[House Hearing, 107 Congress]
[From the U.S. Government Publishing Office]
CORPORATE ACCOUNTING PRACTICES:
IS THERE A CREDIBILITY GAAP?
=======================================================================
HEARINGS
BEFORE THE
SUBCOMMITTEE ON
CAPITAL MARKETS, INSURANCE, AND
GOVERNMENT SPONSORED ENTERPRISES
OF THE
COMMITTEE ON
FINANCIAL SERVICES
U.S. HOUSE OF REPRESENTATIVES
ONE HUNDRED SEVENTH CONGRESS
SECOND SESSION
__________
MAY 1, 14, 2002
__________
Printed for the use of the Committee on Financial Services
Serial No. 107-67
U. S. GOVERNMENT PRINTING OFFICE
79-559 WASHINGTON : 2002
___________________________________________________________________________
For Sale by the Superintendent of Documents, U.S. Government Printing Office
Internet: bookstore.gpr.gov Phone: toll free (866) 512-1800; (202) 512-1800
Fax: (202) 512-2250 Mail: Stop SSOP, Washington, DC 20402-0001
HOUSE COMMITTEE ON FINANCIAL SERVICES
MICHAEL G. OXLEY, Ohio, Chairman
JAMES A. LEACH, Iowa JOHN J. LaFALCE, New York
MARGE ROUKEMA, New Jersey, Vice BARNEY FRANK, Massachusetts
Chair PAUL E. KANJORSKI, Pennsylvania
DOUG BEREUTER, Nebraska MAXINE WATERS, California
RICHARD H. BAKER, Louisiana CAROLYN B. MALONEY, New York
SPENCER BACHUS, Alabama LUIS V. GUTIERREZ, Illinois
MICHAEL N. CASTLE, Delaware NYDIA M. VELAZQUEZ, New York
PETER T. KING, New York MELVIN L. WATT, North Carolina
EDWARD R. ROYCE, California GARY L. ACKERMAN, New York
FRANK D. LUCAS, Oklahoma KEN BENTSEN, Texas
ROBERT W. NEY, Ohio JAMES H. MALONEY, Connecticut
BOB BARR, Georgia DARLENE HOOLEY, Oregon
SUE W. KELLY, New York JULIA CARSON, Indiana
RON PAUL, Texas BRAD SHERMAN, California
PAUL E. GILLMOR, Ohio MAX SANDLIN, Texas
CHRISTOPHER COX, California GREGORY W. MEEKS, New York
DAVE WELDON, Florida BARBARA LEE, California
JIM RYUN, Kansas FRANK MASCARA, Pennsylvania
BOB RILEY, Alabama JAY INSLEE, Washington
STEVEN C. LaTOURETTE, Ohio JANICE D. SCHAKOWSKY, Illinois
DONALD A. MANZULLO, Illinois DENNIS MOORE, Kansas
WALTER B. JONES, North Carolina CHARLES A. GONZALEZ, Texas
DOUG OSE, California STEPHANIE TUBBS JONES, Ohio
JUDY BIGGERT, Illinois MICHAEL E. CAPUANO, Massachusetts
MARK GREEN, Wisconsin HAROLD E. FORD, Jr., Tennessee
PATRICK J. TOOMEY, Pennsylvania RUBEN HINOJOSA, Texas
CHRISTOPHER SHAYS, Connecticut KEN LUCAS, Kentucky
JOHN B. SHADEGG, Arizona RONNIE SHOWS, Mississippi
VITO FOSELLA, New York JOSEPH CROWLEY, New York
GARY G. MILLER, California WILLIAM LACY CLAY, Missiouri
ERIC CANTOR, Virginia STEVE ISRAEL, New York
FELIX J. GRUCCI, Jr., New York MIKE ROSS, Arizona
MELISSA A. HART, Pennsylvania
SHELLEY MOORE CAPITO, West Virginia BERNARD SANDERS, Vermont
MIKE FERGUSON, New Jersey
MIKE ROGERS, Michigan
PATRICK J. TIBERI, Ohio
Terry Haines, Chief Counsel and Staff Director
Subcommittee on Capital Markets, Insurance, and
Government Sponsored Enterprises
RICHARD H. BAKER, Louisiana, Chairman
ROBERT W. NEY, Ohio, Vice Chairman PAUL E. KANJORSKI, Pennsylvania
CHRISTOPHER SHAYS, Connecticut GARY L. ACKERMAN, New York
CHRISTOPHER COX, California NYDIA M. VELAZQUEZ, New York
PAUL E. GILLMOR, Ohio KEN BENTSEN, Texas
RON PAUL, Texas MAX SANDLIN, Texas
SPENCER BACHUS, Alabama JAMES H. MALONEY, Connecticut
MICHAEL N. CASTLE, Delaware DARLENE HOOLEY, Oregon
EDWARD R. ROYCE, California FRANK MASCARA, Pennsylvania
FRANK D. LUCAS, Oklahoma STEPHANIE TUBBS JONES, Ohio
BOB BARR, Georgia MICHAEL E. CAPUANO, Massachusetts
WALTER B. JONES, North Carolina BRAD SHERMAN, California
STEVEN C. LaTOURETTE, Ohio GREGORY W. MEEKS, New York
JOHN B. SHADEGG, Arizona JAY INSLEE, Washington
DAVE WELDON, Florida DENNIS MOORE, Kansas
JIM RYUN, Kansas CHARLES A. GONZALEZ, Texas
BOB RILEY, Alabama HAROLD E. FORD, Jr., Tennessee
VITO FOSSELLA, New York RUBEN HINOJOSA, Texas
JUDY BIGGERT, Illinois KEN LUCAS, Kentucky
GARY G. MILLER, California RONNIE SHOWS, Mississippi
DOUG OSE, California JOSEPH CROWLEY, New York
PATRICK J. TOOMEY, Pennsylvania STEVE ISRAEL, New York
MIKE FERGUSON, New Jersey MIKE ROSS, Arizona
MELISSA A. HART, Pennsylvania
MIKE ROGERS, Michigan
C O N T E N T S
----------
Page
Hearings held on:
May 1, 2002.................................................. 1
May 14, 2002................................................. 47
Appendixes:
May 1, 2002.................................................. 91
May 14, 2002................................................. 145
WITNESSES
May 1, 2002
Boehm, Kenneth F., Chairman, National Legal and Policy Center.... 16
Hill, Charles L., CFA, Director of Research, Thomson Financial/
First Call..................................................... 13
Holder, William W., Ernst & Young, LLP Professor of Accounting,
Director, SEC and Financial Reporting Institutes, University of
Southern California............................................ 9
Montgomery, Hon. Betty D., Attorney General, State of Ohio....... 7
APPENDIX
Prepared statements:
Oxley, Hon. Michael G........................................ 92
Gillmor, Hon. Paul E......................................... 94
Kanjorski, Hon. Paul E....................................... 96
Jones, Hon. Stephanie T...................................... 98
Boehm, Kenneth F. (with attachment).......................... 123
Hill, Charles L.............................................. 119
Holder, William W............................................ 109
Montgomery, Hon. Betty D..................................... 100
WITNESSES
May 14, 2002
Herdman, Robert K., Chief Accountant, U.S. Securities and
Exchange Commission............................................ 51
Jenkins, Edmund L., Chairman, Financial Accounting Standards
Board.......................................................... 53
Litan, Robert D., Co-director, AEI-Brookings Joint Center for
Regulatory Studies............................................. 74
Masterson, Ellen, Partner, PricewaterhouseCoopers, Partner-in-
Charge of Global Audit Methodology and Global Leader,
ValueReporting................................................. 76
Verrecchia, Robert E., Putzel Profesor of Accounting, The Wharton
School, University of Pennsylvania............................. 77
Wallman, Steven M.H., Chairman, Founder and CEO, Foliofn, Inc.,
Commissioner, Securities and Exchange Commission............... 79
APPENDIX
Prepared statements:
Oxley, Hon. Michael G........................................ 146
Kanjorski, Hon. Paul E....................................... 148
Jones, Hon. Stephanie T...................................... 150
Herdman, Robert K............................................ 152
Jenkins, Edmund L. (with attachments)........................ 164
Litan, Robert D.............................................. 248
Masterson, Ellen............................................. 259
Verrecchia, Robert E......................................... 285
Wallman, Steven M.H.......................................... 289
Additional Material Submitted for the Record
Herdman, Robert K.:
Written response to a question from Hon. Brad Sherman........ 293
CORPORATE ACCOUNTING PRACTICES:
IS THERE A CREDIBILITY GAAP?
----------
WEDNESDAY, MAY 1, 2002
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.]
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.
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.
STATEMENT OF HON. BETTY D. MONTGOMERY, ATTORNEY GENERAL, STATE
OF OHIO
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.
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.
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.
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.]
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.
STATEMENT OF WILLIAM W. HOLDER, ERNST & YOUNG LLP PROFESSOR OF
ACCOUNTING; DIRECTOR, SEC AND FINANCIAL REPORTING INSTITUTE,
UNIVERSITY OF SOUTHERN CALIFORNIA
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.
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.
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.
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.
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.
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.
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.
Our next witness, Mr. Charles Hill, is not a newcomer,
Director of Research, Thomson Financial/First Call. Welcome,
Mr. Hill.
STATEMENT OF CHARLES L. HILL, CFA, DIRECTOR OF RESEARCH,
THOMSON FINANCIAL/FIRST CALL
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.
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.
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.
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.
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.
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.
Welcome, Mr. Boehm.
STATEMENT OF KENNETH F. BOEHM, CHAIRMAN, NATIONAL LEGAL AND
POLICY CENTER, FALLS CHURCH, VA
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.
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.
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.
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.
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.
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?
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?
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?
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.
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.
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.
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.
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.
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.
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?
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.
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.
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.
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.
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.
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.
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.''
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?
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.
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.
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.
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.
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?
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.
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?
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?
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.
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.
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.
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?
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?
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.
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.
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.
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.
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.
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.
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.
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.
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----
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.
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.
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.
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.
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.
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.
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?
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.
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?
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.
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.
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.
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.
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.
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.]
CORPORATE ACCOUNTING PRACTICES:
IS THERE A CREDIBILITY GAAP?
----------
TUESDAY, MAY 14, 2002
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 notice, at 2:05 p.m., in
room 2128, Rayburn House Office Building, Hon. Richard H.
Baker, [chairman of the subcommittee], presiding.
Present: Chairman Baker; Representatives Kanjorski,
Gillmore, Castle, Royce, Lucas, Weldon, Hart, Sherman, and
Lucas.
Chairman Baker. I would like to call this hearing of the
Capital Markets Subcommittee to order. This hearing today
represents another step in the subcommittee's continuing effort
to properly assess the reporting of corporate financial
condition to the market.
It appears, in the aftermath of Enron, Global Crossing, and
others, there is a need for the subcommittee and the Congress
to carefully review all of the elements that bring about market
discipline and to ensure that shareholders and investors are
getting concise and accurate reports on the companies in which
they are invested, or in which they are considering making such
investment.
Over the past few months, there have been many troubling
revelations, and I wish to make it clear that I think our
system by and large works very well, and that it is, in the
aggregate, a system that is conducted by professional people
trying to do a professional task. And it is unfortunate that
the inappropriate conduct of so few has brought about such
broad-based market dislocation. Nonetheless, it is our
responsibility, I believe, to fairly assess where there may be
inadequacies, and for the subcommittee to act appropriately
based on the best counsel that we can receive.
I am pleased today to have the participants that we do have
for our hearing. I think all of them will be very helpful in
helping the subcommittee arrive at appropriate considerations
and recommendations for future committee action.
At this time, I would recognize Mr. Kanjorski for any
opening statement he might make.
Mr. Kanjorski. Thank you. Mr. Chairman, I ask that my full
remarks be made a part of the record.
Chairman Baker. Without objection.
Mr. Kanjorski. Mr. Chairman, I want to congratulate you,
first, for having this hearing. I then want to address some of
the things that have happened over the last 6 months, and their
relationship to some of the groups involved in today's hearing.
Certainly, Enron's collapse and at least some of the other
recent earnings restatements that have occurred in corporate
America over the last year, and which will continue for a short
period in the future, are disturbing. More disappointing, from
the standpoint of the world's wealthiest, freest economy, is
that excess sometimes drives good, reasonable people to
unacceptable extremes.
Even though I am a lawyer and I have gotten used to the
legal profession being kicked around in my life, I have to say
that I have great sympathy for the accounting profession. In a
broad sweep, they seem to be being painted with the primary
responsibility for Enron's collapse and these other weaknesses
in our system. They have been burdened with our unwillingness
as a society and as an economy to decide whether we are going
to use principle-based or rule-based accounting systems. The
excesses in our capitalistic system that have occurred over the
last 8 or 10 years could have driven the weakest among us to
steer away from our values or basic principles.
In terms of the accounting profession, they do not need a
defender, but I will try to defend them a little bit. I hope
that we as a committee, a Congress, and American people do not
castigate the profession unduly, or fail to recognize the
importance of the profession and their incredible contribution
to the free economy of the United States over the years. It is
only through their very professional activity that the economy
of the United States has gotten to the point it is now, which
is the greatest economy in the world.
There seems to be a problem with some management in
corporations. There seems to be a problem of corporate
governance in some corporations. There seems to be a problem
with some accountants that work for some corporations. And as a
lawyer, I have to say, there seems to be an awful lot of
questions as to whether the legal profession has risen to the
occasion.
But I do distinguish in our society the difference between
people that are in business to do things, and people in the
professions to maintain standards. I hope that we do not
discourage the future students of this country from entering
the honorable profession of accounting because of what has
occurred. The behavior of a few represents a very, very small
portion of the accounting profession. Those accountants that I
have had the pleasure of knowing over my lifetime and doing
business with, I can say have acted with incredible ethics and
proper conduct within the system. I want to make that point as
a matter of record.
We have also had in this situation a merging of the
question of what is a professional and what is a businessman.
As I was coming back to the hearing today, I was thinking--not
to further alienate another group--about investment bankers. I
sort of thought: Maybe we could say that investment bankers are
businessmen, and businessmen are to a large degree salesmen;
these investment bankers are salesmen in Brooks Brothers suits.
But, there is a difference between them and a lawyer and an
accountant. The latter are professionals. They really deal with
such substance, and have had such high credibility, that even
raising a question about them injures them and injures our
society.
I think this hearing today can be very productive, and I
think we should look into what new rules have to be put in
place and what can be done to tighten the accounting system.
The new economy is so significantly changed. We have moved from
accounting for the production of screwdrivers, which was rather
easy, to trying to figure out the value of derivatives, which
is not easy. But we should not just find a target defendant, if
you will, and castigate them because of some of the failures of
this system. Instead, we should concentrate on the positive.
What can we do for better governance? What can we do to make
sure that management is more responsive to the marketplace and
to the shareholders? What can we do to the professionals that
step out of line? We should also ask whether or not the free
market system or the profession can respond appropriately, or
whether there is need for new rules and regulations?
But, by no means should we run down this path with
tremendous speed. I think the fear I have now is more that we
can injure the system and have unintended consequences come out
of our acts, than if we act deliberatively. We must study what
has happened, and try and only be as responsive as absolutely
necessary.
So I look forward to the very competent list of witnesses
we have today to give us the proper map to follow on that
course.
Thank you, Mr. Chairman.
[The prepared statement of Hon. Paul E. Kanjorski can be
found on page 148 in the appendix.]
Chairman Baker. Thank you, Mr. Kanjorski.
Mr. Lucas, or Ms. Hart, either one have an opening
statement?
[No response.]
Chairman Baker. Mr. Sherman.
Mr. Sherman. Thank you, Mr. Chairman. I regret, I think my
statement will have a slightly different tone than that of my
more senior, more learned, and more knowledgeable colleagues.
I don't think that we can say all is going well, and we
just had a problem with one company due to the moral failings
of a few individuals, and now that those individuals are no
longer making important national economic decisions, everything
is fine. And I realize that is not what my colleagues have
said, but to the extent anybody would exaggerate their comments
to reach that conclusion, I would respond that instead, the
markets don't think that way.
The market value of what is being traded on Wall Street has
not just dropped by a few tens of billions of dollars
representing the overstatement of the value of the stock of
Enron, but rather our markets are selling for perhaps a
trillion dollars less than they would be if, in virtually every
company, but especially those that deal with derivatives or
those that deal with energy--but across the board, people did
not factor in as bigger than any terrorism risk, as big as
perhaps a recession risk, an accounting risk.
In our first set of these hearings, we discovered--at least
a USC accounting professor told us, and I am not blinded by my
UCLA loyalties to the wisdom of that professor--that if only
the Enron folks had dotted their i's and crossed their t's,
perhaps any one of several different accounting firms would
have blessed, correctly--or at least arguably correctly--what
they did. If only they had put up a few additional millions of
dollars to make sure that their special-purpose entities
reached that glorious 3 percent independence level, then they
would have been allowed to use those special-purpose entities
for covering the billions of dollars of losses through the
appearance of being insured against those losses by
derivatives, and without the accounting system taking into
account the fact that they had, in effect, insured the
creditors of their insurer, and, in fact, had no insurance
against the losses which they chose not to state; and this
whole house of cards came tumbling down not because it was a
phony house of cards that the accounting profession would never
allow to stand, but just because it didn't meet those
independence standards that could have been met for a few
million dollars of additional capital.
We have had a rules-based system and a principles-based
system. The principles are always there. They don't need to
change, but they are never enough. They weren't enough for
Enron, they weren't enough for the accounting scandals of ten
or 20 or 30 years ago. You, in addition, need rules, and the
rules do have to change, because there are two accounting
systems that we have in this country, and we can compare them.
We have a tax accounting system and a financial accounting
system.
The tax accounting system, we know we have to plug new
loopholes every couple of years, because the tax lawyers come
up with new loopholes every couple of years. And if we still
had the 1939 code, we wouldn't be collecting any taxes at all,
at least from more sophisticated taxpayers.
And we need to also plug loopholes in the accounting
principles promulgated by the FASB. And I would hope that you
are moving--and we have talked about this privately--very
quickly--not precipitously, but very quickly--toward special
rules dealing with derivatives, dealing with a company's own
stock, and dealing with, especially derivatives on and dealing
with the company's own stock.
I think the SEC and FASB have failed us to some extent up
until now in allowing smart people to logically talk to other
smart people in one of the most respected accounting firms in
this country, and convince each other that they were in
compliance with the rules. If only a few million dollars had
been there, as they thought it had been--if only these SPEs had
really been independent--when, in fact, the rules should have
prohibited them from getting anywhere close to where they were.
I would add that we also, perhaps, need to look at--and I
brought this up in legislation, but I know that was just the
first piece of legislation--the fact that the AICPA, in its
governance of the ethics of accounting firms, allowed a
situation where David Duncan was the final decisionmaker as to
whether Arthur Andersen would sign an opinion, when, in fact,
it ought to be the Quality Review or Technical Review
department of any accounting firm that makes that decision.
So I do think we have some changes to make--SEC, FASB,
AICPA--and that not only was there an Enron problem, but the
market perceives a great risk, and I think correctly, that
perhaps to a less than Enron extent we have problems with other
companies being traded on the exchanges.
Thank you.
Chairman Baker. Thank you, Mr. Sherman.
Mr. Sherman. Mr. Chairman, if I could also honor Mr.
Jenkins in his last month of service with the FASB. It is my
understanding that after many years of outstanding service,
that he will be leaving.
Chairman Baker. Absolutely. If there are no further opening
statements, I would like to recognize our panelists.
We have with us today Mr. Robert K. Herdman, who is the
Chief Accountant for the Securities and Exchange Commission,
and appears before this subcommittee for the first time.
Welcome, Mr. Herdman--second time? Welcome here. Glad to have
you, sir. Your full testimony will be made a part of the
record, but feel free to proceed as you choose.
STATEMENT OF ROBERT K. HERDMAN, CHIEF ACCOUNTANT, SECURITIES
AND EXCHANGE COMMISSION
Mr. Herdman. Thank you, Mr. Chairman. Chairman Baker,
Ranking Member Kanjorski, and Members of the subcommittee, I am
pleased to appear before you on behalf of the Securities and
Exchange Commission to testify concerning the roles of the SEC
and the Financial Accounting Standards Board in establishing
generally accepted accounting principles, and questions that
have arisen with respect to the relevancy of generally accepted
accounting principles in today's business environment.
I know that all of the Members of this subcommittee have
worked diligently over the past few months, and I would like to
commend the leadership shown by you, Mr. Chairman and Ranking
Member Kanjorski, as well as Chairman Oxley and Ranking Member
LaFalce of the full committee, in exploring these important
issues and working to maintain investor confidence. I would
also like to add that the SEC has appreciated the opportunity
to work with you and your staffs, and we look forward to
continuing that cooperation.
Recent events and press articles have raised questions
about the transparency of the accounting and disclosure
practices of some companies. While our financial reporting
system in the U.S. continues to be the best in the world,
certain aspects of the system can and should be improved. In
particular, the Commission believes that the process for
setting financial accounting standards must be enhanced so that
changes to accounting standards can be implemented more
quickly, be more responsive to market changes, and provide more
transparent information to investors.
The SEC has a unique position in the financial reporting
process. The Commission not only has authority under the
securities laws of the United States to set accounting
standards to be followed by public companies, but also the
power to enforce those standards. Practically since its
inception, the Commission has looked to the private sector for
leadership in establishing and improving the accounting methods
used to prepare financial statements. The body currently
performing that function is the FASB.
With this context in mind, I would like to share with the
subcommittee the SEC's insights into the standards-setting
process, and the reforms needed to continue to support our
capital markets. The SEC is on the front line of financial
reporting by virtue of its day-to-day activities, and often is
among the first to identify emerging issues and areas of
accounting that need attention. On issues already identified,
such as revenue recognition and accounting for business
combinations, the staff refers them to the FASB for guidance.
As the FASB conducts its deliberations, the SEC staff monitors
the project to ensure that any final standard improves
financial reporting for investors.
The SEC staff should not dictate final standards, but
rather we should allow the private sector standard-setting
process to work under our oversight. Once a project is
completed, the SEC staff should evaluate the final product
taken as a whole, and only if the product taken as a whole is
not in the best interest of investors would action on our part
be necessary.
As companies adopt new standards, the SEC staff also
monitors implementation, addresses additional questions, and
refers unique issues to the FASB's interpretive body, the
Emerging Issues Task Force. Through this cycle, many EITF
issues that have been addressed were done so at the request of
the SEC because of implementation problems it observed in
practice.
In light of the SEC's unique role, it is critical that the
SEC work closely with the FASB. However, no matter how good
accounting standards are, there always will be instances where
some answers will not be clear and additional guidance will be
needed. In these instances, we have encouraged companies and
their auditors to discuss the issue with the staff on a so-
called pre-clearance basis. The cooperative efforts between the
public and private sectors has given the United States the best
financial reporting system in the world, and the Commission is
working to make it even better.
In this day and age, one cannot talk about standard-setting
in the United States without discussing international
convergence. While convergence can have a variety of different
meanings, it is generally assumed that ultimately all standard-
setters should agree on a single high-quality accounting
answer. To this end, the SEC has encouraged both the IASB and
the FASB to re-examine their agendas in order to speed up their
short-term convergence efforts.
I would also like to address another critical and related
part of the financial reporting process, which is the oversight
of the accounting profession. Auditing provides credibility to
financial statements and comfort to investors. Accordingly, the
Commission is actively exploring ways to strengthen the system
of overseeing the work of the accountants that perform audits
of public companies. In my written testimony, I have outlined
the model we are pursuing, which is similar to the CARTA bill
passed by the House last month.
In summary, even though our system is the best at present,
there is room for improvement. Recent events have been a
catalyst for reform, and the work related to implementing
needed reforms. While it is imperative that the criticism of
the accounting standards-setting process be addressed, we
should not abandon the system that has allowed us to achieve
what we have to date. Instead, we must take the opportunity to
make fundamental improvements to standard-setting and
oversight.
Thank you for your interest and having scheduled this
hearing today, and inviting me to participate. I am pleased to
answer any questions that the subcommittee Members may have.
[The prepared statement of Robert K. Herdman can be found
on page 152 in the appendix.]
Chairman Baker. Thank you, Mr. Herdman.
Our next witness is Mr. Edmund L. Jenkins, Chairman of the
Financial Accounting Standards Board, and certainly no stranger
to the subcommittee.
We have worked with you over the years, Mr. Jenkins, on a
number of topics, and I know that retirement plans are in the
offing. My best to you in whatever the future may bring, and we
certainly have regard for your years of work and contribution.
Please proceed as you choose.
STATEMENT OF EDMUND L. JENKINS, CHAIRMAN, FINANCIAL ACCOUNTING
STANDARDS BOARD
Mr. Jenkins. Thank you very much. Chairman Baker, Ranking
Member Kanjorski, and Members of this subcommittee, I am
pleased to appear before you today on behalf of the Financial
Accounting Standards Board. I have brief prepared remarks, and
I appreciate your entering my full testimony into the record.
The FASB is an independent private-sector organization. We
are not part of the Federal Government, and we receive no
Federal funding. Our independence from the Federal Government,
reporting enterprises, and auditors, is fundamental to
achieving our mission to set accounting and reporting standards
to protect the consumers of financial information, most notably
investors and creditors. Those consumers rely heavily on
credible, transparent, and comparable financial reports for
effective participation in our capital markets.
The FASB has no power to enforce its standards.
Responsibility for ensuring that financial reports comply with
accounting standards rests with the officers and directors of
the reporting enterprise, with the auditors of the financial
statements, and for public companies, ultimately the SEC.
The FASB also has no authority with respect to auditing,
including auditor independence and scope of services. Rather,
our responsibility relates solely to establishing financial
accounting and reporting standards.
The title of this hearing, ``Corporate Accounting
Practices: Is There a Credibility GAAP?''--with two A's--might
be read to imply that generally accepted accounting principles,
or GAAP, are the main contributor to what many perceive to be
the growing lack of credibility of corporate financial reports.
I strongly disagree. U.S. GAAP, when properly applied,
still produces the most transparent financial reports in the
world, financial reports that are an essential element of an
efficient capital market.
Should U.S. GAAP be improved? Without question. And as part
of the Board's ongoing process, the FASB is actively working
with our constituents, including the SEC, as Mr. Herdman
mentioned, to continue to make necessary improvements to GAAP.
In addition, the FASB--and our financial accounting foundation,
which has oversight over us--is reviewing and modifying our due
process procedures and taking other steps to improve the
efficiency and effectiveness of the standards-setting process.
Those actions are described in detail in the full text of my
testimony.
In my opinion, the most efficient and effective accounting
standards-setter imaginable, and the highest quality accounting
standards conceivable, could not have prevented the Enron
bankruptcy; could not have prevented the many corporate
restatements of recent years; and could not alone improve the
credibility of financial reports.
Remember that restatements, including the Enron
restatements, are done to bring financial statements into
compliance with existing accounting standards. By working
together, standards-setters, reporting enterprises, auditors,
and regulators share the responsibility for a credible and
transparent financial reporting system. Each party must carry
out its responsibilities in the public interest.
Reporting entities seeking to access the capital markets
for financing are responsible for preparing the financial
reports and presenting those reports to investors. Those
enterprises must apply GAAP in a way that is faithful to the
intent of the standards. Unfortunately, the far too common
practice of seeking loopholes to find ways around the intent of
the standards obfuscates reporting and does not result in a
transparent and true reflection of the economics of the
underlying transactions. That practice must end.
Auditors examine the financial reports of enterprises to
determine that GAAP has been fairly applied. Auditors also must
assure that the stated intent of the standards are followed,
and not accept facile arguments that the reporting is
acceptable because the standard does not explicitly say that
the reporting is unacceptable.
Auditors have a primary responsibility to the public, since
consumers do not have the same access to the underlying facts
about an enterprise's operations and transactions. Auditors
must end the practice of accepting ``Show me where it says I
can't do this'' accounting.
Finally, regulators, principally the SEC, are responsible
for protecting the investor. Through their oversight and
enforcement activities, regulators assure that enterprises
report their financial statements based on GAAP, and that
auditors are independent and examine financial statements using
accepted auditing standards. The SEC must have the resources
that it needs to fulfill that important role.
Thank you, Mr. Chairman. I very much appreciate this
opportunity and your courtesy, and I would be pleased to
respond to any questions.
[The prepared statement of Edmund L. Jenkins can be found
on page 164 in the appendix.]
Chairman Baker. Thank you very much.
I would like to start with the announcement made today by
Standard and Poor's to go to a ``core value'' reporting
assessment methodology where, for example, one-time non-
recurring revenues are not booked as operating profits in a
quarterly statement--from a sale of an asset, for example. Have
you had a chance yet, Mr. Jenkins, to be familiar with those,
or do you have some opinion about what they are doing?
Mr. Jenkins. I have only seen the reports in the media
about this, and I just, prior to this hearing, did receive the
news release from Standard and Poor's, which I have quickly
read. But I am generally familiar with what Standard and Poor's
is trying to do. They announced a couple of months ago that
they were going to look into this area.
And I believe that they are doing what analysts truly
should do--analyze the financial statements. I believe it is
the role of financial reports and financial statements to
provide the information that is necessary for analysts to do
their job. And that includes providing good information that
they can use to make adjustments.
The core earnings approach is one that is an important
approach, because it is designed to provide the information
that is most likely to be replicable in the future--and, after
all, it is future operations that form the basis for investment
decisions. But it is all based, as Standard and Poor's
acknowledges, on the underlying information in financial
statements, reported earnings.
I wouldn't want to, without further study, get into the
individual adjustments that they are making. But I believe that
this approach is entirely appropriate. It is very consistent
with the AICPA's Special Committee's report on improving
financial reporting, that recommended that we try to do a
better job of displaying information that is recurring from
that that is non-recurring.
So I think this is--as long as it is based on information
that comes from audited financial reports, and the items and
the amounts that are used to come up with the core earnings are
clearly displayed, so that investors can make their own
determinations on whether those adjustments are the ones they
would make, I would support this effort.
Chairman Baker. Well, I only have concern with regard to
the possible creation of another set of accounting standards
with which businesses have to comply and still have to meet the
generally accepted standard, which, of course, FASB generates.
What was of interest to me is that from their statement of
a couple of months ago, that they were able to move so quickly
to the presentation of these standards in such a short fuse,
realizing the potential consequences of this announcement for
capital formation generally. Which gets to the question that is
obvious and evident of concern: why does it take so long to go
from an Emerging Issues list to a final statement that changes,
ultimately, market compliance with a new standard?
Almost any subject--we can even go back to the SPEs
themselves--from the initial authorization to the statement
issued last--well, this April--relative to the committee's
work. What is it that can be done to expedite a more prompt
reaction to evidently market difficulty?
Mr. Jenkins. Well, one very significant and important
difference, particularly for this subcommittee, I believe,
between Standard and Poor's and the FASB is that they have no
responsibility to carry out any open public due process with
respect to what they are doing. And I, for one, believe that
our open due process--an opportunity to listen and hear from
all of our constituents before we make decisions--is central to
the credibility of the FASB. And I believe that Congress, as
well, wants to be assured that constituents have adequate
opportunity to weigh in on our decisions. So that is at the
core of the difference between, I think, between Standard and
Poor's and the FASB's activities.
We also undertake really fundamental changes. Standard and
Poor's approach--and this isn't to denigrate it in any way--is
going to take information that comes from our accounting
standards to come up with the amounts that they are going to
use for these adjustments. But without the standards that we
have, they wouldn't have reliable, consistent information,
perhaps, about unrealized gains or losses from hedging
activities, for example. So those complex issues do take time
to research and study.
Still, there is no question that we need to move more
rapidly in establishing standards. And we have undertaken some
efforts, even before Enron, to do that. Most recently, as you
perhaps know, the voting majority required for issuing a
standard has been changed from a supermajority to a simple
majority. That, at the margin, will help speed things up.
We are changing our internal process. We intend to go more
toward a principle-based approach to standards, as Congressman
Sherman mentioned. We have principles in our standards. It is
trying to answer every conceivable standard that, as a part of
setting standards, that gets into overly detailed rules. We do
this for the benefit of our constituents, but it takes time and
it increases the complexity. So we are going to try to cut down
on the number of detailed questions that we answer as a part of
our approach. Internally, we have undertaken new internal plans
with respect to how we approach projects.
We accept the criticism that we need to move more quickly.
But it is also essential that we end up with high quality
standards, and that they have been subjected to open due
process.
Chairman Baker. Thank you. We will, I am certain, come back
for an additional round of questions, given the number of
Members here. But I do want to give other Members a chance to
proceed.
Mr. Sherman.
Mr. Sherman. Yes, Mr. Chairman. I am a little less sanguine
than the other Members of this subcommittee. We are told over
and over again that the U.S. accounting system is the best and
the most transparent in the world. I would add that Nero fiddle
as Rome burned, and as he was fiddling he would have been
justified in singing along with the fiddled that Rome, even
after the fire, was the most powerful city in the world. We do
need to do more than just say we are better than other systems,
such as the Russian business system.
There is a huge credibility gap. And even Nero, I think,
ordered that the fire be extinguished before due process was
fully carried out. We do have a fire going on here.
Now, Mr. Jenkins points out that the SEC is responsible for
enforcing FASB standards with regard to publicly traded
companies. Mr. Herdman, I am told that during all of 1999 and
2000--roughly 730 days--that not a single hour of SEC
professional time was spent with regard to looking at or
enforcing the FASB standards on the Enron financial statements,
even though those statements included absolutely
incomprehensible footnotes. Can you tell me that that
information is wrong?
Mr. Herdman. No, I believe that is correct, Congressman.
Mr. Sherman. So Mr. Jenkins tells us that the SEC is
supposed to enforce, and in this case--even on my quiet,
residential street, a policeman comes by, you know, more than
once every 2 years.
I think that we have also left out one element of the
enforcement, and it is, in fact, the primary element of
enforcement, and that is the trial lawyer system, the civil
bar. In fact, if any company's stock drops according to a
variety of formulas, you can count on a lawsuit.
And what worries me, Mr. Jenkins, is if we go to a system
that says, we are not really relying on specific rules, we are
relying on principles like ``do the right thing.'' First, if we
could really rely on such principles, we wouldn't need auditors
at all. Shouldn't businesspeople just do the right thing? Why
do we have to audit them to make sure they do the right thing?
But putting that aside, if we rely just on relatively
simple principles, could you ever get summary judgment against
a plaintiff who sued, noting that stock had declined
significantly and that other people applying those same
relatively vague principles would have provided a much less
rosy picture of the company the investor invested in?
Mr. Jenkins. Well, I am not an attorney, so I am not going
to opine on whether you could get summary judgment on anything.
But I think it is a matter of finding the right balance. I
agree with you that it is not enough to say look to our rather
complete conceptual framework, for example, on which we start
when we develop a standard, because it doesn't address the
specific issue that is under consideration. We need to develop
the principles that come from that conceptual framework that
are relevant to the particular issue at hand.
Then I think it is not enough, either, to quite stop there.
We need to make sure that there is sufficient guidance as to
how to implement those principles to a reasonable extent to
assure that people will generally apply those principles in a
consistent way.
Mr. Sherman. If I can cut you off, what if we went with a
simple income tax law? Just a dozen pages, basically, and then
at the end we just say, ``Pay your fair share''? Do you think
Federal revenues would go up or down?
Mr. Jenkins. I don't have an opinion on that, either.
Mr. Sherman. Let's face it. They would go down
precipitously, and this country would not be a superpower
anymore.
Mr. Jenkins. Well, I think there is, though, in fairness,
the purpose of the Internal Revenue code and the purpose of
financial reporting, I think, are significantly different.
Mr. Sherman. They are somewhat different and somewhat the
same. You go to an accounting firm; you pay that accounting
firm. They complete your income tax statement, and you will be
most happy with their services if they report the lowest
possible earnings to the Federal Government. You go to an
accounting firm; you pay that accounting firm. And you will be
most happy with their services if they report the highest
possible earnings to your shareholders.
Now, the only difference--and it is a difference none of us
delight in--is that the second kind of accounting activity can
result in a civil lawsuit against the accountant. There are
some other differences as well. But to say that the pressure on
the financial accountant is less than on the tax accountant; to
say that we accept as a society that the tax accountant will do
everything legal to report the lowest possible earnings to the
Federal Government, but that the financial accountant will
somehow be immune from the same principle, from the same fact
that they are being paid by the client, I think, asks us to
substitute wishful thinking for an examination of the economic
structure.
Tax accountants are professionals, too. Yet, if we were to
discover that tax accountants tried to come up with the lowest
possible reported earnings, we wouldn't have hearings here. We
wouldn't be surprised. We would have hearings if a tax
accountant wasn't doing that.
And I don't think that we can rely on general principles,
enforced not at all by the SEC--at least with regard to Enron
during 1999 and 2000--and enforced chiefly by a civil bar. But
I shudder to think what the civil bar will do if the standards
are made, are replaced with principles.
But I get your point; you are trying to do both. And I
think I have run out of time.
Chairman Baker. And if I can, just for the record, if the
IRS is listening, my tax accountant always makes me pay the
higher amount.
[Laughter.]
Mr. Sherman. He will be losing all of his clients, except
one.
Chairman Baker. Yes, but I won't be audited.
I think for the moment I will start with another round
while we are waiting for other Members to return. I want to get
back to this timeliness question, and how we can construct a
system which gives opportunity for public comment, but draws a
more narrowly defined constraint around that activity.
For example, if a problem would come up through the
Emerging Issues Committee, as of that date when it is on that
agenda--sort of a starting gun--that within a year, if there
hasn't been some resolution or final statement issued--there
may be work documents, there may be some other background that
has been assigned to get us close to a position, but yet not
yet there, as in the case of SPEs--shouldn't there be some
other mechanism--perhaps throw it over the fence at the SEC
shop and have them, with some time obligation come up with the
resolution? In other words, a predetermined series of steps
that lead us to a judgment?
It is like a court proceeding. Sometimes you don't get all
the stuff timely filed; sometimes it is not admissible--
whatever the case may be. But ultimately, you have to deal with
a certain set of facts and reach the best judgment you can
within the constraints in which you operate. But I think in
this instance, our constraints are so difficult we can't get
there. And I think the cost of that is worse than not having
ample input from all parties concerned.
Would you like to respond, Mr. Jenkins, to that approach or
concept?
Mr. Jenkins. Well, I think it is fair to say that we ought
to set appropriate goals in terms of timeliness for each
individual subject that we take up. But I don't think that
those goals would be the same in each case; it would depend on
the complexity of the issue.
But I think it is fair to set some goals and to stick with
them. That means, particularly, I think--and this is something
else that we are working on--is making sure that the scope of
the issue is narrow enough, that we get the inadmissible stuff
out at the front end, so that we have a good shot at reaching a
conclusion on what we do undertake to address in a relatively
short period of time.
Chairman Baker. Let me jump in on that goal description
that we are talking about. What troubles me is rules that are
not intended--that are perhaps manipulated by smart individuals
for a specific unintended consequence--which create the
difficulty. But if we go at it with the view that ultimately an
accounting activity is--two things in mind: one is to give a
fair snapshot of true financial condition at the time of its
preparation, which is always understood; but two, it is an
activity which will enhance the ability of the corporation to
succeed, in a very broad statement. In other words, if we do it
this way, we are likely to be successful.
What troubles me about--let's take indefeasible rights of
use. And looking at a particular statement--I don't remember
the corporation at the time. But they were booking revenue in a
current quarter from the prospective sale of a
telecommunications service for which the network did not yet
exist.
Now, I don't know how that could possibly be held up to be
a measure that adds value to the system. And from my limited
understanding of how these things should work, that ought to be
a prohibited activity. Perhaps you can book one-time sales, or
one-time events, or aberrant activity in revenue, but it
certainly ought to be noted, so that if you are in the business
of making shoes, and you happen to have a rich uncle who passes
away and you get a $500,000 life insurance benefit and you put
that in the business, you have got to show that that is
$500,000 of Old Uncle Joe, and not sales of shoes.
We are not there. I think my problem with the current
system is when you look at a statement, you can't determine,
from the current reporting requirements, what their underlying
business activity is generating.
Mr. Herdman, you want to jump in on any of this?
Mr. Herdman. Thank you, Mr. Chairman. I think, on the
example you just cited, on the indefeasible rights of usage,
that there needs to be some real care taken here between what
was being done in the financial statements prepared under
generally accepted accounting principles and filed with the
SEC, as opposed to what was being disclosed in earnings press
releases using alternative measurement sources commonly
referred to as pro forma earnings, and certainly the kind of
thing that Standard and Poor's action today is intended to
prevent.
And while we have some investigations in process with
respect to some of the companies that engaged in the
Indefeasible rights of use-types of transactions--and I can't
get into specifics--I do think that it is very important to--
and I hope you get some comfort from the fact that the
Commission has put out some advice, some cautions to companies
with respect to their earnings press releases, that the minute
they depart from generally accepted accounting principles in
those press releases, they run the risk of violating the Anti-
Fraud provisions of the securities laws.
And we also have pointed out to them that when they do
present these alternative measurements, that the only way that
they in effect have what you might call a safe harbor from
violations of the securities laws is to present a clear,
specific, itemized reconciliation between the results under
generally accepted accounting principles and under this
alternative measurement that they have forwarded to the public
through their press releases.
Chairman Baker. Well, I will press it just a little bit
further. Let's assume for the moment that it is clear, at least
from the outside looking in, that the corporate structure was
intended to obfuscate debt, or to create revenue. When you ask
the individuals involved in the creation of these accounting
methodologies, ``What was the business purpose for doing
this?'' there ought to be a rational explanation as to the
public benefit or shareholder benefit that accrued from that
activity.
Where that is absent, and it appears to be obfuscating true
financial condition, some sort of liability ought to attach to
that effort. And that, I think that is my frustration, is it
appears that people are saying, well, this complies with GAAP.
Well, if that is complying with GAAP, we need to make it clear
that GAAP provides for honest disclosure of true financial
condition.
Is there a question about that? I mean, when somebody says
it is GAAP-compliant, does that obviate you from any criminal
liability?
Mr. Jenkins. Well, I think that the whole goal of
presenting financial statements is to provide transparency of
information, which is another way of saying what you have just
said, I believe. And we need to do that. That has to be our
goal. That is why financial statements and financial standards
need to be continually improved.
Chairman Baker. Well, it is a fine point. But for me, it is
important anyway--if you are GAAP-compliant----
Mr. Jenkins. Yes.
Chairman Baker. But, the consequences of being GAAP-
compliant in some circumstances lead to a hiding of true
financial condition, that still should be a violation of
something. Is it?
Mr. Jenkins. Well, I think that gets to the issue of how
the GAAP information is displayed in the financial statements.
And that gets to your question of putting the proceeds from a
life insurance policy in revenues; I don't think that that is
in compliance with GAAP. I don't think that that should be
done. I am not aware that it is done.
And there are some fundamental rules of what goes into
revenues and what is other kinds of income. But we need to have
disclosures when we have these unusual or one-time revenues.
Chairman Baker. Yes, sir?
Mr. Herdman. And there are a couple of cases that are very
much on point. In the late 1960s, one of the Federal courts
handed down a decision in a case called U.S. vs. Simon, in
which the decision was that just because financial statements
comply with all of the measurement requirements of generally
accepted accounting principles is not an absolute defense if
the result is misleading, and the disclosures about it are
misleading.
And the SEC has, I think, a very instructive enforcement
case from the mid-1990s against Caterpillar Corporation, in
which the company had a huge increase in sales in one of its
foreign divisions as a result of basically putting a big sale
on toward the end of the year. And it was accounted for, it was
all accounted for correctly. These were valid sales, there was
nothing wrong with them. But their management discussion and
analysis, which is intended to be an adjunct to the financial
statements and through which management is supposed to explain
through its eyes to the investors what is happening with the
company, what has happened, and what has happened in the past
that may not be repeated in the future--and in that particular
case, there was no mention of the fact that the huge increase
in sales in the fourth quarter--and I believe it was a
Brazilian subsidiary--was entirely due to a very unusual event
that didn't have a chance of being replicated in the next year.
And so there are indeed strictures against providing a
misleading picture, even if the underlying financial statements
are presented in accordance with GAAP.
Chairman Baker. I will follow that up with a more detailed
written inquiry. But it is a point around which I think there
is some considerable difficulty.
Mr. Royce. Mr. Chairman.
Chairman Baker. Mr. Royce.
Mr. Royce. Thank you, Mr. Chairman. I had an opening
statement that I would just like to introduce for the record,
if that would be all right.
Chairman Baker. Without objection.
Mr. Royce. And then I would like to go to Mr. Jenkins, as
Chairman of the Financial Accounting Standards Board, and ask
him a question about a 1994 report which he directed. He wrote
about special-purpose entities in that report, ``Users are
concerned that current rules may permit companies to exclude
from their balance sheets rights and obligations that make
companies appear to be less risky''--less risky--``than they
are''--of course, that is exactly what Enron did. Yet FASB did
not issue a definitive statement on these special-purpose
entities, other than two short letters, one in 1990 and one in
1991. And the 3 percent rule in those letters was what Enron,
in fact, abused.
And so my question would be, couldn't FASB have possibly
reduced the risk of the abuse by acting decisively at that
time? I mean, the problem had been identified, but there wasn't
decisive action taken. And that is my initial question.
Mr. Jenkins. Well, as you know--and this isn't an answer to
your question directly, but I will get to that--we are working
to provide guidance specifically on accounting for SPEs, and
now on an expedited basis. I know that that sounds a little bit
like closing the barn doors after the horse is gone, and I
accept that criticism.
We at the FASB have been working over the years to try to
come to some acceptable decisions with respect to accounting
for special-purpose entities. But it is not sufficient to
simply say that every special-purpose entity should be
consolidated, because special-purpose entities have a variety
of purposes, and it is only where the special-purpose entity
does not have sufficient independent purpose, and/or is not
capitalized sufficiently by an independent third party, that
consolidation should really take place. And the devil is, we
found, in the details of defining those particular
circumstances.
We at the FASB have tried twice since 1994 to issue
guidance on consolidations. And in each case, the concerns
raised about our proposal, and how those proposals were
overreaching, from both the business community and the
accounting profession, caused the board to conclude that it
could not go forward and develop a standard that would be
generally accepted.
Mr. Royce. Which of the major accounting firms opposed
that?
Mr. Jenkins. All of them.
Mr. Royce. Every one of them?
Mr. Jenkins. The 3 percent rule was designed to address a
particularly unique circumstance involving a single type of a
transaction. And through practice, it was probably appropriate
for that particular transaction--it got extended in practice to
apply to some other transactions. Of course, the essence of the
Enron situation as I understand it is not the 3 percent rule
per se--in some cases, apparently, they didn't have 3 percent;
in other cases they didn't follow the 3 percent rule because
the 3 percent had to be maintained throughout the life of this
entity, and it went down, and they didn't replenish it, so to
speak. So they apparently didn't follow the rules.
It also had to be independent, and there couldn't have been
any other guarantees or support, nor could the 3 percent have
come through the back door as being provided by Enron or one of
the affiliates, apparently, in some of the transactions that
part of the requirement wasn't followed as well.
So that is why I said in my opening remarks that the
standards, even if they are minimal, and perhaps need to be
improved, if the standards aren't followed for whatever reason,
the best standards in the world aren't going to solve these
issues.
Mr. Royce. No. But I think they did cite this rule as their
argument.
Mr. Jenkins. Yes.
Mr. Royce. I mean, they attempted, at least, to attach
their line of reasoning to this rule.
Mr. Jenkins. I believe that is correct.
Mr. Royce. I was going to ask Mr. Herdman if he thought
that FASB could have taken better measures to reduce the risk
of abuse of special-purpose entities. I know this is in
hindsight, but what does the Securities and Exchange Commission
think now about that?
Mr. Herdman. Congressman, I think this is an example of
what Mr. Jenkins was alluding to earlier when he talked about
the size of projects and the scope of projects that FASB
undertakes. The particular subject matter where this was being
considered was the Board's project on consolidations.
The proposals that Mr. Jenkins referred to were not focused
solely, or even principally, on special-purpose entities. They
were focused on the question of consolidation of subsidiaries
more broadly, and proposed sweeping changes to that particular
practice, which many accountants felt had not been
controversial.
And so, when something like that occurs, it occurs to us
now, that that is the time when it is important for the Board
to re-examine the scope of its product. In other words, if they
have a project, they come out with a proposal that would
attempt to deal with four or five things. And if there are one
or two that there is general agreement should be done and it is
important to get them done, but the other two or three have
failed yet to capture the imagination of the audience, we think
that it would be better for the Board to go on and fix the one
or two things that everyone is in agreement need to be fixed,
and work harder on the others or reconsider whether they need
to be done.
And so that is, I hope, a lesson for all of us for the
future in terms of how this agenda can be better managed to
make sure that the pressing issues do get dealt with promptly.
Mr. Royce. Are you familiar with Arthur Andersen or Enron
marketing their unique interpretations of how to utilize
special-purpose entities in order to boost earnings per share,
and basically going into the market and saying let us work with
you, with other companies, to show you how we can do this? Are
you familiar with a history of Andersen doing that?
Mr. Herdman. Congressman, we are still investigating Arthur
Andersen and Enron, and I can't comment on that.
Mr. Royce. Can't comment on that? OK. Thank you again.
Thank you, Mr. Chairman.
Chairman Baker. Mr. Sherman.
Mr. Sherman. Yes. I would hope that the FASB would be
closing this barn door, because I think you have got tens or
hundreds of billions of dollars' worth of horses that still
haven't escaped the corral.
I do think there is a legitimate purpose for special-
purpose entities--for example, in my hometown it is not unusual
to legitimately shift the risk that a particular movie or group
of movies is going to be successful or fail to a group of
investors. While the studio does the work of creating the
movie, other people can take the risk and place their bets as
to whether the latest film will be successful.
The Chairman puts forward an interesting idea, and that is
that there be a business purpose doctrine, and those
transactions that have no business purpose not be recognized.
That is an interesting part of tax accounting. Is that part of
financial accounting as well?
Mr. Jenkins. Well, I think we try to understand the
business purpose of transactions and, as I say, develop
standards that do the best job they can of displaying that
purpose.
Mr. Sherman. If there is a transaction that has no purpose
other than causing the recognition of income or deferring the
recognition of loss, does that transaction give an effect in
preparing financial statements?
Mr. Jenkins. Well----
Mr. Sherman. Is there a clear yes or no? Or is that one of
those hazy things?
Mr. Jenkins. I think it is pretty hazy, but----
Mr. Herdman. Well, Congressman, just like under the tax law
there is a concept that if the only motivation for a
transaction is to reduce taxes, then as I understand it, it is
not lawful.
Mr. Sherman. Yes. I am familiar with it in tax law. I am
asking whether there is a similar principle----
Mr. Herdman. However, certainly when we look at
transactions with companies, if it is clear that the only
reason they entered into a transaction was to achieve a
particular financial statement result that would not have been
attained had they not entered into the transaction, then we
would generally disagree with their proposed accounting.
However, I will caution you, just as in the tax area, that
it is very difficult to find a transaction that can be
characterized as solely being done to achieve a particular----
Mr. Sherman. It is always possible to find a tail, even if
that tail isn't big enough to wag the dog.
Mr. Herdman. There are always other motivations,
absolutely. So that is not a very good principle.
Mr. Sherman. It is not a bad principle. It is helpful.
Mr. Herdman. It is not a very effective one, though,
perhaps.
Mr. Sherman. Speaking of effective enforcement, and the
whole idea of enforcing general principles--not numerical
principles, where we can say, oh, here is this exact rule, but
rather, the general principle that, for example, the prose in
the financial statement and in the report to shareholders be
accurate--you pointed out the Caterpillar example. But it is my
understanding that in Caterpillar, with its failure to tell
shareholders about the Brazilian situation, that not a single
day of jail time was done by a single executive, accountant, or
auditor. Can you tell us how large a fine--or let me know if I
am wrong on the jail time. But also, can you tell us how large
a fine was imposed on Caterpillar?
Mr. Herdman. I don't recall, Congressman.
Mr. Sherman. Could it have been that no fine or a fine of
just $50,000 or $100,000 was imposed?
Mr. Herdman. Since I can't recall, it could be.
Mr. Sherman. So even the preeminent example of enforcing
vague principles, we are not, we don't have a specific level of
punishment? I would hope you would furnish that for the record,
but it is my understanding of SEC general practice that they
might have gotten, you know, a really tough letter in their
file. And given what is at stake in these transactions, perhaps
the only enforcement we really have, much to our own chagrin
and not to our joy, is the trial bar.
I would like to posit--we have talked about special-purpose
entities, which is part of the Enron problem. And I have asked
the FASB on more than one occasion to expedite a review also of
another part, and that is, even if you are transacting with a
fully legitimate entity, the transaction in derivatives may be
misstated.
I would like to conjure up the idea of a Genron Corporation
that wants to state the largest possible earnings per share. It
has two portfolios of investment securities. One is in the
restaurant industry, where they have gained $1 billion and they
have recently sold at a $1 billion profit. And, of, that is a
$1 billion profit. They have another portfolio that they
haven't liquidated their position in of high-tech companies,
which on a mark-to-market basis has declined by $2 billion.
But they don't want to recognize a $2 billion loss, because
they have a derivative issued by the Kiticorp--not to be
confused with Citicorp--but a large, completely independent,
very financially sound corporation. And this derivative says
that if you lose any money, up to $2 billion, on your high-tech
portfolio, we will give you the money. So you haven't lost
anything; it is like your factory burned down, but you have
perfect fire insurance.
But then there is a provision that says, to the extent that
Kiticorp has got to give money under this debenture, Genron
Corporation must give shares with a value of, in this case, $2
billion to Kiticorp's parent corporation, so that in effect,
they owe something--they have insured their insurer.
Is it clear under FASB pronouncements that under these
circumstances the $2 billion loss must be recognized, because
although it is in effect insured by a completely independent,
highly creditworthy company, the provisions of that derivative
or insurance policy, if you will, require Genron to issue stock
to Kiticorp or its parent?
Mr. Herdman. We are investigating that company,
Congressman.
Mr. Sherman. Well, I am asking what--this is not something
you are investigating. This is Genron Corporation; I just made
it up.
Mr. Herdman. But the facts are----
Mr. Sherman. Do we know what accounting principles call
for? Or is the accounting result of this transaction unknowable
at this time?
Mr. Herdman. It would depend, I believe, on the terms of
the equity derivative, and whether it could be settled net or
would require the outlay of cash or the distribution of shares.
Mr. Sherman. In this situation, Genron Corporation is to
receive $2 billion in cash to make it whole from its $2 billion
of investment losses in high-tech stock. And Genron Corporation
is to issue $2 billion worth of Genron shares for no additional
compensation to the parent company of Kiticorp, of the company
that is giving it the cash. Under those circumstances, must the
$2 billion be recognized as a loss?
I mean, it is either ``yes,'' ``no,'' or ``we don't know.''
Mr. Herdman. I would have to consult further with--there
are some very complicated requirements that need to be looked
at with respect to equity----
Mr. Sherman. In fairness, this is a question I have asked
behind closed doors two or three different times. I am not
completely sandbagging you, although I guess you didn't know I
would be asking it quite this way at this time. I wonder if Mr.
Jenkins can give us an answer; what does the FASB have to say
about this transaction?
Mr. Jenkins. Well, I think, first of all, I would say that
there needs to be disclosure of these arrangements in the
financial statements. And we are issuing shortly some
clarifying guidance of existing literature to make it clearer
than it should have been in the past, apparently, that
disclosures with respect to guarantees, even if they are remote
or not likely to be called, need to be disclosed.
Mr. Sherman. Well, this one is clear. I mean, they owe the
$2 billion worth of stock. They have a right to receive the $2
billion in cash. Both of these are triggered the moment they
sell their high-tech portfolio at market. This isn't a remote
contingency like ``what if our factory does burn down?'' The
factory has burned down. You have a right to cash from your
insurance company, and under my example, you have an obligation
to give that insurance company $2 billion worth of your stock.
Mr. Jenkins. I didn't understand your example to say that
the loss had incurred, and under the insurance policy the money
was now due.
Mr. Sherman. Well, it would be due upon the liquidation at
market of a portfolio of publicly traded corporate stock that
is usually mark-to-market. So if you are going to mark-to-
market under ordinary circumstances, the sale transaction of
the stock is thought to be irrelevant.
Mr. Jenkins. Well, again, you understand----
Mr. Sherman. OK. Well, let's put it like this: it is not a
remote contingency that you would choose to sell a stock on
which you have lost $2 billion, losses that have already--would
have been recognized on a mark-to-market basis.
Mr. Herdman. I would start with the presumption that the
loss needs to be recognized. But I would need to consult
further very complicated accounting rules that pertain to the
issuance of so-called equity derivatives.
Mr. Sherman. OK. I would hope that--it is my
understanding--I mean, I didn't make this one up completely. I
mean, this is the loophole that Enron thought they found. They
think it works. They think they didn't dot their i's and cross
their t's. There are a lot of other companies out there who are
capable of dotting i's and crossing t's. And I would like to
know whether this loophole exists. And that is why I would ask
each of our two witnesses to furnish for record an answer to
this excessively complex question.
And so I will ask you to do that in the future.
Chairman Baker. Thank you, Mr. Sherman.
Mr. Royce, did you want another round?
[No response.]
Chairman Baker. Mr. Herdman, before we conclude the panel,
do you have a position on behalf of the SEC relative to where
we might go with regard to shortening time consideration for
development of financial accounting standards? Have you arrived
at any recommendations yet?
Mr. Herdman. We have. We have spoken with the FASB about
this issue at some length, and we believe that--of course, it
is a mixture of things. It is scope definition. We believe that
the move toward a more principles-based approach, and not
needing to attempt to answer every question that comes along
the way, should enable the Board to move faster on its
projects.
It is very time-consuming to try to come up with the
definitive answer for every question that comes up. And they
should really need only to answer enough to make sure that the
principle that they have in mind is operable in the real world.
And I think that that is something that can be done.
We believe that the recent decision by the FASB trustees to
change the voting requirement from 5 to 2 to 4 to 3, if
implemented aggressively, should enable the Board to move more
quickly because, to the extent that there are minority views,
at some point in time it will be possible for the Board,
presumably through its Chairman, to say, we have heard enough
and now we need to proceed and get this thing done. So we think
that is positive.
We also think that it is positive that the board of
trustees has asked the question about whether the size of the
Board should be reduced from seven members to five. It has
concluded at this point to leave the size of the Board at seven
members, but it has charged Mr. Jenkins's successor, Mr. Herz,
with the task of conducting his own study over the next few
months as to what he believes needs to be done to increase the
timeliness and efficiency of the Board, and report back to the
trustees with a view toward they would implement whatever
changes he recommends, that they believe are reasonable.
So I think that it is a combination of factors, Mr.
Chairman. And I think that the Board and its oversight
foundation show all signs that they are working to improve in
this regard. And over the next 6 months or thereabouts,
hopefully they will be able to demonstrate the improvement in
terms of the projects that they are working on.
Chairman Baker. Well, just, again, without having the
competency to make the judgment, I make it anyway. It seems
that a principles-based value reporting system, some of which
we will hear about in the next panel, offers a great deal of
appeal. I don't know, frankly, other than marketing purposes
and to show that you are running faster than you were a year
ago, that historical 90-day-old data, at best, really tells you
about what the company is doing tomorrow--especially in light
of the apparent use of accounting methodologies which do not
result in an accurate financial picture being portrayed even of
the historic data.
Now, I don't ascribe that to the fault of FASB, because in
good intent, with arduous and lengthy study, the rules have
been developed for what we believe to be the best public
policy. And they have been misused. It would seem, at the end
of the day, if we are building value and we want to encourage
corporate CEOs to invest for the long term and not worry about
the next quarterly earnings report, that there are some simple
principles we could outline, and that if you were consistent
with those principles--until we catch you otherwise--that the
core reporting that maybe Standard & Poor has talked about is a
good place to start, and move from there.
But the current system, I think, given the speed with which
technology enables businesses to develop new product and new
business structure--we are trying to regulate traffic on the
interstate while we are still hooking our horses up to the
wagon. And they are running by us. And I think we have to be
more nimble in our ability to respond to identifiable problems
in a short period of time.
No response needed, but if you would like, please.
Mr. Herdman. That is the danger of the cookbook-style of
standards, that while it appears to close off all possible
avenues of different interpretation, the people who are out
there creating transactions are always going to be way ahead of
those who are writing the rules, the detailed, loophole-closing
rules intended to try and close off their initiatives.
And so accounting principles that are more principles-based
will be simpler. And a principle is not to say ``pay your fair
share'' or ``do the right thing.'' The principle has to be
expressed in the context of the particular area that is being
addressed. For example, the Board's recent standards on
business combinations, I think, are a real positive step in the
right direction, in that they really did approach this whole
area in a very principled basis, and there are implementation
details that need to be applied by individual companies.
But the principles are clear, the objectives are clear. And
while there will be some differing interpretations on some of
the implementation details, I believe that the resulting
reporting will be comparable, and the product will be useful to
investors.
Chairman Baker. I think it is certainly worthy of pursuit.
I thank you. Mr. Castle, I know you have just arrived, but did
you have a question for this panel?
Mr. Castle. I do, Mr. Chairman, if I may take a moment.
Chairman Baker. Certainly.
Mr. Castle. I am sort of starting from scratch, and I guess
my question is of Mr. Jenkins.
But I am interested in--and I guess concerned; but in all
candor, I don't really know enough about it to express my
concern, articulate it as well as I should--with the stock
options situation and the accounting side of it. And I am
worried about it from an executive compensation point of view,
but I am not too sure we can legislate in that area, so I won't
ask you questions about that.
But it is my understanding that FASB had some sort of an
expense option on this--I am not sure I understood exactly how
that was going to work--and I think backed off at some point,
maybe under congressional pressure or whatever the reasons may
be. But I am interested as to the status of that now. I realize
that as the value of companies was growing, it was a valuable
tool. And I am not even suggesting options are not a valuable
tool, and I am not even saying they should not be part of
executive compensation.
But I am just amazed in my reading about it that there is
not an accounting entry at some point or another. It obviously
has to dilute capital. I mean, it just automatically has to at
such time as it is exercised. And at such time as it is
granted, it essentially is giving a right which could dilute
capital, which greatly impacts stockholders and can impact the
entire valuation of a company. In fact, there have been studies
showing that some profits would be losses if this was properly
accounted for.
And if you could just give me the rationale of FASB now--or
is it changing again, and you are about to look at it again and
have some sort of firm accounting practices with respect to
stock options?
Mr. Jenkins. Let me first describe where we are today.
Mr. Castle. Thank you.
Mr. Jenkins. Our standards require that the use of stock or
stock options for almost every transaction would result in an
expense charge. So if you issue, if you give stock to an
employee--not a stock option--you expense it. If you give stock
to pay your attorney or to buy a truck, you recognize it either
as an expense or an asset.
We have one exception, and that exception is the
employees--certain types of employee stock options that you
have referred to. Not even all employee stock options. That is
an exception.
Our standard says that even those--it is preferable that
those options be expensed at their value determined at the date
they are granted. Our standard--it is preferable, but it is not
required. And the reason that it is preferable but not required
is, as you also suggested, the Board received intense criticism
and pressure from Congress in 1994, leading to a sense of the
Senate resolution requiring us to stop work on stock options,
and proposed legislation that in effect would have put the FASB
out of business.
Mr. Castle. Well, let's look at it in the year 2000. And I
thought it was actually later in 1994 that all that pressure
occurred.
Mr. Jenkins. No.
Mr. Castle. But let's look at it in 2002, maybe with the
advantage of hindsight. I mean, I would hope that Congress
wouldn't feel quite the same way it felt in 1994--perhaps none
of us individually do; perhaps FASB does not, I don't know. My
sense is that a lot of wise heads around Washington and
economists around this country are certainly thinking the other
way now.
And to me, it just seems absolutely apparent. I mean, I
don't know how the heck you can have an entry, a numerical
impact on a corporation of such magnitude, and not somehow or
another do something with it at this point. Is there a change
going on? Is FASB looking at it differently? Can we put all
this pressure from before behind us so we can go forward with
doing something?
And I want to do the right thing. I am not trying to----
Mr. Jenkins. Yes.
Mr. Castle. And I realize it is extraordinarily difficult
to determine the actual value at the time of issuance. But to
me, it just seems completely wrong to ignore it.
Mr. Jenkins. That is one of the principal arguments that is
used against recognizing the expense. We do require disclosure
of the amount. We require that in diluted earnings per share,
that the impact of these options be reflected so the dilutive
effect is shown. There is work going on internationally in the
International Accounting Standards Board. Their goal and their
objective is to expense all share-based payments. The
circumstance outside of the United States is significantly
different than it is here in the U.S., in that virtually no
share payments or share-based payments, even the ones I
described that are getting expensed here, are expensed outside
the United States. So they have a longer way to go than we do.
My belief is that if the international board is successful
in meeting their objective, that consistent with our pledge at
the FASB to work toward convergence of standards around the
world, that the Board at that time--I won't be here, or be at
the Board, but at that time I believe it would be incumbent
upon the Board to consider then whether or not it would
undertake a project in this area.
Chairman Baker. If I could also add, too, Mr. Castle, the
Standard and Poor's announcement today on the core valuation
does require the expensing of the stock options as an element
of their reform. It is probably the most controversial part of
their package. But that was announced earlier today, Mr.
Castle.
Mr. Castle. As something Standard and Poor's is going to
require?
Chairman Baker. Right, in their valuation on the companies
on which they report.
Mr. Castle. On their ratings?
Chairman Baker. They have a new core value assessment they
are going through, which basically gets rid of any non-related
revenues, requiring disclosure of certain types of debt
structures, and part of that is requiring the expensing of
options for employees. And that is the basis on which the S&P
will now rate the productivity of companies. And it was just
announced this morning.
Mr. Castle. Well, Mr. Chairman, my time is up, and I will
yield back. But I would just like to close by saying--and I
appreciate your answers on this, Mr. Jenkins. I realize the
political circumstance, although I thought it was later. But my
own judgment is that out of all this Enron mess and Andersen
mess, what we really need are clear rules and laws with respect
to this.
And if there is anything that is ambiguous to me, it is
stock options. If I look at a report, a quarterly report, and I
see that a million stock options were issued--and again, to the
executive compensation, particularly when it is issued by a
company which has lost money the year before, so they rewrite
it, but it is with a lower ceiling or whatever the effect is
where it would take hold, so that the corporate executive can
take advantage of it. To me, that is a corporate compensation,
executive compensation issue of huge magnitude we need to
consider.
But having said that, I just think there is also an
accounting entry, automatically, that needs to be looked at. I
think it is really unfair, frankly, to the companies as well as
the stockholders, and even to some of the executives who would
take advantage of it. I think a good executive would tell you
do it in such a way that it measures our worth in terms of what
we are doing, and show it in some way or another. And I just
feel that something should be worked out on this.
So I hope that FASB, working with the international folks,
and Standard and Poor's, anyone else who is discussing this,
will come up with some common standard so all of us, as just
average poor investors out there, can figure out what is
happening.
I yield back, Mr. Chairman.
Chairman Baker. Thank you, Mr. Castle.
Mr. Weldon, do you have a question?
Dr. Weldon. Yes, thank you, Mr. Chairman, I just have a
couple of quick questions. Sorry I missed your testimony,
gentlemen.
But for Mr. Herdman, I had a question about FASB's sources
of funding. As I understand it, their sources of funding are
publication sales and contributions from accounting firms and
companies. As I understand it, there has been some recent
debate about securing a constant funding source for FASB. Can
you give me the SEC's view on this issue, or do you have a
view?
Mr. Herdman. Well, there are a couple of things that have
been happening historically. The first is that the FASB has
been engaged in deficit spending for the last 4 or 5 years, I
believe. Its funds today come from a combination of--I think it
is very clear from Mr. Jenkins's testimony--two-thirds of their
revenues come from the sale of their publications, their
standards and what have you. The other one-third comes from
contributions from the business community and from the
accounting profession.
And we think that it would be beneficial if FASB could get
a broader source of more assured funding in the future so that
there no longer are questions about whether the fact that their
support comes from those who must abide by their rules creates
the impression that somehow that impacts the quality of their
rules. And also, just because it is a tough world out there,
and if the way that you are getting your support is to go
around and solicit contributions, when times get tough that is
often one of the first things to go.
So we believe that as we consider what needs to be done
with respect to oversight of the auditing profession and the
ways to achieve funding for that, that there are some very
promising ideas with respect to how the FASB might be included
in that type of funding--broad-based, private sector funding
that would be an assured source of funds for the Board and for
any organization, assuming that there isn't a legislated
organization that would have a different source of funding. But
as we think of alternatives and what we must do from a
regulatory standpoint, if there was not a legislated
organization to oversee the auditors, we have to create funding
ideas there. We think that the same ideas ought to be
applicable to FASB's support.
Dr. Weldon. Thank you very much. I just had a quick follow-
up question. Maybe it is not a quick question. Mr. Jenkins was
referring to international accounting standards, and I
understand that you in your testimony provided some mention of
the convergence of international accounting standards with U.S.
standards. We were talking a few minutes ago about expensing
share-based payments.
Did you want to elaborate on that a little bit more? I have
got a few minutes left here. Did you want to say anything more?
Mr. Herdman. I would be glad to.
Dr. Weldon. Where is that heading?
Mr. Herdman. The SEC's mission is really twofold. The first
is to protect investors. The second is to make sure that
American markets stay competitive with the rest of the world.
And for a number of years the SEC has had rules on its books
with respect to foreign companies that want to list their
shares on U.S. exchanges or otherwise register them with the
Commission. And those rules pertaining to filing requirements--
taking into account, from the time that they were written, that
there are many countries out there and a great diversity of
quality of accounting standards--have required from the outset,
and continue to require today, that those so-called foreign
private issuers either prepare their financial statements for
U.S. filing purposes using U.S. GAAP, or reconcile from their
home country GAAP to what the results would be under U.S. GAAP.
And that is done for net income typically as the principal
reconciling item.
There has been a lot of staff work done by the SEC over the
years looking at the quality of so-called international
accounting standards written by the International Accounting
Standards Committee initially. And now for the last year-and-a-
half that has been reformed, restructured into the
International Accounting Standards Board. A couple of years
ago, the European Union decided that all 7,000 listed companies
domiciled in EU member countries, starting in the year 2005,
would have to use international accounting standards as opposed
to French or German or Spanish standards in their annual
reports that get filed with the various exchanges in Europe.
A combination of the two things, the restructuring of the
IASB and the step taken by the European Union, really makes the
IASB a major player in the development of accounting standards
around the world. They have a lot of work to do to go back and
improve the quality of some of their older standards. They are
very much engaged in that right now. We have encouraged both
the IASB and the FASB to take a single-minded approach to
trying to achieve convergence with one another--approximate
convergence--by the year 2005. We recognize that there are
going to be huge efforts underway by the IASB and by European
companies to convert to these international accounting
standards, and we think--I personally think that the time is
right for the Commission to consider whether the confluence of
those events and the continued improvement in the international
standards is such that they should be permitted for U.S. filing
purposes by these foreign private issuers.
Chairman Baker. Thank you, Dr. Weldon. Mr. Sherman, you had
a wrap-up?
Mr. Sherman. Yes. I think we have loophole-ridden financial
accounting standards; that we are painfully slow in plugging
those loopholes; that we have a system for financial accounting
standards publication which, if we applied it to tax
accounting, would cause this country no longer to be a
superpower in the world because it wouldn't have the revenue.
And the argument against all this is, well, principles--no
matter--will be enough. We don't make anybody do anything, but
ask them to--just give them some vague guidance.
And one illustration of whether this works or not is in the
area of putting a charge to earnings when you issue a stock
option. The FASB has indicated that it is preferable to have
such a charge to earnings. But that is a principle; the rule is
you don't have to do it.
Can either of the witnesses identify any of the Big Four-
and-a-half accounting firms that has as its uniform policy that
a charge to earnings must be made by its clients, when
material, when they provide an employee stock option? Can you
name any of the firms?
Mr. Herdman. Congressman Sherman.
Mr. Sherman. A simple question. Can you name a firm?
Mr. Herdman. But the accounting firms don't make those
decisions for clients. When the rule is as explicit as it is
here, companies have a choice, and----
Mr. Sherman. OK, companies have a choice. And if they
don't--can you name a single company that follows the preferred
standard, or a single auditor who has failed, who has issued an
adverse or qualified opinion because the company has failed to
follow the best principle as stated by the FASB?
Mr. Herdman. Two companies that follow the preferred
approach out of the Fortune 500. Boeing is one of them, and for
the life of me, I can't recall who the second one is.
Mr. Sherman. So that would be one half--no, that would be
less than a half of a percent.
Let me shift over to something else, and that is I know the
wringer that a small company goes through to go public with
their initial public offering, IPO. And sometimes they are
trying to raise $10 million, $20 million in assets. How many
accountants reporting to you, Mr. Herdman, work on these
initial public offerings, as compared to the number of
accountants that you have deployed to read and ensure at least
the completeness, if not the accuracy, of statements filed by
the thousand biggest companies in the country?
Mr. Herdman. None of those accountants actually report to
me. They are all in our Division of Corporation Finance.
Mr. Sherman. OK. How many at the SEC?
Mr. Herdman. I believe the number of accountants in the
Division of Corporation Finance is approximately 100 people.
Mr. Sherman. One hundred people. So you have 100
accountants that can look at both the new small companies and
the big established companies. Now, of those 100, how are they
divided between those two tasks?
Mr. Herdman. It depends on the volume of IPO transactions.
In the current environment, virtually everyone is looking at
filings of established public companies. A couple of years ago,
when there were a lot of IPOs, then those have to take
precedence.
Mr. Sherman. Those take precedence?
Mr. Herdman. Because they are new to the system. And so it
depends on the relative volume of what is going on at a
particular point in time.
Mr. Sherman. So if a company is trying to go public and
raise $20 million, they are guaranteed to have a careful SEC
review of their filing, and a comment letter that requires that
they provide supplemental and corrective information necessary
to make everything clear and up to spec. Is that a----
Mr. Herdman. For a company undergoing an IPO, they are
guaranteed they would have a review. They are not guaranteed
they would have a comment letter, but they can be pretty
assured they will get one.
Mr. Sherman. OK, so they will get a comment letter. So you
are trying to raise $20 million, you are pretty sure you are
going to get a comment letter, guaranteed review. And yet if
you are Enron, a company that was accused of fraud by the
entire California Democratic delegation back a couple of years
ago--so not a company with necessarily the highest business
standards, or at least not in the opinion of the Democrats from
California--you could go a couple of years without a review at
all?
So you could be one of the ten largest companies in
America, no review; trying to raise $20 million, guaranteed
review? Maybe that is one of the reasons we have got a problem.
Mr. Chairman, I yield back.
Chairman Baker. Thank you, Mr. Sherman. That is, I think,
why some Members have a bill in to make sure that some of those
big corporations file appropriately with the SEC. I think they
are called GSEs, something like that. That is another whole
subject matter.
Mr. Sherman. I think that would not include Enron, would
it?
Chairman Baker. No. I was making a very small joke about
the volatility of the reporting issue.
Mr. Sherman. I would agree with you. It is a small joke.
Chairman Baker. I want to thank the Members of the panel
for their courteous use of time today and their participation.
Your insights have been helpful to the subcommittee. We know we
have a long road ahead of us and a lot of work to do in this
area, and we look forward to working with both FASB and the SEC
in the future in resolution of these important matters. Thank
you very much for your participation.
Mr. Herdman. Thank you.
Mr. Jenkins. Thank you.
Chairman Baker. At this time, I would like to call the
members of our second panel to the witness table at their
convenience.
I would like to welcome each of you here this afternoon. We
thank you for your time and willingness to participate.
Our first witness to be heard from is the Co-Director of
the AEI-Brookings Joint Center for Regulatory Studies, Dr.
Robert Litan. Welcome, Dr. Litan.
STATEMENT OF ROBERT E. LITAN, CO-DIRECTOR, AEI-BROOKINGS JOINT
CENTER FOR REGULATORY STUDIES
Mr. Litan. Thank you very much, Mr. Chairman, for inviting
me here today to summarize some of the key conclusions of a
book called The GAAP Gap, a book that I recently wrote with
Peter Wallison at American Enterprise Institute about the
future of corporate disclosure in the internet age. In brief, I
think we will agree with a number of panelists today--and I am
guessing here--that corporate reporting needs to be updated to
fit with modern business realities.
One of the purposes of disclosure rules is to help
investors make informed judgments about the future, because
equity prices, after all, embody the collective judgment of
investors about the future prospects of companies. Current
GAAP-based financial statements, even if they are clean as a
whistle, only go so far toward meeting this objective, for four
reasons.
Number one, recent financial reports inherently are
backward-looking, especially so because, for the most part,
assets and liabilities are recorded at historical cost, not
current market values.
Number two, much of the value the market assigns to many
companies cannot even be found on their balance sheet or income
statements. That is because this value is intangible and cannot
be easily bought and sold on the marketplace independent of the
value of the firm.
Number three, non-financial information relevant to price
in the future that may never directly show up in any financial
report, such as the gain or loss of new customers, insider
stock sales or purchases, is constantly being generated--and in
any event, much more frequently than quarterly. To its credit,
the SEC has recently proposed that more such information should
be disclosed in such 8-K filings by companies, and more rapidly
than ever before.
And finally, the development of new computer-based
technologies may soon make it possible for investors, on their
own or through independent advisors, to manipulate company-
specific information so that they don't have to rely on GAAP-
based financial statements that companies now produce.
Specifically, I refer here to a new computer language,
Extensible Business Reporting Language, that allows firms to
place what are called ``tags,'' or identifiers, on all kinds of
financial and non-financial information. Investors and analysts
can then easily manipulate and compare these data, which is not
possible with financial reports that are now available on the
internet in the language HTML.
These four conclusions have several policy implications.
Number one, while it is tempting to solve the intangibles
problem by having firms place values on those assets, this is
not generally appropriate, in my view, because it puts auditors
in an impossible situation, especially in the wake of Enron.
There are few if any organized markets for intangibles, so
auditors have no objective benchmarks for verifying those
values. The better approach, and one which addresses the need
for more forward-looking information, is for firms to disclose
more non-financial information that may give rise to intangible
value, such as employee turnover, product return rates,
measures of innovation and so forth. The SEC can and should
accelerate the disclosure of such information by convening
working groups of experts from different industries to identify
which of these measures are most helpful and to publicize the
results, so that investors, analysts, and other professionals
can begin demanding to see such data.
Second, the SEC should encourage more frequent internet-
based reporting, not only of non-financial information, but
even financial data. Companies already balance their books and
compile information internally much more frequently than
quarterly. If investors had access to real-time data, it is
conceivable--not certain, but conceivable--they would place
less emphasis on the quarterly earnings figures with which
markets and firms are now obsessed. In turn, this could reduce
incentives for firms to manage their quarterly earnings to hit
expected targets.
Third, the SEC should encourage the use of XBRL, and thus
give powerful tools to investors, by perhaps requiring
Electronic Data Gathering Analysis and Retrieval System
submissions to be in XBRL by a fixed date.
And finally, the movement toward a new reporting model will
not, in my view, eliminate investor demand for having financial
reports comply with a certain standard, whether it be U.S. GAAP
or the international accounting standards that you just
discussed. In my written testimony, I argue that it is highly
unlikely in this country that we will ever replace GAAP with
IAS. Instead, I try to make the case for allowing all firms--
not just foreign firms, but all firms listing their shares on
U.S. exchanges--to choose between GAAP or IAS without
necessarily having to do reconciliation, as is now required for
foreign companies, as was just explained.
Competition between standard-setters would encourage both
standard-setters to respond to market developments more
rapidly, and thus solve a problem that you, Mr. Sherman,
identified, which is the slowness of FASB. It may also--that
is, competition also may reduce some of the political influence
that has affected FASB rule-making in the past, since firms
choosing what is perceived by investors to be the weaker
standard would be punished by the markets for doing so.
Thank you, Mr. Chairman, and I look forward to answering
your questions.
[The prepared statement of Robert E. Litan can be found on
page 248 in the appendix.]
Chairman Baker. Thank you very much, Dr. Litan.
Our next witness is Mrs. Ellen Masterson, Partner-in-Charge
of Global--lost my glasses, wait a minute--in charge of Global
Audit Methodology and ValueReporting, PricewaterhouseCoopers.
And for the record, I have read ValueReporting about a half-
dozen times trying to absorb it all, and I think it is an
excellent piece of work. And the conclusions reached, I think,
are excellent in the publication.
Ms. Masterson. Great. Thank you, Mr. Chairman.
Chairman Baker. You will need to hit that little button.
Ms. Masterson. Oh. Thank you.
STATEMENT OF ELLEN H. MASTERSON, PARTNER-IN-CHARGE OF GLOBAL
AUDIT METHODOLOGY AND VALUEREPORTING, PRICEWATERHOUSECOOPERS,
LLP
Ms. Masterson. Thank you for those kind words, and thank
you for the invitation to speak with you today.
When we wrote The ValueReporting Revolution at PwC in the
fall of 2000, the topic of transparency was not as in vogue as
it is today. Our book captures the results of our research into
the effectiveness of corporate reporting in meeting the needs
of investors around the world. Based on surveys of thousands of
investors, analysts, and managers, there were several
consistent messages that came out.
One, at the time surveyed, more than a third of the
companies believed they were undervalued in the marketplace.
Second, few investors regard corporate reports as very useful.
Third, the market is excessively focused on short-term
earnings; we can all agree on that. And finally, it was clear
that companies could benefit significantly by improved
transparency, including higher share prices where warranted.
From our research, which is ongoing today, we have defined
certain communication gaps that drive the difference between
the way management values their business and the market value
today. The most significant of those communication gaps are
three that I would like to discuss with you. One we call the
information gap: investors need information they don't get.
Second, there is a reporting gap: management agrees information
is important and that they are not reporting it. And thirdly,
the quality gap, where management simply doesn't have all the
important performance information they need.
This quality gap often underlies the reporting gap.
Management doesn't have all the information; they don't report
it because they don't have it. And that gap is by far the most
troublesome.
We group the kinds of information that investors want into
four categories, fairly simple: market information, company
strategy, and the key information used to manage the company;
finally, the value platform, measures of the real drivers such
as innovation and brands, people and customers, as Dr. Litan
just mentioned.
Many of the elements underlying the four categories will
differ by industry sector, but the four categories hold true
for all companies. Investors and analysts and managers all
agree this is the information that is important and that they
need.
So if all agree, why doesn't management communicate more?
There are likely many answers, some of which we have heard--it
is not required, it is competitive, it is not reliable, we
don't want to go first, there are no standards. And the more we
disclose, the more legal liability we have.
And yet we haven't met a CEO or CFO who doesn't basically
agree that eventually the market will approach a new model for
communication similar to our ValueReporting framework. Many
companies are leading the way on a voluntary basis.
In the spirit of transparency, we have no conclusive
evidence that better disclosure will actually lead to accurate
share prices. But our survey respondents did indicate the
benefits of greater transparency to companies would be
increased management credibility, more long-term investors,
improved access to capital, and more accurate share prices.
There are benefits to investors as well. Simply put, value
reporting would give investors the information they need to
make better investment decisions.
ValueReporting requires dramatic changes in management and
board attitudes toward corporate reporting. In recent hearings,
I understand, the subcommittee has looked at the role of the
board and the audit committee in corporate governance. Boards
of Directors need the information embodied in ValueReporting to
properly evaluate management, and they have a responsibility to
make sure that investors get such information as well.
We encourage the creation of new venues for reporting,
beyond the boundaries of traditional financial statements, to
give investors more information about the real sources of value
in the business. Thus, we don't propose to make traditional
financial reporting less relevant, or to replace it, or to put
lots of intangibles on the balance sheet.
Thinking in terms of the balance sheet probably misses the
point. Companies should give the market reliable and relevant
information, and the market will figure out what to do with it.
I appreciate the opportunity to be with you today, and look
forward to answering questions.
[The prepared statement of Ellen H. Masterson can be found
on page 259 in the appendix.]
Chairman Baker. Thank you very much.
Our next witness is Professor of Accounting, The Wharton
School, University of Pennsylvania, Dr. Robert Verrecchia.
Welcome, Doctor.
STATEMENT OF ROBERT E. VERRECCHIA, PUTZEL PROFESSOR OF
ACCOUNTING, THE WHARTON SCHOOL, UNIVERSITY OF PENNSYLVANIA
Mr. Verrecchia. Thank you for inviting me.
In the brief time that I have to testify, I would like to
offer the perspective of someone who wears the proverbial ``two
hats.'' That is, first I would like to offer the perspective of
someone whose instruction material touches on many of the
issues that are central to the debate about the process that
promulgates accounting standards and firms' adherence to those
standards. Later, I would like to offer the perspective of the
researcher who has attempted to document the economic benefits
of increased disclosure and greater transparency.
With regard to pedagogy, it is at least a partial
indictment of the financial reporting process that one of the
most popular elective classes in the Wharton MBA program is an
accounting class whose chief purpose is to discuss how firms
gerrymander their financial statements to conform to the letter
of various U.S. generally accepted accounting principles, U.S.
GAAP, but not necessarily the spirit. Further, one of the most
popular executive education programs sponsored by Wharton is
one in which the financial reporting peccadilloes of firms are
brought out into the open and put forth for ridicule.
Many of the instructors at Wharton are sensitive to the
concern that in regaling students with tales of financial
reporting chicanery, we may also be promoting this behavior on
the part of our graduates. In our conceit, we rationalize our
way around this dilemma by arguing that in any accounting
Armageddon, it is important for our students to be better-armed
than the students from our peer institutions.
In short, viewed from the rarified air of academe, the
accounting standard process appears structured in such a
fashion as to produce the occasional accounting debacle.
Industry and financial groups, and their auditors, sponsor a
private sector agency, the Financial Accounting Standards
Board, to offer accounting pronouncements and guidance from
which the very same corporations and their auditors will either
benefit or suffer. In other words, it is a process that, at
best, seems fraught with moral hazard problems, and, at worst,
results in accounting opinions that appear to pander to the
worst aspects of corporate America.
These problems are only exacerbated when auditors who lobby
the rule-making process in behalf of their corporate clients
are then asked to implement these rules. In an environment like
this, should we have expected anything less than the occasional
Enron/Andersen misadventure?
Part of the problem with the rule-making process is the
failure to be guided by two broad principles. One, wherever
practical, all publicly traded companies should be required to
adhere to a regime of full and fair disclosure. And two,
whenever effective control is exercised over an entity,
financial results of that entity should be fully consolidated
into the controlling firm.
Unfortunately, all too often in the rule-making process,
corporations, through their lobbyists, appear to employ a
variety of self-serving arguments to circumvent these
principles. This problem is further exacerbated by the fact
that the rule-making process itself seems more absorbed in the
detailed minutiae of accounting transactions than in the
economic substance of those transactions.
Opponents of the recognition of substance employ these
arcane debates to frustrate rule-making at all levels. No
better example of this exists than the treatment of employee
stock options.
But from a research perspective, the real tragedy of recent
financial reporting deficiencies is the failure of all
representatives in this debate to recognize the clear and
obvious economic benefits of increased disclosure and greater
transparency--lower costs of capital for firms, increased
liquidity for firm equities, greater participation in the
capital generation process by the public, and so forth.
Recently, contemporary accounting research has attempted to
document these benefits. While somewhat nascent, this research
nonetheless is consistent with prevailing notions that
increased disclosure is beneficial to the capital generation
process.
Commitments to increase disclosure on the part of firms do
indeed result in lower costs of capital, increased liquidity,
and so forth. The research results are clear and compelling,
and buttress traditional claims that greater transparency
enhances access to capital markets.
But if contemporary research can document the benefits of
increased disclosure, why do publicly listed corporations not
embrace it to the fullest extent? One rationale for less than
full disclosure is that disclosure may require disseminating
information about a firm's proprietary business model,
proprietary management expertise, proprietary technology, and
so forth. This, in turn, may work against the interests of a
firm that reports publicly, and to the benefit of firms that
compete against it.
To the extent to which these competitors are based outside
the U.S. or report under accounting standards other than U.S.
GAAP, this provides powerful political leverage for less
disclosure. But in a sense, a call for greater disclosure is no
different from a variety of welfare arguments. While full
disclosure and full consolidation may lead to both winners and
losers in capital markets, indisputable increased disclosure
serves the greater good.
In short, the thought with which I would like to leave the
subcommittee is that the rule-making process be governed by an
ideal of full and fair disclosure and full consolidation.
Perhaps stated differently, arguments in favor of anything less
than full and fair disclosure and full consolidation should
require a high burden of proof. While full and fair disclosure
and full consolidation will not eliminate failures that result
from fraud, flawed business models, and/or unexpected industry
and economic downturns, they will work to ensure that failures
are not the results of a reporting system that gives firms and
their managers unwarranted discretion to obfuscate an entity's
overall financial condition.
Thank you very much, and I will await any questions.
[The prepared statement of Robert E. Verrecchia can be
found on page 285 in the appendix.]
Chairman Baker. Thank you very much, Doctor.
Our final witness on this panel is Mr. Steven Wallman, CEO
of FOLIOfn, and a former SEC Commissioner from 1994 to 1997.
Welcome, sir.
STATEMENT OF STEVEN M.H. WALLMAN, CEO, FOLIOFN, INC., AND
COMMISSIONER, SECURITIES AND EXCHANGE COMMISSION, 1994-1997
Mr. Wallman. Thank you, Mr. Chairman. And today I am
representing only myself.
Our capital markets are clearly the means pursuant to which
capital flows from those who have it to those who need it. I
don't think there is any proposition that can be gainsaid other
than that our capital markets do, in fact, work better than
anybody else's. They work better now than they have in the
past. But the recent events of the last year have also shown
how much more we need to do in order to make them work even
better.
Capital markets rely on public disclosure to work
efficiently. Financial statements, along with other mandated
and voluntary disclosures, are, if you will, the bedrock of
that system. And they are what allow investors to make
efficient resource allocations.
Generally accepted accounting principles are the language
of financial statements. More than half-a-dozen years ago, it
was apparent that GAAP was starting to fail in one of its most
essential purposes, which was to be able to provide useful,
timely, and relevant disclosures to investors. About 6 years
ago, we commenced a study at the SEC looking into these issues.
At that time, the whole proposition that there might be
something failing with regard to GAAP was viewed as somewhat
heretical. I think today, in hindsight, it is not quite as
heretical.
Let me explain five ways, sort of the normal who, what,
where, when, and how, where GAAP is currently having some
difficulties in fulfilling its purposes.
First, in connection with sort of what is measured,
accounting principles are geared to measure bricks and mortar--
basically a tangibles-dominated world from the past.
Increasingly today, the drivers of wealth production are
intangibles. They are generally created internally, not
acquired, but GAAP generally measures them only when acquired,
not generally when they are created internally. So we have a
sort of what is measured inconsistency.
Who is measured has been brought to light in connection
with what we are seeing now with special-purpose entities and
other arrangements, where the boundaries of a firm are
increasingly difficult to discern. It used to be you could tell
where a firm began and where it ended, and what business it was
in. But derivatives today, SPEs, off-balance-sheet activities,
partnership arrangements, and other kinds of things have
blurred that boundary quite considerably.
A third area obviously is timeliness of measurement. Things
move more quickly now than they have in the past. Financial
statements clearly are generally backward-looking, even though
there is forward-looking disclosure embedded in financial
statements--reserves, for example, are clearly forward-looking.
Yet the concept of a forward-looking financial statement is one
that is hard for some to discern.
Access to information is another. GAAP is its own language
at this point. Those who wish to understand what is truly going
on in a financial statement have to spend some significant
amount of time investigating it. And in fact, there are people
who spend their careers taking the aggregated information in
financial statements and then disaggregating it in order to
understand what is really happening.
Moreover, the language of GAAP is now sufficiently esoteric
and specialized in many cases that it has even its own dialects
with regard to specific industries and different instruments
and circumstances within those industries. And even though
financial statements increasingly, I think, fairly put, are
beyond the comprehension of the lay person, and even many
professional investors, we continue to require their
distribution to all, maintaining the to-some-degree fiction
that they should be useful to all. At base, I think we in a
sense almost mislead people when we suggest that financial
statements should be distributed widely because they are widely
understandable. They clearly, at this point, are not.
Finally, how things are measured; accounting requirements
clearly, in my view, have become very rules-oriented. You heard
earlier somebody talk about them as sort of a by-the-book type
of check-the-box type of accounting, and I think that that is a
problem. We need to have more goals-oriented, more principle-
oriented approaches. We will not be able to close loopholes,
but one of the most effective, one of the most overwhelmingly
effective standards in the securities laws for the last three-
quarters of a century has been one very simple concept, the
notion of 10(b)(5). And that is in essence a very broad-based
principle with regard to disclosure, and it has been, if you
will, one of the most effective means for ensuring appropriate
disclosure ever created.
The current scandals clearly indicate, I think, how
outdated GAAP can be when people stretch it to the extreme. Let
me talk about a couple things that might be useful to try to
address some of these concerns.
One is, FASB and the SEC have already taken important steps
to address some of the intangibles deficiencies. And they are
doing more, and I think that is worthwhile, in terms of general
principles there. In addition, Chairman Pitt and the SEC have
already asked for further disclosure with regard to the
principal accounting judgments that are currently being made by
accountants and issuers. I think that is a very important thing
to get out into the public disclosure.
In addition, there are other incremental steps that I think
are worthwhile to take. One is the idea of re-educating the
profession that the overall principle of financial statement
reporting is that they have to present a true financial picture
of the company, and not basically what is in accordance only
with respect to generally accepted accounting principles, but
whether or not the overall presentation is in accordance with
generally accepted accounting principles and a fair
presentation.
And finally, there are some other suggestions that one
could explore, such as requiring a second firm to provide a
review of the more important principles and judgments being
made by an auditing firm, at least in connection with the
largest corporations, so that there is a means for some double-
check with regard to the very broad-based and important
decisions that are being made in connection with major firm
audits.
Thank you.
[The prepared statement of Steven M.H. Wallman can be found
on page 289 in the appendix.]
Chairman Baker. Thank you, Mr. Wallman. You were discussing
a point which I had raised with the earlier panel, with regard
to the obligation to present an accounting methodology that
reflects true value, and that where the utilization of an
accounting mechanism is not for the purpose of building value
or enhancing shareholder perspective, that that be questioned
or noted in some special way. Is it your view that that is not
the underlying principle of compliance with GAAP today, that we
are so technically focused on the construction of the rule that
bright people spend a lot of time trying to figure out how to
comply with the rule and become, therefore, GAAP-compliant, but
by so doing obfuscate the true financial condition of the
company?
Mr. Wallman. I think there are two points in what you are
bringing up. One is the question of whether there are
transactions engaged in that have no true business purpose, but
which are being done in order to take advantage of a rule. And
the second is whether or not, even when that is not being done,
are the rules such that the presentation to investors that is
generated by the operation of those rules is such that it does
not fairly present the overall financial picture of the
company?
With regard to the latter, I think the answer is clearly
yes. I think people who read financial statements today, unless
they are well-endowed with an interest in financial reporting
and accounting, must have difficulty understanding the true
nuances of what it is that is being described. The descriptions
are no longer in plain English. The words that are being used,
whether it is net income or something else, clearly have at
this point a whole language behind them that is far beyond what
the assumption is when you look at the word, from an English
standpoint.
With regard to the first, whether or not there are those
who attempt purposefully to obfuscate, it is a large world. I
am sure the answer is that there are those who do, and there
are, I am sure, those who get away with it as well. There are
those who, I think, could be caught, if you will, by having a
simple principle that says if the accountants cannot be
convinced that there is a business purpose for something,
regardless of what the accounting is, there should be
disclosure of the fact that it appears that there is no
business purpose for the transaction. That obviously would stop
those transactions from going forward. And I am not sure there
is anything negative with regard to that conclusion.
Chairman Baker. Thank you.
Did anybody want to jump in on the topic, with regard to--
and I know your general views about what the current
deficiencies are of the rules. But I am getting at the
consequence of the current rules. Even when you comply, you may
not be presenting a clear picture of financial condition.
Certainly with regard to forward-looking statements or
identifiable business risk or new market development, or
whatever might be the thing of value down the road that you are
not disclosing, but I am even worried about the accuracy of the
historical statement that is GAAP-compliant, in light of the
technicalities in which the rules are constructed. They are
very difficult for anyone to understand, and more FASB tries to
define it, the more complicated the system becomes that they
are trying to fix.
I don't know how we get out of this. I don't think we can
go from a historical-looking current system to a forward-
looking internet-based system overnight. But certainly there
has to be some force in the market to bring about these
changes--and I don't know that the Congress is the appropriate
forum for that to occur. But what are your recommendations
about how we get where we need to be? What is the first next
step?
Dr. Litan.
Mr. Litan. Well, I think there are several steps. On the
forward-looking information question, which relates to all
these non-financial indicators that several of us talked about,
as well as to moving to the internet, the prime mover, in my
opinion, has to be the SEC. It shouldn't do it by mandate; it
should do it by encouragement, arm-twisting, if you will,
education. But it has to be the agency out in front helping to
create a demand among investors--working through the media,
because once people know that this information is out there, or
capable of being produced, then sophisticated investors, namely
institutional investors, I think, will begin to demand it. And
you will see a virtuous cycle. But somebody has got to start
the cycle, and it has got to be the SEC.
Now, the second point concerns the existing GAAP-based
system, not the forward-looking information. Now you get into
this debate which has no clear resolution, where you have GAAP,
which has highly detailed rules versus international accounting
standards, which are basically principles-based, and much more
general in nature. But, as Congressman Sherman pointed out, the
international rules may allow too much discretion. So you're
damned if you do and damned if you don't.
There are problems with each approach, which is why I end
up recommending competition. Rather than give a monopoly to one
rule-setter in one geographic area, I would like at least to
see some marketplace competition. Firms choose among the
standards, and then what the media will do and the analysts
will do is they will write about which standard, on the whole,
better serves investor interests. And you will get investor
demand, I think, for the better standard. And let them go at
each other, head to head.
But I think in the absence of competition, you are going to
be beating a dead horse.
Chairman Baker. Ms. Masterson, or Dr. Verrecchia? Can you
comment on the subject?
Ms. Masterson. Yes, I would. I think there is a lot--as you
said, this is not a one-step process. In fact, it is probably a
longer process than any of us wants to think about.
But certainly one of the outcomes of the system we have
today is this, I think several of us mentioned the obsession
with earnings, with current short-term earnings. And the
earnings game is very real. We see that; we got a lot of
information about it in our research.
And the fact is that those short-term earnings pressures
don't really turn into that long-term investor value in many
cases. And so where we get the rules that are so focused on
short-term wins and companies feeling that it has got to be
this quarter over last quarter, and immediate results, and not
an ability to really talk with investors about what they are
doing to build long-term value--I think that is where, whether
it is rules or principles, we just get caught in that same old
cycle.
So getting more information about the long term--I agree
that the SEC is a main player here. I think industry-driven
initiatives have got to come into play, and the FASB has
actually sponsored some of the industry-based coalitions. We do
have early adopters in the marketplace today, and hopefully
there will be some pressure to follow them.
But giving investors more information about the long term
can hopefully balance out that obsession with short-term
earnings, which I think is at the heart of the manipulation,
whether there are rules or principles.
Chairman Baker. Right, thank you.
Mr. Castle, did you have a question?
Mr. Castle. Thank you, Mr. Chairman. I want to sort of
start where I stopped before. And I am delighted that you gave
me the information about Standard and Poor's beginning to bring
stock options into their corporate reporting. Maybe they heard
I was going to ask questions about this today or something like
that.
I would like to really, I think, ask all of you this
question. And you all were in the room when I asked questions
about it before. But I am a little hung up on this subject,
admittedly. I know it is a smaller part of the transparency
issues, and I agree with the Chairman, I think accounting
methodology which reflects true value is what we are all after.
I think we all would basically agree on that. And I agree with
the short-term earnings pressures that Dr. Litan and Ms.
Masterson have both talked about. If there is some way to
spread it out so we didn't always look for it, I think it would
be helpful indeed.
But stock options in particular do trouble me. I have seen
all kinds of opinions on it. I have seen expensing options when
granted, expensing options when they are actually executed, or
just leaving it alone and doing it in the footnote. I see here
from an article in Business Week, which I clipped out, the
boards make matters worse by so lavishing options on executives
they now account for a staggering 15 percent of all shares
outstanding--whether it is true or not, if it was even remotely
close to true, that is an astounding number, a percentage of
the capital of any corporation which exists out there.
And I don't know what the right answer is. And as I said at
the beginning--and I am not getting into this--I just think
executive compensation has perhaps gotten out of hand in this
country. And that is something that I think the corporations
are going to have to look at in terms of their own management.
And their directors--although the directors benefit from all
this as well--and everybody else.
But from an accounting point of view, it seems to me that
all of us who are interested in this have a responsibility. And
I can't imagine you haven't thought about this issue in some
way or another, even though some of you didn't speak to it
directly here today. And I would be interested in your views on
it. What are your views on what we should do on the accounting
entries on stock options?
And you can do whatever you want. You can duck and say, ``I
haven't thought about it.'' You can say we should expense it
when they are granted, or expense it later, and the methodology
by which that would be done. And you will probably have about a
minute apiece, when it is all said and done. But I would just
be interested--you are four diverse people, even though you
have commonality in terms of the area you look at. And I would
just be interested in your views on this. Apparently, everybody
seems to have different views--the President and Mr. Greenspan
differ, others differ. And I am just interested in what the
wealth of good, valuable opinion on this subject is.
So maybe we could just go across the table and start with
Dr. Litan and go from there.
Mr. Litan. I will side with Chairman Greenspan. He said
that the one thing we know is that the right answer is not
zero. The stock options are valuable; we know that, and they
are valuable at the time of granting.
Now, the people who oppose assigning a value say the so-
called Black-Scholes method of valuing options is not perfect
because the options have all kinds of restrictions; a lot of
times the stock isn't well-traded, so you don't have the data
to do the precise Black-Scholes valuation. My answer to that,
and I think Chairman Greenspan said the same thing, is you do
an estimate off that, and even if it is arbitrary, it is better
than nothing.
We do it all the time. We have depreciation schedules which
are arbitrary. We have loss estimation for bad loans, which is
not a science. It is more an art than a science, but we don't
just simply pretend the loan is good when it isn't and put a
100 percent value on it. I think an estimate here is better
than zero. And so yes, I think there is a right answer. It may
not be the perfect answer, but we know that the current system
is not the right answer.
Mr. Castle. Thank you. Ms. Masterson?
Ms. Masterson. I think I am going to take Steve's line and
say I am going to speak for myself and not my firm on this one,
if I may.
Mr. Castle. I actually was only asking you, not for your
firm's opinion.
Ms. Masterson. Because I am not here to make a statement on
behalf of PricewaterhouseCoopers about the accounting for stock
options. So I am going to take a little bit different tack, if
you don't mind.
But I think you have hit the point on the head, and that is
executive comp in general. One of the things that all investors
really want more information about is the quality of
management. And management, by and large, is what they are
investing in. And whether it is in the income statement, on the
balance sheet, in the notes, the information needs to be there
about management, the quality of management, the compensation
of management, the value that the board has placed on
management and where the incentives are leading management
behavior.
So I think that fulsome disclosure--with all due respect,
if I can dodge the placement of that, I would appreciate it.
Mr. Castle. Thank you. And Dr. Verrecchia, I will throw a
kicker in on yours, because I think you said in your testimony,
and I think I saw it in your writing, that you actually think
this has enhanced value to the corporation, if stock options
are correctly reported. Maybe I am mis-stating that. I would be
interested in that as well as the other question.
Mr. Verrecchia. Well, I think any disclosure enhances. But
I think that specifically with regard to this, this strikes me
as so straightforward and obvious that I think it speaks very
much to the controversy about rule-making in general. Obviously
they should be an expense. It is probably much easier to
measure, through Black-Scholes or otherwise, the value of that
expense, than it is a whole bunch of other things that are
synthetically amortized.
So in a way, what has happened is people have used this
measurement issue to, if you will, put forth an agenda that
nothing be recognized at all in the form of an expense, without
recognizing that something like that option, like in very
sophisticated communities, can be valued with a high degree of
accuracy. And so I think most of the arguments are totally
disingenuous, that suggest somehow it should not be recognized
as an expense because of measurement issues. And if we can't
see through this issue, then there is no hope for rule-making
in general.
Chairman Baker. Thank you.
Mr. Wallman.
Mr. Wallman. The measurement issue, I think, is a red
herring. And I don't think the argument has really been on that
since it was first raised in the mid-1990s. I think everybody
understands that issue, both sides.
The question is how best to present the information, and
what is--in some cases, the perception of broader-based
impacts. And you have had the argument for quite a number of
years that expensing it would be something that could deter the
use of stock options. As a society, is that something we want
or not? Should accounting be neutral or not? These are a number
of interesting and important policy decisions that transcend
the mechanical questions of whether or not you can come up with
a value. The answer is, of course you can. The question is
really how best to then use that information.
Some have suggested that there be additional disclosure of
the actual calculated expense, and that can be a disclosure.
Others have suggested a separate line-item in the financial
statements that would break this out, because you get one of
the other confusing aspects, as you mentioned yourself earlier,
that operating profits, for example, in some companies could be
wiped out by showing expenses which are not cash expenses and
which could be, therefore, quite misleading to investors
looking at the financial statements, wondering how it is that
this company can keep making a lot of money in the traditional
sense of making a lot of money, but keep reporting losses
because the stock price keeps going up.
And you do get very strange anomalies where the more the
stock price goes up, the more there could be an expense; the
more the stock price goes down, the less of an expense. Yet
management or the employees haven't changed. So you get some
very interesting circumstances as to how best to describe,
disclose, and present this information.
So I don't think the focus ought to be on the measurement
issues. Clearly, that is inapposite, and I think everybody
understands that. The real issue or debate has been for the
last decade how best to present this information, both to
investors so they understand what it is, to managers so it can
be used, and also how do these factors implicate themselves in
more broad-based societal issues that people have been arguing
about for a long time.
I think we should remember this whole debate started in
part when managers and others used to get a lot of cash. And
there was an awful lot of movement on the corporate governance
side to start paying managers not in cash, but in stock and
stock options, in order to better align their interests with
the corporation. And the view was that we needed to have some
way of trying to convince companies and managers to take
equity-based compensation so their interests would be aligned
with shareholders, as opposed to simply taking cash from the
company.
Mr. Castle. Are you willing to opine how you would do it,
if you were doing the accounting?
Mr. Wallman. Actually, I am happy to, because I was on the
record as proposing an answer that was in between. And I would
be happy to pursue that in detail if you would like. But in
essence, it was a hybrid that came up with the equivalent of a
charge in terms of coming up with the amount, the measurement
amount, but showing it on a separate item, so that it was fully
disclosed and people could understand what it was, as opposed
to mixing it into an overall cash, otherwise understood
compensation expense.
Mr. Castle. Thank you. I appreciate all of your answers,
which I think were clear and helpful, and I yield back, Mr.
Chairman.
Chairman Baker. Mr. Castle, on that subject, the Chairman
wrote on October of last year to FASB relative to the expensing
of stock options. And in the response that FASB gave to the
Chairman, they arrived at a disclosure regime, not requiring
expensing. But they got to this point in a rather convoluted
way, because their preference was to expense, but because of
the divisiveness of the subject matter, I quote, ``the Board
chose a disclosure-based solution for stock-based employee
compensation to bring closure to the divisive debate on the
issue, not because it believes that solution is the best way to
improve reporting.''
So our non-political board happened to make a political
judgment, I guess, which gets me to the next difficult question
that none of you have spoken to yet. Can we get where we need
to go with FASB as the accounting regulator, centered on a
rule-based system? Aren't we looking at a very--this issue
itself presents evidence of the difficulty. With regard to
derivatives treatment, there was a 10-year debate. With regard
to SPEs, there was a 10-year debate and then a statement issued
saying we have decided not to take a position.
In the world in which we live, it may not be the fairest,
but we need decisive response to inappropriate market conduct,
so that investors at any time and moment are getting access to
clear-cut, helpful, usable information. We are trying to put a
horse and an automobile together here, and I think that we
maybe better advised to go get us another mechanic. What is
your view about the viability of reform versus a whole new
approach?
Yes, sir?
Mr. Litan. Well, I think, as I said in my written
testimony, a second-best solution to the slowness problem is to
have the SEC threaten to step in and set a rule with some kind
of deadline. I want to be clear, I don't think that is a
perfect solution, but it is better than where we are now.
Now, the problem inherently, both as to slowness and to
political influence, is that ultimately FASB can, at any
moment, be influenced by the Congress. And it will be as long
as FASB reports to the SEC. It is inherently a political
creature. I think the only way to reduce political influence is
to have competition in standards, as I said before.
Now, you could imagine replacing FASB with IAS,
international standards. But that would just move the politics
to some other place, it would move it to London. And then it
would dilute American interests, obviously. We would have to
compete with overseas interests. But I am not sure that would
be a necessarily better answer. London may be even slower than
Greenwich, Connecticut.
And, by the way, I am not sure IAS would be a stable
solution. I think we would end up, over time, having national
accounting bodies potentially interpret IAS to apply to
specific countries. And so we could end up right back where we
are now, with different flavors of different accounting
standards.
Chairman Baker. From your perspective, is FASB asset-
limited? If they have been operating in a deficit posture for
the past 4 years, they obviously can't be adding on any large
numbers of staff. Is it advisable to consider a federally based
support system for FASB to break the tie between the industry
and the FASB regulatory body, and to give them pay parity in
order to do the work they need to do? Is that an element of the
delay, or is that a factor at all?
Mr. Litan. Well, I will give my opinion, and then I don't
want to monopolize attention. I think that a more stable
funding source could help reduce the perception that FASB is in
anybody's pocket. But it doesn't solve the political problem
that I put my finger on, because you can still get political
interests working through the Congress who don't like stock
option expensing, and they can still stop FASB in its tracks.
So I don't think the funding thing, while it may be
meritorious, is a perfect magic bullet. I think the only chance
you have got is competition, and let the market pressure both
FASB and IAS to come up with more rapid standards, and also to
do so in a way that is in the investor's interest.
Chairman Baker. Any differing opinions?
Mr. Wallman. Yes. I mean, I think competition is an
interesting idea, and people have suggested it a number of
different places. It is not a panacea, though, and it will not,
in my opinion, I think, do much other than create two fora
where politics can be brought to bear in various respects. And
I don't think you are guaranteed a better result out of either
of them just because you now have competition between them.
I think we also end up with the potential issue for there
to be misunderstandings. It obviously becomes somewhat more
confusing for investors who now have two different sets of
standards. It is already confusing for investors in trying to
figure out what GAAP is meaning; forget trying to figure out
what two different kinds of GAAP mean. I mean, there are a
number of different issues.
On the other hand, I think the convergence that has been
talked about is also happening, and I think on most issues you
end up with people who are intelligent concluding reasonably
the same thing with regard to how to try to do something. The
problem is that the world is very complex, and the problem is
that when you continue to try to come up with specific rules
that cover things, it becomes increasingly like the tax code.
And like the tax code, we don't have people out there who
decide that they can intrinsically and inherently understand it
just by sort of looking at a bunch of books. There are tax
lawyers who are paid to do nothing but try to figure it out,
and we have courts that are specialized in trying to understand
it.
We are in a position here where we are looking for
something that is useful for the marketplace as a whole and for
investors generally speaking. And in order to provide something
to them that is useful, it needs over time to be something that
has more and better disclosures with respect to it. And to some
degree, we create, I think, a problem by trying to roll things
up to specific numbers.
I think Standard and Poor's is a great example of an entity
that has attempted at this point--in part because there were
concerns about whether or not the numbers it is using are
useful for what it is trying to do--to now itself try and
analyze it better, and to come up with its own view of core
numbers, separate from what FASB and what the SEC and others
think are the generally accepted accounting numbers that ought
to be suggested to the public, and different from what it is
that we will have the public see in audited financial
statements. S&P will basically use its own.
That is an interesting opportunity, if you will, for
competition. We already have competition there, if you will,
and we will see whether or not people prefer to see what S&P
produces versus what it is that somebody else produces.
I think it was said earlier in the previous panel, too,
that you can end up in a position where as long as you have got
full information out there, and the line items are clear and
the disclosure is obvious, you can end up with others--whether
they are analysts, whether they are entities like S&P or
others--creating, if you will, their own view of what financial
statements are like.
So I think that we, in essence, end up with sort of the
competition, if you will, for ideas and thoughts through that
means, without trying to come up with multiple places to have
influence peddled with regard to politics and financials.
Chairman Baker. Do I take from that, then, you do not
believe that a regulatory restructuring makes any sense? That
it is pressure to get the current structure to move in the
disclosure regime that you see as appropriate?
Mr. Wallman. I think that whenever there is a failing,
there is a question of whether or not there needs to be a
change in the overall structure. And I think it is a worthwhile
question to ask. Personally, I think that to some degree the
failing has been in the approach. It has been too much of an
attempt at, if you will, closing barn doors after horses have
escaped, trying to come up with the next rule to take care of
the last problem. And what we need is a more forward-looking
approach, if you will, to regulation.
I think that the people are in a position to be able to
exercise that, and to do it appropriately, if one can step back
and take a more general approach to rule-making. And I think
the SEC has begun to do that, and has done it in various
instances. And I think the FASB, with its new business
combinations approach, has done that as well. So I think you
are starting to see that, and I think people have recognized
that that is a necessary element to appropriate rule-making
going forward. That, I think, is the restructuring.
There is a separate set of issues, which is whether or not
there is a sufficient level of resources both at the Commission
and at FASB, whether or not the funding really ought to be
something where the private sector has to step up to fund this,
which necessarily entails the question of where is influence
coming from with regard to that.
But I think stock options is a worthwhile point in case:
the pressure there came not from the private sector suggesting
they were going to withdraw funds from the FASB if it went
forward with the project; the pressure there came from Congress
suggesting that FASB was doing something inappropriate if it
were to expense stock options.
Chairman Baker. Thank you.
Mr. Castle, did you have any further questions?
[No response.]
Chairman Baker. I don't know if anybody wants to make any
further comment on the Standard and Poor's approach that was
issued today, if you have any degree of familiarity with it.
But if, after review, you find it of interest, or if there is
comment worthy to send to the Committee, we would be
appreciative for analysis and comment as we move forward.
This is a very meager beginning to a very long process, but
I want to express my appreciation to each of you for your time
in being here today. Your insights have been very helpful to
us, and I am certain we will be working together over the
coming months toward the goals we all have in mind.
Thank you very much. Our hearing is adjourned.
[Whereupon, at 4:30 p.m., the hearing was adjourned.]
A P P E N D I X
May 1, 2002
[GRAPHIC] [TIFF OMITTED] 79559.001
[GRAPHIC] [TIFF OMITTED] 79559.002
[GRAPHIC] [TIFF OMITTED] 79559.003
[GRAPHIC] [TIFF OMITTED] 79559.004
[GRAPHIC] [TIFF OMITTED] 79559.005
[GRAPHIC] [TIFF OMITTED] 79559.006
[GRAPHIC] [TIFF OMITTED] 79559.007
[GRAPHIC] [TIFF OMITTED] 79559.008
[GRAPHIC] [TIFF OMITTED] 79559.009
[GRAPHIC] [TIFF OMITTED] 79559.010
[GRAPHIC] [TIFF OMITTED] 79559.011
[GRAPHIC] [TIFF OMITTED] 79559.012
[GRAPHIC] [TIFF OMITTED] 79559.013
[GRAPHIC] [TIFF OMITTED] 79559.014
[GRAPHIC] [TIFF OMITTED] 79559.015
[GRAPHIC] [TIFF OMITTED] 79559.016
[GRAPHIC] [TIFF OMITTED] 79559.017
[GRAPHIC] [TIFF OMITTED] 79559.018
[GRAPHIC] [TIFF OMITTED] 79559.019
[GRAPHIC] [TIFF OMITTED] 79559.020
[GRAPHIC] [TIFF OMITTED] 79559.021
[GRAPHIC] [TIFF OMITTED] 79559.022
[GRAPHIC] [TIFF OMITTED] 79559.023
[GRAPHIC] [TIFF OMITTED] 79559.024
[GRAPHIC] [TIFF OMITTED] 79559.025
[GRAPHIC] [TIFF OMITTED] 79559.026
[GRAPHIC] [TIFF OMITTED] 79559.027
[GRAPHIC] [TIFF OMITTED] 79559.028
[GRAPHIC] [TIFF OMITTED] 79559.029
[GRAPHIC] [TIFF OMITTED] 79559.030
[GRAPHIC] [TIFF OMITTED] 79559.031
[GRAPHIC] [TIFF OMITTED] 79559.032
[GRAPHIC] [TIFF OMITTED] 79559.033
[GRAPHIC] [TIFF OMITTED] 79559.034
[GRAPHIC] [TIFF OMITTED] 79559.035
[GRAPHIC] [TIFF OMITTED] 79559.036
[GRAPHIC] [TIFF OMITTED] 79559.037
[GRAPHIC] [TIFF OMITTED] 79559.038
[GRAPHIC] [TIFF OMITTED] 79559.039
[GRAPHIC] [TIFF OMITTED] 79559.040
[GRAPHIC] [TIFF OMITTED] 79559.041
[GRAPHIC] [TIFF OMITTED] 79559.042
[GRAPHIC] [TIFF OMITTED] 79559.043
[GRAPHIC] [TIFF OMITTED] 79559.044
[GRAPHIC] [TIFF OMITTED] 79559.045
[GRAPHIC] [TIFF OMITTED] 79559.046
[GRAPHIC] [TIFF OMITTED] 79559.047
[GRAPHIC] [TIFF OMITTED] 79559.048
[GRAPHIC] [TIFF OMITTED] 79559.049
[GRAPHIC] [TIFF OMITTED] 79559.050
[GRAPHIC] [TIFF OMITTED] 79559.051
[GRAPHIC] [TIFF OMITTED] 79559.052
[GRAPHIC] [TIFF OMITTED] 79559.053
A P P E N D I X
May 14, 2002
[GRAPHIC] [TIFF OMITTED] 79559.054
[GRAPHIC] [TIFF OMITTED] 79559.055
[GRAPHIC] [TIFF OMITTED] 79559.056
[GRAPHIC] [TIFF OMITTED] 79559.057
[GRAPHIC] [TIFF OMITTED] 79559.058
[GRAPHIC] [TIFF OMITTED] 79559.059
[GRAPHIC] [TIFF OMITTED] 79559.060
[GRAPHIC] [TIFF OMITTED] 79559.061
[GRAPHIC] [TIFF OMITTED] 79559.062
[GRAPHIC] [TIFF OMITTED] 79559.063
[GRAPHIC] [TIFF OMITTED] 79559.064
[GRAPHIC] [TIFF OMITTED] 79559.065
[GRAPHIC] [TIFF OMITTED] 79559.066
[GRAPHIC] [TIFF OMITTED] 79559.067
[GRAPHIC] [TIFF OMITTED] 79559.068
[GRAPHIC] [TIFF OMITTED] 79559.069
[GRAPHIC] [TIFF OMITTED] 79559.070
[GRAPHIC] [TIFF OMITTED] 79559.071
[GRAPHIC] [TIFF OMITTED] 79559.072
[GRAPHIC] [TIFF OMITTED] 79559.073
[GRAPHIC] [TIFF OMITTED] 79559.074
[GRAPHIC] [TIFF OMITTED] 79559.075
[GRAPHIC] [TIFF OMITTED] 79559.076
[GRAPHIC] [TIFF OMITTED] 79559.077
[GRAPHIC] [TIFF OMITTED] 79559.078
[GRAPHIC] [TIFF OMITTED] 79559.079
[GRAPHIC] [TIFF OMITTED] 79559.080
[GRAPHIC] [TIFF OMITTED] 79559.081
[GRAPHIC] [TIFF OMITTED] 79559.082
[GRAPHIC] [TIFF OMITTED] 79559.083
[GRAPHIC] [TIFF OMITTED] 79559.084
[GRAPHIC] [TIFF OMITTED] 79559.085
[GRAPHIC] [TIFF OMITTED] 79559.086
[GRAPHIC] [TIFF OMITTED] 79559.087
[GRAPHIC] [TIFF OMITTED] 79559.088
[GRAPHIC] [TIFF OMITTED] 79559.089
[GRAPHIC] [TIFF OMITTED] 79559.090
[GRAPHIC] [TIFF OMITTED] 79559.091
[GRAPHIC] [TIFF OMITTED] 79559.092
[GRAPHIC] [TIFF OMITTED] 79559.093
[GRAPHIC] [TIFF OMITTED] 79559.094
[GRAPHIC] [TIFF OMITTED] 79559.095
[GRAPHIC] [TIFF OMITTED] 79559.096
[GRAPHIC] [TIFF OMITTED] 79559.097
[GRAPHIC] [TIFF OMITTED] 79559.098
[GRAPHIC] [TIFF OMITTED] 79559.099
[GRAPHIC] [TIFF OMITTED] 79559.100
[GRAPHIC] [TIFF OMITTED] 79559.101
[GRAPHIC] [TIFF OMITTED] 79559.102
[GRAPHIC] [TIFF OMITTED] 79559.103
[GRAPHIC] [TIFF OMITTED] 79559.104
[GRAPHIC] [TIFF OMITTED] 79559.105
[GRAPHIC] [TIFF OMITTED] 79559.106
[GRAPHIC] [TIFF OMITTED] 79559.107
[GRAPHIC] [TIFF OMITTED] 79559.108
[GRAPHIC] [TIFF OMITTED] 79559.109
[GRAPHIC] [TIFF OMITTED] 79559.110
[GRAPHIC] [TIFF OMITTED] 79559.111
[GRAPHIC] [TIFF OMITTED] 79559.112
[GRAPHIC] [TIFF OMITTED] 79559.113
[GRAPHIC] [TIFF OMITTED] 79559.114
[GRAPHIC] [TIFF OMITTED] 79559.115
[GRAPHIC] [TIFF OMITTED] 79559.116
[GRAPHIC] [TIFF OMITTED] 79559.117
[GRAPHIC] [TIFF OMITTED] 79559.118
[GRAPHIC] [TIFF OMITTED] 79559.119
[GRAPHIC] [TIFF OMITTED] 79559.120
[GRAPHIC] [TIFF OMITTED] 79559.121
[GRAPHIC] [TIFF OMITTED] 79559.122
[GRAPHIC] [TIFF OMITTED] 79559.123
[GRAPHIC] [TIFF OMITTED] 79559.124
[GRAPHIC] [TIFF OMITTED] 79559.125
[GRAPHIC] [TIFF OMITTED] 79559.126
[GRAPHIC] [TIFF OMITTED] 79559.127
[GRAPHIC] [TIFF OMITTED] 79559.128
[GRAPHIC] [TIFF OMITTED] 79559.129
[GRAPHIC] [TIFF OMITTED] 79559.130
[GRAPHIC] [TIFF OMITTED] 79559.131
[GRAPHIC] [TIFF OMITTED] 79559.132
[GRAPHIC] [TIFF OMITTED] 79559.133
[GRAPHIC] [TIFF OMITTED] 79559.134
[GRAPHIC] [TIFF OMITTED] 79559.135
[GRAPHIC] [TIFF OMITTED] 79559.136
[GRAPHIC] [TIFF OMITTED] 79559.137
[GRAPHIC] [TIFF OMITTED] 79559.138
[GRAPHIC] [TIFF OMITTED] 79559.139
[GRAPHIC] [TIFF OMITTED] 79559.140
[GRAPHIC] [TIFF OMITTED] 79559.141
[GRAPHIC] [TIFF OMITTED] 79559.142
[GRAPHIC] [TIFF OMITTED] 79559.143
[GRAPHIC] [TIFF OMITTED] 79559.144
[GRAPHIC] [TIFF OMITTED] 79559.145
[GRAPHIC] [TIFF OMITTED] 79559.146
[GRAPHIC] [TIFF OMITTED] 79559.147
[GRAPHIC] [TIFF OMITTED] 79559.148
[GRAPHIC] [TIFF OMITTED] 79559.149
[GRAPHIC] [TIFF OMITTED] 79559.150
[GRAPHIC] [TIFF OMITTED] 79559.151
[GRAPHIC] [TIFF OMITTED] 79559.152
[GRAPHIC] [TIFF OMITTED] 79559.153
[GRAPHIC] [TIFF OMITTED] 79559.154
[GRAPHIC] [TIFF OMITTED] 79559.155
[GRAPHIC] [TIFF OMITTED] 79559.156
[GRAPHIC] [TIFF OMITTED] 79559.157
[GRAPHIC] [TIFF OMITTED] 79559.158
[GRAPHIC] [TIFF OMITTED] 79559.159
[GRAPHIC] [TIFF OMITTED] 79559.160
[GRAPHIC] [TIFF OMITTED] 79559.161
[GRAPHIC] [TIFF OMITTED] 79559.162
[GRAPHIC] [TIFF OMITTED] 79559.163
[GRAPHIC] [TIFF OMITTED] 79559.164
[GRAPHIC] [TIFF OMITTED] 79559.165
[GRAPHIC] [TIFF OMITTED] 79559.166
[GRAPHIC] [TIFF OMITTED] 79559.167
[GRAPHIC] [TIFF OMITTED] 79559.168
[GRAPHIC] [TIFF OMITTED] 79559.169
[GRAPHIC] [TIFF OMITTED] 79559.170
[GRAPHIC] [TIFF OMITTED] 79559.171
[GRAPHIC] [TIFF OMITTED] 79559.172
[GRAPHIC] [TIFF OMITTED] 79559.173
[GRAPHIC] [TIFF OMITTED] 79559.174
[GRAPHIC] [TIFF OMITTED] 79559.175
[GRAPHIC] [TIFF OMITTED] 79559.176
[GRAPHIC] [TIFF OMITTED] 79559.177
[GRAPHIC] [TIFF OMITTED] 79559.178
[GRAPHIC] [TIFF OMITTED] 79559.179
[GRAPHIC] [TIFF OMITTED] 79559.180
[GRAPHIC] [TIFF OMITTED] 79559.181
[GRAPHIC] [TIFF OMITTED] 79559.182
[GRAPHIC] [TIFF OMITTED] 79559.183
[GRAPHIC] [TIFF OMITTED] 79559.184
[GRAPHIC] [TIFF OMITTED] 79559.185
[GRAPHIC] [TIFF OMITTED] 79559.186
[GRAPHIC] [TIFF OMITTED] 79559.187
[GRAPHIC] [TIFF OMITTED] 79559.188
[GRAPHIC] [TIFF OMITTED] 79559.189
[GRAPHIC] [TIFF OMITTED] 79559.190
[GRAPHIC] [TIFF OMITTED] 79559.191
[GRAPHIC] [TIFF OMITTED] 79559.192
[GRAPHIC] [TIFF OMITTED] 79559.193
[GRAPHIC] [TIFF OMITTED] 79559.194
[GRAPHIC] [TIFF OMITTED] 79559.195
[GRAPHIC] [TIFF OMITTED] 79559.196
[GRAPHIC] [TIFF OMITTED] 79559.197
[GRAPHIC] [TIFF OMITTED] 79559.198
[GRAPHIC] [TIFF OMITTED] 79559.199
[GRAPHIC] [TIFF OMITTED] 79559.200
[GRAPHIC] [TIFF OMITTED] 79559.201
[GRAPHIC] [TIFF OMITTED] 79559.202