Report Finds Accounting Practices That Start at the Bottom Line
Friday, February 24, 2006
It begins with a number -- say, $6.46.
That's the figure Fannie Mae was shooting for after the company set a goal in 1999 of doubling annual earnings per share by the end of 2003. For employees, incentive pay was on the line.
In another time, or another company, success might have been riding on the basics. Making and selling widgets. Or, in Fannie's case, turning mortgages into mortgage-backed securities.
But in the modern corporation, the core mission of delivering products or services can seem like a sideshow to the accounting machinations that ultimately determine the bottom line. Success or failure can come down to such financial esoterica as "back-end credit enhancements," "deferred price adjustments" and the accounting for derivatives in hedge transactions. Not to mention the way accountants interpret the phrase "at acquisition."
U.S. financial markets are supposed to be the most transparent and heavily regulated, with numbers you can trust. But as a 2,652-page report released yesterday shows, government-chartered Fannie Mae, one of the nation's largest and most scrutinized financial companies, was able to create the numbers it wanted.
"For Joe Investor, there's no way sitting here in Berkeley, California, I know whether any company is cooking the books," said Dwight Jaffee, a professor of finance and real estate at the University of California at Berkeley. Investors must rely on the auditors and the board of directors, Jaffee said.
The report, commissioned by members of Fannie's board, says the board was essentially in the dark while improper accounting was inflating Fannie's earnings by billions of dollars.
After 17 months of work, even the lawyers and accountants who labored to produce the report aren't entirely sure what happened.
But some things came across loud and clear -- like the number $6.46.
"You must be able to say it in your sleep, you must be able to recite it forwards and backwards, you must have a raging fire in your belly that burns away all doubts," the former head of Fannie Mae's internal audit unit, Sam Rajappa, said in a pep talk for internal auditors six years ago.
According to the report, Fannie Mae managers wanted to deliver the steady earnings growth that Wall Street favored. The enemy was volatility -- unpredictable fluctuations in the company's financial performance. Those could unsettle investors and force Fannie to hold more money in reserve, thereby eating into profit.
In internal memos and e-mails cited in the report, Fannie insiders refer to the "smoothing" of the numbers and the availability of an "earnings piggy bank" that can "get us to" that year's targeted number. One employee mentions that "Janet's looking for income" and later says, "If Janet needs income, looks like we might have some here."