[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/
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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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    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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    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.]
     


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