Fannie Mae 2004 Annual Report Download - page 260

we incorrectly valued certain option-based and foreign exchange derivatives; and we incorrectly calculated
interest expense by using inappropriate estimates in our amortization of debt cost basis adjustments.
The restatement adjustments associated with these errors resulted in a pre-tax increase in net income of
$4.4 billion and a pre-tax decrease in net income of $5.9 billion for the years ended December 31, 2003 and
2002, respectively. In addition, we recorded a reduction in retained earnings of $10.6 billion as of
December 31, 2001, which reflects derivative restatement adjustments for all periods prior to and including
December 31, 2001. As such, the accumulation of all derivative adjustments through 2003 resulted in a
cumulative reduction in retained earnings of $12.1 billion. This reduction in retained earnings, in combination
with an incremental loss reflected in the 2004 consolidated financial statements of $729 million, resulted in a
cumulative reduction in pre-tax net income of $12.9 billion, or $8.4 billion after tax, as of December 31, 2004.
These restatement adjustments also impacted the consolidated balance sheets, resulting in a decrease in total
assets of $5.0 billion and $3.7 billion as of December 31, 2003 and 2002, respectively, primarily from a
reduction in “Deferred tax assets” as a result of no longer applying hedge accounting and deferring losses.
Additionally, we decreased total liabilities by $9.1 billion and $9.0 billion as of December 31, 2003 and 2002,
respectively, primarily from no longer recording debt at fair value due to the loss of hedge accounting as well
as correcting the amortization of debt cost basis adjustments. The effect from the change in debt cost basis
adjustments, in turn, had the effect of increasing the amount of “Debt extinguishment losses, net” recognized
in the consolidated statements of income. Each of the errors that resulted in these adjustments is described
below.
We incorrectly classified derivatives as cash flow or fair value hedges for accounting and reporting purposes,
even though they did not qualify for hedge accounting treatment pursuant to Statement of Financial
Accounting Standards (“SFAS”) No. 133, Accounting for Derivative Instruments and Hedging Activities
(“SFAS 133”). The primary reasons for the loss of hedge accounting treatment were the improper use of the
“shortcut” method as defined by SFAS 133 and inadequate assessments of hedge effectiveness and ineffective-
ness measurement, both at hedge inception and at each reporting period thereafter. In other instances, hedging
relationships were not properly documented at the inception of the hedge. Under cash flow hedge accounting,
we initially recorded unrealized gains or losses on derivatives in AOCI in the consolidated balance sheets to
be recognized into income in subsequent periods. Under fair value hedge accounting, we recorded unrealized
gains or losses on derivatives in the consolidated statements of income offset by unrealized gains or losses on
the asset or liability being hedged. The impact of correcting errors on derivatives that were previously
classified as cash flow hedges resulted in the reversal of all previously recorded fair value adjustments in
AOCI and the recognition of these fair value adjustments in “Derivatives fair value losses, net” in the
consolidated statements of income. The impact of correcting errors on derivatives that were previously
classified as fair value hedges resulted in the reversal of previously recorded fair value adjustments recorded
on the hedged items. As the majority of these derivatives were designated as hedges against debt, the reversal
of fair value adjustments resulted in a reduction of “Short-term debt” and “Long-term debt” in the consolidated
balance sheets and changes in “Interest expense” in the consolidated statements of income. This error impacted
all previously reported results and varied substantially from period to period based on the portfolio size and
prevailing interest rates.
We incorrectly excluded foreign exchange derivatives from netting adjustments for transactions executed with
the same counterparty where we had the legal right and intent to offset pursuant to Financial Accounting
Standards Board (“FASB”) Interpretation (“FIN”) No. 39, Offsetting of Amounts Related to Certain Contracts
(an interpretation of APB Opinion No. 10 and FASB Statement No. 105) (“FIN 39”). As a result, the amounts
of derivative assets and liabilities in the consolidated balance sheets were misstated. The impact of correcting
this error changed the reported amount of derivative assets and liabilities in the consolidated balance sheets.
We did not record a small number of financial instruments that met the definition of a derivative pursuant to
SFAS 133, which resulted in a misstatement of derivative assets and liabilities at fair value in the consolidated
balance sheets. The correction of this error resulted in the recognition of derivative assets and liabilities at fair
F-9
FANNIE MAE
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)