[House Hearing, 108 Congress]
[From the U.S. Government Publishing Office]
A REVIEW OF FASB ACTION POST-ENRON AND WORLDCOM
=======================================================================
HEARING
before the
SUBCOMMITTEE ON
COMMERCE, TRADE, AND CONSUMER PROTECTION
of the
COMMITTEE ON ENERGY AND COMMERCE
HOUSE OF REPRESENTATIVES
ONE HUNDRED EIGHTH CONGRESS
FIRST SESSION
__________
MARCH 4, 2003
__________
Serial No. 108-17
__________
Printed for the use of the Committee on Energy and Commerce
Available via the World Wide Web: http://www.access.gpo.gov/congress/
house
__________
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COMMITTEE ON ENERGY AND COMMERCE
W.J. ``BILLY'' TAUZIN, Louisiana, Chairman
MICHAEL BILIRAKIS, Florida JOHN D. DINGELL, Michigan
JOE BARTON, Texas Ranking Member
FRED UPTON, Michigan HENRY A. WAXMAN, California
CLIFF STEARNS, Florida EDWARD J. MARKEY, Massachusetts
PAUL E. GILLMOR, Ohio RALPH M. HALL, Texas
JAMES C. GREENWOOD, Pennsylvania RICK BOUCHER, Virginia
CHRISTOPHER COX, California EDOLPHUS TOWNS, New York
NATHAN DEAL, Georgia FRANK PALLONE, Jr., New Jersey
RICHARD BURR, North Carolina SHERROD BROWN, Ohio
Vice Chairman BART GORDON, Tennessee
ED WHITFIELD, Kentucky PETER DEUTSCH, Florida
CHARLIE NORWOOD, Georgia BOBBY L. RUSH, Illinois
BARBARA CUBIN, Wyoming ANNA G. ESHOO, California
JOHN SHIMKUS, Illinois BART STUPAK, Michigan
HEATHER WILSON, New Mexico ELIOT L. ENGEL, New York
JOHN B. SHADEGG, Arizona ALBERT R. WYNN, Maryland
CHARLES W. ``CHIP'' PICKERING, GENE GREEN, Texas
Mississippi KAREN McCARTHY, Missouri
VITO FOSSELLA, New York TED STRICKLAND, Ohio
ROY BLUNT, Missouri DIANA DeGETTE, Colorado
STEVE BUYER, Indiana LOIS CAPPS, California
GEORGE RADANOVICH, California MICHAEL F. DOYLE, Pennsylvania
CHARLES F. BASS, New Hampshire CHRISTOPHER JOHN, Louisiana
JOSEPH R. PITTS, Pennsylvania TOM ALLEN, Maine
MARY BONO, California JIM DAVIS, Florida
GREG WALDEN, Oregon JAN SCHAKOWSKY, Illinois
LEE TERRY, Nebraska HILDA L. SOLIS, California
ERNIE FLETCHER, Kentucky
MIKE FERGUSON, New Jersey
MIKE ROGERS, Michigan
DARRELL E. ISSA, California
C.L. ``BUTCH'' OTTER, Idaho
David V. Marventano, Staff Director
James D. Barnette, General Counsel
Reid P.F. Stuntz, Minority Staff Director and Chief Counsel
______
Subcommittee on Commerce, Trade, and Consumer Protection
CLIFF STEARNS, Florida, Chairman
FRED UPTON, Michigan JAN SCHAKOWSKY, Illinois
BARBARA CUBIN, Wyoming Ranking Member
JOHN SHIMKUS, Illinois HILDA L. SOLIS, California
JOHN B. SHADEGG, Arizona EDWARD J. MARKEY, Massachusetts
Vice Chairman EDOLPHUS TOWNS, New York
GEORGE RADANOVICH, California SHERROD BROWN, Ohio
CHARLES F. BASS, New Hampshire JIM DAVIS, Florida
JOSEPH R. PITTS, Pennsylvania PETER DEUTSCH, Florida
MARY BONO, California BART STUPAK, Michigan
LEE TERRY, Nebraska GENE GREEN, TexasAREN McCARTHY,
ERNIE FLETCHER, Kentucky Missouri
MIKE FERGUSON, New Jersey TED STRICKLAND, Ohio
DARRELL E. ISSA, California DIANA DeGETTE, Colorado
C.L. ``BUTCH'' OTTER, Idaho JOHN D. DINGELL, Michigan,
W.J. ``BILLY'' TAUZIN, Louisiana (Ex Officio)
(Ex Officio)
(ii)
?
C O N T E N T S
__________
Page
Testimony of:
Herz, Robert H., Chairman, Financial Accounting Standards
Board...................................................... 6
Material submitted for the record:
Herz, Robert H., Chairman, Financial Accounting Standards
Board, letter dated March 28, 2003, enclosing response for
the record................................................. 37
(iii)
A REVIEW OF FASB ACTION POST-ENRON AND WORLDCOM
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TUESDAY, MARCH 4, 2003
House of Representatives,
Committee on Energy and Commerce,
Subcommittee on Commerce, Trade,
and Consumer Protection
Washington, DC.
The subcommittee met, pursuant to notice, at 3 p.m., in
room 2123, Rayburn House Office Building, Hon. Cliff Stearns
(chairman) presiding.
Members present: Representatives Stearns, Shimkus, Bass,
Ferguson, Issa, Otter, Schakowsky, Solis, Markey, Green,
McCarthy, and Strickland.
Staff present: Brian McCullough, majority counsel; David
Cavicke, majority counsel; Ramsen Betfarhad, majority counsel;
Shannon Vildostegui, majority counsel; Will Carty, legislative
clerk; and Consuela Washington, minority counsel.
Mr. Stearns. This is the Subcommittee on Commerce, Trade,
and Consumer Protection. Good afternoon. I would like to take
this opportunity to welcome the subcommittee, my colleagues. I
know there is another hearing right now. I also want to welcome
our new subcommittee ranking member, Ms. Jan Schakowsky of
Illinois. I look forward to working closely with her and
advancing our productive agenda, bipartisan, of our committee.
So I appreciate her help and her background.
It is also the first time for Mr. Herz to testify before
the committee since he took the helm of the Financial
Accounting Standards Board. So I want to thank him for coming,
and we appreciate his insight.
What a difference a year makes. Last year at this time we
held hearings in this committee directly related to the
collapse of Enron. Among the most significant questions that
arose were how a Fortune 100 company's true financial condition
could be disguised absent a fraud.
As details of the Enron case surfaced, it was clear that
Enron did not consolidate many of its financial obligations,
often losing the company millions that it had in partnerships
and other entities.
While Enron's use of the special purpose entity was
intended to remove debt from the books of the parent company,
thus presenting a healthier financial picture, we learned that
certain accounting standards permitted many of Enron's
activities.
Foremost among those was the standard for consolidation of
special purpose entities. The standard permitted that the
parent keep the financial partnership off its books for as
little as a 3 percent equity investment.
We subsequently learned that in one case, it was only
because of a technical violation that Enron failed the 3
percent test and was forced to restate its financials. Still,
we learned that the use of special purpose entities was
widespread. And in most cases, they were being used for
legitimate purposes. The fact that SPEs could be both
legitimate and also abused at fantastic levels raised some very
troubling questions about our entire financial accounting
standard system and the standards that govern it.
As more corporate failures and scandals splashed across the
headlines throughout the year 2002, the importance of
transparent accounting standards became clear to everyone.
FASB's mission is laudable but not enviable. It is a difficult
task to develop financial accounting standards that keep pace
with a rapidly changing business environment.
To its credit, the board has undertaken a number of
activities in an unprecedented timeframe trying to bring
greater transparency to financial reporting and ultimately
restoring investor confidence in such reporting. The so-called
special purpose entities standard that was abused by Enron has
already been changed to reflect true economic risk.
Additionally, FASB has addressed the issue of accounting for
and disclosing of guarantees and issued new requirements for
energy trading contracts.
Among the changes FASB has given itself; more specifically,
its administration and processes, a tune-up, so to speak. They
have instituted some key operational changes to improve the
efficiency and timeliness of issuing standards. This is a
welcome change that has already produced results.
Additionally, while FASB should be praised for historically
having an open and inclusive process, it has taken an
additional and indeed very significant step toward both
improving its process and product, the formation of the user
advisory council.
This council was formed to receive input from the user
community; that is, those in the investment community,
including pension funds, mutual funds, and independent analysts
that use the financial reporting.
I understand they held their first meeting last month. And
I, of course, am anxious with my colleagues to hear more about
the council. Although specific standards were often the topic
of discussion, they highlighted the fact that our accounting
system is based on very detailed standards where exceptions to
the standards can be more detailed than even the standards.
By comparison, the European system and specifically the
British model rely more on general accounting principles than
individual standards. This, in turn, requires auditors to make
learned judgments that must be justified.
I think that there is some learning to be had for us from a
principle-based system. In fact, I included a provision in
legislation that I authored last year, H.R. 5058, and that this
subcommittee approved requiring committees to issue financial
statements based on three fundamental principles. I am,
therefore, pleased to see that FASB has already issued a
proposal for comment on the topic of principle-based accounting
and conducted a roundtable discussion to begin the dialog on a
very complex issue. This subcommittee was one of the leaders in
pushing principle-based accounting in our legislation, H.R.
5058, and I am glad to see that FASB is at least starting a
roundtable discussion.
While it may seem less important, the FASB has entered into
a memorandum of understanding with the International Accounting
Standards Board on the goal of convergence of financial
accounting standards as the European Commission is pressing
hard to have all 7,000 public companies in the EU member states
adhere to the international accounting standards by 2005. The
issue of convergence or harmonization of accounting standards
will in my opinion be the most critical issue facing FASB in a
year or 2.
In theory, I am hopeful that in harmonizing, the benefits
of each accounting system will prevail. However, I cannot
dismiss the notion that we may be sacrificing some of our
autonomy in the process. I am also concerned as to how the
convergence will affect our companies. We need to be careful so
that financial accounting standards do not become yet another
set of pawns being played for sake of gaining an advantage in
international trade and competitiveness.
Although this is the first hearing on accounting standards
this Congress, I can assure you it will not be our last.
Unfortunately, as our recent financial history was somewhat
defined by corporate collapses of historic proportions, we all
now realize how vitally important it is to maintain high-
quality and effective financial accounting standards.
Again, Mr. Herz, I want to thank you very much for your
attendance today. And, with that, I welcome the opening
statement of our ranking member.
Ms. Schakowsky. Thank you, Chairman Stearns. I appreciate
your convening this hearing today. This is my first hearing
since becoming the ranking member of this very important
subcommittee. And I am honored to be here. I look forward to
working with you and all of the members on both sides of the
aisle to protect the rights of consumers.
I want to thank the Financial Accounting Standards Board,
FASB, Chairman Herz for appearing before this committee today
and for taking the time before this hearing to come and meet
with me, as I know you have with many of the stakeholders that
are involved in this issue. I appreciate that kind of diligent,
good outreach.
Today's hearing will give us an opportunity to aid FASB's
efforts, to improve our accounting standards and strengthen
corporate accountability. Restoring credibility in accounting
is extremely important to our economy. We need to restore
investor confidence in our financial markets to create jobs and
help our struggling economy.
Since January 2001, we have lost 2 million private sector
jobs. Corporate greed and fraud have had a terrible impact on
our economy. CEOs at firms under investigation by Federal
regulators and law enforcement agencies have pocketed $1.4
billion in the last 3 years. During the first 7 months of 2002,
the value of shares at these firms plunged by $530 billion. And
we can't let history repeat itself.
After initial resistance by the Bush administration and the
House leadership, Congress finally acted by passing the
Sarbanes-Oxley Act. At the time I was a member of the Financial
Services Committee. So I am very familiar with this
legislation.
Sarbanes-Oxley represents a positive first step, but it
will not make a real impact unless it is vigorously implemented
and corporate criminals are aggressively prosecuted. To date,
neither has happened. Here we are over 5 months later, and
corporate criminals remain free while workers and investors are
paying the price of Ken Lay's and other corporate executives'
misdeeds. The SEC has yet to implement many reforms. And the
public accounting office board is still not up and running.
Today we will focus on FASB's role in reforming the accounting
industry.
Mr. Chairman, I thank you for holding this hearing because
we need to make the private sector and Federal regulators
implement reforms. This is an urgent situation. FASB has an
important role to play in this process.
I look forward to hearing from Chairman Herz. In his short
term at FASB, the chairman has taken action to help close
loopholes that have allowed corporations to deceive investors
by creating special purpose entities, or SPEs.
Enron's insiders used SPEs to hide debt and to deceive
workers and investors. FASB has changed the rules for
accounting of SPEs. In order for a corporation to create an
SPE, the parent company must own no more than 90 percent of the
SPE. And they must pass a seven-factor test. In the past, it
was a 97 percent threshold. I look forward to learning more
about this new standard.
FASB is also wrestling with the question of whether or not
to expense stock options. I want to go on record as strongly
supporting expensing stock options. And I recently wrote to you
with several of my colleagues to encourage FASB, to take action
to expense stock options.
Mr. Chairman, I would like to submit that letter for the
record.
Mr. Stearns. By unanimous consent, so ordered.
[The letter offered by Hon. Jan Schakowsky appears at the
end of the hearing.]
Ms. Schakowsky. Opponents of expensing stock options
contend expensing would lead to the elimination of stock option
plans for rank and file workers. However, according to the U.S.
Bureau of Labor Statistics, in 2001 only 1.7 percent of non-
executives received stock options.
Federal Reserve Chairman Alan Greenspan and corporations
such as Coca-Cola, Gnarl Motors, Boeing, Home Depot are among
the over 120 companies that expense stock options. We should
make sure that all corporations play by the same set of rules.
This will help investors get a more accurate picture of their
investments and will help prevent future Enrons.
The Sarbanes-Oxley mandated FASB to collect user fees. I
understand that the fee mechanism has not yet been implemented.
This could lead to a funding crisis later this year. I am eager
to hear Chairman Herz's assessment of when he expects this new
system to be in place.
I know FASB is working to improve international accounting
standards, the accounting treatment of loans, as well as many
other very important initiatives. I look forward to learning
more about FASB's progress on all of these issues.
Finally, in the past, Congress has too often weighed in at
the behest of powerful special interests to block reforms. I
hope members will learn from the past and will allow FASB to do
its job. I look forward to hearing Chairman Herz's testimony.
Thank you very much, Mr. Chairman.
Mr. Stearns. I thank my colleague.
And now the gentleman from Idaho, Mr. Otter.
Mr. Otter. I have nothing.
Mr. Stearns. Okay. Mr. Shimkus.
Mr. Shimkus. Mr. Chairman, is that 5 plus 3 minute rule in
effect here?
Mr. Stearns. We are very flexible.
Mr. Shimkus. I was a few minutes late.
Mr. Stearns. You can have 3 to 5 on your opening statement.
And we are going to go around.
Mr. Shimkus. I think I will defer, Mr. Chairman, and try to
take a few minutes when I get a chance.
Mr. Stearns. That would be fine. Okay.
[Additional statements submitted for the record follow:]
Prepared Statement of Hon. W.J. ``Billy'' Tauzin, Chairman, Committee
on Energy and Commerce
Thank you Chairman Stearns for holding this important hearing
today.
It was this time last year that this Committee held oversight
hearings on the Enron implosion and that this Subcommittee held
legislative hearings on important public policy issues involving
accounting standards. While our work exposing the fraud at Enron and
WorldCom was big news, much of our hard work in the accounting
standards area went unnoticed. These most certainly were not the sexy
issues of corporate governance failures and securities fraud that
dominated the headlines in 2002. Yet our discovery that some of the
accounting standards, when applied improperly, were used to hide the
financial condition of a company instead of reveal it was an important
one. Our work here last year, and the FASB's diligent efforts since
that time, will lay the foundation for reliable and transparent
disclosure in the years to come.
The FASB has been busy over the last year. One of the most
significant changes FASB made was not to the standards themselves but
to its own rules of procedure. FASB instituted new rules for its voting
process, changing the unwieldy supermajority voting mechanism to a
simple majority vote. This is in no small part responsible for the
quantity of issues FASB has begun to tackle in the past year. And, I
might add, the quality of work at the FASB has still been first rate.
Those projects include completed work on off balance sheet accounting
for special purpose entities as well as various proposals for comments
on principle-based accounting; the IASB's proposal for expensing of
stock options; and a myriad of revenue recognition issues.
The FASB Act, sponsored by Mr. Stearns and passed out of this
Subcommittee last Congress required FASB to resolve these issues. I
applaud the FASB for quickly adding these issues to its agenda, and
obviating the need for legislative direction.
The FASB has not yet, however, added the issue of accounting
treatment for loan commitments to its agenda. Since companies generally
invoke their commitments when they are on the brink of filing Chapter
11, these loan commitments leave lenders, and ultimately shareholders,
exposed. Current accounting rules do not require loan commitments to be
carried at fair value. As a result, shareholders have no means of
determining the extent of the lender's exposure to rapidly
deteriorating companies. For this reason, I urge FASB to add this
important issue to its agenda.
Finally, I want to call on the Securities and Exchange Commission
to recognize FASB standards as ``generally accepted'' for purposes of
the securities laws and thereby provide FASB with the funds necessary
for it to carry out its mandate. I encourage Chairman Donaldson to move
expeditiously so that the FASB can continue to do its important work.
I thank Chairman Herz for being here today and look forward to his
testimony. I yield back the balance of my time.
______
Prepared Statement of Hon. Gene Green, a Representative in Congress
from the State of Texas
Good afternoon. I would like to thank Chairman Stearns for having
this hearing on the state of accounting regulations in the aftermath of
the corporate collapses that devastated communities across the country
over the last couple of years.
I am very interested in what Mr. Herz, the Chairman of the
Financial Accounting Standards Board has to tell us about all his
activities in his new post of critical importance to America's life
savings.
My primary concern with the state of the accounting industry is the
lack of auditor independence.
How can individuals and pension funds trust accountants who are
auditing the books for minor fees, while at the same time pulling down
millions and millions over many years in lucrative tax, management, and
information technology (IT) consulting from the same companies?
FASB does not regulate this, but Congress does, and we urgently
need FASB's professional opinion on this issue. It is now accepted that
aggressive accounting has become a way for the Big Four accounting
firms to compete with each other for access to the consulting
businesses.
Unfortunately the questionable practice of accounting firms selling
tax advice has been allowed to continue under Sarbanes-Oxley.
Accounting companies in America, the defenders of the public's right to
know how their money is being spent by these companies, are
simultaneously competing with each other on who can have the most
aggressive accounting and tax treatments.
The result is the fleecing of American investors and American
taxpayers. They are getting us coming and going.
FASB is the ultimate expert in America on issues of accounting, and
I would like to know whether they, as accounting regulatory
professionals, believe it is possible for quality audits to be
performed by the same people shopping tax avoidance schemes.
The most important issue that I believe is before the FASB for
decision making right now is what is known in the industry as ``special
purpose entities'' or SPEs, but what I refer to as pure deception.
These corporate fraud vehicles are intended to conceal debt and
other liabilities from the publicly available, audited balance sheets
of public corporations. Millions of individual American investors and
the many pension funds that hold the life savings of millions more
working Americans depend absolutely on the integrity of the public
financial information.
I am a little concerned that the central part of the new rule
appears to be raising the minimum outside investment in a SPE from 3%
to 10%. On its face, it still seems unnatural for a company to create
an entity in which it has a 90% stake that is not recorded on the
balance sheet. I look forward to learning from the Chairman of FASB the
other specifics of the SPE rule.
Thank you Mr. Chairman, and I look forward to improving corporate
governance with all the Members of this panel.
Mr. Stearns. Well, Mr. Herz, we want to welcome you,
Chairman of the Financial Accounting Standards Board. And we
look forward to your testimony and some of the things you have
been doing. So the floor is all yours.
STATEMENT OF ROBERT H. HERZ, CHAIRMAN, FINANCIAL ACCOUNTING
STANDARDS BOARD
Mr. Herz. Thank you, Chairman Stearns, Ranking Member
Schakowsky, and members of the subcommittee. I thank you for
the invitation to appear today to review with you the actions
and activities of the Financial Accounting Standards Board
since the bankruptcies of Enron and Worldcom.
I have some brief prepared remarks. And I would
respectfully request that the full text of my testimony and all
supporting materials be entered into the public record.
Mr. Stearns. By unanimous consent, so ordered.
Mr. Herz. As you know, the FASB is an independent private
sector organization. We are not part of the Federal Government.
And our independence from reporting enterprises, auditors, and
the Federal Government is fundamental to achieving our mission,
to set accounting and reporting standards to benefit the users
of financial information, most notably investors and creditors.
Those users rely heavily on credible, transparent, comparable,
and unbiased financial reports for effective participation in
the capital markets.
Also, the FASB has no power to enforce its standards.
Rather, 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 enterprises ultimately
with the Securities and Exchange Commission.
Clearly the events of the past year have shaken confidence
in our reporting system and in our capital markets. While I
think most of the problems seem to stem from outright
violations of rules, fraud, and apparent audit and corporate
governance failures, those problems also have prompted broader
questions about virtually every aspect of our financial
reporting system, including financial accounting and reporting
standards and the accounting standard-setting process.
I think those questions are appropriate. I think they are
healthy. Frankly, I think they were overdue. As with crises in
other areas of business or life, this crisis prompts
reflection, introspection, a better understanding, and then
rebuilding, change, and renewal. So it must be with our
financial reporting system. And I think a major lesson and an
indelible reminder from this crisis is that sound financial
reporting is indeed very key to the health and vitality of our
capital markets; our economy; and, therefore, to our society as
a whole. It matters.
So what are we at the FASB doing to fulfill our critical
mission and to play our important role in helping improve
financial reporting and restore investor confidence? I think
the answer is many things, both in regard to specific technical
areas and in terms of our own operations and the whole
structure and direction of accounting standard setting in this
country.
First, on the technical front, we have significantly
modified our agenda and priorities in direct response to issues
that have come to light in the many scandals. These issues
include the accounting for special purpose entities, accounting
for guarantees, energy trading contracts, stock-based
compensation, and the very broad area of revenue recognition.
Let me briefly touch on each of those items and what we have
been doing.
First, with respect to SPEs, as you mentioned, we issued
new requirements in January 2003. Those requirements provide
that enterprises with investments or other relationships with
SPEs must carefully assess their involvement to determine
whether they receive a majority of the risks or rewards of
those SPEs. If so, the enterprises would be required to report
the assets, liabilities, and gains and losses of those SPEs
within their own financial statements.
We expect that under the new requirements, many, but
certainly not all, of the SPEs that are currently not reported
by any enterprise would so be in the future. The new
requirements also significantly improve the disclosures related
to an enterprise's use of and involvement with SPEs.
In a closely related project on accounting and disclosure
for guarantees, we issued new requirements in November 2002.
Those requirements provide that all enterprises recognize a
liability at fair value for the obligations they undertake when
issuing a guarantee and that those enterprises make additional
disclosures about the guarantees. We believe that the new
requirements will result in a more representationally faithful
depiction of an enterprise's obligations.
In October 2002, our Emerging Issues Task Force, known as
EITF, and the FASB staff addressed certain practice issues
related to the accounting for energy trading contracts. The
EITF decided to preclude mark-to-market accounting for certain
difficult-to-value energy trading contracts. The EITF also
decided to require that gains on certain energy trading
contracts be shown net, rather than gross, in the financial
reports.
At the same time, the FASB staff observed that no
enterprise should recognize an up-front gain at the inception
of entering into certain financial contracts unless the fair
value of those contracts is clearly evidenced by observable
market transactions or market data.
We also have a current project on our agenda to improve the
existing accounting requirements for measuring and disclosing
the fair value of essentially all financial instruments.
In December 2002, we issued new requirements relating to
the accounting for stock-based compensation in order to deal
with the more than--it is now about 180 enterprises that have
voluntarily said they would change to the preferable fair value
approach for expensing of stock-based compensation. Those
requirements address how the companies make that switch.
Moreover, the new requirements also provide for clearer and
more prominent disclosures about the costs of stock-based
compensation. They also increase the frequency of key stock-
based compensation disclosures from annually to quarterly.
We also issued a preliminary document for public comment
about the accounting for stock-based compensation in November
2002. That document was issued to explain the similarities and
differences between the recent proposed requirements by our
international counterpart, the International Accounting
Standards Board, and the preferable fair value approach under
existing U.S. standards.
We have been carefully reviewing the input received on that
document and other input we have been receiving from investors,
analysts, enterprises, and Members of Congress about a variety
of issues relating to the accounting for stock-based
compensation. We will soon deliberate at a public meeting
whether the board should add a new project to its agenda to
pursue further improvements in this area, including whether we
should mandate the preferable fair value approach to stock
options. Of course, any new project to pursue further changes
to the accounting and reporting for stock-based compensation
would be subject to the FASB's open and thorough due process
procedures.
Finally, with respect to our technical activities, our EITF
issued new requirements in November 2002 addressing certain
revenue recognition issues arising from revenue arrangements
with multiple deliverables. Those requirements should improve
the comparability and transparency of the reporting of revenue
from the delivery or performance of multiple products,
services, or rights to use assets.
As a longer-term solution to the many issues surrounding
the accounting for revenue recognition, we also added a major
project to the FASB's agenda addressing this whole area. The
objective is to develop jointly with the international board a
coherent, conceptually consistent model for revenue recognition
that would replace much of the existing literature and that
would serve as a principles-based source for developing future
accounting guidance as new types of transactions emerge in the
marketplace.
Now let me turn to our own operations and some comments
about the structure and direction of accounting standard
setting in this country.
Last year when I joined, we launched a series of wide-
ranging reviews covering a broad range of issues. Some of the
key aspects of our reviews and findings relate to improving our
speed and timeliness, increasing the involvement of investors
and other users of financial reports in our activities, the
topic of principles-based accounting and international
convergence and how all of these things impact the structure
and direction of U.S. accounting standard setting.
With respect to improving our own speed and timeliness, our
independent oversight body, the Financial Accounting
Foundation, amended our rules of procedure last year to require
only a four to three vote of the board, rather than the
previous 5 to 2 vote, to issue both proposals and final
standards.
Also, last year we implemented a reorganization of our
senior staff to enhance the focus and accountability of our
staff activities. We are also conducting a thorough process of
mapping all our procedures in order to identify and to
hopefully eliminate those procedures that are redundant or do
not add value, while at the same time not compromising our
thorough and open due process.
To increase the involvement of investors and other users of
financial reports in our activities, we recently established
the User Advisory Council. The council includes representatives
from mutual fund groups, major investment and commercial banks,
rating agencies, and other groups that represent investors and
other key users. We held our first public meeting of the UAC on
February 13, 2003. We intend to use the UAC as a source of
input on our agenda and on specific issues within ongoing
projects.
We issued a proposal for public comment on the whole
subject of principles-based accounting standards in October
2002. In December, we held a public roundtable on that subject.
In coming weeks, we expect to discuss at public board
meetings the input received we have received on that. And we
plan to continue to work closely with the SEC as it responds to
the principles-based study requirements contained in the
Sarbanes-Oxley Act.
We also have, as you mentioned, been devoting significant
resources to the area of international convergence. We are
working together on several major projects.
We also, as you noted, reached a historic agreement with
the international board to use our best efforts to align our
agendas and, very importantly, undertake a specific project
with the help and support of the SEC staff aimed at
accelerating the convergence process by trying to eliminate or
narrow some of the areas of difference between current U.S. and
international standards. Because there are literally hundreds
of differences between U.S. and international standards,
realistically this effort will still be ongoing well beyond
2005, when Europe adopts international standards en masse. But
we need to set this process in motion so that we can make real
progress.
Finally, with respect to structural improvements to U.S.
standard setting, we have made recent changes that we believe
are necessary to better control the proliferation and
consistency of U.S. accounting standards. First, we decided
that the role of the Accounting Standards Executive Committee
of the American Institute of Certified Public Accountants as a
second senior-level accounting standard setter in the U.S.
would after a transition period of approximately 1 year be
discontinued.
Second, we decided that with regard to our own EITF, we
needed to take more involvement in the agenda deliberations and
ultimate decisions of that group.
This has been a brief summary of some of our many actions
and activities at the FASB. These actions and activities are
designed to better meet the challenges and opportunities that
face us and that I believe face the financial reporting system.
I hope you will agree that it is not business as usual for us.
I believe the overriding goal must be improvement of the
overall financial accounting and reporting system in this
country. That's what it is all about: sound, transparent,
unbiased information that the system needs to work effectively.
I know that many Members of Congress and the investing public
are demanding that we and others continue to take bold and
decisive actions to restore investors' confidence. The capital
markets expect it. And I believe that our country deserves
nothing less.
Thank you again, Mr. Chairman, Ranking Member Schakowsky,
and all members of the subcommittee. I appreciate your
continued interest in support of our mission and our
activities. And I would be happy to respond to any questions
you may have.
[The prepared statement of Robert H. Herz follows:]
Prepared Statement of Robert H. Herz, Chairman, Financial Accounting
Standards Board
Chairman Stearns, Ranking Member Schakowsky, and the Members of the
Subcommittee, thank you for the invitation to appear today to review
with you the actions and activities of the Financial Accounting
Standards Board (``FASB'' or ``Board'') since the bankruptcies of Enron
Corp. (``Enron'') and WorldCom, Inc. (``WorldCom''). I have brief
prepared remarks, and I would respectfully request that the full text
of my testimony and all supporting materials be entered into the public
record.
The FASB is an independent private-sector organization. We are not
part of the federal government. Our independence from reporting
enterprises, auditors, and the federal government is fundamental to
achieving our mission--to set accounting and reporting standards to
benefit the users of financial information--most notably, investors and
creditors. Those users rely heavily on credible, transparent,
comparable, and unbiased financial reports for effective participation
in the 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 enterprises,
ultimately with the Securities and Exchange Commission (``SEC'').
Clearly, the events of the past year have shaken confidence in our
reporting system and in our capital markets. While most of the problems
seem to stem from outright violations of rules, fraud, and apparent
audit and corporate governance failures, those problems also have
prompted broader questions about virtually every aspect of our
financial reporting system, including financial accounting and
reporting standards and accounting standard setting.
I think those questions are appropriate and are healthy, and, quite
frankly, I think they were overdue. As with crises in other areas of
business or life, this crisis prompts reflection, introspection, a
better understanding, and then rebuilding, change, and renewal. So it
must be with our financial reporting system. And, I think a major
lesson and an indelible reminder from this crisis is that sound
financial reporting is indeed very key to the health and vitality of
our capital markets, our economy, and our society as a whole. It
matters!
So, what are we at the FASB doing to fulfill our mission and to
play our important role in helping improve financial accounting and
reporting and restore investor confidence? The answer is many things--
in regard to specific technical areas, in terms of our own operations,
and in terms of the whole structure and direction of accounting
standard setting in this country.
On the technical front, we have significantly modified our agenda
and priorities in direct response to issues that have come to light
since the Enron and WorldCom bankruptcies. These issues include the
accounting for special-purpose entities (``SPEs''), guarantees, energy
trading contracts, stock-based compensation, and the broad area of
revenue recognition. Let me touch briefly on each of those items.
With respect to SPEs, we issued new requirements in January 2003.
Those requirements provide that enterprises with investments or other
relationships with SPEs must carefully assess their involvement to
determine whether they receive a majority of the risks or rewards of
those SPEs. If so, the enterprises are required to report the assets,
liabilities, and gains and losses of those SPEs within their own
financial statements. We expect that under the new requirements many,
but certainly not all, of the SPEs that currently are not reported by
any enterprise will be reported in the future. The new requirements
also significantly improve the disclosures related to an enterprise's
use of, and involvement with, SPEs.
In a closely related project on accounting and disclosure of
guarantees, we issued new requirements in November 2002. Those
requirements provide that all enterprises recognize a liability at fair
value for the obligations they undertake when issuing a guarantee and
that those enterprises make additional disclosures about the
guarantees. We believe the new requirements will result in a more
representationally faithful depiction of an enterprise's liabilities.
The requirements will also improve the transparency of enterprise's
obligations and liquidity risks related to the guarantees it issues.
In October 2002, our Emerging Issues Task Force (``EITF'') and the
FASB staff addressed certain practice issues related to the accounting
for energy trading contracts. The EITF decided to preclude mark-to-
market accounting for certain difficult-to-value energy trading
contracts. The EITF also decided to require that gains on certain
energy trading contracts be shown net (rather than gross) in financial
reports. At the same time, the FASB staff observed that no enterprise
should recognize an upfront gain at the inception of entering into
certain financial contracts, unless the fair value of those contracts
are clearly evidenced by observable market transactions or market data.
We also have a current project on our agenda to improve the
existing accounting requirements for measuring and disclosing the fair
value of essentially all financial instruments, including those whose
fair value cannot be reliably measured by observable market
transactions or market data.
In December 2002, we issued new requirements relating to the
accounting for stock-based compensation. Those requirements allow the
more than 170 enterprises that are voluntarily changing to the
preferable fair value approach of accounting for stock-based
compensation to effect that change in several alternative manners.
The new requirements also provide for clearer and more prominent
disclosures about the costs of stock-based compensation. Finally, the
new requirements increase the frequency of key stock-based compensation
disclosures from annually to quarterly.
We also issued a preliminary document for public comment about the
accounting for stock-based compensation in November 2002. That document
explains the similarities and differences between recent proposed
requirements by our international counterpart, the International
Accounting Standards Board (``IASB''), and the preferable fair value
approach under existing US standards.
We have been reviewing the input received on that document and
other input we have been receiving from investors, analysts,
enterprises, and some Members of Congress about a variety of issues
relating to the accounting for stock-based compensation. We will soon
deliberate, at a public meeting, whether the Board should add a new
project to its agenda to pursue further improvements in this area,
including whether we should mandate the preferable fair value approach.
Of course, any new project to pursue further changes to the accounting
and reporting for stock-based compensation would be subject to the
FASB's open and thorough due process procedures.
Finally, with respect to our technical activities, our EITF issued
new requirements in November 2002 addressing certain revenue
recognition issues arising from revenue arrangements with multiple
deliverables. Those requirements should improve the comparability and
transparency of the reporting of revenue from the delivery or
performance of multiple products, services, or rights to use assets.
Examples of those types of arrangements include the sale of a cellular
telephone with related telephone service, or the sale of medical
equipment with related installation service.
As a longer-term solution to the many issues surrounding the
accounting for revenue recognition, we added a major project to the
FASB's agenda addressing this whole area broadly. The objective is to
develop, jointly with the IASB, a coherent, conceptually consistent
model for revenue recognition that would replace much of the existing
literature and that would serve as a principles-based source for
developing future accounting guidance as new types of transactions
emerge in the marketplace.
In terms of our own operations and the whole structure and
direction of accounting standard setting in this country, last year we
launched a series of wide-ranging reviews covering a broad range of
issues in this area. Some of the key aspects of our review and findings
relate to improving our speed and timeliness, increasing the
involvement of investors and other users of financial reports in our
activities, the topic of a principles-based accounting system,
international convergence, and how all of these things impact the
structure and direction of US accounting standard setting.
With respect to improving speed and timeliness, our independent
oversight body--the Financial Accounting Foundation--amended our Rules
of Procedure last year to require only a four to three vote of the
Board, rather than a five to two vote, to issue both proposals and
final standards.
Also last year we implemented a reorganization of our senior staff
to enhance the focus and accountability of our staff activities. We
also are conducting a thorough process mapping of all our procedures in
order to identify and to hopefully eliminate those procedures that are
redundant or do not add value, while at the same time not compromising
our thorough and open due process.
To increase the involvement of investors and other users of
financial reports in our activities, we recently established the User
Advisory Council (``UAC''). The UAC includes representatives from
mutual fund groups, major investment and commercial banks, rating
agencies, and other groups that represent investors and other key
users. We held our first public meeting of the UAC on February 13,
2003. We intend to use the UAC as a source of input on FASB agenda
decisions and on specific issues within ongoing FASB projects.
We issued a proposal for public comment on the whole subject of
principles-based accounting standards in October 2002. In December
2002, we held a public roundtable meeting with respondents to discuss
various aspects of that proposal.
In the coming weeks, we expect to discuss at public Board meetings
the input received in response to the proposal and decide what
additional actions, if any, the FASB should pursue in this area. We
also plan to continue to work closely with the SEC as it responds to
the principles-based study and reporting requirements contained in the
Sarbanes-Oxley Act of 2002.
We also have been devoting significant resources to the area of
international convergence. Our recent work in this area includes
developing procedures and protocols used not only by the FASB but also
by the IASB and other major national standards setters in working
together. In addition, we are working with the IASB on several major
joint projects, including, as mentioned earlier, revenue recognition,
business combinations, and reporting on financial performance. We are
also closely monitoring the progress of the IASB on other key projects.
In October 2002, we reached a historic agreement with the IASB to
use our best-efforts to align our agendas and, very importantly, to
undertake a specific project (with the help and support of the SEC
staff) aimed at accelerating the convergence process by trying to
eliminate or narrow some of the areas of difference between current US
and international standards. Because there are literally hundreds of
differences between US and international standards, realistically, this
effort will still be ongoing, well beyond 2005 when Europe adopts
international standards en masse. But we need to set this process in
motion now, so that we can achieve greater progress in this important
area going forward. The overall objective of international convergence
is not convergence just for the sake of convergence, but rather to
arrive at high-quality accounting solutions that improve the
transparency of financial reporting in the US and abroad.
Finally, with respect to structural improvements to US accounting
standard setting, the FASB made several recent changes that we believe
are necessary to better control the proliferation and consistency of US
accounting requirements. First, we decided that the role of the
Accounting Standards Executive Committee of the American Institute of
Certified Public Accountants as a second senior-level accounting
standard setter in the US would, after a transition period of
approximately one year, be discontinued. We also decided that, in the
future, the maintenance and development of any industry-based standards
would reside with the Board.
Second, we decided that with regard to our EITF, two FASB Board
members would become members of the EITF agenda committee and the FASB
Board members would more actively participate at all EITF meetings.
Moreover, all future EITF decisions would be subject to the FASB
Board's review and ratification. Finally, we broadened the composition
of the EITF to include a user representative to ensure that the user
perspective is properly considered in the EITF's deliberations.
This has been a brief summary of some of our many actions and
activities at the FASB, post-Enron and WorldCom. These actions and
activities are designed to better meet the challenges and opportunities
that face us and that face the financial reporting system. I hope you
will agree that it is not business as usual at the FASB and that we are
on the right track.
I believe that the overriding goal must be improvement of the
overall financial accounting and reporting system in this country.
That's what it is all about--sound, transparent, unbiased information
that the system needs to work effectively. I know that many Members of
Congress and the investing public are demanding that we and others
continue to take bold and decisive actions to restore investors'
confidence, the capital markets expect it, and I believe that our
country deserves nothing less.
Thank you again, Mr. Chairman, Ranking Member Schakowsky, and all
of the Members of the Subcommittee. I very much appreciate your
continuing interest in, and support of, the mission and activities of
the FASB.
I would be happy to respond to any questions.
Mr. Stearns. I thank the chairman.
Just for the members' record, if you were here when the
gavel came down and you did not have an opening statement,
you're passing on your opening statement, you will get 8
minutes for questions. Otherwise, everyone gets five. And so we
will proceed under that basis. And I will start.
Mr. Herz, I heard all the things you did. Could you say
today that what you did with special purpose entities, if that
had been in place, we would not have had an Enron perhaps?
Mr. Herz. Well, we would have had rules that would not have
allowed off balance sheet financing of some of the things that
Enron did. Whether or not the company and the auditors would
have acted as they did is another matter, I believe, but we
would have had rules that would have caught the type of
transactions, at least in theory, you know, the rules----
Mr. Stearns. So the transaction that supposedly Jeff
Skilling said he didn't know about but went forward could not
have gone forward under this scenario that you just----
Mr. Herz. It would have been counter to the new rules.
Mr. Stearns. So, instead of getting a 3 percent equity,
they would have to get a 10 percent equity.
Mr. Herz. Well, probably even more. I mean, the way the
standard is----
Mr. Stearns. What you might do is just briefly tell us in
reference to maybe an Enron what they would have to do under
this scenario that you have outlined so a layman could
understand it.
Mr. Herz. Yes. I will try as best I can after 30 years in
accounting.
The old rules, as you mentioned, allowed----
Mr. Stearns. And I might point out FASB took 25 years to
study the SPEs and came up with no clear conclusion. And you
have been in office 3 or 4 months, and you have already made
some major direction.
Mr. Herz. Thank you. I attribute that not only to me but to
all my board members and our staff.
Mr. Stearns. Well, it shows you did. The urgency was there
once we saw how easy it was to develop special purpose
entities.
Mr. Herz. Yes. The old rules, as you referred to, which, by
the way, the FASB did not actually write, if you can believe
it, they were contained in a question and answer by an SEC
staff question and answer that was appended to an EITF issue on
what were called build-to-suit leases, a very specific
transaction, but somehow that answer using the 3 percent as an
example kind of got canonized in practice. And people then used
it to develop a whole industry, so to speak, of off balance
sheet financing using special purpose entities.
That rule basically, as you outlined it correctly, was that
as long as somebody put up at least 3 percent, an independent
party, 3 percent of the total capitalization, meaning both debt
and equity, of an entity, the assets and borrowings could be
kept off the balance sheet and that entity would be treated as
if it were an independent party. So you could deal back and
forth with that entity as if you were doing it with General
Motors.
Mr. Stearns. You could hide lots of debt.
Mr. Herz. Yes. That really was manifested from the normal
consolidation rule that said that if somebody held the majority
of the voting equity, that party would consolidate, even though
that equity might be extremely thin and that vote may have
really no effect because the entity was largely on autopilot.
Its actions were predetermined.
Mr. Stearns. So tell me now how under the new rules what
the new rules would do to make----
Mr. Herz. Well, if the new rules first make a cut as to
whether one would use the old voting interest model for a
normal operating subsidiary, if you owned the majority of the
voting stock, you would consolidate, but what it looks at is
whether or not that entity is properly capitalized and whether
the people who have the vote have a meaningful vote if the
entity is a real operating entity. That requires, among other
things, kind of a presumption that there has to be at least 10
percent of capital to run that entity self-sustained.
Mr. Stearns. Independent of the corporation?
Mr. Herz. Independent of the corporation. And then if you
fail that, you then go into this realm of SPEs. The notion
there is that----
Mr. Stearns. How could you do an SPE if you failed that?
Mr. Herz. Well, you now say you are in a different model.
You are in a model that looks at risks and rewards, rather
than----
Mr. Stearns. It's no longer an SPE?
Mr. Herz. No, no. You are an SPE.
Mr. Stearns. But it's a different model of an SPE?
Mr. Herz. No, no. It's a different model for consolidation.
Mr. Stearns. Oh, okay.
Mr. Herz. The normal model for consolidation is still if
you own an operating subsidiary and you own 51 percent of the
stock and you control it or you have 100 percent of the stock
and it's a properly capitalized entity, it's self-sustaining,
you would continue to use the normal what we call voting
interest or control model.
The problem with SPEs was that they didn't suit that model.
They were thinly capitalized. The votes may have meant nothing.
And so we first have to filter to determine whether or not you
go into this alternative model, which is more of a risks and
rewards kind of model.
When you go in there, basically the principle is you look
for whoever has the majority of risks and rewards, no matter
how it is derived. It could be derived from the thin equity,
but it might be more often derived from various other forms of
interests and arrangements in that entity.
So, for example, in the Enron-type arrangements, where
basically they would have 100 percent of the up side and 97-
plus percent of the down side, even though somebody else might
have put up a thin amount of the actual equity, you would say,
``Well, I know who has the majority of the risks and the
rewards. It's not the person who owns that nominal amount of
equity. It's somebody else.'' And you would look for that party
looking for all of the arrangements. In the Enron situations,
it would have been clear.
Mr. Stearns. I can't say after listening to your
explanation that I am 100 percent confident that we could stop
Enrons. I mean, that is just my first observation, especially
when you say you don't have the power to enforce your
standards. So someone else has to enforce your standards once
you come up with this new--and I assume that would be the SEC.
Mr. Herz. At the first line of enforcement are the company
accountants, then the auditors, and ultimately the SEC.
Mr. Stearns. The gentleman from Massachusetts.
Mr. Markey. Thank you, Mr. Chairman.
Welcome. God bless you. God bless America. And we are going
to need a little help in this area and all of the people who
work with you.
How confident are you that the loopholes exploited by some
of the accounting professionals working at Enron and WorldCom
have been closed?
Mr. Herz. Again, I think I would like to kind of give you
total assurance in that regard, but that is beyond our role. We
write accounting and reporting standards. And we have written
standards to close----
Mr. Markey. Do you feel that you have closed the loopholes?
Mr. Herz. We believe we have closed----
Mr. Markey. And now it's an enforcement issue? Do you think
all of the loopholes are closed?
Mr. Herz. Then it becomes an application and enforcement
issue.
Mr. Markey. So you don't think there are any more
loopholes?
Mr. Herz. You know, in an area where there is endless
structuring, there are people who still spend most of their
time trying to find ways around whatever we do. I will never
say, ``Never.''
Mr. Markey. How can you in the future prevent the same type
of bootstrap argument by the issuers and the accounting
profession that you just described to the chairman of the
committee where a 3 percent equity interest test developed in
some real estate leases was transformed into the Enron SPE,
special purpose entity, loophole?
Mr. Herz. Well, I think we need to do our best in order to
identify all of those areas where you would look at it and say
the current accounting rules don't reflect the kind of
economics or common sense.
Mr. Markey. I guess what I am asking is, is it something
that you've looked at in the past that allowed for that
transformation, that in all subsequent regulations, you are
going to ensure that you protect against occurring?
Mr. Herz. I would say that we are trying to identify
through looking at reports, through discussion with the SEC,
through discussion with many groups, through discussion with
our new User Advisory Council all of those areas where
accounting doesn't seem to suit the underlying economics. Those
are the kind of areas where I think the exploitation occurs.
People say like the 3 percent rule, maybe other areas, like
leasing, that still exist. They say, ``Gee, this is an
opportunity to achieve an accounting result,'' favorable
accounting result, that doesn't match what is really going on.
Mr. Markey. So what are accounting issues, then, other than
the ones that you have noted in your testimony?
Mr. Herz. Well, these are only my personal opinion. I am
one of seven board members. So it's, again, my personal
opinion. I have a few----
Mr. Markey. Well, you are like the chairman of the
committee. My personal opinion doesn't count as much as the
chairman's personal opinion counts.
Mr. Herz. Right.
Mr. Markey. And the same thing is true, I assume, at FASB.
Mr. Herz. No, no. One member, one vote. And I have
administrative responsibilities, but all seven members vote on
our agenda and all seven members have one vote on all technical
issues.
That is important because we have a very deliberative
process.
Mr. Markey. Well, you know what would be important, Mr.
Chairman, I think at some point in the future, have all seven
of them sit here. Then we can ask each one of them if they
agree with the chairman so that we can see the difficulty that
he has in actually implementing the philosophy which he is
enunciating today.
Mr. Stearns. Yes. I think my colleague has got a good
point. We intend to have more hearings on this because it is
obviously a little complicated and we would like to see the
ongoing work that they are doing.
Mr. Markey. I think what he is telling us is that he is
constrained. Shakespeare used to say that the will is infinite,
but the execution is confined. What he is saying here is that
he has the will to do it, but his execution is confined in
getting the----
Mr. Stearns. When he was smiling a lot, I think that is
what he was conveying.
Mr. Markey. Yes, I know that.
Mr. Herz. I would have a very efficient process if I could
sit in the room and just write the rules myself, but they may
not be as good, high-quality as what comes out of our seven-
person process.
Mr. Markey. I think it is important for us to see of the
seven which of them has a blind eye and see how many of them
are coming into this, you know, that way. On the one hand, in
the land of the blind, the one eye is king, but in an era where
all investors can see quite clearly, what happened to them? And
what projections have to be put on the books? They don't want
any more blind-eyed regulators out there.
So it is very important, Mr. Chairman, for that to be made
clear because I think you can't answer with the specificity
that we need. And you are under tremendous pressure not to do
the right thing, tremendous pressure. I appreciate that because
the history of the agency is such that in 27 years on this
committee, I know how much pressure FASB has been under. I've
seen it, and I've heard it from your predecessor chairman.
I just want to make sure that we see more clearly what the
pressure is on you each day. Who are the other people? What are
their philosophies? Who are they responding to? Because that
ultimately will determine the compromises which you have to
accept that is less than what you would like to put on the
books as a full guarantee. I think that is absolutely critical
because we can't repeat the mistake again.
My district is a high tech district. And it's essentially
seen a shambles of hundreds of companies' stocks. And it's just
not something that investors or workers want to see happen
again. Honesty is ultimately the long-term best strategy. And
the puffing that went on is just something that can't be
allowed to recur again.
Mr. Herz. I appreciate your observations. I would note,
however, that just to make sure everybody in the audience
understands, all of our board members are full-time board
members. They severed their prior connections. So the seven-
person board is there to add quality. It comes from people with
different backgrounds, different pieces of insight. Again, I
wouldn't judge it as more kind of internal pressures and
compromise. It's a process to build in views and qualities.
Mr. Markey. If I may finish up, Mr. Chairman, you see, Mark
Twain used to say that history doesn't repeat itself, but it
does tend to rhyme. So you kind of wind up with a similar kind
of debate, a little bit different, but pretty much the same
debate, different characters, and whatever. So that's where you
are right now, not identical, but the same pressures are out
there.
And, again, it's the same eerie situation that we have with
the war in Iraq, where the price of oil is up at $40 a barrel.
It could be up there for 6 months. Somebody named Bush is
conducting a war. It's not identical, but it rhymes, you know,
looks close.
And that is really, I have found here after 27 years, the
way these issues tend to evolve. The pressures that you are
under I think are probably no different than the pressures that
any of your predecessors were under.
Anyway, I thank you, Mr. Chairman.
Mr. Stearns. I thank the colleague.
Mr. Otter from Idaho, you are recognized for 8 minutes.
Mr. Otter. Well, thank you, Mr. Chairman.
Following up on my colleague just prior to me, one of my
favorite quotes is what I am afraid we are practicing here
today. It comes from Matthew 15:14. That is, if the blind
leadeth the blind, they will both falleth in the ditch.
I am concerned about some of your responses to previous
questions. I guess I have to start out by asking, ``Have you
talked to the SEC about these new rules and regulations?''
Mr. Herz. We talk to the SEC every day.
Mr. Otter. Has the SEC agreed that these will stop the
loopholes?
Mr. Herz. They have reviewed, participated in what we do,
and I think they believe that the standard we have come out
with is a good, solid standard.
Mr. Otter. And they are prepared to say that?
Mr. Herz. Oh, yes. They have.
Mr. Otter. They have said it?
Mr. Herz. Yes.
Mr. Otter. So, then, let me ask you this question, why is
it ever necessary for an accounting product from a public
corporation ever to reflect anything but the value? Why would
an accounting product ever reflect off balance sheet loans or
off balance sheet obligations?
Mr. Herz. Well, the model you are espousing actually would
have allowed Enron to continue to show things, maybe 97 percent
on balance sheet, 100 percent, somewhere in that range, but the
accounting rules, I said, the longstanding accounting rule
before these things were engineered, was that you consolidate
something based upon being able to control that. If you don't
control something, at least then what you do is you show your
investment in it.
Now, we have changed that with this rule to reflect what we
regard as what you are saying, better economics, the risk and
reward kind of model for these situations.
Mr. Otter. And you think that that will now close all of
the loopholes?
Mr. Herz. I think it will close all the ones that we know
about. I will repeat. And this may not comfort you, but there
are people that spend all of their time structuring. And no
matter what we do, they sit in our audience. And we believe
they try and figure out ways around things that we do.
Now, we think because our rule is broad, because there are
anti-abuse clauses in the way we have crafted it--and that is a
little new for U.S. accounting standard-setting, that we think
it will catch everything that we know about and even things
that we couldn't think about.
Mr. Otter. Let me phrase this in a different way. Walk me
through the scenario, this lease scenario, that would provide a
corporation to offer for public consumption a balance sheet
which doesn't reflect total liabilities and total assets. Walk
me through that scenario.
Mr. Herz. That wouldn't reflect total liabilities and total
assets? What is the involvement of that entity in the other
entity? You would have to give me all of those facts.
Mr. Otter. Well, you are the one who stated that the way
this happened was under a lease purchase agreement. Under a
lease purchase agreement, they have control of the asset----
Mr. Herz. Yes.
Mr. Otter. [continuing] through a lease agreement, which is
once-a-year payments. So all they have to reflect, then, is
``We owe you for 1 year.'' Is that what you are saying?
Mr. Herz. I understand what you are saying now. That was
the original derivation of the 3 percent rule, what were called
these synthetic leases or build-to-suit lease transactions. In
those transactions, people were allowed to basically retain 100
percent of the up side and bear 97 percent of the down side.
And they didn't reflect that.
Mr. Otter. I want to stop right there for a minute. You got
me through part of the scenario. How could, then, the owner of
the asset that was leasing to the other entity have any kind of
a collateral balance sheet which would reflect anything more
than a 1-year lease? The rest of it would be total liability
not matched by the asset. Right?
Mr. Herz. The owner, the legal owner, of the asset was not
the enterprise leasing the asset or using it.
Mr. Otter. I understand that.
Mr. Herz. This could have been your corporate headquarters
or company's corporate headquarters owned by a special purpose
entity, a charity, something like that, that was owning the
asset. The financing was derived by the support of the lease
arrangements and by a guarantee from the corporate lessee,
whose asset it really was.
You asked me, ``was it a bad rule?'' It was a terrible
rule. We have changed it.
Mr. Otter. Well, I guess maybe we don't have enough people
watching enough people. I don't know how else you stop that.
I am going to end here, Mr. Chairman, and thank you for the
time. But I would have to agree with Mr. Markey, and that is
that we get all seven faces here before us, all at once, so
that we can ask one a question and have the other six respond
to it as well.
Mr. Stearns. Thank the gentleman. The ranking member?
Ms. Schakowsky. Thank you, Mr. Chairman, both Messrs.
Chairman.
Stock options in the past have masked or perhaps were even
used to deceive investors and workers as to the true financial
conditions of the company. I think Warren Buffett put it best.
This is his quote, ``If options aren't a form of compensation,
what are they? If compensation isn't an expense, what is it?
And if expenses shouldn't go into the calculations of earnings,
where in the world should they go?'' I wondered what your
thoughts were on Mr. Buffett's rhetorical questions.
And you also mentioned that a deliberation is going to
begin. I would like to know what your view is and a little bit
about that deliberation, particularly its timing.
Mr. Herz. Yes. Well, I agree with Mr. Buffett. Until I
joined the FASB, I was actually a member of the International
Accounting Standards Board. That board undertook starting in
August 2001, put on its agenda the whole topic of what they
call share-based payments or what we call stock compensation,
which includes stock options and after a year of what I thought
were thorough deliberations came to very similar conclusions,
as the FASB had done 10 years prior to that, namely that
granting a stock option is compensatory, that it should be
measured at the grant date. The best way possible that people
come up with are using option pricing models but making certain
adjustments. So a couple of things. But, of course, as you
know, the FASB was essentially thwarted by lobbying efforts and
by political interference at that point in time from making
that carry.
We are, as I said, committed to the idea of international
convergence, but even if we weren't, it is clear from the first
day I got to the FASB from the many e-mails, letters I have
gotten from individual investors, from analysts, from others,
that this is a topic that needs to be revisited.
So the first thing we did was to try and address the issue
for the many companies that have switched as to how they make
the switch to the preferable method.
The second thing we did was say, ``Here is what the
international fellows came up with, our colleagues. It is very
similar to what the FASB concluded, but there are some
important differences. What do you think about those?'' We have
gotten the comments in. We are summarizing them, analyzing. And
probably at our board meeting next week, we will decide whether
or not we put on our agenda now a formal project to say,
``Let's go back and decide whether or not we should mandate
expensing of options.''
Assuming we put that project on our agenda,--and, again,
there are seven people who vote; I certainly will vote for
that--the question is, what will be the methodologies? Will it
be what the FASB came up with 10 years ago and have been
incorporated in footnotes for many years now? Will it be the
IASB method or will it be some other method?
We have gotten a lot of suggestions in between, you know,
if a way is to potentially enhance the consistency of the
evaluation. We have also gotten a lot of recommendations from
many people as to other forms of disclosure that might be
useful. So what I anticipate is we are going to have another
look at all of those and see if we can come up with what we
believe is the best accounting and the best disclosure.
Ms. Schakowsky. How long will that process take assuming
that it is on your agenda?
Mr. Herz. Well, that will depend. I would like to do it as
quickly as possible, but that, again, will depend. If we were
just to say, ``What is in the footnotes now gets moved into the
financial statements,'' what we call the 123 method for FASB
statement 123, which is what the FASB came up with a decade
ago, that could be relatively quick.
On the other hand, if we say, ``No. There are some real
areas that we think could be improved, there are ways to maybe
improve the consistency of the measurement,'' then that may
take a little longer.
Ms. Schakowsky. I don't have much time left, but I do want
to know more about what it means to harmonize the FASB and the
IASB, particularly from a consumer standpoint. So while there
is not much time remaining now, maybe you could help educate me
about that.
Mr. Herz. I would be happy to.
Ms. Schakowsky. Let me just ask you this, then, briefly,
``How would you characterize IASB in terms of its stringency
and its impact on transparency disclosure,'' all the things
that we care about?
Mr. Herz. Well, the IASB was set up a little bit like the
FASB model. It has a group of trustees, of which Paul Volcker
is the chairman, just like we have a group of trustees. The
board itself is 14 members because of the need for geographic
representation from various parts of the world.
Their processes are very similar to ours. I would say while
they have headed more toward less detailed standards, I think
their standards have become more detailed and ours a little
less detailed. So I think there is also harmonization in kind
of level of detailed implementation guidance in the standards.
That is also important to that effort to have the rules
actually look and feel the same.
Mr. Stearns. I thank the gentlelady. The gentleman from New
Hampshire, Mr. Bass.
Mr. Bass. Just a quick question, sir. Do you have
jurisdiction over the issue of accountants performing
consulting services?
Mr. Herz. No.
Mr. Bass. Okay. I didn't think so.
I will yield back, Mr. Chairman.
Mr. Stearns. Ms. Solis?
Ms. Solis. Yes. Thank you, Mr. Chairman.
I apologize for coming in late. I didn't hear all of the
testimony presented, Mr. Herz, but I did have just two basic
questions. My first is the issue regarding funding for the FASB
by the SEC. And I am trying to understand that the SEC under
the leadership of Chairman Harvey Pitt failed to take steps to
fund the FASB. To me funding is crucial obviously to your
organization to do its job and to fulfill its mandates and
missions.
When do you expect SEC under the new chairmanship, Mr.
Donaldson, to begin assessing a fee on the public companies?
Mr. Herz. Let me, if I can, clarify that a little bit. I
think you are essentially correct, but let me clarify it.
Sarbanes-Oxley, what it says is that the SEC essentially should
recognize us, and thereafter a fee would be levied on all
public companies. That fee would be levied in the same way as
the fee for the Public Company Accounting Oversight Board, the
PCAOB, which, as you know, is still in the formation stages in
that.
My expectation from recent conversations with Chairman
Donaldson, with the other commissioners is that they are now
working on the recognition quite diligently. There are
documents going around in there, in-house there. So we expect
that to be concluded in the not-too-distant future.
The issue then becomes the mechanics of the billing
mechanism because, remember, this is going to be levied on all
15-17 thousand issuers based upon a computation. The data is
being gathered by our people, by the SEC, by the PCAOB people
together. It may require some SEC rulemaking.
We are eager to get that all in place because, as you said,
we are well into our new fiscal year and our voluntary
contributions. People know that we are now going to be getting
this new mandatory funding mechanism and have said, ``We wish
you well.''
So getting all of that coordinated because I think the SEC
is right, it has the view that if you're sitting out there and
you're IBM, you ought to get one bill that covers both. But, of
course, we are ready for them. We have been ready to go. We
submitted our budget. But the PCAOB because of the gestation
period of formation is still a little behind that. Getting that
all together there are still some implementation issues to go.
Now, I think the good thing is that our trustees had some
foresight in the past and put away a reserve fund that we are
now using. I think we have enough cash to keep on going for a
while, but we also have deferred some hiring. So there are
certain things we would like to do that until we see the cash
coming in the door, we are not going to do certain things.
Ms. Solis. My second question, if I might, is with the
issue regarding revenue recognition. Of course, one of the
issues of the accounting standards that I am most concerned
about is the impediments that prevent positive changes from
being made in the standards. I believe that a single standard
for revenue recognition that is out there applicable to all
companies would help to prevent any abuses there. So what is
the status, if you can elaborate on that, on your project?
Mr. Herz. Yes. As I mentioned in my opening statement, we
have put a major project on our agenda and have started it to
try and do exactly what you say because the existing rules on
revenue recognition which are voluminous but are contained by
our count in over 140 different standards, rules, regulations,
pronouncements by various groups over a 40-year period, they do
have inconsistent rules, they have contradictory rules, there
are things that are hard to understand. And so we think we need
to build a better conceptually, consistent, coherent model or
models on this topic.
Because of the breadth of this subject, it affects almost
every company. A couple or 3 or 4 years ago, maybe it wasn't
every company that had revenues, but nowadays I guess it's just
about everyone, various industries, all sorts of different
transactions. The task is daunting for us to come up with
something that would meet the needs of investors and other
users because it could represent a big change that would be
operational, could be implemented by companies, all of that. So
we need to carefully not only develop the method but check it
out very carefully.
Ms. Solis. Do you expect any major opposition?
Mr. Herz. People don't like change.
Ms. Solis. Then how do we----
Mr. Herz. I have already learned that. But we are in the
change business. We are going to do what we think is right. We
need the input, and we need to test. It is very important to us
that something we develop is actually useful. It is also
important to us that it can be actually put into practice in a
faithful way and can be done in a cost-effective way.
So we need to check all of those things out, but I
personally--you know, the fact that people oppose things, if
they oppose them on good, sound grounds, good, sound arguments
related to the accounting, to the usefulness, things like that,
listen but not if they oppose it because they don't want change
or because it might have detrimental economic effects to their
particular interests.
Ms. Solis. Thank you very much. Thank you, Mr. Chairman.
Mr. Stearns. Thank the gentlelady. Mr. Issa?
Mr. Issa. Thank you, Mr. Chairman.
Mr. Herz, let me start off with a broad question. Would it
be fair to say that your goal and that of your six colleagues
should be to have the information that the CEO gets, the
information that the board of directors gets, the information
stockholders have available to them, and the information the
IRS acts upon for purposes of taxation? In a perfect world,
this should be the same information.
Mr. Herz. You got there until you went to taxing. Okay?
Mr. Issa. At the present time--and I asked it deliberately
for a reason. The first three if you like.
Mr. Herz. The first three I like provided that it is also
that information is really--let me say I don't want to sound
pejorative at all, but one of the things that I have found--and
maybe it is a sign of the times--is that the needs and views of
investors and analysts and people who run the money is often
very different as to what is useful from the views of the
people running the companies.
Ideally it should be the same. I agree with you. But it
isn't.
Mr. Issa. Let me rephrase the question. I will break it
down a little bit. When it comes to whether or not an asset is
an asset, a liability is a liability, and profit is profit or
losses are losses, would you say that as to the state to the
balance sheet and the state of the real profit, that the
information should be transparent, that that information should
always be the same dollars and cents?
Mr. Herz. I believe so, yes.
Mr. Issa. And then you took exception to the word ``tax.''
Mr. Herz. Right.
Mr. Issa. Are you of the opinion that it is reasonable and
fair to state profits or lack thereof for purposes of generally
accepted and FASB accounting differently than you do for taxes,
that two sets of books are reasonable to maintain in that case?
Mr. Herz. Well, this is not my area of expertise. Fiscal
policy, including taxes, are for you to decide, but I know that
the taxes are used to raise revenues, are used to produce
certain stimulus, things like that now----
Mr. Issa. I am thrilled to have you in front of me so I can
ask the question to make exactly that point.
Mr. Herz. I don't know enough to judge whether I can have a
substantive view on that.
Mr. Issa. Well, since you have had 30 years of accounting,
would it be correct to say that today for purposes of profit,
we tend to have greater profits for tax purposes? I will assume
that it is because Congress wants the money but that, in fact,
we take different amounts for tax purposes than we show on
compliant information given to stockholders.
Mr. Herz. I don't know whether it is greater or less. I
have seen some reports recently that say the amount of taxable
profit is generally less.
Mr. Issa. I guess it all depends on your business.
Certainly you are trying to make your taxable profit less while
the government perhaps, as you alluded to, is trying to make it
more.
Do you have an opinion, forgetting about what is our job,
that it would be better if there were one system?
Mr. Herz. Well, I believe that we try in what we do to
mirror what we believe are economics, what we believe is proper
accounting. So if you want to say that things are going to get
taxed on that basis, understanding that that is the way we
develop our rules, I wouldn't personally object to that. I
don't know whether it would satisfy all the other objectives of
taxation.
Mr. Issa. I am going to go out on a limb and say this in
the form of a question but probably a little bit of a statement
at the same time. Since it appears as though the Federal
Government and our insistence as legislators allows a system
that says tell your stockholders you're making a profit when,
in fact, you tell the IRS you're not or tell your stockholders
you're not making a profit while you are paying taxes on a
profit that you've told your stockholders you didn't make,
wouldn't you say that that is, in fact, the first step to
telling corporate America that two sets of books are okay as
long as you're compliant with a set of rules, even if the fact
that that occurs means one of those books is cooked? And we'll
use the word ``cooked'' in a broad and only slightly pejorative
way.
Mr. Herz. I don't think I can respond to that, as I say, in
this without knowing enough about--I am not an expert in either
the tax code or the motivations behind specific provisions in
the tax code to judge as to whether it is cooked or not.
Regulators also have different systems, and they are done for
safety and soundness. So if your purpose is a little bit
different, the way you do things can be a little different.
Now, we happen to think that our objective is to design
good information for investors, creditors, and other users of
that financial information. It is not designed for regulatory
purposes. It is not designed for tax purposes because that is
not what we think about when we design the rules.
Mr. Issa. So, if I can, Mr. Chairman, in the spirit of Mr.
Markey's closing statement, it would be fair to say that, to a
certain extent, each of your agencies, the IRS, FASB, et
cetera, enjoys the same set of criteria as the guy who wants to
hire an accountant and one says, ``One and one is two,'' and
the next one says, ``No. One and one is two,'' and the third
one says, ``One and one is two,'' and the last guy says, ``What
would you like it to be?'' and he gets the job.
I would propose that today our problem is that we are not
looking for the consistency that true and proper statement and
accounting and tax should be all the same. And I would say
until we get to that point, until we get to one set of books as
at we are not heading toward the type of accounting that is
going to help the business world be consistent and honest and
ethical, as we certainly want them to be.
I yield back the balance of my time.
Mr. Stearns. I thank the gentleman. The gentleman from
Texas, Mr. Green.
Mr. Green. Thank you, Mr. Chairman. I am going to be brief
because we are going to have a vote in our Health Subcommittee
downstairs.
I can understand the concern about the tax avoidance and
tax schemes coming from Texas, but Enron hasn't paid Federal
taxes in I don't know how many years because of some of those.
So obviously they were successful.
I know in your response to Mr. Bass concerning that FASB
doesn't have jurisdiction over the issue of accounting work
versus consulting, in your opinion as an accountant, it just
seems like, again, with examples of not just Enron but a host
of other companies, that we have a conflict that maybe this
Congress or the SEC ought to look at that issue and say, ``You
can't serve two masters,'' just in your professional opinion.
Mr. Herz. Yes. And I was an accountant, an auditor, for a
long time. My belief is that the master is the public, is the
public interest. And that is the overriding interest. That
means the ability to do excellent audits that meet the public
expectation.
Now, I think in order to do those audits, you do need some
tax capabilities. You do need some systems capabilities and all
of that. But that is not rendered necessarily to provide the
additional service. It is rendered to provide the excellent
audit.
Mr. Green. Okay. Again, tell me--and I will use Enron
because it is my hometown--the accounting firm, 27 million is
consulting and 25 is auditing. Do you see that that is almost a
prima facie case? In hindsight, we can say it is, that there is
a conflict between having consulting and auditing with the same
firm at the same company. Again, in your opinion, should we try
to address it?
Mr. Herz. First of all, I think the Sarbanes-Oxley and the
SEC is addressing it. Whether you need to do more I don't know.
I mean, I believe that the issue of the 25 million was probably
significant also. And the question is, what was in the heads of
the people who were making the bad decisions? Was it the
consulting fees? Was it keeping the audit client? How were they
compensated?
Learning about that is really the key to driving behavior.
That could vary firm to firm. It could vary circumstance to
circumstance.
Mr. Green. I understand that problems with Enron, like a
lot of companies, it just was not the conflict between the
consulting and the auditing function. There were boards of
directors. There's lots of problems. But that is something I
think that the SEC--and I know it is not within your purview,
but hopefully the SEC will address it as strong as they could.
Do the fact that accountants also sell tax advice, which in
many documented cases turned out to be illegal, if not
questionable, tax shelters, in a subtle way alter the way that
they would interpret subjective accounting questions?
Mr. Herz. Again, I think on the audit you do need good tax
accountancy just to do--you know, taxes are still a major part
of getting to the bottom line.
The question of whether the firm or even other people ought
to be in the business of peddling aggressive tax arrangements,
that to me is the broad issue. Whether it's an auditor, a
lawyer, or anybody else, some of these arrangements in my own
view--and I am not a tax expert, but I did come across some of
them in practice. They defy belief.
Mr. Green. I appreciate that. In your professional opinion,
is the FASB offering accountants guidance on how to treat these
tax questions?
Mr. Herz. We have an existing standard, standard number
109, which has been in place for 12-13 years that deals
comprehensively with accounting for income taxes, but, like a
lot of other things and like what people would like to go to,
principles-based, it requires good, honest, professional
judgment in a lot of cases.
Mr. Green. Since it has been in place for 10 to 12 years
and most of what we have seen is the last 5 to 6 years,
obviously we might need to revisit that.
Mr. Herz. I have been reading the Senate joint committee
report quite eagerly and carefully that looked over all the
Enron arrangements to understand whether there might be some
implications on the accounting side. Most of that is not
targeted at the accounting side. It is targeted at the actual
use of tax arrangements there. But I read that stuff.
Mr. Green. Thank you, Mr. Chairman. Mr. Chairman, I am
going to go vote. I also appreciate the effort by the chair and
the committee to talk about the special purpose entities. I
think that's----
Mr. Stearns. And I thank the gentleman. And just to the
gentleman's question to you, the Sarbanes-Oxley Act identified
non-prescribed types of consulting. You can't do information
technology, investment banking, but there are others that you
can. And so the whole thing is not prohibited, but at the same
time, there are in place legislative fits to do this. The
question is, are people going to comply with it?
Mr. Herz. I don't know. I think that that's one thing that
what you'll have to need--they will probably also thank me for
this--is somebody needs to bring in the new auditing board, the
PCAOB, once they get up and running. I am sure that will be a
key part of their examination process.
Mr. Stearns. Mr. Ferguson?
Mr. Ferguson. Thank you, Mr. Chairman.
I thank Mr. Herz for being here today. I am new on the
committee. I just came from a term on the Financial Services
Committee, which is not only interesting but exciting given
everything that happened last year, the last couple of years.
Obviously we did a lot of work on Financial Services last year,
as they did here on Energy and Commerce, relating to Enron,
WorldCom, transparency issues.
And I just wanted to touch on that for a minute in terms of
loan commitments with banks, investment banks and commercial
banks. Can you just walk with me through that for a moment? My
understanding is it's a----
Mr. Herz. Yes.
Mr. Ferguson. [continuing] different treatment in how these
institutions treat loan commitments and why there is a
difference.
Mr. Herz. Yes. Loan commitments, of course, are a form of
financial instrument and one of many. Traditionally, those who
have traded loan commitments have shown them on a mark-to-
market basis as a trading activity. And that has traditionally
been some of the investment banks.
Loan commitments, however, are not only traded. They are
extended more generally by commercial banks as a line of
credit, which may or may not be drawn down, may end in the
origination of a loan.
I think that we have been doing some work in that. We are
just about to issue a new standard that says that commitments
to purchase or sell loans are really what we call derivatives
and, therefore, ought to be carried on a mark-to-market or fair
value basis, whether you are an investment banker or bank,
whoever you are. So that activity would be now more common,
common accounting across the same different types of
enterprise, whether it be an investment bank or a commercial
bank.
I know that some of the investment banks, or at least one
that I am familiar with, believe that loan commitments to
originate loans ought to also be carried on a mark-to-market
basis. That has traditionally been viewed as a more normal
traditional banking activity accounting for banks. The bank
regulatory accounting does not require fair value for that in
the financial statements. We require supplementary footnote
disclosure relating to the fair value of all financial
instruments, including loan commitments, or actually working on
improving that whole supplementary data.
But right now for a bank that extends loan commitment that
are intended to result in the issuance of a loan, it is not
done on a mark-to-market basis. Now, some of the investment
banks I think believe that it ought to be, and they believe
that that is not only the better accounting because they
certainly believe in fair value. That is how they live their
world. But they believe that in certain cases, large ticket
commercial loans to big companies are being used in the loss
leader kind of mode to garner investment banking business and
are being underpriced, essentially, are being given a favorable
interest rate.
That is of concern to us. And we have discussed it directly
with bank regulators, with major banks who seem to view it
otherwise, either don't believe it is happening or don't
believe the mark-to-market accounting is the right way to go on
that.
I think it was Congressman Dingell who asked the GAO to
look at that. I am very eager to understand the results of that
review to see whether or not there is something that is being
disguised here.
Mr. Ferguson. What has lead you to--you are talking about
perhaps pending issuance of a new regulation. Am I paraphrasing
it properly?
Mr. Herz. Only in regard to loan commitments to purchase or
sell loans, not commitments to originate a loan.
Mr. Ferguson. Is that also under discussion or not?
Mr. Herz. It is not formally under discussion, but we are
certainly aware of all of the activity around it.
Mr. Ferguson. Why is there differential treatment now?
Mr. Herz. Well, I think because if you're originating a
loan, it's like selling your own product. It's not dealing in
other people's product, which is a commitment to buy or sell
other people's loans. That, the origination of loans, is viewed
as a normal banking activity that is covered by a non-mark-to-
market model.
Mr. Ferguson. the regulation that you were talking about,
the new regulation that you are talking about, why is that
being pursued? Is that an effort toward transparency as well?
Mr. Herz. Well, we believe in looking at that issue, that
those are really like derivatives. We already have a rule that
says that derivative contracts should be mark-to-market.
Mr. Ferguson. Is there a mechanism now, though, under
current accounting rules that allows for investors to know if
loans or loan commitments have been made by banks under market
rates, below market rates?
Mr. Herz. Only annually through the disclosures which we
mandate on fair values.
Mr. Ferguson. Would that make sense in terms of kind of
this climate that we are in today in terms of----
Mr. Herz. It might make sense.
Mr. Ferguson. [continuing] protection of investors and
transparency?
Mr. Herz. Again, we talked to banks and bank regulators.
And they say their evidence indicates that that is not
happening, that origination are done at the fair rate.
Mr. Stearns. The gentleman's time has expired.
Mr. Ferguson. Thank you, Mr. Chairman.
Mr. Stearns. The gentlelady from Missouri, Ms. McCarthy.
Ms. McCarthy. Thank you, Mr. Chairman.
I appreciate very much the opportunity, Mr. Herz, you have
given us to discuss some of our, as you would so politely put
in your paper, shaken confidence in the reporting system and
capital markets. And I very much appreciate all that you and
your organization are trying to do.
I wanted to pose a situation to you and wonder if you are
looking into this or, if not, who in this fast world of
corporate governance and audit is looking into it. In my area,
the two top executives of the company had considerable gains on
stock options. The corporate auditors, the auditors that were
advising the company, the board, et cetera, advised these two
executives who were no longer with the company to create a tax
shelter, to put those stock options in tax shelters so they
could avoid the tax on them. The IRS is looking into it, and it
looks like they will both be very poor people when this is
over.
Mr. Herz. Yes.
Ms. McCarthy. I guess my question is hopefully you or
someone is looking into this very issue of there is a
governance failure, yes, a corporate governance failure, but
there is an audit failure here, too. These auditors are paid by
the corporation to advise the board and the corporation. And
then they were paid by the corporation to advise these two
executives how to avoid taxes.
I thought there was a bright line from the legislation that
we thought we had passed that was going to avoid things like
this.
Mr. Herz. Well, it's not our area. We deal with accounting
and financial reporting rules that would be----
Ms. McCarthy. This is accounting, financial reporting
rules. How can the auditors be paid by the company to advise
two executives how to avoid taxes?
Mr. Herz. That is my understanding. I may be wrong. I am
just saying what I remember was something that was addressed by
the SEC as part of their recent looking at implementation of
parts of Sarbanes-Oxley. I remember reading some articles back
and forth about that issue as to how far the tax advocacy work
ought to be restricted or not.
I can't remember exactly where it came out. I am sure Ms.
Washington does because she knows everything about that.
Ms. McCarthy. I just learned they took it out. That's too
bad.
Mr. Herz. Again, that's not what we do. Again, I think that
is something that the new PCAOB presumably in the course of
what they are going to be monitoring the auditors, auditing
standards, all of that, will be part of, I would expect, their
charge and their role.
Ms. McCarthy. It would seem to me whoever advises the
accounting industry ought to probably step up to the plate on
this one. I mean, it's one thing if those executives had paid
the auditors themselves. The company was paying for that advice
to them to avoid the taxes. It doesn't help the confidence of
any of us taxpayers when those kinds of things go on within an
industry. So that's why I wanted to pose it to you, to get your
thoughts on it.
We may have to readdress some of the legislation. It is
hard to make a perfect bill, but I believe on this one, we
should have been a little bit more strident.
Mr. Herz. Yes. I personally think--and, again, this is only
putting on the hat of my experience in my prior incarnations,
so to speak--I think there is not only that issue but the issue
of how was it that the auditors, whoever was selling these
schemes concluded that those schemes were viable under the tax
code. I think that is the root of the problem.
Ms. McCarthy. Well, Mr. Chairman, thank you for this
hearing.
Mr. Stearns. Sure. Let me just ask my members. I think we
are going to do another short round. So if you want to stay and
ask questions? Are you finished?
Ms. McCarthy. Yes. I yield back.
Mr. Stearns. Okay. I want to follow up a little on what Mr.
Ferguson's question was. You have an investment corporation.
You have a banking corporation. And you look at their books.
Forget Enron and WorldCom. You look at these banks, investment
companies. You have no clue that these folks from their balance
sheet have a huge amount of commitments, loan commitments, to
these people and that they're moving exponentially.
So just tell me briefly, how do commercial bank accounts
for loan commitments differ from investment bank accounts for
loan commitments? We'll take that difference there. And what
could FASB do so that--you know, I am not investing in Enron or
WorldCom. I am investing in an investment company, Salomon
Brothers or I am investing in Bank of America. How could I
determine that these folks are on the hook with an Enron for
billions and billions of dollars? It keeps getting larger and
larger.
Mr. Herz. Well, I think first there are overall disclosures
relating to all commitments.
Mr. Stearns. But you couldn't tell it in Enron's case.
Mr. Herz. You couldn't tell----
Mr. Stearns. You couldn't know until they declared
bankruptcy, right?
Mr. Herz. You're right.
Mr. Stearns. And even after they declared bankruptcy, the
whole thing didn't come out. And now, as we stand today, it is
not millions. It's billions. And it is hard even to
understand----
Mr. Herz. The investment banking model, the mark-to-market
model, would say, ``I look at that commitment. I look at the
company's credit. And I evaluate how much in the marketplace I
could not redo that commitment for today's current facts.'' So
it kind of says, ``What are today's facts? And what is that
commitment worth or how much is it likely to cost me on a value
basis?''
The traditional banking model is to look at all credit
exposures by whomever the counter party is, the borrower,
whether it is a loan outstanding, whether it is a commitment to
that, and say, ``Okay. What do I think I need to put up as a
loan loss reserve.'' There are two ways of getting to the
exposure model.
Mr. Stearns. An investment corporation doesn't have to do
that to put up----
Mr. Herz. No. They assess value, rather than saying, ``What
do I think my gross losses are going to be?''
Mr. Stearns. Because the taxpayers are supporting the FDIC
in banks, really, the taxpayers have a lot here at stake
because if the banks go under, then taxpayers are going to
support them. So I think it's crucial, the distinction between
the two of them, and that the fiduciary responsibility is
higher for you in dealing with bank transparency because
taxpayers are on the hook. Is that true?
Mr. Herz. That is partially true. I mean, there are two
sides to every argument. I will give you the side that the bank
regulators would give. They would say that using a hard-to-
measure fair value model for these kinds of things in place of
a loan loss reserve is going to unnecessarily create false
volatility in the earnings. That will produce false results as
well. I am not of that opinion.
Mr. Stearns. So if I get a look at one of these investment
companies and find this information, it is going to create a
problem for Enron or WorldCom?
Mr. Herz. The view is that fair valuing these things is not
only hard to do but is not the proper accounting. That is a
traditional banking view of the world.
Mr. Stearns. Say that statement again. It sounds like the
corporation and the investment company are sort of keeping all
of the information and that it is not transparent. Say that
statement again.
Mr. Herz. Well, the banking model assesses all of your
exposures to a particular credit or borrower, whether it be
outstanding loans, loan commitments, other arrangements, and
then provide your best estimate of what you think your losses
are going to be based upon the current facts.
Mr. Stearns. So CitiBank should have done that with Enron?
Mr. Herz. As the facts emerged, yes.
Mr. Stearns. As the facts emerged.
Mr. Herz. Yes. Now, of course, with Enron, most of the--I
don't know. You may know better, but, of course, what happened
publicly all happened in one quarter.
Mr. Stearns. Well, it didn't happen all in one quarter.
Mr. Herz. I agree with you, but the information that came
out----
Mr. Stearns. Mr. Skilling left in the summer, months
before, because, in my humble opinion, he knew what was
happening.
Mr. Herz. The real acid test would be, what would a mark-
to-market model have said in August 2001 versus a banking
model?
Mr. Stearns. Right.
Mr. Herz. That is the way to look at it. Both would look at
the current information, by the way.
Mr. Stearns. Would you consider adding a project of loan
commitments to FASB's agenda? Do you think it is important?
Mr. Herz. We have discussed that a number of times. We said
loan commitments are one of many financial instruments. It
would be hard to do just one in isolation. We are committed
toward moving toward more fair value in general, but we would
like to do that in a way that also achieves international
convergence. I would say that--and this, again, is my own view.
Mr. Stearns. Not the other six members?
Mr. Herz. Not necessarily the other six. I'm not saying it
isn't. I'm saying not necessarily.
Mr. Stearns. Is this a yes? Am I hearing you say yes?
Mr. Herz. Mr. Markey can ask each one of them.
Mr. Stearns. From your standpoint, if you had to vote
today, you would put loan commitment on FASB's agenda?
Mr. Herz. No, I would not.
Mr. Stearns. You would not?
Mr. Herz. Not with our existing resource base, I would not.
It is not the highest of our priorities in my view.
Mr. Stearns. Well, if you had the resource base, you would?
Mr. Herz. I would, yes.
Mr. Stearns. you think it is important, but you realize----
Mr. Herz. Yes. I also would like to understand. For me, it
is kind of a baffling debate and pieces of evidence. We have
been presented from the investment banks or one largest
investment bank evidence as to this being a systematic problem
not using fair value.
Mr. Stearns. ``Systematic'' meaning not 1 or 2 years but 25
years?
Mr. Herz. Well, no. Across many large commercial loans.
Mr. Stearns. I see. Okay.
Mr. Herz. We have discussed this with bank regulators,
banks, and all of that. And they say, ``No. These people are
not correct.'' Now----
Mr. Stearns. ``These people'' being?
Mr. Herz. The investment banks.
Mr. Stearns. Okay.
Mr. Herz. Their evidence is not correct. This is not going
on. Again, we don't have investigatory powers.
Mr. Stearns. But you think it is going on?
Mr. Herz. I think Congressman Dingell asked----
Mr. Stearns. You personally think it is going on?
Mr. Herz. I don't know whether it is going on now, but I do
think that if it is going on and if there are--to me, fair
value accounting is an earlier detection device for those kinds
of things than the normal ongoing accounting.
Mr. Stearns. Because they have a lot to lose.
Mr. Herz. It is just the way it worked. When something is
properly valued, it tells you what the situation is, rather
than trying to make, kind of, guesses. Again, I am interested
in what the GAO came up with because they have been asked I
understand by Congressman Dingell to look at this issue.
Mr. Stearns. At least you agree that banks should not have
hidden liabilities, like loan commitments, that are disclosed
to investors only when the entity goes bankrupt. I mean, there
should be some precursor out there to say, ``Something is
happening here at Enron/WorldCom'' well in advance, instead of
when they file bankruptcy. That is when CitiBank says, ``Oh.
Here. By the way, we are not talking about $300 million. We are
talking about $1.3 billion.''
Mr. Herz. Yes. But, to be fair, the existing rules on
accounting for loan loss allowances required an assessment of
current facts in order to make the estimate of what the loss
allowance ought to be. So it's also supposed to take into
account current facts.
Mr. Stearns. Yes. Okay. My time has expired. Ranking
member, questions?
Ms. Schakowsky. No. Maybe you answered this already when
Congresswoman Solis was talking to you about the fees that you
need to operate FASB. When do you expect to have this process
completed? I understand it has to do with developing the
formula, et cetera.
My concern is exacerbated by what you just said about
resource base. I am assuming that you are limited in what you
can do because of the money. So what about your fees?
Mr. Herz. Well, again, we are one party of three parties in
getting this accomplished. So our desire would be tomorrow.
Again, noting that it ought to be done properly, it probably
makes sense to have one billing that includes both our fees and
the fees to the PCAOB.
I have heard--I don't know that this is definitely the
case--that it may require some SEC rulemaking in order to get
that done. I would estimate based upon all that the earliest
that everything can get done is probably April or May.
Now, if the bills go out in April or May, people start to
pay, then I think we start hiring.
Ms. Schakowsky. I want to get back just briefly to this
business of harmonizing FASB and IASB. Just as we are now
really focusing on the issues of corporate governance and
accountability, I want to be sure that this notion doesn't
delude those efforts. Since I don't know anything about it,
maybe it's strengthening those efforts. I don't know. If you
could talk a little bit more about that?
Mr. Herz. Well, I do want to make a very important point
that we are not doing convergence just for the sake of
convergence. I mean, the most overriding goal to us is
improvement of U.S. financial reporting. But we do think that
having common reporting across the global capital markets, the
major capital markets, is something that certainly we have been
told is desired by investors, by analysts, by the companies
that operate----
Ms. Schakowsky. It's useful unless we are going to the
lowest common denominator.
Mr. Herz. Exactly. And I believe, having been a member of
the IASB, I believe that they have quality processes and
quality people. So, in fact, I think it actually makes the
process richer than it probably would have been just----
Ms. Schakowsky. Can you give me an example of some way that
going by the IASB standard might improve our situation?
Mr. Herz. Well, again, these are my own personal biases,
but I think, for example, they have a better model for
impairment of assets than we do. Our model is based on what are
called undiscounted cash-flows. It doesn't take into account
the time value of money at all.
Their standard does in looking at whether or not an
impairment has arisen. We kind of say, ``As long as you're
going to recover it over the remaining life of the asset, even
though the value might be miles below the carrying value, as
long as you're going to recover it, you don't have to impair
it.'' They would look at it more on a value basis. So that's,
for example, one area where I think they have better rules.
One area that we are looking at, we may converge sooner,
hopefully in the not-too-distant future, but we will see, is on
business acquisitions. We have a rule that you have to value
the in-process research and development, the value of the
projects, research projects, under development at the company
you buy. You have to do a precise valuation. Then you write it
off immediately, which doesn't to me make a lot of sense
because it says that these have some value. That is often what
you paid for. Their rule would say, ``No. This is an asset, and
we ought to carry it as an asset.''
That is why we are going through this very systematic
process of we have identified all of the differences, at least
all the ones we think we know about, which are in the hundreds.
And we are systematically trying to say, ``Your standard better
than ours, ours better than yours. Let's see if we can come to
a common answer.'' In some cases, we find that neither of our
standards are particularly good.
Ms. Schakowsky. Is the IASB flexible in terms of changing?
Are we the only ones that----
Mr. Herz. No. The boards are both very open to change, and
the idea is to find the best solution. The issue then is with
the constituents and the politics.
Ms. Schakowsky. Thank you. I wish you the best.
Mr. Stearns. I thank the gentlelady. The gentleman from
Massachusetts.
Mr. Markey. Thank you, Mr. Chairman.
Media reports indicate that Royal Abhold's recent financial
shenanigans were not the first time the company engaged in
accounting subterfuge. CFO magazine reported this week that
when Abhold first filed its results for 2001, differences in
accounting treatment led to a 90 percent disparity between
earnings under Dutch and U.S. GAAP rules. Abhold buried the
explanation for this disparity in a footnote in one of its SEC
filings, which currently is not a violation of any rules. Is
FASB concerned that disclosing a 90 percent disparity in a
footnote is inconsistent with the principles of transparency?
Mr. Herz. I think that is exactly why we are trying to move
to common global standards so you don't even have that issue
arising.
Mr. Markey. What steps would you recommend that FASB take
today?
Mr. Herz. First of all, that disclosure is a reconciliation
that is mandated by the Securities and Exchange Commission.
Mr. Markey. What recommendation would you make to make sure
this is nonrecurring?
Mr. Herz. My recommendation would be that the MDNA
requirement specifically address those kinds of situations.
Mr. Markey. What is the deadline that you would like to see
established so that this 90 percent disparity not again inflict
investors?
Mr. Herz. I'm not at the SEC, but the sooner the better.
Mr. Markey. It should be done immediately? Is this a
serious problem before you?
Mr. Herz. I believe. And the question is whether or not--
and you would have to ask the SEC whether they believe that
that should have been done under their existing MDNA
requirements.
Mr. Markey. I appreciate that, but it appears to have been
legal. Would you change that standard so there is more
information?
Mr. Herz. I don't know whether it is legal or not, but
certainly I agree with your premise that something like that
needs to be clearly explained in a prominent way.
Mr. Markey. All right. Then we will send your
recommendation on to the SEC out of this committee, I would
hope.
Now, you noted in your testimony that FASB recently decided
that AICPA's accounting standards executive committee would no
longer act as a senior-level accounting standards setter in the
United States. You explained that maintenance and development
of any industry-based standards should reside with FASB. As you
know, the accounting oversight board established by Sarbanes-
Oxley has authorized to establish or adopt auditing
independence and other standards relating to the preparation of
audit reports for public companies.
Given FASB's decision to retain responsibility for the
maintenance and development of any industry-based standards,
should the new public company accounting oversight board
outsource its standard settings responsibility to private,
professional, accounting organizations, or should it do this
work in-house?
Mr. Herz. Yes. Again, this is only my opinion. This is, to
make it clear to anybody following this, not part of our charge
or mandate, but I think the premise of what you read is a
reasonable analogy and reasonable thought process to go
through. My view, personal view,--and I can't say I have
studied all of this--would be that the PCAOB needs to probably
figure out some kind of, for want of a better word, its own
conceptual framework for auditing standards, develop some
principles and expectations, and then decide what structure it
needs and the kinds of people it needs.
Mr. Markey. In-house? You are saying do it in-house?
Mr. Herz. No. I think that they need to bring in some
outsiders as well because----
Mr. Markey. But bring the insiders in to do it in-house?
Outsiders to help do it in-house?
Mr. Herz. I believe what they need to do is to develop a
set of concepts, principles, and expectations. You desperately,
though--and we do it through developing our own standards. You
need to make sure you have the right kinds of people in the
process and input.
Mr. Markey. I appreciate that. As you may know, the
Sarbanes Act provides the oversight board with the authority to
conduct investigations and disciplinary proceedings. There has
been some discussion that the oversight board should contract
out this responsibility in a manner similar to the peer review
process used by the now defunct public oversight board. In your
opinion, should the accounting oversight board established by
the Sarbanes Act conduct audit inspections or should the
inspections be performed by private contractors?
Mr. Herz. I think that if they can get the qualified
people, they ought to do it.
Mr. Markey. Is that in-house?
Mr. Herz. Yes, but it is going to take a massive number of
people.
Mr. Markey. I appreciate that.
Mr. Herz. In the U.K., for example, they have had for a
number of years a group called a joint monitoring unit, which
does inspections of the auditors. It is a separate unit. This
is just for the U.K., which is a much smaller country, a much
smaller market. I believe they just have over 100 inspectors.
So you can kind of figure out what it would need in this
country probably, 300, if not more.
Mr. Markey. Well, they have 100 million people. We have 270
million. Can we----
Mr. Herz. Their capital market is not proportional to ours.
Mr. Markey. You would still do it, but you would do it in-
house?
Mr. Herz. I think if they get the qualified people, I think
they should conduct the inspections.
Mr. Markey. You need as many policemen as you need. You are
saying the crime rate is higher potentially in the United
States. So we need more policemen here than in England.
Mr. Herz. I would say the playing field for the crime rate
is larger.
Mr. Markey. Yes, I've got you. They can do it with billy
bats, although we need bigger weapons.
The FASB, the advisory council, let me go to this. You have
noted now here today that FASB recently established a user
advisory group to increase the investing community's
participation in accounting standards activity. According to
the materials that FASB provided for today's hearing, it
appears that virtually all of the members of the council are
affiliated with the Nation's largest banks, brokerages, and
financial management firms with the exception of a
representative from the AFL-CIO. Was there any effort to
include representatives from shareholder advocacy groups, such
as the Council of Institutional Investors?
Mr. Herz. Yes. In fact, I am going to be talking with them
in a couple of weeks, them and the National Association of
Investors, and all of that. We welcome any and all people from
the small investor groups. I think that would----
Mr. Markey. You are going to put them on the council?
Mr. Herz. I would love to.
Mr. Markey. So the invitation is in the mail out there to
you at the Council of Institutional Investors. You are in.
Mr. Herz. I would like to get, actually, some of the people
from the investment clubs as well.
Mr. Markey. How about the Investment Company Institute?
Mr. Herz. Actually, we got a lot of the nominations from
the Investment Company Institute.
Mr. Markey. Okay. That's good. Thank you.
I appreciate your indulgence, Mr. Chairman.
The Joint Committee on Taxation report just out recently
talked a lot about abusive tax shelters created by investment
banks like Merrill Lynch, Bankers Trust for the express purpose
of tax avoidance. Now, these deals had no real underlying
economic purpose. I understand that many of the reports'
findings and recommendations get at issues dealing with the tax
code. But, as you said earlier here today, there could be
implications for financial disclosure.
Mr. Herz. Yes.
Mr. Markey. Exactly what are you doing to make sure that
transactions or entities created for tax avoidance purposes are
clearly flagged for ordinary investors in the company's
accounting statements? Can you give us a succinct statement?
Mr. Herz. I will tell you first I have read not all 3,000
pages of the report but a good part of it. I have had my staff
studying it. Our next step is I have asked our staff to arrange
a meeting with the joint Senate staff, committee staff, and
others who were involved in preparing that to discuss what we
might do, what the IRS might do, all of that.
Mr. Markey. Could you report back to Chairman Stearns and
to the committee on any changes you decide to make as a result
of your review of the joint report? Can you do that for the
committee?
Mr. Herz. Yes.
Mr. Markey. Thank you. I think it is important for us to
get the report back as well.
Can I ask one final question, Mr. Chairman?
Mr. Stearns. Sure. Go ahead.
Mr. Markey. Mr. Chairman, some companies that oppose
expensing of stock options claim that the expenses associated
with options already are incorporated in diluted earnings per
share figures and, therefore, there is no need to expense
options. What is your response to that argument?
Mr. Herz. I don't agree. Would you like to know why?
Mr. Markey. I would love to hear it.
Mr. Herz. Options are equity instruments. That argument to
me is like saying any time you buy anything with an equity
instrument, including your stock, you shouldn't account for it
other than in earnings per share.
So if I buy legal services or I buy a car, I pretend I got
the car for free. I wouldn't depreciate it. All I would say is
I have got another share outstanding. And so that to me is not
the way I understand the transaction. There is a transaction
which you paid for with a valuable instrument. That is how you
acquired it. It happens that that instrument is also an equity
instrument, which, therefore, deludes the existing shareholders
as well.
Mr. Markey. I thank you so much. I think you for that
answer. And I thank you for your service to our country. You
have a valuable a job, as important a job in restoring investor
confidence and, therefore, our economy. Thank you.
Mr. Stearns. I thank my colleague.
Mr. Herz, as I understand it, there might be one other FASB
board member in the audience.
Mr. Herz. Yes.
Mr. Stearns. I thought you might want to just tell us,
introduce the person.
Mr. Markey. It's like the Ed Sullivan Show here. Yes. And
in our audience, my colleague, Dr. Katherine Schipper.
Mr. Stearns. Welcome, Dr. Schipper. We just are not going
to ask you. We just obviously want to say hello.
Mr. Herz. Not until the next time.
Mr. Stearns. Until the next time.
I want to also leave the record open for 5 working days so
that if members want to ask any additional questions. And I
would hope that, Mr. Herz, you can answer some of the questions
our staff might submit to you.
Let me just say that I think you provide a fresh breeze
here, and we appreciate your honesty. I hope in the future that
you will continue this and fight the status quo, which you
pointed out is hard to change. We are here to try and help do
that.
With that, the subcommittee is adjourned.
[Whereupon, at 4:53 p.m., the foregoing matter was
adjourned.]
[Additional material submitted for the record follows:]
Financial Accounting Standards Board
March 28, 2003
Via Hand Delivery
The Honorable Cliff Stearns
United States House of Representatives
Washington, DC 20515
Dear Mr. Chairman: Attached is my written response to the questions
submitted by the Members of the Subcommittee on Commerce, Trade and
Consumer Protection of the Committee on Energy and Commerce and
attached to your letter of March 13, 2003.
I look forward to seeing you again on April 1, 2003. Please contact
me or our Washington, DC representative, Jeff Mahoney (703-243-9085),
if any additional information is required.
Sincerely,
Robert H. Herz
Attachment
Follow-up Questions to March 4, 2003 Hearing
ACCOUNTING FOR LOAN COMMITMENTS
Question 1) How do commercial banks and investment banks account
for loan commitments? Why is there a difference in the accounting
treatment for the same loan commitment?
Response: Historically, commercial banks and investment banks have
had very different business models. The business of commercial banks
has traditionally included accepting deposits from entities with idle
funds and originating loans to entities with investment or spending
needs.1 In contrast, the business of investment banks has
traditionally included buying, holding as inventory, and selling
financial instruments for their own accounts from and to customers and
other dealers and traders.2 The distinct activities of
commercial banks and investment banks have resulted in different
financial accounting and reporting practices.
---------------------------------------------------------------------------
\1\ AICPA Audit and Accounting Guide, Banks and Savings
Institutions (2001), para. 1.01.
\2\ AICPA Audit and Accounting Guide, Brokers and Dealers in
Securities (2002), para.para. 1.04, 1.07.
---------------------------------------------------------------------------
In general, commitments to originate loans in the ordinary course
of business when no fee is charged have no immediate accounting effect,
though enterprises, including commercial banks, are required to
consider such commitments when evaluating the liability for other
credit exposures.3 If, however, any fee is received for a
commitment to originate or purchase a loan or group of loans, that fee
is initially reported as a liability.4 If the commitment is
exercised, the fee is recognized and reported in income over the life
of the loan as an adjustment of the loan yield, or if the commitment
expires unexercised, the fee is recognized in income upon expiration of
the commitment.
---------------------------------------------------------------------------
\3\ Banks and Savings Institutions, para. 6.71.
\4\ FASB Statement No. 91, Accounting for Nonrefundable Fees and
Costs Associated with Originating or Acquiring Loans and Initial Direct
Costs of Leases (1986), para. 8. The accounting for loan and commitment
fees received or paid by mortgage banking enterprises is subject to the
requirements of FASB Statement No. 65, Accounting for Certain Mortgage
Banking Activities (1982), para.para. 20-27.
---------------------------------------------------------------------------
In addition, information about loan commitments,5
including their fair value (and the fair value of loans and other
financial assets and liabilities) and the methods and assumptions used
to estimate the fair value,6 is required to be disclosed in
the notes to enterprises' financial statements. The fair value
disclosures must also be in a form that makes clear whether the fair
value and related carrying amount represent assets or
liabilities.7
---------------------------------------------------------------------------
\5\ FASB Statement No. 5, Accounting for Contingencies (1975),
para.para. 18 and 19.
\6\ FASB Statement No. 107, Disclosures about Fair Value of
Financial Instruments (1992), para. 10.
\7\ FASB Statement No. 133, Accounting for Derivative Instruments
and Hedging Activities (1998), para. 532(b).
---------------------------------------------------------------------------
As active dealers and traders of financial assets and liabilities,
investment banks have historically employed specialized industry
practices for both internal and external reporting of financial
instruments, including loan commitments.8 That practice
provides that inventory and other positions in financial instruments,
including loan commitments, be reported at fair value.9 In
addition, changes in the fair value of those instruments are reported
in income in the period in which the changes occur. The specialized
industry practices are intended to reflect the economic substance of
the unique activities of those enterprises.10
---------------------------------------------------------------------------
\8\ Brokers and Dealers in Securities, para. 7.01.
\9\ Brokers and Dealers in Securities, para. 7.02; see FASB
Statement No. 91, para. 34.
\10\ Brokers and Dealers in Securities, para. 7.01.
---------------------------------------------------------------------------
The Financial Accounting Standards Board (``FASB'' or ``Board'')
has two active projects that will improve the existing accounting and
reporting for loan commitments. First, the FASB plans to issue a new
standard in April 2003 that will amend the existing requirements for
the accounting and reporting for derivative instruments and hedging
activities. That standard will clarify that enterprises that issue
commitments to originate mortgage loans that will be held for resale,
and most commitments to purchase or sell loans, should be accounted for
as derivative instruments. Thus, as derivative instruments, those loan
commitments will be required to be accounted for and reported at fair
value.11
---------------------------------------------------------------------------
\11\ FASB Statement No. 133, para. 17.
---------------------------------------------------------------------------
Second, the Board has a current project to improve the existing
fair value disclosures of financial assets and liabilities, including
loan commitments. The objectives of that project are (1) to provide
guidance relating to the often-difficult issue of measuring the fair
value of financial instruments and (2) to improve the form and content
of the information about those fair values. We are currently
deliberating those issues at public meetings and plan to issue a
proposal for public comment before the end of this year.
Finally, the Board recognizes that business models change and in
the case of commercial banks and investment banks they appear to be
converging. Having different accounting for similar transactions or
financial instruments based on business models is a concern to the
Board. As new accounting guidance is issued, consideration is given to
eliminating business model differences where appropriate. Also with
respect to financial instruments, the Board has indicated its desire to
require all enterprises to report all financial instruments at their
current fair value when the conceptual and practical issues relating to
fair value measurement are resolved. The Board is working on those
issues. The second project discussed above is part of that process.
Question 2) How can we make sure that accounting policy does not
encourage imprudent lending activity?
Response: The mission of the FASB is to establish and improve
standards of financial accounting and reporting for both public and
private enterprises. The focus of the FASB's mission is on consumers--
users of financial information, such as investors, creditors, and
others. We attempt to ensure that financial accounting and reporting
standards result in financial reports that provide consumers with an
informative picture of an enterprise's financial condition and
activities and do not color the image to influence behavior in any
particular direction.
The FASB has no power to enforce its standards. Responsibility for
ensuring that financial reports comply with the FASB's standards rests
with the officers and directors of an enterprise, the auditors of the
financial statements, and for public enterprises, ultimately with the
United States (``US'') Securities and Exchange Commission (``SEC'').
Representatives of the FASB have had recent informal discussions
with representatives from a major investment bank that included
discussions about the existing accounting for loan commitments. Those
representatives indicated that they believe the existing accounting for
loan commitments encourages imprudent lending activity by commercial
banks.
Representatives of the FASB also have had recent informal
discussions with representatives from commercial banks and financial
institution regulators. The discussions included discussions about the
existing accounting for loan commitments. Those representatives
indicated that they do not believe that the existing accounting for
loan commitments encourages imprudent lending activity.
It is our understanding that the US General Accounting Office, in
response to a request by Energy and Commerce Committee Ranking Member
the Honorable John D. Dingell, is in the process of updating its May
1997 report, ``Bank Oversight: Few Cases of Tying Have Been Detected.''
It is our understanding that that update may include consideration of
whether the current accounting for loan commitments encourages
imprudent lending activity by commercial banks. The FASB will carefully
review the results of that report to the extent that it contains any
findings or recommendations relevant to the Board's mission.
Question 3) Is there a mechanism to ensure that banks are
adequately pricing their credit in order to compensate them for any
attendant risks at the time the loans and loan commitments are made?
Response: Existing financial accounting and reporting standards
require enterprises, including banks, to evaluate at each reporting
date the incurred credit losses related to loans and off-balance-sheet
financial instruments, including loan commitments.12
Provisions for incurred loan and loan commitment credit losses are
required to be reported as a charge to enterprises' operating income
with the corresponding entry to an allowance for loan losses account or
a liability for credit losses account, respectively, in enterprises'
financial statements.
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\12\ FASB Statement No. 5, para. 8; FASB Statement No. 114,
Accounting by Creditors for Impairment of a Loan (1993), para. 8.
---------------------------------------------------------------------------
Actual credit losses for loans and off-balance-sheet financial
instruments, including loan commitments, are required to be deducted
from enterprises' reported account balances for the allowance for loan
losses or the liability for credit losses, respectively.
In addition to the disclosures discussed in response to question 1,
existing financial accounting and reporting standards also require
enterprises, including banks, to disclose (1) information about
impaired loans, including information about the recorded investment in
impaired loans, enterprises' income recognition policy, restructured
loans, and the activity in the allowance for loan losses reported
balance;13 (2) information about estimates used in
determining the carrying amounts of assets and liabilities, including
estimates about loan losses;14 and (3) information about all
significant concentrations of credit risk arising from all financial
instruments, including loans and loan commitments.15
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\13\ FASB Statement No. 114 (amended 1994), para. 20.
\14\ AICPA Statement of Position (SOP) 94-6, Disclosure of Certain
Significant Risks and Uncertainties, para.para. 12 and 13.
\15\ FASB Statement No. 133, para. 531(d).
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The FASB also has under its review and consideration two current
projects of the Accounting Standards Executive Committee of the
American Institute of Certified Public Accountants (``AcSEC'') that are
expected to improve the existing financial accounting and reporting
requirements relating to the credit risks of loans.
The first project will improve the accounting and reporting for
loans and certain debt securities acquired in a transfer. The project
is intended to update the existing guidance related to the amortization
of discounts on certain acquired loans. AcSEC plans to issue the
updated guidance in the near future.
The second project will improve the accounting and reporting for
the allowance for credit losses. The project is intended to provide
additional guidance to enterprises, including banks, on the
recognition, measurement, and disclosure of the allowance for credit
losses related to loans. AcSEC expects to issue a draft of the proposed
guidance for public comment in the near future.
Question 4) Would requiring banks to recognize up front losses from
mispriced loans discourage this practice, or, at least, provide
meaningful transparency to regulators and investors?
Response: As indicated in response to question 3, enterprises,
including banks, are required to report incurred and actual credit
losses related to loans on the face of their financial statements. As
indicated in response to question 1, enterprises, including banks, also
are required to disclose the fair value of those loans in the notes to
their financial statements.
There are a number of difficult conceptual and practical issues
that the Board would need to resolve before it could consider requiring
all financial assets and liabilities, including all loans, to be
reported on the face of all enterprises' financial statements at fair
value. As indicated in response to question 1, the Board is actively
addressing some of those issues in its current project to improve the
existing fair value disclosures of financial assets and liabilities.
Finally, as indicated in response to question 2, in recent informal
discussions, representatives of commercial banks and financial
institution regulators indicated that they did not believe that there
exists a prevalent practice by banks to misprice loans.
Question 5) Do current accounting rules require banks to disclose
on a real time basis that they have not priced their loans correctly?
Response: As indicated in response to question 3, enterprises,
including banks, are required under existing accounting and reporting
requirements to report incurred and actual credit losses related to
loans on the face of their financial statements. As indicated in
response to question 1, enterprises, including banks, also are required
to disclose the fair value of those loans in the notes to their
financial statements.
The FASB has in recent years conducted and sponsored research
related to issues surrounding ``real time'' financial reporting. As one
example, on January 31, 2000, the FASB issued a report that identified
practices for the electronic distribution of business information and
considered the implications of technology for business reporting in the
future.16 Any movement to real-time financial reporting
would require that the SEC pursue significant changes to the existing
rules and regulations governing the reporting requirements for public
enterprises, including banks.
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\16\ Business Reporting Research Project, Steering Committee
Report, Electronic Distribution of Business Reporting Information
(2000).
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Question 6) If a bank makes a loan commitment at below market
rates, should it immediately recognize a loss?
Response: As indicated in response to questions 1 and 3, under
existing accounting and reporting requirements a loan commitment,
including a loan commitment issued at below market rates, generally has
no immediate accounting effect, though an enterprise, including a bank,
would be required to consider such commitments when evaluating its
allowance for credit losses.
In addition, the fair value of a loan commitment, including the
fair value of a loan commitment with a below market rate, would be
required to be disclosed in the notes to enterprises' financial
statements as part of the overall disclosure of the fair values of
financial instruments.
Finally, as indicated in response to question 1, the FASB has two
active projects that will improve the existing accounting and reporting
for loan commitments, including loan commitments issued at below market
rates.
Question 7) Is there a mechanism under current accounting rules
that lets an investor know if loans and loan commitments have been made
at below market rates? Isn't FAS 107 supposed to require footnote
disclosure of the losses incurred as a result of making below market
interest rate loans?
Response: See response to question 6.
Question 8) Can we improve upon the existing standard so that
investors get better information about the financial impact of these
mispriced loans on a real time basis?
Response: As indicated in response to question 2, there are
differing views between the investment banks and the commercial banks
and financial institution regulators as to the prevalence of mispriced
loans. Also, as indicated in response to questions 1 and 3, several
active projects are under way to improve the existing financial
accounting and reporting standards related to loans.
Question 9) Has FASB examined the explosions in bank balance sheets
that resulted when bankrupt firms like Enron and WorldCom drew their
loan commitments?
Response: As indicated in response to question 2, the mission of
the FASB is to establish and improve standards of financial accounting
and reporting for both public and private enterprises. The FASB has no
power to enforce its standards.
It is our understanding that the banks that transacted with Enron
and WorldCom included some of the largest banks in the US with assets
exceeding hundreds of billions of dollars.17 Some,
therefore, might question the characterization of ``explosions in bank
balance sheets'' when ``Enron and WorldCom drew their loan
commitments.''
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\17\ For example, Citigroup Inc. reported $1,097,190,000,000 and
$1,051,450,000,000 in total assets as of December 31, 2002, and
December 31, 2001, respectively. Citigroup, Inc., 2002 Annual Report
(2003), p. 31.
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Question 10) Is it desirable for bank financial statements to have
hidden liabilities like loan commitments that are not disclosed to
investors until the lines are drawn by near bankrupt entities?
Response: As indicated in response to question 1, under existing
financial accounting and reporting standards, information about loan
commitments, including the fair value of loan commitments and whether a
loan commitment represents an asset or a liability, is currently
required to be disclosed in the notes to enterprises' financial
statements. The Board also has a current project to improve those
disclosures.
Also as indicated in response to question 1, the FASB plans to
issue a new standard that will clarify that enterprises' that issue
commitments to originate mortgage loans that will be held for resale,
and most commitments to purchase or sell loans, should be accounted for
as derivative instruments. Thus, enterprises that issue those types of
loan commitments will be required to report those instruments as assets
or liabilities on the face of their financial statements at fair value.
Question 11) Will you consider adding a project on loan commitments
to FASB's agenda?
Response: As indicated in response to question 1, the FASB has two
active projects that will improve the existing accounting and reporting
standards for loan commitments.
The FASB receives many requests for action on various financial
accounting and reporting topics from all segments of a diverse
constituency, including the SEC. Agenda requests from constituents are
periodically reviewed and evaluated by the Board at public meetings.
The FASB's limited resources require that the Board be selective in
determining which requests should be further considered for inclusion
on the FASB's technical agenda. Moreover, the FASB's independence
requires that the Board must, after soliciting input from constituents,
make its own decisions about its agenda.
To aid the Board in its agenda decision-making process, the Board
has developed a list of factors to which it refers in its periodic
review and evaluation of proposed topics. Any constituent request to
add a project to the Board's technical agenda, including a request to
add an additional project on loan commitments, would include
consideration of the following factors:
Pervasiveness of the issue--the extent to which an issue is
troublesome to users, preparers, auditors, or others; the
extent to which there is diversity of practice; and the likely
duration of the issue (i.e., whether transitory or likely to
persist);
Alternative solutions--the extent to which one or more
alternative solutions that will improve financial reporting in
terms of relevance, reliability, and comparability are likely
to be developed;
Technical feasibility--the extent to which a technically sound
solution can be developed or whether the project under
consideration should await completion of other projects;
Practical consequences--the extent to which an improved
accounting solution is likely to be acceptable generally, and
the extent to which addressing a particular subject (or not
addressing it) might cause others to act, e.g., the SEC or
Congress;
Convergence possibilities--the extent to which there is an
opportunity to eliminate significant differences in standards
or practices between the US and other countries with a
resulting improvement in the quality of US standards; the
extent to which it is likely that a common solution can be
reached; and the extent to which any significant impediments to
convergence can be identified;
Cooperative opportunities--the extent to which there is
international support by one or more other standard setters for
undertaking the project jointly or through other cooperative
means with the FASB; and
Resources--the extent to which there are adequate resources
and expertise available from the FASB, the International
Accounting Standards Board (``IASB''), or another standard
setter to complete the project; and whether the FASB can
leverage off the resources of another standard setter in
addressing the issue (and perhaps thereby add the project at a
relatively low incremental cost).
It is not possible to evaluate the above factors in precisely the
same way and to the same extent in every instance, but identification
of factors to be considered helps to bring about consistent decisions
regarding the Board's technical agenda.
PRINCIPLES-BASED ACCOUNTING
Question 12) Are accountants required under GAAP to apply rules in
a way that illuminate financial results rather than obscure them? What
rules under GAAP require accountants to do this?
Response: Under existing generally accepted auditing standards, an
independent auditor of an enterprise's financial statements is required
to state in the auditor's report his or her opinion about whether the
enterprise's financial statements ``present fairly'' the enterprise's
financial position, results of operations, and cash flows.18
Auditing standards provide that the auditor's opinion
---------------------------------------------------------------------------
\18\ AICPA Statement on Auditing Standards (SAS) No. 69, The
Meaning of Present Fairly in Conformity with Generally Accepted
Accounting Principles in the Independent Auditor's Report (1992).
---------------------------------------------------------------------------
. . . should be based on his or her judgment as to whether
(a) the accounting principles selected and applied have general
acceptance; (b) the accounting principles are appropriate in
the circumstances; (c) the financial statements, including the
related notes, are informative of matters that may affect their
use, understanding, and interpretation . . .; (d) the
information presented in the financial statements is classified
and summarized in a reasonable manner, that is, it is neither
too detailed nor too condensed . . .; and (e) the financial
statements reflect the underlying transactions and events in a
manner that presents the financial position, results of
operations, and cash flows stated within a range of acceptable
limits, that is, limits that are reasonable and practicable to
attain in financial statements. [Footnote reference omitted.]
19
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\19\ SAS No. 69, para. 4.
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Those standards also recognize that there may be an occasion where
the literal application of generally accepted accounting principles
(``GAAP'') by enterprises might have the effect of rendering the
enterprise's financial statements misleading. In those cases, the
auditing standards provide that the ``proper accounting treatment is
that which will render the financial statements not misleading.''
20 Moreover, in those cases the auditor's opinion is
required to describe ``the departure [from GAAP], its approximate
effects, if practicable, and the reasons why compliance with the
principle would result in a misleading statement.'' 21
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\20\ AICPA Professional Standards, ``General Standards, Accounting
Principles,'' ET Sec. 203[.02] (1988).
\21\ ET Sec. 203[.01].
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In addition to the existing auditing standards, in January 2003, as
directed by the Sarbanes-Oxley Act of 2002 (``2002 Act''),
22 the SEC adopted rules that require that an issuer's
principal executive and financial officers each certify the financial
statements and other information contained in the issuer's quarterly
and annual reports.23 Those rules require officers to
certify, among other things, that based on such officer's knowledge
``the financial statements, and other financial information included in
the report, fairly present in all material respects the financial
condition, results of operations and cash flows of the issuer as of,
and for, the periods presented in the report . . .'' 24
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\22\ Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204, Sec. 302(a),
116 Stat. 745, 777 (2002).
\23\ Final Rule: Certification of Disclosure in Companies'
Quarterly and Annual Reports, Release No. 33-8124 (August 29, 2002).
\24\ Certification of Disclosure in Annual and Quarterly Reports,
17 CFR Sec. 240.13a-14(3) (2002).
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The 2002 Act also required that the SEC ``conduct a study on the
adoption by the United States financial reporting system of a
principles-based accounting system.'' 25 The FASB has been
working closely with the SEC staff in this area, and in October 2002,
we issued for public comment a proposal on this whole subject
(``Proposal'').26 The Proposal included the following
statement:
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\25\ Pub. L. No. 107-204, Sec. 108(d).
\26\ FASB Proposal, Principles-Based Approach to U.S. Standard
Setting (October 2002).
---------------------------------------------------------------------------
The Board . . . expects to consider the need for an overall
reporting framework similar to that in IAS 1 (Revised),
Presentation of Financial Statements. The main objective of
that reporting framework would be to provide guidance on issues
such as materiality assessments, going-concern assessments,
professional judgments, accounting policies, consistency, and
presentation of comparative information. It also could include
a true and fair override to deal with the extremely rare
circumstances in which management concludes that compliance
with a requirement in an accounting standard would be so
misleading that it would conflict with the objectives of
financial accounting and reporting. Some believe that such an
override is needed to more clearly convey the economic
substance of transactions and events in such circumstances,
while others believe that such an override would undermine the
principles in the standards, regardless of limitations on its
use. [Footnote reference omitted.] 27
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\27\ FASB Proposal, p. 7.
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As part of the Proposal process, respondents were asked to comment
on whether the Board should develop a similar reporting framework and
include a true and fair override in US GAAP. The Board received more
than 130 comments in response to the Proposal. The Board also held a
public roundtable discussion in which 30 individuals participated.
With respect to the reporting framework: Some of the respondents
that addressed that question said that the Board should develop a
similar reporting framework--separately or as part of a conceptual
framework improvements project. Some of those respondents said that
while similar guidance is contained in US GAAP, it is disbursed among
many different sources and that having that information in one place
(in a single framework) would make it easier to understand the
accounting model.
Others disagreed with the need for such an accounting standard,
some stating that such a standard is only necessary when accounting
practice is widely divergent and that that environment does not exist
in the US.
With respect to a true and fair override: Some of the respondents
that addressed that question said that they supported a true and fair
override for US GAAP but only in rare situations and if properly
disclosed to ensure that users understand that an override has occurred
in the preparation of financial statements.
Other respondents disagreed with the need for a true and fair
override, some stating that such an override already exists in US
auditing standards.
In the coming weeks, the Board plans on continuing to discuss
issues raised by constituents in response to the Proposal and decide
what additional actions, if any, the FASB should pursue in this area.
We also plan to continue to work closely with the SEC as it responds to
the 2002 Act's requirement to study and report on the potential
adoption by the US of a principles-based system.
Question 13) English accounting rules provide that accountants must
certify that financial accounts are ``True and Fair''--presenting
results that are both correct and understandable. Please explain how
this concept works and how it differs from U.S. Accounting Standards.
Response: The United Kingdom's (``UK'') Companies Act 1985 (as
amended) (``1985 Act'') provides that:
Directors of companies incorporated under the Companies Acts
. . . prepare accounts that give a true and fair view of the
state of affairs of the company, and where applicable the
group, at the end of the financial year and of the profit or
loss of the company or the group for the financial year.''
28
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\28\ UK Accounting Standards Board, Foreword to Accounting
Standards (1993), para. 8.
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UK accounting standards incorporate the true and fair view in a
``Foreword to Accounting Standards'' (``Foreword''). The Foreword, in
addition to describing the 1985 Act, states:
Accounting standards are authoritative statements of how
particular types of transaction and other events should be
reflected in financial statements and accordingly compliance
with accounting standards will normally be necessary for
financial statements to give a true and fair view . . .
The requirement to give a true and fair view may in special
circumstances require a departure from accounting standards.
However, because accounting standards are formulated with the
objective of ensuring that the information resulting from their
application faithfully represents the underlying commercial
activity, the Board envisages that only in exceptional
circumstances will departure from the requirements of an
accounting standard be necessary in order for financial
statements to give a true and fair view.
If in exceptional circumstances compliance with the
requirements of an accounting standard is inconsistent with the
requirement to give a true and fair view, the requirements of
the accounting standard should be departed from to the extent
necessary to give a true and fair view. In such cases informed
and unbiased judgement should be used to devise an appropriate
alternative treatment, which should be consistent with the
economic and commercial characteristics of the circumstances
concerned. Particulars of any material departure from an
accounting standard, the reasons for it and its financial
effects should be disclosed in the financial statements. The
disclosure made should be equivalent to that given in respect
of departures from specific accounting provisions of companies
legislation.
The Financial Reporting Review Panel . . . and the Department
of Trade and Industry have procedures for receiving and
investigating complaints regarding the annual accounts of
companies in respect of apparent departures from the accounting
requirements of the Act, including the requirement to give a
true and fair view. The Review Panel will be concerned with
material departures from accounting standards, where as a
result the accounts in question do not give a true and fair
view, but it will also cover other departures from the
accounting provisions of the Act. 29
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\29\ Foreword to Accounting Standards, para.para. 16 and 18-20;
footnote reference omitted.
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As indicated in response to question 12, a concept somewhat
analogous to the UK true and fair view currently exists in the US. In
the coming weeks, the Board plans on continuing to discuss issues
raised by constituents in response to the Proposal and decide what
additional actions, if any, the FASB should pursue in this area. We
also plan to continue to work closely with the SEC as it responds to
the 2002 Act's requirement to study and report on the potential
adoption by the US of a principles-based system.
Question 14) Chairman Stearns proposed in legislation that
accountants be required to reconcile FASB's fundamental principles of
transparency and understandability for every application of accounting
rules. Please explain how this proposal would work.
Response: The FASB is uncertain how Chairman Stearns proposal would
work in light of the existing auditing standards requirements and the
recently enacted officer certification requirements of the 2002 Act. As
indicated in response to question 12, in the coming weeks, the Board
plans on continuing to discuss issues raised by constituents in
response to the Proposal and decide what additional actions, if any,
the FASB should pursue in this area. We also plan to continue to work
closely with the SEC as it responds to the 2002 Act's requirement to
study and report on the potential adoption by the US of a principles-
based system.
STOCK OPTIONS
Question 15) Please explain the difference between the tax
treatment of options and the GAAP treatment.
Response: Under existing US GAAP most grants of stock options to
employees are reported in the financial statements at zero expense
because enterprises have the choice, if the options meet certain
criteria, to measure expense using the intrinsic value of the options
at the date of grant.30 The intrinsic value is the
difference between the exercise (or strike) price of the option and the
market price of the underlying stock.
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\30\ FASB Statement No. 123, Accounting for Stock-Based
Compensation (1995), para. 11.
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The other choice, which is the preferable method of accounting
under US GAAP, is to measure the option grants at fair value at the
date of grant. Until recently only a few companies chose the preferable
method. In recent months, however, more than 200 companies decided to
expense or intend to expense stock compensation using the preferable
method.31
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\31\ Pat McConnell, Janet Pegg, Chris Senyek, and Dane Mott,
``Companies That Currently Expense or Intend to Expense Stock Options
Using the Fair Value Method,'' Bear Stearns (March 24, 2003).
---------------------------------------------------------------------------
In contrast, it is our understanding that the tax treatment for
enterprises issuing stock compensation is dependent upon the tax
classification of the options issued. The two primary types of options
recognized in the tax code are incentive stock options and nonqualified
stock options.
Incentive stock options are options that meet special conditions
under the tax code. Incentive stock options have no tax consequences at
grant or exercise date to the employer. The employer, however, may
obtain a tax deduction if the employee sells the shares received from
exercising the option if those shares are sold within one year of
exercise or within two years of grant. If that occurs, the employer
receives a deduction equal to the intrinsic value of the option at
exercise.
Nonqualified stock options are deductible by the employer as
compensation expense upon exercise. The measurement of the expense
typically is based on the intrinsic value at exercise date.
Question 16) What would be the implication of harmonizing the
treatment?
Response: The purpose of financial accounting and reporting
standards is to provide investors with unbiased, transparent, and
comparable information about enterprises' underlying economic
activities. It is our understanding that the purpose of tax accounting
is to raise revenues for the US Government and to promote various
public policies. It, therefore, is not surprising that the financial
accounting and tax accounting treatment for many transactions,
including stock compensation, differ.
The tax accounting treatment of stock compensation may not be
consistent with the purpose of financial accounting and reporting. For
example, the tax treatment (1) ignores recognition of an expense for
stock compensation until long after the exchange transaction has
occurred and (2) permits noncomparable expense recognition treatment
for economically similar types of stock compensation arrangements. The
latter reason is also viewed by many investors and other users of
financial statements as a flaw in the existing financial accounting and
reporting standards for stock compensation and has, in part, resulted
in the Board recently adding a project to its agenda to improve the
reporting for stock compensation.32
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\32\ FASB News Release, ``FASB Adds Projects to Its Agenda on
Employee Stock Options and Pensions'' (March 12, 2003).
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Moreover, the FASB is committed to promoting the international
convergence of accounting standards concurrent with improving the
quality of financial reporting. It is not likely, for the reasons
stated above, that the IASB and our other international counterparts
would conclude that adopting the US tax treatment as the financial
accounting and reporting standard for stock compensation would improve
the quality of international financial reporting.33
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\33\ See IASB Proposed IFRS, Share-Based Payment (November 2002)
(proposing a fair value grant date approach to the accounting for stock
compensation similar to the preferable fair value method contained in
FASB Statement No. 123).
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USER ADVISORY COUNCIL
Question 17) Who sits on the Advisory Council--i.e., what groups
are represented? Who formed the group and who will determine its
composition?
Response: Attachment 6 to FASB Chairman Robert H. Herz's March 4,
2003, testimony before the Subcommittee on Commerce, Trade and Consumer
Protection contains a listing of the initial members of the FASB's User
Advisory Council (``UAC'') and their affiliations. The UAC was formed
by the FASB, and the FASB will determine its composition.
Question 18) What role will the Council play in the FASB's process
of developing an agenda and accounting standards?
Response: The FASB expects that the UAC will assist the FASB in
raising awareness of how investors and investment professionals, equity
and credit analysts, and rating agencies use financial information. The
UAC will serve as another resource to the FASB both in formulating its
technical agenda and on specific projects that the Board undertakes.
Question 19) The legislation passed out of the Subcommittee last
Congress included principles that financial reporting should be
transparent and equally usable for both the average investor and
industry professionals. Will the Advisory Council's input balance the
goal of providing useful information that meets the needs of both
groups (Professionals and consumers)?
Response: The objectives of US financial reporting are to
. . . provide information that is useful to present and
potential investors and creditors and other users in making
rational investment, credit, and similar decisions. The
information should be comprehensible to those who have a
reasonable understanding of business and economic activities
and are willing to study the information with reasonable
diligence.34
---------------------------------------------------------------------------
\34\ FASB Concepts Statement No. 1, Objectives of Financial
Reporting by Business Enterprises (1978), para. 34 (emphasis added).
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Thus, US financial reports are not intended (nor is it a realistic
to expect financial reports) to be useful to all investors. Rather,
financial reports are intended to provide useful information only to
those investors and other users of financial statements that have a
reasonable understanding of business and economic activities and
exercise reasonable diligence. The FASB expects that the UAC's input
will assist the FASB in raising awareness of how those investors (both
professionals and consumers) use financial information.
PRIMACY OF FASB
Question 20) FASB has discontinued the role of the AICPA as a
senior level standard setter. FASB has also decided that development of
industry-based standards should reside with FASB. Do you expect that
this determination will be challenged? Should this determination be
codified?
The AICPA issued a press release announcing that it supported the
FASB's decision that, after a transition period, the AcSEC should cease
issuing Statements of Position that create new US GAAP.35 In
addition, as indicated in the memorandum from the Office of Chief
Accountant attached to the March 7, 2003, letter from SEC Chairman
William H. Donaldson and FASB Chairman Robert H. Herz to Chairman Cliff
Stearns and Representative Janice D. Schakowsky, the SEC anticipates
finalizing a policy statement in the near future that will recognize
the FASB under the 2002 Act as the independent private-sector
accounting standard-setting body in the US.
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\35\ AICPA Press Release, ``American Institute of Certified Public
Accounts Shifts Focus to Industry-Specific Accounting Guidance''
(November 5, 2002).
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[GRAPHIC] [TIFF OMITTED] T6050.001
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