Segment 2 Of 2     Previous Hearing Segment(1)

SPEAKERS       CONTENTS       INSERTS    
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THE FASB STOCK OPTIONS PROPOSAL: ITS
EFFECT ON THE U.S. ECONOMY AND JOBS

Tuesday, May 4, 2004
U.S. House of Representatives,
Subcommittee on Capital Markets, Insurance
and Government Sponsored Enterprises,
Committee on Financial Services,
Washington, D.C.
    The subcommittee met, pursuant to call, at 2:05 p.m., in Room 2128, Rayburn House Office Building, Hon. Edward R. Royce presiding.
    Present: Representatives Shays, Royce, Hart, Sherman, Moore, Frank (ex officio) and Hinojosa.
    Mr. ROYCE. [Presiding] I would like to call this meeting of the capital market subcommittee to order.
    This afternoon we are going to convene for the purpose of reviewing the pending Financial Accounting Standards Board employee stock option expensing proposal, and we are also going to be looking at the potential effects its adoption may have on job creation and on the U.S. economy.
    In previous hearings on this subject, I have expressed deep concerns about the potential economic consequences of FASB's proposal to require the mandatory expensing of employee stock options.
    Like other supporters of Chairman Baker's legislation, H.R. 3574, I believe that broad-based stock options have played an important and positive role in our economy. Stock options enable emerging companies which often do not have a tremendous amount of excess cash or a tremendous cash flow to attract talented employees that would otherwise not work for such innovative firms.
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    Some people claim that issuing stock options represents an expense to a firm. However, stock options do not represent a cost to an entity. No cash is ever disbursed from the company's treasury. Existing shareholders may see their ownership diminished through dilution, but current accounting standards already require potential dilution to be fully disclosed.
    In the not-so-certain case that employee options are actually exercised and the employing company then receives cash, employees who accept options are taking a well-known risk. There are no guarantees a firm will succeed and its stock price will rise.
    We hear about the successes in business, but we should not forget there are far more failures. Creative destruction leaves a wake of failed ideas.
    The specific purpose of today's hearing is to explore the economic impact of FASB's proposal. Economic behavior has already changed because of this proposal. Many technology firms have already announced that they will no longer issue employee stock options. As a result, many firms have not been able to attract needed employees. Whether an individual is risk-averse or that individual is risk-taking, or even risk-loving, he or she is not likely to leave their job with a large, mature firm to go to a start-up for a compensation package containing less cash and no stock options.
    If one accepts the premise that FASB's proposal will end broad-based stock option plans as we know them today, then we should think about the potential long-term negative consequences for our economy. Firms like Intel, Microsoft, Cisco and Yahoo all used stock options at their early stages to attract their employees. Other nations in Asia are now trying to incubate an environment like the one that we had here.
    Would these firms have reached their amazing levels of success had stock options not been an available tool for recruitment? Will this proposal inhibit the development of the next Intel? Established firms will survive and prosper under any new rule issued by FASB, but I think some of us are concerned that new firms may not develop as a result, and I believe that it is important for Congress to raise these concerns.
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    We are very fortunate to have Mr. Herz and Mr. Batavick here today to help deal with these issues, and I hope that in your opening remarks you will address such questions as has FASB field-tested valuation models? Has FASB considered the economic consequences of mandating expensing? Has FASB considered that mandatory expensing could give foreign-based firms a competitive advantage in attracting employees? Is FASB concerned that its proposal could make financial comparability between firms more difficult? And lastly, is FASB still open to considering other nonbinomial methods or models for this approach?
    I look forward to hearing answers to these and many other questions, and I would like to turn to my California colleague now, Mr. Brad Sherman, for any opening statement he might like to make.
    [The prepared statement of Hon. Edward R. Royce can be found on page 164 in the appendix.]
    Mr. SHERMAN. I thank my friend and colleague from the Los Angeles area. I want to commend Chairman Baker for having hearings where at least we finally hear from the FASB, since we have had so many hearings criticizing their work or their intended work. It would have been nice if the Chairman had gone one step further and scheduled these hearings at a time when most of our colleagues would be able to attend, and that these hearings could be as widely attended as the hearings bashing the FASB were. Of course, those were scheduled at a time when there could be votes on the floor. These are scheduled many hours before the first vote of the week, and it would have been nice, I guess, if the Chairman had at least scheduled these hearings at a time that was convenient for him to attend.
    I have signed letters for a long time, as one of the few CPAs in Congress, saying let the FASB do its job. My problem is the FASB has not been doing its job in two areas, both directly related to high-tech firms principally, although—stock options go way beyond high-tech.
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    The first is stock options where for—going back to the APBs, let alone the FASB announcements, you have punted on this issue with a unique approach where you say, this is the right way, but you are free to do it some other way.
    Where are the plaintiff's lawyers when you need them in that?
    The second area is in research, where you and I have talked, Mr. Herz. You know that demanding the write-off of research is very harmful to our economy and is wrong accounting and has been, and that there isn't a single accounting theory book I can find published in the last century that would form a basis for the immediate write-off of research; and, yet, what we have here is, in some bizarre way, compensating errors. You don't make high-tech firms write off their executive compensation, but you do force them to treat every research project as if it is a black hole that produces no asset.
    Now you are undoing one part of the problem without the other. It may very well be that we should wait to deal with one issue until you can deal with the other. Correcting one of two errors where there are compensating errors may give you a worse appraisal of how the high-tech sector is doing than leaving the matter alone until you can deal with both.
    But let me put some dollar figures to contrast the size of these two. Stock options, if expensed last year, total expense would have been $47.6 billion. Some roughly $10 billion of that was expensed as companies voluntarily decided to expense stock options, but roughly $38.6 billion, to calculate it in a variety of different ways, would have been expensed had this provision been applicable last year.
    In contrast, on the research side—and I think this number is way too low, but the number I have been given by the National Science Foundation is $176 billion, and I would suggest that the private sector is probably doing a lot more research than that.
    So the research is at least triple in importance, perhaps a factor of 5, a factor of 10. And so when you go to determine what are the net results of our high-tech firms as compared with firms that don't do much research and may not do much in the way of stock options, you have these offsetting errors. The one you are not—the one we are not dealing with, the one you haven't dealt with yet, is at least five times as big and would cause more investment in companies that do research.
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    Now, we are told that stock options aren't an expense. Let's apply this to every use of stock options other than compensation. Well, first we are told stock options are not cash. Well, you could issue shares of stock, and that would not be cash either, and I won't bother to ask this as a question, because we all know the answer.
    If you issue a bunch of shares of stock to compensate your employees, you have to list it as an expense even though it cost you no cash. The sole effect is to dilute the shares outstanding. You have to list it as an expense. You issue stock to your lower-level employees, to your upper-level employees, to your board members an expense.
    If you were to issue shares to the best charity in our country, you would have to list it as an expense. If you were to issue shares to an insurance company to provide health care for your employees, an expense. And if you did options, if you gave options to a charity, you gave options to a health insurance company, you gave options to a special fund that was rebuilding Iraq, it is on that we have decided that the only thing that is so important that we as a Congress should interfere with the FASB and interfere with the basic rules of accounting theory is not in the area of charity. We could get more charitable contributions if we just decided charity never has to be listed as an expense, or if you use stock or you use options to make a charitable contribution. We could have more health care for employees if we just tweaked the accounting rules and said cash or stock or options used to pay for health care doesn't have to be listed as an expense. But health care for our employees, charity paid for by the corporate sector, these do not attract the attention of Congress. The only area where Congress wants to tweak the employees is in executive compensation.
    Now, we are told that it is broad-based. We were told that a lot of low-level employees get some options, but almost all the options are going to some people who are at the top of corporations, and it is that reason that the bill itself is written to define broadly based as, well, you are just not one of the top five employees, so if you are the number six person in Intel or the number six person at Disney, you are a poor, struggling secretary, I don't think so.
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    We are told about competitiveness. Well, we can compete for capital around the world with two approaches. One is the European approach, and it has always been the American approach. That is, have tough accounting standards, do the best job of enforcing them, give investors the most accurate possible picture according to accounting theory. You guys haven't done a good job on research in stock options, but on everything else that has been our proposal. That is the European approach.
    The other way to compete is to emulate what I would call the Bangladesh model. That is to say, let companies report what they want. They will report high earnings, and everybody will want to invest.
    I would suggest nobody in this room has chosen to invest in whatever stock market can give them the loosiest, goosiest, rosiest accounting picture possible, but rather they turn to those stock markets which have the toughest standards.
    So I look forward to questioning my friends at the FASB on whether their exposure draft really does do the job, and I have got some severe problems with it, why they have decided to take an industry that is punished unfairly by your rule on research and punish them fairly by correcting your multiyear problem on stock options, and to proceed with these hearings. But I would say that before we tweak the accounting rules to encourage executive compensation, we ought to tweak the accounting rules to encourage health care coverage for rank-and-file employees.
    Now, I do have—I would like unanimous consent to insert in the record a letter from the SEC Chairman to the Ranking Member of the subcommittee Mr. Kanjorski dated May 3rd in which he states that the process established by the FASB to consider the pending stock option proposal should be allowed to run its course. I wonder if there is any objection.
    Mr. ROYCE. Without objection.
    [The following information can be found on page 210 in the appendix.]
    Mr. SHERMAN. I yield back.
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    Mr. ROYCE. If they are so ordered.
    If there are no more opening statements, I would like to——
    Mr. SHERMAN. There may be some.
    Mr. ROYCE. All right. Let me turn to Mr. Shays and——
    Mr. SHAYS. I would be happy to defer to the Ranking Member.
    Mr. ROYCE. We will go to our Ranking Member.
    Mr. FRANK. I want to be brief, because I just want to, first of all, make clear the Ranking Member of the subcommittee Mr. Kanjorski had requested this and thought it was very important, but a resident of his district was killed in Iraq, and he is understandably at that funeral. So I want to make clear that his absence is not anything that was avoidable, and this remains a very important subject to him, and I appreciate the fact that we are going ahead with the hearing at his request.
    And secondly, I want to say I am torn, as I have said before. I am very reluctant to see us interfere with the FASB, partly because while the previous speaker is an accountant, almost nobody else around here is, and we as Members of Congress inevitably have to deal with subjects where the subject matter is very difficult for lay people. I am loathe to get us into more of these.
    Of all the roles I do not wish to play, it is being the appeals board to the FASB. Indeed, I think one sure way to cut down on campaign spending would be if Members knew that the consequence of winning a congressional seat and spending all that money was that you got to be the superappellate board on the most arcane accounting issues, I think that would be a severe disincentive.
    On the other hand, I have listened to some people for whom I have an enormous amount of respect in an industry which is very important to us, both because of the inherent good it does and because of the contribution it makes to our economy in various forms of high technology, and I am struck by the virtual unanimity of their concern. And so one of the things that I am going to hope that Mr. Herz can address is who is getting hurt by this.
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    Obviously there are technical questions to be resolved about what is or isn't the appropriate accounting, but accounting is, after all, the—a functional discipline. It is not an abstract one. We use accounting so we can better understand reality, and I do have a question as to whether or not—and maybe this isn't within FASB's jurisdiction—but is it the view of the Board and others who are advocates of this change that there are now investors who are being misled? Are there people who invest in these companies, and because options are not expensed but are listed elsewhere—obviously, I think we all agree, if people were giving the options and weren't telling you, that would be a terrible problem, but that is not what is currently allowed.
    So the question is are there people now who are being misled into investing, because while the information is being presented, it is being presented in a form different than you think accounting principals require? And that is really, I think, a very important question for us, at least within the FASB.
    I continue to believe myself that the damage that I have seen done by options has come in the perverse incentive in some case options have given the heads of some corporations, in many cases not high-tech corporations, who give themselves options, cash them in after the stock price has been driven up, and shortly thereafter the stock price tumbles, partly because some of the things that drove the price up weren't very good things for the long term. That is an abuse. I see it. I think we should try and deal with that and ask the SEC to help.
    But that is the central question, because I accept what I hear from a large number of people in the high-technology area that this will be damaging to them, and I want to know what harm are we undoing.
    So the last thing I would say is that it is also the case obviously that I guess there are very few—we know the perception and reality intermingle. This appears to be a case where perception is everything, because the reality is not being changed. The reality of options being granted won't change. Apparently a lot of people on both sides of this issue think in enormous-amount terms on how they are described, and I would hope that we could address the implications of that. Thank you, Mr. Chairman.
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    Mr. ROYCE. Thank you.
    Mr. ROYCE. Mr. Shays.
    Mr. SHAYS. Thank you. I just want to disclose the fact that FASB is in the 4th Congressional District of Connecticut, so I may be unduly influenced by that; to say that we are grateful FASB is in the Fourth Congressional District, we appreciate the good work the Board does, even if some of its members are not enlightened enough to live in the 4th Congressional District. And I would say to you that in my judgment, a tie goes to FASB.
    Mr. ROYCE. Mr. Moore.
    Mr. MOORE. Thank you, Mr. Chairman. I just want to thank the Chairman, the Ranking Member for convening this hearing. I want to also extend my appreciation to the witnesses for appearing. I look forward to your testimony. We will have questions. Thank you very much.
    Mr. ROYCE. Any other opening statements from the Members?
    In that case we will go to an introduction of our witnesses. First we have Mr. Robert H. Herz. Mr. Herz was appointed Chairman of the Financial Accounting Standards Board effective July 1st of 2002. Previously he was a senior partner with PricewaterhouseCoopers.
    Prior to joining the Financial Accounting Standards Board, Mr. Herz was PricewaterhouseCoopers' North American theater leader of professional, technical risk and quality, and a member of the firm's global and U.S. Boards. He also served as a part-time member of the International Accounting Standards Board. Mr. Herz is both a certified public accountant and a chartered accountant.
    We are also fortunate to have here his colleague Mr. George Batavick. Mr. Batavick was appointed to the Financial Accounting Standards Board effective August 1st of 2003. Prior to joining FASB, Mr. Batavick was most recently the former controller of Texaco. In this post he had companywide responsibility for strategy and policy matters covering all aspects of accounting and financial reporting, special studies, internal controls and tactical plan coordination.
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    Welcome back, Mr. Herz. You have the floor, and I would ask both of our witnesses—you will be recognized for a 5-minute summary of your testimony. Your written statements will be made part of the record. Mr. Herz.
STATEMENT OF ROBERT H. HERZ, CHAIRMAN, FINANCIAL ACCOUNTING STANDARDS BOARD
    Mr. HERZ. Thank you, Representative Royce and members of the subcommittee. George is with me because he heads up our Small Business Advisory Committee, and he will be talking about some of that activity.
    We are pleased to appear before you today on behalf of the FASB. We are very happy to participate in this hearing, particularly since H.R. 3574 or any similar legislation if enacted would preempt and override our ongoing public due process to improve the accounting and financial reporting for equity-based compensation.
    We have some brief prepared remarks, and we would respectfully request that the full text of our testimony and all the supporting materials be entered into the public record.
    Mr. ROYCE. Without objection.
    Mr. HERZ. As you know, our ability to conduct our work in a systematic, thorough and unbiased manner is fundamental to achieving our mission of improving accounting and financial reporting standards in this country. Those standards are essential to the growth and stability of the U.S. economy because investors, creditors and other consumers of financial reports rely heavily on credible, transparent, comparable, unbiased financial information to make their investment and credit decisions.
    Now, because the actions of the FASB affects so many organizations, our decision-making process must be open, thorough and as objective as possible, and therefore, our rules of procedure require a very extensive and public due process.
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    We issue proposals for comment, and then after that, when we get the comments, we hold roundtables, we actively redeliberate all the key issues. Those redeliberations often do result in significant changes and improvements to the proposals.
    The Board makes final decisions only after carefully considering and analyzing the input of all interested parties. We do our best to try and balance the often conflicting perspectives of various parties and make independent, objective decisions guided by the fundamental concepts and key qualitative characteristics of sound, fair and transparent financial reporting.
    In March of 2003, at a public meeting, we decided to add a project to our agenda to address issues relating to improving the accounting for equity-based compensation. The project was in response to the high level of public concern expressed by many individual and institutional investors, financial analysts, creditors, major accounting firms, many study groups and many other parties, including many Members of Congress, about the need to improve the accounting for equity-based compensation.
    Many believe that the existing reporting for equity-based compensation results in significant distortions in the reporting of earnings, operating results and operating cash flows, distortions that they believe cannot be remedied solely by improvements in disclosures. So the ultimate goal of our project is to develop a standard that results in reporting that more faithfully reflects the underlying economic effects of equity-based compensation and that brings about greater comparability of reporting.
    The project also provides an opportunity to achieve greater international convergence of accounting standards, an objective that we have been specifically encouraged to pursue by the Sarbanes-Oxley Act, by the U.S. SEC and by many other parties.
    On March 31st of this year, we issued by a unanimous vote a proposal for public comment to improve the accounting for a wide range of equity-based compensation arrangements. That proposal is a result of a very extensive public due process. The process included the issuance of a preliminary document for public comment, the review of over 300 comment letters and over 130 unsolicited letters, review of research and consultation with many, many parties.
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    Based on our extensive public due process to date, the Board believes that the proposal would significantly improve the financial reporting for equity-based compensation arrangements. By creating greater transparency, completeness and a more level playing field in the accounting for different forms of equity-based compensation, we believe that the proposal would enhance the comparability of reported results between enterprises that choose to compensate their employees in different ways.
    The proposal would achieve it through a number of provisions, including eliminating the existing exception for so-called fixed-plan employee stock options, which, as Representative Sherman indicated, are the only form of equity-based compensation that is not currently required to be reported as an expense in the financial statements.
    The proposal also includes provisions that we believe would improve the transparency of the effects of equity-based compensation on reported cash flows and that are aimed at addressing what many believe have been significant distortions in the reporting of operating cash flows by companies that make significant use of employee stock options.
    The proposal reflects the view that all forms of equity-based compensation should be properly accounted for as such, and that the existing exception for fixed-plan employee stock options results in reporting that not only ignores the economic substance of those transactions, but also distorts reported earnings, profitability and other key financial metrics.
    I would note in contrast that this distortion again, as Representative Sherman indicated, does not occur when the same company uses stock options or similar instruments such as warrants for purposes other than compensating employees; for example, in acquiring goods or other services, or in financings or M & A transactions. In all those cases the current accounting has long required that the options or warrants be properly valued and accounted for in the financial statements.
    In the public company arena, the proposal would bring about greater comparability between the now over 575 companies that have voluntarily opted to account for the cost of employee stock options and the many others that have not done so.
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    It would also be responsive to the growing number of companies, including a number of major technology companies, whose shareholders by a majority vote have approved nonbinding proxy resolutions mandating expensing of all employee stock options. Managers of a number of those companies have indicated that they are awaiting completion of our project in order to respond to the demands of their shareholders.
    The proposal would also result in substantial convergence in the accounting for equity-based compensation between our standards and international standards that are followed in over 90 countries around the world.
    I would also note that in Canada, who often follows the lead of the U.S. in improving accounting standards, they felt they could not wait on this topic and decided to mandate expensing of all employee stock options beginning in January of this year, and I understand that implementation of their new standard is going very smoothly.
    Finally, with regard to the potential economic consequence of our proposal, many economic experts that have addressed the issue of the accounting for employee stock options, including Federal Reserve Chairman Alan Greenspan, former Federal Reserve Chairman Paul Volcker, Nobel Prize-winning economists Robert Merton, and Joseph Stiglitz, and groups like the Financial Economist Roundtable, the Republican staff of the Joint Economic Committee of the Congress, the Conference Board Commission on Public Trust and Private Enterprise co-chaired by Pete Peterson and John Snow, major investment banks, and the Congressional Budget Office have all indicated support for mandatory expensing of employee stock options.
    Indeed, many of these experts have also indicated that mandatory expensing could have positive economic consequences because of the improvements in capital allocation that would result from having more credible, comparable and transparent financial information, not to mention helping to continue to shore up public confidence in financial reporting.
    Now, we recognize that one size may not fit all, so I am going to hand over to George in a second who will discuss the several special provisions contained in our proposal relating to small businesses and start-ups, as well as other matters relating to our continuing work and due process on this topic.
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    I would like to assure you that we recognize the importance of small business and start-ups to job creation, to entrepreneurship and to our Nation's economy, so we also understand that any standards we prescribe that apply to small business must not only be conceptually sound, but also must be operational and cost-effective.
    Mr. ROYCE. Mr. Batavick.
STATEMENT OF GEORGE J. BATAVICK, BOARD MEMBER, FINANCIAL ACCOUNTING STANDARDS BOARD
    Mr. BATAVICK. Thank you, Mr. Royce, and thank you, Bob, and good afternoon everyone. Before I outline the special small business provisions contained in our proposal to improve the accounting for equity-based compensation, I would first like to provide some brief background on small businesses and financial and accounting reporting standards.
    First, there is no Federal law requiring nonpublic enterprises to use FASB standards. Thus, for most small businesses, the use of our standards is primarily a private choice. For some small businesses, that choice may be influenced by whether they have plans to become a public enterprise. For other small businesses, the decision to follow FASB standards may be influenced or controlled by their current or potential lenders-suppliers, other contracting parties or State regulators. To the extent that one of these parties requires that the financial reports of small businesses comply with our standards, that requirement presumably reflects the party's opinion that our standards result in better, more transparent information for their respective purposes.
    Second, it is also important to note that the FASB has long recognized as part of our public due process procedures that the cost of complying with our standards can fall disproportionately on small businesses. In recognition of that fact, the Board actively solicits and carefully considers requests from users, auditors and preparers of the financial reports of small businesses to provide for special provisions to alleviate the costs of implementing our standards. Those requests come from our continuous and ongoing due process and deliberations throughout the life of the project.
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    If you are following our project on equity-based compensation, and you wanted to keep up on what was happening, all interested parties, including small businesses, can take advantage of our free weekly action alert, which is by e-mail. We discuss current agenda items and past Board decisions. Interested parties can also attend our Board meetings, call in or listen to our free Webcast of our meetings on the day of the meeting, with replays of our meetings available 1 week thereafter.
    Our meetings also get extensive news coverage by the top news agencies, and our free Web site includes up-to-date summaries of all equity-based compensation issues discussed in our tentative decisions.
    We actively seek input from various State CPA societies, and membership in turn brief their clients, in many cases small businesses, on the status of this and other Board activities.
    In addition, liaison meetings with various groups having small-business representation and Board member and staff speaking engagements provide additional means of receiving valuable input from the small-business community.
    With respect to this proposal on stock-based compensation, it is our understanding that although the use of employee stock options is present at some small businesses, particularly start-ups and venture capital-backed enterprises that plan to become public enterprises, the vast majority of small businesses, over 95 percent, in the U.S. do not grant employee stock options.
    As indicated earlier, however, for those small businesses that are affected by our proposal, the proposal includes several provisions intended to alleviate the cost of implementation. First, the proposal includes a special provision that would permit most small businesses, including all that are not public, to measure compensation costs using a simpler, less costly intrinsic value method rather than the fair value method that would be required for most public enterprises. Under the intrinsic value method, the amount of compensation expense required to be reported would generally be equivalent to the amount of the income tax deduction for stock options.
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    Second, the proposal includes a special provision that provides most small businesses that are nonpublic enterprises with a simpler, less costly prospective transition to the new requirements.
    Finally, the proposal includes a special provision that provides that the effective date of the proposed standard for nonpublic enterprises would be delayed for 1 year until 2006.
    I also would like to note that the proposal includes a notice for recipients that highlights and describes all these special provisions. The notice requests that respondents to the proposal indicate whether there are other special provisions for small businesses that might be appropriate and whether any or all such special provisions should be extended to public enterprises that are small business issuers under the Federal securities laws.
    The Board currently plans to discuss the proposal, special provisions and other issues about the proposal with representatives of small business at the inaugural public meeting of our Small Business Advisory Committee next week, May 11th. Our request for agenda items for this meeting showed interest in this proposal. We also plan to hold public roundtable meetings in June with valuation and compensation experts, and users, auditors, preparers of financial reports to discuss a broad range of issues about the proposal.
    Following the end of the proposal's comment period in June, the Board plans to redeliberate at public meetings issues raised in response to the proposal. Those redeliberations will include very careful consideration of the ongoing input received from all parties, including ongoing input from the members of the Small Business Advisory Committee. Only after carefully evaluating the input at public meetings will the Board consider whether to issue a final standard.
    The Board's current plans are to complete its deliberations and be in a position to issue a final standard in the fourth quarter of this year.
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    On behalf of myself and Bob, I would again like to express our deep appreciation for inviting us to participate in this hearing. All the information we obtain in connection with this hearing will be carefully considered.
    In conclusion, let me assure you that you, the users, auditors and preparers of financial reports, including small business financial reports, can have confidence that the Board will continue to actively reach out and solicit input in response to our proposal. That input will be carefully considered in an open, thorough and objective manner. Our ultimate goal is to develop an accounting standard that will faithfully report the underlying economic effects of equity-based compensation transactions and thus significantly improve the transparency and integrity of financial reporting in the United States.
    Thank you again, Representative Royce and other subcommittee members. Bob and I would welcome the opportunity to respond to any questions.
    Mr. ROYCE. I thank you, Mr. Batavick.
    [The prepared statement of Robert Herz and George Batavick can be found on pages 172 and 175 in the appendix.]
    Mr. ROYCE. Let me begin by asking a question of Mr. Herz.
    Mr. Herz, in a letter to the Financial Accounting Standards Board dated December 29th of 1993, Coopers and Lybrand contended that using option pricing models results in unreliable information and would have an adverse impact on the comparability and usefulness of financial statements, and your name and number are provided as contact information to discuss this letter. I wanted to ask you how you reconcile your position in this letter with your position today. We are assuming that the letter would not have provided your contact information without your endorsement of the arguments that are made there, which are some of the arguments that we have heard on the Hill over the last month again replayed as we have discussed this issue.
    Mr. HERZ. Well, I don't remember the particular memorandums. I obviously take good faith that that is it.
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    Mr. ROYCE. Well, don't take it on faith. It says, if you have any questions regarding our comments, please contact Ronald Murray or Bob Herz at this number, or David Lookate.
    Mr. HERZ. Right. I think that, you know, at that time I did believe on the face of it without a lot of investigation, I just had come into the national office of Coopers and Lybrand, and from the practice that, you know, those were the views. Those were the views that we were hearing from many clients at the time.
    I have now had the benefit of an intensive look at this subject, both on the International Accounting Standards Board and also at the FASB, I mean, an intensive look at it, and you live and you learn. I don't believe that those arguments, as far as at least the valuation, hold water. Will they have an impact on emerging businesses? Well, we have got special provisions in our proposal, A; and, B, yeah, there are economic consequences in terms of better information that arise from changing accounting standards.
    Mr. ROYCE. Well, let me ask you a question about that intensive look, and I may be wrong on this, but to my knowledge, as far as the Board is concerned, I don't think that you field-tested valuation models when it comes to trying to determine this new methodology. I don't know that you have taken various valuation models by a cross-section of companies so the significant data would be collected on the accuracy and reliability of these different valuation models. And I was going to ask you, are there any studies that you have relied on that show specifically that the binomial method values employee stock options accurately?
    Mr. HERZ. Well, we have done a lot of work on the valuation area. We have convened a group of expert panel called our Options Valuation Group, which are experts in valuation compensation, equity derivatives, which a stock option is. Our staff and the Board met with them a number of times. We did have field visits to a number of companies that included a cross-section of companies across industries and sizes of companies, both public and private. We have reviewed the results of research studies on data that exists.
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    Let me step back, though, that——
    Mr. ROYCE. Let me explain where I am going with this so that you better understand my point. Your spokesman Cheryl Thompson defended the decision not to field-test valuation models by telling the press that the ultimate field test has already taken place. She added that public companies have been performing this field test for 7 consecutive years, so the test sample is huge. It involves thousands of companies.
    I believe I am correct in assuming that Ms. Thompson is referring to the use of Black-Scholes in footnote disclosures over the past number of years. I suppose that one could argue that it makes sense if the exposure draft required all companies use the Black-Scholes model, but what we are now doing is urging companies to use something different, which is the binomial method. And so my question here is why not conduct field tests on the accuracy of that particular model?
    Mr. HERZ. Well, the—first of all, there are now 575 companies that are expensing in their income statements. Some of those use the binomial model, and we have talked to them.
    Secondly, it is a misnomer to call them completely two different models. They are basically related. They are derived from the same financial economic theorem. The binomial model is really opening up the Black-Scholes model. The Black-Scholes is kind of a hard-wire model that you put in one set of assumptions, and you get a result. The binomial works off of exactly the same theory, but you can peer into the hard-wiring and look at it period by period, and you can make adjustments for better data period by period.
    Mr. ROYCE. Well, you make the point that 576 firms, in your words, have——
    Mr. HERZ. Can I——
    Mr. ROYCE.—expense—let—let me just ask you, do any of those companies have broad-based stock option programs? Because there are thousands and thousands of companies that have not embraced this, that do have broad-based stock option programs, and that is where we are focused. And I will let you respond to that, and then I have one last question before we go to my colleague here.
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    Mr. HERZ. Well, there are a number of companies with broad-based plans that have gone to expensing, like Netflix and Home Depot and Wal-Mart and the like.
    My other point I was trying to make is that the binomial model is regularly used on a daily basis to value equity derivatives and other derivatives. It is a model that works.
    Mr. ROYCE. My last question is this, and I realize the Financial Accounting Standards Board is pretty far down the path on this proposal, but that said, just yesterday I learned of a new proposed method of expensing options that works very differently than Black-Scholes and works differently than this binomial method and that you have articulated, and I was going to ask what your opinion would be in terms of being open to consider this new proposal for expensing at this point in the process.
    Mr. HERZ. Oh, we are open—we get suggestions almost daily, so——
    Mr. ROYCE. So what would the process and the timetable be——
    Mr. HERZ. The process is they should send us something in writing, and then we will have a look at it, and we will meet with them. And we have done that with many different parties. And we also, when we get something like that, consult with our panel of experts also.
    Mr. ROYCE. Thank you, Mr. Herz.
    We will go to Mr. Sherman.
    Mr. SHERMAN. Thank you, Mr. Chairman.
    Mr. Batavick, your testimony provided really useful, personally, information. Right after these hearings I am going to go out and sell all the stock in the company that makes Ambien. That stock is going to crash once everyone becomes aware that replays of FASB meetings are available for free.
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    It is rather absurd for you to say that small businesses don't have to use FASB pronouncements in preparing their financial statements if they choose not to go public. Every bank wants statements prepared under Generally Accepted Accounting Principles, and FASB pronouncements cannot be ignored in determining what is generally accepted. And, of course, our State corporate laws make certain dividends illegal unless certain capital—certain amounts of capital are available calculated under GAAP. So you understate the importance of your Board if you say that you are not legally binding on nonpublic companies in this country.
    Speaking, though, of small businesses, the binomial method, as I understand it, could be expensive to use, could involve many thousands of dollars of accounting fees. Let's say you had a small company, you used Black-Scholes, and you came out with, say, half a million dollars of stock option compensation expense. But that half million was material. Is there anything in the exposure draft that says in order to help you save on accounting fees, as long as your Black-Scholes number is under half a million, you can use binomial; or does the exposure draft say if you are tiny, then whatever amount that is material to you, you have to go spend the money on the accounting fees to use the more sophisticated approach? Do you allow a less expensive calculation method for small companies?
    Mr. BATAVICK. Right now we are not requiring one method over the other. What we are saying is the fact that we have a Black-Scholes method, we also have the binomial method, and the statement we make in the proposal is that in certain circumstances that may be preferable, but it is also based on if you have the information available to——
    Mr. SHERMAN. I would hope that—and I will get to this in a second. I think it is a tragic flaw in your exposure draft that you provide so little guidance as when to use one method or when to use the other and——
    Mr. HERZ. Could I just interject, if I might?
    Mr. SHERMAN. Yes.
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    Mr. HERZ. In our proposal if a small business is a private company, they don't even have to use option pricing models. They can elect not to use option pricing models.
    Mr. SHERMAN. Yes, but many of—if they are not someday going to be public, nobody may want the stock options anyway. Stock options are generally used for companies that intend to go public. I realize there may be some exceptions to that.
    Mr. HERZ. We don't say if you are going to go public. If you are private, you——
    Mr. SHERMAN. You don't have to. I would hope that GAAP would mean the same thing, that we would take the—I know you can propose vague standards. That is what you have done the last 30 years. You said you can expense them or not expense them, your choice. Now you are going to say, well, by Black-Scholes, binomial, or if you are not public, some other guesstimate.
    I would hope that you would provide real guidance to the profession, that people reading financial statements are not going to have to look at the footnotes and try to guess what was done and how to make two statements comparable. The whole idea here is you should be able to compare Coke and Pepsi, not the taste test, the financial test. And for a while there, one was expensing and one wasn't. Now we are going to have one binomial and one Black-Scholes and then some small beverage company using a third method or no method at all.
    I would hope that if you are in the standards-writing business, you would write standards, not guidelines, not guesstimates, especially when those who oppose what you are doing have said this could be a fertile area for lawsuits.
    Now, I realize there are other areas of accounting where a judgment is required, but here you are talking about executive compensation, the juiciest thing to bring before a jury. You are inviting lawsuits when you take that juicy area and you don't provide guidance.
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    I would hope that guidance would factor in availability of information, would factor in cost of calculation, and would then say, okay, apply Black-Scholes. If you meet these standards of materiality, if you meet this dollar figure, then you have got to go use the binomial, and here's how you ought to use it.
    Let's see. My next question, though, is why don't you delay this whole thing until you get the research thing right, and are you concerned that you are now going to have—eliminate this compensating error, and you are going to adopt an accounting system for this country that discriminates against our high-tech sector?
    Mr. HERZ. Let me go back to a few other points you made and then go to the R&D point.
    I think if you look at our exposure draft, there is plenty of guidance on valuation. It may not be hard-wired guidance. It is guidance that fulfills what we have been told to do in objectives-oriented standards by the SEC in the report they issued to you last summer, to Congress on Sarbanes-Oxley. It is much more detailed, for example, than in many other areas of valuation. I——
    Mr. SHERMAN. As is executive compensation. Two accounting firms should come up with the same answer. If they don't, there is going to be lawsuits, and if there is going to be lawsuits, that is a strong argument for us to pass this bill.
    Mr. HERZ. If you look at our notice to recipients, there are several questions specifically on that point, how hard-wired, how prescriptive would you like us to get, models, assumptions. Now, we have already gotten some responses that say we have already provided too much guidance. So there is a diversity of views. I——
    Mr. SHERMAN. Well, of course. The people who don't want to expense options want as much looseness as possible so they can state as low a number as possible.
    Mr. HERZ. But one of those responses is from a major audit firm. Okay? So——
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    Mr. SHERMAN. But they tend to agree with their clients. Surprise.
    Mr. HERZ. I don't know if their clients feel that way. I mean, the point is there is a diversity of view. We have asked the question specifically because we recognize that sensitivity. We can hard-wire everything if that is what people want.
    Mr. SHERMAN. Or that one accounting firm could compete under the slogan, we use the play in the joints to understate your executive—to minimize the statement of your executive compensation. It would be a whole new slogan.
    Mr. HERZ. I think one of the benefits of the Sarbanes-Oxley, the auditors are doing more robust audits, I believe. The SEC is certainly reviewing a lot more, and this is an area they would intend to review.
    On your R&D question—and, you know, you and I have had discussions. I personally agree with you, but thousands don't. And I will tell you there is good news on that front, or potentially good news on that front, in that we met with the International Accounting Standards Board, like we do every 6 months, and we, subject to our own agenda processes, agreed to look at the area of both R&D and more broadly intangibles.
    Mr. SHERMAN. But, Mr. Chairman, shouldn't you stop all work on this stock option thing, which is going to hit high-tech hard—and they are already screaming—when you are already hitting them? And fairly, I might add, but you have been hitting them hard and pounding them hard, much harder unfairly. Shouldn't you abstain from correcting this mistake until you can deal with that mistake, or do you think you should just pound high-tech when they are right on the accounting and when they are wrong on the accounting?
    Mr. HERZ. Well, again, the issue of R&D, you and I may agree personally. There are many who don't, so——
    Mr. SHERMAN. Is there any accounting theory textbook, that supports the idea of expensing every research expenditure done in-house no matter how valuable the results are and no matter how provable the value of those results are?
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    Mr. HERZ. The accounting rationale is that it is not sufficiently measurable.
    Mr. SHERMAN. You can't measure—yes. That is—you know how—let's put it like this: There is no accounting theorist I am aware of anywhere in this country that would come to the conclusion that you should write off all R&D.
    Mr. HERZ. I would ask the—in response to your suggestion, which, you know, I agree with—as you know, I agree with not only capitalizing R&D per se, but I think the whole area of intangibles that are big-business value drivers is something that is missing off of contemporary balance sheets.
    I will tell you, though, the history of this issue
    being—the last time, I understand, it was raised by the FASB a few years ago, the biggest opponents of it were the high-tech firms.
    Mr. ROYCE. Mr. Frank.
    Mr. FRANK. Mr. Herz, in the full text that you gave us, and I appreciate it, on page 27, you address towards the end the objections, and you list four of them. The last one is you phrase the objection as mandatory expensing of employee stock options will have negative economic consequences.
    To me that is the nub of what we are here for. We are not the plutonic board of perfect accounting. We get involved where there are negative economic consequences, and I have to tell you, I don't—I think if I were a judge and this was the argument, you would lose on summary judgment. I mean, you make a lot of good arguments, but there is none.
    You kind of implicitly—and that may not be controlling, but this is so you will understand the dilemma. Implicitly, in the beginning of the second paragraph of that page, the Board's operating precepts require it to consider issues in an even-handed manner without attempting to encourage or to discourage specific actions. That does not imply that improved financial reporting should have no economic consequences, but it seems to me to be a concession that—not a concession, a statement that you are going to go ahead and do this, and that is the dilemma many of us have, because I certainly agree on the accounting—let me ask you, to go back to the question I posed, other than aesthetically, who is getting hurt now by the current accounting firm options? Who is the victim?
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    Mr. HERZ. Well, I think this all kind of relates together.You know, our mission is to improve financial reporting——
    Mr. FRANK. I understand that, but if that is the answer, okay, but is somebody being hurt now by the current situation?
    Mr. HERZ. Well, certainly the people who were surveyed the financial analysts, surveys of investors, tech investors, all say they want it in the score because it is not transparent right now. They don't—they pick up numbers from databases. The CBO said that it would be more transparent——
    Mr. FRANK. Please, I don't need you to tell me what the CBO said. I rarely pay attention to them. And transparency is a means, if not the end. And if the answer is it is wrong and it doesn't make a difference if anybody is getting hurt, then okay. But as far as transparency, let me say this: The information is there now, isn't it? It is just not—if I were going to invest in a company, which I—we get enough ethics from—so I don't address individual companies. But if I was going to invest in an individual company, I or somebody I was paying to help me do this would read the footnote. So let me put it this way: If I were going to invest in an individual company, would I get more information about what is actually happening one way versus the other?
    Mr. HERZ. You're going to get more information the way we are proposing it
    Mr. FRANK. What information would I get from you that I don't now get? I would get the fact that the options would be—would I not now get the fact that the options were being granted and how many there were? Would I not know that?
    Mr. HERZ. You would know that, but you would not know things like operating margins, return on equity, all those things that are just—by not running it through the financial statements, you are not getting the full accounting
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    Mr. FRANK. You are saying that I would be—that the investors can't do that themselves. I get everything else and then I get the options, and I wouldn't be able to, myself, figure out or decide for myself to what extent the existence of the options added to or detracted from the value of the investment?
    Mr. HERZ. If you were a sophisticated investor and you took the footnote, you would be able to get part of that information, not all of it
    Mr. FRANK. What wouldn't I be able to get?
    Mr. HERZ. You wouldn't be able to get things like gross margin, you wouldn't be able to get operating results, you would have to recompute——
    Mr. FRANK. Well, those are things to which there is some element of uncertainty, though; right?
    Mr. HERZ. Well, they are things that if you do the accounting properly, they are just there.
    Mr. FRANK. Well, but isn't there some element of uncertainty there? I mean, I was struck when you told Mr. Sherman that the obstacle to dealing with research differently is that it is hard to measure. Is it a lot easier to measure than the options, or a lot harder?
    Mr. HERZ. No, the options are much easier to measure than the early stage of research
    Mr. FRANK. And you couldn't just make available to people what the measurements are and let them do it themselves?
    Mr. HERZ. We have been doing that
    Mr. FRANK. Okay, we have been doing that. Who has been hurt? Have you gotten any complaints? Is there anyone we know of that?
    Mr. HERZ. Yes.
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    Mr. FRANK. No, I know they said we would rather. Did anyone say I was misled?
    Mr. HERZ. Yes.
    Mr. FRANK. I invested unwisely?
    Mr. HERZ. Yes, we have lots of letters from individual investors.
    Mr. FRANK. Well, I have read your comments and the samples you gave. None of them say that. You gave one set of samples. You didn't give the other. You gave people that said, oh, these greed-mongers, they are terrible. You have people saying it would be more desirable. But surely you understand the difference between a general assertion that it would be desirable and an assertion that an individual was hurt.
    Does anybody anywhere—I will make a plea. There are other people here from the SEC; would anyone bring forward to me some individual who was misled because the options were not expensed? Do you know of any claims of that sort, Mr. Herz?
    Mr. HERZ. Yes.
    Mr. FRANK. Where are they, Mr. Herz? They are not in your statement. Point them to me. Which one did I miss?
    Mr. HERZ. I don't know, we have got hundreds and thousands.
    Mr. FRANK. Well, you picked some out. None of the ones you picked out say that. None of the ones you picked say ''I was misled,'' and I am reading them. I strongly recommend people like me will stay away from the market as long as they are passed out like funny money
    Mr. HERZ. Can we follow up with you?
    Mr. FRANK. Yes. Okay. And I am surprised we haven't heard reports because this is the issue.
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    Mr. HERZ. I think an important point is that it is a well-known, well-accepted thing in accounting, that disclosure doesn't cure bad accounting. And we get requests all the time for just put it in the footnotes. When we were going through the improvements——
    Mr. FRANK. Sir, you do realize this is totally irrelevant to my question? If you want to give more general statements about why you should do this, okay. And that is part of the problem you have got.
    I thank the Chairman for the indulgence. Here is the problem you have got, and I don't want—I am not a co-sponsor of the bill. I am really torn here. But I have people telling me this is going to cause a problem. I mean, I have a technical intellectual argument. Clearly these are not free. I understand that. How you account for them there is a question.
    But a lot of people are saying, look, this is going to cause a problem; and they are going to cause a problem again because of the way the market will perceive this. And so as a public policymaker, not as an accounting technical specialist, I say, okay, well, if there is a potential for the problem here, what are we solving? What are we solving? What problem am I solving other than an intellectual failure?
    Frankly, if I was going to go around this city and resolve every intellectual failure, I would be a wreck. So I am looking for some public policy break. And, yes, I would appreciate it, please follow up with me, because I think that is why you are here. You are not here because people differ with you technically on the accounting. As was implied in the question from Mr. Sherman, no one cares about that. That is your job, and we are glad you have it and are ready to do it.
    The issue here is, is there some real economic harm that could come? And that is the area I think in which further help from you would help your cause, and so that is it.
    Yes, I yield to my colleague from California.
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    Mr. SHERMAN. I would say the one obvious harm is that those companies that choose not to use stock options are at a disadvantage in attracting capital as opposed to those who do.
    Mr. FRANK. Okay. But I would say again, because people in the market don't understand this, it all comes down—to some extent I have to say I feel a little bit good about this in one sense, having been for years told, listen—well, let me say there was a former majority leader of this institution who used to say government is dumb and markets are smart. Well, these markets ain't the smart ones. These are the markets that are confused because of the accounting.
    So I am just a little glad to say that. I agree. But that is the issue; it is not the investor being misled, it is the competitive disadvantage to the other people.
    I am sorry. Did the other gentleman from California want me to yield?
    Mr. ROYCE. No, I was just going to make the point that it is easier just to point out the intellectual failures in this city than in the market.
    But we are going to go to Mr. Hinojosa.
    Mr. FRANK. Thank you
    Mr. ROYCE. Mr. Hinojosa, you also had an opening statement you wanted to make, and at this point we will give you that opportunity, and then, please, go to your questions.
    Mr. HINOJOSA. I will submit my opening statement in writing.
    Mr. ROYCE. Without objection.
    [The prepared statement of Hon. Rubén Hinojosa can be found on page 81 in the appendix.]
    Mr. HINOJOSA. I would like to make a statement and ask a question or two. Thank you, Chairman Royce.
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    I am very pleased that the subcommittee had the opportunity to hear the views of the Financial Accounting Standard Boards, or FASB, on its proposal to expand stock options, especially since you are the entity that will be directly impacted by the legislation I have co-sponsored and supported thus far, H.R. 3574, the Stock Option Accounting Reform Act.
    I am aware of the allegations that have been made, that FASB has been hiring lobbyists, or, rather, actually having registered lobbyists on staff who have been encouraging Members of Congress to support its proposed legislation, thus calling into question the longstanding perception of FASB as an independent agency. Certain individuals have come to my office recently to express concerns about particular aspects of H.R. 3574. And after listening to you make your statement and the questions that the Chairman and others have asked, I will reread through today's testimony and have my staff obtain a copy of it to determine if those concerns were addressed, as well as having them follow up with FASB.
    Mr. Batavick, what is your background?
    Mr. BATAVICK. Most recently, I was the retired comptroller of Texaco, Inc. We were acquired by Chevron a few years ago, and because of that I left the combined company. Prior to that I was with Getty Oil Company. That was acquired by Texaco. And before that I was in public accounting.
    Mr. HINOJOSA. Those are very good companies, very large, and I just cannot understand how you can be speaking so much for the small businesses unless you ran small businesses before you went to Texaco.
    Mr. BATAVICK. Actually, when I was going through school, I worked two summers at a public accounting firm that only did the accounting for small businesses. I did both accounting as well as auditing. Also, when I joined Getty Oil Company, most of our service stations are not owned by the company themselves, they are owned by small businesses. And I worked very closely with those small businesses during my early years.
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    Mr. HINOJOSA. Well, Mr. Chairman, and Ranking Member Barney Frank, and Congressman Sherman, again thank you for calling this important hearing and I look forward to working with you.
    Mr. ROYCE. Thank you. Mr. Herz, you wanted to respond?
    Mr. HERZ. Yes, I wanted to respond to the question about lobbyists. I want to be very clear on this. We have not asked any firm to lobby for us with respect to our proposed standard to improve the accounting for equity-based compensation.
    Our Washington, D.C. Representative, Jeff Mahoney, since 1996 has provided information and responded to questions about the FASB and its activities from staff and Members of Congress, Federal Government officials and other interested parties in Washington, D.C. He also works hard to keep interested parties informed. And, yes, we do speak our minds when there is proposed legislation that would intrude upon our independence and upon our ability to do our work in a thorough, open, and objective way.
    Jeff also arranges for me to meet directly with Members of Congress, Federal Government officials, and other interested parties to provide them with timely information on our activities.
    Because our communications sometimes entail lobbying contacts, as defined in the Lobbying Disclosure Act, relating to proposed legislation like this one, relating to our mission and activities, Jeff and I, and my predecessor since 1998, were registered under the Lobbying Disclosure Act on behalf of the Financial Accounting Foundation, our parent group.
    Basically, the history of this is that when Chairman Baker introduced a bill in 1998 relating to accounting for derivatives, many Members of Congress solicited the views of Mr. Mahoney and our then-chairman Ed Jenkins. They consulted with legal counsel who advised them to be safe, to register as lobbyists. When I came on board they registered me as a lobbyist. That has nothing to do with this particular matter in question.
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    In fact, I think it is a little bit like the pot calling the kettle black. We have all read all the stories, and in a Senate hearing last week one of the Senators used the term high-tech lobbyists swarming all over Capitol Hill. We did not start anything here in Congress. It is your purview. We welcome the inquiry and all of that, but we try to respond to the questions of Members about the proposed legislation. But that is all.
    Mr. ROYCE. Mr. Herz and Mr. Batavick, we want to thank you both for appearing before our panel today. Let me also note that some members may have additional questions for both of you which they might want to submit in writing. If we can give them 30 days to submit those questions, and within those 30 days if you would complete your response for the record, we will collect those from you.
    Again, we thank you both for making the trip here to testify today. This hearing is adjourned.
    [Whereupon, at 3:17 p.m., the subcommittee was adjourned.]