Freddie Mac 2006 Annual Report Download - page 122

The periodic interest cash Öows related to derivative contracts currently accrued, which are derived primarily from
interest-rate swap contracts and include imputed interest on zero-coupon swaps, are classiÑed as Income (expense) related
to derivatives for derivatives in hedge relationships and as Derivative gains (losses) for derivatives not in hedge accounting
relationships.
Real Estate Owned
REO is initially recorded at fair value, net of estimated disposition costs and is subsequently carried at the lower-of-
cost-or-market. Amounts we expect to receive from third-party insurance or other credit enhancements are recorded when
the asset is acquired. The receivable is adjusted when the actual claim is Ñled, and is a component of Accounts and other
receivables, net on our consolidated balance sheets. Material development and improvement costs relating to REO are
capitalized. Operating expenses on the properties, net of any rental or other income, are included in REO operations income
(expense). Estimated declines in REO fair value that result from ongoing valuation of the properties are provided for and
charged to REO operations income (expense) when identiÑed. Any gains and losses on REO dispositions are included in
REO operations income (expense).
Income Taxes
We use the asset and liability method of accounting for income taxes pursuant to SFAS No. 109, ""Accounting for
Income Taxes.'' Under this method, deferred tax assets and liabilities are recognized based upon the expected future tax
consequences of existing temporary diÅerences between the Ñnancial reporting and the tax reporting basis of assets and
liabilities using enacted statutory tax rates. To the extent tax laws change, deferred tax assets and liabilities are adjusted,
when necessary, in the period that the tax change is enacted. Valuation allowances are recorded to reduce deferred tax
assets when it is more likely than not that a tax beneÑt will not be realized. For all periods presented, no such valuation
allowance was deemed necessary by our management. Reserves are recorded for income tax contingencies and related
contingent interest where the potential for loss is probable and reasonably estimable in accordance with SFAS 5.
Income tax expense includes (a) deferred tax expense, which represents the net change in the deferred tax asset or
liability balance during the year plus any change in a valuation allowance and (b) current tax expense, which represents the
amount of tax currently payable to or receivable from a tax authority plus amounts accrued for expected tax deÑciencies
(including tax and related interest and penalties). Income tax expense excludes the tax eÅects related to adjustments
recorded to equity as well as the tax eÅects of the cumulative eÅect of changes in accounting principles.
Stock-Based Compensation
We record compensation expense for stock-based compensation awards based on the grant-date fair value of the award
and expected forfeitures. Compensation expense is recognized over the period during which an employee is required to
provide service in exchange for the stock-based compensation award. The recorded compensation expense is accompanied
by an adjustment to Additional paid-in capital on our consolidated balance sheets. The vesting period for stock-based
compensation awards is generally three to Ñve years for options, restricted stock and restricted stock units. The vesting period
for the option to purchase stock under the Employee Stock Purchase Plan, or ESPP, is three months. See ""NOTE 11:
STOCK-BASED COMPENSATION'' for additional information.
The fair value of options to purchase shares of our common stock, including options issued pursuant to the ESPP, is
estimated using a Black-Scholes option pricing model, taking into account the exercise price and an estimate of the
expected life of the option, the market value of the underlying stock, expected volatility, expected dividend yield, and the
risk-free interest rate for the expected life of the option. The fair value of restricted stock and restricted stock unit awards is
based on the fair value of our common stock on the grant date.
Incremental compensation expense related to the modiÑcation of awards is based on a comparison of the fair value of
the modiÑed award with the fair value of the original award before modiÑcation. We generally expect to settle our stock-
based compensation awards in shares. In limited cases, an award may be cash-settled upon a contingent event such as
involuntary termination. These awards are accounted for as an equity award until the contingency becomes probable of
occurring, when the award is reclassiÑed from equity to a liability. We initially measure the cost of employee service received
in exchange for a stock-based compensation award of liability instruments based on the fair value of the award at the grant
date. The fair value of that award is remeasured subsequently at each reporting date through the settlement date. Changes
in the fair value during the service period are recognized as compensation cost over that period.
Excess tax beneÑts are recognized in Additional paid-in capital. Cash retained as a result of the excess tax beneÑts is
presented in the consolidated statements of cash Öows as Ñnancing cash inÖows. The write-oÅ of deferred tax assets relating
to unrealized tax beneÑts associated with recognized compensation costs reduces Additional paid-in capital to the extent
there are excess tax beneÑts from previous stock-based awards remaining in Additional paid-in capital, with any remainder
reported as part of income tax expense.
110 Freddie Mac