[House Hearing, 108 Congress]
[From the U.S. Government Publishing Office]




                  THE FASB STOCK OPTIONS PROPOSAL: ITS
                  EFFECT ON THE U.S. ECONOMY AND JOBS

=======================================================================

                                HEARINGS

                               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

                             SECOND SESSION

                               __________

                         APRIL 21, MAY 4, 2004

                               __________

       Printed for the use of the Committee on Financial Services

                           Serial No. 108-80



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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          MICHAEL E. CAPUANO, Massachusetts
    Carolina                         HAROLD E. FORD, Jr., Tennessee
DOUG OSE, California                 RUBEN HINOJOSA, Texas
JUDY BIGGERT, Illinois               KEN LUCAS, Kentucky
MARK GREEN, Wisconsin                JOSEPH CROWLEY, New York
PATRICK J. TOOMEY, Pennsylvania      WM. LACY CLAY, Missouri
CHRISTOPHER SHAYS, Connecticut       STEVE ISRAEL, New York
JOHN B. SHADEGG, Arizona             MIKE ROSS, Arkansas
VITO FOSSELLA, New York              CAROLYN McCARTHY, New York
GARY G. MILLER, California           JOE BACA, California
MELISSA A. HART, Pennsylvania        JIM MATHESON, Utah
SHELLEY MOORE CAPITO, West Virginia  STEPHEN F. LYNCH, Massachusetts
PATRICK J. TIBERI, Ohio              BRAD MILLER, North Carolina
MARK R. KENNEDY, Minnesota           RAHM EMANUEL, Illinois
TOM FEENEY, Florida                  DAVID SCOTT, Georgia
JEB HENSARLING, Texas                ARTUR DAVIS, Alabama
SCOTT GARRETT, New Jersey            CHRIS BELL, Texas
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          MICHAEL E. CAPUANO, Massachusetts
DONALD A. MANZULLO, Illinois         HAROLD E. FORD, Jr., Tennessee
SUE W. KELLY, New York               RUBEN HINOJOSA, Texas
ROBERT W. NEY, Ohio                  KEN LUCAS, Kentucky
JOHN B. SHADEGG, Arizona             JOSEPH CROWLEY, New York
JIM RYUN, Kansas                     STEVE ISRAEL, New York
VITO FOSSELLA, New York,             MIKE ROSS, Arkansas
JUDY BIGGERT, Illinois               WM. LACY CLAY, Missouri
MARK GREEN, Wisconsin                CAROLYN McCARTHY, New York
GARY G. MILLER, California           JOE BACA, California
PATRICK J. TOOMEY, Pennsylvania      JIM MATHESON, Utah
SHELLEY MOORE CAPITO, West Virginia  STEPHEN F. LYNCH, Massachusetts
MELISSA A. HART, Pennsylvania        BRAD MILLER, North Carolina
MARK R. KENNEDY, Minnesota           RAHM EMANUEL, Illinois
PATRICK J. TIBERI, Ohio              DAVID SCOTT, Georgia
GINNY BROWN-WAITE, Florida           NYDIA M. VELAZQUEZ, New York
KATHERINE HARRIS, Florida
RICK RENZI, Arizona


                            C O N T E N T S

                              ----------                              
                                                                   Page
Hearings held on:
    April 21, 2004...............................................     1
    May 4, 2004..................................................    51
Appendixes:
    April 21, 2004...............................................    73
    May 4, 2004..................................................   163

                               WITNESSES
                       Wednesday, April 21, 2004

Grady, Robert E., Managing Director, Carlyle Venture Partners....    24
Hassett, Kevin A., Director of Economic Policy Studies, American 
  Enterprise Institute...........................................    21
Holtz-Eakin, Douglas, Director, Congressional Budget Office......    20
Kruse, Douglas, Professor, School of Management and Labor 
  Relations, Rutgers University..................................    18
Scalise, George M., President, Semiconductor Industry Association    28
Smith, Phillips W., Chairman of the Board, TASER International, 
  Inc............................................................    23
Thomas, Jeff, Field Applications Engineer, Altera Corporation....    16

                                APPENDIX

Prepared statements:
    Oxley, Hon. Michael G........................................    74
    Gillmor, Hon. Paul E.........................................    77
    Hinojosa, Hon. Ruben.........................................    81
    Kanjorski, Hon. Paul E.......................................    82
    Grady, Robert E..............................................    84
    Hassett, Kevin A.............................................    90
    Holtz-Eakin, Douglas.........................................   107
    Kruse, Douglas...............................................   125
    Scalise, George M............................................   148
    Smith, Phil..................................................   152
    Thomas, Jeff.................................................   157

              Additional Material Submitted for the Record

Baker, Hon. Richard H.:
    FASB Chairman calls for Investors to Speak up on Options, 
      ``The Wall Street Journal'' April 19, 2004.................   159
Royce, Hon. Edward R.:
    Treausurer's Office, State of California, prepared statement.   161

                               WITNESSES
                          Tuesday, May 4, 2004

Batavick, George, Small Business Advisory Committee, Financial 
  Accounting Standards Board.....................................    60
Herz, Robert, Chairman, Financial Accounting Standards Board.....    57

                                APPENDIX

Prepared statements:
    Royce, Hon. Edward R.........................................   164
    Gillmor, Hon. Paul E.........................................   166
    Batavick, George.............................................   168
    Herz, Robert.................................................   168

              Additional Material Submitted for the Record

Sherman, Hon. Brad:
    U.S. Securities and Exchange Commission, letter to Hon. Paul 
      Kanjorski, May 3, 2004.....................................   210
Herz, Robert:
    Written response to questions from Hon. Brad Sherman.........   212

 
                  THE FASB STOCK OPTIONS PROPOSAL: ITS
                  EFFECT ON THE U.S. ECONOMY AND JOBS

                              ----------                              


                       Wednesday, April 21, 2004

             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 Baker 
[chairman of the subcommittee] presiding.
    Present: Representatives Baker, Ose, Gillmor, Lucas of 
Oklahoma, Royce, Manzullo, Oxley (ex officio), Kelly, Ney, 
Shadegg, Biggert, Capito, Hart, Kennedy, Tiberi, Kanjorski, 
Hooley, Sherman, Inslee, Moore, Capuano, Frank (ex officio), 
Hinojosa, Lucas of Kentucky, Crowley, Clay, McCarthy, Matheson, 
Lynch, Miller of North Carolina, Emanuel, Scott and Velazquez.
    Chairman Baker. [Presiding.] I would like to call this 
meeting of the Capital Markets Subcommittee to order.
    This morning we are convened for the purpose of reviewing 
the pending Financial Accounting Standards Board stock option 
expensing proposal and the potential effect its adoption may 
have on job creation and our economic recovery, which I believe 
to be fully engaged. I have given some thought to my opening 
statement this morning and the past few days, but I had the 
occasion to read press reports of yesterday that changed my 
intentions to open the hearing.
    The congressional process is a very open and public 
process. No one ever has accused the Congress of moving too 
fast, to my knowledge, on anything. It is a process subject to 
hearings and review which we will benefit this morning from our 
panel of witnesses in getting additional comment, and then 
subject to our ability, a markup subsequent to recorded vote, 
publicly recorded, then a full committee review, then if 
leadership so chooses for consideration, then of course a 
bicameral process and subject to the presidential veto. 
Although many criticize the political process, it is the one 
forum in which every person's perspective can be vented, can be 
put on the public record, and elected officials held 
accountable for the decisions they make.
    In the matter before the committee today, it is the 
presumption that the Financial Accounting Standards Board is an 
entity which will conduct and review appropriate financial 
standards absent such political necessities, and that 
professionals for the public good shall make determinations in 
the best interests of our economic stability. Given that 
history of the Financial Accounting Standards Board, I am the 
first to acknowledge that I have on prior occasions disputed 
the decisions of the Standards Board on various other matters 
of accountancy practice. I felt, as a public official, the 
right to express those opinions and to disagree on occasion 
where I thought it in the public interest to do so.
    However, it has always been past practice of the Board to 
refrain from engaging in the seamier side of the public policy 
business and was surprised to learn that FASB now has engaged 
its own lobbying firm. But what really got me more engaged in 
this matter were the comments of the Chairman of the Board, and 
again let me quickly add, if this press report is true, I have 
also been on that side of the coin where my representations 
have not always been accurately reflected, and quick to respond 
that should this press account be accurate, from the Wall 
Street Journal, it raises concerns which I think appropriate to 
bring to the committee's attention.
    When Chairman Herz yesterday criticized a well-organized 
lobbying effort within the Congress, but then went on to say, 
``One thing I cannot control is Congress.'' I would say, that 
is a good thing. No one person should control the Congress, nor 
enterprise. It acknowledged in the comment that the proposed 
rule is now open to public comment until the end of June. 
Apparently, members of Congress are the only group that can 
have no comment on the matter until the close of the 
consideration at the end of June, but calling on all in the 
investor class and those within the business community to make 
your views known to people in Washington; a call for investors, 
again, to make your views known.
    We cannot have it both ways. If you expect the Congress to 
have a hands-off approach and allow a regulatory entity to act 
without comment from anyone, I question the need for a public 
comment period because in the midst of the public comment 
period, this hearing has been called for the sole purpose of 
having those make comment on the effect of this proposed rule 
on the broader economy. To engage the resources of a lobbyist 
and for the chairman of the board to then make a political 
request of constituencies to affect and influence the Congress 
has now opened the door. If you want to have a public 
discussion where all interested parties express their opinion, 
there is no more open venue, no more free of influence, no more 
publicly recorded venue than the United States Congress.
    Now, I do not always agree with the outcomes of the 
congressional process, but I have great regard for the process 
and respect the wisdom of 435 members of the House and 100 
members of the Senate in coming to what is the best-balanced 
conclusion for the public interest. I make no apologies today 
about having introduced a bill and brought this matter to 
public discussion. I happen to personally believe it is the 
right thing to do. I will acknowledge there are other people 
with different opinions and I may be wrong, but today we have 
had a group historically known for its nonpolitical 
determinations open the door to political judgments. I hope we 
can do it going forward in a professional manner and all have 
respect for each other at the conclusion of the process, that 
professionals with differing opinions can come to some 
resolution that ultimately is in the best interest of the 
public.
    I apologize to the committee for going on at length, but I 
felt the necessity to express those views.
    Mr. Kanjorski?
    Mr. Kanjorski. Mr. Chairman, I am not aware of the press 
comments, but it strikes me that it poses the question of 
whether you will respect me in the morning.
    Chairman Baker. No.
    [Laughter.]
    Mr. Kanjorski. Actually, Mr. Chairman, I think this is an 
important issue, and we meet for the third time in the 108th 
Congress to study the accounting treatment of stock options. I 
have a prepared statement that I will submit for the record. I 
guess the interests are that this is a recognized problem, one 
for the accounting industry and the need for certainty in how 
things are done.
    I am not an accountant by profession, but I also feel that 
it perhaps is a dangerous ground for us to tread on that the 
Congress will interpose its position on a board that is 
dedicated and structured to make these determinations. That is 
not to say that that board's determinations come with the 
weight of the Constitution or perhaps the actions of God to 
Moses on the mount.
    It is, however, a struggle that could be off-course in 
terms of I think there are two major issues here. One is 
whether or not this Congress supports the fact that we have a 
structured entity in the private sector to make final 
determinations of accounting rules. I think that is vitally 
important for our system domestically and internationally. Two, 
my interest in this is that I truly believe that accounting is 
for the purposes of transparency of investors and people, that 
they have a right and a want to know what is the structure and 
the commitment of the organizations they potentially want to 
invest in.
    I have had the occasion over the last several weeks to 
visit with people that are on both sides of this issue. I have 
listened to them as hard as I can. I remember having a 
discussion with the president and CEO of one of the major 
California new-tech companies just 2 weeks ago. He struck me 
with the importance of this for his industry. I have great 
sympathy that in that particular industry, this could create a 
problem, the rule as it is structured. But as we discussed it 
together, he tended to agree with me with the need for 
transparency; that we cannot have every company doing with 
their stock options as they will and anticipate that analysts 
will discern every one of the 27,000 public companies in the 
United States. That is not going to happen, and particularly 
with the loss of respect for the analysts over the last several 
years. They probably will not be performing that function 
sufficiently to give transparency.
    So I do not understand why we get to the point of one way 
and not another. I think potentially, and it is too bad we do 
not have both the SEC and FASB here today, but I understand 
most of those groups are on travel internationally and are not 
available for us today. So in that regard, before we conclude 
and go to markup on this subject, I think it is only right that 
we bring representation of FASB and SEC before the committee so 
that they can spell out their arguments, because quite frankly 
I have a question that I would like to pose to them that I 
think is very fundamental and important.
    Are there other ways, in accordance with accounting 
principles, that we can get to transparency without necessarily 
going the full gamut of a single rule applying across the board 
that could disadvantage some of our major technology companies? 
I do not know what the answer to that is, but being rather 
Burkean in my philosophy that unless you show me the benefits 
of change, I am more apt to hold with tradition. My natural 
proclivities lead me to support the institutions, whether they 
are courts of law or organizations such as FASB, that they have 
the ultimate insight and interest and intention of doing the 
right thing and propounding the proper rules, always subject to 
review.
    But before we get to the final decision and whether or not 
the Congress should take up singular activity of reviewing, 
sometimes under pressure, the implementation of a rule across 
the board, I think it could be fundamentally destructive to our 
system if we encourage people to believe that FASB is okay to 
some extent, but where there are interest groups that can rise 
above that and put significant pressure on the Congress of the 
United States to interpose their will and its will on an 
organization like FASB, that could be very destructive to the 
entire process of the system.
    Those that favor that position today on a particular 
accounting rule may find out that when they become less 
significant or less important or less apt to be able to affect 
the actions of Congress, they can have suppressive activity 
brought on them by other special interest groups or pressure 
groups within our system. That tends to go to the destruction 
of the system as we have it.
    With that in mind, Mr. Chairman, I do ask that we have an 
additional hearing before we go to markup on this situation, 
having in FASB and the SEC. I look forward to today's hearing. 
I think the weight of the witnesses, as I discern them, are 
significantly disadvantaged one side of this proposition right 
now, although I look forward to the testimony particularly 
given by some of our industrial leaders that are here today to 
give us an insight on how the impact will be in the capital 
markets and on these particular corporations that exist, and 
that had some advantage by using stock options as a methodology 
of not tapping into their capital assets when they were at the 
beginning stage or formative stage of their endeavors.
    With that in mind, I offer my full statement in the record, 
Mr. Chairman, and look forward to it. I guess I will read The 
Wall Street Journal the day before such hearings so that I am 
fully equipped to respond to the Chairman's views.
    [The prepared statement of Hon. Paul E. Kanjorski can be 
found on page 82 in the appendix.]
    Chairman Baker. I thank the gentleman for his statement. It 
certainly will be made part of the record, as will all 
members's opening statements.
    Mr. Ose, did you have an opening comment?
    Mr. Ose. Thank you, Mr. Chairman.
    I am appreciative of the fact that you are having another 
of these hearings. I remain somewhat bemused by our ongoing 
debate here. We have yet to define a system whereby we can 
accurately value these options, whether it be Black-Scholes or 
binomial equation or something of that sort. And yet we are 
hurtling down a path, at least from a regulatory standpoint, to 
impose a requirement of a blanket nature on America's 
corporations without defining yet exactly how we are going to 
value it.
    I would submit to the body that the various opinions that 
are being put forth by people who have moved to expense options 
on their financial statements, as opposed to those who have yet 
not made that move, largely track the enterprise models that 
they speak from. For instance, let us take Mr. Buffett. Mr. 
Buffett has argued in favor of expensing options, but I think 
if you look at Mr. Buffett's investments, you will find very 
few of them in the technology business, where options are used 
for significant compensation to employees.
    I would submit to the body that the difference of opinion 
in corporate America as to how to treat options, whether to 
expense them or make them transparent within the notes to 
financial statements, reflects the needs of different 
enterprises to either compensate their employees or reduce 
their tax liability. Those who are advocating for leaving 
options in the current situation whereby they are disclosed 
within the notes, are using options as a compensation tool, by 
and large. Those who are advocating for the expensing of 
options look at the net impact on their tax liability by 
expensing those options. The net income for that enterprise 
would be less.
    It is perfectly logical, but we still come back to this 
same point, and that is however you value these options, 
whether you are a strong advocate for leaving it the way it is 
or a strong advocate for changing the system, however you value 
these options your valuations are based on assumptions. If it 
is the assumptions that are driving FASB's concern, that is if 
the assumptions may or may not be valid, we ought to talk about 
that, rather than whether or not to put them into the financial 
statements.
    I thank the Chairman for having this hearing. I am still 
waiting for somebody to definitively quantify for me how you 
value these options. Thank you, Mr. Chairman.
    Chairman Baker. I thank the gentleman for his interest in 
the subject and his statement.
    Ranking Member Frank?
    Mr. Frank. Thank you, Mr. Chairman. I appreciate the 
attention you are giving to this.
    This is a very difficult issue for me. Intellectually, it 
is one of the harder ones that we deal with. When I was in law 
school, accounting overlapped with my duties as a state 
legislator. I was absent a lot of times that day when we came 
up with the issue. I am continually impressed both with the 
complexity of accounting issues and even more difficult for us 
with their fluidity.
    We have an issue here, though, where I am conflicted. I 
have been convinced by people, particularly in the high 
technology industry, that this change could do them some 
damage. I will get in a minute to what I think of that, but 
facts have to be taken into account. On the other hand, setting 
a very strong precedent of this Congress setting rules on a 
specific and technical accounting issue is difficult. So we 
often in this body use procedural arguments to reinforce our 
substantive preferences. The tough time comes when you have 
both a genuine procedural preference, as the Ranking Member 
talked about, and a substantive view which will not be well 
served by following that procedural preference. If it is up to 
me, I would not be demanding that these be expensed, but I do 
not want to go into a situation where we become the appellate 
Financial Accounting Standards Board.
    I must say, while I accept what the high technology people 
tell me, they are a lot of very smart, very decent people who 
have done a lot of good for this economy, and they are 
overwhelming in their view. I must say that what they tell me 
is somewhat distressing because I have to say in substantive 
terms, this issue to me is frankly like some other issues where 
the reality seems to me to have been swamped by perceptions 
that have taken over. That is, whether or not the accounting is 
changed, whether options are expensed or not, does not change 
the reality.
    Currently, I am told, they are available in the footnotes. 
I am not a regular reader of the footnotes of financial company 
statements. If we changed the rule, they will not be in 
footnotes; they will be treated differently. The reality will 
not change. So what we are being told, and this is a disturbing 
fact for me, is that the investment community of America will 
react very differently to an identical reality depending on how 
it is presented in financial statements. That is disappointing 
to me.
    Perhaps one of my illusions was that these cold-headed, 
hard-hearted financial people would be less influenced by 
whether it was in the footnote or not in the footnote. But 
being told that without a change in the reality, the method of 
presentation of the reality will have an enormous impact, but 
both sides seem to agree that it would have this impact, 
whether or not there is a nominal profit or not. I am hoping 
that people in the high tech industry if this does go through 
will turn out to have underestimated the financial community, 
and that they will be able to tell the difference between 
reality and perception, but I understand this is troubling.
    I have an alternative that I am going to be introducing 
later. I will be filing the bill later in the week. As I have 
looked at this, I find it hard to see what damage has been done 
by the current accounting treatment of options. I have not had 
anybody write to me and say I was terribly misled because they 
did not expense the options and I invested in them, and look 
what happened to me. But there have been problems with options.
    It seems to me, from what I have learned in my role here on 
this committee, is that the problem with the stock options in 
our economy is the perverse incentive they have given in some 
cases to the top decision makers in some corporations to spike 
the stock price and then cash in and walk away. There have been 
large corporate entities that have done things that made no 
sense from the standpoint of the corporation over time, but did 
make sense because there were some corporate executives who 
benefited short-term.
    I am going to file legislation that would direct the SEC to 
promulgate rules that will deal with a situation in which the 
top decision makers in corporations cash in stock options and 
there is subsequently a drop in the value, because I think that 
is the public policy issue. I am not at this point ready to 
tell FASB what to do or what not to do on a subject which is 
such a difficult one intellectually. But I would hope that the 
existence of this option, the ability of the regulators to deal 
with the abuse of the perverse incentives given by stock 
options to chief executives, would be a relevant factor in the 
field, because we do have a genuine comment period. I think it 
is possible for some of us to say to the FASB that we are 
skeptical of the rectitude of their action, without being 
committed to overturning them congressionally because I am in 
that bind.
    So I am going to be filing this legislation later that 
would direct the SEC to deal with what seems to me the serious 
problem here, which is the perverse incentive that the current 
stock option rules give to a handful of irresponsible and 
unethical chief executives and their top aides, and hope that 
that might be a factor in the debate.
    Thank you, Mr. Chairman.
    Chairman Baker. I thank the gentleman for his statement.
    Chairman Oxley?
    Mr. Oxley. Thank you, Mr. Chairman.
    Let me congratulate my friend from Massachusetts, the 
Ranking Member, for his thoughtful statement. I think his 
statement does point out some of the difficulties that we as 
policymakers have in dealing with this complicated issue.
    This is the third time in this Congress that we will 
discuss stock option accounting. The number of hearings this 
subcommittee has held demonstrates how important this issue is. 
I applaud Chairman Baker for his good work on this subject. In 
light of the Financial Accounting Standards Board's recent 
proposal, it is particularly important now.
    The question of whether stock options should be expensed 
has been debated for many years. Some, like the former Chief 
Accountant of the Securities and Exchange Commission, Walter 
Schuetze and numerous experts in accounting, believe that the 
FASB's position that the issuance of employee stock options 
creates an expense is simply improper accounting. Mr. Schuetze 
observes that the issuance of a stock option to an employee 
does not change the market capitalization of the corporation, 
as measured by the market value of the outstanding shares and 
the value of the outstanding option. Thus, there is no expense. 
If there had been a true expense, which he defines as the 
``using up'' of an owned asset or the decline in the value of 
an owned asset, then the market value of the outstanding shares 
and option should have declined, but that is not the case. It 
also makes me particularly glad that I did not take accounting 
in college.
    Others, like FASB, as evidenced by its recently released 
proposal, take the contrary view, arguing that employee stock 
options do constitute a corporate expense. FASB's position is 
that all employee stock options have value, which employees 
purchase with the services they provide. Because they have 
value, FASB asserts, when stock options are given to employees 
they give rise to compensation costs that are properly included 
in measuring an enterprise's net income.
    Some point out that the grant of an employee stock option 
is an opportunity cost to the issuer. They argue that if a 
company were to grant stock, rather than options, to employees, 
the company's cost for this transaction would be the cash it 
otherwise would have received if it had sold the shares at the 
current market price to investors. But this situation is not 
analogous to that of the issuance of employee stock options. 
Not only are employee stock options issued exclusively to 
employees of the issuer, but each employee stock option is 
written for a specific individual. Thus, there is, by 
definition, no market into which these options can be sold.
    Another significant problem is the accurate valuation of 
stock options, and we have been through this many times. While 
there is a diversity of opinion on the merits of requiring the 
expensing of employee stock options, there is uniform agreement 
on at least one aspect of this debate. It is extremely 
difficult to value these options. This gives rise to concerns 
that strike at the heart of financial statements. What use are 
they if not for purposes of comparing one company's statement 
against another's?
    The FASB itself recognizes that there is no options-pricing 
model that gives an accurate assessment of the value of options 
across all enterprises. The Black-Scholes model has been shown 
to have significant deficiencies for purposes of valuing 
employee stock options. The Binomial method has similar 
problems. FASB's solution is to provide no guidance as to what 
method a company must use to calculate value.
    The lack of a uniform, reliable valuation method creates 
problems of comparability among companies, accuracy of the 
financial statements themselves, and, as one of our witnesses 
today suggests, even opens up the possibility of manipulation 
of earnings by management. These are concerns that merit 
further consideration. But as Craig Barrett, the CEO of Intel, 
has observed, whether or not stock options should be expensed 
is not just an accounting issue. It is also an economic issue. 
And that is the focus of today's hearing.
    Preserving the independence of the Financial Accounting 
Standards Board is a consideration. That is an issue of process 
and jurisdiction and certainly the members of this panel have a 
great respect for FASB's expertise. However, some issues go 
beyond that of accounting and enter the mainstream of economic 
policy. If it is true that the adoption of FASB's employee 
stock option expensing rule would cause significant and serious 
damage to job creation, then it becomes an economic policy 
issue and one that Congress should certainly review.
    Dozens of chief executives have publicly stated that their 
firms will reduce or eliminate options if the FASB proposal is 
enacted in order to avoid the negative impact that expensing 
will have on earnings per share, and in turn, the company's 
share price. If this is the case, then shareholders and our 
economy as a whole will sacrifice some measure of economic 
growth.
    The venture capital community has been quite outspoken on 
this issue. One of our witnesses today discusses the great 
extent to which venture-backed companies rely on stock options 
to attract and retain talent. He also points out that in over 
70 percent of venture-backed companies, stock options were 
awarded to all employees, not just top executives. These 
companies are a significant component of our economy. He cites 
statistics illustrating that venture-backed companies directly 
or indirectly accounted for 27 million jobs in 2000 and had 
sales constituting about 11 percent of our GDP. These are 
compelling figures. If the FASB proposal will undermine job 
creation and economic growth, then it calls for closer scrutiny 
by the Congress.
    The Congressional Budget Office study concluded that 
expensing employee stock options will not have a significant 
effect on the economy. The study argues that the information 
has already been disclosed in footnoted financial statements 
and thus is reflected in the stock price. We will examine today 
whether this analysis is correct.
    While there are many informed experts on both sides of this 
issue, there are some aspects of this debate on which there is 
agreement. First, expensing employee stock options is not a 
silver bullet for achieving better corporate governance. 
Second, the importance of transparent, accurate financial 
statements cannot be overstated.
    Mr. Chairman, I look forward to hearing from our esteemed 
panel of experts today as we consider once again the far-
reaching implications of the FASB proposal.
    I yield back.
    [The prepared statement of Hon. Michael G. Oxley can be 
found on page 74 in the appendix.]
    Chairman Baker. I thank the Chairman for his statement and 
for his attendance here today.
    Ms. Velazquez?
    Ms. Velazquez. Thank you, Mr. Chairman.
    First, I want to thank Chairman Baker and Ranking Member 
Kanjorski for holding this important hearing. Stock options 
have contributed significantly to the economic growth of the 
U.S. economy, allowing smaller firms to grow and expand in a 
time when the labor markets may have chosen otherwise. During 
periods of strong economic growth and low unemployment, such as 
the late 1990s, the demand for specialized labor outstripped 
supply. As a result, wages and benefits were bid up to levels 
unseen in previous periods.
    During such previous periods, companies that were rich were 
often able to attract and retain employees, effectively beating 
out smaller firms that lacked the cash flow of the larger 
competitors. During the 1990s, however, stock options leveled 
the playing field and permitted startups to compete with 
Fortune 500 companies for talented employees. Instead of 
economic oligopoly, new firms sprouted up across the country, 
providing the critical mass for new industries and markets.
    The accounting treatment of stock options is a complex 
issue. If it were not, this issue would not be before us today. 
First and foremost, I am concerned about any regulatory change 
that will threaten entrepreneurial activity. I believe that the 
churning of ideas is necessary for the U.S. economy to move 
forward and create the jobs that we so desperately need. Such 
creative destructionism can provide the U.S. with a model for 
long-term economic stability.
    FASB has proposed a rule that will alter the accounting 
treatment of stock options. While the proposed rule does not 
prohibit firms from issuing stock options, it will require 
firms to expense these options in their financial statements, a 
distinct departure from FASB's current approach. I do have 
serious concerns with this proposed rule as it appears that it 
will disproportionately impact smaller companies relying on 
stock options to finance their early development and growth.
    While it is not clear to me that the proposed rule will 
result in more accurate or comparable financial information for 
public companies, it is apparent that the rule will impose 
substantial compliance costs on startups. In addition, I am 
suspicious of any proposal that restricts smaller firms's 
access to the equity markets. By impeding smaller firms's 
ability to be competitive, as I believe this proposed rule 
does, our national economy and more importantly our local 
communities will be less likely to realize the benefits that 
innovation and risk-taking bring: new jobs, an expanded tax 
base, and opportunity for future generations.
    Mr. Chairman, I too echo Mr. Kanjorski's request for an 
additional hearing with the FASB Chairman and the appropriate 
SEC officials before we move to mark up the legislation. With 
this in mind, I thank you for your leadership on this issue and 
I look forward to hearing the testimony of the witnesses on 
this complex issue.
    Thank you, Mr. .Chairman.
    Chairman Baker. I thank the gentlelady for her statement.
    Mr. Royce?
    Mr. Royce. Thank you, Mr. Chairman. Once again, I want to 
thank you for the hearing, and I want to thank you for 
introducing H.R. 3574, the Stock Option Accounting Reform Act.
    Also, on behalf of my colleague from California, 
Representative Eshoo, and Representative Eshoo is your lead co-
sponsor of H.R. 3574, I would like to submit for the record a 
letter from our California Treasurer, Philip Angelides in which 
he endorses this bill.
    [The following information can be found on page 161 in the 
appendix.]
    Let me say, Mr. Chairman, that I am extremely troubled by 
FASB's proposal which would require firms to expense employee 
stock options. Expensing options will have very negative 
consequences. In fact, just the threat of expensing has already 
changed the behavior in many firms. Mandatory expensing of 
employee options will effectively end the practice of granting 
employee stock options as we know it.
    Stock options enable firms, often new economy-oriented 
firms, to attract talent that otherwise would go to companies 
able to pay higher salaries through cash compensation 
arrangements. Newer growth companies tend not to have large 
stable cash flows. However, through stock options, they can 
compete by offering employees an up-side in the event that the 
firm succeeds.
    Incentive is perhaps the most important driver of economic 
growth. People advocating expensing are taking incentive for 
success away from the very companies that could be producing 
the next generation's goods and services. No economic model can 
dispute this argument.
    California rests on the banks of the Pacific Rim. All of 
our country's new economy firms, but particularly those in 
California face greater and greater competition from businesses 
in Central and East Asia. I ask my colleagues to reflect on the 
fact that companies in China are striving to take away our 
global edge in technology. China graduates now 195,000 
engineers and computer programmers annually. Many have made the 
point that the Chinese government has embraced stock options in 
its 5-year plan. Here is my point. I am worried that while 
communist China is learning capitalism, we are forgetting it.
    Again, Mr. Chairman, thank you for the leadership on this 
issue. I look forward to the testimony of our distinguished 
witnesses. I yield back.
    Chairman Baker. I thank the gentleman.
    Mr. Crowley?
    Mr. Crowley. Thank you, Mr. Chairman. Thank you for holding 
this hearing today. I want to thank the ranking member as well, 
Mr. Kanjorski, for his input and his presence here today, as 
well as the Chairman and the Ranking Member of the full 
committee for their interest in this issue.
    I want to begin by expressing my gratitude for FASB and the 
role that it plays in our economy, that of ensuring 
independence and credibility of our nation's accounting 
systems. At the same time, I also have to state that I disagree 
with FASB's recently proposed rule change, the mandatory 
expensing of all stock options as I believe this rule does not 
deal solely with accounting principles, but rather also deals 
with economic policy as well.
    While accounting standards should be left to FASB, economic 
policy should and must remain with Congress and the executive 
branch. I believe this differentiation between accounting 
policy and economic policy must be made when discussing this 
proposed rule change. This proposed regulation will not address 
concerns about excessive executive compensation or reliability 
of a company's financial statements. Rather, I believe this 
rule will adversely affect employees who receive stock options, 
especially employees whose companies provide broad-based stock 
option plans, thereby hurting wealth creation and weakening or 
eliminating the basic economic instrument that created the 
economic boom of the 1990s and is still used frequently today 
by venture capital startups.
    Besides delving into economic policy, which is not I 
believe the role of FASB, I have additional concerns about this 
rule, such as that this expensing mandate will provide less, 
not more, integrity in accounting. Supporters of this rule will 
argue that it makes accounting more honest. I have to differ. 
In fact, this rule will allow two different methods for 
companies to expense their options, either binomial or Black-
Scholes, both of which are not considered accurate evaluation 
models. In essence, this rule will allow companies to pick and 
choose their accounting methods, providing more confusion, I 
believe, and more dishonesty in financial statements. This rule 
will allow corporate accountants to decide which expensing 
system works best for their company's goals.
    Whereas today, to keep accounting honest, those same firms 
with stock options must, under FASB's guidelines, disclose the 
value of their options in the company's financial footnotes, as 
mentioned earlier, or charge it directly against income, 
leaving no economic surprise for any investor.
    Additionally, supporters of this rule will argue that there 
is nothing in this rule that prevents the issuance of stock 
options and that the CBO report states that expensing of 
options will not have any adverse consequences. They go on to 
argue that some companies such as Coca-Cola expense their 
options now and have not seen a drastic adverse affect in their 
stock price. But when referencing Coke as an example or using 
the CBO report to justify this expensing mandate, supporters of 
expensing do not take into account the issue of broad-based 
stock option plans that benefit all company employees, not the 
regular stock option plan that benefits the few at the top of 
the corporate pyramid. Companies like Coke provide and expense 
their options, but they are not broad-based plans. They are 
options for top corporate executives.
    The mandatory expensing of stock options would effectively 
destroy broad-based stock option plans which enhance financial 
opportunities for workers at all levels, stimulate economic 
growth, and help create the new economy of the 1990s, a new 
economy, as I mentioned before, that we are still feeling the 
effects of today. In fact, it is these broad-based plans that 
have spread wealth throughout all sectors and to all employees 
of our new economy, from CEO to secretary. Ninety-eight of the 
nation's top 100 largest high-tech firms that focus on the 
Internet provide options to most or all of their employees, and 
most of these options go to the rank-and-file workers, helping 
stimulate wealth creation for employees while allowing 
employers to attract the best talent.
    Contrary to popular belief, these people receiving broad-
based stock options are not all located in Boston and San 
Francisco. Statistics show that 41 percent of those receiving 
broad-based stock options live in the South and 24 percent live 
in the Midwest. Unfortunately, we already are starting to see, 
as was mentioned before, the negative effects of this FASB 
rule. It has not even been finalized as of yet. Some companies 
are already beginning to scale back their broad-based option 
plans in anticipation of the FASB rule, and I believe this 
hurts employees and not the executives.
    I am supportive of an independent FASB for the purpose of 
making accounting rules, but again this rule is not about 
accounting. It is about economic policy, and I believe that 
belongs with Congress and the executive.
    I yield back the balance of my time.
    Chairman Baker. I thank the gentleman for his statement.
    I have no further members on our side seeking recognition 
for an opening statement, so the next person to go to is Mr. 
Scott.
    Mr. Scott. Thank you very much, Mr. Chairman. Certainly, 
this is an extraordinarily important and yet complex issue.
    I think that as we move forward on this, and I have enjoyed 
working with the Chairman on this issue, but it is clear that 
the legislative process is really working here and raising some 
questions and putting some issues on the table that certainly 
need to be dealt with as we move forward.
    My understanding of H.R. 3574 is that it does indeed 
immediately dispense with the stock options requirement for the 
top five executives in a corporation. It provides for a study 
before moving forward, and certainly exempts small businesses 
from the first three years. The question is, though, is that 
enough.
    I think there are three issues here that we certainly have 
to exhaust before we move forward. First of all, what impact 
does this have by immediately stopping the stock options for 
the top five executives in a corporation, for the rank-and-file 
members who for years have benefited from stock options. I 
think we have to move gingerly to make sure that is continued.
    The other issue, of course, is small startup businesses. Is 
the exemption enough for the first 3 years, especially our 
technology companies. It is very important that we respond to 
that concern. The third area of concern for me, of course, is 
to hear from the SEC, to hear from FASB, to make sure as we 
move forward we are doing the right thing in dealing with the 
abuses and to stop that and regain the confidence of the 
American people in our most treasured possessions, and that is 
in our corporations that are the bulwark of our economic 
system, without doing tremendous damage otherwise.
    So Mr. Chairman, I really look forward to this, going 
forward, and I hope that we can address those three concerns as 
we move forward as we deal with this very complex issue.
    Thank you.
    Chairman Baker. I thank the gentleman.
    Mr. Sherman?
    Mr. Sherman. Thank you, Mr. Chairman. As the only member 
who will begin his statement by saying I am glad the FASB is 
looking at this issue, I do have a lot to say.
    Let me begin by looking at this whole idea of broad-based 
options. I have drafted the option plans. I have consulted with 
the companies on their option process. Yes, there are a few 
companies that have broad-based plans, but in general you are 
talking about 80 percent of this benefit going to the top 8 
percent of the employees across the board in this economy. When 
we look at the bill that is being proposed to deal with this, 
it supposedly is there just to protect broad-based.
    Look at two important details in the bill. First, even when 
options are granted to the top five people in the company, you 
have to assume zero volatility. So it is not just a bill to 
protect broad options. It is a bill to massively undervalue 
options given to the top five executives. Second, if you are 
number six at GM, you are probably doing pretty good. We should 
instead, if we want to focus on broad-based options, look at 
options which when valued at time of grant are less valuable 
than $100,000 per employee per year. That would allow us to 
make sure that we are giving a special benefit only to those 
options that are not being used for the purpose that options 
have been used for, and that is to make our corporate 
executives the richest corporate executives in the world by 
far.
    Now, we should be matching expenses and revenue. That is 
basic accounting. So we are told that somehow a stock option is 
not really an expense. It is not anything of value. Well, if it 
was not anything of value that was being given up, why does 
everybody want it? More importantly, what is an option? It is a 
piece of the future growth of the company, transferred from the 
current shareholders to the option grantees, the executives. 
That is very much a transfer of something of value.
    That is why if the company were to grant options which 
could be very similar in their form to employee stock options, 
would it grant those to private investors? That would be a 
recognized transaction. The proof of what I am saying is this. 
Let's say we really cared not about whether the executives got 
compensated, but there was health care for the bottom half of 
the employees, particularly in big companies that may not even 
use stock options now.
    We told corporate America, you can grant stock options to 
insurance companies if those insurance companies are giving 
health care to the bottom half of your employees. That is an 
expense. It has always been an expense. That is why companies 
do not use that as a device to pay their insurance companies. 
Instead, they have to pay them in cash, and increasingly they 
decide not to pay the cost of today's health care.
    If the transfer of an option to acquire something use for 
the company, like the work of the employees, is not an expense, 
why just employee stock options? Why can't you buy your 
building for stock options and not list that as a cost? Why 
can't you pay your telephone bill with stock options and not 
list that as a cost? The reason is because stock options is 
another way of paying an expense.
    Now, if we do things right and expense stock options, then 
we will I think show the world that perhaps unlike China, 
unlike some others, we have the best, clearest, most 
transparent, fairest, most logical accounting system being 
imposed, even when powerful interests disagree. The effect will 
be to reduce executive compensation in this country. The effect 
will also be, and it will not be a major effect, but it will be 
an effect. There will be a slight reduction in the amount of 
capital flowing to those companies that use stock options and 
that capital will instead flow to some older companies that 
tend not to use stock options. Is it better that a stock that 
somebody invest in Intel than invest in Proctor and Gamble? 
Gee, I do not know, but picking winners and losers has never 
been a proper role for this Congress.
    So I would like to argue that FASB is doing its job and we 
should leave them alone. There is one problem. FASB is not 
doing its job, two huge problems up there in Connecticut. 
First, this exposure draft just kind of leaves drifting do you 
use binomial? Do you use Black-Scholes? When do you use one? 
When do you use the other? Any guidance? Or do you just hire 
the accounting firm, there are not many left, but do you just 
hire the accounting firm that will give you the lowest stock 
option value? If they are going to do their job, they ought to 
do it.
    But there is a much greater problem with FASB and it is a 
related issue. We cannot talk about stock options without 
talking about research expense, because the biggest argument 
against what FASB is doing is that it will hurt high tech. 
Well, let's talk about something that really hurts high tech, 
not just something that may disadvantage a few executives in 
high tech, but rather that disadvantages high tech in general. 
FASB will admit it is completely wrong as a matter of 
accounting theory, but they have left it in place for over 30 
years, and that is the expensing of all research. The effect is 
for us as an economy to under-invest in research, for 
stockholders to under-invest in companies that do research.
    Why is this related? Because if we are going to hit tech 
with bad accounting for research, should we also hit them with 
good accounting for stock options? Is it fair to take a sector 
of our economy and require them to expense stock options, which 
is good accounting, while at the same time requiring them to 
expense the nearly $2 billion they do every year of research, 
which is bad accounting.
    So when this bill comes up, I will propose an amendment 
that it remains in effect only so long as FASB fails to allow 
for the capitalization of successful research and development 
expenditures. When FASB solves that problem, it will have a far 
greater affect on encouraging investment in high tech than 
anyone ever argued that this stock option thing has a negative 
affect. If I am able to get that amendment passed, and I 
realize it will be a matter of first impression to most of my 
colleagues, I will support the bill, in which case, and I think 
right now I am the only one speaking against it.
    So we need to have a fair accounting system for tech 
companies, one that recognizes that when you give a stock 
option, you have given something, but when you have done 
research and it is successful research, you have bought an 
asset.
    I yield back and I thank the Chairman for his indulgence.
    Chairman Baker. I thank the gentleman.
    Mr. Lucas?
    Mr. Lucas. I am ready to hear from the witnesses.
    Chairman Baker. Thank you, Mr. Lucas.
    Mr. Miller?
    Mr. Miller of North Carolina. I agree with Mr. Lucas.
    Chairman Baker. And Mr. Hinojosa?
    Mr. Hinojosa. Thank you, Mr. Chairman.
    Chairman Baker and Ranking Member Kanjorski, I want to 
thank you for holding this very important and timely meeting. 
Chairman Baker, I want to note first and foremost that I am a 
co-sponsor of your legislation, H.R. 3574, the Stock Option 
Accounting Reform Act. I remain an ardent supporter of this 
legislation despite FASB's March 31 proposed rulemaking that 
would require companies to report as an expense the value of 
stock options they give to executives and rank-and-file 
employees.
    In fact, FASB's recent proposed rulemaking demonstrates how 
important it is that Congress pass your legislation, 
particularly section three of your bill. Section three would 
prohibit the SEC from recognizing as generally accepted any 
accounting principle established by a standard-setting body 
relating to the expensing of stock options pending the 
completion of an economic impact study by the Secretary of 
Commerce and the Secretary of Labor.
    What everyone here needs to recognize is that stock options 
are an important tool to attract talent to new ventures, and 
that mandatory expensing of stock options will stifle their 
issuance, reduce company profits, and deter innovation and 
economic growth. FASB's proposed rulemaking likely would result 
in the disappearance of stock options. The disappearance of 
stock options will inhibit a company's ability to attract and 
retain skilled employees.
    If the FASB rule takes effect, many of the companies will 
stop issuing options to their rank-and-file employees. There is 
no reliable nor accurate formula to properly value them, 
contrary to what FASB contends.
    In closing, I want to include in my comments concerns that 
I see in global competition with large importing nations like 
China. Mr. Chairman, the Chinese government has incorporated 
stock options into its 5-year economic plan to boost its 
technology industry. As a member of the House Manufacturing 
Caucus, I know all too well that many of America's 
manufacturing jobs have already been outsourced to China, thus 
negatively impacting our U.S. economy. FASB's proposed 
rulemaking poses a similar risk in that venture capital 
companies and high-tech companies might relocate to China or 
other stock option-friendly nations if registered companies are 
required to expense their stock options in the United States.
    Mr. Chairman, I want to work with you and other co-sponsors 
of your legislation to at least delay the implementation of 
FASB's proposed rulemaking, either by passing your legislation 
as a stand-alone measure, or working together to incorporate it 
into other legislation to ensure its passage. Hopefully, we 
will succeed in this endeavor.
    I yield back the balance of my time.
    [The prepared statement of Hon. Ruben Hinojosa can be found 
on page 81 in the appendix.]
    Chairman Baker. I thank the gentleman.
    If there are no other members desiring to make an opening 
statement, I want to welcome our witnesses to our hearing. I 
hope you have enjoyed it today. We would like to remind each of 
you that despite the length of members's comments, we do 
request that each of you try to limit your remarks to 5 
minutes. Your formal statement will be made part of our hearing 
record. I welcome each of you. We look forward to your 
comments.
    I would turn first to Mr. Jeff Thomas, field applications 
engineer, Altera Corporation. Welcome.

 STATEMENT OF JEFF THOMAS, FIELD APPLICATIONS ENGINEER, ALTERA 
                          CORPORATION

    Mr. Thomas. Chairman Baker, members of the subcommittee, I 
want to thank you for hearing my testimony today.
    My name is Jeff Thomas. I am a field applications engineer 
for the Altera Corporation in San Jose, California. Altera 
Corporation manufactures and sells programmable logic devices, 
which are semiconductor chips used in a broad range of 
applications. In my role as an FAE, it is my responsibility to 
provide on-site technical support to one of our largest 
customers, which is a major telecommunications company.
    In my daily work, I train engineers on how to use our 
chips. I present our new technology to our customers and I 
ensure that their systems are successful. I am here today 
because I volunteered to participate in this hearing because 
stock options have played a large role in my decision to pursue 
a career in the high-tech field. I wanted to communicate to you 
the impact that they have on employees as well as companies 
that offer broad-based stock option plans.
    I graduated from Carnegie Mellon University in 2000 with a 
bachelor's degree in electrical and computer engineering. I had 
job offers from a broad range of companies at the time of my 
graduation. During my time at CMU, I had a couple of summer 
internships at Fortune 500 companies, and both companies 
offered me a job upon graduation. However neither offered a 
broad-based stock option plan.
    I also interviewed with a number of high-tech firms, and 
every job offer that I got from a high-stock firm did include 
stock options. So I decided that I wanted to work where I had a 
stake in the success of the company. I decided I liked the idea 
of being able to profit not only from my salary, but also from 
the growth of the company.
    In retrospect, I can definitely say I have seen a 
difference in both the behavior and performance of employees in 
high-tech firms that have a vested stake in their company, 
compared to the people that I worked with at companies where 
they did not have that ownership stake.
    My first day at Altera, I was granted stock options that 
would vest over the next four years. So after one year if I 
stayed with the company, 25 percent of those options would 
vest. If the stock price had gone up, I could buy and sell 
those options and realize a profit. I could not transfer those 
options or sell them on an open market of any kind. I could 
only use them for my own personal gain.
    Also each year at my annual review, I was granted a new 
batch of stock options based on my performance that would 
follow a similar vesting schedule. This ensures that I was 
constantly motivated to stay with the company and continue to 
work for its long-term growth .
    Stock options are a great incentive for employees. People 
work hard not only to advance their personal companies, but to 
grow the company as a whole. They allow all employees to grow 
into the success of the company. As the sales and profits of a 
company increase, the employees benefit through the 
appreciation of the stock price. This fosters an environment 
where employees will go out of their way and beyond their job 
descriptions to grow the company as a whole.
    Stock options are also a strong motivation to stay with a 
company. Because of their vesting schedule, employees are 
incentivized to stay with a good company. Since I believe in 
Altera's long-term vision, I want to stay with the company and 
continue to build my ownership share in that company through 
the stock option program. Because everybody at Altera has a 
stake in the company, we are all committed to making the 
company successful in the long term.
    This behavior is not unique to Altera. I see this type of 
dedication and work ethic at companies all around Silicon 
Valley. All my friends, whether they work at big telecom 
companies or small startups, share the same desire to see their 
company become successful because they share a stake in that 
company. Engineers in the valley often work long hours and 
weekends to make sure their company succeeds because each 
person has a personal stake in the enterprise beyond just their 
salary.
    Already in my career I can say I have seen the effect of 
broad-base stock option plans in action. I have been able to 
compare the atmosphere at a high-tech company in Silicon Valley 
to some of the Fortune 500 companies I worked at as a summer 
intern. I can definitely say that people in Silicon Valley work 
harder, longer and care more about the long-term performance of 
the company than employees that are just there to get a 
paycheck.
    Throughout my career, I want to continue to work at 
companies like Altera that offer stock options to a broad base 
of employees so that I can continue to work towards the shared 
goal of increasing the company's value. I believe this promotes 
an extremely valuable working environment.
    I also believe that anything that would make it more 
difficult for a company to grant stock options would hurt the 
company's performance overall. The success of Silicon Valley is 
based on the work ethic and dedication of its employees. This 
work ethic is a direct result of the fact that employees know 
that they will share in the success of their company. If 
anything happens that would not allow the companies to offer 
their employees a share in that success, I believe the overall 
performance of that company would be hurt.
    I sincerely hope you will consider these positive impacts 
of stock options on both employees and their companies while 
you are determining the fate of this bill.
    Thank you again, Mr. Chairman and members of the 
subcommittee. I am happy to answer any questions you have at 
this time.
    [The prepared statement of Jeff Thomas can be found on page 
157 in the appendix.]
    Chairman Baker. Thank you very much, sir.
    I follow a script, Mr. Kruse, and I should have recognized 
you first, but your name did not appear first on my list. So I 
recognize you at this time, Mr. Douglas Kruse, professor, 
School of Management and Labor Relations, Rutgers University. 
Welcome, sir.

STATEMENT OF DOUGLAS KRUSE, PROFESSOR, SCHOOL OF MANAGEMENT AND 
              LABOR RELATIONS, RUTGERS UNIVERSITY

    Mr. Kruse. Thank you. I am pleased to be here.
    I am a professor at the Rutgers University School of 
Management and Labor Relations. I am also Research Associate at 
the National Bureau of Economic Research in Cambridge, 
Massachusetts. At the NBER, I am working with Professor Richard 
Freeman of Harvard University and my Rutgers colleague Joseph 
Blasi. We are co-directing a project looking at shared 
capitalist programs in U.S. companies.
    I am also co-author of a book that came out last year, In 
the Company of Owners, that looks at broad-based stock options 
in U.S. companies, co-authored with Joseph Blasi and Aaron 
Bernstein. I regret that I did not bring a copy of the book to 
wave around. As Doug was pointing out, my publisher will never 
forgive me for forgetting that today.
    As part of the NBER project, we added some questions to the 
2002 General Social Survey, a representative survey of working 
Americans. I want to summarize a few results from that and some 
other evidence for you very quickly. What we found was that 13 
percent of private sector employees say they hold stock 
options. That translates into 14 million stock option holders. 
We also found that 23 million workers say they own company 
stock, 15 million of them through employee stock purchase 
plans.
    Contrary to popular impression, most stock option holders 
are not rich executives. In fact, a very striking finding, the 
one that I would really point to, is in appendix one of my 
testimony. It turns out that 79 percent of stock option holders 
earn less than $75,000 a year, and well more than half earn 
less than $50,000 a year. We provide a variety of breakdowns in 
appendix two showing that the majority of the stock option 
holders are non-managers. More than 90 percent say that they 
are in the middle-or working-class, and they are spread across 
regions and across the social and political spectrum. We do the 
same thing in appendix three for holders of company stock, and 
find very similar results. They are very representative.
    I have strong reservations about expensing, since many 
companies say that they are going to first cut broad-base stock 
options if expensing takes place. There were four studies last 
year in 2003 that analyzed hundreds of corporations. They found 
that one-half to one-third were already making large cuts in 
stock option plans. One-half to two-thirds planned cuts in 
employee stock purchase plans.
    One might say, well, maybe the companies are just crying 
wolf. In the last few days, Joseph Blasi and I looked at the 
first 10 companies to file SEC proxies for 2003 out of the 
largest 20 companies, the Fortune 20 companies. Of these 10, 
six had already announced that they will expense stock options. 
Five of those six have already increased the share of stock 
options going to the top five executives from 2002 to 2003, and 
all six of them increased the share going to the CEO. If this 
trend continues, we think it will be deeply troubling. It could 
be bad not just for regular employees who will be cut out of 
stock options, but it could be bad for company value as well.
    We did a recent study on executive compensation over the 
past 11 years in the 2,000 largest companies. We found that 
increases in executive compensation, including different 
measures of stock options, do not predict future shareholder 
returns. In contrast, we surveyed over 20 years of evidence on 
broad-based employee ownership, profit sharing and stock 
options in chapter seven of our book, that I should be waving 
around now. The evidence clearly shows that broad-based plans 
are linked to higher productivity and shareholder return on 
average; not in every company, of course, but on average.
    It would be a shame if expensing discourages companies from 
using and extending these plans that can improve performance. 
Public policy should be encouraging policies that improve 
performance.
    So our conclusion is if there is expensing, it makes sense 
to somehow preserve broad-based plans. One good approach could 
be to expense just for the top five executives, as the current 
bill proposes. If expensing does go through for all employees, 
another possibility is to create a tax credit that would offset 
the option expense only for companies with truly broad-based 
plans. This could be an alternative to the existing deduction 
when options are exercised, so it could end up actually being 
revenue-neutral, a tax credit that would end up being revenue-
neutral.
    Finally just as a last note, I call attention to another 
House bill that would create a presidential commission on 
employee ownership. Given the importance of all these issues, 
given the debate around this, we think a presidential 
commission on employee ownership could be a good way to explore 
those issues.
    Thank you very much.
    [The prepared statement of Douglas Kruse can be found on 
page 125 in the appendix.]
    Chairman Baker. We thank you very much. You may wave the 
book at any time you choose. Thank you.
    [Laughter.]
    We welcome next Mr. Douglas Holtz-Eakin, Director of the 
Congressional Budget Office. Welcome, sir.

   STATEMENT OF DOUGLAS HOLTZ-EAKIN, DIRECTOR, CONGRESSIONAL 
                         BUDGET OFFICE

    Mr. Holtz-Eakin. Mr. Chairman, Congressman Kanjorski, 
members of the committee, the CBO recently delivered to 
Congress a study entitled Accounting for Employee Stock 
Options, which details the fact that employee stock options are 
an economic cost to firms. They represent an exchange of value 
in return for labor services, and displaying that value--
measured by the fair value or cash equivalent of the option and 
recognized over a period that the labor services are used, the 
vesting period--leads to a more accurate portrayal of net 
income in economic terms.
    Correspondingly, the failure to display this on financial 
statements leads to an overstatement of economic net income. 
Valuing employee stock options is a difficult task and is 
complicated by features such as vesting periods, forfeiture 
provisions and non-transferability of these options. However, 
advances in financial analysis permit reasonable valuation of 
such options, as they do comparable instruments such as 
warrants which are currently held in many entities portfolios. 
And such valuations are similar in their accuracy to those of 
such complicated issues involving uncertainty as retiree health 
benefits, the impairment of goodwill, or the cost of 
environmental cleanup, which may occur in the future.
    These are all currently displayed in the firm's financial 
statements. One would anticipate that the increased use of 
these techniques under the prospect of the proposed FASB 
standard might lead to further advances in the ability to value 
these options more accurately. Recognizing the expense of 
employee stock options would not alter the economic 
fundamentals of any business. It would not alter the markets in 
which they compete for customers, their international or 
domestic competitors, or the prices that they charge.
    It would not have any impact on the labor markets in which 
they hire their workers or the need for compensation and 
appropriate incentives for those workers. It would not alter 
the technologies that they currently deploy nor the incentives 
to acquire and deploy new technologies. And fundamentally, it 
would not alter the cash flows used to conduct their 
operations.
    Any potential economic impact of expensing employee stock 
options will come through changes in investors's evaluations of 
these firms. For savvy investors and for most firms, no new 
information will be provided by moving the disclosure from the 
current notes onto the face of the statement. Expensing would 
simply make it easier and more broadly possible to do the same 
valuations that are available today.
    It is the case that some valuations may decline. If so, 
those firms and their workers would suffer the costs and 
experience disruption from the reduced availability of equity 
capital to those firms in the near term. However some may also 
rise, and on balance one would expect that there would be no 
great overall impact on the U.S. economy and that any targeted 
impacts on particular firms would be outweighed by the improved 
allocation of capital on the economy, resulting in increased 
employee productivity, and improved economic performance.
    One cannot know for sure the overall economic impact in 
advance of the adoption of the FASB standard. However, the 
experience as displayed thus far for those firms which have 
voluntarily undertaken expensing or from the experience from 
countries such as Canada which has not only proposed, but 
implemented an expensing standard, or the area of the European 
Union which has announced a standard, but not yet implemented 
it, all suggest that there would be no broad-based economic 
impact.
    Mr. Chairman, we thank you for the chance to discuss our 
report today and look forward to your questions.
    [The prepared statement of Douglas Holtz-Eakin can be found 
on page 107 in the appendix.]
    Chairman Baker. I thank you very much for your 
participation in our hearing today and your statement.
    Next, I wish to welcome Mr. Kevin Hassett. Please proceed 
at your leisure.

    STATEMENT OF KEVIN HASSETT, DIRECTOR OF ECONOMIC POLICY 
             STUDIES, AMERICAN ENTERPRISE INSTITUTE

    Mr. Hassett. Thank you very much, Mr. Chairman.
    I agree with Mr. Oxley and Mr. Ose, Mr. Chairman, that the 
best reading of the literature is that right now the literature 
is not exactly sure how to value these options. The literature 
is not sure how to value these options because of issues 
mentioned by Mr. Holtz-Eakin, but also because the options have 
a much longer life than the type of options that are marketed 
these days. To my mind, having been immersed in the technical 
details since my dissertation, I think that is the most 
relevant issue here.
    Indeed, Warren Buffett himself said in the Financial Times 
that the minute you get into longer-term options, it is crazy 
to use Black-Scholes. The fact is that is true. In fact, this 
issue has even made it into the leading text books, as is 
mentioned in my testimony, and developed in more detail in a 
recent paper prepared by Glenn Hubbard and Charles Calomiris 
for the American Enterprise Institute.
    So I think this explains why it is that FASB has been going 
so slowly on this issue, given their clear designs on 
expensing. The fact is, as you get close to expensing and think 
about how to do it, contrary to Mr. Holtz-Eakin's statement, 
you find that it is not the case that there is an accepted way 
to do it, which is why FASB has refused to specify, it appears 
to me in reading their documents, precisely how firms are 
supposed to do it.
    So in my testimony, what I do is really go after the 
question that Mr. Frank raised in his opening statement. How is 
it that you could actually change the world if the market is 
efficient, if it is looking at the details on options already, 
then if you move an expense calculation maybe that is incorrect 
up to the top line, what effect does that really have on 
anything? Just like if we subtracted 10 from earnings, then 
what a rational investor would do is they would just add 10 
back in. So if we do something wrong, the rational market ought 
to see through it.
    What I found after studying this issue with my colleague 
Peter Wallison at the American Enterprise Institute, who as you 
know is a very distinguished attorney who has worked for 
President Reagan and has had other positions in town, is that 
it is very likely that if we do not tell firms how to expense 
options and know that we are basically giving them a problem to 
solve that has not been solved by the literature, then we are 
going to open up a real legal mess that will potentially tie 
firms up in class action lawsuits for years and cause you to 
have to consider new legislation.
    In my testimony, I provide a simple example of the state 
that I think we might end up in if FASB has its way. That is, 
suppose that for example a publisher that finishes a book in 
2003 and plans to send it to the book stores in 2004, is 
required to forecast the sales in 2004 for that book by FASB 
and include that in their 2003 statement. And FASB does not 
tell them how to forecast it. They just say, you have to say, 
since you paid for the expenses of the book in 2003 what the 
sales are going to be in 2004.
    Well, the firm would presumably try its best to develop a 
model to forecast sales, but of course on average there would 
be a whole lot of firms that would make errors. As soon as they 
make those errors, the earnings will be misstated, and that 
will open the firm up to class action lawsuits. It is my belief 
and Mr. Wallison's belief, and we have spelled this out in 
great detail in a paper that is just coming out in Regulation 
magazine, that the real reason why the expensing of options is 
going to cause firms to not use them as much as they do now, 
and to shy away from them, is because if you do not specify a 
model, then everybody is going to get the expense wrong. 
Probably about half the firms at least are going to have over-
stated their earnings because their model led them to do that. 
With that over-statement, they are going to find themselves 
enmeshed in really difficult lawsuits.
    So I think it would be a big mistake for FASB to require 
the expensing of options without expressly stating how to do 
it. If they expressly state how to do it, then the firm will at 
least have the defense that we are just following FASB's 
directions and that defense might well be a reasonable one and 
a successful one. Absent that, I think that FASB is creating a 
real mess for our corporations and one that will lead them to 
shy away from the use of options.
    Thank you.
    [The prepared statement of Kevin A. Hassett can be found on 
page 90 in the appendix.]
    Chairman Baker. Thank you very much. I appreciate your 
participation.
    Our next witness is Mr. Phil Smith, chairman of the board, 
Taser International. Welcome, sir.

     STATEMENT OF PHIL SMITH, CHAIRMAN OF THE BOARD, TASER 
                      INTERNATIONAL, INC.

    Mr. Smith. Thank you, Mr. Chairman and subcommittee 
members. It is a pleasure to be here. Let me give you a quick 
background and then launch into what I have to say.
    I have an undergraduate degree from West Point, MBA and I 
have a PhD in business and a specialty in finance, so I clearly 
understand all the theoretical arguments. I have been a 
corporate officer in three Fortune 500 companies and I have 
done five high-tech startups. I spent the last 35 years in this 
business, so I have lived it from almost the inception.
    I guess I am one of the few guys here who can talk from 
practical reality and not some theory. I really get a kick out 
of most of the people testifying yesterday in the Senate and 
have never seen an option, used an option, have ever benefited 
from an option or ever used them to try and attract employees 
to a company. That is what is most disappointing to me. The 
people that are really involved have had very little voice in 
what is going on. I hope that this committee takes this to 
heart.
    I can give you one example, of these five startups. I did 
one in the Silicon Valley in 1983 that we sold in 1985 very 
successfully. The employees out of that company started 12 new 
companies. They took the money they earned from the options and 
literally like a thing exploding with seeds, 12 new companies 
started in the Silicon Valley in 1985 from the people from that 
company.
    I can go through example after example. I do not have the 
time. Options are used not only for employees. As I pointed out 
in my testimony, when we went public 3 years ago at my current 
company, Taser International, we were in need of some 
interesting board members to comply with the corporate 
governance that Chairman Oxley has been kind enough to levy on 
all corporations in America. When you go out and talk to 
significant board members and people with a strong background, 
there is a real risk in coming on a public company's board 
today. The trial lawyers love to have them. People are very 
concerned about joining public boards, especially young public 
companies. One of the ways we got the people we did, the 
caliber we got, was the ability to use options.
    Now, it turned out they have been very successful. They all 
have made quite a bit of money as a result of that. But at the 
time they took those options, they accepted the risk. You take 
this option away from us and force to expense and I do not know 
how we are going to attract these board members. We could not 
have afforded to pay them the money it would have taken to get 
them on our board and provide the governance that the Congress 
is looking for.
    The second thing is, it is a double whammy for small 
companies. A current thing, our stock is extremely volatile. It 
fell 32 percent yesterday, which happens to be just one data 
point. The stock is up 6000 percent over the last 12 months. We 
have what is called a very high volatility. We get penalized 
because, one, we are a small company and secondly, we are 
highly volatile. You take the measurement of our company. We 
will get two penalties, not just one. One, we are small; 
second, we are highly volatile.
    Those will really impact the bottom line of our company, 
and obviously a lot of our investors are retail investors. I 
agree, the sophisticated investor can read the footnotes in our 
balance sheet. They are cops. They are police officers around 
the country that own 100 or 200 shares. They do not understand 
the sophistication of footnotes, and they are not going to 
understand when all of a sudden the earnings drop on the 
company compared to other companies in the industry.
    Third, I would like to talk about the issue of tax. Our 
corporation has not paid tax for the last couple of years 
because of employee options. When they exercise their option 
and make the profit, they pay a personal tax. The corporation 
gets the benefit. We have been able to retain that tax and use 
it to grow, and we have grown our employee base to 199 
employees from 70 a year ago by using that cash flow. It would 
normally have been paid as corporate income tax. Nobody has 
talked about the tax issue here, about the corporations that 
are allowed to retain that tax, the cash on their balance 
sheets and use it to grow.
    Let me give you one last thing. We have stopped issuing 
options. We have given all our employees their final options 
this year. They vest by the end of the year, merely because of 
this legislation. We do listen to what goes on in Washington. 
We do watch what is going on and we are not about to penalize 
our shareholders and ourselves by issuing a bunch of options 
that we have to expense in future years. We have told our 
employees there will be no more options if this passes, and the 
only people that are going to get it are the top five.
    My last comment, as Mr. Sherman mentioned, he tried to 
contain executive compensation with the $1 million salary cap, 
and we all see how effective that was. They just reported the 
highest executive compensation in the country this past year, I 
think it was in USA Today. So it had very little effect on the 
top five. Your proposal will address the top five and let the 
average employee have a chance to benefit in the success of 
their company. At Taser, we have 20 millionaires, from 
secretaries to production employees, right up the line. They 
are the ones who are going to lose out. Those are the ones who 
will not get the options. It will still go to the top five. I 
certainly hope you are successful, Mr. Chairman.
    Thank you.
    [The prepared statement of Phil Smith can be found on page 
152 in the appendix.]
    Chairman Baker. Thank you very much for your contribution 
here.
    Our next witness is Mr. Robert Grady, managing partner, 
Carlyle Venture Partners. Welcome.

STATEMENT OF ROBERT E. GRADY, MANAGING PARTNER, CARLYLE VENTURE 
                            PARTNERS

    Mr. Grady. Thank you, Mr. Chairman and members of the 
subcommittee. I appreciate the opportunity to present this 
morning, not only on behalf of the Carlyle Group, which is one 
of the world's largest private equity firms, but also I serve 
as a member of the board of directors of the National Venture 
Capital Association. By coincidence, I also have taught for the 
last decade on the faculty of the Stanford Business School, 
which we will come back to in a minute.
    The FASB has asked for comment on this exposure draft, and 
our comment is simple. The proposal is inappropriate. It is 
incorrect as a matter of financial and accounting theory. I 
think it is poorly thought-out and it is very definitely 
unworkable.
    Before I comment directly on the exposure draft, let me 
just offer a little context that makes clear the typical use of 
stock options today in the economy.
    The two venture capital funds that I spend every day 
managing, which were started in 1997 and 2002 respectively, 
have investments in about 38 different companies, all started 
from the ground up. Those 38 companies employ over 4,000 
people. In the five private companies on whose boards I sit, 
Blackboard here in Washington, DC; Panasas in Fremont, 
California; USBX in Los Angeles; Secure Elements out in the 
Virginia suburbs; and Ingenio, also in California; incentive 
stock options are granted to every single employee, from the 
receptionist to the CEO. That is typical in the venture capital 
world. In fact, according to a recent survey by the NVCA, over 
70 percent of venture-backed companies award stock options to 
every single employee. You heard Professor Kruse state that 
half of all option holders in the country earn less than 
$50,000 a year.
    The standard type of grant in a venture-backed company is a 
grant that is vested to encourage an employee to stay at the 
company. A typical structure, in fact the most commonly used in 
venture-backed companies, calls for the grant to vest over 4 
years, just like the grants that Mr. Thomas received when he 
joined his company, with so-called ``cliff vesting'' on the 
first anniversary of employment of one-quarter of the options 
and then monthly vesting of the remaining three-quarters each 
month over the next 3 years.
    That is an important point to understand about how options 
work, because under the FASB's exposure draft, with its 
provisions for graded vesting, the normal grant of stock 
options, the one that virtually every venture-backed company in 
America uses, will have to be valued 37 different times per 
grant. Somehow, the FASB believes this will make financial 
statements more understandable.
    Let me turn to the FASB's exposure draft and how its 
policies will work or not work if implemented. First, I do feel 
compelled to start with a fundamental conceptual point, and 
that is that options are units of ownership. They are shares. 
They are not expenses. They are not claims of cash against the 
company's resources. They are not the use of a company asset. 
Basically, they should be treated and disclosed, in my view, in 
the denominator, if you will, of the earnings-per-share 
calculation. If you account for them in both the numerator and 
the denominator, you are double-counting them.
    So if in fact FASB were proposing in this exposure draft 
that when companies report earnings per share, they had to 
disclose in every case the fully-diluted share count, that is, 
including all options outstanding in the denominator, I think 
that would be a fair and very workable proposal. I think this 
point is essential, because at its heart, what this debate is 
all about is that many Americans, and in fact people all over 
the world, are willing to trade off cash compensation for units 
of ownership. They are willing to earn less cash today and 
thereby create less in terms of ongoing expenses by the 
company, so that over the long term the company will be worth 
more. In other words, they are thinking like owners. It is good 
for other shareholders who might choose to join them along the 
way that they are thinking like owners, because their interests 
are aligned as mutual owners of the securities of the company.
    Ironically, the proponents of expensing say that requiring 
it will not have the dire effect that many predict, that some 
of us predict, because they say investors will just in effect 
ignore it. Investors will basically strip out the effect of 
expensing and look straight to cash EPS. So in other words, 
they will ignore GAAP. The reason they will do it is precisely 
because it will not be representative of the company's true 
expenses. That is exactly what I believe Representative Frank 
was saying, if reality does not change. So the irony of the 
FASB proposal, in other words, is that it is likely to 
undermine confidence in and the use of GAAP accounting, which 
one presumes to be the exact opposite of the objective of the 
proposal.
    In the gymnastics that FASB has had to go through to get 
over this fundamental point, in trying to define units of 
ownership as expenses instead of shares, they have created a 
number of problems that I would just like to touch on and 
enumerate briefly.
    The first obstacle, of course, is trying to define the 
appropriate measurement date at which to value an option. There 
are two different possibilities. The FASB has suggested that 
the grant date is appropriate. The problem with this, of 
course, is that the value of the option at grant date is highly 
uncertain. It may never vest. The employee might leave. It may 
never be exercised because the stock may never be ``in the 
money'' during the appropriate time frame.
    An alternative is to move the measurement date to the 
exercise date, and that would even be worse because it would 
simply penalize the most successful companies, those with the 
brightest prospects, for the mere fact that their stock has 
appreciated. You have heard the example of Taser. Their profits 
would be wiped out by the mere fact that their stock had 
appreciated, regardless of the performance of the company.
    A second problem which the committee has discussed today is 
how to value what an option would be worth. FASB suggests using 
observable arms-length transactions, but of course for private 
company options they have never traded, so the value of the 
option has to be modeled somehow. There is a choice of modeling 
and methodologies to use, and whatever choice you make leads to 
a radically different assessment of value.
    That, of course, leads to the third problem, which is that 
any of the models that one could choose, including Black-
Scholes, named for the late Fisher Black and my former 
colleague at the Stanford Business School, Myron Scholes, and a 
binomial model for that matter, rely on one key variable and 
that is the estimate of the volatility of the underlying stock. 
Of course, since private company shares have not traded, any 
estimate of volatility is basically a guess. Actually, FASB 
makes it worse because they say we are not to look at 
historical volatility; you are to estimate future volatility. 
So any estimate of volatility will be subject to both potential 
manipulation and inaccuracy.
    That, of course, leads to a fourth problem, which is to try 
to get around this problem of estimating in advance the 
volatility, FASB has given private companies in the proposal 
the option to use intrinsic value as a way of valuing options. 
Under this methodology, the value of the option is adjusted for 
every reporting period, every quarter, or in some cases of 
private companies, every month, and is changed to reflect an 
estimate of value or stock price if it is a public company. 
That is basically a form of variable accounting which brings 
stock price directly into the income statement of the company, 
and of course introduces the potential for wild swings from 
quarter to quarter of the value of any given option, so it will 
be massively confusing for investors.
    The fifth problem is that FASB ignored that most private 
company employee options are highly restricted. That is, they 
are not only subject to vesting, but they cannot be 
transferred; they cannot be hedged; they cannot be pledged; 
they cannot be sold. So it is very hard to value these 
restrictions. Interestingly, FASB argues that no restrictions 
that exist during the vesting period should even be considered 
in valuing the options. Clearly, an option that is subject to 
restrictions is worth less than an option that is subject to no 
restrictions, yet FASB would have them be recorded at exactly 
the same price. So much for the concept of fair value.
    Finally, in seeking to identify the proper time period over 
which to attribute the expense that the exposure draft would 
require, the FASB creates a whole new set of problems. For 
example, the exposure draft suggests that companies should try 
to model or predict the groups of their employees for purposes 
of predicting their exercise behavior. That is because the 
proposal calls for them to adjust the contractual term for 
expected early exercise or post-vesting behavior. Obviously, 
that would be a completely speculative exercise that would be 
almost preposterous in its unreliability.
    All of these obstacles, by introducing theory, uncertainty 
and subjectivity in place of the actual experience, which is 
what financial statements are supposed to reflect, will make 
the income statements of companies less reliable, not more 
reliable.
    In the end, Mr. Chairman, I think what is clear from FASB's 
proposal is, as you suggested in your opening statement, that 
it is responsive not to the volume of comments it has received 
from the venture capital community or companies that use 
options, but rather to the political process. I do believe this 
is fundamentally a political proposal and, as you said, Mr. 
Herz is quoted as inviting people to contact their 
representatives. I do believe it is in response to something 
that has nothing to do with employee options, which is the 
reported abuses at places like Tyco, WorldCom, Adelphia, et 
cetera, where people stole company resources, allegedly, or 
reported incorrectly the financial performance of the company.
    In this regard, the National Venture Capital Association 
does support the legislation you have proposed. We believe it 
is responsible. We believe it is appropriate to exempt private 
companies where it is impossible to value the options from the 
expensing requirement. Having taken 175 or so companies public 
in my career, I believe it is appropriate to exempt companies 
during their first three years of being a public company so 
that you can get some trading experience and understand how to 
assess the volatility of the stock. With that, we do hope that 
the Congress will act on your proposal.
    Thank you, Mr. Chairman.
    [The prepared statement of Robert E. Grady can be found on 
page 84 in the appendix.]
    Chairman Baker. Thank you very much.
    Our final participant this morning is Mr. George Scalise, 
president of the Semiconductor Industry Association. Welcome.

   STATEMENT OF GEORGE M. SCALISE, PRESIDENT, SEMICONDUCTOR 
                      INDUSTRY ASSOCIATION

    Mr. Scalise. Thank you, Mr. Chairman and members of the 
committee. I am George Scalise. It turns out I have been in the 
semiconductor industry for about 45 years, so I have seen it 
from the very earliest days and I have seen what stock options 
have done to help build this industry from a startup to what is 
now a $200 billion a year industry. I also have been the 
beneficiary of that process of stock options.
    First of all, the SIA strongly supports H.R. 3574 and we 
commend the leadership of the Chairman as well as the 30 
members of the committee that are co-sponsors of the 
legislation. Going back to the industry for just a moment, the 
U.S. semiconductor industry, the U.S.-based companies, are the 
most competitive in the world today and have been since the 
onset of this industry. We currently have about 50 percent of 
that $200 billion a year market. It turns out that only 20 
percent of that market is here in the U.S. However, about 70 
percent of our manufacturing is located here in the U.S. The 
average employee earns about $97,000 and we have about 255,000 
employees here.
    So this program that we are talking about is very vital to 
this industry and has been since the onset. Semiconductors, as 
you probably know, are the building blocks for the whole 
information technology market, which is now a $1 trillion 
export market for the U.S. So whether you are talking about 
equipment or software, it does not really matter; whether it is 
games or automobiles, they all embody semiconductors.
    The other thing that is important about this is that 
semiconductors and the IT industry now represent about 8 
percent of the economy, but it turns out they are more than 30 
percent of the growth; they reduce inflation by about 1 percent 
a year; they increase productivity by about 1 percent a year. 
As a consequence, they make a major contribution to the overall 
economy.
    Keep in mind, our prices go down every year by at least 30 
percent. Every year the prices go down by at least 30 percent. 
So if you bought a bit of memory in 1995 for $1, you would be 
paying about 2 cents for that today. In a few more years, you 
will be paying 1/100th of a cent or less than that as we go 
along. So this kind of contribution is something that we need 
to find ways to encourage and support and make continue to 
happen going forward.
    Going on to the competition, as I said, this is a worldwide 
market. It is also worldwide competition. As someone said 
earlier, our competitors overseas have now seen the wisdom of 
using stock options as a method of dealing with their 
employees, compensating their employees. In a recent forum that 
we had at Stanford University, about a month ago, we had 
representatives from Taiwan, China, Korea and the U.S. talking 
about the industry and what was going on, and what the 
competition was all about. One of the folks from Taiwan pointed 
out that they do not really have a cost associated with stock 
options because there is no tax benefit, therefore they can 
grant these very lavishly, if you will, and the employee gets a 
great benefit from it.
    As a consequence, they have now attracted about 5,000 of 
some of the very best engineers we have in this industry, to go 
to Taiwan to be a part of the industry there today. Now, 
granted, a number of our employees are foreign-born. They come 
to our universities, are trained, and they come to work with us 
here. But up until very recently, they have been employees that 
stayed with us. We are now beginning to see that migration 
reversing and going the other direction. In large part, it is 
because of the kind of compensation and the kind of tax 
structure that is associated with stock options.
    Let me just turn for a moment to the accounting side of 
this, because I know that is one of the important arguments 
that is being put out here. I think that our greatest concern, 
I think you have seen editorials on the part of some of our 
CEOs in the industry, who are making it very clear that if 
there is going to be a change, the investing public is going to 
have to see something that is very transparent, that is very 
accurate, and is very comparable from company to company. I 
think the evidence that we have heard about here today, and I 
do not want to go into it again because I think you have heard 
it, is that that is not possible with the proposal that is in 
front of us today.
    Therefore, I think the legislation that is being proposed 
to take a hard look at this and make sure we understand just 
what the consequences are, is very, very critical, so that we 
do not make that mistake of adopting something that is not 
going to be transparent, that is not going to be accurate, and 
will not be comparable from company to company. That would 
create more confusion, and in particular it will disadvantage 
the small investor versus the professional investor by a wide 
margin. That is the last thing that we should have happen.
    The other point that I would like to make is on the stock 
purchase plan, which is a very important part of all of our 
companies. Again, the companies that have stock purchase plans 
is for 100 percent of the employees, just like our stock 
options are for anywhere from 80 to 95 percent of our 
employees; in some cases 100 percent. That will absolutely 
destroy the employee stock purchase plan if this proposal goes 
forward.
    Again, I think this is one of the great opportunities for 
young people to get their first real shot at building equity 
for themselves and their families is through these stock 
purchase plans. They are very, very quick to unfold, and again 
if the company does well, these people can do very well and 
they can begin to buy their homes and do the other things that 
young families do. So I think it is very important that we make 
certain that we maintain the vigor and the opportunity 
associated with employee stock purchase plans.
    Finally, as far as international convergence is concerned, 
I do not really see why we have to rush to try and come 
together with IASB and whatever their proposal happens to be, 
because first of all I do not think there is a timetable 
associated with that that is going to necessarily come to pass. 
There is a lot of controversy with the European companies on 
the IASB proposal, and therefore I think we ought to set that 
aside as having no real validity as far as consideration as we 
take a look at this FASB proposal that is in front of us.
    Thank you. I am ready to answer any questions.
    [The prepared statement of George Scalise can be found on 
page 148 in the appendix.]
    Chairman Baker. Thank you, sir. Before I proceed with 
questions of my own, I just want to yield time to Mr. Shadegg 
for purposes of an introduction. Mr. Shadegg?
    Mr. Shadegg. Thank you, Mr. Chairman.
    I simply want to welcome Mr. Phil Smith of Taser 
International, chairman of the board. I apologize. I was across 
the hall in a hearing of the Commerce Committee which happens 
to be dealing with some issues that affect Arizona, Luke Air 
Force Base, the Goldwater Range right now, so I had to be there 
and could not be here during opening statements.
    I welcome Mr. Smith. Taser is located in the metropolitan 
Phoenix area where my congressional district is. I appreciate 
his testimony here today. Mr. Chairman, as you know as a member 
of the Congress who is deeply concerned about the FASB proposal 
and believes the better alternative is in fact the legislation 
you have introduced, I appreciate Mr. Smith's comments on that 
point, and I simply wanted to be able to welcome him to the 
committee as a fellow Arizonan.
    Thank you, Mr. Chairman. I yield back.
    Chairman Baker. Thank you, Mr. Shadegg.
    Professor Kruse, I am interested based on your study of 
industry practice that is evident in the book. In identifying 
the problem that started the current academic discussion, was 
there evidence in your view of broad-based plans being 
manipulated adverse to either the corporate or public interest?
    Mr. Kruse. With respect to broad-based plans, no. We came 
to this interest in broad-based plans out of a couple of 
decades of research we have done on broad-based employee 
ownership, profit sharing, programs that involved employees in 
company performance. That is where we came at it from.
    When we looked into broad-based plans, doing very extensive 
research on this, both quantitative and qualitative research, 
we did not find the broad-based plans being manipulated in the 
way that a lot of the executive plans obviously have been.
    Chairman Baker. Is it not true that with regard to SEC rule 
treatment of the top five proxy requirements for disclosure and 
disclosure of compensation, that there is now precedent for the 
top five being treated differently today from others within a 
corporate reporting structure?
    Mr. Kruse. Yes, that is true.
    Chairman Baker. So I can make the legitimate claim that the 
selection of the top five is consistent with other body of law 
and regulation by way of special disclosure for those set of 
individuals?
    Mr. Kruse. I believe so.
    Chairman Baker. Thank you.
    Mr. Grady, you made comment with regard to the difficulty 
of predicting accurately volatility in a startup company. Is it 
not the case that FASB now and has historically allowed 
privately held corporations to set volatility at zero?
    Mr. Grady. Yes. The current rule allows minimum value to be 
the methodology used in calculating the value of an option, but 
the proposed rule disallows the use of that going forward. It 
actually complicates matters by allowing three different ways 
for options to be valued. It says for the old options, you can 
use minimum value, but going forward you have to switch to 
using one of the models I suggested, one of the lattice or 
binomial models.
    Chairman Baker. Let me help make that point. Where you have 
a historic record and could possibly predict volatility, you do 
not have to; and going forward on startups that you can't, you 
are going to be required to.
    Mr. Grady. Right. Well, for all options going forward under 
the proposal. Yes.
    Chairman Baker. Mr. Smith, you discussed the fact that in 
your corporation you have now given notice to employees going 
forward that this year's grant of options is it. It has also 
been stated by others on the panel and from other reports that 
foreign competitors now put banners up at job fairs, ``options 
granted.'' What is the potential impact from your perspective 
on future startups on innovation if we, within the United 
States, preclude granting of options without expensing, and our 
competitive industries in international markets are allowed to 
proceed as they have historically, given the allegations of job 
economic recovery and all the concerns about outsourcing.
    Mr. Smith. In our company today it is not as important as 
it was. We are now a pretty visible company and we have a lot 
of cash. But when we started the company, over the 11 years it 
took to get there, it was extremely important. We were hiring 
people at below-market wages, no question about it. Our average 
people make $40,000 a year, by the way, that have the stock 
options that I referenced in my written statement. So it is not 
the high-paid people.
    We have a lot of people who come into the company and take 
those jobs. Think about it. A person is sitting in a large 
corporation with a 401(k), a pension plan, great health 
benefits, and you are going to give him a chance to come into a 
less-than-ideal working environment, nothing is fancy in a 
small startup company. It is pretty rough-going. You ask him to 
work 12 or 14 hours a day, and they don't generally have very 
good health benefits and certainly do not have 401(k) or 
pension plans. What is the incentive for a person to do that? 
And you are going to pay him less money?
    I remember when I left Boston, I was working for 
Computervision. It was a Fortune 500 company at the time. We 
were standing in a 9,000 square-foot house, and my wife says: 
let me understand this; you are taking a cut in pay to 40 
percent of what you are making now; you have options in a 
company which is out of money, it was a venture startup; and I 
am going to have a house that is about as big as the garage on 
this house. Why am I not excited about moving to the Silicon 
Valley?
    That is the issue. You have to have some compensation for 
these people to take that risk and make those moves. I have 
done it multiple times in my life. I have been broke more times 
than I have made money by doing that, but that is the whole 
part of an entrepreneur. Getting these people to take that 
risk, you have to offer them something.
    One thing I would like to point out. I do not know why we 
are in such a rush to be like everybody else. The last thing I 
want to be is like everybody else. Everybody else in the world 
did not create the growth engine and jobs that we did in the 
Silicon Valley, right out to the beltway here with AOL and MCI 
and many great companies got started. These options were an 
instrumental part of it.
    I do not know why we are in such a heck of a hurry to go 
out there and dismantle the machine that has worked and served 
us so well in the past, especially now when we need to develop 
the next new thing to put people back to work in this country. 
I would not be tampering with anything in this area for the 
next couple of years until we find what the next new thing is 
and get these people back to work.
    A long-winded answer.
    Chairman Baker. I thank you for the answer. It is sort of 
like the fire department showing up when the house is on fire 
and simply burning the rest of the neighborhood. It just does 
not seem to be a responsive solution to the problem at hand.
    Mr. Frank?
    Mr. Frank. Thank you, Mr. Chairman.
    I would just say to the previous witness that I do not know 
when you sold that house, but given what has been happening to 
house prices in Massachusetts, a 9,000-square-foot house, you 
would have to have some pretty good options to beat what you 
could have made on that if you had held it.
    I want to just expand on what I said before. Let me talk to 
the people who are in the industry, who have told me, and I 
take this with great seriousness, that if the expensing 
requirement goes through they will stop giving options. I guess 
we ought to be very specific why. Obviously, the reality will 
not have changed. Why will you have to stop giving options? Is 
it the reaction of the investor community, the lender 
community? What will require you to stop granting these if the 
reality has not changed, but the way in which you are to 
account for them does?
    Mr. Smith. Is that question for me, sir?
    Mr. Frank. Any of you.
    Mr. Smith. I will take a shot at it. We stopped it because 
we do not want to impact our operating performance next year 
for our shareholders because of these options being expensed.
    Mr. Frank. Excuse me. The question is this, it is not the 
reality. So the shareholders, what will cause the share price 
to drop? Is it the reaction of an investor community that says, 
hey, they moved this from the footnote to the bottom line. That 
is my frustration.
    Mr. Smith. Let me explain it to you. I think you were out 
of the room. A lot of our shareholders are policemen. They are 
cops. They own 100 to 200 shares of our stock. When they look 
at the income statement, they have no idea what footnotes are 
or anything else. All of a sudden they are going to see this 
dramatic change next year. I would say a good 40 percent----
    Mr. Frank. There are two problems with that. I would hope 
we could try to just educate the community. Cops have to be 
fairly sophisticated about something. The other thing is, 
unfortunately your arguments cuts a little bit both ways 
because one of the arguments people have now is, well, that 
information about the options is already there. It is in the 
footnote. When you argue that while it is in the footnote, they 
will not read it, you are unfortunately frankly giving support 
to some who say people do not know it is there. It cannot be 
both. It can't be available and impervious.
    Mr. Smith. I am going to make one comment and pass it off 
to some of my colleagues. If it ain't broke, don't fix it.
    Mr. Frank. I am sorry. That is not good enough for me. We 
are here in a deliberative process and I am trying to express 
the sympathy I feel. But sloganeering like that does not help 
me. I am not a car. Don't put a bumper sticker on me. I am 
asking you a question and I want an answer. There is a problem 
here. It may lead us to a broader problem. Your argument 
appears to be that the investor community on which you have to 
depend, in particular an investor community because of the 
nature of your product that is not the broader one, does not 
understand this. We need to have more than just a bumper 
sticker.
    Mr. Grady?
    Mr. Grady. Congressman Frank, I think it does beyond that. 
What clearly will happen if you move it into the income 
statement, it will reduce, of course, the reported 
profitability of the company, even though the operating 
circumstances of that company will not have changed, the cash 
will not have changed, the cash expenses will not have changed.
    Mr. Frank. No reality will have changed.
    Mr. Grady. But it will radically reduce----
    Mr. Frank. Okay. Who will be influenced by that?
    Mr. Grady. I think investors will be influenced by that.
    Mr. Frank. Okay.
    Mr. Grady. As we have discussed during the hearing, the 
method by which people will calculate how much that expense 
will be will be highly variable from company to company. It 
will make, in effect, the reported P/E ratios of all companies, 
which is how the comparing is done, less comparable.
    I will give you a real world example. The way people 
calculate earnings will be just considerably more different 
from company to company because there are all these 
methodological issues.
    Mr. Frank. But can't you say, then, look, this is the way 
it used to be, and this is the reason for that volatility. It 
is there now, the reality is there now. Options are clearly not 
a nothing. They have some impact.
    Mr. Grady. The reality is there now and most investors, to 
your point, are sophisticated enough to look at the fully 
diluted share price and calculate their EPS.
    Mr. Frank. Are they able to make comparisons?
    Mr. Grady. The sophisticated investor will strip out the 
option expense and compare cash EPS, which means they will 
render GAAP irrelevant.
    Mr. Frank. Are you saying a sophisticated investor would 
disregard the existence of options in deciding whether or not 
to, you say, strip out. Please let me finish the question, Mr. 
Grady.
    You are telling me that the sophisticated investor would 
simply ignore the existence of the options? I assume that is 
what ``strip out'' means.
    Mr. Grady. They would ignore it for purposes of comparing.
    Mr. Frank. Mr. Grady, please stop, because I think you are 
obfuscating, unintentionally.
    Mr. Grady. No, I am not.
    Mr. Frank. Then I may be, but here is the deal. I am an 
investor and I am trying to make a decision. When I make a 
decision based on, I do not invest in any real companies 
because we get enough people claiming we are guilty of conflict 
of interest, so fortunately I am free of that, but I am an 
investor and I am looking, you say, well, after the FASB thing, 
it will be hard to make comparisons. But how do I make the 
comparison now?
    Presumably, if I am a sophisticated investor and I am 
trying to decide between one or another company and one has a 
certain amount of options and one does not, and another has 
options. How do I value those now? Or do I not take those into 
account in deciding when to invest?
    Mr. Grady. You do take them into account, as I said, in 
determining the share count for the company in the denominator 
of the earnings-per-share calculation. I believe that people 
will continue to do that.
    Mr. Frank. But is that easier to do now than it would be 
later? Why? Why is it easier to make those comparisons now than 
it would be if the accounting treatment differed?
    Mr. Grady. The ability to calculate the number of shares 
will be the same as it is now. What will be different will be 
the quality of the earnings being reported.
    Mr. Frank. I understand that. But you understand that those 
are just affected by the accounting. The reality has not 
changed, has it?
    Mr. Grady. The reality is being proposed to be changed, and 
that is that people have to take into----
    Mr. Frank. They do not have to. Investors are free to make 
his or her own decisions. The company is still there and those 
things are still there and the investor can still make the 
decisions based on----
    Mr. Grady. Here is what will change, I believe, in reality. 
The most common means by which investors compare stocks is 
price/earnings ratio. You will now have a wildly different set 
of assumptions that go into the ``E'' in a PE ratio.
    Mr. Frank. Okay. My last question is this, because here is 
what we are saying is that frankly the people who are getting 
more beat up here are the investors who do not come out of this 
looking all that smart.
    Mr. Grady. But I think----
    Mr. Frank. Excuse me, Mr. Grady, please stop interrupting. 
This is just not helpful. The point is this, what you are 
telling me is that if FASB's rule goes through, even though the 
reality of the company will not have been changed if they 
continue to give options, investors will look only at the P/E 
and will make bad decisions. They will make decisions on 
inadequate information. Inevitably, this has got to be 
something of a negative judgment on the investor community 
because you are saying if you do this, they will just look at 
the P/E and that will make this enormous difference to them, 
when in fact you were telling me it really should not, given 
that this is a perfectly reasonable thing to continue to do.
    Mr. Grady. May I make one comment?
    Mr. Frank. Sure.
    Mr. Grady. I believe that to avoid the confusion, which we 
were both just speaking about, what will happen is people 
creating the companies, people starting the companies, people 
running the companies will say, to avoid the confusion I will 
use more cash to reward employees and less options.
    Mr. Frank. I understand. But the confusion is on the part 
of the investor who is reading the situation.
    Mr. Grady. Which means less companies will be started.
    Mr. Frank. I understand that. The question is why that 
would be the case. It really does come down to apparently a 
lack of confidence that investors will be able to sort this 
out.
    Mr. Grady. Right. I believe this will make reporting more 
confusing, not less confusing.
    Mr. Smith. Let me add one thing. Reporting is one thing. 
Hiring employees is another. If you are out there, Mr. Frank, 
and you are trying to hire employees as a young startup company 
and you are competing against well-established big companies 
that have much better benefits, better pay, et cetera, what the 
heck are you going to offer them?
    Mr. Frank. Excuse me. You totally misunderstand my point. I 
understand that, that options are attractive. What I was trying 
to get at is, what about FASB would lead you to stop issuing 
options? That is the question. So your answer is totally 
irrelevant to what I was asking.
    Mr. Grady. It is the cost, the cost on the bottom line.
    Mr. Frank. I have gone over my time and I do not think this 
is going to be enlightening.
    Chairman Baker. If the gentleman would yield for just a 
minute, I appreciate the gentleman's sincere effort at this. I 
just want to make one small explanation if it might be helpful. 
It does change economic reality in this case. If there is a 
granting of an option at a fixed price, and going forward the 
price does not move in the money and the option is not 
exercised, the FASB requirement would require you to expense 
that in the current dollar disclosure, so you would have a 
negative impact on the corporate profit, which is not an 
accurate disclosure of true financial condition.
    However, going forward if the option is exercised at a 
higher dollar price, I think argument can be made that 
contributions of those individuals who are engaged in the 
corporate structure as a result of the grant of the options, 
have increased value and therefore the dilutive effect on the 
residual shareholders is minimal, if at all. So it is not 100 
percent accurate, but I think the negative effect of expensing 
when they are not exercised is far worse than the residual 
effect of expensing at the time of exercise, which is now 
required.
    Mr. Frank. I thank the Chairman. That is in the spirit of 
what I was saying. Again, it all comes down, unfortunately, to 
the way it is perceived. Let me just say one further thing, Mr. 
Chairman. I just want to now, in the absence of the Ranking 
Member of the subcommittee who had to leave, I just want to 
notify you that we are going to use our Rule 11 rights to ask 
for another day of hearings. A letter with the appropriate 
number of signatures will be delivered to you before the end of 
this hearing so that we can have another hearing.
    Let me just say, this comes from people both for and 
against the bill. This is not a sign that people are against 
the bill. This is just an important subject and we will be 
asking for it. There is no reason that they should hold up any 
schedule of any action, so it is not to be taken as hostile to 
the bill.
    Chairman Baker. The Ranking Member had indicated to me his 
interest in that, and I said I have no such reluctance, but out 
of courtesy to the chairman I have not had a chance to visit 
with him about the schedule.
    Mr. Frank. That is why we thought we would use Rule 11, 
because that is an option to the chairman. He is a busy fellow. 
We do not like to bother him.
    [Laughter.]
    Chairman Baker. We always appreciate your creative 
assistance in the conduct of the committee.
    [Laughter.]
    Mr. Frank. Mr. Chairman, I cannot take credit for creating 
Rule 11. That somewhat pre-dates me.
    Chairman Baker. I recognize that and am thankful for that.
    Chairman Oxley?
    Mr. Oxley. Thank you, Mr. Chairman. I certainly would not 
have any objection to another hearing on this matter. It is 
complicated and difficult, but very, very important in terms of 
our economic future in this country.
    Mr. Grady, good to see you again. Welcome back to Capitol 
Hill.
    Mr. Grady. Thank you, Mr. Chairman. It is good to be here.
    Mr. Oxley. It is good to know that there is life after work 
at the White House.
    [Laughter.]
    You had emphasized in your testimony the issue of 
competition, particularly as the FASB proposal may very well, 
as I understand your testimony, put us at a disadvantage versus 
some of the Asian tigers, for example, that have learned some 
things, apparently, from our system and are quite aggressive in 
that area. I wonder if you would care to comment specifically 
on the competitiveness issue. Mr. Scalise and others that want 
to join in, I would be glad to hear from you as well.
    Mr. Grady. I think you can look in both directions, both to 
the east and toward Europe as well. I was struck by something 
that the Director of CBO said regarding CBO's study and saying 
that they did not see different effects in Europe versus the 
United States, where IASB is now of course proposing expensing 
of stock options.
    What is observable is that I believe the United States has 
outperformed the EU countries quite substantially, and I 
believe one of the principal reasons that has been true is 
because of the availability of risk capital, which has gone 
into startups, and because of the contribution of startups to 
U.S. GDP. What you now see is Europe has lower levels of 
venture capital investment, lower economic growth, and 
considerably higher unemployment. That has been the case for 
some time.
    We did a study at the National Venture Capital Association 
to try to measure the contribution of venture-backed companies, 
mainly startup companies, to the U.S. economy. I refer to it in 
my written testimony, but I think it is important to highlight 
the results to the members. It showed that venture-backed 
companies in the year 2000 employed directly 12 million 
Americans and directly and indirectly, as Chairman Baker said 
earlier, 27 million Americans. Some of the other findings were 
that these companies accounted for $1.1 trillion in sales or 11 
percent of U.S. GDP on far less than 1 percent of the invested 
capital in the country for the entire 30-year period measured.
    So the job-creating leverage of these startup companies has 
been very high. The principal tool that they have used, as 
everyone on the panel has noted, has been to on the one hand 
pay people less cash, but by allowing them to trade-off units 
of ownership for cash compensation. That has been the model 
that has worked. People have wanted a piece of the rock. I do 
believe, as a number of witnesses and Mr. Smith have said, 
Taser is witnessing it and other companies are witnessing it on 
the competitive front, that people in both companies in Taiwan 
and China and elsewhere are advertising their willingness to 
give ownership to employees as a way of inducing them to come 
to work there.
    Mr. Oxley. So really one of the concerns, the latest buzz 
word around here, is outsourcing, and we are hearing all about 
that. In fact, this issue certainly cuts into that entire 
issue, does it not?
    Mr. Grady. I believe it does, because it will also raise 
the cost of creating the jobs here in the United States, as I 
was attempting to comment to Mr. Frank. I believe what will 
happen is that at the margin, startup companies will be 
required to raise more cash with which to compensate employees, 
which just means there will be less startups funded because 
there is only in effect so much cash to go around. So I think 
this would be adverse to the job creation prospects of the 
economy going forward.
    Mr. Oxley. Thank you.
    Mr. Smith, why are so many CEOs opposed to expensing? Is it 
because it would lower the value of the options? From a CEO's 
standpoint, what is the major issue that you have with the 
proposal?
    Mr. Smith. I think Mr. Grady covered it pretty well. It is 
the valuation of the company. People look at price/earnings to 
justify purchasing or not purchasing a stock, the availability 
of capital in the equity markets. One of the things I pointed 
out before you came into the room, and that is we were able to 
attract some pretty significant board members on our company by 
using options. Without those, I frankly do not know how we 
would have gotten those people to come on and help us with the 
corporate governance we are now facing.
    That is a real issue for small companies. You do not have a 
lot of cash. You have a lot of risk to offer people that come 
on the board. The trial lawyers love small public companies 
because their stock is pretty volatile and they generally get 
into a lot of stockholder lawsuits in which directors do not 
want to be involved. So I frankly am at a loss. This is going 
to be my last startup. I would be concerned about how you are 
going to get the right types of individuals to sit on these 
boards if you take away some of these incentives.
    We just stopped giving them. We have already told our 
employees no more options. They all vest by the end of this 
year. That is it. If this legislation passes, the only people 
that are going to get them are going to be the four or five 
senior people at the top. I do not know what we are going to do 
in the future going forward.
    Mr. Oxley. That is interesting. It hearkens back to our 
hearings we had on securities litigation reform, which I think 
really did enhance our knowledge about what was going on out 
there. One area that has not been well discussed, and I am glad 
you brought it out, was the large potential for litigation in 
these areas, to the point where some of these trial lawyers 
were having computers that essentially spit out complaints 
based on a loss of value in the market. Quite extraordinary, 
and that ultimately led, as you know, to passage of that 
legislation, and I think I am right, the only veto President 
Clinton had overridden, with a strong bipartisan effort on both 
the House and the Senate.
    So I think you have touched upon another interesting issue 
that is certainly important in this debate, that I had not 
considered until recently. I appreciate your testimony.
    I yield back.
    Chairman Baker. I thank the Chairman.
    Mr. Scott?
    Mr. Scott. Thank you very much, Mr. Chairman.
    It is the general feeling on this committee that you 
support H.R. 3574, the basically immediate expensing of the top 
five executives's stock options. Correct? And that the concern 
is that it goes no further, that there be no expensing of 
options for rank-and-file employees. In this legislation, it 
does not exactly, it is my understanding and I am a co-sponsor 
of it, but what we are saying is that no further expensing of 
these stock options until a couple of things take place; that 
there be an economic cost-benefit analysis study of different 
elements; and that the accountants come up with a more accurate 
way of measuring cost.
    What say you about that? Is that enough to register safety 
on any concerns that we go beyond? I am not sure what I am 
hearing here, and especially from you, Mr. Smith. Did that 
satisfy you?
    Mr. Smith. Let me just say one thing. My mother had some 
ugly kids, but no dumb ones. What I have worked out is that we 
are not going to get this thing through. I think expensing any 
options is a bad idea, but I am practical enough to understand 
to get some change, to hold off this gigantic force to get 
options expensed, we are willing to concede to the five top 
people.
    I think we do need a study because I think there are some 
real impacts people have not thought about, not only the 
lawsuits that are going to erupt, the cash that young companies 
are using from these employee options. The way it works is if 
an employee exercises their option, they pay the government 
taxes, but the company gets a credit for that. It keeps our 
cash and allows us to hire more people. I do not know whether 
anybody has even looked at that aspect of this thing.
    There is an enormous tax base sitting out there of cash 
being used by young startup companies to fund their operations. 
If you take that availability of cash away and they now have to 
pay taxes to the federal government, you are going to start 
impacting these small companies's growth. So from those 
aspects, I would like to see nothing expensed, but being a 
practical person, as I said, my mother did not have any dumb 
kids, we are deciding this is the best option we can see to go 
forward. We think those economic studies will prove that out in 
the future.
    I will yield to my other colleagues.
    Mr. Scott. Professor Kruse, what percentage of companies 
that offer stock options offer them to a broad spectrum of 
their employees?
    Mr. Kruse. I do not have a ready answer to that off the top 
of my head what percent do. We have found that at least in a 
related survey of companies, we did find that about 3 percent 
of companies gave broad grants to employees, to more than 50 
percent of their employees in the past year. But the number 
that may have done that in the years prior to that, we do not 
know. Still, 3 percent of companies gave grants in the past 
year and that is consistent with a BLS study as well.
    Mr. Scott. And you believe the FASB rule would act as a 
deterrent to incentives for the rank-and-file employees?
    Mr. Kruse. Based on what companies are saying, that this is 
going to be something that causes them great concern, that they 
are likely to cut back on the broad-based plans and encourage 
concentration of executive options.
    Mr. Scott. Mr. Scalise, you mentioned that stock options 
are granted to around 90 percent of high-tech employees. What 
posture would we be in with this rule in terms of the 
semiconductor industry especially, and its ability to compete 
with foreign companies?
    Mr. Scalise. I think it would have a major impact on our 
ability to compete. Again, getting back to your prior question, 
100 percent of our companies grant stock options. As you 
pointed out, roughly 95 percent of those go to a broad base of 
employees outside of the executive ranks.
    I recently completed a study for the President's Council of 
Advisors on Science and Technology dealing with manufacturing 
and innovation. This is one of the issues that we dealt with. I 
think what we have to recognize today is that we are truly in a 
new competitive environment out there, not only in 
manufacturing, but for people. I just gave you one data point 
there saying that roughly 5,000 of our good engineers, these 
are not just the rookies, these are the good well-trained 
engineers that have been in the business for a number of years, 
have now gone back to Taiwan. A number of them are going to 
China now.
    So we are going to be greatly impacted if they can offer 
the stock option with the tax treatment they have, which is no 
taxable event; versus ours which is a highly taxed event as it 
currently stands. Then you have the other part of the problem 
which is dealing with the expensing issue, which makes for the 
volatility within the company, which the companies have to 
dampen if they are going to avoid some of the litigation that 
has been talked about here.
    So it is a very complex set of issues that come together 
here. Suffice it to say that for the two reasons, the expensing 
and the volatility as associated with that, and the tax 
treatment we have versus the tax treatment of our competitors 
overseas, these are both working against us as far as 
maintaining our technology leadership going forward.
    Mr. Scott. Thank you very much.
    Chairman Baker. Thank you, Mr. Scott.
    Mr. Royce?
    Mr. Royce. Thank you, Mr. Chairman.
    I would like to begin by building on your last point, and 
maybe ask Dr. Smith, if we look at these proposed rules and 
let's say we take a hypothetical, and we have a company that 
has to expense $100 million of option grants. So the accounting 
rules would have that firm debit expense and credit paid-in 
capital. So now we look forward 1 year, 2 years, 3 years into 
the future, and let's say none of the options have been 
exercised because the firm's stock has declined in value during 
that time period.
    So now what do we have? I would say we have a balance sheet 
that borders on being fraudulent at this point, and investors 
would be getting a false sense of the company's true financial 
picture at that moment. At the same time, we have passed 
Sarbanes-Oxley. Under Sarbanes-Oxley, we have dictated that you 
signed under perjury that the financials reflect the true 
operating income and expense and the correct balance sheet 
position of the company.
    The question that I have, Dr. Smith, is, given our 
hypothetical, because you have now expensed that $100 million 
in option grants several years prior, are you now in violation 
of Sarbanes-Oxley? And more importantly, could some trial 
lawyers believe you are in violation of Sarbanes-Oxley?
    Mr. Smith. Let me just say one thing. The only employment 
this is going to impact is the trial lawyers are going to make 
more money and hire more trial lawyers. It is hard for me to 
guess, but you can bet they will sue. If you look at most of 
the cases out there, they never go to court. These lawyers are 
into the idea of settling with these companies and insurance 
companies outside of court.
    So the answer is, anything like this that opens a door, 
they will definitely come in.
    Mr. Royce. More slap suits?
    Mr. Smith. Absolutely. We may have been delivered a lawsuit 
today. Our stock dropped 32 percent yesterday and that 
generally brings them right out of the woodwork. That is the 
one company fear of most of us here, so this is just one more 
thing we have to deal with.
    Mr. Royce. I will also ask you, we heard from the CBO 
director. Director Holtz-Eakin argued that expensing will help 
the economy because resources will be allocated more 
efficiently. Do you agree with that argument?
    Mr. Smith. Absolutely not. It is the big companies that 
benefit from this. These are not the people who employ and 
create the new jobs. They employ lots of people, but they are 
not the growth gazelles that really provide a lot of 
employment. Those are coming from young startup companies like 
us. The big companies will benefit because they have no 
volatility in their stock. They give very few options out to 
people. The penalties will go to the people like us who are 
creating the jobs, who are small and have the very volatile 
stock. So I absolutely take issue with that, and I do not know 
anybody at the CBO that ever started a company or ever gave out 
a stock option or ever received a stock option.
    Mr. Royce. I am going to ask Mr. Grady to respond to that 
question as well. The other suggestion that was made by the CBO 
director was that the venture capital community will fill the 
void. I would just like to ask Mr. Grady, it seemed earlier 
that you disagreed with that argument. I would like to hear 
your reasons.
    Mr. Grady. I do disagree because what will happen is the 
venture capital community will have to use more cash to 
compensate employees, which means we will create fewer 
companies with fewer employees, by definition.
    On the first question of the efficient allocation of 
capital, I believe it will not increase the efficiency because 
it will create some of the anomalies that you have suggested. 
Your first question was not merely hypothetical. For example, 
Intel Corporation, and maybe Mr. Scalise wants to comment on 
this, I believe reported that they would have taken charges if 
expensing were a requirement, into the several billions of 
dollars, more than $2.5 billion, for options granted in 2001 
and 2002 or 2003 that expired without being exercised; that 
were never in the money and that therefore basically never 
existed. Under this proposal, the accounting for those options 
that never existed, those shares that never existed, would be 
identical to the case in which Intel had spent $2.5 billion or 
$3 billion of cash. Clearly, that is not an optimal or even 
accurate result.
    As I said in my earlier statement, that is the problem with 
being required to value the options on grant date. You could 
switch it and say, gee, we will value them on exercise date or 
you could use this intrinsic value method that I mentioned. 
That creates its own anomalies, because if you use the 
intrinsic value and say a stock comes public at $20 and the 
stock trades down, but you recorded a value the day the company 
came public at $20 and the options had a certain assessed 
value.
    If the stock went down, you would actually decrease the 
value of those options. So what you would be saying is, because 
the stock went down you are judging that company now to be more 
profitable.
    Mr. Royce. We have an opportunity for a real-world response 
if we could go to Mr. Scalise and just let him respond in terms 
of the actual difficulty we would be putting a firm like Intel 
into.
    Mr. Scalise. I think it would be significantly more 
difficult. Your mention of the Sarbanes-Oxley Act is really 
critical here, because these two do come together. When you 
look at the lack of transparency, the lack of comparability, 
and then the volatility that results from that, and then the 
requirement to attest to all of these documents when in fact 
you will create expenses on issues that never really occurred 
in the final analysis, as just pointed out by Mr. Grady here, 
it is very complicated and it is very interrelated.
    It is going to create a lot of hesitation with regard to 
putting out more stock options because they are not going to do 
it. They are not going to want to increase the volatility and 
increase the risk of more and more litigation, because as we 
all know we have folks just sitting out there waiting to drop 
that next lawsuit.
    Mr. Royce. Thank you, Mr. Chairman.
    Chairman Baker. I thank the gentleman.
    Mr. Sherman?
    Mr. Sherman. Yes, as I count, we have six panelists who are 
in favor of the bill. My guess is that that is reflected up 
here as well.
    We can compete with China to have the loosest accounting 
standards so our companies can report the highest income, no 
matter how much money they spend on this or that, report a lot 
of income. Or we can compete with Europe to have the tough and 
reasonable accounting standards uninfluenced by what would be 
viewed at least by the public in a highly publicized first-ever 
intervention to provide looser accounting standards to 
encourage what is viewed as executive compensation. I think we 
need to compete with Europe for capital by showing that we have 
the best accounting standards.
    What flabbergasts me is that this bill, if I hear Mr. Grady 
and others correctly, would have the effect of helping high-
tech companies like the ones based in my state compete for 
capital against these lower-tech companies that are most 
associated with some of the other regions of the country. I 
have folks from other regions of the country supporting the 
bill and trying to help high-tech companies in my state get 
capital. I thank them.
    Mr. Smith points to this big practical problem. He could 
not afford to adequately compensate board members. The company 
could not afford to do that without the stock options. You 
know, now and then I hear from one of my constituents that 
board members are not being adequately compensated, or the 
company cannot afford to compensate board members. But I hear 
more often that the company cannot afford to provide health 
care.
    So if we want for the first time ever to tell the FASB to 
do something because we want to encourage companies to do 
something, why don't we tell them that what you pay for health 
insurance should never be listed as an expense? Or at least 
provide them with an avenue, if you give a 30-year promissory 
note to the health insurance company, you do not have to list 
it as an expense. Give stock options to a health insurance 
company; provide coverage for your employees, you do not have 
to list it as an expense.
    Why have we decided that the first time Congress will 
demand a departure from regular accounting is to encourage 
companies to do something we think is vital. Stock options, not 
health care.
    Mr. Hassett points out that it would invite lawsuits if we 
tell companies they have to expense stock options, but we do 
not tell them how. And Mr. Grady echoes this. I could not agree 
with you more. But Mr. Hassett, how is it that we have not had 
a lot of lawsuits already because we have a requirement that 
this information be disclosed in footnotes and we have no real 
standards to tell companies how to put it in the footnotes. 
Don't trial lawyers read footnotes? I know they are real small, 
but you can blow them up and show them to a jury.
    Mr. Hassett. Here is the state of affairs that concerns us. 
When we put the account for options into earnings, we say, 
well, it used to be we thought we were making $8 this year, but 
now we are going to put in the expense for options and it is 
$7. And then we run for a few years, say, at $7 as earnings 
every year. And then at the end of that period, people vest and 
realize, and it turns out that when we said that our earnings 
were $7, which will be true for probably half the companies, we 
were incorrect because it was a prospective figure.
    Mr. Sherman. I understand the incorrectness.
    Mr. Hassett. The point is that it is in the earnings 
statement.
    Mr. Sherman. So you are saying that you cannot go to a jury 
and say, I am an investor; I thought that their adjusted 
earnings adjusted for the expense of compensating people with 
options was such and so, as disclosed in their footnote, and it 
turned out to be such and so. I think we have some lazy trial 
lawyers out there that are not taking advantage of the 
vaguenesses of our current accounting standards.
    Mr. Hassett. May I respond, Mr. Sherman?
    Mr. Sherman. Yes.
    Mr. Hassett. Thank you. I think that the current state of 
the accounting rule suggests that we are not so sure precisely 
whether it is $5 or $4 or $3 and that we are leaving it in the 
footnotes. For the shrewd investor, it is his or her job to 
figure out what he thinks they are worth when he is deciding 
whether or not to buy the stock. I think that is the 
appropriate state of affairs. I think when we put it in the 
earnings statement, we are giving people the false impression 
that we know exactly the value.
    Mr. Sherman. You are making a policy argument. I was just 
wondering why creative trial lawyers are not making the 
counter-argument.
    Mr. Hassett. I think because the ambiguity is there.
    Mr. Sherman. Let me go on. This bill is being put forward 
as protection for broadly based stock options. You can put a 
lot of lipstick on a pig. Zero volatility for the options given 
to the richest executives in America, and you put that in a 
bill and you say you are trying to help secretaries? The number 
six guy at GM; the number six guy at Intel are somehow 
struggling manufacturing workers?
    If the bill was well crafted to achieve its alleged 
purpose, it would deserve a lot more support than a bill, a 
huge portion of the benefit of which is going to go to the 
number six guy at General Motors and the number one guy at 
Intel whose options will be valued at zero volatility.
    We have heard discussions of employee stock ownership 
plans, ESOPs, none of which are affected by the FASB 
pronouncement that we are here to discuss. In fact, those plans 
are going forward. They are big in our economy and they do not 
get any favored accounting treatment, nor is anybody arguing 
that they should get a favored accounting treatment.
    Mr. Kruse tells us that 79 percent of those who hold 
options make under $75,000. Let's say in your survey there was 
a company, because I have seen a company like this, 100,000 
options held by each of the top two guys. Another 100 
employees, all with incomes under $75,000, each get about 50 or 
100 options. If you were surveying that company, wouldn't you 
conclude that 98 percent of the option holders are people who 
make under $75,000, if that was your whole population of the 
survey?
    Mr. Kruse. That is absolutely true.
    Mr. Sherman. So what we do know is that there are a lot of 
working-class folks and middle-class folks who have stock 
options, but there may not be a lot of options in the hands of 
working-class folks.
    Mr. Smith. Let me answer that one because I have a 
practical application.
    Mr. Sherman. Your company is great.
    Mr. Smith. Forty-five percent is going to the top; 55 
percent goes to the working people below that.
    Mr. Sherman. Your company is great, but that does not tell 
us about the economy overall. If you were running all these 
companies, things might be different.
    Mr. Smith. GM does not tell us about the economy overall 
either. It is the small companies that are providing the jobs. 
The guys you are going to penalize are the job-creators. That 
is the reason we are here today.
    Mr. Sherman. Mr. Smith, I just want to comment. Not every 
small company is giving stock options. Your beauty shop, no 
stock options. Your local dry cleaner, no stock options. Lots 
of small companies. Your machine shop, very rarely do they give 
stock options.
    So to take the idea that all the jobs created by small 
business are driven by stock options, they are driven by other 
things.
    Mr. Smith. How about a few facts here? The facts are the 
job gazelles, the small growth companies that are providing the 
jobs are not the hairdressers and not the ones you mentioned. 
They are companies just like us. Those other people that are 
giving the jobs in this economy----
    Mr. Sherman. Mr. Smith, it is my time. I did not even ask 
you a question. Your gazelle-like feistiness is appreciated. 
But the fact is that is we as a Congress decide to contort the 
accounting rules for the purpose of pulling capital out of the 
old economy and putting it into the kinds of companies that Mr. 
Smith thinks should get the capital, that is a whole new 
economic planning role for this Congress. I do not know whether 
it is better to see stock purchased in Proctor and Gamble or in 
Mr. Smith's company. I know he thinks that his company is the 
best way for our society to allocate its capital.
    I yield back.
    Chairman Baker. Thank you, Mr. Sherman. I let you go on 
well beyond time in recognition of your position on the issue, 
but for members's purposes, I am going to try to recognize as 
many as we can before adjourning. We have a set of five 
recorded votes which would disrupt the committee process 
significantly.
    So Mr. Shadegg, if you have a comment?
    Mr. Shadegg. Thank you, Mr. Chairman. Let me begin with one 
question.
    As I understand the FASB proposal, they do not say how to 
do this. They say you simply have to do it. So let me begin, 
since we can obviously make it clear as the questioning has 
just suggested, I will ask each of you quickly, and I would 
like you each to answer, is there a single agreed-upon method 
by which this ought to be done that will make the reporting of 
all companies parallel or comparable for stock evaluators? Just 
yes or no.
    Mr. Scalise. No.
    Mr. Grady. No, there is not, and especially not for private 
companies.
    Mr. Smith. No.
    Mr. Hassett. No.
    Mr. Holtz-Eakin. No.
    Mr. Thomas. No.
    Mr. Kruse. No.
    Mr. Shadegg. I think that kind of sums up my deep concern. 
Mr. Grady, my friend Mr. Frank on the other side I do not think 
ever let you get across that point. I am going to tell you what 
I think your point was, and then you tell me if I am right. I 
think your point was, look, yes there are footnotes now; yes, 
people can evaluate this information; yes, sophisticated 
investors can look at it. But if you compel it to be a much 
more prominent factor in the reporting of the company's 
performance and in this calculation of P and E, given that 
nobody has agreed upon the right way to do it, then we are 
going to have inconsistent results and it could lead to much 
greater abuse of investors than what we currently have. Is that 
the essence of your position?
    Mr. Grady. I would agree exactly with that statement.
    Mr. Shadegg. I just think this is a huge deal. We just 
heard a comment about how we could create the loosest 
accounting system in the world. I would suggest quite frankly I 
think FASB is proposing that we make the accounting system 
looser than it is right now. I understand IASB has said we are 
going to do this in Europe. It seems to me, first of all, I am 
aware that in some countries in Europe right now they require 
stock expensing and in those countries there are essentially no 
options or option expensing, and essentially there are no 
options.
    It seems to me perhaps what we ought to do this time, if 
IASB has decided this is a great idea, why don't we let Europe 
go first and watch them and see if in fact it does not damage 
them. My concern, given a world market, is that if we do it and 
some others do not do it, we could be putting ourselves at a 
dramatic competitive disadvantage which I would rather not do 
at this particular point in time.
    Mr. Holtz-Eakin, I know that you did the study and the 
analysis that looked at how stock options would affect both 
stock prices and the company's access to capital. Is that 
right?
    Mr. Holtz-Eakin. We did a study on the accounting of 
employee stock options.
    Mr. Shadegg. Right. Here is the question I want to know. 
How did you go about evaluating the question I have raised, 
which is, how many companies would continue to offer stock 
options and to what extent does your report give us the answer 
to that question?
    Mr. Holtz-Eakin. The report actually does not address the 
individual decision by firms to offer options versus other 
forms of compensation.
    Mr. Shadegg. So it does not look at the issue of whether--
--
    Mr. Holtz-Eakin. It looks at the accounting of those two 
activities.
    Mr. Shadegg. So it kind of assumes a static situation and 
says, if these companies are offering stock options now, this 
is how they are performing and they are not expensing them. If 
they continue to offer them, here is what would happen under 
that static kind of analysis. It was not looking at the 
question of whether or not they would be disincented from 
continuing to offer stock options.
    Mr. Holtz-Eakin. I think a fairer way to say it would be 
that it looks at the relative treatment of stock options as 
employee compensation versus other forms of compensation. It 
puts them on a level playing field and examines the accounting 
treatment in that setting.
    Mr. Shadegg. Given the great concern expressed by Mr. Smith 
and others that the net effect of this rule is going to be to 
disincent companies from offering stock options, and indeed 
from my perspective since I like startup companies and I like 
innovation and I like new people coming into the market and I 
think that is where America leads the world, wouldn't you agree 
that that is an issue we should look at before adopting a 
change in policy?
    Mr. Holtz-Eakin. I think it has been a bit frustrating to 
hear the way the issue has been characterized today because the 
key issue here is to remember that the income statement is 
designed to display in a fair fashion the net income, the 
matching of costs and the revenues generated by a firm for 
purposes of financial disclosure. It is clearly the case that 
stock options could still be a part of that employee 
compensation.
    Mr. Shadegg. Let me go back to Mr. Frank's style. You are 
not answering my question. My question was as a policymaker, 
not can they do it differently, my question was shouldn't we 
look at the effect of the policy not just on what will it do to 
stock prices, but rather on the incentives it would create to 
continue or discontinue engaging in the process of offering 
options?
    Mr. Holtz-Eakin. It depends on the question you want 
answered. If the question is, what will produce broad economic 
performance in the United States, I do not think that is the 
central question. If the question is, how many stock options 
will be granted in the United States, it is a very central 
question.
    Mr. Shadegg. Since I think how many are issued affects our 
economy and at the end of the day everything I look at I have 
to put at least through that filter, it seems to me to be of 
grave concern.
    Mr. Chairman, I know you want to get to a number of other 
witnesses. I strongly feel that with the concerns that have 
been expressed here by all of the witnesses, before we leap off 
into this abyss, we need to look at it more carefully. It is 
odd to me. It seems to me strange that the IRS would put out a 
regulation that says we want every taxpayer to report X, but 
quite frankly we do not know how you are going to value X. I 
have trouble with a policy that says we are going to solve this 
problem; we are going to tell you to address this issue, but we 
are not going to give you a uniform method for calculating it, 
and we think we are bringing more certainty to the market. That 
is just a grave concern on my part.
    I yield back the remainder of my time.
    Chairman Baker. Mr. Miller?
    Mr. Miller of North Carolina. Thank you, Mr. Chairman.
    Mr. Smith, I know that you expressed at the beginning a 
frustration that no one who seems to be involved in this debate 
on our side knows anything about stock options. I admit that I 
never have had one, but my brother works for a bank. He has 
described to me what he does. At the end of it, I knew he 
worked for a bank.
    [Laughter.]
    He has some fairly impressive titles, but I also know that 
banks pass out titles instead of compensation. I hope we never 
have to value that.
    [Laughter.]
    I am trying to figure out how this works and whether it 
really is going to provide any kind of useful information to 
middle-class investors. Let me try to get a feeling for how 
this works. My understanding is a mid-level employee may be 
given 3,000 options. The market price of the company now is 
$55, and one-third or 1,000 are exercisable in a year, say, at 
$60; the next one-third a year later at $65; the next year, the 
last 1,000 at $70. They expire if not exercised within 5 years 
of when they vest and they cannot be transferred and they are 
forfeited if they are not exercised at the time the employee 
leaves the company. Is that generally the way it works? Kind 
of, Mr. Grady?
    Mr. Grady. That is generally the way it works. The only 
slight correction I might make is that typically the strike 
price on those options would be the $55 at which they were 
granted. They probably might choose to exercise them if the 
stock went up to $60 or $70 a year later; and if the stock went 
down to $40, they would not exercise.
    Mr. Miller of North Carolina. But if they have an option at 
$60, they would rather buy it through the market rather than by 
exercising the option.
    Mr. Grady. Because it goes below, yes, sir.
    Mr. Miller of North Carolina. But it has some value, but if 
it is not traded, would you value it by what? If the company 
has analysts and they project a 10 or 15 or 20 percent stock 
price per year in the next 5 years. Do you look at that? If 
there are no analysts following the company, do you look at 
what the board of directors or the management forecasts are for 
growth of earnings? How do you value something that can be 
exercised in the future?
    Is there any understanding at all whether these will be 
valued at the time of exercise or when they vest, when you can 
exercise them, or at the time of their issue in the first 
place?
    Mr. Grady. The exposure draft suggests valuing them at the 
time of grant, when they are issued in the first place, when 
their value is frankly highly speculative.
    Mr. Miller of North Carolina. So even when you are being 
granted something that is only at $70, that you can exercise at 
$70, even though the stock is trading at $55, you have to 
establish some value for that and declare it now.
    Mr. Grady. Yes. You have to estimate what the value would 
be.
    Mr. Miller of North Carolina. Okay. If stocks are not 
exercised in the next year or the year after that, is there any 
requirement that the company go back and true up the cost 
because the stock went up or down?
    Mr. Grady. Generally, no. For public companies if they 
value them at the time of grant, that is it. Now, there are 
different methods. Some have said intrinsic value would be 
allowed for private companies where you would go back and true 
up each quarter. The FASB actually seeks comment on whether 
instead of using grant date as the measurement period, you 
should use exercise date.
    As I mention in my testimony, while that would get around 
the problem of how hard it is to value the options at grant 
date, it creates a different problem which is if you require 
them to be expensed on the exercise date, what you are in 
effect doing is penalizing the most successful companies and 
helping those whose stock price has languished.
    Mr. Miller of North Carolina. I think most of the testimony 
today has been about the effect on the economy of encouraging 
or discouraging, or to use the current noun-verb, incentivize 
or incent or disincentivize or disincent. But just looking at 
this from the standpoint of middle-class average investors, is 
this going to provide them more useful information than a 
footnote telling them how many options are out there and what 
the terms are under which they can be exercised.
    Mr. Grady. I believe it will provide them with less 
reliable information, far less reliable information for the 
investor for all the reasons we said in our testimony.
    Mr. Miller of North Carolina. Alright. I am probably the 
last one to have anything. Mr. Smith, I want to assure you that 
I have lived my brother's experience. My brother and his wife 
and my wife and I have a beach cottage together. When the stock 
of his company is doing well, he wants to go in together and 
reupholster the furniture and buy a DVD for the cottage. When 
the stock is not going well, he wants to sell.
    Mr. Smith. My comments have related primarily to the people 
testifying, not the people sitting on that side, obviously, the 
policymakers. I am more frustrated by the fact that like 
yesterday in the Senate, all the people that were testifying 
basically there were no business people. They were people 
having FASB, prior Federal Reserve chairmen, and all those 
sorts of folks. Great folks, but never in my opinion ever 
started a company.
    Chairman Baker. The gentleman's time has expired.
    I will get Mr. Lynch in, if I can.
    Mr. Lynch. Thank you, Mr. Chairman.
    I want to thank you, Mr. Chairman, for your good work and 
the panel for helping us out. I apologize for having to rush 
out here at the end. Prior to coming to the Congress, I was 
actually an iron worker for about 20 years, so I am similar to 
some of the production employees you have been talking about 
earlier today. I also was a former union president of the iron 
workers. So I spent a considerable amount of time working 
toward greater corporate responsibility, greater corporate 
accountability, transparency, and those issues.
    That much being said, I have to say that I have some very, 
very, very serious concerns about this FASB exposure draft that 
is under consideration today. I think it is a real mistake. It 
has been my own experience that the granting of stock options 
has given a lot of opportunity for rank-and-file employees to 
own a piece of the rock, as has been said earlier here today.
    It does in fact incentivize the workplace for many of our 
workers, if they know that if they work their tail off that 
they are going to help the company succeed, and then by doing 
so they themselves will be enriched. That is a good thing for 
America and I think it is a good thing for our corporations 
here.
    Again, Gillette Safety Razor Corporation is in my district. 
A lot of the young fellows and women who went to high school 
with me, went to work. Some husbands and wives in the same 
corporation for Gillette. They have a great stock purchase 
program at Gillette. A lot of the folks that I went to high 
school with went to work on the assembly line and now they are 
looking pretty closely at retirement. Some of those people when 
Gillette was at their high end were millionaires, based on the 
amount of stock that they had purchased in their own company. 
Good hard workers. I do not want to see that opportunity denied 
from rank-and-file workers. I think that it would be a mistake 
to adopt this rule that would basically kill that whole 
process.
    I know especially in the high-tech area, this is an 
important tool in bringing bright young employees into the 
workplace. I do have one question, and then I am going to run 
out. I know that we have talked about H.R. 3574, which would 
basically expense the options granted to the top five 
employees. In thinking about this problem in a different way, 
would it be better, and this is for the entire panel, and you 
might have to holler your answers as I run down the hallway, 
would it be better to look at some fixed percentage of the 
stock options granted each year and expense those some small 
percentage, so that it is not just the top five? Because the 
top five companies, as Mr. Smith has pointed out, in a small 
corporation to force expensing on that small group may have a 
detrimental effect on the operation of the corporation itself. 
I just wanted to get that out there. I think it is a great 
suggestion in terms of a compromise, but there might be a 
better compromise out there.
    I want to thank you for coming here. Mr. Chairman, I want 
to thank you for your enormous patience.
    Chairman Baker. I thank the gentleman.
    Did anyone care to respond?
    Mr. Holtz-Eakin. The key for fair portrayal of net income 
is the value of options granted, not the number of people that 
you choose to expense, or to the extent that you have revealed 
the value of options granted, you will become closer to net 
income as measuring the economics of the corporation.
    Mr. Lynch. Right. I understand that.
    Mr. Holtz-Eakin. A fixed fraction of the value reveals the 
value of options granted. That would be tremendous.
    Mr. Lynch. Okay. Thank you. Thank you, gentlemen.
    Chairman Baker. Let me express my appreciation to each of 
the witnesses. We certainly do appreciate your participation. 
This obviously is a difficult subject and we are doing our best 
to achieve the best public policy.
    There being no further members to be recognized, I do now 
adjourn this meeting of the Capital Markets Subcommittee.
    Thank you.
    [Whereupon, at 12:40 p.m., the subcommittee was adjourned.]

                  THE FASB STOCK OPTIONS PROPOSAL: ITS
                  EFFECT ON THE U.S. ECONOMY AND JOBS

                              ----------                              


                          Tuesday, May 4, 2004

             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 2:05 p.m., in 
Room 2128, Rayburn House Office Building, Hon. Edward R. Royce 
presiding.
    Present: Representatives Shays, Royce, Hart, Sherman, 
Moore, Frank (ex officio) and Hinojosa.
    Mr. Royce. [Presiding] I would like to call this meeting of 
the capital market subcommittee to order.
    This afternoon we are going to convene for the purpose of 
reviewing the pending Financial Accounting Standards Board 
employee stock option expensing proposal, and we are also going 
to be looking at the potential effects its adoption may have on 
job creation and on the U.S. economy.
    In previous hearings on this subject, I have expressed deep 
concerns about the potential economic consequences of FASB's 
proposal to require the mandatory expensing of employee stock 
options.
    Like other supporters of Chairman Baker's legislation, H.R. 
3574, I believe that broad-based stock options have played an 
important and positive role in our economy. Stock options 
enable emerging companies which often do not have a tremendous 
amount of excess cash or a tremendous cash flow to attract 
talented employees that would otherwise not work for such 
innovative firms.
    Some people claim that issuing stock options represents an 
expense to a firm. However, stock options do not represent a 
cost to an entity. No cash is ever disbursed from the company's 
treasury. Existing shareholders may see their ownership 
diminished through dilution, but current accounting standards 
already require potential dilution to be fully disclosed.
    In the not-so-certain case that employee options are 
actually exercised and the employing company then receives 
cash, employees who accept options are taking a well-known 
risk. There are no guarantees a firm will succeed and its stock 
price will rise.
    We hear about the successes in business, but we should not 
forget there are far more failures. Creative destruction leaves 
a wake of failed ideas.
    The specific purpose of today's hearing is to explore the 
economic impact of FASB's proposal. Economic behavior has 
already changed because of this proposal. Many technology firms 
have already announced that they will no longer issue employee 
stock options. As a result, many firms have not been able to 
attract needed employees. Whether an individual is risk-averse 
or that individual is risk-taking, or even risk-loving, he or 
she is not likely to leave their job with a large, mature firm 
to go to a start-up for a compensation package containing less 
cash and no stock options.
    If one accepts the premise that FASB's proposal will end 
broad-based stock option plans as we know them today, then we 
should think about the potential long-term negative 
consequences for our economy. Firms like Intel, Microsoft, 
Cisco and Yahoo all used stock options at their early stages to 
attract their employees. Other nations in Asia are now trying 
to incubate an environment like the one that we had here.
    Would these firms have reached their amazing levels of 
success had stock options not been an available tool for 
recruitment? Will this proposal inhibit the development of the 
next Intel? Established firms will survive and prosper under 
any new rule issued by FASB, but I think some of us are 
concerned that new firms may not develop as a result, and I 
believe that it is important for Congress to raise these 
concerns.
    We are very fortunate to have Mr. Herz and Mr. Batavick 
here today to help deal with these issues, and I hope that in 
your opening remarks you will address such questions as has 
FASB field-tested valuation models? Has FASB considered the 
economic consequences of mandating expensing? Has FASB 
considered that mandatory expensing could give foreign-based 
firms a competitive advantage in attracting employees? Is FASB 
concerned that its proposal could make financial comparability 
between firms more difficult? And lastly, is FASB still open to 
considering other nonbinomial methods or models for this 
approach?
    I look forward to hearing answers to these and many other 
questions, and I would like to turn to my California colleague 
now, Mr. Brad Sherman, for any opening statement he might like 
to make.
    [The prepared statement of Hon. Edward R. Royce can be 
found on page 164 in the appendix.]
    Mr. Sherman. I thank my friend and colleague from the Los 
Angeles area. I want to commend Chairman Baker for having 
hearings where at least we finally hear from the FASB, since we 
have had so many hearings criticizing their work or their 
intended work. It would have been nice if the Chairman had gone 
one step further and scheduled these hearings at a time when 
most of our colleagues would be able to attend, and that these 
hearings could be as widely attended as the hearings bashing 
the FASB were. Of course, those were scheduled at a time when 
there could be votes on the floor. These are scheduled many 
hours before the first vote of the week, and it would have been 
nice, I guess, if the Chairman had at least scheduled these 
hearings at a time that was convenient for him to attend.
    I have signed letters for a long time, as one of the few 
CPAs in Congress, saying let the FASB do its job. My problem is 
the FASB has not been doing its job in two areas, both directly 
related to high-tech firms principally, although--stock options 
go way beyond high-tech.
    The first is stock options where for--going back to the 
APBs, let alone the FASB announcements, you have punted on this 
issue with a unique approach where you say, this is the right 
way, but you are free to do it some other way.
    Where are the plaintiff's lawyers when you need them in 
that?
    The second area is in research, where you and I have 
talked, Mr. Herz. You know that demanding the write-off of 
research is very harmful to our economy and is wrong accounting 
and has been, and that there isn't a single accounting theory 
book I can find published in the last century that would form a 
basis for the immediate write-off of research; and, yet, what 
we have here is, in some bizarre way, compensating errors. You 
don't make high-tech firms write off their executive 
compensation, but you do force them to treat every research 
project as if it is a black hole that produces no asset.
    Now you are undoing one part of the problem without the 
other. It may very well be that we should wait to deal with one 
issue until you can deal with the other. Correcting one of two 
errors where there are compensating errors may give you a worse 
appraisal of how the high-tech sector is doing than leaving the 
matter alone until you can deal with both.
    But let me put some dollar figures to contrast the size of 
these two. Stock options, if expensed last year, total expense 
would have been $47.6 billion. Some roughly $10 billion of that 
was expensed as companies voluntarily decided to expense stock 
options, but roughly $38.6 billion, to calculate it in a 
variety of different ways, would have been expensed had this 
provision been applicable last year.
    In contrast, on the research side--and I think this number 
is way too low, but the number I have been given by the 
National Science Foundation is $176 billion, and I would 
suggest that the private sector is probably doing a lot more 
research than that.
    So the research is at least triple in importance, perhaps a 
factor of 5, a factor of 10. And so when you go to determine 
what are the net results of our high-tech firms as compared 
with firms that don't do much research and may not do much in 
the way of stock options, you have these offsetting errors. The 
one you are not--the one we are not dealing with, the one you 
haven't dealt with yet, is at least five times as big and would 
cause more investment in companies that do research.
    Now, we are told that stock options aren't an expense. 
Let's apply this to every use of stock options other than 
compensation. Well, first we are told stock options are not 
cash. Well, you could issue shares of stock, and that would not 
be cash either, and I won't bother to ask this as a question, 
because we all know the answer.
    If you issue a bunch of shares of stock to compensate your 
employees, you have to list it as an expense even though it 
cost you no cash. The sole effect is to dilute the shares 
outstanding. You have to list it as an expense. You issue stock 
to your lower-level employees, to your upper-level employees, 
to your board members an expense.
    If you were to issue shares to the best charity in our 
country, you would have to list it as an expense. If you were 
to issue shares to an insurance company to provide health care 
for your employees, an expense. And if you did options, if you 
gave options to a charity, you gave options to a health 
insurance company, you gave options to a special fund that was 
rebuilding Iraq, it is on that we have decided that the only 
thing that is so important that we as a Congress should 
interfere with the FASB and interfere with the basic rules of 
accounting theory is not in the area of charity. We could get 
more charitable contributions if we just decided charity never 
has to be listed as an expense, or if you use stock or you use 
options to make a charitable contribution. We could have more 
health care for employees if we just tweaked the accounting 
rules and said cash or stock or options used to pay for health 
care doesn't have to be listed as an expense. But health care 
for our employees, charity paid for by the corporate sector, 
these do not attract the attention of Congress. The only area 
where Congress wants to tweak the employees is in executive 
compensation.
    Now, we are told that it is broad-based. We were told that 
a lot of low-level employees get some options, but almost all 
the options are going to some people who are at the top of 
corporations, and it is that reason that the bill itself is 
written to define broadly based as, well, you are just not one 
of the top five employees, so if you are the number six person 
in Intel or the number six person at Disney, you are a poor, 
struggling secretary, I don't think so.
    We are told about competitiveness. Well, we can compete for 
capital around the world with two approaches. One is the 
European approach, and it has always been the American 
approach. That is, have tough accounting standards, do the best 
job of enforcing them, give investors the most accurate 
possible picture according to accounting theory. You guys 
haven't done a good job on research in stock options, but on 
everything else that has been our proposal. That is the 
European approach.
    The other way to compete is to emulate what I would call 
the Bangladesh model. That is to say, let companies report what 
they want. They will report high earnings, and everybody will 
want to invest.
    I would suggest nobody in this room has chosen to invest in 
whatever stock market can give them the loosiest, goosiest, 
rosiest accounting picture possible, but rather they turn to 
those stock markets which have the toughest standards.
    So I look forward to questioning my friends at the FASB on 
whether their exposure draft really does do the job, and I have 
got some severe problems with it, why they have decided to take 
an industry that is punished unfairly by your rule on research 
and punish them fairly by correcting your multiyear problem on 
stock options, and to proceed with these hearings. But I would 
say that before we tweak the accounting rules to encourage 
executive compensation, we ought to tweak the accounting rules 
to encourage health care coverage for rank-and-file employees.
    Now, I do have--I would like unanimous consent to insert in 
the record a letter from the SEC Chairman to the Ranking Member 
of the subcommittee Mr. Kanjorski dated May 3rd in which he 
states that the process established by the FASB to consider the 
pending stock option proposal should be allowed to run its 
course. I wonder if there is any objection.
    Mr. Royce. Without objection.
    [The following information can be found on page 210 in the 
appendix.]
    Mr. Sherman. I yield back.
    Mr. Royce. If they are so ordered.
    If there are no more opening statements, I would like to--
--
    Mr. Sherman. There may be some.
    Mr. Royce. All right. Let me turn to Mr. Shays and----
    Mr. Shays. I would be happy to defer to the Ranking Member.
    Mr. Royce. We will go to our Ranking Member.
    Mr. Frank. I want to be brief, because I just want to, 
first of all, make clear the Ranking Member of the subcommittee 
Mr. Kanjorski had requested this and thought it was very 
important, but a resident of his district was killed in Iraq, 
and he is understandably at that funeral. So I want to make 
clear that his absence is not anything that was avoidable, and 
this remains a very important subject to him, and I appreciate 
the fact that we are going ahead with the hearing at his 
request.
    And secondly, I want to say I am torn, as I have said 
before. I am very reluctant to see us interfere with the FASB, 
partly because while the previous speaker is an accountant, 
almost nobody else around here is, and we as Members of 
Congress inevitably have to deal with subjects where the 
subject matter is very difficult for lay people. I am loathe to 
get us into more of these.
    Of all the roles I do not wish to play, it is being the 
appeals board to the FASB. Indeed, I think one sure way to cut 
down on campaign spending would be if Members knew that the 
consequence of winning a congressional seat and spending all 
that money was that you got to be the superappellate board on 
the most arcane accounting issues, I think that would be a 
severe disincentive.
    On the other hand, I have listened to some people for whom 
I have an enormous amount of respect in an industry which is 
very important to us, both because of the inherent good it does 
and because of the contribution it makes to our economy in 
various forms of high technology, and I am struck by the 
virtual unanimity of their concern. And so one of the things 
that I am going to hope that Mr. Herz can address is who is 
getting hurt by this.
    Obviously there are technical questions to be resolved 
about what is or isn't the appropriate accounting, but 
accounting is, after all, the--a functional discipline. It is 
not an abstract one. We use accounting so we can better 
understand reality, and I do have a question as to whether or 
not--and maybe this isn't within FASB's jurisdiction--but is it 
the view of the Board and others who are advocates of this 
change that there are now investors who are being misled? Are 
there people who invest in these companies, and because options 
are not expensed but are listed elsewhere--obviously, I think 
we all agree, if people were giving the options and weren't 
telling you, that would be a terrible problem, but that is not 
what is currently allowed.
    So the question is are there people now who are being 
misled into investing, because while the information is being 
presented, it is being presented in a form different than you 
think accounting principals require? And that is really, I 
think, a very important question for us, at least within the 
FASB.
    I continue to believe myself that the damage that I have 
seen done by options has come in the perverse incentive in some 
case options have given the heads of some corporations, in many 
cases not high-tech corporations, who give themselves options, 
cash them in after the stock price has been driven up, and 
shortly thereafter the stock price tumbles, partly because some 
of the things that drove the price up weren't very good things 
for the long term. That is an abuse. I see it. I think we 
should try and deal with that and ask the SEC to help.
    But that is the central question, because I accept what I 
hear from a large number of people in the high-technology area 
that this will be damaging to them, and I want to know what 
harm are we undoing.
    So the last thing I would say is that it is also the case 
obviously that I guess there are very few--we know the 
perception and reality intermingle. This appears to be a case 
where perception is everything, because the reality is not 
being changed. The reality of options being granted won't 
change. Apparently a lot of people on both sides of this issue 
think in enormous-amount terms on how they are described, and I 
would hope that we could address the implications of that. 
Thank you, Mr. Chairman.
    Mr. Royce. Thank you.
    Mr. Royce. Mr. Shays.
    Mr. Shays. Thank you. I just want to disclose the fact that 
FASB is in the 4th Congressional District of Connecticut, so I 
may be unduly influenced by that; to say that we are grateful 
FASB is in the Fourth Congressional District, we appreciate the 
good work the Board does, even if some of its members are not 
enlightened enough to live in the 4th Congressional District. 
And I would say to you that in my judgment, a tie goes to FASB.
    Mr. Royce. Mr. Moore.
    Mr. Moore. Thank you, Mr. Chairman. I just want to thank 
the Chairman, the Ranking Member for convening this hearing. I 
want to also extend my appreciation to the witnesses for 
appearing. I look forward to your testimony. We will have 
questions. Thank you very much.
    Mr. Royce. Any other opening statements from the Members?
    In that case we will go to an introduction of our 
witnesses. First we have Mr. Robert H. Herz. Mr. Herz was 
appointed Chairman of the Financial Accounting Standards Board 
effective July 1st of 2002. Previously he was a senior partner 
with PricewaterhouseCoopers.
    Prior to joining the Financial Accounting Standards Board, 
Mr. Herz was PricewaterhouseCoopers' North American theater 
leader of professional, technical risk and quality, and a 
member of the firm's global and U.S. Boards. He also served as 
a part-time member of the International Accounting Standards 
Board. Mr. Herz is both a certified public accountant and a 
chartered accountant.
    We are also fortunate to have here his colleague Mr. George 
Batavick. Mr. Batavick was appointed to the Financial 
Accounting Standards Board effective August 1st of 2003. Prior 
to joining FASB, Mr. Batavick was most recently the former 
controller of Texaco. In this post he had companywide 
responsibility for strategy and policy matters covering all 
aspects of accounting and financial reporting, special studies, 
internal controls and tactical plan coordination.
    Welcome back, Mr. Herz. You have the floor, and I would ask 
both of our witnesses--you will be recognized for a 5-minute 
summary of your testimony. Your written statements will be made 
part of the record. Mr. Herz.

  STATEMENT OF ROBERT H. HERZ, CHAIRMAN, FINANCIAL ACCOUNTING 
                        STANDARDS BOARD

    Mr. Herz. Thank you, Representative Royce and members of 
the subcommittee. George is with me because he heads up our 
Small Business Advisory Committee, and he will be talking about 
some of that activity.
    We are pleased to appear before you today on behalf of the 
FASB. We are very happy to participate in this hearing, 
particularly since H.R. 3574 or any similar legislation if 
enacted would preempt and override our ongoing public due 
process to improve the accounting and financial reporting for 
equity-based compensation.
    We have some brief prepared remarks, and we would 
respectfully request that the full text of our testimony and 
all the supporting materials be entered into the public record.
    Mr. Royce. Without objection.
    Mr. Herz. As you know, our ability to conduct our work in a 
systematic, thorough and unbiased manner is fundamental to 
achieving our mission of improving accounting and financial 
reporting standards in this country. Those standards are 
essential to the growth and stability of the U.S. economy 
because investors, creditors and other consumers of financial 
reports rely heavily on credible, transparent, comparable, 
unbiased financial information to make their investment and 
credit decisions.
    Now, because the actions of the FASB affects so many 
organizations, our decision-making process must be open, 
thorough and as objective as possible, and therefore, our rules 
of procedure require a very extensive and public due process.
    We issue proposals for comment, and then after that, when 
we get the comments, we hold roundtables, we actively 
redeliberate all the key issues. Those redeliberations often do 
result in significant changes and improvements to the 
proposals.
    The Board makes final decisions only after carefully 
considering and analyzing the input of all interested parties. 
We do our best to try and balance the often conflicting 
perspectives of various parties and make independent, objective 
decisions guided by the fundamental concepts and key 
qualitative characteristics of sound, fair and transparent 
financial reporting.
    In March of 2003, at a public meeting, we decided to add a 
project to our agenda to address issues relating to improving 
the accounting for equity-based compensation. The project was 
in response to the high level of public concern expressed by 
many individual and institutional investors, financial 
analysts, creditors, major accounting firms, many study groups 
and many other parties, including many Members of Congress, 
about the need to improve the accounting for equity-based 
compensation.
    Many believe that the existing reporting for equity-based 
compensation results in significant distortions in the 
reporting of earnings, operating results and operating cash 
flows, distortions that they believe cannot be remedied solely 
by improvements in disclosures. So the ultimate goal of our 
project is to develop a standard that results in reporting that 
more faithfully reflects the underlying economic effects of 
equity-based compensation and that brings about greater 
comparability of reporting.
    The project also provides an opportunity to achieve greater 
international convergence of accounting standards, an objective 
that we have been specifically encouraged to pursue by the 
Sarbanes-Oxley Act, by the U.S. SEC and by many other parties.
    On March 31st of this year, we issued by a unanimous vote a 
proposal for public comment to improve the accounting for a 
wide range of equity-based compensation arrangements. That 
proposal is a result of a very extensive public due process. 
The process included the issuance of a preliminary document for 
public comment, the review of over 300 comment letters and over 
130 unsolicited letters, review of research and consultation 
with many, many parties.
    Based on our extensive public due process to date, the 
Board believes that the proposal would significantly improve 
the financial reporting for equity-based compensation 
arrangements. By creating greater transparency, completeness 
and a more level playing field in the accounting for different 
forms of equity-based compensation, we believe that the 
proposal would enhance the comparability of reported results 
between enterprises that choose to compensate their employees 
in different ways.
    The proposal would achieve it through a number of 
provisions, including eliminating the existing exception for 
so-called fixed-plan employee stock options, which, as 
Representative Sherman indicated, are the only form of equity-
based compensation that is not currently required to be 
reported as an expense in the financial statements.
    The proposal also includes provisions that we believe would 
improve the transparency of the effects of equity-based 
compensation on reported cash flows and that are aimed at 
addressing what many believe have been significant distortions 
in the reporting of operating cash flows by companies that make 
significant use of employee stock options.
    The proposal reflects the view that all forms of equity-
based compensation should be properly accounted for as such, 
and that the existing exception for fixed-plan employee stock 
options results in reporting that not only ignores the economic 
substance of those transactions, but also distorts reported 
earnings, profitability and other key financial metrics.
    I would note in contrast that this distortion again, as 
Representative Sherman indicated, does not occur when the same 
company uses stock options or similar instruments such as 
warrants for purposes other than compensating employees; for 
example, in acquiring goods or other services, or in financings 
or M & A transactions. In all those cases the current 
accounting has long required that the options or warrants be 
properly valued and accounted for in the financial statements.
    In the public company arena, the proposal would bring about 
greater comparability between the now over 575 companies that 
have voluntarily opted to account for the cost of employee 
stock options and the many others that have not done so.
    It would also be responsive to the growing number of 
companies, including a number of major technology companies, 
whose shareholders by a majority vote have approved nonbinding 
proxy resolutions mandating expensing of all employee stock 
options. Managers of a number of those companies have indicated 
that they are awaiting completion of our project in order to 
respond to the demands of their shareholders.
    The proposal would also result in substantial convergence 
in the accounting for equity-based compensation between our 
standards and international standards that are followed in over 
90 countries around the world.
    I would also note that in Canada, who often follows the 
lead of the U.S. in improving accounting standards, they felt 
they could not wait on this topic and decided to mandate 
expensing of all employee stock options beginning in January of 
this year, and I understand that implementation of their new 
standard is going very smoothly.
    Finally, with regard to the potential economic consequence 
of our proposal, many economic experts that have addressed the 
issue of the accounting for employee stock options, including 
Federal Reserve Chairman Alan Greenspan, former Federal Reserve 
Chairman Paul Volcker, Nobel Prize-winning economists Robert 
Merton, and Joseph Stiglitz, and groups like the Financial 
Economist Roundtable, the Republican staff of the Joint 
Economic Committee of the Congress, the Conference Board 
Commission on Public Trust and Private Enterprise co-chaired by 
Pete Peterson and John Snow, major investment banks, and the 
Congressional Budget Office have all indicated support for 
mandatory expensing of employee stock options.
    Indeed, many of these experts have also indicated that 
mandatory expensing could have positive economic consequences 
because of the improvements in capital allocation that would 
result from having more credible, comparable and transparent 
financial information, not to mention helping to continue to 
shore up public confidence in financial reporting.
    Now, we recognize that one size may not fit all, so I am 
going to hand over to George in a second who will discuss the 
several special provisions contained in our proposal relating 
to small businesses and start-ups, as well as other matters 
relating to our continuing work and due process on this topic.
    I would like to assure you that we recognize the importance 
of small business and start-ups to job creation, to 
entrepreneurship and to our Nation's economy, so we also 
understand that any standards we prescribe that apply to small 
business must not only be conceptually sound, but also must be 
operational and cost-effective.
    Mr. Royce. Mr. Batavick.

   STATEMENT OF GEORGE J. BATAVICK, BOARD MEMBER, FINANCIAL 
                   ACCOUNTING STANDARDS BOARD

    Mr. Batavick. Thank you, Mr. Royce, and thank you, Bob, and 
good afternoon everyone. Before I outline the special small 
business provisions contained in our proposal to improve the 
accounting for equity-based compensation, I would first like to 
provide some brief background on small businesses and financial 
and accounting reporting standards.
    First, there is no Federal law requiring nonpublic 
enterprises to use FASB standards. Thus, for most small 
businesses, the use of our standards is primarily a private 
choice. For some small businesses, that choice may be 
influenced by whether they have plans to become a public 
enterprise. For other small businesses, the decision to follow 
FASB standards may be influenced or controlled by their current 
or potential lenders-suppliers, other contracting parties or 
State regulators. To the extent that one of these parties 
requires that the financial reports of small businesses comply 
with our standards, that requirement presumably reflects the 
party's opinion that our standards result in better, more 
transparent information for their respective purposes.
    Second, it is also important to note that the FASB has long 
recognized as part of our public due process procedures that 
the cost of complying with our standards can fall 
disproportionately on small businesses. In recognition of that 
fact, the Board actively solicits and carefully considers 
requests from users, auditors and preparers of the financial 
reports of small businesses to provide for special provisions 
to alleviate the costs of implementing our standards. Those 
requests come from our continuous and ongoing due process and 
deliberations throughout the life of the project.
    If you are following our project on equity-based 
compensation, and you wanted to keep up on what was happening, 
all interested parties, including small businesses, can take 
advantage of our free weekly action alert, which is by e-mail. 
We discuss current agenda items and past Board decisions. 
Interested parties can also attend our Board meetings, call in 
or listen to our free Webcast of our meetings on the day of the 
meeting, with replays of our meetings available 1 week 
thereafter.
    Our meetings also get extensive news coverage by the top 
news agencies, and our free Web site includes up-to-date 
summaries of all equity-based compensation issues discussed in 
our tentative decisions.
    We actively seek input from various State CPA societies, 
and membership in turn brief their clients, in many cases small 
businesses, on the status of this and other Board activities.
    In addition, liaison meetings with various groups having 
small-business representation and Board member and staff 
speaking engagements provide additional means of receiving 
valuable input from the small-business community.
    With respect to this proposal on stock-based compensation, 
it is our understanding that although the use of employee stock 
options is present at some small businesses, particularly 
start-ups and venture capital-backed enterprises that plan to 
become public enterprises, the vast majority of small 
businesses, over 95 percent, in the U.S. do not grant employee 
stock options.
    As indicated earlier, however, for those small businesses 
that are affected by our proposal, the proposal includes 
several provisions intended to alleviate the cost of 
implementation. First, the proposal includes a special 
provision that would permit most small businesses, including 
all that are not public, to measure compensation costs using a 
simpler, less costly intrinsic value method rather than the 
fair value method that would be required for most public 
enterprises. Under the intrinsic value method, the amount of 
compensation expense required to be reported would generally be 
equivalent to the amount of the income tax deduction for stock 
options.
    Second, the proposal includes a special provision that 
provides most small businesses that are nonpublic enterprises 
with a simpler, less costly prospective transition to the new 
requirements.
    Finally, the proposal includes a special provision that 
provides that the effective date of the proposed standard for 
nonpublic enterprises would be delayed for 1 year until 2006.
    I also would like to note that the proposal includes a 
notice for recipients that highlights and describes all these 
special provisions. The notice requests that respondents to the 
proposal indicate whether there are other special provisions 
for small businesses that might be appropriate and whether any 
or all such special provisions should be extended to public 
enterprises that are small business issuers under the Federal 
securities laws.
    The Board currently plans to discuss the proposal, special 
provisions and other issues about the proposal with 
representatives of small business at the inaugural public 
meeting of our Small Business Advisory Committee next week, May 
11th. Our request for agenda items for this meeting showed 
interest in this proposal. We also plan to hold public 
roundtable meetings in June with valuation and compensation 
experts, and users, auditors, preparers of financial reports to 
discuss a broad range of issues about the proposal.
    Following the end of the proposal's comment period in June, 
the Board plans to redeliberate at public meetings issues 
raised in response to the proposal. Those redeliberations will 
include very careful consideration of the ongoing input 
received from all parties, including ongoing input from the 
members of the Small Business Advisory Committee. Only after 
carefully evaluating the input at public meetings will the 
Board consider whether to issue a final standard.
    The Board's current plans are to complete its deliberations 
and be in a position to issue a final standard in the fourth 
quarter of this year.
    On behalf of myself and Bob, I would again like to express 
our deep appreciation for inviting us to participate in this 
hearing. All the information we obtain in connection with this 
hearing will be carefully considered.
    In conclusion, let me assure you that you, the users, 
auditors and preparers of financial reports, including small 
business financial reports, can have confidence that the Board 
will continue to actively reach out and solicit input in 
response to our proposal. That input will be carefully 
considered in an open, thorough and objective manner. Our 
ultimate goal is to develop an accounting standard that will 
faithfully report the underlying economic effects of equity-
based compensation transactions and thus significantly improve 
the transparency and integrity of financial reporting in the 
United States.
    Thank you again, Representative Royce and other 
subcommittee members. Bob and I would welcome the opportunity 
to respond to any questions.
    Mr. Royce. I thank you, Mr. Batavick.
    [The prepared statement of Robert Herz and George Batavick 
can be found on pages 172 and 175 in the appendix.]
    Mr. Royce. Let me begin by asking a question of Mr. Herz.
    Mr. Herz, in a letter to the Financial Accounting Standards 
Board dated December 29th of 1993, Coopers and Lybrand 
contended that using option pricing models results in 
unreliable information and would have an adverse impact on the 
comparability and usefulness of financial statements, and your 
name and number are provided as contact information to discuss 
this letter. I wanted to ask you how you reconcile your 
position in this letter with your position today. We are 
assuming that the letter would not have provided your contact 
information without your endorsement of the arguments that are 
made there, which are some of the arguments that we have heard 
on the Hill over the last month again replayed as we have 
discussed this issue.
    Mr. Herz. Well, I don't remember the particular 
memorandums. I obviously take good faith that that is it.
    Mr. Royce. Well, don't take it on faith. It says, if you 
have any questions regarding our comments, please contact 
Ronald Murray or Bob Herz at this number, or David Lookate.
    Mr. Herz. Right. I think that, you know, at that time I did 
believe on the face of it without a lot of investigation, I 
just had come into the national office of Coopers and Lybrand, 
and from the practice that, you know, those were the views. 
Those were the views that we were hearing from many clients at 
the time.
    I have now had the benefit of an intensive look at this 
subject, both on the International Accounting Standards Board 
and also at the FASB, I mean, an intensive look at it, and you 
live and you learn. I don't believe that those arguments, as 
far as at least the valuation, hold water. Will they have an 
impact on emerging businesses? Well, we have got special 
provisions in our proposal, A; and, B, yeah, there are economic 
consequences in terms of better information that arise from 
changing accounting standards.
    Mr. Royce. Well, let me ask you a question about that 
intensive look, and I may be wrong on this, but to my 
knowledge, as far as the Board is concerned, I don't think that 
you field-tested valuation models when it comes to trying to 
determine this new methodology. I don't know that you have 
taken various valuation models by a cross-section of companies 
so the significant data would be collected on the accuracy and 
reliability of these different valuation models. And I was 
going to ask you, are there any studies that you have relied on 
that show specifically that the binomial method values employee 
stock options accurately?
    Mr. Herz. Well, we have done a lot of work on the valuation 
area. We have convened a group of expert panel called our 
Options Valuation Group, which are experts in valuation 
compensation, equity derivatives, which a stock option is. Our 
staff and the Board met with them a number of times. We did 
have field visits to a number of companies that included a 
cross-section of companies across industries and sizes of 
companies, both public and private. We have reviewed the 
results of research studies on data that exists.
    Let me step back, though, that----
    Mr. Royce. Let me explain where I am going with this so 
that you better understand my point. Your spokesman Cheryl 
Thompson defended the decision not to field-test valuation 
models by telling the press that the ultimate field test has 
already taken place. She added that public companies have been 
performing this field test for 7 consecutive years, so the test 
sample is huge. It involves thousands of companies.
    I believe I am correct in assuming that Ms. Thompson is 
referring to the use of Black-Scholes in footnote disclosures 
over the past number of years. I suppose that one could argue 
that it makes sense if the exposure draft required all 
companies use the Black-Scholes model, but what we are now 
doing is urging companies to use something different, which is 
the binomial method. And so my question here is why not conduct 
field tests on the accuracy of that particular model?
    Mr. Herz. Well, the--first of all, there are now 575 
companies that are expensing in their income statements. Some 
of those use the binomial model, and we have talked to them.
    Secondly, it is a misnomer to call them completely two 
different models. They are basically related. They are derived 
from the same financial economic theorem. The binomial model is 
really opening up the Black-Scholes model. The Black-Scholes is 
kind of a hard-wire model that you put in one set of 
assumptions, and you get a result. The binomial works off of 
exactly the same theory, but you can peer into the hard-wiring 
and look at it period by period, and you can make adjustments 
for better data period by period.
    Mr. Royce. Well, you make the point that 576 firms, in your 
words, have----
    Mr. Herz. Can I----
    Mr. Royce.--expense--let--let me just ask you, do any of 
those companies have broad-based stock option programs? Because 
there are thousands and thousands of companies that have not 
embraced this, that do have broad-based stock option programs, 
and that is where we are focused. And I will let you respond to 
that, and then I have one last question before we go to my 
colleague here.
    Mr. Herz. Well, there are a number of companies with broad-
based plans that have gone to expensing, like Netflix and Home 
Depot and Wal-Mart and the like.
    My other point I was trying to make is that the binomial 
model is regularly used on a daily basis to value equity 
derivatives and other derivatives. It is a model that works.
    Mr. Royce. My last question is this, and I realize the 
Financial Accounting Standards Board is pretty far down the 
path on this proposal, but that said, just yesterday I learned 
of a new proposed method of expensing options that works very 
differently than Black-Scholes and works differently than this 
binomial method and that you have articulated, and I was going 
to ask what your opinion would be in terms of being open to 
consider this new proposal for expensing at this point in the 
process.
    Mr. Herz. Oh, we are open--we get suggestions almost daily, 
so----
    Mr. Royce. So what would the process and the timetable be--
--
    Mr. Herz. The process is they should send us something in 
writing, and then we will have a look at it, and we will meet 
with them. And we have done that with many different parties. 
And we also, when we get something like that, consult with our 
panel of experts also.
    Mr. Royce. Thank you, Mr. Herz.
    We will go to Mr. Sherman.
    Mr. Sherman. Thank you, Mr. Chairman.
    Mr. Batavick, your testimony provided really useful, 
personally, information. Right after these hearings I am going 
to go out and sell all the stock in the company that makes 
Ambien. That stock is going to crash once everyone becomes 
aware that replays of FASB meetings are available for free.
    It is rather absurd for you to say that small businesses 
don't have to use FASB pronouncements in preparing their 
financial statements if they choose not to go public. Every 
bank wants statements prepared under Generally Accepted 
Accounting Principles, and FASB pronouncements cannot be 
ignored in determining what is generally accepted. And, of 
course, our State corporate laws make certain dividends illegal 
unless certain capital--certain amounts of capital are 
available calculated under GAAP. So you understate the 
importance of your Board if you say that you are not legally 
binding on nonpublic companies in this country.
    Speaking, though, of small businesses, the binomial method, 
as I understand it, could be expensive to use, could involve 
many thousands of dollars of accounting fees. Let's say you had 
a small company, you used Black-Scholes, and you came out with, 
say, half a million dollars of stock option compensation 
expense. But that half million was material. Is there anything 
in the exposure draft that says in order to help you save on 
accounting fees, as long as your Black-Scholes number is under 
half a million, you can use binomial; or does the exposure 
draft say if you are tiny, then whatever amount that is 
material to you, you have to go spend the money on the 
accounting fees to use the more sophisticated approach? Do you 
allow a less expensive calculation method for small companies?
    Mr. Batavick. Right now we are not requiring one method 
over the other. What we are saying is the fact that we have a 
Black-Scholes method, we also have the binomial method, and the 
statement we make in the proposal is that in certain 
circumstances that may be preferable, but it is also based on 
if you have the information available to----
    Mr. Sherman. I would hope that--and I will get to this in a 
second. I think it is a tragic flaw in your exposure draft that 
you provide so little guidance as when to use one method or 
when to use the other and----
    Mr. Herz. Could I just interject, if I might?
    Mr. Sherman. Yes.
    Mr. Herz. In our proposal if a small business is a private 
company, they don't even have to use option pricing models. 
They can elect not to use option pricing models.
    Mr. Sherman. Yes, but many of--if they are not someday 
going to be public, nobody may want the stock options anyway. 
Stock options are generally used for companies that intend to 
go public. I realize there may be some exceptions to that.
    Mr. Herz. We don't say if you are going to go public. If 
you are private, you----
    Mr. Sherman. You don't have to. I would hope that GAAP 
would mean the same thing, that we would take the--I know you 
can propose vague standards. That is what you have done the 
last 30 years. You said you can expense them or not expense 
them, your choice. Now you are going to say, well, by Black-
Scholes, binomial, or if you are not public, some other 
guesstimate.
    I would hope that you would provide real guidance to the 
profession, that people reading financial statements are not 
going to have to look at the footnotes and try to guess what 
was done and how to make two statements comparable. The whole 
idea here is you should be able to compare Coke and Pepsi, not 
the taste test, the financial test. And for a while there, one 
was expensing and one wasn't. Now we are going to have one 
binomial and one Black-Scholes and then some small beverage 
company using a third method or no method at all.
    I would hope that if you are in the standards-writing 
business, you would write standards, not guidelines, not 
guesstimates, especially when those who oppose what you are 
doing have said this could be a fertile area for lawsuits.
    Now, I realize there are other areas of accounting where a 
judgment is required, but here you are talking about executive 
compensation, the juiciest thing to bring before a jury. You 
are inviting lawsuits when you take that juicy area and you 
don't provide guidance.
    I would hope that guidance would factor in availability of 
information, would factor in cost of calculation, and would 
then say, okay, apply Black-Scholes. If you meet these 
standards of materiality, if you meet this dollar figure, then 
you have got to go use the binomial, and here's how you ought 
to use it.
    Let's see. My next question, though, is why don't you delay 
this whole thing until you get the research thing right, and 
are you concerned that you are now going to have--eliminate 
this compensating error, and you are going to adopt an 
accounting system for this country that discriminates against 
our high-tech sector?
    Mr. Herz. Let me go back to a few other points you made and 
then go to the R&D point.
    I think if you look at our exposure draft, there is plenty 
of guidance on valuation. It may not be hard-wired guidance. It 
is guidance that fulfills what we have been told to do in 
objectives-oriented standards by the SEC in the report they 
issued to you last summer, to Congress on Sarbanes-Oxley. It is 
much more detailed, for example, than in many other areas of 
valuation. I----
    Mr. Sherman. As is executive compensation. Two accounting 
firms should come up with the same answer. If they don't, there 
is going to be lawsuits, and if there is going to be lawsuits, 
that is a strong argument for us to pass this bill.
    Mr. Herz. If you look at our notice to recipients, there 
are several questions specifically on that point, how hard-
wired, how prescriptive would you like us to get, models, 
assumptions. Now, we have already gotten some responses that 
say we have already provided too much guidance. So there is a 
diversity of views. I----
    Mr. Sherman. Well, of course. The people who don't want to 
expense options want as much looseness as possible so they can 
state as low a number as possible.
    Mr. Herz. But one of those responses is from a major audit 
firm. Okay? So----
    Mr. Sherman. But they tend to agree with their clients. 
Surprise.
    Mr. Herz. I don't know if their clients feel that way. I 
mean, the point is there is a diversity of view. We have asked 
the question specifically because we recognize that 
sensitivity. We can hard-wire everything if that is what people 
want.
    Mr. Sherman. Or that one accounting firm could compete 
under the slogan, we use the play in the joints to understate 
your executive--to minimize the statement of your executive 
compensation. It would be a whole new slogan.
    Mr. Herz. I think one of the benefits of the Sarbanes-
Oxley, the auditors are doing more robust audits, I believe. 
The SEC is certainly reviewing a lot more, and this is an area 
they would intend to review.
    On your R&D question--and, you know, you and I have had 
discussions. I personally agree with you, but thousands don't. 
And I will tell you there is good news on that front, or 
potentially good news on that front, in that we met with the 
International Accounting Standards Board, like we do every 6 
months, and we, subject to our own agenda processes, agreed to 
look at the area of both R&D and more broadly intangibles.
    Mr. Sherman. But, Mr. Chairman, shouldn't you stop all work 
on this stock option thing, which is going to hit high-tech 
hard--and they are already screaming--when you are already 
hitting them? And fairly, I might add, but you have been 
hitting them hard and pounding them hard, much harder unfairly. 
Shouldn't you abstain from correcting this mistake until you 
can deal with that mistake, or do you think you should just 
pound high-tech when they are right on the accounting and when 
they are wrong on the accounting?
    Mr. Herz. Well, again, the issue of R&D, you and I may 
agree personally. There are many who don't, so----
    Mr. Sherman. Is there any accounting theory textbook, that 
supports the idea of expensing every research expenditure done 
in-house no matter how valuable the results are and no matter 
how provable the value of those results are?
    Mr. Herz. The accounting rationale is that it is not 
sufficiently measurable.
    Mr. Sherman. You can't measure--yes. That is--you know 
how--let's put it like this: There is no accounting theorist I 
am aware of anywhere in this country that would come to the 
conclusion that you should write off all R&D.
    Mr. Herz. I would ask the--in response to your suggestion, 
which, you know, I agree with--as you know, I agree with not 
only capitalizing R&D per se, but I think the whole area of 
intangibles that are big-business value drivers is something 
that is missing off of contemporary balance sheets.
    I will tell you, though, the history of this issue
    being--the last time, I understand, it was raised by the 
FASB a few years ago, the biggest opponents of it were the 
high-tech firms.
    Mr. Royce. Mr. Frank.
    Mr. Frank. Mr. Herz, in the full text that you gave us, and 
I appreciate it, on page 27, you address towards the end the 
objections, and you list four of them. The last one is you 
phrase the objection as mandatory expensing of employee stock 
options will have negative economic consequences.
    To me that is the nub of what we are here for. We are not 
the plutonic board of perfect accounting. We get involved where 
there are negative economic consequences, and I have to tell 
you, I don't--I think if I were a judge and this was the 
argument, you would lose on summary judgment. I mean, you make 
a lot of good arguments, but there is none.
    You kind of implicitly--and that may not be controlling, 
but this is so you will understand the dilemma. Implicitly, in 
the beginning of the second paragraph of that page, the Board's 
operating precepts require it to consider issues in an even-
handed manner without attempting to encourage or to discourage 
specific actions. That does not imply that improved financial 
reporting should have no economic consequences, but it seems to 
me to be a concession that--not a concession, a statement that 
you are going to go ahead and do this, and that is the dilemma 
many of us have, because I certainly agree on the accounting--
let me ask you, to go back to the question I posed, other than 
aesthetically, who is getting hurt now by the current 
accounting firm options? Who is the victim?
    Mr. Herz. Well, I think this all kind of relates 
together.You know, our mission is to improve financial 
reporting----
    Mr. Frank. I understand that, but if that is the answer, 
okay, but is somebody being hurt now by the current situation?
    Mr. Herz. Well, certainly the people who were surveyed the 
financial analysts, surveys of investors, tech investors, all 
say they want it in the score because it is not transparent 
right now. They don't--they pick up numbers from databases. The 
CBO said that it would be more transparent----
    Mr. Frank. Please, I don't need you to tell me what the CBO 
said. I rarely pay attention to them. And transparency is a 
means, if not the end. And if the answer is it is wrong and it 
doesn't make a difference if anybody is getting hurt, then 
okay. But as far as transparency, let me say this: The 
information is there now, isn't it? It is just not--if I were 
going to invest in a company, which I--we get enough ethics 
from--so I don't address individual companies. But if I was 
going to invest in an individual company, I or somebody I was 
paying to help me do this would read the footnote. So let me 
put it this way: If I were going to invest in an individual 
company, would I get more information about what is actually 
happening one way versus the other?
    Mr. Herz. You're going to get more information the way we 
are proposing it
    Mr. Frank. What information would I get from you that I 
don't now get? I would get the fact that the options would be--
would I not now get the fact that the options were being 
granted and how many there were? Would I not know that?
    Mr. Herz. You would know that, but you would not know 
things like operating margins, return on equity, all those 
things that are just--by not running it through the financial 
statements, you are not getting the full accounting
    Mr. Frank. You are saying that I would be--that the 
investors can't do that themselves. I get everything else and 
then I get the options, and I wouldn't be able to, myself, 
figure out or decide for myself to what extent the existence of 
the options added to or detracted from the value of the 
investment?
    Mr. Herz. If you were a sophisticated investor and you took 
the footnote, you would be able to get part of that 
information, not all of it
    Mr. Frank. What wouldn't I be able to get?
    Mr. Herz. You wouldn't be able to get things like gross 
margin, you wouldn't be able to get operating results, you 
would have to recompute----
    Mr. Frank. Well, those are things to which there is some 
element of uncertainty, though; right?
    Mr. Herz. Well, they are things that if you do the 
accounting properly, they are just there.
    Mr. Frank. Well, but isn't there some element of 
uncertainty there? I mean, I was struck when you told Mr. 
Sherman that the obstacle to dealing with research differently 
is that it is hard to measure. Is it a lot easier to measure 
than the options, or a lot harder?
    Mr. Herz. No, the options are much easier to measure than 
the early stage of research
    Mr. Frank. And you couldn't just make available to people 
what the measurements are and let them do it themselves?
    Mr. Herz. We have been doing that
    Mr. Frank. Okay, we have been doing that. Who has been 
hurt? Have you gotten any complaints? Is there anyone we know 
of that?
    Mr. Herz. Yes.
    Mr. Frank. No, I know they said we would rather. Did anyone 
say I was misled?
    Mr. Herz. Yes.
    Mr. Frank. I invested unwisely?
    Mr. Herz. Yes, we have lots of letters from individual 
investors.
    Mr. Frank. Well, I have read your comments and the samples 
you gave. None of them say that. You gave one set of samples. 
You didn't give the other. You gave people that said, oh, these 
greed-mongers, they are terrible. You have people saying it 
would be more desirable. But surely you understand the 
difference between a general assertion that it would be 
desirable and an assertion that an individual was hurt.
    Does anybody anywhere--I will make a plea. There are other 
people here from the SEC; would anyone bring forward to me some 
individual who was misled because the options were not 
expensed? Do you know of any claims of that sort, Mr. Herz?
    Mr. Herz. Yes.
    Mr. Frank. Where are they, Mr. Herz? They are not in your 
statement. Point them to me. Which one did I miss?
    Mr. Herz. I don't know, we have got hundreds and thousands.
    Mr. Frank. Well, you picked some out. None of the ones you 
picked out say that. None of the ones you picked say ``I was 
misled,'' and I am reading them. I strongly recommend people 
like me will stay away from the market as long as they are 
passed out like funny money
    Mr. Herz. Can we follow up with you?
    Mr. Frank. Yes. Okay. And I am surprised we haven't heard 
reports because this is the issue.
    Mr. Herz. I think an important point is that it is a well-
known, well-accepted thing in accounting, that disclosure 
doesn't cure bad accounting. And we get requests all the time 
for just put it in the footnotes. When we were going through 
the improvements----
    Mr. Frank. Sir, you do realize this is totally irrelevant 
to my question? If you want to give more general statements 
about why you should do this, okay. And that is part of the 
problem you have got.
    I thank the Chairman for the indulgence. Here is the 
problem you have got, and I don't want--I am not a co-sponsor 
of the bill. I am really torn here. But I have people telling 
me this is going to cause a problem. I mean, I have a technical 
intellectual argument. Clearly these are not free. I understand 
that. How you account for them there is a question.
    But a lot of people are saying, look, this is going to 
cause a problem; and they are going to cause a problem again 
because of the way the market will perceive this. And so as a 
public policymaker, not as an accounting technical specialist, 
I say, okay, well, if there is a potential for the problem 
here, what are we solving? What are we solving? What problem am 
I solving other than an intellectual failure?
    Frankly, if I was going to go around this city and resolve 
every intellectual failure, I would be a wreck. So I am looking 
for some public policy break. And, yes, I would appreciate it, 
please follow up with me, because I think that is why you are 
here. You are not here because people differ with you 
technically on the accounting. As was implied in the question 
from Mr. Sherman, no one cares about that. That is your job, 
and we are glad you have it and are ready to do it.
    The issue here is, is there some real economic harm that 
could come? And that is the area I think in which further help 
from you would help your cause, and so that is it.
    Yes, I yield to my colleague from California.
    Mr. Sherman. I would say the one obvious harm is that those 
companies that choose not to use stock options are at a 
disadvantage in attracting capital as opposed to those who do.
    Mr. Frank. Okay. But I would say again, because people in 
the market don't understand this, it all comes down--to some 
extent I have to say I feel a little bit good about this in one 
sense, having been for years told, listen--well, let me say 
there was a former majority leader of this institution who used 
to say government is dumb and markets are smart. Well, these 
markets ain't the smart ones. These are the markets that are 
confused because of the accounting.
    So I am just a little glad to say that. I agree. But that 
is the issue; it is not the investor being misled, it is the 
competitive disadvantage to the other people.
    I am sorry. Did the other gentleman from California want me 
to yield?
    Mr. Royce. No, I was just going to make the point that it 
is easier just to point out the intellectual failures in this 
city than in the market.
    But we are going to go to Mr. Hinojosa.
    Mr. Frank. Thank you
    Mr. Royce. Mr. Hinojosa, you also had an opening statement 
you wanted to make, and at this point we will give you that 
opportunity, and then, please, go to your questions.
    Mr. Hinojosa. I will submit my opening statement in 
writing.
    Mr. Royce. Without objection.
    [The prepared statement of Hon. Ruben Hinojosa can be found 
on page 81 in the appendix.]
    Mr. Hinojosa. I would like to make a statement and ask a 
question or two. Thank you, Chairman Royce.
    I am very pleased that the subcommittee had the opportunity 
to hear the views of the Financial Accounting Standard Boards, 
or FASB, on its proposal to expand stock options, especially 
since you are the entity that will be directly impacted by the 
legislation I have co-sponsored and supported thus far, H.R. 
3574, the Stock Option Accounting Reform Act.
    I am aware of the allegations that have been made, that 
FASB has been hiring lobbyists, or, rather, actually having 
registered lobbyists on staff who have been encouraging Members 
of Congress to support its proposed legislation, thus calling 
into question the longstanding perception of FASB as an 
independent agency. Certain individuals have come to my office 
recently to express concerns about particular aspects of H.R. 
3574. And after listening to you make your statement and the 
questions that the Chairman and others have asked, I will 
reread through today's testimony and have my staff obtain a 
copy of it to determine if those concerns were addressed, as 
well as having them follow up with FASB.
    Mr. Batavick, what is your background?
    Mr. Batavick. Most recently, I was the retired comptroller 
of Texaco, Inc. We were acquired by Chevron a few years ago, 
and because of that I left the combined company. Prior to that 
I was with Getty Oil Company. That was acquired by Texaco. And 
before that I was in public accounting.
    Mr. Hinojosa. Those are very good companies, very large, 
and I just cannot understand how you can be speaking so much 
for the small businesses unless you ran small businesses before 
you went to Texaco.
    Mr. Batavick. Actually, when I was going through school, I 
worked two summers at a public accounting firm that only did 
the accounting for small businesses. I did both accounting as 
well as auditing. Also, when I joined Getty Oil Company, most 
of our service stations are not owned by the company 
themselves, they are owned by small businesses. And I worked 
very closely with those small businesses during my early years.
    Mr. Hinojosa. Well, Mr. Chairman, and Ranking Member Barney 
Frank, and Congressman Sherman, again thank you for calling 
this important hearing and I look forward to working with you.
    Mr. Royce. Thank you. Mr. Herz, you wanted to respond?
    Mr. Herz. Yes, I wanted to respond to the question about 
lobbyists. I want to be very clear on this. We have not asked 
any firm to lobby for us with respect to our proposed standard 
to improve the accounting for equity-based compensation.
    Our Washington, D.C. Representative, Jeff Mahoney, since 
1996 has provided information and responded to questions about 
the FASB and its activities from staff and Members of Congress, 
Federal Government officials and other interested parties in 
Washington, D.C. He also works hard to keep interested parties 
informed. And, yes, we do speak our minds when there is 
proposed legislation that would intrude upon our independence 
and upon our ability to do our work in a thorough, open, and 
objective way.
    Jeff also arranges for me to meet directly with Members of 
Congress, Federal Government officials, and other interested 
parties to provide them with timely information on our 
activities.
    Because our communications sometimes entail lobbying 
contacts, as defined in the Lobbying Disclosure Act, relating 
to proposed legislation like this one, relating to our mission 
and activities, Jeff and I, and my predecessor since 1998, were 
registered under the Lobbying Disclosure Act on behalf of the 
Financial Accounting Foundation, our parent group.
    Basically, the history of this is that when Chairman Baker 
introduced a bill in 1998 relating to accounting for 
derivatives, many Members of Congress solicited the views of 
Mr. Mahoney and our then-chairman Ed Jenkins. They consulted 
with legal counsel who advised them to be safe, to register as 
lobbyists. When I came on board they registered me as a 
lobbyist. That has nothing to do with this particular matter in 
question.
    In fact, I think it is a little bit like the pot calling 
the kettle black. We have all read all the stories, and in a 
Senate hearing last week one of the Senators used the term 
high-tech lobbyists swarming all over Capitol Hill. We did not 
start anything here in Congress. It is your purview. We welcome 
the inquiry and all of that, but we try to respond to the 
questions of Members about the proposed legislation. But that 
is all.
    Mr. Royce. Mr. Herz and Mr. Batavick, we want to thank you 
both for appearing before our panel today. Let me also note 
that some members may have additional questions for both of you 
which they might want to submit in writing. If we can give them 
30 days to submit those questions, and within those 30 days if 
you would complete your response for the record, we will 
collect those from you.
    Again, we thank you both for making the trip here to 
testify today. This hearing is adjourned.
    [Whereupon, at 3:17 p.m., the subcommittee was adjourned.]


                            A P P E N D I X



                            April 21, 2004


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                            A P P E N D I X


                              May 4, 2004


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