Segment 1 Of 2     Next Hearing Segment(2)

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U.S. House of Representatives,
Subcommittee on Capital Markets, Insurance and
Government Sponsored Enterprises,
Committee on Financial Services,
Washington, DC.

    The subcommittee met, pursuant to call, at 10:10 a.m., in room 2128, Rayburn House Office Building, Hon. Richard H. Baker, [chairman of the subcommittee], presiding.

    Present: Chairman Baker; Representatives Gillmor, Castle, Oxley, Lucas of Oklahoma, Miller, Kanjorski, Bentsen, Sandlin, Hooley, S. Jones of Ohio, Sherman, Moore, Maloney of CT, Meeks, Inslee, and Lucas of Kentucky.

    Chairman BAKER. I would like to call this hearing of the Capital Markets Subcommittee to order. The hearing today is called for the purpose of examination of the adequacy of our current financial reporting system in light of the speed with which market transactions occur.

    Although much attention has been given to the failure and use of sophisticated accounting instruments, there, quite frankly, is a much larger question, I think, that the subcommittee will turn its attention to; that is, the adequacy of the current regulatory system to appropriately and timely assess the accuracy of financial reporting statements.
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    There is, it appears at least, extraordinary pressure on management to meet quarterly earnings expectations, and if by utilizing available methodologies they can meet or exceed street expectations for quarterly reports, that, in fact, enhances shareholder value. Unfortunately, when those expectations are not met, the perverse result of these accounting mechanisms is to leverage the amount of loss for shareholders as a result of management's use of these instruments.

    It does not follow, however, that the utilization of those instruments is inherently in itself a bad thing. There are those who have used similar instruments for legitimate business purposes and, in fact, have profited from their use, resulting in enhanced corporate value for shareholders.

    Going back just for a short period of time, immediately after the Orange County bankruptcy proceeding, there was much skepticism in the market concerning inappropriate use of derivatives, causing many in the Congress to express support for an outright ban of their use. I think further discussion by those appropriately utilizing those risk-hedging devices found there to be value added, and a responsible use benefited all parties concerned. That is why I believe that the use of special purpose entities and indefeasible rights of use or whatever else may be devised in the near term in themselves do not lead one to conclude there is inappropriate conduct, but without appropriate explanation by those responsible market participants, it makes the subcommittee's work very difficult.

    Unfortunately, there were many asked who were unable to appear today that perhaps could have shed more light on the appropriate utilization of those instruments for the subcommittee's analysis. And I would hope that in future hearings we have the opportunity to better understand market function in relation to these sophisticated accounting tools.
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    However, the Financial Accounting Standards Board, which is the primary location for initial approval of the utilization of these instruments, unfortunately has been unable to act very swiftly or act at all in light of the apparent identifiable instances in which these instruments have not been appropriately utilized.

    The elimination of fuzzy accounting is our principal goal. We should have an ability for a shareholder, a consumer, to pick up a piece of paper and get an accurate understanding of the true financial condition prior to making an investment. We start there, and it should go all of the way up from the pension manager to the institutional investor. All should be treated similarly. Ultimately the performance of a sound capital markets economy must be based on the free flow of information to all parties concerned in the same timeframe, without prejudice or manipulation.

    Today, I hope to hear from those who have chosen to participate in our hearing today, for which I am grateful, how the Congress may appropriately respond or work with others to instill confidence in the marketplace, enable consumers to make informed investment decisions, and assist in the free flow of capital that ultimately creates jobs and opportunity in this country. The current question, the current skepticism serves no one well, and we must figure out the best and most appropriate manner in which to respond to the problems we face.

    Mr. Kanjorski.

    Mr. KANJORSKI. Mr. Chairman, we meet today to learn more about the problems in corporate accounting practices. Although this matter has attracted considerable media attention in recent months, I have held serious reservations about the reliability of certain corporate accounting practices for some time. These problems could also have potentially serious and negative consequences on our country's flourishing capital markets. After all, if investors cannot trust the reliability of the numbers produced by corporate accountants in audited statements, then they might as well spend their hard-earned money on lottery tickets.
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    Because of my concerns, Mr. Chairman, I wrote to you last June, well before the collapse of Enron, about the techniques used by some corporations in order to meet their quarterly earnings estimates. In that letter I urged you to convene hearings on the many accounting irregularities that contribute to the problem of earnings management. Included among those practices are the accounting treatment of derivatives, swaps, special purpose entities, goodwill and stock options.

    In my view, we should have convened this hearing before considering the Corporate and Auditing Accountability, Responsibility, and Transparency Act on the floor of the House last week.

    Such a hearing would have helped us to develop a more comprehensive piece of legislation. Nevertheless, Mr. Chairman, I am pleased that you have called this hearing today. I believe that we must continue our efforts to guarantee that we maintain the vibrancy of our country's capital markets in the long term. Our work today will begin that process.

    Our capital markets are the most successful in the world for one simple reason: investor confidence. The transparency fostered by the application of the United States Generally Accepted Accounting Principles, or GAAP, has played an important role in this achievement. Unfortunately, the failure to implement GAAP consistently has now led to an almost daily discovery of accounting irregularities at American corporations. This evolving situation has also sparked a crisis of confidence that continues to ripple through our capital markets.

    We have, however, known about these problems for some time. For example, research published in 2001 by Financial Executives International identified some startling facts. The study found 464 cases of earnings restatements in corporate America over a 3-year period, more than the previous 7 years combined. It also determined that 156 earnings restatements in 2000 wiped out more than $31 billion in market capitalization. I suspect that when we tabulate these figures for 2001, these two already sizable statistics will grow considerably.
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    In recent months the Securities and Exchange Commission has also broadened the scope of its inquiry beyond the accounting issues raised by the collapse of Enron to include a laundry list of other potential accounting abuses at some of the country's largest companies. In fact, during the first quarter of 2002, the Commission opened 64 new financial reporting investigations, an increase of more than 100 percent over the cases begun during the same timeframe in 2001.

    What factors contributed to this troubling state of affairs? In recent decades the rules governing corporate accounting have become increasingly complex. Since the early 1990s, for example, the Financial Accounting Standards Board has developed several fair-value measurement, recognition and disclosure standards. These standards often permit multiple interpretations. Accounting has also evolved from determining the cost of producing and the revenue from selling a good like a screwdriver to ascertaining the cost and revenue from selling an intangible service like a 25-year energy derivative. These and other developments have helped to make corporate financial statements increasingly impenetrable and confusing.

    From my perspective, an effective accounting system must ensure the comparability of financial data from one company to another. Comparability in the data used by investors will allow them to evaluate apples against apples, and oranges against oranges. Improvements in accounting transparency will also facilitate the efficient flow of capital.

    Since we assumed jurisdiction over securities issues last year, investor protection and financial literacy have become top priorities for my work on this panel. Investors deserve to have timely financial reports that they can read and understand instead of annually receiving a Byzantine, incomprehensible document dotted with countless footnotes.
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    The collapse of the internet bubble and the downfall of Enron have only heightened the skepticism of American investors about accounting practices generally. After our hearings today, we need to work to change those attitudes by ensuring that our public companies return to the basics of accounting and avoid financial gimmicks and gymnastics in their future filings.

    In closing, Mr. Chairman, I believe our committee should comprehensively explore the issues related to corporate accounting practices. This hearing should also help us to alert investors about some of the key accounting issues that could affect their portfolios, and assure them that they are being examined by the Congress.

    [The prepared statement of Hon. Paul Kanjorski can be found on page 96 in the appendix.]

    Chairman BAKER. Thank you.

    Chairman Oxley.

    Mr. OXLEY. Thank you, Mr. Chairman. And I want to commend you for this hearing.

    As we all know, last week the House overwhelmingly passed H.R. 3763, The Corporate and Auditing Responsibility, Transparency, and Accountability Act of 2002, or CARTA. Chief among the provisions passed by a strong bipartisan vote were mandates for increased financial disclosures by publicly traded companies. We also set forth a new regime for tough oversight of the accounting profession by the creation of a new board under the SEC, which is the only legally recognized authority over this important function of our economy. We look forward to the Senate's swift and bipartisan passage of CARTA.
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    However, our responsibilities for protecting American households, public pension funds and private investment accounts cannot end with CARTA. We must continue to review the generally accepted accounting principles and discretionary accounting practices that American companies use every day to report on their operations.

    During the initial phase of our CARTA hearings, and by the way, we had 7 hearings with 33 witnesses, the Committee publicly discussed the complex principles involved in accounting for financing tools, such as special purpose entities. We disclosed that those principles had not been clearly stated by the FASB and the SEC, and that Enron clearly and continually abused these principles.

    We also discussed the principles involved in accounting for sales and swaps of fiber-optic cable capacity among telecom companies such as Global Crossing, QWEST and WorldCom. After a change in the principles in 1999, companies increasingly turned to unaudited pro forma statements to better explain the cash flow in their business. There is no guidance on the consistent preparation of those statements, however, which leaves investors and even seasoned professionals unsure of a company's or industry's results or direction.

    Clearly there are plenty of other events that we should have also reviewed. Accounting principles and corporate practices for reporting revenue from the sale of a business, changes to accounts receivable, company loans to corporate insiders, special accounting mechanisms designed to minimize taxes, and pension fund transactions have all been raised in the financial press and have been the subject of SEC reviews.

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    There have been too many restatements of financial statements, too many SEC investigations, and too many pension plan losses for us not to dig further into this area.

    Our witnesses today will give us their perspectives on the problems in accounting principles and practices and the impacts on different sectors of American life.

    I am especially pleased that Betty Montgomery, the distinguished Attorney General of Ohio, has taken the time from her extremely busy schedule to come to Washington today in order to discuss how she is trying to recover losses suffered by public employees. Attorney General Montgomery, who, by the way, is the first woman Attorney General in the State of Ohio, is now serving her second term. She and other expert witnesses will, I am sure, advise us of ways by which we can help investors and employees by encouraging more information and updated financial information by publicly traded companies. As I said at our Global Crossing hearing on March 21, it is only by reviewing those practices that we can help investors to base their decisions upon a company's real financial condition.

    Mr. Chairman, I am going to be having to leave for the floor relatively soon for the Export-Import Bank debate, but we appreciate your hard work in this area and look forward to a continued dialogue with you. And I yield back.

    [The prepared statement of Hon. Michael Oxley can be found on page 92 in the appendix.]

    Chairman BAKER. Thank you, Mr. Chairman. Of course, I am appreciative of your participation here today. I know of the legislative schedule on the floor today, and more importantly your keen interest in having the committee take appropriate action with regard to all of those matters. We are always appreciative of your willingness to be such a leader in these issues.
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    Mr. Bentsen.

    Mr. BENTSEN. Thank you, Mr. Chairman. And thank you for calling this hearing. I think that it is appropriate that the committee continue its hearings on these issues even after the passage of the CARTA bill, which, as I said at the time during the debate, was a good first step. But we may find there are other things that we have to do, so I am eager to hear from our panel.

    I might also add in a speech that Fed Chairman Alan Greenspan gave recently, which caused a lot of focus for other reasons, he commented that our economy is changed to where we value companies not so much because of physical assets, but because of conceptual assets. And I think because of that it has changed a lot of the ground rules of accounting to things that we don't know in the Congress, where a lot of judgment calls are having to be made in the profession. And so as such, I think it is appropriate that both the Congress as well as the industry itself and the ancillary industries, the research analysts and others, continue to review exactly how you are able to provide a proper assessment of value to investors, to analysts and others.

    And so I appreciate the fact that you called this hearing. I hope that it is one of many more that we will have.

    Chairman BAKER. Thank you, Mr. Bentsen.

    Mrs. Jones.
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    Mrs. JONES. Thank you, Mr. Chairman, Chairman Oxley, other Members of the subcommittee. I am pleased to have an opportunity to give a brief opening statement. I would ask that my written opening statement be made part of the record, Mr. Chairman.

    Chairman BAKER. Without objection.

    Mrs. JONES. First of all, I would like to welcome Ohio attorney general Betty Montgomery to Washington as well. We were prosecutors together in our prior lives, and so I am glad to see you. And also I am a PERS retiree, so I am also interested in you holding onto my dollars. That is personal.

    But it is very important that we continue those hearings. I was one of those Members who voted against the legislation we passed last week, and the reason I voted against the legislation was because we refused to hold the CEOs accountable for the representations of the financial viability of their companies. I think in order for us to get by the situations that we find ourselves in in these current times, we should hold them individually accountable for their representations of financial viability.

    As we go through this process this morning, I will be interested in hearing from each one of the witnesses who will be testifying. I thank you very much for taking time out of your schedule for coming this morning. And I yield the balance of my time.

    [The prepared statement of Hon. Stephanie Jones can be found on page 98 in the appendix.]
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    Chairman BAKER. Thank you.

    Mr. Gillmor, did you have an opening statement?

    Mr. GILLMOR. Thank you, Mr. Chairman. Very briefly. I am sorry that I was delayed. I have another Subcommittee on Oversight and Investigations going on.

    I just wanted to welcome Betty Montgomery, our attorney general. When I was elected to Congress and left the State senate, Betty took my place as a State senator. She didn't stay there long. She became the attorney general. She has been doing a great job. A lot of people would like to see her stay in that position, but we have term limits in Ohio, so she is going to be our auditor next year.

    I just want to welcome you to Washington, Betty.

    [The prepared statement of Hon. Paul E. Gillmor can be found on page 94 in the appendix.]

    Chairman BAKER. Thank you very much, Mr. Gillmor.

    Chairman BAKER. Mr. Lucas. No.

    Mr. Miller.

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    Mr. MILLER. Thank you, Chairman Baker. I really appreciate you holding this hearing today on accounting practices. I would like to thank you for your leadership on H.R. 3763. It was commendable. And I just look forward to the testimony today. Thank you.

    Chairman BAKER. You could have taken a bit longer. You were on a roll there.

    Is there any further opening statement? If not, I wish to comment on most Members' observations that we have a continuing obligation. The passage of CARTA is a significant first step, but we recognize as a committee that market conditions are continually changing, and our responsibility can no longer be a one-press-conference obligation. It has got to be an ongoing oversight and attempt to understand what is happening in the marketplace.

    To that end we very much appreciate each of you participating here today and giving us your perspectives. As is the custom, your written statements will be made part of the official record. To the extent possible, if you can constrain your remarks to the 5-minute opening period, it helps us in having a better interchange with Members in the follow-up question period.

    I would first like to welcome, as others have, the Honorable Betty Montgomery, Attorney General for the State of Ohio. We are indeed pleased that you would give up of your time to be here today. Welcome.

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    Ms. MONTGOMERY. Thank you, Mr. Chairman.

    I want to thank you so much for allowing me to testify today and inviting me to be here today, as well as thank Congressman Kanjorski and all of the other Members.

    As you have noted, Mr. Chairman, this committee has a number of Ohio legislators, so I forgive you for being provincial with each other, but you have a great committee.

    I was interested particularly in coming to talk to you today because of the enormous impact Enron and Global Crossing, just those two cases alone, have had on our pension systems in Ohio. And I have to applaud the House for passing Congressman Oxley's legislation in reining in the fraudulent accounting practices which have cost billions of dollars to investors, millions of dollar to Ohio pensioners.

    My goal today is twofold: to help you draw further public scrutiny on the practices and concerns that have brought us here today, as well as to help you continue the congressional pressure that you are discussing here today also. The more public scrutiny that we place on the scenarios that led to the debacles such as Enron and Global Crossing, the less likely other companies will be to issue blatantly false and misleading financial statements.

    The impact of Ohio in the ''for what it is worth'' department, which we think is very important, is significant. Two of Ohio's public employee pension funds have lost millions of dollars as they were investors in both Enron and Global Crossing. We lost more than $116 million in Global Crossing. We have lost an additional $114 million in the Enron debacle.
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    The reason for—we are, at this point, engaged in seeking to be lead counsel on the Global Crossing litigation as a class action lawsuit, because at this point even—we are unfortunately the largest—I think we have lost the most among those who have any losses in the Global Crossing battle here.

    Ohio's pension funds, I want to remind everyone, however, are strong. We are some of the largest pension funds in the world, and so this tends to be—although it is an enormous number, still I think it is certainly, I believe, only less than 1 percent of the value of those funds.

    But nevertheless, one of the things as we sat down with our pension funds and pressed to forward litigation on this is that it was so critical for us as public entities and certainly critical because of the fraudulent practices involved that we stand up and draw focus and spotlight on the problem. It is incumbent upon us as public servants, just as your obligations are, to work diligently to ensure that these kind of fraudulent disasters don't happen again.

    Since before Global Crossing went public, Arthur Andersen was its accounting firm, and Andersen not only provided auditing for Global, but provided consulting work for them, as you know. For the year 2000, the most telling statistic that we have is that Global allegedly paid Andersen $2.26 million for auditing, yet paid a staggering $12 million for consulting. Herein lies the beginning of the problem.

    Andersen lead auditor for Global Crossing was Joseph Perrone. Perrone co-wrote a memo outlining the aggressing plan for Global's executives. He talked about aggressive accounting treatments called swap agreements—I know you have alluded to this, and you heard the testimony already—allowing Global to circumvent certain rules regarding swaps. A swap is an exchange of network capacity between telecommunication companies, as you know. Perrone's idea: Use swaps to enable Global to record huge gains on exchanges of capacity, and the exchange of capacity on the books, even though the swaps had no cash value. Yet it allowed plumping up of the financial statement to make it look a much wealthier company than it was.
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    Global adopted Perrone's proposal and, frankly, adopted him, handsomely rewarding him with a position as executive vice president of finance. We know, we believe, we will show in the litigation, that Global entered into swaps that had no legitimate business purpose except to enhance the financial statements, and that is a very troubling problem that you need to address.

    Roy Olofson, the formal Global executive vice president for finance and the whistleblower, said Global routinely entered into swaps, exchanged network capacity for identical or unnecessary routes, without exchanging any cash. The sole purpose was to generate paper revenue, increase cash flow, show higher earnings.

    We have begun as part of the litigation interviewing employees of Global Crossing. Part of the ongoing investigation confirmed that Global entered into the swaps with the knowledge that the transactions and the improper revenue accounting go to the highest levels of Global Crossing. Specific examples are included in my submitted testimony which you have before you.

     There are obscure and misleading disclosures, and in no way did the financial statements disclose the real truth about the swaps. Frankly, Global Crossing lied to the expense of pensioners, investors and individual John Qs that you and I represent on a daily basis.

    The whistleblower we are lucky to have, Roy Olofson, was Global's former executive vice president of finance. He sent letters and memos to ethics officers, requested an investigation of the accounting methods. He wanted to review the priority of the swaps. And yet nothing happened with Global Crossing.
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    Finally, the house of cards began to fall. Cash revenue statement for the third quarter of 2000 was $400 million less than analysts had predicted. And in January of 2002, Global filed their voluntary bankruptcy. So within 2 months we have, between Enron and Global Crossing, two of the largest bankruptcies this country has ever seen, both involving allegations regarding the accounting and the false accounting, inappropriate counseling.

    You know, when Global first entered the publicly traded market, they were worth $64 per share. Now it is down to literally nothing, and that is based on fraud, deceit, untruthful accounting and the like. I conclude by saying to you, we believe it is clear that Global used false accounting methods to undertake schemes to circumvent existing rules and to essentially defraud investors.

    We thank you for the ability to speak to you today. Unfortunately, Enron was not an isolated incident. Investors, both public and private, deserve accurate, honest information so they can make sound investment decisions. Even expert investors, such as those working for public pensions funds, cannot make good choices when the financial information provided is less than truthful. If the market can't trust financial information validated by supposedly independent corporate auditing firms, our free market system of trade is in great danger.

    Thank you so much, Mr. Chairman, for allowing me to speak today.

    [The prepared statement of Hon. Betty D. Montgomery can be found on page 100 in the appendix.]
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    Chairman BAKER. Thank you very much, Attorney General. We appreciate your presence today.

    Our next witness is Professor William Holder, Professor of Accounting, University of Southern California. Welcome, Professor.


    Mr. HOLDER. Thank you, sir. Thank you, Chairman Baker. I am pleased to appear before you today to testify about corporate accounting practices that are of significance to our capital markets. The topic is of obvious great importance, and your attention to it is essential.

    As the subcommittee has requested, my testimony will be based on publicly available information and will address two matters: One, the use of questionable accounting practices and the degree of management discretion that is involved in reporting results of operations that have led to financial statement restatements; and second, the circumstances surrounding reports of accounting problems at the following companies: Xerox, Adelphia, Dynegy, AOL and WorldCom, and whether these problems at these companies are further reflected in other publicly traded companies.

    Our system of financial reporting which supports the functioning of our capital markets has developed over a relatively long period of time, and like other complex systems, financial reporting has been developed with certain expectations, capabilities, limitations and conditions in mind.
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    That system has served us exceptionally well for many years, but like many such systems, what has been historically exceptional may require substantial improvement to continue to fulfill its responsibilities. The financial reporting problems of several companies that you have identified provide examples of many of the changes and the related challenges for the financial reporting system.

    With respect to AOL Time Warner, I understand that this company wrote down assets approximating $54 billion in recent days. This loss generally resulted from acquisitions of companies that did not prove to be as successful as was anticipated. The need to write down these assets was generally brought about through a new accounting standard, or relatively new accounting standards, recently published by the Financial Accounting Standards Board. I also understand the company has acknowledged that a special purpose entity with which it is related has approximately $2 billion of debt not reflected on its own balance sheet. These circumstances illustrate the effect that new accounting standards can have on financial statements, the subjective nature of many accounting determinations, and how the manner in which a company's management decides to structure and operate a company can affect the financial reporting of its transactions and business activities.

     With respect to Dynegy, I understand the company entered info certain derivative contracts that were accounted for in accordance with FASB Statement 133. That standard requires such contracts to be valued at their fair values for financial reporting purposes. As has been pointed out earlier in the session, estimating the value of such contracts frequently involves the use of relatively sophisticated modeling techniques and the use of a number of specific, but necessarily subjective assumptions. Because of the inherent uncertainties involved in developing these assumptions, estimates of the fair value of such instruments requires complex and subjective judgments, and the resulting amounts may vary substantially.
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    Increasing estimated fair values of contracts boosted the company's income; however, they did not directly nor simultaneously contribute to the company's operating cash flows. According to published accounts, the company developed a device referred to as Project Alpha, involving a borrowing plan which provided income tax benefits, but that also allowed the company to report additional cash flows from operating activities. This circumstance illustrates both inherent uncertainties involved in financial reporting, again, as well as, again, management's ability to design transactions and programs that may accomplish other management objectives, but that also accomplish financial reporting goals as well.

    With respect to WorldCom, I understand that certain accounting and financial reporting practices of WorldCom have been characterized as aggressive. Specific aspects of these practices have been characterized as pushing the envelope by capitalizing certain costs of assets that may have been more appropriately reported as expenses.

    The SEC, according to published accounts as recently as this morning's Wall Street Journal, is involved in investigating revenue recognition issues at WorldCom with respect to customers who had already dropped services or otherwise couldn't—the company would be unable to collect the amounts. I also understand that there are disputed sales commissions issues resulting in the possible overbooking of sales.

    Practices of such as those characterized in the press are illustrative of the inherent subjectivity of many accounting decisions and the related necessary professional judgments. They also indicate that the accounting model, because of those subjective aspects, is subject to potential abuse. These same articles also indicated the belief that WorldCom is expected to write down goodwill in much the same manner as I described for AOL Time Warner.
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    Adelphia Communications. I understand that an important issue for this company is the appropriate treatment of certain borrowings by its owners. According to press reports, the Rigas family interest in Adelphia is reported to approximate a 23 percent economic stake, majority voting control, five board seats on the nine-member board, and five top executive positions. I understand that the loans to the Rigas are guaranteed by Adelphia. A portion of the proceeds of that debt was used to acquire Adelphia stock, again according to press reports.

    An important financial reporting question relates to whether the debt of the owners, which is guaranteed by Adelphia, should be reported as the debt of the company. This circumstance also illustrates some of the judgments that are necessary about such fundamental issues as whether and to what extent a company may have incurred a liability that should be reported on its balance sheets.

    Finally, with respect to Xerox Corporation, I understand that the financial reporting problems here involved accounting for agreements that called for Xerox to lease equipment and to provide related goods and services to their customers. I understand that inappropriate allocations of the overall contractual consideration for these various goods and services were made to the equipment lease portions of these contracts. In such a fashion, gross profit on the lease portion was inappropriately recognized at the beginning of the lease agreements.

    Professional standards provide much valuable guidance on lease accounting, and they have been in existence since—well, for over 25 years, but, again, the need for professional judgment remains.
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    I further understand that Xerox changed certain aspects of its employee benefit programs and systematically and improperly recognized the effects of that change over a number of periods, rather than recognizing the effects immediately in earnings.

    These examples you have asked me to address, and that I have described very briefly, illustrate that financial reporting requires many subjective judgments and seasoned judgments. Those that are generally unfamiliar with the detailed aspects of preparing financial statements are sometimes surprised at the inherent ambiguity and subjectivity of that process. Although financial statements contain and convey the appearance of great precision, many significant amounts contained therein are inherently imprecise. The inherent subjectivity provides opportunities for management to bias and for bias to intrude on the financial reporting process.

    Accounting estimates, management's ability to structure transactions to achieve financial reporting objectives, increasingly complex business transactions and events, and accounting judgments that must sometimes be made in the absence of professional standards which often naturally lag behind the development of business transactions and events that they are designed to address each are important aspects of financial reporting and complicate the accountant's work.

    Differing but good-faith interpretations of existing accounting standards can and do result from this process. If management perceives accounting numbers to be important, than it is reasonable to expect them to exercise the inherent discretion provided by financial reporting to manage those numbers.

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    Management discretion can be abused, and financial reports can be misstated. As pressure increases on management to achieve earnings and other financial goals, the motivation to bias information presented in financial statements increases. Many of the elements of our financial reporting system that are currently in place are designed, in my view, to limit such discretion. Financial reporting standards, the auditing function, the regulatory function, and the system of corporate governance that we put in place should each contribute to attaining this goal. Those aspects of financial reporting do not lend themselves, in my view, to easy solution.

    It is not sufficient, in my view, to adopt some simplistic approach, such as an unbending obedience to conservatism, and charge all expenditures about which there is any doubt of realization to expense immediately. Systemic conservatism itself introduces bias into the securities market, and generally unbiased information is considered to be of greater value.

    Financial statements are the responsibility of the company. The auditor also has substantial responsibilities for those statements, and those responsibilities today, in my view, require that the auditor consider the substance of the transaction in evaluating whether financial statements may be materially misstated. The inherent subjectivity of many decisions, however, precludes a singular interpretation of the substance of many transactions. The auditor cannot insist, on pain of a qualified or adverse opinion, that the client use accounting principles that the auditor considers preferable today as long as those used by the client are generally acceptable in the circumstances and appropriately meet other criteria. This has led on occasion to the alleged use of least common denominator accounting principles. The importance of and need for objectivity by all of those that are involved in the financial reporting process, I think, are self-evident as a result of this discussion.
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    In terms of accounting standards setting and regulation, both the FASB and the SEC have worked diligently and for the most part successfully to address significant financial reporting issues. The Financial Accounting Foundation, the organization that oversees the FASB, has recently taken a number of actions to change the structure and process of standard setting. Additional steps may be necessary. My written submission contains some suggested approaches to address those aspects of financial reporting.

    Those who are responsible for interpreting and applying financial reporting and accounting standards must be objective and independent in their work, as I have said, but they also must not perceive themselves as the adversary of those charged with setting the standards and enforcing those standards.

    Finally, the accounting profession, in my view, should be structured so that it continues to be an attractive career opportunity for individuals with great intellectual capacity, lofty ambition, and high ethical standards. To do less relegates this essential profession to diminished capacity, to the detriment of us all.

    Thank you for your attention. I will be pleased to answer any questions that you may have.

    [The prepared statement of Prof. William W. Holder can be found on page 109 in the appendix.]

    Chairman BAKER. Thank you.
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    Our next witness, Mr. Charles Hill, is not a newcomer, Director of Research, Thomson Financial/First Call. Welcome, Mr. Hill.


    Mr. HILL. Good morning, Chairman Baker, Ranking Member Kanjorski, and Members of the House Subcommittee on Capital Markets, Insurance and Government-Sponsored Enterprises. Thank you for again giving me the opportunity to testify in front of this subcommittee. I am particularly glad to do so because I believe this subcommittee on both sides of the aisle and its staff have taken the time to do their homework and understand the problems.

    This subcommittee's early involvement got the ball rolling, thereby either stimulating others to get involved or in some cases forcing their hand to get involved. I also believe this subcommittee is truly trying to reach a solution that is for the good of all concerned. Therefore, I am glad to try to help in any way that I can.

    The outcome is important not only to restoring investor confidence in the system, but it is important to maintaining the general public's confidence in the capitalist system. My goal today is to examine why the system got to the sorry state and what needs to be done to right the ship.

    But why were the abuses greater this time? Three reasons stand out: One, huge management compensation incentives; two, bigger and longer bubble during the last economic expansion; three, increasing dependence of analyst compensation on investment banking.
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    First and foremost in our judgment is that management compensation at public companies has become increasingly dependent on the relatively short-term performance of the company's earnings and/or stock performance. The potential compensation if certain milestones were met, and often the compensation realized, skyrocketed in the late 1990s to previously unheard of heights. There was so much at stake that the incentive to push the envelope on accounting or on the adjusted earnings cited in the earnings release was huge. Apparently some managers succumbed to temptation.

    In general, the abuses can be divided into those generated by cyclical factors and those generated by secular factors. Even without the increased monetary incentives for management, the business cycle would have fostered a number of abuses similar to what happened in previous cycles, but in the 1990s the level of abuses was exaggerated by both the increased incentives for management and by the fact that the bubble created during the last cycle was bigger and longer than in earlier cycles. Therefore, it should come as no surprise that the abuses in accounting and in earnings releases were far more egregious than in the just-ended cycles. That the poster child this time is a company as big as Enron and one who committed so many serious abuses should be no surprise.

    The cyclical problems are the excesses that creep into the system at the frothy part of the business cycle when investors tend to be careless and overlook the warning signs that companies are pushing the envelope on accounting rules and earnings releases. The excesses become even more excessive when the economy begins to slow. Companies push even harder in order to keep up the appearances of continuing good earnings growth.

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    The inevitable market correction tends to correct most of the abuses of this type. The investor backlash causes companies to modify their behavior for the good, and investor confidence returns until the next market correction reminds investors that they again let their vigilance slip and that company managements had again misbehaved. The corrective behavior process starts all over again.

    It is kind of like when you go to the carnival, and they have this game there where they have the gophers that keep popping up. Well, when we have a market correction, you get the stick, and you try to beat down as many of these gophers as you can, but you know that in the next cycle they are going to be popping up again. But we are going to keep working on it in each cycle.

    Sometimes some tightening up of the accounting rules or other regulations is necessary in each cycle to close some of the loopholes that emerged in the last cycle as a clever way to inflate earnings. Several obvious, but in some cases not obvious until after the bubble broke, loopholes that became newly fashionable in the last cycle include special purpose entities to hide debt off the balance sheet, a more liberal use of stock options to reduce employee compensation on the income statement, indefeasible rights of use swaps to inflate revenues, and heavy use of derivatives that resulted in reduced transparency.

    Among the old favorites that blossomed again in the last cycle were the changing of pension funds to inflate or to smooth earnings, and stretching the accounting rules on revenue recognition to inflate current revenues by including those that would not be unequivocally consummated until a later period.

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    Another abuse created by the increased management compensation incentives was one that was more of a secular issue and not just an extension of prior cyclical abuses. That abuse is the pressure that is put on brokerage analysts to help inflate the perceived earning.

    Analysts routinely adjust a company's GAAP earnings, the earnings required to be reported by the SEC using Generally Accepted Accounting Principles as enumerated by the Financial Accounting Standards Board, to exclude these items, the analysts consider non-recurring or non-operating. Companies often would provide earnings in their quarterly releases that were adjusted to a basis of the company's choosing.

    There was a cyclical nature to this problem in that the company pushed the envelope on what they considered non-operating or non-recurring and, therefore, excludable from GAAP earnings.

    For example, costs for layoffs and plant shutdowns triggered by a slow economy became a restructuring charge. The new twist in the 1990s was that the companies pressured analysts to go along with the company basis for adjusting earnings, even when the exclusions ran counter to common practice.

    Some companies also pressured analysts to maintain favorable recommendations on the company's stock. Aiding management in achieving this was a—was that an increasing part—in many cases, the majority part of analysts' compensation was coming from the investment banking side of the analysts' firm. Therefore, in addition to the threat of cutting off analyst communication with a company, companies could use the lure of investment banking business to have additional pressure put on the analyst by the investment banking arm of the analyst firm.
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    Even more damning than what happened in the late 1990s is that the companies still did not seem to get it. Investors had hoped that the actions of Enron and other abusers of the system would have led companies to bend over backward to do the right thing in accounting for their earnings and in presenting them to the public. Yet some companies continue to abuse the system.

    Companies are still providing the so-called ''pro forma'' or ''adjusted earnings'' that continue to be on highly questionable footing. Even some companies that announced in January that they would no longer be reporting pro forma earnings welshed on their promise and continued to report them in their first quarter releases.

    The new accounting change, FASB 142, that eliminates the amortization of goodwill requires that companies include pro forma results for any prior period cited in their 10(q) and 10(k) filings that restate the prior period earnings as if FASB 142 had been implemented before the start of those periods. Yet no pro forma first quarter 2001 results were included in the first quarter 2002 earnings releases in many companies, and some said, when called, that they would not provide them until the 10(q) was filed.

    One company that had provided a pro forma result for first quarter 2001 for the accounting change when they reported last year, even though FASB 142 had not yet even been issued, chose not to report a first quarter pro forma number this year when they reported first quarter results. Doing so in the first quarter 2001 release made first quarter 2001 earnings growth look better, but doing so in the first quarter 2002 release would have made first quarter 2002 earnings growth look worse—therefore, no surprise in why they conveniently forgot this year.
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    Another company that omitted the pro forma first quarter 2001 number showed an earnings increase by doing so. But if the first quarter 2002 results had been compared to the pro forma first quarter 2001 earnings, the earnings were down by 1 cent, yet the company and the analysts reports only discussed earnings as being up.

    The net result of this abuse is that it is misleading investors by inflating the apparent first quarter 2002 earnings growth for many companies. Unless this practice is changed, it likely will be repeated in the next three quarterly reporting periods.

    Despite some companies last year raising the assumed returns on their pension fund investments in the year when the market was down, we are not aware of any reducing their assumptions so far for this year. In the face of growing opposition to the current accounting rules on stock options, companies continue to announce repricing of options. Because the cyclical abuses were greater this time, because the analyst conflict is a new one and because some companies still do not get it, it follows that the remedies for this cycle may have to be more severe and more far reaching than those in prior cycles. We have got to knock a few more gophers down.

    [The prepared statement of Charles L. Hill can be found on page 119 in the appendix.]

    Chairman BAKER. Thank you, Mr. Hill.

    Our next witness is Mr. Ken Boehm, Chairman of the National Legal and Policy Center.
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    Welcome, Mr. Boehm.


    Mr. BOEHM. Thank you, Mr. Chairman, and I want to thank Members of the subcommittee for this opportunity to testify.

    The Global Crossing bankruptcy, the fourth largest in U.S. history, has cost investors billions. It has cost 9,000 people their jobs. It has raised serious questions about accounting practices, corporate governance and conflicts of interest in the financial services industry.

    Following some recent articles in both Business Week and the Wall Street Journal and this morning's New York Times, a whole new controversy linked to Global Crossing has arisen. The controversy involves Ullico, formerly the Union Labor Life Insurance Company, a privately-held company owned by unions and their pension funds.

    Ullico was an early major investor in Global Crossing, and its directors, who were mostly union leaders and former union leaders, used the telecom's volatile stock price history to enrich themselves, apparently, at the expense of the union members and those retirees whose pension funds own Ullico.

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    Gary Winnick, the Global Crossing CEO, appreciated Ullico's early investment, and he appreciated it so much he cut Ullico's directors in on purchases of Global Crossing stock at IPO prices. According to labor officials quoted in the Business Week account, this sweetheart deal enabled Ullico's directors to make millions of dollars personally. It also raised serious questions as to whether the stock deal was an improper inducement to Ullico investors to invest pension funds, which are supposed to be invested conservatively, in a series of dubious investments with Winnick and his Pacific Capital Group.

    Many of those companies later had problems like—for example, you remember Value America, which subsequently went bankrupt. The major focus in the series of insider stock deals, though, was what allowed Ullico directors to buy and sell Ullico stock in such a way as to virtually guarantee that they personally made profits and avoided losses. The profits, they got; the losses went to Ullico, and Ullico is owned by the pension funds.

    In 1998, departing from a longstanding conservative practice of giving Ullico stock a fixed value of just $25 a share, Ullico began changing its share price annually according to the value determined by an accounting review. Insiders, meaning the directors, knew in advance of the price change whether the stock would go up or down, and with Global Crossing being such a large percentage of the portfolio, it wasn't hard to follow. It was the equivalent of investing in the stock market when you knew for sure which way a given stock would go. It adds a whole a new meaning to ''market timing.'' .

    To further fix the rules, Ullico directors were allowed to profit at the expense of Ullico itself because the repurchase of stock from shareholders was set up in such a way as those who held smaller shares—the directors—could get in on some of those repurchases, while those holding the larger number of shares, which would be the pension funds, the retirees and union members, could not participate to the same degree as the directors.
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    Here is what Business Week labor reporter Aaron Bernstein describes as how this profiting worked:

    ''In the fall of 1999, Ullico was losing money on its operations, but earned $127 million from selling Global stock. The directors and the insiders knew that the gains would lift the annual evaluation of Ullico shares from $54 to almost triple that amount, $146, when the books closed on December 31, so in December of 1999, Ullico offered each director a chance to buy 4,000 shares at the 1998 evaluation of $54, a can't-miss proposition. The union pension funds, that own almost all of Ullico, were not given the same offer or even told about it.

    ''In December of 2000 and January 2001, Ullico bought back 205,000 of its 7.9 million shares at $146. The stockholders with fewer than 10,000 shares are allowed to sell all their holdings, so officers and directors can take full advantage; again, the pension funds can't. Insiders know the decline of Global Crossing stock puts the true value closer to $75.''

    So it is nice when you can sell shares at $146 knowing they are only really worth 75.

    ''In December of 2001, they bought back an additional 200,000 shares, allowing officers and directors who hadn't sold before to cash out at 75; again, insiders know that the further collapse of Global has again cut Ullico's true value, this time to $44. This was a zero-sum gain. The directors won; the pension funds lost.''

    Just blocks from this hearing room, a Federal grand jury is hearing evidence about the Ullico case. At the same time, the Department of Labor is investigating, as well. The board of directors were finding more and more who have personally profited. One of the directors, Arthur Coia, former head of the Laborers Union, was recently banned for life from all union positions after pleading guilty to fraud involving failure to pay taxes on a million dollar Ferrari. A good question might be why a convicted felon is overseeing pension fund investments.
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    Others have been implicated as well. Marty Maddaloni, plumber's union, cashed out at a six-figure amount in terms of profit. He is under investigation by the Department of Labor for abuses related to his union's pension fund, which he also heads.

    The union official most on the spot is Morton Bahr, a long-time head of the Communications Workers of America; he is a Ullico Director since 1996. Many of the workers who lost their life savings because of the Global Crossing bankruptcy were members of his own union. The emerging record shows he was intimately involved in the Ullico-Global Crossing deal from the beginning. He pushed the Global Crossing deal even though the company was not unionized at the time; and he used his authority as a CWA boss to weigh in for Global Crossing in other business deals.

    The favoritism was not a one-way street. The Wall Street Journal recently reported that Bahr had personally profited to the tune of $27,000 in his Ullico stock deals, and a spokesman for Mr. Bahr assured the reporter that Bahr was, quote: ''Concerned about the propriety of the stock trading by the Ullico board.''

    These are conflicts of interest on their face. Union leaders, not to belabor the point, have a fiduciary duty to serve the best interest of their union members and certainly the retirees who depend on the pensions. The big picture here is that this case is important because it involves the heads of some of the largest unions in the country improperly, if not illegally, enriching themselves at the expense of union members.

    It is also important because it illustrates a growing trend in union corruption. The Department of Labor IG recently pointed out he has 357 labor racketeering investigations. Of those, 39 percent involve organized crime and 44 percent involve pensions and welfare funds. He says that the plan assets that are under risk in these investigations are more than $1 billion.
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    What can be done? I think the first step is to acknowledge we have got a major problem. There are trillions of dollars in pension funds, hundreds of millions and billions actually in some of these that are at risk. The public, especially union members, have a right to know what their directors have done with their money.

    There are laws that have major loopholes, and one of them recently pointed out by the Inspector General of the Department of Labor is that independent accountants are not required to report ERISA violations to the Department of Labor. That is a loophole that should be closed.

    Union members are entitled to know, or should be entitled to know, the sources of income of their top officials. Top union officials should disclose their outside income most probably on the financial disclosure forms they file annually with the Department of Labor.

    If protecting the integrity of billions of dollars in pension funds, relied upon by millions of honest, hard-working Americans, is not an issue worth addressing, what is? Thank you.

    [The prepared statement of Kenneth F. Boehm can be found on page 123 in the appendix.]

    Chairman BAKER. Thank you, Mr. Boehm.

    I must say each of you presents a disturbing reason for a critical analysis of our current system. As a defender of the free market, I really believe that market discipline reacting to facts is the most severe and appropriate quick remedy to abusive practices. However, it is obvious that in some instances—not in all—that the pressure on management to meet earnings expectations and to preserve shareholder value results in authorized accounting methods being used for purposes for which they were not intended. And when the losses occur, the resulting leverage brought about by the accounting misstatement causes the losses to be far more severe than had you simply addressed the fact that you have a small economic downturn in business performance, and instead of making 2 cents, you are going to make 1.
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    It is a result of management's intention to preserve corporate growth and to strengthen expectations that 16 or 18 percent rates of return are somehow normal. Given that and the fact that the system missed it, it isn't just the analyst, it isn't just the accountants; it goes all the way to the financial press. I mean, you can go back now and get articles written weeks before, months before the Enron debacle, where they were held out to the world as the new business paradigm for the next century. Nobody knew what was about to occur.

    The big question here is—without casting blame on any particular participant, is our current system really adequate in light of the business speed with which we act? How is it possible that a statement which is based on data at least 3 months old by the time of its publication, which is a backward-looking analysis, a retrospective view of where the company was, is in any way appropriate to make a forward-looking judgment about where the corporation may be headed?

    Since we have relatively few here, I am hopeful we can have more questions to follow up. But, anybody, jump in here.

    Mr. Hill, you are the one who, I believe, said we may be needing to hit a few more gophers a little more rapidly with this particular set of circumstances than ever before. I have concerns about FASB's slow pace, their academic perspective and their disconnect from accounting reality to accounting philosophy.

    Should we be looking at a much bigger solution here than what we have talked about in the past?
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    Mr. HILL. That is a tough one. In the interest of full disclosure, I should say that I am on one of the FASB task forces on financial reporting.

    I think that FASB understands that some things have to change, that they have to speed up the process. That is easier said than done. It probably means more resources for FASB. There is still—even though FASB members are paid and they have a staff, there is a lot of work done by committees, like the one I am on, that volunteer. And we have plenty of other duties in addition to trying to help out with FASB. So, I mean, that is one of the things I think that slows the process down.

    But on the other hand, it is good to get the input from people who are active in the industry and understand the day-to-day nature of the problems.

    Chairman BAKER. And just in perspective, FASB could be a research agency to the SEC, to advise and research questions.

    For example, they approved the utilization of SPEs. I don't envision anyone there at the time anticipated how the SPEs would eventually be utilized in the market, and that is the distinction between a policy and implementation. And the SEC ought to be on deck looking at those things with the capacity to respond.

    And I have been informed that the Attorney General has to leave here momentarily to catch a plane. Before you depart, from your perspective, what additional advice would you give to the subcommittee in light of the structural concerns I have? Do you think we need to be looking at a broader structural remedy, or do you believe that merely additional disclosure standards and transparency is sufficient to arm you with the tools you need?
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    Ms. MONTGOMERY. Mr. Chairman and Members of the subcommittee, I hate to echo what you have already said, but what you have done already is a great first step. The transparency is really critical.

    I would defer to some of these folks here who are more engaged in security and investment issues than I. But for an Attorney General, we need to have very clear rules with regard to self-dealing—they are already existing, but walls between accounting, doing accounting and auditing versus making some consultation, and what happens when there are accountants that do that; and certainly the self-dealing that happens on board with the directors.

    Chairman BAKER. And after my slight interruption, Mr. Kanjorski had a short question.

    Mr. KANJORSKI. Madam Attorney General, it is not on this issue today, but in prior testimony the Attorney General of the State of Washington mentioned that their pension funds lost $100 million as a result of Enron's collapse. But the lawsuits that she is bringing will only be able to afford the recovery about half of that amount because of the statute of limitation being 3 years, and most of these fraudulent occurrences went beyond the 3-year period, although they were disclosed just recently.

    I notice that Ohio's pension funds lost $270 million because of Enron and Global Crossing. Are you running into the same problem? Does a 3-year statute of limitations inhibit your ability to get back a good portion of these losses?

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    Ms. MONTGOMERY. At this point, Mr. Kanjorski, it doesn't apply to us, although I will say to you in the earlier—obviously, we were a part of the Washington coalition on the Enron matter. And the statute of limitations generally is a concern to attorneys general because we always have various individual State statute limitations which can affect us.

    In this instance, it doesn't affect us.

    Mr. KANJORSKI. We discussed that issue in this committee before it went to the floor last week to expand the statute of limitations from 3 years to 5 years, and it is to run from the period of discovery.

    Do you have an opinion as to whether or not that expansion would be worthwhile?

    Ms. MONTGOMERY. Mr. Chairman and Mr. Kanjorski, as an Attorney General, I will say to you when you give us a longer amount of time to recover, generally we are going to tell you we like that, particularly when the time doesn't run until after discovery, or when it should have been discovered or when it was discovered. So obviously that is a tool that is very helpful to us.

    Chairman BAKER. Thank you very much, Attorney General. I understand the constraints of your schedule.

    Ms. MONTGOMERY. I apologize.

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    Chairman BAKER. Mr. Bentsen.

    Mr. BENTSEN. Thank you, Mr. Chairman, and I thank our panel.

    I have to say I am reminded of when I went to Wall Street and was going through my training program, and the head of the program said, if anything goes wrong with the transaction, the first thing you do is sue everybody and then figure out afterwards what you are going to do.

    I think the testimony of Mr. Holder and Mr. Hill are pretty interesting. And, Mr. Hill, I think in your opening part, you hit the nail right on the head, particularly in two out of three, and maybe three out of three, that a lot of what we have going on in this market we have seen before.

    But I think you are right about the short-run aspect of management compensation which—that is just how it is, but it is one that has been short-sighted from an economic perspective and, apparently, short-sighted from a market perspective. And I think the level of exuberance, where we went through, where you ended up having to chase money—I think it was in 1987 when the UAL buyout deal was going to happen, and the pro forma said they expected the airline industry to have positive growth for the next 7 years; and somebody finally looked at that and said, that is probably realistic. And that fell apart, and the junk market fell apart for other reasons.

    But the question is—and, Mr. Holder, in your testimony you lay out the issues of subjective accounting and why it has to be subjective. And I appreciate your insight on that and where there can be abuse.
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    I guess the question comes down to, other than some very strict standards on the market—similar to what the Congress did with respect to banks and thrifts at the end of the last bubble, where the Congress had arguably a clear line of intent because of the payment system and the Federal backstop to the banking system, whereas here we are talking about the capital markets where we do want to have sufficient protection for investors against fraud and fraudulent activity and ensure there is confidence in the market—but how far can we go? How paternalistic should we be in setting guidelines for management, setting guidelines for auditors? And to what extent do we impose, you know, the old standard of caveat emptor?

    And the other question I would ask, and particularly to Mr. Hill, because you at the end say we need some tough remedies, and I would be interested in knowing what those are.

    With respect to research analysts, do you think—I am not proposing this, but I am curious because we keep talking about this issue—do you think that the time has come that research analysts on the sell side should be a disclosure item for purposes of the 1933 act in the same way that an offering document is? Either one on those points?

    Mr. HOLDER. Well, with respect to the earlier question you asked and sort of directed to me, I don't think there is a silver bullet to fix these problems. I think there are a great preponderance of accountants in the country who go to work and do their job in an appropriate fashion; but the weakest link fails when pressures increase, and we have seen a number of those. And in my own view, I think some fixes are necessary.

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    I think the FASB can become more nimble on some aspects of the due process procedure which they go on writing standards probably becomes as much a vice as a virtue. The learning curve in terms of information coming to their attention flattens out and yet there is still due process in which to go.

    But if there is a silver bullet or something that comes close to it, in my own view, I think it lies in strengthening the system of corporate governance, particularly in boards of directors and, even more specifically, with audit committees. In my written submission, I suggested that audit committee Members may, for example—it may be reasonable to require them to maintain independence from the company and not be compensated through options or stock of the company in fulfilling their roles as audit committee members.

    I think the whole relationship between an audit committee and the external auditors can be strengthened and made more muscular, so the audit committee has the sole responsibility and authority to retain and to discharge auditors.

    I believe there are a number of promising avenues in the area of corporate governance that may bear fruit. Again, as you may have detected from my comments, because of the inherent features of financial reporting, no matter what you do in standard setting, no matter what you do in regulation, to get better accounting and financial reporting answers, the people applying those standards and rules have to be objective and have to be independent, and if they are not, bias will intrude. So it is in the area of corporate governance for a variety of reasons that I believe the greatest benefit may lie at this point.

    Certainly there are other things that affect all aspects—the auditing standards that exist, the culture of the auditing profession, and the culture of the financial reporting profession deserve attention as well.
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    Mr. BENTSEN. Mr. Hill.

    Mr. HILL. Let me first say in the comments before, about the nature of accounting being subjective, that is certainly true, and I don't think we can do a whole lot about it. We can try to tighten it up as much as we can, but there will always be judgment involved.

    And a system like that only works if the conflicts are removed; and by the ''conflicts,'' I mean the financial incentives. It is the old story, follow the money. I have said that before here.

    But specifically in relation to your question, I think some sort of separation of the analysts from investment banking is probably desirable. I am not sure what the ultimate answer is. We do need, certainly, to rebuild the Chinese Wall if we are going to continue to have research be part of an investment banking firm. But to solve that problem—I mean to be able to rebuild the Chinese Wall—we have to have compensation no longer coming from the investment banking side of the house to the analysts. There was a day when it was that way.

    But, you know, the underlying problem—I mean, it is really only a symptom that the analysts are increasingly being paid by the investment banking side of the house. The underlying problem is that the research departments can't get paid for the research anymore with negotiated rates. Why, they have been driven down to the point where there aren't enough commission dollars to go around anymore for research.

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    Now, what is the answer to that? I don't know. We can't put the fixed-rate genie back in the bottle. Do we go to some sort of hard dollar arrangement? Maybe that is what we have to find somewhat, to incentivize or regulate; I don't know.

    But, you know, the culture of the institutional investment houses has been to try to soft hour everything, even though it is a diminishing soft hour pie. I mean, if they could soft hour the janitorial service, they would.

    So I don't know what the ultimate answer is, but that is the problem. I mean, until we solve the issue of being able to get paid for research—I mean, you can't. The Attorney General of New York's idea of separating research off, spinning it off as a separate thing, I mean, how are they going to get paid?

    Mr. BENTSEN. I agree with what you are saying.

    Would you agree with the idea, with saying that idea of a research document is treated under the law the same way as an offering document is?

    Mr. HILL. Well, I think that would have a chilling effect on research. I think we have to hold the analysts more accountable, but I don't think going that far would be a good idea. I mean, it is really an opinion; it is like an opinion you get from a consultant.

    I mean, there is no right answer. I mean, if an analyst could be right all the time, they no longer would be an analyst after a short time.
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    Chairman BAKER. In my continuing effort to be extraordinarily fair, I yielded time to Mr. Kanjorski to ask a question of the Attorney General before her departure. I then stepped over Mr. Kanjorski's time and went to Mr. Bentsen. So to kind of get us back on track, I am going to take about a minute to follow up on my questions and then recognize you for your full 5.

    First, on the question of analyst disclosure, I think the rules that are now soon to be implemented, out for public comment only in the last 45 days, will go a very long way down that road in making public the intended effort to simply disclose where you have the conflict, where you can't at least trade against your own public recommendations. You can't have family and friends trading off an upgrade-downgrade price target change; you must make disclosures if you are paid by investment banking.

    I think it is a good first step, and we ought to let that be operative before we go too much further in that arena. I still think the focus has to be on value added to the corporation. If, in fact, it is a subjective valuation, somehow that has got to be noted, and then you can agree or disagree with the subjective determination. But that has got to be different than one and one equals two; that can't be subjective.

    So if we have hard dollar value, and we can present that information and, in a B part, have values and subjective opinion so you can make your appropriate judgment, that, to me, seems to be the goal.

    Can you comment with regard to that approach?
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    Mr. HILL. It is an interesting thought. I hadn't really thought it out. It is the first time I heard a suggestion like that.

    Chairman BAKER. Well, what we do now is take the subjective data and put subjective footnotes; and so you scroll through the facts, and then you get influenced by what is not disclosed as being subjective. So somehow, just identifying, as we have tried to do with the analysts, where you have a conflict—the conflict may be fine and you may be managing it well within the firm, but you have to let people know that is what you are doing; you can't keep that from public light.

    I think that is what they tried to do to Members of Congress. We have to disclose who gives us money, what they do, all sorts of limits and that is hopefully enough to ensure that Members act appropriately in light of the fact that they still get financial contributions from various interests. That is the whole basis on which our ethics code is structured, and it seems to be appropriate for others.

    Mr. Kanjorski.

    Mr. KANJORSKI. Thank you, Mr. Chairman.

    Mr. Hill, you suggested that fixing accounting problems is somewhat like beating down the gophers. I wanted to make this suggestion to you because we both love cartoon characters from our past: How about the slaughter of the Schmoos? Every time you hit them, they divide. And it seems, with this catastrophe, every time we see something, it multiplies.
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    The reason I opposed the legislation last week on the floor is, I do not think we have seen a real analysis of what really happened at Enron, Global Crossing, and other accounting disasters. As a matter of fact, I suspect there is almost a conspiracy of silence as to whom some of the culpable parties are by their absence of being examined and asked to testify here. And I do not want to necessarily name whom I suspect played a large part in these parties' involvement.

    But, I also think you struck at something: Follow the money. We have not nearly seen where the big money was made in these transactions that were set up. This was not some lowly accountant sitting around a corporation, or even their accounting firm, that sat down at a low, tertiary level coming up with these gimmicks. This was real, extraordinary brain power that came out of the sharpest minds in the accounting field and the investment field in the United States of America.

    And to a large extent, I do not think the accounting firms reaped all these benefits of extraordinary amounts. I think there are other parties out there that reaped incredible sums and created this activity. And I am disappointed that the Congress has not gotten to these parties yet. We have not asked any of these people to testify.

    I mean, who wrote these documents? Who came up with these ideas? Where are the notes? What did they anticipate? Why did they not see conflicts of interest, violations of the law, lack of standards, criminality?

    Quite frankly, I have talked to some of the people that have participated in the writing of these things, and there is a great deal more for this Congress to learn, which we have not yet learned. And yet, we are out there trying to thrash around making a decision. I am disturbed because I am wondering whether or not this is something more than just the excess at the end of a bubble. It may be an infectious disease of greed and inability to contain oneself in their lust for using the system and abusing the system to earn money.
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    There was a column by Mr. Samuelson in the paper this morning that really strikes home. It goes to financial literacy. I am still confused in my mind about his conclusions. Forgetting the average investor, who gets snookered all the time, let us take a look at the sophisticated pension fund investors, the real corporate investors, the people that are paid and supposedly have all the genius to come up with the right answers. Why are they buying stocks 100 times over earnings?

    When Samuelson analyzed the market today, he said—I think—one of the price-to-earnings figures, on average, was 45-to-1. I don't know. Maybe I slipped off the cabbage truck or something, but I do not ever recall companies profits alone going to inflate the stock. To a large extent it used to be that stocks' prices were calculated on what was their payment, what was their dividend, what was their revenue. These institutions seem to have lived on that ''profit'' mentality.

    It does not surprise me that this mentality has filtered down into the union pension funds and everything. Those guys are peripheral actors. We are talking about a guy making $27,000 on stocks. That is a joke. There are people that made billions upon billions of dollars on these transactions, and they took it out of the pension funds. And we were conspirators in that, the Congress.

    I just remember a few years ago in this Congress when we passed legislation in the height of the interest bubble to allow the corporate pension funds to calculate the value of the pension funds based on the capital market value of their stock and investments, and if it was in excess of a certain amount, they could start withdrawing funds. And I have not seen any writers talking about how many crippled pension funds there are out there that in 1999 and 2000 had huge amounts of these funds drawn out by companies, and utilized for company purposes. And now, with the market having fallen, I wonder what those funds are worth out of those pension funds.
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    I just reviewed one report the other day. In 1999, the pension fund was, I believe, in the vicinity of about $100 million. Today, it is worth less than $30 million on a market cap basis and it cannot really cover its long-term obligations. And there is nobody responsible under the law to step up and fill that void, so ultimately it is going to go to the Government under our pension guarantee program, and the taxpayers are going to pick up the shortfall.

    But where are the people writing about these things, analyzing these effects? When $54 billion disappears, it is a paper loss. But there are many sets of papers that will get reflected in that loss. And I am worried about the financial literacy of our geniuses on Wall Street and around the country. Maybe we have to go back and reeducate these people or restructure how they get paid. We are always talking about how the analysts get paid.

    I just want to bring up another point. In Pennsylvania we used to have a process where the most junior judiciary—the justice of the peace—was paid on a per case. If he found the defendant guilty, the defendant had to pay him a fee for the justice's time. It was amazing how any charge led to a conviction. If you went to a justice of the peace in Pennsylvania at that time, you were about 99 percent certain that you were going to be found guilty.

    Chairman BAKER. Maybe that is how we ought to prosecute these guys.

    Mr. KANJORSKI. Talking about how people get paid, in tort law, the judges sitting in the common pleas level of court systems were paid a percentage of the recovery in a tort case. I can just imagine how much evidence would go to the jury and how much material would go to allow a higher verdict for a higher payment.
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    These are solvable things.

    I guess my question is at what point should Government step in? Have we stepped in enough? Have we stepped in not enough? What we have already done—last week in the House—I think, is superficial. I do not think it solves the problem. I do not know where the measure is as to how far we have to go, but I hope we have hearings to determine that.

    I think professionally you have your hand in it. I do not care what we do on subjective rules. If we have avarice, greed, and malcontents in the professions and in the leadership roles of these corporations, they are going to find a way to accomplish their fraud. We can pass all the statutes we want, they are just going to find another way to commit fraud. My experience with good lawyering is that you get what you pay for. Someone will find a way around the barrier we construct, and generally, good lawyers do that all the time.

    I am wondering whether we need some basic public discussion in this country as to the nature of this problem. Does this situation reflect something of far greater concern to our society, a far greater threat to our society than just the loss of some stock value, or just the loss of some money or just, sometimes, limited abuses. I think it may acutally indicate that we have much more serious systemic failures in the overall system that are merely being reflected by what has happened in the last several years in our corporate governance.

    Chairman BAKER. If anybody wants to respond, Mr. Hill.

    Mr. HILL. I agree with most everything that you said.
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    And as far as the cultural aspect of it, I think it is this instant gratification that pervades our culture these days; and as a result, why everything has become so short-term oriented. I mean, you ask why a pension fund manager was paying 100 times earnings. Well, I will tell you why. Because the pension fund managers, the outside ones, are measured every quarter. They have maybe five different institutions managing their pension fund. Every quarter they kick one out and add a new one.

    Everywhere you turn, the pressure is on short-term performance. I mean, the mutual funds, individuals don't have any patience. This one is down this quarter, they sell that one and try another one.

    Why did the managers then buy this stuff? Because to keep up with the guy that was buying the junk and having better performance, he said, well, I have to, too. I know a lot of portfolio managers who were buying stocks that they knew were questionable, but they felt they had to play the momentum game.

    So you are right. We have to find some way to get away from this short-term orientation and get rid of these incentives that encourage it, like company management compensation, which is so short-term oriented.

    I mean, I think the regulations that come out of Congress should be of a more positive nature. How can we incentivize managers, analysts, and so forth, to do the right thing rather than saying, well, you can't do this because as soon as you say you can't do this, as you pointed out, there are going to be some smart guys to figure out how to get around it. So we have to change the incentives.
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    Chairman BAKER. Mrs. Jones is next.

    Mrs. JONES. Thank God for that rule.

    Couple of questions. I am going to stick with you, Mr. Hill. Are you aware that last week, the SEC issued a new rule—number 8K—with regard to disclosure of certain management transactions?

    Mr. HILL. I am aware of it, but that is not one that I have looked at really.

    Mrs. JONES. The purpose was to—in Enron and Global Crossing, the testimony was that everybody—all the CEOs and the directors were able to have a way of relieving themselves of their assets while the value was very high, while the rest of the employees were stuck with what they had when they finally got to their dollars; and they were at nothing.

    Is this one of the things that might assist us in getting where you are suggesting that we might go?

    Mr. HILL. That is certainly a positive step, but it is a drop in the bucket.

    Mrs. JONES. I believe this rule change actually came as a result of some conversations that we had with Chairman Harvey Pitt, Chairman of the SEC Harvey Pitt that we had at an earlier hearing. Because there was in place a rule that would allow directors and managers to have a plan in place to dispose of their assets, and then they could be shielded from quote/unquote, ''any insider trading.''
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    Let me ask you another question in that line, and I will get to the other witnesses. With regard to your whole conversation about compensation, I was just stunned, based on the arrogance of the Enron and Global Crossing CEOs that came in before this hearing in response to our questions about what their compensation was and what their—and unwillingness on their part to even, A, tell us what the compensation was publicly; and B, to say in response to some of my questions, ''I didn't set the salary,'' and, ''You don't know how busy I am as a CEO,'' and so forth.

    I have come to the conclusion, based on the short time I have been in the Congress, in going through this process, that we really—no matter how much legislation we pass, no matter how many rules we put in place, to—like they just started doing in law schools about 15 years ago, requiring that ethics be a part of the curriculum for lawyers—that each year they would be required to do an ethical—I think every 2 years in the State of Ohio lawyers are required to get 2 or 3 or 4 hours of ethics training.

    But also just to put out in the world that, hey, that right is right, and you can't misuse people, it seems to me is one of the things we need to look at.

    I am going on for a little while, but I am going to ask you a question at this point. I guess all of my colleagues and I do that.

    Anyway, though, what do you think, where do we need to go first in trying to resolve this situation that we find ourselves in in terms of accounting principles? Where do we strike first?
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    Mr. HILL. I think you strike for the low-hanging fruit first.

    Mrs. JONES. And the low-hanging fruit is?

    Mr. HILL. Well, I think the NASD and NYSE proposals that were are alluded to earlier, that will presumably be OKed pretty much in their original form a week from today by the SEC, and will presumably go into effect pretty quickly.

    There is a max of 90 days, a 60-day and a 30-day, but I think they will go for the short end of both of those. That is a tremendous step. If you look at that and divide it into three parts—one is the conflict issue that I talked about, the compensation issue.

    They only did a few perfunctory things there, and I am glad, because if they had tried to solve the problem which—as I mentioned, the underlying problem really is getting paid for research, but things would have been so bogged down that we wouldn't have gotten to the other good things that were in there.

    So I am glad that in round one they didn't try to solve that problem.

    Mrs. JONES. On that point, let me ask you this: Do you believe that CEOs and directors ought to stand behind the representations that they make about the financial condition of their companies?

    Mr. HILL. I agree with some of the proposals that Chairman Pitt has put forth in that line. I think there should be more responsibility and penalties for CEOs if they are pushing the envelope, and obviously, if they are cooking the books. But fraud provisions take care of that.
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    Mrs. JONES. Mr. Chairman, could I ask unanimous consent for him to finish the answer to that last question?

    Chairman BAKER. We have been very liberal with the use of time today, so please proceed.

    Mr. HILL. The other two parts of the NASD and NYSE proposals were the disclosure and the recommendations.

    Now I think probably some of the discussions in this committee last year set the stage for what came out of that—I think they really hit a home run in what they have done in terms of the recommendation issues.

    I mean, there were two things that—Congressman Kanjorski is gone, but we joked about that you needed a decoder, a two-level decoder, to figure out what was going on with the recommendations. One was to put everybody on a common standard, you know, buy at one firm that was at the top category on a 5-tier basis, and second tier at another and third tier at another. So you had all these different terminologies and scales.

    The other problem was that there was this extreme optimistic bias in the recommendations, over 100 to 1 in terms of buys and strong buys, to sells and strong sells in the most commonly used terminology. But the NASD proposals, I think, really go a long way to solving that.

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    As far as the first problem, you can still have your proprietary recommendation scale, but it becomes supplementary because you are going to have—at the end of the day, in that report, have to say it is a buy, a hold, or a sell. So there will be a common scale and everybody's recommendations can be compared against each other.

    The second thing is on the optimistic distribution. Every report is going to have to show the firm's number of recommendations in each of those three categories and what percent of those are investment banking clients. In addition, the analyst has to put in a price chart of the stock with his or her recommendations superimposed on it.

    Chairman BAKER. If I may jump in on that point, given Mr. Kanjorski's reference to the cartoon, this is the coloring book chart, so any consumer, a Member of Congress I think can understand this.

    You have the price target and the line goes down away from the estimate. I think that is a very persuasive tool that anybody can use to get an understanding of what the analyst is doing in relation to the real performance, and it is historical over a 12-month period.

    Mr. HILL. And I think it will force the analysts to say what they mean and mean what they say.

    I mean, if the reports are going to come out for the year or whatever, and every analyst's report coming out of that firm is going to be showing that 80 percent of their recommendations are buys and all their investment banking clients are in the buy category, pretty soon they are going to have a reputation as a shill. And we have seen Morgan Stanley come out with a change in their recommendation system that was obviously in anticipation of what they saw coming; and their distribution initially—I don't know what it is today, but initially 22 percent were sells. That is a reasonable distribution. The highest we had seen for any broker prior to that was 8 percent. And there were damn few, you know, that were more than 1 or 2. Sorry, I shouldn't have said that.
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    Chairman BAKER. Mr. Sandlin.

    Mr. SANDLIN. Thank you, Mr. Chairman, for calling this hearing. And we thank the panel for appearing today.

    Professor Holder, I wanted to ask just a brief few questions to understand what you are saying about the intangibles and goodwill. I noticed in your written testimony, you indicated that AOL-Time Warner wrote down intangibles and according to the information we have here, is about $54 billion in intangible assets. Is that correct?

    Mr. HOLDER. That is my understanding, yes.

    Mr. SANDLIN. That AOL-Time Warner merger was in January, 2000, would that be correct?

    Mr. HOLDER. I have that general understanding, yes.

    Mr. SANDLIN. And from what I understand in your testimony, the goodwill write-off merely reflects the decrease in value of the stocks since that merger in January of 2000; would that be correct?

    Mr. HOLDER. It is a little more complex than that, I think. But basically, yes, the standard requires a fair value test for potential impairments of goodwill.

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    Mr. SANDLIN. So the drop in the value of the stock directly affects the value of the goodwill?

    Mr. HOLDER. It certainly can and, in that case, did in a profound way.

    Mr. SANDLIN. With the changes in the stock market since that time and particularly in the high tech area and the internet area and things like that, I think you would logically expect a fairly significant write-off, wouldn't you?

    Mr. HOLDER. I am sorry, sir. In general, you mean?

    Mr. SANDLIN. Yes, sir.

    Mr. HOLDER. Well, a stock value is diminished and there is goodwill that is on the books of companies from acquisitions of other companies. While not axiomatic, that would certainly be the relationship you would expect.

    Mr. SANDLIN. And there have been particular problems in the area of high tech stocks. And I guess that is what I was saying.

    Mr. HOLDER. Yes, sir.

    Mr. SANDLIN. Obviously, this is a very huge merger, and so while 54 billion is clearly a very large amount of money, it is not unusual in a transaction of this size, would you say? Does that seem to be proportionate to you?
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    Mr. HOLDER. $54 billion write-downs, in my experience at least, would not be unusual in the accounting term of our sense, but it is a very large loss.

    Mr. SANDLIN. It is large, but these are huge corporations.

    Mr. HOLDER. Indeed, they are, and the dollars that are involved in those mergers lead to those kinds of valuations of assets acquired certainly.

    Mr. SANDLIN. Correct me if I am wrong. Previously companies amortized a portion of their goodwill each year; is that the way it worked?

    Mr. HOLDER. Yes, sir, with the exception of some pre–1970 goodwill that wasn't subjected to that standard, that is generally the case.

    Mr. SANDLIN. And you refer in your testimony about FAS 142, and my understanding is that intangibles acquired after June 30 have to be annually reviewed with a charge against the earnings if the market value of the assets drop, or if there is an impairment, as defined by FAS 142; is that correct?

    Mr. HOLDER. Very generally, I think that is a fair statement, yes, sir.

    Mr. SANDLIN. I am not an accountant. I am just a country lawyer.
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    Mr. HOLDER. I will accept your characterization. I am a simple teacher.

    Mr. SANDLIN. So in my reading of your testimony, you analyze this transaction and talked about this write-down of intangibles, but you are not indicating under the rules, under FAS 142 or any other rules, that that write-down was handled improperly, are you?

    Mr. HOLDER. No, sir. The description that I tried to write in here, based upon publicly available information, would lead me to believe at least that this is unremarkable, at least in a couple of senses. A business decision got made leading to the acquisition of a company with certain consideration involved. That decision was predicated upon expected outcomes, how successful the combined entities would be.

    When that business decision, through hindsight, didn't come to pass in the way that was anticipated, then the accounting implication of that is the—and I will say routine application of that accounting standard to value goodwill in light of a possible impairment.

    So in that sense, I think the accounting model—and this is a rather new standard, but the accounting model in that sense works and achieved what it was designed to do.

    Mr. SANDLIN. Right, and I think that is my point. The rules seem to work and flow naturally from the transaction that happened, correct?
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    Mr. HOLDER. That certainly is my understanding at this point, based upon the publicly available information, sure.

    Mr. SANDLIN. Thank you for coming today. I appreciate your testimony.

    Chairman BAKER. Thank you, Mr. Sandlin.

    Just to follow on Mr. Sandlin's line of questioning, one point of clarification, the 10K restatement on the $54 billion write-down occurred and was made public December 31 of 2001. Since that point until now, there has been an additional $10 decline in stock value.

    Based on your comment earlier about the not-necessary-but-likely correlation between stock price and deterioration of goodwill, one might not be surprised to see an additional restatement in some future months, given the current stock deterioration. Would that not be expected?

    Mr. HOLDER. To the extent further impairment occurs, according to the accounting standard, one would expect to see those losses being reported as of the time the deterioration takes place, yes, sir.

    Mr. HILL. Could I just jump in on that for a second?

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    Chairman BAKER. Sure.

    Mr. HILL. Here is an example, though, of the subjective nature of accounting. Typically, in the kind of transactions we are talking about, it is saying that you paid too much for this because it deteriorated in value and didn't perform as you expected.

    But you also can have a situation where a company acquired somebody with stock and now is subject to this—or in the past, even when we had pooling, didn't qualify for a pooling—but you took our overvalued stock, and you knew it was overvalued, and you went out and acquired somebody else's stock that may be overvalued and incurred some goodwill in doing it.

    Was that a bad decision? No. You used your funny money to take advantage of it at that time. But it shows up here eventually as a write-down of goodwill or impairment. But that is why—you know, it is not just the numbers, you have to look at what is behind them.

    Mr. HOLDER. Could I just add one bit of perspective?

    Chairman BAKER. Let me just recognize Ms. Hooley.

    Ms. HOOLEY. I would like to hear the rest of his answer, and then I will go on.

    Mr. HOLDER. Well, all I was going to say is the accounting standard on how valuations and how acquisitions get recorded is really pretty clear that what one looks to is the fair value of shares in the market. So whatever that market value is generally would be the number that an accountant would use to record the acquisition. And while you might personally believe that that number is greater than the actual value, you are still basically obliged to use that number because it represents the most objective evidence of value that is attainable. That is all I wanted to say.
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    Ms. HOOLEY. Thank you, Mr. Chairman. Thank you for testifying.

    One of the things that I think has been fascinating and interesting with the debacle of Enron, you have now seen several other things happen across the United States, whether that is with analysts and who is paying them and that whole situation.

    There is another thing that is happening which is—for some of us finding out about it is relatively new, and this is the corporate-owned life insurance that they take out on employees. And we have a situation where Enron took out corporate-owned insurance, life insurance, on PGE employees who—this is an Oregon company, about 2,000 men and women. These are people who virtually lost all of their retirement savings when Enron imploded. In the case of Portland General Electric, more than $78 million in such benefits have been set aside for long-term compensation for managers and directors and supplemental retirement and bonuses for its top executives. And I understand that life insurance has a legitimate role in our economy.

    And FASB rule 106 requires any publicly traded company that has an unfunded liability such as retiree health care plans to account for it in the annual financial statement, and life insurance is often used as the source of that funding.

    And the IRS can find out about the COLIs policies directly from the companies, but there aren't tight requirements, and this makes it hard for others to determine just how much money is squirreled away in the insurance permitting employers to use COLIs to pay for lavish retirement benefits for executives, such as the situation at PG&E and Enron. This is because current disclosure rules don't require them to distinguish between the executive life insurance and rank-and-file life insurance.
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    First of all, do you think these disclosure rules should be amended to require companies to distinguish between the two types of insurance?

    Mr. Holder.

    Mr. HOLDER. As far as financial reporting goes, the financial statements generally have been viewed, historically at least, as providing an overview of the enterprise and its past ability to generate earnings and cash flows from various sources and its general financial structure at a particular point in time. So to require that kind of a distinction would certainly deviate, I think, at least from the historic general purpose of financial reporting in accordance with Generally Accepted Accounting Principles.

    I certainly recognize that the information you describe would have relevance to a good number of people. Rather than require that kind of information as a function of accounting principles, I probably would advocate that it be provided through other communication mechanisms required by the Securities and Exchange Commission.

    I think that vehicle of additional information outside of the financial statements is well understood, and you see a lot of information of that type contained in official filings, 10-Ks and certainly other documents filed. To the extent that information was considered to be sufficiently useful, that is where I would recommend it be provided.

    I am shooting from the hip here. I would like to think a little bit more about it, but I don't have that opportunity. That is my immediate reaction.
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    Ms. HOOLEY. Well, when companies report all of their life insurance in an aggregate, accounting rules require that they report the increases in the aggregate cash value of those life insurance policies, and only if the increases are material. But material is not defined. So do you think we need to define materiality?

    Mr. HOLDER. I think the SEC has done a pretty good job in Staff Accounting Bulletin 99, I think, if I recall correctly, in tightening what materiality means and reminding the accounting profession generally that there are qualitative aspects as well as quantitative aspects to materiality. The FASB has declined to do that beyond providing very general guidance.

    I believe the staff accounting bulletin has had a substantial affect on the way materiality is viewed. It is rather recent. But I would be content at least myself, to see, you know, the effect that it has had before I would propose at least additional information.

    I believe that was the extent of your question. There may have been something on the cash value side of it.

    Ms. HOOLEY. No. I think you have answered the question. I have just one other quick question, and this goes back to private companies and what Mr. Boehm was talking about in terms of some of the pension funds. Certainly we have had some problems in my State again with this issue.

    Private companies generally aren't required to make public filings with the Securities and Exchange Commission. Why do we treat them differently? Should they make filings with the SEC? Would that be helpful, not helpful?
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    Mr. HOLDER. Private companies or employee benefit plans?

    Ms. HOOLEY. Well, employee benefit plans, pension funds, should those be reported to the SEC? Just sort of what are your thoughts on that?

    Mr. HOLDER. Well, certainly there have been some problems in that area, as you know. Most employee benefit plans have reporting obligations to the Department of Labor and to the IRS generally if they are subject to ERISA, the Employee Retirement Income Security Act.

    Anyway, those two agencies, I believe, are charged with oversight of financial reporting by pensions and have specified rules over the years. At this point I wouldn't be inclined to recommend transferring that responsibility to the SEC.

    Certainly financial reporting by employee benefit plans can be improved, and certainly there are incentives for bias and for self-dealing that exist anywhere economic resources are probably aggregated. So many of the things we have said about business enterprises and the issues that need addressing there would certainly apply to employee benefit plans generally, I think.

    Ms. HOOLEY. Mr. Chairman, can I ask one more question?

    If there was one thing and only one thing that you would do to change the law or change reporting or change what we do so that—you know, I don't know that you can ever stop what happened with Enron, but what is the one thing that you would have the most—you think would be the most significant change we could make?
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    Mr. HOLDER. I would empower audit committees. I would act to make them independent of the companies that they serve. I would make their relationship with the external auditor far more muscular and robust. I would also make that same relationship more muscular and robust with the chief accounting officer, the chief financial officer of the company.

    Ms. HOOLEY. Thank you very much.

    Chairman BAKER. Thank you, Ms. Hooley.

    Gentlemen, you have done such a good job. The bad news is the committee is going to do a second round. We have more questions, so I am going to start off.

    First, for the record, I want the subcommittee to know that subcommittee efforts were made to secure comment on these subjects from AOL Time Warner, from Xerox, from Dynegy, from CALPERS, and from various pension union management representatives. All, at least for purposes of today's hearing, declined to appear, and I think that unfortunate because not every action taken was necessarily taken for untoward purposes. It may have been legitimate business management decisions that simply turned out, in retrospective analysis, not to be good judgment.

    But I think it important that we do get before the subcommittee at some appropriate time representatives of market participants to explain how special purpose entities, IRUs, goodwill, all of those various accounting methodologies are utilized for valid business purposes that do, in fact, result in shareholder value being enhanced.

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    Yesterday, I understand that the SEC has released for public comment a new standard of disclosure requirement, specifically in the management discussion and analysis section of annual reports that relates to critical accounting policies. In summary, as I understand it from reading it this morning, it requires in that section management to describe the assumptions used to arrive at values. For example, if we are back in our widget manufacturing mode, we are assuming widget market price will be $10, and that the pricing for construction and delivery of the widget will be 5. All of those things are based on certain assumptions: That the cost of raw materials won't be adversely impacted, that market price will actually be sustained at $10. And there must be some discussion in a simplistic way of how management came to represent the net value after expenses of $5 per widget.

    Are any of you in a position to be able to comment as to the adequacy of this new disclosure standard and your view of its appropriateness?

    Professor Holder.

    Mr. HOLDER. I just received the document that you referred to myself last evening and got a chance to read it. I think as far as accounting standard setting goes, I tried to be inclusive of—there are lots of ways to improve the system, and standards is one of those. In recent years you have seen the FASB, as they have produced standards, rather routinely requiring, when accounting estimates are required, that companies disclose the estimate of the requirement for making the estimate, the methods used to make that estimate, and the significant assumptions that were adopted in the application of that method.

    A couple of years ago, I and a colleague of mine published an article calling for the generalization of that kind of disclosure. And as I read the—because right now the disclosures are inconsistent between different estimates, and, you know, it has been done on a rather ad hoc basis.
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    This seems to be consonate with the belief that I have had for some time that where you have ambiguous accounting numbers, subjective accounting numbers, that one pathway to transparency is revealing the methods used to make the estimates and the significant assumptions that were adopted in applying those methods.

    So I would wholeheartedly support this type of an initiative. As I understand it, most of this would go at MD&A, in management's discussion and analysis. And, as I testified earlier, I think this stuff might well—I know the SEC doesn't like to set accounting standards because it is FASB's province, and there are features like that. But I think this kind of information, I would advocate it becoming an integral part of the financial statements.

    Chairman BAKER. Mr. Hill.

    Mr. HILL. I would agree with all of that. I think though, that—I mean, the SEC can kind of get the word out of how they are going to interpret some of those things, and I would hope that that interpretation would include that in this kind of discussion, which is really, I think, taking the footnotes stuff and putting it into layman's language here, but I think it should include things like, you know, what percent of our earnings this quarter came from the pension fund. And, you know, but—and also this—this pro forma aspect. I think that companies have the right to say this—this is the way that we think our earnings should be valued, but I think somewhere they should have to spell out what each of these items are and defend why they think it should be counter to what common practice is.

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    So, I don't know. We will have to wait and see what the SEC interpretation is and how they enforce it, but I think it certainly is a good step forward and hopefully goes as far as what I am suggesting.

    Chairman BAKER. Mr. Boehm.

    Mr. BOEHM. My background is as a prosecutor and ethics lawyer, not an accountant. I will pass.

    Chairman BAKER. Thank you.

    Mr. Bentsen, another round?

    Mr. BENTSEN. Thank you, Mr. Chairman.

    Although the prosecutors and ethnics lawyers are getting a lot of work right now.

    Mr. Holder, I want to go back to—and Mr. Hill actually—back to the Enron case, because we looked at that more closely than others, and with respect to both the use of SPEs, which in and of themselves I don't think are particularly evil instruments, but obviously can be overused and misused. In the case of Enron—also I wanted to talk about management compensation.

    There has been a lot of discussion about the issue—about whether or not and how options should be disclosed, whether they should be treated as an expense, whether or not shareholders should have the right to approve options for management officers and directors. In addition, in the case of Enron, we saw, I believe, if I recall correctly, that in a number of financing vehicles, SPEs and I guess some others, Enron put a pledge behind or guarantee behind it, which they guaranteed that they would—they pledged stock that would be—to be issued later, which would have the effect obviously of diluting the stock that had already been issued.
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    Are those disclosable events, or is it a subjective call on the part of the company or the accountants as to whether or not that dilution of the stock or potential dilution of the stock would be disclosable?

    Do you think that it is a good idea that Congress should require public companies to expense options once they are issued? And do you think that we should beef up the disclosure particularly—and also have shareholders approve options extended to officers and directors?

    Mr. HOLDER. With respect to the options, I have—in fact, I signed a letter addressed to Congress along with several hundred or a couple hundred other professors advocating that the fair value method of accounting for stock-based compensation, particularly options, be the only method allowed under Generally Accepted Accounting Principles, and that the intrinsic value method of Opinion 25 be discontinued.

    So I do believe that that is the appropriate accounting solution here, because options generally do have a cost. They are a mechanism to a company. And it dilutes the value of shares. And in addition to that, we have empirically demonstrated metrics, options pricing models, that, in my view, at least sufficiently value them with sufficient precision and reliability to warrant their recognition in financial statements.

    As it relates to the Enron commitments, we do have an accounting standard that requires that guarantees of the indebtedness of others be disclosed, even if the possibility of a loss resulting from that is remote. I have struggled to understand why there was—and I have not found it—but why there was no disclosure of those guarantees, why there was no disclosure of those commitments. Using my own reasoning, I can start to develop pathways for why it may have been believed that the disclosure standard I just referred to didn't apply in that circumstance, but it gets rather speculative. And so I just—I haven't seen enough facts in the public record for me to dispositively say, here is why they did what they did or didn't do what they did.
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    Mr. BENTSEN. I would just add, in our hearings, the Chairman may recall, when we had the dean of the University of Texas law school testify on his report that a number of these options to issue that were written as a form of a guarantee were also not approved by the board. It would seem to me again that you are extending a lot of credit on behalf of the company and thus on behalf of the shareholders with one or two people apparently making that decision. Is that something where you would see a board function come into play?

    Mr. HOLDER. I don't understand what you just said. All I said was, based on what I have seen in the public record, I can't explain from a financial reporting standards perspective why a disclosure wasn't made. As it relates to the authority to issue or to engage in such contracts and so on, that is a feature of corporate governance, and I mean—if a company has policies that require a board approve a particular type of transaction, then that is how that company should operate, I would think. I mean, I am probably missing——

    Mr. BENTSEN. Well, I guess the question is if you are providing a guarantee using the ability to issue stock in the future to fund that guarantee, is that a function—if the shareholders aren't approving the option, should at least the board of directors be approving that option since it is very likely that this action will dilute the value of the stock that has already been issued? And do the board of directors have a responsibility to the shareholders to give that approval?

    Mr. HOLDER. In all honesty I am, like I said, I am an accounting person. You are speaking now of corporate governance and where the authority to issue stock should be vested. You know, my sphere of competence, I have an idea, and I have thoughts, but, I mean, I don't have particular expertise there that would inform a judgment that might result in legislation. I am happy to give you my view, but I just feel uncomfortable venturing onto that turf as to how corporations should operate, what rules should I evolve on them for issuing the stock.
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    Mr. BENTSEN. Mr. Hill, if I could you get your comments on the question of disclosure, shareholder approval of the issuance of options. You raised management compensation as an important issue and cause. Do you think we need to crack down on the use of options in this respect?

    Mr. HILL. Well, I do think there needs to be more control over them, and I think that shareholder approval of officer and management options is probably a good thing. It has kind of been open season. But, you know, even if you had that, the problem is if it is essentially an inside board, why is it going to matter?

    But I think it would be a good step, and hopefully the shareholders themselves would step up and actually take a look at the proxy and vote accordingly. But you know, on the option expense issue, I kind of—I guess I am going in dangerous ground here to take a different position than the professor, because I am just like the Congressman from Texas, a poor country boy here. I know more about milking than I do about accounting.

    But I think we need to think something—on the earnings statement here, we are getting too complex and getting too many what-if things in there, whether it is the market ruling—I forget the FASB number, but if you can help me out there.

    Mr. HOLDER. On derivatives? 133.

    Mr. HILL. Thank you.

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    But, I mean, this is distorting earnings. It is going to render them meaningless. People can't make estimates. What is going to come on the future on these things? Is it really representative of what the company is earning? No. Does the issue need to be raised? Yes.

    But I think—again, I am thinking off of the top of my head here, but maybe we need to do something where you take some of these things out of the income statement and you have sort of a risk category where you have the what-ifs. And maybe that is the answer to it.

    But I think, you know, when we—on the option issue, if we are going to expense them, I think it ought to be when they are exercised, because that is when the lost opportunity cost is for the company, whatever the difference is in the stock price and the exercise price. Essentially if they had sold that to an outsider, they would have had full price, but with the option holder, they are foregoing some of that. So I think even though it is kind of not when the option was granted, obviously, but that is when the company really incurred the cost and lost the opportunity to have gotten full value for that share.

    Mr. BENTSEN. Thank you, Mr. Chairman.

    Chairman BACHUS. Mrs. Jones.

    Mrs. JONES. Thank you, Mr. Chairman.

    Mr. Holder, I am going to ask you questions this time around since I asked Mr. Hill before.
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    And, Mr. Boehm, don't think we aren't happy that you are here.

    With regard to Time Warner, Mr. Holder, Professor Holder, excuse me, the write-down of Time Warner as you speak to in your statement is that they are complying with this FASB 142 or FAS 142.

    Mr. HOLDER. Yes.

    Mrs. JONES. So that was appropriate conduct for them to—understanding the rule—to then do the write-down. Is that a fair statement?

    Mr. HOLDER. Based on the public information that I am aware of, yes, that the accounting was called for in that circumstance.

    Mrs. JONES. They stepped forward and did what they were supposed to do?

    Could you tell me, do you believe this standard should change at all or that it should be modified any more than it has been?

    Mr. HOLDER. It is a very new standard. Certainly it is having an effect, as we can see. The issue of how to account for goodwill has been around for a long time and has been controversial in the——

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    Mrs. JONES. What did they use to do 20 years ago, if you have been around that long?

    Mr. HOLDER. Unfortunately, I have. Sadly, I have.

    When the predecessor standard, APB Opinion 17, was written, somewhere around 1970, the treatment of goodwill was, subsequent to its recognition in a purchased business combination, simply one of amortization, and the standard then said over a period not to exceed 40 years.

    My own sense is, and my understanding of some experience from long ago, were that the accounting for goodwill subsequent to its acquisition at that time was a systematic and rational amortization of that total amount over some future period, and many companies were using 40 years. As time passed, that period shortened, and challenges were raised about things that were becoming goodwill. People were attempting to take what perhaps earlier would have been recognized as goodwill and recognized it as other types of intangible assets.

    Certainly I am not a tax expert in any sense, but the tax law intruded here because some things would be amortizable and deductible, but not goodwill during periods of time.

    But there really was an impairment test for goodwill until rather recently. There certainly was not one contained in Opinion 17. And so this standard is sort of a fresh way to look at accounting for goodwill subsequent to it—and other intangibles for that matter—subsequent to its acquisition. And it is an impairment-based, not an amortization or a spreading of cost-based accounting standard.
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    You can build a case for either, depending upon what your view of a measure of earnings ought to be, but I believe the new standard is certainly much more aligned with the conceptual framework of financial reporting that has been developed also over the last 20 years.

    Mrs. JONES. It is fair to say that it is a lot easier for you as a professor, and Mr. Hill as an experienced accountant, and Mr. Boehm coming from lawyer ethics, for us to sit in and, for lack of a better term, pontificate about all of those issues. It is a lot easier for us to do that than individuals coming from particular companies to come to this subcommittee and in 5 minutes tell their whole company history and to be able to make some sense of it.

    It is a lot easier for us to do that than for an AOL or a Dynasty or Dynegy or whatever it is—excuse me, anybody here from Dynegy, I don't know the name correctly—than for us, in this circumstance—I find myself as a former trial lawyer, 5 minutes to ask questions, I am just getting rolling before the time is up. So the forum of congressional hearings, it is a difficult format to present a situation. Would you agree on that?

    Mr. HOLDER. I myself had difficulty trying to confine my remarks to that period of time. I would suspect that others would be.

    Mrs. JONES. Thank you.

    Let me, Mr. Boehm, give you the last few minutes of my time just to speak on anything you would care to speak on, just so we didn't bring you here and you don't feel that you were part of this.
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    Mr. BOEHM. No. I appreciate that. And I am sorry the Congresswoman from Oregon isn't here. She alluded earlier to a situation in her State involving pension funds. What had happened there in Oregon is that $100 million in pension funds belonging to union members was lost through racketeers, and that is money that is lost. And I viewed this case that is developing on Ullico, as there is a duty that is owed to the retirees, to the people whose money has been put at risk.

    And in my exhibits, I have 25 recent cases, these are all cases in the last year or two. Some of the numbers are staggering. When the FBI swooped down on the Lucchese family in the year 2000 on the scheme they had, they were on the verge of transferring $300 million from union pension funds into a management company controlled by the Lucchese crime family. I think it is fair to say that this particular entity did not have the best interests of the union workers, the retirees, at stake.

    I appreciate the opportunity to answer a question, too. I have a problem with the 5 minutes and so forth, but I realize the constraints of time, but if I had one thing to leave folks with here, it would be this: That you have 7 trillion in pension funds in the United States. You have literally billions of dollars in what they call those Taft-Hartley funds that are union pension funds. There are some of the same issues that affect Enron and affect Global Crossing, which are transparency, accountability, and that the stakeholders, whether it is a shareholder or a retired union member, ought to have more quality information, accurate information, as to how their assets—they own the pension fund just as the shareholders own the corporation—how they are being protected or not protected.

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    So you had asked earlier what is one thing that could be done. The one thing would be laws and policies that have a stronger emphasis on disclosure, because the time-honored saying is sunshine is the best disinfectant. That is how we prevent these things.

    Mrs. JONES. Thank you.

    Chairman BAKER. In today's hearing I will say that no one has been constrained to 5 minutes.

    Mr. HILL. I just was going to add something to your first question about AOL Time Warner. What we are seeing this year is sort of a one-time event. I mean, there will be impairment of goodwill as we go forward in future years, but because of the implementation of this new impairment test, why a lot of—I mean, yeah, there was probably some impairment last year, but we are going back and applying it to all of those other periods. So you are going to see some big hits at a lot of companies, whether they are old-line companies or whether they are new-line companies, this year.

    Mrs. JONES. So it is magnified.

    Mr. HILL. It is magnified this year. But it will subside in future years.

    The other thing in relation to the history is if you go back 10 or 20 years, most of the goodwill was created by a company paying cash to buy another company, paying a modest premium over the value of that company. So a fairly reasonable amount of goodwill was created and amortized over 40 years.
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    But what has happened with the information age is that we had these companies that—as I mentioned before, that go out and make acquisitions with their highly valued stock, so a huge amount of goodwill is created. And on top of it, given the nature of these companies, they say you have to amortize it over 3, 4, 5 years. So that changed the whole situation with goodwill here in recent years and was one of the reasons why—of moving to—the current system where we do away with the amortization of goodwill, but have tougher impairment tests.

    Chairman BAKER. Mr. Sherman.

    Mr. SHERMAN. I have quite a few questions.

    I see that we have a professor here from USC. As one of the few CPAs to come out of UCLA long ago, I may have dreamed of this situation.

    Mr. HOLDER. That bodes ill for me.

    Mr. SHERMAN. No, I think we will get along fine. Let's first take a look at Enron. Let's assume that those who were putting this whole thing together hadn't been so sloppy or so cheap or so unable to get Barclay's Bank to loan them $15 million when they needed to borrow $15 million. Let's assume that every one of the special purpose entities met the 3 percent capital test, so that those who wanted to prop up this $100 billion house of cards actually had the few additional million dollars in that that they should have.

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    Under those circumstances, could Arthur Andersen have legitimately stated that, or even arguably stated, that the Enron financial statements were within the range of materiality, within the range of possible interpretations of GAAP? Could they have given them a clean opinion?

    Mr. HOLDER. Let me try to answer the question this way. If the SPEs had complied with all of the requirements that would avoid their consolidation, then I think not consolidating them would have complied with Generally Accepted Accounting Principles as a general matter.

    My view is reinforced by the belief that professionals need clear and unequivocal standards to the extent they are possible. And as I have said earlier, there is great subjectivity in this area that standards can't remove. But to the extent that clear, unequivocal standards could be produced, they should be, and if one complies with those, then one should be comfortable their conduct is——

    Mr. SHERMAN. I couldn't agree with you more on the need for clear standards. There are those who have come before this subcommittee or my colleagues who have said, if we could just get together and sing Kumbaya, if we could just tell people in the business world, do the right thing, then they all would. The fact is that businesses are run by the people who have the best records, and they get there by being aggressive. And then companies competing for capital on the stock market, the edge goes to the most aggressive company run by the most aggressive people that run the most aggressive company.

    And to think that long term, because short term everybody remembers Enron, everybody is quaking in their boots, that will last another 6 months, maybe a year, and then if we don't—the idea that those who are singing Kumbaya as they drive to work are going to be running the most aggressive companies with the highest stock performances kind of ignores our culture.
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    But I want to get back to the need. Let's go back to Enron, because what I have said in this room before is that it appears that this is a company that got a ticket for going 101 miles an hour in a school zone, but the posted limit was 90. That is to say, if they had just gotten—put in that extra money to reach that 3 percent, as you said, Enron, I don't know if they would be selling for, you know, 80 bucks a share, because their stock had started to go down for a number of other reasons, but they would be a happy company selling for 20, 25 bucks a share. Someone would be buying their shares today, and that person would be making a mistake.

    My concern is go back to the—if we don't consolidate the SPEs—the SPEs, as I understand it, borrowed money from the investment bankers, and so it looked like the investment bankers were taking the risks. And if you don't consolidate the SPEs and you issue those financial statements, aha, the risk has been borne by those who lent money to the SPEs.

    What concerns me is that the SPEs, as I understand it, had received assurances from Enron—not the SPEs, but the lenders to the SPEs had received assurances from Enron that if those loans ever went in the tank, Enron would issue them a line of Enron stock. It is as if I go to my accountant and say, my factory burned down, but don't worry about it, I have an insurance policy. And he says, well, yeah, but didn't you insure your insurer? Well, that doesn't count because I am only going to give stock to my insurer.

    Under the most liberal reasonable interpretation of today's Generally Accepted Accounting Principles, and assuming the SPEs are independent, not only do we not consolidate the SPEs, but do they achieve the result that the derivatives provided by those SPEs are recognized and the assurances given by Enron to the creditors of the SPEs are not reflected in the financial statements?
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    Mr. HOLDER. Your general question is, is that appropriate?

    Mr. SHERMAN. Yes. Within the most reasonable definition of GAAP.

    Mr. HOLDER. It is a very difficult question. The temptation is obviously here to say, obviously not, that there should be greater disclosure and so on.

    If I may for just a moment, I think it is probably axiomatic that the evolution of business transactions and events will exceed even the most nimble of standard-setters. And so in order to—there are a whole host of other reasons that I believe as I do, but that is certainly one of them.

    Are there deficient standards, standards that may have been acceptable in yesteryear that today aren't, because transactions are being written to which those standards apply, that didn't even envision the——

    Mr. SHERMAN. The people looking for loopholes in either Generally Accepted Accounting Principles or in the Internal Revenue Code will always find them. If you go to sleep for 50 years, you will collect no revenue, and every company will be reporting higher earnings every year, because you can't go to sleep and let the loophole finders get a 50-year head start.

    Mr. HOLDER. As unfortunate as it is, that is an abiding feature of the way financial reporting, the way a lot of things, the rulemakers write rules. Those subject to them craft transactions, sometimes to try to avoid those rules, and I can't think of a way to stop that.
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    But in addition to better standards——

    Mr. SHERMAN. Professor, with all due respect, I can; that is, be as nimble as you possibly can be, and as quick as you possibly can be. This Congress has passed quite a number of loophole plugs to the Internal Revenue Code. And now and then there is a loophole that some who disagree with a tax prevent us from plugging. Like there are those who are opposed to a corporate income tax, so there is a gaping loophole in the corporate income tax. They say, don't plug it.

    But while there is disagreement in this House as to whether we should have a corporate income tax, nobody disagrees that we should have accurate financial statements given to shareholders, and the way you get there is you plug the loopholes and also have a general overarching standard that financial statements should accurately reflect the situation.

    What I am asking here is, is there a loophole that the FASB did not plug that a reasonable, though somewhat liberal, accountant could allow a company to exploit that allows the reliance on a derivative issued by a genuinely independent SPE whose creditors have received assurance from the Enron company that if those creditors lose money on the loans, they will get Enron stock? Is the speed limit here 90 miles an hour?

    Mr. HOLDER. Hindsight would suggest that is certainly the case, sir.

    Mr. SHERMAN. I mean, my image of the accountants at Arthur Andersen is not that they were idiots, delusional, or viewed themselves as intentionally committing a crime. They thought the company had found a loophole that worked, and they only gave the company a ticket leading to that company and their own demise when they realized they were doing not 90, but 101 miles an hour. And I have been pressing the FASB not only to deal with the SPE issue, not only to deal with the mileage above 90, but to deal with the derivative issue, to deal with the issue of what if you go to a genuinely independent company and they insure you, but you insure them. What if your factory burns down and you have fire insurance, but, oh, wait a minute, you owe a whole lot of stock to the fire insurance company?
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    Mr. HOLDER. Sure.

    Mr. SHERMAN. Can you identify other areas where the FASB has allowed a loophole of this magnitude to exist?

    That will have to be my last question. Perhaps other members of the panel would be allowed to comment on it, but the Chairman has been incredibly generous with time.

    Mr. HOLDER. Adopting your view of loopholes and so on, over the years a great many accounting standards that have been produced have been produced in response—at least in the eyes of some as a response to an accounting abuse. You can go almost as far as back as accounting standards have been crafted and see that thread of logic. I think of leases, I think of accounting for leases. I think of accounting for pensions.

    It was earlier a Congresswoman alluded to the other postemployment benefits standard, 106, that was produced. In many cases there are unanswered questions that require a standard to be produced. FAS 133 on accounting for derivatives is one of those. Certainly the future will reveal instances where accounting standards need to be created, and if we had the ability to foresee that need, certainly they should be crafted and produced today.

    Accounting standards can be written better. There is no question about that. There are a whole lot of structural issues, some of which I relate in my written testimony, on how to improve the standard-setting function. And certainly we should try to anticipate unfolding transactions, and certainly we should be nimble in responding to those that arise, and we can get better at it, I think, as a profession, and should, and should be provided the tools to do that.
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    But I continue to say, I don't think that is a complete answer, because no matter how nimble you are, you can't be that nimble. And the people implementing and applying, even if you have got the best standards, have to apply professional judgment in areas of great subjectivity, unless you just wring out of the standards almost every aspect of relevance.

    Chairman BAKER. Thank you, Professor Holder.

    Let me maybe add on just one comment to that of Mr. Sherman's relative to FASB. Let's make a grand assumption, Mr. Sherman, that you and I are both qualified CPAs in business together. We are monitoring this SPE transaction over at Enron. We consult. We can't get to the right determination as to what we should do, so we flip over to our FASB home page and turn to the technical inquiry service where we find a helpful suggestion that the FASB will—in response to an inquiry we might make, the FASB will not issue a written response to any technical inquiry; that the staff recommendations are only those; that the only font of authority on all of this would be an official position by the Board; that we can only respond to inquiries that relate to an applicable FASB pronouncement.

    But listen to what they cannot pontificate on. I shall read. The FASB staff cannot answer questions in the following areas: Auditor independence; audit procedures or related auditor reports; compilation and review procedures of related accountants reports; SEC filing requirements; Federal, State or local income tax issues; legal or contractural issues; structuring of transactions; materiality; detailed, fact-specific questions. And here is the one which I found of particular interest, which I think is the only appropriate exclusion from response: research for school assignments.
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    Now, if that is what our regulator of accounting practices can do for a CPA in distress in this marketplace, gentlemen, we are in serious difficulty. And I just only learned of that helpful page just a few moments ago.

    We have to have a clear, concise, nimble response someplace where an inquiry can be made where you know when you get the answer, you can rely on it. This basically says, we can give you advice, but it doesn't matter, because if the Board decides otherwise, you are still in trouble. I think the IRS technical helpline is a pillar of exemplary service compared to this.

    We have a real problem. And let me add that next week we will have another hearing on this matter at which time we will hear from the Chief Auditor of the SEC and other interested parties. This is not the end of our process, this is merely a step in the right direction.

    Did you wish to make further comment, Professor?

    Mr. HOLDER. Only if you have an interest. I would react to what you said.

    Chairman BAKER. Certainly. Yes, sir.

    Mr. HOLDER. In my written testimony I said additional steps can be taken about the standards-setting and regulatory function. As the current time many of the things you mentioned are not part of FASB's charter. They have no authority to speak on auditing issues. They are confined just to financial reporting. That may not be the right way for it to be. And certainly we need to be responsible and responsive to inquires from practitioners. SEC filings, I mean generally you would ask the SEC about those.
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    So I clearly understand why you would see many of the limitations of what the FASB——

    Chairman BAKER. But on the areas of questionable advice, it ought to be understood, let's help you comply with the SEC filings if we can, but this clearly is outside of our bailiwick. On areas which should be our responsibilities, you ought to be able to get a definitive response within a few days on which you base a professional judgment and not be held liable. Why would any CPA step out and advise a client with the presumption that at a later time they would be found guilty of non-professional performance?

    Mr. HOLDER. Mr. Baker, I think that absolutely makes a lot of sense. In order to do that, the resources available to FASB to provide responses to the kinds of inquiries they would then expect to get would be extraordinary relative to what they have today.

    They also will have to change some of the Financial Accounting Foundation's due process requirements, because once you begin to provide those kinds of authoritative answers, you would run afoul of the current due process through which the FASB is supposed to go before they establish authoritative standards. And so additional steps need to be taken.

    Chairman BAKER. We don't have a place where the buck stops. Everybody points at everyone else, and it is not my fault. Accountability is the only answer to this. If you know you are the one at the end of the game who is going to be held accountable, you have a tendency to be a lot more critical in your casual assessment.
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    Mr. SHERMAN. Mr. Chairman, if I could comment on this.

    Chairman BAKER. It would be unusual if we had any panel that even got remotely close to 10 minutes.

    Mr. SHERMAN. I want to thank my many colleagues who aren't here, thereby giving us more time to talk.

    Chairman BAKER. We have, by the way, dissolved our partnership example for the moment.

    Mr. SHERMAN. I was looking forward to it.

    Chairman BAKER. Well, if there is profitability there.

    Mr. SHERMAN. As long as I was the first-named partner.

    I would point out that when it comes to independence issues and especially audit issues, that the AICPA is supposed to fill the function that the FASB fills for Generally Accepted Accounting Principles. Whether that is the right way to do it, whether they do a good job I will put aside. Likewise the SEC answers some of those SEC questions. But the most interesting part of your litany, when the FASB says, we don't want to deal with fact-based issues, hello.

    Chairman BAKER. If it can't be fact-based, I am going to make up something here and see if you can answer this one.
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    As I say, I think that we have a real policy discussion ahead of us on all of these matters. I do very much appreciate each of your long-standing participation in the hearing. It has been productive for the subcommittee's understanding, and the written record will remain open for an additional 5 days for Members to forward any written questions they may have or further materials provided by you.

    We appreciate your courtesy, and our hearing stands adjourned. Thank you.

    [Whereupon, at 12:50 p.m., the hearing was adjourned.]

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