[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
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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
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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.
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* Held in Committee files.
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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.*
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* 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.
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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.
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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\
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\8\ Value Line Investment Survey, Oct. 17, 2003, p. 1151;
www.staples.com.
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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.
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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.*
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* Held in Committee files.
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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.
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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\
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\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\
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\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.
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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\
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\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.
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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\
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\4\ The FASB's website includes the minutes from the Board's July
8, 2003, public meeting with the Option Valuation Group.
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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\
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\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\
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\6\ Testimony of Paul A. Volcker before the U.S. House of
Representatives, Committee on Financial Services, June 3, 2003, page 2.
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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.
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\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.
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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:
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\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\
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\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.
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\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.
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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.