[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

                              ----------                              


                         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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \1\ H.R. 3574, 108th Congress, 1st Session (November 21, 2004).
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \4\ Sarbanes-Oxley Act of 2002, Public Law Number 107-204, Sections 
108-109.
---------------------------------------------------------------------------
    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
---------------------------------------------------------------------------
    \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).
---------------------------------------------------------------------------
    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:
---------------------------------------------------------------------------
    \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
---------------------------------------------------------------------------
    \7\ Policy Statement, page 5 of 8.
---------------------------------------------------------------------------
The SEC, together with the private-sector Financial Accounting 
Foundation (``FAF''),8 maintains active oversight of the 
FASB's activities.
---------------------------------------------------------------------------
    \8\ See Attachment 1 for information about the Financial Accounting 
Foundation.
---------------------------------------------------------------------------
 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.
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    \14\ See Attachment 3 for a list of 576 companies that have 
voluntarily adopted option expensing under the fair value method.
---------------------------------------------------------------------------
    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
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    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
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \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
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    \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
---------------------------------------------------------------------------
    \39\ ``High-Tech Holdup,'' The Washington Post (June 10, 2004), 
page A18.
---------------------------------------------------------------------------
    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
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    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
---------------------------------------------------------------------------
    \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
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
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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