[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

                              ----------                              


                         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.
---------------------------------------------------------------------------
    \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
---------------------------------------------------------------------------
    \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).
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \16\ Business Reporting Research Project, Steering Committee 
Report, Electronic Distribution of Business Reporting Information 
(2000).
---------------------------------------------------------------------------
    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.''
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    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
---------------------------------------------------------------------------
    \19\ SAS No. 69, para. 4.
---------------------------------------------------------------------------
    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
---------------------------------------------------------------------------
    \20\ AICPA Professional Standards, ``General Standards, Accounting 
Principles,'' ET Sec. 203[.02] (1988).
    \21\ ET Sec. 203[.01].
---------------------------------------------------------------------------
    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
---------------------------------------------------------------------------
    \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).
---------------------------------------------------------------------------
    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:
---------------------------------------------------------------------------
    \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
---------------------------------------------------------------------------
    \27\ FASB Proposal, p. 7.
---------------------------------------------------------------------------
    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
---------------------------------------------------------------------------
    \28\ UK Accounting Standards Board, Foreword to Accounting 
Standards (1993), para. 8.
---------------------------------------------------------------------------
    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
---------------------------------------------------------------------------
    \29\ Foreword to Accounting Standards, para.para. 16 and 18-20; 
footnote reference omitted.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \30\ FASB Statement No. 123, Accounting for Stock-Based 
Compensation (1995), para. 11.
---------------------------------------------------------------------------
    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
---------------------------------------------------------------------------
    \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
---------------------------------------------------------------------------
    \32\ FASB News Release, ``FASB Adds Projects to Its Agenda on 
Employee Stock Options and Pensions'' (March 12, 2003).
---------------------------------------------------------------------------
    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
---------------------------------------------------------------------------
    \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
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    \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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