Alternative course of action

As stated, above statement seems that the company should improve their internal management.

1. The company should recruit an accounting expert.

 This is to keep the financial well-being of a company. Such as understanding of internal
control to obtain reasonable assurance whether the financial statements as a whole are
free from misstatement individually or in the aggregate, whether due to fraud or error,
forgery, and internal omissions. To design and perform procedures responsive to those
risks and to issue a report that is sufficient and appropriate to provide their opinion to
be expected to influence the economic decisions of users. This would help a company to
cease to continue as a going concern.

2. Established a more efficient and autonomous regulatory agency

 The freddie mac should have the same disclosure rules that apply to other financial
institutions for them to comply with the provisions and the privacy rule. The rule
focuses not only on regulating the disclosure of customer and consumer financial
information, but also on requiring each financial institution to give its customers initial
and annual notices of its policies. Given that the transparency in today’s financial
environment matter this would fill an important gap in disclosures for the company to
adopt the specific disclosures to assess this sector to regulators and to have a standard
setting to be considered as a new requirements to enhanced .

fix weaknesses in accounting and management controls. These include the expansion of senior
accounting staff, creation of an operating risk oversight unit, and strengthening the review of accounting
and other critical business operations.

Ms. Schakowsky. Thank you, Chairman Stearns, for convening

this important hearing to follow up on the accounting scandal
at Freddie Mac. I appreciate, Mr. Falcon, and accompanied by
Ms. DeLeo this morning and Mr. Baumann's attendance today so
that we can go over the Office of Federal Housing Enterprise
oversight examination of just what went wrong at Freddie Mac
and Freddie Mac's actual restatement of earnings.
According to OFHEO's report, Freddie Mac used a variety of
accounting tricks to move gains and losses around to smooth out
and meet earning expectations. Through their manipulations,
steady Freddie seemed to live up to its name. However, as its
restatement shows, and we all know, the cumulative effect of
their attempts was the hiding of $5 billion of volatility.
Some have been lulled into a sort of complacence with the
accounting scandal at Freddie Mac because they under reported
their earnings. It seemed that while their true earnings
revealed some unsteadiness, what they were hiding was not so
bad. They hid profits. But this reporting has been misleading
as well. In 2001, Freddie's restatement reveals that they over
reported their earnings by $989 million. Earnings for 2001
actually were about $1 billion less than they reported. Again,
that $5 billion was accumulative effect of their restatement.
My concerns today are not just with Freddie Mac but also
with the agency put in charge of their oversight. OFHEO's
oversight was created in 1992 to ensure the safe and sound
operations of Freddie Mac and Fannie Mae. However, as OFHEO's
report reveals, a lot was happening at Freddie Mac under their
oversight.
Today, we'll focus on the accounting issues that were
raised by Freddie Mac. Our subcommittee has the responsibility
to ensure that all companies provide clear and accurate
financial information to the public. The scandal at Freddie Mac
is a clear example of what can happen when corporate officers
do not abide by the rules of clear and accurate accounting.
All publicly traded companies need to have clear and
accurate books. This is especially true for Freddie Mac. What
happens at Freddie Mac has a major impact on the housing
markets. Freddie purchased almost $600 billion in mortgages in
2002. It also has helped finance homes for nearly 2.5 million
low and moderate income families and families living in under
served areas. It was able to do so at least in part because of
the benefits and freedoms enjoyed in an established mission as
a government-sponsored enterprise.
As we all know, with freedoms come responsibilities. While
Freddie was trying to live up to their reputation, they were
not living up to their responsibilities. As a GSE and as one of
the largest players in the housing market, playing accounting
games puts more than the corporation's financial standing at
risk. It puts taxpayers and people's homes in jeopardy.
As I said before, Freddie Mac is not just another company.
Therefore, we need to make sure that Freddie Mac is as
transparent as possible and while I applaud the work that OFHEO
has done since the scandal has come to light, and appreciate
Freddie's restatement of earnings, willingness to take steps
toward remediation, we still have a long way to go.
Freddie Mac needs to be registered with the SEC and
voluntary registration is taking too long and does not have the
same power as mandated. And that is why I support my
colleagues' efforts, Congressmen Shays and Markey, to require
Freddie Mac to abide by the same rules of transparency
available. Because of who you are and place you have in making
money available for home ownership, it is vital that Freddie
Mac is held to at least the same standards as other publicly
traded companies, if not higher.

In your statement, as well as in members' here, words like

manipulated, misled, scandal, scheme, deception, disguised
earnings, circumvented, undermanned, undermined, market
awareness, pervasive, these are the terms that have been used.
Freddie Mac's problems were discovered by the board of
directors, as I understand. Is that correct?
Mr. Falcon. This all was uncovered initially as a result in
a change in external auditors by the company.
Mr. Stearns. Mr. Falcon, since your job is oversight, why
didn't your office detect it first, since you had a fiduciary
responsibility, as the oversight for the government, why
wouldn't your office detect it, identify this problem in your
normal accounting and oversight?
Mr. Falcon. That's a fair question, Mr. Chairman. We were
aware of these transactions, but we weren't aware of the
accounting for these transactions. These transactions,
generally, did not pose additional risk to the company from a
safety and soundness perspective. We would have prevented them
from entering into them had we understood the purpose of these
transactions.
So we're familiar with them from a risk management
standpoint, but the accounting for these transactions is really
what's at issue here.
Mr. Stearns. Do you think your office has enough people,
enough expertise to identify these problems?
If you were going to say to someone today, by golly, this
is what I want, so this won't happen again, what would you say?
Mr. Falcon. I think what's required on the part of OFHEO,
Mr. Chairman, is additional resources and expertise, not just
across the board, but more specifically in the accounting area.
Safety and soundness regulators generally do not secondarily
certify that the financial statements----
Mr. Stearns. Only the accountant?
Mr. Falcon. Right, only the external auditor does that.
Mr. Stearns. So really your office could never detect this
kind of mismanagement, misled, schemes, scandals, all these
things. Your office could never have detected this?
Mr. Falcon. We weren't equipped to----
 Mr. Stearns. You weren't equipped to detect this.
Mr. Falcon. [continuing] this kind of accounting
misconduct.

The management of a corporation is responsible for maintaining a

control environment that will, among other things, accurately record
transactions to provide for published financial statements that are
consistent with the true financial condition of the firm. In that
regard, the obsession of Freddie Mac with steady, stable growth in
earnings was at the expense of proper accounting policies and strong
accounting controls. Weaknesses in the staffing, skills, and resources
in the Corporate Accounting Department of the Enterprise led to weak or
nonexistent accounting policies, an over reliance on the external
auditor, weak accounting controls, and an over reliance on manual
systems. Given the size of the company and its role in the housing
finance and capital markets, those weaknesses effectively increased the
systemic risk posed by the Enterprise.
accounting personnel and expertise
The staffing levels and experience in the financial accounting
reporting functions were insufficient throughout the restatement
periods. The key finance functions over this period were unbalanced
with major gaps either left unfilled or filled with interim personnel
with inadequate skills. This shortage of staff and experience caused
key person dependencies in crucial control areas. The need for skill
and experience is heightened when the process is complex, as is the
derivatives and securitization accounting process at Freddie Mac. Many
of the strategies and transactions during this period were not GAAP
compliant; therefore, Freddie Mac was faced with one of the largest
restatements in corporate history.
Senior management and the Board failed to provide adequate
resources to the corporate accounting function even though they were
being continuously told about the weaknesses.
Senior management simply ignored warning signs about problems in
Corporate Accounting and/or did not consider the problems important
enough to provide adequate supervision, funding and or insist on a
timely resolution. The lack of attention to staffing, skill set and
resources led to weak or non-existent accounting policies, weak
accounting controls, over reliance on manual systems and over reliance
on the external auditor. Each of these areas will be discussed in turn.
accounting policies
A thorough review and update of accounting policies had not
occurred at Freddie Mac in over twelve years. Accounting policies
should be researched and documented regularly to assure proper
accounting treatment of existing and new business transactions. They
should be used as a mechanism to keep employees informed of how to
account for new and recurring transactions. Many of the transactions
and policies that have been investigated at Freddie Mac did not have
established accounting policy guidance and/or the policies in place
were outdated, insufficient or incorrect, leading to misapplication of
GAAP and, ultimately, to the need to reaudit and restate its financial
statements.
Freddie Mac's accounting errors during this time period had been
pervasive and persistent; occurring in more than 30 different
accounting issue groups. The weaknesses in accounting policies created
an environment that allowed for and even encouraged transacting around
GAAP. These weaknesses also encouraged an over reliance on Arthur
Andersen, the external auditor, a situation which led to questions as
to auditor independence.
Management used the weak accounting policy group and the non-
existent process surrounding the setting of accounting policies to
justify accounting practices after transactions had taken place rather
than allowing the group to set ``best practice''. Freddie Mac, as part
of the restatement process, has rewritten and/or reviewed 150
accounting policies.
over reliance on arthur andersen
Freddie Mac's shortage of accounting staff, inadequate expertise
and weak or non-existent accounting policies led to an environment that
encouraged reliance on the external auditors for basic accounting
functions and decisions. This dependency led to the external auditor
acting in a first-line management capacity, taking part in day-to-day
operations, and, to an extent, and auditing its own work.
In 2001, Arthur Andersen received $1 million for its audit work and
$3.7 million for its consulting fees, of which $1.5 million related to
FAS 133 consulting. OFHEO believes that Arthur Andersen's independence
as an auditor may have been compromised by the size of the consulting
fees compared to the fees charged for the audit work.
SEC requirements for independence of auditors are clear that in
day-to-day operations of the business, external auditors may not
function as management or as an employee of its audit client. Arthur
Andersen appears to have disregarded this principle by counseling the
company on issues ranging from FAS 133 implementation to accounting
affects of new products. The many organizational changes in the
accounting department heads, especially at the controller position, led
to the accounting staff heavily relying on Arthur Andersen.
In this regard, evidence supports the conclusion that Arthur
Andersen was participating in day-to-day decisions and often acting as
an employee or in a management capacity. They also performed extensive
consulting work that may have led them to use extreme and sometimes
unsupportable assumptions to support specific transactions. Couple this
with an environment where management often negotiated accounting
decisions and in some cases went as far as suggesting a change in
auditors if desired results were not achieved, and the result is an
environment which can compromise the auditor's independence.
There are also indicators that the Board was comfortable relying
completely on the external auditor for accounting expertise. This
contradicts current accounting literature, which holds management
accountable for the accuracy of their financial statements.
accounting controls
Senior management and the Board did not establish and maintain a
strong internal control system. Therefore, they could not provide
reasonable assurance that transactions were recorded as necessary to
permit preparation of financial statements in accordance with GAAP. As
a direct result of management and the Board not addressing these
weaknesses in a timely fashion, Freddie Mac went ten months without
audited financial statements for 2002, was forced to reaudit and
restate both 2000 and 2001 financial statements, and will not be able
to provide investors with current quarterly information during 2004.
As noted previously, staffing levels and expertise in the financial
accounting area have been insufficient since at least 1998. It has also
been demonstrated that the enterprise operated from 1991 to 2003 with
non-existent or outdated accounting policies and manuals. Add to this
insufficient controls over the financial reporting process such as
system and data integrity issues in debt and derivatives accounting,
account reconciliation issues, an ineffective process to react promptly
to new transactions, and a labor intensive close-out process and you
have an environment that will not only allow errors but will most
likely result in material misstatements in the financial reporting
process. Discussed below are some of the weaknesses in controls that
existed during the restatement period.
derivatives
In an internal audit report dated December 1996, the General
Auditor reported that controls over the derivatives execution,
administration, and accounting processes require improvement and that
further deterioration in controls could prevent objectives relating to
the effectiveness and efficiency of operations and the reliability of
financial reporting from being achieved.
Management through their internal self-assessment process also
identified these same weaknesses. Weaknesses within the derivative area
continued to be identified, but not addressed by management, internal
audit, or the external auditor during the next seven years. The latest
internal audit report stated that inadequate documentation of hedge
effectiveness and other required information could disqualify the use
of favorable FAS 133 accounting treatment. The report also stated that
procedures for derivatives accounting processes, including
documentation, effectiveness testing, quality control, analysis, and
management review, need improvement to ensure compliance with hedge
accounting standards. Significant functional limitations in the
derivatives accounting systems create an elevated risk of material
operational error. It should be noted that inadequate documentation and
controls surrounding the accounting for derivatives were identified as
one of the six major restatement issues and constitute the largest
dollar impact of the restatement.
reconciliations
General ledger account reconciliations are a key internal control
necessary/used to provide reasonable assurance that the corporation's
financial statements fairly present its financial position and results
of operations. Not reconciling general ledger accounts dramatically
increases the risk that financial reports will not be accurate. The
issue regarding reconciliation was brought to management's attention as
early as 1995. At that time Internal Audit reported that corporate
accounting was not effectively monitoring account reconciliations
performed by the decentralized account unit.
Internal Audit again identified reconciliation weaknesses in their
1998 audit. And in 1998 and 1999 Arthur Andersen addressed the issues
regarding reconciliation and data integrity in its management letters.
In fact, in 1998 Arthur Andersen said that guidance should be provided
for the timely and consistent reconciliation of data to the general
ledger and other approved sources of data. Reconciliation issues were
still outstanding in 2002.
internal audit function
Many of the weaknesses discussed to date were identified by
Internal Audit but remained outstanding for a number of years. In
evaluating the role of the Internal Audit Department the investigation
revealed that Internal Audit did not fully comply with industry
standards or best practices in the areas of competency and
communication with the Board and Management.
Best practices do not require internal auditors to conduct
financial audits, but the Internal Audit Department of Freddie Mac
should have policies and procedures in place to address its obligation
to evaluate risk exposure relative to the reliability and integrity of
the financial information of the Enterprise. Given the volume and wide
range of accounting errors made by Freddie Mac, the conclusion of the
Internal Audit Department that financial accounting and reporting
controls were marginal was a substantial overstatement of their
quality.
Internal auditors should review operations and programs to
ascertain the extent to which results are consistent with established
goals and objectives to determine whether operations and programs are
being implemented or performed as intended. A review of relevant
internal audit reports noted several instances where major control
weaknesses identified as early as 1998 remain unresolved five years
later. In many of these instances, internal audit identified major
control weakness and set agreed upon actions as well as target
completion dates. However, the completion dates of the corrective
actions were repeatedly extended. As a result, each of the issues
remained outstanding.
By not following up quickly enough or failing to report the failure
of management to remedy major control weakness during the period of the
restatement, the internal audit function increased the exposure of
Freddie Mac to risk.
The Internal Audit Department of Freddie Mac did not accept
responsibility for the reliability and integrity of the financial
information of the Enterprise, did not follow-up effectively on
identified deficiencies, and did not communicate effectively with
management and the Board. In combination, the weaknesses in Corporate
Accounting, the Internal Audit Department, and questionable
independence of the external auditor meant that there were weak points
at each major control juncture at Freddie Mac.
conclusion
Weaknesses in the Corporate Accounting area with respect to
staffing, skill set, and resources led to weak or non existent
accounting policies, an over reliance on the external auditors, weak
accounting controls and an over reliance on manual systems. Couple this
with a weak internal audit department that did not accept
responsibility for the reliability and integrity of financial
information, did not maintain effective controls over the review and
follow-up of audit findings and you have an environment with weak
points at each major control juncture.
This weak control environment provided the opportunity for
management to promote an attitude that GAAP was something to be
transacted around. In this regard, the attention of management on
meeting analyst's expectations at the expense of proper accounting
policies and strong accounting controls lead to aggressive accounting
and concurrently resulted in the restatement and reaudit. Management
and the Board continually ignored their responsibility for adopting
sound accounting policies, establishing and maintaining a strong
internal control system to assure that financial statements were
prepared in accordance with GAAP. The Board appeared to be operating
under the misconception that as long as the external accounting firm
signed off on a policy or transaction that management's responsibility
was fulfilled.
Management and the Board must accept full responsibility for the
Company's financial statements. The auditor's responsibility is to
express an opinion on the financial statements. It is management's
responsibility to adopt sound accounting policies and to establish and
maintain an internal control environment that among other things will
ensure the effectiveness of the accounting and financial reporting
processes. Freddie Mac's Senior Management and Board did not live up to
these responsibilities during this timeframe.
recommendations
The examination report recommended that OFHEO and Freddie Mac take
a broad range of actions. I agree with the recommendations and we are
moving to implement them. As a general matter, the report concluded
that OFHEO must ensure that Freddie Mac has established an adequate
remediation plan and is allocating the necessary resources to establish
a new corporate culture that rewards integrity and the acceptance of
responsibility, and that penalizes failure to meet appropriate
standards of conduct.
The report also detailed a number of specific actions. To improve
the effectiveness of the Board of Directors, Freddie Mac should
separate the functions of the Chief Executive Officer and the Chairman
of the Board, impose strict term limits on Directors, and require that
the Board meet more frequently.
To address Freddie Mac's general neglect of operations risks and
compliance issues, the report recommends that Freddie Mac establish a
formal compliance provision and a position of Chief Risk Officer,
reporting directly to the CEO, with explicit responsibility for
operations risk, as well as credit and market risk. In addition,
Freddie Mac's Internal Audit Department needs to be strengthened so
that it can play a more effective role.
To address accounting weaknesses, Freddie Mac will review all
accounting and financial reporting changes and communicate this to
OFHEO. The enterprise must also act to improve its internal audit and
accounting functions. The report also recommends that OFHEO consider
requiring a periodic change of external audit firms. Freddie Mac needs
to establish and maintain superior accounting controls and prevent
undue reliance on its external auditor. It must also document the
legitimate business purpose of every significant business transaction.
To address inappropriate managerial incentives, the report
recommended that Freddie Mac refocus its compensation program more on
long-term goals, not on short-term earnings.
Until remediation efforts have taken full effect, Freddie Mac
remains exposed to substantial management and operations risk. The
report recommends that OFHEO consider addressing this concern by
requiring Freddie Mac to hold significant regulatory capital surpluses,
at least until it can produce timely and GAAP--consistent financial
reports.
Finally, the report recommends that OFHEO take three additional
steps to reduce the possibility of future Enterprise difficulties.
First, OFHEO should implement regulations that provide for mandatory
disclosure, similar to that required of SEC-registered companies, if
Congress does not repeal the exemptions of the Enterprises from
securities law. Second, OFHEO should expand its capacity to detect and
investigate misconduct by including more substantive tests of the
internal control frameworks at the Enterprises, including procedures to
identify pressures to commit fraud and opportunities to carry it out.
Third, OFHEO should conduct a special examination of the accounting
practices of Fannie Mae.
ofheo actions