Fannie Mae 2004 Annual Report Download - page 80

not record a small number of financial instruments as derivatives; 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 cumulative pre-tax reduction in retained
earnings of $12.1 billion as of December 31, 2003. This pre-tax loss, 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 resulted in a reduction in total assets of $5.0 billion as of December 31, 2003, 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 as of December 31, 2003, 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
ineffectiveness 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). 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
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
adjustments 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
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