    [Senate Hearing 108-612]
    [From the U.S. Government Publishing Office]

                                                            S. Hrg. 108-612

                       IMPACT OF STOCK OPTION EXPENSING
                              ON SMALL BUSINESSES

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

                                    HEARING

                                   BEFORE THE

                          COMMITTEE ON SMALL BUSINESS
                              AND ENTREPRENEURSHIP

                              UNITED STATES SENATE

                          ONE HUNDRED EIGHTH CONGRESS

                                 SECOND SESSION

                                   __________

                                 APRIL 28, 2004

                                   __________

          Printed for the use of the Committee on Small Business and
                                Entrepreneurship

     Available via the World Wide Web: http://www.access.gpo.gov/congress/
                                     senate

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                COMMITTEE ON SMALL BUSINESS AND ENTREPRENEURSHIP

                          ONE HUNDRED EIGHTH CONGRESS

                                 SECOND SESSION

                         OLYMPIA J. SNOWE, Maine, Chair
    CHRISTOPHER S. BOND, Missouri        JOHN F. KERRY, Massachusetts
    CONRAD BURNS, Montana                CARL LEVIN, Michigan
    ROBERT F. BENNETT, Utah              TOM HARKIN, Iowa
    MICHAEL ENZI, Wyoming                JOSEPH I. LIEBERMAN, Connecticut
    PETER G. FITZGERALD, Illinois        MARY LANDRIEU, Louisiana
    MIKE CRAPO, Idaho                    JOHN EDWARDS, North Carolina
    GEORGE ALLEN, Virginia               MARIA CANTWELL, Washington
    JOHN ENSIGN, Nevada                  EVAN BAYH, Indiana
    NORMAN COLEMAN, Minnesota            MARK PRYOR, Arkansas

                        Weston J. Coulam, Staff Director
        Patricia R. Forbes, Democratic Staff Director and Chief Counsel

                                C O N T E N T S

                                  ----------

                               Opening Statements

                                                                       Page

    Allen, The Honorable George, a United States Senator from
      Virginia.......................................................     5
    Bayh, The Honorable Evan, a United States Senator from Indiana...     7
    Ensign, The Honorable John, a United States Senator from Nevada..     8
    Enzi, The Honorable Michael B., a United States Senator from
      Wyoming........................................................     1
    Levin, The Honorable Carl, a United States Senator from Michigan.     3
    Pryor, The Honorable Mark, a United States Senator from Arkansas.    10

                                   Testimony

    Herz, Robert H., Chairman, Financial Accounting Standards Board,
      Norwalk, Connecticut...........................................    10
    Batavick, George J., Board Member, Financial Accounting Standards
      Board, Norwalk, Connecticut....................................    10
    Holtz-Eakin, Douglas, Director, Congressional Budget Office,
      Washington, DC.................................................    21
    Levin, The Honorable Carl, a United States Senator from Michigan.    33
    Carron, Keith, Ph.D., Founder and President, CC Technology,
      Laramie,
      Wyoming........................................................    51
    Diamond, Stephen F., Visiting Assistant Professor of Law, Cornell
      Law School, and Assistant Professor of Law, Santa Clara
      University School of Law.......................................    59
    Glover, Jere W., Brand and Frulla, Washington, DC................    69
    Jones, Marc, President and Chief Executive Officer, Visionael
      Corporation, Palo Alto, California.............................    81
    Kavazanjian, John, President and Chief Executive Officer,
      Ultralife Batteries, Inc., Newark, New York....................    89
    Mendoza, Roberto G., Chairman, Integrated Finance Limited, New
      York, New York.................................................    96
    Schnittker, Christopher P., Senior Vice President and Chief
      Financial Officer, Cytogen Corporation, Princeton, New Jersey..   100

              Alphabetical Listing and Appendix Material Submitted

    Allen, The Honorable George:
        Opening statement............................................     5
    Batavick, George J.
        Testimony....................................................    10
        Prepared statement...........................................    15
    Bayh, The Honorable Evan:
        Opening statement............................................     7
    Carron, Keith:
        Testimony....................................................    51
        Prepared statement...........................................    53
    Diamond, Stephen F.:
        Testimony....................................................    59
        Prepared statement...........................................    61
    Ensign, The Honorable John:
        Opening statement............................................     8
       Alphabetical Listing and Appendix Material Submitted--[continued]

                                                                       Page

    Enzi, The Honorable Michael B.:
        Opening statement............................................     1
        Post-hearing questions posed to Professor Diamond............   131
        Post-hearing questions posed to Mr. Herz.....................   133
        Post-hearing questions posed to Mr. Holtz-Eakin..............   149
        Post-hearing questions posed to Mr. Mendoza..................   154
    Fitzgerald, The Honorable Peter G.:
        Prepared statement...........................................   120
        Excerpts from testimony provided by the Honorable Alan
          Greenspan, Chairman, Federal Reserve Board, during the
          Joint Economic
          Committee Hearing on Economics Outlook.....................   122
        Remarks by Chairman Alan Greenspan at the 2002 Financial
          Markets Conference of the Federal Reserve Bank of Atlanta,
          Sea Island,
          Georgia, concerning Stock Options and Related Matters......   123
    Glover, Jere W.:
        Testimony....................................................    69
        Prepared statement...........................................    71
    Herz, Robert H.:
        Testimony....................................................    10
        Prepared statement...........................................    15
    Holtz-Eakin, Douglas:
        Testimony....................................................    21
        Prepared statement...........................................    24
    Jones, Marc:
        Testimony....................................................    81
        Prepared statement...........................................    83
    Kavazanjian, John:
        Testimony....................................................    89
        Prepared statement...........................................    92
        Subsequent submission of added comments......................   156
    Kerry, The Honorable John:
        Prepared statement...........................................   301
    Levin, The Honorable Carl:
        Opening statement............................................     3
        Prepared statement...........................................    33
        Letter of Clarification on tax treatment of incentive stock
          options (ISOs).............................................   129
    Mendoza, Roberto G.:
        Testimony....................................................    96
        Prepared statement...........................................    98
    Pryor, The Honorable Mark:
        Opening statement............................................    10
    Schnittker, Christopher P.:
        Testimony....................................................   100
        Prepared statement...........................................   103
                            Comments for the Record

                                                                       Page

    Burns, The Honorable Conrad, a United States Senator from
      Montana:
        Prepared statement...........................................   166
    Coalition to Stop Stock Option, The, prepared statement..........   170
    E*Trade Financial, prepared statement............................   173
    Herz, Robert H., Chairman, Financial Accounting Standards Board,
      Norwalk, Connecticut, prepared statement and attachments.......   177
    Kerry, The Honorable John, prepared statement....................   301
    Mendoza, Roberto G., Chairman, Integrated Finance Limited, New
      York, New York, Proposal by IFL for Expensing Ex-employee
      Compensatory Stock Options for Financial Reporting Purposes....   303
    Smith, Dr. Craig, Chairman, President and CEO, Guilford
      Pharmaceuticals, Baltimore, Maryland, prepared statement.......   325
    TechNet New England, prepared statement..........................   329

                       IMPACT OF STOCK OPTION EXPENSING
                              ON SMALL BUSINESSES

                                  ----------

                           WEDNESDAY, APRIL 28, 2004

                          United States Senate,
              Committee on Small Business and Entrepreneurship,
                                                        Washington, DC.
        The committee met, pursuant to notice, at 10:04 a.m., in
    room 428A, Russell Senate Office Building, Hon. Michael Enzi
    presiding.
        Present: Senators Enzi, Fitzgerald, Allen, Ensign, Levin,
    Bayh, and Pryor.

           OPENING STATEMENT OF THE HONORABLE MICHAEL ENZI,
                  A UNITED STATES SENATOR FROM WYOMING

        Senator Enzi. I will go ahead and call this hearing to
    order. I want to welcome all of the panelists from our two
    distinguished panels and express appreciation for all of you
    taking the time to provide us with the information. This is the
    Small Business Committee, and the approach is on small
    business. I have to admit that early on in this process I made
    the mistake of calling in some people that had experience with
    what I was talking about, had resources to be able to talk
    about it, and some of those were big businesses and it confused
    the message. So I am very pleased that we are able to do a
    small business hearing to emphasize some of the small business
    aspects and to make sure that there is some kind of a positive
    delineation between the requirements that we have for mature
    businesses and growing businesses, particularly small
    businesses. Small businesses do make up a significant part of
    all business. There are 23 million small businesses, which is
    99.7 percent of all employers. That is one-half of the private
    sector employers and 60 percent of the net new jobs, 50 percent
    of the non-farm private GDP and 13 times more patents per firm
    than the big patenting firms.
        Now, I do want to congratulate FASB for work that they have
    done and for their importance to the international economy. I
    have been a very strong defender of their independence and am
    still a strong defender of their independence. It is extremely
    important that they be an independent board.
        I am recognizing kind of a failure to communicate, and it
    is a failure on my part because I have not been able to get
    across this small business aspect, the start-up that has been
    so important in the United States and so important that China
    is now outdoing new start-ups about 40-to-1 over us. It is
    because they have a business plan that calls for stock options
    for small businesses, for start-ups.
        Again, small business does not have the opportunity that
    big business does to represent themselves in a lot of these
    things. I mentioned a hearing--my first year, this Small
    Business Committee allowed me to hold a hearing in Casper,
    Wyoming, on some of the difficulties small businesses were
    having with the Federal Government. When it was over, one of
    the news media came up to me and said, ``You didn't have a very
    good turnout today. Only about 100 businesses showed up.''
    Well, Casper is not all that big compared to here, and my
    comment was, ``Any small business that has the extra resources
    and people to be able to come and testify would fire that
    person because they can't afford him.''
        I was pleased that Chairman Herz announced in the November
    hearing that he was going to have a Small Business Advisory
    Committee, and I had emphasized it in my opening comments. So,
    I was particularly pleased that he had paid attention to that.
        Now, I had envisioned it to be like NASD's Advisory
    Committee, and NASD's Advisory Committee meets 4 times a year
    and they kind of pick what things they want to review on behalf
    of business. It is my impression that the advisory committee
    that has been selected at this point for FASB is going to meet
    twice a year, and they are only going to talk about the topics
    that FASB wants them to address. I hope there can be some more
    flexibility in there.
        I have also been a little disturbed at some of the letters
    coming from Members of that Small Business Advisory Committee
    lobbying on behalf of FASB. I am very worried about the
    lobbying aspect of this whole thing. Answering questions is
    extremely important. Educating us is extremely important, but
    out-and-out lobbying is something that seems kind of out of
    place in all of this.
        I do appreciate the opportunities that I have had to meet
    with the Chairman and members of FASB. When I see that there is
    a conference call with institutional investors and they are
    being encouraged by the Chairman to contact Congress--now,
    institutional investors are people that, you know, even delve
    in the realm of hedge funds. It is not small business, and they
    are being asked to tell us that it is all okay.
        Now, in some testimony last week, it was mentioned that the
    rule is only eight pages long. Well, if you count the
    appendices, it is 229 pages, and it is very disturbing to me
    that there are only two mentions in that whole thing about
    small business.
        Now, small business has an investment in stock options.
    There are 1.4 million businesses. They represent 15.4 million
    jobs, and they are concerned about what is happening with their
    stock options.
        Another thing that disturbed me about the rule, without any
    advance warning, suddenly employee stock purchase plans showed
    up in that. Now, when we are talking about small business in
    Wyoming, that means that the mom-and-pop business trying to
    sell their business to their employees, trying to give their
    employees an opportunity to take it over so there is continuity
    in the business, are now going to pay attention to FASB and
    have some complicated rules that they have to follow. I know in
    last week's testimony that there was mention that the FASB
    standards for small business are a private choice.
        Well, unless it says so somewhere, unless there is a very
    definite statement, every bank, every supplier, anybody that
    deals with the business is going to have to make sure that they
    are following the standard that FASB put out. Somehow we have
    to make a distinction on that, and until we make a distinction,
    there isn't any business that really has a choice.
        So I think we are kind of passing the buck and shirking the
    responsibility for small business. It is kind of a mad hatter's
    game of hide-and-seek for small business where they try to find
    things out.
        I know that a lot of the controversy around this hinges
    around executive compensation. I know that Congress is very
    jealous of a lot of people that make a lot of money. We have
    shown it in actual bills that we have passed limiting the cash
    compensation that executives can make.
        It doesn't matter what we do. There are ways around what we
    do. Sometimes as we try to put those things into place, we kind
    of foul things up for everybody.
        A recent article in The Washington Post found that with or
    without stock options, executives are going to get their pay.
    So this proposal wouldn't do anything to curb executive
    compensation, but it will curb the ability of ordinary workers
    to receive stock options, and it will curb small business'
    ability to hire workers and to create new jobs.
        One of the ways that a start-up business gets really good
    technical people is to offer stock options so that they can
    grow with the business. These small businesses don't have any
    other way to really provide that incentive for them to come in.
    They don't have enough cash to pay them cash up front, so it
    will have a drastic effect on small businesses. This hearing is
    intended to hear what small business has to say, and that will
    be the second panel.
        I would like to welcome our witnesses today and thank them
    in advance for their testimony. I will mention that I have
    condensed my opening comments considerably and hope that people
    will kind of stick to a format of about 5 minutes on their
    statements so that we will have time for questions. There are a
    lot of things we need to go over in this.
        On our first panel today, we have two members of FASB: the
    Honorable Chairman Robert Herz and George Batavick who is
    chairing the Small Business Advisory Committee. In addition, we
    have the Honorable Douglas Holtz-Eakin, the Director of the
    Congressional Budget Office. I appreciate all of you appearing
    today.
        Senator Levin, any opening comments?

            OPENING STATEMENT OF THE HONORABLE CARL LEVIN,
                 A UNITED STATES SENATOR FROM MICHIGAN

        Senator Levin. Thank you very much, Mr. Chairman.
        This is a very important hearing, and we look forward to
    hearing from our panelists as to the purpose of the FASB rule,
    what the origin of the rule is, and as to whether or not it has
    a particular effect on small businesses as distinguished from
    other companies, and if so, what that effect is.
        We adopted a reform following the Enron disaster called
    Sarbanes-Oxley, and one of the things we did in Sarbanes-Oxley
    was to give FASB greater independence by giving it a source of
    revenue which would be protected. We saw that FASB was put
    under huge, huge political and lobbying pressure about 10 years
    ago when they decided to require that options be expensed like
    all other forms of compensation. FASB had to back off at that
    time despite their beliefs. It is supposed to be an independent
    accounting board which adopts accounting standards free from
    political pressure, and this time around it did what it
    believed was the right thing to do, which is to treat stock
    options as compensation like all other forms of compensation.
        Stock options are the only form of compensation which, up
    until now, do not need to be expensed. If you give somebody
    stock, conditional or otherwise, if you give somebody a bonus,
    conditional or otherwise, based on performance, that must be
    expensed at one point or another. It is compensation. It has
    got to show up on the books.
        There has been this treatment of stock options which is
    unlike any other incentive pay or any other pay or compensation
    of any kind, which for reasons we saw very clearly in the early
    1990s, are excluded from the usual rule, which is that
    compensation is going to show up on the books. Companies get a
    tax deduction for compensation. They get a tax deduction when
    the stock options are exercised. In fact, it is now typical
    that employees get tax deductions up front when the stock
    options are granted. That is even now allowed, and many
    employees of small businesses take tax deductions immediately.
        So in terms of the argument you can't value stock options,
    they are valued all the time. They are valued in footnotes
    which are shown, and employees who take tax deductions now,
    when given the stock option are allowed in many instances to
    take tax deductions now. Yet, it doesn't show up on the
    company's books as an expense.
        That double standard fueled the Enron disaster. What
    happened in Enron and many other companies is that the
    executives enriched themselves by taking huge amounts of stock
    options, made the company look a lot better than it was through
    phony accounting, made the books look great, showed a big
    profit for the company, had the stock value go up, exercised
    their options, enriched themselves, and left their companies
    bankrupt.
        The question always haunted me: How could they do that? How
    can they make the books show a profit and not pay income tax on
    that profit? How do they survive as an executive by showing a
    profit on their books but not having to pay Uncle Sam the
    income tax on that profit? The answer was stock options,
    because those same stock options which enrich them, in Enron
    and too many other companies, at the expense of stockholders
    and employees, those same stock options are a tax deduction. So
    Enron could deduct the value of those stock options on its
    income tax, but not show the value of those stock options as an
    expense on its books. So it had these large profits shown,
    which were phony profits, but did not have to honestly show the
    stock option value as an expense on its books. That was a major
    part of the Enron disaster for us.
        Putting all that aside, we have an independent accounting
    board now, which has made a decision that it is going to
    require that stock options be expensed. Our Chairman points out
    that stock options are an extremely valuable tool. They are. So
    are bonuses a valuable tool for performance. So are grants of
    stock based on performance, but they all have to be expensed.
        Our Chairman points out that stock options are being used
    in China, and that is great. The issue here isn't whether or
    not stock options are used. The question here is the accounting
    for stock options. What will the accounting rule be for stock
    options? That is the issue, not whether stock options are
    granted; not anymore than it is whether or not bonuses are
    granted for performance or whether or not stock itself is given
    for performance.
        Again, when bonuses and stock are given based on
    performance, they are shown as an expense on the books. That is
    what the accounting rule is. Stock options are the only form of
    compensation which is not treated like other forms of
    compensation, and that is what FASB is proposing to change.
        One final comment on China. I understand--and I would like
    our witnesses to comment on this--that in focusing on stock
    options, China is also adopting the International Accounting
    Standard Board rule, which is going to go into effect next
    year, which requires that stock options be expensed. If we are
    correct, in China, which is going to make greater use of stock
    options, they are going to adopt the same accounting principle
    for those stock options in China as FASB is proposing here
    domestically.
        Finally, a very small percentage of our small businesses
    use stock options, as far as we can tell. I hope our witnesses
    will comment on that. The best figure that we can get is that
    about 3 percent of small businesses, according to one study,
    use stock option grants. So regardless if or not we have the
    same accounting rule or a different accounting rule for stock
    options relative to small businesses under the current rule,
    which does not require expensing, those stock options do not
    need to be expensed at all, since only 3 percent of our small
    businesses apparently use the stock options. Of course, no
    business, unless it is incorporated, unless it is public, has
    to adopt the Generally Accepted Accounting Principles, (GAAP).
    So I think--and I would like statistics on this from our
    witnesses--the vast majority of small businesses do not follow
    the GAAP rules because they are not public companies. I would
    like to hear some testimony on that as well.
        Thank you very much, Mr. Chairman, for bringing us
    together. It is a very important subject, and I look forward,
    at least as long as I can stay here, to hearing from our
    witnesses.
        Senator Enzi. Senator Allen.

           OPENING STATEMENT OF THE HONORABLE GEORGE ALLEN,
                 A UNITED STATES SENATOR FROM VIRGINIA

        Senator Allen. Thank you, Mr. Chairman, for having this
    hearing, and thank you for your expert leadership on this very
    important issue, which I think affects our economy, our jobs,
    and the opportunities particularly for small businesses, start-
    ups, and those that may be small businesses and not publicly
    traded, but ultimately might be.
        I vow to stay here through much of this hearing. We have a
    battle on the floor possibly on trying to stop taxing of the
    Internet, so I may have to leave if we get back to that.
        Let me make a few observations here on why I think the way
    that you are bringing the Small Business and Entrepreneurship
    Committee into focus here on the impact, particularly on
    smaller businesses, is so right and so appropriate.
        First, let me just give everyone here my view. I think
    incentives are a great idea. I think it is a great idea if
    employees own part of the company or have the potential of
    owning more of the company. It has been suggested--and I think
    it makes a great deal of sense intuitively--that if an employee
    cares more about just a paycheck every two weeks and actually
    cares about the market share and how a company is growing and
    they also have that incentive that those stock options that
    they might someday get will actually have some value, I think
    that is a great motivation. In fact, one respected technology
    CEO said, ``Employees with stock options are like homeowners;
    whereas, those without stock options are like renters.'' He saw
    a difference in attitude, commitment, and the level of
    entrepreneurial spirit. It all makes a great deal of sense.
        My concern with what the Financial Accounting Standards
    Board is planning to do with this exposure draft--and it seems
    like they have preordained that they are going to do it--is the
    impact all this is going to have on jobs and the ability of
    broad-based stock ownership for broad-based employees, not the
    top executives of the company, but the ability for companies
    that may have 50, that may have 500 employees, they may have
    even 5,000 employees. The point is all the employees from
    clerical to some of the engineers, to the scientists, to the
    innovators, all of that is going to have an adverse impact on
    their productivity and those opportunities for those
    individuals.
        Now, what we have here is an elected Senate, and we are
    faced with unelected officials on the Financial Accounting
    Standards Board. And the effect of all the benefits of stock
    options for employees, broad-based employee stock options, will
    come to an end if this proposal goes forward. The question,
    though, and the whole issue here is how are you going to treat
    employee stock options as an accounting expense and disregard
    just certain fundamental issues.
        First, employees' stock options are not freely tradable.
    They inure to the benefit of an employee, and they only have
    any value of whatever that strike price is eventually achieved
    4 or 5 or 6 years down the road. So how do you value something
    that has no market? How do you put a price on something if it
    is not for sale? The answer is you cannot, and there is no
    accurate way to value these options without an open market.
        On top of it all, we have a proposal now that really hasn't
    been field-tested very much, this binomial approach as opposed
    to Black-Scholes, which has generally been discredited. So on
    top of it all, an untested proposal is going forward on
    something that really is not evaluable.
        The stock options, of course, take several years, and the
    other thing is for small businesses--and even larger
    businesses--when they have downturns, say in the technology
    sector, because they are using stock options, which may or may
    not become worth something someday, rather than laying off
    employees, they don't have that underlying expense because say
    their salary component. Their salary that they pay every month,
    is not as high because they are giving more in stock options.
    So instead of laying people off, their expenses are less, and
    that keeps folks motivated, staying with the company, not
    jumping to another job, so that when the demand kicks in, that
    talent is still there for that company.
        I do also find it distressing that on the Pacific Rim and
    particularly in China, the People's Republic of China has
    companies in that country advertising and promoting themselves
    that they have employee stock options. I would hope in the
    United States of America that we would want to make sure that
    we are competitive and that we do not lose talent, we do not
    lose those jobs, offshoring, so to speak, because of the better
    incentive packages that creative innovators can get from
    working in a company in the People's Republic of China. I will
    also point out Bear Stearns said that if FASB is determined to
    fundamentally change--to go with their flawed assumptions about
    their proposals as far as expensing stock options, there will
    be a 44-percent decline in the Nasdaq 100 companies' profits
    that they would have been required to expense, employee stock
    options, if they had to in 2003. So, granted, the Nasdaq 100
    are not necessarily small businesses; however, they are
    businesses--and I do care about businesses, large, small, and
    medium size, and a lot of small businesses, a lot of those
    companies on Nasdaq at one time were small businesses. So I
    think it is very important that we address the economic impact
    of this on jobs, the competitiveness of the country, and
    particularly in looking at small start-up companies that want
    to retain good people, quality people in their workforce, as
    well as attract people to serve on the board of directors that
    will also help those companies grow.
        I thank you, Mr. Chairman, for your leadership on this very
    important issue.
        Senator Enzi. Thank you.
        Senator Bayh.

             OPENING STATEMENT OF THE HONORABLE EVAN BAYH,
                  A UNITED STATES SENATOR FROM INDIANA

        Senator Bayh. Thank you, Mr. Chairman. As much as I would
    like to think that the audience is gathered here today to hear
    me give a speech, I suspect that they are here to listen to our
    panel, and I am here to listen and learn. Let me just take 2
    minutes to sort of share my perspective with which I am
    approaching this issue.
        It seems to me that our job as public policymakers is to
    attempt to reconcile a couple of very important and potentially
    competing concerns that will be brought up in the course of
    these deliberations. The first is the importance of the
    accounting aspect of all of this, the need for accuracy and
    transparency in accounting that is vitally important to the
    functioning of our capital markets, the confidence and trust
    that investors, both large and small, can place in the American
    system of free market enterprise. That is a very important
    concern I know we are going to be hearing about today.
        Senator Allen alluded to some of the difficulties of
    achieving accuracy in this context. It seems to me from what I
    can hear that perfection is likely to escape us, but,
    nevertheless, we need to do the best we can in terms of
    achieving accuracy and transparency.
        There is also a set of other issues that some of our
    colleagues have touched upon here. I refer to these as the
    macroeconomic issues: incenting innovation, which I think is
    very important in terms of what the competitiveness of the
    American economy is going to be going forward; global
    competitiveness, vitally important at this juncture with
    increased globalization and competition.
        It is possible that there is going to be some tension
    between these different principles that we seek to embody in
    our decisionmaking. I was going to say the potential
    consequences are significant. A couple of decades ago, I
    believe, the treatment for health care expenses was changed,
    moving that from a footnote up into the balance sheet, and it
    set off a chain of events, which may be good, may not be good,
    depending on your perspective. They were very significant.
    Companies began to take health care costs much more seriously.
    That led to the rise of managed care organizations, which has
    led to, in some respects, a backlash against the provision of
    care in that regard, which has then led to the call for the
    Patient's Bill of Rights, et cetera, et cetera, et cetera. A
    change in the accounting treatment of health care expenses led
    to really some profound changes in a seventh of the American
    economy. That touches upon the daily lives of almost every
    American.
        So as I said, that may have been good, it may not have been
    good, but it was profound. It makes it vitally important that
    we get this right and at least make some attempt to anticipate
    what the impact of all this is going to be on accuracy and
    transparency, but also on the rate of innovation and our
    ability to compete globally with those we have to compete with.
        Those are sort of some of the principles I am trying to
    approach this debate with. I want to thank our panel members
    and others for being here today, and I look forward to
    receiving their wisdom.
        Thank you, Mr. Chairman.
        Senator Enzi. Thank you.
        Senator Ensign.

            OPENING STATEMENT OF THE HONORABLE JOHN ENSIGN,
                  A UNITED STATES SENATOR FROM NEVADA

        Senator Ensign. Thank you, Mr. Chairman. I think this is a
    vitally important issue when it comes to the competitiveness of
    America in the global economy. What Senator Bayh just talked
    about, I think, is exactly right. If we mess this up, there
    could be severe consequences, and I hope that our panel is
    taking that to heart.
        What Senator Levin mentioned was that this isn't about
    whether to use stock options or not. This is just about how to
    account for those. The problem with that statement is that the
    people who are issuing stock options are telling us that if
    FASB goes ahead with what they are planning, broad-based stock
    option plans will come to an end.
        Now, are the top employees going to get stock grants and
    are some companies going to use stock grants? Yes. The top
    employees aren't the people that we are worried about. It is
    the rank and file employee out there that will no longer, as
    Senator Allen talked about, be an owner in the company. Silicon
    Valley was built on stock options. A lot of these start-up
    companies that could not afford to pay the top prices were
    giving lower wages, and stock options, basically allowing the
    individual employees themselves to be an entrepreneur. Part of
    being an entrepreneur is being a risk-taker. As a veterinarian,
    I started my own animal hospital in Las Vegas. I was a risk-
    taker. I was putting my own heart, sweat, money, everything at
    risk.
        Well, that is what broad-based stock options plans do to
    the front-line employee, do to the secretary, do to the
    engineer, do to all rank and file workers. They become owners
    in the company, believers in the company.
        When we put in these types of accounting standards that are
    so complex, you confuse people. I am not an expert, I am not an
    accountant like our Chairman is. Listening to the CFOs out
    there and to the people that are going to actually have to
    comply with this, they are pulling their hair out. They are
    saying there is no way that they are going to do this. Company
    after company after company is telling us that, and especially
    now if--in this draft proposal, you give two different options,
    binomial, Black-Scholes, and a company is forced to pick one
    and not the other, you are setting people up for frivolous
    lawsuits from trial lawyers.
        If we are going to expense--which I disagree with in the
    first place--then we should certainly have a valuation method
    that is accurate, but also one method that everybody uses so
    there isn't a choice out there because, otherwise, I believe it
    is going to once again be just a tremendous windfall to the
    trial lawyers in America.
        What we should be after is accuracy and transparency, and I
    still don't understand--and maybe the panel can address this--
    why disclosing stock options at the various prices that they
    were given on the various financial statements and income
    statements, why those wouldn't be accurate enough for the
    average investor. I mean, that is what you are trying to do.
    You are trying to say, okay, as an investor I see those out
    there, I can figure out any dilution that represents. But if
    they are actually being expensed and forcing restatements and
    effecting the stock price, it just doesn't seem to make sense.
    My father is a chairman and CEO of a public company. It started
    at $25 a share, went to $42 a share, to $17 a share, back to
    $28, down to $7 a share, back to $28 a share, back to $15 a
    share, to $42, back to $25, and now it is up to $60.
        The volatility of markets makes expensing of stock options
    so incredibly complex that I frankly think that is going to
    hurt investors and our company and the biggest thing I think
    that is going to hurt is our competitiveness in the global
    community. We should be looking at everything we can do to make
    American business more competitive in the global marketplace.
    That means reforming regulation and the way we tax our
    companies and accounting rules. That is certainly a regulation,
    and we should not be making American companies less
    competitive, especially with the Pacific Rim, which anyway, is
    by far the most competitive place for the United States.
        So I look forward to hearing from our panel today and
    certainly hope that our panel is listening to the people who
    are on the front lines making these decisions. You are not
    responsible for the competitiveness of the United States. You
    know, they are, we are, and I hope that we do this right
    because I am very afraid of what is going to happen.
        Senator Enzi. Thank you.
        Senator Pryor.

            OPENING STATEMENT OF THE HONORABLE MARK PRYOR,
                 A UNITED STATES SENATOR FROM ARKANSAS

        Senator Pryor. Mr. Chairman, I am glad you brought this
    very important issue before the committee today. I appreciate
    your leadership on it, and I think any comments I would have
    would really just be ground that has already been plowed by
    these other Senators. So I would like to just hear from the
    panel now.
        Thank you.
        Senator Enzi. Thank you.
        We will move to the panel then, and the first person to
    present, of course, will be the Chairman of the Financial
    Accounting Standards Board, Chairman of FASB, Robert Herz. He
    joined PricewaterhouseCoopers in 1974 after graduating from the
    University of Manchester in England with a B.A. degree in
    economics, and moved on to Coopers and Lybrand. He has been
    real active in the AICPA with the security regulations
    committee and a transnational auditors committee of the
    International Federation of Accountants. An amazing background,
    and he has a recent book, ``The Value of Reporting Revolution:
    Moving Beyond the Earnings Game.''
        Mr. Chairman.

      STATEMENT OF ROBERT H. HERZ, CHAIRMAN, FINANCIAL ACCOUNTING
    STANDARDS BOARD, NORWALK, CONNECTICUT; AND GEORGE J. BATAVICK,
        BOARD MEMBER, FINANCIAL ACCOUNTING STANDARDS BOARD, AND
      CHAIRMAN, FASB SMALL BUSINESS ADVISORY COMMITTEE, NORWALK,
                              CONNECTICUT

        Mr. Herz. Well, thank you, I guess it is Acting Chair Enzi,
    and thank you, Members of the Committee. I am Bob Herz,
    Chairman of the FASB. With me, as you said, is George Batavick,
    one of my fellow Board members, and he will be chairing our
    newly established Small Business Advisory Committee. That very
    good idea did come from Senator Enzi, and we thank him for
    that. We are pleased to appear before you today on behalf of
    the FASB and thank you for allowing us to participate in this
    very important and timely hearing.
        We certainly recognize the importance of small business to
    job creation, to entrepreneurship, and to our Nation's economy.
    Accordingly, we also recognize the need to carefully evaluate
    whether our proposed improvements to financial reporting, not
    just on this subject but in general, not only are conceptually
    sound and meet the needs of the users of those reports, but
    also whether the proposed improvements can be implemented by
    small businesses in a cost-effective manner.
        We have got some brief prepared remarks, and I would
    respectfully request that the full text of our testimony and
    all supporting materials be entered into the public record.
        Senator Enzi. Without objection, they will be included.
        Mr. Herz. As you know, we are an independent private sector
    organization. Our ability to conduct our work in a systematic,
    thorough, and unbiased manner is fundamental to achieving our
    mission, which is to establish and improve general purpose
    standards of financial accounting and reporting for both public
    and private enterprises. We believe those standards are
    essential to the growth and stability of the U.S. economy
    because creditors, investors, and other consumers of financial
    reports rely quite heavily on credible, transparent,
    comparable, and unbiased financial information to make their
    economic and investment decisions.
        Now, because the actions of the FASB affect so many
    organizations, our decisionmaking process must be open, it must
    be thorough, and it must be as objective as humanly possible.
    Our rules of procedure require an extensive and public due
    process. That process involves public meetings, public hearings
    or roundtables, field visits or field tests, liaison meetings
    with many interested parties, consultations with our advisory
    councils, exposure of our proposed standards to external
    scrutiny and public comment, and then after the comment period,
    public redeliberation by the Board, which often, I will tell
    you, does result in significant changes and improvements to
    proposals.
        Our due process procedures do include participation by
    users, auditors, and preparers of the financial reports of
    small business. The recent formation of the Small Business
    Advisory Committee is intended to further enhance that
    participation.
        We make final decisions only after carefully considering
    and analyzing input of interested parties. We try our darndest
    to balance the often conflicting perspectives of the various
    parties in order to make independent, objective decisions
    guided by the fundamental concepts and key qualitative
    characteristics of sound, fair, and transparent reporting.
        On March 31, we issued a proposal for public comment to
    improve the accounting for equity-based compensation. It is out
    for a comment period of 90 days, and we will be holding
    roundtables and other meetings. George will talk about that. It
    is the result of an extensive public due process that began in
    November 2002. That process included the issuance of a
    preliminary document for public comment, review of over 300
    comment letters received and over 130 further unsolicited
    letters, consultation with advisory committees, review of
    relevant research, meetings with valuation and compensation
    experts, field visits to companies, public and private
    discussions with hundreds of individuals, and active
    deliberation of the Board at 38 public Board meetings, of which
    about half of those meetings small business issues and non-
    public-company issues, were discussed.
        Based on our work to date, we believe the proposal would
    significantly improve the financial reporting for equity-based
    compensation arrangements. We would do that by creating greater
    transparency and completeness in the reporting and a more level
    playing field in accounting for different forms of equity-based
    compensation. We believe the proposal would enhance the
    comparability of reported results, profitability, and other key
    financial metrics between companies that choose to compensate
    their employees in different ways. The proposal would achieve
    this by a number of provisions, but most notably, and I guess
    most controversially, by the proposed elimination of the
    existing exception for so-called fixed-plan employee stock
    options, which are the only form of stock option, and which are
    the only form of equity-based compensation that is not
    currently required to be reported as an expense in the
    financial statements. The proposal reflects our view that all
    forms of equity-based compensation should be properly accounted
    for and that the existing exception for fixed-plan employee
    stock options results in reporting that not only ignores the
    economic substance of those transactions, but that also
    distorts reported earnings, profitability, and other key
    financial performance metrics.
        Thus, under the current rules, the greater the use of these
    instruments to compensate employees, the greater the distortion
    of the reported results. I would note in contrast, this
    distortion does not occur when companies use stock options or
    similar instruments which can often be quite complex, such as
    stock purchase warrants for purposes other than compensating
    employees, for example, to acquire goods and services, employ
    consultants, or in financed M&A transactions, because in those
    cases, the current rules do require that the options or the
    warrants be valued and properly accounted for.
        Now, just to digress into the public company arena for just
    one second, and then we are going to have George focus on small
    business, in the public company arena the proposal would also
    bring about greater comparability between the nearly 500
    companies that have now voluntarily opted to account for the
    cost of employee stock options in their financial statements
    and the many others that have elected not to do so.
        It would also result in substantial convergence in the
    accounting for equity-based compensation between U.S. standards
    and the international accounting standards that are followed by
    companies, including many small and non-public companies in
    over 90 countries around the world.
        I would like to now hand it over to George who will discuss
    the several special provisions contained in the proposal that
    relate to small business as well as some other small business
    matters and, very importantly, talk about our continuing work
    and due process on this important subject.
        Mr. Batavick. Thank you, Bob, and good morning, everyone.
    Before I outline the special small business provisions
    contained in our proposal to improve the accounting for equity-
    based compensation, I would first like to provide some brief
    background on small businesses and financial accounting and
    reporting standards.
        First, there is no Federal law requiring non-public
    enterprises to use FASB standards. Thus, for most small
    businesses, the use of our standards is primarily a private
    choice. For some small businesses, that choice may be
    influenced by whether they have plans to become a public
    enterprise.
        For other small businesses, the decision to follow FASB
    standards may be influenced or controlled by their current or
    potential lenders, suppliers, other contracting parties, et
    cetera. To the extent that one of those parties requires that
    the financial reports of small businesses comply with our
    standards, that requirement presumably reflects that party's
    opinion that our standards result in better, more transparent
    information for their respective purposes.
        Second, it is also important to note that the FASB has long
    recognized, as part of our ongoing public due process
    procedures, that the costs of complying with our standards can
    fall disproportionately on small businesses. In recognition of
    that fact, the Board actively solicits and carefully considers
    requests from users, auditors, preparers of financial reports,
    and considers whether or not there should be special provisions
    to alleviate the costs of implementing our standards.
        These requests come from our continuous and ongoing due
    process and deliberations throughout the life of a project. In
    this project on equity-based compensation, if you are following
    it, all constituents, large and small, could have taken
    advantage of our free weekly action alert e-mail subscription,
    which discusses current agenda items and past Board decisions.
    They could have attended an open Board meeting. They could have
    called in, or they could have listened to our free webcasts of
    meetings on the day of the meeting and one week after. Our
    meetings also get extensive news coverage, and our free website
    includes an up-to-date summary of all equity-based compensation
    issues as well as our tentative decisions. We sought input from
    various State CPA societies, who in turn briefed their
    clients--in many cases small businesses--on the status of the
    project. Lastly, liaison meetings with various groups having
    small business representation and Board and staff speaking
    engagements provided additional means of receiving valuable
    input from the small business community.
        With respect to this proposal, it is our understanding that
    although the use of employee stock options is prevalent at some
    small businesses, particularly start-ups and venture capital-
    backed enterprises that plan to become public enterprises, the
    vast majority of small businesses, 3 percent or less, in the
    U.S. do not grant employee stock options. As indicated earlier,
    however, for those small businesses that are impacted by our
    proposal, the proposal includes several special provisions
    intended to alleviate the costs of implementation.
        First, the proposal includes a special provision that would
    permit most small businesses, including all that are non-
    public, to measure compensation cost using a simpler, less
    costly intrinsic value method, rather than the fair-value-based
    method. Under the intrinsic value method, the amount of
    compensation expense required to be reported would generally be
    equivalent to the amount of the income tax deduction for stock
    options.
        Second, the proposal includes a special provision that
    provides that most small businesses that are non-public
    enterprises would have a simpler, less costly prospective
    transition to the new requirements. Finally, the proposal
    includes a special provision that provides that the effective
    date of the proposed standard for non-public enterprises would
    be delayed 1 year until 2006.
        I would also like to note that the proposal includes a
    Notice for Recipients that highlights and describes these
    special provisions. The notice requests that respondents to the
    proposal indicate what other special provisions for small
    businesses might be appropriate and whether any or all such
    provisions should also be extended to public enterprises that
    are small business issuers.
        The Board currently plans to discuss the proposal's special
    provisions and other issues about the proposal with
    representatives of small businesses at our inaugural public
    meeting of our Small Business Advisory Committee on May 11. Our
    request for agenda items, which was made to this committee for
    this meeting, showed interest in this proposal. We also plan to
    hold several public roundtable meetings with valuation and
    compensation experts, users, auditors, preparers, et cetera, in
    June to discuss a broad range of issues.
        Following the end of the comment period in June, the Board
    plans to redeliberate, at public meetings, issues raised in
    response to the proposal, including all those issues raised by
    the small business community. Those redeliberations will
    include careful consideration of these requests, including
    ongoing input from the Small Business Advisory Committee.
        Only after evaluating the input at public meetings will the
    Board consider whether to issue a final standard.
        On behalf of myself and Bob, I would again like to express
    our appreciation for inviting us to participate in this
    hearing. All the information we obtain at this hearing will be
    carefully considered.
        In conclusion, let me assure you--and I know Bob will also
    assure you--that you and the users, auditors, and preparers of
    small business financial reports can have confidence that the
    Board will continue to reach out actively and solicit input
    from representatives of small businesses in response to our
    proposal. That input will be carefully considered in an open,
    thorough, and objective manner that will best serve the
    interests of all parties.
        Thank you again, and Bob and I would welcome any
    opportunity to respond to questions you may have.
        [The prepared statement of Mr. Herz and Mr. Batavick
    follows:]

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        Senator Enzi. Thank you.
        That was Mr. George Batavick, who is not only on FASB, but
    he is the Chairman of the Small Business Advisory Committee. He
    is the former Comptroller of Texaco, Inc. He has company-wide
    responsibility for strategy and policy matters covering all
    aspects of accounting and financial reporting, special studies,
    internal controls, and tactical plan coordination, and he has
    had a career in public accounting at Arthur Andersen. Thank you
    for the testimony.
        The next person to testify will be Dr. Douglas Holtz-Eakin,
    who is the sixth Director of the Congressional Budget Office.
    He spent 18 months as a Chief Economist for the President's
    Council on Economic Advisers, and he serves as CBO's
    representative on the Federal Accounting Standards Advisory
    Board. He served as editor of a number of publications--the
    National Tax Journal, been involved with the Journal on Human
    Resources, and a whole list of them, very impressive list of
    them. We look forward to your testimony, Dr. Holtz-Eakin.

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

        Mr. Holtz-Eakin. Mr. Chairman, members of the committee,
    the Congressional Budget Office recently delivered to Congress
    a report on the accounting for employee stock options, which
    examined the issue from an economic perspective, with a
    particular focus on measurement issues and on the economic
    implications of accounting for stock options. I want to
    highlight three main points of that report, and then I would be
    happy to take your questions.
        The first point is that granting stock options to employees
    results in a cost to the firm that is equivalent to cash and
    other non-cash compensation. Using the fair value or cash
    equivalent of compensatory options at grant and recognizing
    that value over the period when the corresponding labor
    services are provided--the vesting period--brings accounting
    closer to the economic reality of total firm expenses and net
    income.
        That finding is based on three observations:
        First, is that stock options are valuable to employees;
    otherwise, they would not accept them as a substitute for other
    compensation.
        Second, the value of options can differ among employees and
    change over time. However, the reporting entity is the firm. In
    reporting net income for the firm, costs should be recognized
    at the time the labor services are provided; expensing over the
    vesting period reports that cost for the firm. Any subsequent
    changes in the value of the options represent a shift of
    resources among stakeholders in the firm and not a change in
    the cost of labor compensation--a point that we explain in more
    detail in the report.
        Finally, stock options can be cost-effective. Beneficial
    incentive or productivity effects will be reflected in
    earnings. A fair display of the cost-effectiveness will be
    achieved by showing the cost of labor services required to
    produce those earnings. For that reason, any accounting
    standard should recognize their value, but not prohibit the use
    of stock options.
        The second major point is that valuing stock options is
    more difficult than valuing cash compensation. The difficulty
    does not appear to preclude the recognition of their fair
    value, however, especially when compared with the intricacy of
    other calculations of compensation expenses.
        It is more difficult than cash or non-cash benefits, such
    as employee health insurance, largely because the price is not
    observed and because it has some special features, such as
    vesting periods, forfeiture provisions, and restrictions on
    transferability. However, advances in financial analysis now
    permit reasonable valuation of a wide variety of such warrants,
    and indeed they are present in many investment portfolios,
    including those of the Federal Government.
        To provide some perspective, the valuation of employee
    stock options can be compared with another form of
    compensation: retiree health benefits. To value those, a firm
    must forecast employees' tenure, the retirees' marital status,
    trends in health and mortality, changes in medical technology,
    and the ultimate cost and utilization of medical services. In
    short, the valuation exercise is forward-looking and is based
    on uncertain and volatile prices. Current methods for employee
    stock options address an analogous situation, and robust
    options-pricing methods are now available to every MBA.
    Moreover, as the demand for such valuation increases, we would
    anticipate further analytic advances and an increased supply of
    people providing this service to firms.
        The final point I want to make from our report is on the
    economic implication of recognizing the expense of employee
    stock options. This accounting requirement would not change the
    economic fundamentals of any business, large or small. Firms'
    cash flows would not be affected. Their customers, product
    markets, and competition would be unchanged. Small and large
    businesses would face the same labor market conditions, and
    they would have the same tools available to attract highly
    productive labor. Their taxes would be unchanged. In fact, the
    underlying financial facts would be precisely the same for all
    businesses after the accounting change. Thus, the only channel
    for any real economic effect would be changes in investors'
    valuation of these businesses.
        One would expect that for savvy investors and for most
    firms, expensing would provide no new information and,
    therefore, no change in value. Current standards require firms
    to calculate and disclose, in audited notes, the fair value of
    the options grants and the effect of recognizing them as an
    expense, on net income. Expensing would only make this
    information available more easily and to a broader audience.
        Now, it has been argued that there will be a significant
    decline in stock prices as a result of expensing. In advance,
    no definitive evidence can be offered for this claim. However,
    evidence from other similar events--for example, the early
    1990s exposure draft from the FASB, firms that have voluntarily
    adopted expensing in the United States, and firms that have
    expensed these grants in Canada or the European Union--argues
    against any significant overall effect on stock prices.
        A related concern is that stock prices of businesses too
    small to be tracked by market analysts may be adversely
    affected by expensing. Many of the CEOs of such firms believe
    that expensing will reduce their stock prices and have
    announced that they will stop granting options. This is a
    serious issue. The economic importance of these entrepreneurial
    firms and the informed source of these reports requires that we
    consider it carefully.
        It may be the case that investors in such small firms may
    be surprised by the information received from expensing stock
    options and that this will cause a decline in stock prices, an
    increase in the cost of equity capital, and potentially sizable
    near-term losses for managers and employees. If some firms are
    relatively overvalued, other firms are relatively undervalued,
    and those firms will enjoy a corresponding increase in their
    stock prices as a result of the accounting change. This would
    permit near-term expansion of markets and employment by such
    firms. Those offsetting effects reduce the possibility of a
    significant overall effect.
        Moreover, these same considerations suggest that improved
    information will allow capital in the economy as a whole to
    flow to its most productive uses. For the economy as a whole,
    this would provide a benefit in the form of increased
    productivity and competitiveness.
        Thanks, and I look forward to your questions.
        [The prepared statement of Mr. Holtz-Eakin follows:]

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        Senator Enzi. I want to thank all three of you for your
    outstanding testimony and particularly for the more extensive
    documents that you have provided for us. I was able to go
    through quite a few of those, but I need to have some answers
    to some more general questions to start out with.
        I am concerned about the method of gathering information
    about the proposed standard. I guess I am a little disappointed
    that the concentration is on convincing Congress that what you
    are doing is right rather than soliciting comments to find out
    whether what you are doing is right. I am just not familiar
    with this process of a Board that is supposed to be
    soliciting--and everything that they write talks about
    listening and process and accountability and thoroughness, and
    they have had the appearance of being locked into a primary
    approach from the very beginning, and everything that seems to
    be happening continues to put forward that approach.
        For instance, I got a letter from the Big Four accounting
    firms, and they said that that was at the solicitation of FASB
    officials, asking us not to do any legislation. I have said a
    number of times that if the small business aspect--if there is
    an appearance that it has been listened to, then legislation
    may not be necessary. But if it isn't listened to, there may be
    a landslide toward doing it.
        It is based around listening, not about legislating, and
    there is so much concentration being done on the legislation
    that I am not sure that the listening is being done.
        Chairman Herz, would you comment on that, as well as your
    role as a lobbyist?
        Mr. Herz. Well, I think we listen a lot. We meet with many
    people. We get lots and lots of input. I went over that.
    Inevitably, some people have views, and when you don't accept
    their views, they say you are not listening. Listening does not
    necessarily mean that you agree or obey.
        We are continuing to listen. We really are. In fact, on the
    small business aspect, your suggestions have been outstanding,
    I think, on the Small Business Committee. Just from my meetings
    with you, I think I have taken on some of your infectious
    passion for the subject, and we will continue to do that.
        At a hearing actually on the House side back in June, I
    said that I don't think personally one-size-fits-all in that
    regard. One of my involvements was being a managing partner of
    a series of investment funds that invested in a lot of things,
    including venture capital, direct equity investments in start-
    ups and the like. I think I have got a pretty decent feel for
    that.
        Our job is ultimately to find the right accounting,
    accounting that is sound, accounting that is also cost-
    beneficial, that is understandable, and we are going to listen
    real hard and work it real hard. You have my commitment to
    that.
        As for the lobbying, I can't help but thinking that it is
    kind of a little bit like the pot calling the kettle black. You
    know, we all know from all the press reports--and we didn't
    want to politicize this issue. Long before we even put this on
    the agenda, the International Stock Option Coalition was
    formed, was ready--you know, the press, on Capitol Hill, you
    called a roundtable yourself right after we put this on the
    agenda. I think that was a useful roundtable, but hearings were
    all called. This is about the fifth or sixth hearing this month
    on this subject.
        I understand. I actually think Senator Bayh's perspective
    is kind of where I would come down. You guys have got--I mean,
    this is a public policy issue, and there are competing--there
    may be competing goods. I hope there aren't competing goods. I
    mean, my view is let's get the accounting right. If you want to
    incent innovation through stock options, triple the tax
    deduction, do something else, but let's get the information set
    right so that the capital markets can work.
        In regard to lobbying, we have not asked any firm to lobby
    for us with respect to our proposed standard to improve the
    accounting for equity-based compensation. Since 1996, our
    Washington, DC representative, Jeff Mahoney, has provided
    information and responded to questions about the FASB and our
    activities from staff and Members of Congress, Federal
    Government officials, and other interested parties here in
    Washington, DC. He also arranges for me to meet directly with
    many of you, with your staff, and other people in Washington.
    Our communications sometimes entail lobbying contacts as
    defined in the Lobbying Disclosure Act relating to proposed
    legislation that relates to our activities, both Jeff and I and
    my predecessor, Ed Jenkins, were registered under the Lobbying
    Disclosure Act on behalf of the Financial Accounting Standards
    Board.
        Our intent is not to lobby, not to politicize at all, but,
    we have seen on the other side since this issue began and more
    lately with the well-publicized fly-ins of executives and, as
    Senator Fitzgerald said at last week's hearing--I don't know
    what adjective he used--that the place was swarmed with,
    crawling with high-tech lobbyists. We would rather have this
    issue discussed on its merits like we are doing today rather
    than through a political context.
        Senator Enzi. Well, I appreciate that. I can tell you, I
    wouldn't have been nearly as surprised had I gotten a letter
    from each of the Big Four accounting firms instead of a joint
    one from the Big Four accounting firms. I didn't know they got
    together on that personal of a basis.
        But to move on, I am really pleased that you did a Small
    Business Advisory Committee. I am hoping that you will perhaps
    make it a little bit more of a Small Business Advisory
    Committee. Under NASD--and I keep using that as an example
    because I am hearing a lot of good reports on things that are
    happening as a result of it, the chairman is actually from a
    small firm. The advisory committee meets on a regular basis.
    The advisory committee selects what it is going to hear. On
    your advisory committee, they are going to have a half a day, I
    think, to look at this proposal and go into the details on this
    intrinsic and fair value and Black-Scholes and binomial
    valuation models. I am also wondering if that is nearly
    adequate. And I am wondering how the comments by the Small
    Business Advisory Committee will become a part of the docket
    then on what you are actually going to do. I am also a little
    concerned about people from that committee already writing
    letters and saying what is going to happen. If it hasn't even
    met, it seems a little premature for the committee to have any
    kind of an opinion yet.
        Would either of you care to comment on that?
        Mr. Batavick. Yes, Senator, I would. Going back to the
    meeting itself, as you know, when we formed this committee, we
    reached out to over 20 different organizations for
    representation--the American Community Bankers, the National
    Venture Capital Association, Small Business Administration,
    etc. We believe we have an excellent committee. I have spoken
    with just about everyone that was nominated for the committee,
    and I can tell you they are very enthusiastic on two fronts.
    They are enthusiastic that they are going to be providing us
    with important issues that we can consider, but they are also
    interested in getting together as a group so the users and the
    preparers and the auditors can hash out issues.
        It was raised earlier today: Why do some of these private
    companies follow our standards? Well, these are the types of
    issues we are going to be discussing to make sure that the
    users understand what the preparers and the auditors are going
    through.
        We did go out prior to the meeting with a suggestion for
    agenda items. We did receive a number of requests, and those
    requests were around the area of equity-based compensation,
    which, as Senator Enzi said, is going to be the largest topic
    discussed at our meeting. We also thought it was important to
    discuss other issues that they brought up. They brought up our
    Standard 150 on mandatory redeemables. They brought up issues
    on business combinations. They brought up issues on various
    other matters like the accounting environment, and whether we
    should we have differential accounting standards.
        So based on those agenda requests from the committee, Mr.
    Senator, we formed the agenda itself. Also, we are not looking
    to have just two meetings a year. Unfortunately, that was mis-
    communicated. What we meant to communicate is that, at a
    minimum, 2 times a year we will meet. We are going to discuss
    during this meeting what type of frequency will make sense.
    Even if the frequency of the meetings is only 3 or 4 times a
    year, let's say, or 5 or whatever, that doesn't mean that we
    don't reach out to this committee whenever we want to. That
    doesn't mean that they can't pick up the phone and call us and
    give us their input.
        If you look at the agenda on equity-based compensation,
    what you will see is that when we talk about the provisions,
    when I brief this committee on some of the differential
    provisions we have for non-publics, we are going to ask them:
    Should this be expanded to other small businesses and how? What
    do you need to educate yourself? What help do you need to
    implement the requirements?
        These are all the questions that we are going to be
    spending a considerable amount of time on at our inaugural
    meeting. The people that I spoke with are very energetic, very
    excited about getting together. And I believe they feel coming
    in here that they will be able to have input and they will be
    able to make a difference.
        Senator Enzi. I appreciate that, and it is very
    encouraging, and I will be looking forward to the results on
    that. I know that my time has run out, but I have to ask Dr.
    Holtz-Eakin a question. I will mention that I would appreciate
    it if we could put some additional questions to everybody in
    writing and get some responses. What we are doing, of course,
    is building a record so that we know what to do in the future
    and how things are going based on what we have heard today.
        Dr. Holtz-Eakin, in the CBO study on FASB, was there any
    independent technical accounting analysis or just the
    documentation used from FASB itself? I noticed that there
    wasn't any mention of small business in the CBO study. So was
    there any input from small business? Were there any additional
    studies that were used besides information from FASB?
        Mr. Holtz-Eakin. Well, certainly the CBO study reflects our
    reading of the broad accounting and research literature in
    economics on both the measurement issues and the economic
    implications. So it is far from focused on just the materials
    received from FASB but, rather, on the entire record of
    published research.
        Senator Enzi. Okay. I will have some additional questions.
        Mr. Holtz-Eakin. Certainly.
        Senator Enzi. I appreciate it.
        Senator Levin.
        Senator Levin. Thank you, Mr. Chairman.
        Mr. Chairman, first of all, I would like my statement to be
    made part of the record, including that portion which lists
    some of the leaders in the financial and accounting world who
    have supported the expensing of stock options.
        Senator Enzi. Your full statement will be a part of the
    record.
        [The prepared statement of Senator Levin follows:]

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        Senator Levin. These supporters include Alan Greenspan,
    Treasury Secretary Snow, SEC Chairman Donaldson, Public Company
    Accounting Oversight Board Chairman McDonough, former SEC
    Chairman Levitt, and a lot of investors, including Warren
    Buffett, the Council of Institutional Investors, the Investment
    Company Institute, Financial Services Forum, Consumer
    Federation of America, National Association of State
    Treasurers, Institute of Management Accountants, and the
    Conference Board's Commission on Public Trust and Private
    Enterprise.
        None of these folks want to hurt small business. All of
    these folks want honest accounting, and that is what this is
    all about.
        Second, I must say I admire the guts and the courage of the
    major accounting firms in this country because they have
    decided to do what they believe is right, which is to support
    the FASB approach. I can't tell you the pressure that was put
    on those accounting firms to go against FASB. It was huge. We
    talk about lobbying? The pressure placed on the accounting
    firms by their clients to go against FASB was intense.
        I have seen that kind of lobbying, by the way, up close and
    personal. I testified in front of FASB 10 years ago when it
    first tried to adopt this rule, and there was a room full of
    hundreds of executives all testifying against FASB, putting
    huge pressure on them, and they backed down.
        They didn't back down this time, and rather than being
    critical of the four accounting firms for coming together and
    standing together to do what they believe is right, despite
    huge pressure from their own clients, I give them great credit
    for coming together. If they feel that they have to stand
    together because they are stronger when they are all taking a
    similar position, then that is not uncommon around here. We can
    understand that, and I give them credit for their courage. I
    hope we have the courage not to interfere with the independence
    of FASB, just the way accounting firms have the courage now to
    protect the independence of FASB, because that is what this is
    about. It is not about whether or not we are going to promote
    incentive pay or stock options.
        I am all for stock options. I am all for honest accounting.
    These are not inconsistent. The question is: How do you account
    for incentive pay? That is the issue here--not whether you give
    stock options or bonuses or other forms of incentives, which I
    think all of us are for. It is a question of accounting for it,
    and when the professionals who are in charge of the accounting
    rules tell us honest accounting requires that they be accounted
    for just like other kinds of incentive pay, I think it would be
    a mistake for the political leaders of this country to then
    interfere with that judgment. That is what we are being asked
    to do, to overturn the independent judgment of FASB. I hope we
    resist that pressure just the way the accounting firms have
    resisted the pressure and just the way FASB has resisted the
    intense pressure from mainly executives. Let's not kid
    ourselves, what is involved here for the most part are stock
    options going to executives, because that is where most of the
    stock options go. The vast majority of them go to executives
    and have fueled the huge increase in executive pay that we have
    seen in this country.
        In 1990, the pay gap between CEOs and average workers was
    100 times. Last year, CEO pay at 350 of the largest public
    companies was 300 times average worker pay, and stock options
    were the largest single factor in that pay gap.
        Now, with the time that is left, I just want to ask a few
    questions about some of the statements which have been made
    about the alleged negative impacts of honest accounting. There
    has been a study made of companies that have switched to stock
    option expensing voluntarily, without being required to, and
    this was a Towers Perrin study. Are any of our panelists
    familiar with that study?
        Are you, Dr. Holtz-Eakin?
        Mr. Holtz-Eakin. The staff has looked at it. It was part of
    the input into our report.
        Senator Levin. Does that study show that of the 335
    companies that switched to stock option expensing, their stock
    performance was the same, on average, as the rest of the S&P
    500?
        Mr. Holtz-Eakin. It showed a minimal impact of the move to
    expensing on stock prices.
        Senator Levin. All right. Now, Merrill Lynch has taken the
    following position, against the argument that expensing options
    will harm U.S. technology leadership and job creation. Their
    point is this: the logic that expensing stock options will harm
    technology leadership leads you to the following faulty logic:
    U.S. technology leadership and job creation depend on the
    systematic misrepresentation of financial statements.
        ``One might as well argue,'' Merrill Lynch says, ``that
    money spent on research and development shouldn't count as an
    expense because it provides employment and helps industries
    advance.''
        Do you agree with that, Mr. Herz?
        Mr. Herz. Yes, I agree with that, and I would go further.
    There are lots of good things that, you know, we just account
    for properly: pensions, training, occupational health and
    safety costs. All those, I think we would agree, are good
    things. But we do proper accounting for them.
        So it is hard to understand why for this particular item--
    and I guess I understand a little bit the emotionalism because
    it involves the ownership and motivation of the people through
    the ownership. But, you know, the question really from our
    point of view is: What is the right accounting? What will make
    the financials more transparent? What will make the capital
    markets work better?
        Senator Levin. On that issue, on the ownership issue--
    because I think all of us want to promote ownership. I have
    been a big supporter of ESOPs, employee stock ownership plans.
    I think they are great. I am all for them. It is a different
    issue from how do you account for stock options and other
    incentive pay. I want to just get into one particular kind of
    stock options, incentive stock options, ISOs, that are given to
    employees that qualify for special treatment under the Tax
    Code. I want to see if I understand this correctly.
        These incentive stock options which are given are taxable
    when they are given.
        Is that correct, Mr. Herz?
        Mr. Herz. I am not a tax expert, but there used to be a
    thing called an 83(b) election, which effectively says tax on
    the grant date, and that is a decision versus kind of waiting
    to get the final result and the appreciation and get taxed at
    that point.
        Senator Levin. So we have a situation where a lot of our
    employees have the option to pay the tax when the option is
    granted to them rather than when it is exercised. Is that
    correct, as far as you know?
        Mr. Herz. Well, yes. Based upon this conversation, that is
    my recollection. But I am not a tax expert.
        Senator Levin. Okay. Does anyone else on this panel know
    about that?
        Mr. Holtz-Eakin. No.
        Senator Levin. All right. Well, then, let me just make this
    statement, and if it is not true, I will have to ask someone on
    the second panel. Unhappily, I can't be here to hear the
    answer, but we will find out for the record.
        The National Center for Employee Ownership has reported the
    following: in a 2002 survey of 275 high-tech, venture-backed
    firms with 20 to 100 employees, over 80 percent of the firms
    gave their employees incentive stock options that qualify for
    special treatment under the Tax Code. Incentive stock options,
    or ISOs, allow an employee to pay the tax on the value of their
    stock options on the grant date, employees who prefer to pay
    for them because they think they have less value now than they
    will downstream, which means they have to be valued now. And it
    happens all the time.
        Do you disagree with that?
        Senator Ensign. Yes.
        Senator Levin. All right. In other words, if I am
    misstating that, fine. What I am saying is that under this
    provision of the Tax Code, employees with these incentive stock
    options have the right----
        Senator Ensign. They pay ordinary income when they take the
    gain.
        Senator Levin. They can also value them now. They have an
    option--no, no. Excuse me. I hope we have a tax expert in the
    room here because this is a very important point. We all assume
    that employees pay the tax when they exercise the options, and
    that is probably the case much of the time. But employees under
    these incentive stock option plans qualify for special
    treatment under the Tax Code where they are allowed to pay a
    tax when it is granted, before it is exercised. In order to do
    that, they have to be valued.
        Now, again, if I am right--and I believe I am--this is a
    very significant point because what it means is that the
    argument about valuation, that you can't value these things, is
    wrong on many counts. We value things that are much more
    difficult to value than stock options. For instance, grants of
    stock which will be given to you if a company reaches a certain
    profitability level, those grants of stock are valued now, even
    though you don't know if a company will ever get to that
    profitability level. They value that now. It is compensation.
    There is no exception for that. It must be valued on this
    year's--it must be shown, excuse me, on this year's books of
    the company. So there are very difficult things to value in
    terms of compensation which may or may not be achieved
    downstream.
        For instance, if a company reaches a certain point, you
    promise a bonus, that must show on the company's books as
    compensation. Even though it is conditional upon a company
    reaching a certain point, it must show as compensation on a
    company's books, unlike stock options which never have to show
    on a company's books as a compensation.
        I want to go back to this one point. I think it is
    important for this committee to get the answer to the question
    I am raising on the incentive stock options that qualify for
    special treatment under the Tax Code where an employee is
    allowed now to take a tax deduction based on the value now of
    that stock option, even though it cannot be exercised now and
    can only be exercised later.
        Mr. Chairman, I think I have probably taken more time than
    I should, and I want to thank the Chair and my colleagues for
    their leniency on this.
        Senator Enzi. Thank you.
        Senator Ensign.
        Senator Ensign. Thank you, Mr. Chairman.
        I do want to address some of the things I talked about in
    my opening statement. First of all, Senator Enzi's legislation
    would exempt the top five executives. We have heard that this
    is all about the executives in the company and that would
    exempt the top five executives.
        In the light of Sarbanes-Oxley, if you are a CFO/CEO and
    you have to certify these financial statements, and now with
    the severe penalties that Sarbanes-Oxley brings to the fore, if
    you were one of those CEOs/CFOs, would you continue broad-based
    stock option plans if you had been giving them in the past?
        Mr. Herz. If I think they are good thing, yes, absolutely.
        Senator Ensign. And you think you could value them
    accurately based on----
        Mr. Herz. Oh, yes. They are already in the footnotes, and
    those are part of the audited certified financial statements,
    have been for 8 years. There are 500 companies doing it.
    Microsoft just took a charge of $2.5 billion or something.
        Senator Ensign. Isn't Microsoft now doing stock grants,
    though?
        Mr. Herz. Going forward they are going to restricted stock
    grants, but they took their charge for the existing options,
    some number like that. You know, it takes some work,
    particularly if you have got a broad-based plan; just like if
    you have a pension plan you have got to do some work. But these
    things--our experience, you know, we had a whole panel of
    valuation experts. We talked to the companies that are actually
    putting it in their----
        Senator Ensign. Would you use binomial or Black-Scholes
    going forward?
        Mr. Herz. It depends on the company's circumstances, and
    that is why we--first of all, the myth that there are two
    different methods is not right. They are based on the same
    financial economic theory. The binomial model is just a more
    flexible version of Black-Scholes. Black-Scholes is just like a
    hard-wired thing. The binomial is like being able to open it up
    by periods, but they are based on the same financial economic
    theory. The binomial allows you to put in more inputs, model in
    blackout periods. So if you have a more complicated plan that
    goes out longer, you might want to use the binomial in order to
    get a more refined estimate, just like if I am a company that
    only has a few fixed assets and figuring out depreciation, I
    will probably use some historical kinds of facts versus doing--
    if I had a lot of fixed assets and different types, I would
    probably do what are called lifing studies.
        Senator Ensign. Well, why do you think--because the
    chairman's bill exempts the top five executives. Why----
        Mr. Herz. No, the other way around. It captures the top
    five.
        Senator Ensign. That is what I mean. But what I mean is
    that it basically takes away the argument that--the CEOs/CFOs
    of the company would be arguing to keep broad-based stock plans
    because it benefits them. So we have taken that off the table.
    Why would they, in arguing against what you all are doing
    because they believe that it has been a valuable tool, and the
    feedback that I am getting from them is negative, and I don't
    know that a lot of you understand it, or accountants in the
    public understand it. Why do they think there are so many
    problems with it? Why are they concerned about Sarbanes-Oxley?
    Why have we heard from so many of them that they will do away
    with broad-based stock option plans because of what you are
    doing? I mean, why are those concerns out there if they are not
    real?
        Mr. Herz. Well, let me make a few comments before I try to
    play psychologist.
        Senator Enzi's legislation, we believe it is fatally,
    seriously flawed conceptually on a number of grounds, and it
    really would amount to no expensing, largely. It has a method
    where there is zero volatility, it doesn't capture the actual
    value of the options, and it can be manipulated very easily to
    come to no expense. So, you know, I don't think that does any
    kind of trick, with all deference to my colleague accountant
    here, the good Senator.
        Why they are arguing that, they may believe it. I happen--
    this is only my own view, okay? I am not them. I believe that
    they truly believe, you know, in their business model. I have
    seen it because I have invested in some of those companies,
    start-ups. Some of them went public, and they have very much a
    culture of that and a true belief that that is the secret
    formula to success. I think that they are, therefore, almost
    foisting one argument after another after another after another
    after another.
        Our role is to try and get as much information and input as
    we can to understand as best we can what the real situation is,
    and that is what we try to do.
        Senator Ensign. Well, Mr. Chairman, like I said, I know my
    time has expired, and I just think that the people who are out
    there who have created these successful business models ought
    to be paid attention to more closely than they are today
    because we are in a highly competitive global marketplace, and
    if we take away one of the tools that has led to this high-tech
    revolution that we have had in the United States of America, if
    we take away one of the most valuable tools they have to
    attract great employees, we could do some great damage to our
    economy. I know that that is not what you are after, but that
    may be, in effect, what you end up doing.
        Thank you, Mr. Chairman.
        Senator Enzi. Thank you.
        Senator Bayh.
        Senator Bayh. Thank you, gentlemen, for your time today.
        Let me start off by asking a couple of questions about the
    differing institutional roles of the organizations you
    represent and our responsibility here in the United States
    Congress. Am I right in saying, Mr. Herz, I think I wrote down
    during your opening remarks that you realize that the
    accounting issues are important to innovation and
    competitiveness. That is why you take your time to try and get
    it right. My understanding is your charge is, while you
    understand those are important, it is not really to take into
    account macroeconomic issues like innovation and global
    competitiveness and that sort of thing; is that correct?
        Mr. Herz. Yes. We have a charge that says we must be what
    we call neutral. That does not mean we apply Swiss accounting.
    It means that in developing what we think is the better
    accounting, we look at the economic attributes of the
    transactions, how they impact on the company, its earnings, its
    cash flow, its financial position, earnings per share.
        Senator Bayh. My point is you focus strictly on the
    accounting and not so much on the--once you are convinced you
    have got the accounting right, in your opinion, you do not
    focus on the ramifications quite so much.
        Mr. Herz. And I think the belief there is that the public
    good we are serving is that the better information therefore
    makes for a better capital market, you mentioned all of that.
        Senator Bayh. Right. Let me follow up on that. It is
    possible that these different concerns need not be in
    competition with one another. As I said in my opening comments,
    I hope we can reconcile it because you do not want to sacrifice
    transparency and accuracy for the sake of competitiveness and
    innovation. At the same time, innovation and competitiveness
    are important, and to the extent there is interplay between
    these two things, we need to figure out what it is and try and
    get the balance right so that we do not just serve the
    interests of accounting accuracy, and that is very important,
    but that we serve the overall interests of the society we
    represent well.
        So there are some institutional differences here in terms
    of the breadth of issues we look at, and I am interested to
    know, is there any analysis been done to see if these things,
    first of all, can be--I am going to have you, Mr. Eakin--is
    that how you pronounce your last----
        Mr. Holtz-Eakin. Holtz-Eakin.
        Senator Bayh. I am sorry. You did address this at least in
    theoretical terms, but have any of you done any analysis on
    what the impact the proposed changes would have on innovation,
    on global competitiveness, on those sorts of broader concerns?
        Mr. Herz. My esteemed colleague can answer that.
        Senator Bayh. I assume the answer would be no and no, and
    Mr. Holtz-Eakin, let me get to you.
        You did mention some of these concerns. I took from the
    tenure of your answer though, that your response was sort of
    from a theoretical economic perspective as opposed to having
    actually done an in-depth survey of some kind.
        My additional question to you would be, I wonder if when
    the change in the treatment of health costs was done, did
    people anticipate the sort of profound impact that it was going
    to have on the health care system, or at least did they try to
    anticipate what the consequences were going to be? As I said in
    my opening statements, those changes may have been good, they
    may have been bad, but they were profound, and I would hope
    that before we undertook that kind of thing somebody would have
    attempted to think it through.
        Mr. Holtz-Eakin. There are a lot of different dimensions to
    your question, and I will address them one at a time. The first
    is that there is a lot of research on the importance of
    institutions, legal, regulatory and accounting institutions for
    economic performance.
        Senator Bayh. These specific proposed changes.
        Mr. Holtz-Eakin. These specific proposed changes, we have
    seen----
        Senator Bayh. The effect on innovation----
        Mr. Holtz-Eakin. Canada propose to----
        Senator Bayh. ---- [continuing]. And global
    competitiveness.
        Mr. Holtz-Eakin. We have seen Canada propose and implement
    this.
        Senator Bayh. I am sorry, we have seen?
        Mr. Holtz-Eakin. We have seen Canada propose and implement
    expensing. We have seen the EU move there, but we have not had
    a chance to observe what happens after the fact. But we will
    have the chance to observe changes from regimes where you did
    not expense to where you did.
        Senator Bayh. We will have.
        Mr. Holtz-Eakin. We do not have----
        Senator Bayh. But have we as we are sitting here today?
        Mr. Holtz-Eakin. We do not have this exact isolated change,
    but we have observed comparable events.
        You talk about retiree health benefits, the evidence from
    that, again not definitive, is that it did not change
    dramatically overall valuations of firms. Investors were
    broadly aware of the----
        Senator Bayh. It had a dramatic effect on----
        Mr. Holtz-Eakin. It had implications----
        Senator Bayh.----[continuing]. Health care was treated.
        Mr. Holtz-Eakin. But the channels were--we can talk about
    those channels, but in terms of the impact that we would see
    from this expensing proposal, you would expect it to affect
    valuations of firms.
        Senator Bayh. Again, this gets to my first question, which
    is the range of issues that you have to consider may in some
    respects be different than the range of issues we have to
    consider, and while it may not have led to the change in
    valuations, it did have broad societal impacts that at least
    deserve some discussion and understanding before you embark
    upon a profound change I would think.
        Yes, Mr. Herz?
        Mr. Herz. I will use some loose wording. Let us suppose
    that we all agree that a proposed accounting change is
    absolutely right from accounting, a strict accounting point of
    view, that it is the right information. It provides better
    information, better capital allocation because people are now
    better informed and can make better decisions. Are we saying
    the truth hurts? I am trying to figure this out because we are
    visited all day long by people from different industries who
    will make cases like that. When we went to bat trying to deal
    with the special purpose entity problems that were highlighted
    by Enron, and that turned out to be fairly widespread, people
    would come to us and say: Yes, well, I understand it is really
    the company's debt, but my special purpose entity is very good.
    It allows the company to borrow more, to employ more people, to
    do more R&D. That is good for the economy.
        We had a person a while back come from--was advocating we
    do something related to the steel industry as they were having
    some problems, and he said: You know, the problem, the steel
    industry, backbone of America, absolutely needed for national
    defense. And I do not want to seem cynical here, but it is just
    that we are on the front line of listening to these things. He
    said: The problem is we are not cost competitive. We need to be
    more cost competitive. The big problem there is we have all of
    these pension costs. You, Mr. FASB, we want you to put all that
    in the footnotes, take it out of the financial statements.
        That is not going to make him more cost competitive. It is
    just going to hide the information.
        Senator Bayh. Of course. My point simply is to you that
    accuracy is important. There may be consequences to changing
    the accounting treatment that I think at least from the broader
    societal perspective, you may reach a decision it is the right
    thing to do, let us go ahead. But to ignore the fact that there
    may be other consequences, it seems to me, would be a
    dereliction of our duty.
        Mr. Herz. I absolutely agree with that. I agree with that,
    and I thought you couched your opening remarks--you guys have a
    tough job every day balancing the----
        Senator Bayh. Which leads me to my last set of questions
    for all three of you, which is, has there been any analysis
    done of some of these other proposals that seek to strike a
    balance and to reconcile the competing differences, things that
    would treat large companies and small companies somewhat
    differently, things that would restrict the exercise of options
    on the part of executives so they could not game the system, so
    to speak, things that would encourage or treat differently
    companies that had broad democratic use of options as opposed
    to those that were highly concentrated among use?
        There are several other suggestions that have been made
    about how you might be able to try and reconcile these two
    things. Has there been any attempt to look at those
    alternatives and to see how they would kind of stack up versus
    the ones we have been presented with here?
        Mr. Herz. It seems to me they are not mutually exclusive,
    doing the right accounting and doing some of those other things
    ought to be potentially complementary. That is why I said
    that--and again, I am advocating my public policy. That is my
    job, to do the right, get the right accounting. But I believe
    very strongly in that, and it seems to me that if you then say,
    well, I want to counteract, notwithstanding the accounting, I
    really want to continue to make sure there are broad-based
    plans. Let us figure out some other way through means at your
    disposal, taxes or whatever. And I understand that bumps up
    against other competing priorities.
        Senator Bayh. It reminds me--and this will be my final
    comment, Mr. Chairman. It reminds me in some ways some of the
    curriculum we had in law school where we would focus on
    efficiency analysis, what was the most efficient allocation of
    resources, and you tried to enact the laws in a way that would
    promote maximum efficiency. However, you also had to be aware
    that there were other societal concerns in addition to
    efficiency, and there were times in a democratic society that
    perhaps you would choose not to take the most efficient path,
    you would try and quantify what the cost was, but you were
    trying to achieve other objectives. I do not know whether it is
    innovation or competitiveness. That is why I ask.
        And, Mr. Chairman, I am concerned. What if any--there may
    be none--but what, if any, is the effect on innovation? What is
    the effect, if any, on global competition? It is only then that
    you can see, well, is there a tradeoff here, and if so, how big
    is it, and what is the price we are paying for going one
    direction or the other?
        Mr. Herz. I am with you, but the best I can do is all the
    highly-esteemed people that have spoken, Mr. Greenspan, former
    Chairman Volcker, other people whose analysis seems to be that
    it would not have those negative effects. I do not know what
    their basis is other than the genius in their head.
        Senator Bayh. Yes, Mr. Batavick?
        Mr. Batavick. Yes. The only thing that I would like to add
    to what Bob said is that for the most part this information is
    already included in footnote disclosures. So when we first
    adopted our Statement 123, the analysts and other users of that
    information could very well have taken that information into
    account. I do not believe there are any studies out there that
    show that putting the information in the footnotes caused
    innovation to be hurt whatsoever. And also, if our proposal
    does go through and we do require expensing on the income
    statement, that information will be readily available, be
    readily disclosed. We have specific disclosures around that
    information so the readers of the financial statements can tell
    exactly what the expense is of the stock options.
        Although I do not have any empirical data, my gut tells me
    that it should not hurt innovation because if it is a good
    business decision to have a stock option plan, then the
    accounting for that really should not impact innovation in the
    company.
        Senator Bayh. Then, Mr. Holtz-Eakin, I will let you finish
    up because you have been generous with your time, and there are
    other hearings going on, unfortunately simultaneously. Your gut
    tells you, your intuition tells you, that may all be exactly
    right, but I go back to the retirees' health care cost
    situation. You know, from an accounting standpoint, absolutely,
    and it may have been, in fact, the absolute right thing to do,
    but there were some pretty significant consequences, non-
    accounting consequences that flowed from that. That had a big
    impact on society, and I think at least we have some
    responsibility to try and anticipate what those impacts are
    going to be, and is it, in fact, the right thing to do on
    balance? That is really my whole point here today.
        Mr. Holtz-Eakin, you get the last word as far as I am
    concerned.
        Mr. Holtz-Eakin. What I hear you saying, Senator, is that
    there may be larger policy objectives than simply the good
    accounting and that is certainly the case.
        The evidence in the economics literature is that efficient
    well-informed capital markets on average engender innovation
    and productivity growth better than almost any other instrument
    that the private market could imagine. It still may be the case
    that as a policy matter you might wish to, for example, target
    more societal resources toward the high-tech industry for a
    policy objective, and if so, the efficiency question becomes
    whether an accounting tool focused on employee compensation is
    the best way to achieve that.
        Senator Bayh. I am glad you mentioned that.
        Mr. Holtz-Eakin. That is the way to frame the issue.
        Senator Bayh. Because Mr. Herz mentioned this in his
    remarks too, and this really will be my final word. Do these
    interests in some way compete? If so, how significant is it,
    and if it is in some way significant, are there different ways
    to achieve the other societal objectives, innovation, global
    competitiveness, other than the accounting treatment? And most
    importantly for us, Mr. Chairman, have these questions been
    answered? It seems to me that is kind of a big issue hanging
    over us today.
        Thank you.
        Senator Enzi. Thank you very much. I do have to comment in
    regard to one of your comments about the courage of the Big
    Four accounting firms. I am told by businesses that the cost of
    doing this binomial or the Black-Scholes calculation will run
    about half-a-million dollars a year. That is not courage. That
    is compensation.
        I appreciate all the comments here. In that previous round,
    I concentrated on both applauding you for the small business
    aspect that you put in there, and encouraging you to go
    further, and I am very encouraged by those comments. But I do
    have to ask just a little bit about the stock option expensing
    itself.
        Mr. Herz, I would like your comments on this statement: Key
    valuation assumptions are subject to considerable judgment and
    significantly affect option values. For example, a 5 percentage
    point change in volatility, which you mentioned in regard to my
    bill, which can be justified solely by alternative ways of
    looking at historical volatility, produced on the average a 15
    percent change in option value, a change in expected term from
    3 to 5 years, again, easily justifiable, produce on average
    nearly a 40 percent increase in option value. The key
    assumptions are subject to so much judgment and guesswork that
    selections among a wide range could be justified as the best
    estimates. The end result would adversely affect the
    comparability of financial statements of companies in the same
    industry and at the same stage of development.
        Do you have a reaction to that?
        Mr. Herz. Yes. We have met several times and our staff with
    our panel of very knowledgeable people. We have also visited
    companies, and there is some judgment involved and there is
    some skill involved in doing this. They posited though that the
    range would be a lot tighter than you are stating, and
    certainly the ranges historically have been tighter than that,
    and that is because there is some market discipline in all of
    this that goes on. There are the auditors or the SEC looking at
    things. There are people that, quantitative people, buy side
    analysts and all that that compare one company with another,
    and it imposes some discipline.
        This is a real issue and we have posed in our book here,
    which by the way most of it is just explaining why the
    rationale behind our decisions and then providing useful
    guidance and some examples for people, not the standard itself.
    We have posed a lot of questions around the valuation. Some
    people would like us to basically get much more prescriptive so
    that you would almost ensure that the range is very small. We
    could prescribe volatilities. We could prescribe--we could take
    the term out of it and just see how long the employee actually
    stays. All those things are possible.
        We are trying to go along the lines of an SEC study that
    was delivered to Congress last summer on what is called
    principles-based accounting, where they strongly advocated that
    the use of bright lines and arbitrary uniform assumptions did
    not get to the best reporting. What got to the best reporting
    was diligent analysis and judgment by the companies and by the
    auditors. I recognize, however, that there are tensions in this
    current environment. There are people who--and I understand
    it--that are concerned with the second guessing aspect, whether
    it be the trial bar or enforcement agencies or whatever, and
    that is a much broader issue than I think this particular
    topic.
        All registrants now disclose what are called critical
    accounting estimates, and those are inherent areas in
    accounting that have significant judgment and impact on the
    reported financial statements. I can read you the one from--I
    just happen to have Intel Critical Accounting Estimates: The
    methods, estimates and judgments we use in applying our
    accounting policies have a significant impact on the results we
    report in our financial statements. Some of our accounting
    policies require us to make difficult and subjective judgments,
    often as a result of the need to make estimates of matters that
    are inherently uncertain. Our most critical accounting
    estimates include assessment of recoverability or goodwill,
    which impacts write-offs of goodwill, valuation of non-
    marketable securities, et cetera., valuation of inventory, and
    they go on and on and on.
        Senator Enzi. And they charge considerably for the work
    that they do, and then put in a little protector from the trial
    lawyers, right?
        Mr. Herz. No, this is something that the SEC put in, not
    the other--it is to inform people that the income statement and
    the balance sheet include a lot of estimates. We have a cash
    flow statement that, for those who say that accounting ought to
    be much more cash-based, well, you have a cash flow statement,
    but there is a whole package of financials.
        Senator Enzi. I want to go ahead with that statement that I
    was using because it goes on to say: Beyond the complex
    accounting questions involved, the issue of employee stock
    options also raises some significant economic considerations.
    Not only would the approach under consideration be harmful to
    mature companies, it would impose the heaviest burden on
    emerging high-growth companies. There is some more to the
    statement, but that is enough to get the flavor for it. That is
    from a Coopers & Lybrand letter of February 5th, 1993, and the
    person to be referred to for questions is you. I do not want to
    put you in the category of a reformed Senator, but----
        Mr. Herz. We live and learn.
        Senator Enzi. I appreciate the testimony of all three of
    you, and I do have quite a few additional questions in more
    detail. I have learned that if I do the really detailed
    questions here, it puts people to sleep, but it is information
    that we significantly need, and particularly from Dr. Holtz-
    Eakin.
        Thank you very much.
        We will change now to the second panel, and I want to
    sincerely thank the second panel for their patience and
    consideration, but mostly for the outstanding testimony that
    they have that we are about to put into the record so that it
    can be shared extensively.
        While they are taking their position there, I would like to
    take this opportunity to welcome our second panel to the Senate
    Committee hearing on the impact of stock option expensing on
    small business. This is a rather large panel, and we look
    forward to hearing all of your comments on the important issue.
        First I would like to welcome Dr. Keith Carron, the
    President and Founder of CC Technology, and the CEO of Delta
    Nu, both small business start-ups located in Laramie, Wyoming.
    I thank you for coming here to testify, Dr. Carron, and let me
    personally thank you for all you have brought to Laramie
    through your hard work and enterprise. CC Technology and Delta
    Nu are great examples of the positive impact that small
    businesses can have on our rural communities.
        Our second panelist will be Professor Stephen Diamond, and
    Professor Diamond is visiting us today from Cornell Law School,
    where he teaches international corporate governance issues. He
    also fills various advisory and consulting positions for large
    and small companies, and we thank you for coming today.
        Next I would like to welcome Dr. Jere Glover back to the
    Senate Committee on Small Business. Mr. Glover has worked on
    both his committee and the House Small Business Committee and
    has testified before Congress many times concerning the matters
    of small business, and we appreciate his expertise.
        Following Mr. Glover is Marc Jones. He is the President and
    CEO of Visionael Corporation, a small business located in Palo
    Alto, California. He is here before us as a small business
    owner, and an executive involved in every aspect of his company
    from strategy implementation to administration.
        Then we have--I am going to need some help with this name--
    John Kavazanjian, the President and CEO of Ultralife Batteries,
    Inc. Ultralife was incorporated in 1991 and has since become a
    public company with offices in New York and England.
        Then Mr. Robert Mendoza will be testifying. Mr. Mendoza is
    the Founder and Chairman of Integrated Finance Limited, a
    global financial advisory committee. Mr. Mendoza is also a
    Managing Director of IFL Capital, which is a limited liability
    company, and the U.S. broker-dealer affiliate of IFL.
        Next we have Mr. Christopher Schnittker, the CFO of Cytogen
    Corporation, located in Princeton, New Jersey, and Cytogen is a
    publicly traded biopharmaceutical company that develops
    medicines for cancer, respiratory and other diseases, and as a
    fellow accountant, I welcome your comments and insight here
    today.
        Dr. Smith was not able to be here so we will submit his
    testimony for the record.
        We will begin then with Dr. Keith Carron of Laramie,
    Wyoming.
        Dr. Carron.

      STATEMENT OF KEITH CARRON, Ph.D., FOUNDER AND PRESIDENT, CC
     TECHNOLOGY, LARAMIE, WYOMING, ON BEHALF OF THE UNIVERSITY OF
                                WYOMING

        Dr. Carron. Thank you, Chairman Enzi and members of the
    committee for inviting me here. I am President and Founder of a
    technology small business start-up. We are in Laramie, Wyoming,
    and I would like to explain the role that stock options play in
    the development of our company and to tell you why I believe
    the proposed FAS 123 would be detrimental to our growth and
    perhaps even our survival.
        Our company was conceptualized in 1997 by two chemistry
    professors from the University of Wyoming, and I want to state
    right off the bat that we did not follow the traditional rules
    of finding large capital to start our company. Instead we wrote
    Small Business Innovation Research proposals and Small Business
    Technology Transfer proposals, otherwise known as SBIR and STTR
    proposals.
        We waited until the proposals were funded, then we
    incorporated the company, and being two university professors,
    somewhat naive in business, we added a third founder who is an
    expert in entrepreneurship.
        Since 1998, our company has acquired over $3.7 million in
    seed capital from the SBIR and STTR programs. These grants have
    led to two important outcomes, first as intellectual property
    in the form of patents which are owned by the university and
    licensed back to us for commercialization, and second, we
    developed a manufacturing division which designs, manufactures,
    and sells our products.
        The first outcome, I would like to comment, is a direct
    result of the Bayh-Dole Act in 1980, which was conceived to
    capitalize on a pool of knowledge that exists in academia. The
    SBIR/STTR programs have provided us with an avenue that takes
    this knowledge from the university and to produce it in the
    marketplace.
        The second outcome, our manufacturing division, has already
    created jobs and wealth in Laramie. Laramie is a small
    community, about 30,000 people. Companies such as ours are rare
    in Wyoming, but we are now demonstrating how a technology based
    enterprise can play a vital role in bringing new wealth to our
    community by creation of high value-added products that are
    sold worldwide.
        Our manufacturing division has grown out of a single
    engineer and myself to a business with six full-time employees,
    and five part-time employees. These employees have made
    significant contributions to the growth of the enterprise and
    will continue to do so. In Laramie it is very hard to find key
    employees, so we have to either retain them when we do find
    them, or we have to recruit the experience from elsewhere.
    Recruitment requires cash. In a start-up business cash is
    short. We are usually cash starved, and as my business adviser
    reminds me, when you are out of cash, you are out of business.
        So one of the most important components of our cash
    preservation plan is to replace cash incentives with stock
    options. The best method we have found is the IRS-endorsed
    Incentive Stock Option Plan, which provides our employees with
    the opportunity to participate in the wealth creation from
    their own ongoing contributions. For example, we are now trying
    to recruit a high-salaried employee from California, and the
    most compelling component of our offer has been the stock
    option plan which will allow him to share in the wealth that he
    will help create.
        Lowering profits by expensing stock options creates, in my
    opinion, a circular problem. Under FAS 123, the options will be
    expensed, resulting in decreased profitability for my company.
    The grantee is thus less likely to exercise the option,
    rendering invalid the whole original assumption that the option
    has incurred an expense.
        Our small business was funded by seed capital provided by
    the United States Government through the SBIR/STTR programs,
    and this model, by its very nature, leads to neutral income
    statements. These programs are not intended, in themselves, to
    be a source of wealth creation. When a company is ready to
    emerge from the R&D mode and to commercialize, it must achieve
    and maintain profitability to attract working capital.
    Expensing stock options works against this goal and adds an
    intangible imbalance to the income statements.
        Why do I say intangible? The majority of small businesses
    fail. The expensing of options will only increase this failure
    rate, and the irony is that the expense will never be incurred
    because the options will never be exercised.
        Finally, to comment on how widespread the knowledge of FAS
    123 is, a week ago I was approached by two bankers from
    Wheatland, Wyoming. They wanted to bridge our company with a
    Government agency, the Export-Import Bank, to support a working
    capital line of credit. The Export-Import Bank is designed to
    help small companies export their products and reduce the
    country's trade imbalance. But it is required right up front
    that their clients have a positive net worth. I believe that by
    expensing stock options, we would decrease our likelihood of
    ever receiving this assistance.
        I would also like to note that neither of the bankers from
    Wheatland, Wyoming had heard of FAS 123, and I would also like
    to note that when we formed our stock option plan through a CPA
    firm, we were never told that they would show up as an expense
    on our balance sheet.
        I would like to end by saying that, I believe because of
    the recent abuses highly visible by public companies, the FASB
    is trying to create a solution, but it will have unintended
    consequences of doing significant harm by slowing the growth or
    preventing the growth of private small business start-ups.
        Thank you.
        [The prepared statement of Dr. Carron follows:]

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        Senator Enzi. Thank you very much.
        Mr. Diamond.

     STATEMENT OF STEPHEN F. DIAMOND, VISITING ASSISTANT PROFESSOR
      OF LAW, CORNELL LAW SCHOOL, AND ASSISTANT PROFESSOR OF LAW,
                  SANTA CLARA UNIVERSITY SCHOOL OF LAW

        Mr. Diamond. Thank you, Chairman Enzi, for having this
    important hearing and inviting me to testify.
        I will suggest today that, one, the expensing of stock
    options is an important step towards restoring accuracy,
    transparency and credibility to the American economy, and two,
    American managers should reconsider their aggressive use of
    stock options as a form of compensation because options create
    a hidden conflict of interest between inside option holders and
    outside shareholders.
        While there may be some difficulty for some companies in
    adjusting to this new regime, that will be temporary and it
    will be more than compensated for by an overall lower cost of
    capital for those same companies, and for those companies that
    are now only the dream of a young inventor putting in long hard
    hours in a garage or a university laboratory somewhere.
        I am a law professor who specializes in corporate finance
    and corporate governance, but my interest in this issue is not
    just an abstract academic exercise. After graduating from Yale
    Law School, I practiced corporate law in New York and in
    Silicon Valley for 5 years. While in private practice, I
    advised dozens of start-ups and public companies, as well as
    the investment banks and venture capital firms that provide
    them with financing. I continue to serve as an adviser to
    start-up companies and was recently elected to a seat on the
    board of directors of a small publicly-traded technology
    company, where I also serve on the audit committee and chair
    the compensation committee.
        As an academic it is my job to study and help design
    institutions to improve overall economic performance. An
    important principle guiding such institutions in this country
    is our 70-year-old dedication to providing investors with the
    best information we can about what is happening to their money.
    Failing to expense stock options violates this core principle.
    It undermines the fragile relationship between insiders and
    outsiders in our corporate system, thus raising the cost of
    capital for new investment projects.
        It also creates an often hidden and little understood
    conflict of interest between outside shareholders on the one
    hand and inside option holders on the other. Granting corporate
    insiders huge option packages allegedly motivates the insiders
    to manage the corporation in the long-term interest of public
    shareholders. But this argument is based on a mistaken
    assumption that stock options are the same as stock. They are
    not. Options are a different financial instrument from the
    stock that an option holder receives in exchange for the
    exercise of the option. In fact, recipients of options do not
    look forward to becoming long-term investors in a company's
    stock alongside their fellow outside investors. No, instead
    they look to the day when they can exchange their option for
    stock and then immediately sell it for a profit. In many cases
    that profit is cash they receive from the company and its long-
    term outside shareholders in the form of costly debt incurred
    by the company to pay for the shares given to the option
    holders. In the world of stock options, insiders get paid
    first, and it is the remaining shareholders who must pay them.
        Investors provide the capital to entrepreneurs, who by
    virtue of their specialized technical or managerial talent, are
    tasked with the control of the day-to-day operations of a
    business. In return, investors expect those entrepreneurs will
    not only work hard on their behalf, but will also be fair and
    honest in their dealings with them. This relationship is known
    in corporate law as the separation of ownership and control.
    When the separation between investors and managers widens, it
    can cause money to stay on the sidelines.
        Today investors are still reluctant to make the very risky
    and uncertain investments that need to be made to kick start a
    recovery of the high tech sector. As one example of investor
    discontent, at Texas Instruments, one of our country's oldest
    and most successful high technology companies, 57 percent of
    shareholders voted earlier this month in favor of a proposal
    recommending to the Board of Directors that they expense stock
    options.
        That is why it is so perplexing to me that so many resist
    such a basic reform. In fact, Silicon Valley ought to be doing
    precisely the opposite of what it is doing. It should be
    showing as much leadership and innovation on this issue as it
    does on basic scientific research and development. Is it not
    just a bit strange in these circumstances that corporate
    managers want to deny their own investors access to vital
    financial information such as the impact of stock option grants
    on the overall value of the company? That stock options have
    value is certainly beyond debate. It is confirmed simply by the
    fierceness of the opposition to expensing them. One can only
    conclude that the defensive posture of some is about protecting
    a strategy of shifting wealth from outside investors to insider
    option holders, when the insiders have a significant advantage
    in assessing the real value of the company.
        This increases investor uncertainty about value, and thus
    damages the credibility of all potential entrepreneurs who hope
    to raise capital for new companies in the future.
        Thank you again for the opportunity to share my views with
    you today. I ask that my written statement be submitted for the
    record, and I look forward to answering your questions.
        [The prepared statement of Mr. Diamond follows:]

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        Senator Enzi. Thank you very much. Everyone's full
    statement or additional statement, if they want to submit it
    for the record, will become a part of the record. We do
    appreciate your testimony, so even if you have a couple of
    additional thoughts that you need to put in, that is welcome as
    well.
        Mr. Glover.

     STATEMENT OF JERE W. GLOVER, BRAND AND FRULLA, WASHINGTON, DC

        Mr. Glover. Thank you, Chairman Enzi. I am pleased to be
    here to testify about FASB's proposal to expense stock options.
        While I have been and am a CEO of several high-tech
    companies, my primary experience in my career has been involved
    in helping reduce regulatory burdens on small business and
    create a fair marketplace and playing field for small
    businesses. The one thing that I have learned is that one size
    does not fit all. That is true in shoes and it is especially
    true in standards and Government regulations.
        During the last 3 years of my experience as Chief Counsel
    for Advocacy at the Small Business Administration, we reduced
    unnecessary regulatory burdens on small businesses by over $20
    billion. We were consistently faced with agency claims that
    protecting the public interest forced the agencies to place
    specific burdens on small business, just as FASB is proposing
    to do now.
        These officials routinely said that if their regulations
    were not finalized exactly as they had proposed, that the
    environment, worker safety, investor trust, or whatever, would
    cease to exist.
        Forced to reexamine the problems that their regulations
    were causing, agencies found that small businesses were not the
    cause of the problem in most cases, and that the regulatory
    burdens they were proposing were unnecessary and could be
    modified. In some instances small businesses were completely
    exempted and the public interest was still served.
        I oppose any agencies or organizations that are imposing
    unnecessary and unintended burdens on small business. FASB's
    proposal, if finalized as proposed, while well intended, will
    have a devastating impact on growing small businesses,
    especially those in Government contracting and those who need
    to finance their businesses. The burdens in dollars, lost
    management time and lost opportunities will adversely affect
    innovation and job creation in America.
        Let me explain why I believe the expensing proposals will
    have an adverse impact that is contrary to the public interest.
    First, many companies will simply stop giving employees stock
    options. This to me is the worst possible outcome because it
    would deprive them of key employees that are necessary to grow
    and expand their businesses.
        Second, many companies will find that they cannot comply
    with the requirements simply because of the cost will be
    prohibitive.
        Third, for those companies who choose to comply, what if
    they are Government contractors? Will they be determined,
    because they have negative net worths and negative profit
    statements, to be financially not feasible. Under the FAR
    Regulations, they are not feasible or capable of providing the
    work because they have loss or bad financial statements.
    Likewise, when companies turn to borrowing, as the first
    witness just talked about on this panel, will the banks
    understand when they come in with negative financials? More
    importantly, will the Government agencies like the Export-
    Import Bank, or like the Small Business Administration, make an
    exception? And what is going to happen when the auditors from
    the Federal Reserve, Comptroller of the Treasury and FDIC come
    into the bank and say, look at the financials of the companies
    you are lending to. I think that that is going to create an
    additional problem.
        Of course, there is the issue of tax consequences on how
    these options are being treated. Today there is a good bit of
    flexibility, and I certainly use that in my companies and I
    know many, many companies do have that flexibility. Will FASB's
    new proposal change their ability to have that flexibility? I
    suspect so.
        FASB could have avoided this problem if they had, one,
    adequate representation on the board itself, who fully
    understood small business and implications. One of the critical
    problems here is they do not understand--and accountants, by
    and large, many of them do not understand--how tight cash is
    for starting companies. They do not have $100,000 or $200,000
    or $300,000 to spend on valuation, and even if they did, it
    would be taking away from other activities.
        If they had done a regulatory flexibility analysis. If they
    had even looked at the opportunity to propose separate
    regulations for small businesses, they would have proposed
    different regulations for small businesses. There is no tiering
    of their proposed regulations. Of course, they could have
    easily exempted small businesses.
        The Regulatory Flexibility Act, which applies to all
    Federal and most State agencies, has had a phenomenal impact,
    $40 billion of regulatory savings to date. FASB has completely
    ignored it.
        Under the circumstances, I think that you have to look at
    the situation. The SEC has found it could live with the
    Regulatory Flexibility and live well with it, and they do a
    wonderful job. Had they considered small business at the
    beginning, I do not think we would be here, and I do not think
    they would be under the pressure that they are under now. I
    think small businesses have historically, these solutions that
    we have talked about are not new. Each White House Conference
    has recommended them. Congress has recommended them. Most
    Presidents have required them. FASB has chose to fit everything
    into one-size-fits-all, and quite frankly, that is not proper.
        Thank you.
        [The prepared statement of Mr. Glover follows:]

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        Senator Enzi. Thank you very much.
        Mr. Jones.

             STATEMENT OF MARC JONES, PRESIDENT AND CHIEF
    EXECUTIVE OFFICER, VISIONAEL CORPORATION, PALO ALTO, CALIFORNIA

        Mr. Jones. Thank you, Mr. Chairman. My name is Marc Jones,
    and as you mentioned, I am the President and Chief Executive
    Officer of Visionael Corporation. I appreciate you giving me
    the opportunity to share my views on the recently released
    Financial Accounting Standards Board draft calling for the
    expensing of these broad-based stock option plans that are so
    prevalent and in favor in Silicon Valley, and the impact of
    this proposal on small businesses like Visionael.
        Our small business is a leading provider of network
    security and network management solutions designed for the
    largest and most complex corporate government and service
    provider networks. We have more than 60 large customers
    worldwide including customers like Sprint, Verizon, EDS, IBM,
    the Pentagon and the White House Communications Agency.
        Thus, the importance of the stock option issue in front of
    the committee cannot be overemphasized. Broad-based stock
    option plans have given me the opportunity to live the American
    dream. I have been able to buy a house, send my children to
    good schools, and now be the CEO of a small business. Broad-
    based stock option plans have also given quite a few Visionael
    employees the possibility to dream that dream that they
    themselves can be entrepreneurs, that they can be partners in
    owning a business and that they can dream one day of the
    financial success and the rewards that are associated with our
    company's success.
        Now we have a stock option system that works, and it is
    being threatened by FASB's current exposure draft. FASB is
    proposing to require all businesses, including small businesses
    like Visionael, to use a complex formula to calculate the value
    of stock options, and count that inaccurate cost as an expense.
    The FASB proposal will curtail or perhaps even eliminate the
    ability of small business owners to offer our employees stock
    options.
        There are a number of problems with the FASB proposals.
    Fundamentally, small business owners are opposed to the
    creation of inaccurate expenses on our financial statements.
    Our survival is predicated on being able to provide our
    customers, our suppliers and our financial backers accurate,
    easy to understand financial statements. For example, an
    important component of Visionael's capital structure is a line
    of credit we have with a local bank. They provide us funds
    while we wait to collect monies owed to us by our customers.
    However, any borrowings under that line of credit must be
    repaid if we are unprofitable. Thus, including inaccurate
    expenses related to our stock option plan into our financial
    statements could have the impact of us losing an important
    source of capital for our business.
        In addition, it will be difficult to absorb the additional
    cost of complying with the FASB proposed regulations. We will
    need to hire outside consultants, some of those accounting
    firms that you mentioned earlier, along with additional finance
    personnel in order to comply with the FASB regulations. I
    currently estimate that Visionael compliance could easily cost
    us $100,000 or more annually. This means that we will not be
    hiring two additional engineers, sales people or perhaps we may
    not undertake certain marketing programs that we would
    otherwise invest in. These compliance costs are true hard
    costs, and we will be using expensive capital to pay for them.
        I am going to move off of my prepared remarks for a minute
    because I listened to the panel previously, and the problem
    that I am having with the previous discourse is that I hear
    lots and lots and lots about policy this and economic that, and
    that footnotes here and all that stuff.
        The reality of it is that this is equity. It is a form of
    equity. Who has what piece of the pie? And from a financial-
    statement perspective, 97 or 98 percent of the issue is a
    balance sheet issue of, if you look at the company, how is it
    split up. We currently handle 97 and 98 percent of the issue
    already on the balance sheet, with full disclosure to anyone--
    investors and other people interested and other stakeholders in
    the country.
        We are now talking about 1 or 2 percent of this issue, and
    we are potentially creating rules, and regulations and costs on
    small businesses that none of the previous panel talked about
    the small business. They couched it in terms of Texas
    Instruments that, and HP this, and whatever. That is not the
    point. The point is how are small businesses supposed to deal
    with this situation, and what impact will that have on their
    cultures, their people, their environments, and their
    opportunities to be successful? So, from Visionael's
    perspective, and I represent--I am one of the ``they,'' right?
    Our company is a venture-backed technology company that is
    trying to create value for our customers here and around the
    world. We do not get it. And the impact of these proposed
    regulations on our business are very, very ominous, and for us
    to willy-nilly look for the truth--the question was about, what
    is wrong with the truth? Well, if we could come up with the
    truth, it might help. And the question is what is the cost of
    getting to the truth? So those kinds of considerations, in my
    humble opinion, need to be addressed as part of what we do, the
    decisions that this committee is responsible for making.
        So I apologize for taking more time, and I thank you, and I
    would be happy to answer any questions you might have.
        [The prepared statement of Mr. Jones follows:]

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        Senator Enzi. Thank you very much.
        Mr. Kavazanjian.

     STATEMENT OF JOHN KAVAZANJIAN, PRESIDENT AND CHIEF EXECUTIVE
                  OFFICER, ULTRALIFE BATTERIES, INC.,
                            NEWARK, NEW YORK

        Mr. Kavazanjian. Thank you, Mr. Chairman. Thanks for
    allowing us to express our opinions. I hope I can be as
    eloquent as Mr. Jones.
        The issue of expensing of stock options is a very
    significant one to us. We make batteries. We are a small
    company in Upstate New York, Newark, New York, outside of
    Rochester. We have been in business for 14 years. Five years
    ago, I became the President, and the company had never been
    profitable. We are now profitable, over the last year, and we
    employ 900 people now, up from about 250 several years ago, and
    stock options are a very important part of the way we have been
    able to attract and retain our professional talent. Without the
    engineers, the sales people, the professional managers in the
    company, there would be no work for the 75 percent of the
    people who come in every day to make batteries.
        Expensing stock options serves no useful purpose in the
    basic reason we do financial reporting. That is what everybody
    is missing. Implementing the standard will hurt everyone, but
    the big companies do not notice it. It will fall heaviest on
    the small and growing companies like Ultralife, and I will tell
    you why.
        First, financial reporting has one purpose. It is to
    provide the shareholders with the information on the
    operational performance of the firm and the data on which to
    calculate the value of the firm. There are multiple methods for
    this, and most of them come down to a discounted present value
    of cash flows, but the fact is that expensing stock options has
    no added value to that function.
        It provides cash, when people exercise them. We are missing
    that, also. People actually have to buy the stock. And, number
    two, it dilutes the stock. Well, we already do a Treasury
    method dilution which takes into account that. It hurts us in
    our EPS when stock options are exercised. It is accounted for
    already. Both of these effects are very adequately accounted
    for.
        And, in fact, I was thrilled to hear some of our previous
    people say, in the footnotes to the financial statements, all
    of the data is there already. So what purpose is the rule aimed
    at?
        Well, it seems it is not aimed at giving investors an
    easier way to evaluate a company. In fact, it is going to do
    the opposite. It is going to make it tougher. And for small
    companies like us, who do not have all of this analyst coverage
    to go wade through it, I mean. Certainly, McDonald's, and
    Microsoft, and AT&T, no problem. The analysts will just back it
    out. What it is aimed at is to curb excessive executive
    compensation. I cannot think of a less-effective way to do this
    than through an accounting change; that really obscures the
    real operating effectiveness of a company. Put in restrictions,
    put in standards, put in additional shareholder approvals, take
    away the tax deductibility, any of that stuff, but do not screw
    up the one way we reflect to our shareholders how we are doing
    and what we are worth.
        For a small company like us, there is a whole bunch of
    things it is going to do:
        First, it is going to make it harder to attract talent. I
    mean, you hear that from anybody here. We have to compete
    against stable companies in our area, like Xerox, Kodak, and
    Bausch and Lomb, three large companies that are very stable.
    People take a risk when they come to work for us. We have been
    able to give stock options to the lowest level of the company.
    The majority of our grants go to non-executives. It is a major
    reason we did not lose people when we went through tough times
    in retrenching the company, and it is a major reason why we
    retain our talent ever year. The shareholders want this, and
    they approve of our option plans.
        I have done well, because I took a risk in joining the
    company, coming from Xerox, on the stock options. I have
    investors who call me up and say, ``We are really glad that you
    are doing well on it because you earned it.''
        We have been able to grant those stock options down into
    the company. We have a big challenge, as I said, of being
    noticed by the marketplace. Most investors look right to the
    bottom line. And, in fact, we made money in the first and
    second quarters of last year for the first time. I think--I
    have not done the detailed calculation--but when our stock went
    up, if we redid the calculation, we probably would have had to
    take a charge that would have put us in a loss position in the
    third quarter. Imagine sitting in a conference call and saying
    to your investors, we did great this quarter, but we lost money
    because you wanted our stock so badly, the price went up. It is
    hard to understand. We increased the value of the firm. We had
    a positive cash flow. We had good results from operations, but
    we would have had a loss. It does not make sense.
        We need access to capital. I think Mr. Jones was exactly
    right. We are going to bump up against loan covenants. It is
    going the put a damper on the share price. I do not want to get
    too technical on finance, but the corollary to the Modigliani-
    Miller papers, which are the seminal paper on valuing a firm,
    from Merton said that if you have less information about a
    company, the share price will be down because of systematic
    risk. This is what is going to happen. It is going to obscure
    information about the company, and it is also going to put more
    overhead in our financial statement. So $100,000 is probably
    kind of what we are looking at here. We have already doubled
    our accounting costs because of Sarbanes-Oxley. I am not going
    to begrudge that, because if it helps investor confidence, we
    will do what we have to do, but this does not help investor
    confidence.
        And the last thing is it is going to cause is fluctuations.
    When interest rates change and basic assumptions change, we are
    going to have a duty to redo these models. So the better we do
    in some cases, the worse we are going to do--because we are
    going to take a charge--and then the worse we do, the better we
    are going to do because when they reverse that charge, it will
    actually increase the fluctuations, and fluctuations are bad
    for companies like us because investors are worried about
    stability.
        So it just seems like this does not make sense to me and to
    a lot of people here. We cannot let the accounting community
    bow to the pressure to try to quantify something that is
    already adequately disclosed, it is already accounted for in
    our EPS, and it adds nothing to the ability of investors to
    judge us as a business. It is going to hurt our access to
    capital, it is going to hurt our ability to invest in capital,
    to reduce our cost of labor so that we can keep production in
    the United States, and it is going to hurt jobs. It is
    disproportional on small businesses. The big ones, it is not
    going to hurt as much, and that is why they do not want to
    fight the political battle, and they are just letting it
    happen.
        I will also be happy to answer any questions, and thank you
    so much.
        [The prepared statement of Mr. Kavazanjian follows:]

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        Senator Enzi. Thank you very much.
        Mr. Mendoza.

     STATEMENT OF ROBERTO G. MENDOZA, CHAIRMAN, INTEGRATED FINANCE
                      LIMITED, NEW YORK, NEW YORK

        Mr. Mendoza. Mr. Chairman, I would like to thank the
    committee for giving me the opportunity to testify on this
    important matter. I do so with some trepidation, though, as you
    will understand in a second.
        I believe that the FASB's position is generally correct,
    and furthermore that the expensing of options will, in fact,
    prove beneficial to small businesses and the entrepreneurial
    spirit. Essentially, I conclude that the analysis of the
    expensing issue does not differ materially for small companies
    relative to larger ones and that no constituency benefits from
    omitting any compensation costs from the income statement.
        The fundamental point, of course, is whether or not options
    represent an expense; that is to say, a cost which should be
    deducted from revenue in the income statement in the same way
    as all of the other forms of employee compensation. Since there
    is general acceptance that options are a highly valued form of
    employee compensation, it seems clear that they should be
    expensed provided that it is feasible to measure adequately the
    cost to the issuer of expensing them and, B, that there is no
    public policy imperative to require a different, legislatively-
    mandated accounting treatment.
        Financial markets provide compelling evidence that it is
    perfectly practical to value options which are far more complex
    than employee stock options through the use of models. Each day
    literally billions of dollars are traded based on models which
    depend on the fundamental insight of the Black-Scholes-Merton
    formula. While it is true that models will only provide an
    estimate of the cost of granting options, this is not a reason,
    in my opinion, for not expensing them. The preparation of
    financial statements requires judgment and a great deal of
    reliance on estimates; for example, amortization and
    depreciation schedules and the value of intangibles such as R&D
    expenses, to name but two. Model-based expensing of options
    provides approximately the right answer. Failure to expense
    options provides a precisely wrong answer because, clearly, the
    cost cannot be zero.
        I do not believe that the argument that expensing options
    through the income statement results in double-counting of the
    expense withstands logical scrutiny. To make the point with an
    extreme example, let us assume two identical companies, each
    with annual income of $100,000, and each with non-employee
    compensation expenses of $20,000. So, at that level, we have
    $100,000 of revenue. Both companies have $20,000 of cost.
    However, one company pays its employees $10,000 in cash, plus
    sufficient option grants to enable it to attract and retain the
    employees it needs, and the other pays its employees solely in
    cash of $40,000. These two companies are otherwise totally
    identical. The only difference is that one of them pays its
    employees wholly in cash, the other one pays them partly in
    cash and partly with options. If you fail to expense the
    options, the first company will record pre-tax income of
    $70,000, while the second one will show pre-tax income of only
    $40,000. Such a result distorts the comparability of financial
    statements even between two otherwise identical companies.
        My final point is that expensing options will actually
    benefit small companies and encourage start-ups. The
    calculation procedure will not impose a material cost on
    management either in terms of time or expense, and in a moment,
    rather than give you an estimate, I am going to give you some
    precise numbers. Income statements which properly reflect the
    real costs incurred by the business, specifically including all
    of the compensation costs, will make it easier to attract
    capital because investors will be able to measure properly the
    potential returns from the investment.
        My conclusion is that it would not serve the public
    interests for the Congress to mandate a different accounting
    treatment, but I make this point not simply from a theoretical
    corporate finance perspective, but also from recent personal
    experience.
        In December 2002, my two partners--Peter Hancock and Bob
    Merton--and myself raised a substantial amount of money from
    third-party investors to found an international firm, IFL,
    which you referred to in your opening, Mr. Chairman. Our goal
    is to do an IPO within 5 years. We, too, are living the
    traditional American Dream. We have made considerable progress
    during our first year. We now have 40 colleagues--we did not
    start in a garage. We started in a spare office at a law firm
    with three people--we now have 40 colleagues, are licensed as a
    broker-dealer in the United States and Japan and are growing
    rapidly. We told our investors that we planned to expense
    compensatory options, whether or not we were required to do so,
    before we started the company.
        We believe that this commitment to realistic and
    transparent accounting helped us to raise the capital for a
    venture which was both highly risky and highly ambitious.
        Thank you.
        [The prepared statement of Mr. Mendoza follows:]

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        [GRAPHIC] [TIFF OMITTED] T5840.053

        Senator Enzi. Thank you very much.
        Mr. Schnittker.

     STATEMENT OF CHRISTOPHER P. SCHNITTKER, SENIOR VICE PRESIDENT
     AND CHIEF FINANCIAL OFFICER, CYTOGEN CORPORATION, PRINCETON,
                               NEW JERSEY

        Mr. Schnittker. Thank you, Senator Enzi, for the
    opportunity to participate in this hearing and to round out
    this panel. My name is Chris Schnittker, and I am a Senior Vice
    President and the Chief Financial Officer of Cytogen
    Corporation. I am here today on behalf of my company and
    millions of other public and private small companies that stand
    to be seriously impacted by the proposed accounting rules set
    forth by the FASB in their recent exposure draft on share-based
    payment.
        First, allow me to provide a brief description of my
    company and how it relates to this hearing. Cytogen Corporation
    is a small, publicly held biopharmaceutical company located in
    Princeton, New Jersey, at the very heart of the East Coast
    pharmaceutical corridor. We recently have grown to 65
    employees, most of whom are dedicated to selling and marketing
    our two lead oncology products-Quadramet, a therapeutic
    radiopharmaceutical to ease the pain of metastatic cancer, or
    cancer that has spread to the bone, and ProstaScint, a
    monoclonal antibody-based molecular imaging agent used to image
    the extent and spread of prostate cancer. We are also
    developing Combidex, a novel molecular metastatic lymph node
    imaging agent which is currently under review by the FDA.
        Further, we support a research and development joint
    venture to develop prostate cancer therapies based on our
    proprietary prostate-specific membrane antigen, or PMSA, marker
    technology. Clearly, each product or product candidate
    addresses the serious and substantial unmet medical needs of
    cancer patients and the physicians who serve them.
        Cytogen relies on the dedication and drive of our board of
    directors, officers and employees to achieve its reach on our
    currently marketed products and to progress its other product
    candidates through the long and expensive process of drug
    research and development. To this end, we have chosen a
    compensation program for our employees which includes, among
    other elements, stock option grants and participation in an
    employee stock purchase program. Our stock option program is a
    broad-based one, granting stock options to every employee of
    the company, from our CEO, to my department's staff
    accountants, to each of the company's administrative
    assistants. We believe such a program best aligns the interests
    of all employees with that of the company and its outside
    shareholders--simply stated, improving shareholder value--but
    also boosts productivity and allows each and every employee to
    own a part of our success. I would suggest it also allows them
    to feel some of the pain of an unsuccessful business or a
    market downturn with underwater stock options plaguing our
    industry during the past few years.
        At the company level, stock-based compensation allows us to
    attract, retain, and motivate highly qualified scientific and
    management personnel, many of whom are courted by the Fortune
    500 pharmaceutical companies that surround us in our region. To
    illustrate the difference between those pharmaceutical
    companies and Cytogen, I offer a very brief story.
        From the window of my offices in Princeton, which literally
    sits in the shadow of a Top Five pharmaceutical company, I
    often watch their corporate helicopter deliver people from
    their New York City offices for meetings, a trip that probably
    takes them, at best, 20 minutes. This is the same trip that my
    CEO and I have done several times a week, by car or by train,
    which often take upwards of 3 hours each way. I certainly do
    not begrudge this company its success. In fact, in certain
    aspects of our business, they are a critical business partner
    of ours. But I do hope that someday Cytogen has access to that
    level of capital, where private aircraft is a necessity rather
    than a distant luxury. As we are both competitors for the same
    intellectual capital in the oncology drug development arena,
    clearly, much of the deck is stacked against a company like
    Cytogen because of its size and resource constraints. The
    promise of stock-based compensation among the smaller
    companies' employees help to level this playing field.
        Further, on our employee compensation model, as the cash
    outlays for our employee health insurance programs and defined
    benefit pension plans increase exponentially, we--and most
    other smaller start-up companies--look to non-cash compensation
    to supplement cash compensation so as to retain and motivate
    our employees. In order to compete with large pharmaceutical
    companies, we need to be able to offer meaningful equity
    compensation in lieu of the larger cash salaries, bonus
    programs and other perks offered by other employers in our
    industry.
        I am afraid that, with the expensing of stock options,
    small businesses will be denied yet another form of
    compensation to level the playing field and its larger
    counterparts in the industry. We may investigate the same moves
    made by other companies towards restricted stock grants and
    performance-based stock options, but each carries with them a
    complexity that can be difficult for small companies to
    administer and equally difficult for rank-and-file employees to
    understand and, perhaps more importantly, believe in their
    value. Even with those new compensation methods, I hope we will
    be able to keep the critical ownership and entrepreneurial
    spirit alive across all employees at Cytogen.
        One of my responsibilities as the chief financial officer
    is to budget and plan for our future growth, but also to
    allocate our scarce capital resources, both human and
    financial, in the pursuit of our corporate goals. The
    appropriate mix of cash-based versus equity-based compensation
    for our employees is just one of these decisions. Clearly, the
    current market has told us that companies who have not yet set
    a clear course toward a sustainable and profitable business
    model will not survive. This initiative is especially
    challenging in the biotechnology industry with our 10-year-plus
    drug development time lines, disappointments or delays inherent
    to research and the enormous capital required to progress that
    research in a timely way.
        Cytogen has made several conscious choices in this regard,
    and we believe the market has rewarded us by moving from a
    market capitalization of just under $30 million in late 2002,
    to a current market capitalization of $230 million, a greater
    than 600-percent improvement in shareholder value.
        I would like to sum up my comments with my reflections as
    to why, and perhaps other employees like me, choose to work for
    small, development-stage businesses. It is not for the
    stability of a big company around you with adequate capital to
    ensure its existence, it is not for the businesses that, to
    some degree, run themselves due to their market share on vast
    resources. Among many other reasons, it is simply the speed of
    innovation, a responsiveness to change, the ability to work
    with leaders and coworkers who embrace entrepreneurial spirit
    and the chance to change the face of a dreaded disease like
    cancer and improve the quality of life for the patients and
    their families who are affected by it.
        On behalf of Cytogen and other similar small businesses, I
    sincerely appreciate the opportunity to express our views on
    this issue.
        [The prepared statement of Mr. Schnittker follows:]

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        [GRAPHIC] [TIFF OMITTED] T5840.057

        Senator Enzi. Thank you.
        I want to thank all of the panelists for their enthusiastic
    and varied testimony. It covered a wide range of information
    here. I also want to thank Chairman Herz for staying and
    listening to the comments. There was just a tremendous amount
    there, and I think it helps to explain a little bit why some of
    the big mature companies are particularly excited about
    expensing theirs and why small companies may not be. I am
    reminded, when I went to Kyoto for some of the negotiations on
    global warming, and when I got there I found out that the
    United States was the only country that was there under the
    impression that it was an environmental conference. All of the
    rest of them realized it was an economics conference, and we
    took some blows as a result of that, and some of the other
    countries did very well.
        This is perhaps a mature versus growing company issue, but
    I do really get excited when I'm around small businessmen, and
    I know that it is that excitement that you have and your
    understanding of what you are doing that is really the secret
    to the success of your companies. You have taken some risk and
    been willing to do that, and I have no doubt that the companies
    here will succeed.
        Mr. Kavazanjian, did I get it?
        Mr. Kavazanjian. Yes.
        Senator Enzi. All right. Your presentation made me think
    that your batteries will do better than that company that has
    the funny bunny.
        [Laughter.]
        Mr. Kavazanjian. We hope so.
        Senator Enzi. You really did a great job. All of you are
    excellent spokesmen on the issue, and again there is that
    variety of information, and I want to get into that a little
    bit.
        I will start with Dr. Carron because you have worked with
    SBIR and STTR and competitively competed for awards. Will the
    stock option hamper the growth and ability of firms to
    participate in that, and can you provide any examples of areas
    that it might have an affect on the business?
        Dr. Carron. Well, those programs, again by their very
    nature, you write a budget, and at the end of the grant period,
    you had better have matched your budget. So they lead to
    balanced income statements.
        If we try to attract employees through the stock option
    plan, that will give us a negative balance on our income sheets
    and, I believe, lead to the failure of our company just because
    we will not be able to grow out of that R&D mode into a mode
    that actually manufactures and sells products, which I believe
    is the goal of the SBIR and STTR programs.
        Senator Enzi. Right. When you get one of those grants, it
    is my understanding that you are routinely audited. Do you
    think there would be any concerns on how the expensing of
    options is done and what impact that might have?
        Dr. Carron. Well, you are correct. We do have to undergo an
    annual audit. I am not sure how the agencies would view a
    negative income statement, but I am sure it would be a bad
    strike on our company.
        Senator Enzi. Thank you.
        Mr. Schnittker, you broke away from a large pharmaceutical
    company to pursue a specialized niche in technology, and one of
    the things that kind of is in the back of my mind is can all of
    your employees pronounce the names of the stuff that you have?
    Is that a part of the test?
        Mr. Schnittker. I think we work very hard to try to make
    those names difficult to pronounce.
        [Laughter.]
        Senator Enzi. I was impressed that you just rattled those
    off. But you have pursued a specialized niche in technology,
    and given that your firm was able to retain and recruit
    personnel, and you said through stock options, how would you
    propose to recruit and retain employees if this rule is
    finalized this way?
        Mr. Schnittker. Well, there are other alternatives that are
    out there. It is something that we have considered a lot
    lately. In fact, just two weeks ago, we took on a very
    important hire who was an individual from Amgen. It involved a
    relocation to the East Coast, and he will now be our senior
    vice president of sales and marketing.
        One of the considerations that obviously any employee makes
    when they decide to come on with a firm is what the package is
    worth and what the company offers. For us, we are looking at
    things like restricted stock programs, perhaps increased
    compensation, perhaps increased bonus programs, a variety of
    other things, many of which are cash based, which is difficult
    for us. Capital comes at a great cost. I heard somebody else on
    this panel mention that.
        The other option that we are looking into are performance-
    based stock options, which have a little bit of a different
    accounting impact, but are extremely difficult to administer,
    especially in the rank-and-file employee range. It is very
    difficult to create a series of objectives that are
    quantifiable and measurable for absolutely all of your 65
    employees.
        My CEO is compensated with stock options that are
    performance based, and I think that is very important, and it
    is very clear to identify for a CEO what his four or five goals
    are over the next 5, 10 years, but I really question our
    ability to do that much broader than senior management.
        Senator Enzi. So the other employees there, their
    performance measurement is how well the stock does, then.
        Mr. Schnittker. How they support the company and its
    success. We have a very robust goal-setting program. We have a
    lot of requirements that go right down into the individual
    departments: Clinical Development, Research, Sales and
    Marketing. So they all understand what their piece is of the
    bigger pie, and as long as they do their piece, the theory is
    that that will support the company's success.
        Senator Enzi. I have been trying to get the Federal
    Government to do a performance and results type of
    compensation. I have not had much success.
        Thank you.
        Professor Diamond, on the last page of your written
    testimony, you mentioned getting rid of options altogether. So
    are you against stock options or just because they are
    accounted for differently at the present time? I am curious as
    to that statement.
        Mr. Diamond. I think that stock options, as I suggested in
    my oral statement, create a conflict of interest between the
    optionholders and outside investors. And we have to keep in
    mind that wherever there is a small business, there are also
    lots of small investors, and they deserve a clear and unbiased
    picture of the financial condition of the company. And I think
    stock options induce insiders, and particularly senior
    managers, to manage the company in a way that increases risk
    and volatility and then distorts the outcome for the company.
        So, in the long run, I think that we should move away from
    stock options. I favor use of restricted stock or cash-based
    forms of compensation.
        Senator Enzi. So that would be why it was noticeably absent
    in your testimony--any discussion about the accounting of the
    evaluation process, which is one of the concerns of the small
    business is how you get to that number.
        Mr. Diamond. Well, I am not particularly troubled by the
    resources that will be required to provide accurate valuation.
    The market does it already in part, and I think that services
    will emerge to provide that for small companies, if it is
    necessary. I think we have to be very careful here about
    blurring the lines. We are talking about small companies that
    want to go public. Stock options for small companies that do
    not want to go public are really irrelevant. So we are talking
    about small companies that want to tap into the public markets.
    That is where the options have real value for the employees.
        That talented individual did not leave Amgen to join a
    small, I am sorry, company that I had not heard of before in
    Princeton, New Jersey, right, because he expects to be part of
    a private company for the rest of his life. He expects it to be
    a public company and to sell his shares into the public markets
    at some great profit to himself. So we have to be careful that
    we do not blur the line between all 22.9 million small firms in
    this country and maybe the million or so that really are
    looking to tap into the public markets.
        If you are looking to tap into the public markets, you are
    tapping into the large retirement systems of America's workers,
    teachers, toll booth collectors, police officers, nurses, et
    cetera, whose retirement assets provide the fundamental capital
    that goes into our public markets. And those individuals
    deserve a clearer, better picture, more accurate picture of the
    financial condition of these companies. It seems appropriate
    for certain small companies that intend to move in that
    direction to begin to adopt the FASB approach. A company that
    does not intend to go public does not have to because they do
    not have to use GAAP accounting. So really, the option for many
    small companies is just to ignore the FASB.
        But if you are going to be talking about tapping into the
    public markets, where the real payoff is for these individual
    employees, you are living in a different world.
        Senator Enzi. I will move to Mr. Mendoza because we are
    talking about here, at this point, the ability to easily
    calculate that. Mr. Mendoza, you used to be with JP Morgan as
    an investment banker, and so you worked with Mr. Merton of the
    Black-Scholes-Merton valuation model. Last year, JP Morgan
    Chase entered into an agreement with Microscoft, where JP
    Morgan Chase would buy the outstanding stock options of the
    Microsoft employees, and based on our calculations, the pricing
    is well below the valuation that would occur of Black-Scholes-
    Merton was actually used.
        How would you account for the discrepancy, especially since
    Microsoft is one of the most heavily followed stocks by
    researchers? If they do not use Black-Scholes-Merton, then why
    would small growing companies do it? They made a major shift,
    and you probably have some insight into that for us.
        Mr. Mendoza. Well, I will try, Mr. Chairman.
        First of all, in terms of my own background, I did work for
    JP Morgan for 31 years, but left before the merger with Chase
    Manhattan. So I was not involved in that particular
    transaction. I do know something about it and have, together
    with my partners, written about it in an op-ed piece.
        I think that the fundamental point that I would make is
    that the purchaser of those options--in that case, the bank--
    did use a pricing methodology which was either a naive Black-
    Scholes model or some variant, as the chairman of the FASB
    discussed this morning. Those valuation models all have a
    common heritage. They are not different in the way that has
    been represented, but I think it was as simple as the buyer
    using a valuation model, and the seller not doing so. The
    seller got too low a price, and the buyer got the difference.
    It was pure economics.
        Senator Enzi. But heavily discounted.
        Mr. Mendoza. Absolutely. It was heavily discounted because
    the buyer did use the model and bought the options at a lower-
    than-model price.
        Senator Enzi. You were able to raise $45 million, I think,
    to start an international investment banking firm and are
    planning to do an IPO?
        Mr. Mendoza. We are hoping to, but it is a few years away.
        Senator Enzi. Have you evaluated what the cost of expensing
    your stock options will have on the ability to do that IPO?
        Mr. Mendoza. Yes, sir. We think it will facilitate it, as
    it facilitated the raising of the money because we believe that
    honest, transparent, realistic accounting just attracts buyers.
    As Chairman Greenspan has recently said, we believe that the
    market is going to place an increasing premium on the integrity
    of financial statements and not counting a very important part
    of your compensation cost, expensing some of it and not the
    rest of it, does not, I think, promote integrity of financial
    statements.
        I did mention in my prepared remarks that I was going to
    give you some numbers on the actual costs in terms of time or
    money of expensing options. Our small company has just
    negotiated an agreement with a new investor who is going to
    purchase around 10 percent of our stock. He, quite
    appropriately, asked for audited statements which we did not
    have. Our accounting firm is PricewaterhouseCoopers, and we
    asked them how long it would take to provide audited statements
    from the drafts they had already given us, and it takes about 3
    weeks.
        The draft came back yesterday, and one of the things that
    had not been done was to expense our options. So we called up
    and said, well, we need to expense the options because that is
    what we believe is right. They told us that under APB 25, you
    could use a zero volatility assumption which, again, would
    result in no expense. We said, no, we need to expense them, but
    we do not want to be silly about this. If it is going to delay
    the process so we cannot raise our additional funding, we will
    not do it. We are not required to.
        The answer came back that it would not delay the process,
    it would not increase the cost of our audit, and we computed
    the number, the actual expense number, in under 20 minutes.
        Senator Enzi. Thank you.
        Mr. Glover, since FASB is not a Federal agency, but a
    private-sector entity, are there any remedies available to
    small business if FASB does get it wrong?
        Mr. Glover. I do not know of any, sir. I think all Federal
    agencies and most State agencies have to comply with some
    version of the Regulatory Flexibility Act. While this is a
    quasi-Government or Government-sanctioned entity, the
    Regulatory Flexibility Act, the Administrative Procedures Act,
    none of the safeguards apply. And I would think, candidly, that
    there are no small businesses with the financial resources to
    have challenged it under any circumstances.
        Senator Enzi. Since FASB is a federally recognized
    standard-setter, should the FASB 123 proposal be subjected to
    the Regulatory Flexibility Act or should FASB be required to
    live up to the standards set in the act?
        Mr. Glover. I think the latter part of that question is
    very clear. They certainly should be. We have not found any
    Federal agencies, despite protestations at the beginning, that
    could not meet and comply with the law, and when they did, they
    found that they got a better outcome. So I think that they
    should.
        The legal issue of whether the law should be changed, I
    think that is going to be dependent upon whether FASB changes
    its existing pattern of activities and really does take it
    seriously. I am dead serious, when somebody does a regulation
    that one size fits all, it will not work. Small businesses
    cannot afford and cannot handle the kinds of burdens, problems,
    and they do not have the facts upon which to make these
    assumptions. Many of these companies simply do not have the
    experience.
        So I think, if they do not take that into consideration, if
    they do not begin considering small business seriously, if they
    do not have a very active advisory board and make that happen,
    I think you will have to consider making the law, including
    them and some other quasi-Federal agencies that have similar
    situations.
        Senator Enzi. FASB is reaching out to small business with
    their advisory board. A question that I have for all of you is
    how would you suggest getting the word out to the small
    business community? Most of them are not going to notice until
    a FASB directive actually impacts them, but we would like for
    them to be involved in the comment period so that they can--and
    I will start with you, Mr. Glover.
        Mr. Glover. Well, I alerted, I am also the Executive
    Director of the Small Business Technology Coalition, which is
    the largest group of SBIR companies in the country, and I did
    alert our board to that issue. They generally were supportive
    of my comments today, in the board action, and have directed
    that we comment on this.
        So I think we will get the word out to companies. Because I
    think the unintended consequences for Government contracting
    firms and other firms is they will suddenly find themselves in
    a situation where they cannot obtain audited financial
    statements for no other reason--and I disagree that all of
    these companies are going public. They are going to be
    impacted, and I think we will try to get the word out to those
    companies, and hopefully some of the other small business
    groups will do the same.
        Senator Enzi. Thank you.
        Mr. Jones, do you want to comment on that?
        Mr. Jones. Just on that particular issue. As I listened to
    that, I thought it was kind of interesting because I know, in
    our company, our heads are pretty down. I had no idea that the
    Small Business Advisory Committee had this website and
    whatever, and the real question is how would I?
        And so the big issues for, I think, our small companies are
    what is the composition of the Advisory Committee? Where do the
    people come from, and what are their backgrounds that they can
    help in, one, understanding the issues, truly understanding,
    not that they are not responsible, but that they understand the
    issues because they are living it, in terms of the composition
    of the committee itself. And then those people have access to
    lots of other similarly situated people who can provide the
    kind of input that I understood from the testimony today was
    wanted by the committee, the Advisory Committee.
        Senator Enzi. From your testimony, and also Mr.
    Kavazanjian's, you mentioned that you had kind of a broad base,
    and I am curious as to what you think the effect will be on
    your lower-level employees, the non-executives. I appreciated
    your comments that this becomes an extra step and does not have
    a lot of value. Now, if you are going to be doing some
    additional capital-raising or something like that, then there
    could be some additional value to it, but if you are just
    trying to operate, as you have been operating, what effect is
    it going to have on your lower-level employees?
        Mr. Jones. It has a significant impact on our lower-level
    employees because I think part of what has been missing in the
    debate about all of the stock options is that there are all
    sorts of things that can happen, but the question is, for
    lower-level employees, how much capital do they have with which
    to actually buy restricted stock or to purchase the actual
    stock options?
        I will not go into it, but I can actually answer the
    questions that came up earlier about the tax implications of
    the grant of a stock option and what is the difference between
    a non-qualified and an incentive stock option and so on and so
    forth. All of us, we actually live that stuff each and every
    day, and suffice to say, without getting into the details, it
    was totally mischaracterized this morning. The impact that was
    characterized and the truth is 180 degrees different.
        Anyway, putting that aside, the impact on our employees
    would be significant because, for us, it is all around capital,
    how do we get capital, and what is the impact of our financial
    statements on capital? So, if we have to spend a
    disproportionate amount of money in order to get what FASB
    believes are accurate financial statements, that is
    disproportionate in the context of what impact it will have on
    our financial statements, that is sort of backwards from our
    perspective.
        So, when we look at, in our case, the reality--and I am
    sure Mr. Diamond, who has been in Silicon Valley, would attest
    to this, the way that we today understand the market value of
    our companies, there are two ways:
        The first is when you are raising capital. So, in our
    particular case, we have raised $40 million with kind of--I
    guess we have messed-up, if they have got clean financial
    statements, we have messed-up financial statements, but somehow
    we have been able to raise $40 million with those messed-up
    financial statements because we have not been expensing stock
    options. And so the only time the market determines the value
    of our business is when you go out and you raise money, and you
    have various people who set the price for the stock as they
    purchase into your company.
        Every other period is done by the board of directors, and
    the board of directors are not experts in the financial
    valuation of a particular company on a particular day. And if
    you look at companies which go public, a significant amount of
    effort, and time and expense comes in the SEC process, where
    all of those stock grants are reviewed, and there is an
    understanding based on sort of what has happened so that you
    can look backwards as to whether the valuation of those
    companies were appropriate for stock issuance purposes, stock
    option issuance purposes at each of those various points.
        And that is probably the single biggest issue of investment
    and time as part of the public offering process. That, by
    itself, says that small companies don't have any of the art and
    skill that was referred to before around being able to
    implement these set of proposed regulations, and so we will
    have no choice, because we do not have it, our board of
    directors do not have it, the liability associated will be
    very, very significant in terms of, because it goes directly to
    the financial statements, so you have got to go and make sure
    you have got experts that are providing you with the
    information. It is going to be a significant impact on our hard
    costs in terms of complying with the proposed regulations.
        Mr. Kavazanjian. Can I build on that a little bit?
        First, this whole thing, the reason why small business is
    having a hard time being heard here is because there is a sense
    of inevitability about this thing happening. I had a director
    tell me, who was a former CEO, he just retired, he said, ``Yes,
    you are right, but it is going to happen anyway.''
        And the way the inevitabilities had happened is in the
    assumption that a stock option is an expense like any other
    expense. And to characterize it any other way is dishonest. I
    have heard a lot of times from several people today about we
    have to have honest financial statements, and I am insulted by
    that. We have very honest financial statements. All of the data
    is there. Every piece of data is there
        And so we have a little different viewpoint of it as an
    expense. Yes, it is an expense in one regard, but it is an
    equity expense. The shareholders have said to the employee, if
    you will stay here and be dedicated to this company, we will
    let you buy the stock as if you are reaching back to the day
    that we gave you the option. I sold equity at $4, I sold equity
    at $5, I sold it at $13, and my stock is $22. I did not revalue
    that equity on my balance sheet.
        We will never win that battle. The accountants have decided
    that there are beans that are not in a jar that have to be put
    in a jar somewhere. It does not help the investment community
    value the firm. We will do nothing different. We will try to do
    nothing different, assuming I keep my job, we will try to do
    nothing different, except to educate people, if this happens,
    about what the real performance of the company is.
        And that is where my accounting firm has a heart attack
    because I say, gee, what I am going to lead with in my press
    release is our profitability, before stock option expensing,
    was ``X,'' and they have a heart attack because it is not GAAP.
    I am not a financial professional, although I was trained in
    finance, 2 or 3 years ago the flexibility was taken away from
    us to present alternative ways of looking at our financial
    statements that might enhance things because they are not
    GAAP--Generally Accepted Accounting Principles.
        So we have this one-dimensional model in what is a four-
    dimensional world: three dimensions plus time. And everybody
    wants to sound bite one number. And we give them the sound bite
    of one number that does not let them evaluate the firm, that
    further obscures it, it is going to be a mess. So we are going
    to try to educate the community if it does happen. The problem
    is that the initial assumption that is an expense, not an
    equity expense, but a period expense having to do with
    performance of the company, it is wrong, and I am not going to
    waste my time trying to convince FASB of that because I do not
    think they are going to get it. That is where we are.
        Senator Enzi. Thank you.
        Mr. Diamond.
        Mr. Diamond. If I could just reply to some of this. Look,
    the problem is Enron had its SPEs, its off-balance sheet
    vehicles, disclosed in its footnotes, also. It also had its
    stock option grants disclosed in its footnotes, but no one
    could figure out the toxic combination of the two, and the
    danger is that you get boards of directors who think that stock
    options are far less costly to a company than they really are,
    and you create a mono-culture inside the firm to take risks
    with other people's money, as Justice Brandeis called it, and
    you drive the company into the ground.
        Now, it may be that, historically, we thought that American
    managers were too risk averse, and a shift to an equity-based
    world in the 1970s and 1980s was important, and that is where
    the stock option culture first emerged. But it took hold with
    toxic effect in the late 1990s, and we are still feeling the
    effects of that. We funded far too many companies, quite
    frankly, in the late 1990s, too much money chasing too few good
    projects, and we ended up with a huge crash.
        The NASDAQ is still only at about 50 percent of its peak in
    the spring of 2000. Confidence has not returned to the market.
    Money is sitting on the sidelines. I am quite certain that you
    run an honest business and that you do the best to disclose to
    your shareholders, but the world gets a little bit more complex
    than that, and we are talking about the larger picture here.
        If I could make just one comment about the issues that came
    up this morning with respect to global competition. I would not
    look to China as a model for how to disclose information to
    investors. It is a corrupt system. There is no rule of law.
    There is no transparency. There is no independent Securities
    and Exchange Commission. There is nothing that looks like the
    Financial Accounting Standards Board. There is no genuine
    private sector. It is an entirely politically controlled
    regime.
        We have to tap into the world capital markets in this
    country for a $1.5 billion every day, net, to keep funding our
    businesses. Foreign investors continue to be willing to put
    money into this economy for one simple reason, and this is what
    makes the American economy more competitive than any other
    economy in the world. We protect minority shareholders' rights.
    We give them information under the securities laws, and we give
    them State corporate law to govern the way in which companies
    are managed. If minority shareholder rights are not protected
    in this country, people would not invest here.
        Foreigners know they can pour money into the American
    economy and know that there is some basic protection for
    investors while they do so, and that is why this reform is such
    a crucial signal to the global economy and to the U.S. economy
    as a whole.
        Senator Enzi. I want to tell you that one of the reasons
    that I have a lot of faith in this country is because there are
    a lot of small businesses, and there are a lot of small
    businessmen like we have on this panel here today. It highly
    encourages me, when we talk about Enron or WorldCom or Tyco or
    some of those, we are not talking about small business, and we
    are really not talking about an accounting problem. We are
    talking about out-and-out fraud. We are talking about a lack of
    ethics in this country among certain people, not all of them.
    There are a lot of big businesses out there that are acting
    ethically. All of the accounting rules in the world did not
    keep Enron from doing what they were doing.
        There were people--and I recommend a book called, ``My
    Brother's Keeper,'' which is a biography of a guy that teaches
    at George Washington University by the name of Emitai Etzioni,
    who had the opportunity to teach an ethics class at the Harvard
    School of Business. He went through, in his opening session, a
    series of questions asking about ethical problems. He started
    out with some that were grey, and he worked through to some
    that were absolutely black and white to everybody I know, and
    he still had these Harvard Business School future executives.
    In fact, at the time that he did that, they would be the
    executives that are running these companies right now, saying,
    ``Well, how does it affect the bottom line?'' They did not say,
    ``Is it right?'' They said, ``How does it affect the bottom
    line?''
        The stock options question for small business is not that
    same kind of a question. I have got to tell you, when I was
    working on that Sarbanes-Oxley, a little over a year-and-a-half
    ago, companies were afraid to do restatements, even if
    restatements raised the value of their company because, even if
    it raised the value of their company, their stock went in the
    toilet because people were equating a restatement with
    fraudulent activity.
        For small business, this is going to be--probably for big
    business, too, but they have more capability to explain what is
    going on--it is going to be a restatement. These companies that
    already exist are going to be restating what they have been
    doing and winding up with some negative balance sheets. The
    Small Business Administration may get it and may make some
    exceptions, but it is going to require some changes there.
    Bankers, when the meeting started, there was standing room
    only. In the back of the room, there must have been 10 or 15
    bankers. I know they were from Wyoming. I will get to meet with
    them later today. I do not think they loan on negative balance
    sheets either.
        I am also concerned about one line replacing many
    footnotes. People I know have been able to look at the
    footnotes, make some translation, decide how the company was
    doing. So I really have some concerns about what we are doing
    here, but mostly from the standpoint of small business because
    we have small businesses in this country that are growing, and
    we need to make sure that we keep new small businesses.
        I held an inventors conference this last summer, and
    Wyoming is the least-populated State in the Nation, and because
    of Senate ethics, I was not able to advertise for it. I still
    had 85 people show up that were right on the verge of having,
    they have got an invention. They just were not sure what to do
    with it next, and they have been concerned about how are they
    protected. We had people there that talked about trademarks,
    and patents, and copyrights, and prototyping, and venture
    capital, and marketing, and manufacturing, and shipping, and I
    am pretty sure I am going to get probably about 75 businesses
    out of that, some of them with some absolutely great products
    that I wish could talk about, but they are still in proprietary
    stage.
        I am hoping that some of those companies will be able to
    use stock options to get the talent they need because, while
    they may have $100,000, it is going to cost them more than
    $10,000 for their employees unless they can use stock options,
    and they are limited on cash. We are having trouble attracting
    venture capital out our way. So I am trying to watch out for
    those folks.
        I do appreciate everybody's testimony today. The witnesses
    were outstanding on both panels, but there obviously appears to
    be a significant difference of opinion. Our small business
    witnesses have a completely different perspective on FASB's
    stock option expensing proposal than FASB or the non-small
    business witnesses.
        As we heard from our witnesses and the former chief counsel
    for advocacy, it is absolutely essential that FASB get it right
    the first time. I want you folks to still be in business after
    the rule goes into effect. If FASB gets it wrong, some small
    businesses will not have any recourse. They will not last long
    enough for any changes to be made.
        I do look forward to hearing the comments from the Small
    Business Advisory Committee, and I am very encouraged by the
    comments today that it will be opened up, perhaps with more
    meetings and more opportunities to have some say in what the
    agenda will be.
        With respect to due process, I am extremely concerned that
    FASB seems to have already made up its mind on the proposals,
    and the words do not match up with the actions. If anything, it
    appears that FASB is orchestrating, through members of its
    parent board and through a one-sided outreach effort, the
    notice and the comment process. Now, I hope I am proven wrong
    on that. FASB's actions do not live up to the high standards
    that we expect of federally recognized standard-setters, and I
    strongly believe that if FASB were a Federal agency, then its
    actions would violate the due provisions of the Administrative
    Procedures Act. I know there have been some field tests. I am
    not aware of any of those being done on a small business.
        I would like to thank Chairman Herz for being here for the
    entire thing. It is really outstanding when somebody from that
    level stays for all of the testimony and the questions. I would
    like to personally thank Chairman Snowe for allowing me to
    chair this vital Small Business and Jobs hearing today.
        I thank all of you for your time. The record will remain
    open for 10 days. We will be submitting some more detailed
    questions to you and would really appreciate your responses.
        Thank you.
        [Whereupon, at 1:10 p.m., the hearing was adjourned.]

                                A P P E N D I X

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