[Senate Hearing 108-862]
[From the U.S. Government Publishing Office]



                                                        S. Hrg. 108-862

 
   THE FINANCIAL ACCOUNTING STANDARDS BOARD AND SMALL BUSINESS GROWTH

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

                                HEARING

                               before the

               SUBCOMMITTEE ON SECURITIES AND INVESTMENT

                                 of the

                              COMMITTEE ON
                   BANKING,HOUSING,AND URBAN AFFAIRS
                          UNITED STATES SENATE

                      ONE HUNDRED EIGHTH CONGRESS

                             FIRST SESSION

                                   ON

THE IMPORTANCE OF SMALL BUSINESS INPUT INTO THE DRAFTING OF ACCOUNTING 
                     STANDARDS AND INTERPRETATIONS

                               __________

                           NOVEMBER 12, 2003

                               __________

  Printed for the use of the Committee on Banking, Housing, and Urban 
                                Affairs


   Available at: http: //www.access.gpo.gov /senate /senate05sh.html


                                 ______

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            COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

                  RICHARD C. SHELBY, Alabama, Chairman

ROBERT F. BENNETT, Utah              PAUL S. SARBANES, Maryland
WAYNE ALLARD, Colorado               CHRISTOPHER J. DODD, Connecticut
MICHAEL B. ENZI, Wyoming             TIM JOHNSON, South Dakota
CHUCK HAGEL, Nebraska                JACK REED, Rhode Island
RICK SANTORUM, Pennsylvania          CHARLES E. SCHUMER, New York
JIM BUNNING, Kentucky                EVAN BAYH, Indiana
MIKE CRAPO, Idaho                    ZELL MILLER, Georgia
JOHN E. SUNUNU, New Hampshire        THOMAS R. CARPER, Delaware
ELIZABETH DOLE, North Carolina       DEBBIE STABENOW, Michigan
LINCOLN D. CHAFEE, Rhode Island      JON S. CORZINE, New Jersey

             Kathleen L. Casey, Staff Director and Counsel

     Steven B. Harris, Democratic Staff Director and Chief Counsel

              Stephen R. Kroll, Democratic Special Counsel

                 Dean V. Shahinian, Democratic Counsel

   Joseph R. Kolinski, Chief Clerk and Computer Systems Administrator

                       George E. Whittle, Editor

                                 ______

               Subcommittee on Securities and Investment

                   MICHAEL B. ENZI, Wyoming, Chairman

            CHRISTOPHER J. DODD, Connecticut, Ranking Member

MIKE CRAPO, Idaho                    TIM JOHNSON, South Dakota
JOHN E. SUNUNU, New Hampshire        JACK REED, Rhode Island
CHUCK HAGEL, Nebraska                CHARLES E. SCHUMER, New York
JIM BUNNING, Kentucky                EVAN BAYH, Indiana
ROBERT F. BENNETT, Utah              DEBBIE STABENOW, Michigan
WAYNE ALLARD, Colorado               JON S. CORZINE, New Jersey
RICK SANTORUM, Pennsylvania

                       Greg Dean, Staff Director

           Alexander M. Sternhell, Democratic Staff Director

                                  (ii)
?

                            C O N T E N T S

                              ----------                              

                      WEDNESDAY, NOVEMBER 12, 2003

                                                                   Page

Opening statement of Senator Enzi................................     1

Opening statements, comments, or prepared statements of:
    Senator Ensign...............................................     1
    Senator Allard...............................................    19
    Senator Bunning..............................................    37

                               WITNESSES

Robert H. Herz, Chairman, Financial Accounting Standards Board...     6
    Prepared statement...........................................    38
    Response to written questions of Chairman Enzi...............    86
Peter A. Salg, President, QSC Restaurants, Fort Collins, Colorado 
  on Behalf of the International Franchise Association...........    17
    Prepared statement...........................................    62
James K. Glassman, Resident Fellow, American Enterprise Institute    19
    Prepared statement...........................................    64
Richard Forrestel, Jr., Treasurer, Cold Spring Construction 
  Company, Akron, New York on Behalf of the Associated General 
  Contractors of America.........................................    22
    Prepared statement...........................................    70
Walter K. Moore, Vice President, Government Affairs, Genentech, 
  Inc............................................................    23
    Prepared statement...........................................    72
Jeannine Kenney, Vice President, Public Affairs and Member 
  Services, National Cooperative Business Association............    25
    Prepared statement...........................................    76
Mark Heesen, President, National Venture Capital Association.....    28
    Prepared statement...........................................    81

              Additional Material Supplied for the Record

Statement of David A. Raymond, President, American Council of 
  Engineering Companies..........................................    94
News Release from the Biotechnology Industry Organization........    96

                                 (iii) 


   THE FINANCIAL ACCOUNTING STANDARDS BOARD AND SMALL BUSINESS GROWTH

                              ----------                              


                      WEDNESDAY, NOVEMBER 12, 2003

                                       U.S. Senate,
                 Subcommittee on Securities and Investment,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.
    The Subcommittee met at 2:03 p.m., in room SD-538, Dirksen 
Senate Office Building, Senator Michael B. Enzi (Chairman of 
the Subcommittee) presiding.

          OPENING STATEMENT OF SENATOR MICHAEL B. ENZI

    Senator Enzi. Since the hour of 2:00 o'clock has arrived, 
and since we are going to have two votes probably beginning at 
2:45, we will have some interruptions today and we will have to 
work around that. When Senator Ensign arrives, we will have him 
give his statement. He and I were just in some meetings where 
there were some very important discussions going on, and I 
appreciate him arriving timely.
    Senator Ensign, of course, is the Chair of the High 
Technology Task Force, and as such he has had a lot of insight 
into the effect on small entities. We will now welcome you and 
look forward to hearing your testimony.

                    STATEMENT OF JOHN ENSIGN

            A U.S. SENATOR FROM THE STATE OF NEVADA

    Senator Ensign. Thank you, Mr. Chairman, and thank you for 
this opportunity to testify.
    Mr. Chairman, as Chairman of the High Tech Task Force for 
Republicans in the Senate, I get a lot of opportunities to go 
out and visit businesses and listen to them and find out how 
did they--some of these are big companies--how did they become 
big, how did they start up? Others of them are just starting 
up, and as a profession I am a veterinarian and started two 
different animal hospitals, so I have a lot of small business 
experience. There are unique things that happen to small 
businesses that they cannot afford that big businesses can 
afford. There is everything from regulation and complying with 
certain laws, and there are a lot of unique things. There is 
also a lot of lack of experience in small business people. They 
are learning as they go along.
    Most small business people are entrepreneurs, and it is 
that entrepreneurial spirit that I want to talk about this 
morning. That is the thing that has made America so great and 
has driven that economic engine that has driven us to the top 
of the world.
    Being an entrepreneur means you take risks. Small 
businesses, especially in the high-tech industry that want to 
go out there and compete--remember Big Blue, IBM, and way 
before Microsoft, you could never compete with IBM. It is the 
small companies like Microsoft at that time that saw an 
opportunity with the development of technology to get into a 
marketplace where there were needs that were not being met. One 
of the tools that they used was the idea of stock options. They 
could not afford to pay their employees what the big companies, 
like Big Blue could pay their employees. So they decided to 
attract people to their company who wanted to take risks with 
them. So not only the person with the idea to start the 
company, but also attracting highly talented people to come to 
them and share in those risks.
    The idea of risk taking is so critical to innovation, and 
because small business is truly the engine that is driving our 
economy, we want to encourage more and more of those risk 
takers to associate with small businesses, not just big 
business.
    Mr. Chairman, you and I have worked on this issue quite a 
bit, on the issue of stock options and expensing and what FASB 
is doing, I believe that they are completely misguided in what 
they are doing. We have been working with industry types to try 
to make it much more reasonable. I appreciate the legislation 
that you have proposed as a compromise piece of legislation, 
and I think that we can develop some momentum with that and try 
to do the right thing so that entrepreneurial spirit in 
business can be maintained so the start-up company that cannot 
afford the big salaries can attract the highly talented people 
that they need to be able to compete now with today's 
Microsofts, with today's Sun Microsystems, with today's 
Oracles, with today's whatever big business is today that did 
not start out as a big business.
    Really, the summary of my testimony is that people who care 
about small business need to care about this issue. We need to 
continue to raise it up because as the Chinese are now talking 
about going to stock options because they have recognized how 
well it has worked in America, and now in America we are 
thinking about basically doing it in such a way that we cannot 
offer stock options. It would be a critical mistake for this 
country to do that.
    Mr. Chairman, I appreciate working with you on this issue 
and your leadership, and for you calling the hearing to focus 
on items, especially with your background as an accountant, 
items that can so severely affect small business in this 
country. We have to continue to allow the incentives there for 
small business to flourish.
    One last comment. If people say they care about minorities 
and women having opportunities, 80 percent of those 
opportunities come in small business. If we want America to be 
that opportunity society, we need to make sure that there are 
not regulatory entities out there that destroy that 
entrepreneurial spirit in America.
    I appreciate your time and your indulgence, Mr. Chairman.
    Senator Enzi. Thank you, Senator. I appreciate your 
comments, and I appreciate all of the work that you have done, 
not just in the high-tech task force area, but as one small 
businessman to another, all that you have done in the area of 
small business.
    Senator Ensign. Thank you, Mr. Chairman.
    Senator Enzi. The Subcommittee at today's hearing will 
explore the important role of small business in our Nation's 
economy and the important role played by the Financial 
Accounting Standards Board in establishing accounting 
standards.
    The purpose of this hearing or any other hearing is 
actually to build a record on the issue, and full statements 
made by any of the parties will be a part of the record. We 
will ask all of you to summarize your comments so that we will 
have an opportunity to ask some questions to clarify what you 
had in your testimony. As I mentioned, we will be interrupted 
by votes today. That is fairly normal. As a result, there will 
be some necessity to submit questions in writing, and so I will 
ask you to help in getting answers to those.
    Our country's small business and entrepreneurial spirit 
have become woven into the fabric of our Nation. Countries all 
over the world should emulate and replicate our high technology 
centers. Recent press articles cite efforts by a city in China 
to replicate the operations of Silicon Valley, as Senator 
Ensign pointed out.
    Figures cited by the Small Business Administration 
demonstrate the importance of small business to our Nation's 
economy. I have some charts here that show that nearly 23 
million strong, small businesses represent more than 99.7 
percent of all employers in the United States. They employ half 
of all of the private sector employees. They generate 60 
percent of the net new jobs annually. They create more than 50 
percent of nonfarm private gross domestic product, and they 
produce 13 to 14 times more patents per employee than large 
patenting firms.
    The Financial Accounting Standards Board also is very 
important to the health of our Nation's economy. This private 
sector, independent board is responsible for establishing and 
interpreting the accounting standards for our Nation's 
companies. I have been an ardent supporter of FASB and its 
independence. The importance of FASB was seen last year with 
the passage of the Sarbanes-Oxley Act. The accounting scandals 
of Enron, WorldCom, and others highlighted to us that an 
independent accounting body is essential to maintain the high 
standards and integrity of our Nation's public markets. With 
this high level of responsibility, it is vital that FASB retain 
an objective and open process so that accounting standards can 
be thoroughly discussed with all sectors of our economy. 
Sarbanes-Oxley worried about a ``cascading effect'' to small 
business. We concentrated a lot on that, and want to continue 
to concentrate on that. It was, and is, a justified concern, 
and it needs to be recognized by all boards and commissions.
    Generally it is very difficult for a small business to 
participate in the Federal rulemaking process. Small businesses 
do not have the time or the resources, as compared to their 
large-business
counterparts, to sift through the thousands of pages of Federal 
regulations, to analyze and comment on the effects on these
small entities.
    I remember my first year in office, holding a hearing for 
small business under the auspices of the Small Business 
Committee in Casper, Wyoming, and had about 100 businesses show 
up, very pleased. Afterwards the media said to me, ``Aren't you 
a little disappointed in the number of businesses that showed 
up?'' I said, ``No, this is small business. If they had an 
extra person that could attend an all-day hearing, they would 
fire him.''
    [Laughter.]
    There just is not that kind of flexibility in small 
business. In 1980, Congress recognized this fact and passed the 
Regulatory Flexibility Act, Reg Flex. The Reg Flex Act requires 
Federal agencies to conduct an economic analysis on virtually 
all Federal rulemaking proposals to determine if there is a 
disproportionate burden on small entities. Congress also 
established a ``small business watchdog,'' the Office of 
Advocacy, within the Small Business Administration, to monitor 
Federal agencies' compliance with the Act. In addition, 
Congress amended the Act in 1996 to allow small entities to sue 
in court, to have the implementation of an agency's rule set 
aside until an adequate small business economic analysis had 
been conducted.
    Since the rise of accounting scandals, FASB has become more 
active in updating and establishing accounting standards. The 
Board, in its attempt to quell the accounting problems of 
companies in the Fortune 500 may have overlooked or have not 
paid enough attention to how the draft statements and 
interpretations may affect small entities. In addition, FASB 
may not have sought enough input from small firms.
    I have another chart here.* For example, FASB relies upon 
the Financial Accounting Standard Advisory Council--I think 
that is called FASAC--for guidance and advice on draft 
accounting statements and interpretations. However, out of the 
33 members of FASAC, there are only five small entities and 
three of those are financial entities. They are marked with 
stars there. That may not represent the operations of a typical 
small business.
---------------------------------------------------------------------------
    * Held in Committee files.
---------------------------------------------------------------------------
    In addition, FASB played a critical role in the early and 
mid-1990's on the Securities and Exchange Commission's 
Government-Business Forum on Small Business Capital Formation. 
FASB was represented on the Executive Committee and actively 
participated in the annual forum. Unfortunately, during the 
past 2 years FASB has withdrawn from the Executive Committee 
and did not participate in the forums. I understand that at 
this year's forum, held in September, the participants 
discussed the potential effects of FAS 123 and FAS 150 in 
detail, but FASB had already withdrawn.
    Today, our second panel will highlight three separate 
accounting issues that if fully implemented would have 
substantial effects on small entities. The first issues concern 
FIN 46. In January 2003, FASB released FIN 46 and 
interpretation of the Financial Accounting Statement 46, 
requiring the consolidation of variable interest entities. Does 
that not sound exciting?
    [Laughter.]
    Two of our witnesses will discuss that the interpretation 
would have a serious effect on venture capitalists investing in 
small entities, as well as franchisees' ability to negotiate 
franchise agreements with franchisers.
    The second issue concerns a soon-to-be-released proposal by 
FASB on Financial Accounting Statement 123 concerning the 
expensing of stock options. Two of our witnesses will discuss 
the detrimental effects if this proposal is not fully vetted, 
as it would place a tremendous strain for entrepreneurs trying 
to gain access to the equity markets. In addition, the adoption 
of this proposal may place U.S. small businesses at a 
competitive disadvantage with overseas companies, as Senator 
Ensign pointed out, that will not be bound by the standards.
    With respect to this initiative I have had serious concerns 
about whether FASB has sufficient inclusion of small business 
entities in the drafting process. This is an extremely complex 
initiative. Even FASB recognized how complex and intricate a 
project this was when it established an ad hoc committee, the 
Option Valuation Group, to come up with a standard valuation 
model for stock option expensing. It is my understanding the 
group met for the final time in early October. However, the 
group was unable to achieve consensus on a valuation model. In 
addition, the FASB has stated that it will ``road test the 
valuation model.'' I am very interested in how this will 
operate and how many small businesses will be involved in the 
road testing.
    Finally, we have two witnesses who will discuss Financial 
Accounting Statement 150. Earlier this year, FASB issued a 
proposal that would require closely held companies to count its 
mandatory redeemable shares as liabilities. If implemented, it 
would have had a devastating effect on thousands of closely 
held businesses across the country.
    With respect to FAS 150, the comment period ended on 
October 30. In lightning-fast speed, FASB reviewed the small 
business comments and immediately issued a statement that the 
implementation of this initiative was put on hold indefinitely. 
I applaud FASB for the quick action in this process and the 
result. In addition, I applaud the work of Mr. Forrestel. I 
believe that it was his hard work and dogged perseverance that 
made FASB see the potential effects of the proposal on small 
entities, and he will be testifying later today. However, the 
question that should be asked is whether the problems with the 
proposal could have been foreseen earlier.
    In light of this, I am proposing that FASB immediately 
establish a Small Firm Advisory Committee to work with FASB and 
FASAC to address small business concerns early in the process. 
Currently, the National Association of Security Dealers 
effectively use its Small Firm Advisory Board to review all of 
the National Association of Securities Dealers' rulemaking 
prior to the rulemaking being issued for comment by NASD and by 
the SEC. I strongly believe that such a small business 
committee is essential for FASB.
    With respect to FASB, there is no Regulatory Flexibility 
Act for small businesses. There is no small business watchdog, 
and there is no recourse when an accounting standard has been 
adopted. Once FASB adopts an accounting standard it is final 
until the FASB board members change their mind. Unlike the 
Regulatory Flexibility Act, small entities cannot seek a higher 
authority for appeal if the small entities believe an 
accounting standard was adopted with insufficient small 
business information.
    This Small Firm Advisory Committee should review all 
pending and future FASB draft proposals and interpretations to 
ensure there are no unintended consequences on small business.
    I would like to welcome our witnesses today and thank them 
in advance for their testimony. I do greatly appreciate, 
Chairman Herz, you for changing your schedule to be with us 
today. I guess I will give him a chance to get to the table 
before I have him testify. If you would move up there, I would 
appreciate it.
    We welcome Robert Herz, who is the Chairman of the 
Financial Accounting Standards Board. FASB is a private sector 
independent body recognized by the SEC as the entity 
responsible for establishing accounting standards. As the sole 
accountant in the Senate I fought very hard for the 
independence of FASB during the debates on Sarbanes-Oxley, and 
I look forward to your testimony on this extremely important 
topic of small business and the accounting standards.

                  STATEMENT OF ROBERT H. HERZ

         CHAIRMAN, FINANCIAL ACCOUNTING STANDARDS BOARD

    Mr. Herz. Thank you, Chairman Enzi.
    I am very pleased to appear before you today on behalf of 
the FASB, and I want to personally thank you, Mr. Chairman, for 
inviting me to testify on this very important topic, because 
the active participation of users, auditors, and preparers of 
small businesses in our process is absolutely essential to the 
development of high-quality financial accounting and reporting 
standards.
    I have some brief prepared remarks, and I would 
respectfully request that the full text of my testimony and all 
supporting materials be entered into the public record.*
---------------------------------------------------------------------------
    * Held in Committee files.
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    Senator Enzi. We appreciate all 100 or so pages.
    [Laughter.]
    They will be.
    Mr. Herz. It is a principles-based document.
    [Laughter.]
    Mr. Herz. Our independence from enterprises, auditors, and 
other constituents is fundamental to achieving our mission to 
establish and improve general purpose standards of financial 
accounting and reporting for both public and private 
enterprises. Those standards are essential to the growth and 
stability of the U.S. economy because investors, creditors, and 
other users of financial reports rely heavily on credible, 
transparent, comparable, and unbiased financial information to 
make rational resource allocation decisions.
    The FASB's independence, which through your leadership and 
hard work, Mr. Chairman, was recently reaffirmed and enhanced, 
as you noted, through the Sarbanes-Oxley Act. That 
independence, as you also noted, is fundamental to our mission 
because our work is technical in nature, designed to provide 
preparers the guidance necessary to report their economic 
activities. That guidance creates the yardstick to measure and 
report on the underlying economic transactions of business 
enterprises. Like investors and creditors, I think Congress and 
other policymakers also need an independent FASB to maintain 
the integrity of a properly designed yardstick in order to 
obtain the financial information necessary to appropriately 
assess and implement public policy. While bending the yardstick 
to favor a particular outcome or type of transaction or 
industry may seem attractive to some in the short-run, in the 
long-run an inaccurate yardstick, that is, a biased accounting 
standard, is, I believe, harmful to investors, creditors, and 
the U.S. economy in general.
    The FASB's open and thorough due process is also 
fundamental to our mission. Because the actions of the FASB 
affect so many organizations, its decisionmaking process must 
be fair, and as far as possible, objective. The FASB solicits 
and carefully considers the views of all interested parties--
users, auditors, and preparers of financial information. Our 
rules of procedure require an extensive due process. It 
involves public meetings, public hearings or roundtables, field 
visits or field tests, liaison meetings and other meetings with 
interested parties, and exposure of our proposals to external 
scrutiny and public comment.
    As part of our due process, the FASB, and our Emerging 
Issues Task Force, regularly provide additional guidance to 
assist preparers in implementing the requirements of new and 
existing standards. For example, as described in more detail in 
the full text of my testimony, we have recently issued 
implementation guidance and a proposed modification pertaining 
to our Interpretation No. 46, or as you said, the exciting 
topic of Consolidation of Variable Interest Entities. That 
includes additional guidance addressing the application of 
certain provisions of the interpretation to franchises and 
other industries.
    We have also recently issued implementation guidance for 
our Statement No. 150 on Accounting for Certain Financial 
Instruments with Characteristics of Liabilities and Equity. 
That guidance includes an indefinite deferral of the effective 
date of certain provisions of that statement relating to the 
accounting for certain mandatorily redeemable instruments. That 
particular deferral is applicable to all nonpublic enterprises, 
including cooperatives.
    More generally, with respect to the FASB and small 
businesses, which is the subject of this important hearing, I 
would like to make four brief points. Each of these points is 
discussed in more detail in the full text of my testimony.
    First, small businesses are difficult to define. From our 
perspective different constituents have very different notions 
of what is a small business. To the extent that a small 
business is a registrant, under the Federal securities laws the 
enterprise is required by the SEC to prepare financial reports 
in accordance with generally accepted accounting principles, 
which include the FASB standards. For most other small 
businesses the use of GAAP is primarily a private choice. For 
many small businesses, their current and potential lenders, 
suppliers, and other contracting parties may influence or 
control that choice. To the extent, however, that one of those 
parties requires that financial reports of a small business 
comply with GAAP, that party has also made a private choice. 
That choice presumably reflects that party's opinion that GAAP 
results in better, more complete, and more transparent 
information than the use of other existing comprehensive bases 
of accounting, such as tax basis, cash basis, or regulatory 
reporting. And we are very pleased that they do make the choice 
for GAAP.
    Second, it has been our experience that the views of 
representatives of small businesses about financial accounting 
and reporting are not monolithic. Historically, the users, 
auditors, and preparers of small business financial reports 
have provided the FASB with distinct and sometimes conflicting 
input on FASB proposals and other activities. As I indicated 
earlier, our mission and due process procedures require that we 
carefully consider all views and make an independent, objective 
judgment on what will provide the most decision-useful 
information, subject always to the constraints of the costs and 
benefits of implementing changes to GAAP.
    Third, the Board has long recognized that the cost of 
complying with financial accounting and reporting standards 
fall disproportionately on smaller businesses. In recognition 
of that fact, the FASB carefully considers requests received 
from small businesses to defer effective dates and provide for 
differential disclosures to alleviate the costs of implementing 
changes to GAAP. The Board has also explored on many occasions 
requests by representatives of small businesses to provide for 
differential recognition and measurement provisions in GAAP for 
small business. After public deliberations, the Board has 
generally rejected those requests. Why? Many of our 
constituents, particularly the users of financial reports, have 
expressed concerns that a big GAAP/little GAAP system could 
undermine the comparability and credibility of financial 
reports. They also say that such a two-tiered system would add 
costs to the users, auditors, and preparers of those reports 
that would likely more than offset any perceived benefits 
achieved by a differential reporting system.
    Finally, the Board actively solicits the views of users, 
auditors, and preparers of the financial reports of small 
businesses in several ways, including through seeking their 
participation in our Emerging Issues Task Force, as you 
mentioned, our Financial Accounting Standards Advisory Council, 
the recently established User Advisory Council, and also on 
other less formal project task forces and working groups. By 
scheduling regular public liaison meetings and less formal 
private meetings with representatives of small businesses. Two 
examples include our public liaison meetings and regular 
contacts with the Technical Issues Committee of the AICPA 
Private Companies Practice Section, and with the Accounting 
Practices Committee of the Risk Management Association. And 
finally, through participating in many conferences and other 
speaking opportunities sponsored by or attended by 
representatives of small businesses around the country.
    We are very aware of the significant focus over the past 
year on the financial accounting and reporting of public 
enterprises, in part because of the many activities relating to 
Sarbanes-Oxley, and also because of the increased attention on 
the movement toward international convergence of accounting 
standards. We, however, remain very committed to serving all of 
our constituents including private companies and small 
businesses, and not-for-profit entities.
    Accordingly, Mr. Chairman, we very much appreciate the 
opportunity that this hearing presents to publicly encourage 
representatives of private companies, small businesses, and 
not-for-profits to more actively participate in our activities, 
and I very much like your idea of the advisory committee as 
well. Greater participation by those constituents will be very 
welcome. They will help ensure that consistent with the FASB's 
mission and rules of procedures, the various perspectives of 
those constituents are effectively communicated to the Board 
and that they receive the careful consideration that they 
deserve.
    Thank you again, Mr. Chairman, and if you do not break for 
a vote, I will take any questions.
    Senator Enzi. I hope even when we break for a vote that you 
will stay for a few minutes, because I suspect that my 
colleagues who said they would be here are waiting until they 
vote because they just finished lunch. We started this little 
early, anticipating there would be afternoon votes, but not 
quite that early in the afternoon.
    I do applaud your quick response to the indefinite 
implementation of the FAS 150 issue. I know that prior to the 
announcement many of the small businesses thought that FASB was 
not taking their concerns seriously. I do understand that the 
issue is not completely settled and that FASB needs to continue 
working with the small business owners and representatives on 
the issue as it is being studied further.
    But in the process of reviewing comment letters, it appears 
that FASB quickly recognized the problems that small businesses 
would face with FAS 150. Why was the problem not found earlier 
though?
    Mr. Herz. I asked that myself, did a little bit of a 
postmortem, and I did that just for my own personal 
edification. I arrived at the Board in July 2002. The original 
exposure draft had gone out in late 2000, and a lot of the 
deliberations had been done, but I participated in many 
deliberations after that.
    I think the particular issues, from what I can tell going 
back and talking to people and looking at letters, and field 
visits that had been done then, I think the issues related to 
the effect on loan covenants, bonding arrangements, all of 
those were identified or actually discussed fairly 
comprehensively with, for example, lenders, who actually 
preferred the proposal and said they could easily adjust to it.
    This is only in my own mind, and as you know as a 
policymaker, you balance a lot of things. What swayed me from 
all of those letters--and then I came actually down here to 
Washington to meet with a group of contractors, and other 
groups went up to meet with us in Norwalk--was the biggest 
issue that I do not think had been identified, and I am not 
sure exactly why, was the ability to bid on contracts, that 
written into many State and local municipality requirements, to 
actually bid, are kind of hard-wired requirements relating to 
GAAP numbers. I, for one, when I heard that, got convinced that 
even a 2-year deferral, which is what we had been proposing, 
would not be enough, that we needed to step back and think 
about the issue more.
    Senator Enzi. We do appreciate that, and depending upon 
what answers come out of that, I will shift gears a little bit 
on all of my questions. In the Federal regulatory process, 
small entities are able to petition a court to have a Federal 
agency's implementation of a final rule delayed until a correct 
economic analysis, and its effect on the small entities, is 
conducted. Since FASB is a private sector entity and not the 
Federal Government, a private right of action is not available 
to small entities. What is the recourse for small entities if 
they believe an accounting standard or interpretation adopted 
by FASB was based on information that was faulty
or incorrect?
    Mr. Herz. I think it is demonstrated by that episode. I 
think not only are our doors open, our letter boxes, our e-
mail, our faxes, our everything, and I think our minds are open 
too. We get many, many letters every day through the transom 
and e-mails, and I think when you have gotten about three or 
four of them on the same topic you do start believing that 
there is an issue. So, I think that is part of it.
    I also think that we do meet regularly, as I said, with a 
number of different groups, and on those groups, there are 
representatives of small business. They are usually industry-
type groups. A lot of these issues tend to be industry by 
industry as well as being overall small business issues. But as 
I said, I really do like your suggestion of the advisory 
council.
    When I first came to the FASB, one of the complaints was 
that users of financial information, investors, creditors, and 
bond rating agencies, did not have enough of an active voice, 
and so I formed a user advisory council, and I think the same 
model, if we can get the right people that can get engaged, 
would be a great thing.
    Senator Enzi. I am pleased to hear you say that if four or 
five letters come in, and that over the transom thing rings 
particularly strong in Wyoming, but that it makes a difference 
to you, and I really appreciate that and hope that small 
business heard that as well. I know that the FASB staff has 
looked at alternative ways that small business can listen to 
FASB and the advisory committee meetings. Can you share with me 
some of those alternative ways? I think that currently small 
business has to either travel to Norwalk, Connecticut or pay 75 
cents a minute to listen in. Do you have any other 
alternatives?
    Mr. Herz. Yes, that is correct. That is something that the 
foundation, the trustees, the commercial arrangements are kind 
of in their hands, but I will tell you, my own view is that 
this is a public service, and I would think it should be free. 
I know we are also exploring doing webcasts as well.
    Senator Enzi. Good. I would encourage you to think of as 
many different ways as you can. For small business, 75 cents a 
minute on the phone sounds like a pornographic call.
    [Laughter.]
    Mr. Herz. Not as exciting.
    [Laughter.]
    Senator Enzi. I had to notice in your testimony, and I read 
not only your summary but also all of the other pages that you 
submitted, that in your opening statement you did not mention 
your initiative on stock option expensing. Is that because you 
believe that it is simply not a small business issue? Small 
business representatives have told me that you and other FASB 
Board Members dismiss their concerns outright with respect to 
the issue. Does that mean that three or four letters have not 
come through?
    Mr. Herz. No. We have had more than three or four letters 
and many, many meetings. Would you like me to update you where 
we are in that project?
    Senator Enzi. Yes, that would be great.
    Mr. Herz. As you know, we put that on our agenda last 
March, and as I noted in the roundtable that you organized in 
May on that topic, we had a plan and we were going to 
systematically, thoroughly go through all the issues with a 
view toward issuing a proposal by the end of this year. We have 
stuck to that plan. We have been going through many, many 
issues, not only on stock options, but also other equity-based 
awards. Over the summer, as you mentioned, we focused on 
valuation issues. I would say that the Option Valuation Group, 
all but one person, did agree on recommendations. So, I think 
there was a consensus as it applied, I will say, to large 
public businesses. The issue there is that it requires more 
data. Private companies, which obviously include small 
businesses, I think our valuation group thought that in many 
cases you could get a valuation. I think some of us are more 
skeptical as to whether you can in all cases get a robust 
valuation. Certainly it might be difficult, for example, 
determining the volatility for a very young company.
    What we have tentatively--and this is very tentatively--
decided, and it ain't over till it is over, is that companies 
that do not feel confident in their ability to get a grant date 
fair value would be able to, as a policy matter, adopt an 
alternative method which would basically measure the intrinsic 
value of options granted through exercise or expiration so that 
the total expense that they would accumulate in the income 
statement through the exercise date would be the same as the 
tax deduction that they take. That is tentative.
    As you said, we are not meeting our original goal of 
getting an exposure draft out by the year end. One of the 
reasons is that we are going to do a number of field visits to 
large public companies, smaller public companies, and some 
private companies. We are trying to enlist private companies at 
the moment through accountants and anybody else that would like 
to do it. We have had some volunteers on that, but we are going 
out there to meet with them, go through how would they do this, 
could they gather the data, how do they overall feel about the 
proposal?
    Right now our expectation would be that we would issue a 
proposal for public comment probably in February. It would be 
out for public comment for a lengthy period, and we would 
probably have some public roundtables, so there is still plenty 
of time for input.
    Senator Enzi. I appreciate that, and you mentioned that 
this option value group did reach consensus except for one 
person?
    Mr. Herz. That is what I remember, yes. He was a supporter 
of minimum value, that individual.
    Senator Enzi. Pardon?
    Mr. Herz. He was a minimum value supporter, what is called 
minimum value method.
    Senator Enzi. Okay. But the valuation model potentially 
talked about by this group for the upcoming stock expensing 
proposal, currently it is my understanding that the option 
traders use physicists to calculate the pricing model for stock 
options, and most of the people that voluntarily started 
expensing stock options early on have gotten to me, saying that 
they had a lot of difficulty with Black-Scholes, so I am glad 
you are discounting the value of that, and I do not know 
whether you are considering several pricing models or just this 
one pricing model that requires physicists.
    Mr. Herz. No. We are going to set out a framework, an 
objective, and explain how one would accomplish that objective. 
We would talk about the different models that would be 
available, but we would not mandate a particular model, and 
that is because it may be that for particular option grants, 
and given the number and materiality for a particular company, 
Black-Scholes may get you a result that is close enough. For 
use for a company that had more awards of lengthier periods, it 
probably would not be good enough.
    Senator Enzi. But you will wind up with one formula or
a multiple?
    Mr. Herz. No. We will describe objectives and how to get 
there.
    Senator Enzi. You mentioned that you will be field testing 
the valuation models with business entities and accounting 
firms. Is a field test the same as a road test?
    Mr. Herz. It is a field visit.
    Senator Enzi. Field visit.
    Mr. Herz. Visit, which means we go there, we have a 
detailed checklist, we send them information in advance, and 
then we hold meetings. We ask them to see how they would do it, 
whether they can do it, how they would do it, what data would 
be needed, as well as just general overall feelings about it.
    Senator Enzi. I assume from some of your criteria that you 
would be talking about what the cost and the benefit is as 
well?
    Mr. Herz. Yes. That is a key aspect of those visits.
    Senator Enzi. You will be including small businesses in 
those road tests?
    Mr. Herz. In fact, the more volunteers we can get, the 
better. We just do not show up on people's doorsteps.
    Senator Enzi. I am hoping you will be prepared to help them 
with the calculations.
    In your testimony you stated that FASB's open and thorough 
due process is also a fundamental to the mission. ``Because the 
actions of FASB affect so many organizations, its 
decisionmaking process must be fair and as objective.'' That is 
a quote from you. It is my understanding that FASB has not 
issued FAS 123 for public comment, and will not do so until the 
spring of 2004. However, I did receive an unsolicited letter 
last week from the American Business Conference, stating that 
having met multiple times with the members of FASB on this 
issue, we recognize that the Board, as one of the members 
candidly told us last month, is set in concrete on the matter 
of expensing. If the matter is set in stone by FASB members, 
then where is this due process for small business, who have not 
even seen the proposal, let alone be able to comment on it yet?
    Mr. Herz. Well, I cannot comment on a secondhand comment.
    Senator Enzi. I would hope that does not turn out to be a 
set-in-concrete situation for the Board. And I would hope that 
the Board members would not make those kind of comments, 
particularly to small businessmen who take all of that very 
seriously.
    Mr. Herz. Perhaps somebody made that, but I often get 
reports back from meetings I was at of what supposedly 
occurred, and I must have been at a different meeting.
    Senator Enzi. I want to congratulate you on the number of 
speaking things that I did. I think that you probably do more 
speaking events than most of the Senators do.
    Mr. Herz. It seems to be a hot topic, and if you get the 
right group, an audience, I think it is important to do that, 
and also to hang around and talk with people.
    Senator Enzi. Also in the paperwork that you submitted to 
me--I will find it here in a second. I apologize, I thought I 
had it. In your attachment on facts about FASB, 2003 and 2004, 
you mentioned the precepts in the conduct of your activities. I 
really appreciate those. I started with the fourth one and 
worked back in order of importance to me, but that was to bring 
needed changes in ways that minimize disruption to the 
continuity of the reporting practice, to promulgate standards 
only when the expected benefits exceed the perceived costs, to 
weigh carefully the views of its constituents, and to be 
objective in its decisionmaking, and of course, to review the 
effects of past decisions was the last one. I think that is an 
excellent statement of precepts. I am curious as to what point 
FASB reviews this compared to a FAS that they are putting out.
    Mr. Herz. I think the basic mission statement has stayed 
intact for a number of years, and it is something that is also 
discussed with our trustees of the Financial Accounting 
Foundation. I can tell you though that our detailed operating 
procedures to implement these, we regularly review them in kind 
of a continuous improvement mode. I know it is hard to believe, 
but we are not perfect, and you learn a lot.
    Senator Enzi. We all do. I guess the reason that I listed 
that fourth one as the first one is under the explanation, the 
last sentence said, ``The Board considers it desirable that 
change be evolutionary to the extent that it can be 
accommodated by the need for relevance, reliability, 
comparability, and consistency.''
    Mr. Herz. I think that is right, and there are counter-
tensions right now, as you know, as you expressed, in the wake 
of at least in the public company arena, given some of the 
revelations and the need to at least there to move fairly 
expeditiously to deal with some of the problems that were 
revealed.
    Senator Enzi. Definitely, as part of the team that worked 
on Sarbanes-Oxley, we knew that something needed to be done and 
did provide some revolutionary, rather than evolutionary, 
legislation. The implementation of it will be very important 
because how revolutionary each of the steps of the 
implementation are will ensure the economy moving forward, but 
hopefully we will remember the engine of the small businesses 
that are 50 percent of the GDP and all of the jobs and things 
that we have up there.
    Can you share any economic impact studies you have done on 
FAS 150, FIN 46, and FAS 123, or any of the other statements? 
Is there an economic impact statement that is done, referring 
back again to those four principles?
    Mr. Herz. We do an analysis of costs and benefits, and the 
benefits are in terms of better information, and sitting down 
with users and understanding how they would use it in their 
decisionmaking, and hopefully they are promoting better 
decisionmaking and resource allocation through the change in 
the information.
    The costs we look at are the costs, the one-time cost to 
implement by preparers and auditors, the cost of retraining and 
ongoing systems changes and the like. I think it is well known, 
we do not have an office of economic analysis, per se, and the 
philosophy is that if you get better information into the 
system in a cost-effective way, that better information will 
enable better decisions and better resource allocation.
    Senator Enzi. I do thank you for rearranging your time and 
being here, and the vote has started now, but I will not expect 
you to stay after, although I would hope that you would stay 
and hear the testimony from the next panel, and short of you 
being able to stay, would hope that some of your staff would 
stay and do it.
    Mr. Herz. Absolutely.
    Senator Enzi. They have some excellent observations, which 
of course you can get through the testimony as well, but you 
will not be here for the questions, and I am told that four 
people will be joining me for the questions. They were hoping 
to be able to do that with you, but I will not hold you up for 
that.
    When we sent out the notice for this hearing last Wednesday 
night, we did not have any idea how much attention it would 
receive. Since that time our phones have not stopped ringing, 
and it has been from small businesses and their representatives 
from across the country that have contacted the office to see 
if they could come and testify. Now, clearly, we could have had 
two or more additional panels. It should be noted that the 
small businesses did not want to come and talk about just these 
three accounting issues, FIN 46, FAS 123, and FAS 150, but 
other issues as well. So, obviously, there appears to be a lot 
of concern and interest on the part of small business.
    Mr. Herz. Can I make a comment on that?
    Senator Enzi. Sure.
    Mr. Herz. And in my introductory remarks I talked about 
there is this big GAAP/little GAAP issue that every so often 
comes up, and it has been surveyed fairly regularly, and the 
surveys usually come back and say, well, the people who demand 
the financial statements want to keep it the way it is, maybe 
different disclosures, but if an asset is an asset or if you 
have a derivative transaction I want it accounted for the same 
way as a big company. If you got a special purpose entity, I 
want it accounted for the same way.
    I think that is generally right, although you can probably 
tell from my New Jersey accent, I actually spent a number of 
years in my career in the UK. Over there they have developed a 
differential set of standards. Most of it is the same, but 
there are some shortcuts in some areas, and at least in their 
market it seems to work fairly well.
    The real point I am making is that the issue is about 
satisfying the needs of the market, and that to me is where it 
is at. If the market were to want a credible, slightly 
different product, I think it will be somebody's responsibility 
to try and fill that need.
    Senator Enzi. On the differential with the small 
businesses, they are just hoping of course that the cascading 
effect does not happen, and that is why we put some statements 
in Sarbanes-Oxley to indicate to States that they did not have 
to adopt Federal principles to do it, and perhaps some wording 
in there that makes it clear that small businesses may not have 
the same capability to generate the information. As I 
mentioned, some small businesses think it takes a physicist to 
come up with valuations on stock options, and they do not have 
those.
    Mr. Herz. That is why we propose as an alternative a much 
simpler calculation. They may not like it because it 
potentially creates volatility.
    Senator Enzi. Anything you can do to prevent that cascading 
effect from happening in instances where it is not necessary, 
where they are not affecting the outside individual investors 
who may not have the knowledge to interpret some things, but 
are rather working with professionals like their bankers, who 
do have the capability. They know the person. They know the 
business. In most cases with these small businesses, the audit 
and an exact inventory can be done particularly easily because 
they do not have anything.
    Mr. Herz. Yes. I have audited a lot of small businesses.
    Senator Enzi. So, the requirements cannot be the same for 
them, one of the important things is for it to be clear that 
way, but I am also hoping that small businesses do not have to 
wage an 11th hour campaign in order to have FASB listen to 
their concerns.
    Mr. Herz. I would rather that not happen either.
    Senator Enzi. I am very encouraged by your comments about 
the small business advisory committee or council or whatever, 
and I do applaud you on your recent decisions on FIN 46 and FAS 
150 issues. I know there is still a lot of work to be done in 
that, and in addition these issues should be addressed much 
earlier in the process.
    In your statement you readily acknowledge that you have a 
long-standing position recognizing that the cost of complying 
with financial accounting and reporting standards do fall 
disproportionately on small business.
    With respect to the advisory committees that FASB has 
established, the FASAC, the Emerging Issues Task Force, and the 
Users Advisory Council, very good. However, small business 
representation is a very small proportion of the overall 
membership, and reading through the minutes of certain 
meetings, the concerns raised by small business sympathizers 
are given less weight as a result of having less weight on the 
committee, and in some instances are dismissed.
    You have also submitted the list of speeches, which I 
already commented on, but I notice that you spend five times as 
much speaking as you do appearing to listen, and the listening 
is the part that comes through to me from the small business.
    As FASB is an independent body there is an even higher 
standard for FASB to remain open and objective about the 
standard-setting process. In addition, the due process rights 
for small entities must be clearly delineated. I do have 
extreme concerns about that statement about ``set in concrete'' 
that I mentioned.
    Again, I thank you for appearing here today.
    Mr. Herz. Thank you.
    Senator Enzi. It has been most helpful, and we will be 
submitting some questions, and those who were not able to be 
here will be doing that, and I look forward to your answers on 
that.
    Mr. Herz. Thank you very much.
    Senator Enzi. Thank you.
    Senator Enzi. At this point, since we are past the halfway 
point on the vote, I will have a short recess while I go and 
vote, and there will be a second vote which should follow 
shortly after that, and then we will come back and reopen it 
with the second panel.
    [Recess at 2:59 p.m.]
    Senator Enzi. While I was over voting on the two measures, 
Senator Allard was here, left for the second one. He will be 
back. When he is back, we will allow him an opportunity to make 
some comments as well. And then, of course, following the panel 
we will have questions and an opportunity for comments again.
    I appreciate everyone's patience during the vote. Two 15-
minute votes around here can take an hour. But it is so that we 
make sure that everybody gets their opportunity to cast their 
vote and--so I was able to vote at the beginning of the next 
one and come back.
    Today's second panel is a cross-section of the small 
business community with small business owners, financial 
experts, and a former small business that can describe what it 
is like to grow from small to large while trying to comply with 
the accounting standards.
    In this second panel we have a very distinguished panel of 
witnesses. We have Peter Salg of Fort Collins, Colorado, who is 
the owner/president of a company that has five Wendy's 
restaurants. He is here representing tens of thousands of small 
franchisers and franchisees for the International Franchise 
Association, and has had some very personal effects on what has 
happened with FASB.
    James Glassman, a Resident Fellow with the American 
Enterprise Institute and a syndicated columnist with The 
Washington Post. He has been closely following and writing 
about small business financing issues for quite some time.
    We have Jeannine Kenney, who is with the National 
Cooperative Business Associations, here representing tens of 
thousands of small co-ops across the country.
    Richard Forrestel is the CFO of a smaller-sized 
construction company in Akron, New York. I firmly believe that 
without his dogged perseverance on FAS 150 issue, FASB would 
not have arrived at its decision today to delay the 
implementation of FAS 150.
    And finally, Walter Moore, who will be filling in for Lou 
Levine, as Mr. Levine is home with the flu. I remind everybody 
to get their flu shots. He will discuss how an entrepreneurial 
business started by two gentlemen grew into a multibillion-
dollar corporation and how they managed to deal with the 
accounting standards while growing from a small business to a 
large business.
    I thank all of the members of the panel for being here and 
for their comments.
    Oh, yes, there is one more there than I introduced. I also 
thank Mark Heesen, the President of the National Venture 
Capital Association, for being here. And he deals with a lot of 
the start-ups of the small businesses that we have been talking 
about. I put him in as the clean-up batter there.
    And I appreciate the testimony that all of you provided. I 
learned a lot from the testimony, and do know that we picked a 
significant panel here of solutions for FASB.
    So with that, Mr. Salg, you may proceed.

                   STATEMENT OF PETER A. SALG

       PRESIDENT, QSC RESTAURANTS, FORT COLLINS, COLORADO

                          ON BEHALF OF

            THE INTERNATIONAL FRANCHISE ASSOCIATION

    Mr. Salg. Thank you, Chairman Enzi, and thanks for the 
opportunity to testify at this important hearing.

    I have worked in franchising since 1968, doing everything 
from running a restaurant to running a franchisor with 450 
units. My company, QSC Restaurants, Inc., owns five Wendy's 
restaurants in Colorado. I will be testifying today on behalf 
of the International Franchise Association, which represents 
franchisees, franchisors, and others in the franchise 
community. I will be focusing my comments on the impact of FIN 
46 as a small franchisee. But I also want to make sure that you 
know that the great majority of franchisors are small 
businesses, too.

    The typical franchisor has less than 200 units and revenues 
of less than $5 million. If FIN 46 goes into effect as written, 
here is what it would mean to franchisees like me. We would 
have to have audited financial statements. This is not required 
currently, and would be very expensive. It is not required 
because it does not make sense, for two reasons. One, Wendy's 
has no contingent liability from my business; and two, I am not 
a public company.

    We might be required to use the same outside auditor as our 
franchisor. This is not an explicit requirement of FIN 46, but 
if my franchisor's auditors say they will only be comfortable 
if my statements are prepared by their people, we are left with 
little choice. This requirement will hit single-unit 
franchisees the hardest. It is needless to say not every mom-
and-pop business can afford PricewaterhouseCoopers.

    We would also be required to adhere to the franchisor's 
internal accounting standards. Franchisees like me have made 
enormous investments in the way we have chosen to set up our 
financial statements. Wendy's P&L does not look like my P&L, 
and we both have good business reasons why they should not.

    We would have to develop a system to provide internal 
control reports to franchisors and adhere to internal-control 
dictates of the franchisor's auditor. I can understand why the 
franchisor would want this, since the CEO and CFO are on the 
hook for criminal penalties in Sarbanes-Oxley. But why on earth 
should a privately held small operator have to institute an 
extensive internal control system? This unintended consequence 
of FIN 46 is, in my opinion, pure overkill.

    Now let us look at the impact on small franchisors. If you 
have a successful small business and you are thinking of ways 
to expand it, franchising is a great method for a lot of 
people. But FIN 46 makes franchising much less appealing. First 
of all, it just got a lot more expensive to be a franchisee. As 
I described earlier, you have to have audited statements done 
by an expensive firm and acceptable internal control systems, 
et cetera. Second, your freedom to operate your franchise just 
got more limited. I have chosen to operate my restaurants the 
Wendy's way. The menu, the appearance of the store, the quality 
of the food--things like this must be standardized across the 
system so that you, the customer, know what you are going to 
get when you walk into any Wendy's in the country.
    But on the other hand, I am an independent businessman. I 
decide how to set up my business. I decide whether it is a 
partnership or an S corp. And I decide who my lawyer and 
accountant are. I decide on what capital expenditures I make, 
and I decide on product pricing. Furthermore, I decide who to 
hire and fire, what salaries and benefits to offer, and what 
pension plan to set up. I make decisions every day that 
directly affect my bottom line.
    So in deciding whether franchising is the way to go, some 
prospective franchisees will find the level of intrusion called 
for in FIN 46 more than they can live with. This is, in my 
opinion, a very serious threat to franchising. If FIN 46 had 
been in effect when I made my decision to become a franchisee, 
I am not sure I would have made the leap.
    There is another problem with FIN 46. When and if I want to 
sell my business one day, there will be fewer prospective 
buyers, and that will lower the value of my business.
    I know the mission of the FASB is to improve financial 
reporting so that the public is protected. The entire franchise 
community supports that vital goal. But I cannot understand how 
FASB could come to the conclusion that hobbling franchising is 
an acceptable price to pay for preventing another Enron.
    To make matters worse, I do not think FIN 46 accomplishes 
FASB's goal to improve financial reporting when it comes to 
franchising. If FIN 46 results in a franchisor consolidating 
the financial results of its franchisees, it may confuse 
investors who are not familiar with franchising. A franchisor's 
financial results just are not one and the same with its 
franchisees' results.
    In other words, FIN 46 is going to make me and a lot of 
other people in the franchising world jump through a lot of 
hoops and pay a lot of money, with zero public benefit.
    In conclusion, it is clear that FASB has not sufficiently 
understood the implication of their proposal. They apparently 
have not been listening to real business people like me. 
Frankly, I am surprised that FASB would consider doing 
something like this. FASB needs to better understand that the 
rules they set are not just academic exercises. These rules 
have real-life consequences, and FASB needs to understand what 
those consequences are and take them into account before they 
act.
    In the case of FIN 46, FASB needs to listen carefully to 
the concerns of the franchising community before its 
implementation. Given what Chairman Herz said earlier, it 
appears FASB is moving in that direction. I like the idea of an 
advisory council, especially in light of the fact that I did 
not see franchisees on that big chart you had up here.
    I would be happy to answer any questions that you might 
have.
    Senator Enzi. Thank you. At this point, as I mentioned 
before, I will call on the Senator from Colorado for any 
opening comments that he might have.

                COMMENTS OF SENATOR WAYNE ALLARD

    Senator Allard. I would just like to take a moment to 
welcome and thank Mr. Salg for coming here and testifying 
before the committee. You know, when you are running your own 
business it is not easy to get away. And to come all the way to 
Washington from Fort Collins, Colorado, is not an easy task.
    Mr. Salg. And on my wife's birthday.
    Senator Allard. On your wife's birthday?
    Mr. Salg. Yes, I have to go home and fix that tonight.
    Senator Allard. Hey, I had better send her a birthday card.
    Mr. Salg. I think that would be a good idea.
    Senator Allard. Okay. Drop by the office here. We will take 
care of that. Do you want to sign it, too?
    [Laughter.]
    You know, Mr. Salg epitomizes entrepreneurship. He is a 
hard-working individual, puts in extra hours, and has an 
extensive record of involvement in the restaurant franchise 
business. Anybody that has been in the business of grocery 
stores and food, whether it is a restaurant or whatever, you 
put in long, hard hours, and you have rules and regulations you 
must adhere to. And one of the reasons I ran for the Senate is 
because as a small businessman, I was impacted by all these 
rules and regulations and high taxes, and it felt like I wanted 
to have some impact and certainly be a voice for small 
business. Mr. Salg being here, I think, is refreshing to hear 
what he has to say as a small businessman.
    As he mentioned, he is testifying on behalf of the 
International Franchise Association, as an example of a 
successful franchisee and a business person, and it is a 
pleasure to have you hear before us. Thank you for your 
comments and your testimony before this Committee. They will 
become a part of the record and will have serious consideration 
by the Committee.
    Thank you, Mr. Chairman.
    Senator Enzi. Thank you, Senator.
    Mr. Glassman.

                 STATEMENT OF JAMES K. GLASSMAN

         RESIDENT FELLOW, AMERICAN ENTERPRISE INSTITUTE

    Mr. Glassman. Thank you, Mr. Chairman, Mr. Allard.
    Mr. Chairman, you are to be congratulated for calling a 
hearing on this urgent subject. And it is an honor for me to be 
here on this panel with real-life practitioners rather than 
Washington policy wonks like me.
    The determination of the Financial Accounting Standards 
Board to require mandatory expensing of stock options by U.S. 
firms, FAS 123, threatens small businesses and imperils the 
fragile economic recovery. The FASB states that its sole 
mission is,

    to establish and improve standards of financial accounting 
and reporting for the guidance and education of the public, 
including issuers, auditors, and users of financial 
information.

    In my view, the proposed expensing of options does not 
achieve this aim. But even if it did, you as policymakers, you 
Senators, have a more comprehensive mission than the FASB. Your 
concerns include improving the economy and increasing job 
opportunities in small businesses and elsewhere. The FASB's 
proposed action does the opposite. Small business is the engine 
that drives the U.S. economy. Small businesses create 60 to 80 
percent of net new jobs annually. And small businesses, 
moreover, grow into large businesses. For example, Microsoft 
started in Bill Gates's garage with two employees as a 
partnership in 1975. It now has 47,000 employees and $282 
billion in stock market value.
    Surveys show that three of the key ingredients in the 
success of small businesses are attracting a talented and 
motivated work force, limiting compensation outlays, and 
conserving cash during the early years of growth. I do not have 
to tell anyone on this panel about that. Lately, small 
businesses as well as large have increasingly turned to 
employee stock options to satisfy these needs and achieve 
success. And unfortunately, the FASB is moving quickly to 
change an accounting rule in order to require mandatory 
expensing of stock options on corporate income statements.
    Such a change would cause a significant reduction in the 
issuance of stock options, especially to employees below the 
top five corporate officers. For example, America's best known 
venture capitalist, John Dorr, said in testimony that he 
thought, ``broad-base employee stock ownership will disappear 
if expensing is mandated.'' And a review of the economic 
literature by Brian Hall and Kevin Murphy concluded that, 
``parties on both sides of the debate agree that such a change, 
expensing stock options, would result in granting fewer 
options, especially to rank-and-file workers.''
    Without the incentive tool of stock options, many of 
America's most innovative firms, small businesses and large, in 
technology and nontechnology, will suffer declining 
productivity with dangerous consequences for national 
competitiveness, growth, and employment. And one result is that 
talented workers in the United States will seek options 
elsewhere, mainly from our competitors in Asia. In an article 
in Barron's last summer, George Chamillard, the CEO of 
Teradyne, wrote that ``while options are under attack in the 
United States, elsewhere the stock option as a recruiting tool 
is on the rise.'' Options are drawing scientists from the 
United States to Asia, to Taiwan in particular. As a result, he 
says, the United States is losing engineers educated at MIT, 
Stanford, and Caltech. Asian Nations understand the attraction 
of options, and they do not have the same taste for the fetish 
of expensing options as American regulators. In fact, the 
latest 5-year plan of the People's Republic of China 
specifically states that options should be used to motivate 
managers.
    The FASB, however, has made it clear that it will shortly 
require U.S. companies to adopt fair-value accounting under FAS 
123. The problem of valuing the options, however, remains. The 
FASB acknowledged that its proposed standard on stock options 
``should not prescribe a particular option pricing model.'' And 
what is the model that would be applied? Well, either a Black-
Scholes or a binomial model, it appears, and both of them 
seriously lack reliability and accuracy. And my complete 
testimony gives examples of the lack of reliability and 
accuracy, and critical quotes from very distinguished people.
    In other words, the same deterrent that prevented the 
FASB's predecessor from requiring the expenses of options in 
1972 still exists today. No one can place an accurate value on 
them. But 30 years of economic history have confirmed that 
options help improve the operations of small and large 
businesses and improve the economy. And for that reason, 
President Bush supported the current accounting treatment of 
options in an interview a year and a half ago. And in addition, 
leading Democratic presidential candidates--Representative 
Richard Gephardt, Howard Dean, Senator Joseph Lieberman--also 
oppose expensing of options.
    The FASB is trying to find a single number, but one that 
can be derived by different means, to describe a highly complex 
situation. Such a perversion reminds us of the purpose of 
accounting conventions in the first place, which is to convey 
information about the health and prospects of a company for 
investors and potential investors. But some information cannot 
be reduced to a single number, nor should it be. The expensing 
proposal, nonetheless, as The Wall Street Journal said, 
``serves to satisfy an unquenchable fetish to see a contingent 
liability converted, however clumsily and unconvincingly, into 
a dollar amount that can be charged against earnings without 
caring in the slightest whether it is helpful or meaningful to 
do so.''
    And in this case, it is not helpful or meaningful to reduce 
all that information about options to a single number. It is 
confusing, misleading, and utterly unnecessary. In fact, for 
typical companies, the information that is provided on stock 
options today far exceeds information that is provided for far 
more important aspects of businesses, including intellectual 
property assets, cash compensation expenses, leases, and 
investments.
    Finally, the case for stock options is built on a faulty 
premise, that investors do not understand, from the current 
data with which they are presented, the true status of the 
firm. In their article, Hall and Murphy write, ``Several 
studies have shown that the cost of
options are indeed reflected in stock prices.'' I noted earlier 
that Mr. Herz listed as a benefit of expensing options ``better 
resource allocation,'' as though the managers did not 
understand themselves the importance of stock options in their 
own businesses. Managers understand, investors understand.
    And if investors have the proper information currently, 
then why, at this critical time in the economic cycle, should 
we tamper with a system that provides incentives and conserves 
capital? There is no reason at all. The number one rule in 
public policy should be that of the Hippocratic Oath in 
medicine: First do no harm. Discourage stock options and you 
discourage a management tool that works for vast numbers of the 
best American companies, including the small businesses that 
have made the U.S. economy the envy of the world.
    Thank you.
    Senator Enzi. Thank you very much.
    Mr. Forrestel.

        STATEMENT OF RICHARD FORRESTEL, JR., TREASURER,

        COLD SPRING CONSTRUCTION COMPANY AKRON, NEW YORK

                          ON BEHALF OF

         THE ASSOCIATED GENERAL CONTRACTORS OF AMERICA

    Mr. Forrestel. Good afternoon, Chairman Enzi, Mr. Allard. I 
am Richard Forrestel, Jr., a CPA and Treasurer of Cold Spring 
Construction Company based in Akron, New York. I am testifying 
on behalf of the Associate General Contractors of America, AGC, 
a national trade association and the voice of the construction 
industry. While AGC's membership is diverse, the majority of 
AGC firms are closely held businesses just like ours.

    I would like to thank Chairman Enzi and the other Members 
of this distinguished Committee for the opportunity to discuss 
both a potentially devastating impact of FAS 150 on family-
owned businesses as well as the general process of 
communication between American small businesses and FASB. Cold 
Spring Construction Company was founded by my grandpa in 1911. 
We are a closely held family-owned construction firm that 
specializes in highway and bridge construction.

    The risk of FAS 150 to privately held firms like ours and 
the majority of AGC members cannot be overstated. As written, 
FAS 150 would have dramatically affected all privately held 
companies with mandatory redemption clauses in their buy-sell 
agreements. The result will be to take our companies' more than 
$10 million in net worth and make it zero through the 
imposition of this standard. I will briefly touch upon the 
ramifications of such an accounting bombshell.

    Cold Spring builds only public works projects, and all 
require surety bonds. First, wiping out our equity would make 
us unable to obtain bonds. Second, we would be in violation of 
loan covenants. Third, many States, like Pennsylvania, have 
prequalification requirements in order to bid on public works 
projects. FAS 150 would have rendered us unqualified to bid on 
many projects in Pennsylvania. Finally--and this is strictly a 
psychological reason--this change would have dramatically 
altered the way our balance sheet looked. Dad first worked for 
Cold Spring the summer after the Japanese bombed Pearl Harbor. 
No way, not on my watch, will he be told that the company that 
he has worked to build for more than six decades, the equity 
just went to zero. No chance.

    FAS 150 first came to my attention at an AGC Tax and Fiscal 
Affairs Committee meeting in June of this year. AGC wrote a 
letter to FASB with our concerns and requested a private 
meeting in Norwalk, Connecticut. This was set for October 30. 
After much thoughtful preparation, two ABC representatives and 
I met for 3 hours with two board members and five staff members 
of FASB. These people are, in my opinion, the best and the 
brightest people in the country in the accounting profession. 
The seven FASB representatives asked direct and penetrating 
questions. Honestly, it made the CPA exam seem awfully easy in 
comparison. They gave us a chance to tell our stories and 
listened well. They did not promise an outcome, but did thank 
us for our input.

    My mindset walking out of the meeting was completely 
unexpected. Rather than a brick wall, I found an intelligent, 
thoughtful group interested in hearing about my nonpublic 
company and how FASB standards affected me and my industry. I 
believed FASB heard us. Last week, FASB issued a change and 
indefinitely suspended a portion of the standard. In summary, 
there is no change to my financial statement.

    But the other shoe has yet to drop, because it is FASB's 
apparent intention to address this issue again in the future. 
The uncertainty of not knowing what will happen, if anything, 
will undoubtedly continue to cause heartburn for lots of people 
currently contemplating buy-sell agreements.

    While the process ultimately worked, it is unfortunate that 
the standard caused such turmoil. Large public companies are 
accustomed to lobbying for or against changes with FASB. We 
small companies are not. We often get caught up in changes that 
probably should be intended for public companies. I think this 
is exactly the case with FAS 150.

    One possible solution is to consider a semiannual or annual 
meeting with FASB staff and representatives of small business. 
FASB would benefit from having small business representatives 
provide their point of view and at the same time share drafts 
of upcoming new standards.

    I know that AGC is moving forward with FASB on a new 
working relationship. The AGC Tax and Fiscal Affairs Committee 
will meet in January, and we are inviting a representative from 
FASB to join us. We are going to work proactively and ensure we 
are staying abreast of the new standards, and will continue to 
work with FASB until 150 is finalized.

    In conclusion, I would like to thank you for the chance to 
testify today and your willingness to listen and, potentially, 
address our concerns. As a fellow CPA, I agree with what I 
believe is Chairman Enzi's viewpoint. Congress should not be 
legislating accounting standards. I appreciate and agree with 
the many reasons FASB is an independent organization; 
nevertheless, this Committee's oversight is critical to 
ensuring all standards-setting agencies are responsive to both 
large and small entities.

    Thank you, and I will gladly answer any questions you might 
have.
    Senator Enzi. Thank you very much.
    Mr. Moore.

                  STATEMENT OF WALTER K. MOORE

      VICE PRESIDENT, GOVERNMENT AFFAIRS, GENENTECH, INC.

    Mr. Moore. Mr. Chairman, Senator Allard, I am Walter Moore, 
Vice President of Government Affairs at Genentech.

    Today, Genentech has a market cap of over $40 billion. Why 
the heck, you might ask, is a company the size of Genentech 
even interested in the topic of FASB and small business growth? 
It is because Genentech is the classic American small business 
story.

    The biotech industry was born 25 years ago when a UCSF 
biochemist and a young venture capitalist each agreed to 
contribute $500 to start Genentech. They fought convention. 
Researchers could publish their studies. Employees could dress 
as they liked. And all employees were given stock options. 
Among the young scientists who came to Genentech in 1980 was 
Art Levinson, our current Chairman and CEO.
    A primary factor that allowed Genentech to move from a 
startup biotech to where it is today was our ability to use 
broad-base employee stock options. Options make employees think 
and act like owners, not just employees who do their job, 
collect a paycheck, and go home. Genentech issued stock options 
to all employees when it was founded and still does so today.
    Genentech actively competes for talent with at least 60 
other biotechs in our ZIP Code. Our ability to remain 
competitive is directly related to our ability to offer options 
to all our employees. However, this is being directly 
threatened by FASB.
    FASB's proposed stock option rules will impact all 
companies that use broad-base stock options without providing 
investors better financial information. Although we 
fundamentally disagree that employee options represent a 
corporate-level expense, we do believe that credible, 
transparent, and comparable financial information is essential. 
We also believe that all companies, not just small businesses, 
face the same valuation issues. Existing valuation models were 
designed to value freely tradable options, not employee stock 
options with all of their restrictions. If expensing is 
required based on these models, the integrity and comparability 
of financial reporting will be compromised.
    A better approach is to require more disclosure. As you can 
see from our 10-K, which is Appendix 1 of my testimony, the 
dilutive effect that an investor could have from our stock 
options is readily apparent at any price point. Because we 
cannot accurately value options, expensing will create investor 
confusion and make income statements less reliable.
    There are many areas of concern about valuation, but I will 
focus on only one in my talk today--volatility. Volatility at 
Genentech ranged, from 2000 to 2003, from 43 to 75 percent. 
Appendix 2 is our stock price over the last 3 years. Curiously, 
it ranges year-by-year 43 to 75, but I have drawn a line 
through right here--the 3-year average is zero.
    What is concerning about that is the fact that we do not 
know what period to use for volatility. Do we use month, 
quarter, or year? Three years? Who knows? In our case, a 20 
percent change in volatility prediction results in a 100 
percent change in the option expense itself.
    This should be of concern to you and to the SEC because it 
is very easy for us to make a knowledgeable estimate and to 
have it be way off. You will not be able to discern the 
difference between a knowledgeable estimate and manipulation. 
And that should be of concern to everybody involved in public 
companies.
    If FASB really believes stock options are an expense, they 
have an obligation to get valuation right. FASB used to believe 
Black-Scholes could accurately predict option expense. They 
recently changed course and considered even prohibiting Black-
Scholes, the method virtually every company has used in their 
footnotes since 1994. Because all current option pricing models 
suffer from the same flaws as Black-Scholes, all current models 
will reach the same ultimate wrong number.
    Some believe that expensing any number, however wrong, is 
better than expensing nothing. We disagree. Under existing 
accounting rules both here and abroad, an expense is to be 
recognized only if it can be reliably measured. Unlike cash 
compensation or any other expense that results in an outflow of 
cash, employee stock options cannot be reliably measured. 
Mandatory expensing of broad-base stock options flies in the 
face of the most fundamental accounting rules. FASB must 
address the significant shortcomings of stock option pricing 
models and develop new models before mandating the expensing of 
all options.
    Genentech has met with FASB to communicate the problems 
with existing valuation models, and our detailed presentation, 
we fear, has fallen on deaf ears. One prudent way to proceed is 
to road-test models through footnote disclosure and study how 
they actually work, rather than mandating the wholesale 
changes. Indeed, Genentech would welcome that and would 
volunteer to work with the FASB to road-test these.
    Thank you.
    Senator Enzi. Thank you very much.
    Ms. Kenney.

                  STATEMENT OF JEANNINE KENNEY

       VICE PRESIDENT, PUBLIC AFFAIRS AND MEMBER SERVICES

           NATIONAL COOPERATIVE BUSINESS ASSOCIATION

    Ms. Kenney. Thank you, Mr. Chairman. I am Jeannine Kenney, 
Vice President of Public Affairs with the National Cooperative 
Business Association. On behalf of my members and the thousands 
of other co-ops that we represent through our national 
association members, we appreciate this opportunity to testify 
specifically on the impact of FAS 150 on cooperatives.
    NCBA is the only National organization representing all 
types of cooperatives across all sectors, and it is a very 
diverse group. Our members include farmer-owned agricultural 
marketing and supply cooperatives, small parent-owned child 
care cooperatives, consumer-owned electricity, food, health 
care, housing, and telecommunications cooperatives, consumer-
owned credit unions, and small business purchasing and shared 
services cooperatives, among others.
    Purchasing cooperatives should be of particular interest to 
this Subcommittee because they help small businesses band 
together to procure inputs and services that make thousands of 
independent businesses more successful.
    There are more than 40,000 co-ops in the United States, and 
they serve 120 million members. That is more than half of all 
adults. To put the size of the co-op sector into perspective, 
we outnumber publicly traded investor-owned firms by more than 
2 to 1. The vast majority of co-ops are themselves small local 
businesses or are purchasing cooperatives that represent 
thousands of small local independents. They provide jobs, 
wealth, and opportunity for millions of Americans.
    Of the many financial challenges confronting co-ops in 
recent years, few have generated the level of concern and 
uncertainty as FAS 150 has regarding co-op balance sheets. In 
its last comment period, FASB received more than 70 comments 
from cooperatives out of the one-hundred-and-some comments on 
the extension of the implementation period for FAS 150. That is 
70 percent of comments from co-ops.
    By issuing comments and conducting personal meetings with 
FASB staff, co-ops and their representatives have participated 
in the lengthy consideration and comment processes leading up 
to FAS 150. However, until last Friday, it seemed as though 
these comments had fallen on deaf ears.
    Cooperatives were initially told that to address their 
concerns regarding FAS 150's impact, they merely needed to 
educate their lenders about their equity structure. Over time, 
we have received the clear impression that FASB does not 
consider cooperatives to represent a significant business 
constituency.
    It is absolutely critical that co-ops have the opportunity 
to participate in and be regarded as true stakeholders in 
FASB's standards development processes, including having 
representatives serve on the Advisory Council.
    Mr. Chairman, NCBA supports your notion of a Small Business 
Advisory Committee for FASB and would hope that co-ops would be 
included on that committee. Even the establishment of a Small 
Business Advisory Committee, however, should not preclude the 
presence of co-ops and credit unions on the primary Advisory 
Council. I would note that there is a credit union 
representative on FASAC, and it is noted as a small business 
representative. It actually happens to be one of the larger 
credit unions in the country, with more than $1 billion in 
assets.
    Notwithstanding these concerns, we are grateful to FASB for 
its recent decision to indefinitely defer the most concerning 
provisions of FAS 150 relating to mandatorily redeemable 
financial instruments. To understand why this is such a concern 
for co-ops requires a basic understanding of the co-op 
structure.
    Co-ops are owned and governed by their members. Those are 
the people or the businesses that buy the goods and services of 
the co-op--also known as the patrons. Members make an equity 
investment in a cooperative when they join. It is risk capital. 
In the case of bankruptcy, it may never be returned to members. 
Debt holders are paid first; equity holders last, if at all.
    Co-ops return profits to their members in the form of end-
of-year dividends based on the amount of business that member 
did with the co-op. They receive these either in the form of 
cash or as equity held by the co-op and allocated to individual 
members known as allocated patronage capital, or in both forms. 
A member's equity rises or falls with the profitability of the 
business.
    Because co-ops typically do not issue public debt, 
allocated patronage capital is how they accumulate equity. It 
typically represents most and, in many cases, all of a co-op's 
equity.
    Co-ops redeem patronage capital in a variety of ways. Some 
may never redeem it, others repurchase the shares of members 
upon their withdrawal from the co-op, upon death, or upon 
reaching retirement or other age. Other co-ops revolve equity 
over a period of time when specific equity levels are reached 
and the financial condition of the co-op allows. Some 
purchasing cooperatives for small businesses have agreements 
with their members to redeem shares upon their withdrawal of 
the business, raising concerns similar to those raised by Mr. 
Forrestel.
    Redemption decisions are generally based in board policy or 
practice and are occasionally stipulated in the bylaws. But, 
generally, redemption decisions are at the board's discretion. 
They have no such discretion for repayment of debt.
    FAS 150 requires the classification of mandatorily 
redeemable financial instruments as liabilities. On its face, 
cooperatives did not think FAS 150 applied to them. However, of 
principal concern to us is that the standard appears to 
include, under some circumstances, patronage capital in FASB's 
definition of mandatorily redeemable instruments.
    Such instruments are defined as those for which the issuer 
had an obligation to redeem. Because of the vagueness of FAS 
150 regarding what is considered an obligation, past 
cooperative discretionary practices to redeem shares could be 
construed as a constructive obligation in the future, requiring 
reclassification of the entirety of the co-op's capital as a 
liability. This uncertainty has resulted in different 
interpretations of FAS 150 by co-op accountants in identical 
fact situations.
    Equally concerning is the lack of recognition that, in a 
cooperative, patronage capital as its primary asset is never 
redeemed all at once, except in the case of sale or dissolution 
of the business. It is completely implausible that all of a co-
op's members would die, withdraw, or retire in a single year. 
It is equally nonsensical, then, to represent that possibility 
on the balance sheet.
    FAS 150, in the absence of the indefinite deferral, and by 
requiring reclassification of equity as debt, would have 
created the appearance of insolvency for financially thriving 
businesses and badly misstated the financial health of 
thousands of small businesses across America. This would have 
put cooperatives in technical default of their loan agreements. 
It would also have made it more difficult for them to access 
new debt financing which, for cooperatives, is already a 
challenge because few conventional lenders truly understand the 
co-op structure. Co-ops would have just one more thing to 
explain to lenders.
    Moreover--and this a particularly a concern for purchasing 
cooperatives for small business--having zero equity on your 
balance sheet would have damaged your credit worthiness in the 
eyes of suppliers, which is critical for purchasing 
cooperatives seeking to leverage the best deal from suppliers 
for their members. And, ultimately, this would have harmed the 
millions of Americans who are members of cooperatives.
    Throughout this process, FASB either did not understand the 
co-op structure and the implications of FAS 150 on cooperatives 
or they chose to disregard them. We understand that the 
cooperative structure is unique, but FASB has an obligation to 
understand it. In any case, NCBA looks forward to working with 
FASB as stakeholders to ensure that what would have been a 
disastrous outcome for cooperatives will not occur as the board 
reevaluates the implementation and other issues associated with 
FAS 150.
    Thank you.
    Senator Enzi. Thank you.
    Mr. Heesen, again, I apologize. I had meant in the opening 
to mention my regret that we are not in hearings to do slide 
shows. I really appreciate the slides that you gave us, which 
make a nice clear statement, and I will make sure that 
everybody takes a look at that as well.
    Mr. Heesen.

                    STATEMENT OF MARK HEESEN

        PRESIDENT, NATIONAL VENTURE CAPITAL ASSOCIATION

    Mr. Heesen. Very good. Thank you.
    Cisco, Intel, Genentech, Home Depot, Outback Steakhouse, 
eBay, Dell, today, household names; once, all small venture-
backed companies, and hopefully there will be a lot more coming 
down the pike. In fact, in the United States today, 11 percent 
of annual U.S. GDP comes from small venture-backed companies, 
and we employ 12 million people. This is why NVCA has a vital 
interest in this hearing.
    While we recognize the pressure that has been placed on 
FASB to issue standards more quickly, we have a grave concern 
that this rush to regulate has needlessly burdened young 
companies in several ways.
    My first example involves FIN 46, which has frankly created 
havoc within the entrepreneurial and private equity 
communities. This highly complex interpretation sought to 
define what types of entities must be consolidated into a 
company's financial statements. This interpretation was 
extremely complicated, covered new ground, lacked adequate 
guidance, and allowed for no transition time.
    To remain GAAP-compliant, private equity firms, and 
companies in which they invested, would be forced to 
consolidate the assets, liabilities, and operating results of 
certain, but not all, investments, thereby significantly 
altering their financial statements.
    Given the frequency of transactions occurring in the start-
up and private equity sectors, the resulting hodgepodge of 
consolidated information would have so convoluted those 
entities' financials that they would have had to maintain two 
sets of books--one to meet FASB's requirements and one to meet 
the investors' requirements. This result is counterintuitive to 
FASB's stated goal of producing relevant, reliable, and 
comparable financial statements for all investors.
    Over the last several months, CFO's of private equity firms 
and start-ups have spent hours and hours attempting to decipher 
FIN 46 and how it would apply to them with virtually no 
guidance from the FASB. FASB's aggressive time line exacerbated 
the situation with rapid implementation, no new comment period, 
no new exposure draft, and no attempt to solicit input. We all 
reacted to this interpretation only to have FASB recently 
decide that private equity funds should not implement FIN 46, 
at least for the time being.
    While we are relieved by this reversal of opinion, we 
believe that a process that solicited input up front would have 
averted this mess. And your suggestion, Senator, of a FASB 
Small Business Committee may have accomplished that. At this 
point, FASB is still determining to whom and how FIN 46 should 
apply, leaving small business investors and the private equity 
firms in a state of uncertainty and confusion.
    The second example is FASB's quest to mandate the expense 
of employee stock options. NVCA has consistently asserted that 
the forced expensing of these options will create a financial 
albatross for U.S. start-up companies, leaving them no choice 
but to negatively alter their critical option programs.
    The FASB agreed that these companies are fundamentally 
different when it passed its current rule, FAS 123, in which 
specific provisions are promulgated for private companies. Yet, 
today, FASB has inexplicably decided to change the rule and 
subject private companies to the same rules as public 
companies. Since the early 1990's, we have implored the FASB to 
identify an acceptable option valuation standard for all 
companies. Otherwise, the option expense number will be 
meaningless to investors and too costly for young companies to 
derive.
    Their response has been to fall back on two old models 
already discussed--Black-Scholes and binomial methods. Both of 
them, the Black-Scholes being tentatively rejected by the FASB 
themselves and the binomial methods being extremely complex and 
even more subjective than Black-Scholes.
    Further, while FASB has acknowledge that it is impossible 
to measure the volatility of a company whose stock does not 
trade, its recent reversal will now require that volatility be 
determined by private companies. We, frankly, cannot comprehend 
FASB's sudden reversal on this issue, as there has been no 
material change in option pricing theory since 1994, and 
determining the volatility of a company whose stock does not 
trade has not become any easier.
    We made these exact points before the FASB board in August. 
A copy of that FASB presentation is part of the record. FASB 
listened and quickly did exactly the opposite of what we were 
saying.
    Both FIN 46 and stock option expensing will not only render 
a small company's financials meaningless, but will also require 
small companies who do not have large accounting staffs to hire 
costly outside experts.
    Further, implementing ill-conceived regulation imposes a 
financial reporting credibility cost that heavily impacts small 
companies. Public company analysts have said that they will 
look through numbers impacted by stock option expensing to a 
company's underlying financials. Yet over 50 percent of Nasdaq 
companies and virtually all private companies do not have 
analyst coverage. Who is going to look through their numbers?
    Today, we urge Congress to engage in the discourse so that 
we might avoid serious consequences. Specifically, we believe 
that Congress has a role in reviewing FASB's due process 
system, how FASB determines which businesses will be impacted 
by its rules, how FASB field tests their proposals, and what 
the economic and practical impact of FASB pronouncements are on 
small businesses and the emerging business community as well.
    Thank you very much for this opportunity to speak to you.
    Senator Enzi. Thank you, and thank all of you for your 
excellent testimony and for summarizing your remarks. As I 
mentioned before, the full text will be in the record. And I 
have dog-eared all of the testimony and taken some quotes that 
I will be using frequently to make the case among my colleagues 
and on the floor, and they are well-worded and very helpful. I 
learned a lot from it. I still have a few questions, though.
    Mr. Forrestel, Mr. Salg, and Ms. Kenney, how did you first 
find out about FASB's initiatives that were going to affect the 
businesses you work with? How far down the road was FASB on 
these efforts, and did FASB make any attempt to reach out to 
your business or association prior to publishing the proposal 
for comment?
    Mr. Salg, you may proceed.
    Mr. Salg. Mr. Chairman, I found out about FASB 46 about 10 
days ago at the Wendy's convention in Las Vegas from Mary 
Shell, who is in Government Relations, and 2 days later got an 
e-mail from IFA, sent to all members. But certainly I had heard 
nothing about it prior to that. Now, you might consult with 
Wendy's, the franchise, to see when they first heard about it, 
but it certainly was not on my radar screen. I was certainly 
horrified to hear about it.
    Senator Enzi. Thank you.
    Mr. Forrestel. As a CPA, I had heard a bit about FAS 150, 
but we really focused on it at our AGC tax and fiscal meeting 
in June, and it was at that point that we started the process 
of communicating with FASB, and we found them very responsive 
once we specifically asked for a private meeting with them.
    Senator Enzi. Thank you.
    Ms. Kenney.
    Ms. Kenney. In the case of cooperatives, there is a 
technical group within our sector, the National Society of 
Accountants for Cooperatives, who had been following this from 
the beginning and has been commenting. As it became clear that 
FAS 150 was moving forward despite co-op input, other groups 
within the cooperative sector got involved. Notably, the 
National Rural Electric Cooperative Association was actively 
involved in this, and they are one of our members. 
Additionally, NCBA became involved when it became clear that 
FASB was going to move forward with the rule.
    Senator Enzi. Thank you.
    Mr. Forrestel, your dad, who is a businessman like mine, 
was probably very proud when you became an accountant.
    Mr. Forrestel. Probably not. He wanted me to be an 
engineer.
    [Laughter.]
    Senator Enzi. There are some interesting parts to being in 
a business that your dad has some knowledge of. I know that 
from experience.
    Mr. Glassman, how do you feel about FASB being required to 
take into consideration the economic effects of accounting 
standards on small business?
    Mr. Glassman. That is a good question. My position is I 
think that Congress should take those issues into effect. I am 
not sure whether FASB is competent to take economic issues into 
effect, but clearly there is an economic impact to what it 
does--not everything it does, but absolutely in FAS 123, and I 
think it is incumbent on the Senate and the House to exert its 
will here and should not be shy about it. I know there is all 
of this talk about the independence of FASB. I really think it 
is your responsibility because you have a much broader purview 
to say this is going to have an economic effect and do what you 
can.
    Senator Enzi. As I mentioned before, I was pleased that in 
their precepts they listed that economic effect as one of the 
precepts that they are supposed to take a look at. As 
accountants, we are concerned about their independence, but it 
has occurred to me that independence is a lot like freedom. It 
has to be earned, and that is one of the reasons we are looking 
at this issue, to see how earned the independence is, but I 
appreciate your answer.
    Ms. Kenney, how difficult is it for the small cooperative 
businesses to participate in the FASB drafting process for the 
accounting standards? Should FASB be required to do outreach to 
the small businesses prior to the draft proposal or 
interpretation that is put out for public comment? What is your 
feeling about the process for involving the cooperatives?
    Ms. Kenney. I think it is really critical that, in 
particular, cooperatives, but of course all small businesses, 
be a community that FASB actively reaches out to. As small 
businesses, in most cases, even the trade associations 
representing them do not have the resources at their disposal 
that a Fortune 500 company might have, say, to retain 
accountants who track everything that FASB does.
    So, I would like to see FASB reach out actively and include 
cooperatives, credit unions, and other small businesses in 
their process for both identifying emerging issues and 
addressing them.
    Senator Enzi. Did you feel that their statement here today 
about having a Small Business Advisory Committee might solve 
some of these problems?
    Ms. Kenney. Yes. I think that would be an excellent idea, 
and I look forward to working with them to include co-ops in 
it.
    Senator Enzi. Thank you.
    Mr. Moore, I do appreciate your being with us today and for 
filling in for Mr. Levine. Please give him our regards and 
hopes that he recovers from the flu very soon. I am sure that 
he is more concerned about that even than we are.
    The question is, if FASB stock option expensing proposal 
were in place today, what effect would it have on Genentech and 
others like that? Would they have gotten off the ground?
    Mr. Moore. It would have a profound effect at Genentech, 
since we obviously give broad-based stock options. I am more 
concerned about the 60 small biotechs that surround Genentech 
who have been recruiting Genentech employees and other 
scientists from Stanford, UCSF, and the other local 
universities.
    As Mr. Glassman said, they do not have much money, and one 
of the success traits is to hoard their money and give a piece 
of their company.
    While Genentech will survive whatever happens on FAS 123, I 
do worry about companies like Tularik, Theravance, names that 
you have never heard of that are in South San Francisco near 
us, small businesses that without stock options are not going 
to be able to recruit either Genentech employees, with the kind 
of expertise that they need, or academics from our surrounding 
community.
    Senator Enzi. Thank you.
    With that lead-in, Mr. Heesen, what effect do you think the 
stock option expensing is having on initial public offering 
market right now? What effect particularly is it having on 
small businesses who are considering using options?
    Mr. Heesen. Right now, because you are still able to 
expense, I do not think that has been a direct impact on 
companies presently because you can either expense or you can 
elect to simply disclose, and so venture-backed companies are 
disclosing. They are not like Coca-Cola who have decided to go 
out and expense.
    Having said that, the real concern we have is that if 
companies are forced to expense, it is going to take a much 
longer time for those companies to be able to be attractive in 
the public market, which will mean that venture capitalists 
will have to spend a lot more time with those companies, which 
means that they will have less time to put money and talent 
into new companies so that there will be fewer new venture-
backed companies being created in the long-term, and those 
companies that are on the cusp of going public will not be able 
to do so because their financials will suddenly look very 
different than they were looking 2 days before.
    Senator Enzi. Thank you.
    Mr. Glassman and Mr. Heesen, can you give me a little bit 
of a feel for what the ramifications for U.S. small businesses 
will be when they are bound by more stringent accounting 
standards than businesses located overseas, what kind of a 
comparative--that is supposed to be under the precepts looked 
at as well, but what would be the effect as you see it?
    Mr. Glassman. Well, I think it should have a serious 
effect, and we are already beginning to see it. As I said in my 
testimony, and as I said further in my written testimony, there 
is a difference in the way that many Asian countries treat 
stock options, and there is not the political pressure against 
stock options that there is in this country. And as a result, 
there is at least anecdotal evidence that many American-trained 
scientists are going to countries in Asia because they are 
being recruited by companies that are offering them very 
lucrative stock options, which makes sense.
    That is how Silicon Valley recruited engineers from Route 
128 in Boston. It took them a long time in Boston to catch on 
to what was going on, and now the same thing is happening in 
Asia. So it would certainly get a lot worse if we began to 
expense stock options with the result that fewer companies in 
this country would issue stock options. That seems to be what 
almost everyone agrees with. And with other countries still 
offering them, you are going to get the best, the brightest, 
and the most motivated. These are the people who are attracted 
by stock options.
    Senator Enzi. Mr. Heesen.
    Mr. Heesen. I think that FASB talks a lot about 
international harmonization and that we should have the same 
accounting standards as, and normally it is European accounting 
bodies, be it England or France. They do not talk about China 
and India. China and India are not going to suddenly say we are 
going to change our accounting for stock options if they see a 
powerful incentive to get Americans to start moving to China 
and India. There is no question in my mind about that.
    Entrepreneurs are not jumping to go to France and England, 
frankly, but they will go to India and China to get those 
options and make a new life, and they are doing it actually 
right now.
    Senator Enzi. Thank you. My time has expired.
    Senator Allard.
    Senator Allard. Thank you, Mr. Chairman.
    Ms. Kenney, there are a number of accounting alternatives I 
think available to co-ops, perhaps more than just the average 
small business that might be out here. If, for some reason or 
another, you find options something that you cannot offer, what 
other incentives might you use in co-ops to attract good 
employees?
    Ms. Kenney. That is a very good question. Because co-ops 
are not publicly traded companies, they do not issue stock 
options, and frankly that is one of the characteristics I think 
that has helped keep co-ops relatively free of the Enron-
related scandals. There are a couple of types of incentives 
stock options can produce.
    I believe that for retention of co-op employees, obviously 
competitive salary compensation is critical. Co-ops also offer 
tremendous benefits, both in terms of health and retirement 
benefits. But retaining and recruiting employees to the 
cooperative sector is not a simple issue, and I think it is 
certainly one that the cooperative sector is working to address 
because we do not have some of the financial wherewithal that 
other companies might have to attract certain candidates.
    However, employees of cooperatives I think are attracted to 
the community-based nature, the community commitment that co-
ops embrace as part of the principles under which they do 
business.
    Senator Allard. Now, in a co-op, everybody owns an interest 
in the business.
    Ms. Kenney. Correct.
    Senator Allard. The way you use, for lack of a better 
word--call them options or that type of instrument--is that 
available to everybody, in a way, or is it just offered to your 
better employees--how is that handled?
    Ms. Kenney. Some co-ops are jointly owned by their members, 
that is, the people who use the goods or services of the co-op, 
and by their employees. That is relatively rare. Most co-ops 
are not able to issue options to their employees because there 
is no stock in the company that is publicly traded or valued in 
that way.
    So the only beneficiaries of a co-op's value are the equity 
holders, which are the members of the cooperative themselves. 
And in the case of your State, certainly that includes many 
electric co-ops serving rural consumers.
    Senator Allard. Mr. Salg, you have several restaurants that 
are incorporated, and then my understanding is that then that 
corporation is a member of a larger franchise; is that the way 
that works?
    Mr. Salg. That is correct.
    Senator Allard. In your restaurants, do you try and 
establish a value for each one of those restaurants and then 
bring that value into the corporation or the five Wendy 
restaurants that you have, do you consider them as one entity 
when you are doing your accounting?
    Mr. Salg. When we do our accounting, we consolidate into 
one entity.
    Senator Allard. Into one entity.
    Mr. Salg. Yes.
    Senator Allard. Do you and other members of the franchise, 
you have options that are available to just the officers in 
your corporation or are they available to the managers of the 
restaurants and the employees, also?
    Mr. Salg. Well, since we are not a publicly traded 
corporation, the way we handle that aspect of our business is 
to have a profit-sharing plan for all of our employees, 
regardless of the level, into which we put 10 percent of our 
pretax budget and anything that we are over budget.
    So stock options really are not going to affect my 
business, but I can tell you that Wendy's International, who 
also operate 1,200 restaurants of their own, have a program 
called We Share, where every employee, whether he is flipping 
burgers or carrying out the trash or the manager has a shot at 
getting options in Wendy's stock. And I am only guessing, 
because I am not an accountant, that this ruling could have a--
those are the people, my guess is, that would get dropped out 
of the program first.
    Senator Allard. I see.
    Mr. Salg. It wouldn't the senior VP's.
    Senator Allard. Now, the corporation that you have itself 
does not own options.
    Mr. Salg. No.
    Senator Allard. But each individual employee--so it is not 
an accounting problem, as far as your corporation is concerned.
    Mr. Salg. If you are speaking of Wendy's International, I 
think it could be a problem.
    Senator Allard. No, I am talking about your----
    Mr. Salg. QSC Restaurants, Inc.?
    Senator Allard. Yes.
    Mr. Salg. No, it is not a problem.
    Senator Allard. It is all individual.
    Mr. Salg. Yes.
    Senator Allard. So as far as the corporation being part of 
this whole franchise, you are comfortable with the type of 
disclosure and public information, and I assume that all of the 
franchisees understand the impact of options? I am also 
assuming they own stock, and if somebody exercises an option, 
it comes out of the profits on the stockholders' side, and I am 
sure they understand all of that, and your franchisees 
understand that aspect of it?
    Mr. Salg. I think that they do. I happen to own some 
Wendy's stock, and my accountant tells me I have enough 
invested in Wendy's, but----
    Senator Allard. Diversify.
    [Laughter.]
    Mr. Salg. But of course I know them, personally, and I 
trust them. I think they are good people. But I think somebody 
has to watch, and these guys know a lot more about stock 
options than I do because that is not the way I make my living.
    What you have heard here from a lot of these people that 
concerns me, as a guy from out in the sticks, is why don't they 
talk to people like us before they draft this stuff? I mean, if 
somebody had--not me, somebody like me--come in and said, what 
kind of problem would you have consolidating your financial 
statement under FAS 46, consolidating your statement with 
Wendy's International, they would have gotten an earful real 
quick.
    I mean, number one, from a timing standpoint, heck, my 
partner's wife and I do the accounting. It takes us 10-15 days 
to get a statement out at the end of the period, but now you 
want us to send it down to an auditor. I mean, how fast can 
that get done by over 500 individual Wendy's franchisees across 
the country, and get into Columbus, Ohio, and get put into some 
kind of a meaningful order in any kind of a timely fashion? 
Forget the fact that my franchise agreement with Wendy's 
International, which I have had for 20 years, does not require 
me to send my financial information, other than some 
verification of my sales, to Wendy's.
    Believe it or not, there are going to be some guys out 
there who say, ``Stick it in your ear,'' when they are asked 
for their financial information. You cannot require me to send 
it to you.
    So, I mean, why didn't somebody talk to people prior to 
this happening and find out what the practical applications of 
this are? Just speaking as a guy from outside, you know, out in 
the ``toolies.''
    Senator Allard. Thank you for your comments.
    Mr. Moore, in the growth of your company, do you think that 
there would have been other options available than other than 
going with your options, I mean, other solutions? Let me put 
the question this way. Are there other solutions that you could 
have used to attract employees, other than just options that 
you think could have been as effectively?
    Mr. Moore. Certainly, there are other options to giving 
employees stock options. The question is, as a start-up 
biotech, what kind of people can we afford on a straight-pay 
basis? We certainly could not afford the kind of science we got 
out of the scientists we hired. The innovation that Genentech 
came up with, and continues to come up, I would submit is the 
basis of top scientific minds that, quite frankly, we could 
have never afforded 25 years ago, barely afforded 10 years ago, 
and are just beginning to afford today.
    So what you have is a lot less innovation out of our firm, 
and multiply that 60 times by the small companies that surround 
us, and that is a lot of noninnovation in life sciences that I 
think we are all counting on in terms of serious unmet medical 
need today. And I do not see another way to generate it because 
there is not enough money except with options moving out.
    Senator Enzi. Thank you.
    I see my time has expired, Mr. Chairman.
    Senator Enzi. Thank you.
    I want to thank all of our witnesses for appearing before 
us today. You did an outstanding job. There does appear to be 
some significant communications and process problems in FASB 
reaching out to and the consideration of small business 
concerns in the establishment of accounting standards.
    I applaud FASB's commitment today to establish a Small Firm 
Advisory Committee to work with FASB and FASAC on small 
business concerns. I think that will take care of quite a few 
of the problems at least early enough that small business can 
be a bigger voice in making sure that what works for big 
business also works for small business.
    Small businesses should not have to initiate eleventh-hour 
campaigns to get their concerns heard.
    I mentioned earlier that I received many calls from 
associations who had businesses who wanted to testify at this 
hearing. It is probably just as important to mention that every 
single one of those that called that wanted to be here all had 
the same approach that this panel did. There was not anyone 
from the other side, if there is another side.
    I think that is very significant, that all of them were 
concerns very similar to what you have given today. It is only 
my regret that we were not able to get the details from 
everyone because, in each of the presentations, there were some 
parts that will be very significant that hopefully FASB will 
listen to and that all of us will be able to use.
    I thank you very much for your time. The hearing record 
will be open for 10 days in order to accommodate Members' 
statements and also the opportunity to give you some additional 
questions in writing, which I hope you will respond to. While 
you are doing that, if you have any other thoughts that we 
should have, if you would submit those as well, I would 
appreciate it.
    Today, America's community bankers, engineering, 
contracting, financial executives all submitted testimony as 
well, and I appreciate and will try to attribute the quotes 
from each of you as I use them over the next few days, weeks, 
and months.
    Thank you all very much. The hearing is adjourned.
    [Whereupon, at 4:41 p.m., the hearing was adjourned.]
    [Prepared statements, response to written questions, and 
additional material supplied for the record follow:]

               PREPARED STATEMENT OF SENATOR JIM BUNNING

    Mr. Chairman, I would like to thank you for holding this hearing 
today. I would like to thank all of our witnesses for testifying.
    I have been very concerned with the reports that I am hearing 
regarding the Financial Accounting Standards Board or FASB. We have 
many small businesses here today that will tell us that FASB does not 
listen to them or take their opinion into account. We also have many 
large corporations telling us the same thing.
    This is very disturbing to me. If FASB is not going to follow their 
own procedures that call for public input and make a decision before 
the comment period has even begun, why have a comment period? Why even 
invite input from the industries and businesses affected if FASB's 
decision is a foregone conclusion? It is a waste of time for everyone 
involved if FASB is simply going to go through the motions on a comment 
period.
    I certainly respect the independence of FASB. I want them to 
continue to be independent. I think it is a very bad idea if Congress 
gets involved in telling private boards what to do. I think it is an 
even worse idea to have Congress legislating accounting standards. But 
FASB is proposing things that may harm our economy. If Members of 
Congress think FASB is going to harm our economy, they will be forced 
to act. This a bad idea, and it sets a terrible precedent, but many may 
feel they will have to for the good of our Nation's economy. I am 
pleading with FASB, do NOT force Congress to act. Listen to the people 
affected, do not just go through the motions, and make arbitrary 
decisions. We do not want to get involved. And believe me, you do not 
want us to be involved, so do not force us to get involved.
    A few years ago, there was a large controversy about the pooling 
accounting method and whether or not it should be done away with. This 
Committee held a roundtable with FASB and those affected. Both sides 
realized there was some common ground. They got together and worked out 
a solution that everyone could live with. I would respectfully suggest 
that FASB could solve a lot of the controversies they face right now by 
following the pooling example. Please sit down with an open mind with 
those who are affected by your rules and see if you can come up with a 
solution that both FASB and the industry can live with.
    I am very happy that FASB has always taken its job of being the 
police for accounting standards seriously and I am glad they have 
renewed that commitment after Sarbanes-Oxley. But any cop on the beat 
will tell you, you are a much more effective policeman if you can work 
things out amongst disputing parties. The most effective cops do not 
feel the need to arrest everyone.



                  PREPARED STATEMENT OF PETER A. SALG
           President, QSC Restaurants, Fort Collins, Colorado
          On Behalf of the International Franchise Association
                           November 12, 2003

    Chairman Enzi, Senator Dodd, Senator Allard, other Members of the 
Subcommittee, thank you for opportunity to testify before you on the 
impact the Financial Accounting Standards Board (FASB) has on small 
business growth.
    As you know, my name is Pete Salg. I have worked in franchising 
since 1968, doing everything from running a restaurant, to running a 
franchisor with 450 units. Today, I am a small franchisee. My company, 
QSC Restaurants, Inc. owns five Wendy's restaurants in Colorado.
    I will be testifying today on behalf of the International Franchise 
Association (IFA), which represents franchisees, franchisors, and 
others in the franchise community. In the 44-year history of the 
organization, there has been a clear and constant effort to promote 
entrepreneurship for all sectors of American society.
    I will be focusing my comments on the impact of FASB FIN 46 on the 
small franchisee, but I also want to make sure you know that the great 
majority of franchisors are small businesses too. The typical 
franchisor has less than 200 units and revenues of less than $5 
million. I will mention some of the hardships they face as a result of 
FIN 46 as well.
    If FIN 46 goes into effect as written, here is what it could mean 
to franchisees like me:

 We would have to have audited financial statements. This is 
    not required currently and would be very expensive. It is not 
    required currently because it does not make sense to require it for 
    two reasons: one, Wendy's has no contingent liability, and two, 
    mine is not a public company!
 We might be required to use the same outside auditor as their 
    franchisor. This is not an explicit requirement of FIN 46, but if 
    my franchisor's auditors say they will only be comfortable if my 
    statements are prepared by their own people, Wendy's is left with 
    little choice and neither am I. This requirement will hit the 
    single-unit franchisees the hardest. Needless to say, not every mom 
    and pop small business can afford PriceWaterhouseCoopers or KPMG.
 We would also be required to adhere to the franchisor's 
    internal accounting standards. Franchisees like me have made 
    enormous investments--enormous at least in relation to my 
    business--in the way they have decided how best to create their 
    financials. Wendy's P&L Statement does not look like my P&L. We 
    both have good business reasons why they look the way they do and 
    there is no reason they should look the same.
 We would have to develop a system to provide internal control 
    reports to franchisors and adhere to internal control dictates of 
    the franchisor's auditor. I can understand why the franchisor would 
    want this since the CEO and CFO are on the hook for criminal 
    penalties provided for in Sarbanes-Oxley, but why on earth should a 
    small operator have to institute an extensive internal control 
    system? An individual Subway sandwich shop that probably grosses 
    under $400,000 is not the same as IBM and should not be treated as 
    such. This unintended consequence of FIN 46 is pure overkill.

    Now let us look at the impact on small franchisors.
    Typically, franchisors generate all of their revenue from royalties 
paid by the franchisee and that royalty is usually around 5 percent of 
sales. When you read about a franchise company you often see reports in 
the media about their system-wide sales figures. For example, if a 
franchisor with 100 percent franchises has system-wide sales of $100 
million dollars, that sounds impressive. But what it means is that the 
franchisor probably has an annual income of around $5 million--5 
percent of $100 million. Of the 1,500 franchisors in the United States, 
probably half have annual incomes of $5 million or less. So it is 
important to remember that not just franchisee--but also most 
franchisors--are very small businesses.
    This hearing is about the impact on small business growth and it is 
hard to think of something more stifling to growth than FIN 46.
    If you have a successful small business and you are thinking of 
ways to expand, franchising is a great method for a lot of people. You 
share your brand and operating plan with others willing to invest their 
money to start a franchise and you both can profit while your brand 
takes off.
    FIN 46 makes franchising much less appealing. First of all, it just 
got a lot more expensive to be a franchisee. As I described earlier, 
you have to have audited statements done by an expensive firm, 
acceptable internal controls systems, etc. etc.
    Second, your freedom to operate your franchise just got more 
limited. I have chosen to operate my restaurants the Wendy's way--the 
menu, the appearance of the store, the quality of the food--things like 
this must be standardized across the system so that you the customer 
knows what you are going to get when you walk into any Wendy's in the 
country. This consistency is critical to my success.
    On the other hand, I am an independent businessman. I decide how to 
set up my business. I decide whether it is a company, a partnership, or 
an S Corp, and I decide who my lawyer and accountant are. I decide on 
what capital expenditures I make and I decide on product pricing. 
Furthermore, I decide who to hire and fire, what salaries and benefits 
to offer, and what pension plan to set up. I make decisions that 
directly affect the bottom line. There are reasons that some franchises 
within a system fail and others succeed and the biggest one is the 
abilities of the franchisee.
    So, in deciding whether franchising is the way to go, some 
prospective franchisees will find the level of intrusion called for in 
FIN 46 more than they can live with.
    This is a very serious threat to franchising. I was an employee of 
a franchisor for decades, but I chose to become a franchisee because of 
the freedom to be an independent businessman and to build my family's 
future security through owning my own business. My restaurants do 
better than other restaurants because they are mine. My success is the 
direct result of my ability to run my operation as I see fit. If FIN 46 
had been in effect when I made my decision to become a franchisee, I do 
not think I would have made the leap. That is another problem with FIN 
46. When and if I want to sell my business one day, there will be fewer 
prospective buyers and that will lower the value of my business.
    Looking at another example, suppose you are a publicly traded 
company with hundreds of units. First of all, you have the flip side of 
all the problems facing franchisees I mentioned earlier. For example, 
you have to convince hundreds of independent business people to hire 
expensive firms to audit your financials and develop internal controls, 
and you have to convince them to give you a lot of financial 
information they have not had to. You also have the Sarbanes-Oxley 
problem I mentioned earlier. You may want to sell out just to avoid the 
headaches.
    I know that the mission of FASB is to improve financial reporting 
so that the public is protected and I know that FIN 46 is supposed to 
prevent shady Enron-style arrangements. The entire franchise community 
supports this vital goal.
    But I can not understand how FASB could come to the conclusion that 
the only way to prevent another Enron is to hobble a way of doing 
business so important to our economy and job creation. To make matters 
worse, I do not think FIN 46 even accomplishes FASB's goal of improved 
financial reporting when it comes to franchising. If FIN 46 results in 
a franchisor consolidating the financial results of its franchisees, 
FIN 46 may reduce financial statement transparency and clarity, as well 
as confuse investors who are not familiar with how franchisors and 
franchisees work together and how real it is that a franchisor's 
financial results are not one and the same with its franchisee's 
results.
    For example, for the income statement, this means no longer 
including franchise royalty revenue, but instead essentially grossing-
up the franchisor's income statement for the franchisee's results of 
operations and then eliminating their combined impact on the 
franchisor's income statement through an adjustment to ``minority 
interest.''
    For the balance sheet, this means consolidating a franchisee's 
assets and liabilities, including, as an example, the franchisees' 
debt, even though the franchisor has no legal obligations associated 
with the debt. Amounts owed to the franchisor would be eliminated in 
consolidation.
    Additional disclosure would be needed to explain the consolidated 
financial results--disclosure necessary not only to provide better 
information, but also necessary to provide clarity to allow financial 
statement users to understand the consolidated financial statements 
presented and distinguish between the economic benefits and risks 
inuring to the franchisor and those not.
    Due to the different business models of franchisors and 
franchisees, the transparency of the franchisor's financial position 
and results of operations often can be dramatically altered. Consider 
the example of a 100 percent franchised system that collects a 5 
percent royalty from franchisees. If the franchisees were to be 
consolidated, the franchisor would report a twenty-fold increase in 
sales (net of eliminated royalty income) materially distorting the 
franchisor's revenues, gross margin and expenses. Further, note that 
while the franchisor would gross up the income statement revenue and 
expenses by a factor of twenty, the franchisee net income would be 
entirely eliminated as minority interest such that the franchisor's net 
income would be the same before and after consolidation. A reader of 
the financial statements might ask whether this results in greater 
clarity and understanding of the operations of the franchisor.
    In fact, there has been a longstanding concern expressed by the 
Securities and Exchange Commission (SEC) staff, about the use of 
``system wide sales'' information (for example, combining franchisee 
sales with franchisor company sales) in ``selected financial data'' and 
``management's discussion and analysis'' as being potentially 
misleading.
    In other words, FIN 46 is going to make me and a lot of other 
people in the franchising world jump through a lot of hoops and pay a 
lot of money with zero benefit to the public.
    Clearly, FASB has not sufficiently understood the implication of 
their proposal. They apparently have not been listening to small 
business concerns, or to big business concerns for that matter.
    I was surprised to see FASB acknowledge in the October 31 exposure 
draft that, ``[t]he Board's assessment of the benefits and costs of 
clarifying and modifying Interpretation 46 was based on discussions 
with preparers and auditors of financial statements and on 
consideration of the needs of users for more consistent application of 
that Interpretation.''
    It does not seem that real business people like me were consulted 
on the costs as well.
    In conclusion, thank you for holding this hearing. This experience 
has been a real eye opener for me. I am certain there are not very many 
small franchisees like me that would ever have thought that FASB could 
do something like this that could have such a devastating impact on our 
businesses. I consider myself to be a pretty sophisticated franchisee, 
but I do not think I would have heard of FIN 46 in time had it not been 
for the International Franchise Association.
    FASB needs to better understand that the rules they set are not 
just academic exercises. Those rules have real life consequences and 
FASB needs to understand what those consequences are and take them into 
account before they act.
    IFA and its 30,000 members stand steadfast in their opposition to 
the current iteration of FIN 46 and urge the Subcommittee to take 
appropriate action.
    I would be happy to answer any questions you have.
    Thank You.

                               ----------
                PREPARED STATEMENT OF JAMES K. GLASSMAN
             Resident Fellow, American Enterprise Institute
                           November 12, 2003

Introduction
    The determination of the Financial Accounting Standards Board to 
require mandatory expensing of stock options by U.S. firms threatens to 
harm small businesses and imperils the fragile economic recovery. The 
FASB's self-stated mission is to improve accounting standards. I do not 
believe that its proposed expensing of options achieves this aim, but, 
even if it did, you as policymakers have a more comprehensive mission 
than the FASB. Your concerns include improving the economy and 
increasing job opportunities.
    In the testimony that follows, I review the importance of small 
business, the key role played by stock options, and the potential 
damage that the expensing of options will do to businesses, jobs, and 
the economy. One inevitable result will be to send U.S. jobs offshore. 
I urge you to rein the FASB in by acting immediately to delay 
implementation of new standards on options.
    Accounting rules may seem arcane and boring, but they are far too 
important to be left in their entirety to an unelected board in 
Norwalk, Connecticut.
Small Business and Stock Options
    Small business is the engine that drives the U.S. economy. 
Businesses with fewer than 500 employees represent 99.7 percent of all 
American firms, employ more than half of private-sector employees, 
create more than half of private gross domestic product and, perhaps 
most important at a time of economy recovery, create 60 percent to 80 
percent of net new jobs annually.\1\ According to the most recent data, 
in 1999-2000, ``small businesses created three-quarters of U.S. net new 
jobs (2.5 million of the 3.4 million total).'' \2\
---------------------------------------------------------------------------
    \1\ Small Business Administration, ``Small Business by the 
Numbers,'' online publication updated May 2003: http://www.sba.gov/
advo/stats/sbfaq.pdf.
    \2\ Ibid.
---------------------------------------------------------------------------
    Small businesses, moreover, grow to large businesses. For example, 
Microsoft, started in Bill Gates' garage, began with two employees as a 
partnership in 1975 and now has 47,000 employees, 118,000 shareholders, 
and $282 billion in stock market value.\3\
---------------------------------------------------------------------------
    \3\ Value Line Investment Survey, Aug. 29, 2003, p. 2207; Yahoo 
Finance; Microsoft Corp. annual report, 2003, Form 10-K, p. 17.
---------------------------------------------------------------------------
    Three of the key ingredients in the success of small businesses are 
attracting a talented and motivated workforce, limiting compensation 
outlays, and conserving cash during their early years of growth.\4\ 
Over the past 10 to 15 years, small businesses, as well as large, have 
turned to employee stock options as a reasonable means to achieve 
success:
---------------------------------------------------------------------------
    \4\ A survey by the National Federation of Independent Business 
asked respondents to list problems in order of importance. Ranking 
third (after health insurance and Federal taxes) was ``locating 
qualified employees.'' Ranking seventh, out of more than 70 listed 
problems, was ``workers' compensation costs.'' Ninth was ``cashflow.'' 
See http://www.nfib.com/cgi-bin/NFIB.dll/Public/SiteNavigation/
home.jsp.
---------------------------------------------------------------------------
    Stock option plans give executives a greater incentive to act in 
the interests of shareholders by providing a direct link between 
realized compensation and company stock price performance. In addition, 
offering employee stock options in lieu of cash compensation allows 
companies to attract highly motivated and entrepreneurial employees and 
also lets companies obtain employment services without (directly) 
expending cash. Options are typically structured so that only employees 
who remain with the firm can benefit from them, thus also providing 
retention incentives.\5\
---------------------------------------------------------------------------
    \5\ Brian J. Hall and Kevin J. Murphy, ``The Trouble With Stock 
Options,'' Journal of Economic Perspectives, vol. 17, no. 3, Summer 
2003, p. 49.
---------------------------------------------------------------------------
    It is evident that the use of options is critical to smaller, 
early-stage businesses and that the use of options has broadened and 
deepened.\6\ For example, top managers and employees below the top five 
executive officers in 2002 received more than 90 percent of the total 
value of options granted--up from less than 85 percent in the mid-
1990's. Both ``Old Economy'' and ``New Economy'' firms issue options. 
For Old Economy firms, the average grant-date value of options per 
employee (below the top five executives) went from $522 in 2001 to 
$2,856; for financial firms, from $1,007 to $5,562; for New Economy 
firms, from $1,684 to $18,882. (All of these figures are adjusted for 
inflation, using 2002 constant dollars). \7\
---------------------------------------------------------------------------
    \6\ For a good overview of the subject, see Josph Blasi, Douglas 
Kruse and Aaron Bernstein, In the Company of Owners (Basic Books, 
2003).
    \7\ Hall and Murphy, op. cit., pp. 51-52.
---------------------------------------------------------------------------
    High-tech companies are not alone in relying on stock options to 
motivate their workforces. One of the great options success stories, 
for instance, comes from Staples, Inc., the office supply chain, which 
was launched in 1986 with a single store in Brighton, Mass., and now 
has 1,500 stores worldwide and employs 58,000.\8\
---------------------------------------------------------------------------
    \8\ Value Line Investment Survey, Oct. 17, 2003, p. 1151; 
www.staples.com.
---------------------------------------------------------------------------
Expensing Options Would Reduce Issuance of Options
to Lower-Level Workers
    Unfortunately, the FASB is moving quickly to change an accounting 
rule in order to require mandatory expensing of stock options on 
corporate income statements issued under generally accepted accounting 
principles (GAAP).
    Such a change, it is widely agreed, would cause a significant 
reduction in the issuance of stock options, especially to employees 
below the top five corporate officers. For example, America's best-
known venture capitalist, John Doerr, said in testimony he that thought 
``broad-based employee stock ownership . . . will disappear if 
expensing is mandated.'' \9\ A study by consultants at Mellon's Human 
Resources & Investor Solutions also found that companies intend to cut 
back significantly on options programs for employees below the top 
executive level if expensing is enacted.\10\ A review of the economic 
literature by Brian J. Hall and Kevin J. Murphy concluded that 
``parties on both sides of the debate agree that such a change 
[expensing stock options] would result in granting fewer options, 
especially to rank-and-file workers.'' \11\ Dozens of chief executive 
officers have publicly stated that their firms will reduce or eliminate 
options if expensing is enacted. Typical is the CEO of Advanced Fiber 
Communications, which stated in a letter to the FASB: ``The expensing 
of stock options would likely require AFC to discontinue its broad-
based stock option plan that helps us to retain and motivate our 
employees.'' \12\
---------------------------------------------------------------------------
    \9\ Committee on Banking, Housing, and Urban Affairs, U.S. Senate, 
May 8, 2003; transcript at p. 55. Mr. Doerr has been a partner in the 
firm of Kleiner, Perkins, Caulfield & Byers since 1980. The firm has 
sponsored investments in such companies as Compaq, Cypress, Intuit, 
Macromedia, Lotus, Netscape, Sun Microsystems, and Symantec, which have 
led to the creation of over 30,000 jobs.
    \10\ Mellon, ``SFAS 123: Responding to Mandatory Option 
Expensing,'' September 2003 survey, p. 9.
    \11\ Hall and Murphy. op. cit., p. 68.
    \12\ FASB Comment Letter No. 185. See also many others (Staples, 
Altera, Genentech, etc.), including, poignantly, FASB Comment Letter 
No. 29 from Vermont Teddy Bear Company: ``If options are expensed, I 
can tell you that a small company like the Vermont Teddy Bear Company 
will no longer grant them.''
---------------------------------------------------------------------------
    It is reasonable to predict that, without the incentive tool of 
stock options, many of America's most innovative firms--small 
businesses and large, in technology and nontechnology industries--will 
suffer declining productivity, with dangerous consequences for national 
competitiveness, growth, and employment.
Talented Workers Will Move from United States to Asia
    Already, the consequences are becoming apparent. In an article in 
Barron's last summer, George Chamillard, the CEO of Teradyne, a Boston-
based maker of automatic test equipment for the electronics industries, 
wrote that one major factor in the ``flight of the semiconductor 
industry from Route 128 [in Massachusetts] to Silicon Valley'' was 
``stock options.'' Bay Area start-ups ``were romancing East Coast 
talent with the opportunity to strike it rich through options . . . 
Stock options were a low-cost way to draw talent away from mature 
companies and into start-ups. In return for assuming higher risk, the 
options-givers offered the recruit the chance for high rewards through 
equity ownership and a piece of the action. Best of all, the cost did 
not hit the P&L--an important point, since there usually were little or 
no profits in the early years of a start-up . . . Other industries 
learned the lesson well, using options to drive new companies and 
inject excitement into older ones.'' \13\
---------------------------------------------------------------------------
    \13\ ``Go West Again? Lured by Stock Options, Techland's Best and 
Brightest Moved to California; Next Stop, Asia?'' Barron's, July 21, 
2003.
---------------------------------------------------------------------------
    Now, writes Chamillard, the next cycle of ``Go West, Young Man'' 
has begun. ``While options are under attack in the United States, 
elsewhere the stock option as a recruiting tool is on the rise.'' 
Options are drawing scientists from the United States to Asia--Taiwan 
in particular. As a result, says Chamillard, the United States is 
losing ``engineers educated at MIT and Stanford and CalTech.'' \14\ 
Asian nations understand the attraction of options, and they do not 
have the same taste for the fetish of expensing options as American 
regulators. In its 2001-2005 5-year plan, China officially encourages 
the use of stock options to motivate managers.\15\ A recent study by 
the consulting firm Towers Perrin found that, with the exception of 
Singapore, ``stock options still remain companies' most popular long-
term incentive for their executives.'' \16\ So, where did the fetish 
for expensing options--which, at a critical time, imperils U.S. small 
businesses and the economy as whole--come from?
---------------------------------------------------------------------------
    \14\ Ibid.
    \15\ Five-Year Plan of the People's Republic of China. (2001-2005)
    \16\ Agence France Presse, Sept. 24, 2003. http://
asia.news.yahoo.com/030924/5/singapore49820.html
---------------------------------------------------------------------------
Background
    An option is literally a choice. The owner of a fixed stock option 
has the choice of purchasing shares at a fixed time in the future at a 
price that was fixed at the date it was granted. Often, that price is 
the market price at the date of the option grant. Therefore, if, by the 
time of the exercise date, the stock rises above the price at which it 
was granted, the owner of the option will exercise the option, purchase 
the stock, then either sell the stock at a profit or hold it for a 
longer period. It is easy to see how such options help align the 
interests of managers with those of shareholders, whose main concern is 
that the value of their stock increase.
    Encouraging management to adopt a shareholder-orientation became a 
major concern in the 1970's when managers, who typically owned little 
stock, were criticized for using corporate assets for their own benefit 
and paying scant attention to the interests of institutions and 
individuals who were the actual owners of their companies. Options 
helped change that situation, and they played a key role in the 
economic revival in the United States that began in the early 1980's 
and has lasted, on an unprecedented scale, for two decades. 
``Options,'' as two distinguished economists recently wrote, ``are 
needed to ensure compatibility of the interests of stockholders and 
management, whose divergence has recently been so dramatically 
demonstrated.'' \17\
---------------------------------------------------------------------------
    \17\ ``A false cure for the ills of stock options,'' by William 
Baumol and Burton Malkiel, Financial Times (London), April 3, 2003.
---------------------------------------------------------------------------
    The controversy over the accounting treatment for stock options 
goes back more than 30 years. In 1972, the Accounting Principles Board 
issued Opinion No. 25, which stated clearly that no compensation 
expense need be recognized for fixed stock options granted to employees 
``because of the concern that stock options could not be reliably 
valued at the exercise date.'' \18\ As the use of such options 
increased, the FASB in 1984 began to reconsider the earlier ruling by 
its predecessor.\19\
---------------------------------------------------------------------------
    \18\ Dechow, P., Hutton, A., and Sloan, R., ``Economic Consequences 
of Accounting for Stock-Based Compensation,'' Journal of Accounting 
Research, 1996, 1:2, p.2-3.
    \19\ Ibid, p. 3.
---------------------------------------------------------------------------
    As a result, companies today have two choices. They can adopt the 
``fair-value'' method of treating options and record them as an expense 
against earnings in the year in the which the grant is made, or they 
can use the ``intrinsic-value'' method, which discloses the impact on 
net income in footnotes but not as a charge against reported earnings; 
if shares are issued to accommodate the exercise of options, then a 
dilution will occur on that date. Most public companies use the second 
method.
    The FASB, however, has made it clear that it will shortly require 
U.S. companies to adopt ``fair-value'' accounting under FAS 123. The 
problem of valuing the options, however, remains. The FASB acknowledged 
that its proposed standard on stock options ``should not prescribe a 
particular option-pricing model. Rather the objective would be to use 
the option-pricing model that produces the best estimate of fair value 
given all the facts and circumstances.'' \20\ And what is that model? 
Either a Black-Scholes or a binomial model, it appears--both of which 
seriously lack reliability and accuracy.\21\ In other words, the same 
deterrent that prevented the FASB's predecessor from requiring the 
expensing of options in 1972 still exists today: No one can place an 
accurate value on them.
---------------------------------------------------------------------------
    \20\ Financial Accounting Standards Board User Advisory Council 
Meeting, Attachment 2, Memorandum on ``Equity Based Compensation,'' 
FASB User Advisory Council, Oct. 7, 2003, p.1.
    \21\ Many statements attest to this fact. See, for example, 
criticism of Black-Scholes (``it is crazy to use Black-Scholes'') by 
Warren Buffett, the Chairman of Berkshire Hathaway, Inc., in Andrew 
Hill, ``Buffett and Munger--In Their Own Words,'' Financial Times, May 
2003. Also, the investment firm Warburg Pincus advised the FASB, ``We 
feel very strongly that these models [Black-Scholes and binomial] do 
not recognize the fact that employee options are nontransferable [and] 
are not liquid'' (FASB Comment Letter No. 194).
---------------------------------------------------------------------------
    But there is another reason that the past 30 years of economic 
history have confirmed: Options help improve the operations of small 
and large businesses and improve the economy. For that reason, 
President Bush supported the current accounting treatment of options in 
an interview a year and a half ago, saying that ``they should be 
dilutive in [a company's] earnings per share calculations'' \22\--the 
situation that currently prevails. In addition, leading Democratic 
presidential candidates also oppose expensing of options. Rep. Richard 
Gephardt (D-Mo.), for example, supported the current accounting 
treatment, saying in June that ``stock options are a very important way 
to get employees to think like owners.'' \23\ Howard Dean said he would 
``not favor expensing stock options if at least 65 percent of the 
options were distributed widely throughout a company'' \24\--a 
description of the majority of businesses today.
---------------------------------------------------------------------------
    \22\ ``Bush Supports Businesses in Debate Over Changing Options 
Accounting,'' by Michael Schroeder, Wall Street Journal, April 10, 
2002.
    \23\ ``Gephardt Backs Foes of Options Expensing,'' by Laura 
Kurtzman, San Jose Mercury News, June 18, 2003.
    \24\ ``Dean Castigates Bush During Visit to San Jose,'' by Dana 
Hull, San Jose Mercury News, Sept. 8, 2003.
---------------------------------------------------------------------------
    Why, then, has intense pressure developed to expense options?
    There is little doubt that the campaign for expensing originated in 
the wake of the corporate scandals involving such firms as Enron and 
WorldCom--although in no case did options play a role in the fraud and 
deception at the root of the scandals. There is, as well, an earnest 
desire by policymakers to provide investors with accurate information 
about the companies in which they invest. But it is my belief that 
expensing options will confuse such investors, not enlighten them.
Expensing of Options Will Confuse and Mislead Investors
    Stocks options issued by companies to their employees cannot be 
accurately valued at the time they are issued. They do not comprise a 
cash cost, and they have no market price since they cannot be sold. The 
Black-Scholes method of valuation, the ``gold standard'' for 
determining the value today of options subject for future 
contingencies, applies to options that are tradable--not to options 
whose ownership is restricted to specific individuals. Consider just 
one contingency: Many employees will quit before they options can be 
exercised and lose all their rights to the value of the options. That 
cannot happen with conventional options purchased in open markets.
    ``Mark Rubenstein, a finance professor at the University of 
California at Berkeley, found that some models used to value options 
require as many as 16 separate variables.'' Adjusting only a few of 
those variables, he found, could produce ``huge differences in costs.'' 
For example, in one test, Rubenstein discovered that the value an 
option for a theoretical $100 stock could range from under $20 to over 
$300.\25\ How valuable is such information to investors? Not very. Can 
such information be easily manipulated by firms to meet earnings 
targets? Of course.
---------------------------------------------------------------------------
    \25\ ``The Imperfect Science of Valuing Options,'' by Howard 
Gleckman, Business Week, Oct. 28, 2002.
---------------------------------------------------------------------------
    Think about how an employee stock option works. If a company issues 
an option today, when the price of its stock is $50 per share, allowing 
an employee to buy stock at the same $50 in 5 years time, how can the 
firm accurately value the option today if it does not know the price 5 
years from today? It cannot, so it has to guess the value using those 
multiple variables, including interest rates, volatility, earnings, 
likelihood of job retention, and on and on.
    For that guess to have any usefulness to investors, it needs to be 
updated frequently. Imagine that the firm originally estimates its 
stock price at $120 5 years from now and that, after 1 year, the stock 
drops to $15. Is it reasonable to believe that in 4 years, the price 
will rise to $120? Probably not. So the company should then reduce its 
estimate for the value of the options issued the previous year. Such a 
reduction would create increased earnings! So as the firm's stock price 
drops, its earnings increase.
    Such a perversion reminds us of the purpose of accounting 
conventions in the first place--to convey information about the health 
and prospects of a company for investors and potential investors. But 
some information cannot be reduced to a single number. Nor should it 
be. The expensing proposal, nevertheless, ``serves to satisfy an 
unquenchable fetish to see a contingent liability converted, however 
clumsily and unconvincingly, into a dollar amount that can be charged 
against earnings--without (and here's the fetish element) caring in the 
slightest whether it is helpful or meaningful to do so.'' \26\
---------------------------------------------------------------------------
    \26\ ``Much Ado About Stock Options: The Epilogue,'' editorial, 
Wall Street Journal, April 23, 2003.
---------------------------------------------------------------------------
    In this case, it is not helpful or meaningful to reduce all the 
information about options to one number. It is confusing and 
misleading--and utterly unnecessary.
    The current regime gives firms a choice: Expense options at the 
time they are granted or provide information about the options in the 
footnotes and record a dilution when the options are exercised. The 
information provided today by companies is highly detailed. Consider, 
for example, the Form 10-K of Gilead Sciences, Inc., a 
biopharmaceutical company based in Foster City, California. The 
footnote on stock options extends for four pages. It shows the number 
of options outstanding, forfeited, exercised, and outstanding for the 
preceding 3 years, the weighted average exercise price of those options 
and the weighted average fair value of options granted. It then breaks 
down, by four price categories, the number of options and their average 
price and contractual life. And it presents a table that shows what net 
income would be if the company had chosen the alternative method, 
``fair value'' accounting, under FAS 123. There is more information as 
well.\27\
---------------------------------------------------------------------------
    \27\ Gilead Sciences, Inc., Form 10-K, submitted to the Securities 
and Exchange Commission, March 11, 2003.
---------------------------------------------------------------------------
    In fact, for typical companies, the information provided on stock 
options far exceeds information provided for far more important aspects 
of the business, including intellectual-property assets, cash 
compensation expenses, leases, and investments.
    Under the current regime, investors who require information on 
stock options can get it--and get it in spades. They can use it--not as 
a single number--but as a mass of detail more important than a single 
number--to make their decisions. Perhaps there could be even more 
transparency. Perhaps the disclosures could be made in a more uniform 
way. H.R. 1372 addresses such improvements.
    Since 1993, I have written a regular financial column for The 
Washington Post, which is syndicated into many other newspapers, 
including the International Herald Tribune and the New York Daily News. 
I have written about investing for many other publications as well, 
including The Wall Street Journal, Los Angeles Times, The New Republic, 
The Weekly Standard, Forbes, and Worth magazine. I have devoted much of 
my professional life to educating small investors, so I have a keen 
interest in ensuring that investors get all the information they need 
to make good decisions.
    Do current accounting rules give them such information? Absolutely. 
Will expensing help them make better choices? Not at all. Will it 
confuse them and actually increase the fog surrounding investment 
decisions? That is highly likely.

Investors Understand the Cost of Options
    The case for expensing stock options is built on a faulty premise: 
That investors do not understand, from the current data with which they 
are presented, the true status of the firm. In their article, Hall and 
Murphy write, ``Several studies have shown that the costs of options 
are indeed reflected in stock prices.''
    That leads to two further questions:
    First, if investors already can figure out the cost of options 
without an accounting change, then why make the change to expensing and 
jeopardize small businesses and the economy as a whole? And
    Second, if options are already reflected in stock prices, then why 
should small businesses fear the change to expensing? If the costs are 
known already, then stock prices should not change.
    Let me take the second question first and let Hall and Murphy 
answer it: ``The fact that financial markets see through the `veil of 
accounting' does not imply that accounting considerations are 
irrelevant since accounting rules affect--and sometimes distort--
managerial decisions.'' In other words, whatever economists think, 
managers fear that a change in the rules will indeed hurt their 
companies in the stock market and raise their costs of capital. Such 
managers--and we have heard from dozens of them--will cut back their 
options programs, with an adverse effect on the economy. My guess, as 
well, is that stock prices will fall in the short-term and the cost of 
capital will rise. Stock prices may rebound, but the damage will be 
done. Why, at this critical time in the economic cycle, should we 
tamper with a system that provides incentives and conserves capital?
    Which brings me back to the first question: Why make a change if 
the change threatens to harm the economy and produce no benefit? There 
is no reason at all. The number one rule in public policy should be 
that of the Hippocratic Oath in medicine: First, do no harm.
    So why is the FASB, an unelected group of accounting mavens, bent 
on making such a dangerous change?

The FASB's Mission
    The answer lies in FASB's sole mission, which it states this way:
    ``. . . to establish and improve standards of financial accounting 
and reporting for the guidance and education of the public, including 
issuers, auditors, and users of financial information.'' \28\
---------------------------------------------------------------------------
    \28\ On the home page of the FASB website: www.fasb.org.
---------------------------------------------------------------------------
    But Federal policymakers have a far broader mission.
    For example, they are responsible for encouraging--or at least not 
discouraging--economic growth, for preserving and increasing jobs, 
innovation, and U.S. competitiveness. Even if the FASB expensing 
proposal were cogent from an accounting viewpoint (and it is not), it 
would be the duty of Congress and the executive branch to consider its 
economic impact. I do not have to remind you. That is your job. You 
cannot abdicate it. You cannot farm it out to a group of accountants, 
however well-meaning.
    Some issues, quite literally, are beyond the FASB.
    As a result of expensing options, many firms--among them some of 
America's most successful and innovative--will be forced to take 
massive charges against earnings. ``Accounting for [options'] cost by 
the usual method (the Black-Scholes options-pricing model) would cut 
tech firms' reported profits by 70 percent, on some estimates.'' \29\ 
Although they will not alter the firms' cashflow or actual business 
prospects from what they are today without mandatory expensing of 
options, the reduced reported earnings are almost certain to lead, at 
least in the short-term, to lower stock prices and a higher cost of 
capital for the firms. Companies, in addition, will be discouraged from 
issuing options in the future. The effect will be to reduce economic 
growth, U.S. competitiveness, and job creation.
---------------------------------------------------------------------------
    \29\ ``Now for Plan B: Expensing Share Options,'' The Economist, 
March 15, 2003.
---------------------------------------------------------------------------
    While some critics have made wild claims about the uselessness of 
stock options,\30\ the truth is that firms issue options because they 
work. They represent an efficient method, especially for companies that 
have limited cash and depend on innovation to prosper, to spur 
employees at all levels to work harder and accomplish more--and thus to 
increase the value of the corporation and ultimately its stock price.
---------------------------------------------------------------------------
    \30\ Typical is Charles Munger, Vice Chairman of Berkshire 
Hathaway, Inc., who has said, ``In 90 percent of the cases, the handing 
out of options is excessive.'' Quoted in ``Options Vigilantes,'' by 
Robert Lenzner, Forbes, Dec. 23, 2002, p. 67. In addition, the U.S. 
Secretary of the Treasury, John Snow, derided stock options in an Oct. 
15, 2003, speech as a ``freebie,'' claiming that, ``in many cases 
[options] shortened the time horizon of management and accentuated the 
`short-term-it-is' that addicted the markets in the 1990's.'' There is, 
no surprisingly, no economic evidence for this view. In fact, the 
problem in the 1990's was that investors took too long a view, not too 
short. They thought that companies that were losing money would make 
money somewhere in the future--lots of money--and bid up stock prices 
accordingly. Since stock-option use started to accelerate, the United 
States has enjoyed a period of enormous prosperity, with only two brief 
and shallow recessions.
---------------------------------------------------------------------------
Conclusion
    Are other incentives, such as cash or perks or the awarding of 
restricted stock, better incentives than options? Perhaps for some 
companies, and nearly all firms diversify their incentives beyond cash. 
But academic research shows that ``incentive-intensive'' firms favor 
the use of stock options.\31\ No one knows more about incentives at an 
individual company than the shareholders, the board, and the top 
managers of that firm. When they choose stock options, it is hubristic 
and foolish for outsiders to second-guess them. Discourage stock 
options and you discourage a management tool that works for vast 
numbers of the best American companies--including the small businesses 
that have made the U.S. economy the envy of the world.
---------------------------------------------------------------------------
    \31\ Bryan, S., op. cit.
---------------------------------------------------------------------------
    Thank you.
                               ----------

              PREPARED STATEMENT OF RICHARD FORRESTEL, JR.
      Treasurer, Cold Spring Construction Company, Akron, New York
       on Behalf of the Associated General Contractors of America
                           November 12, 2003

    The Associated General Contractors of America (AGC) is the largest 
and oldest national construction trade association in the United 
States. AGC represents more than 35,000 firms, including 7,500 of 
America's leading general contractors, and over 12,000 specialty-
contracting firms. Over 14,000 service providers and suppliers are 
associated with AGC through a nationwide network of chapters. These 
contractors are engaged in the construction of the Nation's commercial 
buildings, shopping centers, factories, warehouses, highways, bridges, 
tunnels, airports, waterworks facilities, waste treatment facilities, 
dams, water conservation projects, defense facilities, multifamily 
housing projects, and site preparation/utilities installation for 
housing development.
    I am Richard Forrestel, Jr., a CPA and Treasurer of Cold Spring 
Construction Company, based in Akron, NY. I am testifying on behalf of 
the Associated General Contractors of America (AGC), a national trade 
association representing more than 33,000 firms, including 7,200 of 
America's leading general contractors, and 12,000 specialty-contracting 
firms. AGC is the voice of the construction industry.
    While AGC's membership is diverse, the majority of AGC firms are 
closely-held businesses like ours. AGC member firms are 94 percent 
closely held, 81 percent are owned by fewer than four people.
    I serve as the Chair of AGC's Tax and Fiscal Affairs Committee. It 
is this subgroup of small business CFO's and construction accounting 
professionals who have spent the last few months trying to understand 
why the Financial Accounting Standards Board (FASB) would inflict 
Financial Accounting Standard 150 (FAS 150) on the industry. This FASB 
standard has hit our industry and my committee like an earthquake. Its 
has the potential to undermine the fiscal stature of tens of thousands 
of construction companies, like mine.
    I would like to thank Chairman Enzi and the other Members of this 
distinguished Committee for the opportunity to discuss both the 
potentially devastating impact of FAS 150 on family-owned businesses as 
well as the general process of communication between American small 
businesses and FASB.
    Cold Spring Construction Company was founded by my grandpa in 1911. 
We are a closely held, family-owned construction firm that specializes 
in highway and bridge construction. Our projects range in size from $1 
million to $40 million. Dad and his brother, Uncle Tom, both entered 
the business after serving our country in WWII and worked together 
until Uncle Tom died in 1977. As Dad, our Chairman, approaches his 79th 
birthday, he still remains very active in the business. In addition, my 
brothers, Steve, President and CEO, and Andrew, Vice President, are 
actively involved in managing our business today. We have eight 
siblings who have chosen other career paths; however, each worked for 
the company every summer to pay for college, as did 12 of my first 
cousins.
    You get the picture, we, like thousands of other businesses in this 
industry, are privately held and intend to remain so. It was with this 
backdrop that we faced the potential onslaught of FAS 150. Through our 
involvement with AGC, I was able to visit FASB in Norwalk, CT, along 
with two other representatives of AGC on October 30, 2003.
    The risks of FAS 150 to privately held firms like ours, and the 
majority of AGC members, cannot be overstated. As written, FAS 150 
would have dramatically affected all privately held companies with 
mandatory redemption clauses in their buy-sell agreements. That is, if 
your ``buy-sell''\1\ agreement is written so that the company must buy 
your stock back at some point in the future (for example at death or 
retirement), then the contingent future liability must be booked or 
accounted for today. For my family's company, this is all our shares. 
The result will be to take our company's more than $10 million net 
worth and make it zero through the imposition of this standard.
---------------------------------------------------------------------------
    \1\ Buy-sell agreements are an agreement between shareholders, and 
possibly the corporation, for the transition of ownership.
---------------------------------------------------------------------------
    I will briefly touch upon the ramifications of such an accounting 
bombshell. Cold Spring builds only public works projects, all of which 
require surety bonds.\2\ First, wiping out our equity would make us 
unable to obtain bonds. Second, we would be in violation of loan 
covenants.\3\ Third, many States like Pennsylvania have 
prequalification requirements \4\ in order to bid on public works 
projects. FAS 150 would have rendered us unqualified to bid on most 
projects in Pennsylvania, because the State requires the contractor to 
show net worth in order to bid. Finally--and this is strictly a 
psychological reason--this change would have dramatically altered the 
way our balance sheet looked. Dad first worked for Cold Spring the 
summer after the Japanese attacked Pearl Harbor. He has worked his tail 
off for more than six decades. No way, not on my watch, will he be told 
that the company just lost all it is net worth, even if it is only on 
paper.
---------------------------------------------------------------------------
    \2\ Surety bonds are guarantees that the contract will be completed 
and that workers, suppliers, and subcontractors will be paid. Virtually 
all public contracts require surety bonds.
    \3\ Loan covenants often require a target net worth.
    \4\ Prequalification: In order to bid on public projects, 
contractors are required to submit information to the agency. The 
agency evaluates the contractor's financial ability to complete the 
contract.
---------------------------------------------------------------------------
    FAS 150 first came to my attention at an AGC Tax and Fiscal Affairs 
committee meeting in June of this year. During our two-day meeting, we 
discussed the implications of the standard--which at that point was 
effective in December 2003--and decided our best course of action was 
to put together a task force to contact FASB with our concerns. At the 
end of August, AGC sent our four-page letter. This letter was timed to 
arrive at FASB the day before their board meeting addressing FAS 150. 
Because of our letter, and the letters of other associations of 
nonpublic companies, FASB delayed extension of FAS 150 for an 
additional year.
    While we appreciated the delay, FAS 150 still needed to be 
permanently amended for nonpublic companies. During the AGC Midyear 
Convention in Washington DC in September, contractors began to educate 
Members of Congress about this issue. The Tax and Fiscal Affairs 
Committee met at the same time, and decided to request a personal 
meeting with FASB in Norwalk. FASB responded and began the process of 
putting a meeting together. Schedules being what they are, the meeting 
was set for October 30, 2003.
    Walking into this meeting, I was unwilling to accept any other 
outcome other than a complete change by FASB regarding 150. There is 
absolutely no way I would have followed through with this standard--and 
I told FASB this. I was frustrated that this standard was in place, 
which seemed like such an obvious mistake to me, and I believed this 
was my best, and possibly only, chance to make myself heard. I could 
not let this standard be enacted. At the same time, as a contingency 
effort, AGC continued educating Congress about the devastating impact 
of this standard.
    After much thoughtful preparation, on October 30, two AGC 
representatives and I met for three hours with two Board members and 
five staff members of FASB. These people are, in my opinion, the best 
and the brightest people in the country in the accounting profession. I 
found them engaging and concerned with the way FAS 150 would affect my 
company, Cold Spring, and the rest of the industry. The seven FASB 
representatives asked direct and penetrating questions--honestly, it 
made the CPA exam seem easy in comparison. They gave us a chance to 
tell our stories and listened well. They did not promise an outcome but 
did thank us for our input. We could have asked for nothing more. My 
mindset walking out of that meeting was completely unexpected to me. 
Rather than a brick wall, I found an intelligent, thoughtful room 
interested in hearing about my nonpublic company and how FASB standards 
affected me and my industry.
    I believe FASB heard us. Last week, FASB issued a change and 
indefinitely suspended the portion of the standard that would have 
forced companies like ours, who have mandatory redemption clauses with 
an uncertain date and value of redemption, to book it. In summary, 
there is no change to my financial statement. But, the other shoe has 
yet to drop because it is FASB's apparent intention to address this 
issue again in the future. The uncertainty of not knowing what will 
happen, if anything, will undoubtedly continue to cause heartburn for 
lots of people currently contemplating buy-sell agreements.
    I intend to remain available to FASB if I can be of further 
assistance. Having been through this process now, I know I will find 
the doors of FASB wide open to the concerns of my company and to small 
businesses in general as they move forward. It appears to me that FASB 
board members and staff are incredibly interested in how their standard 
will affect all the users of the financial statement, and willing to 
hear from everyone.
    So, FASB's process worked, but it is unfortunate that it came down 
to the eleventh hour. The small business community is certainly partly 
to blame for our late involvement in this issue. However, I believe 
that this experience can be instructive for others. A better, more 
public, mechanism could be put in place to ensure useful communication 
between FASB and the American small business community at large.
    Large, public companies are accustomed to lobbying for or against 
changes with FASB. We small companies are not. We often get caught up 
in changes that probably should be, at least in my opinion, intended 
for public companies. I think this is exactly the case with FAS 150. 
Great idea for the public companies, disastrous for us. Our small 
construction company perspective is necessary to ensure they have 
evaluated all of the potential wrinkles in their standard.
    One possible effort to consider is a biannual or annual meeting 
with FASB staff and representatives of small businesses. Just as the 
IRS, the Small Business Administration, and other entities have 
meetings just with small businesses, this would be an opportunity for 
all sides to meet and talk. FASB would benefit from having small 
business representatives provide their point of view, and at the same 
time, share drafts of upcoming new standards. In this way, both small 
business and FASB are ``on the hook'' and working together.
    I know that AGC is moving forward with FASB on a new working 
relationship. The AGC Tax and Fiscal Affairs committee will meet in 
January, and we are inviting a representative from FASB to join us. We 
are going to work proactively and ensure we are staying abreast of new 
draft standards. We also will continue to provide information on FAS 
150 until this standard is finalized. Our intention is to keep the 
lines of communication open and make sure our voice is heard.
    In conclusion, I would like to thank you for the chance to testify 
today, and your willingness to listen to and potentially address our 
concerns. As a fellow CPA, I agree with what I believe is Chairman 
Enzi's viewpoint--Congress should not be legislating accounting 
standards. I appreciate and agree with the many reasons FASB is an 
independent organization. Nevertheless, this Committee's oversight is 
critical to ensuring all standard-setting agencies are responsive to 
the industry.
    I would also like to thank the members of the FASB and their staff. 
Having now had the opportunity to work with them directly, I have found 
them to be smart, dedicated, and responsive. I would also like to 
suggest that a better communication mechanism between the FASB and 
American small business would benefit the entire economy and its 285 
million participants. Thank you and I will gladly answer any questions 
you might have.

                               ----------

                 PREPARED STATEMENT OF WALTER K. MOORE
          Vice President, Government Affairs, Genentech, Inc.
                           November 12, 2003

    Good afternoon. I am Walter Moore, Vice President for Government 
Affairs with Genentech. Unfortunately, Lou Lavigne, Genentech's Chief 
Financial Officer, is unable to be here today and sends his regrets. As 
you are probably aware, Genentech is the founder of the biotechnology 
industry and is still among the world's leading biotech companies, with 
12 protein-based products on the market for serious life-threatening 
medical conditions and 20 drug candidates in the pipeline. Our strength 
is in all areas of the drug development process--from research and 
development to manufacturing and commercialization. Genentech continues 
to transform the possibilities of biotechnology into improved outcomes 
for patients.
    Today, Genentech has a market capitalization of over $40 billion. 
Why, you might ask, is a company the size of Genentech testifying today 
or even interested in the topic of FASB and Small Business Growth? 
Because Genentech has a classic small business story to tell.
    Genentech was founded over 25 years ago by a UCSF Biochemist and 
young venture capitalist. The biotechnology industry was born when they 
agreed to each contribute $500 to start the company. They fought 
convention in their business practices. Researchers could publish their 
findings of their studies, casual dress for all employees, and all 
employees were given stock options when the company went public in 
1980. Among the young scientists who came to Genentech in 1980 to enjoy 
this atmosphere was Art Levinson, our current Chairman and CEO. 
Genentech issued stock options to all employees when it was founded, 
and still does today.
    One of the primary factors that allowed Genentech to move from a 
small start up biotech company to where it is today was its ability to 
use broad-based employee stock options. Employee stock options make 
employees think and act like owners, not just employees who do their 
job, collect a pay check, and go home. Genentech actively competes for 
talent with at least 60 other biotechnology companies located within 
our zip code, let alone throughout California and the rest of the 
country. Our ability to remain competitive is directly related to our 
ability to offer and provide robust and broad-based options to our 
employees at all levels. This has clearly helped Genentech build and 
maintain a dynamic team of people that discover, develop, and market 
life-saving therapies to patients all over the world. However, the 
ability for new Genentechs or other success stories to be created is 
being directly threatened by the Financial Accounting Standards Board 
(FASB).
    FASB's proposed new rules on how to account for employee stock 
options will greatly impact all companies that use broad-based employee 
stock options--without providing investors with consistent, comparable, 
and reliable financial information. In the current accounting standard 
for employee stock options, FAS 123, companies are allowed, but not 
required, to expense employee stock options. Private companies that 
choose to expense their stock options are allowed to do so under rules 
that are different than those applicable to all other companies. The 
reason for the different treatment is that it simply is too difficult 
to value stock options for a company whose stock either does not trade, 
or trades infrequently. FASB, without any justification, has decided 
that this distinction should be eliminated.
    We disagree and also believe that all companies, and not just small 
businesses and private companies, face the same valuation problems. In 
fact, we at Genentech fundamentally disagree with those who believe 
that employee stock options represent a corporate level expense. That 
said, we do believe that credible, transparent, consistent, comparable, 
and unbiased financial information is essential.
    As I mentioned earlier, there are 60 biotech companies in South San 
Francisco. The vast majority of these companies are small businesses 
and their recruitment strategy is to provide broad-based options to 
employees to compete with Genentech and other mature biotechs in our 
area. Expensing stock options will be a burden on companies of 
Genentech's size, but it will be a much heavier impediment to 
recruitment of scientists by these small businesses. These small 
businesses operate in a global marketplace. One of small neighbors has 
recently begun construction of a manufacturing facility in Korea. If 
the FASB mandates stock option expensing in the United States and the 
EU mandates it Europe, some companies will relocate to countries 
without mandated stock options expensing.
    My testimony today will focus on mandated stock options expensing 
while highlighting myriad problems with existing valuation methods. 
Existing models fail to adequately incorporate factors unique to 
employee stock options and, if used to establish a corporate expense, 
will compromise the integrity and comparability of financial reporting. 
Proponents of mandatory stock option expensing have held that expensing 
options will provide investors a more clear understanding of the 
financial state of the company. I believe, however, that the current 
footnote disclosure method provides more clarity. As you can see from 
Genentech's 10-K disclosure, an investor with a target price can 
determine the exact dilution in the stock price he or she can expect. 
Conversely, expensing options will take the focus away from the real 
cost of options, dilution. Instead, companies will report a seemingly 
``precise'' number in the income statement, which, in fact, is totally 
subjective, unreliable, and cannot account for scientific and 
technological breakthroughs or failures.
    From Genentech's perspective, the major areas of concern on 
valuation relate to FASB's view that any option pricing model used to 
compute a corporate expense must take into account volatility, expected 
holding periods, and the risk free rate of return. Moreover, all of the 
existing models assume that the options being valued are freely 
transferable and, to date, FASB has not allowed companies to factor in 
this difference between employee stock options and the options that the 
models were designed to value. In addition, FASB has not allowed 
companies to factor in other significant restrictions that impact 
employee stock options, such as black out periods. Trading black out 
periods can also have a significant impact on the ``value'' of an 
employee stock option. Blackouts, time periods when options cannot be 
exercised, are frequently the equivalent of 5 months or more in any 
given year. For some employees, blackout periods can extend for up to 8 
months in any given year. To date, FASB has not permitted this 
significant restriction to be taken into account in determining the 
supposed ``fair value'' of employee stock options.
    One might think that the risk free rate of return should be 
consistent across companies and industries. This, however, is not the 
case. Even in our own industry segment, the risk free rates used in the 
footnote disclosures of Genentech and three of our chief competitors 
ranged from 3.9 percent to 5.5 percent in 2001.
    When you move on to the issue of volatility, the differences are 
even greater. At any point in time the volatility of companies even 
within the same industry can be radically different. For example, in 
our industry in 2001, four companies used volatility assumptions in 
their 2001 footnote disclosures that ranged from 44 percent to 63 
percent. What is the correct volatility to use? Who knows? Biotech is a 
stunningly risky business: Clinical trials of promising therapies fail 
more often than they succeed.
    To make matters worse, FASB's rules require that companies predict 
their future volatility. Even if one were to use past volatility as a 
predictor of future volatility, which is a dubious proposition to begin 
with, you can derive significantly different answers depending upon the 
number of data points you use. For example, you will get entirely 
different answers if you use an average of the prior 3 years' stock 
volatility as compared to an average of the quarterly, monthly, or 
daily volatility over the same period. At Genentech, our stock 
experienced a curious volatility over the last 3 years. Our volatility 
for calculating stock option disclosure was 75 percent in 2000, 63 
percent in 2001 and 43 percent for 2002. We estimate expected stock 
volatility for 2003 to be 45 percent. However, our actual volatility 
over 3 years is near zero. For growth companies, estimating future 
stock volatility is highly subjective and the impact of inaccuracies 
can be material both to reported earnings and potentially to the stock 
price. If an expected volatility of 60 percent turns out to be 40 
percent in practice, estimated options expense is skewed by almost 100 
percent, or $119 million versus $62 million.
    No specific number is right or wrong. Virtually any number is a 
possible answer, and each can be supported, but you will get a 
different stock option value depending on which you use. These 
differences can be significant, and it will be impossible to discern 
the difference between a knowledgeable projection that is wrong and one 
that is manipulative.
    For small companies whose stock either does not trade at all or 
trades infrequently it is virtually impossible to compute 
``volatility.'' Yet, that is precisely what FASB is proposing. How can 
it be that something that is no more than a mere guess can result in 
more meaningful, comparable, and consistent financial statements?
    FASB's desire to finish its stock option project quickly should not 
overtake the need to determine whether, and if so how, employee stock 
options can be accurately valued. When FASB promulgated FAS 123, it was 
believed that the Black-Scholes method could be used to determine an 
accurate value for employee stock options. Time showed that FASB's 
determination was wrong. Indeed, FASB recently considered prohibiting 
the use of this method because they determined that it simply does not 
work. Instead, FASB is now advocating that companies be allowed to use 
whatever method they want, with at least some preference for the use of 
what is known as a binomial model.
    Binomial models require the use of ``binomial trees.'' These are 
analogous to a series of decision trees that are used to predict 
possible future events. As a result, binomial models permit the 
modeling of behavior over time, thereby allowing the inputs used in the 
model to change during the life of the option. Black-Scholes, on the 
other hand, uses a specific and constant number throughout the life of 
the options. For example, under Black-Scholes, once an assumption is 
made about volatility, that assumed number remains constant over the 
term of the option. Under a binomial model, multiple assumptions could 
be made about volatility, so that the volatility estimate could change 
over the term of the option. Unfortunately, the volatility estimate, 
whether it changes or not, is still a guess. A binomial model, while 
more complicated than Black-Scholes, still suffers from the same 
problems.
    Moreover, a binomial model can produce any answer you want, 
depending on how many binomial trees, or iterations, are performed. The 
following is a chart that shows just how different the answers will be 
depending on how many binomial iterations are performed.*
---------------------------------------------------------------------------
    * Held in Committee files.
---------------------------------------------------------------------------
    According to binomial theory, the more decision trees that are 
used, the more precise the answer. The problem is that the more trees 
that are used, the closer the binomial estimate becomes to the Black-
Scholes estimate. As a result, although the answer derived from a 
binomial model at any given point in time will likely differ from the 
answer derived under Black-Scholes, it will not be a ``better'' number, 
it will just be different. And if you follow binomial theory and use a 
significant number of binomial trees, you are back to the Black-Scholes 
number that FASB has already determined is inaccurate in virtually 
every circumstance.
    Another model being considered as acceptable by FASB is known as 
``Crystal Ball.'' This model, like a binomial model, is more 
``flexible'' than Black-Scholes. There are no set parameters. This 
means that one can use an unlimited number of variables, and that one 
can set each variable to a constant number or model the variable using 
what is called ``Monte Carlo'' simulation. As is the case with binomial 
methods, the more ``sophisticated'' the analysis--that is, the more 
variables and inputs used--the more the ``Crystal Ball'' number will 
converge to the Black-Scholes number.
    In the end, all of the option pricing models that exist today were 
designed to value something else--freely tradable options--that are 
fundamentally different than employee stock options. Black-Scholes, 
binomial models, and Crystal Ball are identical in one key respect--
they all require companies to predict the future, including future 
stock price and volatility. The only difference is that binomial models 
and Crystal Ball use more inputs to try to predict the future. One does 
not need to be a mathematician to know, however, that whether one is 
using 5 variables or 500 variables, the future remains impossible to 
predict accurately. Thus, if one agrees that continued use of Black-
Scholes is not warranted, so, too, should one conclude that the use of 
binomial models or Crystal Ball is not warranted--they both lead 
inexorably to the wrong answer.
    As I said in the beginning, this is a problem for companies, large 
and small. The problems for small companies are even worse because they 
frequently do not have staff qualified to run the models and make 
determinations as to what assumptions to use. This all translates to 
added cost. Any added cost uses precious resources needed my small 
companies to grow and add jobs.
    I recognize that there are many who believe that expensing some 
number in the financial statements is better than expensing nothing. I, 
however, disagree. Under existing accounting rules, both here and 
abroad, an expense is to be recognized only if it can be reliably 
measured.
    It is beyond doubt that current stock option pricing models cannot 
accurately value employee stock options in the hands of an employee let 
alone estimate a cost of those options to the company. Mandatory 
recognition of an expense that cannot be reliably measured flies in the 
face of the most fundamental accounting rules.
    Some have also argued that there are lots of estimates in financial 
statements and that employee stock options are no different. This is 
false. Some estimates that are included in the financial statements, 
like deprecation, only present timing issues. A company knows how much 
it spent to buy, for example, a machine. But under the accounting 
rules, it is not allowed to expense the entire amount paid in the year 
of acquisition. Instead, the company must estimate the useful life of 
the machine and expense a prorata portion each year. While the company 
has to estimate the useful life, it still knows exactly how much it 
paid so, over time, the correct amount will ultimately be expensed. 
With stock options, the company not only has no reliable way to measure 
the anticipated ``cost'' of the options, but it also has no idea when, 
or even if, a single option will ever be exercised. Yet, under a 
mandatory expensing scheme, it would be required to determine the 
expense up front and recognize an expense. Even if you believe that 
options should be expensed, how can it be that an option that is never 
exercised can result in any expense?
    For other types of estimates, like pension costs, companies are 
required to estimate their total out-of-pocket costs and expense these 
anticipated costs over time. To the extent the company's estimates 
prove incorrect, however, the company is allowed to ``true-up'' its 
expenses to equal what it actually ended up paying. Again, stock 
options are different. First and foremost, there never is any out-of-
pocket cost for stock options. Further, while, like pension costs, a 
company must estimate its costs up front, unlike with pension costs, 
the company is never allowed to true up those costs.
    There are other areas where estimates are so imprecise that no 
expense is recognized as in the contingent liability area. For example, 
assume a company is in litigation. Unless a loss is probable, it is not 
permitted to recognize an expense. However, even if the company knows 
it will end up paying something to either settle the case or as part of 
a judgment, unless the company can reliably estimate what that amount 
will be, which is virtually never the case, the company cannot 
recognize an expense until that expense actually materializes. It must, 
however, report the contingency in its financial statement footnotes. 
Stock options should not be treated differently. In the end, mandatory 
expensing of employee stock options is bad accounting and is in direct 
conflict with fundamental accounting principles.
    In conclusion, Genentech strongly urges that neither FASB nor the 
Congress rush to judgment on this complicated yet important issue. 
Rather, we must attempt to address the significant shortcomings of 
existing option pricing models or develop new models before mandating 
their inclusion on the face of financial statements. One prudent way of 
moving forward would be to ``road test'' models through footnote 
disclosure to discern whether they actually work, rather than mandating 
whole-scale change and risking what we believe would be severe 
consequences for small businesses and their employees.
    We look forward to working with this Committee and with FASB on 
this issue. Thank you for the opportunity to testify.

                               ----------

                      STATEMENT OF JEANNINE KENNEY
           Vice President, Public Affairs and Member Services
               National Cooperative Business Association
                           November 12, 2003

     Senator Enzi and Members of this subcommittee, on behalf of the 
National Cooperative Business Association and the thousands of U.S. 
cooperative businesses that we represent, thank you for the opportunity 
to testify on the need for clarity on, and resolution of, issues raised 
by Financial Accounting Standard No. 150.

Introduction
    The National Cooperative Business Association is the only national 
organization representing cooperatives across all sectors of our 
economy including agriculture, childcare, electricity, finance, food 
retailing and distribution, healthcare, housing, insurance, purchasing 
and shared services, telecommunications and many others. Our mission is 
to develop, advance and protect cooperative enterprise.
    Of the many financial challenges confronting cooperatives in recent 
years, few have generated as much concern and uncertainty as FAS 150. 
How and whether these concerns are resolved will have enormous impact 
on the balance sheets of cooperatives, and equally important, on the 
individual members those cooperatives serve, many of whom are small 
business people themselves--farmers and ranchers, and the independent 
owners of local hardware stores, pharmacies, hotels, restaurants, 
office supply stores, newspapers, and the many other independents 
served by purchasing cooperatives.
    For this reason, NCBA and its members are extremely grateful to 
FASB for its decision last Friday to indefinitely defer FAS 150 for 
mandatorily redeemable instruments, other than those that are 
redeemable on fixed dates. We hope to work with FASB as it reconsiders 
and evaluates the implementation issues associated with FAS 150. Our 
comments below reiterate and build upon the comments submitted to FASB 
in past comment periods for FAS 150.

Co-op Basics: 40,000 Strong With 120 Million Members
    To understand why FAS 150 has been so troubling to co-ops first 
requires an introduction to co-op structure.
    The more than 40,000 co-ops in this country are, by definition, 
businesses that are owned and democratically controlled by their 
members--the people who buy the goods or services provided by the 
cooperative, rather than by outside investors. About 120 million 
Americans are members of a cooperative--or more than half of all 
adults. To put the importance of the cooperative sector into 
perspective, note that cooperatives outnumber investor-owned firms by 
more than two-to-one.
    Though many cooperatives are large and well-known businesses--some 
are included in the Fortune 500--the vast majority of cooperatives are 
small, community-based businesses such as food cooperatives, electric 
cooperatives, agricultural marketing and supply co-ops, worker-owned 
cooperatives, and purchasing and shared services cooperatives that 
serve tens of thousands of independently owned businesses across 
America's towns and cities. These cooperatives and their members 
generate millions in economic activity, creating jobs, wealth, and 
opportunity.

Cooperatives Fall Into Four Categories:
 Producer-owned cooperatives--These are cooperatives owned by 
    farmers or craftsmen who form a co-op to jointly market, process or 
    produce a like-product. There are 1,600 farmer- or rancher-owned 
    marketing or processing cooperatives in the United States, most of 
    which are local co-ops. The growth of new generation cooperatives-
    small co-ops that specialize in value-added agricultural processing 
    has been spurred by programs and incentives, such as USDA's Value-
    added Producer Grants program, that have originated in the U.S. 
    Senate. Renewable fuels cooperatives--those that process ethanol, 
    biodiesel, and wind power--are a growing segment of this category.
 Consumer-owned cooperatives--Representing the largest category 
    of co-ops, these cooperatives are owned by the consumers who buy 
    the goods or services of the business. They are largely small and 
    local in nature and include food co-ops, credit unions, rural 
    electric and telecommunications cooperatives, housing co-ops, 
    parent-owned childcare co-ops, and consumer-owned HMO's.
 Worker-owned cooperatives--These are cooperatives that are 
    owned and controlled by their employees. They are similar to 
    companies with Employee Stock Ownership Plans (or ESOP's) in that 
    the workers own the company. However, in a worker cooperative, the 
    employees benefit from the profitability of the company earlier 
    than ESOP employees. Members of worker-owned co-ops receive annual 
    taxable dividends on the company's earnings, rather than waiting 
    for retirement to cash in their stock.
 Purchasing and shared services--These are cooperatives that 
    are owned by individuals or small businesses that band together to 
    jointly buy goods or services as a group, thereby lowering their 
    input costs. Unlike buying clubs, the members of purchasing 
    cooperatives actually own the company, ensuring that it is acting 
    only in their best interests in procuring inputs and services. This 
    is a growing segment of the co-op sector, as more and more small 
    businesses see purchasing co-ops as the key to their survival. We 
    estimate that, nationwide, more than 50,000 independent businesses 
    are members of purchasing co-ops. The Nation's 1,600 local farm 
    supply and service co-ops fall into this category, since they are 
    effectively purchasing co-ops for farmers and ranchers.

Co-op Patronage Equity
    Because co-ops are member-owned businesses, their equity is 
provided by their members. Generally speaking, co-ops do not issue 
public debt, though there are a few exceptions to this rule. Co-op 
equity, in most cases, consists largely of, or in many cases, solely of 
member equity.
    A co-op member will make an equity investment, usually in nominal 
amounts, in a cooperative upon becoming a member. This investment 
represents a member's ownership interest in the cooperative. This 
equity stake grows or declines depending on the co-op's profitability.
    It is important to understand that, unlike investors, co-op members 
join a cooperative in order to benefit from the goods and services it 
offers, not to make a substantial return on their initial investment. 
That is, consumers join food co-ops or credit unions in order to shop 
at a particular grocery store and enjoy discounted prices to members or 
better rates and lower fees. Farmers join an agricultural marketing co-
op to benefit from the improved leverage that cooperative has in 
negotiating prices for their crop or the premium enjoyed through the 
co-op's branding of products. Small businesses join a purchasing co-op 
to reduce their costs of doing business, and workers join a worker-
owned co-op to better enjoy the profitability of that company through 
annual dividends.
    All co-ops operate as not-for-profit businesses in that they return 
any profits they earn to their members in the form of end-of-year 
dividends based on the amount of business a member did with the co-op--
these are referred to as patronage dividends. Members receive dividends 
either in the form of cash, or as equity held by the co-op and 
allocated to individual members-often known as allocated patronage 
capital or capital credits or both. Cooperative patronage capital 
therefore is the accumulation of capital from revenues in excess of 
expenses over time.
    Allocated patronage capital is how a cooperative, and often the 
only way, builds up equity in the company. It is recognized by members 
as risk capital. In the unfortunate incidence of a bankruptcy, co-ops 
may never return equity to members. Debt holders are paid first. 
Patronage capital is an asset that can be called in by lenders. Holders 
of equity are paid last, if at all.
    By FASB's own definition, allocated patronage equity is true 
equity. FASB Statement of Financial Accounting Concepts Statement No. 
6, defines equity as the
ownership interest in the business. In a co-op, the equity shares of 
members--the owners--is their ownership interest. Further, Concepts 
Statement No. 6 states,
``equity distributions to owners are at the discretion and volition of 
the owners or their representatives after satisfying restrictions 
imposed by law, regulation, or agreements with other entities.''
    In the case of cooperatives, the representatives of the owners are 
the members of the co-op board of directors. Co-op boards of directors, 
which are elected by members, retain the ultimate discretion as to how 
or whether to return allocated equity to members. Co-ops have a variety 
of arrangements regarding redemption of members' shares.
    Some co-ops repurchase the shares of members upon their withdrawal 
from the co-op, upon death, or upon reaching retirement or a certain 
age. Other cooperatives have a policy of revolving equity of the 
cooperative over a period of time once specific equity levels are 
achieved and the financial condition of the co-op allows.
    Redemption decisions may be based in board policy, practice, or in 
the co-op's bylaws. However, most co-ops have no provisions in their 
bylaws, but have a past practice of repurchasing members' shares upon 
withdrawal, death, retirement, or on some revolving basis. And some co-
ops may never redeem member equity. Co-op boards make such 
discretionary redemption decisions based on the financial and other 
needs of the cooperative. Boards have no such discretion with respect 
to repayment of true debt obligations.
    It is important to note that cooperative boards are elected by the 
members and change over time. There can be no assumption, then, that 
the practices and policies of past boards will be adopted by future 
boards.
    Finally, in instances when the discretion of a co-op board to 
redeem equity has been challenged, courts have consistently affirmed 
that the board of a cooperative has discretion with respect to 
redemptions.
    Therefore, regardless of redemption policies, co-op patronage 
capital retains all the characteristics, as defined by FASB, of equity.

FAS 150
    FAS 150, in the form approved by FASB in May, raises serious and 
unanswered questions for cooperatives that affect their financial 
solvency, their ability to meet loan agreements and ultimately, the 
ability of the co-op board of directors to exercise its authority over 
redemption of equity.
    Again, we are grateful to FASB for its decision to indefinitely 
defer FAS 150's provisions regarding mandatorily redeemable shares of 
nonpublic entities--the provision of greatest concern to co-ops--
pending further board action. This will provide time for cooperatives 
to work with FASB on unresolved issues raised by any new accounting 
standard.
    Cooperatives and their membership organizations have been following 
FASB's work that culminated in FAS 150 for several years and have 
actively participated in the comment periods throughout FASB's process. 
The recent comment period on FAS FSP 105-c, the staff position 
regarding delay of the effective date, drew more than 70 comments from 
cooperatives, or roughly 70 percent of all comments FASB received on 
this staff position.
    However, we are troubled that the concerns and substantive 
arguments of cooperatives, expressed through the series of FASB comment 
periods and personal meetings, were not heard until the eleventh hour. 
These concerns are similar to those raised by other professions that 
actively participated in this process, architectural, engineering and 
construction-related firms.

Key Issues Regarding Mandatorily Redeemable Financial Instruments
    At the heart of co-op concern regarding FAS 150 is how the 
accounting profession will interpret the new rule with respect to 
cooperative patronage capital and whether it will be considered a 
``mandatorily redeemable financial instrument'' under the varying 
conditions for redemption. Fundamentally, we believe that co-op 
patronage capital should be classified as equity, rather than as 
liabilities, until such time as it will be redeemed.
    FAS 150 stipulates that mandatorily redeemable financial 
instruments shall be classified as liabilities unless redemption is 
required to occur only upon the liquidation or termination of the 
reporting entity. FASB defines ``mandatorily redeemable'' to include 
instruments that embody ``an unconditional obligation requiring the 
issuer to redeem the instrument by transferring its assets at a 
specified or determinable date, or upon an event certain to occur.'' 
[Emphasis added.]
    FASB defines ``obligation'' as a ``conditional or unconditional 
duty or responsibility to transfer assets or to issue equity shares.'' 
Meanwhile, in the Statement of Financial Accounting Concepts No. 6, 
FASB notes that an obligation is broader than a ``legal'' obligation. 
Concepts No. 6 states that FASB uses ``obligation'' with ``its usual 
general meaning to refer to duties imposed legally or socially; to that 
which one is bound to do by contract, promise, moral responsibility, 
and so forth.''
    This very broad definition of ``obligation'' has raised significant 
questions about what an ``unconditional obligation'' within the context 
of FAS 150 will actually mean in practice and how it will be 
interpreted by the accounting profession.
    Cooperatives and their accountants have questioned whether the 
absence of an unconditional legal obligation with respect to co-op 
equity redemptions is sufficient to exclude co-op patronage capital 
from reclassification as ``mandatorily redeemable instruments.'' Though 
most co-op boards retain discretion on equity redemptions as noted 
above, past discretionary practices to redeem such equity under 
different situations could constitute a constructive duty or 
obligation, even though there is no legal obligation to redeem.
    Unofficial conversations between cooperative representatives and 
FASB staff made clear that this could indeed be an outcome of FAS 150. 
A history of certain discretionary redemption practices could therefore 
require reclassification of all member equity as liabilities even if 
there is no obligation to continue those practices in the future.
    Without such clarification, co-ops with a practice of redeeming 
capital to heirs of deceased members, to retiring members, or of 
revolving capital run the risk of having all of their equity 
reclassified as debt even though only a fraction or no capital may be 
redeemed in a given year. Co-op equity is never redeemed all at once, 
except upon the sale or dissolution of the cooperative. This would be a 
nonsensical outcome.
    In addition, cooperatives are concerned that FASB has failed to 
recognize the similarities between co-op patronage capital redemption 
and similar instruments issued by for-profit companies that are not 
considered by FASB to be mandatorily redeemable.
    For example, allocated patronage capital in a cooperative is 
analogous to retained earnings in a for-profit firm. Just as for-profit 
companies may distribute retained earning to owners by paying 
dividends, cooperatives may return patronage capital to owners by 
retiring patronage capital. In both instances, the payments are made at 
the discretion of the board of directors. The decision to return 
capital to owners in a co-op is made using the same decision process as 
that used by for-profit companies regarding dividend payouts for 
preferred or nonredeemable common stock--by managing the entities' 
capital structure and cashflow and examining income tax ramifications.
    FAS 150 clearly states that for companies issuing nonredeemable 
common or preferred stock, ``Declaration of dividends is at the 
discretion of the issuer, as is a decision to reacquire shares.'' It 
therefore concludes, ``Nonredeemable outstanding shares of both common 
and preferred stock lack an essential characteristic of a liability.'' 
This is also clearly the case with co-op patronage capital--in most 
cases, the co-op has no obligation to redeem member shares. But FAS 150 
provides no clarification on this matter for cooperatives.
    We are concerned by what will be, without further clarification, 
disparate treatment of cooperatives relative to for-profit companies 
exercising similar discretion. If a for-profit company with continuing 
dividend payouts is not considered by FAS 150 to have mandatorily 
redeemable retained earnings, it follows that a cooperative that has 
regular redemptions of patronage capital must not be considered to have 
mandatorily redeemable patronage capital.
    For this reason, cooperatives are seeking greater clarification by 
FASB that just as companies issuing nonredeemable common stock have no 
obligation to pay dividends or reacquire shares despite a past practice 
of doing so, cooperatives likewise have no obligation to redeem member 
shares, although they may have in the past.
    In some cooperatives, the agreement between a member and the co-op 
does include redemption upon termination of membership. However, since 
it is unclear when or if such termination will occur, equity associated 
with such agreements should not be considered mandatorily redeemable. 
It is important to underscore, here, that regardless of such 
agreements, a member may never receive equity redemption, depending on 
the financial state of the business--this is because such equity 
represents a true ownership interest.
    Moreover, we seek clarification that patronage capital shall not be 
classified as debt until such time as a co-op makes a decision to 
redeem it and then only that portion of capital would be classified as 
a liability. Any other outcome seriously mistakes the nature of the 
relationship between a cooperative and its owners.

Events Certain to Occur
    Also unclear in FAS 150 is what constitutes an ``event certain to 
occur.'' While death falls into this category, it is unclear what other 
events might be captured.
    For example, some cooperatives, such as purchasing cooperatives for 
small businesses, may have an obligation to redeem a member's equity 
when that member leaves the co-op. However, in cases where the member 
is a small business corporation--as is the case for many small business 
purchasing cooperatives--there can be no certainty that the membership 
of that corporation in the purchasing cooperative will ever be 
terminated. In many cases, membership is maintained by the successor 
owners of the small business. Such obligations to redeem equity should 
not be reclassified as mandatorily redeemable since the event 
triggering the redemption is not certain to occur.
    Moreover, FASB should reevaluate whether it is appropriate to 
reclassify equity as debt even for some events that are certain to 
occur, such as the death of a member. In this example, it is 
preposterous that all member-owners of a cooperative would die in a 
given year, bringing into question why the equity of all members should 
be reclassified as debt, even if there were a mandatory obligation to 
redeem.
    In summary, NCBA and its cooperative members seek greater 
clarification from FASB on the following:

 Co-op patronage capital represents a true ownership interest 
    of the members of a cooperative and is properly classified as 
    equity.
 Co-op patronage capital shall not be considered a mandatorily 
    redeemable financial instrument until a decision is made or action 
    taken to redeem a portion of that capital, and that only that 
    portion scheduled for redemption is properly classified as a 
    liability.
 For the purposes of FAS 150, unconditional obligations shall 
    include only legal obligations rather than those perceived as 
    ``constructive obligations,'' a ``socially imposed duty'' or 
    ``moral responsibility.'' Uncertainty in this area could be 
    disastrous for many small businesses around the country.
 That ``events certain to occur'' be narrowly defined so as not 
    to include events that may or may not occur depending on the 
    nature, type and structure of a business.

Potential Impact of FAS 150 on Cooperatives
    The uncertainties associated with the application of FAS 150 to 
cooperative patronage capital generated significant concern among 
cooperatives because for many of them, patronage capital makes up the 
entirety of the business's equity. The new standard, if implemented as 
originally proposed and without further clarification, could have 
required many cooperatives to reclassify all of their equity as debt, 
creating the appearance of insolvency. It is hard to overstate the 
negative consequences of that outcome.

Other Impacts Include:
 Debt Financing--The impact of a dramatic increase in 
    liabilities on co-op balance sheets would put many cooperatives in 
    technical default of their loan agreements that require certain 
    levels of equity. Moreover, a balance sheet that reflected zero 
    equity would make it difficult for co-ops to secure new debt 
    financing agreements.
 Relationships with Suppliers--Vendors and suppliers to 
    cooperatives also frequently rely on the business's balance sheet 
    to assess credit worthiness. An increase in a co-op's liabilities 
    could adversely affect its relationships with its suppliers.
 Impact on Members--If FAS 150 would have required co-ops to 
    discontinue discretionary redemptions, co-op members and their 
    heirs would be adversely affected by the standard. For purchasing 
    cooperatives, FAS 150 could jeopardize the financial solvency of 
    the co-op, adversely impacting its ability to serve its small 
    business owners. And to the extent the reclassification would 
    jeopardize the financial solvency of the business, all member-
    owners of a cooperative would be harmed.
 Reduced board discretion on equity redemptions--If FAS 150 had 
    required reclassification of all member equity, it would have 
    effectively converted what had been discretionary redemptions into 
    mandatory redemptions. That is, the standard could have reduced the 
    discretion of the board in managing the overall financial health of 
    the cooperative by eliminating its ability to determine when and 
    whether equity would be redeemed. This outcome would imperil many 
    cooperatives.

FAS 150 Does Not Improve Transparency of Financial Statements
    Though one intent of FAS 150's provision on mandatorily redeemable 
shares was to improve the transparency and accuracy of financial 
statements, for cooperatives it would have had the opposite effect. It 
would have seriously misstated the financial health of financially 
sound and thriving businesses.
    FAS 150 addressed this situation by allowing a business with only 
mandatorily redeemable shares to include them under liabilities listed 
separately as ``shares subject to mandatory redemption,'' in order to 
distinguish them from other liabilities. But this allowance tacitly 
suggests that, in fact, there is something about these instruments that 
is different from standard liabilities that should not give lenders 
pause. What is different, of course, is that for cooperatives, the 
instrument is truly equity.
    FASB staff also suggested that the issues raised by cooperatives 
could be addressed by educating lenders and suppliers regarding the 
nature of co-op patronage capital. However, changes to accounting 
standards that require more, not less, explanation cannot represent an 
improvement in transparency.

Conclusion
    NCBA hopes to work with FASB over the coming months to clarify that 
co-op patronage capital remains properly classified as equity. 
Moreover, discretionary redemptions in the past should not result in 
constructive obligation for redemptions in the future.
    The satisfactory resolution of these accounting standard questions 
is critical to the continued health and growth of community-based 
cooperatives across the United States, and their ability to serve their 
members, including the many small businesses that belong to 
cooperatives.
    Mr. Chairman, we thank you for opportunity to testify on this 
important issue.

                               ----------

                   PREPARED STATEMENT OF MARK HEESEN
            President, National Venture Capital Association
                           November 12, 2003

Introduction
    Good afternoon. I am Mark Heesen, President of the National Venture 
Capital Association (NVCA). My comments today reflect the views of the 
NVCA and its members. Our mission includes stimulating the flow of 
equity capital to emerging growth companies by representing the public 
policy interests of the entrepreneurial community. The NVCA represents 
more than 460 venture capital and private equity firms, both large and 
small, throughout the United States. As you know, private equity is the 
investment of equity money to support the creation and development of 
new businesses. Venture capital and private equity backed companies are 
very important to the United States in a classic economic sense and 
probably even more important in terms of creating and developing those 
businesses that are on the leading edge technologically. Many people 
argue that this entrepreneurial segment of the economy is the real 
growth engine for the United States in terms of employment, global 
competitiveness, and innovation.
    A few years ago DRI/Wharton Econometrics undertook a detailed study 
of the role of venture capital in the U.S. economy. They reported that 
over the 30 year period that there has been a formal venture capital 
industry, more than 16,000 companies received $154 billion in equity 
financing from private capital sources.
    While most of these companies did not turn into big successes, and 
in fact, most start-ups fail, those that worked had become a huge 
portion of the U.S. economy contributing 11 percent of annual GDP worth 
over $1 trillion and employing over 12 million people. We have looked 
at these numbers since the economic downturn and they appear to remain 
valid.
    The NVCA has a vital interest in the subject of this hearing 
because the future viability of our country's young start-up companies 
has, in the last year, been compromised by the hasty actions taken by 
the Financial Accounting Standards Board (FASB). While we recognize the 
tremendous pressure placed on the FASB to issue rules and standards 
more quickly, we have a grave concern that this rush to regulate has 
come at the expense of our country's small businesses who are often the 
unintended victims of rules targeted at large corporations.
    We recognize fully that Members of Congress are understandably 
reluctant to become the arbiters of accounting standards. However, the 
examples I will discuss in my testimony present a compelling need for 
checks and balances in our system. Recent FASB decisions have been 
steeped in flawed processes that provide little opportunity for input 
from the small business sector. Further, it appears the FASB is making 
more of its decisions in a vacuum, broadly applying accounting theories 
without any intention of testing whether such theories have practical 
problems before implementation. Unfortunately, FASB's rulings must be 
adhered to by real-life companies--often by the ones least able to bear 
a diversion of resources from their fundamental business purpose to 
piloting the latest FASB proposal.
    Today, I will talk about two examples where FASB's actions have had 
or could have significant detrimental effects on small business. If 
left unquestioned to continue on this path, I submit that FASB's 
decisions will ultimately affect the growth of our economy by 
needlessly raising the cost of capital for young start up companies--
the fulcrum of our economic system. This is a dire prognosis and I hope 
my testimony will convince you of the seriousness with which we view 
this situation.

FASB'S Issuance of Financial Interpretation Number 46 Lacked Adequate
Industry Input, Guidance and Transition Time, Creating Significant
Chaos in the Private Equity and Entrepreneurial Communities
    The first instance involves the FASB's January 2003 issuance of 
Interpretation No. 46 (FIN 46), Consolidation of Variable Interest 
Entities (VIE's). FIN 46 was intended to provide new guidance on what 
constitutes a VIE and when a VIE is required to be consolidated with 
another enterprise. FIN 46 was issued as a rapid fire response to 
Enron's flagrant abuse of special purpose entities (SPE's) and was 
intended to prevent further manipulation by large corporations. 
However, the broad sweep of the rule would have also required many 
private equity funds to consolidate the assets, liabilities, and 
financial results of selected portfolio companies. ``VIE'' is a new 
accounting term for the majority of entities we used to call special 
purpose entity, or ``SPE.'' While VIE's are often entities created for 
a single purpose like securitizations, leasing, or R&D, FIN 46 
considers neither an entity's purpose, nor its activities. Indeed, 
``VIEs'' are defined only as entities subject to consolidation under 
FIN 46. In order to know if a portfolio company is a VIE, a fund would 
have had to evaluate each investment based on: (1) ``the nature and 
amount of the equity investment in the entity;'' and (2) ``the rights 
and obligations of the equity investors.'' These tests are complex and 
each must be passed to avoid VIE status.
    The capital structures of many private equity funds' portfolio 
companies have characteristics that make it difficult to clear these 
hurdles. Therefore, FIN 46 would have certainly required private equity 
funds to consolidate the assets, liabilities, and results of operations 
of selected portfolio companies. This consolidation requirement would 
severely impact the private equity fund, its portfolio companies, and 
its limited partner investors. Although we do not believe that this was 
the intended result of FIN 46, it would have been the practical 
consequence.
    Under FIN 46, private equity funds that were required to 
consolidate their portfolio companies would have found that their GAAP-
compliant financial statements resembled, a conglomerate of some of the 
companies in which it has invested. While the requirement to 
consolidate may not have applied to every portfolio company, only a few 
consolidations would render the financial reports of the fund nearly 
meaningless for limited partner investors such as universities, 
endowments, and public pension funds. Furthermore, a portfolio 
company's variable operating results would obscure changes in the 
investment value of the total fund, impairing comparability of a fund's 
performance over time.
    By their nature, private equity portfolios undergo significant 
changes in their composition as additional investments are made, 
companies go public or are acquired. As a result, from quarter to 
quarter, portfolio companies would go from being consolidated to being 
divested, or vice versa, again and again. This variability impairs 
comparability of results and diminishes the overall relevance of the 
reports.
    FIN 46 also would impact our small and emerging growth portfolios 
companies themselves. For example, if a portfolio company were to enter 
into a joint venture, purchase a minority interest in another 
enterprise, recapitalize, or engage in any kind of off-balance sheet 
activity such as synthetic leases, securitizations, or factoring, FIN 
46 would force the addition or removal of assets and/or liabilities 
from the company's financial statements. This, in turn, could 
significantly change the company's financial picture and could impact 
loan covenants and other matters. When this is coupled with the fact 
that many of these very different portfolio companies may also have 
been consolidated with the financial statements of the private equity 
fund, the resulting hodgepodge of information would have met none of 
FASB's stated goals of producing relevant, reliable, and comparable 
financial statements. Private equity financial reports, which limited 
partners rely upon to make allocation decisions, would be so convoluted 
that firms would be forced to derive and maintain two sets of books--
one to meet the FASB requirement and one that investors could 
comprehend.
    Given the potential impact on the VC firms, their portfolio 
companies, and their investors, our industry spent an incredible amount 
of time trying to decipher FIN 46 and how it would apply to current and 
past transactions. Virtually no guidance was provided by the FASB 
despite numerous appeals for assistance from various constituents. 
FASB's deadlines further exacerbated the situation. Issued in January 
2003, FIN 46 was to be effective immediately for all VIE's created 
after January 31, 2003 and would have also applied to VIE's created 
before February 1. Although FASB had created a completely new 
terminology with broad ranging implications in its shift from SPE's to 
VIE's, there was no new comment period; no new exposure draft and no 
attempt to solicit input.
    FIN 46 effectively created an emergency call to action to which we 
all responded. Thousands of hours were spent on this issue by CFO's of 
small start-ups and private equity firms, attempting to understand its 
application to our industry and to understand how it would affect each 
of us. While we are somewhat relieved that FASB has recently suggested 
that private equity funds should not implement FIN 46, we believe that 
a process that solicited input from the beginning could have averted 
this crisis. And the destiny of others still hangs in the balance. Even 
now, FASB determined that a limited deferral of the rule was necessary 
for all businesses. At this date, FASB is still mulling over these 
rules, determining to whom and how they should apply, leaving the small 
business, investors, and private equity community hostage to 
uncertainty and confusion.

FASB'S Quest to Mandate the Expensing of Stock Options has Bulldozed
Ahead Despite Major Flaws in Their Approach at the Expense of Small
Businesses
    NVCA has a long history of working with FASB on the issue of stock 
options and our opposition to mandatory expensing is well known. We 
assert that the mandatory expensing of employee stock options will 
transform a critical incentive utilized by the majority of U.S. start-
up companies into a financial albatross that will harm small 
organizations to such an extent that they will have no choice but to 
negatively alter their option programs. The FASB accepted this 
conclusion in 1995 when it issued the current rule, FAS 123 in which 
specific provisions were promulgated for private companies. Yet, today 
FASB has inexplicably decided to change the rules to subject private 
companies to the same rules as public companies despite overwhelming 
consensus that such a move is fatally problematic.
    Stock options are a critical factor in fueling entrepreneurial 
innovation and economic growth, and they embody a principle that 
employees should have a financial stake in, and financial 
responsibility for, the companies they help to build. Almost without 
exception, young, start up companies use options to compete for talent 
when cash is scarce. Stock options allow these organizations to attract 
the best and the brightest human capital to bring new ideas to life. 
The enfranchisement effect has fostered the entrepreneurial spirit at 
all levels of organization and has given U.S. -based companies a 
competitive advantage over their foreign counterparts. The mandatory 
expensing of these options carries with it a host of dilemmas with the 
most widely-spread concern today being the issue of valuation.
    No viable method of valuing employee options exists today. Once 
thshould be the definitive answer, the Black Scholes option pricing 
model has now been virtually rejected by FASB and other experts as an 
appropriate method for valuing employee stock options, particularly for 
private companies. Other models, such as binomial methods, suffer from 
the same fatal flaws as Black Scholes and are even more complex. During 
the last year, we have implored the FASB to address the issue of 
valuation for employee stock options because without a common, accurate 
standard, an expense number will be meaningless to investors and too 
costly for young companies to derive.
    While public companies face a challenge of valuing these options, 
private and newly public companies are confronted with even greater 
problems. In August of this year, NVCA sat before the FASB and 
presented the facts that show that a valuation standard cannot exist 
for private companies because it is impossible to measure the 
volatility of a company whose stock does not trade. Volatility is a 
mandatory input to the models currently supported by the FASB. From a 
formulaic perspective, if one uses the ``wrong'' volatility there will 
be a meaningful distortion of the value of the stock option. FASB is 
familiar with this issue. In promulgating the current stock options 
rules contained in Statement No. 123, FASB determined that measuring 
volatility for private companies was too difficult. The FASB stated:
    ``An emerging entity whose stock is not yet publicly traded may 
offer stock options to its employees. In concept, those options also 
should be measured at fair value at the grant date. However, the Board 
recognizes that estimating expected volatility for the stock of a newly 
formed entity that is rarely traded, even privately, is not feasible. 
The Board therefore decided to permit a nonpublic entity to omit 
expected volatility in determining a value for its options. The result 
is that a nonpublic entity may use the minimum value method . . .'' 
Basis for conclusions para.174. (The minimum value method allows the 
volatility input to be set at zero.)
    While there have been no material changes in the theory of option 
pricing since 1994, and estimating the volatility of a stock that does 
not trade has not become any more feasible, the FASB has chosen to 
reverse their previous conclusion and move forward with a mandate that 
requires private companies to derive a volatility number.
    In this regard, we have raised another series of questions: How 
often do we calculate the value of stock options? Public companies work 
on a quarterly basis. Private companies do not. They focus on results 
month-to-month. Should small companies hire experts to come in each 
month to derive the value of newly granted stock options are each 
month? Who will do this work? What will they charge? Can the Big 4 
firms do this work? Who has the liability if there is a mistake? And 
exactly how does one compute the volatility of a company whose stock 
does not trade? FASB has provided no answers and is unlikely to do so. 
As I sit before you today, FASB has failed in its attempts to address 
the critical issue of valuation, but is nevertheless moving forward in 
its quest, at the expense of privately held and small businesses.

FASB'S Decisions are Increasing Monetary Costs and Lowering Financial
Reporting Credibility for Small Business
    While debating the substance of FASB's decisions on entity 
consolidation and stock option expensing may seem esoteric, the results 
of those decisions are not. They translate into significant monetary 
and credibility costs related to financial reporting that are 
disproportionately borne by small business.
    Aside from the obvious issues of the financials becoming inaccurate 
and unstable, a more practical concern is the monetary and human cost 
that will be required for young companies to undertake the 
consolidation and valuation processes. These organizations cannot 
afford the outside expertise required to work through complex models. 
They can no more afford to spend the time to do this themselves. But 
FASB's mandate will nonetheless force them to spend time and money on 
these accounting issues, raising expenses and lowering the bottom line.
    At a time when the overall costs for regulatory compliance continue 
to escalate for small business, FASB continues to place additional 
burdens on small companies, effectively lengthening the reliance on 
private equity to sustain a company until it can reach the profit 
levels necessary for an IPO or acquisition. This reliance on the most 
expensive form of risk capital will subsequently raise the overall cost 
of capital throughout the entire system.
    Congress has frequently stepped in and compelled Government 
regulators to perform a cost-benefit analysis prior to the imposition 
of new regulatory burdens. FASB too has readily acknowledged the need 
for this analysis but, apparently, has decided to ignore the approach 
they took in Statement No. 123 and in Statement No. 126, where they 
stated:

        ``The Board strives to determine that a proposed standard will 
        fill a significant need and that the costs imposed to meet that 
        standard, as compared with other alternatives, are justified in 
        relation to the overall benefits from improvements in financial 
        reporting. . . The Board has long acknowledged that the cost of 
        any accounting requirement falls disproportionately on small 
        entities because of their limited accounting resources and need 
        to rely on outside professionals.'' FAS 126, Exemption from 
        Certain Required Disclosures about Financial Instruments for 
        Certain Nonpublic Entities, basis for conclusions para.para. 9, 
        10.

    Implementing ill-conceived regulations also imposes a credibility 
cost that heavily impacts small companies. For example, if stock option 
expensing becomes mandatory, many analysts have said that they will 
``look through'' those numbers to a company's' underlying financials. 
But who will protect the smaller companies who do not have analysts to 
make this interpretation? Over 50 percent of the Nasdaq companies do 
not have analyst coverage. With only 50 percent of the small public 
companies receiving analyst coverage, what is the implication for 
private companies? It will be up to the banks, customers, and 
creditors--who have little access to detailed financial statements--to 
try to determine the underlying financial health of emerging growth 
companies.
    When we met with the FASB Board in August, one participant argued 
that the public needed to realize that GAAP financials are only 
accurate +/-50 percent. With that view, it is perhaps understandable 
that FASB feels any number is better than no number when it comes to 
valuing stock options. Unfortunately, we believe that path will have 
the result of making GAAP financials increasingly irrelevant. For large 
public companies, analysts will look through the GAAP numbers to pro 
forma statements. At the end of the day, it will be the small start-up 
segment that is left holding the bag and bearing the burden of this 
unnecessary complexity.
    To summarize, should the FASB move forward with its current 
consolidation and stock options proposals, private and young public 
companies will have inaccurate financial statements, prepared at a 
crippling cost. The entrepreneurial energy that now accounts for over 
10 percent of the U.S. economy will be drained at a time when the 
competitiveness and the robustness of the U.S. economy is severely 
challenged. The FASB remains silent on these challenges and is 
unequivocally pushing forward.
    Rapidly restoring investor confidence in the public markets has 
been a priority for many of us during the last 2 years. Reform 
continues to be required and we are all in favor of improving 
transparency and enhancing financial reporting. However, the FASB has 
fallen short in its efforts to enact meaningful changes quickly and has 
done so at the expense of small business. Ironically, large 
corporations, who are the targets of these reforms, are insulated from 
this ``ready, shoot, aim'' approach. Small start-up companies are not 
and feel the brunt FASB's lack of comprehensiveness and concern. We 
urge Congress to engage in this discourse so that we might avoid these 
serious consequences.
    Thank you for the opportunity to express NVCA's views on these 
vital issues.

         RESPONSE TO WRITTEN QUESTIONS OF SENATOR ENZI

                      FROM ROBERT H. HERZ

Q.1. In your written testimony you referred both to ``field 
visits'' and ``field testing'' that FASB occasionally conducts. 
Please elaborate on the difference between the two. Please list 
all companies currently involved in the testing process and 
denote which are small businesses. Please list all small 
companies that will be included in any future testing.

A.1. A ``field visit'' generally involves Financial Accounting 
Standards Board (FASB or Board) members or staff meeting with 
representatives of individual enterprises or firms that 
volunteer to engage in an in-depth discussion of a proposed 
approach or a proposed standard. In contrast, a ``field test'' 
generally involves the volunteer representatives engaging in 
the actual application of a proposed accounting approach or 
standard to certain past or current transactions.
    Field visits or field tests are not required by the FASB's 
Rules of Procedure. They are supplemental to the Board's open, 
extensive, and public due process procedures. The Board, on 
occasion, has chosen to conduct field visits or field tests 
when, in the judgment of the Board, those procedures might 
provide the Board with new information that may assist in 
obtaining a better understanding of the types of incremental 
costs and benefits that various parties may incur or realize in 
gathering, processing, understanding, and using the information 
that results from a proposed approach or standard.\1\
---------------------------------------------------------------------------
    \1\ The FASB recently revised its internal procedures to provide 
that field visits be undertaken prior to the issuance of a proposal for 
public comment for projects that are expected to introduce significant 
change or cost to users, auditors, and preparers of financial reports.
---------------------------------------------------------------------------
    Field visit participants may request that their 
participation and the information they provide to the FASB 
receive confidential treatment. Consistent with the FASB's 
Rules of Procedure, those requests are routinely granted.
    Below is the current list of enterprises that have, to-
date, volunteered to participate in the field visits in 
connection with the project to improve the accounting for 
equity-based compensation. As noted, some participants have 
requested confidential treatment.
    Your question does not include a definition of ``small 
businesses.'' As I indicated in my testimony, it has been our 
experience that users, auditors, and preparers of financial 
reports have very different notions of what constitutes a small 
business. The list, therefore, denotes three objective 
categories of field visit participants: (1) public enterprises 
(those companies that are registrants under the Federal 
securities laws); (2) nonpublic enterprises (those enterprises 
that are not registrants under the Federal securities laws); 
and (3) compensation consulting firms (those firms having both 
public and nonpublic enterprises as clients).

Public Enterprises
    Aetrium Incorporated
    Baxter International Inc.
    CVS Corporation
    EMC Corporation
    J.P. Morgan Chase & Co.
    Siebel Systems, Inc.
    6 additional enterprises requesting confidential treatment

Nonpublic Enterprises
    Cargill, Incorporated
    Google, Inc.
    3 to 5 additional enterprises to be identified by Grant 
Thornton LLP \2\
---------------------------------------------------------------------------
    \2\ Grant Thornton LLP (GT) is a national accounting, auditing, and 
business advisor whose clients are largely nonpublic enterprises. GT 
has agreed to assist the FASB in conducting the field visits for some 
nonpublic enterprises. GT is currently in the process of identifying 
three to five nonpublic enterprises to volunteer to participate in the 
field visits.
---------------------------------------------------------------------------
Compensation Consultants
    Aon Consulting
    Mercer Inc.
    Mellon Consulting

Q.2. Will the field visits and/or road testing include testing 
of the valuation models to be set forth in the upcoming draft 
proposal for FAS 123? Will the testing look at the degree of 
sophistication that is necessary by small companies to 
implement a valuation model to be set forth in the upcoming 
draft?

A.2. As indicated above, the FASB's ongoing field visits in 
connection with the project on improving the accounting for 
equity-based compensation are designed to provide additional 
supplemental input to the Board. That input is intended to 
further assist the Board in assessing and understanding the 
nature of the costs that some enterprises would incur as a 
result of applying the major tentative decisions made by the 
Board at public meetings since March 2003.\3\
---------------------------------------------------------------------------
    \3\ All of the Board's major tentative decisions in connection with 
the project to improve the accounting for Equity-Based Compensation, 
and other FASB projects, are publicly available on the FASB's website 
at www.fasb.org.
---------------------------------------------------------------------------
    More specifically, the Board's field visits are designed to 
solicit a broad range of information from participants about 
the Board's tentative decisions. That information is expected 
to include input on costs that participants would expect to 
occur in training or educating personnel or employees about the 
requirements to estimate the fair value of equity-based 
compensation as described in the Board's tentative decisions. 
Participants will be encouraged to comment on all aspects of 
the changes to reporting that are contemplated in those 
decisions.
    As indicated in my testimony, the Board's tentative 
decisions would not require that a nonpublic enterprise, 
including a small business, use an option-pricing model to 
determine the fair value of equity-based compensation. The 
Board has tentatively decided that nonpublic enterprises would 
be permitted to account for equity-based compensation using the 
intrinsic value method through exercise date. That method, 
defined as the difference between the exercise price of the 
award and the underlying stock price, is relatively simple, is 
well understood, and will result in a total expense for 
financial reporting purposes equal to the amount of expense 
that the enterprise would currently report for income tax 
purposes.

Q.3. What does the FASB intend to pursue in connection with its 
equity based compensation project?

A.3. The Board plans to continue its public deliberations on 
the project to improve the accounting for equity-based 
compensation. Those public meetings will include deliberations 
about the results of the field visits and other miscellaneous 
issues that have not yet been deliberated at public meetings. 
Announcements of those public meetings, the minutes of previous 
meetings, a detailed summary of the Board's tentative decisions 
to-date, and other materials relating to the project are 
publicly available on the FASB's website.
    The Board currently plans to be in a position to issue a 
proposed standard for public comment in the first quarter of 
2004. The Board, at public meetings, will carefully consider 
all input received in response to any proposal before any final 
decisions are made. The Board's current plan is to be in a 
position to complete its public redeliberations of the proposal 
and issue a final standard in the second half of 2004.

Q.4. Will the Option Value Group's final recommendation be made 
publicly available?

A.4. The FASB established the Option Valuation Group (OVG) to 
provide the Board with an additional source of input on how 
best to develop a standard to measure the fair value of equity-
based compensation. The OVG is composed of individuals who are 
leading experts on issues relating to equity pricing.\4\
---------------------------------------------------------------------------
    \4\ The FASB's website includes the minutes from the Board's July 
8, 2003, public meeting with the Option Valuation Group.
---------------------------------------------------------------------------
    Like other FASB task forces and advisory groups, the OVG is 
purely advisory. Thus, the OVG has not, and will not, be 
requested by the Board to develop a proposal or form a 
collective view or recommendation on any specific issue. 
Rather, individual members of the OVG are solicited by the 
Board and FASB staff on an ongoing basis to obtain their 
individual views, comments, and recommendations on specific 
issues that are within their areas of expertise and relevant to 
the Board's deliberations.
    As was indicated above, those individual views, comments, 
and recommendations are only one source of input to the Board 
in considering how best to measure the fair value of equity-
based compensation. All decisions of the Board, including all 
measurement decisions, are deliberated at public meetings after 
carefully considering the views, comments, and recommendations 
of all interested parties, including users, auditors, and 
preparers of the financial reports of public and nonpublic 
enterprises.

Q.5. In your testimony, you refer to the precepts that FASB 
adheres to when establishing an accounting standard. One of 
those precepts is a ``cost-benefit'' analysis that FASB 
conducts on each proposal. Please elaborate on the ``cost-
benefit'' you intend to conduct in connection with your equity-
based compensation project, and please indicate whether or not 
such a ``cost-benefit'' analysis includes an economic impact 
study assessing the consequences of a mandatory expensing 
standard.

    Please elaborate on findings of the cost-benefit analysis 
that was done on the proposal for FAS 150. Was a cost-benefit 
analysis done for FIN 46. If so, please elaborate on how the 
analysis was done and the findings of the analysis.

A.5. As indicated in my testimony, assessing the benefits and 
costs of a new or different method of accounting is integral to 
the Board's decision-making process. Every issue in an FASB 
project has its own mix of incremental improvement and 
incremental cost for the Board to consider.
    The principal benefit of any new accounting standard is to 
provide information that is useful in making business and 
economic decisions. Secondary benefits include:

 Maintaining and increasing the credibility of 
    financial statements, which is critical to investor 
    confidence.
 Lowering the cost of capital.
 Increasing the utility that users gain from the new 
    accounting information, including the ability to select 
    better among various investment options.
 Increasing the knowledge that a preparer gains about 
    the financial position and results of the enterprise.

    The Board's assessment of a standard's benefit to 
preparers, auditors, creditors, investors, and other users is 
unavoidably subjective. In making that assessment, the Board 
also considers the costs of not issuing a standard (for 
example, shareholder losses associated with nontransparent 
accounting), which is inherent in the benefits indicated above.
    As with the benefits associated with a new standard, a 
standard's incremental costs are borne by preparers of 
financial reports as well as by auditors and users of those 
reports. The types of costs associated with a new accounting 
standard are varied; some are one-time costs, while others are 
ongoing costs. The FASB' s conceptual framework identifies a 
number of costs that are relevant for the Board to consider as 
part of its assessment. Those costs include:

 Costs to the preparer of analyzing, developing, 
    collecting, and processing the information,
 Costs to the preparer and the auditor of understanding 
    the new requirements, and
 Costs to the users of analyzing and interpreting the 
    new information.\5\
---------------------------------------------------------------------------
    \5\ Statement of Financial Accounting Concepts No. 2, Qualitative 
Characteristics of Accounting Information, May 1980, paragraph 137.

    Those costs do not include potential ``economic impact'' 
costs. As indicated in my testimony, the mission of the FASB is 
to develop and improve financial accounting and reporting 
standards that result in transparent, credible, and unbiased 
financial information. Our mission is premised on the long and 
widely held belief that unbiased and objective financial 
information enhances economic and policy decisions, comparisons 
between enterprises, capital allocation, investor trust and 
confidence in financial reporting and the capital markets, and 
the growth and stability of the U.S. economy. Slanting an 
accounting standard to favor a particular transaction, 
industry, or special interest group, because of some potential 
``economic impact,'' thwarts the attainment of those 
objectives.
    There will always be many different business, economic, and 
social objectives that many may agree are worthy of 
encouraging, promoting, or otherwise subsidizing in some 
manner. Most users, auditors, and preparers of financial 
reports, however, agree that permitting or creating distortions 
through accounting standards and the resulting financial 
information is not the way to achieve those objectives.
    The purpose of financial accounting and reporting is to 
facilitate and promote sound, fair, and credible information to 
enable informed economic decisions. Diverging from that purpose 
to fulfill some other objective severely impairs the benefits 
and utility of accounting standards, weakening the fabric of 
the capital market system.\6\
---------------------------------------------------------------------------
    \6\ Testimony of Paul A. Volcker before the U.S. House of 
Representatives, Committee on Financial Services, June 3, 2003, page 2.
---------------------------------------------------------------------------
    In addition to undertaking the field visits, described 
above, the Board's assessment of the costs and benefits 
resulting from the project to improve the accounting for 
equity-based compensation will include the following additional 
procedures:

 Continuous dialogue with users, auditors, and 
    preparers of financial reports throughout the deliberations 
    and redeliberations about the types of benefits they expect 
    to realize and the costs they expect to incur as a result 
    of any new requirements,
 An explicit request in any proposal for public comment 
    for input on how the Board could further reduce the related 
    costs without reducing the benefits of the proposed 
    requirements, and
 Discussions at public Board meetings about the results 
    of the steps the Board has taken or will take to further 
    consider and balance the costs and benefits of applying any 
    new requirements and the relative costs and benefits 
    associated with alternative approaches that were considered 
    and rejected.

    The Board will not issue a final standard in connection 
with the project on equity-based compensation unless it can 
conclude, after deliberations at public meetings, that the 
issuance of any new requirements is a sufficient improvement to 
financial reporting to justify the perceived costs.
    With respect to Statement of Financial Accounting Standards 
No. 150, Accounting for Certain Financial Instruments with 
Characteristics of both Liabilities and Equity (Statement 150), 
and FASB Interpretation No. 46, Consolidation of Variable 
Interest Entities (FIN 46), both standards address certain 
financial accounting and reporting issues that were brought 
into the spotlight following the Enron Corp. bankruptcy.\7\ 
Those issues include the accounting for certain debt 
obligations that were classified as equity and the accounting 
for certain off-balance-sheet entities, respectively. Many 
preparers, auditors, and users of financial reports, including 
the U.S. Securities and Exchange Commission and many Members of 
Congress, requested that the FASB promptly address those 
issues. The Board worked as expeditiously as practicable to 
establish improved requirements in those areas while at the 
same time fully complying with our open, extensive, and public 
due process procedures.
---------------------------------------------------------------------------
    \7\ ``Rebuilding Investor Confidence, Protecting U.S. Capital 
Markets--The Sarbanes-Oxley Act: The First Year,'' House Committee on 
Financial Services, pages 3 and 4; Olaf de Senerpont Dornis, 
``Consolidating Options,'' Daily Deal, June 2, 2003; ``Accounting 
Rulemakers Tighten Rules on Liabilities,'' Reuters News, May 15, 2003; 
``In Quick Compromise, FASB Issues Tighter Rules on SPE's,'' Accounting 
Today, March 2003; ``New Rule to Curb Accounting Abuse,'' The Seattle 
Times, January 17, 2003; Jackie Spinner, ``FASB Tightens Rules on 
Special Purpose Entities,'' Washingtonpost.com, January 17, 2003; Deepa 
Babington, ``Tougher Rules on Enron-Type Deals Approved,'' Reuters, 
January 15, 2003.
---------------------------------------------------------------------------
    In connection with both Statement 150 and FIN 46 the Board 
concluded, in large part because of the broad and heightened 
level of concern about certain of the issues addressed in those 
standards, that issuance of the new requirements resulted in a 
sufficient improvement to financial reporting to justify the 
perceived costs. The Board, however, provided for special 
transition provisions, and special deferred effective dates for 
nonpublic entities in both standards to minimize the costs of 
the new requirements.\8\ Statement 150 included the following 
summary description of the Board's assessment of the costs and 
benefits of that standard:
---------------------------------------------------------------------------
    \8\ Statement 150, May 2003, paragraphs 29 and 30; FIN 46, January 
2003, paragraphs 27-29.

    The mission of the FASB is to establish and improve 
standards of financial accounting and reporting for the 
guidance and education of the public, including preparers, 
auditors, and users of financial information. In fulfilling 
that mission, the Board endeavors to determine that a proposed 
standard will fill a significant need and that the costs 
imposed to meet that standard, as compared with other 
alternatives, are justified in relation to the overall benefits 
of the resulting information. Although the costs to implement a 
new standard may not be borne evenly, investors and creditors--
both present and potential--and other users of financial 
information benefit from improvements in financial reporting, 
thereby facilitating the functioning of markets for capital and 
credit and the efficient allocation of resources in the 
economy.
    The Board determined that the requirements in this 
Statement would result in improved financial reporting. In this 
Statement, certain obligations that require a transfer of 
assets and that meet the definition of liabilities in Concepts 
Statement 6 will be reported as liabilities rather than as 
equity or between the liability and equity sections of the 
statement of financial position. Also, certain obligations that 
can be settled by issuance of an entity's equity shares but 
lack other characteristics of equity will be reported as 
liabilities, rather than as equity as previously required under 
Issue 00-19. Those changes result in financial statements that 
are more representationally faithful and present a more 
complete depiction of an entity's liabilities that will assist 
users in assessing the future cash flows and equity share 
issuances of an entity.
    The Board believes that the incremental costs of 
implementing this Statement have been minimized principally by 
(a) requiring cumulative-effect transition instead of 
restatement of financial statements and (b) providing a delayed 
effective date for mandatorily redeemable financial instruments 
of nonpublic companies. Although the one-time costs for changes 
needed to apply the accounting requirements of this Statement 
may be significant, the benefits from more representationally 
faithful information will outweigh those one-time 
implementation costs and will be ongoing.\9\
---------------------------------------------------------------------------
    \9\ Statement 150, paragraphs B82-B84.

    As indicated in my testimony, since the issuance of 
Statement 150 and FIN 46, the FASB has received input from many 
users, auditors, and preparers of financial reports, including 
representatives of small businesses, about implementation 
issues relating to the application of certain provisions of 
those standards. In response to that input, the FASB has issued 
over a dozen FASB Staff Positions,\10\ and a proposed 
modification to FIN 46,\11\ to address certain of the technical 
and implementation issues that have been raised.
---------------------------------------------------------------------------
    \10\ FASB Staff Position No. 150-1, ``Issuer's Accounting for 
Freestanding Financial Instruments Composed of More Than One Option or 
Forward Contract Embodying Obligations under FASB Statement No. 150, 
Accounting for Certain Financial Instruments with Characteristics of 
both Liabilities and Equity,'' October 16, 2003; FASB Staff Position 
No. 150-2, ``Accounting for Mandatorily Redeemable Shares Requiring 
Redemption by Payment of an Amount that Differs from the Book Value of 
Those Shares, under FASB Statement No. 150, Accounting for Certain 
Financial Instruments with Characteristics of both Liabilities and 
Equity,'' October 16, 2003; FASB Staff Position No. 150-3, ``Effective 
Date, Disclosures, and Transition for Mandatorily Redeemable Financial 
Instruments of Certain Nonpublic Entities and Certain Mandatorily 
Redeemable Noncontrolling Interests under FASB Statement No. 150, 
Accounting for Certain Financial Instruments with Characteristics of 
both Liabilities and Equity,'' November 7, 2003; FASB Staff Position 
No. 150-4, ``Issuers' Accounting for Employee Stock Ownership Plans 
under FASB Statement No. 150, Accounting for Certain Financial 
Instruments with Characteristics of both Liabilities and Equity,'' 
November 7, 2003; FASB Staff Position No. 46-1, ``Applicability of FASB 
Interpretation No. 46, Consolidation of Variable Interest Entities, to 
Entities Subject to the AICPA Audit and Accounting Guide, Health Care 
Organizations,'' July 24, 2003; FASB Staff Position No. 46-2, 
``Reporting Variable Interests in Specified Assets of Variable Interest 
Entities as Separate Variable Interest Entities under Paragraph 13 of 
FASB Interpretation No. 46, Consolidation of Variable Interest 
Entities,'' July 24, 2003; FASB Staff Position No. 46-3, ``Application 
of Paragraph 5 of FASB Interpretation No. 46, Consolidation of Variable 
Interest Entities, When Variable Interests in Specified Assets of a 
Variable Interest Entity Are Not Considered Interests in the Entity 
under Paragraph 12 ofInterpretation 46,'' July 24, 2003; FASB Staff 
Position No. 46-4, ``Transition Requirements for Initial Application of 
FASB Interpretation No. 46, Consolidation of Variable Interest 
Entities,'' July 24, 2003; FASB Staff Position No. 46-5, ``Calculation 
of Expected Losses under FASB Interpretation No. 46, Consolidation of 
Variable Interest Entities,'' July 24, 2003; FASB Staff Position No. 
46-6, ``Effective Date of FASB Interpretation No. 46, Consolidation of 
Variable Interest Entities,'' October 9, 2003; FASB Staff Position No. 
46-7, ``Exclusion of Certain Decision Maker Fees from Paragraph 8(c) of 
FASB Interpretation No. 46, Consolidation of Variable Interest 
Entities,'' November 26, 2003; Proposed FASB Staff Position No. 46-d, 
``Treatment of Fees Paid to Decision Makers and Guarantors as Described 
in Paragraph 8 in Determining Expected Losses and Expected Residual 
Returns of a Variable Interest Entity under FASB Interpretation No. 46, 
Consolidation of Variable Interest Entities;'' Proposed FASB Staff 
Position No. 46-f, ``Evaluating Whether as a Group the Holders of the 
Equity Investment at Risk Lack the Direct or Indirect Ability to Make 
Decisions about an Entity's Activities through Voting Rights or Similar 
Rights under FASB Interpretation No. 46, Consolidation of Variable 
Interest Entities.''
    \11\ FASB Proposed Interpretation, Consolidation of Variable 
Interest Entities, October 31, 2003.
---------------------------------------------------------------------------
    The FASB continues to monitor the application of Statement 
150 and FIN 46. The FASB will consider the issuance of 
additional guidance, if necessary, to assist users, auditors, 
and preparers, including representatives of small businesses, 
in implementing the provisions of those standards in a cost-
effective manner.

Q.6. With respect to FAS 150, you stated that while this 
accounting standard has been postponed indefinitely with 
respect to closely held companies there is still more to be 
accomplished. How will the FASB reach out to small entities to 
ensure that they are part of the discussion process for the 
remaining elements?

A.6. As indicated in my testimony, the Board has begun 
embarking on Phase 2 of its project to improve the accounting 
for Financial Instruments: Liabilities and Equity. The 
objectives of Phase 2 include:

 To improve the accounting and reporting by issuers for 
    financial instruments that contain characteristics of 
    equity, liabilities, or assets, and
 To amend and improve on the definitions of liability, 
    equity, and, perhaps, assets in the FASB's conceptual 
    framework, such that decisions made in Statement 150 and in 
    Phase 2 are consistent with those definitions.

    Phase 2 also will include a reconsideration of 
implementation issues, and, perhaps, classification or 
measurement guidance, for mandatorily redeemable instruments of 
nonpublic enterprises. As part of that consideration the Board 
plans to again actively solicit the views of users, auditors, 
and preparers of the financial reports of nonpublic 
enterprises, including representatives of small businesses, in 
several ways, including:

 Seeking participation by representatives of small 
    businesses on an FASB small business advisory committee,
 Seeking participation by representatives of small 
    businesses on an FASB Financial Instruments: Liabilities 
    and Equity resource group,
 Scheduling regular public liaison meetings and less-
    formal meetings with representatives of small businesses, 
    and
 Participating in conferences and other speaking 
    engagements sponsored by or attended by representatives of 
    small businesses, which provide opportunities for having a 
    dialogue with a broad range of users, auditors, and 
    preparers of the financial reports of small businesses.

    The Board presently expects to issue a proposal for public 
comment in connection with Phase 2 of the project on Financial 
Instruments: Liabilities and Equity in the second half of 2004.
    As indicated in my testimony, the Board is aware of the 
significant focus over the past year on the financial 
accounting and reporting of public enterprises, in part, 
because of the many activities relating to the Sarbanes-Oxley 
Act of 2002. We, however, remain committed to serving the needs 
of all users, auditors, and preparers of financial reports, 
including those representing small businesses.

                     STATEMENT OF DAVID A. RAYMOND

          President, American Council of Engineering Companies
                           November 12, 2003

    Mr. Chainnan, on behalf of the American Council of Engineering 
Companies (ACEC), I am pleased to submit this testimony today before 
the Subcommittee on Securities and Investment hearing on the Financial 
Accounting Standards Board and Small Business Growth.
    ACEC is the business association of America's engineering industry, 
representing 6,000 independent engineering companies throughout the 
United States engaged in the development of America's transportation, 
environmental, industrial, and other infrastructure. ACEC member firms 
represent the broad spectrum of the engineering industry, from very 
large firms to small, family-owned businesses. More than 60 percent of 
ACEC's membership, about 4,000 firms, are small businesses with fewer 
than 30 employees each. Overall, our members employ approximately 
500,000 people throughout the 50 States. Founded in 1910 and 
headquartered in Washington, DC, ACEC is a national federation of 51 
State and regional organizations.
    ACEC is very appreciative of your leadership, Mr. Chairman, and 
that of the Ranking Member, Senator Dodd, in focusing the 
Subcommittee's attention on the Financial Accounting Standards Board 
(FASB) and the impact of FASB's actions on our members, particularly 
smaller engineering firms. The Statement of Financial Accounting 
Standards 150 (FAS 150), which was originally released last May, has 
generated considerable concern in the engineering industry. While it 
appears that FASB has made modifications to the statement in response 
to industry comments, we remain concerned over what the future may hold 
should FASB decide to proceed with implementation.
    ACEC remains strongly opposed to FAS 150 as it was originally 
released. If implemented, FAS 150 will artificially and unfairly 
eliminate the net worth of many nonpublic engineering firms throughout 
the country. The statement will distort the true economic value of 
these firms and present a false picture to the readers of their 
financial statements, leading to errors, misunderstandings, and 
possibly the wrong conclusions.
    As you know, Mr. Chairman, FAS 150 requires non-public companies to 
classify as liabilities any financial instrument issued in the form of 
equity that is ``mandatorily redeemable.'' A financial instrument is 
``mandatorily redeemable'' if it requires the company or entity to buy 
back the assets of a shareholder at a specific date or time, such as 
the death of the shareholder, retirement, or termination.
    Since many firms have such arrangements in place where shares are 
automatically repurchased when a shareholder retires, resigns, or dies, 
the new standard is expected to affect most non-public engineering 
firms. Repurchasing arrangements are typically put in place in order to 
keep ownership within a family or small group of key management 
employees. Stock ownership in small companies is needed to fuel the 
entrepreneurial spirit; where an individual's efforts will reap future 
rewards based on such efforts. The obligation today is on the 
individual to perform; the firm's obligation to redeem the shares 
sometime in the future is affected by events that may or may not 
happen. More importantly, the value of this obligation varies based on 
a variety of internal and external factors, such as profitability (or 
lack thereof), industry or market conditions, and even gross national 
product (as it may relate to the availability of funding for Federal 
and State projects.). All of these factors, I am sure you will agree, 
are largely volatile, yet FASB apparently believes a specific and 
accurate valuation can be assigned. Worse still, any change in the 
valuation is to be reflected in the income statement of the entity.
    Firms must follow FASB's standards to comply with generally 
accepted accounting principles and receive an unqualified audit opinion 
from their certified public accountant (CPA). Unfortunately, by 
classifying as debt equities held by company shareholders, the affect 
of the new standard would significantly reduce, or even eliminate, the 
net worth of non-public engineering firms. The revisions to financial 
statements as required by FAS 150 will not reflect an engineering 
firm's real financial condition, yet they will have dire consequences 
on its ability to obtain new clients, loans, bonding and insurance.
    For example, under the requirements of FAS 150, an engineering firm 
seeking prequalification with a State department of transportation will 
present the agency with a financial statement characterized by an 
artificially high debt load that could effectively shut them out from 
competing for the design work on a road or bridge project.
    The accounting required by FAS 150 recognizes only the eventual re-
purchase obligation. It does not recognize the increase in assets that 
will result from the ``re-cycling'' of such re-purchased shares for 
sale to other owners. When such re-cycling is recognized, there is no 
need for FAS 150.
    Mr. Chairman, ACEC strongly recommends that FASB take steps to 
ensure that the new standard does not apply to non-public, non-SEC 
registered firms. We believe very strongly that more time and study is 
needed to carefully and completely assess the impact this standard will 
have on privately held engineering firms and others in the business 
community. We applaud FASB's efforts to bring more truth into financial 
reporting and believe that disclosure is important, but requiring the 
recording of redeemable stock as a liability when no date for 
redemption is known and where the valuation is questionable is wrong.
    Today's hearing is a necessary and important first step in the 
education process. Once again, Mr. Chairman, on behalf of ACEC and the 
Nation's engineering industry, we thank you and Senator Dodd for your 
leadership on this important issue. We look forward to working with you 
in coming months. Thank you.



