Angelica Olivarez 430 ethics
Fannie Mae Accounting Scandal 2001 Ethics is based on how people should act through well-based standards. Ethics on the other hand, does not describe the way people actually act. Ethics is a prescriptive term in which people should always aim to make the right decision. Those who act on ethics do not rationalize their actions founded own perceived self-interest. The accounting profession has its own understanding and framework of ethics. Accounting applications of ethical reasoning can become a common dilemma faced by auditors, internal auditors and all others who work in the business field. For example, The American Institute of Public Accountants (AICPA) Code requires CPAs to place the interest of the public first. To place the interest of the public first means that CPAs should not place themselves, their client or their employer’s interest above the public. Many business dilemmas involve managers, CPAs, and/or top management who have placed their interest above the public’s interest. An example of an accounting and business dilemma where the public interest was not placed first is Fannie Mae accounting scandal in 2001. Fannie Mae is the Federal National Mortgage Association, a government supported entity that assist lower and middle income Americans to buy homes. The Federal Home Loan Mortgage Corporation (Freddie Mac) also assists lower and Middle Americans to buy homes. Both supported entities gain special treatment and “aimed to increase home ownership by decreasing the cost for homeowners to borrow money.” In order for the entities to decrease the cost for homeowners to borrow money they purchased home mortgages from banks. The home mortgages are then guaranteed and then sold to investors. The treatment of the mortgages helped minimize the credit and interest risk. Fannie Mae “makes money by buying, guaranteeing, and then reselling home mortgages for a fee or by buying mortgages, holding them and then taking a risk.” When mortgages are sold they eliminated the interest rate risk. When the mortgages are held Fannie Mae made money off the spread because it had “low cost of capital.” In the late 90’s Fannie Mae made billions of dollars off mortgages and mortgages-backed securities. Fannie Mae soon began to grow and flourish. Although pressured by many economic turns Fannie Mae’s CEO was confident that their earnings per share would double during the 2000’s. To continue growth and avoid economic pressures the entity began to use “more derivatives to hedge interest rate risk.” Many creditors believed that the entity would default due to the risk being taken. Creditor commented that the entity would have no federal guarantee if the entity defaulted. On the other hand Fannie Mae “encouraged the concept that if it defaults, the government would back it.” Fannie Mae’s top executives were gaining large bonuses due to business growth and large profits. “In the 1900’s, Fannie Mae was growing and the market loved it.” The growth was said to be cause by increased risk. After Fannie Mae fired its auditor in 2001 (auditor Arthur Anderson), an accounting scandal was soon discovered. PricewaterhouseCoopers (PwC) was then hired to review the entities books and discovered that “it had understated its profits in an attempt to smooth earnings.” Fannie Mae took action and fired many of its top executives and arranged a five million restatement. “Fannie Mae continued on its course and accused Freddie Mac of causing collateral damage.” The entity soon released on its website: “Fannie Mae reported financial results follow to the letter. There should be no question about our accounting.” The Office of Federal Housing Enterprise Oversight (OFHEO), a government agency that regulated Fannie Mae and Freddie Mac, assured that the entities internal controls were reliable and accurate. Once Fannie Mae released the statement to the public on its web site the OFHEO was forced to take a second look into Fannie Mae’s accounting practices. It was imperative that the government avoid another Enron debacle. Four years of investigation the OFHEO in 2004 released to the public its investigations on Fannie Mae. The results concluded that the entity was breaking accounting rules and “fostering an environment of weak or nonexistent internal controls.” The investigation of OFHEO focused on the derivatives used by Fannie Mae that were being used during the time the critics purposed the entities default. The investigation also focused on the deferred derivatives losses that inflated the entities profits. Fannie Mae failed to apply appropriate accounting practice on its derivatives. “Fannie Mae’s application of SFAS 133 did not comply in material respect with the accounting requirements of GAAP.” Statement of Financial Accounting Standards (SFAS) number 133 states the rules that govern the accounting for derivatives instruments and hedging activities. The accounting chief of the SEC at the time affirmed that Fannie Mae’s practice failed to comply with SFAS 133 requirements. Fannie Mae was then required to document its “derivative use and file with the SEC.” Fannie Mae’s accounting practice of putting the deferred derivative losses on the balance sheet resulted in overstated earnings and high executive bonuses. A charged issued report of the OFHEO stated that in 1998 Fannie Mae recognized expenses of two-hundred million when actual expenses were four-hundred million. Earning of $3.23 and twenty seven million of executive bonuses were due to underreporting of expenses. The SEC was soon to take notice of the OFHEO’s charge against Fannie Mae. Only two weeks after OFHEO released its report “the House of Representatives Subcommittee on Capital Markets called a hearing.” As a result it was imperative that Fannie Mae’s top management and its executives underreported expenses and manipulated earning in an attempt to inflate their bonuses. During the year 2006, the OFHEO issued another report which stated that Fannie Mae’s executives were purposely manipulating accounting to receive bonuses. Fannie Mae’s executives not only received unearned bonuses they also deceived many investors. A four-hundred million fine was placed on Fannie Mae for fraud and three-hundred and fifty million of the fine would be returned to its investors under the provision of SOX. The reports done by OFHEO consist of multiple documents with detail on Fannie Mae’s unethical corporate culture. One of the final reports of the OFHEO charged the entity’s executives “with perpetrating an eleven billion accounting fraud in order to meet earning targets that would trigger a twenty five million in bonuses for top executives.” Executives that were charged were former CFO and CEO, J. Timothy Howard and Franklin Raines. The former executives earned nearly thirty seven million in roughly two years during 2002 through 2004. Reports issued by the OFHEO also included several faults of Fannie Mae. Fannie Mae violated accounting standards and failed to perform task with proper corporate governance. After Fannie was charged for its violations it began to make changes to its operations. Changes to its operations include:
1. Limit the growth of its multibillion-dollar mortgage holdings.
2. Changes in corporate culture, accounting procedures and ways of managing risk.
3. Thomas Gerrity, former chair of the audit committee was replaced by Dennis Beresford. While OFHEO was taking action on the event so was the SEC. The SEC civil action placed in 2006 charged Fannie Mae for multiple violations of GAAP. The entities financial statements were not properly reported and did not comply with GAAP. The action of the SEC included information and details on accounting deficiencies and financial reporting. Four of the most serious accounting deficiencies and financial reporting include improper accounting for loan fees, discounts and premiums, improper hedge accounting, accounting for loan loss reserve and classification of securities held in portfolio. Fannie Mae’s improper accounting for loan fees, discounts and premiums is one of the four major concerns of the SEC. companies are required to recognize loan fees, discounts and premiums by SFAS No. 91 as “ an adjustment over the life of the applicable loans, to generate a constant effective yield on the loans.” SFAS also requires that companies to record any changes in fees, discount and premiums to be recognized as either a gain or loss. Fannie Mae on the other hand did not treat the gains and losses of fees, discounts and premiums as the SFAS states they should have. Fannie Mae willingly referred to the gains and losses as catch-up adjustments. During the year 2008 accounting models of Fannie Mae calculated at least four-hundred and nine million so called catch-up adjustments. This was done in the form of a decrease in net interest income. Fannie Mae’s executives directed employees to record on two hundred and forty million of the four-hundred and nine million of the catch-up amount to the year’s income statement. The understatement of the catch-up account understated its expenses and overstated income. Fannie Mae’s improper hedge accounting was also a big concern of the SEC. SFAS 133 required Fannie Mae to “adjust the value of its derivatives to changing market values.” Fannie Mae used it debt to finance several mortgages acquisitions and mortgage securities. The entity also turned to derivative instruments to “hedge against the effect of fluctuations in interest rates on its debt cost.” Accounting for loan loss reserve was due to qualitative judgment of losses during the 1997 to 2003. During that time management failed to provide quantitative amount of losses in their loan portfolio. Its failure to determine proper losses and the determination of the size of the loan loss reserve resulted in a violation of GAAP rule SFAS 5. Fannie Mae’s reason for having high levels of loan loss reserve was to support and compensate for possible future change in the economy. The reporting of loan loss reserves failed to comply with GAAP standards. By 2002 Fannie Mae had overstated its reserves by one hundred million. Fannie Mae also failed to comply with SFAS 115, in that it “classified its securities it acquired as held-to maturity and then, at the end of the month of acquisition, decided on the ultimate classifications.” Proper classification should be determined when securities are acquired as trading, available-for-sale, or held-to-maturity at the time of acquisition. When a security is finally classified it can only reclassified under strict circumstances. During 2008 the Federal Housing Finance Agency (FHFA) was formed by congress. The FHFA is not the regulator of Fannie Mae, Freddie Mac and many other Federal Home Loan Banks. Fraud and violation of proper accounting should not be tolerated. It is important that auditors perform audits with integrity and due care. Fraud perpetrators usually have a way to explain why their actions are acceptable. Perpetrators in the corporate world may state that committing fraud would produce high stock prices for shareholders. Some may state that aggressive accountings practices were needed. Other statements of why fraud perpetrators think fraud is acceptable may be that they though it was good for the company and the violations would only temporary. Many times employees are “might rationalize fraud with thoughts such as my boss doesn’t pay me enough or I’ll pay the money back before anyone notices it’s gone.” Just as the executives of Fannie Mae committed fraud to gain unearned bonuses. Those effected by fraud are company shareholders, its employees and of course the stakeholders. Public interest should always be placed first. Fraud and accounting violations not only hurt the perpetrators when they are caught but also those who actually rely and invest in the company. In order to minimize and catch fraudulent actions auditors should follow a fraud risk assessment during any audit. One of the first steps to insure a company is being ethically responsive is through the evaluation of its financial statements. The integrity of top management should always be questioned. The auditor should also perform every audit with an adequate amount of skepticism. Skepticism involves asking the right questions and evaluating the corporate culture of the client. “The auditor should obtain information needed to identify the risk of material misstatement due to fraud.” The best way for a company to prevent and minimize fraud it to establish a well formed corporate culture. This will insure that employees are aware of consequences lead by fraudulent actions. Having a corporate culture will also inform employees that fraudulent actions are not tolerated. When employees are aware that fraud is not tolerated they are less likely to commit fraud. When employees become aware of the consequences and they tend to avoid certain situations. Accounting professionals and business personal are subject to many liabilities if they fail to follow standards such as GAAP. For example, the executives of Fannie Mae’s as stated earlier were charged for receiving unearned bonuses due to fraudulent activity. It is imperative that public interest is placed first and that those who commit and perpetrate fraud are more likely to encounter consequences by law.