarded in the Review Period, a total of approximately 29,600 stock option grants, representing approximately 45,380,000 options as well as approximately 4,000,000 restricted stock units for non-directors. These grants included both the Company's annual compensation awards, known as "on-cycle" grants, and all awards made at other times, referred to as "off-cycle" grants. The LTC Review was designed to assess the appropriate measurement date for each of the various types of grants awarded during the Review Period. The Company considered SEC guidance and GAAP in evaluating known facts and circumstances in an attempt reasonably to determine the date that the share-based compensation awards were final. The Company collected information through targeted searches of various sources, including human resources and accounting databases, paper and electronic files and servers, Board of Directors and Compensation Committee meeting minutes, payroll records, and acquisition and business development documentation. The Company also interviewed certain current and former employees, officers and directors.

Although there generally was less documentation readily available for the years 1997-1999, the Company did review grants in those years, and based on available information, attempted to make a reasonable assessment of the correct measurement dates and potential accounting adjustments for the purposes of assessing whether any charge from that period could be material to the Company's financial statements in those years. Based on this analysis, the Company determined that any errors identified during that period would not have resulted in a material impact to the Company's stockholders' equity and no adjustments were made.

The Company's Accounting Adjustments

As a result of the LTC Review, the Company has determined that adjustments
resulting in charges for share-based compensation should be recorded for the
years 2000 through 2005. The additional cumulative pre-tax compensation expense
totals $36 million ($26 million net of taxes). The effect of recognizing
additional non-cash, share-based compensation expense resulting from the charges
mentioned above by year is as follows:

                                                     Pre-Tax      After-Tax
              Fiscal Year Ended (in millions)        Expense       Expense
              2000                                     $   8        $     6
              2001                                     $  15        $    11
              2002                                     $   8        $     5
              2003                                     $   4        $     3
              2004                                     $   -        $     -
              2005                                     $   1        $     1

The Company also is recording a charge of $0.6 million (pre-tax) relating to the first three previously reported quarters of 2006, which primarily relate to prior year grants in which expense was carried forward to 2006.

None of these adjustments, individually or in the aggregate, is quantitatively material to any period presented; however, the Company will reflect these adjustments by reducing stockholders' equity by $25.2 million as of January 1, 2004 for the cumulative effect of the correction of errors for the periods from January 1, 2000 through December 31, 2003. General and administrative expense will be adjusted for the years ending December 31, 2004 and 2005 and the first three quarters of 2006 as outlined above.

Annual On-Cycle Awards. Compensation charges for annual on-cycle grants were determined based upon facts and circumstances relating to the dates the awards were final and the selection of the appropriate strike prices. The Company determined new measurement dates based on a determination of the date an award was final using the following methodology. Grants to Executive Officers and certain other senior executives ("Senior Leaders") were considered to be final for accounting purposes upon Compensation Committee approval of a fixed number of options at a specific exercise price, or in certain years based on subsequent action by the Company establishing the grant date and strike price. Grants to all other employees were considered to be final for accounting purposes on the date that management completed its allocation of substantially all awards to the pool of employees receiving awards. In addition to measurement date changes, the LTC Review identified three years in which the Company had set the strike price for the annual on-cycle grants either as the opening price or as the intra-day low trading price of the Company's stock during a four-day period over which a Board meeting was held. To determine the fair market value of the stock on the re-determined measurement date for accounting purposes, the Company used the closing price of the stock on that date. Accordingly, for financial accounting purposes, the amount of compensation expense recorded by the Company reflects both measurement date changes and intrinsic value changes for annual on-cycle awards. The predominant causes of the charges relating to on-cycle grants were
(i) with respect to Executive Officers and Senior Leaders, use of a grant date associated with an annual Board meeting, where the grant date and strike price had not been determined with finality until several days after the meeting; and
(ii) with respect to all other employees, the failure to finalize a complete and accurate schedule of the awards to be made to the employees contemporaneously with the intended grant date.

Off-Cycle Grants. Compensation charges for off-cycle grants also were based primarily upon the dates the awards were final. The majority of the measurement date changes with respect to off-cycle grants related to the following five categories: (1) awards to newly hired employees; (2) awards upon promotions of existing employees or other change in status; (3) awards made in conjunction with transactions or other successful business development efforts; (4) "Founders" and other similar awards made in recognition of outstanding service, and (5) corrections to previous awards subsequently determined to have been erroneous.

The predominant cause of the measurement date errors in each of these categories of awards was the lack of adequate contemporaneous documentation supporting the intended grant. Accordingly, the amount of compensation expense recorded by the Company for these categories of off-cycle awards is based primarily upon measurement date changes. The adjustments reflect available evidence concerning the dates on which: (i) the recipients were entitled to receive the awards, (ii) the grants were intended to be made, and (iii) the terms of the grants were final.

In addition to the categories above, off-cycle grants also were defined to include modifications of prior grants. Compensation charges for grant modifications were based upon an analysis of changes to vesting and exercise . . .