Updated from 8:03 a.m. EDT

Freddie Mac ( FRE) will upwardly restate its past three years of earnings by as much as $4.5 billion, saying its audit staff was overmatched by derivatives accounting and supervised by weak managers.

"The information we are disclosing today reflects poorly on Freddie Mac's past accounting, control and disclosure practices," said Gregory Parseghian, Freddie's new chief executive officer and president.

The restatement, which has been in the works for months and has spawned a series of criminal and regulatory investigations, reflects reclassification of part of the company's derivative portfolio as "cash market instruments" -- bets on interest rate movements. The derivatives had previously been treated as offsetting hedges to other assets intended to protect the company against rate fluctuations.

(Some experts say telling the difference shouldn't be that hard.)

"A majority of the corporation's derivatives in 2001 and 2002 will not qualify as accounting hedges," said Freddie in a press release. Although the changes will boost past earnings results, Freddie said, the new accounting will lead to "significant volatility" in its reported earnings in the future.

Crime and Punishment

In a conference call, Freddie executives offered a "robbing Peter to pay Paul" analogy for the accounting mess.

While the restatement could add anywhere from $1.5 billion to $4.5 billion in earnings to past results, there will be more volatility in future quarters and earnings in those periods may be lower than expected.

In early trading, shares of Freddie were trading higher, up $1.73, or 3.5%, to $51.76.

The company's comments appear to confirm speculation that Freddie had engaged in a form or earnings management by trying to smooth out its quarterly results and delay the recognition of income from some of its derivatives transactions by inappropriately labeling them as accounting hedges.

Indeed, the company said that its lawyers found "certain capital market transactions and accounting policies had been implemented with a view to their effect on earnings in the context of Freddie Mac's goal of achieving steady earning growth."

The company, however, suggested that the accounting mistakes resulted more from a misunderstanding of the applicable accounting rules than a deliberate attempt to mislead.

Freddie Mac has been the focus of controversy since ousting its top management two weeks ago, following an internal board investigation. The shakeup included the firing of its president, David Glenn, who is accused of failing to cooperate and making alterations in personal diaries he kept about Freddie's business affairs.

The accounting issues also are being investigated by federal prosecutors and the Securities and Exchange Commission. Federal authorities will try to determine whether the past accounting mistakes at Freddie were the result of human error or a deliberate strategy to make Freddie's earnings look more predicatable.

Frayed Nerves

The turmoil at Freddie initially sent a tremor through the financial markets because the company and its close cousin, Fannie Mae ( FNM), are important players in the mortgage market. In the wake of the shakeup, the stock fell some 17%, but it since has recovered more than half of those initial losses.

Investors seemed heartened Wednesday by management's efforts to come clean on the accounting problems and admit past mistakes. The company promised to do better.

"We had numerous problems," said Parseghian. "But we know how to fix them."

New Standards

Among the changes outlined Wednesday, Freddie will no longer report "operating earnings" in addition to standard GAAP earnings. The treatment, which had raised the objections of some critics, "no longer will be meaningful," Freddie said.

Some Wall Street analysts said Freddie's decision to abandon the reporting of operating earnings could create problems in evaluating the company's performance and comparing it with that of Fannie Mae, which relies heavily on its operating, or "core earnings," results.

"That will be a problem in reconciling the differences between the two companies," said Mike McMahon, an analyst with Sandler O'Neil & Partners. "The core fundmental business will remain a very good business, but I suspect that it will be an evolving process how we value their reported numbers."

McMahon also said he was disturbed by Freddie's acknowledgement that its accounting staff had not been adequate. He also worries there may be "another shoe to drop," in light of Freddie's tacit confirmation that prior management may have been trying to smooth out the company's earnings.

Other Issues

The restatement also reflects problems with the accounting treatment for Freddie's large portfolio of mortgage securities.

Freddie said the reclassifications would add to the firm's regulatory capital, a move that could make more money available for stock buybacks in the future.

Freddie announced the preliminary results on the day that a congressional committee is set to hold the first of many hearings into whether it and its peer, Fannie Mae, need additional government oversight. Some in Congress are critical of the role played in the accounting mess by the Office of Federal Housing Enterprise Oversight, the main regulator of the two government-sponsored companies. Freddie officials, however, declined to comment on the controversy surrounding its regulators.

Both companies exist to make secondary markets in home loans and operate under "government sponsorship," a murky status that is generally interpreted to mean that their debt has the unspoken guarantee of the federal government.

Freddie's troubles began to come to light in January, when the board hired James R. Doty, a former Securities and Exchange Commission lawyer, to look into the company's accounting. The SEC, the Office of Federal Housing Enterprise Oversight and the Justice Department have since begun their own inquiries.