[House Hearing, 108 Congress]
[From the U.S. Government Publishing Office]
THE ACCOUNTING TREATMENT
OF EMPLOYEE STOCK OPTIONS
=======================================================================
HEARING
BEFORE THE
SUBCOMMITTEE ON
CAPITAL MARKETS, INSURANCE AND
GOVERNMENT SPONSORED ENTEREPRISES
OF THE
COMMITTEE ON FINANCIAL SERVICES
U.S. HOUSE OF REPRESENTATIVES
ONE HUNDRED EIGHTH CONGRESS
FIRST SESSION
__________
JUNE 03, 2003
__________
Printed for the use of the Committee on Financial Services
Serial No. 108-32
U.S. GOVERNMENT PRINTING OFFICE
90-627 WASHINGTON : 2003
_____________________________________________________________________________
For Sale by the Superintendent of Documents, U.S. Government Printing Office
Internet: bookstore.gpo.gov Phone: toll free (866) 512-1800; (202) 512-1800
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HOUSE COMMITTEE ON FINANCIAL SERVICES
MICHAEL G. OXLEY, Ohio, Chairman
JAMES A. LEACH, Iowa BARNEY FRANK, Massachusetts
DOUG BEREUTER, Nebraska PAUL E. KANJORSKI, Pennsylvania
RICHARD H. BAKER, Louisiana MAXINE WATERS, California
SPENCER BACHUS, Alabama CAROLYN B. MALONEY, New York
MICHAEL N. CASTLE, Delaware LUIS V. GUTIERREZ, Illinois
PETER T. KING, New York NYDIA M. VELAZQUEZ, New York
EDWARD R. ROYCE, California MELVIN L. WATT, North Carolina
FRANK D. LUCAS, Oklahoma GARY L. ACKERMAN, New York
ROBERT W. NEY, Ohio DARLENE HOOLEY, Oregon
SUE W. KELLY, New York, Vice Chair JULIA CARSON, Indiana
RON PAUL, Texas BRAD SHERMAN, California
PAUL E. GILLMOR, Ohio GREGORY W. MEEKS, New York
JIM RYUN, Kansas BARBARA LEE, California
STEVEN C. LaTOURETTE, Ohio JAY INSLEE, Washington
DONALD A. MANZULLO, Illinois DENNIS MOORE, Kansas
WALTER B. JONES, Jr., North CHARLES A. GONZALEZ, Texas
Carolina MICHAEL E. CAPUANO, Massachusetts
DOUG OSE, California HAROLD E. FORD, Jr., Tennessee
JUDY BIGGERT, Illinois RUBEN HINOJOSA, Texas
MARK GREEN, Wisconsin KEN LUCAS, Kentucky
PATRICK J. TOOMEY, Pennsylvania JOSEPH CROWLEY, New York
CHRISTOPHER SHAYS, Connecticut WM. LACY CLAY, Missouri
JOHN B. SHADEGG, Arizona STEVE ISRAEL, New York
VITO FOSSELLA, New York MIKE ROSS, Arkansas
GARY G. MILLER, California CAROLYN McCARTHY, New York
MELISSA A. HART, Pennsylvania JOE BACA, California
SHELLEY MOORE CAPITO, West Virginia JIM MATHESON, Utah
PATRICK J. TIBERI, Ohio STEPHEN F. LYNCH, Massachusetts
MARK R. KENNEDY, Minnesota ARTUR DAVIS, Alabama
TOM FEENEY, Florida RAHM EMANUEL, Illinois
JEB HENSARLING, Texas BRAD MILLER, North Carolina
SCOTT GARRETT, New Jersey DAVID SCOTT, Georgia
TIM MURPHY, Pennsylvania
GINNY BROWN-WAITE, Florida BERNARD SANDERS, Vermont
J. GRESHAM BARRETT, South Carolina
KATHERINE HARRIS, Florida
RICK RENZI, Arizona
Robert U. Foster, III, Staff Director
Subcommittee on Capital Markets, Insurance and Government Sponsored
Enterprises
RICHARD H. BAKER, Louisiana, Chairman
DOUG OSE, California, Vice Chairman PAUL E. KANJORSKI, Pennsylvania
CHRISTOPHER SHAYS, Connecticut GARY L. ACKERMAN, New York
PAUL E. GILLMOR, Ohio DARLENE HOOLEY, Oregon
SPENCER BACHUS, Alabama BRAD SHERMAN, California
MICHAEL N. CASTLE, Delaware GREGORY W. MEEKS, New York
PETER T. KING, New York JAY INSLEE, Washington
FRANK D. LUCAS, Oklahoma DENNIS MOORE, Kansas
EDWARD R. ROYCE, California CHARLES A. GONZALEZ, Texas
DONALD A. MANZULLO, Illinois MICHAEL E. CAPUANO, Massachusetts
SUE W. KELLY, New York HAROLD E. FORD, Jr., Tennessee
ROBERT W. NEY, Ohio RUBEN HINOJOSA, Texas
JOHN B. SHADEGG, Arizona KEN LUCAS, Kentucky
JIM RYUN, Kansas JOSEPH CROWLEY, New York
VITO FOSSELLA, New York, STEVE ISRAEL, New York
JUDY BIGGERT, Illinois MIKE ROSS, Arkansas
MARK GREEN, Wisconsin WM. LACY CLAY, Missouri
GARY G. MILLER, California CAROLYN McCARTHY, New York
PATRICK J. TOOMEY, Pennsylvania JOE BACA, California
SHELLEY MOORE CAPITO, West Virginia JIM MATHESON, Utah
MELISSA A. HART, Pennsylvania STEPHEN F. LYNCH, Massachusetts
MARK R. KENNEDY, Minnesota BRAD MILLER, North Carolina
PATRICK J. TIBERI, Ohio RAHM EMANUEL, Illinois
GINNY BROWN-WAITE, Florida DAVID SCOTT, Georgia
KATHERINE HARRIS, Florida
RICK RENZI, Arizona
C O N T E N T S
----------
Page
Hearing held on:
June 03, 2003................................................ 1
Appendix:
June 03, 2003................................................ 73
WITNESSES
Tuesday, June 03, 2003
Dreier, Hon. David, Member, U.S. House of Representatives........ 2
Eshoo, Hon. Anna G., Member, U.S. House of Representatives....... 4
Barrett, Craig R., Chief Executive Officer, Intel Corporation.... 48
Glassman, James K., Resident Fellow, American Enterprise
Institute...................................................... 53
Herz, Robert H., Chairman, Financial Accounting Standards Board.. 21
Hills, Hon. Roderick M., Partner, Hills & Stern.................. 51
Nightingale, Deborah, Project Manager, Sun Microsystems.......... 7
Volcker, Hon. Paul A., Chairman, International Accounting
Standards Committee Foundation Trustees........................ 45
APPENDIX
Prepared statements:
Oxley, Hon. Michael G........................................ 74
Dreier, Hon. David........................................... 75
Eshoo, Hon. Anna G........................................... 78
Gillmore, Hon. Paul E........................................ 81
Kanjorski, Hon. Paul E....................................... 82
Royce, Hon. Edward R......................................... 84
Stark, Hon. Pete............................................. 86
Barrett, Craig R............................................. 88
Glassman, James K............................................ 102
Herz, Robert H............................................... 113
Hills, Hon. Roderick M....................................... 158
Nightingale, Deborah......................................... 166
Volcker, Hon. Paul A......................................... 169
Additional Material Submitted for the Record
Eshoo, Hon. Anna G.:
Employee Stock Options: The untold story..................... 173
Stark, Hon. Pete:
Copy of H.R. 626............................................. 190
Financial Accounting Standards Board letter, February 3, 2003 193
Hills, Hon. Roderick M.:
``True and fair is not hard and fast,'' article, The
Economist, April 24, 2003.................................. 199
THE ACCOUNTING TREATMENT
OF EMPLOYEE STOCK OPTIONS
----------
Tuesday, June 3, 2003
U.S. House of Representatives,
Subcommittee on Capital Markets, Insurance
and Government Sponsored Enterprises,
Committee on Financial Services,
Washington, D.C.
The subcommittee met, pursuant to call, at 10:05 a.m., in
Room 2128, Rayburn House Office Building, Hon. Richard H. Baker
[Chairman of the subcommittee] presiding.
Present: Representatives Baker, Ose, Shays, Gillmor, Oxley
(ex officio), Castle, Lucas of Oklahoma, Manzullo, Ney, Kennedy
of Minnesota, Brown-Waite, Renzi, Royce, Kelly, Shadegg, Green,
Miller of California, Toomey, Capito, Hart, Tiberi, Harris,
Kanjorski, Hooley, Sherman, Meeks, Inslee, Gonzalez, Hinojosa,
Crowley, McCarthy, Matheson, Miller of North Carolina, Emanuel
and Scott.
Chairman Baker. Welcome all those who are in attendance
today.
Because of the nature of the panels we have this morning,
there being three in number and the distinguished participants
in each of those panels, I am going to suggest--I have
discussed with Mr. Kanjorski and his side minimizing opening
statements to myself and Mr. Kanjorski, and we will enter into
the record all of the members' statements for that purpose,
simply to expedite our hearing and move forward to important
testimony which we will receive.
Today, the Subcommittee on Capital Markets turns its
attention to expensing employee stock options and, more
specifically, H.R. 1372, the Broad-Based Stock Option Plan
Transparency Act introduced by Representatives Dreier and
Eshoo. This hearing is especially timely as we are moving
towards issues of proposed standards on the mandatory expensing
options later this year.
Stock options for executives, managers and employees have
served as an important tool for cash-strapped companies in
their efforts to attract and retain skilled management and
employees. However, there are clearly two schools of thought on
the methodology for proper accounting treatment.
Proponents of expensing include the big four accounting
firms, institutional investors, as well as the current Chairman
Greenspan and former Chairman Volcker. Their views and options
are a form of compensation just like salary and bonuses. As
compensation is an expense and as expenses eventually impact
earnings, options should therefore be recorded and subtracted
from income.
Opponents justifiably argue expensing has a different view.
They believe that mandatory expensing would discourage the use
of options and adversely have an affect on innovation, economic
growth, job opportunity and national competitiveness.
Furthermore, options for expenses to company valuation is a
most difficult issue. For example, use of different option
pricing models and different assumptions can lead to
significantly different economic consequences.
H.R. 1372 would seek to have SEC issue regulatory
requirements which would enhance disclosure of employee stock
options while prohibiting the SEC to recognize new accounting
standards related to stock options until a report is submitted
to Congress and to this committee on the cost-effectiveness of
such regulation. This report would follow a period of 3 years
of study.
This is a very controversial but very important issue, and
I look forward to hearing from each of our distinguished
panelists this morning.
I will turn to Mr. Kanjorski for an opening statement.
Mr. Kanjorski. Thank you, Mr. Chairman.
Mr. Chairman, I, too, am interested in the stock option
issue. We should look at its effect on corporate returns and
disclosures.
I think we should move forward with our panel, however. In
the nature of saving time and efficiency, I move that my
opening remarks be entered into the record.
Chairman Baker. Without objection. Thank you, Mr.
Kanjorski.
[The prepared statement of Hon. Paul E. Kanjorski can be
found on page 82 in the appendix.]
Chairman Baker. If there be no further statements at this
time, I would like to move forward quickly to our distinguished
panel and recognize the Chairman of the Rules Committee, the
distinguished David Dreier.
STATEMENT OF THE HON. DAVID DREIER, A REPRESENTATIVE IN
CONGRESS FROM THE STATE OF CALIFORNIA
Mr. Dreier. Thank you thank you very much, sir. This is the
first time I have been in this room; and this room has changed
a lot since I have been in here, Mr. Chairman.
Let me say I appreciate the fact that you and Mr. Kanjorski
and the members of this subcommittee have agreed to hold what I
think is a very important hearing, and I believe that what we
have really done here is recognize that there is a problem. We
all know that the problem of corporate corruption came to the
forefront, and your full committee addressed that issue with
passage of the Sarbanes-Oxley legislation. I know that there
are many people out there who are still focused on a number of
the concerns, and I believe that Ms. Eshoo and I are focused on
those and really have tried to step up to the plate and
responsibly address this issue with the legislation that we
have introduced.
Now, some have alleged that our legislation is an
interference in the accounting standards setting process. The
fact is, Mr. Chairman, we can't divorce--as Members of Congress
we can't divorce ourselves from our responsibility for dealing
with accounting standards, but we also have to look at the very
real impact that those standards will have on economic growth,
investors in this country, shareholders and the economy as
well.
Unlike the FASB board members, we are elected officials.
And I am not an accountant, I am not an expert on this, Mr.
Chairman, but I will tell you that I know that we have an
obligation to the American worker and to the American investor
to do everything that we can to preserve an environment that
allows entrepreneurs to play a role in growing our economy.
Now, there is a disagreement between those who take a
static view of the economy and see stock options as something
that could theoretically impact shareholders today and those
who understand the dynamics of an evolving, technology-based
economy that views stock options as an important tool for
increasing all share value in the future.
Now, if you try to cement the cost of those stock options
and their grants up front, you will undermine the engine that
will grow the company pie, because mandatory expensing--and I
have no problem with voluntary expensing, but mandatory
expensing will eliminate the use of broad-based employee stock
option plans.
I am not concerned about executive compensation. We know
there has been some abuse there, and obviously that needs to be
addressed. What I am concerned about is the potential to
jeopardize the stock option plans for employees. I mean, this
is a public policy issue, Mr. Chairman. It is not an accounting
issue.
Expensing--mandatory expensing will do little to curb the
number of stock options granted to top executives, but it will
directly harm, as I said, the ability of rank and file
employees who enjoy corporate ownership.
Deborah Nightingale from Sun is going to be testifying in
just a moment, and she is going to talk about--I read her
testimony last night. She is going to talk about the
innovation, creativity and the role that she plays as a partner
in her company.
Mandatory stock option expensing not only threatens the
high-growth sectors of our economy but will actually result in
an investor receiving inaccurate information about a company's
use of employee stock options.
Now, our bill will mandate--Mr. Chairman, our bill will
mandate the uniform and standardized disclosure of employee
stock options without resulting in the elimination of broad-
based stock options.
Now you don't have to be an accountant to recognize that
stock options are not actually an expense. If you look at the
definition of an expense, that is anything that results in an
outflow of a company's assets or an increase in the company's
liabilities. Employee stock options meet neither test.
I mean, let's propose, for instance, that on the first of
January of this year company A had hired a computer programmer
at a salary of $50,000 a year plus 100 stock option grants that
can be exercised at a price of $10 no earlier than 5 years from
the date of hire. Only the cash salary and nothing for the
options. There is no cash outflow for the options and no
liability created at any time, not when they are granted,
vested or exercised. Indeed, when the stock options are
exercised, the company actually receives money, and obviously
the only thing that ultimately happens is the potential
dilution of that stock. So all shareholders need to do is be
informed of exactly what that option package consists of, and
that is what our legislation is designed to do.
Now, Mr. Chairman, the fact is employee stock options never
actually impose an expense or cost on companies. Since that is
the case, why is there this endless debate with FASB and others
in the accounting community over expensing stock options or
explaining exactly what the cost to companies is?
Well, that brings me to, actually, a visual aid that I have
here, Mr. Chairman; and I would just like to share this with
you.
This is a map of the universe from 2,000 years ago; and
basically Claudius Ptolemy, as we all know, came up with this
amazing theory that the earth was the center of the universe,
and for 1,500 years--that is 15 centuries, Mr. Chairman--that
view continued on and on and on by great minds who basically
supported the Ptolemaic theory and Copernicus, Galileo, Brahe,
the whole gang of these people ended up supporting it. The
Mathematical Compilation, a 13-volume treatise, was put
together, and guess what? We found, when all of a sudden Johann
Kepler came forward, that while 15 centuries of stating that
the earth was the center of the universe was out there, they
were wrong.
It is true that you can take all kinds of facts and justify
almost anything, but it doesn't necessarily make it right. That
is why I don't believe that options are an expense, and I hope
very much that we will be able to expeditiously move forward
with this legislation to address the understandable concerns
that FASB and all the rest of us raise.
Thank you very much, Mr. Chairman.
Chairman Baker. Thank you, Chairman Dreier. We have members
requesting copies of that chart for further----
Mr. Dreier. And I will tell you that likely you might
conclude that this is a meeting of Sherwood Boehlert's Science
Committee.
Chairman Baker. It could be helpful to a lot of us I think.
Thank you.
[The prepared statement of Hon. David Dreier can be found
on page 75 in the appendix.]
Chairman Baker. Our next witness this morning is the
Honorable Anna Eshoo, distinguished Member, and glad to have
you here as a cosponsor of this important legislation.
STATEMENT OF THE HON. ANNA G. ESHOO, A REPRESENTATIVE IN
CONGRESS FROM THE STATE OF CALIFORNIA
Ms. Eshoo. Good morning, Mr. Chairman. Thank you for having
me here today to testify on the issue of expensing of stock
options to the distinguished ranking member Mr. Kanjorski and
to the Chairman of the full committee Mr. Oxley, who has worked
with us to have this hearing. We very, very much appreciate it.
I want to divide my comments up into what the expensing of
stock options will not do and then the plus side of what stock
options represent to the rank and file employees in so many
companies in our companies today.
I think, first of all, that the term stock options is
something that people instantly think of when the term is
stated that it has--it is a term that has become sullied; and
that, of course, is the result of the misuse and the abuse of
stock options that produced the scandals and the excessive
executive compensation. I believe really that these events have
led to a renewed call, because this is a call that took place
many years ago in my first term when I came to the Congress in
1993, and I think that these events have led to the call for
expensing, leading many to believe that this is the ultimate
prescription for what might ail us.
Congress, as you know, and this committee of course knows,
responded by the Sarbanes-Oxley bill that passed in the last
Congress.
So what will the expensing of stock options not accomplish?
What will it not do?
First of all, in my view, the expensing of stock options
will not rein in any excessive executive compensation in
corporate America. If in fact stock options are not available,
anyone that is at the top of a company, a corporation, that
board of directors is going to find some way to compensate
people that are at the top. There may be some things that we
haven't heard of, but certainly top executives in this country
will be compensated, compensated well, and it is their board of
directors and their respective committees that will take care
of that.
I think it is relatively easy for companies like GE and
Coca-Cola to expense stock options. Keep in mind that they
provide stock options to only a few, a very small number of
their rank and file, and provide those stock options on a
smaller basis to their executives.
Companies in my district and many other companies across
the country today--in my district, it is mostly biotechnology
and high-technology sectors. They use stock options very
differently than the companies that became the poster children
for corporate fraud.
If in fact the expensing of stock options had been on the
books, the debacle at Enron would have still taken place. So it
should not be thought of as the prescriptive that some have
described.
Rather than handing out options only to senior executives,
new economy companies offer them broadly, and when I say
broadly, it is very broad. They turned their entire employee
base into corporate partners who have a stake in the future
success of their company.
Recent research indicates that at the top 800 technology
companies in our country, 80 percent of the stock options are
granted to the rank and file employees, not senior executives,
and in the last decade over 10 million employees have received
stock options.
So who loses if stock options are required to be expensed?
Not senior executives who will be compensated, as I said, in
one way or another. But it is the rank and file employees. They
are the ones that would lose out on this benefit. Why? Because,
faced with the prospect of taking a huge charge against their
bottom line in accounting statements, most companies would
simply drop the broad-based option plans and eliminate this
benefit to all but senior executives.
Broad-based--I think it is very important for the committee
members to take this out of the hearing, that broad-based stock
option plans have turned employees into corporate partners by
tying the interest of the employee together with the company
and its shareholders.
Small entrepreneurial companies start up with very little
capital, and so they have used stock options as the magnet to
attract and to retain bright and talented employees that are
critical to that company's success. And seated to my left is
one of those employees, Debbie Nightingale of Sun Microsystems.
She obviously is going to testify and speak to you in her
personal story, but what you should also know is that she
serves part time as a lieutenant colonel in the Army Reserves.
I just returned from Iraq with Chairman Hunter, and were it
not for the role that our Reserves are playing, we would have
had a much, much tougher time in the engagement there.
I also have brought, Mr. Chairman, a very thick compilation
of statements from employees that I ask be placed in the record
as well.
Chairman Baker. Without objection.
Ms. Eshoo. Thank you.
[The following information can be found on page 173 in the
appendix.]
Ms. Eshoo. These employees have used their options to
purchase their first homes, to send their kids to college, to
finance their retirements, to donate and sometimes begin
foundations and charities; and they have contributed to our
economy every step of the way.
Now, the FASB has indicated it will only focus on
accounting standards and not economic standards when it rules
whether to require stock option expensing. I agree that
accounting standards are best left to FASB, but promoting job
growth and economic viability is a responsibility of the
Congress. It is something that we all have the responsibility
for. So while FASB says it won't look at the economic impact
its decision will have, again, we have the responsibility to
examine these factors and ensure that our national policies
foster economic growth.
Investors and shareholders access to information on how
companies use stock options can and should be bolstered without
throwing the baby out with the bath water, as expensing really
would do.
The legislation that Chairman Dreier and I have introduced
we believe strikes an appropriate balance by requiring
companies who offer stock options to disclose additional
information to every shareholder and potential investor. Our
bill, H.R. 1372, requires and includes plain English
descriptions of share value dilution. That is something that
investors and potential investors should be able to see and
understand.
The bill expands and builds a more prominent disclosure of
stock option-related information, and it includes a summary of
stock options granted to the five most highly compensated
officers in a company or corporation.
The bill also directs the SEC to monitor the effectiveness
for investors of the enhanced disclosure requirements and
report its findings back to this committee, and during that
time frame the SEC would be prohibited from recognizing as a
generally accepted accounting principal any new accounting
standard on stock options.
What our legislation does not set is accounting standards.
Some have criticized this provision as a mandate on FASB, and
nothing in our bill requires Congress to get into the standard-
setting business. Congress can and should do many things. I
don't think it should do that. We have problems keeping up with
our own books, much less do otherwise.
The legislation directs the SEC to exert its appropriate
role in maintaining the integrity of our markets and to ensure
that our economic policies foster growth. Forcing companies to
expense stock options at some arbitrary value as the FASB
decision is likely to require I think would be both misleading
to investors and to shareholders alike. Our legislation
provides greater transparency about the use of stock options
without unfairly penalizing the innovative employees that are
really building America's economic future.
So I thank you, Mr. Chairman, to the ranking member, and to
the Chairman of the full committee for inviting us here today
to speak to a story of success in our country and that we can
move on in terms of transparency and other reforms without
damaging what has become one of the most important recruiting
and maintenance tools for small companies and others in our
country. Thank you very, very much.
Chairman Baker. Thank you, Ms. Eshoo.
[The prepared statement of Hon. Anna G. Eshoo can be found
on page 78 in the appendix.]
Chairman Baker. Which leads us to our final participant in
this panel, a Project Manager for Sun Microsystems, Ms. Deborah
Nightingale. Welcome, Ma'am.
STATEMENT OF DEBORAH NIGHTINGALE, PROJECT MANAGER, SUN
MICROSYSTEMS
Ms. Nightingale. Thank you, Mr. Chairman.
Thank you, Mr. Chairman and committee members, for the
opportunity to speak to you today about the importance of
broad-based stock options to rank and file employees
nationwide. I would also like to thank Representatives Dreier
and Eshoo for their leadership on this important issue.
I am here today speaking as one individual, but I know that
I represent the view of thousands of my colleagues at Sun
Microsystems and hundreds of thousands of employees nationwide.
Today, I have a dual career, working full time for Sun
Microsystems, and I serve part time as a lieutenant colonel in
the Army Reserves. I started my career on active duty, and
after 5 years I did make the decision to pursue some civilian
opportunities. However, I have always remained in the Reserves,
because I enjoy the military.
Within several weeks after 9/11, I was mobilized for over 6
months to help lead the airport security mission at San
Francisco and other northern California airports. In the 15
years since I have left active duty, I have worked for four
companies, both high-tech and non-high-tech.
Having worked in both high-tech and non-high-tech, one big
differentiator, in my opinion, is employees in high-tech do
tend to be more innovative and entrepreneurial. Granted, high-
tech often pays more, but the question is, once you have a
well-paid, secure employee, how do you keep him or her
motivated to keep innovating and taking risks? One simple and
very effective answer--solution is stock options.
I think and work differently as a result of stock options.
I have always been a dedicated employee, but due to stock
options I am incented to do much more than simply work hard and
please the boss. I am motivated to drive results for Sun
Microsystems so that I can participate in some sizable profit
sharing, not just a better-than-average pay raise.
Working in operations, I am constantly looking for
innovative ways to cut costs so that Sun Microsystems can
continue to invest in their R&D. I have a strong sense of
ownership and a real stake in Sun. Simply put, Sun does well, I
do well.
As a member of the Armed Forces, I know that the
technologies developed by U.S. high-tech are key elements of
our military strength and our national security. A unit under
my command as a battalion commander deployed to Iraq about 4
weeks ago. As a result of a recent fire fight in Iraq, one
soldier has been evacuated to Spain and will be coming back to
the U.S. for major surgery before he will be returning home.
These soldiers are in harm's way every day. I will never forget
what one senior officer said to me: We need to do whatever we
can to make sure it is a very unfair fight in our favor.
I worry every day about those soldiers over there, but I do
feel just a little bit better knowing that we have given them
the best technology and equipment in the world. We need to
ensure that U.S. high-tech companies maintain their competitive
edge. I definitely worry about the possibility that other
foreign competitors could begin using broad-based stock options
just when the U.S. is taking measures to curtail the
feasibility for our U.S. companies.
In summary, broad-based stock options are really good for
both companies and employees. Stock options are a key reason
that I came to work for a high-tech company and a key reason
that I stay at Sun. Broad-based stock options create employee
commitment and loyalty. They attract and encourage innovators
and entrepreneurs. They give U.S. companies a competitive
advantage, and stock options really do matter to rank and file
employees like myself.
In summary, H.R. 1372 makes a lot of sense to me. It
increases disclosure requirements right now without
discouraging any broad-based stock options. It also provides
for more time to study the issue and look for win-win
solutions. This issue is an important issue to me and my fellow
employees. We do not want to see broad-based stock options
eliminated.
Thank you very much.
Chairman Baker. Thank you very much, Ms. Nightingale.
[The prepared statement of Deborah Nightingale can be found
on page 166 in the appendix.]
Chairman Baker. Ms. Eshoo, you raised a point in your
comments with regard to FASB's focus on accounting principles
as opposed to economic policy. Is it your judgment that the
current availability and reporting methodology for options
enhances capital formation, business creation? It is a tool of
principal value to the smaller not necessarily technology based
but innovative companies that are out there that otherwise
might have difficulty in attracting capital that a larger brick
and mortar institution with a track record might not have.
Ms. Eshoo. There isn't any question in my mind that it has
served as a very, very effective tool. I am looking across both
sides of the committee, and I think most of the members have
come to--at one time or another travelled to my Congressional
district, and so--and because members wanted to learn how these
small companies, these incubators were--you know, what the
ingredients were that was spawning the companies, the ideas,
but also the tools that help attract employees and to hold
them.
Now, I think it is really a great American story. Now, why
we would want to take an accounting standard to rejigger this
and destroy it is still a real question to me. There is not--
there isn't any question in my mind that this has served very,
very well. I mean, Debbie's story is one of--an eloquent story
of tens of thousands. So I think that we really shouldn't be
throwing the baby out with the bath water.
Are there more reforms that can take place? Absolutely. But
this accounting standard that wipes out what the rank and file
are going to get, keeping in mind that executives will always
be recompensed in some way I think is wrong-headed. But has it
attracted employees? Absolutely, and it is a retention tool as
well. And keep in mind, again, that small companies don't start
up with a great deal of capital. This is one of the magnets
that has drawn some of the best and the brightest to the
companies that then go on and build, and the average person has
really won under this--you know, what has taken place. I don't
have any question in my mind, and I think that members that
have travelled to my district and the region that I am from
have seen this firsthand.
Chairman Baker. Chairman Dreier, do you see it as a start-
up issue, or do you see it in a broader perspective with regard
to expensing of options?
Mr. Dreier. Well, I mean, it is a broad issue. But I will
tell you that if you take, Mr. Chairman--look, up until
recently, 45 percent of the gross domestic product growth in
this country has emanated from the tech sector of our economy.
We are hurting--and I represent the Los Angeles area. I am not
from the Silicon Valley, but we know that this has been
broadening all across the country.
This morning I was listening to National Public Radio, and
they were talking about a program that is going on today on the
technology sector right here in the District of Columbia. We
know we have the corridor going out to Dulles Airport. It has
grown all over. There are start-up companies that need to have
an incentive to continue to pursue their work, and we all
recognize that there has been a problem of corporate abuse. I
mean, there is no secret about that whatsoever.
That is why I believe empowering shareholders and investors
with more information as to what the policy is rather than
putting into place a policy which frankly not FASB--I don't
believe FASB--but there are some forces out there, Mr.
Chairman, that have as a goal the complete elimination of stock
options, and to me that would do more to undermine the
entrepreneurial spirit for existing companies as well as those
start-ups than almost anything else.
Chairman Baker. I thank the gentleman.
I think much of the comment is based on the presumption
that when an option is granted the only way that thing is going
to go is up. There hasn't been a lot of discussion about the
consequences of when things go in reverse, and I think that is
an area where we need to do a lot of examination.
Mr. Dreier. We have certainly seen that.
Chairman Baker. I have no further questions but just want
to thank both of you for your testimony and participating in
this hearing this morning.
Mr. Kanjorski.
Mr. Kanjorski. Thank you, Mr. Chairman.
An interesting history lesson Mr. Dreier gave us, 1,500
years of perhaps incorrect analysis of where we were. I wonder
if that applies to the----
Mr. Dreier. I wouldn't say perhaps. I don't think that--we
still think that the earth is the center of the universe.
Mr. Kanjorski. I know there are some members of this
committee, Mr. Dreier, that may be flat-earthers that don't
overargue that point.
Mr. Dreier. They didn't believe there was a flat earth,
actually, about--that is another misnomer, if you want to
continue the history lesson.
Mr. Kanjorski. But it just raises the question that there
is a large, compelling thought that tax cuts will stimulate the
economy by a large element. So that theory may also be tested
sometime in the future.
Mr. Dreier. Well, it worked under President Kennedy and it
worked under President Reagan and it worked under President
Harding and I think that it will work under President Bush.
Mr. Kanjorski. Well, if we assume that that is what--the
compelling reasons for the successes of those economies, but we
will argue that another day.
There has to be a middle ground here. Certainly I don't
think we should take it upon ourselves to make a judgment as to
what the proper tools to stimulate the economy, encourage
entrepreneurial activity is, but, on the other hand, we have
seen that in some instances stock options have led to abuses
which have caused problems which have put investors at risk,
just as off-shore deals in Enron caused a great deal of
problem.
I just looked at a paraphrase that I was going to ask two
congressional witnesses, particularly Mr. Barrett of Intel, who
will be on the next panel. He suggests certain conditions under
which we could establish a rhyme or reason how you look upon--
if you have had an opportunity to know what his position is and
how you look upon his thoughts of--maybe I should relate it to
all employee stock option plans should be approved by
shareholders. No more than 5 percent of the options should go
to the top executives, while permitting substantial majorities
of employees to participate. Companies should provide more
frequent and understandable disclosures. Options should vest
over longer periods, like 4 years, and compensation committees
should be comprised of outside directors. Finally, he argues
that expensing options under the Black-Scholes technique is
inherently inaccurate.
Do you have any thoughts on his proposals?
Mr. Dreier. Well, I don't know that he is proposing
actually mandating all of those provisions. I believe that the
policies that a company moves ahead with are policies which
clearly should be disclosed to shareholders. That is the goal
that Ms. Eshoo and I have with our legislation here.
I know that there are--and I am not going to speak for any
of the other witnesses who are going to be coming forward, but
I know that there are some of the panelists who are proponents
of expensing who actually believe that Black-Scholes should not
be the guide here, just as Mr. Barrett points out in his
statement. But I think that, again, empowering investors,
shareholders with as much information as possible as to what
that company's policies are, if they choose to expense, they
clearly should be able to do that. We just want with our
legislation to have as much information made available as
possible so that they understand the impact that it will have
on the value of their investment.
Ms. Eshoo. To the distinguished ranking member, I think
that Mr. Dreier has covered that well. I would just put out on
the table a couple of other thoughts, and that is that, again,
the term stock options having become sullied, and I think that
the way perhaps you look at this legislation should be that we
are establishing a firewall so that the broad-based is not
wiped out.
When you think of the companies--and we--there was a lot of
debate and reference to the companies that were involved in the
scandals. You didn't read or hear about those that did broad-
based stock options as being part of that mess, most frankly;
and I don't think you can point to an employee stock option
anywhere in the country that has been abused or is the source
of some kind of scandal. So it is something that I think
Republicans and Democrats alike should be looking to protect.
This is for extraordinary, ordinary people. We are not talking
about the top. We are talking about what goes across a company,
whether it is small, medium or large. So I think the
appreciation of what they are should be what is kept in the
forefront and what it does for our overall economy.
This one-size-fits-all accounting standard that is being
proposed by FASB is what is going to wipe it out. We are saying
don't let that take place, and I think the ideas that--and I
think it is important that the scandal that ripped through this
country that lessened the confidence of the American people to
invest, that those that head up companies and corporations
certainly should be coming forward with ideas about how to
create greater transparency and such, and we have some of those
things built into the bill.
Mr. Kanjorski. Thank you, Mr. Chairman.
Chairman Baker. Chairman Oxley.
Mr. Oxley. Thank you, Mr. Chairman.
Let me first welcome our witnesses, particularly our good
friend, the Chairman of the Rules Committee, the distinguished
Chairman of the Rules Committee.
Mr. Dreier. Nice to be on this side of the table.
Mr. Oxley. Yes.
And to my former colleague from the committee across the
hall, we are glad to have you with us as well; and we are glad
to have an opportunity to provide a forum for this most
interesting issue. It has been my experience that after passage
of Sarbanes-Oxley that the perception out there, right or
wrong, is that somehow by expensing stock options you have got
a silver bullet that would somehow end all of the problems that
we have had in corporate America, and obviously you have been
around long enough to know that it is not that easy, and it is
a far more complicated than that.
Let me ask both of our congressional witnesses to respond.
Greg Barrett, the Intel Chief Executive Officer, is going to be
on our third panel; and reviewing his statement, he says that
mandatory expensing of stock options means that stock options
ultimately will only be offered to the most senior managers, if
at all.
From your perspective, is it good public policy to go in
that direction? And what does that say about rank and file
workers and the potential for growth in the economy and
particularly attracting those kinds of workers?
Mr. Dreier. Well, thank you very much for that question,
Mr. Chairman.
I think that we have tried to make it very clear here. I am
not going to worry about the compensation of executives. I
mean, these men and women are very smart, shrewd, capable
people. They are going to figure out how to get compensated.
But if we move towards expensing, which jeopardizes the
potential for growth in so many of these companies, my fear is
that what will happen is that the Deborah Nightingales of the
world will be the ones who will not have the incentive that is
necessary to continue with this creativity.
Remember, Mr. Chairman, I mean, our quality of life and the
number of jobs that have been created have been tremendous. Our
quality of life has been improved because of technological
advances that we have seen.
Deborah was just talking about the very important national
security, the armed services aspect of this in dealing with the
war in Iraq. We know that so many of the things that we enjoy
have come from this, and the idea of squelching this creativity
among rank and file employees I think would have a devastating
impact on both job creation and our quality of life.
Ms. Eshoo. Mr. Chairman, first, let me thank you again for
your leadership and your working with us to create this forum
and examine this issue, which is really so important to the
economic life of our country, healthy economic life of our
country.
I think that any suggestions that corporate leaders have,
both Mr. Barrett--that the committee should pay close attention
to it. I mean, this is all about ideas on how to create better
transparency and to continually rebuild the confidence that the
American people have ultimately in our markets and the system
that we have. I mean, that is the coin of the realm. That is
why we have the broadest, deepest markets in the world. If
there is anything that we have worried about is what the
scandals did to affect the average investor, and we know that
we have many average investors in our country today.
So on what any of the ideas are, certainly pay close
attention to them for more transparency and increasing the
confidence of potential investors and the investors that are
there, but also I think that, again, we can't--I think at a
time--I have almost 10 percent unemployment in my congressional
district today, close to 10 percent unemployment, and this is
the place more than any other place in the country that fuels
our national economy. Why would we choose to take something
that has been an overwhelming success with employees, broad-
based stock options, and cast it aside today, I really don't
know.
I think the Congress can accomplish two things: higher
transparency, better transparency and the protection of these
broad-based stock options. I think we can do both. I think we
can accomplish both.
Mr. Oxley. Thank you.
Mr. Chairman, let me commend you for putting together an
all-star group of witnesses today, and we look forward to the
testimony of the other panels as well. But we appreciate our
colleagues, particularly Ms. Nightingale, to have you with us
today, and I yield back.
Chairman Baker. Thank you, Mr. Chairman. We appreciate the
courtesy of your attendance as well.
We will go regular order. I just have--note that we have a
number of members who have expressed an interest in questions,
and we do have a couple of more panels of prominence this
morning. So I will go down the order by time of arrival and
certainly want to be recognized, but the courtesy of brevity
will be most appreciated and noted.
Mr. Gonzalez.
Mr. Gonzalez. The simple question is, who will determine
the method--or the manner of methodology? Is it going to be
FASB? Is it going to be the SEC? Is it the new accounting
board? Because the final analysis, whether we wait 3 years or
not, if we disagree with the findings or the determination of
FASB, what are the options?
Mr. Dreier. Well, let me just say that our goal with the
legislation is very clearly just to have each company provide
whatever structure they have in place for their handling of
options, have that information become--be made available to the
investors who are out there, to the shareholders. That is our
goal with this legislation. That is why it is called the Broad-
Based Transparency Act.
Ms. Eshoo. Well, what the bill calls for is for the SEC to
examine how the higher transparency that is called for in the
bill actually works, and that is very important. I think for
those of you that may not be absorbing the message that
Chairman Dreier and Debbie and myself are here to talk about
today, I think it is very important that the SEC examine this.
We really should have a definitive statement based on a good,
solid period of time to understand what this means to our
economy and also what the greater transparency would bring
about, and the bill provides for that.
Mr. Gonzalez. And at the end of 3 years if FASB remains in
their position today?
Ms. Eshoo. Pardon me?
Mr. Gonzalez. What happens is they come out with the same
methodology whether you wait 1 year, 2 years or 3 years. Are we
going to have someone trumping basically FASB?
Ms. Eshoo. Well, I think that it is very important to build
into this something that FASB does not do, and they have stated
that, and it is fair enough for them to state that they do not
include economic considerations in their considerations for
accounting standards. They stop at accounting standards. They
do not take into consideration economic impacts. That is where
we come in, and that is why we have built what we have built
into in the bill.
Mr. Dreier. Obviously, Mr. Gonzalez, this is something that
will continue to be addressed as we go down the road. We just
believe that right now it is important for us, recognizing,
having put into place the Oxley-Sarbanes legislation, we need
to ensure that we don't throw the baby out with the bath water.
We want to do everything that we can to make sure that the
Deborah Nightingales of the world still have opportunity. That
is our goal.
Mr. Gonzalez. Thank you very much.
Chairman Baker. Thank you, Mr. Gonzalez.
Mr. Shays.
Mr. Shays. Mr. Chairman, in the sake of moving forward, I
happen to agree with my colleagues and understand where they
are coming from. I thank you for being here, thank you and
would defer questions.
Chairman Baker. Thank you for your insight, Mr. Shays.
Ms. McCarthy.
Mrs. McCarthy. I thank my colleagues. Again, my question
was actually already answered the second time around, so I will
pass on to the next speaker.
Chairman Baker. Thank you very much.
Mr. Green.
Mr. Green. Thank you, Mr. Chairman.
Mr. Chairman, I am interested in hearing from the next
panel, so in the interest of time I will pass as well.
Chairman Baker. Thank you, sir.
Mr. Emanuel.
Mr. Emanuel. This is a question for both Members. Have you
found any difference between a start-up company and its use of
options to recruit talent versus an established company that is
already a NASDAQ-listed company and its use of options where
they permeate throughout the company from top management down
and how--because I have heard in your presentation, obviously,
the importance of options in the sense of recruiting talent,
but where does that exist for a company in the early studies
today versus a start-up, versus an established company listed
on NASDAQ, et cetera?
Mr. Dreier. Well, it is a very good question, Mr. Emanuel;
and I will tell you that I believe that both are equally
important. Obviously, when we think about the technology sector
of our economy, we think about the amazing success stories,
created from absolutely nothing over a relatively short period
of time, ultimately being job creators and then, as I was
saying to Mr. Oxley, improving our quality of life, our
standard of living. So the real attention is focused on those
new start-ups, but this is obviously something that you are
going to be hearing from Mr. Barrett in his testimony about the
impact that mandatory expensing could have on a large company
which is out there, still very creative, but obviously it would
have a greater impact on a larger number of people, a
detrimental impact on a larger number of people than the
potential that exists with the start-up companies.
Ms. Eshoo. I agree with Chairman Dreier. I think it is
important--and you already know this--that just as your
children are small and they grow, these small companies have
grown in relatively short periods of time.
Mr. Emanuel. You are not suggesting I give options to my
kids.
Ms. Eshoo. Well, you have a real investment in them. That
is for sure.
I would suggest to members that they get a copy of this
book, In the Company of Owners, and it says why every employee
should have them. I think it is the most definitive look at
stock options. It is by Joseph Blasi, Douglas Kruse and Aaron
Bernstein; and if any of you have questions on where to get it
or wherever, I can tell you about it.
Mr. Dreier. You can get it online, is where you can get it.
Ms. Eshoo. Well, it may have been sent to Members as well.
If it is sitting in your office, take it home, because this
will be highly instructive to you and goes to the heart of many
of the questions that have been asked, both in terms of small
companies, large, how they would be affected. They all have
employees, and I think that the story over the last decade of
what broad-based stock options have done, both in the offering
of them and the growth of companies, is pretty clear.
I think that Debbie wanted to add something to this.
Ms. Nightingale. Thank you very much.
I just want to add that, living and working in Silicon
Valley, I definitely have seen and had a perspective of friends
and peers of mine that have taken that big leap and gone off to
work for a small company that has offered them a bunch of stock
options. They leave a larger-paying job to go to a smaller-
paying job to go off and be entrepreneurs and take that chance.
In addition, though, I would say, as an employee of Sun
Microsystems, Sun at one point not too long ago was one of
those little start-ups. It is now a very big company. But
working within a big company, I think the stock options
absolutely have a role as well. Because big high-tech companies
that don't keep innovating go out of business. The history
books show lots of examples.
So while I might have a little bit more security working
for Sun Microsystems, if myself and my peers and everybody else
does not keep innovating and keep taking chances then Sun is in
trouble. And it is really because of those stock options, as I
mentioned in my testimony that we go the extra mile. You know,
I could just sit by, easily doing my job, keeping the boss
happy, not really taking that risk, but instead myself and my
peers absolutely will go the extra mile, work those 60, 70, 80-
hour weeks that we are not being paid for because we stand to
benefit a lot if these stock options become of great value.
Thank you.
Chairman Baker. Thank you, Mr. Emanuel.
Mr. Ose.
Mr. Ose. Thank you, Mr. Chairman.
I want to welcome our witnesses here. I am ordinarily on
the other side of this discussion from the Chairman, so it is
good to see you. Ms. Eshoo, nice to see you. Ms. Nightingale,
Lieutenant Colonel, welcome.
I think at the heart of this legislative proposal is the
issue of mandating a certain treatment for these stock options,
and at the heart of that question is how do you go about
valuing them. One of the things that I struggle with, which I
would appreciate your input on, is whatever system you use for
valuating these stock options, whether they be narrowly or
broadly distributed, there are assumptions underlying the
valuations. Is it your concern that the assumptions, say, under
a Black-Scholes method or some iteration of that, is it your
concern that the assumptions will be as inaccurate, perhaps, as
the current levels of disclosure might be?
Mr. Dreier. Absolutely. I mean, that is--I think that it is
virtually impossible to make a determination as to exactly what
that value is; and, as I say, the only impact that really is
going to come here upon exercise of those options is ultimately
diluting the value of that stock. That is why our goal here is
to focus on the shareholders, the investors to provide them
with as much information as possible.
Ms. Eshoo. I think it is important to note that in the
Sarbanes-Oxley legislation that executives are now required in
a very clear and--a clear and strict manner to report under
penalty of law what--you know, their statement of financial
health of the company, and they are held responsible for that.
Now, if in fact you add to this the mandatory expensing of
options and you cannot predict what the value of those options
are going to be, what does that do to Sarbanes-Oxley? What does
it do to people that have to report as that law requires? So it
points to the weakness I think of the FASB proposal in that it
is next to impossible to state what the value that--the value
of those options are going to be, and I think it is an
intrinsic weakness of what the proposal presents. In real life,
I don't know how these executives are going to be able to, as I
said, stay true to and remain whole and legal, so to speak,
under Sarbanes-Oxley in the obligations that they have as a
result of that law.
Mr. Ose. If I might recast Ms. Eshoo's remarks, I think
this exactly pinpoints the problem here. We are potentially
criminalizing by mandate assumptions having to do with future
interest rates, future discount rates, future earnings, future
inflation, future changes to market conditions and the like
that no one from Mr. Greenspan to Mr. Buffett to Mr. Baker or
Mr. Ose can accurately predict, and this is a horrendously
questionable approach, notwithstanding our desire to disclose
to the investing public what it is they need to understand in
these financial statements. I just want to be clear. We are
potentially criminalizing mistakes on assumptions made in
valuing these options that no one can predict with certainty
out into the future.
Thank you, Mr. Chairman.
Mr. Dreier. Thank you, Mr. Ose, for being a cosponsor of
our legislation.
Chairman Baker. Thank you, Mr. Ose. I don't know about Mr.
Greenspan or Mr. Buffett, but you certainly were right with
regard to forecasting my abilities.
Mr. Scott.
Mr. Scott. Thank you very much, Mr. Chairman.
I would just like to ask a question of my distinguished
colleagues, Ms. Eshoo and Congressman Dreier. On the stock
options, do you believe that stock options provide appropriate
incentives to executive employees, number one? And, secondly,
do you believe that stock options should be spread out among
employees other than executives or that executives should have
only a certain percentage of their compensation in stock
options?
Mr. Dreier. Well, those are good questions, Mr. Scott.
Thank you for them.
I will say that, as Mr. Kanjorski pointed out in outlining
Mr. Barrett's testimony that you will be hearing in a few
minutes, he talks about a level of compensation that executives
should receive as far as options are concerned; and, as I have
said, I am not concerned about the compensation that executives
get. I mean, they are going to figure out how to be
compensated. My concern is that this proposal could jeopardize
the opportunity for the Deborah Nightingales of the world, the
rank and file employees who are coming up with these
innovative, creative proposals to succeed, and that is really
what I think we are getting at here.
So the answer to your question, sir, yes, I want to make
sure that we have these options made available to those who are
working on the front line in these companies. I think that is a
very, very important thing, and that is part of the incentive,
as Deborah just said. People who are actually in reasonably
high-paying jobs, they will take a lower level of compensation
to go to a start-up company with options being made available
so that they can be part of that engine for growth.
Mr. Scott. Thank you.
Ms. Eshoo. I think, to my colleague and friend, that it is
important to note that in H.R. 1372 that we call for a summary
of stock options granted to the five most highly compensated
officers. I think that that is very important not only for
investors and potential investors but for everyone in a
company, in an organization to know who has what and how much
of it. I don't think that information was readily available in
many of the companies that brought about and participated in
the ruination, really, of many people's lives in the country
and the companies that they worked for. So I think that is a
very important consideration.
There may very well be coming from this committee and from
outside the Congress some even better ideas for transparency,
and I think that we should--I know that Mr. Dreier and I are
open to that, and also the members of the committee as well,
because this is all about a delicate balance. And I have
respect for FASB. I don't think that they are in the business
of writing accounting standards, and I respect that, and I have
in the past with legislation where I didn't direct them to do
anything, but I thought it was the responsibility of the
Congress on economic issues to step in.
So, yes, this is important and should be protected for rank
and file for the broad-based organizations, those that are a
part of it, but I also think that--and we know what we have
built into the bill, and that is why I restated.
I think that--I hope we have, you know, answered your
questions. They are very good ones, and we have to keep being
sensitive to that. It is not just because we are in the
aftermath of these scandals. I think what the scandals have
taught us is that we better very well take care of the
investing public. Otherwise, no matter what is on the stock
market, they are not going to want to go near it.
Ms. Eshoo. These options and what they represent to people
are a very important part of that mix.
Mr. Scott. Thank you both very much.
Chairman Baker. Thank you, Mr. Scott.
Mr. Royce.
Mr. Royce. Thank you.
Chairman Dreier, I think your point is the question of
whether we are really making financial statements more precise,
if they are really going to be more accurate if we are forced
to adjust the actual earnings by inputting noncash charges
derived through a flawed model in there, into the income
statement. And I guess your position is that because the
supporters of this Black-Scholes model say at best it is kind
of right, it is in the ballpark--and detractors, of course, say
it is way off the mark--that instead you want publication of
shared dilution in financial statements in plain English and
that that is going to objectively reflect how stock options are
going to impact shareholdings, is that your position?
Mr. Dreier. Exactly. You got it exactly right.
Mr. Royce. The thing I have a harder time understanding is,
when you mandate charts and graphs on the part of the SEC in
order to show the dilution effects, would you have any mock-up
or would you have an example of what you have in mind with
respect to how you are going to convey that?
Mr. Dreier. I don't know what it would consist of. I can't
tell you what it would consist of.
Mr. Royce. The SEC is going to basically make that
interpretation.
Mr. Dreier. Clearly will do that.
Mr. Royce. Well, thank you, Mr. Chairman.
Chairman Baker. Thank you, Mr. Royce.
Mr. Meeks.
Mr. Meeks. Thank you, Mr. Chairman.
I want to thank my colleagues. This is one of those
occasions when you come to a hearing where you are completely
undecided. I am completely undecided, and the information that
you have provided is very valuable to me to come to a
determination because I think it is absolutely important for
the American public that we bring back some integrity into our
system.
My question just went along the same lines of
Representative Scott. You know, I understand the transparency
issue, and I think that it is important. I understand that we
don't need to throw the baby out with the bath water. The whole
thing with executive pay as to maybe limiting it to something,
I want to hear the rest of the testimony. Because it seems to
me that those top executives, particularly the CEO, the CFO,
would be the ones that would have the ability as well as the
motivation, even though you may have transparency issues there,
to try to manipulate the value of those stock options to their
benefit because they have it; and that becomes the key, is to
being sure that someone does not manipulate the value of it so
that you have it falling through the bandwagon.
The question I have is, basically, within the bill, is
there any way, any disincentive in the bill to prevent the top
executives from--you know, other than maybe eliminating them
having the possibility of having stock options so they won't
manipulate the value of it to their benefit?
Mr. Dreier. Well, I mean, I will just say to you that I
believe that everyone who is involved in a company should have
the opportunity to benefit. Again, I argue that the threat of
mandatory expensing will not hurt in any way the plans for
compensation for those executives, Mr. Meeks. The people who
will be hurt by expensing and those who are moving down the
road and some who, as I said earlier, support the actual
elimination of stock options, it will be the rank and file
employees will be hurt.
The reason I say it is that the executives of these
companies will continue to find other ways to be compensated.
And I don't think that we should stand in the way of their
being compensated. I mean, I am not one who is a proponent of
dictating exactly what the salary level should be for
executives. I think that should be determined by the boards of
directors and the shareholders. But I think that empowering
people with as much information is as far as I happen to
believe we should go.
I want to thank you for being a cosponsor of our
legislation, too.
Ms. Eshoo. To my colleague, Mr. Meeks, you asked I think in
many ways the $64,000 question. I think it is important to keep
in mind that stock options in and of themselves did not cause
the scandal. It was, as you pointed out or touched on, the
manipulation of the statement of earnings and all that
followed, which really goes to the heart of what Sarbanes-Oxley
was all about. That is what that legislation sought to correct.
There is now appropriate and enormous burdens, as it were,
which need to be borne legitimately by those at the top of a
company where they sign off in terms of the accounting and
everything that goes with it and file those statements with the
SEC. That is an enormous change and I think is a very important
and healthy one to take.
But this accounting standard as expressed by FASB I think,
and I don't know want to keep repeating it, is so detrimental
to what stock options, the broad based for the employees, would
do; and that is what we are seeking to protect.
I am just as outraged as you and all the members of the
committee, the Congress and our constituents over the abuses.
There is no way to defend the indefensible, and that is what
that legislation directed itself toward. We want to build on
some of the things that we think can and should be accomplished
for more transparency. But I think it is a very clear case of
what we really should protect and not cast overboard.
Mr. Meeks. Yield back.
Chairman Baker. Mr. Gary Miller.
Mr. Miller of California. Thank you for being here. I am a
cosponsor of the bill, so I do support it 100 percent.
I agree with you. Executives are going to be taken care of.
It is the rank and file that generally get left behind, if
anybody.
It is a great bill. I support it. I am looking forward to
the next panel.
Mr. Dreier. Thank you for your support, Mr. Miller.
Chairman Baker. Mr. Crowley.
Mr. Crowley. I thank you, Mr. Chairman. I will be very
brief as well.
I want to thank my colleagues for testifying today, Ms.
Nightingale for her testimony. Most impressed, especially you,
Ms. Eshoo, in terms of impact on your district, what this means
in terms of job loss, a district that is experiencing a great
deal of job loss in this current crisis.
I had the opportunity of being in India last year talking
about the need for the Indians to be more transparent, to
encourage more investment by the United States investor and at
the same time having to defend our own system here because of
Enron, a company that had considerable trouble gaining a
contract, putting a contract to rest in India. There is still a
great deal of bad taste in the mouths of many Indians,
especially the government. So I do think it was interesting to
be talking today about the need for transparency.
I agree 100 percent that the more the investor knows about
what the stock options are, especially of the top executives,
but also the employees themselves of the company, the more they
know about that as well, I think the broader and more light of
day that is shown on this issue can have a major impact as to
the actions of those who would try to manipulate the value of
those stocks to defraud the company, to defraud the people who
work there but, more importantly, to defraud the American
investor, the mom and pop who are now engaged in the stock
market like never before.
So I appreciate all of your testimony today, especially
you, Chairman Dreier. I want to make sure I made the point that
the Chairman--appreciate having you in front of us as well.
Mr. Dreier. You sound like a co-sponsor of our legislation.
Mr. Crowley. Well, not as of yet. But the option is always
open, so we will talk about it.
Chairman Baker. Mrs. Kelly.
Mrs. Kelly. Mr. Chairman, I have no questions for my
colleagues. I appreciate their testimony today.
Chairman Baker. Thank you very much.
Ms. Hooley.
Ms. Hooley. Hopefully, a quick question to my colleagues.
Thank you for being here today, talking about this issue. I
think it is an important issue for many of the companies.
The question is, if we are going to provide transparency
information--and I absolutely believe we need to do that--are
we going to treat companies differently if only the executives
get stock options as opposed to a company with broad-based
stock options?
Mr. Dreier. Well, I just say that that is information that
would be made available to the shareholders; and, quite
frankly, it is my view that I would rather be invested in a
company that provides options to the Deborah Nightingales of
the world who are going to come up with the creative proposals
that will ensure the success of that company than I would
simply to the executives of the company.
Ms. Eshoo. It is a good question. The legislation doesn't
change what you describe. In fact, I think today we probably
have more companies in the country that do not offer broad-
based stock options, but it is growing, and that is why we want
to protect it. It is an important tool. But it doesn't--the
legislation doesn't differentiate between the two.
Ms. Hooley. Thank you. I yield back.
Chairman Baker. Thank you, Ms. Hooley.
Mr. Inslee.
Mr. Inslee. Thank you.
I want to thank the sponsors for their work. Because we sat
through scores of hearings in this room following the Enron
collapse and the like. I can't think of a case where this
really would have solved the problem that caused those
collapses, and I think it is important not to let our
justifiable concern about those defaults lead us to something
that may not get where we want to go.
I want to thank you, particularly, Ms. Eshoo, your comment
about there are better ways to go about this, particularly
looking at shareholder approval, which is important to these
issues. I hope we go in that direction. Thank you.
Chairman Baker. Mr. Kanjorski.
Mr. Kanjorski. I request a statement be made for the record
by Congressman Pete Stark. It is included together with his
statement, an analysis and letters and a bill.
Chairman Baker. Without objection. Thank you, Mr.
Kanjorski.
[The prepared statement of Hon. Pete Stark can be found on
page 86 in the appendix.]
Chairman Baker. There being no further questions of this
panel, I want to express my appreciation to you for your time
committed to this hearing. It has been very valuable to the
committee.
Mr. Dreier. Thanks again for holding this hearing. I know
you will get some very interesting input from the next two
panels, and we look forward to the conclusion that you will
draw on that.
Chairman Baker. Look forward working with you.
Ms. Eshoo. Thank you very much to your legislative
hospitality, to the ranking member and to all the members that
came to this hearing today, I think speaks highly of the
committee that there would have been the kind of participation
that we saw here today. Thank you very much.
Chairman Baker. We have a total of 47 members on the
subcommittee. We had in excess of 30 here today, which speaks
to, I think, the importance of the issue. Thank you for your
courtesy.
Ms. Eshoo. Thank you.
Chairman Baker. At this time, I would ask our next witness
to come forward, Mr. Rob Herz. It is my pleasure to welcome as
our next panelist Mr. Robert Herz, Chairman of the Financial
Accounting Standards Board. Welcome, sir.
STATEMENT OF ROBERT H. HERZ, CHAIRMAN, FINANCIAL ACCOUNTING
STANDARDS BOARD
Mr. Herz. Thank you Chairman Baker, Ranking Member
Kanjorski, and members of the subcommittee.
As you said, I am Robert Herz, Chairman of the Financial
Accounting Standards Board. I am very pleased to appear before
you today on behalf of the FASB.
I have some brief prepared remarks. I would respectfully
request that those remarks and the full next of my testimony
and all supporting materials be entered into the public record.
Chairman Baker. Without objection.
Mr. Herz. The FASB is an independent private-sector
organization subject to oversight by the U.S. Securities and
Exchange Commission. Our independence from enterprises,
auditors, and other constituents is fundamental to achieving
our mission--to establish and improve standards of financial
accounting and reporting for both public and private
enterprises. Those standards are essential to the efficient
functioning of the capital markets and the U.S. economy because
investors and other users of financial reports rely heavily on
credible, transparent, comparable and unbiased information to
make rational resource allocation decisions.
Our work is designed to provide investors and the capital
markets with the most useful yardstick to measure and report on
the underlying economic transactions of business enterprises.
Like investors, Congress and other policymakers also need an
independent and objective FASB to maintain the integrity of a
properly designed yardstick in order to obtain the financial
information you need to properly assess and implement public
policies. While bending the yardstick to favor a particular
outcome may seem attractive to some in the short run, in the
long run a crooked yardstick in the form of a biased accounting
standard is harmful to investors, to capital markets, and the
U.S. economy.
In March of this year, at a public meeting, our Board
unanimously decided to add a project to its agenda to address
issues relating to improving the financial accounting and
reporting for stock-based compensation. That decision was based
largely on three factors:
First, the high level of concern expressed by individual
and institutional investors, pension funds, mutual funds,
creditors, financial analysts and other users of financial
statements, as well as America's trade unions, consumer groups,
the conference board's Commission on Public Trust and Private
Enterprise, and the major accounting firms about the need to
improve the reporting for stock-based compensation, in
particular the need to eliminate the narrow but often used
exception for so-called fixed plan employee stock options,
which are the only form of stock-based compensation that is not
currently reported as an expense in the financial statements.
Secondly, the growing noncomparability and, thus, potential
lack of transparency created by the alternative accounting
treatments presently available for reporting stock-based
compensation which has been magnified by the recent trend of
hundreds of major U.S. companies--sometimes as a result of
shareholder resolutions and votes--to adopt the voluntary
expense recognition provisions of our 1995 standard.
And, third, the opportunity to achieve convergence to a
common, high-quality global accounting standard for stock-based
compensation. There is no subject on our current agenda on
which we have received so many strong and heartfelt calls for
action. They go beyond the abuses of executive pay to just
plain wrong accounting.
In April, the Board began its initial public deliberations
to consider improvements to the recognition, measurement and
disclosure of stock-based compensation. To date, we have held
four public meetings and have reached certain tentative
conclusions.
In the coming weeks and months, at public meetings, the
Board will continue its deliberations of the many issues
relating to this project, including the measurement issues and
special issues related to private companies, to start-ups, to
venture-backed companies. The Board's public deliberations of
the issues will be systematic, thorough and objective. The
deliberations will benefit from a review and analysis of the
vast amount of research and other literature in this area. The
deliberations will also benefit from the ongoing input of our
constituents, including the advice of leading valuation and
compensation experts that we will consult with throughout the
entire process.
We currently plan to be in a position to issue a proposal--
we have not issued anything yet--for public comment in the
fourth quarter of this year. Any proposal would have to be
approved by an affirmative vote of the majority of the Board.
The proposal would be exposed for an ample public comment
period so that all interested constituents will have the
opportunity to provide detailed responses. The Board will also
consider whether to hold public roundtables or public hearings
to solicit additional input on the proposal.
Prior to making any final decision on any changes to the
accounting for stock-based compensation, the FASB would
consider at public meetings all of the input received in
response to the proposal. The Board would not issue any final
standard until it has carefully considered at public meetings
the views of all constituents. Like any proposal, any final
standard would have to be approved by an affirmative vote of
the majority of the Board.
We have reviewed H.R. 1372. We note that, if enacted, it
would impose a more than 3-year moratorium on any FASB
improvements to the financial accounting and reporting for
stock-based compensation. We strongly oppose H.R. 1372 for a
number of reasons.
First, the moratorium would unduly intervene in the Board's
independent, objective and open process to make unbiased
decisions on the substance and timing of improvements to the
accounting for stock-based compensation. Such intervention
would be in direct conflict with the express needs and demands
of many investors and other users of financial reports. Such
intervention would also appear to be inconsistent with the
language and intent of the Sarbanes-Oxley Act and the related
and recently issued SEC policy statement reaffirming the FASB
as the Nation's accounting standard setter.
Second, the moratorium would have an adverse impact on the
FASB's efforts to achieve timely convergence of high-quality
global accounting standards on stock-based compensation. The
FASB is actively working with the International Accounting
Standards Board and other national standard setters in an
effort to achieve convergence in this important area and in
many other important areas. The moratorium would likely hamper
those efforts and again appears inconsistent with the language
and intent of the Act and the related SEC policy statement,
both of which explicitly encourage international convergence.
Finally, and perhaps most importantly, the moratorium would
establish a potentially dangerous precedent in that it would
sent a clear and unmistakable signal that Congress is willing
to intervene in accounting standards based on factors other
than the pursuit of appropriate accounting. That signal would
likely prompt others to seek political intervention into future
accounting standard activities.
We have all witnessed the devastating effects and loss of
investor confidence in financial reporting that have resulted
from companies intentionally violating or manipulating
accounting requirements. What impact then on the system and on
investors' trust in financial reports might there be if it were
perceived that accounting standard setting was being
deliberately biased toward the pursuit of particular objectives
other than those relating to appropriate financial reporting or
that the FASB was being blocked from pursuing timely
improvements in financial reporting?
For all these reasons, again, we strongly oppose H.R. 1372
and any other legislation that would seek to undermine and
impair the Board's independent, objective and open standard
setting process.
Again, thank you, Mr. Chairman. I would be happy to respond
to any questions.
Chairman Baker. Thank you, Mr. Herz. I appreciate you being
here this morning.
[The prepared statement of Robert H. Herz can be found on
page 113 in the appendix.]
Chairman Baker. I have a series of questions that go really
to a broader issue. The question of valuation of stock options
is a very fine point on a big platform of issues. It would be
my view that if you go back over the past 24 months and look at
the volatility of the NASDAQ and require an individual to value
the options granted to employees and then look at the value of
those options 89 days later, it would be a very difficult
calculation to know which way the wind was blowing.
On the other hand, the underlying argument for additional
transparency and the ability of the prospective shareholder to
understand the current valuation of a corporation is something
no one could possibly object to. It would seem the current
retrospective rules-based system that is based on the reporting
paper data on a 90-day trail gives a false impression of
understanding corporate performance. Have you or has the agency
explored extensible business reporting language as a platform
on which to have a real-time market performance analysis where
an empowered shareholder could at the close of business on a
daily basis not only look at options but look at the loss of a
particular customer, look at the loss of a supplier, the award
of a big contract?
If we are trying to eliminate volatility, you have to do
what large corporations do in this country on a daily basis: At
the close of business, look at your risk, look at your assets
and determine where you are. Arguing over whether we price
options on a 90-day platform, given underlying market
volatility, interest rate exposure, credit risk, if we adopted
everything FASB proposes right now I wouldn't feel a bit better
than I do this morning.
Can you respond?
Mr. Herz. Yeah. Thank you. Very excellent set of questions.
I think you had two main questions in there, one about the
valuation of stock options, although that kind of led to
another broader question.
You know, the issue of the valuation first, we are going to
have a hard look at it. We are consulting with lots of experts.
Our predecessors 10 years ago concluded that it could be
appropriately valued, reliably valued----
Chairman Baker. Let me jump back in on that point on
valuation. Whether we use binomials or Black-Scholes, if you
had an extensible business recording platform, you could sit at
your own PC Apple mainframe and say, the value today at the
close of business Black-Scholes, value today binomial A, B, C.
Then you could get all the variables because there isn't a
single way to arrive at value, and the number of variables
outside the formula assessment also vary. So you could plug in
different valuables on different analyses and come up with a
recommendation.
Now, the typical investor may not want to do that, but this
is where you get back to turning to my local accountant and
say, figure this out for me, as long as he has got the tools to
do it. Shouldn't we be moving more in that direction?
Mr. Herz. Well, let me continue. Thank you.
You know I am a big supporter of XBRL and expansion of
business reporting. You know I was a co-author of a book called
The Value Reporting Revolution: Moving Beyond the Earnings
Game.
Chairman Baker. I have read it many times.
Mr. Herz. That is something that I think not only we but I
think the whole private sector with I think some regulatory
stimulus from the SEC needs to pursue. I agree with your point
there.
The other point is--and that would provide additional
information. But there is a basic accounting system which keeps
a base score on earnings, cash flows, other things. And all
transactions, whether they be cash, whether salary, profit
sharing, and all stock compensation transactions other than a
narrow form of stock options are accounted for at fair value in
the financial statements. They are scored that way in
determining earnings.
And the issue of, you know, can you calculate the value of
this particular instrument at a point in time--and those
calculations take into account current data. They don't project
future data. Take into account the current prices of stock,
current interest rates and the like, and they calculate values.
That is what underlies trillions of dollars of options trading
markets. People trade in options, and there is a value at a
point in time.
I agree that you can get--like you say, you know, you can
plug it in, and you could get values every day and deliver them
over XBRL, and that would be very informative. But that doesn't
mean that the basic accounting information itself at the date
of grant, the value of the date of grant consistent with all
other stock-based compensation gets scored then.
Chairman Baker. But that is like taking a photograph of
your child while you are overseas and snail mailing it. By the
time it gets to you, that is what your child used to look like.
But that is not what he looks like today. He has got a buzz cut
and a ring in his ear. I mean, things have changed.
That is my point. In dealing with reporting in business
accounting we are still using a system built in many years ago.
We are in the slide-rule era and people are using PCs at home.
Arguing this specific point, although understandably
important in the overall assessment of business performance, I
understand, but it goes to the broader issue of FASB's policy
mission of advising the policymakers on our end, does the
current system provide a responsive measure of corporate
performance, given the decade we have just endured? I don't
think anyone can say it does, particularly when we are trying
to move to an international accord where there are considerable
differences between a rules- and principles-based system.
Mr. Herz. Well, I agree with you. But I think financial
reports are an integral part, a very vital part, because they
are the ultimate score, the ultimate feedback. All the other
information, including the kind of information that I advocated
in the value reporting revolution, is both supplementary and
very complementary. You get a better picture through all of
that.
Chairman Baker. My time has expired.
I find it very difficult to focus solely on this issue,
make a judgment that this is going to satisfy the information
that is really needed in order to make an informed judgment
when the presumption for this modification is that people can't
make an informed judgment using--without modifying the current
rule. Although it is not the obligation of FASB to be concerned
about economic models, many of us in the Congress are very
concerned about economic models and how we can encourage
business growth. This goes right at the heart of that.
Mr. Kanjorski.
Mr. Kanjorski. Thank you, Mr. Chairman.
Mr. Herz, I want to reiterate for the record you are an
independent nonprofit organization. Is that correct?
Mr. Herz. Yeah. We are independent, and under Sarbanes-
Oxley we hope we have been made more independent through the
mandated funding mechanism that now applies to both us and the
public company accounting oversight board.
Mr. Kanjorski. You are charged with establishing a single
rule to apply for accounting purposes to public corporations.
Is that it?
Mr. Herz. Public corporations, private companies and not-
for-profit entities.
Mr. Kanjorski. It seems that our prior panel felt that this
was above an accounting rule problem but goes to the essence of
whether or not the economy survives and grows. Do you feel your
organization is able to establish a rule for accounting
purposes that will cause greater transparency for the investing
public and not interfere with or in some way compromise the
growth of the economy of start-up and high-tech companies?
Mr. Herz. Yes.
A couple of points there. First, you know, we believe
clearly that better accounting information adds to better
decisions in the marketplace, better credibility in the
marketplace; and that has its own huge economic benefits when
you translate it over the whole overall economy.
Second, and, again, we are not looking per se at the macro
issues, but I can't help but have noticed that the issue of
stock options is, this particular instrument, according to the
U.S. Bureau of Labor Statistics in the year 2000, which was
apparently a banner year for the issuance of stock options by
companies, was only granted to 1.7 percent of the total U.S.
nonexecutive work force.
Thirdly, as I said, in terms of the private companies,
start-ups, we are going to look at that separately, apart from
the large public companies.
Mr. Kanjorski. So that it is possible to take into
consideration start-up companies and particular specialized
high-tech companies, that they could get a different rule that
applies to them as opposed to across the board?
Mr. Herz. I can't speak for my fellow board members, but I
think the distinction would be with companies that have an
actively traded stock versus those that don't.
Mr. Kanjorski. I am sort of amazed here today that after
all these years it seems to me such a contested issue and the
desire now to impose legislation to affect that. What is your
general opinion as to what kind of a precedent this would set,
that if the Congress adopts a particular piece of legislation
to somewhat change the independence of FASB in establishing
accounting rules?
Mr. Herz. Well, I think--as I said in my opening remarks, I
think it would be a dangerous precedent, because we are
constantly faced with groups that want to basically--they have
gotten comfortable with the existing rules and how they can
then use those in their business transactions. Any time we want
to move things forward by proposing change to get better
accounting, closer to economic concepts, you know, we are often
opposed by the people who would rather keep the status quo; and
they will always argue economic consequences. I think the
history of that would show that those usual dire predictions of
major negative economic consequence were not borne out once the
better standard was put in place.
Mr. Kanjorski. Do you feel that we also have to take into
consideration the international accounting standards that we
are in competition with now in terms of the global economy and
that, in effect, the rule that you are trying to put together
and propose would take us closer to international accounting
standards?
Mr. Herz. Yeah. This issue, you know, was not only looked
at by the FASB over the last 20 years, the last time 10 years
ago, but it has been looked at by the International Accounting
Standards Board and by accounting standard setters in many,
many other counties; and everybody comes to a very similar
conclusion about the accounting aspects of this. As I said, the
IASB is ahead of us. They are intending to propose--issue their
final standard later this year, probably around the time we
just issue a proposal. The international accounting standards
will apply starting 2005 for all of Europe. They are going to
apply for Australia, New Zealand, Russia. They already apply
for many other parts of the world that for years used
international accounting standards. So to a certain extent we
would be the odd man out.
Mr. Kanjorski. Thank you, Mr. Chairman.
Mr. Ose. Mr. Shays.
Mr. Shays. Thank you very much, Mr. Chairman.
For the sake of honesty, I have to disclose that FASB is in
my district. There are many things about FASB that I love and
cherish. There is only one that I don't. That is it sometimes
takes you all too long to act.
I am in a quandary because I believe we need to have better
formation of capital, but I also believe that we need to have
disclosure. I believe that that people need to know the facts.
But what I am wrestling with is that this is an issue of
valuation. In other words, by disclosing the stock option are
we--you are only making money--you only take advantage of the
option if the stock goes up.
I would also say to you I had a number of parents call me
because their children had been given these glorious stock
options which they never took advantage of but had to pay a
significant tax on when the companies went out of business,
which was a tragedy for these young kids who thought somehow
they had a great future.
My question to you is, why are we acting now and why didn't
we act 5 years ago?
Mr. Herz. I think we are--first of all, let me--three
issues, valuation issue, the issue of the stock price going
down, and the option being worthless or deep out of the money,
and then why are we acting now.
On the first issue, again, we are going to look at that
very carefully. Again, the models--and we have got lots of
suggestions as to how to improve the valuation. Things come
into our door every day. You know, again, the models that
support the public option trading markets, whether it be equity
options, interest rate currency options, commodity options and
lots of other options, those models all support this trillion--
trillions of dollars of trading in markets. The question is
then can you apply those models to employee stock options
because they have certain other features, including the
forfeitures prior to vesting, nontransferability and other
kinds of adjustments?
The issue is really what is the cost to the company.
Because we are preparing the financial statements for the
company. The accounting standards deal with the company's
financial report.
Mr. Shays. You say what is the cost of the company or the
value of the company?
Mr. Herz. It is viewed to be, from the company's
perspective, what is the value of the instrument that it
grants. And that is the real issue. What is the commitment and
hence the value of that instrument that is granted by the
company unilaterally at that date, and how do you value that
most reliably?
The third issue of why are we taking action now, because we
have gotten hundreds of letters, e-mails, input from people,
recommendations of many, many groups who have studied this to
say that action needs to be taken. I think it has been prompted
in the wake of the--not only the scandals but the market
meltdown of people believing that the financial information was
incorrect.
Mr. Shays. Is it also an issue of political pressure and is
it also a question of, frankly, not knowing what to do?
Mr. Herz. Is it an issue of political pressure in what
regard?
Mr. Shays. Well, did FASB feel that for the last so many
years that had they acted there would have been a fire storm
that would have been difficult to contend with.
Mr. Herz. Of course, I only joined July 1st. So I can only
relate what people have told me. But certainly, after the
experience of 10 years ago, I think FASB was a little gun shy
and virtually, other than academics and some people who
understood options, no one supported the FASB at that point.
Now there are many, many parties who are not only supporting
this change but have demanded it.
Mr. Shays. The bottom line is that there was some--well,
part of it was being a little gun shy, as you say, and from
your standpoint that no longer exists.
Mr. Herz. I am not gun shy. I am careful, and I study
things, but I am not gun shy, and I don't think my colleagues
are.
Mr. Shays. So that issue is resolved.
The second issue is a reluctance because--maybe not knowing
what is the right thing to do. A lot of letters saying you need
to act. Are you totally comfortable that your actions will be
the right thing?
Mr. Herz. Well, I have a lot of confidence in our process.
As I said, we are early on. We haven't even gotten to a
proposal yet, which is kind of what I always find amusing.
Mr. Shays. So your argument here is let us go through the
process and let Congress evaluate what we have done.
Mr. Herz. Exactly. We have a very rigorous, thorough and I
believe objective process. We get input from everybody. We send
out a proposal. We get wide comment.
Mr. Shays. How long is it going to take for that process to
end?
Mr. Herz. Our goal right now is to get a proposal out by
year end. That would be out probably, my guess, for a 90-day
comment period. We would probably hold some public roundtables.
We then analyze what all the input is.
Mr. Shays. Thank you for your good work and the good work
of your organization.
Thank you, Mr. Chairman.
Mr. Ose. [Presiding.] Mr. Gonzalez.
Mr. Gonzalez. Thank you, Mr. Chairman.
Thank you, Mr. Herz.
I guess I need to frame the question a certain way. I love
process. I love systems. I like predictability. I like to look
at other certain boards or whatever that we look to for their
expertise that set certain standards, that it is my
understanding. At the present time, people are questioning
whether--how relevant your standards are going to be, that they
don't really reflect the real world. I tend to lean in that
direction. I guess I am like Galileo, who really didn't believe
that the Earth was the center of the universe until the
Catholic church had a talk with him. So while I await some
religious experience, I am leaning over there.
You heard Congressman Dreier, especially Congressman
Dreier, who basically made that analogy with what you are doing
today. Do you share any of their fears, though? Is that what
you are going to do, that you have some sort of accounting
certainty in that pure world of accountants, which is wonderful
in many ways, but what is the advantage, what is the benefit?
Everything that we feared and that happened and we are trying
to avoid, again the Enrons and the WorldComs, what you are
going to do, according to a lot of people, and again I tend to
agree with them, wouldn't have avoided any of those disasters
or catastrophes. So what I am saying is, is there a real-world
application with what you are about to do? And do you disagree
with Congressman Dreier's opinion that this could be something
that could be disastrous for many companies?
Mr. Herz. Well, first of all, I also enjoyed Congressman
Dreier's map of the world. I thought the conclusion was going
to be that California was the center of the universe. But----
Mr. Ose. The Chairman would instruct the witness that that
is accurate.
Mr. Gonzalez. Only if Texas supplies you guys with enough
energy.
Mr. Herz. I am in trouble because I am from New Jersey.
Mr. Ose. You send it. We are still not going to pay for it.
Mr. Herz. Nobody from New Jersey here, huh?
The issue on pure certainty, and we are never purely
certain, but I think our process comes up with the right
accounting. And I think accounting is very important. There is
a whole discipline to it, and there is a whole way we measure
incomes, show balance sheets, show cash flows and the like.
I read those articles--or editorials yesterday in the Wall
Street Journal, as you may have; and I know the two gentlemen
quite well, Bennett Stewart and Peter Wallison because I have
worked with them. Some of what they say I agree with, and some
of it I don't agree with. In fact, the parts that I and others
agree with at the Board, we have been moving aggressively to
try and build more economic concepts into the accounting, more
reflection of cash flows and the like.
You know, there is--just wanted to--because I was struck by
those works, and I particularly--I met with Bennett Stewart
when he was developing his work last fall on Accounting is
Broken--Here is How to Fix It--a Radical Manifesto. He suggests
a number of adjustments to accounting, and one of the ones he
suggests are stock option grants are an expense.
He says many corporate managers have found it difficult to
understand that the cost of handing out options is an expense
because they have collapsed two steps into one. An employee
option grant is substantively the same as compensating the
employee with cash, which is an obvious operating expense, and
then compelling the employee to turn around and use the cash to
purchase an option from the company for its fair market value.
The true option expense is given by the option's fair market
value of the date of grant. Once the option is outstanding, the
employee becomes like any other equity holder and the gains and
losses from exercising the option or letting it expire should
not be recognized as a corporate expense or income item.
He goes on to expound as to why, you know, based on
economics that is just the right answer. He has other
adjustments. For example, he strongly argued about special
purchase entities that they ought to be consolidated. Well, we
took care of that earlier this year. He argues that there ought
to be better delineation between operating items in the income
statement and financing. We totally agree. We are working
towards that with the International Accounting Standards Board.
So we are working on those kinds of things in order to improve
the utility of the information.
As to the disastrous impacts, no, I don't believe there
will be. I believe that certain companies have gotten used to
using a particular form of stock option.
Let me be very clear on this: There are many forms of
equity-based compensation. There are restricted stock grants.
There are employee stock option plans, ESOPs. There are various
forms of stock options, stock options that are tied to
corporate performance or unit performance. There are stock
options that are tied to an interest rate, that are tied to
your performance relative to a competitor's performance. And
all of those get expensed. There is just this one form which
has been an accounting anomaly for 30 years now.
Mr. Gonzalez. Thank you very much.
Mr. Ose. Mr. Herz, I just I believe you have set a new
record here with your submitted testimony.
Mr. Herz. We like to be complete.
Mr. Ose. I do want to compliment you on the thoroughness of
your presentation.
In the attachments, attachment number 7, there is a
submittal from the conference board I believe, and one of the
footnotes--the Conference Board, Commission on Public Trust and
Private Enterprise. One of the footnotes on page 5 indicated
that a Merrill Lynch study shows that expensing stock options
would result in a decline of approximately 70 percent in
earnings per share in the high-tech industry compared with
declines of 12 percent in telecom industry, 9 percent in the
consumer materials industries, from 2 to 7 percent in other
industries, and 10 percent in the overall S&P 500.
Now there may be some accountants within our membership
here in the House of Representatives, but I can tell you that
every one of us would hear about declines in valuation of
401(k)s and IRAs and individual portfolios. If expensing stock
options were to cause a decline in the value of people's
portfolios, why would any Member of Congress vote for it?
Mr. Herz. Well, it is because I would hope that you would
believe in the importance and value of the right information.
The right information then leads to certain things happening,
people understanding what the performance really is.
Mr. Ose. You are suggesting Sarbanes-Oxley does not
accomplish the transparency that you are seeking.
Mr. Herz. Well, I think on this issue, clearly this issue
has been left unresolved. It was left to us to decide whether
or not to try and address it, and based upon all the input we
decided unanimously that it was something that needed to be
addressed.
Mr. Ose. I do want to highlight one point. Within the
financial statements of America's corporate industry, those
that are publicly traded, are the impacts of dilution reflected
in the statements themselves for granting of options?
Mr. Herz. That is an excellent question. Earnings per share
is a calculation. It is a metric. It is not part of an
accounting system. All it says is that if you--everybody who
basically, you know, could be a shareholder based on a
calculation you then divide that into the current earnings
number. So it is not captured--economic dilution is not
captured in the accounting numbers.
It is the same issue as, for example, you know, if you pay
a lawyer with stock or stock options, it is absolutely clear
that you would show that legal expense as an expense and you
would reduce earnings. You would also show it in the numerator
to the earnings per share calculation in addition to the
denominator. The only instrument which escapes that treatment
are these so-called fixed plan stock options. They get in the
earnings per share calculation once the option is in the money,
but they don't get an economic charge in the income statement.
Mr. Ose. Within the statements themselves, perhaps in the
footnotes, are not the effects of dilution reflected?
Mr. Herz. There is a pro forma disclosure that came about
as a result of the FASB's action in 1995. Most of the
commentators that we have had for a variety of reasons that,
you know, users of financial statements have said that is not
adequate. It needs to be factored into the accounting numbers
themselves.
One of the reasons is that they cite--I guess there are a
couple of reasons--is they use not just earnings per share
numbers, but they also calculate all sorts of other numbers
based on the accounting numbers, things like return on equity,
return on assets; and unless you put it into the accounting
numbers, it makes their life quite difficult. Further, they
pick up numbers from databases, and unless you put it into the
accounting numbers those things are not picked up.
Mr. Ose. But the information is in the statements.
Mr. Herz. The information is in a footnote. By the way, it
is in an audited footnote. It has been there for----
Mr. Ose. Sort of like this.
Mr. Herz. Which, by the way, is covered by the Sarbanes-
Oxley certification--has been. And it is there. But it is not--
it is a pro forma number. It is kind of like saying on special
purpose entities, why don't you just put the information
relating to a special purpose entity in the footnotes and don't
make them show the debt or the assets on their balance sheet.
Mr. Ose. We will come back to the special purpose entities,
because that is not related to this issue at all. But my time
has expired.
I would like to recognize Mr. Emanuel.
Mr. Emanuel. Thank you, Mr. Chairman. I will follow up with
a question I asked earlier.
We have got this either/or choice and a failed attempt to
try to find if there is a middle ground here. Has anybody
looked at or have you looked at the difference of how you
would--whether you would expense stock options on a private--
not private but a public company, recruiting--they are used
differently for a big public company versus an early stage
company.
I have this kind of aversion to Congress getting into the
accounting business. I have an aversion of FASB getting into
the--no. But how do you get towards maybe finding at a certain
point whether it is a market capital company, you--maybe it is
a stupid question.
Mr. Herz. No, I think it is an excellent question. It is an
excellent question. It is a question we intend to look at.
Because certainly, if nothing else, the valuation issues when
you don't have publicly traded stock become of another realm on
valuing an option. Companies that have publicly traded stock
they may themselves have traded options. So when you have a
private company, a start-up, even if it is pre-IPO I think that
is a real issue.
Plus you take a start-up, and you get six guys together in
a garage, and you say we are going to divide, you know, divide
it into six pieces, that to me is a formation issue, a founders
issue, rather than a compensation arrangement. So we are going
to look very carefully at those issues and where that dividing
line might lie.
Mr. Emanuel. Because I think this--you know, companies use
options to attract talent early on, which is so important to
the creation of that company and its ability to go public, that
options may be used later on in later stage companies that one
could argue it is--I think the panel before you, one of the
members--one of our colleagues said it is like other forms of
compensation package. Well, health care, retirement benefits
therefore do get expensed at that level. Why options would be
treated differently is something else.
On the other hand, I am sensitive to the fact that it has
become so ingrained in the culture, in the economy and the
everyday running of a business that you don't want to--you know
this is going to have a negative effect. A decision that you
guys made to expense options will have a negative impact. And
maybe short-term companies and CEOs and management will adjust,
but to disregard it at----
Mr. Herz. Remember, across the whole capital market, as I
said, according to the statistics only a small portion of
nonexecutive workers receive stock options; and of course we
have gotten fairly strong support from the trade unions that
represent America's workers on the need to change the
accounting. So, you know, I agree with your thinking, the
thinking about different companies, different uses.
Mr. Emanuel. Most importantly, different points in their
maturity. That actually, rather than this being linear, options
change over time as the company has developed into a different
place, where it started and where in its midlife, so to say,
and that therefore the options become something different over
time, et cetera. I don't know, as you look at that, you think
about it as you guys analyze this.
Mr. Herz. Thank you.
Mr. Emanuel. Thank you, Mr. Chairman.
Chairman Baker. [Presiding.] Mr. Toomey.
Mr. Toomey. Thank you, Mr. Chairman; and thank you, Mr.
Herz.
I may be getting in a little over my head here because I am
not an accountant, but I do understand something about the
economic of options. I used to trade options professionally.
One of my concerns here, and I appreciate this is a tricky
dilemma that we face here, but I guess my concern is whether or
not the proposal that seems to be coming from the FASB here is
going to best reflect the economic reality of these
transactions. And specifically my concern is that if you go
down the road of expensing, which I am not advocating, but as
you seem to be heading down that road, it occurs to me that you
may be doing it in a way that by design almost necessarily
misrepresents the economics of the transaction. Because you
recognize an expense at one point in time sort of, you then
spread it over the life of the option, but you never do
anything to reflect the change in value.
As you know, if a company were to short a call option on
another company, which is what this is, we are taking a short
position and a call option on one's company, you would have
that as a liability which would you then mark to market. You
would capture that value on day one, but you would then
recapture the change in value if it diminished in value or you
would show greater expense if it became a greater liability.
But that provides a convergence to economic reality.
And I understand that what you are doing instead seems to
be more consistent with the way other forms of equity are
treated, but it seems to end up misrepresenting the economic
reality. And now I am further concerned--and one of the reasons
I am not comfortable with expensing is if you go down this
other road of showing it as a liability and marking it to
market, you create this bizarre anomaly of showing earnings or
losses that are a function solely of fluctuations of the stock
price and have nothing to do with the operating forms of the
company, which one suspects this is not necessarily very useful
to investors, which is why I sort of end up thinking that
really the best reflection of the economic reality here is to
show the impact of the dilution in the event that the options
are in fact issued.
So could you comment on this? It seems to me--and I don't
mean to be harshly critical here, but it seems to be almost a
half measure in terms of capturing expense, because it never
captures the change that would better reflect economic reality.
Mr. Herz. Yeah. I don't know if I can do justice to this
discussion in this hearing or make my points succinctly enough,
because this is an issue that we and accountants and economists
have debated for a long, long time, the issue of when to
measure. We call it the measurement date issue. Do you measure
it solely at grant date? Do you measure it from grant date
through to the vesting date when the person has performed the
services, or do you measure it right to the exercise date, kind
of like the way the tax method does it? And there can be
arguments for all three, but I think the argument--the last
argument that you argued about--maybe it was the next to the
last one about the idea of marking it to market right through
exercise date, there are some proponents that would say not
only employee stock options but all call options issued by a
company ought to be accounted for that way, including a call
option that is embedded in convertible debt or warrants that a
company issues for financing or to obtain goods and services.
That is an issue we are looking at also internationally in
terms of the distinction between liability and equity. Where is
that line?
Accounting traditionally has drawn the line at things that
are equity, a stock option is an equity, just like a share of
stock. And when you use that to acquire goods and services,
that becomes the measure of that transaction.
Now, I would posit that that is the accurate measure of
that transaction at that point.
Mr. Toomey. Is or is not?
Mr. Herz. Is. The question then is, is something else going
on after that, which is more of a financing item, and I think
you would have to look at it not only for just employee stock
options but all call options that a company may issue related
to its stock. We are going to look at that, but I think the
measure of the compensation or if you use options to buy goods,
that is what they are recorded at at that date. That is a
pretty clear issue in accounting right now.
Mr. Toomey. It just seems worrisome to me that we would go
down a road that says we will knowingly and intentionally
refuse to recognize that an expense that we put on an income
statement on day one and that we subsequently learn is never
going to occur in any economic reality but we are never going
to do anything about correcting that, and that is where you end
up if you don't do the--again, I am not advocating that we use
that model, but that is--given that inherent set of difficult
choices, it seems the dilution model is rather appealing.
Mr. Herz. Yeah. I understand the accounting conclusion is
different. The conclusion of many economists, including
Chairman Greenspan, including three Nobel prize winners, is not
that. But it is a good debate to have.
Mr. Toomey. Thank you.
Chairman Baker. Thank you, Mr. Toomey.
Mr. Gonzalez.
Mr. Crowley.
Mr. Crowley. Thank you, Mr. Chairman. Thank you, Mr. Herz,
for being here today and for your comments. I think that many
of us could look back in the 1990s and see both the positive
and the negative effects of the market and what took place
during then, especially in the high-tech industry, but I think
we can all agree that for overall what took place during the
1990s was highly beneficial towards the economy of our country,
and especially the growth of the high-tech industry and the
impact that that had. Many would argue because of the ability
to not have to necessarily expense these items that that
actually encouraged growth in development within high-tech, and
it has been touched upon by a number of my colleagues.
What I would be interested in knowing is do you think, one,
that it is appropriate for Congress to be inquiring into this
issue? Because I think it goes beyond just technical accounting
standards. It goes towards the larger macro economic policy
issues, job creation, job loss potential because of these new
standards that you are suggesting. Are you factoring in the
macroeffect that this would have on our economy? And can you
tell us--I mean, I know who is supporting the standards change.
Can you tell us about what comments you received in opposition
to it? And just lastly, in terms of your time line, I believe
you expect to have these standards in place by the spring,
April of 2004. Do you think that that is realistic given I
think all of our experience with government how slow we are to
move, whether or not you as quasi will do it any faster than we
in government can?
Mr. Herz. Thank you. On the macroeffects again, you know,
we study the economic effects of the transactions, and our
clear belief is and our mandate is that we then come up with an
accounting that we think under our concepts, under looking at
characteristics like relevance or reliability or what is the
better accounting, and we test that out with users, financial
information to see how they use it, how they make decisions,
things like that. And then we weigh that against the costs, the
costs of the company to provide that information and the like.
You know, our clear mandate is to produce accounting
information that is more useful for people who need to have
independent neutral information to make decisions.
On the opposition, we got opposition from a number of
companies, particularly in the high-tech industry, you know,
who wrote us a lot, a lot of letters. There was opposition
earlier from other people in industry, but I think most of
industry has now said let's focus on the measurement issues,
you know, can it be done reliably, how, you know, what is the
best way to measure it.
The April 2004, we would like to stick to that, but we are
going to do this thoroughly and objectively and systematically
and consult with lots and lots of people and get lots and lots
of input. You know, I am committed to try and move the FASB
more quickly than it has in the past, and I think we have
demonstrated that on some of the things we have done over the
last year, but I don't want to sacrifice the appropriate due
process to make sure that we are getting to the appropriate
result.
Mr. Crowley. I would just in closing say that it has been
suggested to me that FASB in this case is acting more like
Congress and this committee acting more like FASB in terms of
our approach, possibly in terms of looking at this and
examining it before we throw the baby out with the bath water.
But I appreciate the gentleman, his testimony and his time this
afternoon.
Chairman Baker. Thank you, Mr. Crowley. Mr. Tiberi.
Mr. Tiberi. Thank you, Mr. Chairman. Following up a bit on
Mr. Toomey's questioning with respect to the cost issue of
expensing stock options, do you believe there is a cost to the
companies?
Mr. Herz. Oh, absolutely.
Mr. Tiberi. Explain how.
Mr. Herz. It is the economic cost of issuing that option at
that date. I don't know if you were here when I read the piece
by----
Mr. Tiberi. I wasn't. I apologize.
Mr. Herz. By Bennett Stewart, but basically to paraphrase
it, there are lots of different ways of looking at it. I mean,
you are issuing an economic instrument that you could have
issued a similar instrument to the market, got the cash and
paid the employee in cash. Another way that economists look at
it is that you are basically forcing the employee to buy the
instrument. So I think most economists say that, yes, there is
a cost at that date to the company. It is an opportunity type
cost, but it is relevant in terms of comparing the company's
actions versus other actions.
Mr. Tiberi. And you believe that there is a cost to the
shareholder as well then?
Mr. Herz. Well, any cost that is a cost to the company is a
cost to the shareholder.
Mr. Tiberi. And not just a cost to the shareholder as
opposed to the company?
Mr. Herz. Again, let me explain that there is an accounting
system that measures revenues, costs to the company. There is
also a metric called earnings per share. That is a metric. It
is just a calculation. It is a calculation that says instead of
looking at the existing number of outstanding shares let's take
this period's earnings and pretend that there were more shares
outstanding based upon things like options, and it spreads
that--then says instead of, you know, there being a dollar
earnings based upon the outstanding issues shared, you factor
in the options, maybe it is 80 cents and the like. But that is
outside of the accounting system.
Mr. Tiberi. Were you here for Ms. Nightingale's testimony?
Mr. Herz. Yes.
Mr. Tiberi. Referring to her testimony, she talked about
this issue of options being a benefit to her as an employee, a
benefit to her as an employee, a tool that her company can use
to attract not only employees but also potentially capital.
What is your response to that?
Mr. Herz. Well, first of all, we don't set the laws, and we
are not telling anybody that they can't issue options. And,
again, this form of option is one of many forms of options, and
the other forms of options already get expensed. It is one of
many forms of equity-based compensation, some of which are very
broad-based that get expensed and the like. So I don't know
whether her particular employer might decide to consider that
form, another form or the like. I would think they might
consider continuing it. I don't know. One of the great things
about stock options is they have very favorable tax treatment.
You get a tax deduction for the full-spreaded at exercise, and
many, many companies have gotten lots and lots of tax benefits
in a form of reduced tax payments from this device.
Mr. Tiberi. Would you agree that there are many, many
people who have been the beneficiary of stock options, who have
done quite well and otherwise wouldn't have if there were the
ability to have stock options given them?
Mr. Herz. Well, again, across the economy the best
statistic I have available is that only 1.7 percent of the
nonexecutive workforce has received any options. So I am sure
there are many people that have benefited from other forms of
equity compensation. I am sure there are many people that have
benefited from profit sharing plans that a company has or stock
appreciation rights or lots of other ways that companies can
innovatively compensate people.
Mr. Tiberi. Do you think--where did this information come
from, the 1----
Mr. Herz. The U.S. Bureau of Labor Statistics, their figure
for year 2000.
Mr. Tiberi. And you believe that your proposal at FASB
won't prohibit this from----
Mr. Herz. No.
Mr. Tiberi. Explain why.
Mr. Herz. We can't prohibit any transaction. We just say if
you do something, here is how to account for it.
Mr. Tiberi. Obviously there are some who believe that your
role is--some up here believe that your role is--you are
overstepping your role in what you are doing.
Mr. Herz. We set accounting standards for transactions and
economic events that occur to business enterprises. So if you
choose to issue stock options or if you choose to issue other
forms of compensation, all we would say is here is how to
account for them.
Mr. Tiberi. You don't believe that your role will stop
that?
Mr. Herz. No.
Mr. Tiberi. Thank you, Mr. Chairman.
Chairman Baker. Thank you, Mr. Tiberi.
Mr. Inslee.
Mr. Inslee. Thank you. I have yet to win a Nobel prize in
economics, so I approach this issue with some humility. But
there are a couple of things that I want to--that I have sort
of concluded and I want to ask you a question. If you reach my
conclusions, what do we do then?
First, I sat through a score of hearings about all the
Enron-related debacles, and I was struck during those hearings
of repeated rapacious behavior by these what I believe to be
criminals. It didn't involve this issue. I mean, we went
through months of testimony, and I just can't remember seeing
that the lack of expensing was really the critical thing that
occurred to these corporations. That is just an observation
that I had throughout these hearings.
Secondly, this concerns me a little bit, because I
understand the desire for a number, but it bothers me to say
that a bad number is better than no number at all, and I think
that is where we are headed a little bit because of the
difficulty of assessing this vehicle. And to me the real issue
really is dilution, diminution of value to the shareholders,
and if you reach that conclusion that that is really what we
ought to be aiming here for is a fair assessment of the
potential dilution of stockholder value when an option is
issued, if you sort of reach that conclusion as I have, what
advice would you give us on how to form a vehicle to really
give investors that type of information?
Mr. Herz. Okay. Thank you. Let me make sure I got your
questions--your points. On the rapacious behavior, we are not
trying to cure that. We are just trying to provide an
accounting standard that deals with an anomaly, a 30-year
anomaly that most people recognize is an anomaly among forms of
stock-based compensation and how to account for it.
The issue on the bad number, again, we are going to look at
that. We have been told by a lot of experts that you can get a
pretty reliable number that is more reliable than a lot of
other things in the financial statements. That doesn't mean
that those numbers are bad either. There is a required
disclosure now that the SEC has. It is called critical
accounting policies and estimates, and you will find that
companies disclose those in 10 or 12 areas. And what they are,
they are a fulsome disclosure of the way the company went about
making estimates in the area of inherent uncertainty. Most of
those deal with other types of things. They deal with things
like impairment of long-lived assets. They deal with reserves
like loan loss reserves and the like. They deal with things
like that, and I think you will find that, you know, we are
going to look at this. And we have been told by other people
who have looked at it that the relative precision on these
kinds of things is much higher than on those kinds of numbers
that have been for years and years in the financial statements.
Again, on the dilution, you know, we will agree to disagree
that dilution is not the only effect here, is not the complete
effect. There is an economic cost. It is an economic cost that
is associated with all other equity transactions, and by the
way, these instruments are used not only to compensate
employees. They are used to acquire goods and services from
outsiders. They are used in M&A transactions. They are used to
make investments and the like, and all of those get accounted
for at the value of the option at that date.
Mr. Inslee. Let me--just one closing comment. I think one
of the things you said that is important in the context of how
the public perceives this, that this really is not a response
to the Enron wave. It is coincidental in time, and I think that
is an important point, because I think the public has sort of
washed those two together. And I appreciate your comment that
these are separate issues.
Mr. Herz. I think that is an excellent point, because I
sometimes give it in speeches. I say, you know, on the one hand
we have people saying that if you do this accounting you are
going to destroy America. On the other hand, if you do--people
saying if you don't do this accounting, we are not going to
rein in all this corporate abuse and all that. And I say, gee,
we are just trying to prescribe what we think is the right
accounting.
Mr. Inslee. Thank you.
Chairman Baker. Thank you, Mr. Inslee.
Ms. Hart.
Ms. Hart. Mr. Chairman, I am going to pass to Mr. Shadegg.
I think he has a question.
Chairman Baker. Mr. Shadegg.
Mr. Shadegg. Thank you. Mr. Herz, let me first of all start
with a disclaimer. This is not my field, not my topic. I also
apologize for being here late. I have been bouncing back and
forth between two hearings.
Let me start with a first question. Sophisticated investors
from current disclosures are aware of the existence of stock
options; and to the extent that they dilute the stock that is
out there, they are cognizant of that, are they not?
Mr. Herz. I guess there is some mixed evidence on that.
Before you got here I explained that the fact that it is in the
footnotes most people don't think is enough.
Mr. Shadegg. But it is not footnotes.
Mr. Herz. Yes.
Mr. Shadegg. You propose to go all the way to the solution
of expensing stock options. Pardon me, but have you already
proposed a different method for valuing those stock options
than the--I guess it is Black-Scholes value estimate that is
currently being used?
Mr. Herz. No. We haven't proposed anything yet. We are at
the beginning of a process to assess all these issues.
Mr. Shadegg. If you were to require that stock options be
currently valued, would you use that method, or would you come
forward with another method?
Mr. Herz. We have received numerous suggestions from all
sorts of academics, people who are experts in valuation
compensation, experts on ways to--that they believe would
provide better valuations. Our staff is at the beginning of
looking at all of those kinds of suggestions.
Mr. Shadegg. I think Congress is confronted with an issue
here, and they are trying to resolve it and do what they think
ought to be done. I read a portion of your testimony, and it
pretty much says you don't think the legislation that has been
proposed by those that were on the prior panel is a good idea,
and I have read your specifics on that. And quite frankly, most
of your specifics legitimately go to protecting FASB's turf and
say this is FASB's job. The Congress shouldn't intervene. It
could have an adverse impact on FASB's efforts and it could set
a dangerous precedent. Those are words you used. Well, I
understand that, I understand the role of your agency. Do me a
favor then. Respond for me to those who are going to appear on
the panel after you to the criticism that says, number one,
there is no way to accurately value these stocks now, that the
Black-Scholes process does not provide an accurate valuation
because these are not traded options, and second, address the
issue that those people also raise about how do you set forth a
value for a stock option that will never be used?
I spent the week last week with a good friend. He had some
options issued by the company he used to work for. He was let
go from that company, and he could never exercise the option.
It is not a value. And address the concern of those who say
anything you do will be inaccurate and therefore requiring CEOs
to certify to what is inaccurate puts them in an untenable
position.
Mr. Herz. Yeah. Okay. The issue of valuation--and, again, I
will go over it. You weren't here. Again, we are looking at all
of that. You know, the question is can it be valued with
sufficient reliability. We are going to look at that hard.
People who have looked at that before us, our predecessors at
the FASB 10 years ago, the International Accounting Standards
Board, many experts in the field all say that it can be done.
Chairman Greenspan a few weeks ago in response to a
specific question on this said that is just flat wrong. I was
on the International Accounting Standards Board at the time
they started looking at this issue. Unfortunately or
fortunately, I left for the FASB before they got to this
particular issue of measurement reliability. So I am looking
forward to getting into that and making my own hard judgments
on whether or not these can be sufficiently reliably valued at
the date of grant or any other date after that.
The issue of the certification, the SEC tells me that the
companies that already are certified with the figures in their
footnotes have implicitly already said that, because the
information certified already includes all the information in
the footnotes of which this is in the footnote.
The second thing I would tell you is that 280 companies or
so, major U.S. corporations, have voluntarily switched to the
expensing method. Well, these are among America's biggest, most
respected companies with highly respected CEOs and the like,
and they must believe they can do it.
Mr. Shadegg. I guess I could respond by simply saying if
current disclosure is inadequate, some argue, you say it is in
the footnotes and they are already certifying it, but the new
method is also admittedly inaccurate, maybe we are best to
leave those companies to decide which of the two voluntarily
most accurately tells the public about the condition of their
stock?
Mr. Herz. Yeah. The argument that--well, first of all, we
believe that excluding it from the financial statements makes
the financial statements wrong. You know, obviously if we
conclude that this is a valid expense, then it ought to be in
the income statement just like any other expense.
Mr. Shadegg. So you have already concluded the footnote is
inadequate?
Mr. Herz. Well, we have generally concluded historically
that footnote disclosure is very useful, but it is not a
complete substitute. And I went through this before on this
particular issue. People have said to us that, for example, the
reason it is not enough is that people pick up information,
analysts and the like, from databases. And unless it is in the
accounting information, they don't pick it up.
Mr. Shadegg. I appreciate it. My time is expired. I
appreciate your input.
Chairman Baker. Thank you, Mr. Shadegg.
Ms. Hart, did you have a question at this time?
Ms. Hart. I will just be brief, Mr. Chairman. Thank you.
You had just mentioned in your answer to Mr. Shadegg that, oh,
these corporations have made the decision to expense their
stock options, and, gee, would they do that if they couldn't
figure out a value, and I think my answer to that question,
having been on this committee through the entire storm of the
last session, would be they thought they had to and they will
figure out a way to value them. I don't know that there is
anything that is clear about where they can go with that. And I
am interested in actually seeing your process through to the
end.
Can you give us just a little window about how you would
actually go about valuing an option in light of the fact that
it isn't necessarily worth anything until it is exercised?
Mr. Herz. Well, again, an option is worth something, maybe
not to the employee, but there is a cost to the company.
Options, I mean, there are trillions of dollars of traded
options in the market. There are options embedded in
convertible debt and you get a lower interest cost, and there
are calculations that very precisely do all those things. So I
understand from an employee's point of view that is the case,
but our accounting standards deal with the accounting by a
company and what are its costs, what are its revenues.
Ms. Hart. I follow that, but taking that one step further,
it is the value to a company which they could actually sell out
of market. I understand that, but as far as the date--when you
talk about the date of the valuation, are you looking toward
that date that is actually given to the employee?
Mr. Herz. Yeah. Date of grant to the employee.
Ms. Hart. So that is the actual date that you would use?
Mr. Herz. When the company officially commits itself.
Ms. Hart. So that is your actual date. And from there you
are going to go ahead more based on what that option could be
worth on an open market?
Mr. Herz. Well, what you would do is you would value an
option through whatever technique we would come to, and we are
going to look at this hard, as I say, at the date that the
company commits to the employee to grant the certain number of
options. And then you establish a value. If the terms of the
options say that--to the employee you can't exercise this for,
say, 3 years, a vesting period, the way it is looked at is that
that is the service period over which the company benefits from
that cost. So you spread that cost over the 3 years that the
employee gets it. If the employee never gets it because he
leaves the company, we would reverse everything because a deal
was not consummated.
Ms. Hart. So things can get pretty complicated. Have you
been conferring at all with these companies that have decided
to use the expensing method within the last year or so?
Mr. Herz. We have talked to a lot of them, and, again,
calculations that they think they will be doing are under the
same calculations that they have been doing for 7 years that
are in the footnotes.
Ms. Hart. Okay. Thank you. I have no further questions.
Thank you, Mr. Chairman.
Chairman Baker. Thank you, Ms. Hart.
Mr. Sherman.
Mr. Sherman. I have arrived just at the right time. First,
I don't think you can defend the present system that you have
got or the present rule on stock options. I remember while I
was studying accounting I learned two things. First,
comparability, the ability to compare two like companies and
tell which one is producing more net income or has a higher
book value, is one of the essential elements of any good series
of accounting principles.
The second thing I learned while I was studying accounting
is that you could turn on the TV and see the taste test, Pepsi
versus Coke. There was a big commercial back then. And the
people being tested were often blindfolded. Well, today you are
blindfolded if you are trying to compare earnings per share of
Pepsi and Coke, because of course they use different systems
for comparing the cost of compensating their executives.
But as I understand it, what you are saying is the
professionals dealing with securities can by looking at the
footnotes turn Pepsi into Coke by making some calculations and
determining what Pepsi's earnings per share would be if they
used the same method. Is that true?
Mr. Herz. They can from the footnote data--first of all,
let me go back. Thank you for that comment on comparability,
because that is an absolutely essential ingredient to good
accounting information and to the information that is used in
the marketplace and investment decisions and capital
allocation.
They can make those adjustments, but one of the issues
apparently is that they can't make them everywhere, because the
databases that they use don't pick up--if it is not in the
accounting information, the accounting--you know, they pick up
the straight information from the income statement, not from
footnotes.
Mr. Sherman. Well, you are saying that those who don't
bother to read the footnotes cannot compare Pepsi and Coke, but
if you are getting your advice from a team of professionals in
a few hours, they can do the calculations to put Pepsi's
earnings per share calculated exactly what it would be if they
used----
Mr. Herz. They can do the bottom line but they can't do
other things like gross margin and other aspects that they
might want to calculate, because it is not broken out that way.
Mr. Sherman. Well, once you have determined what the
expense item would have been on Pepsi's financial statements,
can't you then calculate everything else? What is missing?
Mr. Herz. Well, for example, let's say people not only in
production but in sales and marketing and other parts of the
enterprise----
Mr. Sherman. So a portion of the compensation cost should
not be charged to this year's expenses, but instead could be
part of inventory----
Mr. Herz. Inventory or other things below the gross margin
and the like and things that are needed in financial--proper
financial analysis.
Mr. Sherman. So without much controversy, you believed at
least require beefier footnotes so as to provide in effect a
complete restatement of what those financials would look like--
--
Mr. Herz. Yeah.
Mr. Sherman. ----if the expensing method was used?
Mr. Herz. We could. I mean, I think the concern is that you
do it on one item, then we are going to have pro forma
disclosures on everything. Why have financial statements?
Mr. Sherman. Well, the problem you have here is this is the
only item I am aware of where the FASB has announced there is a
right way to do it, but we don't have the fortitude, I think is
the term, to tell everybody to do it that way.
Mr. Herz. Oh, we have the fortitude.
Mr. Sherman. Well, you haven't--I mean, your current
release on this is the right way, and 98 percent of the
companies are doing it a different way.
Mr. Herz. Right.
Mr. Sherman. I don't know of any other issue that is this
hot. I don't know of any other issue where you can't just say,
this is the right way. Do it this way. So at a very minimum, if
you can't impose that same standard on this issue, which is too
high, you could provide the same pro formas. Then the world out
there could decide which of the two numbers to use. The
analysts could all decide that they like the pro forma number
better, or they could like the main number better, but----
Mr. Herz. They could. I mean, we--there was a survey of--
that the AIMR did a couple of years ago of their membership.
The AIMR is the Association for Investment Management Research,
and they surveyed thousands of people. They got about 2,000
responses from financial analysts and portfolio managers, and
one of the questions they asked was is footnote disclosure
enough, and the answer was no.
Mr. Sherman. It is obviously a lot easier for them if you
are able to come up with one number and they don't have to read
the footnote. What you are basically saying in the survey is
they don't want to read the footnotes and they certainly don't
want to do the additional work of----
Mr. Herz. That may be so or there may be others----
Mr. Sherman. Trust me. No one wants to read those
footnotes. Thank you, Mr. Chairman.
Chairman Baker. Thank you, Mr. Sherman.
Mr. Ney, did you have a question?
Mr. Ney. Thank you. Thank you, Mr. Chairman. Welcome. Some
people have argued that requiring expensing of the stock
options will undermine clarity of the financial statements and
provide greater opportunity really for fraud, because the
valuation methodology would not be exact, and I just wonder
what your view on that would be.
Mr. Herz. Well, our view is that--again, once we have gone
through our whole process and we have concluded that not only
conceptually it is an expense but it can be measured with
reliability, that that is the right thing to do, to put that
number in. To leave it out is to make the financial statements
distortive.
You can provide lots of other information in the footnotes,
continue to do that, provide lots of other information. We are
looking at that as well, because there are other aspects
related to these. For example, the ongoing mark to market might
be instructive right through their exercise date, lots of other
things that could be useful and informative, as well as trying
to make the financial statements correct.
Mr. Ney. On a note about the component stock options which
people have pretty well agreed they are difficult to value, and
one of the people testifying--I think it was Mr. Craig
Barrett--he will be on the third panel--points out that the
CEOs are now required to certify the accuracy of their
company's financial results and that the problems inherent in
valuing stock options will make that extremely difficult.
So my question again is the first part I said. How can we
require the CEOs to do that when everybody has kind of agreed
that that is a difficult thing to do?
Mr. Herz. As I said earlier, having talked with the SEC,
their belief is that under section 302, the CEO has already
been certifying the information that is in the footnotes on
this.
Mr. Ney. Thank you.
Chairman Baker. Thank you, Mr. Ney.
Mr. Herz, we appreciate your courtesy in being with us for
such a length of time. This of course is an important issue,
but the broader question of financial reporting generally is of
interest to me, and we look forward to working with you over
the months to come. Thank you, sir.
If I may invite our third panel, participants to come
forward.
I want to welcome each of our panelists here this morning
and for your patience. This has been a much lengthier hearing
than some would have expected, and I know of time constraints
on our first witnesses. I certainly want to express
appreciation for your participation but understand the
necessity for your departure after the conclusion of your
remarks.
Our first to be heard this morning is the Honorable Paul
Volcker, former Chair of the Federal Reserve, and in his
capacity as Chairman of the International Accounting Standards
Committee Foundation Trustees. Welcome, sir.
STATEMENT OF THE HON. PAUL A. VOLCKER, CHAIRMAN, INTERNATIONAL
ACCOUNTING STANDARDS COMMITTEE FOUNDATION TRUSTEES
Mr. Volcker. Thank you, Mr. Chairman. I appreciate your
courtesy in letting me go first, and I will steal out with an
appointment with some of your colleagues, and I will come back
if I can dispose of that and you are still talking. But let me
just be quick with a couple of points.
I am, as you indicated, the Chairman of the Trustees of the
International Accounting Standards Foundation. We appoint the
Board that makes the decisions. I am not the one who makes the
decisions. I am not to interfere with those technical
decisions.
Having said all that, let me make a few comments. I think
the basic issue you are all grappling with here is what should
the role of the determining boards with, whether you are
talking about FASB nationally. You haven't got any jurisdiction
over the international, but we are aiming for consistency
internationally, and those boards, both the domestic and the
international, have been set up to provide insulation from
extraneous influences. They are set up as professional boards
to make professional judgments of integrity, and that decision
making is to be protected by a rather elaborate arrangement,
including my board of trustees, including the trustees of the
domestic FASB.
We have people who are not accountants on the Board. Some
of them are drawn from business. Some of them are accountants.
Some of them are drawn from analysts. They have large and
elaborate advisory procedures. So these decisions are not
reached in a vacuum, but in the end they are reached on the
basis of professional judgments directed to assure what the
best accounting judgment is and hopefully, from my viewpoint,
to achieve international consistency over time.
Now, I recognize it is amply apparent here that how you
value stock options is exceedingly controversial. I might say
to those that argue that it is not an expense, we better stop
the practice of permitting the expense on tax returns. I don't
think we can argue that they are a tax deduction and not an
expense. That is why they are a tax deduction. And we are a
little inconsistent the way they are accounting for now. I
don't think we can argue that they have no cost. It is very
difficult to know what that cost is, certainly on the grant
date.
There is one date where we know the cost, and that is when
they are exercised. You can look it up in the Wall Street
Journal. There is no doubt about it. That is the date that is
used as an expense for tax purposes.
I want to emphasize, when you consider what viewpoint you
might want to take in the area, that while stock options are
controversial, they are not the most controversial issue, in my
judgment, that the standard setters are going to face. There
are a number of extremely basic and controversial issues that
will arise in accounting over the next months and years, and I
think some of those will have a more profound effect on the
financial world than will any decision that is made on whether
there is to be expressing of options.
There is a rather furious debate going on in Europe right
now about the application of a proposed ruling by the
International Board which will become law in Europe unless the
European Commission says no, unless the European Commission
vetoes it, about the handling of financial instruments. This is
a ruling which has already been in effect in the United States
under GAAP for some years. The International Board said they
think they made an improvement, that it should be applied
internationally. There is very great opposition in Europe.
There are very strong political pressures being brought on the
European Commission.
Now, all my point in making this is if Congress wants to
intervene in this particular decision, is a great precedent for
everybody intervening in every decision that they don't like.
The professional standard-making boards have been set up
deliberately to provide a degree of insulation away from the
professional judgment.
So I want you to understand what you do here is not limited
to the particular question of stock options. I think it would
be obviously from my point of view a bad precedent for a
political body to begin overriding the professional judgments
of the independent standard makers, whether they are
international or domestic. It will certainly lead to a lot of
inconsistency internationally and all of that would be damaging
I think to the basic international framework--the financial
framework.
Now, I happen to think, in looking at stock options as a
matter of substance, that they are deeply flawed, and I know of
no other word for it, as an incentive for business management.
I think it is clear after experience, and they are largely a
phenomenon of the last 15 years or so, that in the middle of a
bull market there are enormous rewards that really weren't
intended. They rise to grotesque--and I use that word
advisedly--rewards for some business managers because you were
in the midst of a bull market. People who performed well got
richly rewarded. People that performed mediocrelly when the
stock market was going up so fast got rewarded. People that
performed relatively poorly or the stock performed relatively
poorly got richly rewarded because of the popularity of stock
options.
Not only that, that there are clearly, I think it has been
demonstrated, temptations for abuse in terms of incentives,
that the incentive is given to the manager to attempt to affect
the price of the stock, sometimes in ways that are inconsistent
with the long-term health of the company. And I think we
unfortunately have seen examples of that.
Now, I understand that for start-up companies or venture
capital companies, you have some discussion of that, you are
under somewhat a basically different situation, where you have
the owners of the companies, the founders of the company making
a decision basically about how they want to distribute some
stock, and they are not at that stage publicly owned companies
at all. When I say I think they are basically flawed as a
compensation instrument, I am talking typically about the big
public companies that are tempted to abuse stock options. They
may not abuse it. You have got one company here that feels very
strongly about the use of stock options. They distribute them
very widely, and don't concentrate them so heavily on a limited
group of people. But unfortunately that is not uniform practice
by a long shot. We have seen these egregious examples where
people have gotten very large payoffs for stock options the
very year that company goes bankrupt or has a decline in stock
price of very large amounts. And when you get in a bear market,
nobody gets rewarded, good, bad or indifferent economic
performance.
So I would say there are better ways of motivating people,
better ways of aligning incentives than the use of--I will use
the words carefully--a fixed price stock option by large
publicly owned companies without concentrated ownership, where
the ownership itself is basically not making the decision but
the managers that are affected are making the decision.
I think that is a certain background for this whole
discussion when we talk about the overall impact of stock
options. I am not arguing they should be outlawed. I am just
arguing that as a matter of corporate practice that a company
that wants to use them should do a certain amount of explaining
as to why in their particular circumstances and the manner in
which they use their stock options is justified. I think in the
end of the day, the pricing of the stock option one way or
another will encourage more conservative behavior and more
prudent behavior with respect to fixed price stock options.
The point was made earlier ironically when you have a
performance-based stock option, it is already expensed and it
is an interesting phenomenon. Not many companies use it. So you
have to ask why not. The temptation is because they are not
expensed to abuse them in some cases. You can't avoid the
uncertainty I think of expensing them, which is very real,
because one thing you know is zero expense is not true. I think
the overwhelming professional economic opinion says if there
isn't expense to stock options and there wasn't expense, we
shouldn't be deducting it for tax purposes.
[The prepared statement of Hon. Paul A. Volcker can be
found on page 169 in the appendix.]
Chairman Baker. Thank you, Chairman Volcker. We appreciate
your participation today. We are here. We welcome you back if
it works out for your schedule.
Our next witness would be introduced by Congressman
Shadegg. Congressman.
Mr. Shadegg. Thank you, Chairman Baker. It is my privilege
to introduce today Dr. Craig Barrett, the CEO of Intel. Dr.
Barrett is a constituent of mine from Arizona and one of the
distinguished witnesses we have today. As you know, Intel is
one of the largest, if not the largest supplier of
microprocessors and has played a significant role in shaping
computer and information technologies.
Since joining Intel in 1974, Dr. Barrett helped perfect the
process for manufacturing Intel's powerful microprocessors. He
became CEO of Intel in 1998. Prior to that he had an impressive
record of academic achievement at Stanford University, where he
served on their faculty.
He also has a demonstrated commitment to public service. He
has been a passionate advocate of higher education and of
placing higher education within the reach of a wider range of
students. He has testified before Congress about strengthening
math, science and technology education requirements and has
advised the President on education issues. He has also been an
outspoken advocate for higher standards in education.
It is a privilege to have Dr. Barrett with us today.
STATEMENT OF CRAIG R. BARRETT, CHIEF EXECUTIVE OFFICER, INTEL
CORPORATION
Mr. Barrett. Thank you, Mr. Shadegg. Mr. Chairman, it is a
pleasure to be here. Sometimes after listening to some of the
prior testimony, I wish I was here talking about education and
math and science. It is perhaps a simpler problem to solve.
What I would like to do is perhaps represent the high-tech
community at this table this morning. I have submitted some
prepared remarks. I will try to summarize those briefly. I want
to talk primarily about three subjects. One is the importance
of stock options to America's economic health going forward,
why expensing stock options is not a solution to corporate
corruption, a topic that has been discussed some today, and why
expensing of stock options will confuse corporate financial
statements and confuse investors. We have heard statements to
the contrary this morning, and I would like to give you my
perspective on that.
I also want to compliment Representatives Dreier and Eshoo
for putting H.R. 1372 in play. I enjoyed their comments this
morning. I am going to look forward to working with them on
this bill going forward.
If you look at the United States economy today and
increasingly going forward, it is a knowledge-based economy.
You can determine that either by looking at the number of
knowledgeable workers in the United States over time. You can
look at that, at the assets of companies as they move. If you
look at the nonfinancial assets of the company, they
increasingly move from property and equipment and raw material
to in fact intangibles such as patents, copyrights and
knowledge based on their workers.
Those two trends are absolutely going forward. It is in
fact the only way the United States supports the standard of
living it has today. It has to add more value to its goods and
services than other countries or our standard of living goes
down and our employees can't afford to get paid.
If you look at the company that I am proud to represent,
Intel Corporation, it was founded in 1968 by Bob Noyce and
Gordon Moore. They founded that company out of Fairchild. At
Fairchild they learned the important lesson that employees as
partial owners of companies can contribute more to that
company, will contribute more to that company, will do more to
make that company successful. When Intel started, approximately
30 percent of its employees were given stock options. Today
essentially all of our 80,000 employees receive stock options.
Speaking at this table as a CEO today with experience in
running a major corporation, with 30 years of experience in the
industrial field, I can testify that stock options are a great
incentive to employees to be owners of companies, to work
harder for companies and to make those companies successful. In
my opinion, this is why we give stock options. The owners of
the company recognize that. The owners are the shareholders.
They agree to a dilution of their holdings in the company on
the basis that the employees will work harder and make the pie
bigger.
Intel is not alone in this area. If you look at Intel,
which I think is a company of substantial success over the last
35 years, Microsoft, Dell, Cisco, you can go right down the
list, all of these companies were founded in the same fashion,
founded off of knowledge-based workers, and this incentive
ownership in the company has been a prime motivating factor for
those employees to work hard.
We could look at it slightly differently. Those are all
large companies that I mentioned. If you look at small
companies, start-up companies and start-up companies do create
the basic fuel to create jobs and wealth in the United States,
stock options are an excellent tool for start-up companies.
Those companies cannot afford to pay often the salaries that
major companies can, and therefore they must compete with the
stock options to attract knowledgeable workers into their base.
I think if you were to expense stock options as some of our
previous speakers have mentioned--subjected to and in fact had
the harsh reality of the profit and loss statement, the profit
to earnings ratio, the stock price associated with that
expensing, you would see a dramatic move away from granting
stock options in the United States. You would have to do that.
This would be at the same time when we are competing
increasingly not with Europe, which Mr. Volcker mentioned IASB
represents primarily, but we are increasingly competing with
Asia, and the Asians have no intentions of expensing stock
options. That is where the competition is in the future.
One of the other areas that was mentioned this morning was
this book, which I would suggest that everyone read.
Representative Eshoo mentioned this. If you are interested in
the data in terms of return on investment productivity, return
on capital growth for companies with a wide holding of stock by
their employees, that is, companies with broad-based stock
options, I think this book is the bible on that topic.
Occasionally it is useful to interject data when discussing
this topic. This book is full of data.
There has been a lot of talk about one of the reasons for
expensing options is to curb corporate corruption. I totally
disagree with this topic. The companies such as Enron, WorldCom
and others that have crashed and burned did not crash and burn
because they were not expensing stock options or because they
had broad-based option programs. They crashed and burned
because the executives in those companies broke the law. They
deserve to be punished. They deserve to be prosecuted for what
they did. They betrayed the public trust.
I think what this discussion is all about, though, is the
impact that broad-based options can have on companies and their
success. I would like to make just a few simple suggestions
which would help introduce the topic of broad-based option
programs and the impact they can have on companies and the
value they add. And it is really a five-step program.
First is that option programs should be approved by
shareholders. The shareholders are the owners of the company.
They are the ones that are agreeing to the dilution of their
proportion of the company. Broad-based option plans should be
exactly that, broad-based option programs, and you ought to
limit the amount of options that go to the top executives at
companies. At Intel our compensation committee is taking the
move to limit it to 5 percent or less of the options go to the
proxy five.
A key element of the Dreier-Eshoo bill is that companies
should provide investors with sufficient information, whether
it is a footnote or not, and by golly, if you read any of our
financial statements today, they are filled with footnotes on
all sorts of topics and any seasoned investor who doesn't
bother to read the footnotes is certainly not a seasoned
investor.
But the footnotes should be written in plain English.
Options ought to vest over an extended period of time, 4 years
or so, and compensation committees who are the committees that
dispense options to the executives and companies should be made
up entirely of outside directors. That is the job of the
compensation committee. That is the job of the directors. They
can't shirk that.
If you do those five things, I think you will do more to
solve any potential abuse of option programs, and you will
create jobs. You will create growth. You will create economic
strength and innovation and entrepreneurship in the United
States.
I do want to end my comments with just a brief vignette
about the accuracy of Black-Scholes, which has had some
discussion this morning, the accuracy and transparency of
financial statements and what you would project to the casual
investor if you followed something like the Black-Scholes
technique, which I believe to be inherently inaccurate in
valuing options.
I wrote an op ed piece for the Wall Street Journal a few
weeks ago. I pointed out in the last few years Intel would have
expensed via Black-Sholes over $3 billion worth of expense for
options which are currently underwater. That is, their strike
price is less than the current market price. That $3 billion,
had it been on our expense, would have decreased earnings.
Those options may never be exercised. Stock price may rebound,
they may be exercisable, but unlikely. That $3 billion of
expense would never come back to Intel had it been charged. So
it is a one-way street if you expense on the date of grant.
I can't imagine how any investor would have the situation
clarified by having over $3 billion of expense on RP&L which
may never occur. It may be obvious from my comments that I
disagree with Mr. Herz. I disagree with the direction that FASB
is going. I don't think there is an expense in the form he
suggests to the company.
There is an expense to the shareholders. That expense is
dilution. They approved that dilution when they approved the
shareholder plan.
So I think the shortcomings in the expensing methodology
are profound, but I think perhaps more important would be the
shortcomings to economic development and economic well-being in
the United States if you were to do away with broad-based stock
option programs, which is what I entirely believe expensing
would do.
Thank you.
Chairman Baker. Thank you, Mr. Barrett. We appreciate your
time here today.
[The prepared statement of Craig R. Barrett can be found on
page 88 in the appendix.]
Chairman Baker. Our next witness is the Honorable Roderick
M. Hills, Partner, Hills & Stern. Welcome, sir.
STATEMENT OF THE HON. RODERICK M. HILLS, PARTNER, HILLS & STERN
Mr. Hills. Thank you, Mr. Chairman. I ask that my remarks
that I sent in to you be accepted.
Chairman Baker. Without objection, as will all witnesses'
testimony.
Mr. Hills. I see that an article from The Economist April
24th that was to be with my remarks is not here. If I may
submit that later.
Chairman Baker. Absolutely.
Mr. Hills. I appreciate the opportunity to offer my views
as to H.R. 1372, legislation which I think is fair to say is a
reaction to the problems--I would say the crisis that faces the
accounting profession.
The problems which I list in some detail in my prepared
remarks are, among other things, causing a fundamental change
in accounting to the increasing use of market values, rather
than historic costs, engaging profits and losses, and in the
use of general principles, rather than a myriad of rules to
evaluate financial statements.
Whether options should be accounted for or not I suggest is
part of this process of change. It seems to me there are lots
of reasons why options should be accounted for. They are a
material factor in how companies compensate employees. They can
significantly affect stock prices. And I am sad to say they
have, because they are not accounted for, distorted the
compensation policies of some companies.
Why then is there a problem? Well, it is, of course, the
opinion of many CEOs who believe with justification that their
strong prices may be severely hurt by costing. They believe
that analysts and investors will punish their stock prices if
management, using information that is largely in their
financial papers, public papers today, applies a Black-Sholes
type formula and uses the resulting number to reduce reported
earnings per share.
You might ask why in the world would analysts have any
different view of the value of the company because the
management does the math that he or she could do as an analyst.
The fact is and the problem is that over the years the
accounting profession and the analyst community have not been
making the kinds of judgments about earnings and the kind of
judgments about the assets of corporations that would long ago
have given us an understanding of what the true cost--because
it is a cost--of stock options. It would give us a better
understanding of many other things about our assets and the
costs of running a corporation.
Yet I don't see how you cannot sympathize with CEOs who do
not wish to shoot themselves, if you will, who argue that a
Black-Sholes number will not be a precise gauge of cost. So we
ask why our FASB and the ISAB persist and, in short, why isn't
H.R. 1372 a perfect answer?
It is attractive in one way. It puts the fight off again.
It has been a long fight. It is not going to go away. It is an
understandable approach. But I suggest to you that the studies
contemplated are simply another way to delay something that is
inexorable.
It is only going to be when accountants, companies and
analysts begin to wrestle with the various approaches to
valuation in the context of a profit and loss valuation that we
are going to get the discipline we need to make the world
understand option costs as well as so many other things. The
fight against pricing of options is the lack of precision, the
fear that it will cause so much uncertainty that it becomes a
worthless process and somehow will destroy the use of stock
options.
I have served on boards over 34 years, 18 different boards.
My own view is that this, too, will pass. We will find a way to
value stock options; and stock options used intelligently by
companies, as they have been by Intel, will continue to be
used; and analysts will figure out that the value of the
company has not been affected.
The real point of my remarks is to say that the costing of
options is not the most serious accounting problem facing
corporate America today. This Economist article which I have
asked to be submitted identifies so many other areas that have
even more pressing reasons for reform, and the article warns
again of the confusion that may arise or will arise again and
again as reform continues in these other areas as well as when
the profession moves to the use of general principles in
evaluating companies' presumptions rather than specific rules,
and as we move to market values rather than fixing costs on
historical basis.
Profits, says the article, may come to be stated as a range
of figures, each of them arrived at by using different
accounting assumptions. This, continues The Economist, may
sound worryingly uncertain, but it may be better than trying to
rely on a brittle illusion of accounting exactitude, which is
liable to collapse during times of economic strain.
I suggest to you that the changes of accounting that are
coming is because of a growing realization that we have for too
long relied upon this brittle illusion of accounting
exactitude. I suggest to you that the accounting difficulties
of the past few years are in some significant part caused
because of our reliance upon precision in accounting.
I believe Congress should suffer the transformation to
continue. The role of self-regulation is intact. It has a far
stronger oversight with a new public company, accounting
oversight board, with a newly staffed SEC that has far more
resources to do its job. I suggest to you an effort now by
Congress to stop this fledgling effort will be a serious
interference with the development of the accounting profession
that we so badly need.
I have no love at all for the Black-Sholes formula. I
sincerely hope that it is not adopted as a requirement for a
corporate America.
More important, I very much hope that FASB and the SEC will
allow flexibility in the costing of options, let different
companies use different formulas. The fact that there will be
no precise formula or no precise number should be a vivid
illustration of the fact that much of the information in the
profit and loss statements today, much of that information is
equally imprecise.
If I may close by saying that Robert Frost--and this is as
early as 1905, when he wrote a poem called The Hardship of
Accounting: Never ask of money spent where the spender thinks
it went, for no one was ever meant to remember or invent what
he did with every cent. What Robert Frost knew almost a hundred
years ago is beginning to be understood by us. I fear that H.R.
1372 will impede the development of that understanding.
Thank you very much.
Chairman Baker. Thank you, sir. We appreciate your
contribution this morning.
[The prepared statement of Roderick M. Hills can be found
on page 158 in the appendix.]
Chairman Baker. Our last witness is Mr. James K. Glassman,
Resident Fellow, American Enterprise Institute. Welcome back,
sir.
STATEMENT OF JAMES K. GLASSMAN, RESIDENT FELLOW, AMERICAN
ENTERPRISE INSTITUTE
Mr. Glassman. Thank you, Mr. Chairman.
Mr. Chairman, Mr. Kanjorski, members of the subcommittee, I
am concerned that the FASB is rushing to a decision that is not
in the public interest and that it is ignoring serious critics
of expensing stock options, among them not only successful
business leaders such as Mr. Barrett but respected economists
and a large number of financial and accounting professionals.
By the way, despite Mr. Herz' earlier response to a
question, at last count opposition to expensing is running
three to one ahead of approval in comment letters.
I strongly favor the approach in H.R. 1372. In my view,
requiring the expensing of stock options would be a serious and
disastrous mistake for three reasons:
One, by severely discouraging the use of a powerful
incentive for employees at all levels, all levels, mandatory
expensing is likely to have a dangerously adverse impact on
innovation, economic growth, and national competitiveness.
Options work. They align the interests of managers and
shareholders, and they provide a powerful incentive to
innovation and hard work.
Two, mandatory expensing is likely to confuse and mislead
rather than further enlighten investors. You heard quite simply
there is no way to value stock options accurately at the time
they are granted.
Three, as a long-term strategy, mandatory expensing leads
accounting policy in precisely the wrong direction. The
expensing of stock options has become a prime example of an
accounting fetish, a kind of obsession to reduce contingent
liabilities and other forms of information about a company to a
single number that can be included in earnings statements under
GAAP, Generally Accepted Accounting Principles. GAAP earning
statements in truth comprise only one view of a company's
health and prospects, as my friend Mr. Hills just stated, and
often a distorted one. Investors need many views, and they are
poorly served when policymakers elevate GAAP to a kind of holy
status.
These three points are discussed at great length in my
testimony. But in my remaining time let me just address a
couple of issues that relate directly to the role of Congress.
The FASB has a single mission which it states this way.
This is a quote: ``To establish and improve standards of
financial accounting and reporting for the guidance and
education of the public, including issuers, auditors and users
of financial information.''
Federal policymakers have a far broader mission. For
example, they are responsible for encouraging economic growth,
for preserving and increasing jobs, innovation and U.S.
competitiveness. Even if the FASB is not--even if the FASB
expensing proposal were cogent from an accounting viewpoint,
and it is not, it would be the duty of Congress and the
executive branch to consider its economic impact. I do not have
to remind you. That is your job. You can't abdicate it, you
can't farm it out to a group of accountants, however well-
meaning.
In fact, Mr. Herz said earlier, he said that the moratorium
``unduly intervenes.'' That is a quote. I disagree. I assume
that you disagree, too.
Second, do not be intimidated by all this technical talk
about accounting. Understand that accounting is not a science.
It is not biology or astronomy. Accounting attempts to render
in words and number the history and current status of
businesses. The best way to do that is a matter of opinion.
There is no single right way to do things. And often accounting
rules allow choices and flexibility. And that is a good thing.
The current rule allows companies either to expense options
at the time grants are made or to explain their possible
effects in footnotes and then dilute earnings.
I discussed in my testimony a typical firm, Gilead
Sciences, a biotech company. I just pulled the 10-K off a pile
that I have in my office whose footnote extends to four pages.
Now, understand that footnotes, if you never read a 10-K, and I
am sure every member up there has, footnotes are printed in the
same type as everything else in a statement. They are
tremendously important. No serious investor would ever ignore
footnotes. These footnotes show far more information, quite
frankly, about options than they do about other more important
aspects of the business such as intellectual property assets or
cash compensation and leases.
The current regime is perfectly valid. The accounting
profession and top academics are not united in their support of
the change that the FASB proposes. As a result of expensing
options, many firms, among them America's most successful and
innovative, will be forced to take massive charges against
earnings. These charges are likely to lead to lower stock
prices and higher cost of capital for the firms. Companies, in
addition, will be discouraged from issuing options in the
future; and firms will be less likely to list on the public
markets. The likely effect will be to reduce economic growth,
U.S. competitiveness and job creation.
It is the responsibility, in short, and in conclusion, of
elected public officials to weigh the economic costs and to
act. I do not question the sincere desire of the FASB and its
supporters to restore investor confidence through a mandatory
expensing. But I have written a column for several large
newspapers about investing for many years. I think I know small
investors. It is my judgment that investor confidence will
probably be affected negatively, if at all, and the economy
will be placed at risk. This subcommittee under those
circumstances cannot sit idly by and watch new accounting rules
imperil what is today a tender and tentative recovery.
Thank you.
Chairman Baker. Thank you, Mr. Glassman.
[The prepared statement of James K. Glassman can be found
on page 102 in the appendix.]
Chairman Baker. I will start out by talking about the
current environment we find ourselves in, especially in light
of distinguished Chairman Volcker's comments advising the
committee to be careful in moving forward on any of these
subject matters.
I can go back in financial services in this decade with
regard to proposals relative to the treatment of derivatives,
the adequacy of loan loss reserves. There have been any number
of occasions when there have been public expressions concerning
the manner in which disclosure should be made. I suspect that
will continue. In fact, the FASB approach today is not to act
precipitously but to engage potentially in public roundtables
or public hearings to further assess the feelings of those in
the enterprise in the stake-holding business as to their view
of the proposed rule modification.
To that end, I think it is also important to confirm what
you characterize, Mr. Hills, as the brittle illusion of
exactitude, that in fact in this effort we should move quickly
beyond the issue of the expensing of options and look at the
adequacy of the current reporting methodology in the broad
sense in light of the significant changes in the way our
economy performs today versus two decades ago, much less the
last 50 years.
In an earlier exchange, I was asking the FASB
representative concerning the appropriateness of XBRL and
having a much more rapid reporting of material fact that is
principles based instead of rules based. Just in editorial
comment, our system is defective; and the fact that we find, as
a policy perspective, deficiencies, for example, Sarbanes-
Oxley, requires us to act.
I guess what I am suggesting is that we don't really have
to run very fast to stay ahead of the historic pace of FASB in
promulgating regulations. This ought to be a complementary
approach where we can have a public discussion, allow
professionals to reach their conclusions but, at the same time,
evaluate whether those conclusions fit in the context of our
current economic condition.
I am worried unless we get to real-time material fact
disclosures that everything else is throwing very small life
jackets overboard to people in very deep seas when they really
need a whole new vessel. I don't know how we get there, but I
suggest that, rather than this being an inappropriate
exploratory activity, it is highly appropriate to fully
understand how this expensing of options and the reform
associated with it fits into the broader picture of reform of
our whole financial reporting system.
I don't really have a question, but I just sense that we
are also all so focused on the expensing aspect the bigger
picture is passing us by and that is far more important because
of the inevitable changes that are likely to come.
Mr. Hills, would you want to respond, given your concerns?
Mr. Hills. I appreciate that.
I also want to pay a compliment to my friend, Mr. Glassman,
who has made a wonderful argument for eliminating the profit
and loss statement. But, unfortunately, we have one; and it is
going to change.
This Economist article which I recommend strongly says we
may be looking at ranges of values. We will not have an
earnings per share that we can look at with precision. We may
look at a place where different companies will make different
assumptions as to what they did--the assumptions they used in
coming to the concludes they came. It will be ambiguous. It
will be of concern. But I think it is better the people
understand the ambiguity rather than think it is not ambiguous.
As I said before, there is no reason why an analyst today,
a good one, can't look at the information in the financial
papers and figure out in some fashion what he thinks the cost
is of a company. Because, believe me, some companies abuse
options enormously.
Chairman Baker. Let me jump in. At this point, as opposed
to taking the current methodology of a snapshot of a current
corporation of a date certain with given facts that are in
effect on that specific date, we really ought to have a motion
picture analysis where you can take in variables of your
choosing that you plug into a system that then quantifies your
predictions about corporate performance in light of the
conditions as you view them, interest rate risk, credit rate
risk, customer satisfaction surveys. There is a whole array of
things that tell you where the company is going as opposed to
where it has been. That is the problem, is that the current
system looks back and gives you an old snapshot. It doesn't
tell where the corporate leadership is taking the company over
the next few months.
Mr. Hills. I think that is right, but you need a freeze
frame once a year.
Chairman Baker. But the issue is, on what do you base the
freeze frame? Is it mark to market in current time? I think we
have the technology today to get us to a mark to market on a
daily basis.
Mr. Hills. We are moving, as I said before, like it or not,
inexorably toward market values rather than historic costs and
trying to understand the values of corporations; and that is
going to be a rocky road to get from one place to another.
Mr. Kanjorski. Thank you, Mr. Chairman.
Mr. Chairman, I find myself in a peculiar situation here on
this side of the aisle. We are supposed to be the pragmatists
and the liberals, and I find myself arguing for Edmund Burke's
theory that you don't change it if it is not broken and you
maintain something until it gives value.
Here we have a long-term attempt to take professionals,
create FASB, empower them to establish these rules and
principles. We now have a process we are going to a global
market looking for standardization and transparency so that
securities can be traded world wide and we can have a view. And
yet we are sitting here as the Congress second guessing and
much inferior to the experts I may say at FASB or in the
corporate world. We are imposing on a single basis whether or
not we are going to expense one part of stock options or not
expense it and worried a little bit about the impacts.
Mr. Barrett, I have a great deal of respect for you and
your company, but do you really believe that that $3 billion
that doesn't show up, that the analyst and the people that are
making that evaluation, if we change this rule and you had to
expense that $3 billion in stock options that would appear on
your sheet, suddenly wouldn't be explainable and understandable
and that it would just have a tremendous effect at driving your
stock value down on the market?
The reason I pose that question to you, if that is the
case, then Mr. Glassman and others that have testified aren't
correct that people are paying any attention to the profit and
loss statements. You already show that information in one
place. Now it is going to move to another place in the profit
and loss to be reflected, and yet you seem not to have very
much faith in the analytical community or the investor
community if that is going to so impact on your individual
stock.
Mr. Barrett. As the CEO of a company, I can't say I have no
faith in the investor community. The analyst community is a
different topic.
Mr. Kanjorski. Touche.
Mr. Barrett. My comment was merely that Mr. Sarbanes was
here earlier. I do get to certify my results every quarter,
transparent to the investor community, et cetera, et cetera. I
would suggest that $3 billion is big enough to be noticeable in
a certification process. It is big enough to be noticeable by
an investor. It is big enough to swing the tide. If that is an
error, then everything I do for Sarbanes-Oxley is trivial. I
worry about $1 million and $10 million issues on the financial
statement.
Mr. Kanjorski. Mr. Barrett, I understand that. But I think
Mr. Hills' point is that we are getting so raptured in
absoluteness in accounting when, in fact, it is just another
way of getting a snapshot. The problem I am worried about is
now corporate America that has been using these stock options
are coming for a release or a protection to the Congress of the
United States, and we are going to start establishing this
precedent that every element of our corporate structures that
get impacted in some negative way by accounting rules proposed
by FASB in the future, they don't have to worry about that.
They just turn it into a political issue. Come on up here to
the Congress, probably no greater informed than the average
investor in America.
And I don't have a great deal of respect for that standard
of--in spite of your feeling, Jim, that they are so well
informed, do you really want us up here to turn this into
periodic political issues as to what we do with expensing? It
isn't very sexy. It isn't very attractive. And you are going to
be dealing with people making these decisions on an ad hoc
basis that could be very dangerous for corporate America, for
the accounting profession and what it represents to get any
insight on reliability. You know, we are just going to be where
the numbers are, where the administration feels we should come
down.
In this instance, so many of the respected people in our
society seem to come out on the favor of doing the expensing. I
mean, Paul Volcker is certainly equal in stature to Mr.
Greenspan; and they are both in favor of expensing. And I think
they make an adequate point. If corporate America can take a
tax deduction based on the expense, why in the world can't it
show it on its balance sheet? If I had my way, the statement
would have to be identical to the tax statement so that we have
reality there instead of these special provisions.
Mr. Barrett. But you know that the tax laws are
substantively different from the accounting laws across the
board.
Mr. Kanjorski. But why, Mr. Barrett? Because every time we
have a tax bill on the Hill corporate America fills these halls
with lobbyists who get their special provisions and their
special ways. Now there is no rhyme or reason between what is
good tax policy and what is reality in what should be taxed
because everybody and their mother's uncle have a special
provision up there.
Mr. Barrett. Thirty years ago, Congress decided that it
would be a tax-neutral event to tax stock options; and,
therefore, they gave companies that depreciate a deduction
associated with that.
If I could give you one thought, though, with regard to
your earlier comments.
Chairman Baker. Let me interject, if I might, with a little
bad news. Not to cut Mr. Kanjorski off, we are down to 5
minutes on three votes. There are members who have expressed
significant interest in coming back after the break for the
votes. I don't know that each of you--of your schedules, but
Mr. Volcker possibly could come back. If you are available, we
would like to recess at this moment and return, and that way we
can give adequate time for members to follow up on their
questions. Is that appropriate?
Mr. Kanjorski. Very high-priced talent here, but if they
will remain.
Chairman Baker. We leave it at their scheduled
availability. We certainly understand if you cannot. But we
will be gone about 20 minutes.
We stand in recess.
[recess.]
Chairman Baker. If I may, I will call our subcommittee
meeting back to order.
To continue, Mr. Kanjorski was into his questioning; and we
will put 2 minutes on the clock to pick up where you left off,
if you would like to pick up.
Mr. Kanjorski. I know it was a great question. I just can't
remember it. It was the issue on--Mr. Volcker pointed out if
the corporation can take the tax deduction, obviously that
requires a calculation of what the value is. Why can't we just
disclose it on the form? Why shouldn't we have parity in those
two things? I will throw it out to the committee as a whole.
Mr. Barrett. Well, are we trying to align accounting
principles with Tax Code? I mean, it is my understanding that
30 years ago when Congress decided that options were taxable
income they assigned some value to them, they did a tax-neutral
assessment and allowed the corporations to take a deduction.
Mr. Kanjorski. Right. The point I guess I want to make is,
if you asked, in my opinion, 100 common people walking the
street, most people would assume that, whatever your report is,
a profit as a corporation is also taxed as a profit. They don't
understand the double or triple accounting of tax difference.
I have to tell you something. We went over to vote--I am
not going to name the Members, but several Members were
relatively shocked when they found out--you mean they are not
paying taxes on these options? Or they are not--or they have
given a tax deduction on these options when in fact they are
not reported on the sheet?
So don't overestimate the knowledge of the Congress or the
American people. Most of us would like to think simplistically
of how things are going, and every day we spend here in
Congress we get more confused.
Mr. Barrett. I get more confused every day I read the Tax
Code.
Mr. Kanjorski. Do you have any suggestion on Mr. Volcker's
idea that if we are going to use it for tax deduction it should
be able to be reported?
Mr. Hills. Well, I have to say, in fairness, the Tax Code
is a different bargain than the accounting rules. So I don't
think you can insist upon consistency since there is a
hobgoblin of inconsistency. So it is a good argument, but I
would rather rely upon the fact that we do have GAAP with all
of its weakness.
We do have a profit and loss statement, whether we should
or should not. We do have a requirement of an audited
statement. People can argue about all of those things, but we
do have them, and so we should make them as good as we can make
them. I say soldier on.
I must say I think this hearing and the airing of this
subject is terribly important, and I do think that Congress
should not be unaware of it. I can imagine that there are times
when Congress needs to step in. I think it is premature now. I
don't think the hearing is premature. But it is going to be
another year, perhaps, or more before it moves.
We will know a lot more about this subject when FASB sends
out its pronouncements, and I think we will all be comforted by
the period that this is happening. I truly believe that Intel
will be able to have the same option program it had today, even
if FASB finds a way to require that options be valued in some
fashion for purposes of earnings per share.
Mr. Glassman. Mr. Kanjorski, I associate myself with Mr.
Hills' remarks. Not the last one about the option program. I
think Mr. Barrett is the best expert on that.
But can I comment on something you said earlier about
Edmond Burke and not kind of changing things just to change
them? If we accept your argument, which is that there is enough
information out now or that the information today if it is
sufficient is not going to change the value of the company if
expenses--if options are mandatorily expensed, that seems to me
just as good an argument for keeping the current regime. So I
think Edmond Burke would probably say, well, we have had it for
30 years. Why not continue it? Why make the change if the
information is currently on the table?
Mr. Kanjorski. I guess the argument to that is, then why
have FASB and why have an attempt to go to international
accounting? And then basically what--I just think, Mr.
Glassman, what you are doing is you are telling the Congress
that we are the final arbiters of all these individual rules
and regulations on how we do things. And we like to think that
of ourselves, but then you are talking about the whim and fancy
of Congress as it changes every 2 years. I am not sure we are
going to get the standardization. I am not sure we are going to
get to some certainty, not numbers certainty but at least form
and process certainty.
Mr. Glassman. One last comment. I absolutely respect that
position, Mr. Kanjorski, but I think that this is clearly an
issue that for good reason has disturbed a very important
sector of the U.S. economy. I mean, I think we need--I have I
think--just as you respect the idea that you don't intervene in
every last little accounting issue, I also respect the fact
that the engine behind this economy over the last 10 or 20
years really has been high technology; and high technology
firms are very strongly opposed to this. And I think that
they--among others. And I think we need to--you need to examine
it for that reason. And you are examining it today, and I
congratulate you.
Chairman Baker. Mr. Ose.
Mr. Ose. Thank you, Mr. Chairman.
I am amused by the thought when Chairman Volcker was here--
when Chairman Greenspan comes, the traders all hinge on
everyone's remarks. I am amused by some poor trader in the
options pit trying to follow this discussion today, pro or con,
and what their reaction is.
One of the reasons I am a capitalist is that I enjoy
immensely the dynamic nature of the economy. I think the issue
that I would like to explore is, when we talk about American
standards of corporate transparency relative to reporting this
or that on the financial statements of American corporations,
relative to perhaps the standards in the International
Accounting Standards Board which, correct me if I am wrong, is
largely focused more towards the European-type of corporation,
we end up missing where most of the growth seems to be
occurring now in the world economy and that is around the
Pacific Rim.
One of the tools that our corporate leaders use to attract
talent, obviously, is compensation in one form or another. I
would be curious particularly of Mr. Barrett's input as to, as
America's leading-edge corporate entities compete for talent in
the world economy, what is the value or use of options? And if
we depreciate that value by whim or fancy of Congress what the
impact of that will be.
Mr. Barrett. I think you can get the right vector, the
right direction if you look at just what has happened in the
last 10 years.
First, if you look at Taiwan, with the growth of the high-
tech community in Taiwan which basically grew at the expense of
U.S. firms because it was basically hiring U.S. workers back to
Taiwan with options and start-up companies, you then just
follow that point in time to what has happened in mainland
China, what is happening in India. Mainland China, it is more
in the manufacturing side; and in India it is more in the
software side.
If you look at both of those countries or all three of
those geographic areas building up, you look at the fact that
the U.S. educational institution is still the best in the world
at creating highly educated technical personnel. Roughly half
of the Ph.D.s that graduate in the physical sciences in the
U.S. are foreign nationals. They are increasingly going home.
They are not staying here. And if you put U.S. corporations at
a structural disadvantage I think you will just accelerate
that.
That is where the action is in the future. The action is
not in western Europe. The action is in Asia. You take Intel as
the proxy. Asia Pacific, excluding Japan, is our biggest
marketplace today, bigger than western Europe, bigger than the
United States and growing much faster than either.
Mr. Ose. Are you suggesting that, to use Mr. Kanjorski's
phrase, the whim and fancy of Congress may lead to unintended
consequences of exporting of these high-tech jobs to an even
greater degree than perhaps might be occurring today?
Mr. Barrett. I think that is the potential danger, yes.
Mr. Ose. Thank you, Mr. Chairman.
Chairman Baker. Mr. Sherman.
Mr. Sherman. I have so many comments I would be asking
folks to respond in writing to some of the questions that I
raise here.
The first point some of you have talked about, principles
based rather than rules based accounting, please don't do it.
Don't move in that direction. Investors need solid information
they can rely upon.
Imagine if we had rules for determining, okay, how much
will an appropriations bill cost. We could possibly agree on
something that narrow. But if instead we wanted to apply the
big principle of is it a fiscally responsible appropriations
bill, I suggest you and I might disagree.
Imagine if the Chair of the Appropriations Committee could
hire me to opine on the fiscal responsibility of his
appropriations bill. I do think, though, that you could ask for
three or four different pro formas, each prepared with strict
standards.
Keep in mind that these auditors are selected by and paid
by the company, just as we wouldn't have the Chair of the
Appropriations Subcommittee selecting who is going to opine on
the fiscal responsibility of his or her bill.
Chairman Volcker raises an interesting issue, and that is
that the present system wildly distorts our executive
compensation system.
Imagine if you had a cash-strapped company that was trying
to provide incentives for its workers and managers. That
company might set aside a million shares to be given as bonus
shares. Top management might get the shares not based on
whether the stock price goes up but whether it goes up compared
to an index of companies in the same industry.
Because good management doesn't just ride the wave, good
management outperforms the wave. You might give the division
head bonus shares based upon the success of his or her
division. You might give employee shares based on that
employee's department. But if you did any of those things you
would be using shares to compensate employees in a logical way.
You get penalized by GAAP because, as I understand it, correct
me if I am wrong, all of those methods would be expensed
because you are giving shares to employees based on something
other than the plain vanilla stock option plan.
Another company in the staple industry decides, oh, we are
just going to have stock options for everybody. So some
division head realizes that the success of his or her division
slightly influences the company, provides some incentive.
Now I don't know which of these two systems is the better
way to compensate executives or employees, but you do know that
companies should decide that, without GAAP telling them, that
they are going to be tremendously penalized if they choose
anything other than stock options.
On the other hand, the Black-Sholes formula charging income
when the options are granted seems pretty distortive. If you
bring in an executive and say, Jack, you are doing a good job,
here is a 3-year contract, and we are going to give you a
raise, the cost of that compensation is charged over the 3
future years in which that executive works. But if you call him
in and say, you are doing a great job, here's a 3-year
contract, we are not going to give you a raise, we are going to
give you options, then under Black-Sholes you charge income the
year you give the person the raise rather than the 3 years that
that person is going to work presumably for the company's
benefit. Do I have that right?
Mr. Volcker. I should not pose as an expert in this area,
but my understanding is that what the international body
suggested in their exposure draft--they haven't decided yet--is
that you would amortize.
Mr. Sherman. That you amortize it over a length of time.
Mr. Volcker. Right.
Mr. Sherman. I have been told something else. But clearly
if you have a stock option designed to provide an incentive
over the period of time when the employee holds that option,
that the cost is amortized over the period of time and that
would eliminate that concern.
I agree with several panelists that nothing we do on this
stock option would have solved the Enron or the corruption
thing. Managers are always going to have it in their interest
to overreport earnings, and the corrupt ones will do that
unless the auditors prevent them from doing it. The idea if
they didn't have stock options they wouldn't want to overreport
earnings--there are so many reasons to want to overreport
earnings.
I will ask, starting with Chairman Volcker, if you have any
comments to the----
Mr. Volcker. I don't fully agree with you on your last
point. I fully agree that there are the lot of reasons that go
into corruption or fraud or pressing the envelope too far, but
I am afraid that we do see some evidence that the nature of
fixed price stock options creates a temptation that adds to
other incentives they might have.
Let me quote, if I may----
Mr. Sherman. If we didn't pay our managers so much, then
maybe they wouldn't have as much incentive. But can you think
of any way of rewarding managers for success of a company that
wouldn't cause them to seek to distort any measure of the
success of the company?
Mr. Volcker. You, I think, have a problem. I think some
methods are more vulnerable than other methods. There is
tremendous leverage in a stock option.
So let me just read, if I may, a comment which I found
interesting. It was by a dean of a business school who formerly
was a strong advocate of stock options. He said, ``mea culpa.
You know, it was a simple idea. We compensate managers with
company stock or options so they will do the best for the
shareholders. It doesn't always work that way. Motivating
managers with company stock can damage on a grand scale,
encouraging them to pursue strategies to fatten their wallets
at the shareholders' expense. Consider the trajectories of
Enron and its ilk as well as a host of dot coms, companies
devastated by managers motivated by powerful stock-based
incentives.''
Mr. Sherman. I understand you can find people wailing and
bemoaning stock options and doing it in good prose. But is
there any way to provide large incentive payments to managers
based on a measure of their performance that would not be
subject to--would not provide an incentive to managers?
Chairman Baker. That will be the gentleman's last question.
Mr. Volcker. Are there any that are perfectly----
Mr. Sherman. Or even less likely than stock options.
Mr. Volcker. Restricted stock which you have to hold for
some time, taking the ups and down of the stock and hold it for
a considerable period of time beyond the vesting period. That
has a quite different incentive. Even stock options, if you
were required to hold them for, let's say, your whole period of
employment, would reduce the incentive you have to do short-
range manipulation.
So it is the matter of degree. It is not----
Chairman Baker. The gentleman's time has expired.
Mr. Chairman.
Mr. Oxley. Thank you, Mr. Chairman; and let me welcome this
outstanding, all-star panel. I made a special effort to get
back because I did want to, first of all, welcome you and, many
of you, welcome back. We have some veterans here who have
testified before this committee more than once. But we are
delighted to have all of you here and to have your knowledge
and participation.
Mr. Volcker, fixed-price options are an exceedingly popular
way of providing compensation. Why haven't more companies used
performance-based options in that respect?
Mr. Volcker. Well, I think one reason--I will give you two
reasons. One reason is that the performance based options, I
think it is an anomaly, are expensed. So if you are worried
about how your immediate impact is going to be on the earnings
statement, you are biased towards fixed-price options.
I once was the director of a company that had performance-
based options, and I think it was an appropriate way to do it,
but it does get into a lot of arguments about exactly how you
measure performance. Do you do better than your competitor's
stock price? Do you set some hurdle rate for return on capital?
Mr. Volcker. Do you have a price-earnings ratio?
There are a lot of different measures you can take, but I
know we spent a lot of time arguing about it. So it is more
complicated, but it makes I think, by and large, on the face of
it more sense than a fixed-price option, which demonstrably has
capricious results, because it is so affected by the total
change in the stock market rather than the performance of an
individual company.
You know, American managers suddenly didn't become geniuses
in the 1990s compared to where they were in the 1980s. At
least, they weren't six times more genius, but that is when the
stock market went up. Then it goes down by 50 percent. I don't
think they are all stupid. So you get very capricious results.
It has got quite a lot of resemblance to giving a lottery
ticket, because so much of the result is not dependent upon the
performance of the particular company.
Mr. Oxley. Mr. Barrett, do you have a comment on that?
Mr. Barrett. I think I would echo some of Mr. Volcker's
comments. It is complicated to decide exactly what metrics you
would choose, and you get capricious results on either side.
The market can go up or down without you, and should you be
benefited by that or disciplined by that is always the
question.
We have adopted a fixed-price option. It is relatively
simple and straightforward. If the shareholders benefit, then
they only benefit when the price goes up. Then presumably you
are doing a good job for your shareholders, not perfect but
very simple and straightforward.
Mr. Oxley. Mr. Hills.
Mr. Hills. Devising a compensation policy for any company
is a marvelous task. Cash, stock options, deferred
compensation, retirement benefits, health plan, it is a
complicated transaction. A lot of it should be based upon
performance.
Personally, in the various boards on which I have sat, we
have always had performance-based stock and some performance-
based options. We found performance-based stock is probably a
little easier to work with, is less volatile, but, as Chairman
Volcker said, the decision to use these things is controlled by
GAAP policy more than it is by common sense.
Mr. Oxley. Interesting.
Mr. Glassman.
Mr. Glassman. The use of stock options, it seems to me, is
the purest way to align the interests of management with those
of shareholders. The price of a stock is the best manifestation
of a company's value. It is better than any kind of
performance-based measure because millions of people are voting
on what the value is every day. It is not perfect. Absolutely.
But it really is the best.
So if you want to align the interest of managers and
shareholders, which is what companies want to do and should
want to do and which was not done, by the way, to a great
extent in the 1970s--we got into trouble for that--the best way
to do it is through stock options. And frankly, obviously,
there are some risks to be run there, the temptation to
manipulate in some way the stock, but I don't think there is
any way to avoid that unless you bar managers from owning stock
period, and that wouldn't be a very good idea.
Mr. Hills. Let me comment, Jim.
The best way to align the shareholders' interest of
management is with stock, not stock options. You find
yourself--I found myself more than once in a situation where
you have to make a decision on a board or on a company, and if
that decision means you have nothing, which is what happens if
the stock goes along a certain point, that affects your
decision, as distinguished from the stock goes down a buck. If
the stock goes down a buck, you may have lost 50 bucks. If the
stock goes down a buck, you may have lost all your options. So
I would say to you that the best way to align stockholders and
managers is with stock.
Mr. Oxley. What about that, Mr. Glassman?
Mr. Glassman. I think stock is a good way to align the
interests of stockholders and managers. There is a very
interesting paper on the differences between the two which I
cite in my testimony and I am happy to introduce as an exhibit.
I do think, however, that options in some ways because of
their leverage, because the increases are so dramatic, that
makes it a much more important incentive for managers. I think
options are a very good way to do it, frankly, rather than
awarding stock.
Mr. Oxley. Mr. Volcker.
Mr. Volcker. It is--just an obvious problem with a fixed-
price stock option is you gain when the leverage goes in your
direction; you don't lose when it goes in the other direction.
That is a silly kind of incentive, frankly, for any manager.
You can get a fixed-price stock option, and compare to the
performance of the stock of a company that did no better than
the interest on a government bond in the 1990s, you make a lot
of money. Now, is that a great incentive? I mean, you took no
risk of loss, and you made a lot of money when the shareholder
would have been better off buying a government bond.
Mr. Glassman. I would say, Mr. Volcker, that if your
compensation as a CEO is 50 percent or 30 percent or some large
number tied up in stock options, that if those options become
worthless that is a big hit to you.
Mr. Barrett. Could I offer one comment?
Mr. Oxley. Yes, Mr. Barrett.
Mr. Barrett. I read an interesting summary by the proponent
of expensing stock options who alluded that there would be
immense innovation in the field of executive compensation
associated with this whole movement. I was dismayed by that for
the following reason. The way companies are successful is we
have innovation in products and services and we compete in the
world's marketplace. If all we get out of this is a discussion
on innovation and compensation strategy, I think we will have
collectively lost.
Mr. Oxley. Mr. Chairman, my time is expired. Let me once
again thank our distinguished panel. This has been a most
interesting day--I think the Chair will agree--and one of our
better hearings that we have had because of the quality of
witnesses that we have had. I yield back.
Chairman Baker. Absolutely. Thank you, Mr. Chairman.
Mr. Shadegg.
Mr. Shadegg. Thank you, Mr. Chairman.
Let me start out with what I think are some points of
agreement, and if I am incorrect, please let me know. Let me
start out with a premise that I think all of you are agreed
that stock options are not the cause--were not the cause of the
Enron WorldCom scandals with which we were faced a year ago and
that this committee dealt with. We all agree that they are not
the cause?
Mr. Volcker. Sorry. I don't agree with that. I think they
were probably a contributing factor.
Mr. Shadegg. Okay.
Mr. Hills. I would say that it is a contributing factor.
Certainly not the dominant factor. In many of the scandals it
was a contributing factor.
Mr. Shadegg. Let me try one that I think you will agree
with. I believe we all agreed, particularly, Mr. Volcker, you
and Mr. Hills agreed that there were bigger problems facing us
in terms of corporate accounting than in terms of the stock
option issue. Is that correct?
Mr. Barrett. Yes. I think all three of us--or four of us
might agree on that topic.
Mr. Shadegg. Yeah. I think we all agreed on that, but
particularly the other two.
I think there was agreement that valuing is difficult and
imprecise, and I think both Mr. Volcker and Mr. Hills would
agree with that, even though Mr. Barrett and Mr. Glassman are
stronger critics of the ability to value stock. Is that right?
I think we also have agreed that broad-based stock
options--and here it is particularly Mr. Barrett and Mr.
Glassman have said broad-based stock options are a good vehicle
to give employees ownership in a corporation, to give them a
sense of ownership, to tie them to the company, but I think
there is all agreement across the board that broad-based stock
options have a value in incenting employees and making them a
part of the company.
Mr. Volcker. I agree with that, but I don't know if they
can do it more effectively than giving them stock or a
performance option.
Mr. Hills. I must also say it is company specific. It is
quite true of a wide range of companies that broad based is
terrific, but there are a whole lot of questions that it
doesn't make any sense at all.
Mr. Shadegg. Mr. Glassman made the point and Mr. Barrett
that they are very important in incentivizing particularly in
the high-tech field but generally across the board, and I
didn't find a disagreement with that amongst the other two
witnesses.
I think there also is agreement across the board that
narrow stock options limited just to top management can in fact
distort corporate conduct and hurt the overall interest of the
corporation. Are we pretty much agreed on that?
Go ahead, Mr. Barrett.
Mr. Barrett. We continue to get into this corrupt actions
by senior executives. It is not clear to me always that stock
drives that one way or the other. There are certain rules of
conduct we all ought to be obeying if we are CEOs. If we obey
those rules of conduct, we don't trade on insider information,
we don't do things untoward to the P/L, then I don't see an
issue. But if people want to be criminals, they will be
criminals.
Mr. Shadegg. I agree with that.
The point I thought there was agreement on is that a narrow
stock option could in fact distort the conduct of some
corporate executives even when it is not illegal, causing them
to highlight temporary profits for their personal gain. I guess
I will concede to you that that leads me to the conclusion that
expensing looks like a solution in search of a problem.
I guess I want to ask you, Mr. Hills, if we are agreed that
any particular valuation method will in fact be somewhat
accurate, a point more strongly held by two of your panelists
than by you. Why isn't it better off to simply rely on the
current disclosure mechanism and allow competing mechanisms for
valuating those stock options in the marketplace rather than
prescribing a single one which will have whatever inherent
defects that particular method for valuating them is?
Mr. Hills. I would say two things. First, it is not that it
is inaccurate. It is that it has a lack of--it has an area of
imprecision, no greater, as Mr. Herz said, than other things in
the P/L statement. There are imprecisions in many parts of the
profit and loss statement. Imprecision in cost recognition, for
example, dwarfs any imprecision you get in the cost of a stock
option.
Mr. Shadegg. So aren't we just shifting the imprecision
created by the current footnote structure where you gather a
certain amount of information and all of the observers of the
market can look at that footnote information and make their
valuation of what those options do to the corporation's actual
profit and loss position versus a prescribed method where we
say, okay, this is the way you will valuate these stock
options. And now we have prescribed one error. All we have done
is shift the imprecision, I would argue, from one place to the
other. But the unsophisticated now believe, well, this is the
right answer because government, FASB in this case, mandated
it.
Mr. Hills. This is a good argument for not having an
earnings per share conclusion. But if you have an earnings per
share conclusion, there are things that ought to be in it. Cost
recognition ought to be in it. Cost earnings options should be
in it. There may be, as I indicated from The Economist article,
a range of assumptions that may be chosen differently by one
company from the other, so there will be flexibility left
hopefully in doing it, but imprecision has never been a reason
for not putting something in earnings per share.
Mr. Shadegg. I guess the second question I have is, doesn't
your argument against precision accounting, which I thought was
a fascinating argument, auger against expensing stock options
and having the FASB prescribe the method in which they will be
valued?
Chairman Baker. If I may, let that be your last question so
I can get in one more gentleman in before Mr. Volcker has to
leave. And to whom was that addressed?
Mr. Shadegg. Mr. Hills.
Mr. Hills. My answer is that, first of all, I am not
against precision. I just can't find it.
Mr. Shadegg. But if we can't find it now, are we going to
find it any better with FASB prescribing expensing and how?
Mr. Hills. There is a degree of inexactitude in accounting
and the trick here----
Mr. Shadegg. I thought you made that point compellingly.
Mr. Hills. And the trick here is to do as good a job as you
can for only one measure of the value of the company. One of
the problems here is our analysts aren't trained enough to look
at other values. Earnings per share ought not to be the
controlling factor it is in valuing stocks.
Chairman Baker. Thank you, Mr. Shadegg.
I am understanding you to say that we have that snapshot
once a year, but it may be kind of fuzzy when we look at it?
Mr. Hills. Yes. You need glasses.
Chairman Baker. Thank you.
Mr. Shays.
Mr. Shays. Thank you.
I am sorry you gentlemen had to wait so long and then we
had to have the break. I have been here 16 years, but I feel
like you all know more on this issue in your pinky than I know
on my entire body, but maybe that is why we have witnesses. But
I can react to what you are saying, and some of it to me is
just on the face of it somewhat hard for me to come to grips
with.
I mean, Mr. Glassman, when you talked about FASB rushing
into a decision, I think they act slower than a turtle. You
know, I don't feel there is a rush to a decision. I feel like
this has been an issue that we have been debating for years,
and they are finally doing what they should have done a while
ago. So I am just reacting to that and would love to hear your
comment of why it is a rush.
I feel--and I am looking for reaction. I am asking myself,
is the question we don't want investors to know the truth or is
it we want them to know the truth, we just don't know what the
truth is? But somehow we know how to tell people when we
expense it it has value, and somehow we think--and I am
reacting again to you, Mr. Glassman--that we say, you know,
investors are smart. They read the fine print.
Well, a lot of investors don't read the fine print. They
don't read anything. They just invest. And maybe that is their
problem, but it seems to me that if investors are smart enough
to read the fine print, they are smart enough to recognize that
the company may not have the same value on the marketplace for
some dumb reason, because all of a sudden they have to expense
it. And it would seem to me they would say, well, part of the
reason why they are valued this way is they had to expense it.
But to me it is--I mean, disclose that.
But to me as an investor, I would say, hey, this is
undervalued stock. Now, maybe I am just all screwed up here,
but I would like comments.
I would also like comments on the other issue. It used to
be we took the lead and the ISAB followed. It seems to me
because we have not seized the initiative the ISAB may be
taking the initiative. If they then decide that this has to be
an expensed item and we don't, what challenges are involved
with that?
So I mentioned Mr. Glassman's name more than once. Why
don't you start?
Mr. Glassman. Thank you, Mr. Shays.
The reason I use the word ``rush'' is certainly FASB has
taken a long time to get to this issue, but I think under new
management it seems to be moving very, very quickly and I think
too quickly, but that is a matter of judgment. Mr. Herz said
that there are people--why is it moving quickly? Because people
are not--groups are not only supporting but demanding some kind
of action.
On this fine print--and I think that is a very important
question. First of all, it is not fine print. The print is as
big as it is for the P/L statement. So it is not fine, but it
actually provides fine information, important information.
About half of Americans own shares through mutual funds and
other institutions, and I would hope and I know that the
managers of those institutions in fact do read the footnotes.
And if they don't, they shouldn't be in their jobs, and they
certainly do. So that information is there.
The point I was trying to make in my testimony--and it is
not, as Rod Hills said, that I don't believe in P/L statements.
It is just that----
Mr. Shays. It was a funny comment, and you didn't laugh.
Mr. Glassman. You are right. I didn't laugh, because I
think----
Mr. Shays. That was the high point of the whole damn
hearing, frankly.
Mr. Glassman. Well, now I am going to provide you with
another high point. It is not that I don't believe in P/L
statements. I think they are very, very important, but I think
they are only one way of valuing a company.
Let me quote the sainted Warren Buffett, not on public
policy but on something that he really knows a lot about, which
is investing. He says, how do you value a company? You just
want to estimate a company's cash flows--notice he says cash
flows. He doesn't say earnings or P/L statement--cash flows
over time, discount them back and buy for less than that.
Mr. Shays. See, I think he told you that so you would make
bad investments and he could keep making good ones.
Mr. Glassman. That is true, but I own his stock. So the
point is cash flow is tremendously important.
I think we are headed for a revolution, and the Chairman
recognizes it. He mentioned XBRL. Things are changing in
accounting, and I think we are fighting the last war in talking
about expensing. It is like this is a Crimean War, okay. What
is happening more and more--and I wish FASB and the Congress
and the SEC would start promoting this kind of thinking. We
need more--there is tons of information out there that is okay.
They use it every day. I think investors should have more
access to it, and I actually believe that the current regime
with the footnotes and all that stuff actually promotes that
kind of thinking much more than trying to shoehorn a single
number into a GAAP statement which doesn't tell you all that
much about a company.
Mr. Barrett. I think you have got a good representation of
this just this last quarter. One of the 280 companies who have
said or actually do expense options, Amazon.com, reported their
quarterly earns. They did it precisely with a GAAP P/L and a
pro forma P/L. Nobody paid attention to the GAAP P/L. They only
paid attention to the pro forma P/L. What you are going to see
is precisely that replicated across the board, and frankly I
thought what we were trying to do was harmonize all this stuff
so we would get away from pro forma P/L's.
But in this instance, which I think is representative of
what is going to happen, people went back--you can shake your
head, Paul, but this is what they did. They went back and
looked precisely at the cash flow of that company. They didn't
look at some arbitrary expense.
Mr. Shays. Home Depot and Wal-Mart now have spent----
Mr. Volcker. I am not shaking my head about what they do. I
think you will find----
Mr. Shays. Well, let me just make this point before you
start. Home Depot and Wal-Mart now expense, and has that proved
to be a negative for them?
Mr. Barrett. I think if you look at most of the companies
that expense options, it is a de minimus impact on their P/L.
They only give options to the top executives of the company.
They don't have broad-based option programs. If Intel----
Mr. Shays. Yeah. It is broad based.
Let me just have Paul just respond if I could. You were
going to say something, Paul, and I----
Mr. Volcker. I was going to say, on this pro forma thing,
this has become a big problem, because companies do present pro
forma earnings the way they like to present them, which means
there is no consistency. I would be very disappointed if the
accounting standards setters do not in the next few years
promote a standard for a standard pro forma statement that they
will make a judgment about what should be on the pro forma and
what should not be on the pro forma, what should be on an
operating earnings statement to get some consistency. Because
if you just leave it in a jungle, so to speak, you do get below
the lines the stuff they don't want to report, and the stuff
above the lines is good stuff.
Mr. Hills. Mr. Chairman, would you excuse me? I promised to
give a lesson to 12 Russians on corporate governance at
American University, and I really----
Chairman Baker. I think this effort has been more
challenging than your task. Let me express appreciation.
Mr. Sherman wanted to make a brief statement. Please leave
at your leisure.
Mr. Sherman. Thank you, Mr. Chairman.
I want to agree with Mr. Volcker that we need standardized
rules for the pro forma statements. If they are going to serve
chocolate, vanilla and strawberry, there ought to be a fixed
recipe for each one of those three ice creams.
I think the arguments against expensing options may go too
far. You have said that we have to compete with Asia for
capital and for talent, and anything that impairs that effort
puts us at a disadvantage. I want to point out that maybe
compensation for managers is a good thing, and we want to
encourage it. And we want to make companies that compensate
their managers look good compared to Asian investments, but if
we are going to do that, wouldn't we do the same thing for
employee education programs? Wouldn't we do the same thing for
research and development programs?
If you buy that argument, then maybe it is critical that we
as a Congress instruct FASB to say that employee education and
research programs and maybe all management compensation of all
types ought not be charged against income, since we want to
encourage those things or some of them and we want to make our
companies that do them look good compared to their Asian
competitors.
There is this argument that option holders and stockholders
have identical interests. I think those interests are wildly
different when it comes to risk. If I am a stockholder and I
see one policy gives me a chance at the stock going up 10
percent or maybe it will go down 10 percent, that might be a
good plan. But if I am an option holder, I would much prefer a
company that has a chance to either double in value or go
bankrupt, because whether it goes down 10 percent or goes down
a hundred percent, I am in the same position.
Executives, however, are both salary earners, where they
are going to want a low-risk approach so they keep getting
their salary, and they are option holders, where they are going
to want a high-risk approach. When an executive becomes
primarily not a salary earner but an option holder, you have a
strong incentive for a high-risk approach.
Chairman Baker. Can the gentleman wind up? I have got
somebody else that wants to make a statement before we leave.
Mr. Sherman. And that concludes my remarks.
Chairman Baker. I thank the gentleman for wrapping up.
Mr. Ose.
Mr. Ose. Thank you, Mr. Chairman.
I want to express my appreciation to one of our witnesses
here. When I was a much younger man, I came out of college,
went in the real estate business, and shortly thereafter was
confronted with an inflationary environment that was, to say
the least, challenging. Mr. Volcker played a central role in
bringing that bear under control. If no one else ever says
thank you, I intend to today. Thank you for doing that.
Chairman Baker. If there are no further comments, I just
want to express my appreciation to you for your time and your
willingness to stay with us today. It has really been most
informative. We look forward to FASB's conclusion of their work
product, but I think this marks a beginning of our long-term
review of the appropriateness of current accounting regimes and
not to get into the professional aspects but to the goals of
our accounting methodology, to assist in all shareholders and
those who have interest in a transparent, free flow of
information that benefits the growth of our economy. Thank you
for your participation.
Our meeting is adjourned.
[Whereupon, at 2:37 p.m., the subcommittee was adjourned.]
A P P E N D I X
June 3, 2003
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