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86–050PS 2003

A REVIEW OF FASB ACTION POST-ENRON AND

WORLDCOM

HEARING

BEFORE THE

SUBCOMMITTEE ON

COMMERCE, TRADE, AND CONSUMER PROTECTION

OF THE

COMMITTEE ON ENERGY AND

COMMERCE

HOUSE OF REPRESENTATIVES

ONE HUNDRED EIGHTH CONGRESS

FIRST SESSION

MARCH 4, 2003

Serial No. 108–17

Printed for the use of the Committee on Energy and Commerce

(

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

COMMITTEE ON ENERGY AND COMMERCE

W.J. ‘‘BILLY’’ TAUZIN, Louisiana, Chairman

MICHAEL BILIRAKIS, Florida

JOE BARTON, Texas

FRED UPTON, Michigan

CLIFF STEARNS, Florida

PAUL E. GILLMOR, Ohio

JAMES C. GREENWOOD, Pennsylvania

CHRISTOPHER COX, California

NATHAN DEAL, Georgia

RICHARD BURR, North Carolina

Vice Chairman

ED WHITFIELD, Kentucky

CHARLIE NORWOOD, Georgia

BARBARA CUBIN, Wyoming

JOHN SHIMKUS, Illinois

HEATHER WILSON, New Mexico

JOHN B. SHADEGG, Arizona

CHARLES W. ‘‘CHIP’’ PICKERING,

Mississippi

VITO FOSSELLA, New York

ROY BLUNT, Missouri

STEVE BUYER, Indiana

GEORGE RADANOVICH, California

CHARLES F. BASS, New Hampshire

JOSEPH R. PITTS, Pennsylvania

MARY BONO, California

GREG WALDEN, Oregon

LEE TERRY, Nebraska

ERNIE FLETCHER, Kentucky

MIKE FERGUSON, New Jersey

MIKE ROGERS, Michigan

DARRELL E. ISSA, California

C.L. ‘‘BUTCH’’ OTTER, Idaho

JOHN D. DINGELL, Michigan

Ranking Member

HENRY A. WAXMAN, California

EDWARD J. MARKEY, Massachusetts

RALPH M. HALL, Texas

RICK BOUCHER, Virginia

EDOLPHUS TOWNS, New York

FRANK PALLONE, Jr., New Jersey

SHERROD BROWN, Ohio

BART GORDON, Tennessee

PETER DEUTSCH, Florida

BOBBY L. RUSH, Illinois

ANNA G. ESHOO, California

BART STUPAK, Michigan

ELIOT L. ENGEL, New York

ALBERT R. WYNN, Maryland

GENE GREEN, Texas

KAREN MCCARTHY, Missouri

TED STRICKLAND, Ohio

DIANA DEGETTE, Colorado

LOIS CAPPS, California

MICHAEL F. DOYLE, Pennsylvania

CHRISTOPHER JOHN, Louisiana

TOM ALLEN, Maine

JIM DAVIS, Florida

JAN SCHAKOWSKY, Illinois

HILDA L. SOLIS, California

DAVID V. MARVENTANO, Staff Director

JAMES D. BARNETTE, General Counsel

REID P.F. STUNTZ, Minority Staff Director and Chief Counsel

SUBCOMMITTEE ON COMMERCE, TRADE, AND CONSUMER PROTECTION

CLIFF STEARNS, Florida, Chairman

FRED UPTON, Michigan

BARBARA CUBIN, Wyoming

JOHN SHIMKUS, Illinois

JOHN B. SHADEGG, Arizona

Vice Chairman

GEORGE RADANOVICH, California

CHARLES F. BASS, New Hampshire

JOSEPH R. PITTS, Pennsylvania

MARY BONO, California

LEE TERRY, Nebraska

ERNIE FLETCHER, Kentucky

MIKE FERGUSON, New Jersey

DARRELL E. ISSA, California

C.L. ‘‘BUTCH’’ OTTER, Idaho

W.J. ‘‘BILLY’’ TAUZIN, Louisiana

(Ex Officio)

JAN SCHAKOWSKY, Illinois

Ranking Member

HILDA L. SOLIS, California

EDWARD J. MARKEY, Massachusetts

EDOLPHUS TOWNS, New York

SHERROD BROWN, Ohio

JIM DAVIS, Florida

PETER DEUTSCH, Florida

BART STUPAK, Michigan

GENE GREEN, TexasAREN MCCARTHY,

Missouri

TED STRICKLAND, Ohio

DIANA DEGETTE, Colorado

JOHN D. DINGELL, Michigan,

(Ex Officio)

(II)

C O N T E N T S

Page

Testimony of:

Herz, Robert H., Chairman, Financial Accounting Standards Board .......... 6

Material submitted for the record:

Herz, Robert H., Chairman, Financial Accounting Standards Board, letter

dated March 28, 2003, enclosing response for the record .......................... 37

(III)

(1)

A REVIEW OF FASB ACTION POST-ENRON

AND WORLDCOM

TUESDAY, MARCH 4, 2003

HOUSE OF REPRESENTATIVES, COMMITTEE ON ENERGY AND COMMERCE, SUBCOMMITTEE ON COMMERCE, TRADE, AND CONSUMER PROTECTION

Washington, DC.

The subcommittee met, pursuant to notice, at 3 p.m., in room

2123, Rayburn House Office Building, Hon. Cliff Stearns (chairman) presiding.

Members present: Representatives Stearns, Shimkus, Bass, Ferguson, Issa, Otter, Schakowsky, Solis, Markey, Green, McCarthy,

and Strickland.

Staff present: Brian McCullough, majority counsel; David

Cavicke, majority counsel; Ramsen Betfarhad, majority counsel;

Shannon Vildostegui, majority counsel; Will Carty, legislative clerk;

and Consuela Washington, minority counsel.

Mr. STEARNS. This is the Subcommittee on Commerce, Trade,

and Consumer Protection. Good afternoon. I would like to take this

opportunity to welcome the subcommittee, my colleagues. I know

there is another hearing right now. I also want to welcome our new

subcommittee ranking member, Ms. Jan Schakowsky of Illinois. I

look forward to working closely with her and advancing our productive agenda, bipartisan, of our committee. So I appreciate her help

and her background.

It is also the first time for Mr. Herz to testify before the committee since he took the helm of the Financial Accounting Standards Board. So I want to thank him for coming, and we appreciate

his insight.

What a difference a year makes. Last year at this time we held

hearings in this committee directly related to the collapse of Enron.

Among the most significant questions that arose were how a Fortune 100 company’s true financial condition could be disguised absent a fraud.

As details of the Enron case surfaced, it was clear that Enron did

not consolidate many of its financial obligations, often losing the

company millions that it had in partnerships and other entities.

While Enron’s use of the special purpose entity was intended to

remove debt from the books of the parent company, thus presenting

a healthier financial picture, we learned that certain accounting

standards permitted many of Enron’s activities.

Foremost among those was the standard for consolidation of special purpose entities. The standard permitted that the parent keep

2

the financial partnership off its books for as little as a 3 percent

equity investment.

We subsequently learned that in one case, it was only because

of a technical violation that Enron failed the 3 percent test and was

forced to restate its financials. Still, we learned that the use of special purpose entities was widespread. And in most cases, they were

being used for legitimate purposes. The fact that SPEs could be

both legitimate and also abused at fantastic levels raised some very

troubling questions about our entire financial accounting standard

system and the standards that govern it.

As more corporate failures and scandals splashed across the

headlines throughout the year 2002, the importance of transparent

accounting standards became clear to everyone. FASB’s mission is

laudable but not enviable. It is a difficult task to develop financial

accounting standards that keep pace with a rapidly changing business environment.

To its credit, the board has undertaken a number of activities in

an unprecedented timeframe trying to bring greater transparency

to financial reporting and ultimately restoring investor confidence

in such reporting. The so-called special purpose entities standard

that was abused by Enron has already been changed to reflect true

economic risk. Additionally, FASB has addressed the issue of accounting for and disclosing of guarantees and issued new requirements for energy trading contracts.

Among the changes FASB has given itself; more specifically, its

administration and processes, a tune-up, so to speak. They have instituted some key operational changes to improve the efficiency and

timeliness of issuing standards. This is a welcome change that has

already produced results.

Additionally, while FASB should be praised for historically having an open and inclusive process, it has taken an additional and

indeed very significant step toward both improving its process and

product, the formation of the user advisory council.

This council was formed to receive input from the user community; that is, those in the investment community, including pension

funds, mutual funds, and independent analysts that use the financial reporting.

I understand they held their first meeting last month. And I, of

course, am anxious with my colleagues to hear more about the

council. Although specific standards were often the topic of discussion, they highlighted the fact that our accounting system is based

on very detailed standards where exceptions to the standards can

be more detailed than even the standards.

By comparison, the European system and specifically the British

model rely more on general accounting principles than individual

standards. This, in turn, requires auditors to make learned judgments that must be justified.

I think that there is some learning to be had for us from a principle-based system. In fact, I included a provision in legislation

that I authored last year, H.R. 5058, and that this subcommittee

approved requiring committees to issue financial statements based

on three fundamental principles. I am, therefore, pleased to see

that FASB has already issued a proposal for comment on the topic

of principle-based accounting and conducted a roundtable discusVerDate 11-MAY-2000 13:32 Jul 16, 2003 Jkt 000000 PO 00000 Frm 00006 Fmt 6633 Sfmt 6633 86050.TXT HCOM1 PsN: HCOM1
3

sion to begin the dialog on a very complex issue. This subcommittee

was one of the leaders in pushing principle-based accounting in our

legislation, H.R. 5058, and I am glad to see that FASB is at least

starting a roundtable discussion.

While it may seem less important, the FASB has entered into a

memorandum of understanding with the International Accounting

Standards Board on the goal of convergence of financial accounting

standards as the European Commission is pressing hard to have all

7,000 public companies in the EU member states adhere to the

international accounting standards by 2005. The issue of convergence or harmonization of accounting standards will in my opinion

be the most critical issue facing FASB in a year or 2.

In theory, I am hopeful that in harmonizing, the benefits of each

accounting system will prevail. However, I cannot dismiss the notion that we may be sacrificing some of our autonomy in the process. I am also concerned as to how the convergence will affect our

companies. We need to be careful so that financial accounting

standards do not become yet another set of pawns being played for

sake of gaining an advantage in international trade and competitiveness.

Although this is the first hearing on accounting standards this

Congress, I can assure you it will not be our last. Unfortunately,

as our recent financial history was somewhat defined by corporate

collapses of historic proportions, we all now realize how vitally important it is to maintain high-quality and effective financial accounting standards.

Again, Mr. Herz, I want to thank you very much for your attendance today. And, with that, I welcome the opening statement of our

ranking member.

Ms. SCHAKOWSKY. Thank you, Chairman Stearns. I appreciate

your convening this hearing today. This is my first hearing since

becoming the ranking member of this very important subcommittee. And I am honored to be here. I look forward to working

with you and all of the members on both sides of the aisle to protect the rights of consumers.

I want to thank the Financial Accounting Standards Board,

FASB, Chairman Herz for appearing before this committee today

and for taking the time before this hearing to come and meet with

me, as I know you have with many of the stakeholders that are involved in this issue. I appreciate that kind of diligent, good outreach.

Today’s hearing will give us an opportunity to aid FASB’s efforts,

to improve our accounting standards and strengthen corporate accountability. Restoring credibility in accounting is extremely important to our economy. We need to restore investor confidence in our

financial markets to create jobs and help our struggling economy.

Since January 2001, we have lost 2 million private sector jobs.

Corporate greed and fraud have had a terrible impact on our economy. CEOs at firms under investigation by Federal regulators and

law enforcement agencies have pocketed $1.4 billion in the last 3

years. During the first 7 months of 2002, the value of shares at

these firms plunged by $530 billion. And we can’t let history repeat

itself.

4

After initial resistance by the Bush administration and the

House leadership, Congress finally acted by passing the SarbanesOxley Act. At the time I was a member of the Financial Services

Committee. So I am very familiar with this legislation.

Sarbanes-Oxley represents a positive first step, but it will not

make a real impact unless it is vigorously implemented and corporate criminals are aggressively prosecuted. To date, neither has

happened. Here we are over 5 months later, and corporate criminals remain free while workers and investors are paying the price

of Ken Lay’s and other corporate executives’ misdeeds. The SEC

has yet to implement many reforms. And the public accounting office board is still not up and running. Today we will focus on

FASB’s role in reforming the accounting industry.

Mr. Chairman, I thank you for holding this hearing because we

need to make the private sector and Federal regulators implement

reforms. This is an urgent situation. FASB has an important role

to play in this process.

I look forward to hearing from Chairman Herz. In his short term

at FASB, the chairman has taken action to help close loopholes

that have allowed corporations to deceive investors by creating special purpose entities, or SPEs.

Enron’s insiders used SPEs to hide debt and to deceive workers

and investors. FASB has changed the rules for accounting of SPEs.

In order for a corporation to create an SPE, the parent company

must own no more than 90 percent of the SPE. And they must pass

a seven-factor test. In the past, it was a 97 percent threshold. I

look forward to learning more about this new standard.

FASB is also wrestling with the question of whether or not to expense stock options. I want to go on record as strongly supporting

expensing stock options. And I recently wrote to you with several

of my colleagues to encourage FASB, to take action to expense

stock options.

Mr. Chairman, I would like to submit that letter for the record.

Mr. STEARNS. By unanimous consent, so ordered.

[The letter offered by Hon. Jan Schakowsky appears at the end

of the hearing.]

Ms. SCHAKOWSKY. Opponents of expensing stock options contend

expensing would lead to the elimination of stock option plans for

rank and file workers. However, according to the U.S. Bureau of

Labor Statistics, in 2001 only 1.7 percent of non-executives received

stock options.

Federal Reserve Chairman Alan Greenspan and corporations

such as Coca-Cola, Gnarl Motors, Boeing, Home Depot are among

the over 120 companies that expense stock options. We should

make sure that all corporations play by the same set of rules. This

will help investors get a more accurate picture of their investments

and will help prevent future Enrons.

The Sarbanes-Oxley mandated FASB to collect user fees. I understand that the fee mechanism has not yet been implemented.

This could lead to a funding crisis later this year. I am eager to

hear Chairman Herz’s assessment of when he expects this new system to be in place.

I know FASB is working to improve international accounting

standards, the accounting treatment of loans, as well as many

5

other very important initiatives. I look forward to learning more

about FASB’s progress on all of these issues.

Finally, in the past, Congress has too often weighed in at the behest of powerful special interests to block reforms. I hope members

will learn from the past and will allow FASB to do its job. I look

forward to hearing Chairman Herz’s testimony.

Thank you very much, Mr. Chairman.

Mr. STEARNS. I thank my colleague.

And now the gentleman from Idaho, Mr. Otter.

Mr. OTTER. I have nothing.

Mr. STEARNS. Okay. Mr. Shimkus.

Mr. SHIMKUS. Mr. Chairman, is that 5 plus 3 minute rule in effect here?

Mr. STEARNS. We are very flexible.

Mr. SHIMKUS. I was a few minutes late.

Mr. STEARNS. You can have 3 to 5 on your opening statement.

And we are going to go around.

Mr. SHIMKUS. I think I will defer, Mr. Chairman, and try to take

a few minutes when I get a chance.

Mr. STEARNS. That would be fine. Okay.

[Additional statements submitted for the record follow:]

PREPARED STATEMENT OF HON. W.J. ‘‘BILLY’’ TAUZIN, CHAIRMAN, COMMITTEE ON

ENERGY AND COMMERCE

Thank you Chairman Stearns for holding this important hearing today.

It was this time last year that this Committee held oversight hearings on the

Enron implosion and that this Subcommittee held legislative hearings on important

public policy issues involving accounting standards. While our work exposing the

fraud at Enron and WorldCom was big news, much of our hard work in the accounting standards area went unnoticed. These most certainly were not the sexy issues

of corporate governance failures and securities fraud that dominated the headlines

in 2002. Yet our discovery that some of the accounting standards, when applied improperly, were used to hide the financial condition of a company instead of reveal

it was an important one. Our work here last year, and the FASB’s diligent efforts

since that time, will lay the foundation for reliable and transparent disclosure in

the years to come.

The FASB has been busy over the last year. One of the most significant changes

FASB made was not to the standards themselves but to its own rules of procedure.

FASB instituted new rules for its voting process, changing the unwieldy supermajority voting mechanism to a simple majority vote. This is in no small part responsible for the quantity of issues FASB has begun to tackle in the past year. And,

I might add, the quality of work at the FASB has still been first rate. Those projects

include completed work on off balance sheet accounting for special purpose entities

as well as various proposals for comments on principle-based accounting; the IASB’s

proposal for expensing of stock options; and a myriad of revenue recognition issues.

The FASB Act, sponsored by Mr. Stearns and passed out of this Subcommittee

last Congress required FASB to resolve these issues. I applaud the FASB for quickly

adding these issues to its agenda, and obviating the need for legislative direction.

The FASB has not yet, however, added the issue of accounting treatment for loan

commitments to its agenda. Since companies generally invoke their commitments

when they are on the brink of filing Chapter 11, these loan commitments leave lenders, and ultimately shareholders, exposed. Current accounting rules do not require

loan commitments to be carried at fair value. As a result, shareholders have no

means of determining the extent of the lender’s exposure to rapidly deteriorating

companies. For this reason, I urge FASB to add this important issue to its agenda.

Finally, I want to call on the Securities and Exchange Commission to recognize

FASB standards as ‘‘generally accepted’’ for purposes of the securities laws and

thereby provide FASB with the funds necessary for it to carry out its mandate. I

encourage Chairman Donaldson to move expeditiously so that the FASB can continue to do its important work.

I thank Chairman Herz for being here today and look forward to his testimony.

I yield back the balance of my time.

6

PREPARED STATEMENT OF HON. GENE GREEN, A REPRESENTATIVE IN CONGRESS FROM

THE STATE OF TEXAS

Good afternoon. I would like to thank Chairman Stearns for having this hearing

on the state of accounting regulations in the aftermath of the corporate collapses

that devastated communities across the country over the last couple of years.

I am very interested in what Mr. Herz, the Chairman of the Financial Accounting

Standards Board has to tell us about all his activities in his new post of critical importance to America’s life savings.

My primary concern with the state of the accounting industry is the lack of auditor independence.

How can individuals and pension funds trust accountants who are auditing the

books for minor fees, while at the same time pulling down millions and millions over

many years in lucrative tax, management, and information technology (IT) consulting from the same companies?

FASB does not regulate this, but Congress does, and we urgently need FASB’s

professional opinion on this issue. It is now accepted that aggressive accounting has

become a way for the Big Four accounting firms to compete with each other for access to the consulting businesses.

Unfortunately the questionable practice of accounting firms selling tax advice has

been allowed to continue under Sarbanes-Oxley. Accounting companies in America,

the defenders of the public’s right to know how their money is being spent by these

companies, are simultaneously competing with each other on who can have the most

aggressive accounting and tax treatments.

The result is the fleecing of American investors and American taxpayers. They are

getting us coming and going.

FASB is the ultimate expert in America on issues of accounting, and I would like

to know whether they, as accounting regulatory professionals, believe it is possible

for quality audits to be performed by the same people shopping tax avoidance

schemes.

The most important issue that I believe is before the FASB for decision making

right now is what is known in the industry as ‘‘special purpose entities’’ or SPEs,

but what I refer to as pure deception.

These corporate fraud vehicles are intended to conceal debt and other liabilities

from the publicly available, audited balance sheets of public corporations. Millions

of individual American investors and the many pension funds that hold the life savings of millions more working Americans depend absolutely on the integrity of the

public financial information.

I am a little concerned that the central part of the new rule appears to be raising

the minimum outside investment in a SPE from 3% to 10%. On its face, it still

seems unnatural for a company to create an entity in which it has a 90% stake that

is not recorded on the balance sheet. I look forward to learning from the Chairman

of FASB the other specifics of the SPE rule.

Thank you Mr. Chairman, and I look forward to improving corporate governance

with all the Members of this panel.

Mr. STEARNS. Well, Mr. Herz, we want to welcome you, Chairman of the Financial Accounting Standards Board. And we look

forward to your testimony and some of the things you have been

doing. So the floor is all yours.

STATEMENT OF ROBERT H. HERZ, CHAIRMAN, FINANCIAL

ACCOUNTING STANDARDS BOARD

Mr. HERZ. Thank you, Chairman Stearns, Ranking Member

Schakowsky, and members of the subcommittee. I thank you for

the invitation to appear today to review with you the actions and

activities of the Financial Accounting Standards Board since the

bankruptcies of Enron and Worldcom.

I have some brief prepared remarks. And I would respectfully request that the full text of my testimony and all supporting materials be entered into the public record.

Mr. STEARNS. By unanimous consent, so ordered.

Mr. HERZ. As you know, the FASB is an independent private sector organization. We are not part of the Federal Government. And

7

our independence from reporting enterprises, auditors, and the

Federal Government is fundamental to achieving our mission, to

set accounting and reporting standards to benefit the users of financial information, most notably investors and creditors. Those

users rely heavily on credible, transparent, comparable, and unbiased financial reports for effective participation in the capital markets.

Also, the FASB has no power to enforce its standards. Rather, responsibility for ensuring that financial reports comply with accounting standards rests with the officers and directors of the reporting enterprise, with the auditors of the financial statements,

and for public enterprises ultimately with the Securities and Exchange Commission.

Clearly the events of the past year have shaken confidence in our

reporting system and in our capital markets. While I think most

of the problems seem to stem from outright violations of rules,

fraud, and apparent audit and corporate governance failures, those

problems also have prompted broader questions about virtually

every aspect of our financial reporting system, including financial

accounting and reporting standards and the accounting standardsetting process.

I think those questions are appropriate. I think they are healthy.

Frankly, I think they were overdue. As with crises in other areas

of business or life, this crisis prompts reflection, introspection, a

better understanding, and then rebuilding, change, and renewal. So

it must be with our financial reporting system. And I think a major

lesson and an indelible reminder from this crisis is that sound financial reporting is indeed very key to the health and vitality of

our capital markets; our economy; and, therefore, to our society as

a whole. It matters.

So what are we at the FASB doing to fulfill our critical mission

and to play our important role in helping improve financial reporting and restore investor confidence? I think the answer is many

things, both in regard to specific technical areas and in terms of

our own operations and the whole structure and direction of accounting standard setting in this country.

First, on the technical front, we have significantly modified our

agenda and priorities in direct response to issues that have come

to light in the many scandals. These issues include the accounting

for special purpose entities, accounting for guarantees, energy trading contracts, stock-based compensation, and the very broad area

of revenue recognition. Let me briefly touch on each of those items

and what we have been doing.

First, with respect to SPEs, as you mentioned, we issued new requirements in January 2003. Those requirements provide that enterprises with investments or other relationships with SPEs must

carefully assess their involvement to determine whether they receive a majority of the risks or rewards of those SPEs. If so, the

enterprises would be required to report the assets, liabilities, and

gains and losses of those SPEs within their own financial statements.

We expect that under the new requirements, many, but certainly

not all, of the SPEs that are currently not reported by any enterprise would so be in the future. The new requirements also signifiVerDate 11-MAY-2000 13:32 Jul 16, 2003 Jkt 000000 PO 00000 Frm 00011 Fmt 6633 Sfmt 6602 86050.TXT HCOM1 PsN: HCOM1
8

cantly improve the disclosures related to an enterprise’s use of and

involvement with SPEs.

In a closely related project on accounting and disclosure for guarantees, we issued new requirements in November 2002. Those requirements provide that all enterprises recognize a liability at fair

value for the obligations they undertake when issuing a guarantee

and that those enterprises make additional disclosures about the

guarantees. We believe that the new requirements will result in a

more representationally faithful depiction of an enterprise’s obligations.

In October 2002, our Emerging Issues Task Force, known as

EITF, and the FASB staff addressed certain practice issues related

to the accounting for energy trading contracts. The EITF decided

to preclude mark-to-market accounting for certain difficult-to-value

energy trading contracts. The EITF also decided to require that

gains on certain energy trading contracts be shown net, rather

than gross, in the financial reports.

At the same time, the FASB staff observed that no enterprise

should recognize an up-front gain at the inception of entering into

certain financial contracts unless the fair value of those contracts

is clearly evidenced by observable market transactions or market

data.

We also have a current project on our agenda to improve the existing accounting requirements for measuring and disclosing the

fair value of essentially all financial instruments.

In December 2002, we issued new requirements relating to the

accounting for stock-based compensation in order to deal with the

more than—it is now about 180 enterprises that have voluntarily

said they would change to the preferable fair value approach for expensing of stock-based compensation. Those requirements address

how the companies make that switch.

Moreover, the new requirements also provide for clearer and

more prominent disclosures about the costs of stock-based compensation. They also increase the frequency of key stock-based compensation disclosures from annually to quarterly.

We also issued a preliminary document for public comment about

the accounting for stock-based compensation in November 2002.

That document was issued to explain the similarities and differences between the recent proposed requirements by our international counterpart, the International Accounting Standards

Board, and the preferable fair value approach under existing U.S.

standards.

We have been carefully reviewing the input received on that document and other input we have been receiving from investors, analysts, enterprises, and Members of Congress about a variety of

issues relating to the accounting for stock-based compensation. We

will soon deliberate at a public meeting whether the board should

add a new project to its agenda to pursue further improvements in

this area, including whether we should mandate the preferable fair

value approach to stock options. Of course, any new project to pursue further changes to the accounting and reporting for stock-based

compensation would be subject to the FASB’s open and thorough

due process procedures.

9

Finally, with respect to our technical activities, our EITF issued

new requirements in November 2002 addressing certain revenue

recognition issues arising from revenue arrangements with multiple deliverables. Those requirements should improve the comparability and transparency of the reporting of revenue from the

delivery or performance of multiple products, services, or rights to

use assets.

As a longer-term solution to the many issues surrounding the accounting for revenue recognition, we also added a major project to

the FASB’s agenda addressing this whole area. The objective is to

develop jointly with the international board a coherent, conceptually consistent model for revenue recognition that would replace

much of the existing literature and that would serve as a principles-based source for developing future accounting guidance as

new types of transactions emerge in the marketplace.

Now let me turn to our own operations and some comments

about the structure and direction of accounting standard setting in

this country.

Last year when I joined, we launched a series of wide-ranging reviews covering a broad range of issues. Some of the key aspects of

our reviews and findings relate to improving our speed and timeliness, increasing the involvement of investors and other users of financial reports in our activities, the topic of principles-based accounting and international convergence and how all of these things

impact the structure and direction of U.S. accounting standard setting.

With respect to improving our own speed and timeliness, our

independent oversight body, the Financial Accounting Foundation,

amended our rules of procedure last year to require only a four to

three vote of the board, rather than the previous 5 to 2 vote, to

issue both proposals and final standards.

Also, last year we implemented a reorganization of our senior

staff to enhance the focus and accountability of our staff activities.

We are also conducting a thorough process of mapping all our procedures in order to identify and to hopefully eliminate those procedures that are redundant or do not add value, while at the same

time not compromising our thorough and open due process.

To increase the involvement of investors and other users of financial reports in our activities, we recently established the User

Advisory Council. The council includes representatives from mutual

fund groups, major investment and commercial banks, rating agencies, and other groups that represent investors and other key users.

We held our first public meeting of the UAC on February 13, 2003.

We intend to use the UAC as a source of input on our agenda and

on specific issues within ongoing projects.

We issued a proposal for public comment on the whole subject of

principles-based accounting standards in October 2002. In December, we held a public roundtable on that subject.

In coming weeks, we expect to discuss at public board meetings

the input received we have received on that. And we plan to continue to work closely with the SEC as it responds to the principlesbased study requirements contained in the Sarbanes-Oxley Act.

10

We also have, as you mentioned, been devoting significant resources to the area of international convergence. We are working

together on several major projects.

We also, as you noted, reached a historic agreement with the

international board to use our best efforts to align our agendas

and, very importantly, undertake a specific project with the help

and support of the SEC staff aimed at accelerating the convergence

process by trying to eliminate or narrow some of the areas of difference between current U.S. and international standards. Because

there are literally hundreds of differences between U.S. and international standards, realistically this effort will still be ongoing well

beyond 2005, when Europe adopts international standards en

masse. But we need to set this process in motion so that we can

make real progress.

Finally, with respect to structural improvements to U.S. standard setting, we have made recent changes that we believe are necessary to better control the proliferation and consistency of U.S. accounting standards. First, we decided that the role of the Accounting Standards Executive Committee of the American Institute of

Certified Public Accountants as a second senior-level accounting

standard setter in the U.S. would after a transition period of approximately 1 year be discontinued.

Second, we decided that with regard to our own EITF, we needed

to take more involvement in the agenda deliberations and ultimate

decisions of that group.

This has been a brief summary of some of our many actions and

activities at the FASB. These actions and activities are designed to

better meet the challenges and opportunities that face us and that

I believe face the financial reporting system. I hope you will agree

that it is not business as usual for us.

I believe the overriding goal must be improvement of the overall

financial accounting and reporting system in this country. That’s

what it is all about: sound, transparent, unbiased information that

the system needs to work effectively. I know that many Members

of Congress and the investing public are demanding that we and

others continue to take bold and decisive actions to restore investors’ confidence. The capital markets expect it. And I believe that

our country deserves nothing less.

Thank you again, Mr. Chairman, Ranking Member Schakowsky,

and all members of the subcommittee. I appreciate your continued

interest in support of our mission and our activities. And I would

be happy to respond to any questions you may have.

[The prepared statement of Robert H. Herz follows:]

PREPARED STATEMENT OF ROBERT H. HERZ, CHAIRMAN, FINANCIAL ACCOUNTING

STANDARDS BOARD

Chairman Stearns, Ranking Member Schakowsky, and the Members of the Subcommittee, thank you for the invitation to appear today to review with you the actions and activities of the Financial Accounting Standards Board (‘‘FASB’’ or

‘‘Board’’) since the bankruptcies of Enron Corp. (‘‘Enron’’) and WorldCom, Inc.

(‘‘WorldCom’’). I have brief prepared remarks, and I would respectfully request that

the full text of my testimony and all supporting materials be entered into the public

record.

The FASB is an independent private-sector organization. We are not part of the

federal government. Our independence from reporting enterprises, auditors, and the

federal government is fundamental to achieving our mission—to set accounting and

11

reporting standards to benefit the users of financial information—most notably, investors and creditors. Those users rely heavily on credible, transparent, comparable,

and unbiased financial reports for effective participation in the capital markets.

The FASB has no power to enforce its standards. Responsibility for ensuring that

financial reports comply with accounting standards rests with the officers and directors of the reporting enterprise, with the auditors of the financial statements, and

for public enterprises, ultimately with the Securities and Exchange Commission

(‘‘SEC’’).

Clearly, the events of the past year have shaken confidence in our reporting system and in our capital markets. While most of the problems seem to stem from outright violations of rules, fraud, and apparent audit and corporate governance failures, those problems also have prompted broader questions about virtually every aspect of our financial reporting system, including financial accounting and reporting

standards and accounting standard setting.

I think those questions are appropriate and are healthy, and, quite frankly, I

think they were overdue. As with crises in other areas of business or life, this crisis

prompts reflection, introspection, a better understanding, and then rebuilding,

change, and renewal. So it must be with our financial reporting system. And, I

think a major lesson and an indelible reminder from this crisis is that sound financial reporting is indeed very key to the health and vitality of our capital markets,

our economy, and our society as a whole. It matters!

So, what are we at the FASB doing to fulfill our mission and to play our important role in helping improve financial accounting and reporting and restore investor

confidence? The answer is many things—in regard to specific technical areas, in

terms of our own operations, and in terms of the whole structure and direction of

accounting standard setting in this country.

On the technical front, we have significantly modified our agenda and priorities

in direct response to issues that have come to light since the Enron and WorldCom

bankruptcies. These issues include the accounting for special-purpose entities

(‘‘SPEs’’), guarantees, energy trading contracts, stock-based compensation, and the

broad area of revenue recognition. Let me touch briefly on each of those items.

With respect to SPEs, we issued new requirements in January 2003. Those requirements provide that enterprises with investments or other relationships with

SPEs must carefully assess their involvement to determine whether they receive a

majority of the risks or rewards of those SPEs. If so, the enterprises are required

to report the assets, liabilities, and gains and losses of those SPEs within their own

financial statements. We expect that under the new requirements many, but certainly not all, of the SPEs that currently are not reported by any enterprise will

be reported in the future. The new requirements also significantly improve the disclosures related to an enterprise’s use of, and involvement with, SPEs.

In a closely related project on accounting and disclosure of guarantees, we issued

new requirements in November 2002. Those requirements provide that all enterprises recognize a liability at fair value for the obligations they undertake when

issuing a guarantee and that those enterprises make additional disclosures about

the guarantees. We believe the new requirements will result in a more

representationally faithful depiction of an enterprise’s liabilities. The requirements

will also improve the transparency of enterprise’s obligations and liquidity risks related to the guarantees it issues.

In October 2002, our Emerging Issues Task Force (‘‘EITF’’) and the FASB staff

addressed certain practice issues related to the accounting for energy trading contracts. The EITF decided to preclude mark-to-market accounting for certain difficultto-value energy trading contracts. The EITF also decided to require that gains on

certain energy trading contracts be shown net (rather than gross) in financial reports. At the same time, the FASB staff observed that no enterprise should recognize an upfront gain at the inception of entering into certain financial contracts, unless the fair value of those contracts are clearly evidenced by observable market

transactions or market data.

We also have a current project on our agenda to improve the existing accounting

requirements for measuring and disclosing the fair value of essentially all financial

instruments, including those whose fair value cannot be reliably measured by observable market transactions or market data.

In December 2002, we issued new requirements relating to the accounting for

stock-based compensation. Those requirements allow the more than 170 enterprises

that are voluntarily changing to the preferable fair value approach of accounting for

stock-based compensation to effect that change in several alternative manners.

The new requirements also provide for clearer and more prominent disclosures

about the costs of stock-based compensation. Finally, the new requirements increase

12

the frequency of key stock-based compensation disclosures from annually to quarterly.

We also issued a preliminary document for public comment about the accounting

for stock-based compensation in November 2002. That document explains the similarities and differences between recent proposed requirements by our international

counterpart, the International Accounting Standards Board (‘‘IASB’’), and the preferable fair value approach under existing US standards.

We have been reviewing the input received on that document and other input we

have been receiving from investors, analysts, enterprises, and some Members of

Congress about a variety of issues relating to the accounting for stock-based compensation. We will soon deliberate, at a public meeting, whether the Board should

add a new project to its agenda to pursue further improvements in this area, including whether we should mandate the preferable fair value approach. Of course, any

new project to pursue further changes to the accounting and reporting for stockbased compensation would be subject to the FASB’s open and thorough due process

procedures.

Finally, with respect to our technical activities, our EITF issued new requirements in November 2002 addressing certain revenue recognition issues arising from

revenue arrangements with multiple deliverables. Those requirements should improve the comparability and transparency of the reporting of revenue from the delivery or performance of multiple products, services, or rights to use assets. Examples

of those types of arrangements include the sale of a cellular telephone with related

telephone service, or the sale of medical equipment with related installation service.

As a longer-term solution to the many issues surrounding the accounting for revenue recognition, we added a major project to the FASB’s agenda addressing this

whole area broadly. The objective is to develop, jointly with the IASB, a coherent,

conceptually consistent model for revenue recognition that would replace much of

the existing literature and that would serve as a principles-based source for developing future accounting guidance as new types of transactions emerge in the marketplace.

In terms of our own operations and the whole structure and direction of accounting standard setting in this country, last year we launched a series of wide-ranging

reviews covering a broad range of issues in this area. Some of the key aspects of

our review and findings relate to improving our speed and timeliness, increasing the

involvement of investors and other users of financial reports in our activities, the

topic of a principles-based accounting system, international convergence, and how

all of these things impact the structure and direction of US accounting standard setting.

With respect to improving speed and timeliness, our independent oversight body—

the Financial Accounting Foundation—amended our Rules of Procedure last year to

require only a four to three vote of the Board, rather than a five to two vote, to

issue both proposals and final standards.

Also last year we implemented a reorganization of our senior staff to enhance the

focus and accountability of our staff activities. We also are conducting a thorough

process mapping of all our procedures in order to identify and to hopefully eliminate

those procedures that are redundant or do not add value, while at the same time

not compromising our thorough and open due process.

To increase the involvement of investors and other users of financial reports in

our activities, we recently established the User Advisory Council (‘‘UAC’’). The UAC

includes representatives from mutual fund groups, major investment and commercial banks, rating agencies, and other groups that represent investors and other key

users. We held our first public meeting of the UAC on February 13, 2003. We intend

to use the UAC as a source of input on FASB agenda decisions and on specific

issues within ongoing FASB projects.

We issued a proposal for public comment on the whole subject of principles-based

accounting standards in October 2002. In December 2002, we held a public roundtable meeting with respondents to discuss various aspects of that proposal.

In the coming weeks, we expect to discuss at public Board meetings the input received in response to the proposal and decide what additional actions, if any, the

FASB should pursue in this area. We also plan to continue to work closely with the

SEC as it responds to the principles-based study and reporting requirements contained in the Sarbanes-Oxley Act of 2002.

We also have been devoting significant resources to the area of international convergence. Our recent work in this area includes developing procedures and protocols

used not only by the FASB but also by the IASB and other major national standards

setters in working together. In addition, we are working with the IASB on several

major joint projects, including, as mentioned earlier, revenue recognition, business

13

combinations, and reporting on financial performance. We are also closely monitoring the progress of the IASB on other key projects.

In October 2002, we reached a historic agreement with the IASB to use our bestefforts to align our agendas and, very importantly, to undertake a specific project

(with the help and support of the SEC staff) aimed at accelerating the convergence

process by trying to eliminate or narrow some of the areas of difference between current US and international standards. Because there are literally hundreds of differences between US and international standards, realistically, this effort will still

be ongoing, well beyond 2005 when Europe adopts international standards en

masse. But we need to set this process in motion now, so that we can achieve greater progress in this important area going forward. The overall objective of international convergence is not convergence just for the sake of convergence, but rather

to arrive at high-quality accounting solutions that improve the transparency of financial reporting in the US and abroad.

Finally, with respect to structural improvements to US accounting standard setting, the FASB made several recent changes that we believe are necessary to better

control the proliferation and consistency of US accounting requirements. First, we

decided that the role of the Accounting Standards Executive Committee of the

American Institute of Certified Public Accountants as a second senior-level accounting standard setter in the US would, after a transition period of approximately one

year, be discontinued. We also decided that, in the future, the maintenance and development of any industry-based standards would reside with the Board.

Second, we decided that with regard to our EITF, two FASB Board members

would become members of the EITF agenda committee and the FASB Board members would more actively participate at all EITF meetings. Moreover, all future

EITF decisions would be subject to the FASB Board’s review and ratification. Finally, we broadened the composition of the EITF to include a user representative

to ensure that the user perspective is properly considered in the EITF’s deliberations.

This has been a brief summary of some of our many actions and activities at the

FASB, post-Enron and WorldCom. These actions and activities are designed to better meet the challenges and opportunities that face us and that face the financial

reporting system. I hope you will agree that it is not business as usual at the FASB

and that we are on the right track.

I believe that the overriding goal must be improvement of the overall financial

accounting and reporting system in this country. That’s what it is all about—sound,

transparent, unbiased information that the system needs to work effectively. I know

that many Members of Congress and the investing public are demanding that we

and others continue to take bold and decisive actions to restore investors’ confidence, the capital markets expect it, and I believe that our country deserves nothing less.

Thank you again, Mr. Chairman, Ranking Member Schakowsky, and all of the

Members of the Subcommittee. I very much appreciate your continuing interest in,

and support of, the mission and activities of the FASB.

I would be happy to respond to any questions.

Mr. STEARNS. I thank the chairman.

Just for the members’ record, if you were here when the gavel

came down and you did not have an opening statement, you’re

passing on your opening statement, you will get 8 minutes for

questions. Otherwise, everyone gets five. And so we will proceed

under that basis. And I will start.

Mr. Herz, I heard all the things you did. Could you say today

that what you did with special purpose entities, if that had been

in place, we would not have had an Enron perhaps?

Mr. HERZ. Well, we would have had rules that would not have

allowed off balance sheet financing of some of the things that

Enron did. Whether or not the company and the auditors would

have acted as they did is another matter, I believe, but we would

have had rules that would have caught the type of transactions, at

least in theory, you know, the rules——

Mr. STEARNS. So the transaction that supposedly Jeff Skilling

said he didn’t know about but went forward could not have gone

forward under this scenario that you just——

14

Mr. HERZ. It would have been counter to the new rules.

Mr. STEARNS. So, instead of getting a 3 percent equity, they

would have to get a 10 percent equity.

Mr. HERZ. Well, probably even more. I mean, the way the standard is——

Mr. STEARNS. What you might do is just briefly tell us in reference to maybe an Enron what they would have to do under this

scenario that you have outlined so a layman could understand it.

Mr. HERZ. Yes. I will try as best I can after 30 years in accounting.

The old rules, as you mentioned, allowed——

Mr. STEARNS. And I might point out FASB took 25 years to study

the SPEs and came up with no clear conclusion. And you have been

in office 3 or 4 months, and you have already made some major direction.

Mr. HERZ. Thank you. I attribute that not only to me but to all

my board members and our staff.

Mr. STEARNS. Well, it shows you did. The urgency was there once

we saw how easy it was to develop special purpose entities.

Mr. HERZ. Yes. The old rules, as you referred to, which, by the

way, the FASB did not actually write, if you can believe it, they

were contained in a question and answer by an SEC staff question

and answer that was appended to an EITF issue on what were

called build-to-suit leases, a very specific transaction, but somehow

that answer using the 3 percent as an example kind of got canonized in practice. And people then used it to develop a whole industry, so to speak, of off balance sheet financing using special purpose

entities.

That rule basically, as you outlined it correctly, was that as long

as somebody put up at least 3 percent, an independent party, 3

percent of the total capitalization, meaning both debt and equity,

of an entity, the assets and borrowings could be kept off the balance sheet and that entity would be treated as if it were an independent party. So you could deal back and forth with that entity

as if you were doing it with General Motors.

Mr. STEARNS. You could hide lots of debt.

Mr. HERZ. Yes. That really was manifested from the normal consolidation rule that said that if somebody held the majority of the

voting equity, that party would consolidate, even though that equity might be extremely thin and that vote may have really no effect because the entity was largely on autopilot. Its actions were

predetermined.

Mr. STEARNS. So tell me now how under the new rules what the

new rules would do to make——

Mr. HERZ. Well, if the new rules first make a cut as to whether

one would use the old voting interest model for a normal operating

subsidiary, if you owned the majority of the voting stock, you would

consolidate, but what it looks at is whether or not that entity is

properly capitalized and whether the people who have the vote

have a meaningful vote if the entity is a real operating entity. That

requires, among other things, kind of a presumption that there has

to be at least 10 percent of capital to run that entity self-sustained.

Mr. STEARNS. Independent of the corporation?

15

Mr. HERZ. Independent of the corporation. And then if you fail

that, you then go into this realm of SPEs. The notion there is

that——

Mr. STEARNS. How could you do an SPE if you failed that?

Mr. HERZ. Well, you now say you are in a different model. You

are in a model that looks at risks and rewards, rather than——

Mr. STEARNS. It’s no longer an SPE?

Mr. HERZ. No, no. You are an SPE.

Mr. STEARNS. But it’s a different model of an SPE?

Mr. HERZ. No, no. It’s a different model for consolidation.

Mr. STEARNS. Oh, okay.

Mr. HERZ. The normal model for consolidation is still if you own

an operating subsidiary and you own 51 percent of the stock and

you control it or you have 100 percent of the stock and it’s a properly capitalized entity, it’s self-sustaining, you would continue to

use the normal what we call voting interest or control model.

The problem with SPEs was that they didn’t suit that model.

They were thinly capitalized. The votes may have meant nothing.

And so we first have to filter to determine whether or not you go

into this alternative model, which is more of a risks and rewards

kind of model.

When you go in there, basically the principle is you look for whoever has the majority of risks and rewards, no matter how it is derived. It could be derived from the thin equity, but it might be

more often derived from various other forms of interests and arrangements in that entity.

So, for example, in the Enron-type arrangements, where basically

they would have 100 percent of the up side and 97-plus percent of

the down side, even though somebody else might have put up a

thin amount of the actual equity, you would say, ‘‘Well, I know who

has the majority of the risks and the rewards. It’s not the person

who owns that nominal amount of equity. It’s somebody else.’’ And

you would look for that party looking for all of the arrangements.

In the Enron situations, it would have been clear.

Mr. STEARNS. I can’t say after listening to your explanation that

I am 100 percent confident that we could stop Enrons. I mean, that

is just my first observation, especially when you say you don’t have

the power to enforce your standards. So someone else has to enforce your standards once you come up with this new—and I assume that would be the SEC.

Mr. HERZ. At the first line of enforcement are the company accountants, then the auditors, and ultimately the SEC.

Mr. STEARNS. The gentleman from Massachusetts.

Mr. MARKEY. Thank you, Mr. Chairman.

Welcome. God bless you. God bless America. And we are going

to need a little help in this area and all of the people who work

with you.

How confident are you that the loopholes exploited by some of

the accounting professionals working at Enron and WorldCom have

been closed?

Mr. HERZ. Again, I think I would like to kind of give you total

assurance in that regard, but that is beyond our role. We write accounting and reporting standards. And we have written standards

to close——

16

Mr. MARKEY. Do you feel that you have closed the loopholes?

Mr. HERZ. We believe we have closed——

Mr. MARKEY. And now it’s an enforcement issue? Do you think

all of the loopholes are closed?

Mr. HERZ. Then it becomes an application and enforcement issue.

Mr. MARKEY. So you don’t think there are any more loopholes?

Mr. HERZ. You know, in an area where there is endless structuring, there are people who still spend most of their time trying

to find ways around whatever we do. I will never say, ‘‘Never.’’

Mr. MARKEY. How can you in the future prevent the same type

of bootstrap argument by the issuers and the accounting profession

that you just described to the chairman of the committee where a

3 percent equity interest test developed in some real estate leases

was transformed into the Enron SPE, special purpose entity, loophole?

Mr. HERZ. Well, I think we need to do our best in order to identify all of those areas where you would look at it and say the current accounting rules don’t reflect the kind of economics or common

sense.

Mr. MARKEY. I guess what I am asking is, is it something that

you’ve looked at in the past that allowed for that transformation,

that in all subsequent regulations, you are going to ensure that you

protect against occurring?

Mr. HERZ. I would say that we are trying to identify through

looking at reports, through discussion with the SEC, through discussion with many groups, through discussion with our new User

Advisory Council all of those areas where accounting doesn’t seem

to suit the underlying economics. Those are the kind of areas

where I think the exploitation occurs.

People say like the 3 percent rule, maybe other areas, like leasing, that still exist. They say, ‘‘Gee, this is an opportunity to

achieve an accounting result,’’ favorable accounting result, that

doesn’t match what is really going on.

Mr. MARKEY. So what are accounting issues, then, other than the

ones that you have noted in your testimony?

Mr. HERZ. Well, these are only my personal opinion. I am one of

seven board members. So it’s, again, my personal opinion. I have

a few——

Mr. MARKEY. Well, you are like the chairman of the committee.

My personal opinion doesn’t count as much as the chairman’s personal opinion counts.

Mr. HERZ. Right.

Mr. MARKEY. And the same thing is true, I assume, at FASB.

Mr. HERZ. No, no. One member, one vote. And I have administrative responsibilities, but all seven members vote on our agenda and

all seven members have one vote on all technical issues.

That is important because we have a very deliberative process.

Mr. MARKEY. Well, you know what would be important, Mr.

Chairman, I think at some point in the future, have all seven of

them sit here. Then we can ask each one of them if they agree with

the chairman so that we can see the difficulty that he has in actually implementing the philosophy which he is enunciating today.

Mr. STEARNS. Yes. I think my colleague has got a good point. We

intend to have more hearings on this because it is obviously a little

17

complicated and we would like to see the ongoing work that they

are doing.

Mr. MARKEY. I think what he is telling us is that he is constrained. Shakespeare used to say that the will is infinite, but the

execution is confined. What he is saying here is that he has the

will to do it, but his execution is confined in getting the——

Mr. STEARNS. When he was smiling a lot, I think that is what

he was conveying.

Mr. MARKEY. Yes, I know that.

Mr. HERZ. I would have a very efficient process if I could sit in

the room and just write the rules myself, but they may not be as

good, high-quality as what comes out of our seven-person process.

Mr. MARKEY. I think it is important for us to see of the seven

which of them has a blind eye and see how many of them are coming into this, you know, that way. On the one hand, in the land

of the blind, the one eye is king, but in an era where all investors

can see quite clearly, what happened to them? And what projections have to be put on the books? They don’t want any more blindeyed regulators out there.

So it is very important, Mr. Chairman, for that to be made clear

because I think you can’t answer with the specificity that we need.

And you are under tremendous pressure not to do the right thing,

tremendous pressure. I appreciate that because the history of the

agency is such that in 27 years on this committee, I know how

much pressure FASB has been under. I’ve seen it, and I’ve heard

it from your predecessor chairman.

I just want to make sure that we see more clearly what the pressure is on you each day. Who are the other people? What are their

philosophies? Who are they responding to? Because that ultimately

will determine the compromises which you have to accept that is

less than what you would like to put on the books as a full guarantee. I think that is absolutely critical because we can’t repeat the

mistake again.

My district is a high tech district. And it’s essentially seen a

shambles of hundreds of companies’ stocks. And it’s just not something that investors or workers want to see happen again. Honesty

is ultimately the long-term best strategy. And the puffing that

went on is just something that can’t be allowed to recur again.

Mr. HERZ. I appreciate your observations. I would note, however,

that just to make sure everybody in the audience understands, all

of our board members are full-time board members. They severed

their prior connections. So the seven-person board is there to add

quality. It comes from people with different backgrounds, different

pieces of insight. Again, I wouldn’t judge it as more kind of internal

pressures and compromise. It’s a process to build in views and

qualities.

Mr. MARKEY. If I may finish up, Mr. Chairman, you see, Mark

Twain used to say that history doesn’t repeat itself, but it does

tend to rhyme. So you kind of wind up with a similar kind of debate, a little bit different, but pretty much the same debate, different characters, and whatever. So that’s where you are right now,

not identical, but the same pressures are out there.

And, again, it’s the same eerie situation that we have with the war in Iraq, where the price of oil is up at $40 a barrel. It could

18

be up there for 6 months. Somebody named Bush is conducting a

war. It’s not identical, but it rhymes, you know, looks close.

And that is really, I have found here after 27 years, the way

these issues tend to evolve. The pressures that you are under I

think are probably no different than the pressures that any of your

predecessors were under.

Anyway, I thank you, Mr. Chairman.

Mr. STEARNS. I thank the colleague.

Mr. Otter from Idaho, you are recognized for 8 minutes.

Mr. OTTER. Well, thank you, Mr. Chairman.

Following up on my colleague just prior to me, one of my favorite

quotes is what I am afraid we are practicing here today. It comes

from Matthew 15:14. That is, if the blind leadeth the blind, they

will both falleth in the ditch.

I am concerned about some of your responses to previous questions. I guess I have to start out by asking, ‘‘Have you talked to

the SEC about these new rules and regulations?’’

Mr. HERZ. We talk to the SEC every day.

Mr. OTTER. Has the SEC agreed that these will stop the loopholes?

Mr. HERZ. They have reviewed, participated in what we do, and

I think they believe that the standard we have come out with is

a good, solid standard.

Mr. OTTER. And they are prepared to say that?

Mr. HERZ. Oh, yes. They have.

Mr. OTTER. They have said it?

Mr. HERZ. Yes.

Mr. OTTER. So, then, let me ask you this question, why is it ever

necessary for an accounting product from a public corporation ever

to reflect anything but the value? Why would an accounting product ever reflect off balance sheet loans or off balance sheet obligations?

Mr. HERZ. Well, the model you are espousing actually would

have allowed Enron to continue to show things, maybe 97 percent

on balance sheet, 100 percent, somewhere in that range, but the accounting rules, I said, the longstanding accounting rule before

these things were engineered, was that you consolidate something

based upon being able to control that. If you don’t control something, at least then what you do is you show your investment in

it.

Now, we have changed that with this rule to reflect what we regard as what you are saying, better economics, the risk and reward

kind of model for these situations.

Mr. OTTER. And you think that that will now close all of the loopholes?

Mr. HERZ. I think it will close all the ones that we know about.

I will repeat. And this may not comfort you, but there are people

that spend all of their time structuring. And no matter what we do,

they sit in our audience. And we believe they try and figure out

ways around things that we do.

Now, we think because our rule is broad, because there are antiabuse clauses in the way we have crafted it—and that is a little

new for U.S. accounting standard-setting, that we think it will

19

catch everything that we know about and even things that we

couldn’t think about.

Mr. OTTER. Let me phrase this in a different way. Walk me

through the scenario, this lease scenario, that would provide a corporation to offer for public consumption a balance sheet which

doesn’t reflect total liabilities and total assets. Walk me through

that scenario.

Mr. HERZ. That wouldn’t reflect total liabilities and total assets?

What is the involvement of that entity in the other entity? You

would have to give me all of those facts.

Mr. OTTER. Well, you are the one who stated that the way this

happened was under a lease purchase agreement. Under a lease

purchase agreement, they have control of the asset——

Mr. HERZ. Yes.

Mr. OTTER. [continuing] through a lease agreement, which is

once-a-year payments. So all they have to reflect, then, is ‘‘We owe

you for 1 year.’’ Is that what you are saying?

Mr. HERZ. I understand what you are saying now. That was the

original derivation of the 3 percent rule, what were called these

synthetic leases or build-to-suit lease transactions. In those transactions, people were allowed to basically retain 100 percent of the

up side and bear 97 percent of the down side. And they didn’t reflect that.

Mr. OTTER. I want to stop right there for a minute. You got me

through part of the scenario. How could, then, the owner of the

asset that was leasing to the other entity have any kind of a collateral balance sheet which would reflect anything more than a 1-year

lease? The rest of it would be total liability not matched by the

asset. Right?

Mr. HERZ. The owner, the legal owner, of the asset was not the

enterprise leasing the asset or using it.

Mr. OTTER. I understand that.

Mr. HERZ. This could have been your corporate headquarters or

company’s corporate headquarters owned by a special purpose entity, a charity, something like that, that was owning the asset. The

financing was derived by the support of the lease arrangements

and by a guarantee from the corporate lessee, whose asset it really

was.

You asked me, ‘‘was it a bad rule?’’ It was a terrible rule. We

have changed it.

Mr. OTTER. Well, I guess maybe we don’t have enough people

watching enough people. I don’t know how else you stop that.

I am going to end here, Mr. Chairman, and thank you for the

time. But I would have to agree with Mr. Markey, and that is that

we get all seven faces here before us, all at once, so that we can

ask one a question and have the other six respond to it as well.

Mr. STEARNS. Thank the gentleman. The ranking member?

Ms. SCHAKOWSKY. Thank you, Mr. Chairman, both Messrs.

Chairman.

Stock options in the past have masked or perhaps were even

used to deceive investors and workers as to the true financial conditions of the company. I think Warren Buffett put it best. This is

his quote, ‘‘If options aren’t a form of compensation, what are they?

If compensation isn’t an expense, what is it? And if expenses

20

shouldn’t go into the calculations of earnings, where in the world

should they go?’’ I wondered what your thoughts were on Mr.

Buffett’s rhetorical questions.

And you also mentioned that a deliberation is going to begin. I

would like to know what your view is and a little bit about that

deliberation, particularly its timing.

Mr. HERZ. Yes. Well, I agree with Mr. Buffett. Until I joined the

FASB, I was actually a member of the International Accounting

Standards Board. That board undertook starting in August 2001,

put on its agenda the whole topic of what they call share-based

payments or what we call stock compensation, which includes stock

options and after a year of what I thought were thorough deliberations came to very similar conclusions, as the FASB had done 10

years prior to that, namely that granting a stock option is compensatory, that it should be measured at the grant date. The best way

possible that people come up with are using option pricing models

but making certain adjustments. So a couple of things. But, of

course, as you know, the FASB was essentially thwarted by lobbying efforts and by political interference at that point in time from

making that carry.

We are, as I said, committed to the idea of international convergence, but even if we weren’t, it is clear from the first day I got

to the FASB from the many e-mails, letters I have gotten from individual investors, from analysts, from others, that this is a topic

that needs to be revisited.

So the first thing we did was to try and address the issue for the

many companies that have switched as to how they make the

switch to the preferable method.

The second thing we did was say, ‘‘Here is what the international

fellows came up with, our colleagues. It is very similar to what the

FASB concluded, but there are some important differences. What

do you think about those?’’ We have gotten the comments in. We

are summarizing them, analyzing. And probably at our board meeting next week, we will decide whether or not we put on our agenda

now a formal project to say, ‘‘Let’s go back and decide whether or

not we should mandate expensing of options.’’

Assuming we put that project on our agenda,—and, again, there

are seven people who vote; I certainly will vote for that—the question is, what will be the methodologies? Will it be what the FASB

came up with 10 years ago and have been incorporated in footnotes

for many years now? Will it be the IASB method or will it be some

other method?

We have gotten a lot of suggestions in between, you know, if a

way is to potentially enhance the consistency of the evaluation. We

have also gotten a lot of recommendations from many people as to

other forms of disclosure that might be useful. So what I anticipate

is we are going to have another look at all of those and see if we

can come up with what we believe is the best accounting and the

best disclosure.

Ms. SCHAKOWSKY. How long will that process take assuming that

it is on your agenda?

Mr. HERZ. Well, that will depend. I would like to do it as quickly

as possible, but that, again, will depend. If we were just to say,

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ments,’’ what we call the 123 method for FASB statement 123,

which is what the FASB came up with a decade ago, that could be

relatively quick.

On the other hand, if we say, ‘‘No. There are some real areas

that we think could be improved, there are ways to maybe improve

the consistency of the measurement,’’ then that may take a little

longer.

Ms. SCHAKOWSKY. I don’t have much time left, but I do want to

know more about what it means to harmonize the FASB and the

IASB, particularly from a consumer standpoint. So while there is

not much time remaining now, maybe you could help educate me

about that.

Mr. HERZ. I would be happy to.

Ms. SCHAKOWSKY. Let me just ask you this, then, briefly, ‘‘How

would you characterize IASB in terms of its stringency and its impact on transparency disclosure,’’ all the things that we care about?

Mr. HERZ. Well, the IASB was set up a little bit like the FASB

model. It has a group of trustees, of which Paul Volcker is the

chairman, just like we have a group of trustees. The board itself

is 14 members because of the need for geographic representation

from various parts of the world.

Their processes are very similar to ours. I would say while they

have headed more toward less detailed standards, I think their

standards have become more detailed and ours a little less detailed. So I think there is also harmonization in kind of level of detailed implementation guidance in the standards. That is also important to that effort to have the rules actually look and feel the

same.

Mr. STEARNS. I thank the gentlelady. The gentleman from New

Hampshire, Mr. Bass.

Mr. BASS. Just a quick question, sir. Do you have jurisdiction

over the issue of accountants performing consulting services?

Mr. HERZ. No.

Mr. BASS. Okay. I didn’t think so.

I will yield back, Mr. Chairman.

Mr. STEARNS. Ms. Solis?

Ms. SOLIS. Yes. Thank you, Mr. Chairman.

I apologize for coming in late. I didn’t hear all of the testimony

presented, Mr. Herz, but I did have just two basic questions. My

first is the issue regarding funding for the FASB by the SEC. And

I am trying to understand that the SEC under the leadership of

Chairman Harvey Pitt failed to take steps to fund the FASB. To

me funding is crucial obviously to your organization to do its job

and to fulfill its mandates and missions.

When do you expect SEC under the new chairmanship, Mr. Donaldson, to begin assessing a fee on the public companies?

Mr. HERZ. Let me, if I can, clarify that a little bit. I think you

are essentially correct, but let me clarify it. Sarbanes-Oxley, what

it says is that the SEC essentially should recognize us, and thereafter a fee would be levied on all public companies. That fee would

be levied in the same way as the fee for the Public Company Accounting Oversight Board, the PCAOB, which, as you know, is still

in the formation stages in that.

22

My expectation from recent conversations with Chairman Donaldson, with the other commissioners is that they are now working

on the recognition quite diligently. There are documents going

around in there, in-house there. So we expect that to be concluded

in the not-too-distant future.

The issue then becomes the mechanics of the billing mechanism

because, remember, this is going to be levied on all 15-17 thousand

issuers based upon a computation. The data is being gathered by

our people, by the SEC, by the PCAOB people together. It may require some SEC rulemaking.

We are eager to get that all in place because, as you said, we are

well into our new fiscal year and our voluntary contributions. People know that we are now going to be getting this new mandatory

funding mechanism and have said, ‘‘We wish you well.’’

So getting all of that coordinated because I think the SEC is

right, it has the view that if you’re sitting out there and you’re

IBM, you ought to get one bill that covers both. But, of course, we

are ready for them. We have been ready to go. We submitted our

budget. But the PCAOB because of the gestation period of formation is still a little behind that. Getting that all together there are

still some implementation issues to go.

Now, I think the good thing is that our trustees had some foresight in the past and put away a reserve fund that we are now

using. I think we have enough cash to keep on going for a while,

but we also have deferred some hiring. So there are certain things

we would like to do that until we see the cash coming in the door,

we are not going to do certain things.

Ms. SOLIS. My second question, if I might, is with the issue regarding revenue recognition. Of course, one of the issues of the accounting standards that I am most concerned about is the impediments that prevent positive changes from being made in the standards. I believe that a single standard for revenue recognition that

is out there applicable to all companies would help to prevent any

abuses there. So what is the status, if you can elaborate on that,

on your project?

Mr. HERZ. Yes. As I mentioned in my opening statement, we

have put a major project on our agenda and have started it to try

and do exactly what you say because the existing rules on revenue

recognition which are voluminous but are contained by our count

in over 140 different standards, rules, regulations, pronouncements

by various groups over a 40-year period, they do have inconsistent

rules, they have contradictory rules, there are things that are hard

to understand. And so we think we need to build a better conceptually, consistent, coherent model or models on this topic.

Because of the breadth of this subject, it affects almost every

company. A couple or 3 or 4 years ago, maybe it wasn’t every company that had revenues, but nowadays I guess it’s just about everyone, various industries, all sorts of different transactions. The task

is daunting for us to come up with something that would meet the

needs of investors and other users because it could represent a big

change that would be operational, could be implemented by companies, all of that. So we need to carefully not only develop the method but check it out very carefully.

Ms. SOLIS. Do you expect any major opposition?

23

Mr. HERZ. People don’t like change.

Ms. SOLIS. Then how do we——

Mr. HERZ. I have already learned that. But we are in the change

business. We are going to do what we think is right. We need the

input, and we need to test. It is very important to us that something we develop is actually useful. It is also important to us that

it can be actually put into practice in a faithful way and can be

done in a cost-effective way.

So we need to check all of those things out, but I personally—

you know, the fact that people oppose things, if they oppose them

on good, sound grounds, good, sound arguments related to the accounting, to the usefulness, things like that, listen but not if they

oppose it because they don’t want change or because it might have

detrimental economic effects to their particular interests.

Ms. SOLIS. Thank you very much. Thank you, Mr. Chairman.

Mr. STEARNS. Thank the gentlelady. Mr. Issa?

Mr. ISSA. Thank you, Mr. Chairman.

Mr. Herz, let me start off with a broad question. Would it be fair

to say that your goal and that of your six colleagues should be to

have the information that the CEO gets, the information that the

board of directors gets, the information stockholders have available

to them, and the information the IRS acts upon for purposes of taxation? In a perfect world, this should be the same information.

Mr. HERZ. You got there until you went to taxing. Okay?

Mr. ISSA. At the present time—and I asked it deliberately for a

reason. The first three if you like.

Mr. HERZ. The first three I like provided that it is also that information is really—let me say I don’t want to sound pejorative at all,

but one of the things that I have found—and maybe it is a sign of

the times—is that the needs and views of investors and analysts

and people who run the money is often very different as to what

is useful from the views of the people running the companies.

Ideally it should be the same. I agree with you. But it isn’t.

Mr. ISSA. Let me rephrase the question. I will break it down a

little bit. When it comes to whether or not an asset is an asset, a

liability is a liability, and profit is profit or losses are losses, would

you say that as to the state to the balance sheet and the state of

the real profit, that the information should be transparent, that

that information should always be the same dollars and cents?

Mr. HERZ. I believe so, yes.

Mr. ISSA. And then you took exception to the word ‘‘tax.’’

Mr. HERZ. Right.

Mr. ISSA. Are you of the opinion that it is reasonable and fair to

state profits or lack thereof for purposes of generally accepted and

FASB accounting differently than you do for taxes, that two sets

of books are reasonable to maintain in that case?

Mr. HERZ. Well, this is not my area of expertise. Fiscal policy,

including taxes, are for you to decide, but I know that the taxes

are used to raise revenues, are used to produce certain stimulus,

things like that now——

Mr. ISSA. I am thrilled to have you in front of me so I can ask

the question to make exactly that point.

Mr. HERZ. I don’t know enough to judge whether I can have a

substantive view on that.

24

Mr. ISSA. Well, since you have had 30 years of accounting, would

it be correct to say that today for purposes of profit, we tend to

have greater profits for tax purposes? I will assume that it is because Congress wants the money but that, in fact, we take different

amounts for tax purposes than we show on compliant information

given to stockholders.

Mr. HERZ. I don’t know whether it is greater or less. I have seen

some reports recently that say the amount of taxable profit is generally less.

Mr. ISSA. I guess it all depends on your business. Certainly you

are trying to make your taxable profit less while the government

perhaps, as you alluded to, is trying to make it more.

Do you have an opinion, forgetting about what is our job, that

it would be better if there were one system?

Mr. HERZ. Well, I believe that we try in what we do to mirror

what we believe are economics, what we believe is proper accounting. So if you want to say that things are going to get taxed on that

basis, understanding that that is the way we develop our rules, I

wouldn’t personally object to that. I don’t know whether it would

satisfy all the other objectives of taxation.

Mr. ISSA. I am going to go out on a limb and say this in the form

of a question but probably a little bit of a statement at the same

time. Since it appears as though the Federal Government and our

insistence as legislators allows a system that says tell your stockholders you’re making a profit when, in fact, you tell the IRS you’re

not or tell your stockholders you’re not making a profit while you

are paying taxes on a profit that you’ve told your stockholders you

didn’t make, wouldn’t you say that that is, in fact, the first step

to telling corporate America that two sets of books are okay as long

as you’re compliant with a set of rules, even if the fact that that

occurs means one of those books is cooked? And we’ll use the word

‘‘cooked’’ in a broad and only slightly pejorative way.

Mr. HERZ. I don’t think I can respond to that, as I say, in this

without knowing enough about—I am not an expert in either the

tax code or the motivations behind specific provisions in the tax

code to judge as to whether it is cooked or not. Regulators also

have different systems, and they are done for safety and soundness. So if your purpose is a little bit different, the way you do

things can be a little different.

Now, we happen to think that our objective is to design good information for investors, creditors, and other users of that financial

information. It is not designed for regulatory purposes. It is not designed for tax purposes because that is not what we think about

when we design the rules.

Mr. ISSA. So, if I can, Mr. Chairman, in the spirit of Mr. Markey’s closing statement, it would be fair to say that, to a certain

extent, each of your agencies, the IRS, FASB, et cetera, enjoys the

same set of criteria as the guy who wants to hire an accountant

and one says, ‘‘One and one is two,’’ and the next one says, ‘‘No.

One and one is two,’’ and the third one says, ‘‘One and one is two,’’

and the last guy says, ‘‘What would you like it to be?’’ and he gets

the job.

I would propose that today our problem is that we are not looking for the consistency that true and proper statement and accountVerDate 11-MAY-2000 13:32 Jul 16, 2003 Jkt 000000 PO 00000 Frm 00028 Fmt 6633 Sfmt 6602 86050.TXT HCOM1 PsN: HCOM1
25

ing and tax should be all the same. And I would say until we get

to that point, until we get to one set of books as at we are not

heading toward the type of accounting that is going to help the

business world be consistent and honest and ethical, as we certainly want them to be.

I yield back the balance of my time.

Mr. STEARNS. I thank the gentleman. The gentleman from Texas,

Mr. Green.

Mr. GREEN. Thank you, Mr. Chairman. I am going to be brief because we are going to have a vote in our Health Subcommittee

downstairs.

I can understand the concern about the tax avoidance and tax

schemes coming from Texas, but Enron hasn’t paid Federal taxes

in I don’t know how many years because of some of those. So obviously they were successful.

I know in your response to Mr. Bass concerning that FASB

doesn’t have jurisdiction over the issue of accounting work versus

consulting, in your opinion as an accountant, it just seems like,

again, with examples of not just Enron but a host of other companies, that we have a conflict that maybe this Congress or the SEC

ought to look at that issue and say, ‘‘You can’t serve two masters,’’

just in your professional opinion.

Mr. HERZ. Yes. And I was an accountant, an auditor, for a long

time. My belief is that the master is the public, is the public interest. And that is the overriding interest. That means the ability to

do excellent audits that meet the public expectation.

Now, I think in order to do those audits, you do need some tax

capabilities. You do need some systems capabilities and all of that.

But that is not rendered necessarily to provide the additional service. It is rendered to provide the excellent audit.

Mr. GREEN. Okay. Again, tell me—and I will use Enron because

it is my hometown—the accounting firm, 27 million is consulting

and 25 is auditing. Do you see that that is almost a prima facie

case? In hindsight, we can say it is, that there is a conflict between

having consulting and auditing with the same firm at the same

company. Again, in your opinion, should we try to address it?

Mr. HERZ. First of all, I think the Sarbanes-Oxley and the SEC

is addressing it. Whether you need to do more I don’t know. I

mean, I believe that the issue of the 25 million was probably significant also. And the question is, what was in the heads of the

people who were making the bad decisions? Was it the consulting

fees? Was it keeping the audit client? How were they compensated?

Learning about that is really the key to driving behavior. That

could vary firm to firm. It could vary circumstance to circumstance.

Mr. GREEN. I understand that problems with Enron, like a lot of

companies, it just was not the conflict between the consulting and

the auditing function. There were boards of directors. There’s lots

of problems. But that is something I think that the SEC—and I

know it is not within your purview, but hopefully the SEC will address it as strong as they could.

Do the fact that accountants also sell tax advice, which in many

documented cases turned out to be illegal, if not questionable, tax

shelters, in a subtle way alter the way that they would interpret

subjective accounting questions?

26

Mr. HERZ. Again, I think on the audit you do need good tax accountancy just to do—you know, taxes are still a major part of getting to the bottom line.

The question of whether the firm or even other people ought to

be in the business of peddling aggressive tax arrangements, that to

me is the broad issue. Whether it’s an auditor, a lawyer, or anybody else, some of these arrangements in my own view—and I am

not a tax expert, but I did come across some of them in practice.

They defy belief.

Mr. GREEN. I appreciate that. In your professional opinion, is the

FASB offering accountants guidance on how to treat these tax

questions?

Mr. HERZ. We have an existing standard, standard number 109,

which has been in place for 12-13 years that deals comprehensively

with accounting for income taxes, but, like a lot of other things and

like what people would like to go to, principles-based, it requires

good, honest, professional judgment in a lot of cases.

Mr. GREEN. Since it has been in place for 10 to 12 years and

most of what we have seen is the last 5 to 6 years, obviously we

might need to revisit that.

Mr. HERZ. I have been reading the Senate joint committee report

quite eagerly and carefully that looked over all the Enron arrangements to understand whether there might be some implications on

the accounting side. Most of that is not targeted at the accounting

side. It is targeted at the actual use of tax arrangements there. But

I read that stuff.

Mr. GREEN. Thank you, Mr. Chairman. Mr. Chairman, I am

going to go vote. I also appreciate the effort by the chair and the

committee to talk about the special purpose entities. I think

that’s——

Mr. STEARNS. And I thank the gentleman. And just to the gentleman’s question to you, the Sarbanes-Oxley Act identified non-prescribed types of consulting. You can’t do information technology, investment banking, but there are others that you can. And so the

whole thing is not prohibited, but at the same time, there are in

place legislative fits to do this. The question is, are people going

to comply with it?

Mr. HERZ. I don’t know. I think that that’s one thing that what

you’ll have to need—they will probably also thank me for this—is

somebody needs to bring in the new auditing board, the PCAOB,

once they get up and running. I am sure that will be a key part

of their examination process.

Mr. STEARNS. Mr. Ferguson?

Mr. FERGUSON. Thank you, Mr. Chairman.

I thank Mr. Herz for being here today. I am new on the committee. I just came from a term on the Financial Services Committee, which is not only interesting but exciting given everything

that happened last year, the last couple of years. Obviously we did

a lot of work on Financial Services last year, as they did here on

Energy and Commerce, relating to Enron, WorldCom, transparency

issues.

And I just wanted to touch on that for a minute in terms of loan

commitments with banks, investment banks and commercial

27

banks. Can you just walk with me through that for a moment? My

understanding is it’s a——

Mr. HERZ. Yes.

Mr. FERGUSON. [continuing] different treatment in how these institutions treat loan commitments and why there is a difference.

Mr. HERZ. Yes. Loan commitments, of course, are a form of financial instrument and one of many. Traditionally, those who have

traded loan commitments have shown them on a mark-to-market

basis as a trading activity. And that has traditionally been some

of the investment banks.

Loan commitments, however, are not only traded. They are extended more generally by commercial banks as a line of credit,

which may or may not be drawn down, may end in the origination

of a loan.

I think that we have been doing some work in that. We are just

about to issue a new standard that says that commitments to purchase or sell loans are really what we call derivatives and, therefore, ought to be carried on a mark-to-market or fair value basis,

whether you are an investment banker or bank, whoever you are.

So that activity would be now more common, common accounting

across the same different types of enterprise, whether it be an investment bank or a commercial bank.

I know that some of the investment banks, or at least one that

I am familiar with, believe that loan commitments to originate

loans ought to also be carried on a mark-to-market basis. That has

traditionally been viewed as a more normal traditional banking activity accounting for banks. The bank regulatory accounting does

not require fair value for that in the financial statements. We require supplementary footnote disclosure relating to the fair value

of all financial instruments, including loan commitments, or actually working on improving that whole supplementary data.

But right now for a bank that extends loan commitment that are

intended to result in the issuance of a loan, it is not done on a

mark-to-market basis. Now, some of the investment banks I think

believe that it ought to be, and they believe that that is not only

the better accounting because they certainly believe in fair value.

That is how they live their world. But they believe that in certain

cases, large ticket commercial loans to big companies are being

used in the loss leader kind of mode to garner investment banking

business and are being underpriced, essentially, are being given a

favorable interest rate.

That is of concern to us. And we have discussed it directly with

bank regulators, with major banks who seem to view it otherwise,

either don’t believe it is happening or don’t believe the mark-tomarket accounting is the right way to go on that.

I think it was Congressman Dingell who asked the GAO to look

at that. I am very eager to understand the results of that review

to see whether or not there is something that is being disguised

here.

Mr. FERGUSON. What has lead you to—you are talking about perhaps pending issuance of a new regulation. Am I paraphrasing it

properly?

Mr. HERZ. Only in regard to loan commitments to purchase or

sell loans, not commitments to originate a loan.

28

Mr. FERGUSON. Is that also under discussion or not?

Mr. HERZ. It is not formally under discussion, but we are certainly aware of all of the activity around it.

Mr. FERGUSON. Why is there differential treatment now?

Mr. HERZ. Well, I think because if you’re originating a loan, it’s

like selling your own product. It’s not dealing in other people’s

product, which is a commitment to buy or sell other people’s loans.

That, the origination of loans, is viewed as a normal banking activity that is covered by a non-mark-to-market model.

Mr. FERGUSON. the regulation that you were talking about, the

new regulation that you are talking about, why is that being pursued? Is that an effort toward transparency as well?

Mr. HERZ. Well, we believe in looking at that issue, that those

are really like derivatives. We already have a rule that says that

derivative contracts should be mark-to-market.

Mr. FERGUSON. Is there a mechanism now, though, under current accounting rules that allows for investors to know if loans or

loan commitments have been made by banks under market rates,

below market rates?

Mr. HERZ. Only annually through the disclosures which we mandate on fair values.

Mr. FERGUSON. Would that make sense in terms of kind of this

climate that we are in today in terms of——

Mr. HERZ. It might make sense.

Mr. FERGUSON. [continuing] protection of investors and transparency?

Mr. HERZ. Again, we talked to banks and bank regulators. And

they say their evidence indicates that that is not happening, that

origination are done at the fair rate.

Mr. STEARNS. The gentleman’s time has expired.

Mr. FERGUSON. Thank you, Mr. Chairman.

Mr. STEARNS. The gentlelady from Missouri, Ms. McCarthy.

Ms. MCCARTHY. Thank you, Mr. Chairman.

I appreciate very much the opportunity, Mr. Herz, you have

given us to discuss some of our, as you would so politely put in

your paper, shaken confidence in the reporting system and capital

markets. And I very much appreciate all that you and your organization are trying to do.

I wanted to pose a situation to you and wonder if you are looking

into this or, if not, who in this fast world of corporate governance

and audit is looking into it. In my area, the two top executives of

the company had considerable gains on stock options. The corporate auditors, the auditors that were advising the company, the

board, et cetera, advised these two executives who were no longer

with the company to create a tax shelter, to put those stock options

in tax shelters so they could avoid the tax on them. The IRS is

looking into it, and it looks like they will both be very poor people

when this is over.

Mr. HERZ. Yes.

Ms. MCCARTHY. I guess my question is hopefully you or someone

is looking into this very issue of there is a governance failure, yes,

a corporate governance failure, but there is an audit failure here,

too. These auditors are paid by the corporation to advise the board

29

and the corporation. And then they were paid by the corporation

to advise these two executives how to avoid taxes.

I thought there was a bright line from the legislation that we

thought we had passed that was going to avoid things like this.

Mr. HERZ. Well, it’s not our area. We deal with accounting and

financial reporting rules that would be——

Ms. MCCARTHY. This is accounting, financial reporting rules.

How can the auditors be paid by the company to advise two executives how to avoid taxes?

Mr. HERZ. That is my understanding. I may be wrong. I am just

saying what I remember was something that was addressed by the

SEC as part of their recent looking at implementation of parts of

Sarbanes-Oxley. I remember reading some articles back and forth

about that issue as to how far the tax advocacy work ought to be

restricted or not.

I can’t remember exactly where it came out. I am sure Ms. Washington does because she knows everything about that.

Ms. MCCARTHY. I just learned they took it out. That’s too bad.

Mr. HERZ. Again, that’s not what we do. Again, I think that is

something that the new PCAOB presumably in the course of what

they are going to be monitoring the auditors, auditing standards,

all of that, will be part of, I would expect, their charge and their

role.

Ms. MCCARTHY. It would seem to me whoever advises the accounting industry ought to probably step up to the plate on this

one. I mean, it’s one thing if those executives had paid the auditors

themselves. The company was paying for that advice to them to

avoid the taxes. It doesn’t help the confidence of any of us taxpayers when those kinds of things go on within an industry. So

that’s why I wanted to pose it to you, to get your thoughts on it.

We may have to readdress some of the legislation. It is hard to

make a perfect bill, but I believe on this one, we should have been

a little bit more strident.

Mr. HERZ. Yes. I personally think—and, again, this is only putting on the hat of my experience in my prior incarnations, so to

speak—I think there is not only that issue but the issue of how

was it that the auditors, whoever was selling these schemes concluded that those schemes were viable under the tax code. I think

that is the root of the problem.

Ms. MCCARTHY. Well, Mr. Chairman, thank you for this hearing.

Mr. STEARNS. Sure. Let me just ask my members. I think we are

going to do another short round. So if you want to stay and ask

questions? Are you finished?

Ms. MCCARTHY. Yes. I yield back.

Mr. STEARNS. Okay. I want to follow up a little on what Mr. Ferguson’s question was. You have an investment corporation. You

have a banking corporation. And you look at their books. Forget

Enron and WorldCom. You look at these banks, investment companies. You have no clue that these folks from their balance sheet

have a huge amount of commitments, loan commitments, to these

people and that they’re moving exponentially.

So just tell me briefly, how do commercial bank accounts for loan

commitments differ from investment bank accounts for loan commitments? We’ll take that difference there. And what could FASB

30

do so that—you know, I am not investing in Enron or WorldCom.

I am investing in an investment company, Salomon Brothers or I

am investing in Bank of America. How could I determine that

these folks are on the hook with an Enron for billions and billions

of dollars? It keeps getting larger and larger.

Mr. HERZ. Well, I think first there are overall disclosures relating to all commitments.

Mr. STEARNS. But you couldn’t tell it in Enron’s case.

Mr. HERZ. You couldn’t tell——

Mr. STEARNS. You couldn’t know until they declared bankruptcy,

right?

Mr. HERZ. You’re right.

Mr. STEARNS. And even after they declared bankruptcy, the

whole thing didn’t come out. And now, as we stand today, it is not

millions. It’s billions. And it is hard even to understand——

Mr. HERZ. The investment banking model, the mark-to-market

model, would say, ‘‘I look at that commitment. I look at the company’s credit. And I evaluate how much in the marketplace I could

not redo that commitment for today’s current facts.’’ So it kind of

says, ‘‘What are today’s facts? And what is that commitment worth

or how much is it likely to cost me on a value basis?’’

The traditional banking model is to look at all credit exposures

by whomever the counter party is, the borrower, whether it is a

loan outstanding, whether it is a commitment to that, and say,

‘‘Okay. What do I think I need to put up as a loan loss reserve.’’

There are two ways of getting to the exposure model.

Mr. STEARNS. An investment corporation doesn’t have to do that

to put up——

Mr. HERZ. No. They assess value, rather than saying, ‘‘What do

I think my gross losses are going to be?’’

Mr. STEARNS. Because the taxpayers are supporting the FDIC in

banks, really, the taxpayers have a lot here at stake because if the

banks go under, then taxpayers are going to support them. So I

think it’s crucial, the distinction between the two of them, and that

the fiduciary responsibility is higher for you in dealing with bank

transparency because taxpayers are on the hook. Is that true?

Mr. HERZ. That is partially true. I mean, there are two sides to

every argument. I will give you the side that the bank regulators

would give. They would say that using a hard-to-measure fair value

model for these kinds of things in place of a loan loss reserve is

going to unnecessarily create false volatility in the earnings. That

will produce false results as well. I am not of that opinion.

Mr. STEARNS. So if I get a look at one of these investment companies and find this information, it is going to create a problem for

Enron or WorldCom?

Mr. HERZ. The view is that fair valuing these things is not only

hard to do but is not the proper accounting. That is a traditional

banking view of the world.

Mr. STEARNS. Say that statement again. It sounds like the corporation and the investment company are sort of keeping all of the

information and that it is not transparent. Say that statement

again.

Mr. HERZ. Well, the banking model assesses all of your exposures

to a particular credit or borrower, whether it be outstanding loans,

31

loan commitments, other arrangements, and then provide your best

estimate of what you think your losses are going to be based upon

the current facts.

Mr. STEARNS. So CitiBank should have done that with Enron?

Mr. HERZ. As the facts emerged, yes.

Mr. STEARNS. As the facts emerged.

Mr. HERZ. Yes. Now, of course, with Enron, most of the—I don’t

know. You may know better, but, of course, what happened publicly

all happened in one quarter.

Mr. STEARNS. Well, it didn’t happen all in one quarter.

Mr. HERZ. I agree with you, but the information that came

out——

Mr. STEARNS. Mr. Skilling left in the summer, months before, because, in my humble opinion, he knew what was happening.

Mr. HERZ. The real acid test would be, what would a mark-tomarket model have said in August 2001 versus a banking model?

Mr. STEARNS. Right.

Mr. HERZ. That is the way to look at it. Both would look at the

current information, by the way.

Mr. STEARNS. Would you consider adding a project of loan commitments to FASB’s agenda? Do you think it is important?

Mr. HERZ. We have discussed that a number of times. We said

loan commitments are one of many financial instruments. It would

be hard to do just one in isolation. We are committed toward moving toward more fair value in general, but we would like to do that

in a way that also achieves international convergence. I would say

that—and this, again, is my own view.

Mr. STEARNS. Not the other six members?

Mr. HERZ. Not necessarily the other six. I’m not saying it isn’t.

I’m saying not necessarily.

Mr. STEARNS. Is this a yes? Am I hearing you say yes?

Mr. HERZ. Mr. Markey can ask each one of them.

Mr. STEARNS. From your standpoint, if you had to vote today,

you would put loan commitment on FASB’s agenda?

Mr. HERZ. No, I would not.

Mr. STEARNS. You would not?

Mr. HERZ. Not with our existing resource base, I would not. It

is not the highest of our priorities in my view.

Mr. STEARNS. Well, if you had the resource base, you would?

Mr. HERZ. I would, yes.

Mr. STEARNS. you think it is important, but you realize——

Mr. HERZ. Yes. I also would like to understand. For me, it is kind

of a baffling debate and pieces of evidence. We have been presented

from the investment banks or one largest investment bank evidence as to this being a systematic problem not using fair value.

Mr. STEARNS. ‘‘Systematic’’ meaning not 1 or 2 years but 25

years?

Mr. HERZ. Well, no. Across many large commercial loans.

Mr. STEARNS. I see. Okay.

Mr. HERZ. We have discussed this with bank regulators, banks,

and all of that. And they say, ‘‘No. These people are not correct.’’

Now——

Mr. STEARNS. ‘‘These people’’ being?

Mr. HERZ. The investment banks.

32

Mr. STEARNS. Okay.

Mr. HERZ. Their evidence is not correct. This is not going on.

Again, we don’t have investigatory powers.

Mr. STEARNS. But you think it is going on?

Mr. HERZ. I think Congressman Dingell asked——

Mr. STEARNS. You personally think it is going on?

Mr. HERZ. I don’t know whether it is going on now, but I do

think that if it is going on and if there are—to me, fair value accounting is an earlier detection device for those kinds of things

than the normal ongoing accounting.

Mr. STEARNS. Because they have a lot to lose.

Mr. HERZ. It is just the way it worked. When something is properly valued, it tells you what the situation is, rather than trying

to make, kind of, guesses. Again, I am interested in what the GAO

came up with because they have been asked I understand by Congressman Dingell to look at this issue.

Mr. STEARNS. At least you agree that banks should not have hidden liabilities, like loan commitments, that are disclosed to investors only when the entity goes bankrupt. I mean, there should be

some precursor out there to say, ‘‘Something is happening here at

Enron/WorldCom’’ well in advance, instead of when they file bankruptcy. That is when CitiBank says, ‘‘Oh. Here. By the way, we are

not talking about $300 million. We are talking about $1.3 billion.’’

Mr. HERZ. Yes. But, to be fair, the existing rules on accounting

for loan loss allowances required an assessment of current facts in

order to make the estimate of what the loss allowance ought to be.

So it’s also supposed to take into account current facts.

Mr. STEARNS. Yes. Okay. My time has expired. Ranking member,

questions?

Ms. SCHAKOWSKY. No. Maybe you answered this already when

Congresswoman Solis was talking to you about the fees that you

need to operate FASB. When do you expect to have this process

completed? I understand it has to do with developing the formula,

et cetera.

My concern is exacerbated by what you just said about resource

base. I am assuming that you are limited in what you can do because of the money. So what about your fees?

Mr. HERZ. Well, again, we are one party of three parties in getting this accomplished. So our desire would be tomorrow. Again,

noting that it ought to be done properly, it probably makes sense

to have one billing that includes both our fees and the fees to the

PCAOB.

I have heard—I don’t know that this is definitely the case—that

it may require some SEC rulemaking in order to get that done. I

would estimate based upon all that the earliest that everything can

get done is probably April or May.

Now, if the bills go out in April or May, people start to pay, then

I think we start hiring.

Ms. SCHAKOWSKY. I want to get back just briefly to this business

of harmonizing FASB and IASB. Just as we are now really focusing

on the issues of corporate governance and accountability, I want to

be sure that this notion doesn’t delude those efforts. Since I don’t

know anything about it, maybe it’s strengthening those efforts. I

don’t know. If you could talk a little bit more about that?

33

Mr. HERZ. Well, I do want to make a very important point that

we are not doing convergence just for the sake of convergence. I

mean, the most overriding goal to us is improvement of U.S. financial reporting. But we do think that having common reporting

across the global capital markets, the major capital markets, is

something that certainly we have been told is desired by investors,

by analysts, by the companies that operate——

Ms. SCHAKOWSKY. It’s useful unless we are going to the lowest

common denominator.

Mr. HERZ. Exactly. And I believe, having been a member of the

IASB, I believe that they have quality processes and quality people.

So, in fact, I think it actually makes the process richer than it

probably would have been just——

Ms. SCHAKOWSKY. Can you give me an example of some way that

going by the IASB standard might improve our situation?

Mr. HERZ. Well, again, these are my own personal biases, but I

think, for example, they have a better model for impairment of assets than we do. Our model is based on what are called

undiscounted cash-flows. It doesn’t take into account the time value

of money at all.

Their standard does in looking at whether or not an impairment

has arisen. We kind of say, ‘‘As long as you’re going to recover it

over the remaining life of the asset, even though the value might

be miles below the carrying value, as long as you’re going to recover it, you don’t have to impair it.’’ They would look at it more

on a value basis. So that’s, for example, one area where I think

they have better rules.

One area that we are looking at, we may converge sooner, hopefully in the not-too-distant future, but we will see, is on business

acquisitions. We have a rule that you have to value the in-process

research and development, the value of the projects, research

projects, under development at the company you buy. You have to

do a precise valuation. Then you write it off immediately, which

doesn’t to me make a lot of sense because it says that these have

some value. That is often what you paid for. Their rule would say,

‘‘No. This is an asset, and we ought to carry it as an asset.’’

That is why we are going through this very systematic process

of we have identified all of the differences, at least all the ones we

think we know about, which are in the hundreds. And we are systematically trying to say, ‘‘Your standard better than ours, ours

better than yours. Let’s see if we can come to a common answer.’’

In some cases, we find that neither of our standards are particularly good.

Ms. SCHAKOWSKY. Is the IASB flexible in terms of changing? Are

we the only ones that——

Mr. HERZ. No. The boards are both very open to change, and the

idea is to find the best solution. The issue then is with the constituents and the politics.

Ms. SCHAKOWSKY. Thank you. I wish you the best.

Mr. STEARNS. I thank the gentlelady. The gentleman from Massachusetts.

Mr. MARKEY. Thank you, Mr. Chairman.

Media reports indicate that Royal Abhold’s recent financial shenanigans were not the first time the company engaged in accountVerDate 11-MAY-2000 13:32 Jul 16, 2003 Jkt 000000 PO 00000 Frm 00037 Fmt 6633 Sfmt 6602 86050.TXT HCOM1 PsN: HCOM1
34

ing subterfuge. CFO magazine reported this week that when

Abhold first filed its results for 2001, differences in accounting

treatment led to a 90 percent disparity between earnings under

Dutch and U.S. GAAP rules. Abhold buried the explanation for this

disparity in a footnote in one of its SEC filings, which currently is

not a violation of any rules. Is FASB concerned that disclosing a

90 percent disparity in a footnote is inconsistent with the principles

of transparency?

Mr. HERZ. I think that is exactly why we are trying to move to

common global standards so you don’t even have that issue arising.

Mr. MARKEY. What steps would you recommend that FASB take

today?

Mr. HERZ. First of all, that disclosure is a reconciliation that is

mandated by the Securities and Exchange Commission.

Mr. MARKEY. What recommendation would you make to make

sure this is nonrecurring?

Mr. HERZ. My recommendation would be that the MDNA requirement specifically address those kinds of situations.

Mr. MARKEY. What is the deadline that you would like to see established so that this 90 percent disparity not again inflict investors?

Mr. HERZ. I’m not at the SEC, but the sooner the better.

Mr. MARKEY. It should be done immediately? Is this a serious

problem before you?

Mr. HERZ. I believe. And the question is whether or not—and you

would have to ask the SEC whether they believe that that should

have been done under their existing MDNA requirements.

Mr. MARKEY. I appreciate that, but it appears to have been legal.

Would you change that standard so there is more information?

Mr. HERZ. I don’t know whether it is legal or not, but certainly

I agree with your premise that something like that needs to be

clearly explained in a prominent way.

Mr. MARKEY. All right. Then we will send your recommendation

on to the SEC out of this committee, I would hope.

Now, you noted in your testimony that FASB recently decided

that AICPA’s accounting standards executive committee would no

longer act as a senior-level accounting standards setter in the

United States. You explained that maintenance and development of

any industry-based standards should reside with FASB. As you

know, the accounting oversight board established by SarbanesOxley has authorized to establish or adopt auditing independence

and other standards relating to the preparation of audit reports for

public companies.

Given FASB’s decision to retain responsibility for the maintenance and development of any industry-based standards, should

the new public company accounting oversight board outsource its

standard settings responsibility to private, professional, accounting

organizations, or should it do this work in-house?

Mr. HERZ. Yes. Again, this is only my opinion. This is, to make

it clear to anybody following this, not part of our charge or mandate, but I think the premise of what you read is a reasonable

analogy and reasonable thought process to go through. My view,

personal view,—and I can’t say I have studied all of this—would

be that the PCAOB needs to probably figure out some kind of, for

35

want of a better word, its own conceptual framework for auditing

standards, develop some principles and expectations, and then decide what structure it needs and the kinds of people it needs.

Mr. MARKEY. In-house? You are saying do it in-house?

Mr. HERZ. No. I think that they need to bring in some outsiders

as well because——

Mr. MARKEY. But bring the insiders in to do it in-house? Outsiders to help do it in-house?

Mr. HERZ. I believe what they need to do is to develop a set of

concepts, principles, and expectations. You desperately, though—

and we do it through developing our own standards. You need to

make sure you have the right kinds of people in the process and

input.

Mr. MARKEY. I appreciate that. As you may know, the Sarbanes

Act provides the oversight board with the authority to conduct investigations and disciplinary proceedings. There has been some discussion that the oversight board should contract out this responsibility in a manner similar to the peer review process used by the

now defunct public oversight board. In your opinion, should the accounting oversight board established by the Sarbanes Act conduct

audit inspections or should the inspections be performed by private

contractors?

Mr. HERZ. I think that if they can get the qualified people, they

ought to do it.

Mr. MARKEY. Is that in-house?

Mr. HERZ. Yes, but it is going to take a massive number of people.

Mr. MARKEY. I appreciate that.

Mr. HERZ. In the U.K., for example, they have had for a number

of years a group called a joint monitoring unit, which does inspections of the auditors. It is a separate unit. This is just for the U.K.,

which is a much smaller country, a much smaller market. I believe

they just have over 100 inspectors. So you can kind of figure out

what it would need in this country probably, 300, if not more.

Mr. MARKEY. Well, they have 100 million people. We have 270

million. Can we——

Mr. HERZ. Their capital market is not proportional to ours.

Mr. MARKEY. You would still do it, but you would do it in-house?

Mr. HERZ. I think if they get the qualified people, I think they

should conduct the inspections.

Mr. MARKEY. You need as many policemen as you need. You are

saying the crime rate is higher potentially in the United States. So

we need more policemen here than in England.

Mr. HERZ. I would say the playing field for the crime rate is larger.

Mr. MARKEY. Yes, I’ve got you. They can do it with billy bats, although we need bigger weapons.

The FASB, the advisory council, let me go to this. You have

noted now here today that FASB recently established a user advisory group to increase the investing community’s participation in

accounting standards activity. According to the materials that

FASB provided for today’s hearing, it appears that virtually all of

the members of the council are affiliated with the Nation’s largest

banks, brokerages, and financial management firms with the exVerDate 11-MAY-2000 13:32 Jul 16, 2003 Jkt 000000 PO 00000 Frm 00039 Fmt 6633 Sfmt 6602 86050.TXT HCOM1 PsN: HCOM1
36

ception of a representative from the AFL-CIO. Was there any effort

to include representatives from shareholder advocacy groups, such

as the Council of Institutional Investors?

Mr. HERZ. Yes. In fact, I am going to be talking with them in

a couple of weeks, them and the National Association of Investors,

and all of that. We welcome any and all people from the small investor groups. I think that would——

Mr. MARKEY. You are going to put them on the council?

Mr. HERZ. I would love to.

Mr. MARKEY. So the invitation is in the mail out there to you at

the Council of Institutional Investors. You are in.

Mr. HERZ. I would like to get, actually, some of the people from

the investment clubs as well.

Mr. MARKEY. How about the Investment Company Institute?

Mr. HERZ. Actually, we got a lot of the nominations from the Investment Company Institute.

Mr. MARKEY. Okay. That’s good. Thank you.

I appreciate your indulgence, Mr. Chairman.

The Joint Committee on Taxation report just out recently talked

a lot about abusive tax shelters created by investment banks like

Merrill Lynch, Bankers Trust for the express purpose of tax avoidance. Now, these deals had no real underlying economic purpose.

I understand that many of the reports’ findings and recommendations get at issues dealing with the tax code. But, as you said earlier here today, there could be implications for financial disclosure.

Mr. HERZ. Yes.

Mr. MARKEY. Exactly what are you doing to make sure that

transactions or entities created for tax avoidance purposes are

clearly flagged for ordinary investors in the company’s accounting

statements? Can you give us a succinct statement?

Mr. HERZ. I will tell you first I have read not all 3,000 pages of

the report but a good part of it. I have had my staff studying it.

Our next step is I have asked our staff to arrange a meeting with

the joint Senate staff, committee staff, and others who were involved in preparing that to discuss what we might do, what the

IRS might do, all of that.

Mr. MARKEY. Could you report back to Chairman Stearns and to

the committee on any changes you decide to make as a result of

your review of the joint report? Can you do that for the committee?

Mr. HERZ. Yes.

Mr. MARKEY. Thank you. I think it is important for us to get the

report back as well.

Can I ask one final question, Mr. Chairman?

Mr. STEARNS. Sure. Go ahead.

Mr. MARKEY. Mr. Chairman, some companies that oppose expensing of stock options claim that the expenses associated with

options already are incorporated in diluted earnings per share figures and, therefore, there is no need to expense options. What is

your response to that argument?

Mr. HERZ. I don’t agree. Would you like to know why?

Mr. MARKEY. I would love to hear it.

Mr. HERZ. Options are equity instruments. That argument to me

is like saying any time you buy anything with an equity instruVerDate 11-MAY-2000 13:32 Jul 16, 2003 Jkt 000000 PO 00000 Frm 00040 Fmt 6633 Sfmt 6602 86050.TXT HCOM1 PsN: HCOM1
37

ment, including your stock, you shouldn’t account for it other than

in earnings per share.

So if I buy legal services or I buy a car, I pretend I got the car

for free. I wouldn’t depreciate it. All I would say is I have got another share outstanding. And so that to me is not the way I understand the transaction. There is a transaction which you paid for

with a valuable instrument. That is how you acquired it. It happens that that instrument is also an equity instrument, which,

therefore, deludes the existing shareholders as well.

Mr. MARKEY. I thank you so much. I think you for that answer.

And I thank you for your service to our country. You have a valuable a job, as important a job in restoring investor confidence and,

therefore, our economy. Thank you.

Mr. STEARNS. I thank my colleague.

Mr. Herz, as I understand it, there might be one other FASB

board member in the audience.

Mr. HERZ. Yes.

Mr. STEARNS. I thought you might want to just tell us, introduce

the person.

Mr. MARKEY. It’s like the Ed Sullivan Show here. Yes. And in

our audience, my colleague, Dr. Katherine Schipper.

Mr. STEARNS. Welcome, Dr. Schipper. We just are not going to

ask you. We just obviously want to say hello.

Mr. HERZ. Not until the next time.

Mr. STEARNS. Until the next time.

I want to also leave the record open for 5 working days so that

if members want to ask any additional questions. And I would hope

that, Mr. Herz, you can answer some of the questions our staff

might submit to you.

Let me just say that I think you provide a fresh breeze here, and

we appreciate your honesty. I hope in the future that you will continue this and fight the status quo, which you pointed out is hard

to change. We are here to try and help do that.

With that, the subcommittee is adjourned.

[Whereupon, at 4:53 p.m., the foregoing matter was adjourned.]

[Additional material submitted for the record follows:]

FINANCIAL ACCOUNTING STANDARDS BOARD

March 28, 2003

Via Hand Delivery

The Honorable CLIFF STEARNS

United States House of Representatives

Washington, DC 20515

DEAR MR. CHAIRMAN: Attached is my written response to the questions submitted

by the Members of the Subcommittee on Commerce, Trade and Consumer Protection

of the Committee on Energy and Commerce and attached to your letter of March

13, 2003.

I look forward to seeing you again on April 1, 2003. Please contact me or our

Washington, DC representative, Jeff Mahoney (703-243-9085), if any additional information is required.

Sincerely,

ROBERT H. HERZ

Attachment

38

1 AICPA Audit and Accounting Guide, Banks and Savings Institutions (2001), ¶ 1.01. 2 AICPA Audit and Accounting Guide, Brokers and Dealers in Securities (2002), ¶¶ 1.04, 1.07. 3 Banks and Savings Institutions, ¶ 6.71. 4FASB Statement No. 91, Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases (1986), ¶ 8. The accounting for loan

and commitment fees received or paid by mortgage banking enterprises is subject to the requirements of FASB Statement No. 65, Accounting for Certain Mortgage Banking Activities (1982),

¶¶ 20-27.

5FASB Statement No. 5, Accounting for Contingencies (1975), ¶¶ 18 and 19. 6FASB Statement No. 107, Disclosures about Fair Value of Financial Instruments (1992), ¶ 10. 7FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities

(1998), ¶ 532(b). 8 Brokers and Dealers in Securities, ¶ 7.01. 9 Brokers and Dealers in Securities, ¶ 7.02; see FASB Statement No. 91, ¶ 34. 10 Brokers and Dealers in Securities, ¶ 7.01. 11FASB Statement No. 133, ¶ 17.

FOLLOW-UP QUESTIONS TO MARCH 4, 2003 HEARING

ACCOUNTING FOR LOAN COMMITMENTS

Question 1) How do commercial banks and investment banks account for loan

commitments? Why is there a difference in the accounting treatment for the same

loan commitment?

Response: Historically, commercial banks and investment banks have had very

different business models. The business of commercial banks has traditionally included accepting deposits from entities with idle funds and originating loans to entities with investment or spending needs.1 In contrast, the business of investment

banks has traditionally included buying, holding as inventory, and selling financial

instruments for their own accounts from and to customers and other dealers and

traders.2 The distinct activities of commercial banks and investment banks have resulted in different financial accounting and reporting practices.

In general, commitments to originate loans in the ordinary course of business

when no fee is charged have no immediate accounting effect, though enterprises, including commercial banks, are required to consider such commitments when evaluating the liability for other credit exposures.3 If, however, any fee is received for a

commitment to originate or purchase a loan or group of loans, that fee is initially

reported as a liability.4 If the commitment is exercised, the fee is recognized and

reported in income over the life of the loan as an adjustment of the loan yield, or

if the commitment expires unexercised, the fee is recognized in income upon expiration of the commitment.

In addition, information about loan commitments,5 including their fair value (and

the fair value of loans and other financial assets and liabilities) and the methods

and assumptions used to estimate the fair value,6 is required to be disclosed in the

notes to enterprises’ financial statements. The fair value disclosures must also be

in a form that makes clear whether the fair value and related carrying amount represent assets or liabilities.7

As active dealers and traders of financial assets and liabilities, investment banks

have historically employed specialized industry practices for both internal and external reporting of financial instruments, including loan commitments.8 That practice

provides that inventory and other positions in financial instruments, including loan

commitments, be reported at fair value.9 In addition, changes in the fair value of

those instruments are reported in income in the period in which the changes occur.

The specialized industry practices are intended to reflect the economic substance of

the unique activities of those enterprises.10

The Financial Accounting Standards Board (‘‘FASB’’ or ‘‘Board’’) has two active

projects that will improve the existing accounting and reporting for loan commitments. First, the FASB plans to issue a new standard in April 2003 that will amend

the existing requirements for the accounting and reporting for derivative instruments and hedging activities. That standard will clarify that enterprises that issue

commitments to originate mortgage loans that will be held for resale, and most commitments to purchase or sell loans, should be accounted for as derivative instruments. Thus, as derivative instruments, those loan commitments will be required

to be accounted for and reported at fair value.11

Second, the Board has a current project to improve the existing fair value disclosures of financial assets and liabilities, including loan commitments. The objectives

of that project are (1) to provide guidance relating to the often-difficult issue of

measuring the fair value of financial instruments and (2) to improve the form and

content of the information about those fair values. We are currently deliberating

39

12FASB Statement No. 5, ¶ 8; FASB Statement No. 114, Accounting by Creditors for Impairment of a Loan (1993), ¶ 8. 13FASB Statement No. 114 (amended 1994), ¶ 20.

those issues at public meetings and plan to issue a proposal for public comment before the end of this year.

Finally, the Board recognizes that business models change and in the case of commercial banks and investment banks they appear to be converging. Having different

accounting for similar transactions or financial instruments based on business models is a concern to the Board. As new accounting guidance is issued, consideration

is given to eliminating business model differences where appropriate. Also with respect to financial instruments, the Board has indicated its desire to require all enterprises to report all financial instruments at their current fair value when the conceptual and practical issues relating to fair value measurement are resolved. The

Board is working on those issues. The second project discussed above is part of that

process.

Question 2) How can we make sure that accounting policy does not encourage imprudent lending activity?

Response: The mission of the FASB is to establish and improve standards of financial accounting and reporting for both public and private enterprises. The focus

of the FASB’s mission is on consumers—users of financial information, such as investors, creditors, and others. We attempt to ensure that financial accounting and

reporting standards result in financial reports that provide consumers with an informative picture of an enterprise’s financial condition and activities and do not

color the image to influence behavior in any particular direction.

The FASB has no power to enforce its standards. Responsibility for ensuring that

financial reports comply with the FASB’s standards rests with the officers and directors of an enterprise, the auditors of the financial statements, and for public enterprises, ultimately with the United States (‘‘US’’) Securities and Exchange Commission (‘‘SEC’’).

Representatives of the FASB have had recent informal discussions with representatives from a major investment bank that included discussions about the existing

accounting for loan commitments. Those representatives indicated that they believe

the existing accounting for loan commitments encourages imprudent lending activity

by commercial banks.

Representatives of the FASB also have had recent informal discussions with representatives from commercial banks and financial institution regulators. The discussions included discussions about the existing accounting for loan commitments.

Those representatives indicated that they do not believe that the existing accounting

for loan commitments encourages imprudent lending activity.

It is our understanding that the US General Accounting Office, in response to a

request by Energy and Commerce Committee Ranking Member the Honorable John

D. Dingell, is in the process of updating its May 1997 report, ‘‘Bank Oversight: Few

Cases of Tying Have Been Detected.’’ It is our understanding that that update may

include consideration of whether the current accounting for loan commitments encourages imprudent lending activity by commercial banks. The FASB will carefully

review the results of that report to the extent that it contains any findings or recommendations relevant to the Board’s mission.

Question 3) Is there a mechanism to ensure that banks are adequately pricing

their credit in order to compensate them for any attendant risks at the time the

loans and loan commitments are made?

Response: Existing financial accounting and reporting standards require enterprises, including banks, to evaluate at each reporting date the incurred credit losses

related to loans and off-balance-sheet financial instruments, including loan commitments.12 Provisions for incurred loan and loan commitment credit losses are required to be reported as a charge to enterprises’ operating income with the corresponding entry to an allowance for loan losses account or a liability for credit

losses account, respectively, in enterprises’ financial statements.

Actual credit losses for loans and off-balance-sheet financial instruments, including loan commitments, are required to be deducted from enterprises’ reported account balances for the allowance for loan losses or the liability for credit losses, respectively.

In addition to the disclosures discussed in response to question 1, existing financial accounting and reporting standards also require enterprises, including banks,

to disclose (1) information about impaired loans, including information about the recorded investment in impaired loans, enterprises’ income recognition policy, restructured loans, and the activity in the allowance for loan losses reported balance;13 (2)

information about estimates used in determining the carrying amounts of assets and

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14 AICPA Statement of Position (SOP) 94-6, Disclosure of Certain Significant Risks and Uncertainties, ¶¶ 12 and 13. 15FASB Statement No. 133, ¶ 531(d). 16 Business Reporting Research Project, Steering Committee Report, Electronic Distribution of

Business Reporting Information (2000).

liabilities, including estimates about loan losses;14 and (3) information about all significant concentrations of credit risk arising from all financial instruments, including loans and loan commitments.15

The FASB also has under its review and consideration two current projects of the

Accounting Standards Executive Committee of the American Institute of Certified

Public Accountants (‘‘AcSEC’’) that are expected to improve the existing financial accounting and reporting requirements relating to the credit risks of loans.

The first project will improve the accounting and reporting for loans and certain

debt securities acquired in a transfer. The project is intended to update the existing

guidance related to the amortization of discounts on certain acquired loans. AcSEC

plans to issue the updated guidance in the near future.

The second project will improve the accounting and reporting for the allowance

for credit losses. The project is intended to provide additional guidance to enterprises, including banks, on the recognition, measurement, and disclosure of the allowance for credit losses related to loans. AcSEC expects to issue a draft of the proposed guidance for public comment in the near future.

Question 4) Would requiring banks to recognize up front losses from mispriced

loans discourage this practice, or, at least, provide meaningful transparency to regulators and investors?

Response: As indicated in response to question 3, enterprises, including banks, are

required to report incurred and actual credit losses related to loans on the face of

their financial statements. As indicated in response to question 1, enterprises, including banks, also are required to disclose the fair value of those loans in the notes

to their financial statements.

There are a number of difficult conceptual and practical issues that the Board

would need to resolve before it could consider requiring all financial assets and liabilities, including all loans, to be reported on the face of all enterprises’ financial

statements at fair value. As indicated in response to question 1, the Board is actively addressing some of those issues in its current project to improve the existing

fair value disclosures of financial assets and liabilities.

Finally, as indicated in response to question 2, in recent informal discussions, representatives of commercial banks and financial institution regulators indicated that

they did not believe that there exists a prevalent practice by banks to misprice

loans.

Question 5) Do current accounting rules require banks to disclose on a real time

basis that they have not priced their loans correctly?

Response: As indicated in response to question 3, enterprises, including banks, are

required under existing accounting and reporting requirements to report incurred

and actual credit losses related to loans on the face of their financial statements.

As indicated in response to question 1, enterprises, including banks, also are required to disclose the fair value of those loans in the notes to their financial statements.

The FASB has in recent years conducted and sponsored research related to issues

surrounding ‘‘real time’’ financial reporting. As one example, on January 31, 2000,

the FASB issued a report that identified practices for the electronic distribution of

business information and considered the implications of technology for business reporting in the future.16 Any movement to real-time financial reporting would require

that the SEC pursue significant changes to the existing rules and regulations governing the reporting requirements for public enterprises, including banks.

Question 6) If a bank makes a loan commitment at below market rates, should

it immediately recognize a loss?

Response: As indicated in response to questions 1 and 3, under existing accounting and reporting requirements a loan commitment, including a loan commitment

issued at below market rates, generally has no immediate accounting effect, though

an enterprise, including a bank, would be required to consider such commitments

when evaluating its allowance for credit losses.

In addition, the fair value of a loan commitment, including the fair value of a loan

commitment with a below market rate, would be required to be disclosed in the

notes to enterprises’ financial statements as part of the overall disclosure of the fair

values of financial instruments.

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17For example, Citigroup Inc. reported $1,097,190,000,000 and $1,051,450,000,000 in total assets as of December 31, 2002, and December 31, 2001, respectively. Citigroup, Inc., 2002 Annual

Report (2003), p. 31.

Finally, as indicated in response to question 1, the FASB has two active projects

that will improve the existing accounting and reporting for loan commitments, including loan commitments issued at below market rates.

Question 7) Is there a mechanism under current accounting rules that lets an investor know if loans and loan commitments have been made at below market rates?

Isn’t FAS 107 supposed to require footnote disclosure of the losses incurred as a result of making below market interest rate loans?

Response: See response to question 6.

Question 8) Can we improve upon the existing standard so that investors get better information about the financial impact of these mispriced loans on a real time

basis?

Response: As indicated in response to question 2, there are differing views between the investment banks and the commercial banks and financial institution regulators as to the prevalence of mispriced loans. Also, as indicated in response to

questions 1 and 3, several active projects are under way to improve the existing financial accounting and reporting standards related to loans.

Question 9) Has FASB examined the explosions in bank balance sheets that resulted when bankrupt firms like Enron and WorldCom drew their loan commitments?

Response: As indicated in response to question 2, the mission of the FASB is to

establish and improve standards of financial accounting and reporting for both public and private enterprises. The FASB has no power to enforce its standards.

It is our understanding that the banks that transacted with Enron and WorldCom

included some of the largest banks in the US with assets exceeding hundreds of billions of dollars.17 Some, therefore, might question the characterization of ‘‘explosions

in bank balance sheets’’ when ‘‘Enron and WorldCom drew their loan commitments.’’

Question 10) Is it desirable for bank financial statements to have hidden liabilities

like loan commitments that are not disclosed to investors until the lines are drawn

by near bankrupt entities?

Response: As indicated in response to question 1, under existing financial accounting and reporting standards, information about loan commitments, including the

fair value of loan commitments and whether a loan commitment represents an asset

or a liability, is currently required to be disclosed in the notes to enterprises’ financial statements. The Board also has a current project to improve those disclosures.

Also as indicated in response to question 1, the FASB plans to issue a new standard that will clarify that enterprises’ that issue commitments to originate mortgage

loans that will be held for resale, and most commitments to purchase or sell loans,

should be accounted for as derivative instruments. Thus, enterprises that issue

those types of loan commitments will be required to report those instruments as assets or liabilities on the face of their financial statements at fair value.

Question 11) Will you consider adding a project on loan commitments to FASB’s

agenda?

Response: As indicated in response to question 1, the FASB has two active

projects that will improve the existing accounting and reporting standards for loan

commitments.

The FASB receives many requests for action on various financial accounting and

reporting topics from all segments of a diverse constituency, including the SEC.

Agenda requests from constituents are periodically reviewed and evaluated by the

Board at public meetings. The FASB’s limited resources require that the Board be

selective in determining which requests should be further considered for inclusion

on the FASB’s technical agenda. Moreover, the FASB’s independence requires that

the Board must, after soliciting input from constituents, make its own decisions

about its agenda.

To aid the Board in its agenda decision-making process, the Board has developed

a list of factors to which it refers in its periodic review and evaluation of proposed

topics. Any constituent request to add a project to the Board’s technical agenda, including a request to add an additional project on loan commitments, would include

consideration of the following factors:

• Pervasiveness of the issue—the extent to which an issue is troublesome to users,

preparers, auditors, or others; the extent to which there is diversity of practice;

and the likely duration of the issue (i.e., whether transitory or likely to persist);

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18 AICPA Statement on Auditing Standards (SAS) No. 69, The Meaning of Present Fairly in

Conformity with Generally Accepted Accounting Principles in the Independent Auditor’s Report

(1992). 19SAS No. 69, ¶ 4. 20 AICPA Professional Standards, ‘‘General Standards, Accounting Principles,’’ ET § 203[.02]

(1988). 21 ET § 203[.01]. 22Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204, § 302(a), 116 Stat. 745, 777 (2002).

• Alternative solutions—the extent to which one or more alternative solutions that

will improve financial reporting in terms of relevance, reliability, and comparability are likely to be developed; • Technical feasibility—the extent to which a technically sound solution can be developed or whether the project under consideration should await completion of

other projects; • Practical consequences—the extent to which an improved accounting solution is

likely to be acceptable generally, and the extent to which addressing a particular subject (or not addressing it) might cause others to act, e.g., the SEC

or Congress; • Convergence possibilities—the extent to which there is an opportunity to eliminate

significant differences in standards or practices between the US and other countries with a resulting improvement in the quality of US standards; the extent

to which it is likely that a common solution can be reached; and the extent to

which any significant impediments to convergence can be identified; • Cooperative opportunities—the extent to which there is international support by

one or more other standard setters for undertaking the project jointly or

through other cooperative means with the FASB; and • Resources—the extent to which there are adequate resources and expertise available from the FASB, the International Accounting Standards Board (‘‘IASB’’),

or another standard setter to complete the project; and whether the FASB can

leverage off the resources of another standard setter in addressing the issue

(and perhaps thereby add the project at a relatively low incremental cost).

It is not possible to evaluate the above factors in precisely the same way and to

the same extent in every instance, but identification of factors to be considered helps

to bring about consistent decisions regarding the Board’s technical agenda.

PRINCIPLES-BASED ACCOUNTING

Question 12) Are accountants required under GAAP to apply rules in a way that

illuminate financial results rather than obscure them? What rules under GAAP require accountants to do this?

Response: Under existing generally accepted auditing standards, an independent

auditor of an enterprise’s financial statements is required to state in the auditor’s

report his or her opinion about whether the enterprise’s financial statements

‘‘present fairly’’ the enterprise’s financial position, results of operations, and cash

flows.18 Auditing standards provide that the auditor’s opinion

. . . should be based on his or her judgment as to whether (a) the accounting

principles selected and applied have general acceptance; (b) the accounting principles are appropriate in the circumstances; (c) the financial statements, including the related notes, are informative of matters that may affect their use, understanding, and interpretation . . .; (d) the information presented in the financial statements is classified and summarized in a reasonable manner, that is,

it is neither too detailed nor too condensed . . .; and (e) the financial statements

reflect the underlying transactions and events in a manner that presents the

financial position, results of operations, and cash flows stated within a range

of acceptable limits, that is, limits that are reasonable and practicable to attain

in financial statements. [Footnote reference omitted.] 19

Those standards also recognize that there may be an occasion where the literal

application of generally accepted accounting principles (‘‘GAAP’’) by enterprises

might have the effect of rendering the enterprise’s financial statements misleading.

In those cases, the auditing standards provide that the ‘‘proper accounting treatment is that which will render the financial statements not misleading.’’ 20 Moreover, in those cases the auditor’s opinion is required to describe ‘‘the departure [from

GAAP], its approximate effects, if practicable, and the reasons why compliance with

the principle would result in a misleading statement.’’ 21

In addition to the existing auditing standards, in January 2003, as directed by

the Sarbanes-Oxley Act of 2002 (‘‘2002 Act’’), 22 the SEC adopted rules that require

that an issuer’s principal executive and financial officers each certify the financial

statements and other information contained in the issuer’s quarterly and annual reVerDate 11-MAY-2000 13:32 Jul 16, 2003 Jkt 000000 PO 00000 Frm 00046 Fmt 6633 Sfmt 6621 86050.TXT HCOM1 PsN: HCOM1
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23Final Rule: Certification of Disclosure in Companies’ Quarterly and Annual Reports, Release

No. 33-8124 (August 29, 2002). 24 Certification of Disclosure in Annual and Quarterly Reports, 17 CFR § 240.13a-14(3) (2002). 25Pub. L. No. 107-204, § 108(d). 26FASB Proposal, Principles-Based Approach to U.S. Standard Setting (October 2002). 27FASB Proposal, p. 7. 28 UK Accounting Standards Board, Foreword to Accounting Standards (1993), ¶ 8.

ports.23 Those rules require officers to certify, among other things, that based on

such officer’s knowledge ‘‘the financial statements, and other financial information

included in the report, fairly present in all material respects the financial condition,

results of operations and cash flows of the issuer as of, and for, the periods presented in the report . . .’’ 24

The 2002 Act also required that the SEC ‘‘conduct a study on the adoption by the

United States financial reporting system of a principles-based accounting system.’’ 25

The FASB has been working closely with the SEC staff in this area, and in October

2002, we issued for public comment a proposal on this whole subject (‘‘Proposal’’).26

The Proposal included the following statement:

The Board... expects to consider the need for an overall reporting framework

similar to that in IAS 1 (Revised), Presentation of Financial Statements. The

main objective of that reporting framework would be to provide guidance on

issues such as materiality assessments, going-concern assessments, professional

judgments, accounting policies, consistency, and presentation of comparative information. It also could include a true and fair override to deal with the extremely rare circumstances in which management concludes that compliance

with a requirement in an accounting standard would be so misleading that it

would conflict with the objectives of financial accounting and reporting. Some

believe that such an override is needed to more clearly convey the economic substance of transactions and events in such circumstances, while others believe

that such an override would undermine the principles in the standards, regardless of limitations on its use. [Footnote reference omitted.] 27

As part of the Proposal process, respondents were asked to comment on whether

the Board should develop a similar reporting framework and include a true and fair

override in US GAAP. The Board received more than 130 comments in response to

the Proposal. The Board also held a public roundtable discussion in which 30 individuals participated.

With respect to the reporting framework: Some of the respondents that addressed

that question said that the Board should develop a similar reporting framework—

separately or as part of a conceptual framework improvements project. Some of

those respondents said that while similar guidance is contained in US GAAP, it is

disbursed among many different sources and that having that information in one

place (in a single framework) would make it easier to understand the accounting

model.

Others disagreed with the need for such an accounting standard, some stating

that such a standard is only necessary when accounting practice is widely divergent

and that that environment does not exist in the US.

With respect to a true and fair override: Some of the respondents that addressed

that question said that they supported a true and fair override for US GAAP but

only in rare situations and if properly disclosed to ensure that users understand

that an override has occurred in the preparation of financial statements.

Other respondents disagreed with the need for a true and fair override, some stating that such an override already exists in US auditing standards.

In the coming weeks, the Board plans on continuing to discuss issues raised by

constituents in response to the Proposal and decide what additional actions, if any,

the FASB should pursue in this area. We also plan to continue to work closely with

the SEC as it responds to the 2002 Act’s requirement to study and report on the

potential adoption by the US of a principles-based system.

Question 13) English accounting rules provide that accountants must certify that

financial accounts are ‘‘True and Fair’’—presenting results that are both correct and

understandable. Please explain how this concept works and how it differs from U.S.

Accounting Standards.

Response: The United Kingdom’s (‘‘UK’’) Companies Act 1985 (as amended) (‘‘1985

Act’’) provides that:

Directors of companies incorporated under the Companies Acts... prepare accounts that give a true and fair view of the state of affairs of the company, and

where applicable the group, at the end of the financial year and of the profit

or loss of the company or the group for the financial year.’’ 28

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29Foreword to Accounting Standards, ¶¶ 16 and 18-20; footnote reference omitted. 30FASB Statement No. 123, Accounting for Stock-Based Compensation (1995), ¶ 11.

UK accounting standards incorporate the true and fair view in a ‘‘Foreword to Accounting Standards’’ (‘‘Foreword’’). The Foreword, in addition to describing the 1985

Act, states:

Accounting standards are authoritative statements of how particular types of

transaction and other events should be reflected in financial statements and accordingly compliance with accounting standards will normally be necessary for

financial statements to give a true and fair view... The requirement to give a true and fair view may in special circumstances

require a departure from accounting standards. However, because accounting

standards are formulated with the objective of ensuring that the information resulting from their application faithfully represents the underlying commercial

activity, the Board envisages that only in exceptional circumstances will departure from the requirements of an accounting standard be necessary in order for

financial statements to give a true and fair view.

If in exceptional circumstances compliance with the requirements of an accounting standard is inconsistent with the requirement to give a true and fair

view, the requirements of the accounting standard should be departed from to

the extent necessary to give a true and fair view. In such cases informed and

unbiased judgement should be used to devise an appropriate alternative treatment, which should be consistent with the economic and commercial characteristics of the circumstances concerned. Particulars of any material departure

from an accounting standard, the reasons for it and its financial effects should

be disclosed in the financial statements. The disclosure made should be equivalent to that given in respect of departures from specific accounting provisions

of companies legislation.

The Financial Reporting Review Panel... and the Department of Trade and

Industry have procedures for receiving and investigating complaints regarding

the annual accounts of companies in respect of apparent departures from the

accounting requirements of the Act, including the requirement to give a true

and fair view. The Review Panel will be concerned with material departures

from accounting standards, where as a result the accounts in question do not

give a true and fair view, but it will also cover other departures from the accounting provisions of the Act. 29

As indicated in response to question 12, a concept somewhat analogous to the UK

true and fair view currently exists in the US. In the coming weeks, the Board plans

on continuing to discuss issues raised by constituents in response to the Proposal

and decide what additional actions, if any, the FASB should pursue in this area.

We also plan to continue to work closely with the SEC as it responds to the 2002

Act’s requirement to study and report on the potential adoption by the US of a principles-based system.

Question 14) Chairman Stearns proposed in legislation that accountants be required to reconcile FASB’s fundamental principles of transparency and understandability for every application of accounting rules. Please explain how this proposal

would work.

Response: The FASB is uncertain how Chairman Stearns proposal would work in

light of the existing auditing standards requirements and the recently enacted officer certification requirements of the 2002 Act. As indicated in response to question

12, in the coming weeks, the Board plans on continuing to discuss issues raised by

constituents in response to the Proposal and decide what additional actions, if any,

the FASB should pursue in this area. We also plan to continue to work closely with

the SEC as it responds to the 2002 Act’s requirement to study and report on the

potential adoption by the US of a principles-based system.

STOCK OPTIONS

Question 15) Please explain the difference between the tax treatment of options

and the GAAP treatment.

Response: Under existing US GAAP most grants of stock options to employees are

reported in the financial statements at zero expense because enterprises have the

choice, if the options meet certain criteria, to measure expense using the intrinsic

value of the options at the date of grant.30 The intrinsic value is the difference between the exercise (or strike) price of the option and the market price of the underlying stock.

The other choice, which is the preferable method of accounting under US GAAP,

is to measure the option grants at fair value at the date of grant. Until recently

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31Pat McConnell, Janet Pegg, Chris Senyek, and Dane Mott, ‘‘Companies That Currently Expense or Intend to Expense Stock Options Using the Fair Value Method,’’ Bear Stearns (March

24, 2003). 32FASB News Release, ‘‘FASB Adds Projects to Its Agenda on Employee Stock Options and

Pensions’’ (March 12, 2003). 33See IASB Proposed IFRS, Share-Based Payment (November 2002) (proposing a fair value

grant date approach to the accounting for stock compensation similar to the preferable fair value

method contained in FASB Statement No. 123).

only a few companies chose the preferable method. In recent months, however, more

than 200 companies decided to expense or intend to expense stock compensation

using the preferable method.31

In contrast, it is our understanding that the tax treatment for enterprises issuing

stock compensation is dependent upon the tax classification of the options issued.

The two primary types of options recognized in the tax code are incentive stock options and nonqualified stock options.

Incentive stock options are options that meet special conditions under the tax

code. Incentive stock options have no tax consequences at grant or exercise date to

the employer. The employer, however, may obtain a tax deduction if the employee

sells the shares received from exercising the option if those shares are sold within

one year of exercise or within two years of grant. If that occurs, the employer receives a deduction equal to the intrinsic value of the option at exercise.

Nonqualified stock options are deductible by the employer as compensation expense upon exercise. The measurement of the expense typically is based on the intrinsic value at exercise date.

Question 16) What would be the implication of harmonizing the treatment?

Response: The purpose of financial accounting and reporting standards is to provide investors with unbiased, transparent, and comparable information about enterprises’ underlying economic activities. It is our understanding that the purpose of

tax accounting is to raise revenues for the US Government and to promote various

public policies. It, therefore, is not surprising that the financial accounting and tax

accounting treatment for many transactions, including stock compensation, differ.

The tax accounting treatment of stock compensation may not be consistent with

the purpose of financial accounting and reporting. For example, the tax treatment

(1) ignores recognition of an expense for stock compensation until long after the exchange transaction has occurred and (2) permits noncomparable expense recognition

treatment for economically similar types of stock compensation arrangements. The

latter reason is also viewed by many investors and other users of financial statements as a flaw in the existing financial accounting and reporting standards for

stock compensation and has, in part, resulted in the Board recently adding a project

to its agenda to improve the reporting for stock compensation.32

Moreover, the FASB is committed to promoting the international convergence of

accounting standards concurrent with improving the quality of financial reporting.

It is not likely, for the reasons stated above, that the IASB and our other international counterparts would conclude that adopting the US tax treatment as the financial accounting and reporting standard for stock compensation would improve

the quality of international financial reporting.33

USER ADVISORY COUNCIL

Question 17) Who sits on the Advisory Council—i.e., what groups are represented?

Who formed the group and who will determine its composition?

Response: Attachment 6 to FASB Chairman Robert H. Herz’s March 4, 2003, testimony before the Subcommittee on Commerce, Trade and Consumer Protection contains a listing of the initial members of the FASB’s User Advisory Council (‘‘UAC’’)

and their affiliations. The UAC was formed by the FASB, and the FASB will determine its composition.

Question 18) What role will the Council play in the FASB’s process of developing

an agenda and accounting standards?

Response: The FASB expects that the UAC will assist the FASB in raising awareness of how investors and investment professionals, equity and credit analysts, and

rating agencies use financial information. The UAC will serve as another resource

to the FASB both in formulating its technical agenda and on specific projects that

the Board undertakes.

Question 19) The legislation passed out of the Subcommittee last Congress included principles that financial reporting should be transparent and equally usable

for both the average investor and industry professionals. Will the Advisory Council’s

input balance the goal of providing useful information that meets the needs of both

groups (Professionals and consumers)?

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34FASB Concepts Statement No. 1, Objectives of Financial Reporting by Business Enterprises

(1978), ¶ 34 (emphasis added). 35 AICPA Press Release, ‘‘American Institute of Certified Public Accounts Shifts Focus to Industry-Specific Accounting Guidance’’ (November 5, 2002).

Response: The objectives of US financial reporting are to

. . . provide information that is useful to present and potential investors and

creditors and other users in making rational investment, credit, and similar decisions. The information should be comprehensible to those who have a reasonable understanding of business and economic activities and are willing to study

the information with reasonable diligence.34

Thus, US financial reports are not intended (nor is it a realistic to expect financial

reports) to be useful to all investors. Rather, financial reports are intended to provide useful information only to those investors and other users of financial statements that have a reasonable understanding of business and economic activities and

exercise reasonable diligence. The FASB expects that the UAC’s input will assist the

FASB in raising awareness of how those investors (both professionals and consumers) use financial information.

PRIMACY OF FASB

Question 20) FASB has discontinued the role of the AICPA as a senior level standard setter. FASB has also decided that development of industry-based standards

should reside with FASB. Do you expect that this determination will be challenged?

Should this determination be codified?

The AICPA issued a press release announcing that it supported the FASB’s decision that, after a transition period, the AcSEC should cease issuing Statements of

Position that create new US GAAP.35 In addition, as indicated in the memorandum

from the Office of Chief Accountant attached to the March 7, 2003, letter from SEC

Chairman William H. Donaldson and FASB Chairman Robert H. Herz to Chairman

Cliff Stearns and Representative Janice D. Schakowsky, the SEC anticipates finalizing a policy statement in the near future that will recognize the FASB under the

2002 Act as the independent private-sector accounting standard-setting body in the

US.

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