Fannie Mae 2004 Annual Report Download - page 261

value with subsequent changes in the fair value of these derivatives recognized in the consolidated statements
of income.
We incorrectly valued certain option-based and foreign exchange derivatives. We incorrectly valued certain
option-based derivatives by using inaccurate volatility measures, which resulted in incorrect fair value adjust-
ments to the previously reported consolidated financial statements. To correct this error, we revalued option-
based derivatives with new volatility measures supported by market analysis and revalued foreign exchange
derivatives. We also incorrectly recorded fair value adjustments on foreign exchange derivatives previously
accounted for as fair value hedges. We recorded adjustments on these derivatives equal to foreign currency
translation adjustments of our foreign denominated debt. These foreign exchange derivatives should have been
independently recorded at fair value. The impact of correcting this error resulted in changes in the fair value gain
or loss associated with these derivatives, which was recognized in the consolidated statements of income.
We incorrectly calculated interest expense by using inappropriate estimates in our amortization of debt cost
basis adjustments. We amortized discounts, premiums and other deferred price adjustments by amortizing these
amounts through the expected call date of the borrowings as opposed to amortizing these amounts through the
contractual maturity date of the borrowings. Additionally, we utilized a convention in the calculation that was
based on the average number of days of interest in a month regardless of the days contractually agreed upon.
We corrected these errors by recalculating amortization of these costs through the contractual maturity date of
the respective borrowings and using the contractual number of days in the month. The correction of these
errors resulted in changes in the recognition of “Interest expense” and “Debt extinguishment losses, net” in the
consolidated statements of income.
Commitments
We identified five errors associated with mortgage loan and security commitments. The most significant errors
were that we did not record certain mortgage loan and security commitments as derivatives under SFAS 133
and we incorrectly classified mortgage loan and security commitments as cash flow hedges, which resulted in
changes in fair value not being reflected in earnings. We also incorrectly interpreted SFAS No. 149,
Amendment of Statement 133 on Derivative Instruments and Hedging Activities (“SFAS 149”), and therefore
we incorrectly recorded a transition adjustment in 2003. In conjunction with the review of these transactions,
we identified the following additional errors associated with mortgage loan and security commitments: we did
not record certain security commitments as securities and we incorrectly valued mortgage loan and security
commitments.
The restatement adjustments associated with these errors resulted in a pre-tax decrease in net income of
$1.8 billion and a pre-tax increase in net income of $5.4 billion for the years ended December 31, 2003 and
2002, respectively for a cumulative pre-tax increase in retained earnings of $4.0 billion as of December 31,
2003. This pre-tax increase, combined with a commitments-related gain of $135 million reflected in the 2004
consolidated financial statements, resulted in a cumulative pre-tax increase in retained earnings of $4.1 billion,
as of December 31, 2004. The net impact on retained earnings, including tax effects and the $185 million
after-tax charge to “Cumulative effect of change in accounting principle” as described below, was $2.5 billion
as of December 31, 2004. After considering the increased amortization recognized in restatement attributable
to the commitments adjustment, the total net impact of these commitment adjustments was an increase in
retained earnings of $535 million, net of tax, as of December 31, 2004. Each of the errors that resulted in
these adjustments is described below.
Prior to July 1, 2003, we did not record as derivatives mortgage loan and security commitments that were
derivatives pursuant to SFAS 133, which resulted in a misstatement of our derivative assets and liabilities in
the consolidated balance sheets. The impact of correcting this error resulted in the recognition of these
commitments as derivatives at fair value in the consolidated balance sheets, with changes in the fair value of
these commitments recorded in the consolidated statements of income. This error impacted previously reported
results and varied substantially from period to period based on volume, prevailing interest rates and the market
price of the underlying collateral. The correction of this error also resulted in recording cost basis adjustments
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FANNIE MAE
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)