[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
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                 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


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