SPEAKERS CONTENTS INSERTS
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THE ACCOUNTING TREATMENT
OF EMPLOYEE STOCK OPTIONS
Tuesday, June 3, 2003
U.S. House of Representatives,
Subcommittee on Capital Markets, Insurance
and Government Sponsored Enterprises,
Committee on Financial Services,
The subcommittee met, pursuant to call, at 10:05 a.m., in Room 2128, Rayburn House Office Building, Hon. Richard H. Baker [Chairman of the subcommittee] presiding.
Present: Representatives Baker, Ose, Shays, Gillmor, Oxley (ex officio), Castle, Lucas of Oklahoma, Manzullo, Ney, Kennedy of Minnesota, Brown-Waite, Renzi, Royce, Kelly, Shadegg, Green, Miller of California, Toomey, Capito, Hart, Tiberi, Harris, Kanjorski, Hooley, Sherman, Meeks, Inslee, Gonzalez, Hinojosa, Crowley, McCarthy, Matheson, Miller of North Carolina, Emanuel and Scott.
Chairman BAKER. Welcome all those who are in attendance today.
Because of the nature of the panels we have this morning, there being three in number and the distinguished participants in each of those panels, I am going to suggestI have discussed with Mr. Kanjorski and his side minimizing opening statements to myself and Mr. Kanjorski, and we will enter into the record all of the members' statements for that purpose, simply to expedite our hearing and move forward to important testimony which we will receive.
Page 2 PREV PAGE TOP OF DOC Today, the Subcommittee on Capital Markets turns its attention to expensing employee stock options and, more specifically, H.R. 1372, the Broad-Based Stock Option Plan Transparency Act introduced by Representatives Dreier and Eshoo. This hearing is especially timely as we are moving towards issues of proposed standards on the mandatory expensing options later this year.
Stock options for executives, managers and employees have served as an important tool for cash-strapped companies in their efforts to attract and retain skilled management and employees. However, there are clearly two schools of thought on the methodology for proper accounting treatment.
Proponents of expensing include the big four accounting firms, institutional investors, as well as the current Chairman Greenspan and former Chairman Volcker. Their views and options are a form of compensation just like salary and bonuses. As compensation is an expense and as expenses eventually impact earnings, options should therefore be recorded and subtracted from income.
Opponents justifiably argue expensing has a different view. They believe that mandatory expensing would discourage the use of options and adversely have an affect on innovation, economic growth, job opportunity and national competitiveness. Furthermore, options for expenses to company valuation is a most difficult issue. For example, use of different option pricing models and different assumptions can lead to significantly different economic consequences.
H.R. 1372 would seek to have SEC issue regulatory requirements which would enhance disclosure of employee stock options while prohibiting the SEC to recognize new accounting standards related to stock options until a report is submitted to Congress and to this committee on the cost-effectiveness of such regulation. This report would follow a period of 3 years of study.
Page 3 PREV PAGE TOP OF DOC This is a very controversial but very important issue, and I look forward to hearing from each of our distinguished panelists this morning.
I will turn to Mr. Kanjorski for an opening statement.
Mr. KANJORSKI. Thank you, Mr. Chairman.
Mr. Chairman, I, too, am interested in the stock option issue. We should look at its effect on corporate returns and disclosures.
I think we should move forward with our panel, however. In the nature of saving time and efficiency, I move that my opening remarks be entered into the record.
Chairman BAKER. Without objection. Thank you, Mr. Kanjorski.
[The prepared statement of Hon. Paul E. Kanjorski can be found on page 82 in the appendix.]
Chairman BAKER. If there be no further statements at this time, I would like to move forward quickly to our distinguished panel and recognize the Chairman of the Rules Committee, the distinguished David Dreier.
STATEMENT OF THE HON. DAVID DREIER, A REPRESENTATIVE IN CONGRESS FROM THE STATE OF CALIFORNIA
Mr. DREIER. Thank you thank you very much, sir. This is the first time I have been in this room; and this room has changed a lot since I have been in here, Mr. Chairman.
Let me say I appreciate the fact that you and Mr. Kanjorski and the members of this subcommittee have agreed to hold what I think is a very important hearing, and I believe that what we have really done here is recognize that there is a problem. We all know that the problem of corporate corruption came to the forefront, and your full committee addressed that issue with passage of the Sarbanes-Oxley legislation. I know that there are many people out there who are still focused on a number of the concerns, and I believe that Ms. Eshoo and I are focused on those and really have tried to step up to the plate and responsibly address this issue with the legislation that we have introduced.
Page 4 PREV PAGE TOP OF DOC Now, some have alleged that our legislation is an interference in the accounting standards setting process. The fact is, Mr. Chairman, we can't divorceas Members of Congress we can't divorce ourselves from our responsibility for dealing with accounting standards, but we also have to look at the very real impact that those standards will have on economic growth, investors in this country, shareholders and the economy as well.
Unlike the FASB board members, we are elected officials. And I am not an accountant, I am not an expert on this, Mr. Chairman, but I will tell you that I know that we have an obligation to the American worker and to the American investor to do everything that we can to preserve an environment that allows entrepreneurs to play a role in growing our economy.
Now, there is a disagreement between those who take a static view of the economy and see stock options as something that could theoretically impact shareholders today and those who understand the dynamics of an evolving, technology-based economy that views stock options as an important tool for increasing all share value in the future.
Now, if you try to cement the cost of those stock options and their grants up front, you will undermine the engine that will grow the company pie, because mandatory expensingand I have no problem with voluntary expensing, but mandatory expensing will eliminate the use of broad-based employee stock option plans.
I am not concerned about executive compensation. We know there has been some abuse there, and obviously that needs to be addressed. What I am concerned about is the potential to jeopardize the stock option plans for employees. I mean, this is a public policy issue, Mr. Chairman. It is not an accounting issue.
Expensingmandatory expensing will do little to curb the number of stock options granted to top executives, but it will directly harm, as I said, the ability of rank and file employees who enjoy corporate ownership.
Deborah Nightingale from Sun is going to be testifying in just a moment, and she is going to talk aboutI read her testimony last night. She is going to talk about the innovation, creativity and the role that she plays as a partner in her company.
Page 5 PREV PAGE TOP OF DOC Mandatory stock option expensing not only threatens the high-growth sectors of our economy but will actually result in an investor receiving inaccurate information about a company's use of employee stock options.
Now, our bill will mandateMr. Chairman, our bill will mandate the uniform and standardized disclosure of employee stock options without resulting in the elimination of broad-based stock options.
Now you don't have to be an accountant to recognize that stock options are not actually an expense. If you look at the definition of an expense, that is anything that results in an outflow of a company's assets or an increase in the company's liabilities. Employee stock options meet neither test.
I mean, let's propose, for instance, that on the first of January of this year company A had hired a computer programmer at a salary of $50,000 a year plus 100 stock option grants that can be exercised at a price of $10 no earlier than 5 years from the date of hire. Only the cash salary and nothing for the options. There is no cash outflow for the options and no liability created at any time, not when they are granted, vested or exercised. Indeed, when the stock options are exercised, the company actually receives money, and obviously the only thing that ultimately happens is the potential dilution of that stock. So all shareholders need to do is be informed of exactly what that option package consists of, and that is what our legislation is designed to do.
Now, Mr. Chairman, the fact is employee stock options never actually impose an expense or cost on companies. Since that is the case, why is there this endless debate with FASB and others in the accounting community over expensing stock options or explaining exactly what the cost to companies is?
Well, that brings me to, actually, a visual aid that I have here, Mr. Chairman; and I would just like to share this with you.
Page 6 PREV PAGE TOP OF DOC This is a map of the universe from 2,000 years ago; and basically Claudius Ptolemy, as we all know, came up with this amazing theory that the earth was the center of the universe, and for 1,500 yearsthat is 15 centuries, Mr. Chairmanthat view continued on and on and on by great minds who basically supported the Ptolemaic theory and Copernicus, Galileo, Brahe, the whole gang of these people ended up supporting it. The Mathematical Compilation, a 13-volume treatise, was put together, and guess what? We found, when all of a sudden Johann Kepler came forward, that while 15 centuries of stating that the earth was the center of the universe was out there, they were wrong.
It is true that you can take all kinds of facts and justify almost anything, but it doesn't necessarily make it right. That is why I don't believe that options are an expense, and I hope very much that we will be able to expeditiously move forward with this legislation to address the understandable concerns that FASB and all the rest of us raise.
Thank you very much, Mr. Chairman.
Chairman BAKER. Thank you, Chairman Dreier. We have members requesting copies of that chart for further
Mr. DREIER. And I will tell you that likely you might conclude that this is a meeting of Sherwood Boehlert's Science Committee.
Chairman BAKER. It could be helpful to a lot of us I think. Thank you.
[The prepared statement of Hon. David Dreier can be found on page 75 in the appendix.]
Chairman BAKER. Our next witness this morning is the Honorable Anna Eshoo, distinguished Member, and glad to have you here as a cosponsor of this important legislation.
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STATEMENT OF THE HON. ANNA G. ESHOO, A REPRESENTATIVE IN CONGRESS FROM THE STATE OF CALIFORNIA
Ms. ESHOO. Good morning, Mr. Chairman. Thank you for having me here today to testify on the issue of expensing of stock options to the distinguished ranking member Mr. Kanjorski and to the Chairman of the full committee Mr. Oxley, who has worked with us to have this hearing. We very, very much appreciate it.
I want to divide my comments up into what the expensing of stock options will not do and then the plus side of what stock options represent to the rank and file employees in so many companies in our companies today.
I think, first of all, that the term stock options is something that people instantly think of when the term is stated that it hasit is a term that has become sullied; and that, of course, is the result of the misuse and the abuse of stock options that produced the scandals and the excessive executive compensation. I believe really that these events have led to a renewed call, because this is a call that took place many years ago in my first term when I came to the Congress in 1993, and I think that these events have led to the call for expensing, leading many to believe that this is the ultimate prescription for what might ail us.
Congress, as you know, and this committee of course knows, responded by the Sarbanes-Oxley bill that passed in the last Congress.
So what will the expensing of stock options not accomplish? What will it not do?
First of all, in my view, the expensing of stock options will not rein in any excessive executive compensation in corporate America. If in fact stock options are not available, anyone that is at the top of a company, a corporation, that board of directors is going to find some way to compensate people that are at the top. There may be some things that we haven't heard of, but certainly top executives in this country will be compensated, compensated well, and it is their board of directors and their respective committees that will take care of that.
Page 8 PREV PAGE TOP OF DOC I think it is relatively easy for companies like GE and Coca-Cola to expense stock options. Keep in mind that they provide stock options to only a few, a very small number of their rank and file, and provide those stock options on a smaller basis to their executives.
Companies in my district and many other companies across the country todayin my district, it is mostly biotechnology and high-technology sectors. They use stock options very differently than the companies that became the poster children for corporate fraud.
If in fact the expensing of stock options had been on the books, the debacle at Enron would have still taken place. So it should not be thought of as the prescriptive that some have described.
Rather than handing out options only to senior executives, new economy companies offer them broadly, and when I say broadly, it is very broad. They turned their entire employee base into corporate partners who have a stake in the future success of their company.
Recent research indicates that at the top 800 technology companies in our country, 80 percent of the stock options are granted to the rank and file employees, not senior executives, and in the last decade over 10 million employees have received stock options.
So who loses if stock options are required to be expensed? Not senior executives who will be compensated, as I said, in one way or another. But it is the rank and file employees. They are the ones that would lose out on this benefit. Why? Because, faced with the prospect of taking a huge charge against their bottom line in accounting statements, most companies would simply drop the broad-based option plans and eliminate this benefit to all but senior executives.
Broad-basedI think it is very important for the committee members to take this out of the hearing, that broad-based stock option plans have turned employees into corporate partners by tying the interest of the employee together with the company and its shareholders.
Page 9 PREV PAGE TOP OF DOC Small entrepreneurial companies start up with very little capital, and so they have used stock options as the magnet to attract and to retain bright and talented employees that are critical to that company's success. And seated to my left is one of those employees, Debbie Nightingale of Sun Microsystems. She obviously is going to testify and speak to you in her personal story, but what you should also know is that she serves part time as a lieutenant colonel in the Army Reserves.
I just returned from Iraq with Chairman Hunter, and were it not for the role that our Reserves are playing, we would have had a much, much tougher time in the engagement there.
I also have brought, Mr. Chairman, a very thick compilation of statements from employees that I ask be placed in the record as well.
Chairman BAKER. Without objection.
Ms. ESHOO. Thank you.
[The following information can be found on page 173 in the appendix.]
Ms. ESHOO. These employees have used their options to purchase their first homes, to send their kids to college, to finance their retirements, to donate and sometimes begin foundations and charities; and they have contributed to our economy every step of the way.
Now, the FASB has indicated it will only focus on accounting standards and not economic standards when it rules whether to require stock option expensing. I agree that accounting standards are best left to FASB, but promoting job growth and economic viability is a responsibility of the Congress. It is something that we all have the responsibility for. So while FASB says it won't look at the economic impact its decision will have, again, we have the responsibility to examine these factors and ensure that our national policies foster economic growth.
Page 10 PREV PAGE TOP OF DOC Investors and shareholders access to information on how companies use stock options can and should be bolstered without throwing the baby out with the bath water, as expensing really would do.
The legislation that Chairman Dreier and I have introduced we believe strikes an appropriate balance by requiring companies who offer stock options to disclose additional information to every shareholder and potential investor. Our bill, H.R. 1372, requires and includes plain English descriptions of share value dilution. That is something that investors and potential investors should be able to see and understand.
The bill expands and builds a more prominent disclosure of stock option-related information, and it includes a summary of stock options granted to the five most highly compensated officers in a company or corporation.
The bill also directs the SEC to monitor the effectiveness for investors of the enhanced disclosure requirements and report its findings back to this committee, and during that time frame the SEC would be prohibited from recognizing as a generally accepted accounting principal any new accounting standard on stock options.
What our legislation does not set is accounting standards. Some have criticized this provision as a mandate on FASB, and nothing in our bill requires Congress to get into the standard-setting business. Congress can and should do many things. I don't think it should do that. We have problems keeping up with our own books, much less do otherwise.
The legislation directs the SEC to exert its appropriate role in maintaining the integrity of our markets and to ensure that our economic policies foster growth. Forcing companies to expense stock options at some arbitrary value as the FASB decision is likely to require I think would be both misleading to investors and to shareholders alike. Our legislation provides greater transparency about the use of stock options without unfairly penalizing the innovative employees that are really building America's economic future.
Page 11 PREV PAGE TOP OF DOC So I thank you, Mr. Chairman, to the ranking member, and to the Chairman of the full committee for inviting us here today to speak to a story of success in our country and that we can move on in terms of transparency and other reforms without damaging what has become one of the most important recruiting and maintenance tools for small companies and others in our country. Thank you very, very much.
Chairman BAKER. Thank you, Ms. Eshoo.
[The prepared statement of Hon. Anna G. Eshoo can be found on page 78 in the appendix.]
Chairman BAKER. Which leads us to our final participant in this panel, a Project Manager for Sun Microsystems, Ms. Deborah Nightingale. Welcome, Ma'am.
STATEMENT OF DEBORAH NIGHTINGALE, PROJECT MANAGER, SUN MICROSYSTEMS
Ms. NIGHTINGALE. Thank you, Mr. Chairman.
Thank you, Mr. Chairman and committee members, for the opportunity to speak to you today about the importance of broad-based stock options to rank and file employees nationwide. I would also like to thank Representatives Dreier and Eshoo for their leadership on this important issue.
I am here today speaking as one individual, but I know that I represent the view of thousands of my colleagues at Sun Microsystems and hundreds of thousands of employees nationwide.
Today, I have a dual career, working full time for Sun Microsystems, and I serve part time as a lieutenant colonel in the Army Reserves. I started my career on active duty, and after 5 years I did make the decision to pursue some civilian opportunities. However, I have always remained in the Reserves, because I enjoy the military.
Page 12 PREV PAGE TOP OF DOC Within several weeks after 9/11, I was mobilized for over 6 months to help lead the airport security mission at San Francisco and other northern California airports. In the 15 years since I have left active duty, I have worked for four companies, both high-tech and non-high-tech.
Having worked in both high-tech and non-high-tech, one big differentiator, in my opinion, is employees in high-tech do tend to be more innovative and entrepreneurial. Granted, high-tech often pays more, but the question is, once you have a well-paid, secure employee, how do you keep him or her motivated to keep innovating and taking risks? One simple and very effective answersolution is stock options.
I think and work differently as a result of stock options. I have always been a dedicated employee, but due to stock options I am incented to do much more than simply work hard and please the boss. I am motivated to drive results for Sun Microsystems so that I can participate in some sizable profit sharing, not just a better-than-average pay raise.
Working in operations, I am constantly looking for innovative ways to cut costs so that Sun Microsystems can continue to invest in their R&D. I have a strong sense of ownership and a real stake in Sun. Simply put, Sun does well, I do well.
As a member of the Armed Forces, I know that the technologies developed by U.S. high-tech are key elements of our military strength and our national security. A unit under my command as a battalion commander deployed to Iraq about 4 weeks ago. As a result of a recent fire fight in Iraq, one soldier has been evacuated to Spain and will be coming back to the U.S. for major surgery before he will be returning home. These soldiers are in harm's way every day. I will never forget what one senior officer said to me: We need to do whatever we can to make sure it is a very unfair fight in our favor.
I worry every day about those soldiers over there, but I do feel just a little bit better knowing that we have given them the best technology and equipment in the world. We need to ensure that U.S. high-tech companies maintain their competitive edge. I definitely worry about the possibility that other foreign competitors could begin using broad-based stock options just when the U.S. is taking measures to curtail the feasibility for our U.S. companies.
Page 13 PREV PAGE TOP OF DOC In summary, broad-based stock options are really good for both companies and employees. Stock options are a key reason that I came to work for a high-tech company and a key reason that I stay at Sun. Broad-based stock options create employee commitment and loyalty. They attract and encourage innovators and entrepreneurs. They give U.S. companies a competitive advantage, and stock options really do matter to rank and file employees like myself.
In summary, H.R. 1372 makes a lot of sense to me. It increases disclosure requirements right now without discouraging any broad-based stock options. It also provides for more time to study the issue and look for win-win solutions. This issue is an important issue to me and my fellow employees. We do not want to see broad-based stock options eliminated.
Thank you very much.
Chairman BAKER. Thank you very much, Ms. Nightingale.
[The prepared statement of Deborah Nightingale can be found on page 166 in the appendix.]
Chairman BAKER. Ms. Eshoo, you raised a point in your comments with regard to FASB's focus on accounting principles as opposed to economic policy. Is it your judgment that the current availability and reporting methodology for options enhances capital formation, business creation? It is a tool of principal value to the smaller not necessarily technology based but innovative companies that are out there that otherwise might have difficulty in attracting capital that a larger brick and mortar institution with a track record might not have.
Ms. ESHOO. There isn't any question in my mind that it has served as a very, very effective tool. I am looking across both sides of the committee, and I think most of the members have come toat one time or another travelled to my Congressional district, and soand because members wanted to learn how these small companies, these incubators wereyou know, what the ingredients were that was spawning the companies, the ideas, but also the tools that help attract employees and to hold them.
Page 14 PREV PAGE TOP OF DOC Now, I think it is really a great American story. Now, why we would want to take an accounting standard to rejigger this and destroy it is still a real question to me. There is notthere isn't any question in my mind that this has served very, very well. I mean, Debbie's story is one ofan eloquent story of tens of thousands. So I think that we really shouldn't be throwing the baby out with the bath water.
Are there more reforms that can take place? Absolutely. But this accounting standard that wipes out what the rank and file are going to get, keeping in mind that executives will always be recompensed in some way I think is wrong-headed. But has it attracted employees? Absolutely, and it is a retention tool as well. And keep in mind, again, that small companies don't start up with a great deal of capital. This is one of the magnets that has drawn some of the best and the brightest to the companies that then go on and build, and the average person has really won under thisyou know, what has taken place. I don't have any question in my mind, and I think that members that have travelled to my district and the region that I am from have seen this firsthand.
Chairman BAKER. Chairman Dreier, do you see it as a start-up issue, or do you see it in a broader perspective with regard to expensing of options?
Mr. DREIER. Well, I mean, it is a broad issue. But I will tell you that if you take, Mr. Chairmanlook, up until recently, 45 percent of the gross domestic product growth in this country has emanated from the tech sector of our economy. We are hurtingand I represent the Los Angeles area. I am not from the Silicon Valley, but we know that this has been broadening all across the country.
This morning I was listening to National Public Radio, and they were talking about a program that is going on today on the technology sector right here in the District of Columbia. We know we have the corridor going out to Dulles Airport. It has grown all over. There are start-up companies that need to have an incentive to continue to pursue their work, and we all recognize that there has been a problem of corporate abuse. I mean, there is no secret about that whatsoever.
Page 15 PREV PAGE TOP OF DOC That is why I believe empowering shareholders and investors with more information as to what the policy is rather than putting into place a policy which frankly not FASBI don't believe FASBbut there are some forces out there, Mr. Chairman, that have as a goal the complete elimination of stock options, and to me that would do more to undermine the entrepreneurial spirit for existing companies as well as those start-ups than almost anything else.
Chairman BAKER. I thank the gentleman.
I think much of the comment is based on the presumption that when an option is granted the only way that thing is going to go is up. There hasn't been a lot of discussion about the consequences of when things go in reverse, and I think that is an area where we need to do a lot of examination.
Mr. DREIER. We have certainly seen that.
Chairman BAKER. I have no further questions but just want to thank both of you for your testimony and participating in this hearing this morning.
Mr. KANJORSKI. Thank you, Mr. Chairman.
An interesting history lesson Mr. Dreier gave us, 1,500 years of perhaps incorrect analysis of where we were. I wonder if that applies to the
Mr. DREIER. I wouldn't say perhaps. I don't think thatwe still think that the earth is the center of the universe.
Mr. KANJORSKI. I know there are some members of this committee, Mr. Dreier, that may be flat-earthers that don't overargue that point.
Mr. DREIER. They didn't believe there was a flat earth, actually, aboutthat is another misnomer, if you want to continue the history lesson.
Mr. KANJORSKI. But it just raises the question that there is a large, compelling thought that tax cuts will stimulate the economy by a large element. So that theory may also be tested sometime in the future.
Page 16 PREV PAGE TOP OF DOC Mr. DREIER. Well, it worked under President Kennedy and it worked under President Reagan and it worked under President Harding and I think that it will work under President Bush.
Mr. KANJORSKI. Well, if we assume that that is whatthe compelling reasons for the successes of those economies, but we will argue that another day.
There has to be a middle ground here. Certainly I don't think we should take it upon ourselves to make a judgment as to what the proper tools to stimulate the economy, encourage entrepreneurial activity is, but, on the other hand, we have seen that in some instances stock options have led to abuses which have caused problems which have put investors at risk, just as off-shore deals in Enron caused a great deal of problem.
I just looked at a paraphrase that I was going to ask two congressional witnesses, particularly Mr. Barrett of Intel, who will be on the next panel. He suggests certain conditions under which we could establish a rhyme or reason how you look uponif you have had an opportunity to know what his position is and how you look upon his thoughts ofmaybe I should relate it to all employee stock option plans should be approved by shareholders. No more than 5 percent of the options should go to the top executives, while permitting substantial majorities of employees to participate. Companies should provide more frequent and understandable disclosures. Options should vest over longer periods, like 4 years, and compensation committees should be comprised of outside directors. Finally, he argues that expensing options under the Black-Scholes technique is inherently inaccurate.
Do you have any thoughts on his proposals?
Mr. DREIER. Well, I don't know that he is proposing actually mandating all of those provisions. I believe that the policies that a company moves ahead with are policies which clearly should be disclosed to shareholders. That is the goal that Ms. Eshoo and I have with our legislation here.
Page 17 PREV PAGE TOP OF DOC I know that there areand I am not going to speak for any of the other witnesses who are going to be coming forward, but I know that there are some of the panelists who are proponents of expensing who actually believe that Black-Scholes should not be the guide here, just as Mr. Barrett points out in his statement. But I think that, again, empowering investors, shareholders with as much information as possible as to what that company's policies are, if they choose to expense, they clearly should be able to do that. We just want with our legislation to have as much information made available as possible so that they understand the impact that it will have on the value of their investment.
Ms. ESHOO. To the distinguished ranking member, I think that Mr. Dreier has covered that well. I would just put out on the table a couple of other thoughts, and that is that, again, the term stock options having become sullied, and I think that the way perhaps you look at this legislation should be that we are establishing a firewall so that the broad-based is not wiped out.
When you think of the companiesand wethere was a lot of debate and reference to the companies that were involved in the scandals. You didn't read or hear about those that did broad-based stock options as being part of that mess, most frankly; and I don't think you can point to an employee stock option anywhere in the country that has been abused or is the source of some kind of scandal. So it is something that I think Republicans and Democrats alike should be looking to protect. This is for extraordinary, ordinary people. We are not talking about the top. We are talking about what goes across a company, whether it is small, medium or large. So I think the appreciation of what they are should be what is kept in the forefront and what it does for our overall economy.
This one-size-fits-all accounting standard that is being proposed by FASB is what is going to wipe it out. We are saying don't let that take place, and I think the ideas thatand I think it is important that the scandal that ripped through this country that lessened the confidence of the American people to invest, that those that head up companies and corporations certainly should be coming forward with ideas about how to create greater transparency and such, and we have some of those things built into the bill.
Page 18 PREV PAGE TOP OF DOC Mr. KANJORSKI. Thank you, Mr. Chairman.
Chairman BAKER. Chairman Oxley.
Mr. OXLEY. Thank you, Mr. Chairman.
Let me first welcome our witnesses, particularly our good friend, the Chairman of the Rules Committee, the distinguished Chairman of the Rules Committee.
Mr. DREIER. Nice to be on this side of the table.
Mr. OXLEY. Yes.
And to my former colleague from the committee across the hall, we are glad to have you with us as well; and we are glad to have an opportunity to provide a forum for this most interesting issue. It has been my experience that after passage of Sarbanes-Oxley that the perception out there, right or wrong, is that somehow by expensing stock options you have got a silver bullet that would somehow end all of the problems that we have had in corporate America, and obviously you have been around long enough to know that it is not that easy, and it is a far more complicated than that.
Let me ask both of our congressional witnesses to respond. Greg Barrett, the Intel Chief Executive Officer, is going to be on our third panel; and reviewing his statement, he says that mandatory expensing of stock options means that stock options ultimately will only be offered to the most senior managers, if at all.
From your perspective, is it good public policy to go in that direction? And what does that say about rank and file workers and the potential for growth in the economy and particularly attracting those kinds of workers?
Mr. DREIER. Well, thank you very much for that question, Mr. Chairman.
I think that we have tried to make it very clear here. I am not going to worry about the compensation of executives. I mean, these men and women are very smart, shrewd, capable people. They are going to figure out how to get compensated.
Page 19 PREV PAGE TOP OF DOC But if we move towards expensing, which jeopardizes the potential for growth in so many of these companies, my fear is that what will happen is that the Deborah Nightingales of the world will be the ones who will not have the incentive that is necessary to continue with this creativity.
Remember, Mr. Chairman, I mean, our quality of life and the number of jobs that have been created have been tremendous. Our quality of life has been improved because of technological advances that we have seen.
Deborah was just talking about the very important national security, the armed services aspect of this in dealing with the war in Iraq. We know that so many of the things that we enjoy have come from this, and the idea of squelching this creativity among rank and file employees I think would have a devastating impact on both job creation and our quality of life.
Ms. ESHOO. Mr. Chairman, first, let me thank you again for your leadership and your working with us to create this forum and examine this issue, which is really so important to the economic life of our country, healthy economic life of our country.
I think that any suggestions that corporate leaders have, both Mr. Barrettthat the committee should pay close attention to it. I mean, this is all about ideas on how to create better transparency and to continually rebuild the confidence that the American people have ultimately in our markets and the system that we have. I mean, that is the coin of the realm. That is why we have the broadest, deepest markets in the world. If there is anything that we have worried about is what the scandals did to affect the average investor, and we know that we have many average investors in our country today.
So on what any of the ideas are, certainly pay close attention to them for more transparency and increasing the confidence of potential investors and the investors that are there, but also I think that, again, we can'tI think at a timeI have almost 10 percent unemployment in my congressional district today, close to 10 percent unemployment, and this is the place more than any other place in the country that fuels our national economy. Why would we choose to take something that has been an overwhelming success with employees, broad-based stock options, and cast it aside today, I really don't know.
Page 20 PREV PAGE TOP OF DOC I think the Congress can accomplish two things: higher transparency, better transparency and the protection of these broad-based stock options. I think we can do both. I think we can accomplish both.
Mr. OXLEY. Thank you.
Mr. Chairman, let me commend you for putting together an all-star group of witnesses today, and we look forward to the testimony of the other panels as well. But we appreciate our colleagues, particularly Ms. Nightingale, to have you with us today, and I yield back.
Chairman BAKER. Thank you, Mr. Chairman. We appreciate the courtesy of your attendance as well.
We will go regular order. I just havenote that we have a number of members who have expressed an interest in questions, and we do have a couple of more panels of prominence this morning. So I will go down the order by time of arrival and certainly want to be recognized, but the courtesy of brevity will be most appreciated and noted.
Mr. GONZALEZ. The simple question is, who will determine the methodor the manner of methodology? Is it going to be FASB? Is it going to be the SEC? Is it the new accounting board? Because the final analysis, whether we wait 3 years or not, if we disagree with the findings or the determination of FASB, what are the options?
Mr. DREIER. Well, let me just say that our goal with the legislation is very clearly just to have each company provide whatever structure they have in place for their handling of options, have that information becomebe made available to the investors who are out there, to the shareholders. That is our goal with this legislation. That is why it is called the Broad-Based Transparency Act.
Ms. ESHOO. Well, what the bill calls for is for the SEC to examine how the higher transparency that is called for in the bill actually works, and that is very important. I think for those of you that may not be absorbing the message that Chairman Dreier and Debbie and myself are here to talk about today, I think it is very important that the SEC examine this. We really should have a definitive statement based on a good, solid period of time to understand what this means to our economy and also what the greater transparency would bring about, and the bill provides for that.
Page 21 PREV PAGE TOP OF DOC Mr. GONZALEZ. And at the end of 3 years if FASB remains in their position today?
Ms. ESHOO. Pardon me?
Mr. GONZALEZ. What happens is they come out with the same methodology whether you wait 1 year, 2 years or 3 years. Are we going to have someone trumping basically FASB?
Ms. ESHOO. Well, I think that it is very important to build into this something that FASB does not do, and they have stated that, and it is fair enough for them to state that they do not include economic considerations in their considerations for accounting standards. They stop at accounting standards. They do not take into consideration economic impacts. That is where we come in, and that is why we have built what we have built into in the bill.
Mr. DREIER. Obviously, Mr. Gonzalez, this is something that will continue to be addressed as we go down the road. We just believe that right now it is important for us, recognizing, having put into place the Oxley-Sarbanes legislation, we need to ensure that we don't throw the baby out with the bath water. We want to do everything that we can to make sure that the Deborah Nightingales of the world still have opportunity. That is our goal.
Mr. GONZALEZ. Thank you very much.
Chairman BAKER. Thank you, Mr. Gonzalez.
Mr. SHAYS. Mr. Chairman, in the sake of moving forward, I happen to agree with my colleagues and understand where they are coming from. I thank you for being here, thank you and would defer questions.
Chairman BAKER. Thank you for your insight, Mr. Shays.
Page 22 PREV PAGE TOP OF DOC Mrs. MCCARTHY. I thank my colleagues. Again, my question was actually already answered the second time around, so I will pass on to the next speaker.
Chairman BAKER. Thank you very much.
Mr. GREEN. Thank you, Mr. Chairman.
Mr. Chairman, I am interested in hearing from the next panel, so in the interest of time I will pass as well.
Chairman BAKER. Thank you, sir.
Mr. EMANUEL. This is a question for both Members. Have you found any difference between a start-up company and its use of options to recruit talent versus an established company that is already a NASDAQ-listed company and its use of options where they permeate throughout the company from top management down and howbecause I have heard in your presentation, obviously, the importance of options in the sense of recruiting talent, but where does that exist for a company in the early studies today versus a start-up, versus an established company listed on NASDAQ, et cetera?
Mr. DREIER. Well, it is a very good question, Mr. Emanuel; and I will tell you that I believe that both are equally important. Obviously, when we think about the technology sector of our economy, we think about the amazing success stories, created from absolutely nothing over a relatively short period of time, ultimately being job creators and then, as I was saying to Mr. Oxley, improving our quality of life, our standard of living. So the real attention is focused on those new start-ups, but this is obviously something that you are going to be hearing from Mr. Barrett in his testimony about the impact that mandatory expensing could have on a large company which is out there, still very creative, but obviously it would have a greater impact on a larger number of people, a detrimental impact on a larger number of people than the potential that exists with the start-up companies.
Page 23 PREV PAGE TOP OF DOC Ms. ESHOO. I agree with Chairman Dreier. I think it is importantand you already know thisthat just as your children are small and they grow, these small companies have grown in relatively short periods of time.
Mr. EMANUEL. You are not suggesting I give options to my kids.
Ms. ESHOO. Well, you have a real investment in them. That is for sure.
I would suggest to members that they get a copy of this book, In the Company of Owners, and it says why every employee should have them. I think it is the most definitive look at stock options. It is by Joseph Blasi, Douglas Kruse and Aaron Bernstein; and if any of you have questions on where to get it or wherever, I can tell you about it.
Mr. DREIER. You can get it online, is where you can get it.
Ms. ESHOO. Well, it may have been sent to Members as well. If it is sitting in your office, take it home, because this will be highly instructive to you and goes to the heart of many of the questions that have been asked, both in terms of small companies, large, how they would be affected. They all have employees, and I think that the story over the last decade of what broad-based stock options have done, both in the offering of them and the growth of companies, is pretty clear.
I think that Debbie wanted to add something to this.
Ms. NIGHTINGALE. Thank you very much.
I just want to add that, living and working in Silicon Valley, I definitely have seen and had a perspective of friends and peers of mine that have taken that big leap and gone off to work for a small company that has offered them a bunch of stock options. They leave a larger-paying job to go to a smaller-paying job to go off and be entrepreneurs and take that chance.
In addition, though, I would say, as an employee of Sun Microsystems, Sun at one point not too long ago was one of those little start-ups. It is now a very big company. But working within a big company, I think the stock options absolutely have a role as well. Because big high-tech companies that don't keep innovating go out of business. The history books show lots of examples.
Page 24 PREV PAGE TOP OF DOC So while I might have a little bit more security working for Sun Microsystems, if myself and my peers and everybody else does not keep innovating and keep taking chances then Sun is in trouble. And it is really because of those stock options, as I mentioned in my testimony that we go the extra mile. You know, I could just sit by, easily doing my job, keeping the boss happy, not really taking that risk, but instead myself and my peers absolutely will go the extra mile, work those 60, 70, 80-hour weeks that we are not being paid for because we stand to benefit a lot if these stock options become of great value.
Chairman BAKER. Thank you, Mr. Emanuel.
Mr. OSE. Thank you, Mr. Chairman.
I want to welcome our witnesses here. I am ordinarily on the other side of this discussion from the Chairman, so it is good to see you. Ms. Eshoo, nice to see you. Ms. Nightingale, Lieutenant Colonel, welcome.
I think at the heart of this legislative proposal is the issue of mandating a certain treatment for these stock options, and at the heart of that question is how do you go about valuing them. One of the things that I struggle with, which I would appreciate your input on, is whatever system you use for valuating these stock options, whether they be narrowly or broadly distributed, there are assumptions underlying the valuations. Is it your concern that the assumptions, say, under a Black-Scholes method or some iteration of that, is it your concern that the assumptions will be as inaccurate, perhaps, as the current levels of disclosure might be?
Mr. DREIER. Absolutely. I mean, that isI think that it is virtually impossible to make a determination as to exactly what that value is; and, as I say, the only impact that really is going to come here upon exercise of those options is ultimately diluting the value of that stock. That is why our goal here is to focus on the shareholders, the investors to provide them with as much information as possible.
Page 25 PREV PAGE TOP OF DOC Ms. ESHOO. I think it is important to note that in the Sarbanes-Oxley legislation that executives are now required in a very clear anda clear and strict manner to report under penalty of law whatyou know, their statement of financial health of the company, and they are held responsible for that.
Now, if in fact you add to this the mandatory expensing of options and you cannot predict what the value of those options are going to be, what does that do to Sarbanes-Oxley? What does it do to people that have to report as that law requires? So it points to the weakness I think of the FASB proposal in that it is next to impossible to state what the value thatthe value of those options are going to be, and I think it is an intrinsic weakness of what the proposal presents. In real life, I don't know how these executives are going to be able to, as I said, stay true to and remain whole and legal, so to speak, under Sarbanes-Oxley in the obligations that they have as a result of that law.
Mr. OSE. If I might recast Ms. Eshoo's remarks, I think this exactly pinpoints the problem here. We are potentially criminalizing by mandate assumptions having to do with future interest rates, future discount rates, future earnings, future inflation, future changes to market conditions and the like that no one from Mr. Greenspan to Mr. Buffett to Mr. Baker or Mr. Ose can accurately predict, and this is a horrendously questionable approach, notwithstanding our desire to disclose to the investing public what it is they need to understand in these financial statements. I just want to be clear. We are potentially criminalizing mistakes on assumptions made in valuing these options that no one can predict with certainty out into the future.
Thank you, Mr. Chairman.
Mr. DREIER. Thank you, Mr. Ose, for being a cosponsor of our legislation.
Chairman BAKER. Thank you, Mr. Ose. I don't know about Mr. Greenspan or Mr. Buffett, but you certainly were right with regard to forecasting my abilities.
Page 26 PREV PAGE TOP OF DOC Mr. Scott.
Mr. SCOTT. Thank you very much, Mr. Chairman.
I would just like to ask a question of my distinguished colleagues, Ms. Eshoo and Congressman Dreier. On the stock options, do you believe that stock options provide appropriate incentives to executive employees, number one? And, secondly, do you believe that stock options should be spread out among employees other than executives or that executives should have only a certain percentage of their compensation in stock options?
Mr. DREIER. Well, those are good questions, Mr. Scott. Thank you for them.
I will say that, as Mr. Kanjorski pointed out in outlining Mr. Barrett's testimony that you will be hearing in a few minutes, he talks about a level of compensation that executives should receive as far as options are concerned; and, as I have said, I am not concerned about the compensation that executives get. I mean, they are going to figure out how to be compensated. My concern is that this proposal could jeopardize the opportunity for the Deborah Nightingales of the world, the rank and file employees who are coming up with these innovative, creative proposals to succeed, and that is really what I think we are getting at here.
So the answer to your question, sir, yes, I want to make sure that we have these options made available to those who are working on the front line in these companies. I think that is a very, very important thing, and that is part of the incentive, as Deborah just said. People who are actually in reasonably high-paying jobs, they will take a lower level of compensation to go to a start-up company with options being made available so that they can be part of that engine for growth.
Mr. SCOTT. Thank you.
Ms. ESHOO. I think, to my colleague and friend, that it is important to note that in H.R. 1372 that we call for a summary of stock options granted to the five most highly compensated officers. I think that that is very important not only for investors and potential investors but for everyone in a company, in an organization to know who has what and how much of it. I don't think that information was readily available in many of the companies that brought about and participated in the ruination, really, of many people's lives in the country and the companies that they worked for. So I think that is a very important consideration.
Page 27 PREV PAGE TOP OF DOC There may very well be coming from this committee and from outside the Congress some even better ideas for transparency, and I think that we shouldI know that Mr. Dreier and I are open to that, and also the members of the committee as well, because this is all about a delicate balance. And I have respect for FASB. I don't think that they are in the business of writing accounting standards, and I respect that, and I have in the past with legislation where I didn't direct them to do anything, but I thought it was the responsibility of the Congress on economic issues to step in.
So, yes, this is important and should be protected for rank and file for the broad-based organizations, those that are a part of it, but I also think thatand we know what we have built into the bill, and that is why I restated.
I think thatI hope we have, you know, answered your questions. They are very good ones, and we have to keep being sensitive to that. It is not just because we are in the aftermath of these scandals. I think what the scandals have taught us is that we better very well take care of the investing public. Otherwise, no matter what is on the stock market, they are not going to want to go near it.
Ms. ESHOO. These options and what they represent to people are a very important part of that mix.
Mr. SCOTT. Thank you both very much.
Chairman BAKER. Thank you, Mr. Scott.
Mr. ROYCE. Thank you.
Chairman Dreier, I think your point is the question of whether we are really making financial statements more precise, if they are really going to be more accurate if we are forced to adjust the actual earnings by inputting noncash charges derived through a flawed model in there, into the income statement. And I guess your position is that because the supporters of this Black-Scholes model say at best it is kind of right, it is in the ballparkand detractors, of course, say it is way off the markthat instead you want publication of shared dilution in financial statements in plain English and that that is going to objectively reflect how stock options are going to impact shareholdings, is that your position?
Page 28 PREV PAGE TOP OF DOC Mr. DREIER. Exactly. You got it exactly right.
Mr. ROYCE. The thing I have a harder time understanding is, when you mandate charts and graphs on the part of the SEC in order to show the dilution effects, would you have any mock-up or would you have an example of what you have in mind with respect to how you are going to convey that?
Mr. DREIER. I don't know what it would consist of. I can't tell you what it would consist of.
Mr. ROYCE. The SEC is going to basically make that interpretation.
Mr. DREIER. Clearly will do that.
Mr. ROYCE. Well, thank you, Mr. Chairman.
Chairman BAKER. Thank you, Mr. Royce.
Mr. MEEKS. Thank you, Mr. Chairman.
I want to thank my colleagues. This is one of those occasions when you come to a hearing where you are completely undecided. I am completely undecided, and the information that you have provided is very valuable to me to come to a determination because I think it is absolutely important for the American public that we bring back some integrity into our system.
My question just went along the same lines of Representative Scott. You know, I understand the transparency issue, and I think that it is important. I understand that we don't need to throw the baby out with the bath water. The whole thing with executive pay as to maybe limiting it to something, I want to hear the rest of the testimony. Because it seems to me that those top executives, particularly the CEO, the CFO, would be the ones that would have the ability as well as the motivation, even though you may have transparency issues there, to try to manipulate the value of those stock options to their benefit because they have it; and that becomes the key, is to being sure that someone does not manipulate the value of it so that you have it falling through the bandwagon.
Page 29 PREV PAGE TOP OF DOC The question I have is, basically, within the bill, is there any way, any disincentive in the bill to prevent the top executives fromyou know, other than maybe eliminating them having the possibility of having stock options so they won't manipulate the value of it to their benefit?
Mr. DREIER. Well, I mean, I will just say to you that I believe that everyone who is involved in a company should have the opportunity to benefit. Again, I argue that the threat of mandatory expensing will not hurt in any way the plans for compensation for those executives, Mr. Meeks. The people who will be hurt by expensing and those who are moving down the road and some who, as I said earlier, support the actual elimination of stock options, it will be the rank and file employees will be hurt.
The reason I say it is that the executives of these companies will continue to find other ways to be compensated. And I don't think that we should stand in the way of their being compensated. I mean, I am not one who is a proponent of dictating exactly what the salary level should be for executives. I think that should be determined by the boards of directors and the shareholders. But I think that empowering people with as much information is as far as I happen to believe we should go.
I want to thank you for being a cosponsor of our legislation, too.
Ms. ESHOO. To my colleague, Mr. Meeks, you asked I think in many ways the $64,000 question. I think it is important to keep in mind that stock options in and of themselves did not cause the scandal. It was, as you pointed out or touched on, the manipulation of the statement of earnings and all that followed, which really goes to the heart of what Sarbanes-Oxley was all about. That is what that legislation sought to correct. There is now appropriate and enormous burdens, as it were, which need to be borne legitimately by those at the top of a company where they sign off in terms of the accounting and everything that goes with it and file those statements with the SEC. That is an enormous change and I think is a very important and healthy one to take.
Page 30 PREV PAGE TOP OF DOC But this accounting standard as expressed by FASB I think, and I don't know want to keep repeating it, is so detrimental to what stock options, the broad based for the employees, would do; and that is what we are seeking to protect.
I am just as outraged as you and all the members of the committee, the Congress and our constituents over the abuses. There is no way to defend the indefensible, and that is what that legislation directed itself toward. We want to build on some of the things that we think can and should be accomplished for more transparency. But I think it is a very clear case of what we really should protect and not cast overboard.
Mr. MEEKS. Yield back.
Chairman BAKER. Mr. Gary Miller.
Mr. MILLER OF CALIFORNIA. Thank you for being here. I am a cosponsor of the bill, so I do support it 100 percent.
I agree with you. Executives are going to be taken care of. It is the rank and file that generally get left behind, if anybody.
It is a great bill. I support it. I am looking forward to the next panel.
Mr. DREIER. Thank you for your support, Mr. Miller.
Chairman BAKER. Mr. Crowley.
Mr. CROWLEY. I thank you, Mr. Chairman. I will be very brief as well.
I want to thank my colleagues for testifying today, Ms. Nightingale for her testimony. Most impressed, especially you, Ms. Eshoo, in terms of impact on your district, what this means in terms of job loss, a district that is experiencing a great deal of job loss in this current crisis.
I had the opportunity of being in India last year talking about the need for the Indians to be more transparent, to encourage more investment by the United States investor and at the same time having to defend our own system here because of Enron, a company that had considerable trouble gaining a contract, putting a contract to rest in India. There is still a great deal of bad taste in the mouths of many Indians, especially the government. So I do think it was interesting to be talking today about the need for transparency.
Page 31 PREV PAGE TOP OF DOC I agree 100 percent that the more the investor knows about what the stock options are, especially of the top executives, but also the employees themselves of the company, the more they know about that as well, I think the broader and more light of day that is shown on this issue can have a major impact as to the actions of those who would try to manipulate the value of those stocks to defraud the company, to defraud the people who work there but, more importantly, to defraud the American investor, the mom and pop who are now engaged in the stock market like never before.
So I appreciate all of your testimony today, especially you, Chairman Dreier. I want to make sure I made the point that the Chairmanappreciate having you in front of us as well.
Mr. DREIER. You sound like a co-sponsor of our legislation.
Mr. CROWLEY. Well, not as of yet. But the option is always open, so we will talk about it.
Chairman BAKER. Mrs. Kelly.
Mrs. KELLY. Mr. Chairman, I have no questions for my colleagues. I appreciate their testimony today.
Chairman BAKER. Thank you very much.
Ms. HOOLEY. Hopefully, a quick question to my colleagues. Thank you for being here today, talking about this issue. I think it is an important issue for many of the companies.
The question is, if we are going to provide transparency informationand I absolutely believe we need to do thatare we going to treat companies differently if only the executives get stock options as opposed to a company with broad-based stock options?
Page 32 PREV PAGE TOP OF DOC Mr. DREIER. Well, I just say that that is information that would be made available to the shareholders; and, quite frankly, it is my view that I would rather be invested in a company that provides options to the Deborah Nightingales of the world who are going to come up with the creative proposals that will ensure the success of that company than I would simply to the executives of the company.
Ms. ESHOO. It is a good question. The legislation doesn't change what you describe. In fact, I think today we probably have more companies in the country that do not offer broad-based stock options, but it is growing, and that is why we want to protect it. It is an important tool. But it doesn'tthe legislation doesn't differentiate between the two.
Ms. HOOLEY. Thank you. I yield back.
Chairman BAKER. Thank you, Ms. Hooley.
Mr. INSLEE. Thank you.
I want to thank the sponsors for their work. Because we sat through scores of hearings in this room following the Enron collapse and the like. I can't think of a case where this really would have solved the problem that caused those collapses, and I think it is important not to let our justifiable concern about those defaults lead us to something that may not get where we want to go.
I want to thank you, particularly, Ms. Eshoo, your comment about there are better ways to go about this, particularly looking at shareholder approval, which is important to these issues. I hope we go in that direction. Thank you.
Chairman BAKER. Mr. Kanjorski.
Mr. KANJORSKI. I request a statement be made for the record by Congressman Pete Stark. It is included together with his statement, an analysis and letters and a bill.
Page 33 PREV PAGE TOP OF DOC Chairman BAKER. Without objection. Thank you, Mr. Kanjorski.
[The prepared statement of Hon. Pete Stark can be found on page 86 in the appendix.]
Chairman BAKER. There being no further questions of this panel, I want to express my appreciation to you for your time committed to this hearing. It has been very valuable to the committee.
Mr. DREIER. Thanks again for holding this hearing. I know you will get some very interesting input from the next two panels, and we look forward to the conclusion that you will draw on that.
Chairman BAKER. Look forward working with you.
Ms. ESHOO. Thank you very much to your legislative hospitality, to the ranking member and to all the members that came to this hearing today, I think speaks highly of the committee that there would have been the kind of participation that we saw here today. Thank you very much.
Chairman BAKER. We have a total of 47 members on the subcommittee. We had in excess of 30 here today, which speaks to, I think, the importance of the issue. Thank you for your courtesy.
Ms. ESHOO. Thank you.
Chairman BAKER. At this time, I would ask our next witness to come forward, Mr. Rob Herz. It is my pleasure to welcome as our next panelist Mr. Robert Herz, Chairman of the Financial Accounting Standards Board. Welcome, sir.
STATEMENT OF ROBERT H. HERZ, CHAIRMAN, FINANCIAL ACCOUNTING STANDARDS BOARD
Page 34 PREV PAGE TOP OF DOC
Mr. HERZ. Thank you Chairman Baker, Ranking Member Kanjorski, and members of the subcommittee.
As you said, I am Robert Herz, Chairman of the Financial Accounting Standards Board. I am very pleased to appear before you today on behalf of the FASB.
I have some brief prepared remarks. I would respectfully request that those remarks and the full next of my testimony and all supporting materials be entered into the public record.
Chairman BAKER. Without objection.
Mr. HERZ. The FASB is an independent private-sector organization subject to oversight by the U.S. Securities and Exchange Commission. Our independence from enterprises, auditors, and other constituents is fundamental to achieving our missionto establish and improve standards of financial accounting and reporting for both public and private enterprises. Those standards are essential to the efficient functioning of the capital markets and the U.S. economy because investors and other users of financial reports rely heavily on credible, transparent, comparable and unbiased information to make rational resource allocation decisions.
Our work is designed to provide investors and the capital markets with the most useful yardstick to measure and report on the underlying economic transactions of business enterprises. Like investors, Congress and other policymakers also need an independent and objective FASB to maintain the integrity of a properly designed yardstick in order to obtain the financial information you need to properly assess and implement public policies. While bending the yardstick to favor a particular outcome may seem attractive to some in the short run, in the long run a crooked yardstick in the form of a biased accounting standard is harmful to investors, to capital markets, and the U.S. economy.
Page 35 PREV PAGE TOP OF DOC In March of this year, at a public meeting, our Board unanimously decided to add a project to its agenda to address issues relating to improving the financial accounting and reporting for stock-based compensation. That decision was based largely on three factors:
First, the high level of concern expressed by individual and institutional investors, pension funds, mutual funds, creditors, financial analysts and other users of financial statements, as well as America's trade unions, consumer groups, the conference board's Commission on Public Trust and Private Enterprise, and the major accounting firms about the need to improve the reporting for stock-based compensation, in particular the need to eliminate the narrow but often used exception for so-called fixed plan employee stock options, which are the only form of stock-based compensation that is not currently reported as an expense in the financial statements.
Secondly, the growing noncomparability and, thus, potential lack of transparency created by the alternative accounting treatments presently available for reporting stock-based compensation which has been magnified by the recent trend of hundreds of major U.S. companiessometimes as a result of shareholder resolutions and votesto adopt the voluntary expense recognition provisions of our 1995 standard.
And, third, the opportunity to achieve convergence to a common, high-quality global accounting standard for stock-based compensation. There is no subject on our current agenda on which we have received so many strong and heartfelt calls for action. They go beyond the abuses of executive pay to just plain wrong accounting.
In April, the Board began its initial public deliberations to consider improvements to the recognition, measurement and disclosure of stock-based compensation. To date, we have held four public meetings and have reached certain tentative conclusions.
In the coming weeks and months, at public meetings, the Board will continue its deliberations of the many issues relating to this project, including the measurement issues and special issues related to private companies, to start-ups, to venture-backed companies. The Board's public deliberations of the issues will be systematic, thorough and objective. The deliberations will benefit from a review and analysis of the vast amount of research and other literature in this area. The deliberations will also benefit from the ongoing input of our constituents, including the advice of leading valuation and compensation experts that we will consult with throughout the entire process.
Page 36 PREV PAGE TOP OF DOC We currently plan to be in a position to issue a proposalwe have not issued anything yetfor public comment in the fourth quarter of this year. Any proposal would have to be approved by an affirmative vote of the majority of the Board. The proposal would be exposed for an ample public comment period so that all interested constituents will have the opportunity to provide detailed responses. The Board will also consider whether to hold public roundtables or public hearings to solicit additional input on the proposal.
Prior to making any final decision on any changes to the accounting for stock-based compensation, the FASB would consider at public meetings all of the input received in response to the proposal. The Board would not issue any final standard until it has carefully considered at public meetings the views of all constituents. Like any proposal, any final standard would have to be approved by an affirmative vote of the majority of the Board.
We have reviewed H.R. 1372. We note that, if enacted, it would impose a more than 3-year moratorium on any FASB improvements to the financial accounting and reporting for stock-based compensation. We strongly oppose H.R. 1372 for a number of reasons.
First, the moratorium would unduly intervene in the Board's independent, objective and open process to make unbiased decisions on the substance and timing of improvements to the accounting for stock-based compensation. Such intervention would be in direct conflict with the express needs and demands of many investors and other users of financial reports. Such intervention would also appear to be inconsistent with the language and intent of the Sarbanes-Oxley Act and the related and recently issued SEC policy statement reaffirming the FASB as the Nation's accounting standard setter.
Second, the moratorium would have an adverse impact on the FASB's efforts to achieve timely convergence of high-quality global accounting standards on stock-based compensation. The FASB is actively working with the International Accounting Standards Board and other national standard setters in an effort to achieve convergence in this important area and in many other important areas. The moratorium would likely hamper those efforts and again appears inconsistent with the language and intent of the Act and the related SEC policy statement, both of which explicitly encourage international convergence.
Page 37 PREV PAGE TOP OF DOC Finally, and perhaps most importantly, the moratorium would establish a potentially dangerous precedent in that it would sent a clear and unmistakable signal that Congress is willing to intervene in accounting standards based on factors other than the pursuit of appropriate accounting. That signal would likely prompt others to seek political intervention into future accounting standard activities.
We have all witnessed the devastating effects and loss of investor confidence in financial reporting that have resulted from companies intentionally violating or manipulating accounting requirements. What impact then on the system and on investors' trust in financial reports might there be if it were perceived that accounting standard setting was being deliberately biased toward the pursuit of particular objectives other than those relating to appropriate financial reporting or that the FASB was being blocked from pursuing timely improvements in financial reporting?
For all these reasons, again, we strongly oppose H.R. 1372 and any other legislation that would seek to undermine and impair the Board's independent, objective and open standard setting process.
Again, thank you, Mr. Chairman. I would be happy to respond to any questions.
Chairman BAKER. Thank you, Mr. Herz. I appreciate you being here this morning.
[The prepared statement of Robert H. Herz can be found on page 113 in the appendix.]
Chairman BAKER. I have a series of questions that go really to a broader issue. The question of valuation of stock options is a very fine point on a big platform of issues. It would be my view that if you go back over the past 24 months and look at the volatility of the NASDAQ and require an individual to value the options granted to employees and then look at the value of those options 89 days later, it would be a very difficult calculation to know which way the wind was blowing.
Page 38 PREV PAGE TOP OF DOC On the other hand, the underlying argument for additional transparency and the ability of the prospective shareholder to understand the current valuation of a corporation is something no one could possibly object to. It would seem the current retrospective rules-based system that is based on the reporting paper data on a 90-day trail gives a false impression of understanding corporate performance. Have you or has the agency explored extensible business reporting language as a platform on which to have a real-time market performance analysis where an empowered shareholder could at the close of business on a daily basis not only look at options but look at the loss of a particular customer, look at the loss of a supplier, the award of a big contract?
If we are trying to eliminate volatility, you have to do what large corporations do in this country on a daily basis: At the close of business, look at your risk, look at your assets and determine where you are. Arguing over whether we price options on a 90-day platform, given underlying market volatility, interest rate exposure, credit risk, if we adopted everything FASB proposes right now I wouldn't feel a bit better than I do this morning.
Can you respond?
Mr. HERZ. Yeah. Thank you. Very excellent set of questions. I think you had two main questions in there, one about the valuation of stock options, although that kind of led to another broader question.
You know, the issue of the valuation first, we are going to have a hard look at it. We are consulting with lots of experts. Our predecessors 10 years ago concluded that it could be appropriately valued, reliably valued
Chairman BAKER. Let me jump back in on that point on valuation. Whether we use binomials or Black-Scholes, if you had an extensible business recording platform, you could sit at your own PC Apple mainframe and say, the value today at the close of business Black-Scholes, value today binomial A, B, C. Then you could get all the variables because there isn't a single way to arrive at value, and the number of variables outside the formula assessment also vary. So you could plug in different valuables on different analyses and come up with a recommendation.
Page 39 PREV PAGE TOP OF DOC Now, the typical investor may not want to do that, but this is where you get back to turning to my local accountant and say, figure this out for me, as long as he has got the tools to do it. Shouldn't we be moving more in that direction?
Mr. HERZ. Well, let me continue. Thank you.
You know I am a big supporter of XBRL and expansion of business reporting. You know I was a co-author of a book called The Value Reporting Revolution: Moving Beyond the Earnings Game.
Chairman BAKER. I have read it many times.
Mr. HERZ. That is something that I think not only we but I think the whole private sector with I think some regulatory stimulus from the SEC needs to pursue. I agree with your point there.
The other point isand that would provide additional information. But there is a basic accounting system which keeps a base score on earnings, cash flows, other things. And all transactions, whether they be cash, whether salary, profit sharing, and all stock compensation transactions other than a narrow form of stock options are accounted for at fair value in the financial statements. They are scored that way in determining earnings.
And the issue of, you know, can you calculate the value of this particular instrument at a point in timeand those calculations take into account current data. They don't project future data. Take into account the current prices of stock, current interest rates and the like, and they calculate values. That is what underlies trillions of dollars of options trading markets. People trade in options, and there is a value at a point in time.
I agree that you can getlike you say, you know, you can plug it in, and you could get values every day and deliver them over XBRL, and that would be very informative. But that doesn't mean that the basic accounting information itself at the date of grant, the value of the date of grant consistent with all other stock-based compensation gets scored then.
Page 40 PREV PAGE TOP OF DOC Chairman BAKER. But that is like taking a photograph of your child while you are overseas and snail mailing it. By the time it gets to you, that is what your child used to look like. But that is not what he looks like today. He has got a buzz cut and a ring in his ear. I mean, things have changed.
That is my point. In dealing with reporting in business accounting we are still using a system built in many years ago. We are in the slide-rule era and people are using PCs at home.
Arguing this specific point, although understandably important in the overall assessment of business performance, I understand, but it goes to the broader issue of FASB's policy mission of advising the policymakers on our end, does the current system provide a responsive measure of corporate performance, given the decade we have just endured? I don't think anyone can say it does, particularly when we are trying to move to an international accord where there are considerable differences between a rules- and principles-based system.
Mr. HERZ. Well, I agree with you. But I think financial reports are an integral part, a very vital part, because they are the ultimate score, the ultimate feedback. All the other information, including the kind of information that I advocated in the value reporting revolution, is both supplementary and very complementary. You get a better picture through all of that.
Chairman BAKER. My time has expired.
I find it very difficult to focus solely on this issue, make a judgment that this is going to satisfy the information that is really needed in order to make an informed judgment when the presumption for this modification is that people can't make an informed judgment usingwithout modifying the current rule. Although it is not the obligation of FASB to be concerned about economic models, many of us in the Congress are very concerned about economic models and how we can encourage business growth. This goes right at the heart of that.
Page 41 PREV PAGE TOP OF DOC Mr. Kanjorski.
Mr. KANJORSKI. Thank you, Mr. Chairman.
Mr. Herz, I want to reiterate for the record you are an independent nonprofit organization. Is that correct?
Mr. HERZ. Yeah. We are independent, and under Sarbanes-Oxley we hope we have been made more independent through the mandated funding mechanism that now applies to both us and the public company accounting oversight board.
Mr. KANJORSKI. You are charged with establishing a single rule to apply for accounting purposes to public corporations. Is that it?
Mr. HERZ. Public corporations, private companies and not-for-profit entities.
Mr. KANJORSKI. It seems that our prior panel felt that this was above an accounting rule problem but goes to the essence of whether or not the economy survives and grows. Do you feel your organization is able to establish a rule for accounting purposes that will cause greater transparency for the investing public and not interfere with or in some way compromise the growth of the economy of start-up and high-tech companies?
Mr. HERZ. Yes.
A couple of points there. First, you know, we believe clearly that better accounting information adds to better decisions in the marketplace, better credibility in the marketplace; and that has its own huge economic benefits when you translate it over the whole overall economy.
Second, and, again, we are not looking per se at the macro issues, but I can't help but have noticed that the issue of stock options is, this particular instrument, according to the U.S. Bureau of Labor Statistics in the year 2000, which was apparently a banner year for the issuance of stock options by companies, was only granted to 1.7 percent of the total U.S. nonexecutive work force.
Page 42 PREV PAGE TOP OF DOC Thirdly, as I said, in terms of the private companies, start-ups, we are going to look at that separately, apart from the large public companies.
Mr. KANJORSKI. So that it is possible to take into consideration start-up companies and particular specialized high-tech companies, that they could get a different rule that applies to them as opposed to across the board?
Mr. HERZ. I can't speak for my fellow board members, but I think the distinction would be with companies that have an actively traded stock versus those that don't.
Mr. KANJORSKI. I am sort of amazed here today that after all these years it seems to me such a contested issue and the desire now to impose legislation to affect that. What is your general opinion as to what kind of a precedent this would set, that if the Congress adopts a particular piece of legislation to somewhat change the independence of FASB in establishing accounting rules?
Mr. HERZ. Well, I thinkas I said in my opening remarks, I think it would be a dangerous precedent, because we are constantly faced with groups that want to basicallythey have gotten comfortable with the existing rules and how they can then use those in their business transactions. Any time we want to move things forward by proposing change to get better accounting, closer to economic concepts, you know, we are often opposed by the people who would rather keep the status quo; and they will always argue economic consequences. I think the history of that would show that those usual dire predictions of major negative economic consequence were not borne out once the better standard was put in place.
Mr. KANJORSKI. Do you feel that we also have to take into consideration the international accounting standards that we are in competition with now in terms of the global economy and that, in effect, the rule that you are trying to put together and propose would take us closer to international accounting standards?
Page 43 PREV PAGE TOP OF DOC Mr. HERZ. Yeah. This issue, you know, was not only looked at by the FASB over the last 20 years, the last time 10 years ago, but it has been looked at by the International Accounting Standards Board and by accounting standard setters in many, many other counties; and everybody comes to a very similar conclusion about the accounting aspects of this. As I said, the IASB is ahead of us. They are intending to proposeissue their final standard later this year, probably around the time we just issue a proposal. The international accounting standards will apply starting 2005 for all of Europe. They are going to apply for Australia, New Zealand, Russia. They already apply for many other parts of the world that for years used international accounting standards. So to a certain extent we would be the odd man out.
Mr. KANJORSKI. Thank you, Mr. Chairman.
Mr. OSE. Mr. Shays.
Mr. SHAYS. Thank you very much, Mr. Chairman.
For the sake of honesty, I have to disclose that FASB is in my district. There are many things about FASB that I love and cherish. There is only one that I don't. That is it sometimes takes you all too long to act.
I am in a quandary because I believe we need to have better formation of capital, but I also believe that we need to have disclosure. I believe that that people need to know the facts. But what I am wrestling with is that this is an issue of valuation. In other words, by disclosing the stock option are weyou are only making moneyyou only take advantage of the option if the stock goes up.
I would also say to you I had a number of parents call me because their children had been given these glorious stock options which they never took advantage of but had to pay a significant tax on when the companies went out of business, which was a tragedy for these young kids who thought somehow they had a great future.
My question to you is, why are we acting now and why didn't we act 5 years ago?
Page 44 PREV PAGE TOP OF DOC Mr. HERZ. I think we arefirst of all, let methree issues, valuation issue, the issue of the stock price going down, and the option being worthless or deep out of the money, and then why are we acting now.
On the first issue, again, we are going to look at that very carefully. Again, the modelsand we have got lots of suggestions as to how to improve the valuation. Things come into our door every day. You know, again, the models that support the public option trading markets, whether it be equity options, interest rate currency options, commodity options and lots of other options, those models all support this trilliontrillions of dollars of trading in markets. The question is then can you apply those models to employee stock options because they have certain other features, including the forfeitures prior to vesting, nontransferability and other kinds of adjustments?
The issue is really what is the cost to the company. Because we are preparing the financial statements for the company. The accounting standards deal with the company's financial report.
Mr. SHAYS. You say what is the cost of the company or the value of the company?
Mr. HERZ. It is viewed to be, from the company's perspective, what is the value of the instrument that it grants. And that is the real issue. What is the commitment and hence the value of that instrument that is granted by the company unilaterally at that date, and how do you value that most reliably?
The third issue of why are we taking action now, because we have gotten hundreds of letters, e-mails, input from people, recommendations of many, many groups who have studied this to say that action needs to be taken. I think it has been prompted in the wake of thenot only the scandals but the market meltdown of people believing that the financial information was incorrect.
Page 45 PREV PAGE TOP OF DOC Mr. SHAYS. Is it also an issue of political pressure and is it also a question of, frankly, not knowing what to do?
Mr. HERZ. Is it an issue of political pressure in what regard?
Mr. SHAYS. Well, did FASB feel that for the last so many years that had they acted there would have been a fire storm that would have been difficult to contend with.
Mr. HERZ. Of course, I only joined July 1st. So I can only relate what people have told me. But certainly, after the experience of 10 years ago, I think FASB was a little gun shy and virtually, other than academics and some people who understood options, no one supported the FASB at that point. Now there are many, many parties who are not only supporting this change but have demanded it.
Mr. SHAYS. The bottom line is that there was somewell, part of it was being a little gun shy, as you say, and from your standpoint that no longer exists.
Mr. HERZ. I am not gun shy. I am careful, and I study things, but I am not gun shy, and I don't think my colleagues are.
Mr. SHAYS. So that issue is resolved.
The second issue is a reluctance becausemaybe not knowing what is the right thing to do. A lot of letters saying you need to act. Are you totally comfortable that your actions will be the right thing?
Mr. HERZ. Well, I have a lot of confidence in our process. As I said, we are early on. We haven't even gotten to a proposal yet, which is kind of what I always find amusing.
Mr. SHAYS. So your argument here is let us go through the process and let Congress evaluate what we have done.
Mr. HERZ. Exactly. We have a very rigorous, thorough and I believe objective process. We get input from everybody. We send out a proposal. We get wide comment.
Page 46 PREV PAGE TOP OF DOC Mr. SHAYS. How long is it going to take for that process to end?
Mr. HERZ. Our goal right now is to get a proposal out by year end. That would be out probably, my guess, for a 90-day comment period. We would probably hold some public roundtables. We then analyze what all the input is.
Mr. SHAYS. Thank you for your good work and the good work of your organization.
Thank you, Mr. Chairman.
Mr. OSE. [Presiding.] Mr. Gonzalez.
Mr. GONZALEZ. Thank you, Mr. Chairman.
Thank you, Mr. Herz.
I guess I need to frame the question a certain way. I love process. I love systems. I like predictability. I like to look at other certain boards or whatever that we look to for their expertise that set certain standards, that it is my understanding. At the present time, people are questioning whetherhow relevant your standards are going to be, that they don't really reflect the real world. I tend to lean in that direction. I guess I am like Galileo, who really didn't believe that the Earth was the center of the universe until the Catholic church had a talk with him. So while I await some religious experience, I am leaning over there.
You heard Congressman Dreier, especially Congressman Dreier, who basically made that analogy with what you are doing today. Do you share any of their fears, though? Is that what you are going to do, that you have some sort of accounting certainty in that pure world of accountants, which is wonderful in many ways, but what is the advantage, what is the benefit? Everything that we feared and that happened and we are trying to avoid, again the Enrons and the WorldComs, what you are going to do, according to a lot of people, and again I tend to agree with them, wouldn't have avoided any of those disasters or catastrophes. So what I am saying is, is there a real-world application with what you are about to do? And do you disagree with Congressman Dreier's opinion that this could be something that could be disastrous for many companies?
Page 47 PREV PAGE TOP OF DOC Mr. HERZ. Well, first of all, I also enjoyed Congressman Dreier's map of the world. I thought the conclusion was going to be that California was the center of the universe. But
Mr. OSE. The Chairman would instruct the witness that that is accurate.
Mr. GONZALEZ. Only if Texas supplies you guys with enough energy.
Mr. HERZ. I am in trouble because I am from New Jersey.
Mr. OSE. You send it. We are still not going to pay for it.
Mr. HERZ. Nobody from New Jersey here, huh?
The issue on pure certainty, and we are never purely certain, but I think our process comes up with the right accounting. And I think accounting is very important. There is a whole discipline to it, and there is a whole way we measure incomes, show balance sheets, show cash flows and the like.
I read those articlesor editorials yesterday in the Wall Street Journal, as you may have; and I know the two gentlemen quite well, Bennett Stewart and Peter Wallison because I have worked with them. Some of what they say I agree with, and some of it I don't agree with. In fact, the parts that I and others agree with at the Board, we have been moving aggressively to try and build more economic concepts into the accounting, more reflection of cash flows and the like.
You know, there isjust wanted tobecause I was struck by those works, and I particularlyI met with Bennett Stewart when he was developing his work last fall on Accounting is BrokenHere is How to Fix Ita Radical Manifesto. He suggests a number of adjustments to accounting, and one of the ones he suggests are stock option grants are an expense.
Page 48 PREV PAGE TOP OF DOC He says many corporate managers have found it difficult to understand that the cost of handing out options is an expense because they have collapsed two steps into one. An employee option grant is substantively the same as compensating the employee with cash, which is an obvious operating expense, and then compelling the employee to turn around and use the cash to purchase an option from the company for its fair market value. The true option expense is given by the option's fair market value of the date of grant. Once the option is outstanding, the employee becomes like any other equity holder and the gains and losses from exercising the option or letting it expire should not be recognized as a corporate expense or income item.
He goes on to expound as to why, you know, based on economics that is just the right answer. He has other adjustments. For example, he strongly argued about special purchase entities that they ought to be consolidated. Well, we took care of that earlier this year. He argues that there ought to be better delineation between operating items in the income statement and financing. We totally agree. We are working towards that with the International Accounting Standards Board. So we are working on those kinds of things in order to improve the utility of the information.
As to the disastrous impacts, no, I don't believe there will be. I believe that certain companies have gotten used to using a particular form of stock option.
Let me be very clear on this: There are many forms of equity-based compensation. There are restricted stock grants. There are employee stock option plans, ESOPs. There are various forms of stock options, stock options that are tied to corporate performance or unit performance. There are stock options that are tied to an interest rate, that are tied to your performance relative to a competitor's performance. And all of those get expensed. There is just this one form which has been an accounting anomaly for 30 years now.
Mr. GONZALEZ. Thank you very much.
Mr. OSE. Mr. Herz, I just I believe you have set a new record here with your submitted testimony.
Page 49 PREV PAGE TOP OF DOC Mr. HERZ. We like to be complete.
Mr. OSE. I do want to compliment you on the thoroughness of your presentation.
In the attachments, attachment number 7, there is a submittal from the conference board I believe, and one of the footnotesthe Conference Board, Commission on Public Trust and Private Enterprise. One of the footnotes on page 5 indicated that a Merrill Lynch study shows that expensing stock options would result in a decline of approximately 70 percent in earnings per share in the high-tech industry compared with declines of 12 percent in telecom industry, 9 percent in the consumer materials industries, from 2 to 7 percent in other industries, and 10 percent in the overall S&P 500.
Now there may be some accountants within our membership here in the House of Representatives, but I can tell you that every one of us would hear about declines in valuation of 401(k)s and IRAs and individual portfolios. If expensing stock options were to cause a decline in the value of people's portfolios, why would any Member of Congress vote for it?
Mr. HERZ. Well, it is because I would hope that you would believe in the importance and value of the right information. The right information then leads to certain things happening, people understanding what the performance really is.
Mr. OSE. You are suggesting Sarbanes-Oxley does not accomplish the transparency that you are seeking.
Mr. HERZ. Well, I think on this issue, clearly this issue has been left unresolved. It was left to us to decide whether or not to try and address it, and based upon all the input we decided unanimously that it was something that needed to be addressed.
Mr. OSE. I do want to highlight one point. Within the financial statements of America's corporate industry, those that are publicly traded, are the impacts of dilution reflected in the statements themselves for granting of options?
Page 50 PREV PAGE TOP OF DOC Mr. HERZ. That is an excellent question. Earnings per share is a calculation. It is a metric. It is not part of an accounting system. All it says is that if youeverybody who basically, you know, could be a shareholder based on a calculation you then divide that into the current earnings number. So it is not capturedeconomic dilution is not captured in the accounting numbers.
It is the same issue as, for example, you know, if you pay a lawyer with stock or stock options, it is absolutely clear that you would show that legal expense as an expense and you would reduce earnings. You would also show it in the numerator to the earnings per share calculation in addition to the denominator. The only instrument which escapes that treatment are these so-called fixed plan stock options. They get in the earnings per share calculation once the option is in the money, but they don't get an economic charge in the income statement.
Mr. OSE. Within the statements themselves, perhaps in the footnotes, are not the effects of dilution reflected?
Mr. HERZ. There is a pro forma disclosure that came about as a result of the FASB's action in 1995. Most of the commentators that we have had for a variety of reasons that, you know, users of financial statements have said that is not adequate. It needs to be factored into the accounting numbers themselves.
One of the reasons is that they citeI guess there are a couple of reasonsis they use not just earnings per share numbers, but they also calculate all sorts of other numbers based on the accounting numbers, things like return on equity, return on assets; and unless you put it into the accounting numbers, it makes their life quite difficult. Further, they pick up numbers from databases, and unless you put it into the accounting numbers those things are not picked up.
Mr. OSE. But the information is in the statements.
Page 51 PREV PAGE TOP OF DOC Mr. HERZ. The information is in a footnote. By the way, it is in an audited footnote. It has been there for
Mr. OSE. Sort of like this.
Mr. HERZ. Which, by the way, is covered by the Sarbanes-Oxley certificationhas been. And it is there. But it is notit is a pro forma number. It is kind of like saying on special purpose entities, why don't you just put the information relating to a special purpose entity in the footnotes and don't make them show the debt or the assets on their balance sheet.
Mr. OSE. We will come back to the special purpose entities, because that is not related to this issue at all. But my time has expired.
I would like to recognize Mr. Emanuel.
Mr. EMANUEL. Thank you, Mr. Chairman. I will follow up with a question I asked earlier.
We have got this either/or choice and a failed attempt to try to find if there is a middle ground here. Has anybody looked at or have you looked at the difference of how you wouldwhether you would expense stock options on a privatenot private but a public company, recruitingthey are used differently for a big public company versus an early stage company.
I have this kind of aversion to Congress getting into the accounting business. I have an aversion of FASB getting into theno. But how do you get towards maybe finding at a certain point whether it is a market capital company, youmaybe it is a stupid question.
Mr. HERZ. No, I think it is an excellent question. It is an excellent question. It is a question we intend to look at. Because certainly, if nothing else, the valuation issues when you don't have publicly traded stock become of another realm on valuing an option. Companies that have publicly traded stock they may themselves have traded options. So when you have a private company, a start-up, even if it is pre-IPO I think that is a real issue.
Page 52 PREV PAGE TOP OF DOC Plus you take a start-up, and you get six guys together in a garage, and you say we are going to divide, you know, divide it into six pieces, that to me is a formation issue, a founders issue, rather than a compensation arrangement. So we are going to look very carefully at those issues and where that dividing line might lie.
Mr. EMANUEL. Because I think thisyou know, companies use options to attract talent early on, which is so important to the creation of that company and its ability to go public, that options may be used later on in later stage companies that one could argue it isI think the panel before you, one of the membersone of our colleagues said it is like other forms of compensation package. Well, health care, retirement benefits therefore do get expensed at that level. Why options would be treated differently is something else.
On the other hand, I am sensitive to the fact that it has become so ingrained in the culture, in the economy and the everyday running of a business that you don't want toyou know this is going to have a negative effect. A decision that you guys made to expense options will have a negative impact. And maybe short-term companies and CEOs and management will adjust, but to disregard it at
Mr. HERZ. Remember, across the whole capital market, as I said, according to the statistics only a small portion of nonexecutive workers receive stock options; and of course we have gotten fairly strong support from the trade unions that represent America's workers on the need to change the accounting. So, you know, I agree with your thinking, the thinking about different companies, different uses.
Mr. EMANUEL. Most importantly, different points in their maturity. That actually, rather than this being linear, options change over time as the company has developed into a different place, where it started and where in its midlife, so to say, and that therefore the options become something different over time, et cetera. I don't know, as you look at that, you think about it as you guys analyze this.
Page 53 PREV PAGE TOP OF DOC Mr. HERZ. Thank you.
Mr. EMANUEL. Thank you, Mr. Chairman.
Chairman BAKER. [Presiding.] Mr. Toomey.
Mr. TOOMEY. Thank you, Mr. Chairman; and thank you, Mr. Herz.
I may be getting in a little over my head here because I am not an accountant, but I do understand something about the economic of options. I used to trade options professionally.
One of my concerns here, and I appreciate this is a tricky dilemma that we face here, but I guess my concern is whether or not the proposal that seems to be coming from the FASB here is going to best reflect the economic reality of these transactions. And specifically my concern is that if you go down the road of expensing, which I am not advocating, but as you seem to be heading down that road, it occurs to me that you may be doing it in a way that by design almost necessarily misrepresents the economics of the transaction. Because you recognize an expense at one point in time sort of, you then spread it over the life of the option, but you never do anything to reflect the change in value.
As you know, if a company were to short a call option on another company, which is what this is, we are taking a short position and a call option on one's company, you would have that as a liability which would you then mark to market. You would capture that value on day one, but you would then recapture the change in value if it diminished in value or you would show greater expense if it became a greater liability. But that provides a convergence to economic reality.
And I understand that what you are doing instead seems to be more consistent with the way other forms of equity are treated, but it seems to end up misrepresenting the economic reality. And now I am further concernedand one of the reasons I am not comfortable with expensing is if you go down this other road of showing it as a liability and marking it to market, you create this bizarre anomaly of showing earnings or losses that are a function solely of fluctuations of the stock price and have nothing to do with the operating forms of the company, which one suspects this is not necessarily very useful to investors, which is why I sort of end up thinking that really the best reflection of the economic reality here is to show the impact of the dilution in the event that the options are in fact issued.
Page 54 PREV PAGE TOP OF DOC So could you comment on this? It seems to meand I don't mean to be harshly critical here, but it seems to be almost a half measure in terms of capturing expense, because it never captures the change that would better reflect economic reality.
Mr. HERZ. Yeah. I don't know if I can do justice to this discussion in this hearing or make my points succinctly enough, because this is an issue that we and accountants and economists have debated for a long, long time, the issue of when to measure. We call it the measurement date issue. Do you measure it solely at grant date? Do you measure it from grant date through to the vesting date when the person has performed the services, or do you measure it right to the exercise date, kind of like the way the tax method does it? And there can be arguments for all three, but I think the argumentthe last argument that you argued aboutmaybe it was the next to the last one about the idea of marking it to market right through exercise date, there are some proponents that would say not only employee stock options but all call options issued by a company ought to be accounted for that way, including a call option that is embedded in convertible debt or warrants that a company issues for financing or to obtain goods and services. That is an issue we are looking at also internationally in terms of the distinction between liability and equity. Where is that line?
Accounting traditionally has drawn the line at things that are equity, a stock option is an equity, just like a share of stock. And when you use that to acquire goods and services, that becomes the measure of that transaction.
Now, I would posit that that is the accurate measure of that transaction at that point.
Mr. TOOMEY. Is or is not?
Mr. HERZ. Is. The question then is, is something else going on after that, which is more of a financing item, and I think you would have to look at it not only for just employee stock options but all call options that a company may issue related to its stock. We are going to look at that, but I think the measure of the compensation or if you use options to buy goods, that is what they are recorded at at that date. That is a pretty clear issue in accounting right now.
Page 55 PREV PAGE TOP OF DOC Mr. TOOMEY. It just seems worrisome to me that we would go down a road that says we will knowingly and intentionally refuse to recognize that an expense that we put on an income statement on day one and that we subsequently learn is never going to occur in any economic reality but we are never going to do anything about correcting that, and that is where you end up if you don't do theagain, I am not advocating that we use that model, but that isgiven that inherent set of difficult choices, it seems the dilution model is rather appealing.
Mr. HERZ. Yeah. I understand the accounting conclusion is different. The conclusion of many economists, including Chairman Greenspan, including three Nobel prize winners, is not that. But it is a good debate to have.
Mr. TOOMEY. Thank you.
Chairman BAKER. Thank you, Mr. Toomey.
Mr. CROWLEY. Thank you, Mr. Chairman. Thank you, Mr. Herz, for being here today and for your comments. I think that many of us could look back in the 1990s and see both the positive and the negative effects of the market and what took place during then, especially in the high-tech industry, but I think we can all agree that for overall what took place during the 1990s was highly beneficial towards the economy of our country, and especially the growth of the high-tech industry and the impact that that had. Many would argue because of the ability to not have to necessarily expense these items that that actually encouraged growth in development within high-tech, and it has been touched upon by a number of my colleagues.
What I would be interested in knowing is do you think, one, that it is appropriate for Congress to be inquiring into this issue? Because I think it goes beyond just technical accounting standards. It goes towards the larger macro economic policy issues, job creation, job loss potential because of these new standards that you are suggesting. Are you factoring in the macroeffect that this would have on our economy? And can you tell usI mean, I know who is supporting the standards change. Can you tell us about what comments you received in opposition to it? And just lastly, in terms of your time line, I believe you expect to have these standards in place by the spring, April of 2004. Do you think that that is realistic given I think all of our experience with government how slow we are to move, whether or not you as quasi will do it any faster than we in government can?
Page 56 PREV PAGE TOP OF DOC Mr. HERZ. Thank you. On the macroeffects again, you know, we study the economic effects of the transactions, and our clear belief is and our mandate is that we then come up with an accounting that we think under our concepts, under looking at characteristics like relevance or reliability or what is the better accounting, and we test that out with users, financial information to see how they use it, how they make decisions, things like that. And then we weigh that against the costs, the costs of the company to provide that information and the like. You know, our clear mandate is to produce accounting information that is more useful for people who need to have independent neutral information to make decisions.
On the opposition, we got opposition from a number of companies, particularly in the high-tech industry, you know, who wrote us a lot, a lot of letters. There was opposition earlier from other people in industry, but I think most of industry has now said let's focus on the measurement issues, you know, can it be done reliably, how, you know, what is the best way to measure it.
The April 2004, we would like to stick to that, but we are going to do this thoroughly and objectively and systematically and consult with lots and lots of people and get lots and lots of input. You know, I am committed to try and move the FASB more quickly than it has in the past, and I think we have demonstrated that on some of the things we have done over the last year, but I don't want to sacrifice the appropriate due process to make sure that we are getting to the appropriate result.
Mr. CROWLEY. I would just in closing say that it has been suggested to me that FASB in this case is acting more like Congress and this committee acting more like FASB in terms of our approach, possibly in terms of looking at this and examining it before we throw the baby out with the bath water. But I appreciate the gentleman, his testimony and his time this afternoon.
Chairman BAKER. Thank you, Mr. Crowley. Mr. Tiberi.
Page 57 PREV PAGE TOP OF DOC Mr. TIBERI. Thank you, Mr. Chairman. Following up a bit on Mr. Toomey's questioning with respect to the cost issue of expensing stock options, do you believe there is a cost to the companies?
Mr. HERZ. Oh, absolutely.
Mr. TIBERI. Explain how.
Mr. HERZ. It is the economic cost of issuing that option at that date. I don't know if you were here when I read the piece by
Mr. TIBERI. I wasn't. I apologize.
Mr. HERZ. By Bennett Stewart, but basically to paraphrase it, there are lots of different ways of looking at it. I mean, you are issuing an economic instrument that you could have issued a similar instrument to the market, got the cash and paid the employee in cash. Another way that economists look at it is that you are basically forcing the employee to buy the instrument. So I think most economists say that, yes, there is a cost at that date to the company. It is an opportunity type cost, but it is relevant in terms of comparing the company's actions versus other actions.
Mr. TIBERI. And you believe that there is a cost to the shareholder as well then?
Mr. HERZ. Well, any cost that is a cost to the company is a cost to the shareholder.
Mr. TIBERI. And not just a cost to the shareholder as opposed to the company?
Mr. HERZ. Again, let me explain that there is an accounting system that measures revenues, costs to the company. There is also a metric called earnings per share. That is a metric. It is just a calculation. It is a calculation that says instead of looking at the existing number of outstanding shares let's take this period's earnings and pretend that there were more shares outstanding based upon things like options, and it spreads thatthen says instead of, you know, there being a dollar earnings based upon the outstanding issues shared, you factor in the options, maybe it is 80 cents and the like. But that is outside of the accounting system.
Page 58 PREV PAGE TOP OF DOC Mr. TIBERI. Were you here for Ms. Nightingale's testimony?
Mr. HERZ. Yes.
Mr. TIBERI. Referring to her testimony, she talked about this issue of options being a benefit to her as an employee, a benefit to her as an employee, a tool that her company can use to attract not only employees but also potentially capital. What is your response to that?
Mr. HERZ. Well, first of all, we don't set the laws, and we are not telling anybody that they can't issue options. And, again, this form of option is one of many forms of options, and the other forms of options already get expensed. It is one of many forms of equity-based compensation, some of which are very broad-based that get expensed and the like. So I don't know whether her particular employer might decide to consider that form, another form or the like. I would think they might consider continuing it. I don't know. One of the great things about stock options is they have very favorable tax treatment. You get a tax deduction for the full-spreaded at exercise, and many, many companies have gotten lots and lots of tax benefits in a form of reduced tax payments from this device.
Mr. TIBERI. Would you agree that there are many, many people who have been the beneficiary of stock options, who have done quite well and otherwise wouldn't have if there were the ability to have stock options given them?
Mr. HERZ. Well, again, across the economy the best statistic I have available is that only 1.7 percent of the nonexecutive workforce has received any options. So I am sure there are many people that have benefited from other forms of equity compensation. I am sure there are many people that have benefited from profit sharing plans that a company has or stock appreciation rights or lots of other ways that companies can innovatively compensate people.
Mr. TIBERI. Do you thinkwhere did this information come from, the 1
Page 59 PREV PAGE TOP OF DOC Mr. HERZ. The U.S. Bureau of Labor Statistics, their figure for year 2000.
Mr. TIBERI. And you believe that your proposal at FASB won't prohibit this from
Mr. HERZ. No.
Mr. TIBERI. Explain why.
Mr. HERZ. We can't prohibit any transaction. We just say if you do something, here is how to account for it.
Mr. TIBERI. Obviously there are some who believe that your role issome up here believe that your role isyou are overstepping your role in what you are doing.
Mr. HERZ. We set accounting standards for transactions and economic events that occur to business enterprises. So if you choose to issue stock options or if you choose to issue other forms of compensation, all we would say is here is how to account for them.
Mr. TIBERI. You don't believe that your role will stop that?
Mr. HERZ. No.
Mr. TIBERI. Thank you, Mr. Chairman.
Chairman BAKER. Thank you, Mr. Tiberi.
Mr. INSLEE. Thank you. I have yet to win a Nobel prize in economics, so I approach this issue with some humility. But there are a couple of things that I want tothat I have sort of concluded and I want to ask you a question. If you reach my conclusions, what do we do then?
First, I sat through a score of hearings about all the Enron-related debacles, and I was struck during those hearings of repeated rapacious behavior by these what I believe to be criminals. It didn't involve this issue. I mean, we went through months of testimony, and I just can't remember seeing that the lack of expensing was really the critical thing that occurred to these corporations. That is just an observation that I had throughout these hearings.
Page 60 PREV PAGE TOP OF DOC Secondly, this concerns me a little bit, because I understand the desire for a number, but it bothers me to say that a bad number is better than no number at all, and I think that is where we are headed a little bit because of the difficulty of assessing this vehicle. And to me the real issue really is dilution, diminution of value to the shareholders, and if you reach that conclusion that that is really what we ought to be aiming here for is a fair assessment of the potential dilution of stockholder value when an option is issued, if you sort of reach that conclusion as I have, what advice would you give us on how to form a vehicle to really give investors that type of information?
Mr. HERZ. Okay. Thank you. Let me make sure I got your questionsyour points. On the rapacious behavior, we are not trying to cure that. We are just trying to provide an accounting standard that deals with an anomaly, a 30-year anomaly that most people recognize is an anomaly among forms of stock-based compensation and how to account for it.
The issue on the bad number, again, we are going to look at that. We have been told by a lot of experts that you can get a pretty reliable number that is more reliable than a lot of other things in the financial statements. That doesn't mean that those numbers are bad either. There is a required disclosure now that the SEC has. It is called critical accounting policies and estimates, and you will find that companies disclose those in 10 or 12 areas. And what they are, they are a fulsome disclosure of the way the company went about making estimates in the area of inherent uncertainty. Most of those deal with other types of things. They deal with things like impairment of long-lived assets. They deal with reserves like loan loss reserves and the like. They deal with things like that, and I think you will find that, you know, we are going to look at this. And we have been told by other people who have looked at it that the relative precision on these kinds of things is much higher than on those kinds of numbers that have been for years and years in the financial statements.
Page 61 PREV PAGE TOP OF DOC Again, on the dilution, you know, we will agree to disagree that dilution is not the only effect here, is not the complete effect. There is an economic cost. It is an economic cost that is associated with all other equity transactions, and by the way, these instruments are used not only to compensate employees. They are used to acquire goods and services from outsiders. They are used in M&A transactions. They are used to make investments and the like, and all of those get accounted for at the value of the option at that date.
Mr. INSLEE. Let mejust one closing comment. I think one of the things you said that is important in the context of how the public perceives this, that this really is not a response to the Enron wave. It is coincidental in time, and I think that is an important point, because I think the public has sort of washed those two together. And I appreciate your comment that these are separate issues.
Mr. HERZ. I think that is an excellent point, because I sometimes give it in speeches. I say, you know, on the one hand we have people saying that if you do this accounting you are going to destroy America. On the other hand, if you dopeople saying if you don't do this accounting, we are not going to rein in all this corporate abuse and all that. And I say, gee, we are just trying to prescribe what we think is the right accounting.
Mr. INSLEE. Thank you.
Chairman BAKER. Thank you, Mr. Inslee.
Ms. HART. Mr. Chairman, I am going to pass to Mr. Shadegg. I think he has a question.
Chairman BAKER. Mr. Shadegg.
Mr. SHADEGG. Thank you. Mr. Herz, let me first of all start with a disclaimer. This is not my field, not my topic. I also apologize for being here late. I have been bouncing back and forth between two hearings.
Page 62 PREV PAGE TOP OF DOC Let me start with a first question. Sophisticated investors from current disclosures are aware of the existence of stock options; and to the extent that they dilute the stock that is out there, they are cognizant of that, are they not?
Mr. HERZ. I guess there is some mixed evidence on that. Before you got here I explained that the fact that it is in the footnotes most people don't think is enough.
Mr. SHADEGG. But it is not footnotes.
Mr. HERZ. Yes.
Mr. SHADEGG. You propose to go all the way to the solution of expensing stock options. Pardon me, but have you already proposed a different method for valuing those stock options than theI guess it is Black-Scholes value estimate that is currently being used?
Mr. HERZ. No. We haven't proposed anything yet. We are at the beginning of a process to assess all these issues.
Mr. SHADEGG. If you were to require that stock options be currently valued, would you use that method, or would you come forward with another method?
Mr. HERZ. We have received numerous suggestions from all sorts of academics, people who are experts in valuation compensation, experts on ways tothat they believe would provide better valuations. Our staff is at the beginning of looking at all of those kinds of suggestions.
Mr. SHADEGG. I think Congress is confronted with an issue here, and they are trying to resolve it and do what they think ought to be done. I read a portion of your testimony, and it pretty much says you don't think the legislation that has been proposed by those that were on the prior panel is a good idea, and I have read your specifics on that. And quite frankly, most of your specifics legitimately go to protecting FASB's turf and say this is FASB's job. The Congress shouldn't intervene. It could have an adverse impact on FASB's efforts and it could set a dangerous precedent. Those are words you used. Well, I understand that, I understand the role of your agency. Do me a favor then. Respond for me to those who are going to appear on the panel after you to the criticism that says, number one, there is no way to accurately value these stocks now, that the Black-Scholes process does not provide an accurate valuation because these are not traded options, and second, address the issue that those people also raise about how do you set forth a value for a stock option that will never be used?
Page 63 PREV PAGE TOP OF DOC I spent the week last week with a good friend. He had some options issued by the company he used to work for. He was let go from that company, and he could never exercise the option. It is not a value. And address the concern of those who say anything you do will be inaccurate and therefore requiring CEOs to certify to what is inaccurate puts them in an untenable position.
Mr. HERZ. Yeah. Okay. The issue of valuationand, again, I will go over it. You weren't here. Again, we are looking at all of that. You know, the question is can it be valued with sufficient reliability. We are going to look at that hard. People who have looked at that before us, our predecessors at the FASB 10 years ago, the International Accounting Standards Board, many experts in the field all say that it can be done.
Chairman Greenspan a few weeks ago in response to a specific question on this said that is just flat wrong. I was on the International Accounting Standards Board at the time they started looking at this issue. Unfortunately or fortunately, I left for the FASB before they got to this particular issue of measurement reliability. So I am looking forward to getting into that and making my own hard judgments on whether or not these can be sufficiently reliably valued at the date of grant or any other date after that.
The issue of the certification, the SEC tells me that the companies that already are certified with the figures in their footnotes have implicitly already said that, because the information certified already includes all the information in the footnotes of which this is in the footnote.
The second thing I would tell you is that 280 companies or so, major U.S. corporations, have voluntarily switched to the expensing method. Well, these are among America's biggest, most respected companies with highly respected CEOs and the like, and they must believe they can do it.
Mr. SHADEGG. I guess I could respond by simply saying if current disclosure is inadequate, some argue, you say it is in the footnotes and they are already certifying it, but the new method is also admittedly inaccurate, maybe we are best to leave those companies to decide which of the two voluntarily most accurately tells the public about the condition of their stock?
Page 64 PREV PAGE TOP OF DOC Mr. HERZ. Yeah. The argument thatwell, first of all, we believe that excluding it from the financial statements makes the financial statements wrong. You know, obviously if we conclude that this is a valid expense, then it ought to be in the income statement just like any other expense.
Mr. SHADEGG. So you have already concluded the footnote is inadequate?
Mr. HERZ. Well, we have generally concluded historically that footnote disclosure is very useful, but it is not a complete substitute. And I went through this before on this particular issue. People have said to us that, for example, the reason it is not enough is that people pick up information, analysts and the like, from databases. And unless it is in the accounting information, they don't pick it up.
Mr. SHADEGG. I appreciate it. My time is expired. I appreciate your input.
Chairman BAKER. Thank you, Mr. Shadegg.
Ms. Hart, did you have a question at this time?
Ms. HART. I will just be brief, Mr. Chairman. Thank you. You had just mentioned in your answer to Mr. Shadegg that, oh, these corporations have made the decision to expense their stock options, and, gee, would they do that if they couldn't figure out a value, and I think my answer to that question, having been on this committee through the entire storm of the last session, would be they thought they had to and they will figure out a way to value them. I don't know that there is anything that is clear about where they can go with that. And I am interested in actually seeing your process through to the end.
Can you give us just a little window about how you would actually go about valuing an option in light of the fact that it isn't necessarily worth anything until it is exercised?
Page 65 PREV PAGE TOP OF DOC Mr. HERZ. Well, again, an option is worth something, maybe not to the employee, but there is a cost to the company. Options, I mean, there are trillions of dollars of traded options in the market. There are options embedded in convertible debt and you get a lower interest cost, and there are calculations that very precisely do all those things. So I understand from an employee's point of view that is the case, but our accounting standards deal with the accounting by a company and what are its costs, what are its revenues.
Ms. HART. I follow that, but taking that one step further, it is the value to a company which they could actually sell out of market. I understand that, but as far as the datewhen you talk about the date of the valuation, are you looking toward that date that is actually given to the employee?
Mr. HERZ. Yeah. Date of grant to the employee.
Ms. HART. So that is the actual date that you would use?
Mr. HERZ. When the company officially commits itself.
Ms. HART. So that is your actual date. And from there you are going to go ahead more based on what that option could be worth on an open market?
Mr. HERZ. Well, what you would do is you would value an option through whatever technique we would come to, and we are going to look at this hard, as I say, at the date that the company commits to the employee to grant the certain number of options. And then you establish a value. If the terms of the options say thatto the employee you can't exercise this for, say, 3 years, a vesting period, the way it is looked at is that that is the service period over which the company benefits from that cost. So you spread that cost over the 3 years that the employee gets it. If the employee never gets it because he leaves the company, we would reverse everything because a deal was not consummated.
Ms. HART. So things can get pretty complicated. Have you been conferring at all with these companies that have decided to use the expensing method within the last year or so?
Page 66 PREV PAGE TOP OF DOC Mr. HERZ. We have talked to a lot of them, and, again, calculations that they think they will be doing are under the same calculations that they have been doing for 7 years that are in the footnotes.
Ms. HART. Okay. Thank you. I have no further questions. Thank you, Mr. Chairman.
Chairman BAKER. Thank you, Ms. Hart.
Mr. SHERMAN. I have arrived just at the right time. First, I don't think you can defend the present system that you have got or the present rule on stock options. I remember while I was studying accounting I learned two things. First, comparability, the ability to compare two like companies and tell which one is producing more net income or has a higher book value, is one of the essential elements of any good series of accounting principles.
The second thing I learned while I was studying accounting is that you could turn on the TV and see the taste test, Pepsi versus Coke. There was a big commercial back then. And the people being tested were often blindfolded. Well, today you are blindfolded if you are trying to compare earnings per share of Pepsi and Coke, because of course they use different systems for comparing the cost of compensating their executives.
But as I understand it, what you are saying is the professionals dealing with securities can by looking at the footnotes turn Pepsi into Coke by making some calculations and determining what Pepsi's earnings per share would be if they used the same method. Is that true?
Mr. HERZ. They can from the footnote datafirst of all, let me go back. Thank you for that comment on comparability, because that is an absolutely essential ingredient to good accounting information and to the information that is used in the marketplace and investment decisions and capital allocation.
Page 67 PREV PAGE TOP OF DOC They can make those adjustments, but one of the issues apparently is that they can't make them everywhere, because the databases that they use don't pick upif it is not in the accounting information, the accountingyou know, they pick up the straight information from the income statement, not from footnotes.
Mr. SHERMAN. Well, you are saying that those who don't bother to read the footnotes cannot compare Pepsi and Coke, but if you are getting your advice from a team of professionals in a few hours, they can do the calculations to put Pepsi's earnings per share calculated exactly what it would be if they used
Mr. HERZ. They can do the bottom line but they can't do other things like gross margin and other aspects that they might want to calculate, because it is not broken out that way.
Mr. SHERMAN. Well, once you have determined what the expense item would have been on Pepsi's financial statements, can't you then calculate everything else? What is missing?
Mr. HERZ. Well, for example, let's say people not only in production but in sales and marketing and other parts of the enterprise
Mr. SHERMAN. So a portion of the compensation cost should not be charged to this year's expenses, but instead could be part of inventory
Mr. HERZ. Inventory or other things below the gross margin and the like and things that are needed in financialproper financial analysis.
Mr. SHERMAN. So without much controversy, you believed at least require beefier footnotes so as to provide in effect a complete restatement of what those financials would look like
Mr. HERZ. Yeah.
Mr. SHERMAN. if the expensing method was used?
Page 68 PREV PAGE TOP OF DOC Mr. HERZ. We could. I mean, I think the concern is that you do it on one item, then we are going to have pro forma disclosures on everything. Why have financial statements?
Mr. SHERMAN. Well, the problem you have here is this is the only item I am aware of where the FASB has announced there is a right way to do it, but we don't have the fortitude, I think is the term, to tell everybody to do it that way.
Mr. HERZ. Oh, we have the fortitude.
Mr. SHERMAN. Well, you haven'tI mean, your current release on this is the right way, and 98 percent of the companies are doing it a different way.
Mr. HERZ. Right.
Mr. SHERMAN. I don't know of any other issue that is this hot. I don't know of any other issue where you can't just say, this is the right way. Do it this way. So at a very minimum, if you can't impose that same standard on this issue, which is too high, you could provide the same pro formas. Then the world out there could decide which of the two numbers to use. The analysts could all decide that they like the pro forma number better, or they could like the main number better, but
Mr. HERZ. They could. I mean, wethere was a survey ofthat the AIMR did a couple of years ago of their membership. The AIMR is the Association for Investment Management Research, and they surveyed thousands of people. They got about 2,000 responses from financial analysts and portfolio managers, and one of the questions they asked was is footnote disclosure enough, and the answer was no.
Mr. SHERMAN. It is obviously a lot easier for them if you are able to come up with one number and they don't have to read the footnote. What you are basically saying in the survey is they don't want to read the footnotes and they certainly don't want to do the additional work of
Page 69 PREV PAGE TOP OF DOC Mr. HERZ. That may be so or there may be others
Mr. SHERMAN. Trust me. No one wants to read those footnotes. Thank you, Mr. Chairman.
Chairman BAKER. Thank you, Mr. Sherman.
Mr. Ney, did you have a question?
Mr. NEY. Thank you. Thank you, Mr. Chairman. Welcome. Some people have argued that requiring expensing of the stock options will undermine clarity of the financial statements and provide greater opportunity really for fraud, because the valuation methodology would not be exact, and I just wonder what your view on that would be.
Mr. HERZ. Well, our view is thatagain, once we have gone through our whole process and we have concluded that not only conceptually it is an expense but it can be measured with reliability, that that is the right thing to do, to put that number in. To leave it out is to make the financial statements distortive.
You can provide lots of other information in the footnotes, continue to do that, provide lots of other information. We are looking at that as well, because there are other aspects related to these. For example, the ongoing mark to market might be instructive right through their exercise date, lots of other things that could be useful and informative, as well as trying to make the financial statements correct.
Mr. NEY. On a note about the component stock options which people have pretty well agreed they are difficult to value, and one of the people testifyingI think it was Mr. Craig Barretthe will be on the third panelpoints out that the CEOs are now required to certify the accuracy of their company's financial results and that the problems inherent in valuing stock options will make that extremely difficult.
So my question again is the first part I said. How can we require the CEOs to do that when everybody has kind of agreed that that is a difficult thing to do?
Page 70 PREV PAGE TOP OF DOC Mr. HERZ. As I said earlier, having talked with the SEC, their belief is that under section 302, the CEO has already been certifying the information that is in the footnotes on this.
Mr. NEY. Thank you.
Chairman BAKER. Thank you, Mr. Ney.
Mr. Herz, we appreciate your courtesy in being with us for such a length of time. This of course is an important issue, but the broader question of financial reporting generally is of interest to me, and we look forward to working with you over the months to come. Thank you, sir.
If I may invite our third panel, participants to come forward.
I want to welcome each of our panelists here this morning and for your patience. This has been a much lengthier hearing than some would have expected, and I know of time constraints on our first witnesses. I certainly want to express appreciation for your participation but understand the necessity for your departure after the conclusion of your remarks.
Our first to be heard this morning is the Honorable Paul Volcker, former Chair of the Federal Reserve, and in his capacity as Chairman of the International Accounting Standards Committee Foundation Trustees. Welcome, sir.
STATEMENT OF THE HON. PAUL A. VOLCKER, CHAIRMAN, INTERNATIONAL ACCOUNTING STANDARDS COMMITTEE FOUNDATION TRUSTEES
Mr. VOLCKER. Thank you, Mr. Chairman. I appreciate your courtesy in letting me go first, and I will steal out with an appointment with some of your colleagues, and I will come back if I can dispose of that and you are still talking. But let me just be quick with a couple of points.
Page 71 PREV PAGE TOP OF DOC I am, as you indicated, the Chairman of the Trustees of the International Accounting Standards Foundation. We appoint the Board that makes the decisions. I am not the one who makes the decisions. I am not to interfere with those technical decisions.
Having said all that, let me make a few comments. I think the basic issue you are all grappling with here is what should the role of the determining boards with, whether you are talking about FASB nationally. You haven't got any jurisdiction over the international, but we are aiming for consistency internationally, and those boards, both the domestic and the international, have been set up to provide insulation from extraneous influences. They are set up as professional boards to make professional judgments of integrity, and that decision making is to be protected by a rather elaborate arrangement, including my board of trustees, including the trustees of the domestic FASB.
We have people who are not accountants on the Board. Some of them are drawn from business. Some of them are accountants. Some of them are drawn from analysts. They have large and elaborate advisory procedures. So these decisions are not reached in a vacuum, but in the end they are reached on the basis of professional judgments directed to assure what the best accounting judgment is and hopefully, from my viewpoint, to achieve international consistency over time.
Now, I recognize it is amply apparent here that how you value stock options is exceedingly controversial. I might say to those that argue that it is not an expense, we better stop the practice of permitting the expense on tax returns. I don't think we can argue that they are a tax deduction and not an expense. That is why they are a tax deduction. And we are a little inconsistent the way they are accounting for now. I don't think we can argue that they have no cost. It is very difficult to know what that cost is, certainly on the grant date.
There is one date where we know the cost, and that is when they are exercised. You can look it up in the Wall Street Journal. There is no doubt about it. That is the date that is used as an expense for tax purposes.
Page 72 PREV PAGE TOP OF DOC I want to emphasize, when you consider what viewpoint you might want to take in the area, that while stock options are controversial, they are not the most controversial issue, in my judgment, that the standard setters are going to face. There are a number of extremely basic and controversial issues that will arise in accounting over the next months and years, and I think some of those will have a more profound effect on the financial world than will any decision that is made on whether there is to be expressing of options.
There is a rather furious debate going on in Europe right now about the application of a proposed ruling by the International Board which will become law in Europe unless the European Commission says no, unless the European Commission vetoes it, about the handling of financial instruments. This is a ruling which has already been in effect in the United States under GAAP for some years. The International Board said they think they made an improvement, that it should be applied internationally. There is very great opposition in Europe. There are very strong political pressures being brought on the European Commission.
Now, all my point in making this is if Congress wants to intervene in this particular decision, is a great precedent for everybody intervening in every decision that they don't like. The professional standard-making boards have been set up deliberately to provide a degree of insulation away from the professional judgment.
So I want you to understand what you do here is not limited to the particular question of stock options. I think it would be obviously from my point of view a bad precedent for a political body to begin overriding the professional judgments of the independent standard makers, whether they are international or domestic. It will certainly lead to a lot of inconsistency internationally and all of that would be damaging I think to the basic international frameworkthe financial framework.
Now, I happen to think, in looking at stock options as a matter of substance, that they are deeply flawed, and I know of no other word for it, as an incentive for business management. I think it is clear after experience, and they are largely a phenomenon of the last 15 years or so, that in the middle of a bull market there are enormous rewards that really weren't intended. They rise to grotesqueand I use that word advisedlyrewards for some business managers because you were in the midst of a bull market. People who performed well got richly rewarded. People that performed mediocrelly when the stock market was going up so fast got rewarded. People that performed relatively poorly or the stock performed relatively poorly got richly rewarded because of the popularity of stock options.
Page 73 PREV PAGE TOP OF DOC Not only that, that there are clearly, I think it has been demonstrated, temptations for abuse in terms of incentives, that the incentive is given to the manager to attempt to affect the price of the stock, sometimes in ways that are inconsistent with the long-term health of the company. And I think we unfortunately have seen examples of that.
Now, I understand that for start-up companies or venture capital companies, you have some discussion of that, you are under somewhat a basically different situation, where you have the owners of the companies, the founders of the company making a decision basically about how they want to distribute some stock, and they are not at that stage publicly owned companies at all. When I say I think they are basically flawed as a compensation instrument, I am talking typically about the big public companies that are tempted to abuse stock options. They may not abuse it. You have got one company here that feels very strongly about the use of stock options. They distribute them very widely, and don't concentrate them so heavily on a limited group of people. But unfortunately that is not uniform practice by a long shot. We have seen these egregious examples where people have gotten very large payoffs for stock options the very year that company goes bankrupt or has a decline in stock price of very large amounts. And when you get in a bear market, nobody gets rewarded, good, bad or indifferent economic performance.
So I would say there are better ways of motivating people, better ways of aligning incentives than the use ofI will use the words carefullya fixed price stock option by large publicly owned companies without concentrated ownership, where the ownership itself is basically not making the decision but the managers that are affected are making the decision.
I think that is a certain background for this whole discussion when we talk about the overall impact of stock options. I am not arguing they should be outlawed. I am just arguing that as a matter of corporate practice that a company that wants to use them should do a certain amount of explaining as to why in their particular circumstances and the manner in which they use their stock options is justified. I think in the end of the day, the pricing of the stock option one way or another will encourage more conservative behavior and more prudent behavior with respect to fixed price stock options.
Page 74 PREV PAGE TOP OF DOC The point was made earlier ironically when you have a performance-based stock option, it is already expensed and it is an interesting phenomenon. Not many companies use it. So you have to ask why not. The temptation is because they are not expensed to abuse them in some cases. You can't avoid the uncertainty I think of expensing them, which is very real, because one thing you know is zero expense is not true. I think the overwhelming professional economic opinion says if there isn't expense to stock options and there wasn't expense, we shouldn't be deducting it for tax purposes.
[The prepared statement of Hon. Paul A. Volcker can be found on page 169 in the appendix.]
Chairman BAKER. Thank you, Chairman Volcker. We appreciate your participation today. We are here. We welcome you back if it works out for your schedule.
Our next witness would be introduced by Congressman Shadegg. Congressman.
Mr. SHADEGG. Thank you, Chairman Baker. It is my privilege to introduce today Dr. Craig Barrett, the CEO of Intel. Dr. Barrett is a constituent of mine from Arizona and one of the distinguished witnesses we have today. As you know, Intel is one of the largest, if not the largest supplier of microprocessors and has played a significant role in shaping computer and information technologies.
Since joining Intel in 1974, Dr. Barrett helped perfect the process for manufacturing Intel's powerful microprocessors. He became CEO of Intel in 1998. Prior to that he had an impressive record of academic achievement at Stanford University, where he served on their faculty.
He also has a demonstrated commitment to public service. He has been a passionate advocate of higher education and of placing higher education within the reach of a wider range of students. He has testified before Congress about strengthening math, science and technology education requirements and has advised the President on education issues. He has also been an outspoken advocate for higher standards in education.
Page 75 PREV PAGE TOP OF DOC It is a privilege to have Dr. Barrett with us today.
STATEMENT OF CRAIG R. BARRETT, CHIEF EXECUTIVE OFFICER, INTEL CORPORATION
Mr. BARRETT. Thank you, Mr. Shadegg. Mr. Chairman, it is a pleasure to be here. Sometimes after listening to some of the prior testimony, I wish I was here talking about education and math and science. It is perhaps a simpler problem to solve.
What I would like to do is perhaps represent the high-tech community at this table this morning. I have submitted some prepared remarks. I will try to summarize those briefly. I want to talk primarily about three subjects. One is the importance of stock options to America's economic health going forward, why expensing stock options is not a solution to corporate corruption, a topic that has been discussed some today, and why expensing of stock options will confuse corporate financial statements and confuse investors. We have heard statements to the contrary this morning, and I would like to give you my perspective on that.
I also want to compliment Representatives Dreier and Eshoo for putting H.R. 1372 in play. I enjoyed their comments this morning. I am going to look forward to working with them on this bill going forward.
If you look at the United States economy today and increasingly going forward, it is a knowledge-based economy. You can determine that either by looking at the number of knowledgeable workers in the United States over time. You can look at that, at the assets of companies as they move. If you look at the nonfinancial assets of the company, they increasingly move from property and equipment and raw material to in fact intangibles such as patents, copyrights and knowledge based on their workers.
Those two trends are absolutely going forward. It is in fact the only way the United States supports the standard of living it has today. It has to add more value to its goods and services than other countries or our standard of living goes down and our employees can't afford to get paid.
Page 76 PREV PAGE TOP OF DOC If you look at the company that I am proud to represent, Intel Corporation, it was founded in 1968 by Bob Noyce and Gordon Moore. They founded that company out of Fairchild. At Fairchild they learned the important lesson that employees as partial owners of companies can contribute more to that company, will contribute more to that company, will do more to make that company successful. When Intel started, approximately 30 percent of its employees were given stock options. Today essentially all of our 80,000 employees receive stock options.
Speaking at this table as a CEO today with experience in running a major corporation, with 30 years of experience in the industrial field, I can testify that stock options are a great incentive to employees to be owners of companies, to work harder for companies and to make those companies successful. In my opinion, this is why we give stock options. The owners of the company recognize that. The owners are the shareholders. They agree to a dilution of their holdings in the company on the basis that the employees will work harder and make the pie bigger.
Intel is not alone in this area. If you look at Intel, which I think is a company of substantial success over the last 35 years, Microsoft, Dell, Cisco, you can go right down the list, all of these companies were founded in the same fashion, founded off of knowledge-based workers, and this incentive ownership in the company has been a prime motivating factor for those employees to work hard.
We could look at it slightly differently. Those are all large companies that I mentioned. If you look at small companies, start-up companies and start-up companies do create the basic fuel to create jobs and wealth in the United States, stock options are an excellent tool for start-up companies. Those companies cannot afford to pay often the salaries that major companies can, and therefore they must compete with the stock options to attract knowledgeable workers into their base.
I think if you were to expense stock options as some of our previous speakers have mentionedsubjected to and in fact had the harsh reality of the profit and loss statement, the profit to earnings ratio, the stock price associated with that expensing, you would see a dramatic move away from granting stock options in the United States. You would have to do that. This would be at the same time when we are competing increasingly not with Europe, which Mr. Volcker mentioned IASB represents primarily, but we are increasingly competing with Asia, and the Asians have no intentions of expensing stock options. That is where the competition is in the future.
Page 77 PREV PAGE TOP OF DOC One of the other areas that was mentioned this morning was this book, which I would suggest that everyone read. Representative Eshoo mentioned this. If you are interested in the data in terms of return on investment productivity, return on capital growth for companies with a wide holding of stock by their employees, that is, companies with broad-based stock options, I think this book is the bible on that topic. Occasionally it is useful to interject data when discussing this topic. This book is full of data.
There has been a lot of talk about one of the reasons for expensing options is to curb corporate corruption. I totally disagree with this topic. The companies such as Enron, WorldCom and others that have crashed and burned did not crash and burn because they were not expensing stock options or because they had broad-based option programs. They crashed and burned because the executives in those companies broke the law. They deserve to be punished. They deserve to be prosecuted for what they did. They betrayed the public trust.
I think what this discussion is all about, though, is the impact that broad-based options can have on companies and their success. I would like to make just a few simple suggestions which would help introduce the topic of broad-based option programs and the impact they can have on companies and the value they add. And it is really a five-step program.
First is that option programs should be approved by shareholders. The shareholders are the owners of the company. They are the ones that are agreeing to the dilution of their proportion of the company. Broad-based option plans should be exactly that, broad-based option programs, and you ought to limit the amount of options that go to the top executives at companies. At Intel our compensation committee is taking the move to limit it to 5 percent or less of the options go to the proxy five.
A key element of the Dreier-Eshoo bill is that companies should provide investors with sufficient information, whether it is a footnote or not, and by golly, if you read any of our financial statements today, they are filled with footnotes on all sorts of topics and any seasoned investor who doesn't bother to read the footnotes is certainly not a seasoned investor.
Page 78 PREV PAGE TOP OF DOC But the footnotes should be written in plain English. Options ought to vest over an extended period of time, 4 years or so, and compensation committees who are the committees that dispense options to the executives and companies should be made up entirely of outside directors. That is the job of the compensation committee. That is the job of the directors. They can't shirk that.
If you do those five things, I think you will do more to solve any potential abuse of option programs, and you will create jobs. You will create growth. You will create economic strength and innovation and entrepreneurship in the United States.
I do want to end my comments with just a brief vignette about the accuracy of Black-Scholes, which has had some discussion this morning, the accuracy and transparency of financial statements and what you would project to the casual investor if you followed something like the Black-Scholes technique, which I believe to be inherently inaccurate in valuing options.
I wrote an op ed piece for the Wall Street Journal a few weeks ago. I pointed out in the last few years Intel would have expensed via Black-Sholes over $3 billion worth of expense for options which are currently underwater. That is, their strike price is less than the current market price. That $3 billion, had it been on our expense, would have decreased earnings. Those options may never be exercised. Stock price may rebound, they may be exercisable, but unlikely. That $3 billion of expense would never come back to Intel had it been charged. So it is a one-way street if you expense on the date of grant.
I can't imagine how any investor would have the situation clarified by having over $3 billion of expense on RP&L which may never occur. It may be obvious from my comments that I disagree with Mr. Herz. I disagree with the direction that FASB is going. I don't think there is an expense in the form he suggests to the company.
There is an expense to the shareholders. That expense is dilution. They approved that dilution when they approved the shareholder plan.
Page 79 PREV PAGE TOP OF DOC So I think the shortcomings in the expensing methodology are profound, but I think perhaps more important would be the shortcomings to economic development and economic well-being in the United States if you were to do away with broad-based stock option programs, which is what I entirely believe expensing would do.
Chairman BAKER. Thank you, Mr. Barrett. We appreciate your time here today.
[The prepared statement of Craig R. Barrett can be found on page 88 in the appendix.]
Chairman BAKER. Our next witness is the Honorable Roderick M. Hills, Partner, Hills & Stern. Welcome, sir.
STATEMENT OF THE HON. RODERICK M. HILLS, PARTNER, HILLS & STERN
Mr. HILLS. Thank you, Mr. Chairman. I ask that my remarks that I sent in to you be accepted.
Chairman BAKER. Without objection, as will all witnesses' testimony.
Mr. HILLS. I see that an article from The Economist April 24th that was to be with my remarks is not here. If I may submit that later.
Chairman BAKER. Absolutely.
Mr. HILLS. I appreciate the opportunity to offer my views as to H.R. 1372, legislation which I think is fair to say is a reaction to the problemsI would say the crisis that faces the accounting profession.
Page 80 PREV PAGE TOP OF DOC The problems which I list in some detail in my prepared remarks are, among other things, causing a fundamental change in accounting to the increasing use of market values, rather than historic costs, engaging profits and losses, and in the use of general principles, rather than a myriad of rules to evaluate financial statements.
Whether options should be accounted for or not I suggest is part of this process of change. It seems to me there are lots of reasons why options should be accounted for. They are a material factor in how companies compensate employees. They can significantly affect stock prices. And I am sad to say they have, because they are not accounted for, distorted the compensation policies of some companies.
Why then is there a problem? Well, it is, of course, the opinion of many CEOs who believe with justification that their strong prices may be severely hurt by costing. They believe that analysts and investors will punish their stock prices if management, using information that is largely in their financial papers, public papers today, applies a Black-Sholes type formula and uses the resulting number to reduce reported earnings per share.
You might ask why in the world would analysts have any different view of the value of the company because the management does the math that he or she could do as an analyst. The fact is and the problem is that over the years the accounting profession and the analyst community have not been making the kinds of judgments about earnings and the kind of judgments about the assets of corporations that would long ago have given us an understanding of what the true costbecause it is a costof stock options. It would give us a better understanding of many other things about our assets and the costs of running a corporation.
Yet I don't see how you cannot sympathize with CEOs who do not wish to shoot themselves, if you will, who argue that a Black-Sholes number will not be a precise gauge of cost. So we ask why our FASB and the ISAB persist and, in short, why isn't H.R. 1372 a perfect answer?
Page 81 PREV PAGE TOP OF DOC It is attractive in one way. It puts the fight off again. It has been a long fight. It is not going to go away. It is an understandable approach. But I suggest to you that the studies contemplated are simply another way to delay something that is inexorable.
It is only going to be when accountants, companies and analysts begin to wrestle with the various approaches to valuation in the context of a profit and loss valuation that we are going to get the discipline we need to make the world understand option costs as well as so many other things. The fight against pricing of options is the lack of precision, the fear that it will cause so much uncertainty that it becomes a worthless process and somehow will destroy the use of stock options.
I have served on boards over 34 years, 18 different boards. My own view is that this, too, will pass. We will find a way to value stock options; and stock options used intelligently by companies, as they have been by Intel, will continue to be used; and analysts will figure out that the value of the company has not been affected.
The real point of my remarks is to say that the costing of options is not the most serious accounting problem facing corporate America today. This Economist article which I have asked to be submitted identifies so many other areas that have even more pressing reasons for reform, and the article warns again of the confusion that may arise or will arise again and again as reform continues in these other areas as well as when the profession moves to the use of general principles in evaluating companies' presumptions rather than specific rules, and as we move to market values rather than fixing costs on historical basis.
Profits, says the article, may come to be stated as a range of figures, each of them arrived at by using different accounting assumptions. This, continues The Economist, may sound worryingly uncertain, but it may be better than trying to rely on a brittle illusion of accounting exactitude, which is liable to collapse during times of economic strain.
I suggest to you that the changes of accounting that are coming is because of a growing realization that we have for too long relied upon this brittle illusion of accounting exactitude. I suggest to you that the accounting difficulties of the past few years are in some significant part caused because of our reliance upon precision in accounting.
Page 82 PREV PAGE TOP OF DOC I believe Congress should suffer the transformation to continue. The role of self-regulation is intact. It has a far stronger oversight with a new public company, accounting oversight board, with a newly staffed SEC that has far more resources to do its job. I suggest to you an effort now by Congress to stop this fledgling effort will be a serious interference with the development of the accounting profession that we so badly need.
I have no love at all for the Black-Sholes formula. I sincerely hope that it is not adopted as a requirement for a corporate America.
More important, I very much hope that FASB and the SEC will allow flexibility in the costing of options, let different companies use different formulas. The fact that there will be no precise formula or no precise number should be a vivid illustration of the fact that much of the information in the profit and loss statements today, much of that information is equally imprecise.
If I may close by saying that Robert Frostand this is as early as 1905, when he wrote a poem called The Hardship of Accounting: Never ask of money spent where the spender thinks it went, for no one was ever meant to remember or invent what he did with every cent. What Robert Frost knew almost a hundred years ago is beginning to be understood by us. I fear that H.R. 1372 will impede the development of that understanding.
Thank you very much.
Chairman BAKER. Thank you, sir. We appreciate your contribution this morning.
[The prepared statement of Roderick M. Hills can be found on page 158 in the appendix.]
Chairman BAKER. Our last witness is Mr. James K. Glassman, Resident Fellow, American Enterprise Institute. Welcome back, sir.
Page 83 PREV PAGE TOP OF DOC
STATEMENT OF JAMES K. GLASSMAN, RESIDENT FELLOW, AMERICAN ENTERPRISE INSTITUTE
Mr. GLASSMAN. Thank you, Mr. Chairman.
Mr. Chairman, Mr. Kanjorski, members of the subcommittee, I am concerned that the FASB is rushing to a decision that is not in the public interest and that it is ignoring serious critics of expensing stock options, among them not only successful business leaders such as Mr. Barrett but respected economists and a large number of financial and accounting professionals.
By the way, despite Mr. Herz' earlier response to a question, at last count opposition to expensing is running three to one ahead of approval in comment letters.
I strongly favor the approach in H.R. 1372. In my view, requiring the expensing of stock options would be a serious and disastrous mistake for three reasons:
One, by severely discouraging the use of a powerful incentive for employees at all levels, all levels, mandatory expensing is likely to have a dangerously adverse impact on innovation, economic growth, and national competitiveness. Options work. They align the interests of managers and shareholders, and they provide a powerful incentive to innovation and hard work.
Two, mandatory expensing is likely to confuse and mislead rather than further enlighten investors. You heard quite simply there is no way to value stock options accurately at the time they are granted.
Three, as a long-term strategy, mandatory expensing leads accounting policy in precisely the wrong direction. The expensing of stock options has become a prime example of an accounting fetish, a kind of obsession to reduce contingent liabilities and other forms of information about a company to a single number that can be included in earnings statements under GAAP, Generally Accepted Accounting Principles. GAAP earning statements in truth comprise only one view of a company's health and prospects, as my friend Mr. Hills just stated, and often a distorted one. Investors need many views, and they are poorly served when policymakers elevate GAAP to a kind of holy status.
Page 84 PREV PAGE TOP OF DOC These three points are discussed at great length in my testimony. But in my remaining time let me just address a couple of issues that relate directly to the role of Congress.
The FASB has a single mission which it states this way. This is a quote: ''To establish and improve standards of financial accounting and reporting for the guidance and education of the public, including issuers, auditors and users of financial information.''
Federal policymakers have a far broader mission. For example, they are responsible for encouraging economic growth, for preserving and increasing jobs, innovation and U.S. competitiveness. Even if the FASB is noteven if the FASB expensing proposal were cogent from an accounting viewpoint, and it is not, it would be the duty of Congress and the executive branch to consider its economic impact. I do not have to remind you. That is your job. You can't abdicate it, you can't farm it out to a group of accountants, however well-meaning.
In fact, Mr. Herz said earlier, he said that the moratorium ''unduly intervenes.'' That is a quote. I disagree. I assume that you disagree, too.
Second, do not be intimidated by all this technical talk about accounting. Understand that accounting is not a science. It is not biology or astronomy. Accounting attempts to render in words and number the history and current status of businesses. The best way to do that is a matter of opinion. There is no single right way to do things. And often accounting rules allow choices and flexibility. And that is a good thing.
The current rule allows companies either to expense options at the time grants are made or to explain their possible effects in footnotes and then dilute earnings.
I discussed in my testimony a typical firm, Gilead Sciences, a biotech company. I just pulled the 10-K off a pile that I have in my office whose footnote extends to four pages. Now, understand that footnotes, if you never read a 10-K, and I am sure every member up there has, footnotes are printed in the same type as everything else in a statement. They are tremendously important. No serious investor would ever ignore footnotes. These footnotes show far more information, quite frankly, about options than they do about other more important aspects of the business such as intellectual property assets or cash compensation and leases.
Page 85 PREV PAGE TOP OF DOC The current regime is perfectly valid. The accounting profession and top academics are not united in their support of the change that the FASB proposes. As a result of expensing options, many firms, among them America's most successful and innovative, will be forced to take massive charges against earnings. These charges are likely to lead to lower stock prices and higher cost of capital for the firms. Companies, in addition, will be discouraged from issuing options in the future; and firms will be less likely to list on the public markets. The likely effect will be to reduce economic growth, U.S. competitiveness and job creation.
It is the responsibility, in short, and in conclusion, of elected public officials to weigh the economic costs and to act. I do not question the sincere desire of the FASB and its supporters to restore investor confidence through a mandatory expensing. But I have written a column for several large newspapers about investing for many years. I think I know small investors. It is my judgment that investor confidence will probably be affected negatively, if at all, and the economy will be placed at risk. This subcommittee under those circumstances cannot sit idly by and watch new accounting rules imperil what is today a tender and tentative recovery.
Chairman BAKER. Thank you, Mr. Glassman.
[The prepared statement of James K. Glassman can be found on page 102 in the appendix.]
Chairman BAKER. I will start out by talking about the current environment we find ourselves in, especially in light of distinguished Chairman Volcker's comments advising the committee to be careful in moving forward on any of these subject matters.
I can go back in financial services in this decade with regard to proposals relative to the treatment of derivatives, the adequacy of loan loss reserves. There have been any number of occasions when there have been public expressions concerning the manner in which disclosure should be made. I suspect that will continue. In fact, the FASB approach today is not to act precipitously but to engage potentially in public roundtables or public hearings to further assess the feelings of those in the enterprise in the stake-holding business as to their view of the proposed rule modification.
Page 86 PREV PAGE TOP OF DOC To that end, I think it is also important to confirm what you characterize, Mr. Hills, as the brittle illusion of exactitude, that in fact in this effort we should move quickly beyond the issue of the expensing of options and look at the adequacy of the current reporting methodology in the broad sense in light of the significant changes in the way our economy performs today versus two decades ago, much less the last 50 years.
In an earlier exchange, I was asking the FASB representative concerning the appropriateness of XBRL and having a much more rapid reporting of material fact that is principles based instead of rules based. Just in editorial comment, our system is defective; and the fact that we find, as a policy perspective, deficiencies, for example, Sarbanes-Oxley, requires us to act.
I guess what I am suggesting is that we don't really have to run very fast to stay ahead of the historic pace of FASB in promulgating regulations. This ought to be a complementary approach where we can have a public discussion, allow professionals to reach their conclusions but, at the same time, evaluate whether those conclusions fit in the context of our current economic condition.
I am worried unless we get to real-time material fact disclosures that everything else is throwing very small life jackets overboard to people in very deep seas when they really need a whole new vessel. I don't know how we get there, but I suggest that, rather than this being an inappropriate exploratory activity, it is highly appropriate to fully understand how this expensing of options and the reform associated with it fits into the broader picture of reform of our whole financial reporting system.
I don't really have a question, but I just sense that we are also all so focused on the expensing aspect the bigger picture is passing us by and that is far more important because of the inevitable changes that are likely to come.
Mr. Hills, would you want to respond, given your concerns?
Page 87 PREV PAGE TOP OF DOC Mr. HILLS. I appreciate that.
I also want to pay a compliment to my friend, Mr. Glassman, who has made a wonderful argument for eliminating the profit and loss statement. But, unfortunately, we have one; and it is going to change.
This Economist article which I recommend strongly says we may be looking at ranges of values. We will not have an earnings per share that we can look at with precision. We may look at a place where different companies will make different assumptions as to what they didthe assumptions they used in coming to the concludes they came. It will be ambiguous. It will be of concern. But I think it is better the people understand the ambiguity rather than think it is not ambiguous.
As I said before, there is no reason why an analyst today, a good one, can't look at the information in the financial papers and figure out in some fashion what he thinks the cost is of a company. Because, believe me, some companies abuse options enormously.
Chairman BAKER. Let me jump in. At this point, as opposed to taking the current methodology of a snapshot of a current corporation of a date certain with given facts that are in effect on that specific date, we really ought to have a motion picture analysis where you can take in variables of your choosing that you plug into a system that then quantifies your predictions about corporate performance in light of the conditions as you view them, interest rate risk, credit rate risk, customer satisfaction surveys. There is a whole array of things that tell you where the company is going as opposed to where it has been. That is the problem, is that the current system looks back and gives you an old snapshot. It doesn't tell where the corporate leadership is taking the company over the next few months.
Mr. HILLS. I think that is right, but you need a freeze frame once a year.
Chairman BAKER. But the issue is, on what do you base the freeze frame? Is it mark to market in current time? I think we have the technology today to get us to a mark to market on a daily basis.
Page 88 PREV PAGE TOP OF DOC Mr. HILLS. We are moving, as I said before, like it or not, inexorably toward market values rather than historic costs and trying to understand the values of corporations; and that is going to be a rocky road to get from one place to another.
Mr. KANJORSKI. Thank you, Mr. Chairman.
Mr. Chairman, I find myself in a peculiar situation here on this side of the aisle. We are supposed to be the pragmatists and the liberals, and I find myself arguing for Edmund Burke's theory that you don't change it if it is not broken and you maintain something until it gives value.
Here we have a long-term attempt to take professionals, create FASB, empower them to establish these rules and principles. We now have a process we are going to a global market looking for standardization and transparency so that securities can be traded world wide and we can have a view. And yet we are sitting here as the Congress second guessing and much inferior to the experts I may say at FASB or in the corporate world. We are imposing on a single basis whether or not we are going to expense one part of stock options or not expense it and worried a little bit about the impacts.
Mr. Barrett, I have a great deal of respect for you and your company, but do you really believe that that $3 billion that doesn't show up, that the analyst and the people that are making that evaluation, if we change this rule and you had to expense that $3 billion in stock options that would appear on your sheet, suddenly wouldn't be explainable and understandable and that it would just have a tremendous effect at driving your stock value down on the market?
The reason I pose that question to you, if that is the case, then Mr. Glassman and others that have testified aren't correct that people are paying any attention to the profit and loss statements. You already show that information in one place. Now it is going to move to another place in the profit and loss to be reflected, and yet you seem not to have very much faith in the analytical community or the investor community if that is going to so impact on your individual stock.
Page 89 PREV PAGE TOP OF DOC Mr. BARRETT. As the CEO of a company, I can't say I have no faith in the investor community. The analyst community is a different topic.
Mr. KANJORSKI. Touche.
Mr. BARRETT. My comment was merely that Mr. Sarbanes was here earlier. I do get to certify my results every quarter, transparent to the investor community, et cetera, et cetera. I would suggest that $3 billion is big enough to be noticeable in a certification process. It is big enough to be noticeable by an investor. It is big enough to swing the tide. If that is an error, then everything I do for Sarbanes-Oxley is trivial. I worry about $1 million and $10 million issues on the financial statement.
Mr. KANJORSKI. Mr. Barrett, I understand that. But I think Mr. Hills' point is that we are getting so raptured in absoluteness in accounting when, in fact, it is just another way of getting a snapshot. The problem I am worried about is now corporate America that has been using these stock options are coming for a release or a protection to the Congress of the United States, and we are going to start establishing this precedent that every element of our corporate structures that get impacted in some negative way by accounting rules proposed by FASB in the future, they don't have to worry about that. They just turn it into a political issue. Come on up here to the Congress, probably no greater informed than the average investor in America.
And I don't have a great deal of respect for that standard ofin spite of your feeling, Jim, that they are so well informed, do you really want us up here to turn this into periodic political issues as to what we do with expensing? It isn't very sexy. It isn't very attractive. And you are going to be dealing with people making these decisions on an ad hoc basis that could be very dangerous for corporate America, for the accounting profession and what it represents to get any insight on reliability. You know, we are just going to be where the numbers are, where the administration feels we should come down.
Page 90 PREV PAGE TOP OF DOC In this instance, so many of the respected people in our society seem to come out on the favor of doing the expensing. I mean, Paul Volcker is certainly equal in stature to Mr. Greenspan; and they are both in favor of expensing. And I think they make an adequate point. If corporate America can take a tax deduction based on the expense, why in the world can't it show it on its balance sheet? If I had my way, the statement would have to be identical to the tax statement so that we have reality there instead of these special provisions.
Mr. BARRETT. But you know that the tax laws are substantively different from the accounting laws across the board.
Mr. KANJORSKI. But why, Mr. Barrett? Because every time we have a tax bill on the Hill corporate America fills these halls with lobbyists who get their special provisions and their special ways. Now there is no rhyme or reason between what is good tax policy and what is reality in what should be taxed because everybody and their mother's uncle have a special provision up there.
Mr. BARRETT. Thirty years ago, Congress decided that it would be a tax-neutral event to tax stock options; and, therefore, they gave companies that depreciate a deduction associated with that.
If I could give you one thought, though, with regard to your earlier comments.
Chairman BAKER. Let me interject, if I might, with a little bad news. Not to cut Mr. Kanjorski off, we are down to 5 minutes on three votes. There are members who have expressed significant interest in coming back after the break for the votes. I don't know that each of youof your schedules, but Mr. Volcker possibly could come back. If you are available, we would like to recess at this moment and return, and that way we can give adequate time for members to follow up on their questions. Is that appropriate?
Mr. KANJORSKI. Very high-priced talent here, but if they will remain.
Page 91 PREV PAGE TOP OF DOC Chairman BAKER. We leave it at their scheduled availability. We certainly understand if you cannot. But we will be gone about 20 minutes.
We stand in recess.
Chairman BAKER. If I may, I will call our subcommittee meeting back to order.
To continue, Mr. Kanjorski was into his questioning; and we will put 2 minutes on the clock to pick up where you left off, if you would like to pick up.
Mr. KANJORSKI. I know it was a great question. I just can't remember it. It was the issue onMr. Volcker pointed out if the corporation can take the tax deduction, obviously that requires a calculation of what the value is. Why can't we just disclose it on the form? Why shouldn't we have parity in those two things? I will throw it out to the committee as a whole.
Mr. BARRETT. Well, are we trying to align accounting principles with Tax Code? I mean, it is my understanding that 30 years ago when Congress decided that options were taxable income they assigned some value to them, they did a tax-neutral assessment and allowed the corporations to take a deduction.
Mr. KANJORSKI. Right. The point I guess I want to make is, if you asked, in my opinion, 100 common people walking the street, most people would assume that, whatever your report is, a profit as a corporation is also taxed as a profit. They don't understand the double or triple accounting of tax difference.
I have to tell you something. We went over to voteI am not going to name the Members, but several Members were relatively shocked when they found outyou mean they are not paying taxes on these options? Or they are notor they have given a tax deduction on these options when in fact they are not reported on the sheet?
Page 92 PREV PAGE TOP OF DOC So don't overestimate the knowledge of the Congress or the American people. Most of us would like to think simplistically of how things are going, and every day we spend here in Congress we get more confused.
Mr. BARRETT. I get more confused every day I read the Tax Code.
Mr. KANJORSKI. Do you have any suggestion on Mr. Volcker's idea that if we are going to use it for tax deduction it should be able to be reported?
Mr. HILLS. Well, I have to say, in fairness, the Tax Code is a different bargain than the accounting rules. So I don't think you can insist upon consistency since there is a hobgoblin of inconsistency. So it is a good argument, but I would rather rely upon the fact that we do have GAAP with all of its weakness.
We do have a profit and loss statement, whether we should or should not. We do have a requirement of an audited statement. People can argue about all of those things, but we do have them, and so we should make them as good as we can make them. I say soldier on.
I must say I think this hearing and the airing of this subject is terribly important, and I do think that Congress should not be unaware of it. I can imagine that there are times when Congress needs to step in. I think it is premature now. I don't think the hearing is premature. But it is going to be another year, perhaps, or more before it moves.
We will know a lot more about this subject when FASB sends out its pronouncements, and I think we will all be comforted by the period that this is happening. I truly believe that Intel will be able to have the same option program it had today, even if FASB finds a way to require that options be valued in some fashion for purposes of earnings per share.
Mr. GLASSMAN. Mr. Kanjorski, I associate myself with Mr. Hills' remarks. Not the last one about the option program. I think Mr. Barrett is the best expert on that.
Page 93 PREV PAGE TOP OF DOC But can I comment on something you said earlier about Edmond Burke and not kind of changing things just to change them? If we accept your argument, which is that there is enough information out now or that the information today if it is sufficient is not going to change the value of the company if expensesif options are mandatorily expensed, that seems to me just as good an argument for keeping the current regime. So I think Edmond Burke would probably say, well, we have had it for 30 years. Why not continue it? Why make the change if the information is currently on the table?
Mr. KANJORSKI. I guess the argument to that is, then why have FASB and why have an attempt to go to international accounting? And then basically whatI just think, Mr. Glassman, what you are doing is you are telling the Congress that we are the final arbiters of all these individual rules and regulations on how we do things. And we like to think that of ourselves, but then you are talking about the whim and fancy of Congress as it changes every 2 years. I am not sure we are going to get the standardization. I am not sure we are going to get to some certainty, not numbers certainty but at least form and process certainty.
Mr. GLASSMAN. One last comment. I absolutely respect that position, Mr. Kanjorski, but I think that this is clearly an issue that for good reason has disturbed a very important sector of the U.S. economy. I mean, I think we needI have I thinkjust as you respect the idea that you don't intervene in every last little accounting issue, I also respect the fact that the engine behind this economy over the last 10 or 20 years really has been high technology; and high technology firms are very strongly opposed to this. And I think that theyamong others. And I think we need toyou need to examine it for that reason. And you are examining it today, and I congratulate you.
Chairman BAKER. Mr. Ose.
Mr. OSE. Thank you, Mr. Chairman.
I am amused by the thought when Chairman Volcker was herewhen Chairman Greenspan comes, the traders all hinge on everyone's remarks. I am amused by some poor trader in the options pit trying to follow this discussion today, pro or con, and what their reaction is.
Page 94 PREV PAGE TOP OF DOC One of the reasons I am a capitalist is that I enjoy immensely the dynamic nature of the economy. I think the issue that I would like to explore is, when we talk about American standards of corporate transparency relative to reporting this or that on the financial statements of American corporations, relative to perhaps the standards in the International Accounting Standards Board which, correct me if I am wrong, is largely focused more towards the European-type of corporation, we end up missing where most of the growth seems to be occurring now in the world economy and that is around the Pacific Rim.
One of the tools that our corporate leaders use to attract talent, obviously, is compensation in one form or another. I would be curious particularly of Mr. Barrett's input as to, as America's leading-edge corporate entities compete for talent in the world economy, what is the value or use of options? And if we depreciate that value by whim or fancy of Congress what the impact of that will be.
Mr. BARRETT. I think you can get the right vector, the right direction if you look at just what has happened in the last 10 years.
First, if you look at Taiwan, with the growth of the high-tech community in Taiwan which basically grew at the expense of U.S. firms because it was basically hiring U.S. workers back to Taiwan with options and start-up companies, you then just follow that point in time to what has happened in mainland China, what is happening in India. Mainland China, it is more in the manufacturing side; and in India it is more in the software side.
If you look at both of those countries or all three of those geographic areas building up, you look at the fact that the U.S. educational institution is still the best in the world at creating highly educated technical personnel. Roughly half of the Ph.D.s that graduate in the physical sciences in the U.S. are foreign nationals. They are increasingly going home. They are not staying here. And if you put U.S. corporations at a structural disadvantage I think you will just accelerate that.
Page 95 PREV PAGE TOP OF DOC That is where the action is in the future. The action is not in western Europe. The action is in Asia. You take Intel as the proxy. Asia Pacific, excluding Japan, is our biggest marketplace today, bigger than western Europe, bigger than the United States and growing much faster than either.
Mr. OSE. Are you suggesting that, to use Mr. Kanjorski's phrase, the whim and fancy of Congress may lead to unintended consequences of exporting of these high-tech jobs to an even greater degree than perhaps might be occurring today?
Mr. BARRETT. I think that is the potential danger, yes.
Mr. OSE. Thank you, Mr. Chairman.
Chairman BAKER. Mr. Sherman.
Mr. SHERMAN. I have so many comments I would be asking folks to respond in writing to some of the questions that I raise here.
The first point some of you have talked about, principles based rather than rules based accounting, please don't do it. Don't move in that direction. Investors need solid information they can rely upon.
Imagine if we had rules for determining, okay, how much will an appropriations bill cost. We could possibly agree on something that narrow. But if instead we wanted to apply the big principle of is it a fiscally responsible appropriations bill, I suggest you and I might disagree.
Imagine if the Chair of the Appropriations Committee could hire me to opine on the fiscal responsibility of his appropriations bill. I do think, though, that you could ask for three or four different pro formas, each prepared with strict standards.
Keep in mind that these auditors are selected by and paid by the company, just as we wouldn't have the Chair of the Appropriations Subcommittee selecting who is going to opine on the fiscal responsibility of his or her bill.
Page 96 PREV PAGE TOP OF DOC Chairman Volcker raises an interesting issue, and that is that the present system wildly distorts our executive compensation system.
Imagine if you had a cash-strapped company that was trying to provide incentives for its workers and managers. That company might set aside a million shares to be given as bonus shares. Top management might get the shares not based on whether the stock price goes up but whether it goes up compared to an index of companies in the same industry.
Because good management doesn't just ride the wave, good management outperforms the wave. You might give the division head bonus shares based upon the success of his or her division. You might give employee shares based on that employee's department. But if you did any of those things you would be using shares to compensate employees in a logical way. You get penalized by GAAP because, as I understand it, correct me if I am wrong, all of those methods would be expensed because you are giving shares to employees based on something other than the plain vanilla stock option plan.
Another company in the staple industry decides, oh, we are just going to have stock options for everybody. So some division head realizes that the success of his or her division slightly influences the company, provides some incentive.
Now I don't know which of these two systems is the better way to compensate executives or employees, but you do know that companies should decide that, without GAAP telling them, that they are going to be tremendously penalized if they choose anything other than stock options.
On the other hand, the Black-Sholes formula charging income when the options are granted seems pretty distortive. If you bring in an executive and say, Jack, you are doing a good job, here is a 3-year contract, and we are going to give you a raise, the cost of that compensation is charged over the 3 future years in which that executive works. But if you call him in and say, you are doing a great job, here's a 3-year contract, we are not going to give you a raise, we are going to give you options, then under Black-Sholes you charge income the year you give the person the raise rather than the 3 years that that person is going to work presumably for the company's benefit. Do I have that right?
Page 97 PREV PAGE TOP OF DOC Mr. VOLCKER. I should not pose as an expert in this area, but my understanding is that what the international body suggested in their exposure draftthey haven't decided yetis that you would amortize.
Mr. SHERMAN. That you amortize it over a length of time.
Mr. VOLCKER. Right.
Mr. SHERMAN. I have been told something else. But clearly if you have a stock option designed to provide an incentive over the period of time when the employee holds that option, that the cost is amortized over the period of time and that would eliminate that concern.
I agree with several panelists that nothing we do on this stock option would have solved the Enron or the corruption thing. Managers are always going to have it in their interest to overreport earnings, and the corrupt ones will do that unless the auditors prevent them from doing it. The idea if they didn't have stock options they wouldn't want to overreport earningsthere are so many reasons to want to overreport earnings.
I will ask, starting with Chairman Volcker, if you have any comments to the
Mr. VOLCKER. I don't fully agree with you on your last point. I fully agree that there are the lot of reasons that go into corruption or fraud or pressing the envelope too far, but I am afraid that we do see some evidence that the nature of fixed price stock options creates a temptation that adds to other incentives they might have.
Let me quote, if I may
Mr. SHERMAN. If we didn't pay our managers so much, then maybe they wouldn't have as much incentive. But can you think of any way of rewarding managers for success of a company that wouldn't cause them to seek to distort any measure of the success of the company?
Page 98 PREV PAGE TOP OF DOC Mr. VOLCKER. You, I think, have a problem. I think some methods are more vulnerable than other methods. There is tremendous leverage in a stock option.
So let me just read, if I may, a comment which I found interesting. It was by a dean of a business school who formerly was a strong advocate of stock options. He said, ''mea culpa. You know, it was a simple idea. We compensate managers with company stock or options so they will do the best for the shareholders. It doesn't always work that way. Motivating managers with company stock can damage on a grand scale, encouraging them to pursue strategies to fatten their wallets at the shareholders' expense. Consider the trajectories of Enron and its ilk as well as a host of dot coms, companies devastated by managers motivated by powerful stock-based incentives.''
Mr. SHERMAN. I understand you can find people wailing and bemoaning stock options and doing it in good prose. But is there any way to provide large incentive payments to managers based on a measure of their performance that would not be subject towould not provide an incentive to managers?
Chairman BAKER. That will be the gentleman's last question.
Mr. VOLCKER. Are there any that are perfectly
Mr. SHERMAN. Or even less likely than stock options.
Mr. VOLCKER. Restricted stock which you have to hold for some time, taking the ups and down of the stock and hold it for a considerable period of time beyond the vesting period. That has a quite different incentive. Even stock options, if you were required to hold them for, let's say, your whole period of employment, would reduce the incentive you have to do short-range manipulation.
So it is the matter of degree. It is not
Chairman BAKER. The gentleman's time has expired.
Page 99 PREV PAGE TOP OF DOC Mr. OXLEY. Thank you, Mr. Chairman; and let me welcome this outstanding, all-star panel. I made a special effort to get back because I did want to, first of all, welcome you and, many of you, welcome back. We have some veterans here who have testified before this committee more than once. But we are delighted to have all of you here and to have your knowledge and participation.
Mr. Volcker, fixed-price options are an exceedingly popular way of providing compensation. Why haven't more companies used performance-based options in that respect?
Mr. VOLCKER. Well, I think one reasonI will give you two reasons. One reason is that the performance based options, I think it is an anomaly, are expensed. So if you are worried about how your immediate impact is going to be on the earnings statement, you are biased towards fixed-price options.
I once was the director of a company that had performance-based options, and I think it was an appropriate way to do it, but it does get into a lot of arguments about exactly how you measure performance. Do you do better than your competitor's stock price? Do you set some hurdle rate for return on capital?
Mr. VOLCKER. Do you have a price-earnings ratio?
There are a lot of different measures you can take, but I know we spent a lot of time arguing about it. So it is more complicated, but it makes I think, by and large, on the face of it more sense than a fixed-price option, which demonstrably has capricious results, because it is so affected by the total change in the stock market rather than the performance of an individual company.
You know, American managers suddenly didn't become geniuses in the 1990s compared to where they were in the 1980s. At least, they weren't six times more genius, but that is when the stock market went up. Then it goes down by 50 percent. I don't think they are all stupid. So you get very capricious results. It has got quite a lot of resemblance to giving a lottery ticket, because so much of the result is not dependent upon the performance of the particular company.
Page 100 PREV PAGE TOP OF DOC Mr. OXLEY. Mr. Barrett, do you have a comment on that?
Mr. BARRETT. I think I would echo some of Mr. Volcker's comments. It is complicated to decide exactly what metrics you would choose, and you get capricious results on either side. The market can go up or down without you, and should you be benefited by that or disciplined by that is always the question.
We have adopted a fixed-price option. It is relatively simple and straightforward. If the shareholders benefit, then they only benefit when the price goes up. Then presumably you are doing a good job for your shareholders, not perfect but very simple and straightforward.
Mr. OXLEY. Mr. Hills.
Mr. HILLS. Devising a compensation policy for any company is a marvelous task. Cash, stock options, deferred compensation, retirement benefits, health plan, it is a complicated transaction. A lot of it should be based upon performance.
Personally, in the various boards on which I have sat, we have always had performance-based stock and some performance-based options. We found performance-based stock is probably a little easier to work with, is less volatile, but, as Chairman Volcker said, the decision to use these things is controlled by GAAP policy more than it is by common sense.
Mr. OXLEY. Interesting.
Mr. GLASSMAN. The use of stock options, it seems to me, is the purest way to align the interests of management with those of shareholders. The price of a stock is the best manifestation of a company's value. It is better than any kind of performance-based measure because millions of people are voting on what the value is every day. It is not perfect. Absolutely. But it really is the best.
So if you want to align the interest of managers and shareholders, which is what companies want to do and should want to do and which was not done, by the way, to a great extent in the 1970swe got into trouble for thatthe best way to do it is through stock options. And frankly, obviously, there are some risks to be run there, the temptation to manipulate in some way the stock, but I don't think there is any way to avoid that unless you bar managers from owning stock period, and that wouldn't be a very good idea.
Page 101 PREV PAGE TOP OF DOC Mr. HILLS. Let me comment, Jim.
The best way to align the shareholders' interest of management is with stock, not stock options. You find yourselfI found myself more than once in a situation where you have to make a decision on a board or on a company, and if that decision means you have nothing, which is what happens if the stock goes along a certain point, that affects your decision, as distinguished from the stock goes down a buck. If the stock goes down a buck, you may have lost 50 bucks. If the stock goes down a buck, you may have lost all your options. So I would say to you that the best way to align stockholders and managers is with stock.
Mr. OXLEY. What about that, Mr. Glassman?
Mr. GLASSMAN. I think stock is a good way to align the interests of stockholders and managers. There is a very interesting paper on the differences between the two which I cite in my testimony and I am happy to introduce as an exhibit.
I do think, however, that options in some ways because of their leverage, because the increases are so dramatic, that makes it a much more important incentive for managers. I think options are a very good way to do it, frankly, rather than awarding stock.
Mr. OXLEY. Mr. Volcker.
Mr. VOLCKER. It isjust an obvious problem with a fixed-price stock option is you gain when the leverage goes in your direction; you don't lose when it goes in the other direction. That is a silly kind of incentive, frankly, for any manager. You can get a fixed-price stock option, and compare to the performance of the stock of a company that did no better than the interest on a government bond in the 1990s, you make a lot of money. Now, is that a great incentive? I mean, you took no risk of loss, and you made a lot of money when the shareholder would have been better off buying a government bond.
Mr. GLASSMAN. I would say, Mr. Volcker, that if your compensation as a CEO is 50 percent or 30 percent or some large number tied up in stock options, that if those options become worthless that is a big hit to you.
Page 102 PREV PAGE TOP OF DOC Mr. BARRETT. Could I offer one comment?
Mr. OXLEY. Yes, Mr. Barrett.
Mr. BARRETT. I read an interesting summary by the proponent of expensing stock options who alluded that there would be immense innovation in the field of executive compensation associated with this whole movement. I was dismayed by that for the following reason. The way companies are successful is we have innovation in products and services and we compete in the world's marketplace. If all we get out of this is a discussion on innovation and compensation strategy, I think we will have collectively lost.
Mr. OXLEY. Mr. Chairman, my time is expired. Let me once again thank our distinguished panel. This has been a most interesting dayI think the Chair will agreeand one of our better hearings that we have had because of the quality of witnesses that we have had. I yield back.
Chairman BAKER. Absolutely. Thank you, Mr. Chairman.
Mr. SHADEGG. Thank you, Mr. Chairman.
Let me start out with what I think are some points of agreement, and if I am incorrect, please let me know. Let me start out with a premise that I think all of you are agreed that stock options are not the causewere not the cause of the Enron WorldCom scandals with which we were faced a year ago and that this committee dealt with. We all agree that they are not the cause?
Mr. VOLCKER. Sorry. I don't agree with that. I think they were probably a contributing factor.
Mr. SHADEGG. Okay.
Mr. HILLS. I would say that it is a contributing factor. Certainly not the dominant factor. In many of the scandals it was a contributing factor.
Page 103 PREV PAGE TOP OF DOC Mr. SHADEGG. Let me try one that I think you will agree with. I believe we all agreed, particularly, Mr. Volcker, you and Mr. Hills agreed that there were bigger problems facing us in terms of corporate accounting than in terms of the stock option issue. Is that correct?
Mr. BARRETT. Yes. I think all three of usor four of us might agree on that topic.
Mr. SHADEGG. Yeah. I think we all agreed on that, but particularly the other two.
I think there was agreement that valuing is difficult and imprecise, and I think both Mr. Volcker and Mr. Hills would agree with that, even though Mr. Barrett and Mr. Glassman are stronger critics of the ability to value stock. Is that right?
I think we also have agreed that broad-based stock optionsand here it is particularly Mr. Barrett and Mr. Glassman have said broad-based stock options are a good vehicle to give employees ownership in a corporation, to give them a sense of ownership, to tie them to the company, but I think there is all agreement across the board that broad-based stock options have a value in incenting employees and making them a part of the company.
Mr. VOLCKER. I agree with that, but I don't know if they can do it more effectively than giving them stock or a performance option.
Mr. HILLS. I must also say it is company specific. It is quite true of a wide range of companies that broad based is terrific, but there are a whole lot of questions that it doesn't make any sense at all.
Mr. SHADEGG. Mr. Glassman made the point and Mr. Barrett that they are very important in incentivizing particularly in the high-tech field but generally across the board, and I didn't find a disagreement with that amongst the other two witnesses.
I think there also is agreement across the board that narrow stock options limited just to top management can in fact distort corporate conduct and hurt the overall interest of the corporation. Are we pretty much agreed on that?
Page 104 PREV PAGE TOP OF DOC Go ahead, Mr. Barrett.
Mr. BARRETT. We continue to get into this corrupt actions by senior executives. It is not clear to me always that stock drives that one way or the other. There are certain rules of conduct we all ought to be obeying if we are CEOs. If we obey those rules of conduct, we don't trade on insider information, we don't do things untoward to the P/L, then I don't see an issue. But if people want to be criminals, they will be criminals.
Mr. SHADEGG. I agree with that.
The point I thought there was agreement on is that a narrow stock option could in fact distort the conduct of some corporate executives even when it is not illegal, causing them to highlight temporary profits for their personal gain. I guess I will concede to you that that leads me to the conclusion that expensing looks like a solution in search of a problem.
I guess I want to ask you, Mr. Hills, if we are agreed that any particular valuation method will in fact be somewhat accurate, a point more strongly held by two of your panelists than by you. Why isn't it better off to simply rely on the current disclosure mechanism and allow competing mechanisms for valuating those stock options in the marketplace rather than prescribing a single one which will have whatever inherent defects that particular method for valuating them is?
Mr. HILLS. I would say two things. First, it is not that it is inaccurate. It is that it has a lack ofit has an area of imprecision, no greater, as Mr. Herz said, than other things in the P/L statement. There are imprecisions in many parts of the profit and loss statement. Imprecision in cost recognition, for example, dwarfs any imprecision you get in the cost of a stock option.
Mr. SHADEGG. So aren't we just shifting the imprecision created by the current footnote structure where you gather a certain amount of information and all of the observers of the market can look at that footnote information and make their valuation of what those options do to the corporation's actual profit and loss position versus a prescribed method where we say, okay, this is the way you will valuate these stock options. And now we have prescribed one error. All we have done is shift the imprecision, I would argue, from one place to the other. But the unsophisticated now believe, well, this is the right answer because government, FASB in this case, mandated it.
Page 105 PREV PAGE TOP OF DOC Mr. HILLS. This is a good argument for not having an earnings per share conclusion. But if you have an earnings per share conclusion, there are things that ought to be in it. Cost recognition ought to be in it. Cost earnings options should be in it. There may be, as I indicated from The Economist article, a range of assumptions that may be chosen differently by one company from the other, so there will be flexibility left hopefully in doing it, but imprecision has never been a reason for not putting something in earnings per share.
Mr. SHADEGG. I guess the second question I have is, doesn't your argument against precision accounting, which I thought was a fascinating argument, auger against expensing stock options and having the FASB prescribe the method in which they will be valued?
Chairman BAKER. If I may, let that be your last question so I can get in one more gentleman in before Mr. Volcker has to leave. And to whom was that addressed?
Mr. SHADEGG. Mr. Hills.
Mr. HILLS. My answer is that, first of all, I am not against precision. I just can't find it.
Mr. SHADEGG. But if we can't find it now, are we going to find it any better with FASB prescribing expensing and how?
Mr. HILLS. There is a degree of inexactitude in accounting and the trick here
Mr. SHADEGG. I thought you made that point compellingly.
Mr. HILLS. And the trick here is to do as good a job as you can for only one measure of the value of the company. One of the problems here is our analysts aren't trained enough to look at other values. Earnings per share ought not to be the controlling factor it is in valuing stocks.
Chairman BAKER. Thank you, Mr. Shadegg.
Page 106 PREV PAGE TOP OF DOC I am understanding you to say that we have that snapshot once a year, but it may be kind of fuzzy when we look at it?
Mr. HILLS. Yes. You need glasses.
Chairman BAKER. Thank you.
Mr. SHAYS. Thank you.
I am sorry you gentlemen had to wait so long and then we had to have the break. I have been here 16 years, but I feel like you all know more on this issue in your pinky than I know on my entire body, but maybe that is why we have witnesses. But I can react to what you are saying, and some of it to me is just on the face of it somewhat hard for me to come to grips with.
I mean, Mr. Glassman, when you talked about FASB rushing into a decision, I think they act slower than a turtle. You know, I don't feel there is a rush to a decision. I feel like this has been an issue that we have been debating for years, and they are finally doing what they should have done a while ago. So I am just reacting to that and would love to hear your comment of why it is a rush.
I feeland I am looking for reaction. I am asking myself, is the question we don't want investors to know the truth or is it we want them to know the truth, we just don't know what the truth is? But somehow we know how to tell people when we expense it it has value, and somehow we thinkand I am reacting again to you, Mr. Glassmanthat we say, you know, investors are smart. They read the fine print.
Well, a lot of investors don't read the fine print. They don't read anything. They just invest. And maybe that is their problem, but it seems to me that if investors are smart enough to read the fine print, they are smart enough to recognize that the company may not have the same value on the marketplace for some dumb reason, because all of a sudden they have to expense it. And it would seem to me they would say, well, part of the reason why they are valued this way is they had to expense it. But to me it isI mean, disclose that.
Page 107 PREV PAGE TOP OF DOC But to me as an investor, I would say, hey, this is undervalued stock. Now, maybe I am just all screwed up here, but I would like comments.
I would also like comments on the other issue. It used to be we took the lead and the ISAB followed. It seems to me because we have not seized the initiative the ISAB may be taking the initiative. If they then decide that this has to be an expensed item and we don't, what challenges are involved with that?
So I mentioned Mr. Glassman's name more than once. Why don't you start?
Mr. GLASSMAN. Thank you, Mr. Shays.
The reason I use the word ''rush'' is certainly FASB has taken a long time to get to this issue, but I think under new management it seems to be moving very, very quickly and I think too quickly, but that is a matter of judgment. Mr. Herz said that there are peoplewhy is it moving quickly? Because people are notgroups are not only supporting but demanding some kind of action.
On this fine printand I think that is a very important question. First of all, it is not fine print. The print is as big as it is for the P/L statement. So it is not fine, but it actually provides fine information, important information. About half of Americans own shares through mutual funds and other institutions, and I would hope and I know that the managers of those institutions in fact do read the footnotes. And if they don't, they shouldn't be in their jobs, and they certainly do. So that information is there.
The point I was trying to make in my testimonyand it is not, as Rod Hills said, that I don't believe in P/L statements. It is just that
Mr. SHAYS. It was a funny comment, and you didn't laugh.
Mr. GLASSMAN. You are right. I didn't laugh, because I think
Mr. SHAYS. That was the high point of the whole damn hearing, frankly.
Page 108 PREV PAGE TOP OF DOC Mr. GLASSMAN. Well, now I am going to provide you with another high point. It is not that I don't believe in P/L statements. I think they are very, very important, but I think they are only one way of valuing a company.
Let me quote the sainted Warren Buffett, not on public policy but on something that he really knows a lot about, which is investing. He says, how do you value a company? You just want to estimate a company's cash flowsnotice he says cash flows. He doesn't say earnings or P/L statementcash flows over time, discount them back and buy for less than that.
Mr. SHAYS. See, I think he told you that so you would make bad investments and he could keep making good ones.
Mr. GLASSMAN. That is true, but I own his stock. So the point is cash flow is tremendously important.
I think we are headed for a revolution, and the Chairman recognizes it. He mentioned XBRL. Things are changing in accounting, and I think we are fighting the last war in talking about expensing. It is like this is a Crimean War, okay. What is happening more and moreand I wish FASB and the Congress and the SEC would start promoting this kind of thinking. We need morethere is tons of information out there that is okay. They use it every day. I think investors should have more access to it, and I actually believe that the current regime with the footnotes and all that stuff actually promotes that kind of thinking much more than trying to shoehorn a single number into a GAAP statement which doesn't tell you all that much about a company.
Mr. BARRETT. I think you have got a good representation of this just this last quarter. One of the 280 companies who have said or actually do expense options, Amazon.com, reported their quarterly earns. They did it precisely with a GAAP P/L and a pro forma P/L. Nobody paid attention to the GAAP P/L. They only paid attention to the pro forma P/L. What you are going to see is precisely that replicated across the board, and frankly I thought what we were trying to do was harmonize all this stuff so we would get away from pro forma P/L's.
Page 109 PREV PAGE TOP OF DOC But in this instance, which I think is representative of what is going to happen, people went backyou can shake your head, Paul, but this is what they did. They went back and looked precisely at the cash flow of that company. They didn't look at some arbitrary expense.
Mr. SHAYS. Home Depot and Wal-Mart now have spent
Mr. VOLCKER. I am not shaking my head about what they do. I think you will find
Mr. SHAYS. Well, let me just make this point before you start. Home Depot and Wal-Mart now expense, and has that proved to be a negative for them?
Mr. BARRETT. I think if you look at most of the companies that expense options, it is a de minimus impact on their P/L. They only give options to the top executives of the company. They don't have broad-based option programs. If Intel
Mr. SHAYS. Yeah. It is broad based.
Let me just have Paul just respond if I could. You were going to say something, Paul, and I
Mr. VOLCKER. I was going to say, on this pro forma thing, this has become a big problem, because companies do present pro forma earnings the way they like to present them, which means there is no consistency. I would be very disappointed if the accounting standards setters do not in the next few years promote a standard for a standard pro forma statement that they will make a judgment about what should be on the pro forma and what should not be on the pro forma, what should be on an operating earnings statement to get some consistency. Because if you just leave it in a jungle, so to speak, you do get below the lines the stuff they don't want to report, and the stuff above the lines is good stuff.
Mr. HILLS. Mr. Chairman, would you excuse me? I promised to give a lesson to 12 Russians on corporate governance at American University, and I really
Page 110 PREV PAGE TOP OF DOC Chairman BAKER. I think this effort has been more challenging than your task. Let me express appreciation.
Mr. Sherman wanted to make a brief statement. Please leave at your leisure.
Mr. SHERMAN. Thank you, Mr. Chairman.
I want to agree with Mr. Volcker that we need standardized rules for the pro forma statements. If they are going to serve chocolate, vanilla and strawberry, there ought to be a fixed recipe for each one of those three ice creams.
I think the arguments against expensing options may go too far. You have said that we have to compete with Asia for capital and for talent, and anything that impairs that effort puts us at a disadvantage. I want to point out that maybe compensation for managers is a good thing, and we want to encourage it. And we want to make companies that compensate their managers look good compared to Asian investments, but if we are going to do that, wouldn't we do the same thing for employee education programs? Wouldn't we do the same thing for research and development programs?
If you buy that argument, then maybe it is critical that we as a Congress instruct FASB to say that employee education and research programs and maybe all management compensation of all types ought not be charged against income, since we want to encourage those things or some of them and we want to make our companies that do them look good compared to their Asian competitors.
There is this argument that option holders and stockholders have identical interests. I think those interests are wildly different when it comes to risk. If I am a stockholder and I see one policy gives me a chance at the stock going up 10 percent or maybe it will go down 10 percent, that might be a good plan. But if I am an option holder, I would much prefer a company that has a chance to either double in value or go bankrupt, because whether it goes down 10 percent or goes down a hundred percent, I am in the same position.
Page 111 PREV PAGE TOP OF DOC Executives, however, are both salary earners, where they are going to want a low-risk approach so they keep getting their salary, and they are option holders, where they are going to want a high-risk approach. When an executive becomes primarily not a salary earner but an option holder, you have a strong incentive for a high-risk approach.
Chairman BAKER. Can the gentleman wind up? I have got somebody else that wants to make a statement before we leave.
Mr. SHERMAN. And that concludes my remarks.
Chairman BAKER. I thank the gentleman for wrapping up.
Mr. OSE. Thank you, Mr. Chairman.
I want to express my appreciation to one of our witnesses here. When I was a much younger man, I came out of college, went in the real estate business, and shortly thereafter was confronted with an inflationary environment that was, to say the least, challenging. Mr. Volcker played a central role in bringing that bear under control. If no one else ever says thank you, I intend to today. Thank you for doing that.
Chairman BAKER. If there are no further comments, I just want to express my appreciation to you for your time and your willingness to stay with us today. It has really been most informative. We look forward to FASB's conclusion of their work product, but I think this marks a beginning of our long-term review of the appropriateness of current accounting regimes and not to get into the professional aspects but to the goals of our accounting methodology, to assist in all shareholders and those who have interest in a transparent, free flow of information that benefits the growth of our economy. Thank you for your participation.
Our meeting is adjourned.
[Whereupon, at 2:37 p.m., the subcommittee was adjourned.]
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