[House Hearing, 108 Congress]
[From the U.S. Government Publishing Office]
FASB PROPOSALS ON STOCK OPTION EXPENSING
=======================================================================
HEARING
before the
SUBCOMMITTEE ON
COMMERCE, TRADE, AND CONSUMER PROTECTION
of the
COMMITTEE ON ENERGY AND COMMERCE
HOUSE OF REPRESENTATIVES
ONE HUNDRED EIGHTH CONGRESS
SECOND SESSION
__________
JULY 8, 2004
__________
Serial No. 108-99
__________
Printed for the use of the Committee on Energy and Commerce
Available via the World Wide Web: http://www.access.gpo.gov/congress/
house
__________
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------------------------------
COMMITTEE ON ENERGY AND COMMERCE
JOE BARTON, Texas, Chairman
W.J. ``BILLY'' TAUZIN, Louisiana JOHN D. DINGELL, Michigan
RALPH M. HALL, Texas Ranking Member
MICHAEL BILIRAKIS, Florida HENRY A. WAXMAN, California
FRED UPTON, Michigan EDWARD J. MARKEY, Massachusetts
CLIFF STEARNS, Florida RICK BOUCHER, Virginia
PAUL E. GILLMOR, Ohio EDOLPHUS TOWNS, New York
JAMES C. GREENWOOD, Pennsylvania FRANK PALLONE, Jr., New Jersey
CHRISTOPHER COX, California SHERROD BROWN, Ohio
NATHAN DEAL, Georgia BART GORDON, Tennessee
RICHARD BURR, North Carolina PETER DEUTSCH, Florida
ED WHITFIELD, Kentucky BOBBY L. RUSH, Illinois
CHARLIE NORWOOD, Georgia ANNA G. ESHOO, California
BARBARA CUBIN, Wyoming BART STUPAK, Michigan
JOHN SHIMKUS, Illinois ELIOT L. ENGEL, New York
HEATHER WILSON, New Mexico ALBERT R. WYNN, Maryland
JOHN B. SHADEGG, Arizona GENE GREEN, Texas
CHARLES W. ``CHIP'' PICKERING, KAREN McCARTHY, Missouri
Mississippi, Vice Chairman TED STRICKLAND, Ohio
VITO FOSSELLA, New York DIANA DeGETTE, Colorado
STEVE BUYER, Indiana LOIS CAPPS, California
GEORGE RADANOVICH, California MICHAEL F. DOYLE, Pennsylvania
CHARLES F. BASS, New Hampshire CHRISTOPHER JOHN, Louisiana
JOSEPH R. PITTS, Pennsylvania TOM ALLEN, Maine
MARY BONO, California JIM DAVIS, Florida
GREG WALDEN, Oregon JANICE D. SCHAKOWSKY, Illinois
LEE TERRY, Nebraska HILDA L. SOLIS, California
MIKE FERGUSON, New Jersey CHARLES A. GONZALEZ, Texas
MIKE ROGERS, Michigan
DARRELL E. ISSA, California
C.L. ``BUTCH'' OTTER, Idaho
JOHN SULLIVAN, Oklahoma
Bud Albright, Staff Director
James D. Barnette, General Counsel
Reid P.F. Stuntz, Minority Staff Director and Chief Counsel
______
Subcommittee on Commerce, Trade, and Consumer Protection
CLIFF STEARNS, Florida, Chairman
FRED UPTON, Michigan JANICE D. SCHAKOWSKY, Illinois
ED WHITFIELD, Kentucky Ranking Member
BARBARA CUBIN, Wyoming CHARLES A. GONZALEZ, Texas
JOHN SHIMKUS, Illinois EDOLPHUS TOWNS, New York
JOHN B. SHADEGG, Arizona SHERROD BROWN, Ohio
Vice Chairman PETER DEUTSCH, Florida
GEORGE RADANOVICH, California BOBBY L. RUSH, Illinois
CHARLES F. BASS, New Hampshire BART STUPAK, Michigan
JOSEPH R. PITTS, Pennsylvania GENE GREEN, Texas
MARY BONO, California KAREN McCARTHY, Missouri
LEE TERRY, Nebraska TED STRICKLAND, Ohio
MIKE FERGUSON, New Jersey DIANA DeGETTE, Colorado
DARRELL E. ISSA, California JIM DAVIS, Florida
C.L. ``BUTCH'' OTTER, Idaho JOHN D. DINGELL, Michigan,
JOHN SULLIVAN, Oklahoma (Ex Officio)
JOE BARTON, Texas,
(Ex Officio)
(ii)
C O N T E N T S
__________
Page
Testimony of:
Herz, Robert H., Chairman, Financial Accounting Standards
Board...................................................... 37
Mayer, Steven C., Senior Vice President and Chief Financial
Officer, Human Genome Sciences............................. 60
Walker, Hon. David M., Comptroller General, U.S. General
Accounting Office.......................................... 33
White, Rick, President and CEO, Technet, Chairman,
International Employee Stock Options Coalition............. 48
Material submitted for the record:
Barton, Hon. Joe, letter dated August 9, 2004, to William H.
Donaldson, Chairman, Securities and Exchange Commission,
enclosing followup questions for the record, and responses
to same.................................................... 144
Dingell, Hon. John D., letter dated August 4, 2004, to Robert
H. Herz, Chairman, Financial Accounting Standards Board,
enclosing followup questions for the record, and responses
to same.................................................... 138
Feldbaum, Carl B., President, Biotechnology Industry
Organization, letter dated June 29, 2004, enclosing
comments for the record.................................... 130
Herz, Robert H., Chairman, Financial Accounting Standards
Board, response for the record to questions of Hon. Jim
Davis...................................................... 134
Mayer, Steven C., Executive Vice President and Chief
Financial Officer, Human Genome Sciences, Inc., letter
dated June 29, 2004, enclosing comments for the record..... 120
Trumka, Richard L., Secretary-Treasurer, AFL-CIO, prepared
statement of............................................... 116
(iii)
FASB PROPOSALS ON STOCK OPTION EXPENSING
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THURSDAY, JULY 8, 2004
House of Representatives,
Committee on Energy and Commerce,
Subcommittee on Commerce, Trade,
and Consumer Protection,
Washington, DC.
The subcommittee met, pursuant to notice, at 1:35 p.m., in
room 2123, Rayburn House Office Building, Hon Cliff Stearns
(chairman) presiding.
Members present: Representatives Stearns, Shimkus, Shadegg,
Bass, Terry, Ferguson, Issa, Barton (ex officio), Schakowsky,
Towns, Brown, Stupak, Green, Strickland, Davis, and Dingell (ex
officio).
Staff present: David Cavicke, majority counsel; Chris
Leahy, majority counsel and policy coordinator; Brian
McCullough, professional staff, Will Carty, legislative clerk;
and Consuela Washington, minority counsel.
Mr. Stearns. Good afternoon. Today the subcommittee will
convene and will consider what all of us believe are important
questions concerning accounting treatment of stock options.
This hearing continues the bipartisan work we have done in
this subcommittee to improve accounting standards. This work
has included examination of restatements at Enron, Andersen,
and Freddie Mac. It has also involved extensive oversight on
modernization of FASB and the process by which FASB makes its
rules.
I am pleased that FASB has acted on a number of our
recommendations, including closing loopholes on special purpose
entities and speeding up the process of decisionmaking.
I want to also thank Ranking Member Jan Schakowsky, for her
spirit of bipartisanship that has helped this subcommittee. I
also would like to thank Chairman Barton for his leadership and
for facilitating this hearing, and Ranking Member John Dingell
for his long leadership and vision on accounting issues.
My colleagues, currently FASB provides that companies may
either expense options provided to employees or disclose the
expenses in footnotes. Now, companies that disclose the expense
in footnotes do not reflect the expense in their reported
earnings. About 575 companies, mostly since the excesses of the
1990's, have decided voluntarily to expense options. Now, these
companies include General Motors, Ford, Citigroup, Coca-Cola
and Microsoft. The rest of public companies that have options
choose not to reflect their expense as reported earnings.
FASB is considering a rule change that would require
companies to expense stock options, thereby informing investors
of the effect of the options grants on earnings. This proposal
would make GAAP consistent with international accounting
standards which in January will require the expensing of
options. This proposal by FASB is controversial, we grant that,
and members have legitimate views on both sides of this issue.
The rule would cause stock options to be treated like other
types of compensation paid to employees, including cash and
stock, which expense is reflected in companies' quarterly
earnings. FASB's proposal would also make GAAP consistent with
the tax treatment of options. Currently, companies don't have
to report the expense of options to their shareholders but can
deduct the cost of the same options on their taxes. I
understand that Alan Greenspan, Paul Volcker, SEC Chairman Bill
Donaldson, Treasury Secretary John Snow, and of course Warren
Buffett support FASB's position.
Many of our leading technology companies who are
represented here today oppose FASB's position. They argue that
options are difficult to value and often expire worthless. As
such, the options should not count as an expense.
We learned from Baruch Lev in a previous hearing that all
numbers in accounting, be they accounting, account receivables,
pension expense, or depreciation and amortization, are
literally just estimates.
There are rigorous means available for establishing the
values of options. These means are used to tell senior
executives the expected value of their pay package. Companies
also seem to have an easier time determining the value of
options when they deduct them on their corporate taxes.
My good colleague, Congressman Richard Baker, has
introduced legislation, H.R. 3574, which would direct the SEC
to prevent FASB from requiring the expensing of options. The
Financial Services Committee has approved this legislation,
although the bill has not yet--the committee has not yet filed
the report. I expect our witnesses will discuss this bill
today. I hope they will.
There are two points that I would like to highlight for
members of this subcommittee on this legislation. I am
concerned that the legislation may effectively forbid the more
than 575 companies that are voluntarily expensing options from
doing so in the future. I want each of our witnesses to explain
to us if this reading of this legislation is correct by me: If
companies that are voluntarily expensing options can no longer
do so upon inaction of this legislation, some of those 575
companies, wouldn't they be in violation of GAAP? This
violation could lead to a significant number of restatements of
earnings for those companies.
Regardless of your position, my colleagues, on the merits
of this legislation, forced restatements are not a desirable
outcome. During questions, I will ask each witness to address
the question of how the legislation affects those companies
that are voluntarily expensing their options.
And second, my colleagues, the legislation provides that
options granted to the top five executives in a company should
be expensed. However, the legislation requires by statute that
the volatility of these options be assumed to be zero. The
central insight--the central insight of Fisher Black and Myron
Scholes for which they won the Nobel Prize was that the value
of options is determined predominantly by their volatility. If
volatility is required by statute to be zero, then the value of
the options will likely be zero as well. Stock prices go up,
they go down. That is volatility. I would like the witnesses to
address the question of why assumed volatility of zero for
options should be mandated by statute by this Congress.
If this legislation moves to the floor, I would encourage
Members on both sides of this issue to support amendments that
I believe would cure those two defects.
On the proposal by FASB, I recognize that expensing options
involves estimating their value. Sometimes those estimates will
be incorrect. Accounting statements are supposed to provide
investors with the best current view of the assets and
liabilities of a company at a particular time. Opponents of
FASB are wanting to keep treating options as though they are
worthless in all situations. If they are worthless, people
wouldn't want them. So I prefer that we have financial
statements that be approximately correct rather than completely
wrong.
So I look forward to the testimony. With that, the
distinguished colleague, Ms. Schakowsky.
Ms. Schakowsky. Thank you, Chairman Stearns, and I, too,
appreciate your bipartisan approach to this committee's work
and for holding today's hearing on one of the most important
issues under our subcommittee's jurisdiction, accounting
standards.
Ranking Member Dingell, your presence here signifies how
important accounting standards are to corporate responsibility,
investors, and pension holders, and our country's economic
well-being, especially since you took time out on your birthday
to be here. So I want to wish you a very, very happy birthday.
I also would like to welcome Congressman Rick White. I
thank you for joining us to discuss FASB and the proposed rules
that would require companies to expense all stock options
issued to their employees.
We know from the corporate scandals of the past few years
that accurate and transparent accounting is vital to corporate
accountability and shareholder confidence. Yet, the accounting
treatment of stock options allows corporations to continue to
distort their true financial standing. Stock options make up 80
percent of compensation packages for corporate managers. In
2003, CEO pay at 350 major U.S. public companies averaged $8
million, with stock options typically providing the largest
compensation component. Despite those facts, stock options are
the only form of compensation that may be completely absent
from corporate financial statements.
The unique and unwarranted accounting treatment afforded
stock option has fueled abuses linked to excessive executive
pay, inflated company earnings, dishonest accounting, and
corporate misconduct. Nobel Prize winner Joseph Stiglitz
believes that the absence of stock option expensing
requirements has, quote, played an important part in the spread
of other financial chicanery, end quote, where corporate energy
and creativity was, quote, directed less and less into new
products and services and more and more into new ways of
maximizing executives' gains at unwary investors' expense.
Unquote.
A September 2002 report by a blue ribbon panel of the
Conference Board found that the current accounting treatment of
stock options helped foster a vicious cycle of increasing
short-term pressures to manipulate earnings, to bolster stock
price, so that those receiving options could cash in, take the
money, and run.
FASB's proposed rule would remove these perverse
incentives, and help bring transparency to corporate financial
statements. Investors and pension plan managers want the kind
of accurate financial information that FASB's rule would
provide. It would help them make informed investment decisions
about retirement security.
Since 2002, at least 576 corporations have decided that
expensing options is a sound accounting practice that attracts
investors and have voluntarily begun expensing the options that
they grant all their employees. Yet, some of our colleagues are
trying to prevent FASB's proposed rule with H.R. 3574, the so-
called Stock Option Accounting Reform Act. If this bill is
enacted, it would not only stop FASB's rule but would in fact
stop those nearly 600 corporations from voluntarily providing
an accurate accounting of their expenses.
While it claims to be a compromise and would require the
expensing of options given to the top executive along with the
four highest paid officers, it does so in a way that Warren
Buffett describes as, quote, mathematical lunacy, unquote. In
fact, H.R. 3574 is written so that the options would have no
value and would be reported as a no cost expense. This is not a
compromise but a give-away to corporations at the expense of
investors.
In the wake of Enron, Tyco, WorldCom, and other corporate
scandals, this is the wrong message to be sending to all those
workers and investors who lost their life savings and
retirement security, and it is the wrong policy to pursue if we
want to boost consumer confidence and improve our economy.
Far too often Congress has weighed in at the behest of
powerful special interests to back reforms like the expensing
of stock options. It is my hope that we have learned from the
past and will let FASB do its job.
I look forward to hearing the testimony of our witnesses,
and I thank you, Mr. Chairman.
Mr. Stearns. I thank the gentlelady.
The full chairman of the Energy and Commerce Committee, Mr.
Barton.
Chairman Barton. Thank you, Mr. Chairman. I, too, want to
extend my best wishes to John Dingell on his birthday today. We
had a little birthday party for him upstairs with the staff,
and we appreciate him being in good cheer today and being here.
I also want to welcome Rick, who used to be a member of
this committee, and encourage Sherrod Brown and Bart Stupak to
eat lots of ice cream and cake so they won't be in good shape
for tonight's congressional baseball game which we are going to
have out at the field at 7 o'clock.
Thank you, Mr. Chairman, for holding this hearing. It is a
proper and appropriate exercise of the Energy and Commerce
Committee's jurisdiction. It is obvious that the Financial
Accounting Standards Board proposed rules for stock option
expensing is an issue that is clearly within the jurisdiction
of the Energy and Commerce Committee and within the meaning of
the memorandum of understanding that was reached between this
committee and the Financial Services Committee in January 2001.
That MOU was a document that was negotiated by the Speaker's
office, former Chairman Tauzin, and Chairman Oxley to define
the jurisdiction over the setting of accounting standards by
the Financial Accounting Standards Board. And I quote: This
hearing follows 3\1/2\ years of subsequent work in this area,
including the historic hearings that this committee held on the
collapse of Enron, the problems at WorldCom, and the general
corporate scandals that we have had in the last 3 or 4 years.
Those hearings were led by Chairman Tauzin and led on the
minority side by Congressman Dingell. The Energy and Commerce
Committee is a committee that will get to the bottom of things,
and we will exercise our jurisdiction in an area that we
clearly have jurisdiction.
Having said that, I think I need to comment on the record
on some issues that are probably on a lot of people's minds.
The Financial Services Committee ordered H.R. 3574, the Stock
Option Accounting Reform Act, out of their committee several
weeks ago. I did not oppose that. I didn't oppose obviously Mr.
Baker, Congressman Baker, and Congressman Oxley and others
reporting that bill. I did ask the Energy and Commerce majority
staff to ensure that our committee's jurisdiction be protected.
Quite frankly, that is what committee chairmen are supposed to
do, and that is certainly something that Chairman Dingell did
when he was chairman of this full committee.
When the House leadership announced last week that H.R.
3574 would be on the floor this week, you know, I made a
decision that we would cooperate--and I want to underline
cooperate--with that bill going to the floor. I felt and
continue to feel that the Energy and Commerce Committee should
be entitled to a referral of the bill, and instructed our
general counsel to go to the Parliamentarian and ask that it be
referred. We also at the staff level touched base with the
Rules Committee. The Parliamentarian did issue a ruling that
had the Financial Services Committee reported their bill, had
they actually filed their report, the Parliamentarian indicated
that it would be referred to our committee.
But I did tell the leadership that if we did get a
referral, we would hold a hearing today, a legislative hearing
today on the bill and would report the bill today so that it
would be on the floor tomorrow. At no time did I indicate to
the Speaker's office, the majority leader's office, the Rules
Committee that this committee would in any way obstruct H.R.
3574 from being reported to the floor for an up or down vote by
the House of Representatives. It was not my decision to not
file the report by the Financial Services Committee. That is a
decision that was made by that committee.
So having said that, what we are doing today, since there
is no bill, there is no committee report that has been filed by
the Financial Services, today's hearing is not a legislative
hearing, it is simply an information hearing, and I am very
pleased that FASB and various private sector individuals are
here so that we can have this hearing and get additional
information on the record.
There are substantial policy issues involved. Those issues
need to be aired. The witnesses before us have a wealth of
expertise and are very knowledgeable on the matters that are
important in how we set these standards, if we set standards,
on how stock options are to be expensed. We have asked the
witnesses to share their views because they plainly have
something to say, and I believe they deserve to be heard by
this committee.
The decision has been made on the bill that was reported
out of Financial Services, 3574, to not file the report and not
report it to the floor tomorrow. That is not the fault of this
committee or of my responsibilities as chairman of the Energy
and Commerce Committee. I respect that decision if that is the
decision that has been made, but in some ways I regret it
because I too am concerned about the pending FASB proposal, and
I want the head of FASB to understand that.
I personally think that it is very difficult to value a
stock option at the time it is granted. No one can predict with
any degree of certainty where the future is going to take the
valuation of these companies. Sometimes the stock price will go
up and the option will become extremely valuable. Other times,
certainly in the last 3 or 4 years, stock prices stagnate or
decline precipitously and the options are worthless. I don't
think that we should mandate at the Federal level the expensing
of options that turn out to be worthless. You know, I think you
would set a value on something that can actually be put in the
bank. If you give me a cash bonus of $1,000, it is worth
$1,000. You know, there are ways to determine real value, but
some sort of a guess about where the stock price might be at a
date certain in the future is almost by definition going to be
proven wrong.
Financial analysts analyze companies for a living. They are
very aware of the stock option grants that various companies
give, the impact that they have or might have on earnings, and
presumably these analysts have already discounted into the
price of that company's stock whatever the dilution value is,
if any, of those options. The question becomes that requiring
mandatory expensing, will that in itself change the valuation
of a company? If it does not affect the valuation of the
company, what is gained?
What is certain is that a change to the accounting
standards that would require expensing would transform
corporate governance and would change methods of compensation
and possibly impact our international economic competitiveness.
That is a very, very serious issue that needs to be seriously
addressed. I hope that we can address some of those issues at
the hearing today. I hope we can resolve these issues.
If in fact it is a decision that needs to be made that we
need to report a Federal initiative, a Federal bill on these
issues, to the extent this committee has jurisdiction we will
work to report a responsible bipartisan bill.
I thank Chairman Stearns for holding the hearing. I look
forward to listening to the witnesses, and I thank their
attendance at today's hearing. With that, I yield back the
balance of my time.
Mr. Stearns. And I thank the chairman for his leadership.
The gentleman from Michigan whose birthday is today that we
all wish him the best wishes, Mr. Dingell.
Mr. Dingell. Mr. Chairman, I thank you, and I commend you
for holding this very important hearing.
I want to say a word about my friend, Mr. Barton, the
chairman of the full committee. First, thanks for his good
wishes on my birthday. A day on the green side of the sun is
quite an event in my life. I want to thank him for his kind
comments.
I also want to commend him for the courageous and energetic
way in which he has dealt with this committee's jurisdiction
and the right of this committee to address matters within the
longstanding jurisdiction of this committee over accounting,
accounting standards, and the Financial Accounting Standards
Board, FASB. I want to point out that I know that this is not
always an easy task, and I want him to know that I am
appreciative, as other members of this committee, of the rare
and courageous way in which he has addressed this matter, and I
want him to know of my appreciation. I thank you.
I also want to address the exposure draft of FASB and the
Baker bill. These two items, considered along with or against
each other, are very significant issues that deserve the
attention of this committee and the public. This committee has
been interested in the question of bad and dishonest accounting
going back into the 1970's when we first addressed the question
of dishonest accounting in connection with the Penn Central
bankruptcy. In that instance, the committee found that there
was out and out lying in the accounting, that the insiders
inside the corporation got out of the stock, left it to the
investors, walked away with hundreds of millions of dollars,
and left the taxpayers with a bill for restructuring railroads
in the northeast United States that cost the taxpayers over $7
billion.
It is interesting to note that neither the ICC nor the
Internal Revenue nor the shareholders nor the SEC nor the then
ICC had the vaguest idea of what was happening, because the
accountants had lied, and we were called upon to pony up huge
sums of money on behalf of the taxpayers to address this
problem.
Since that time, you can look at the records of corporate
failures, and you will find consistently that those records of
corporate failures are almost invariably bottomed on or have as
a major participating element dishonest, incompetent, and
improper accounting. Tyco, AOL, WorldCom, Sunbeam, and of
course Enron are splendid examples of how this can be done.
Interestingly enough, the Europeans are beginning to move
toward more responsible kinds of accounting in that they seek
in their handling of these matters to see to it that the
accountant tells everybody truthfully what the state of the
corporation is so that investors know, so that the corporate
officers know, and so that the public knows the state of
affairs in that corporation.
It is to be observed here that the Congress seeks to take
from FASB the authority to address the problem of responsible
accounting standards.
I don't know exactly what is going to be the result of this
by the FASB, and I am willing to wait. I would note that the
investigative hearings chaired by our colleague Mr. Greenwood
as to the causes and effects of Enron, WorldCom, HealthSouth,
and other accounting debacles, and the hearings chaired by you,
Mr. Chairman Stearns, into the failings of U.S. accounting
standards are so that faulty behavior in accounting has
facilitated these debacles, and we are finding that there have
been, amongst other things else, stock option abuses revealed,
accounting standards riddled with loopholes, audit failures,
massive failures of corporate governance, amongst other things.
We have directed FASB to fix the problems within its
purview, such as special purpose entities, stock option
accounting, and establishing a framework for measuring
financial and nonfinancial assets and unfair value. It is,
after all, what accounting is about. And if you look at the
accounting of other countries, you will find that other
countries have seen their economies go south because the
accounting in those countries is so bad. And, indeed, it is so
bad that not only do the investors, the government not know the
state of affairs of the accounting or the state of affairs of
those corporations, but the owners and the operators and the
high corporate officers of those corporations have handled
those matters so poorly and they have been so diligent in lying
to themselves and everybody else that nobody has the vaguest
idea what in the name of common sense the situation might be.
So fixing a situation of this sort so that finally the
corporations are able to restructure themselves and come to a
sound accounting and to a sound business state is almost
impossible.
We are here today because FASB issued an exposure draft
requesting public comment on a proposal to require that
companies account for stock options as an expense using the
fair value method. More than 575 American companies have
announced their intention to or have begun to voluntary expense
their options at fair value. These corporations can do it. Why
is it that others cannot?
I would note that the comment period for FASB's proposal
expired at the end of June. FASB is now in a months long stage
of reviewing all comment letters, including public hearings,
and redeliberating and revising the proposed standard. This is
a fair and an open process, one with which I agree and with
which I think no one may take criticism. I cannot say today
whether I support or disagree with the FASB standard since it
is still in a state of flux. I do agree with the general
principle, and I observe that it is required under
international accounting standards by foreign competitors of
the United States.
As for the Baker bill, all I can say is: ``What were they
thinking?'' I thought this country had seen enough phony
accounting, and yet here we have before us a piece of
legislation which sanctifies and indeed which endorses phony,
false accounting. It also prohibits honest accounting by
corporations that feel that this is in their best interest and
in the interests of the shareholders. This is a clear case
study in why Congress should not be in the business of writing
accounting standards. It decrees that the company shall count
options as an expense for the five highest corporate executives
but not for anybody else. A most curious decision. The bill
prohibits voluntary expensing of options by the 575 companies
that are currently and voluntarily expensing their options. It
mandates that when a company is calculating the expense of
options for the top five executives, it shall assume that the
price volatility is zero.
Has anybody looked at the different indexes in the
securities markets? They will tell you clearly that volatility
is never zero in the stock market. And they are saying then
that it never moves up and it never moves down. If there ever
was an Alice in Wonderland, make believe world, we are seeing
it here.
There are other gems of wisdom before us. I ask unanimous
consent to insert in the record FASB's letter analyzing the
bill in response to questions that I have posed.
Mr. Stearns. By unanimous consent, so ordered.
[The information referred to follows:]
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Mr. Dingell. I thank you. I also ask unanimous consent that
a fine op-ed article by Warren Buffett and a statement by
FACTS, the Financial Accounting Coalition for Truthful
Statements, which is a coalition of over 30 pension funds,
consumer/investor groups, and labor unions who oppose this bill
and support FASB's proposal, also be inserted into the record.
Mr. Stearns. By unanimous consent, so ordered.
[The information referred to follows:]
[Tuesday, July 6, 2004--The Washington Post]
Fuzzy Math And Stock Options
By Warren Buffet
Until now the record for mathematical lunacy by a legislative body
has been held by the Indiana House of Representatives, which in 1897
decreed by a vote of 67 to 0 that pi--the ratio of the circumference of
a circle to its diameter--would no longer be 3.14159 but instead be
3.2. Indiana schoolchildren momentarily rejoiced over this
simplification of their lives. But the Indiana Senate, composed of
cooler heads, referred the bill to the Committee for Temperance, and it
eventually died.
What brings this episode to mind is that the U.S. House of
Representatives is about to consider a bill that, if passed, could
cause the mathematical lunacy record to move east from Indiana. First,
the bill decrees that a coveted form of corporate pay--stock options--
be counted as an expense when these go to the chief executive and the
other four highest-paid officers in a company, but be disregarded as an
expense when they are issued to other employees in the company. Second,
the bill says that when a company is calculating the expense of the
options issued to the mighty five, it shall assume that stock prices
never fluctuate.
Give the bill's proponents an A for imagination--and for courting
contributors--and a flat-out F for logic.
All seven members of the Financial Accounting Standards Board, all
four of the big accounting firms and legions of investment
professionals say the two proposals are nonsense. Nevertheless, many
House members wish to ignore these informed voices and make Congress
the Supreme Accounting Authority. Indeed, the House bill directs the
Securities and Exchange Commission to ``not recognize as `generally
accepted' any accounting principle established by a standard setting
body'' that disagrees with the House about the treatment of options.
The House's anointment of itself as the ultimate scorekeeper for
investors, it should be noted, comes from an institution that in its
own affairs favors Enronesque accounting. Witness the fanciful
``sunset'' provisions that are used to meet legislative ``scoring''
requirements. Or regard the unified budget protocol, which applies a
portion of annual Social Security receipts to reducing the stated
budget deficit while ignoring the concomitant annual costs for benefit
accruals.
I have no objection to the granting of options. Companies should
use whatever form of compensation best motivates employees--whether
this be cash bonuses, trips to Hawaii, restricted stock grants or stock
options. But aside from options, every other item of value given to
employees is recorded as an expense. Can you imagine the derision that
would be directed at a bill mandating that only five bonuses out of all
those given to employees be expensed? Yet that is a true analogy to
what the option bill is proposing.
Equally nonsensical is a section in the bill requiring companies to
assume, when they are valuing the options granted to the mighty five,
that their stocks have zero volatility. I've been investing for 62
years and have yet to meet a stock that doesn't fluctuate. The only
reason for making such an Alice-in-Wonderland assumption is to
significantly understate the value of the few options that the House
wants counted. This undervaluation, in turn, enables chief executives
to lie about what they are truly being paid and to overstate the
earnings of the companies they run.
Some people contend that options cannot be precisely valued. So
what? Estimates pervade accounting. Who knows with precision what the
useful life of software, a corporate jet or a machine tool will be?
Pension costs, moreover, are even fuzzier, because they require
estimates of future mortality rates, pay increases and investment
earnings. These guesses are almost invariably wrong, often
substantially so. But the inherent uncertainties involved do not excuse
companies from making their best estimate of these, or any other,
expenses. Legislators should remember that it is better to be
approximately right than precisely wrong.
If the House should ignore this logic and legislate that what is an
expense for five is not an expense for thousands, there is reason to
believe that the Senate--like the Indiana Senate 107 years ago--will
prevent this folly from becoming law. Sen. Richard Shelby (R-Ala.),
chairman of the Senate Banking Committee, has firmly declared that
accounting rules should be set by accountants, not by legislators.
Even so, House members who wish to escape the scorn of historians
should render the Senate's task moot by killing the bill themselves. Or
if they are absolutely determined to meddle with reality, they could
attack the obesity problem by declaring that henceforth it will take 24
ounces to make a pound. If even that friendly standard seems unbearable
to their constituents, they can exempt all but the fattest five in each
congressional district from any measurement of weight.
In the late 1990s, too many managers found it easier to increase
``profits'' by accounting maneuvers than by operational excellence. But
just as the schoolchildren of Indiana learned to work with honest math,
so can option-issuing chief executives learn to live with honest
accounting. It's high time they step up to that job.
The writer is chief executive officer of Berkshire Hathaway Inc., a
diversified holding company, and a director of The Washington Post Co.,
which has an investment in Berkshire Hathaway.
Copyright 2004 The Washington Post
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Mr. Dingell. Mr. Chairman, in closing, I look forward to
hearing the testimony of FASB, of GAO, and our high tech
witnesses this afternoon. I am not opposed to trying to find a
fair and reasonable way to address the tech industry's concerns
with the FASB proposal. I ask only that at least at this time
we consider that we do not fully understand what the virtues
and vices of this are, nor have we heard from everybody who
wishes to be heard, nor has a fair and open process been
permitted to come to a proper conclusion.
It is clear to me that the Baker bill is not the answer. It
is equally clear to me that it is irresponsible and improper
meddling in a process which is too important to be tinkered
around with by an uninformed and ignorant Congress that doesn't
understand highly technical questions of this kind.
I thank you and yield back the balance of my time.
Mr. Stearns. And I thank the gentleman.
Mr. Ferguson? Okay. Mr. Stupak?
Mr. Stupak. Mr. Chairman, thank you. I would also like to
commend Chairman Barton for his strong defense of the
committee's jurisdiction over the issue before us today. The
Energy and Commerce Committee has a long jurisdictional history
over accounting standards and the Financial Accounting
Standards Board. It is highly appropriate that we are holding
this hearing, and I commend the chairman's leadership and the
subcommittee chair for holding this hearing.
Today's hearing will clarify the need for the expensing of
stock options, the need to keep FASB free from political and
business interference, and the very real problems with H.R.
3574, the bill recently voted out of the Financial Services
Committee, that would block the FASB proposal.
H.R. 3574 is evidence of exactly why Congress should leave
accounting standards to the experts. Politicians are not
accountants. Politicians should leave the rules of balancing
the books to the experts. We can't balance our own books. Under
this Congress, the United States has a debt of at least $7.1
trillion, and we will run a deficit of at least $521 billion.
For over 30 years we have trusted FASB to set accounting
and reporting standards for private and public companies.
Congress interfered once in that independence in 1993 when it
pressured FASB to not implement a stock option expensing plan
then. Had we not made that mistake, perhaps some of the
excesses of the late 1990's could have been avoided.
Frankly, I think a few companies are trying to generate
controversy by making red herring arguments about the FASB
proposal. But a consensus among financial experts, accounting
experts and consumer advocates is that the FASB proposal is
needed. Federal Reserve Chairman Alan Greenspan, Treasury
Secretary John Snow, SEC Chairman William Donaldson, Warren
Buffett, and the big four accounting firms all support
expensing of stock options. Over 500 companies already expense
stock options voluntarily. And the International Standards
Accounting Board, whose standards affect 90 countries, will
require the expensing of stock options in 2005. Canada already
requires it. Stock option expensing is not controversial. It is
long overdue.
Finally, I would like to conclude by saying that H.R. 3574
is a deeply flawed bill. First, it applies expensing of stock
options only to the CEO and the four other highest paid
executives in the company, and the bill sets up a method of
valuing those executives' options that doesn't make sense. When
calculating the value of those options, the company is to
assume that the volatility of the underlying stock is zero.
Stock prices move. In fact, the greater the volatility, the
greater the value of the stock option. Warren Buffett gave
these two measures a flat out F for logic.
Another huge problem with the bill is that it would
prohibit the voluntary expensing of options by over 575
companies that are currently voluntarily exercising their
options including Wal-Mart, Ford, General Motors, Microsoft,
Coca-Cola, and other innovative younger companies like Netflix.
Startup companies that are expensing stock options voluntarily
are often seen as more attractive investments precisely because
they expense stock options. The crux of this matter is
transparency. Investors have the right to receive accurate
information about a company's financial health. We know too
well what happens when companies cook their books. And this
committee knows too well the sham accounting gimmicks used to
inflate earnings and boost stock prices. Soaring stock prices
allowed Enron's CEO Ken Lay to take home $123 million from
exercising his stock options the year Enron went bankrupt. $123
million. Yesterday, Ken Lay was indicted on criminal charges.
His indictment should serve as a reminder to Congress why this
reform is needed. We should let FASB do their job.
With that, Mr. Chairman, I yield back the balance of my
time.
Mr. Stearns. I thank the gentleman.
Mr. Bass.
Mr. Bass. Thank you, Mr. Chairman, and as the Chair well
knows, I welcome this hearing. I welcome this hearing in the
new light, shall we say, of being able to consider before it
reaches the floor an important issue, not having the
jurisdiction of this committee completely obfuscated by another
committee.
We have, as the Chair well knows, taken the time here to
have significant hearings on this issue over the last couple of
years, and the content is extremely important.
I don't want to have any of my comments be interpreted as
either supporting or opposing the issue of expensing of
options, because there are very good arguments on both sides,
both for expensing and against expensing options, and the
purpose of this hearing is to dive into those reasons or
issues. And we have very good witnesses here, not the least of
which is one of my classmates and former member of this
committee, Rick White, from Washington.
However, as some other members of this committee have said
in their opening statements, we passed a couple of years ago as
a result of scandals plaguing our economy, corporate world, the
Sarbanes-Oxley bill, and it contained phrases such as
``independent judgment'' and ``free from bias'' when
establishing the manner in which the FASB should set standards,
and to have credibility given, independent credibility given to
these regulatory agencies.
Now, I have heard from many of my constituents regarding
the concerns with the FASB proposal that would require
expensing, and I question whether the proposed legislation
which might have been on the floor tomorrow had it not been for
the leadership of our full committee chairman and the
subcommittee chairman, whether this is exactly the way we
should be going about it.
So I look forward to hearing the testimony of our witnesses
here today, and I thank you, Mr. Chairman, not only for holding
this hearing which you planned to hold quite a few weeks ago,
but really working hard to make it relevant.
Mr. Stearns. I thank my colleague.
Mr. Davis.
Mr. Davis. I will waive, Mr. Chairman.
Mr. Stearns. Okay. The gentleman waives. He will have 3
extra minutes on his questioning.
Mr. Shadegg.
Mr. Shadegg. I thank you, Mr. Chairman, and I have a full
statement which I will put in the record.
I simply want to start by commending you for holding this
hearing. I think it is very important that we look at this
issue. I am a cosponsor of H.R. 3574, and I believe that there
are legitimate concerns to be looked at here, and I think it is
important that this committee examine those issues.
I personally am not fond of compelling the expensing of all
stock options. I am deeply concerned that that will hurt some
industries, particularly some in my own district that are
technology, high-tech startups and companies that have used
stock expensing to incentivize and to encourage very, very
talented employees to take a risk on their companies, and have
done so successfully. And I think just by dent of philosophy, I
believe that everything we can do within our economic system to
give employees a stake in the profitability of a company or in
its success is a step in the right direction. And so I think it
is important that we look at anything that would put that
structure at risk. And I think stock options are a part of the
structure that give employees a stake in the company.
I am concerned about the FASB proposal for a number of
reasons. I am particularly concerned that there is no agreed
upon method of valuation which everyone says is in fact
accurate. I understand that there is consensus that there are
some proposals that are more accurate than others and some
sense that this might be an improvement, but I think we should,
if anything, in this area go slow. And I think the Baker bill,
the H.R. 3574 is a reasonable compromise in going slow in this
area.
I would suggest that it is focused at the top management of
the company, because those are the individuals who can in fact
manipulate. And if the concern is, as one of my colleagues said
on the other side, abuse of the corporation or of its financial
structure through stock options, those are the individuals that
would be involved in that.
I do want to make two additional points. There has always
been some concern expressed that setting the volatility at zero
as the Baker legislation does means we are setting the value of
the option at zero, and that is clearly wrong. There are five
other factors that go into the valuation of the stock. What
setting at zero does is it creates a level playing field. It is
both simple, understandable, and it produces consistent results
which can be easily verified, according to Frederick Cook, a
FASB appointed member of the Option Valuation Group.
I think the second issue I want to address is the concern
that some have that the Baker bill would prohibit companies
from voluntarily expensing. As has been noted, many companies
are currently doing that. I know that from my work on this
legislation in the Financial Services Committee on which I also
serve, that it was certainly not the intent of the authors of
the bill to prohibit any company that chooses to voluntarily
expense its stock from doing so, and that it is at least the
belief of Mr. Baker and the authors of the bill that it in fact
does not prohibit any company from choosing to voluntarily
expense all of the stock options with which they issue.
I would conclude by simply saying that in a paper entitled
Expensing Options Solves Nothing, a report by Harvard business
professor of Business Administration, he argued that, if
anything, expensing may lead to a more distorted picture of a
company's economic condition and cash-flow than current
financial statements provide. I think we ought to be guided by
those words. I think the Baker compromise is a reasonable
compromise. I certainly believe we ought to examine these
issues. And I commend you, Mr. Chairman, for doing so. But, in
the interest of my constituents who are high-tech companies who
believe this is a critical part of the incentives they use to
make their companies viable and to compete with longstanding
companies, I think it would be very--we would be ill served to
not look at these issues thoughtfully, and, I hope, require
expensing only where it in fact will aid the marketplace and
aid investors, and not where it will harm the viability of the
American economy and particularly high-techs and startups.
With that, Mr. Chairman, I yield back.
Mr. Stearns. I thank the gentleman.
The gentleman from Ohio. Mr. Brown.
Mr. Brown. I thank the chairman. I also wish to send
birthday wishes with Mr. Dingell, who shares a birthday with my
mother. And Mr. Dingell, I would add, since my mother is not
here to hear it, is much younger than my mother.
But the issue of if our publicly traded companies account
for stock options has important implications for the integrity
of corporate governance and the soundness of American financial
markets, that is why as we consider whether to interfere with
efforts to reform stock option accounting Congress should in
fact heed the physician's maxim: First do not harm.
In 1995, as we remember, Congress overrode President
Clinton's veto of legislation limiting shareholder securities
lawsuits. The bill was authored by the then chairman of this
committee and cosponsored by its current chairman as well as
the current chairman of the Financial Services Committee. The
bill was a not particularly partisan one; in fact, the veto
override passed overwhelmingly. But, frankly, we got that one
wrong, after Enron collapsed in 2001, leaving corporate
watchdogs pointing to the 1995 laws, one contributor to a fast
and loose corporate culture that spawned the Enron debacle and
a string of other corporate scandals.
Today, with another reform bill before us, Congress may be
preparing to repeat that mistake. H.R. 3574 derails FASB's
common sense standards, as Mr. Stupak said, for the clear, open
and uniform expensing of stock options. Those standards are
supported by fed Chairman Greenspan, SEC Chairman Donaldson,
institutional investors like the Ohio Public Employees
Retirement System, which incidentally lost $114 million to the
Enron scandal.
H.R. 3574 offers the illusion, as we do so often here, of
corporate accountability, because though it requires expensing
of options to top corporate officers, it also effectively
requires that the company place no value on those options. That
bill actually undermines existing reforms by prohibiting
companies, again as Mr. Stupak said, that have already begun to
expense their options from continuing that practice. GM and GE,
Ford, and UPS and Wal-Mart and Amazon.com and more than 500
other companies believe they can compete effectively with full
disclosure, and shareholders for leading tech firms like HP,
Intel, Apple, and IBM believe their interests are better served
by expensing. But this bill makes that illegal.
Here is what President Clinton had to say in his veto
message of the 1995 securities law: Our markets are as strong
and effective as they are because they operate and are seen to
operate with integrity. I believe this bill would erode this
crucial basis of our market strength. Unquote.
That is just as true today as it was just about a decade
ago. I look forward to the testimony of our witnesses, Mr.
Chairman. I hope we can approach this important issue today and
as the legislation advances with the renewed commitment to do
no harm.
I yield back my time.
Mr. Stearns. I thank the gentleman.
Mr. Green.
Mr. Green. Thank you, Mr. Chairman.
I would like to commend our Chairman Barton for the defense
of our committee's jurisdiction on this legislation in
particular, and I would also like to thank you and our ranking
member for holding this important hearing.
It is interesting as we hold this hearing, Ken Lay, former
CEO of Enron, is in a courtroom in Houston facing charges for
behavior this bill seeks to prevent. Under this bill, Ken Lay's
stock options would have been fully reported. And I support
entrepreneurial spirit of American companies; however, we have
seen in recent years there is need to supply shareholders
better information on the value of their share holdings. This
bill is a step forward in achieving that goal.
The legislation provides protections from deceptive
reporting of stock values and affords businesses the ability to
use such options to entice the best and the brightest. Such
incentives are critical to the development of technology and
related industries where human capital is the driving force of
the industry. Under this legislation, companies must report
stock options going to the top five executives. It is the
behavior of top heavy profits that has gotten many large
corporations in trouble, and I believe this is a strong start
in safeguarding the value of stock other shareholders possess.
And, Mr. Chairman, hopefully this is our first hearing and
we are moving in the right direction with this legislation, and
I yield back my time.
[Additional statements submitted for the record follow:]
Prepared Statement of Hon. Barbara Cubin, a Representative in Congress
from the State of Wyoming
Thank you, Mr. Chairman.
I look forward to our hearing today on an important matter of
competitiveness. The concept of using stock options as an incentive for
employee performance helped contribute to substantial growth in the
tech sector and brought many small businesses from infancy to mega-
employer status. Having employees who have a stake in the health of the
company is not only a good incentive for the employer to offer, but
also a great wealth-building opportunity for wage-earners.
Now, after some high-profile bankruptcies, stock options are looked
upon in a largely negative manner, and the Financial Accounting
Standards Board's proposal for them to be expensed will effectively
kill the goose that laid the golden egg. In anticipation of the pending
accounting rule update, many companies are changing how they
incentivize performance and how they report the awarding of options, I
think this is an unfortunate trend.
I think we need to preserve the ability of small employers to
recruit employees using incentives like stock options. It's difficult
for small and start up companies to compete with large companies on
salary alone. Stock options offer a potential for wealth building and
an incentive for company growth.
I am also concerned with the assumption that we can predict the
cost of stock option such that they can be included on a company's
balance sheet. If someone could really determine what the future value
of a stock is, wouldn't we all buy low and sell high?
There is another aspect to these changes that no one seems to speak
about, and that is the assumption that the stock will always increase.
How fair is it for a company to expense these options, then show a poor
annual report as a result, then watch the stock decline to where it is
worth less than the price it was granted? Certainly nobody will be
exercising their options then.
I look forward to hearing from our distinguished panel on these
matters today and want to continue our dialog as we tackle legislation
addressing this matter. I yield back the balance of my time.
______
Prepared Statement of Hon. Diana DeGette, a Representative in Congress
from the State of Colorado
Thank you Mr. Chairman. I am pleased that the members of the
Commerce, Trade and Consumer Protection Subcommittee have a chance to
weigh in on this very important corporate governance issue, especially
given this Committee's jurisdiction over the Federal Accounting
Standards Board (FASB).
In July 2002, following the revelations of alleged fraud at Enron,
WorldCom and Global Crossing, the Coca-Cola Company, in an
unprecedented move, began to voluntarily report the stock options it
granted to its employees as an expense on its income statement.
According to Coca-Cola's Chief Financial Officer, Gary Fayard, the
expensing of stock options, instead of simply disclosing them in the
footnotes, was the appropriate choice as doing so ``more clearly
reflected economic reality'' and ensured ``that the confidence of our
shareowners was maintained.''
Since July 2002, more than 500 other U.S. reporting companies, such
as Exxon Mobil, General Motors, BankOne, Microsoft, Amazon.Com and
Netflix, have joined Coca-Cola and started treating the stock options
they give to their employees the same way they do any other form of
compensation: as an expense on their income statements. Despite fears,
the expensing of stock options has not led to the sky falling, stock
prices plummeting or an employee exodus to China or India at any of
these companies.
Recognizing that hundreds of public companies are already doing so,
FASB recently released a draft rule that would require all companies to
expense stock options on their income statement. The FASB rule does not
prohibit companies from granting options, but only requires that they
are properly accounted for.
Yet, instead of supporting FASB's efforts in crafting this long
overdue rule that would be instrumental in enhancing the integrity of
companies' financial statements, restoring investor confidence and
strengthening corporate governance in our country, Congress, in an
unprecedented move, is threatening to usurp FASB's authority and block
the Security and Exchange Commission's (SEC) adoption of the FASB rule.
Such a measure would prove to be a significant step backward from
Sarbanes Oxley and would call into question the commitment this body
made to strengthening corporate governance only two years ago. The bill
sponsored by Representative Baker would not only fail to increase
financial transparency or further honest accounting, but would
politicize the accounting standards-setting process and would
compromise the independence of FASB.
Simply stated, Congress should not legislate accounting standards
nor should it interfere with the accounting standards-setting process.
Not only would doing so dramatically undermine the independence of
FASB, it would set a dangerous precedent. If Congress blocked the FASB
rule requiring the expensing of stock options because it might
adversely affect technology companies, what would stop this body from
requiring FASB to change other existing rules, such as its rule on
expensing depreciation that decreases the bottom line for
manufacturers? While unlikely, Representative Baker's bill would open
the door to such actions and potentially set us on a path down a
slippery slope.
It is also important to keep in mind that the very companies who
are lobbying Congress against expensing stock options for accounting
purposes are expensing stock options for tax purposes. Currently, a
company is able to dole out options with no impact to its bookkeeping
bottom line--the one Wall Street is interested in, while simultaneously
expensing options and reducing its bottom line--its tax liability--for
tax purposes. Such a discrepancy not only leads to an overstatement of
earnings for companies, but also a penalty to those companies who do
not use options to compensate their employees. The FASB rule would
rightfully correct this double standard.
Many of the companies and some Members who are against the FASB
rule claim that there is no perfect way to value options and for that
reason, options should not be expensed. But as Warren Buffet recently
stated in a recent Washington Post editorial on the issue, ``estimates
pervade accounting.'' In fact, accountants use estimates for lots of
things, including items already expensed on the income statement, such
as depreciation or amortization. In fact, many accounting experts have
said that the method to value stock options is much more accurate than
the method to value the useful life of a manufacturing plant or a
corporate jet for depreciation purposes. As Warren Buffet has
admonished, ``legislators should remember that it is better to be
approximately right than precisely wrong.''
Therefore, I commend FASB in its continued efforts to increase
financial transparency and strengthen corporate governance in America.
Moreover, Congress should not interfere with the accounting standard
process at FASB nor should it limit the SEC's ability to recognize
FASB's authority. Doing so would seriously compromise the independence
of FASB, politicize the accounting standard setting-process and even
more importantly, undermine Congress' efforts toward improving
corporate governance in our country.
Mr. Stearns. I thank my colleagues. We are ready for the
first panel. We have the honorable David Walker, Comptroller
General of the U.S. General Accounting Office. We have Mr.
Robert Herz, Chairman of the Financial Accounting Standards
Board. And we have our former colleague, Mr. Rick White,
President and CEO of Technet, Chairman, International Employee
Stock Options Coalition. And we have Mr. Steven Mayer, Senior
Vice President and Chief Financial Officer of Human Genome
Sciences.
From our colleagues, we have two individuals that are sort
of pro stock options and we have two individuals who are not
for stock options. So I think we have got a balanced hearing.
And we welcome your opening statements, and we would like you,
if possible, to keep them under 5 minutes, and thank you.
We will start with you, Mr. Walker. Thank you.
STATEMENT OF HON. DAVID M. WALKER, COMPTROLLER GENERAL, U.S.
GENERAL ACCOUNTING OFFICE
Mr. Walker. Thank you, Mr. Chairman, Members of the
subcommittee. It is a pleasure to be before you here today. In
addition to being the Comptroller General of the United States
and head of, effective yesterday, the Government Accountability
Office, still the GAO, I have been a CPA for over 30 years. So
I have had to deal with these issues both in the public sector
and the private sector, the not-for-profit sector, for many
years. I felt it was important that you understand my
background on this issue.
I appreciate the opportunity to share GAO's perspective on
the process of establishing accounting standards for private
sector entities, in general, and the FASB's proposed accounting
for stock options, in particular. As has been noted by a number
of members, we fully recognize that the stock options
accounting issue is a complex and controversial issue on which
reasonable people can and do disagree.
On June 28, 2004, I sent a letter to the FASB as well as to
the Chair and ranking member of the Senate Committee on
Banking, Housing, and Urban Affairs. My testimony is based
primarily on these two letters.
Thank you, Mr. Chairman, for putting my entire statement in
the record, and I will summarize the highlights.
We support the concepts behind FASB's current proposed
statement requiring that companies use the fair market value
method, which essentially results in companies recording stock
options and other share based compensation arrangements as an
expense. In our view, stock options and other forms of share-
based payments have economic value and represent a form of
compensation expense. If they are not compensation, I don't
know what else they are. Therefore, we believe that the
economic substance of such transactions should be reflected as
a compensation expense and in the calculation of a company's
net income in order to accurately portray its financial
results.
The current standard, which permits companies to choose
between the intrinsic and fair market value methods, in effect
allows companies to select their own net income. It also
creates a barrier to comparable financial information, both
domestically and internationally, because the choice of methods
will result in differences in reported amounts across companies
due to the different methods of accounting. We believe that a
requirement to expense stock options and other share-based
payments will provide additional transparency, clarity, and
comparability in financial reporting.
I would also note, as certain other members of the
subcommittee have stated, it would also serve to increase
consistency between accounting and tax treatment for share
based payments.
We also support the four principal reasons that the FASB
has cited for issuing the new proposed standard.
Notwithstanding ours and others' views on the merits of various
accounting methods for stock options, we believe that the
principle of independence, both in fact and appearance, with
regard to standard setting is absolutely crucial. It is
essential to the credibility of and confidence in the
authoritative standard setting process. FASB, in carrying out
its standard setting activities, has an established process in
place to obtain and consider feedback from its constituent
groups, including financial statement preparers, auditors,
institutional investors, lenders, creditors, professional
analysts, and various other parties. This process is especially
important given the complexity and controversial nature of some
accounting standards, including the one being considered today,
accounting for stock options and other share-based payments.
We believe it is critical that the FASB complete its
analysis of comments received on its exposure document on
share-based payments and finalize its proposed statement in
accordance with the established independent standard setting
process. In our opinion, the FASB's independent standard
setting process, subject to SEC oversight, which the Congress
properly enacted, should be allowed to proceed in its
consideration of accounting for stock options.
Mr. Chairman, that concludes my statement. I would be happy
to answer any questions after my fellow panel members have a
chance to speak. Thank you.
[The prepared statement of Hon. David M. Walker follows:]
Prepared Statement of Hon. David M. Walker, Comptroller General, U.S.
General Accounting Office
Dear Mr. Chairman and Members of the Subcommittee: I appreciate the
opportunity to discuss with the subcommittee GAO's perspective on the
process for establishing accounting standards for private-sector
entities and then, more specifically, the current proposals for
accounting for stock options. We recognize that accounting for stock
options is a complex and controversial issue on which reasonable people
can and do disagree. As a result, in light of the Financial Accounting
Standards Board's (FASB) current proposed standard for accounting for
stock options and other share-based compensation, there has been a
renewed interest for the Congress to possibly legislate accounting
rules for stock options. On June 28, 2004, we sent a letter to FASB
commenting on its proposed standard and a letter discussing the
accounting standard-setting process to the Senate Committee on Banking,
Housing, and Urban Affairs.1
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\1\ U.S.General Accounting Office, Independent Standard-Setting
Process for Establishing Accounting Standards for Private-Sector
Entities, GAO-04-480R (Washington, D.C.: June 28, 2004). This letter
contained as an enclosure our comment letter to FASB.
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FASB is a non-governmental organization empowered to establish
financial accounting and reporting standards for private-sector
entities. Although this function legally resides with the Securities
and Exchange Commission (SEC) for public companies as part of its
mandate to administer and enforce the provisions of the federal
securities laws, the SEC has traditionally relied on FASB since 1973 to
fulfill this function. The U.S. capital markets depend on a system of
continuously improving financial information about the underlying
economic activities of companies. This information is fostered and
framed by independently established financial accounting and reporting
standards, collectively referred to as generally accepted accounting
principles (GAAP).
On March 31, 2004, FASB issued an exposure document on a proposed
Statement, Share-Based Payment, an Amendment of FASB Statements No. 123
and 95, which addresses the accounting for compensation to employees in
the form of stock options and other forms of equity. The FASB's
proposed Statement would generally eliminate the ability for public
companies to account for share-based services using the intrinsic
method (which generally results in no expense being recognized) and
would require instead the use of a fair-value-based method, which would
generally result in companies treating stock options granted to
employees as an expense based on their fair value when
granted.2 It is important to note that in 1995, when issuing
the current standard that is in place, FASB clearly stated that the
fair market value is the preferable method. The current standard also
includes guidance to that effect and requires that if the fair market
value method is not used, then disclosure must be made of pro forma net
income and earnings per share presented as if the fair market value
method had been used.
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\2\ The proposed standard would permit nonpublic companies to
measure compensation costs based on the intrinsic method of accounting
at each reporting date until options are exercised or otherwise
settled.
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We support the concepts behind FASB's current proposed Statement
requiring companies to use the fair market value method, which
essentially results in companies recording stock options and other
share-based arrangements as an expense. In our view, stock options and
other forms of share-based payment have economic value and represent a
form of compensation expense. Therefore, we believe that the economic
substance of such transactions should be reflected as compensation
expense in the calculation of a company's net income to accurately
portray its financial results. The current standard, which permits
companies to choose between the intrinsic and fair value methods,
allows companies to select the impact on net income. It also creates a
barrier to comparable financial information, both domestically and
internationally, because the choice of methods used will result in
differences in reported amounts across companies due to the different
methods of accounting. We believe that a requirement to expense stock
options and other share-based payment will provide additional
transparency, clarity, and comparability in financial reporting.
We also support the four principal reasons FASB cited for issuing
the new proposal: (1) addressing concerns of users and others that the
use of the intrinsic value method results in financial statements that
do not faithfully represent economic transactions and can distort the
financial condition and operations of the issuer; (2) improving the
comparability of reported financial information through the elimination
of alternative accounting methods; (3) simplifying U.S. generally
accepted accounting principles by requiring the use of a single method
of accounting for share-based payment; and (4) enabling international
convergence and greater international comparability in the accounting
for share-based payment.
Notwithstanding our and others' views on the merits of various
accounting methods for stock options, we believe that the principle of
independence, both in fact and in appearance, is essential to the
credibility of and confidence in any authoritative standard-setting
processes. With respect to the role of FASB in this and other areas, we
support its efforts, as the SEC's designated independent non-
governmental standard-setting body, to identify issues for
consideration, prepare exposure documents, conduct outreach efforts and
solicit comments on exposure documents, and consider the resulting
comments in finalizing and issuing new accounting standards. FASB, in
carrying out its standard-setting activities, has an established
process in place to obtain and consider feedback from its constituent
groups, including financial statement preparers, auditors, and users
such as individual investors, institutional investors, lenders,
creditors, professional analysts, and various other parties. These
processes were established in order to balance the competing interests
and demands of the various groups while providing standards that
promote transparent, credible, and comparable financial information.
This time-tested and proven deliberative process has served to
strengthen financial reporting and ensure general acceptance of the
nation's accounting standards. This process is especially important
given the complexity and controversial nature of some accounting
standards, including the accounting for stock options and other share-
based payments.
We believe it is critical that FASB complete its analysis of
comments received on its exposure document on share-based payment and
finalize its proposed Statement in accordance with its established
independent standard-setting process. In enacting the Sarbanes-Oxley
Act of 2002, the Congress recognized the importance of having an
independent standard-setting process that facilitates accurate and
effective financial reporting and protects investors. As a safeguard,
the Act specified criteria for the SEC to use for determining whether a
private-sector accounting standard setter's principles will be
considered as generally accepted. The SEC determined that FASB met the
statutory criteria established in the Sarbanes-Oxley Act of 2002. In
our opinion, the FASB's independent standard-setting process, subject
to SEC oversight, should be allowed to proceed in its consideration of
accounting for stock options.
I would like to add that GAO is involved in setting government
auditing standards and accounting standards for federal agencies. We
have also implemented deliberative processes to obtain and consider the
perspectives of affected parties on exposure drafts of proposed
standards. Standard setting is, by its nature, an iterative process and
the standard setter needs a high degree of independence to make
decisions on what represents the best standard in the public interest.
Mr. Chairman, this concludes my statement. I would be pleased to
answer any questions you or other members of the subcommittee may have
at this time.
For further information regarding this testimony, please contact
Jeanette M. Franzel, Director, Financial Management and Assurance, at
202-512-9471 or [email protected]. Michael C. Hrapsky also made key
contributions to this testimony.
Mr. Stearns. Mr. Herz.
STATEMENT OF ROBERT H. HERZ, CHAIRMAN, FINANCIAL ACCOUNTING
STANDARDS BOARD
Mr. Herz. Thank you, Chairman Stearns, Ranking Member
Schakowsky, and members of the subcommittee. I am very pleased
to appear here today. I think this is a very important and
timely hearing. I have brief prepared remarks and a full text
of testimony, which I would request be entered into the record.
Mr. Stearns. By unanimous consent, so ordered.
Mr. Herz. As you well know, our ability to conduct our work
in a systematic, thorough, and unbiased manner is fundamental
to achieving our mission. The standards we produce are
essential to the growth and stability of the U.S. economy,
because creditors, investors, and other consumers of financial
information rely heavily on credible, transparent, comparable,
and unbiased financial reports. Financial accounting reporting
is meant to tell it like it is, not to distort or to skew
information to favor particular industries, particular types of
transactions, or particular political, social, or economic
goals, other than the goal of sound and honest reporting.
We understand that our proposal on share based payments or
equity based compensation is controversial, the subject is
controversial, but we felt it very important to address the
accounting in this important area for a number of reasons.
First, there was a high level of public concern expressed
by investors, creditors, financial analysts, and many other
parties about the need to improve the accounting in this area.
Second, the complexity and noncomparability in this lack of
transparency created by the alternative accounting treatments
presently available for stock based compensation.
And finally, the opportunity to achieve convergence to a
common high quality international accounting standard in this
important area.
Our proposal is the result of an extensive public due
process, a process that began in November 2002 before the
project was added to our agenda. That process included the
issuance of a preliminary document for public comment, the
review of hundreds of comment letters, review of relevant
research studies, consultation with our formal advisory
councils, and with many, many, many other parties, including
users, auditors, and preparers of financial reports of small
businesses, an active board deliberation at 38 public meetings.
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 so-called fixed plan
employee stock options results in reporting that not only
ignores the economic substance of those transactions, but also
distorts reported earnings and other key financial metrics.
As the Congressional Budget Office stated in their recent
report to Congress, if firms do not recognize as an expense the
fair value of employee stock options measured when the options
are granted, the firms' net income will be overstated. Thus,
under current accounting standards, the greater the use of
fixed plan employee stock options, the greater the distortion
of the reported results.
In the public arena, as mentioned, our proposal would bring
about greater comparability between the over 575 companies that
have voluntarily opted to account for stock options and the
many others that have not yet done so. It would also be
responsive to the growing number of companies, including many
major technology companies, whose shareholders by a majority
vote have approved nonbinding proxy resolutions mandating
expensing of all employee stock options. The proposal also
would result in substantial convergence in the accounting for
equity based compensation between U.S. standards and the
international accounting standards that will be followed by
companies in over 90 countries around the world.
As noted, our neighbor to the north, Canada, who usually
follows our lead in modifying their accounting standards, felt
that it could not wait in this area and decided to mandate
expensing of employee stock options beginning in January 2004.
I understand that implementation of Canada's new standard,
which has been adopted by over 1,500 small businesses and over
500 technology companies, has to date gone very smoothly.
Now, since the issuance of our proposal for public comment,
we have continued to actively solicit input and response to the
proposal. In May, the Board discussed the proposal with
representatives of small businesses at the public meeting of
our Small Business Advisory Committee. Mr. Mayer is a member of
that. Discussions focused largely on the special provisions
that were in our proposal that were intended to alleviate the
cost and complexity of implementing the standard for small
businesses. We are very sensitive to the needs and concerns of
startups and small businesses, and recognize that special
provisions might be appropriate.
In June, we held four public roundtable meetings, two in
Palo Alto, California, and two at our offices in Norwalk to
discuss the proposal. Over 70 individuals from a broad range of
companies, investors, small businesses, valuation experts,
auditors, and so on, attended the meeting and gave their views.
To date, the Board has also received thousands of comment
letters in response to the proposal.
Beginning later this month, we will start redeliberating at
public meetings the issues and comments we have gotten on the
proposals. Those redeliberations will be systematic, thorough
and objective and will include careful consideration of the
input already received and input that we will continue to
solicit throughout the process. Only after carefully evaluating
at the public meetings the input received and reaching
decisions on the issues raised will we consider whether to
issue a final standard.
Our current plans are to complete our redeliberations and
be in a position to issue a final standard in the fourth
quarter of this year. So it was with great concern that I
learned that the House of Representatives may soon vote on H.R.
3574, proposed legislation that if enacted would cut short,
preempt and override our current efforts to improve the
accounting for equity-based compensation.
We strongly oppose H.R. 3574, as we believe do most
investors, analysts, accountants and many companies. That
opposition is based on many conceptual and technical reasons,
including, first, the proposed legislation is seriously flawed.
By mandating the expensing of only those stock options held by
the top five executives and stipulating an unorthodox method
for valuing and accounting for those options, the proposed
legislation violates fundamental concepts of economics and
accounting and would legislate significant distortions in
companies' reported earnings, profitability and other key
financial metrics.
Second, the proposed legislation, although titled the Stock
Option Accounting Reform Act, contains provisions that have
exactly the opposite effect by largely preserving, protecting
and perpetuating the nonexpensing of stock options that has
resulted in an unlevel playing field favoring certain companies
that are the greatest user of fixed plan employee stock options
over other companies that have chosen to compensate their
employees in different ways.
Third, the proposed legislation, as mentioned, would be in
direct conflict with the expressed needs and demands of many
investors and shareholders and would appear to prohibit the
voluntary expensing of all employee stock options that has been
adopted by over 575 U.S. companies.
Fourth, the proposed legislation would strike a real blow
to the FASB's efforts to achieve timely convergence of high
quality international accounting standards and is therefore
directly inconsistent with the language and intent of both the
Sarbanes-Oxley Act and the related SEC policy statement
reaffirming the FASB as the Nation's accounting standard
setter.
Fifth, the proposed legislation would raise a host of other
practical and implementation issues for companies, auditors,
regulators and the entire financial reporting system.
Finally, and very importantly, the proposed legislation
would in our view establish a very dangerous precedent in that
it would send a clear and unmistakable signal that Congress is
willing to directly intervene in the independent, objective and
open accounting standard setting process based on factors other
than the pursuit of sound and honest financial reporting.
For those many reasons, we believe that H.R. 3574 if
enacted would result in a major step backwards in the recent
efforts by Congress, the SEC, the FASB and many other parties
to restore public confidence and trust in the integrity of
financial reporting. As Federal Reserve Chairman Greenspan
recently noted, the potential enactment of H.R. 3574 would be a
bad mistake for the Congress. We wholeheartedly agree.
Speaking not just for the FASB but for the millions of U.S.
investors and others that rely on the integrity of financial
reporting and the capital market system, I respectfully urge
all of you to oppose this legislation so that we may continue
our work on developing a high quality standard that will
improve financial reporting in this important area.
Thank you, Chairman Stearns. I too would be happy to
respond to questions.
[The prepared statement of Robert H. Herz follows:]
Prepared Statement of Robert H. Herz, Chairman, Financial Accounting
Standards Board
Chairman Stearns, Ranking Member Schakowsky, and Members of the
Subcommittee: I am Robert Herz, chairman of the Financial Accounting
Standards Board (``FASB'' or ``Board''). I am pleased to appear before
you today on behalf of the FASB. I want to thank you for the
opportunity to publicly express our concerns, and the concerns of
investors, analysts, accountants, and many companies about H.R.
3574,1 which, if enacted, will cut short and override the
FASB's current efforts to improve the financial accounting and
reporting for equity-based compensation.
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\1\ H.R. 3574, 108th Congress, 1st Session (November 21, 2004).
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My testimony includes a brief overview of (1) the FASB, including
the importance of the Board's independence and the ability to conduct
its work in a systematic, thorough, and objective manner, (2) the
process the FASB follows in developing accounting standards, (3) the
basis for the Board's unanimous decision to issue a proposal to improve
the accounting for equity-based compensation, (4) the input received in
response to the proposal, (5) the current status of, and the FASB's
plans relating to, the proposal, and (6) some observations about H.R.
3574.
THE FASB
The FASB is an independent private-sector organization.2
We are not part of the federal government. Our independence from
enterprises, auditors, and the federal government is fundamental to
achieving our mission--to establish and improve standards of financial
accounting and reporting for both public and private enterprises,
including small businesses.3 Those standards are essential
to the efficient functioning and operation of the capital markets and
the United States (``US'') economy because investors, creditors, and
other consumers of financial reports rely heavily on sound, honest, and
unbiased financial information to make rational resource allocation
decisions.
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\2\ See Attachment 1 for information about the Financial Accounting
Standards Board.
\3\ See Attachment 2 for excerpts from recent materials about the
importance of the FASB's independence and concerns about proposed
legislation.
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The FASB's independence, the importance of which was recently
reaffirmed by the Sarbanes-Oxley Act of 2002 (``Act''),4 is
fundamental to our mission because our work is technical in nature,
designed to provide preparers with the guidance necessary to report
information about their economic activities. Our standards are the
basis to measure and report on the underlying economic transactions of
business enterprises. Like investors and creditors, Congress and other
policy makers need an independent FASB to maintain the integrity of the
standards in order to obtain the financial information necessary to
properly assess and implement the public policies they favor.
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\4\ Sarbanes-Oxley Act of 2002, Public Law Number 107-204, Sections
108-109.
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Financial accounting and reporting is meant to tell it like it is,
not to allow distortions or skew information to favor particular
industries, particular types of transactions, or particular political,
social, or economic goals other than sound, and honest reporting. While
bending the standards to favor a particular outcome may seem attractive
to some in the short run, in the long run a biased accounting standard
is harmful to investors, creditors, the capital markets, and the US
economy.
The FASB's authority with respect to public enterprises comes from
the US Securities and Exchange Commission (``SEC''). The SEC has the
statutory authority to establish financial accounting and reporting
standards for publicly held enterprises. For 30 years, the SEC has
looked to the FASB for leadership in establishing and improving those
standards. The SEC recently issued a Policy Statement reaffirming this
longstanding relationship.5
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\5\ ``Policy Statement: Reaffirming the Status of the FASB as a
Designated Private-Sector Standard Setter,'' Exchange Act Release Nos.
33-8221; 34-47743; IC-26028; FR-70 (April 28, 2003).
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The Policy Statement, consistent with the language and intent of
the Act, also reemphasizes the importance of the FASB's independence
described earlier.6 It states:
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\6\ Sarbanes-Oxley Act of 2002, Sections 108-109; the legislative
history of the Sarbanes-Oxley Act of 2002 (``Act'') is clear that the
provisions of the Act relating to the FASB were intended to
``strengthen the independence of the FASB . . . from . . . companies
whose financial statements must conform to FASB's rules.'' Senate
Report 107-205, 107th Congress, 2d Session (July 3, 2002), page 13.
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By virtue of today's Commission determination, the FASB will
continue its role as the preeminent accounting standard setter
in the private sector. In performing this role, the FASB must
use independent judgment in setting standards and should not be
constrained in its exploration and discussion of issues. This
is necessary to ensure that the standards developed are free
from bias and have the maximum credibility in the business and
investing communities.7
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\7\ Policy Statement, page 5 of 8.
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The SEC, together with the private-sector Financial Accounting
Foundation (``FAF''),8 maintains active oversight of the
FASB's activities.
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\8\ See Attachment 1 for information about the Financial Accounting
Foundation.
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what process does the fasb follow in developing accounting standards?
Because the actions of the FASB affect so many organizations, its
decision-making process must be open, thorough, and as objective as
possible. The FASB carefully considers the views of all interested
parties, including users, auditors, and preparers of financial reports
of both public and private enterprises, including small businesses.
Our Rules of Procedure require an extensive and thorough public due
process.9 That process involves public meetings, public
roundtables, field visits, liaison meetings with interested parties,
and exposure of our proposed standards to external scrutiny and public
comment. The FASB members and staff also regularly meet informally with
a wide range of interested parties to obtain their input and to better
our understanding of their views. The Board makes final decisions only
after carefully considering and analyzing the input of all interested
parties.
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\9\ See Attachment 1 for information about the FASB's due process.
---------------------------------------------------------------------------
While our process is similar to the Administrative Procedure Act
process used for federal agency rule making, it provides for far more
public deliberations of the relevant issues and far greater
opportunities for interaction with the Board by all interested parties.
It also is focused on making technical, rather than policy or legal,
judgments. The FASB's Mission Statement and Rules of Procedure require
that in making those judgments the Board must balance the often
conflicting perspectives of various interested parties and make
independent, objective decisions guided by the fundamental concepts and
key qualitative characteristics of financial reporting set forth in our
conceptual framework.
The FASB and the FAF, in consultation with interested parties,
periodically review the FASB's due process procedures to ensure that
the process is working efficiently and effectively for users, auditors,
and preparers of financial reports.10 Over the past two
years, the FASB and the FAF have undertaken a significant number of
actions to improve the Board's due process procedures. Some of those
actions were intended to increase the quality and breadth of input to
our process, including increasing the input from users, auditors, and
preparers of small businesses. Those particular actions include the
following:
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\10\ The Securities and Exchange Commission (``SEC'') also recently
reviewed the FASB's due process and concluded that ``the FASB has the
capacity . . . and is capable of improving both the accuracy and
effectiveness of financial reporting . . .'' Policy Statement, page 5
of 8.
Establishing a Small Business Advisory Committee (``SBAC'') in order
to increase involvement by the small business community in
developing accounting standards. The SBAC, whose members
represent diverse perspectives and experiences, comprises
lenders, investors and analysts, preparers of financial
statements from a broad range of businesses, including
controllers and chief financial officers, and auditors from the
small business community.
Establishing a User Advisory Council (``UAC'') in order to obtain
more active user involvement in our process. The UAC comprises
representatives of individual and institutional investors,
investment and commercial banks, rating agencies, and other
groups that represent investors and key users. Several of the
members of the UAC are primarily users of financial reports of
small businesses.
Making our public Board meeting announcements available to interested
parties more broadly through an email subscription service.
Making our public Board meetings available to interested parties for
monitoring via web cast on our website free of charge and via
the telephone at a reduced cost.
Making all of our proposals for public comment, all of the comments
received, and the full text of all our standards publicly
available on our website.
FASB'S CURRENT PROJECT TO IMPROVE THE ACCOUNTING FOR EQUITY-BASED
COMPENSATION
In March 2003, at a public meeting, the Board decided to add a
project to its agenda to address issues relating to equity-based
compensation. That decision was based largely on three reasons.
The first reason was the high level of public concern expressed by
creditors, individual and institutional investors, pension funds,
mutual funds, financial analysts, and other users of financial
statements about the need to improve the financial accounting and
reporting for equity-based compensation. The concern was not just about
perceived abuses of executive compensation, but the broader issue of
the appropriate financial accounting and reporting for equity-based
compensation, in particular the need to eliminate the exception from
expense recognition that presently exists only for fixed plan employee
stock options. Those users of financial statements that have been
urging the FASB to eliminate the exception for fixed plan employee
stock options include:
The Council of Institutional Investors (an association of more than
130 corporate, public, and union pension funds with more than
$3 trillion in pension assets)
Institutional Shareholder Services (serving more than 950
institutional investors and corporate clients worldwide)
The Office of the State Comptroller of New York (an investor,
shareholder, and sole trustee of the nation's second largest
pension fund at approximately $100 billion in assets)
Moody's Investor Services
The Central Pension Fund of the International Union of Operating
Engineers and Participating Employers (on behalf of more than
150,000 participants of the CPF)
The Teachers Insurance and Annuity Association College Retirement
Equities Fund (a financial services company with approximately
$262 billion in assets under management, serving nearly 3
million education and research employees at 15,000
institutions)
The Investment Company Institute (a national association including
8,938 mutual funds, 535 closed-end investment companies, and 6
sponsors of unit investment trusts; its mutual fund members
have assets of about $6.539 trillion, accounting for
approximately 95 percent of total industry assets, and 90.2
million individual shareholders)
The Association for Investment Management and Research (now known as
the CFA Institute, a nonprofit professional organization of
61,600 financial analysts, portfolio managers, and other
investment professionals).11
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\11\ A 2001 survey conducted by the Association for Investment
Management and Research found that more than 80 percent of financial
analysts and portfolio managers responding to the survey believed that
stock options granted to employees are compensation and should be
recognized as an expense in the income statements of the enterprises
that grant them. AIMR, ``Analysts, Portfolio Managers Want Employee
Stock Options Expensed on Income Statements, Global AIMR Survey Shows''
(November 19, 2001).
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The American Federation of Labor and Congress of Industrial
Organizations (representing 13 million of America's workers in
65 member unions)
The Conference Board Commission on Public Trust and Private
Enterprise (co-chaired by Peter G. Peterson, chairman of the
Blackstone Group, former Secretary of Commerce and chairman of
the Federal Reserve Bank of New York, and John W. Snow,
(former) chairman, CSX Corporation and former chairman,
Business Roundtable).
In 2002, President Bush announced a ten-point plan to improve
corporate responsibility.12 That plan including the
following statement: ``The authors of accounting standards must be
responsive to the needs of investors.'' 13 There is no other
issue on the Board's agenda on which investors have been clearer about
the need for an improvement in the existing accounting standards.
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\12\ Ten-Point Plan to Improve Corporate Responsibility sand
Protect America's Shareholders (March 7, 2002).
\13\ Id.
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The second reason the Board decided to add a project to its agenda
to address issues relating to equity-based compensation was because of
the complexity and noncomparability and, thus, potential lack of
transparency created by the alternative accounting treatments presently
available for reporting equity-based compensation. That lack of
transparency has been magnified by the recent trend of enterprises
adopting the voluntary fair value provisions of FASB Statement of
Financial Accounting Standards No. 123, Accounting for Stock-Based
Compensation (October 1995).14 The trend has increased the
divergence between the financial reports of enterprises that do not
make wide use of employee stock options as compensation and the
financial reports of those that do, and between those enterprises that
voluntarily expense employee stock options and those that do not.
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\14\ See Attachment 3 for a list of 576 companies that have
voluntarily adopted option expensing under the fair value method.
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As indicated above, fixed plan employee stock options are the only
form of employee stock options that is not required to be reported as
an expense in the income statements of the enterprises that grant them.
All other forms of employee compensation, including cash salaries,
bonuses, fringe benefits, restricted stock, stock warrants,
performance-based stock options, indexed-based stock options, employee
stock ownership plans, are (and have long been) required to be reported
as an expense. Moreover, when equity-based grants of any form are
issued to nonemployees for goods or services, they also are (and have
long been) required to be reported as an expense.
The exception for fixed plan employee stock options is clearly an
anomaly in today's financial accounting and reporting. That anomaly
results in an absolute and relative distortion of profitability and
other key financial metrics. The greater the use of those instruments,
the greater the distortion. As indicated above, the distortion creates
an unleveled playing field that inappropriately favors those
enterprises that are the greatest users of fixed plan employee stock
options over other enterprises that either have chosen to compensate
their employees in different ways (including different forms of equity-
based compensation) or use fixed plan employee stock options but have
voluntarily elected to expense them.
The distortion misleads investors, particularly, but not limited
to, less sophisticated investors. The overall effect is a diversion of
investment and capital resources away from their most efficient
employment. As Federal Reserve System Chairman Alan Greenspan stated,
``[if] you don't expense stock options, then you're getting a distorted
view as to what the profitability of a particular operation is, and you
will get a distortion in the allocation of capital.'' 15
Many other economic experts that have reviewed this issue agree,
including former Federal Reserve Chairman (and current chairman of the
Trustees of the International Accounting Standards Committee
Foundation) Paul A. Volcker,16 Nobel Prize winning
economists Robert C. Merton,17 and Joseph E.
Stiglitz,18 the Financial Economist Roundtable,19
the Republican Staff of the Joint Economic Committee of the US
Congress,20 the Conference Board Commission on Public Trust
and Private Enterprise,21 and the Congressional Budget
Office.22
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\15\ Hearing of the Joint Economic Committee, US Congress, on
``Economic Outlook'' (April 21, 2004).
\16\ Hearing before the Subcommittee on Capital Markets, Insurance
and Government Sponsored Enterprises of the Committee on Financial
Services, Testimony of Paul A. Volcker (June 3, 2002), pages 3 and 4.
\17\ Hearing on H.R. 3574: Stock Option Accounting Reform Act,
Before the Subcommittee on Capital Markets, Insurance and Government
Sponsored Enterprises of the Committee on Financial Services, Summary
of Testimony of Robert C. Merton (March 3, 2004), page 2 of 3.
\18\ Joseph E. Stiglitz, ``The Roaring Nineties'' (October 2003),
pages 115-139.
\19\ Statement of Financial Economist Roundtable on the Controversy
over Executive Compensation (November 24, 2003).
\20\ Joint Economic Committee, Republican Senate Staff, Economic
Policy Research, ``Understanding the Stock Option Debate,'' Report 107-
04 (July 9, 2002), page 18.
\21\ The Conference Board, ``The Commission on Public Trust and
Private Enterprise, Findings and Recommendations, Part 1: Executive
Compensation'' (September 17, 2002), page 6.
\22\ The Congressional Budget Office, ``Accounting for Employee
Stock Options,'' Section 3 (April 2003), pages 4 and 5.
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Many enterprises, including some in the high technology industry,
that have voluntarily expensed their employee stock options have
requested that the Board mandate the expensing of all employee stock
options. It is also interesting to note some of those enterprises,
including Wal-Mart Stores, Inc., Netflix Inc., and Home Depot, Inc.,
have historically offered broad-based stock option plans to many
nonexecutive employees and have indicated that adopting fair value
expensing for all employee stock options will not result in a
curtailment of those programs.23
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\23\ News from Carl Levin, US Senator, Michigan, ``Stock Option
Roundtable Dismissed as One-Sided'' (May 8, 2003), page 2; Reed
Hastings, ``Expense It!'' The Wall Street Journal (April 5, 2004).
---------------------------------------------------------------------------
The third reason the Board decided to add a project to its agenda
to address issues relating to equity-based compensation was the
opportunity to achieve convergence to a common, high-quality
international accounting standard in this area. The International
Accounting Standards Board (``IASB'') issued a proposal in November
2002 that would require that all stock options be expensed at their
fair value at grant date.24 To maximize the opportunity for
international convergence, the FASB concluded that it needed to
consider the US accounting requirements for equity-based compensation
concurrently with IASB's consideration of its proposal.
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\24\ IASB Proposed IFRS, Share-Based Payment (November 2002).
---------------------------------------------------------------------------
The FASB has long been committed to actively working with the IASB
and other national accounting standard setters to promote international
convergence of accounting standards concurrent with improving the
quality of financial reporting.25 Both the Act,26
and the Policy Statement,27 indicate the support of the US
Congress and the SEC, respectively, for the FASB's convergence efforts.
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\25\ FASB, Rules of Procedure (December 1, 2002, as amended), page
2.
\26\ Act, Section 108(a)(2).
\27\ Policy Statement, page 4 of 8.
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Since March 2003, the Board has held 38 public meetings to discuss
the project. Preparations for those meetings included thousands of
hours of research on issues relating to the project, including the
review of the results of many research studies on the topic.
In addition, the Board and staff have participated in public and
private discussions about the project with hundreds of individuals,
including members of the Financial Accounting Standards Advisory
Council, the UAC, the Option Valuation Group,28 and other
groups and organizations representing preparers, auditors, and users of
financial reports. The Board also has conducted field visits with a
variety of enterprises of various sizes, including small businesses,
covering a range of industries to discuss issues relating to the
project.
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\28\ The Board established the Option Valuation Group to provide
information and advice on how to improve the guidance in Statement 123
on measuring the fair value of stock options. Proposed Statement of
Financial Accounting Standards, Share-Based Payment (March 31, 2004),
paragraph C37.
---------------------------------------------------------------------------
In February 2004, at a public meeting, the Board unanimously agreed
to the issuance of a proposal for public comment. That proposal was
issued on March 31, 2004, for a 90-day comment period.29
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\29\ Id.
---------------------------------------------------------------------------
The proposal contains a detailed Notice for Recipients encouraging
comments on over 20 specific issues. Attachment 4 includes the Notice
for Recipients and a Summary of the key provisions of the proposal.
what has been the input received in response to the proposal?
Following the issuance of the proposal for public comment the Board
has been actively meeting with and soliciting input from valuation
experts, and users, auditors, and preparers of financial reports on
issues raised by the proposal. For example, on May 11, 2004, at a
public meeting the Board discussed the proposal with over twenty
representatives of small and medium-sized businesses at the inaugural
meeting of the SBAC.
In addition, the Board held public roundtables on June 24, 2004, in
Palo Alto, California, and June 29, 2004, in Norwalk, Connecticut. Over
seventy individuals from a broad range of enterprises, including
representatives from the high-technology industry, small businesses,
valuation experts, compensation consultants, software developers,
auditors, financial analysts, institutional investors, professional and
trade associations, and academics participated at the four half-day
public meetings.
To date the Board has received thousands of comment letters in
response to the proposal. Consistent with the FASB's Rules of
Procedures Board members are required to read all of the comment
letters received.
The vast majority of the comment letters received in response to
the proposal are form-like letters. Some of those letters are from
employees of several high-technology industry companies. While
heartfelt in their urging the Board not to do anything that might
result in their employers' reducing the amount of employee stock option
grants, they generally do not address the financial accounting and
reporting issues raised by the proposal. Thousands of other form
letters were received from union employees and investors expressing
unqualified support for the proposal.
Excluding the form-like letters, we have many other letters from a
broad range of enterprises, accounting firms, valuation experts,
compensation consultants, trade and professional associations, and
academics. Those letters provide detailed input on one or more of the
many financial accounting and reporting issues raised by the proposal.
WHAT IS THE CURRENT STATUS OF, AND THE FASB'S PLANS RELATING TO, THE
PROPOSAL?
Later this month, the Board plans to begin its public
redeliberations of the proposal. The redeliberations, consistent with
the FASB's Rules of Procedure, will address the key conceptual,
measurement, disclosure, and cost-benefit issues raised by the
proposal. Those issues will include (1) what is the relevant
measurement attribute and relevant measurement date for equity-based
compensation; (2) what is the appropriate basis for attribution of
compensation cost; (3) what disclosures should be required; (4) what is
the appropriate transition and effective date for the new requirements;
and (5) what modifications, if any, to the new requirements should be
made for small businesses. For each of these issues the public
redeliberations will include careful consideration of the comment
letters and other input received from all parties.
The redeliberations also will benefit from the FASB staff and
Board's ongoing discussion of the key issues with interested parties
from a broad range of perspectives, including representatives of small
businesses and valuation and compensation experts that the FASB will
continue to consult with throughout the entire process. As with
virtually all FASB projects, the redeliberations will likely result in
a number of changes to improve the proposal.
Only after carefully evaluating all of the key issues and carefully
considering the input received in response to the proposal will the
Board consider whether to issue a final standard. No final standard may
be issued without approval by a majority vote of the Board.
The Board's current plans are to issue a final standard in the
fourth quarter of this year. The Board, however, has no fixed deadline
for issuing a final standard and will continue its public
redeliberations as long as is necessary to develop a high-quality and
cost-effective accounting standard that will best serve the needs of
investors, creditors, and other consumers of financial reports. As with
all of the FASB's activities, the SEC staff will closely monitor and
oversee the Board's due process on this important project.
SOME OBSERVATIONS ABOUT H.R. 3574
As many experts have indicated, the provisions of H.R. 3574 are
seriously flawed, violate fundamental concepts of financial accounting
and reporting, and, if enacted, would be harmful to the overall capital
market system.30 The Board strongly opposes such an effort
to block improvements to the financial accounting and reporting for
equity-based compensation. That opposition is based on many conceptual
and technical reasons, including the following.
---------------------------------------------------------------------------
\30\ Letter from Edward Nusbaum, CEO, Grant Thornton LLP, to the
Honorable Richard H. Baker, US House of Representatives (March 17,
2004), page 4; Hearing on H.R. 3574: Stock Option Accounting Reform
Act, Before the Subcommittee on Capital Markets, Insurance and
Government Sponsored Enterprises of the Committee on Financial
Services, Summary of Testimony of Robert C. Merton; see Attachments 2
and 5 for additional comments from experts on H.R. 3574.
---------------------------------------------------------------------------
First, H.R. 3574 would override the Board's independent, objective,
open, and ongoing due process to make unbiased decisions on the
substance and timing of improvements to the accounting for equity-based
compensation.31 As indicated above, such intervention would
be in direct conflict with the expressed needs and demands of many
investors and other users of financial reports. Such intervention also
would appear to be inconsistent with the language and intent of the Act
and the related Policy Statement, both of which were intended to
enhance the independence of the FASB.
---------------------------------------------------------------------------
\31\ Of note, after appearing to mandate the substance and timing
of the accounting for the expensing of certain stock options in Section
2, and constraining the substance and timing of any existing or future
accounting for expensing stock options in Section 3, Section 5
inexplicably states that ``[n]othing in this Act shall be construed to
limit the authority over the setting of accounting principles by any
accounting standard setting body . . .''
---------------------------------------------------------------------------
Second, H.R. 3574 would have an adverse impact on the FASB's
efforts to achieve timely convergence of high-quality international
accounting standards in this important area. As indicated above, such
Congressional intervention would appear to be inconsistent with the
language and intent of the Act and the related Policy Statement, both
of which indicate support for the FASB's convergence efforts.
Enterprises in 90 countries around the world will begin to report
all equity-based compensation as an expense, in a manner generally
consistent with the proposal, beginning on January 1,
2005.32 Those enterprises will join enterprises in Canada,
which were required to begin expensing all equity-based compensation,
consistent with the proposal, beginning in January of this
year.33 Of note, over 350 Canadian enterprises, and hundreds
of other foreign enterprises that comply with international accounting
standards, are SEC registrants and are required to file their financial
reports in the US.
---------------------------------------------------------------------------
\32\ International Financial Reporting Standard 2, Share-Based
Payment (February 2004).
\33\ Stock-Based Compensation and Other Stock-Based Payments,
Section 3870 (September 2003).
---------------------------------------------------------------------------
Addressing the impact of H.R. 3574 on the independence of the FASB
and the convergence of accounting standards, The Honorable Paul A.
Volcker, Chairman of the Trustees of the International Accounting
Standards Committee Foundation, stated in recent testimony before
Congress:
I suggest that, before acting, Senators and Congressmen ask
themselves two simple questions:
``Do I really want to substitute my judgment on an important
but highly technical accounting principle for the collective
judgment of a body carefully constructed to assure professional
integrity, relevant experience, and independence from parochial
and political pressures?''
``Have I taken into account the adverse impact of overruling
FASB on the carefully constructed effort to meet the need, in a
world of globalized finance, for a common set of international
accounting standards?'' 34
---------------------------------------------------------------------------
\34\ Hearing on Oversight Hearing on Expensing Stock Options:
Supporting and Strengthening the Independence of the Financial
Accounting Standards Board, Before the Subcommittee on Financial
Management, the Budget, and International Security of the Committee on
Governmental Affairs, United States Senate, Testimony of The Honorable
Paul A. Volcker (April 20, 2004), page 2 of 2.
---------------------------------------------------------------------------
Third, although titled the ``Stock Option Accounting Reform Act,''
35 the provisions of H.R. 3574 have exactly the opposite
effect by essentially preserving, protecting, and perpetuating the
existing accounting for stock options that have resulted in an unlevel
playing field favoring certain enterprises that are the greatest users
of fixed plan employee stock options over other enterprises that have
either chosen to compensate their employees in different ways.
---------------------------------------------------------------------------
\35\ H.R. 3574, Section 1.
---------------------------------------------------------------------------
For example, the provisions of H.R. 3574 would appear to require
that only stock options granted after December 31, 2004, to the chief
executive officer and the four other most highly compensated employees
of certain SEC registrants be reported as compensation expense in those
enterprises' income statements.36 Thus, if an SEC registrant
grants stock options to employees other than the top five executives,
that compensation cost would not be reported in the enterprises'
earnings.
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\36\ H.R. 3574, Section 2(m)(1)-(2).
---------------------------------------------------------------------------
Moreover, the provisions of H.R. 3574 would appear to require that
for purposes of determining the ``fair value'' of the stock options
granted to the top five executives the ``assumed volatility of the
underlying stock shall be zero.'' 37 It is universally
accepted that a large part of a stock option's fair value is the result
of volatility of the underlying stock price.38 Thus, the
amount of compensation cost for the top five executives reported in the
enterprises earnings would be substantially less than its fair value.
---------------------------------------------------------------------------
\37\ H.R. 3574, Section 2(m)(3)(A)-(B).
\38\ Hearing on H.R. 3574: Stock Option Accounting Reform Act,
Before the Subcommittee on Capital Markets, Insurance and Government
Sponsored Enterprises of the Committee on Financial Services, Summary
of Testimony of Robert C. Merton (March 3, 2004), page 2 of 2.
---------------------------------------------------------------------------
A recent Washington Post editorial commented on the ``top five
executives'' provisions of H.R. 3574, stating:
The second problem with the bill is its illogical content. In
the past, opponents of expensing options have claimed that the
value of options is unknowable. But the House bill abandons
that claim by requiring that companies include in their profit-
and-loss statements the value of options for their top five
executives. Having conceded that, however, the bill goes on to
say that the cost of options granted to employees outside the
top circle should be left out, implying that they cost nothing.
But they do not cost nothing. In high-tech companies, which
grant options generously to middle-ranking employees, the top
five executives get only a small fraction of the total--less
than 5 percent in the case of Intel Corp. or Cisco Systems Inc.
Moreover, the House bill stipulates that companies should use
an unorthodox method for valuing options that minimizes their
worth. If the bill became law, the options granted by Intel
last year would force it to deduct a modest $3.5 million from
its reported profit--compared with the hefty $991 million it
would have to deduct under the proposed FASB reform. Cisco, for
its part, could report $1.1 billion more in profit if the House
bill passed. Small wonder that Intel and Cisco have led the
lobbying charge in favor of the legislation.39
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\39\ ``High-Tech Holdup,'' The Washington Post (June 10, 2004),
page A18.
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The provisions of H.R. 3574 also would appear to exempt certain SEC
registrants that are ``small business issuers'' from having to report
any compensation expense for stock options granted.40
Similarly, the provisions would also appear to exempt certain SEC
registrants from having to report any compensation expense for stock
options granted to employees for three years after an ``initial public
offering.'' 41 In both cases, to the extent that a
qualifying SEC registrant grants stock options to its employees, the
amount of compensation cost would be understated in those enterprises''
reported earnings.42
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\40\ H.R. 3574, Section 2(m)(4)(A).
\41\ H.R. 3574, Section 2(m)(4)(B).
\42\ In commenting on Sections 2(m)(4)(A) and (B), Associated
Press, Business Writer, Bruce Meyerson stated: ``Bizarrely, though the
purpose of these two exemptions is to ensure a continued source of
cheap fuel for smaller businesses to grow, the bill would also grant a
free three-year pass to Google, an established Internet juggernaut
which plans to sell billions worth of stock in an initial public
offering,'' Bruce Meyerson, ``Congress threatening to derail stock
options reform--again,'' San Jose Mercury News (June 8, 2004), page 2
of 2.
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The provisions of H.R. 3574 also would raise a host of practical
and implementation issues that would likely be very disruptive to
enterprises, auditors, and the entire financial reporting system. As
one example, the provisions would appear to prohibit the SEC from
recognizing any accounting standard relating to the expensing of stock
options unless and until two conditions are met: (1) an economic impact
study by the Secretary of Commerce and the Secretary of Labor has been
completed, and (2) the standard prescribes exercise or other settlement
date measurement for the options granted.43
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\43\ H.R. 3574, Section 3(a).
---------------------------------------------------------------------------
Existing accounting standards prescribe as the preferable method of
accounting for employee stock options a grant date fair value
measurement approach.44 The more than 575 enterprises that
have begun voluntarily expensing all employee stock options are
required to follow the preferable method.45 That method,
however, does not encompass an exercise or other settlement date
measurement approach as would appear to be required by the provisions
of H.R. 3574. Thus, the existing voluntary expensing of all employee
stock options by more than 575 enterprises would no longer be
permitted.
---------------------------------------------------------------------------
\44\ Statement of Financial Accounting Standards No. 123,
Accounting for Stock-Based Compensation (October 1995), paragraph 11.
\45\ Id.; see Attachment 3 for list of 576 companies that have
voluntarily adopted option expensing under the fair value method.
---------------------------------------------------------------------------
In addition, H.R. 3574 has a section entitled ``Improved employee
stock option transparency and reporting disclosures.'' 46
The disclosures required under those provisions, however, are not
``more detailed'' or as comprehensive as those disclosures required
under existing generally accepted accounting principles.47
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\46\ H.R. 3574, Section 4.
\47\ Statement of Financial Accounting Standards No. 148,
Accounting for Stock-Based Compensation--Transition and Disclosure
(December 2002), paragraphs 2(e) and 3.
---------------------------------------------------------------------------
Moreover, the H.R. 3574 disclosures fail to include the proposed
improvements to disclosures contained in the proposal responsive to the
requests of many users of financial reports, including new and improved
disclosures about the related income statement and cash flow effects of
equity-based payment arrangements.48
---------------------------------------------------------------------------
\48\ FASB Exposure Draft, Proposed Statement of Financial
Accounting Standards, Share-Based Payment (March 31, 2004), paragraphs
C144-C156.
---------------------------------------------------------------------------
Finally, and perhaps most importantly, H.R. 3574 would establish a
dangerous precedent in that it would send a clear and unmistakable
signal that Congress is willing to directly intervene in the
independent, objective, and open accounting standard-setting process
based on factors other than the pursuit of sound and fair financial
reporting. That signal would likely prompt others to seek political
intervention in future technical activities of the FASB. In recently
commenting on this issue, the CFA Institute, whose members include more
than 70,000 investment professionals and educators, stated:
Politicizing the process can only work to destabilize it and
will ultimately be detrimental to those investors who have the
least ability to gather political influence.49
---------------------------------------------------------------------------
\49\ Letter from Patricia Doran Walters, PhD, CFA, Senior Vice
President, Professional Standards & Advocacy, CFA Institute, to the
Honorable Richard H. Baker and the Honorable Paul E. Kanjorski, United
States House of Representatives (May 10, 2004), page 3 of 4.
---------------------------------------------------------------------------
For all of the above reasons, H.R. 3574 would result in a giant
step backwards in the recent and ongoing efforts by Congress, the SEC,
the FASB, and many other parties to restore public confidence and trust
in the integrity of financial reporting. As Federal Reserve Chairman
Alan Greenspan recently indicated, the enactment of this proposed
legislation ``would be a bad mistake for the Congress.'' 50
I whole-heartedly agree. Speaking not just for the FASB, but for the
millions of US investors, creditors, and other consumers of financial
reports that rely on credible, transparent, and unbiased financial
information, I respectfully urge you to oppose H.R. 3574.
---------------------------------------------------------------------------
\50\ Hearing of the Joint Economic Committee, United States
Congress, on ``Economic Outlook'' (April 21, 2004).
---------------------------------------------------------------------------
CONCLUSION
In conclusion, let me assure you that you, and the users, auditors,
and preparers of financial reports, including small business financial
reports, can have confidence that the Board will carefully consider the
input received in response to our proposal. That input will be
carefully considered in an open, thorough, and objective manner. Our
ultimate goal is to develop, with oversight by the SEC staff, 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 US. As indicated above, the enactment of H.R. 3574
would undoubtedly have the exact opposite effect.
Thank you again, Chairman Stearns. We would welcome the opportunity
to respond to any questions.
Mr. Stearns. Thank you.
Mr. White, welcome.
STATEMENT OF RICK WHITE, PRESIDENT AND CEO, TECHNET, CHAIRMAN,
INTERNATIONAL EMPLOYEE STOCK OPTIONS COALITION
Mr. White. Thanks very much, Mr. Chairman, Ms. Ranking
Member, and the other members of the committee. It is great to
be back in the best subcommittee of the best committee in
Congress. I see a lot of my old colleagues who have moved up
several rows since I was here last time. It is really great to
be here and great to have this seat before you today.
I am currently the CEO of TechNet, a group of technology
executives; we are kind of a trade organization for the
technology community. I am also Chairman of the International
Employee Stock Options Coalition, which is a group of companies
and associations representing literally thousands of companies,
both technology companies and other companies that are
concerned with the stock options issue.
I guess it is fair to say we frankly don't care what this
committee or FASB or any other committee does with executive
stock options. What we are concerned about, what we do care
very deeply about is preserving the ability, the reasonable
ability, to grant such options to rank-and-file workers as many
companies have done successfully over the past few years.
We do support H.R. 3574. I know that is not directly the
subject of this hearing. I want to address just a couple of
points. I have submitted some testimony for the record. I
appreciate the chairman's willingness to include that.
One issue that has come up and several members have
mentioned it, and also I think Chairman Herz mentioned it
several times in his testimony, is whether it is appropriate
for the Congress even to be involved in this effort. I want to
make sure that people understand how important it is that
Congress should be involved. There are some things that we let
experts decide in our society, but there are some things we
don't let them decide. There are some good reasons for that. We
let engineers decide how to get a spaceship to the Moon, we let
lawyers decide how a contract should be written, but we don't
let them decide whether we go to the Moon, we don't let them
decide whether a contract should be formed. Those are decisions
that we reserve to others.
The reason is that experts are great in their specific area
of expertise but sometimes that high expertise may prevent them
from focusing on the bigger picture. I would submit that is
really the problem we have here. That is the situation I think
Mr. Herz finds himself in, one that is totally understandable
given his position. If you listen to Mr. Herz' testimony and
follow this issue, he will tell you basically two things. No.
1, accounting should be set by the FASB because they are the
experts on accounting and Congress should stay out of that
effort. I think he has said that today. That is certainly
understandable from his perspective. But he will also tell you
that accountants make up FASB, they understand accounting
issues but they really don't understand or don't focus on
anything having to do with the U.S. economy, and FASB will not
consider, and I can give you 20 places where he has made this
comment, will not consider the impact on the U.S. economy of
whatever accounting standard it decides to implement. That is
not in their expertise. He is absolutely correct. So they won't
consider that.
But you put those two comments together and I think it
reveals a flaw at least in the way that Chairman Herz looks at
our system. He basically means we can set any accounting
standard we want but there is nobody in the chain of command
who has the opportunity to decide whether there is going to be
a negative effect on the economy. I would submit to you that
that is not a principle that this committee can live with.
Congress has delegated to the SEC the right to establish
accounting standards but not as a goal in itself. The point of
accounting standards are to accomplish things that this
committee thinks is important, not just to further accounting
theory. I would submit to you that if the FASB came up with an
accounting theory that made sense to accounting professors but
had a really negative impact on the economy, that is something
this committee would want to look at. You wouldn't want to let
them do something that was esoteric and arcane and may make
sense for accounting reasons but had a big impact on economy.
That is something you would not want to happen.
By the same token, if Mr. Herz' committee came up with a
standard for some reason that made a lot of sense to accounting
professors but really was so complicated that it could only be
understood by experts in accounting, I think we have all seen
examples where experts sometimes tend in that direction, but if
it couldn't be understood by the individual investor, the
average investor, I suggest that this committee would be
concerned about that. We want a system in our country where not
just experts but individual investors, the common individual
investor, can understand what accounting statements are all
about. I think the committee would be within its rights to get
involved in a case where that happened, and I would submit to
you that we are in a case right here where both those things
have happened and where it is very important for you to get
involved.
Let me spend just a minute on each one, then I will stop so
you can ask questions. From an economics perspective, let me
make sure you understand the basics of our objection. If there
are two companies out there, one of them owned by the chairman
and one of them owned by the ranking member, that had the exact
same financial performance but let's say the chairman kind of
did the wrong thing and only allowed the top executive to have
stock options and the ranking member decided to do the right
thing, which most of us here I think would agree with, and let
every employee share in the ownership of the company, even
though those companies had the same financial performance, even
though they had the same amount of money in the bank, even
though there was no difference in the actual assets or debits
owned by the corporation, the company owned by the ranking
member would look worse every month, every earnings report
would always look worse than the company owned by the chairman,
who actually did the wrong thing. So if we adopted the approach
that FASB is suggesting to us we are basically penalizing
companies every quarter for doing what we would like them to
do, which is to let their employees have a piece of ownership
of the company. It is a public policy incentive that is 180
degrees from what it should be. I think that is one of the
things we are concerned about.
From an investors' standpoint I think you should understand
that while there definitely is some difference of opinion on
whether we should expense things in the first place, and I
think Mr. Mayer may talk a little bit about some of those
accounting issues, there really isn't any disagreement that any
valuation we come up with for these stock options is going to
be a very complicated formula and won't really correspond to
reality. It may make sense from an abstract theoretical
perspective, I think FASB would tell you that in this situation
any number is better than zero, but I can tell you that if you
take a number that goes through a formula, it is very
complicated, some people think it is better than zero, and you
deduct it from a company's earnings, the company still has the
same amount of money in the bank, still is doing the same
thing, but its earnings look a lot different than they would in
another accounting situation. While Mr. Herz may well
understand that and maybe the experts on Wall Street understand
that and maybe the institutional investors have people who can
re-engineer this formula and back this number out so they can
see what the real economic performance is, the average investor
on the street won't have that ability.
So I would say that the two biggest criticisms that we have
are the very negative economic impact and the difficulty for
the average investor to be able to have transparency in what is
going on. We are going to end up with financial statements that
distort what most people would consider the real economic
performance of the company. That might make sense if there were
a clear accounting consensus and there was a clear way to do it
and everybody thought it had to be done. That is not the case.
We are in a situation where there is a lot of controversy, and
so it doesn't really make sense to go down this path.
I will reserve the rest of my remarks for questions, but
thank you so much, Mr. Chairman.
[The prepared statement of Rick White follows:]
July 8, 2004
The Honorable Cliff Stearns
Chairman
Commerce, Trade, and Consumer Protection Subcommittee of the
Committee on Energy and Commerce
2125 Russell House Office Building
Washington, DC 20510
Dear Mr. Chairman: Thank you for the opportunity to submit
testimony on the vitally important issue of accounting for employee
stock options and to voice TechNet's strong support for H.R. 3574, the
Stock Option Accounting Reform Act of 2003.
The Technology Network, or TechNet, is a national network
representing 200 of the nation's leading companies in the fields of
information technology, biotechnology, venture capital, investment
banking and law. We are proud of the role that our industries have
played in the growth of the U.S. economy, due in large part to the use
of broad-based stock option plans to attract and retain talented
employees.
For many technical and public policy reasons, TechNet strongly
supports H.R. 3574. By protecting broad-based stock option plans while
requiring expensing of options granted to senior corporate officers,
H.R. 3574 represents a compromise that protects American workers while
addressing concerns about senior executive compensation.
Most important, the legislation will preserve broad-based employee
ownership, embodied in the 14 million American workers or 13 percent of
the private sector workforce who hold employee stock options. 94
percent of these stock option holders consider themselves to be middle
class, lower class or working class.
The Financial Accounting Standards Board (FASB) has proposed
mandatory expensing of employee stock options using valuation methods
that will significantly distort financial statements in a way that
threatens this trend toward broad-based employee ownership. Mandatory
expensing using the Black-Scholes or binomial valuation models, as
proposed by the FASB, will result in gross overvaluation of employee
stock options. The resulting inaccuracies will have a tremendous
negative impact on the financial statements of companies that grant
options broadly. If the FASB proposal is enacted, these companies will
have little choice but to severely curtail or eliminate stock options
to rank-and-file employees.
The Stock Option Accounting Reform Act protects rank-and-file
American employees and preserves the broad-based employee ownership
that has been the hallmark of the technology industries and many other
innovative companies.
H.R. 3574 also preserves our nation's international economic
competitiveness. At a time when Congress is focused on domestic job
creation, mandated expensing threatens U.S. innovation and economic
growth. All while many of our foreign competitors are accelerating
efforts to offer stock options without mandated expensing.
TechNet believes it is critical that Congress support this
legislation and not stand by while the FASB creates regulations that
could have significant negative economic ramifications. The FASB is
engaged, perhaps inadvertently, in changing a longstanding accounting
policy that has enabled employee ownership, innovation and
entrepreneurship to thrive in American businesses. The FASB's
accounting regulations will have a significant negative impact on
economic policy in this country. Under the guise of an accounting
standard, the FASB is taking action that will bring the U.S. economic
model closer to that of Europe--an environment that discourages
employee ownership and fails to spur innovation and entrepreneurship.
The American ownership culture is one of our greatest competitive
advantages as a nation.
The Stock Option Accounting Reform Act does not dictate accounting
standards. The legislation preserves the American culture and tradition
of broad-based employee ownership, innovation, hard work and new ideas.
It simply returns to Congress the prerogative to set economic policy.
TechNet also believes strongly that mandatory expensing of all
employee stock options, as proposed by the FASB, is bad accounting. We
have met with the FASB to express our strong concerns with their
proposal on a technical level, although with no impact.
We believe there is a strong technical record that demonstrates
that employee stock options do not represent a corporate expense. There
is also a strong technical record asserting that use of the Black-
Scholes or binomial models, as proposed by the FASB, will result in
inaccurate, unreliable and inconsistent measurement of the fair value
of employee stock options.
Existing option pricing models were created to value market-traded
options, which have very different characteristics than employee
options. The unique features of employee stock options are not
accounted for under the Black-Scholes or binomial models. As a result,
the FASB's proposal will require a wide range of subjective judgments
and estimates, resulting in widely divergent results depending on the
subjective assumptions a company makes. Even Dr. Mark Rubinstein, Ph.D.
of Finance at U.C. Berkeley's Haas School of Business, and a creator of
the binomial model, raised these concerns about his own model when he
testified before the FASB.
I have attached for the record several documents which describe in
detail the technical problems inherent in mandatory expensing under the
FASB's proposal.
In summary, we strongly urge Members of the Committee to support
the Stock Option Accounting Reform Act, H.R. 3574. This legislation
supports broad-based employee ownership, hard work and innovation. H.R.
3574 is a critical economic policy approach and we urge the Congress to
support it.
Sincerely,
Rick White
President and CEO of TechNet
______
June 29, 2004
Ms. Suzanne Bielstein
Director of Major Projects
Financial Accounting Standards Board
401 Merritt 7
P.O. Box 5116
Norwalk, Connecticut 06856-5116
Re: Proposed SFAS--File Reference No. 1102-100
Dear Ms. Bielstein: On behalf of the members of The Technology
Network (``TechNet''), thank you for the opportunity to submit comments
in response to the Proposed Statement of Financial Accounting
Standards, Share-Based Payment, an Amendment of FASB Statements No. 123
and 95. We appreciate the opportunity to offer our views on this
important matter.
TechNet is a national network of 200 chief executive officers and
senior partners of the nation's leading companies in the fields of
information technology, biotechnology, venture capital, investment
banking and law. We are proud of the role that our industries have
played in the growth of the U.S. economy, due in large part to the use
of broad-based stock option and other equity-based incentive plans to
attract and retain talented employees. Many TechNet members maintain
broad-based employee stock option programs. By giving employees at all
levels a chance to share in their company's financial success through
equity ownership, broad-based stock option plans boost productivity and
are essential to America's competitiveness and economic growth.
For reasons discussed in this letter, TechNet has serious concerns
with the Board's proposal to require mandatory expensing of employee
stock options. We believe that the Board's proposal would result in
financial statements that substantially overstate the value of employee
stock options, providing less clarity and comparability to investors.
Because of this substantial overvaluation, the proposal would make it
prohibitive to offer broad-based stock option plans, encouraging
companies to concentrate share ownership in the hands of senior
executives.
The following addresses specific issues on which the Board seeks
comment.
I. RECOGNITION OF COMPENSATION COST
Employee stock options do not constitute an expense.
We fundamentally disagree with the Board's premise that employee
stock options constitute a corporate expense. The issuance of stock
options does not result in a corporate level cost that impacts net
income.
Employee stock options do not represent payment for goods or
services received. Rather, employee stock options represent an
opportunity for employees to share ownership in the enterprise for the
purpose of increasing shareholder value. They are an employee-retention
device, granted with a prospective view of future employment. A promise
to issue employee stock options in return for a promise to provide
services in the future in no way meets the definition of a liability.
The issuance of an employee stock option results in:
No outflow or consumption of corporate assets;
No decline in the value of corporate assets;
No creation of a liability representing actual or expected cash
outflows;
Employee stock options have a contingent or hypothetical value to
the employee who receives them. However, this value is not realizable
at the time of grant and employee stock options cannot be converted
into cash by either the employee or the corporation. In fact, in many
cases, this potential value is never realized. Further, in any event,
employee stock options will never result in the expenditure of cash by
the company but, in fact, have the potential to provide cash flow to
the company. Just as revenues or gains are not recognized until they
are realized or realizable, the grant of an employee stock option that
has no realizable cost should not be considered an expense to the
corporation.
We further believe that requiring a fictional income statement
impact for a transaction that takes place wholly within the balance
sheet is insupportable. Unlike a fixed asset, the cost of which is an
expense that is recognized over its useful life, employee stock options
do not generate an expense that should be recognized either immediately
or over time in the income statement. In fact, employee stock options
cannot be converted into cash and to the extent employee stock options
are ultimately exercised, corporate assets are increased by the amount
of cash that the employee must pay to exercise the option.
Expensing stock options will also result in balance sheet entries
that give a grossly distorted view of a company's capital structure.
When employee stock options are expensed, the value of those options
increases a company's paid-in capital in the equity section of the
balance sheet by a phantom number. The company's capital structure
appears altered although no money has changed hands and no stock has
actually been issued, or may ever be issued. Further, because the
increased expense has impacted the company's net income and therefore
its retained earnings, the balance sheet is further distorted. The
equity section of a balance sheet should represent real dollars
invested in the equity of the company. Expensing will not only corrupt
income statements, it will serve to distort already complex balance
sheets, to the detriment of investors.
Recent studies of employee stock options and compensation at a
comprehensive sampling of companies provides further evidence that
stock options are not compensation in that they are generally not
viewed by the employee or employer as compensation for labor performed
and are not granted in lieu of salary compensation. In their book, In
the Company of Owners: The Truth About Stock Options And Why Every
Employee Should Have Them, Rutgers University Professors Joseph Blasi
and Douglas Kruse found that, in the companies examined, average
employees who held options were paid competitive wages and benefits
irrespective of any options held. Options instead represent ``capital
income'' that workers receive for sharing the risk of ownership in the
corporation.
Some have argued that a corporation incurs an opportunity cost in
issuing employee stock options, but generally accepted accounting
principles have not required the recognition of opportunity costs.
Reliable calculation of the opportunity cost associated with the
issuance of stock options would clearly be impossible. And, indeed, to
do so would lead to confusing results.
If employee stock options are considered an expense on the basis of
opportunity costs, then companies should be able to account for the
economic benefits that result from employee ownership. Amending GAAP to
incorporate such costs or benefits into the financial statement would
clearly lead to distortions, inaccuracies and investor confusion.
Any cost that may exist with respect to shares or options issued to
employees results from the potential dilution of each investor's share
of company ownership, which may increase when options are granted. This
cost is already reflected in the income statement in the earnings per
share (EPS) calculation. Reducing net income when employee stock
options are granted will result in an inaccurate ``double charge'' in
the financial statements.
Because the potential ``cost'' of issuing employee stock options is
borne by existing shareholders in the form of potential dilution, we
believe that the most appropriate way to reflect the so-called ``cost''
of employee stock options is through consistent and extensive
disclosures of data regarding shareholder dilution.
The Board has suggested that financial statements include a range
of subjective estimates and that the estimated valuation of employee
stock options is no different. We firmly disagree with this view. The
subjective nature of the inputs into the Board's proposed option
valuation formulas, the unpredictable nature of factors related to
employee stock options and the resulting challenges in arriving at an
accurate valuation are unique to employee stock options.
Admittedly, there are uncertainties involved in measurement of
other items included in financial statements including depreciation,
pension and other retirement benefits and even stock options granted to
third parties as compensation for prior work performed. All of these
examples, however, involve costs that can be valued and assigned a
definite out-of-pocket expense; or are subject to later truing up.
Depreciation estimates, for example, merely represent timing issues;
the cost of equipment purchased is a readily determined number. Work
performed by third parties can also be assigned a market value. In the
case of pension costs, companies are required to estimate total cost,
but these estimates are trued up to reflect actual costs.
In contrast, there is no reliable way to estimate the value of
employee stock options and the Board's proposal does not provide an
opportunity to correct results to the extent they prove wrong.
The longstanding approach embodied in FASB Statement No. 123 is an
appropriate method of accounting for stock options.
We believe that the approach embodied in Statement 123 is an
appropriate method of accounting for stock options. Statement 123
recognizes that there is not consensus on whether employee stock
options constitute an expense. For all investors, Statement 123
provides relevant information and supports the public policy goal of
fostering broad-based stock option plans.
Investors and accounting experts have expressed considerable doubt
about the accuracy of existing valuation methods include those proposed
by the Board. Mandating that a distorted charge be incorporated into
financial statements will result in significantly less clarity,
consistency and reliability in financial statements. The established
approach required by Statement 123 enables investors who consider the
``compensation cost'' a meaningful number to easily discern a
hypothetical compensation charge and its impact on the financial
statement.
Those who consider the ``compensation cost'' meaningless may ignore
that cost.
II. MEASUREMENT ATTRIBUTE AND MEASUREMENT DATE
The grant date of the option is the appropriate date for public
companies to measure the compensation cost of employee stock
options
Current stock option accounting rules require that if employee
stock options are expensed, they must be expensed at the date they are
granted to the employee. Notwithstanding our position that employee
stock options do not represent an expense, grant date is the correct
valuation date because it is when the employer and the employee agree
to the terms of the stock option award.
Exercise date accounting permits reliance on an actual value,
rather than estimates. However, it would produce substantial swings in
net income based on volatility of the underlying stock. In addition, it
would have the perverse result of creating a higher expense when the
stock performs well. If employee stock options were expensed at
exercise, the better a company is at increasing shareholder value, the
worse its reported earnings would be.
The Board previously considered and rejected expensing employee
stock options at the date they are exercised. FASB also rejected the
view that if employee stock options were expensed at exercise, the
``cost'' of the option would be the difference between the market price
of the stock and the amount paid by the employee on the date the option
is exercised. More recently, the International Accounting Standards
Board concluded that employee stock options that are expensed, must be
expensed on the grant date.
We believe that this issue has been thoroughly examined and that
the Financial Accounting Standards Board and International Accounting
Standards Board reached the appropriate conclusion in determining that
employee stock options should be valued at grant date. Nevertheless, as
discussed below, we believe the Board's current proposal is unworkable
on any basis including a grant-date basis.
III. FAIR VALUE MEASUREMENT
Use of the Black-Scholes, lattice or binomial option pricing models
will not result in accurate, reliable or consistent measurement
of the fair value of employee stock options.
We concur with the Board's view that the fair value measurement
should be based on observable market prices of identical or similar
instruments in active markets. We do not believe, however, that
estimates of fair value arrived at using existing option pricing models
will be accurate and reliable. We also do not believe the Board has
provided sufficient guidance to ``ensure that the fair value
measurement objective is applied with reasonable consistency.''
Current option pricing models, including the Black-Scholes model
and the lattice or binomial models, do not ``reflect[ ] any and all
substantive characteristics'' of an employee stock option. Each of
these models was created to value market-traded options. Specifically,
these models do not factor in the lack of transferability of employee
stock options, as discussed below in the response to the Board's
proposal relative to expected life. As a result, both option pricing
models result in substantial over-inflation of the value of employee
stock options. The result is a material distortion of financial
statements and a negative impact on the quality of financial reporting.
The Black-Scholes model, in particular, has been widely discredited
as a reliable method of valuing employee stock options. The Black-
Scholes model was designed to value short-term, freely tradable stock
options, which have very different characteristics than employee
options. Many of the unique features of employee stock options are not
accounted for by the Black-Scholes model. As a result, companies that
utilize this model must factor a wide range of subjective judgments and
assumptions into a complex valuation formula. Predictions of a range of
variables, including interest rates, stock volatility, and employee
exercise behavior will determine the outcome of these calculations,
resulting in widely divergent results depending on the subjective
assumptions a company makes. The results will be unreliable and will
defy comparability.
We commend the Board's apparent recognition that the Black-Scholes
model has limitations when valuing employee stock options, reflected in
the Board's preference for binomial models. However, binomial models do
not address the shortcomings of the Black-Scholes method. While the
Black-Scholes method is designed to value traded options and has known
limitations with respect to valuation of employee stock options, other
existing valuation models have similar deficiencies. The Black-Scholes
and binomial models essentially rely on the same variables: stock
price, exercise price, time to exercise, risk-free rate of return and
expected volatility of the underlying stock. As with the Black-Scholes
model, volatility is the key input and is difficult to predict.
In addition, these existing option valuation models were designed
to value freely transferable options, yet there are significant
restrictions on the transferability of employee stock options. Employee
stock options cannot be bought, sold or pledged. The Black-Scholes and
binomial models do not incorporate a lack of marketability discount to
address such restrictions.
Further, the Black-Scholes and binomial models were designed for
options that are exercisable only upon expiration. Employee stock
options, in contrast, typically have long vesting requirements of up to
10 years and are then exercisable for a period of time, but are
worthless if the employee terminates employment prior to vesting. The
Board's proposed option pricing models do not accurately account for
these factors.
The Board's proposal also does not take into account restrictions
that exist during the vesting period, on the basis that only
instruments that vest are ultimately expensed. Again, however, a
failure to discount for vesting restrictions overstates the potential
value of an employee stock option.
Any potential value of employee stock options is also significantly
reduced--and made difficult to estimate--by the imposition of blackout
periods or trading restrictions on employees. Many companies prevent
trading of employee stock options based on events such as product
breakthroughs or major announcements. These blackout periods vary by
individual company and by individual employee, restricting options
exercise and trading opportunities for significant periods of the year.
As a result, the potential value of employee stock options is reduced
and made substantially more difficult to estimate.
In short, although the binomial models may have theoretical
advantages over the Black-Scholes method, in practice, they suffer from
similar shortcomings. Binomial models contain a complex series of
subjective inputs, and values calculated are greatly influenced by the
many assumptions and choices made. Investors and other users of
financial statements will have no way to understand the complex process
of arriving at employee stock option valuations, nor will they be able
to interpret or compare the resulting financial statements.
Volatility estimates have a material negative impact on financial
statements that do not accurately reflect a company's actual
financial performance.
The Board seeks comment on whether a specific method for estimating
volatility should be used and if so, what method should be used and
why. We believe that current option pricing models, including those
proposed by the Board, favor companies in non-volatile industries and
penalize companies in highly volatile industries. In addition, these
models do not produce reliable and comparable results in large part
because they require assumptions of expected volatility.
The Black-Scholes and binomial valuation models create a
disadvantage for companies in volatile industries. Assuming stock price
and other terms are the same, if the stock price is declining in the
volatile market and staying constant in the non-volatile market, the
option value will be significantly higher for the company in the
volatile market, under the Black-Scholes formula.
In addition to creating a disadvantage for companies in volatile
industries, the Board's proposal requires estimates of long-term
volatility, inherently unreliable figures. The volatility of the
underlying stock expected over the life of the option, up to ten years,
is perhaps the most significant prediction that must be incorporated
into option pricing models. Volatility estimates have the potential to
result in substantial swings in stock option valuation yet corporate
estimates of future stock volatility truly represent efforts to predict
the future.
Rather than rely on historical volatility, the Exposure Draft
requires companies in most instances to consider the extent to which
``future experience is reasonably expected to differ from historical
experience.'' Companies are further required to estimate future
volatility over the life of the option, up to 10 years in the future.
Wide shifts in volatility are a unique feature of technology and
high-growth companies, in contrast to many other sectors of the economy
with more predictable performance characteristics. The high technology
and biotechnology industries are subject to significant swings in
volatility due to patterns of scientific breakthrough and innovation
that uniquely characterize these industries. Furthermore, these
technological and scientific breakthroughs or setbacks by a company--or
by its competitors--are impossible to predict.
These unpredictable events also have an unpredictable impact on
volatility. Experience illustrates that positive events, including
strong test results, regulatory approvals and technology breakthroughs,
can but do not always increase volatility. In addition, macroeconomic
variables and general market conditions also positively or negatively
impact volatility. Finally, the start and end dates or time period used
to calculate volatility as well as the number of data points used can
significantly impact the resulting volatility estimate. In short,
events and their impact on volatility are not possible to predict and
positive or negative events can instantly make obsolete any valuation
assumptions made at grant date.
Incorrectly estimating the impact of volatility can cause option
valuation and expenses to fluctuate significantly. For example, using
the Black-Scholes formula and making reasonable assumptions about stock
price, option life, risk free rate of return and number of option
grants per year, an estimated volatility of 60 percent yields an
estimated options expense number that is almost 100 percent greater
than the expense number that results from a 40 percent estimated
volatility. Changes in volatility estimates have a dramatic, material
change in employee stock options expense, reported earnings and
potentially to stock price.
Without a consistent or standardized method of estimating expected
volatilities, similar companies can generate significantly different
expense results. Estimates or predictions of volatility based on events
a decade in the future and any valuation based thereon will clearly be
unreliable, except in the case of companies that grant stock options
sparingly (any expense number would be immaterial for companies with
limited option programs). We urge the Board not to adopt a proposal
that will create an unequal playing field by penalizing industries that
experience high stock volatility.
Employee exercise behavior is another significant factor that cannot be
accurately estimated.
The Board's proposal permits use of expected option term rather
than maximum term as a means of addressing the absence of a market for
employee stock options. The Board's proposal, however, would require
companies to forecast employee exercise behavior. Many variables impact
employee decisions to exercise stock options, including vesting
horizon, option term, magnitude of in-the-money position, and the
portfolio of options that the employee can exercise in the near and
long-terms. In addition, employee exercise behavior differs based on
job classification levels, gender and age, restrictions on trading due
to blackout periods and closed trading windows, and a range of other
factors. Personal decision-making based on individual expectations and
needs is virtually impossible to predict, yet the Board's proposal
would require such estimates.
The unique attributes of employee stock options are not taken into
account by the Board's proposal resulting in overstatement of
the value of employee stock option grants.
The Board's proposed valuation models do not provide a sufficient
discount for the unique features of employee stock options. Shortening
the life of an option by adjusting the contractual terms for expected
early exercise and post-vesting employment behavior does not adequately
account for the non-transferability attribute and other unique features
of employee stock options, resulting in overstatement of the value of
employee stock options.
Adjusting the ``life'' of the option from the contractual life may
account in part for the fact that employee stock options vest. However,
this adjustment does not address the other restrictions that exist
including the fact that an option cannot be transferred, hedged,
pledged, or sold. As a result, many options expire unexercised because
an employee left a company before the options had vested or because the
option price was above the price of the stock when the options became
exercisable. In short, the option pricing models proposed by the Board
do not address these features of employee stock options and thus will
result in significant over-inflation of the value of employee stock
options.
As a result of these shortcomings, current option pricing models,
including those proposed by the Board, allow a corporation to come up
with huge differences in the expense number depending on the inputs
that are used. By failing to account for the restrictions and other
characteristics of employee stock options, current option pricing
models produce unreliable and misleading results that overstate the
value of employee stock option grants, particularly with respect to
companies in volatile industries.
A recent study confirmed that the Black-Scholes model
systematically overstates the value of employee stock option
grants.1 In a detailed study of the leading valuation models
applied to an actual set of employee stock option grants covering 403
million options granted by nine major U.S. companies, the Black-Scholes
model consistently overstated the value of the option grants. The
authors of the study cited the failure of the Black-Scholes model to
consider the unique features of employee stock options.
---------------------------------------------------------------------------
\1\ ``Valuing Employee Stock Options: A Comparison of Alternative
Models,'' Analysis Group/Economics for Financial Executives Research
Foundation.
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The Board's proposal does not provide sufficient flexibility to permit
the use of new option pricing models when and if developed.
The Exposure Draft indicates that the Board seeks to adopt a
flexible standard that will permit the use of new option pricing models
when, and if, developed. We are concerned, however, that the Board's
proposed standard appears to preclude the use of any model that is not
based on the Black-Scholes model or a lattice model. Not only must any
model used rely on the Black-Scholes inputs, but the Board's proposal
refers only to lattice and closed and models such as Black Scholes and
there is no clear guidance on the use of alternative models once
developed. We are concerned that, as a practical matter, new models
could not be used unless they were derivations of Black-Scholes or
binomial models.
We have significant concerns about the Board's proposal to require
options that vest on a graded schedule to be valued and
accounted for separately.
In essence, the Board's proposal would require that where options
vest on a ``graded schedule,'' that each set of options constitutes a
separate award that must be valued separately and accounted for
separately. Additional issuances to, for example, new employees, also
would presumably have to be accounted for separately to the extent they
were issued other than on a company-wide grant date. The result would
be multiple valuations for the same option grant and unnecessary
complexity resulting in major implementation costs and challenges.
In addition, this approach will result in inappropriate front-
loading of the option expense. Under the Board's proposal, the expense
of new option grants is based on ``graded vesting'' which accelerates
the expense in the early years. Thus, there is likely to be a greater
financial statement impact, or front-loading of the expense, in the
first few years as each year will carry a ratable piece of the
historical grants and an accelerated portion of the new grants. This
would be extremely difficult to administer and impact comparability of
financial statements.
The Board's proposed transition rules would result in unreliable and
incomparable financial statements.
We are concerned that the Board's proposal will result in a
significant lack of comparability due to the inconsistent treatment of
new option grants versus prior option grants. The Board's proposal
would require unvested options to be expensed based on the Black-
Scholes value that was contained in prior footnote disclosures. Newly
issued options, in contrast, would be valued based on the new standard.
As a result, during the transition period, outstanding options would be
valued in radically different ways.
In addition, estimates of the value of grants made in prior years
using the Black-Scholes method will, under this proposal, impact
financial statements going forward despite recognition that these
``values'' are overstated. The result will be highly confusing for
investors, particularly in the case of companies that offer broad-based
plans.
We believe that the Board's proposal will have a significant, negative
impact on emerging growth companies and other non-public
entities.
We are particularly concerned about the impact of the Board's
proposal on non-public companies given the importance of employee stock
options to the success of emerging growth companies and the reliance of
such companies on stock options to attract, retain and incentivize
employees. Further, we believe that the subjectivity and
unpredictability of the estimates required by the Board's proposal is
exacerbated in the case of non-public companies.
All of the arguments outlined above apply to non-public companies.
In fact, such companies will face heightened challenges in estimating
the volatility of the stock that underlies the employee stock option
and for which there is no market. There is no reliable data to measure
volatility for most non-public companies. Estimates based on market
volatility will not be reliable because company volatility is often not
comparable to industry volatility. In addition, venture-backed
companies often establish new industries with unpredictable
volatilities.
The Board's proposal states that, where it is impossible to
estimate the fair value of employee stock options, companies be
required to use an ``intrinsic value'' method where the value is
adjusted each reporting period. Non-public entities may also elect this
method. We have concerns regarding the Board's proposed use of an
``intrinsic value'' method in which the value of employee stock options
is adjusted each reporting period.
This approach will, in effect, bring the stock price directly into
the income statement. The expense associated with employee stock
options will increase or decrease each quarter depending on changes in
the price of the underlying stock. Under this approach, it is
conceivable that the expense might even be negative in some cases.
In previous examinations of the expensing issue, the Board
determined that measuring volatility would be too difficult, resulting
in the current use of the minimum value method for non-public
companies. We believe that estimating future volatility for new, non-
public entities remains a significant challenge and we urge the Board
not to require this approach.
A one-year extension of the effective date is not sufficient to
address these concerns. The substantial compliance costs that would be
imposed on non-public companies would far outweigh any possibly
perceived benefits resulting from a mandatory expensing standard.
The Board should conduct extensive field-testing of proposed option
pricing models prior to adoption of any final standard.
There are fundamental differences of opinion within the accounting
community on the threshold issue of whether employee stock options
constitute an expense. There is widespread agreement among accounting
experts and in the business community, however, that current valuation
models will not product accurate, reliable and consistent results. As a
result, we strongly urge the Board to require field-testing of any
proposed option pricing models prior to the adoption of any final
standard.
Field-testing should be comprehensive and enable the financial
officers and management of companies to make and test real-life
assumptions to determine whether these models can produce reliable and
comparable results. Further, we believe that the results arrived at
through field-testing should be used to develop footnote disclosures
until it can be determined that they provide accurate and reliable
results. If, based on sufficient field-testing data, it is determined
that the Board's proposed models provide credible, transparent,
consistent, comparable and unbiased information, and that the footnote
disclosure has not addressed investor needs, then the valuation of
stock options on the face of the financial statements should be
considered. There is ample precedent for field-testing in cases such as
this, in which a long-standing method of accounting is replaced with a
newer, untested approach.
The Exposure Draft and resulting standard will not increase clarity or
comparability for companies or investors.
We support the Board's stated goal of issuing ``financial
accounting standards that can be read and understood by those
possessing a reasonable level of accounting knowledge, a reasonable
understanding of the business and economic activities covered by the
accounting standard, and a willingness to study the standard with
reasonable diligence.'' We feel strongly, however, that the proposed
Statement will not achieve this objective.
On the contrary, as detailed in this letter, we believe that the
Board's proposal would establish a standard that significantly reduces
the reliability, comparability and clarity of financial statements for
companies and investors. We believe that the proposed standard would
impose significant burdens on companies, particularly smaller
companies, related to compliance and auditing. Further, we believe the
standard is so complex and subjective as to produce financial
statements that cannot readily be understood or compared across
industries or over time by the average investor.
The Board's proposal will have a negative impact on the ability of
companies to offer Employee Stock Purchase Plans.
The Board has taken the position that any Employee Stock Purchase
Plan (ESPP) is compensatory, and an expense must be recognized, unless
all holders of the same class of stock are entitled to purchase shares
of stock on no less favorable terms than the employee. The proposal
thus requires companies to treat as an expense the discount given to
employees when they purchase shares under these plans.
Employee stock purchase plans are an important benefit to American
workers. More than 15 million workers at 4,000 public companies across
the United States participate in ESPPs. We are concerned that the
likely result of the Board's proposal will be the reduction or
elimination of one of the primary savings vehicles for millions of
average American employees.
IV. ECONOMIC POLICY IMPLICATIONS OF THE BOARD'S PROPOSAL
Mandatory expensing will threaten the trend toward broad-based employee
ownership
Increasingly, employee stock options are being offered by companies
in a range of industries and the clear national trend has been toward
increased employee ownership particularly among non-managers. Data from
the National Center for Employee Ownership and other sources over the
last few years shows that the number of companies that offer options to
all employees continues to grow. Currently, over 14 million American
workers or 13 percent of the entire private sector workforce hold stock
options, according to a recent national study by Professors Joseph
Blasi and Douglas Kruse of Rutgers University's School of Management
and Labor Relations and Professor Richard Freeman of Harvard
University's Department of Economics. 94 percent of these employees
consider themselves part of the middle class, working class or lower
class, while only 15 percent identify themselves managers. Mandatory
expensing will threaten this important trend.
In the high technology and biotechnology industries that TechNet
represents, stock options and broad-based employee ownership have been
an engine of growth, helping to build some of the nation's most
innovative companies. TechNet member companies--including many of
today's technology leaders as well as start-ups--have grown due in
large part to the ability to use employee stock options to attract and
retain skilled employees at all levels of the corporation.
A mandatory expensing standard is likely to result in the
elimination of broad-based employee stock option plans. Professors
Brian Hall of Harvard Business School and Kevin Murphy of the Marshall
School of Business, University of Southern California, have conducted
research showing that the perceived value of stock options to
executives at time of grant is typically one-half to two-thirds of the
value under the Black-Scholes method, and may be as little as one-
third.2 A more recent study of over 640 employees at 300
publicly-traded companies suggests that employees place a 30 to 50
percent discount on the value of stock option grants they receive,
relative to the Black-Scholes value of the options.3 If
forced to absorb a cost 50 to 200 percent greater than their perceived
value, companies will face a major obstacle to offering options.
---------------------------------------------------------------------------
\2\ The Journal of Accounting and Economics, April 2002.
\3\ How Do Employees Value Stock Options, Watson Wyatt Worldwide,
March 2004.
---------------------------------------------------------------------------
For companies that broadly issue employee stock options, the
inaccuracies that result through application of existing option pricing
models are more likely to have a material negative impact on financial
statements, while companies that issue only a small number of options--
usually to senior officers--will not be as significantly affected.
Under a mandatory expensing standard, companies will be forced to
restrict stock option grants rather than adding a significant expense,
in accounting terms, to the financial statement. The result will be a
decline in broad-based stock option plans.
In fact, recent studies and press reports confirm that companies
will restrict option grants if a mandatory expensing standard is
adopted. A 2002 survey of 117 U.S. companies showed that most of the
companies surveyed would restrict option grants to rank-and-file
employees if employee stock options were required to be
expensed.4 In fact, the study suggested that four of every
five companies would grant fewer employee stock options. A number of
corporations have already announced plans to reduce option grants to
non-executive employees in reaction to the Board's proposal.
---------------------------------------------------------------------------
\4\ ``Survey: Firms Say Expensing Would Hurt Rank-and-File,--San
Jose Mercury News, describing a June 2002 study of 117 companies by
iQuantic Buck.
---------------------------------------------------------------------------
The importance of broad-based stock options and their impact on
economic growth is undisputed. Studies confirm that broad-based plans
have a significant impact on productivity, innovation and economic
activity. Companies that offer stock options to most or all employees
have experienced significant increases in productivity.
Most recently, Professors Blasi and Kruse provide empirical
evidence that companies with broad-based employee stock option plans
receive a one-time, but permanent, boost to productivity of
approximately 4 percent, compared to what their productivity would have
been without employee ownership. Total shareholder returns increase by
an average of approximately 2 percent.5 Anecdotal evidence
by employees and managers in a range of industries confirm the power of
stock options to motivate employees through equity ownership.
---------------------------------------------------------------------------
\5\ Joseph Blasi, Douglas Kruse and Aaron Bernstein, In the Company
of Owners: The Truth About Stock Options (and why every employee should
have them), 2003.
---------------------------------------------------------------------------
V. CONCLUSION
TechNet strongly believes that the flexible approach set forth in
Statement No.123 provides appropriate information to investors. We have
serious concerns that an expensing standard utilizing existing
valuation methods as proposed by the Board will result in inaccurate
and inconsistent financial reporting.
Existing valuation models are not adequate for valuing employee
stock options. We believe that the Black-Scholes and binomial models
proposed by the Board fail to adequately incorporate factors unique to
employee stock options. The need to make multiple subjective
determinations of the variables used in the Black-Scholes or binomial
stock option valuation models will threaten the comparability and
consistency of financial reporting across companies and across
industries.
Thank you for the opportunity to comment on this important matter.
Please contact me at (650) 213-1160 for any further discussion of our
comments.
Sincerely,
Rick White
President and CEO
Mr. Stearns. I thank my colleague.
Mr. Mayer.
STATEMENT OF STEVEN C. MAYER, SENIOR VICE PRESIDENT AND CHIEF
FINANCIAL OFFICER, HUMAN GENOME SCIENCES
Mr. Mayer. Thank you, Chairman Stearns, Ranking Member
Schakowsky, and members of the subcommittee. Thank you for the
opportunity to appear before you today at this important
hearing. I have submitted my letter to the FASB, my comment
letter and that of BIO, that I ask be included in the record.
Mr. Stearns. My unanimous consent, so ordered.
[The material appears at the end of the hearing.]
Mr. Mayer. My name is Steven Mayer, Executive Vice
President and Chief Financial Officer of Human Genome Sciences.
I am a member of the Small Business Advisory Committee to the
FASB, as Mr. Herz mentioned, and I did participate in the first
meeting of that committee on May 11 of this year. I have been a
participant in the biotechnology industry for more than 20
years and have served as Chief Financial Officer of a number of
biotechnology companies, both private startups and public
companies, for 19 years.
I am pleased to appear today on behalf of BIO, the
Biotechnology Industry Organization, which represents more than
1,000 biotechnology companies and related organizations. Most
of these companies are engaged in the search for therapies to
prevent, treat and cure diseases, including cancer,
cardiovascular disease, autoimmune disease, infectious diseases
such as HIV/AIDS, and many other serious conditions.
At Human Genome Sciences we were a pioneer in the discovery
of human genes and the application of those discoveries to
human therapeutics. We are currently testing in human clinical
studies breakthrough treatments for cancer, lupus, rheumatoid
arthritis, hepatitis C infection, and even the potential
bioterror threat, anthrax. In addition, we are in preclinical
development of treatments for HIV infection and diabetes.
In all of my experience in the biotechnology industry, in
every company with which I have been associated and in
virtually every company with which I am familiar, stock options
have played a key role in the recruitment, retention and reward
of the scientists, physicians, professionals and staff. In
fact, all of these companies use broad-based plans that
generally extend to most if not each and every employee in the
company. All of our employees at Human Genome Sciences are
eligible for our stock option program.
So I have a pretty good understanding of how stock options
have been used in our industry over a long period of time and
an appreciation of the fact that stock options have been a key
ingredient in making the U.S. biotechnology industry the world
leader by a very wide margin. I am concerned that putting this
structure at risk could jeopardize the important research going
on in the biotech industry. That is why I am here today to
speak on behalf of BIO in support of the legislation that you
are considering, H.R. 3574, and to explain why I believe there
are fundamental and fatal flaws in the exposure draft prepared
by the FASB that would require mandatory expensing of stock
options.
First, I believe mandatory expensing is bad policy that
will diminish the entrepreneurial spirit of our industry,
reduce the availability of capital and decrease the alignment
of interests among employees, management, and stockholders.
Such a change will in all likelihood have a detrimental impact
on a broad range of rank and file employees who today have an
opportunity to accumulate wealth through participation in the
value that they help create.
Second, and most important, I believe expensing is bad
accounting that will cause financial statements to become less
reliable, less transparent, less comparable, more volatile,
less understandable and less useful.
Some points. Employee stock options do not represent an
expense as defined in the FASB's own conceptual framework, CON
6. I would encourage all the members, or perhaps their staffs,
to read the conceptual framework. It is an excellent document.
I commend the FASB on it. But the FASB definition of expenses
in that conceptual framework states that ``expenses represent
actual or expected cash outflows that have occurred or will
eventuate as a result of the entity's ongoing major
operations.'' The grant, exercise or sale of shares from a
stock option never under any circumstances result in a cash
outflow. In fact, they may result in a cash inflow.
Another point. Expensing stock options I believe will
actually distort earnings per share by double counting the
impact of the option, first as an expense and then a second
time as dilution. The true economic impact of issuing stock
options is already fully captured in the dilution of earnings
per share. It is actually the stockholders who give up a share
of their interest in the company in exchange for value created,
not the company that incurs an expense.
Transparency. We hear it a lot. We talk about it a lot.
Transparency means that one can understand where the numbers
come from and how they were derived. Few people I know
understand the Black-Scholes model, including many of those who
use it. No one I know understands the lattice model nor do they
understand how they will come up with the many estimates
required to implement it. This single number is only a
theoretical estimate of a cost that is never actually incurred,
that never results in a cash outflow and that may in our
industry, in the biotech industry, overwhelm every other
category of expense in the income statement.
This is not transparency. What we have today with extensive
footnote disclosure already required by the Securities and
Exchange Commission is much more transparent. The information
is readily available to any investor or creditor who wishes to
use it. Increasing the complexity of financial statements in
this way will only make the information less accessible to the
average investor, the small creditor, the independent analyst.
The large institutions will have the legions of analysts needed
to untangle and interpret these complex statements resulting in
a less level playing field than we have today.
My third point is that the cost of implementation and the
difficulties of auditing the many estimates that would be
required to implement the expensing of stock options have been
severely underestimated and will far exceed, in my view, any
benefit that could possibly be derived from taking the
extensive information already available in the footnotes to
financial statements and embedding it in the income statement
as a single theoretical estimate. The implementation of this
new standard will be a crushing burden to many companies in our
industry.
My grave concern is that the forces that are defining this
new accounting approach are driven by a desire to reshape
executive compensation and not by the goal of improving
financial reporting. Is accounting policy the right way to
address the executive compensation issue? In this setting, I am
hopeful that Congress will act to preserve reporting standards
that result in clear, reliable, comparable and informative
financial statements.
Thank you again for this opportunity. I will be happy to
answer any questions.
Mr. Stearns. Thank you, Mr. Mayer. Let me ask you
something, Mr. Mayer. From your testimony, you are saying that
you would agree to expense stock options for all employees if
we used the lattice model?
Mr. Mayer. No. I am saying that I think using the lattice
model would be an incredible burden on companies because people
don't understand it.
Mr. Stearns. Black-Scholes, you don't think that----
Mr. Mayer. Black-Scholes is a simpler model that people
currently use for doing their footnote----
Mr. Stearns. But your position is you do not think any
stock options should be expensed, is that correct?
Mr. Mayer. That is correct.
Mr. Stearns. Mr. White, is that your position, that no
stock options should be expensed?
Mr. White. As a theoretical matter we don't think it makes
sense to do it. As a matter of policy it may make sense to make
a distinction for the top five since they do have the ability
to manipulate the price of a stock.
Mr. Stearns. So we are clear that your position is pretty
straightforward that no stock option should be expensed. On the
other side, Mr. Walker and Mr. Herz believe they should be.
When you look at other people who have experience in this
matter, I mention Alan Greenspan, Paul Volcker, SEC Chairman
Bill Donaldson, Treasury Secretary John Snow and Warren
Buffett, all think they should be expensed. Both of you
individuals do not agree with them. Canada is starting to
expense them and so is Europe.
So at this point we also have all seven members of the
Financial Accounting Standards Board, we have the four top
accounting firms and legions of investment professionals that
say they should be expensed. Not only that but Warren Buffett,
who has had 62 years of investing, is one of the most wealthy
men in the country, has pointed out in his recent editorial
that he believes stock options should be expensed. The question
is, in his editorial he was concerned about, and as has been
pointed out by one of the members of the panel, is that the
idea of zero volatility means there is no expense.
So I guess the question is, and this is for you, Mr. Herz,
H.R. 3574 requires that the assumed volatility for options
granted to the five highest paid executives in a corporation be
zero. Mr. Buffett says that is impossible. In his 62 years he
has never seen a stock that doesn't fluctuate. He calls it an
Alice in Wonderland assumption to state that it would be zero.
So let me ask you a question. Can you expense a stock if
its volatility is considered to be zero?
Mr. Herz. You would get what is called the minimum value
approach, which is just accounting for the discounting of the
strike price, but you can actually then engineer the strike
price to get a zero expense and just keep the value the same by
multiplying the number of the grant of the options. The answer
is that it defies all rational, proven finance logic that
underlies the whole financial----
Mr. Stearns. Let's be fair. In that bill they also have
other criteria besides the zero volatility. So comment about
those. Do they make it more credible?
Mr. Herz. The bill has what is called a true-up at the end
for the spread between the grant price and the value of the
stock at that end, whether it is higher or lower. That is what
is called exercise data counting. That is not an accounting
that is supported by many accountants. It is an accounting that
the CBO looked into.
Mr. Stearns. Does FASB support the other options that are
in the bill as a criteria?
Mr. Herz. No.
Mr. Stearns. Mr. Walker, the other criteria that is in this
bill besides the zero volatility, do you find those credible to
use for expensing options?
Mr. Walker. I think they are issues that are reasonable to
consider but the fact of the matter is I think it is
unrealistic to not consider volatility. To a certain extent,
Mr. Chairman, what I am hearing is an advocacy for social
accounting.
Mr. Stearns. What is social accounting? Define that.
Mr. Walker. There is a big debate that happens from time to
time saying that you ought to invest or not invest in certain
types of things because of social or societal interests. What I
am hearing from the two panel members who oppose the FASB's
proposed action is that accounting shouldn't be based on
economics, it shouldn't be based upon consistency and
transparency and substance over form, it should be based upon
what kind of social implications it might have.
I might add, as an anology, I used to be Assistant
Secretary of Labor for Pensions and Employee Benefit Programs,
so I am very familiar with ESOPs, employee stock ownership
plans, profit-sharing plans. The Tax Code has all kinds of
incentives in it for broad-based, employee-based share
arrangements. It also has a number of additional flexibilities
with regard to Federal laws in order to try to encourage those
types of arrangements, but that is different than how you ought
to account for those types of arrangements.
Mr. Stearns. Let me just conclude. Mr. White and Mr. Mayer,
you have testified that stock options should not be counted as
expense because, in your words, ``they represent an opportunity
for employees to share in ownership.'' But, Mr. Mayer, don't we
expense the direct grant of stocks? Aren't they expensed when I
give you stocks personally?
Mr. Mayer. Yes. From an accounting treatment----
Mr. Stearns. If it is true that we force you to expense the
stocks when we give them to you, why wouldn't it be possible to
expense the option for the stock?
Mr. Mayer. Stocks have certain value. If I give you a share
of stock, it is liquid, you can take it----
Mr. Stearns. And we are saying options do not have that?
Mr. Mayer. Do not have certain value. In fact that is
exactly the point.
Mr. Stearns. Doesn't the corporation go out and have to
commit those at a certain price before they give it to the----
Mr. Mayer. Absolutely not. No. Typically--it depends on the
company but typically the company will reserve shares.
Mr. Stearns. That is what I mean. When they reserve those
shares, isn't that a commitment by the company typically and at
that point somebody owns those shares and is protecting that
price value before it goes up or down?
Mr. Mayer. No, absolutely not. The shares that are reserved
are set aside at the behest of the stockholders, the owners of
the company, not by management, and under today's rules all
stock option plans must be----
Mr. Stearns. But who is going to buy those stocks when it
is exercised?
Mr. Mayer. The public market would.
Mr. Stearns. And who is going to guarantee that price--if
you are going to buy it at 32 and it is 200, who is going to
guarantee that 32?
Mr. Mayer. Well, the 32 is a contractual commitment by the
company.
Mr. Stearns. Isn't a contractual commitment an expense if
it involves options of stocks?
Mr. Mayer. No, it is not an expense. In fact an expense as
defined by FASB is a cash outflow. There isn't a cash outflow.
Mr. Stearns. Let me just conclude with Mr. Herz. I am a
little over my time. Yes, Mr. Herz.
Mr. Herz. Options clearly do have value and any options are
given for other purposes, to acquire goods and services, they
are used in M&A transactions, stock purchase warrants are used
as part of financing packages. In all those cases, it has been
long established accounting that you value them and you account
for that properly. It is just this one form of employee stock
option that has this kind of narrow aperture in the existing
accounting literature that has been used to not account for
them.
Mr. Stearns. My time has expired.
Mr. Mayer. If I could just correct what I think is a
misconception on the volatility issue. Zero volatility does not
mean zero value by definition under Black-Scholes. I am less
familiar with the lattice model, but you plug in zero
volatility into a Black-Scholes model, you will not get zero
value. You will get a lower value than if you plug in a higher
volatility. In fact volatility is the most sensitive parameter
and is exactly why I am so concerned about this because nobody
here can predict what the stock market volatility will be over
some 7 or 10 years.
Mr. Stearns. My time has expired. The gentlelady.
Ms. Schakowsky. Thank you, Mr. Chairman. Mr. White, I have
to tell you that I was shocked and offended by what I view as
the very--you don't have to put your mike on because I am going
to ask Mr. Herz to respond--patronizing tone of your testimony
in saying that we had to consider these larger economic
questions. I want to tell you something. That is why we are
here right now, the effect on the economy. If you doubt that,
talk to some of these employees of Enron or other victims of
corporate misconduct. The reason that we are so concerned about
setting some neutral industry standards and accounting
standards and looking at what FASB is trying to create here is
because we have economic victims of this corporate
irresponsibility and misconduct and, in the case perhaps of Ken
Lay, of criminal activity. So we are looking at larger
questions here.
I don't want to say too much because I saw Mr. Herz taking
some notes while you were talking. I want to give him some time
to respond to your patronizing testimony. But you were
concerned, Mr. White, about my company not doing as well
because I had to report those expenses. I just wanted to read
to you, in March 2004, a leading compensation firm, Towers
Perrin, issued a study examining 335 companies that switched to
stock option expensing and found that stock performance was the
same on average as the rest of the S&P 500 and Mid Cap 400
indices. Stock option expensing did not affect company stock
prices. The same dire prediction had been made and shown to be
unfounded when FASB first required companies to begin
accounting for their obligations to employees relating to
retiree health care benefits.
So I would say, don't be concerned about my company. Were I
to expense those stock options, it appears that I would be
doing just fine as these nearly 600 other companies seem to be
doing, as Canada, as 90 other countries. And the idea of
harmonizing what we do with the rest of the world, it seems
worth commenting on as well.
I would like, Mr. Herz, to give you the opportunity to
respond to some of the comments that Mr. White made regarding
the inapplicability.
Let me just say one other thing. It seems to me that what
you were suggesting, Mr. White, was politicizing the question
of these accounting standards and it seems to me that your
suggestion, rather than helping, undermines investor confidence
in accounting practices, allows companies to misrepresent their
true financial positions, does not allow for honest and
transparent accounting, and prevents investors and pension
funds from making informed decisions. It seems to me that is
what I heard Mr. Walker saying, too, I think, is if we want to
establish confidence, then doing exactly what FASB, or perhaps
we need more discussion about the exact nature of it, but the
idea of what FASB was suggesting is the direction we ought to
go.
Mr. Herz.
Mr. White. You are not going to let me respond, is that
correct?
Ms. Schakowsky. You took more than your time as it was and
I would like now Mr. Herz to use my remaining time. If there
are others who want to give you time, that would be fine.
Mr. Herz. Thank you. Because I was going to say that I was
kind of grateful to Rick for characterizing my own statements,
which I think he mischaracterized some of them. On the issue of
not considering the impact on the U.S. economy, our mission is
exactly about--as you say, it is about the efficient allocation
of capital in the economy. We think that is a huge public
policy goal.
Different groups come to us, different industry groups come
to us always and say, my public policy mission is the highest
in the economy. We had a group from the steel industry come and
quite rationally say steel needs to be made more competitive,
the costs are too high, we want you to exempt us from showing
pension costs. I asked, do you still have those costs? Yeah,
but we want you to put it in the footnotes, make you look more
competitive. When we were doing the thing on special purpose
entities, we had a number of people who were purveyors of
different structures saying, well, my special purpose entity is
good, it allows companies by keeping it off the balance sheet
to borrow more and they can hire more people and they can
invest in things. We can't make those kind of decisions nor
should we have to.
For us, as I said, it is about trying to get the right
accounting, the issue of investors and backing the thing out.
The fact is that investors, shareholders, institutional
investors have all kind of voted either in resolutions or in
all sorts of surveys and they all back our proposal strongly
and the idea of expensing.
He said there is no clear accounting consensus. Yeah, there
is some debate on some of the technical issues, but on the
basic issue of expensing, as mentioned, all the accounting
firms I know, not just the big four, the next two large ones,
in the international arena, the International Accounting
Standards Board approved their standards by 14 to nothing. On
that board are people from nine different countries from all
parts of the world. So I think there is a fair amount of
consensus on this issue.
Ms. Schakowsky. Thank you. Mr. Chairman, I seek unanimous
consent to put into the record a letter that myself and Mr.
Dingell and 22 Members of the House and Senate sent to FASB and
also the list of the 576 companies that have voluntarily
adopted option expensing, a report from Bear Stearns.
Mr. Stearns. By unanimous consent, so ordered.
[The information referred to follows:]
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Mr. Stearns. Mr. Shadegg.
Mr. Shadegg. Thank you very much, Mr. Chairman. I
apologize, I have very little time. I would like to ask you to
keep your answers brief if you possibly could. Mr. Walker, in
the other committee that considered this legislation, a witness
from CBO came and testified. They were supportive of the FASB
rule. I asked him a question kind of following along Mr.
White's question, which was in your study did you study the
economic impact on the economy; that is, the impact on the
economy of this rule? Actually I asked him what factors did he
look at and what did it show. He responded that in point of
fact in its study CBO had not looked at the impact on the
economy, they had simply looked at how the process could be
done.
To my knowledge, GAO has not done a study of the impact on
the economy of enacting the FASB rule, has it?
Mr. Walker. No, we haven't. It is my understanding CBO did
look at the impact on competitiveness, though, and said it
would not have an adverse impact on the competitiveness of U.S.
companies.
Mr. Shadegg. That is not what he said. I asked him what
factors they looked at and he said they had not.
Mr. Walker. They are different issues. You are correct, he
did not look at the other.
Mr. Shadegg. Mr. Herz, would you agree with me that this is
a gray issue; that is to say, that it is not clear and black
and white and it is not an issue where every logical viewer of
the issue would say yes, we should move to expensing stock
options?
Mr. Herz. I think any knowledgeable person in economics and
accounting would agree.
Mr. Shadegg. I am troubled by that.
Mr. Herz. I think you can debate which method. That is a
debate, a vigorous debate we have had at the Board.
Mr. Shadegg. I think you are interested in where I am going
so let me go there. You have pointed out that all the major
accounting firms are now on the side of expensing and you have
said you are on the side of expensing but just a few brief
years ago in December 1993, your name appeared on a letter by
Coopers & Lybrand saying that using stock option pricing models
would result in unreliable information and would have an
adverse impact on the comparability and usefulness of financial
statements.
Your name appeared on that letter. I presume you supported
that position then. So I guess all of the consensus that you
say everybody now, anybody knowledgeable now, would say
absolutely should expense. So that letter was not only wrong 7
or 10 years ago, it was dramatically wrong?
Mr. Herz. That is not a letter. It is a thing called a data
line to the practice. All it did was explain people's views.
Mr. Shadegg. They seemed to be pretty strong views. They
say point blank using option pricing models results in
unreliable information and would have an adverse impact on the
comparability and usefulness of financial statements. Those are
pretty strong words.
Mr. Herz. As I said, that thing expressed people's views,
reported people's views, my personal views. I can say that
since that time I have studied this issue for many, many, many
years.
Mr. Shadegg. And changed your opinion?
Mr. Herz. I don't think I had that opinion at that time.
Mr. Shadegg. Your name and phone number appeared on the
letter.
Mr. Herz. It says for more information on this subject,
please contact one of the following three people.
Mr. Shadegg. You put your name and phone number on a letter
that says for more information when you disagreed with the
letter?
Mr. Herz. The letter was a report on views. It was not
people's views.
Mr. Shadegg. Mr. White, let me ask you, the chairman read a
pretty lengthy list of people who have said that they think we
should move to expensing. I note that all of those people that
he recited represent large, well-established companies. None of
them, I believe, have made their fortune in startups and quite
frankly I noticed a stark absence of anybody in the high tech
field or the biotech field. I guess I would like to give you an
opportunity to tell me the perspective of startups and the
perspective of biotechs and high techs on this issue and the
concern of those companies.
Mr. White. I appreciate that. Actually what I would like to
do is just read a list of other people who actually don't think
that expensing is appropriate. There is a long list, but a
couple you might consider are Commissioner Paul Atkins from the
SEC. He disagrees with that. Glen Hubbard, formerly at the
White House. Larry Lindsey, formerly at the White House, also
doesn't agree that expensing is appropriate. Some of you may
remember the Honorable Tom Campbell, who was a great Member of
this institution, now the Dean of the Business School at
Berkeley, he doesn't agree with the comments that have been
expressed.
As I think Congressman Shadegg pointed out, there are
professors at Harvard, Princeton, Rutgers, Berkeley, Stanford
and many, many other schools across the country who disagree
with that. I think there has been an effort to suggest that
this is a closed issue by people who really understand it, and
I think that is absolutely false. There is a real, legitimate,
principled debate in accounting as to whether this should be
booked as an expense at all.
Mr. Shadegg. My time is going to run out, Mr. Mayer, but
let me ask you in conclusion, one of the things that troubles
me with the concept of expensing is that there is in fact not
agreement on a correct method of expensing, so much so that
FASB itself doesn't propose to dictate a method for expensing.
I guess I would like you to explore that as a concern, and
there has been reference on the other side to the idea that
this proposal, expensing stock options, would have precluded
the Enron scandals and other recent scandals. My memory tells
me those were not the abuses. As a matter of fact, with regard
to some of those I think they were special entities where those
companies spun off all of their losses, not showing those
losses on their books, which would not in any way have been
improved or given a better picture or been avoided if we had
had this rule.
I appreciate your comments.
Mr. Mayer. Certainly the method of estimate is one of the
great concerns that all of us have in the implementation of
this plan. The Black-Scholes method is one that people do
understand, although we also understand the drawbacks of it.
The lattice model is a model that no one understands. One thing
that has not been addressed is how these will be audited. The
lattice model would require us to make quarterly estimates of
employee behavior going forward 7 to 10 years, of stock market
volatility going forward 10 years, and other factors that would
all get rolled into this model. By rough calculation for our
company, we would have to make several tens if not hundreds of
thousands of calculations each quarter, and how those will be
audited I don't think anyone has yet addressed.
As far as the question of the recent corporate scandals, I
am not a real student of those. However, it is my understanding
that stock option accounting has not played a role in any of
those.
I have to take issue with a couple of people who have said
that this current method prevents investors from making
informed decisions. The current SEC disclosure is very clear
and very fully informs in footnotes of financial statements all
of the information that someone could want and in fact even the
CBO report that has been referenced says that this information
is already available to investors in the notes to firm's
financial reports. So the information is there. This has
nothing to do with cash-flows. It is merely a different type of
accounting treatment from the one that has been in place for I
think some 25 years.
Mr. Shadegg. Thank you very much. My time has expired. I
thank the Chair for indulging me.
Mr. Stearns. I recognize Ranking Member Dingell.
Mr. Dingell. Mr. Chairman, I find myself very interested in
the thesis that this legislation would require that no longer
would corporations that have chosen the method of using fair
valuation of options be able to use those.
Can you explain, Mr. White, or perhaps, Mr. Mayer, why we
should ban General Motors or any of the other U.S. corporations
who have decided they want to use this mechanism from using it?
Mr. White. We shouldn't. I agree. As I understand the bill,
it doesn't do that.
Mr. Dingell. It does do that. Mr. Mayer?
Mr. Mayer. I agree we should not, and it is also my
understanding that the bill does not do that.
Mr. Dingell. I find myself very interested, also, in the
fact that the bill says that there would be no--that it would
be presumed there would be no volatility in the stock. That is
a curious thing. Doesn't that fly in the face of all of our
experiences with the indexes? Most recently, for example, the
Dow has gone from something like 8,000 to 10,000 and it moves
somewhere around 100 or so points a day. That seems to be at
variance with fact, does it not, gentlemen?
Mr. White. It flows out of the great complexity of this and
the inaccuracy of trying to estimate the value of these things
on the date of grant. It is a little like predicting the value
of your stock into the future, which is a very difficult thing
to do. The problem is with volatility a very small change in
your assumptions about volatility drives a huge change in the
valuation, and so it makes it very subject to manipulation. It
is the biggest area of inaccuracy in the whole process.
Mr. Dingell. But to assume that there is no volatility
affords people to do some rather innovative accounting, doesn't
it? And it would enable us to see people who had this
particular responsibility to in fact manipulate the stocks
because they could assume there is no volatility. For example,
when the bottom fell out of AOL or when the bottom fell out of
Tyco, they could assume there is no shift in the value of the
stock.
Mr. Mayer. Actually I think quite the opposite. By having
zero volatility you stabilize the basis on which these
calculations are done. That eliminates a huge variable and in
fact the most sensitive variable to the calculation. If you
allow people or require people to guesstimate or estimate
volatility going forward, that estimate is going to be always
changing and that is where games will be played.
Mr. Dingell. So we have then an assumption that there will
be no volatility in stock. That is a bad assumption, is it not?
Mr. Mayer. I think it is a----
Mr. Dingell. It may be inconvenient that there is this
volatility but it is still there, isn't it?
Mr. White. It just points out the futility of this whole
exercise. You can't get this number right, and so the effort to
make it zero is to stabilize it so it is not quite as wrong as
it otherwise would be. That is really the problem.
Mr. Dingell. Thank you.
Mr. Herz and Mr. Walker, would I be fair in assuming that
all accounting was absolute and was done on absolute numbers?
Or do we find that there are a lot of estimates that occur in
the accounting process?
Mr. Walker. There are a lot of estimates that occur in the
accounting process. Let me give you another one that was
controversial. Health care costs, inflation. There was a huge
controversy over accounting for post-employment health benefits
because of the difficulty in trying to project what the
estimated total cost of health care would be, but in the end
FASB came up with a clear, consistent and transparent
accounting treatment despite that fact.
Mr. Dingell. I note here that the prohibition on using the
fair value of stock options would affect large numbers of U.S.
corporations. This question is to Mr. Herz and Mr. Walker. It
would affect foreign corporations listing on the U.S. market
functioning under international accounting standards, would it
not?
Mr. Herz. Yes. I am not a lawyer but the way I read the----
Mr. Dingell. It would also affect U.S. subsidiaries of
foreign corporations and foreign subsidiaries of U.S.
corporations, would it not?
Mr. Herz. It would affect anybody who doesn't use the
method prescribed by the bill.
Mr. Dingell. So it would ban large numbers of U.S.
corporations and foreign companies from being properly listed
on the securities exchange, would it not?
Mr. Herz. It would make them undo what they believe is the
better accounting.
Mr. Dingell. If you can't get your reports approved by the
SEC, you can't list, and all of a sudden you have got real
problems under our securities laws.
I have been looking here at this business of only the top
five. This question is to Mr. White and Mr. Mayer. Why would we
limit it to only the top five?
Mr. White. I think there are two reasons. One of them is
more of a policy-oriented reason. That is what a lot of people
are really concerned about, making sure that executive
compensation doesn't get out of the control. I think the reason
that is more related to this exercise is that those people are
the ones who have the possibility of manipulating the stock
price so that it artificially would go up.
Mr. Dingell. Let's take your assumption. Let's just talk
about Enron, which is always a nice subject of discussion. The
top Enron executives. All of the above were indicted, Ken Lay,
Jeff Skilling, Andrew Fastow, Richard Causey. These are the
chairman, chief executive officer, chief financial officer and
chief accounting officer. The only one not indicted was Mr.
Jeff McMahon, who was the treasurer. I suspect in part because
he cut a deal with the U.S. Attorney.
As we go on down we find Lea Fastow was also indicted,
Michael Kopper, who was in the treasurer's office and Ben
Glisan. There were a goodly number of others. You would get the
top five but you wouldn't get the others, so you wouldn't know
who was stealing there and who was manipulating the value of
stock options or how this impacted upon the value of the shares
of stock of the ordinary citizen.
Mr. White. And we wouldn't know under this deal either.
Mr. Dingell. Are you advocating that we should take that
course of action?
Mr. White. No. In fact, the real problem here, and I will
let Mr. Mayer respond also, but Enron is an example of where
they, as far as people can tell, complied with a lot of
accounting standards and still defrauded people. No matter what
we do in terms of accounting, if people are going to lie and
break the laws, the rules are not going to change that.
Mr. Dingell. And your prohibition would make it easier?
Mr. White. I don't think so.
Mr. Mayer. I disagree. The value of stock options was not
an issue of all the many issues in the Enron situation.
Mr. Dingell. Stock options were a major inducement because
what was done was to keep up the value of stock to keep the
value of the stock options up.
Mr. Mayer. And that stock option position was fully
disclosed for Enron like all companies who are SEC reporting
companies.
Mr. Dingell. This would require that only the top five be
disclosed. I have mentioned you will find five of those who are
would-be felons here.
Mr. Mayer. This is talking about expensing the top five,
not disclosing. Currently all options are disclosed in the
statements, in the notes to the financial statements. Every
single option is currently disclosed----
Mr. Dingell. You would say then that the options either
should not be disclosed or that the value of the options should
not be disclosed? Which?
Mr. Mayer. No, I think they should absolutely be disclosed
and should be fully disclosed, but not expensed on the income
statement.
Mr. Dingell. Mr. Herz, you and Mr. Walker may be able to
help us out of this thicket.
Mr. Herz. My recollection as I watched a lot of these
hearings on TV was that Mr. Skilling actually testified that he
used stock options as a way to inflate earnings. In fact, he
basically accused you in Congress for allowing that to go on,
having overridden the FASB, so to speak, the last time around.
Mr. Dingell. How then would this five-person exemption or
this five-person requirement impact on the way honest reporting
was done?
Mr. Herz. Honest reporting looks at the same transaction,
whether it be given to the top person or the 800th person. This
is like saying that only the top five salaries ought to be
expensed, the top five pensions, let's just show the five top
pieces of debt to the company. There is no consistency or
coherence to the financial statements once you go down that
path.
Mr. Dingell. I would just note here that Mr. Skilling
admitted the benefits of this substitution in effect during his
congressional testimony. He said as follows: ``You issue stock
options to reduce compensation expense and therefore increase
your profitability.''
What is the amount of some of the corporate salaries in
some of these people that would be exempted? It would run to
millions or even hundreds of millions of dollars a year, would
it not?
Mr. Stearns. The time of the gentleman has expired, but I
certainly will allow----
Mr. Dingell. Just that one question, Mr. Chairman. I thank
you for the very great courtesy you have given me.
Mr. Herz. The amount for individual CEOs can be very large,
but I think from our point of view the issue is that not
expensing it for the rest of the people leaves out a big
element of compensation and of cost from the financial
statements. In the case of certain major high tech companies,
that can run into billions of dollars.
Mr. Dingell. Mr. Chairman, I thank you for your great
courtesy.
Mr. Stearns. Thank you. The full chairman, Mr. Barton.
Chairman Barton. Thank you, Chairman Stearns. I want to
again thank this panel for being here. I want to focus on stock
options and FASB a little bit, but since Mr. Dingell brought up
the issue of Enron, I think I need to say a few things about
that.
This is the committee that did the investigation, that
found the facts that led to all the indictments of Enron, the
Energy and Commerce Committee Oversight and Investigations
staff. Chairman Tauzin worked very hard to expose that. I
totally supported it. But my recollection of Enron was that
they decided, the corporate leadership, that they had a new
corporate model that was not asset based, that they decided
they could run a corporation based on trying to capitalize
transactional expertise in their trading and, to the extent
they had asset problems, they spun them off into these special
entities and tried to convince the capital markets that they
had a new way of making money without having any assets to back
it up. Their problems had nothing to do with stock option
accounting or whether it was disclosed or expensed. It had
everything to do with running a corporation with no assets.
I have simplified it, but is that generally what happened?
They tried harder and harder to hide the fact they had no
assets and it finally caught up with them?
Mr. Walker. Mr. Chairman, it was primarily dealing with
special purpose entities, and that was their problem. At the
same point in time I think it is legitimate to ask what is the
proper accounting for stock options.
If I might quickly add, one of the things that I heard Mr.
Mayer and Mr. White say was their concern about whether this
would have an adverse economic impact. I would raise as a
related question, namely, since you have to disclose in your
financial statements what the impact would be on a fair market
valuation basis, anyway, a sophisticated investor would see
that. Since it is a noncash item, I don't understand why having
consistent accounting treatment is going to have an adverse
impact, because the fact of the matter is a sophisticated
investor would consider that anyway.
Mr. White. But we want accounting for unsophisticated
investors, too. At least that would be our argument.
Chairman Barton. That is true. I agree with that. Let me
ask some questions about stock options.
There is nothing in the law or in SEC regulation that
prevents a company from expensing stock options right now,
isn't that true? If I am the CEO or the board of directors and
I want stock options expensed, generally accepted accounting
principles don't prevent that. It can be done. We don't have to
have a Federal law to expense stock options. We can make it
mandatory, but you can do it voluntarily if your corporate
board wants you to. Isn't that correct?
Mr. Mayer. Absolutely, under FAS 123, and the 575 companies
that have done that are typically the companies that either
don't have a lot of options or for whom the impact is not
particularly large.
Chairman Barton. Again correct me if I am wrong, but under
current law there is nothing that says companies have to grant
stock options but those that do, if they make the decision,
they have to disclose in their annual reports the number of
options that are granted above a certain percent, they have to
disclose who they are granted to and they have to disclose the
strike price at which they can be exercised, isn't that
correct?
Mr. Mayer. That is correct, and the estimate of fair value
of those options.
Chairman Barton. So if I am a financial analyst and can
read, I can read that and if I am the unsophisticated investor
that Mr. White is referring to, I may not understand it but I
can read it and I can call a financial analyst that for a
nominal fee can explain it to me. Isn't that correct?
Mr. Mayer. That is correct. And it will be much harder to
go the other way.
Chairman Barton. What is the worst documented example of a
stock option scandal that has defrauded unsophisticated
investors in that company? Are there examples of companies that
somehow cooked the books on these stock options and the senior
management exercised their options and ran off to Cancun and
left these poor unsophisticated investors with nothing?
Mr. Mayer. I am not aware of any.
Chairman Barton. Is anybody aware of a real world example
of a stock options scandal?
Mr. Walker. We haven't researched that. Let me just say, if
people think that an unsophisticated investor is going to
understand the footnotes of a financial statement, that is
totally unrealistic.
Chairman Barton. I am just trying to find out. We have a
major bill. We have had a real debate in the last several years
about expensing stock options. Chairman Greenspan of the
Federal Reserve has said we ought to expense stock options and
I think Warren Buffett has said we ought to expense stock
options. So the prevailing winds which used to be way back
when, when I was in the private sector, they didn't need to be
expensed. Now the political wisdom is they need to be expensed.
But if we are going to legislate, I want to know, are there
real world examples where the stock options not being expensed
has led to real abuse and real investors being defrauded. I am
not aware of one. That is why I am asking the question.
Mr. Walker. I am not aware of one. I would be happy to take
a look at it, if we were asked to do so. I would say, however,
we have to decide whether or not we want to be a leader or a
laggard with regard to accounting and reporting. We are lagging
the world in this area.
Chairman Barton. So the rest of the world, these paragons
of economic activity in Western Europe are expensing and they
certainly have been leaders, and the Chinese who didn't even
have stock markets until 10 years ago, maybe they are expensing
them, including everything that the Communist politburo in
Peking gets under the table that we never hear about, so now we
have got to decide to expense.
Mr. White. Mr. Chairman, that is a really good point.
Actually the Chinese are not expensing. They have learned from
us. In the 5-year plan of the Communist Party of China, they
encourage the use of stock options to give workers more access
and more ability to own the success of the company.
I would also say I think there is a little misunderstanding
about what has actually happened in Europe. It is true that the
International Accounting Standards Board has finalized their
standard, but there is a lot of uncertainty as to whether the
political process over there is going to allow that standard to
become effective. It has been approved by the Commission but it
has not been approved by the governing body of the EU, which
has to approve it before it can take effect.
Chairman Barton. I am going to come back to Mr. Herz
because he is the long suffering Chairman of the Financial
Accounting Standards Board, which is kind of a thankless job,
and if there is a reason to expense stock options, I would
stipulate that that reason is to give confidence to investors
that everything that can be done is going to be done to try to
have accountability at the senior management level of these
corporations, that there may not be a financial reason to do it
but there may be an openness, transparent, confidence reason to
do it. If you are going to go down that trail, I think Mr.
Dingell's question about why stop at the top five has got
relevance.
If we expense stock options, I think FASB's rules were you
are going to expense them for everybody and Mr. Baker's bill
was just the top five. You know, is there some magic
demarcation line if you believe expensing is the way to go that
we ought to do it, or do you really feel very strongly if you
are going to expense it they should all be expensed?
Mr. Herz. Well, if you believe something is expensed, then
the financial statements are wrong and incomplete without all
those expenses being portrayed in it. I mean, you are again
saying, you know, why don't we just figure out how many of the
pensions, we go down to that level. I think that would be a
very slippery slope for us to go down. Financial statements are
supposed to be a faithful representation of the transactions
and events as they affect the company.
Chairman Barton. So you think for total transparency and
accountability, if you are going to have expensing it should be
for everybody.
Mr. Herz. I believe so.
Chairman Barton. Mr. White, do you think that there can be
an in between.
Mr. White. Well, there actually can be an in-between, and I
think the place where you would draw the line would be right
about where it is, where you are preventing people who might
have the ability to manipulate the price of the stock to
feather their own nest and to make their options worth more.
You are preventing that level of person from doing it. But, you
know, for goodness sake, let us not prevent ourselves from
giving these stock options to the administrative assistants and
the engineers assistants and the people all the way down the
line who have been so successful in creating innovation in
these companies. That is really what we are trying to
accomplish.
Chairman Barton. My time has expired, and I have got one
more question I want to ask, and Mr. Herz wants to add, I
think, something to what Mr. White just said.
Mr. Herz. First of all, we are not against stock options or
saying that companies shouldn't grant stock options or that
stock options are better or worse than restricted stock or
performance grants or cash bonuses or having day care centers
for the employees or training or whatever. We are just saying
let us do the right accounting.
Chairman Barton. Now, this is my final question, and it is
an ``unsophisticated investor-type'' question. If I get a stock
option, and let us make this as simple as possible. I get a
stock option for one share of stock at a strike price of $100 2
years from the date the option is granted, and I can take that
stock option or I can get a cash bonus payable next month for
$100. So I can have $100 cash that I get next month or I can
have a stock option worth $100 at the strike price payable in 2
years. If we decide to expense stock options, do I create, if
we expense them, a tax liability on $100 that is payable this
calendar year, or do I get to defer that until it actually
materializes?
Mr. Herz. My understanding is that the prevalent tax
treatment for what are called nonqualified stock options, which
is the major stock options that are issued by companies, the
tax treatment is that the recipient will have taxable income
upon exercise of that option.
Chairman Barton. So I don't have to pay--even if we expense
it, I don't create a tax liability in the current year that I
have to pay. I don't have to pay the taxes until I realize
something, that there is actually a financial asset that I can
pay part of.
Mr. Herz. Again to you.
Mr. Mayer. Under current tax law, the tax liability is not
related to the incurrence of expense by the corporation. They
are completely separate.
Chairman Barton. So if we expense stock options, there is
not a cash-flow negative to the stock option holder; there is a
contingent fund requirement of the granting corporation to set
up a reserve fund for that option. Is that correct?
Mr. Mayer. That is not a reserve fund, but the taxation of
the individual is completely separate from the taxation of the
corporation, unless Congress or the IRS chooses to change the
regulations. But under current regulations what the corporation
does does not affect the individual.
Mr. Stearns. The gentleman's time has expired.
Mr. Davis is recognized for 8 minutes.
Mr. Davis. Thank you, Mr. Chairman.
I would like to ask Mr. Herz and then Mr. Walker if--and I
don't know how to talk like an accountant, so I will try. In
ascertaining whether an expense or another accounting item
should be included in generally accepted accounting principles,
is there such a thing as an expense or item that is so
sufficiently--that is so difficult to quantify that it should
not be made a part of generally accepted accounting principles?
And, if so, can you offer an example?
Mr. Herz. There are very few examples. But in every project
we look at that issue, of whether there is in our view a
sufficient reliability, and that is a judgment that we have to
make based upon a lot of input, data, visits to companies,
looking in the case of this kind of thing of valuation, to
valuation experts, testing out a lot of things experienced in
other places than that. And then we match that up against other
items. This item, well, we are still getting more data, but
certainly it has already been in the audited footnotes for 8
years. It is based upon accepted models.
The inputs do involve some judgments, as Mr. Mayer said.
But in fact that realm of judgment is probably less than in
many other areas of accounting that involve considerable
judgments, and in fact that is recognized by most users of
financial statements. There is a required disclosure by the SEC
of what is called critical accounting estimates, which a
company has to lay out the areas that involve most estimation
and subjectivity. Those areas can be eight, nine, 10 in a
particular company. Some of them can--my belief and from
valuation experts, are more difficult to do than this item.
Mr. Davis. So there is such a thing as an item that is not
sufficiently reliable, and therefore not something that you
would try to assign a value to?
Mr. Herz. There are some things like that, but they are
very few in number and diminishing. I am getting use of one
here that in contract accounting, construction contracts for
example, one uses the--you don't use the percentage of
completion method for a long contract, you use a completed
contract method. If you think the estimates are not
sufficiently reliable, you go to an alternative measure. But
you don't assume zero either.
Mr. Davis. That is an interesting example you pick, because
I actually--well, I have sued someone for fraud for trying to
state as a fact what is not a fact, which I guess gets me to
another question--I will let Mr. Walker respond to this--which
is, I think you are acknowledging that there are genuine issues
as to the reliability of this value but you think the
reliability meets the sufficiency threshold. But are we going
to create a level of uncertainty in terms of how a corporation
prepares its financials and uses people to prepare financials,
such that we are going to have a lot of liability?
Mr. Walker. I don't think that we are going to create a
significant degree of uncertainty. The fact of the matter is
there are two issues. One issue is whether or not you should
account for these in a consistent manner based upon a fair
market value basis. And then, second, how you do it.
With regard to the first, I believe the answer to that
question is, yes, you should have consistency in order to
improve integrity and public confidence and avoid adverse
selection.
With regard to how do you do it, reasonable people can
differ. Namely, Black-Scholes versus the proposed method. I
think that is a legitimate discussion and debate, if you will.
But I do think this is one that there are generally accepted
methods out there; e.g., Black-Scholes, that have been used for
a number of years and have already been reported and,
therefore, there is a basis to accomplish the objective.
Mr. Davis. Are you or--Mr. Herz.
Mr. Herz. I should add, first, we are continuing to do some
work on that. Some of the large high-tech companies have said
they have done some work, and we are going to be meeting with
them and we would like to look at what they have done. But also
the SEC staff has said that, you know, to the extent if there
are genuine fears here and there is some legitimacy of those
after we go through all that, they are prepared kind of below
our principles to perhaps put in some safe harbors for
companies on some of these assumptions. But that all has to
still--we are not finished, so we are going to look at all
those things.
Mr. Davis. Have you done studies that give you the benefit
of hindsight to go back and use either of these methodologies
to judge what would have caused one of these types of companies
to quantify as an expense for an option versus what the actual
experience was in terms of volatility and choice as to
exercise? And what did that tell you about the sufficiency of
the reliability of your methodology?
Mr. Herz. Well, that is a good question and it gets to kind
of a fundamental point, that when you value something you value
it at that point in time, and that is a valuation for an option
that takes into account thousands if not millions of potential
scenarios. That is the way it works. It is not trying to
pinpoint at one particular scenario. Just like the stock price
at one point in time is a valuation at that point in time, it
is not going to predict what the stock price is going to be 2
years from now, 3 years from now, 4 years from now. So it is
the valuation at that point in time, it is not a prediction.
Mr. Davis. Okay. Do you or Mr. Walker--you haven't really
answered my question. Have you even attempted to go back and do
that type of study in hindsight? And would it be useful to do
so? I understand your point as well.
Mr. Walker. We haven't at GAO. I have got to believe that
there are studies that have been done along those lines in the
private sector.
Mr. Davis. If you all don't know, that is troubling.
Mr. Herz. Well, there have been studies that show the
actual outcome. Just like I said, it is like you enter a
lottery and you pay $4 for a lottery ticket, and you may win
the lottery or you may not win the lottery. The ticket was
still worth $4. Now, some people are going to win the lottery
and others are not. But those are what these models do, is
they, based on all the outcomes, come up with a value at the
date you are doing----
Mr. Davis. Well, but when I buy a lottery ticket it tells
me what the prize might be. It doesn't tell me what my chances
are of winning necessarily.
Mr. Herz. It certainly does.
Mr. Davis. Well, people don't--I don't know that people
really rely upon that.
Mr. Herz. The chances of winning this lottery are much
higher on average than an average lottery.
Mr. Davis. How--to the chairman's question, what is the
level of urgency here? If you come to the conclusion that the
type of studying I describe is a useful exercise, do you think
that you have the luxury of spending more time doing this or do
you feel compelled to come to a result very shortly?
Mr. Herz. We have to balance everything. What we want to do
is get to a good answer, a quality standard, and we are going
to consider all the input we have got and continue the input to
get to a good standard. I will tell you, though, that
investors, analysts believe that this should have been done a
long time ago and they are anxious. And serving the capital
markets, we have to also consider that issue, also the issues
of, you know, the implementation, time lines. All those are the
kind of issues we work on when we decide what kind of timeframe
we ought to do.
Mr. Davis. Mr. Chairman, if I could ask one more quick
question of Mr. White and Mr. Mayer.
The bill, as I read it, contemplates the possibility that
some form of methodology that is sufficiently reliable might be
developed, But I think what I have heard you all testify to
today is you don't believe that is going to occur, and perhaps
a more credible description of the bill is to basically--that
it basically stands for the position that this is, we are
trying to know the unknowable here.
Mr. Herz. I think that is true, and I think that actually,
you know----
Mr. Davis. And I am not saying that I agree with that. I
just want to understand your position.
Mr. White. The reason it is unknowable is--and I think
Chairman Herz has defined it very well. What they are shooting
for is the abstract idea of what these things are worth on the
grant date. They don't really care about what turns out to be
the case in the future. And if you look at an example like
Cisco, if you run those numbers, you get some absolutely
dramatic results. $3 billion.
Mr. Davis. Thank you.
Mr. Stearns. The gentleman's time has expired.
We have three members left and we have six votes. So I
would just ask the members, or a suggestion, if anyone wants to
submit their questions rather than coming back, we could go for
possibly another 10 minutes. We could probably get 5 minutes on
each on a side and then we could adjourn, so you folks wouldn't
have to come back after six votes, which, Rick, as you know,
this could be a long time.
So at this point Mr. Bass would be the next. And Mr. Bass,
my suggestion is----
Mr. Bass. Mr. Chairman, I will tell you what I will do. I
am going to take 3 minutes instead of 5, and then I am going to
yield 2 minutes to whoever is after me. All right?
My position on this bill has not been predetermined before
this hearing, and I am not an accountant either. But I have run
a small business before, and I learned through the school of
hard knocks that there is only one fact in accounting, and that
is cash. And even accounts receivable, inventory, value of
fixed assets, backlog, anything, those are all opinions.
However, I think cash, bonuses, the cost of day care, and
other things that Mr. Herz brought forth really are a fact
because they are cash expenses.
I believe that it is perfectly legitimate for Mr. White to
present a different opinion or a different perspective on the
issue of accounting than the two gentlemen from the General
Accounting Office and the FASB. It is a legitimate part of this
debate. And I appreciate your testimony, Mr. White. I don't
find it patronizing at all. I also don't understand why Enron
is the subject of every single debate that we have had this
week. And I agree with my friend, Mr. Barton, from Texas that
the issues with Enron were quite--the issue of expensing of
options is really superfluous to this debate.
My question for--a quick question is, a concern that I have
that was evidenced to me by Mr. Greenspan when we had a meeting
sometime ago, that the accounting standards or the accounting
practices of businesses is becoming increasingly divergent from
what they submit to the Internal Revenue Service for tax
purposes.
Do you have any comments on that and how this issue
addresses that?
That is my only question, and we will cut it off in a
minute.
Mr. Walker. Well, it is interesting to note that
corporations do get deductions on their income tax return with
regard to the value of stock options even in circumstances
where they don't have to record an expense in their financial
statements. And it could be significant----
Mr. Mayer. Well, that is a bit of an overstatement. Not all
stock options result in a tax deduction. In fact, only a
limited variety of stock options do, and then only when there
is a concomitant tax liability or obligation on the part of the
individual who has the stock option. So there is a perfectly
matched situation there, and the notion that corporations are
getting a big tax deduction without reporting the expense is
completely off the mark, in my view.
I would add, if I may, quickly, that I deal with investors
and analysts every day and I have for 20 years as a CFO of a
publicly held corporation. Not one, not one single one has ever
said to me, you know, you can expense under FAS 123. Why don't
you do that? We would like it if you would do that. Not a
single one has ever asked me to do that. I dispute the fact
that this is a human cry from that community.
Mr. Bass. I yield to the gentleman from California.
Mr. Issa. Thank you, and I will be very, very brief. I
guess my first reaction was hearing that there were 14
accounting firms, including the ones that did WorldCom and
Enron. I, like my colleague, can't understand why we are going
to base it on accounting firms as the basis for it. Plus, to be
honest, Mr. Chairman, if I were an accounting firm, I would not
say anything adverse to the Chairman of FASB.
Mr. Herz. They do all the time.
Mr. Issa. But I will say, and I, like my colleague, have
not made a decision on the underlying bill, including some of
the possible amendments. But I was concerned, Mr. Herz, when
you said that you were concerned about disadvantaging some
companies, as though your job was to level the playing field
between companies. And you can respond in writing because I
don't want to take more time than this 2 minutes.
Mr. Stearns. The time of Mr. Bass has expired. So if you
will answer the question, and then we will ask Mr. Stupak.
Mr. Issa. I will take it in writing because I know we are
in a hurry. Thank you.
Mr. Stearns. Thank you.
Mr. Stupak.
Mr. Stupak. Thank you, Mr. Chairman.
You know, I sat through the Enron hearings. And this double
stock options was a problem. And let me explain the way it was,
because I think it really summarizes where we have been.
The last 5 years before declaring bankruptcy, from 1996 to
2000, Enron told its stockholders and the whole world that it
was rolling in cash, claiming a 5-year U.S. profit of $1.8
billion. During those same years Enron deducted $1.7 billion
from stock option compensation from its tax returns as a
business expense, cutting its taxes by $600 million and
eliminating its tax liability entirely for 4 out of 5 years. In
other words, the stock option double standard allowed Enron to
dole out this form of compensation to its executives, including
$123 million to Mr. Lay, claim a huge tax deduction, and escape
paying U.S. taxes while not showing any stock option expense on
its inflated financial statements.
So this is exactly why this legislation can hurt us, and
Enron had a lot to do with it and those of us who sat through
it understand it.
So how come--and this is this discussion today. How come
you can estimate the value of a stock option for tax purposes
but you can't do so for accounting purposes? Mr. Walker or Mr.
Herz, if you want to hit that.
Mr. Herz. Well, for tax purposes it is computed at a
different point in time than we are proposing for accounting
purposes. We are proposing a grant date measure, which we think
is the right economic measure. The Tax Code says look at the
spread between the exercise price and the strike price at the
time it is exercised.
Mr. Stupak. So really you have a double standard here, once
you are using and then you deduct it. And then how do you
justify the double standard then?
Mr. Walker. Well, the accounting treatment is generally
recorded as of the date of grant and it is based on an
estimate. Tax treatment is generally based on actual experience
at the time the grant is exercised. As a result, you can have a
situation where you don't ever record a financial statement
expense and yet you may still get a substantial tax deduction.
Mr. Stupak. So this has got to be zero, or you don't know
how to do it because it is too complex. They already do it,
because even Enron in these financial statements that many
people looked at but didn't pick up because it was in a
footnote, they had to put a value on the options in the
footnotes. So when you say it is a zero or it is too complex,
you can't figure out, that just doesn't hold water.
Mr. Herz. Unless companies calculate it or communicate it
to the executives and to the employees at the time they do it.
Mr. Stupak. Sure.
Mr. Mayer. If I may, I have to disagree with that. I think
it is dead wrong. The calculation for tax purposes is a
subtraction. $10 minus $6 leaves $4 profit.
Mr. Stupak. But even if there is a subtraction, there is
still a value.
Mr. Mayer. Correct, And that is a very doable calculation
that you can do. The calculation we are talking about here in
the lattice model is a theoretical calculation of a number that
never occurs, that can never be measured or audited.
Mr. Stupak. Let me go to Mr. White, because he argued that
there is no accurate way to estimate the value of stock
options, as you said in your testimony. But the Chicago Board
of Options Exchange facilitates over 8.8 million option trades
each day. Do you believe that professional traders engaging in
millions of trades involving millions of dollars each day do so
without knowing the value of the options or buying or selling?
Mr. White. No, but those are totally different. They are
tradable options. These stock options aren't tradable. You
can't transfer them. It is illegal to transfer them to anybody,
and they have no value at the time they are granted. So it is a
totally different situation.
Mr. Stearns. We have about 4\1/2\ minutes left to get to
the floor.
Mr. Stupak. I have got some more questions. I will put them
in writing.
Mr. Stearns. Let me just conclude the hearing. And I thank
the colleagues. We will leave the record open for 5 days to
allow additional questions. And also, just to notify my
colleagues, Chairman Barton and Mr. Dingell and myself and Ms.
Schakowsky are going to write to the Securities Exchange
Commission in reference to Mr. Barton's question, which I think
is very relevant: Have stock options caused any abuses because
of misinformation for investors? I think that is welcomed to
know.
And I want to thank the witnesses for their patience and
for a lively hearing. The subcommittee is adjourned.
[Whereupon, at 3:57 p.m., the subcommittee was adjourned.]
[Additional material submitted for the record follows:]
Prepared Statement of Richard L. Trumka, Secretary-Treasurer, American
Federation of Labor and Congress of Industrial Organizations
``There are cases where you can use equity to impact your
income statement. And the most--the most egregious, or the one
that's used by every corporation in the world is executive
stock options. And as a matter of fact, I think FASB tried to
change that, and you introduced legislation in 1994 to keep
that exemption. And essentially what you do is you issue stock
options to reduce compensation expense and therefore increase
your profitability.''
Former Enron President And CEO Jeffrey Skilling before the
Senate Commerce, Science And Transportation Committee on February
26, 2002
On behalf of the American Federation of Labor and Congress of
Industrial Organizations (AFL-CIO) and our affiliated unions' 13
millions members, I appreciate the opportunity to comment on the
proposal by the Financial Accounting Standards Board (FASB) to require
the mandatory expensing of stock options and on H.R. 3574, the Stock
Option Accounting Reform Act.
Stock option expensing will have an unambiguously positive impact
on the economic security of America's working families. Our interest in
stock option expensing stems from the fact that our members are also
investors. Union members participate in benefit plans with over $5
trillion in assets. Pension plans sponsored by unions affiliated with
the AFL-CIO hold almost $400 billion in assets, and union members also
participate in the capital markets as individual investors.
The AFL-CIO strongly supports FASB in its recent decision to close
the accounting loophole that has that has allowed corporations to
understate the true cost of executive compensation. FASB's proposal is
part of a global trend towards greater accounting transparency.
Starting in 2005, the International Accounting Standards Board has
ruled that 7,000 companies in 90 countries must start expensing stock
options.
We oppose calls to postpone implementation of mandatory expensing
until 2006 because any delay will only give companies time and an
incentive to award mega-grants to CEO's while they can still do so
without recording them as an expense. Companies that are truly unable
to implement expensing beginning in 2005 should have the option of
delaying implementation of the rule for one or two quarters and then
retroactively applying the new standard.
The FASB proposal provides a reliable cost estimate that takes into
account the unique characteristics of employee stock options. It also
provides broad flexibility for small businesses that are not publicly
traded. Further, the FASB proposal should have zero compliance costs
for publicly traded companies, as the current accounting rules already
require corporations to provide investors with an estimate of their
stock option expense in the footnotes of company earnings statements.
This is not the first time FASB has attempted to require
appropriate expensing of stock options. In the mid-1990's, just as
stock options were becoming a popular form of executive compensation,
FASB attempted to require option expensing, but was pressured by
Congress into abandoning its position. We believe that this thwarting
of FASB's role as an independent body was a key initiator of the chain
of events that led to the corporate scandals of the last several years.
This time, we hope that Congress will respect FASB's independence
and not interfere with its decision. Unfortunately, though, we are
seeing yet again an assault on FASB's independence. Some of those
opponents of mandatory expensing are falsely attempting to portray
FASB's efforts as an attack on workers. They have suggested that
expensing stock options will benefit trial lawyers, encourage
offshoring, and stifle innovation.
We should say at the outset that the AFL-CIO does not oppose broad-
based stock options programs. We are always in favor of better wages
and benefits for workers--be they in the form of stock options,
pensions or health insurance. We view stock options as one appropriate
form of medium-term compensation for employees, but as an inappropriate
substitute for the basic wages and benefits needed to support a family.
What we oppose is giving one particular form of compensation--in
this case, stock options--preferential accounting treatment over other
more important employee benefits such as wages, pensions or health
care. If the corporate opponents of stock option expensing truly want
to help America's working families, they should instead focus their
efforts on encouraging the expansion of retirement plans and health
care coverage.
Executive Compensation and Stock Option Expensing
Not expensing stock options has widened the pay gap between CEOs
and workers. Executives disproportionately benefit from stock options
and this cost has been kept off the books. Moreover, not expensing
stock options has artificially boosted profit reports, thereby
generating further increases in CEO pay. Unfortunately, the voice of
America's working families and their retirement savings is diffused in
comparison to the concentrated interest of highly paid Silicon Valley
executives who are opposing stock option expensing.
In our view, stock options have only widened the pay gap between
executives and ordinary workers. In 1980, prior to the widespread use
of stock options in executive compensation, CEO pay stood at
approximately 42 times the average worker. Two decades later, CEO pay
reached 531 times the average worker's pay. The majority of this
increase was due to stock options, which have become the biggest
component of today's CEO pay packages.
In a last ditch effort to de-link the issue of stock option
expensing from the politically explosive issue of executive pay, the
opponents of stock option expensing have backed H.R. 3574, the Stock
Option Accounting Reform Act. This bill purports to require the
expensing of stock options for the top five most highly paid
executives. However, this so-called compromise bill is a sham. In
addition to creating an accounting fiction that some stock options are
a cost while others are not, this bill will dramatically understate the
true cost of CEO stock options.
Moreover, H.R. 3574 would prohibit companies who already expense
all of their stock option grants from continuing to do so. By limiting
expensing to the top five executives' options grants, this bill will
force companies that already expense all of their employees' options to
report less accurate earnings. According to Bear, Stearns & Co., 576
companies have announced their intention to voluntarily expense stock
options, including companies representing over 40 percent of the market
capitalization of the S&P 500 Index. H.R. 3574 will not just override
FASB, but it will override the stock markets that increasingly demand
expensing as a matter of financial transparency.
The bill would require companies using an option pricing model like
Black-Scholes to assume that the underlying stock price has zero
volatility. This would be accounting fraud by act of Congress. This
``minimum value'' approach--as its name implies--results in
unrealistically low cost estimates. Moreover, the minimum value
approach can easily be manipulated to drive the reported value to zero
or near zero.1 This is done by raising the exercise price
and multiplying the number of options in order to maintain the real
value of the grant while lowering its reported ``minimum value.''
---------------------------------------------------------------------------
\1\ Mark Rubinstein, ``On the Accounting Valuation of Employee
Stock Options,'' Journal of Derivatives, Fall 1995.
---------------------------------------------------------------------------
The bill would allow CEOs to continue to receive stock option mega-
grants without having to report the real cost to shareholders. It is no
secret why Silicon Valley executives are leading the fight against
option expensing. According to SEC filings, the CEOs of the ten public
companies who are the corporate members of the so-called International
Employee Stock Options Coalition hold on paper a combined $916 million
in unexercised stock options.2 Not one dollar of these CEO's
stock options has ever been expensed in these companies' earnings
statements.
---------------------------------------------------------------------------
\2\ Fiscal year 2003 data from company proxy statements.
---------------------------------------------------------------------------
Not expensing stock options has cost shareholders real money by
encouraging their overuse for executive compensation. According to the
Investor Responsibility Research Center, companies in the Information
Technology sector have an average potential dilution from stock options
of 25.7 percent, as compared to 17 percent for the S&P
1500.3 This measure of stock option overhang is one way that
shareholders gauge the potential dilution to their holdings from the
equity being transferred to executives and other employees.
---------------------------------------------------------------------------
\3\ Stock Plan Dilution 2004: Overhang from Stock Plans at S&P
Super 1,500 Companies, Investor Responsibility Research Center.
---------------------------------------------------------------------------
Who Gets Stock Options?
In contrast to CEOs, relatively few ordinary workers receive stock
options. At the height of the stock market boom in 1999, only 1.7
percent of private sector employees received stock options, according
to the Bureau of Labor Statistics (BLS). Stock options are much more
prevalent among the ranks of managers and skilled professionals; the
BLS found that only 0.7 percent of private sector workers earning less
than $35,000 received stock options, compared to 12.9 percent of
workers earning $75,000 and above.4
---------------------------------------------------------------------------
\4\ Bureau of Labor Statistics, ``Pilot Survey on the Incidence of
Stock Options in Private Industry in 1999,'' press release October 11,
2000.
---------------------------------------------------------------------------
Compared with large corporations, few small businesses grant any of
their employees stock options. BLS data shows that only 2.1 percent of
companies with 100 employees or less granted stock options, compared to
10.1 percent of companies with over 100 employees. We believe this data
shows that stock option expensing will have little, if any, impact on
America's small business.
Those who wish to portray stock options as a broad-based benefit
typically focus on technology companies where stock options are
sometimes granted to a cross-section of employees. For example, the
American Electronics Association claims that publicly-traded technology
companies grant stock options to 84 percent of their
employees.5 Even in Silicon Valley, however, households with
stock options are in the upper tax brackets, with a median income of
$122,000.6 According to SEC filings, the CEOs of the ten
public companies who are the corporate members of the so-called
International Employee Stock Option Coalition (the ``IESOC'') hold on
paper a combined $916 million in unexercised stock options. The authors
of the book In the Company of Owners estimate that ``roughly 30 percent
of all options are in the hands of top five executives'' and ``most of
the remaining 70 percent is spread very narrowly among other executives
and managers.''
---------------------------------------------------------------------------
\5\ ``AEA Study Finds 84% of High-Tech Workers Receive Stock
Options,'' AEA press release, August 14, 2002. (This survey almost
certainly suffers from selection bias, as AEA members with broad-based
plans had more incentive to respond.)
\6\ 2002 Gallup Poll of Media Use and Consumer Behavior for the San
Francisco market, cited in Mark Schwanhausser and Jeanne Cardenas,
``Stock Options Slow After Dot-Com Bust,'' San Jose Mercury News,
December 13, 2002.
---------------------------------------------------------------------------
For the reasons discussed above, these statistics are unlikely to
change. Stock options are ill-suited either as a way to make ends meet
from day-to-day or as a substitute for a traditional defined benefit
plan or a properly diversified defined contribution plan. As a result
they have been and are likely to continue to be supplemental medium-
term compensation for high-income employees.
Investor Concern
We agree with FASB Chairman Robert Herz, who last year testified
before the Senate that ``financial reporting standards that bias or
distort financial information to favor a particular transaction,
industry, or special interest group undermine the credibility and value
of that information and the proper functioning of the capital markets
by impairing investors' capital allocation decisions.'' 7
---------------------------------------------------------------------------
\7\ Statement of Robert H. Herz, Chairman, Financial Accounting
Standards Board, for the Roundtable on ``Preserving Partnership
Capitalism Through Stock Options for America's Workforce,'' United
States Senate, May 8, 2003.
---------------------------------------------------------------------------
We believe we speak for most investors on this issue. In a report
released earlier this year, the Congressional Budget Office concluded
that ``recognizing the fair value of employees stock options is
unlikely to have a significant effect on the economy (because the
information has already been disclosed); however, it could make fair
value information more transparent to less-sophisticated investors.''
8
---------------------------------------------------------------------------
\8\ ``Accounting for Employee Stock Options,'' Congressional Budget
Office, April 2004.
---------------------------------------------------------------------------
Since 2003, a majority of shareholders at 44 companies have voted
in favor of resolutions to require stock option expensing. These
include high-profile technology companies such as Intel, Apple
Computer, Adobe Systems, IBM, and Texas Instruments, despite strong
opposition to expensing by these companies' boards of directors. Other
high-tech companies such as Microsoft, Amazon, and Netflix have joined
the nearly 600 companies that voluntarily expense stock options.
There is also near unanimity in favor of mandatory expensing among
institutional investors and governance advocates, including the ``Big
Four'' accounting firms, the Conference Board Commission on Public
Trust and Private Enterprise, the Council of Institutional Investors,
Institutional Shareholder Services, and the Teachers Insurance and
Annuity Association--College Retirement Equities Fund.
Individuals such as Berkshire Hathaway CEO Warren Buffett,
Securities and Exchange Commission Chairman William Donaldson, Public
Company Accounting Oversight Board Chairman William McDonough, General
Accounting Office Comptroller General David Walker, Federal Reserve
Chairman Alan Greenspan, former Federal Reserve Chairman Paul Volcker,
and Nobel Prize-winning economists Robert Merton and Joseph Stiglitz
are all in favor of mandatory expensing.
Valuation Issues
Opponents of mandatory expensing have exaggerated valuation issues
related to stock options. They claim, for example, that options cannot
be accurately valued, that options vary in value after they are
granted, and that options turn up in earnings per share calculations.
The fair value of stock options can be estimated using the Black-
Scholes-Merton formula or a binomial lattice model that incorporates
employees' expected behavior. Though these values are estimates, so are
the values used for numerous other line items on corporate financial
statements, including depreciation, amortization, and inventory-related
adjustments. Options do vary in value after they are granted--but so do
a variety of payments and agreements made by companies including
payments made in foreign currencies or long-term commodity contracts.
No one would suggest that these should be left off the companies'
financial statements.
Opponents of expensing contend that options are double counted if
they are charged to earnings, because the cost of options is already
reflected in dilution. This argument ignores the opportunity cost of
granting stock options to employees. Moreover, other forms of equity
compensation that are expensed also result in dilution. For example,
the estimated value of restricted stock grants to employees is deducted
as a compensation cost, affecting both the EPS numerator and the
denominator. To ignore the cost of stock options in the numerator is to
assume that revenue-increasing labor services provided in exchange for
stock options are provided free of charge.
As for the claim that pricing methods overstate the value of
employee stock options because employees may exercise options early and
may forfeit options if they leave the company, FASB has already
addressed this issue. FASB would allow companies to modify cost
estimates to reflect patterns of forfeiture and early exercise, and
adjust these estimates, if necessary, based on subsequent information.
Perverse Incentives
Because stock options have received preferential accounting
treatment, companies have been reluctant to innovate when it comes to
executive compensation. Many companies, for example, have told us that
they are reluctant to use performance-based stock options that are
indexed to their competitors because indexed stock options must be
expensed under the current accounting rules. That's bad news for
Americans' retirement savings, which depend on companies having
responsible CEO pay.
Unlike actual share ownership, stock option grants to CEOs create
perverse incentives that are not in the best interests of long-term
shareholders:
stock options can encourage executives to take excessive risk-taking
by promising all the benefit of share price increases with none
of the risk of share price declines,
stock options can reward short-term decision-making because many
executive stock options can be exercised just one year after
the grant date;
executives can profit from share price volatility (a measure of
shareholder risk) by timing when they exercise their stock
options;
because option holders are not entitled to dividends, dividend yields
have fallen to historic lows, and many companies have instead
used this cash for stock buybacks to prevent dilution from
executives' stock option exercises; and
stock options can create a strong incentive to manipulate company
stock prices through creative and even fraudulent accounting.
The Securities and Exchange Commission has been examining whether
some companies--particularly in the high tech sector--have
inappropriately timed their stock option grants to
executives.9 By granting stock options just prior to
releasing market-moving information that boosts the stock price,
companies can simultaneously put extra money into the pockets of
executives and understate the estimated costs of these option grants in
their SEC filings. Given all these drawbacks, we believe an over-
reliance on stock options for executive compensation has contributed to
many of the corporate scandals we have witnessed in recent years.
---------------------------------------------------------------------------
\9\ Deborah Soloman, ``SEC Probes Options Grants Made As Company
News Boosts Stock,'' Wall Street Journal, March 30, 2004.
---------------------------------------------------------------------------
Conclusion
The goal of accounting is to facilitate accurate comparisons
between companies--a goal not being met under the current system, when
some companies expense options and others do not. If stock options are
not expensed, a company that pays its employees in stock options has
lower compensation costs and therefore artificially higher earnings. As
former Enron CEO Jeffrey Skilling explained in his Congressional
testimony, ``you issue stock options to reduce compensation expense
and, therefore, increase your profitability.''
Companies that do not expense stock options are hiding their true
cost from investors, creditors, and other consumers of financial
reports. FASB's decision to require stock option expensing in 2005 will
strengthen investor confidence in financial statements. The efficient
allocation of capital to the most economically valuable business
activities depends on consistent accounting rules. For this reason, we
believe all businesses should expense stock options, so that stock
options do not artificially boost any company's profit reports.
Congress should let FASB do its job.
We appreciate the opportunity to present our views on this
important matter.
______
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