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EXECUTIVE STOCK OPTIONS: SHOULD THE

INTERNAL REVENUE SERVICE AND STOCKHOLDERS

BE GIVEN DIFFERENT INFORMATION?

HEARING

BEFORE THE

PERMANENT SUBCOMMITTEE ON INVESTIGATIONS

OF THE

COMMITTEE ON 

HOMELAND SECURITY AND 

GOVERNMENTAL AFFAIRS 

UNITED STATES SENATE

ONE HUNDRED TENTH CONGRESS

FIRST SESSION

JUNE 5, 2007

Available via http://www.access.gpo.gov/congress/senate

Printed for the use of the 

Committee on Homeland Security and Governmental Affairs

(

(II)

COMMITTEE ON HOMELAND SECURITY AND GOVERNMENTAL AFFAIRS 

JOSEPH I. LIEBERMAN, Connecticut, Chairman 

CARL LEVIN, Michigan 

DANIEL K. AKAKA, Hawaii 

THOMAS R. CARPER, Delaware 

MARK PRYOR, Arkansas 

MARY L. LANDRIEU, Louisiana 

BARACK OBAMA, Illinois 

CLAIRE MCCASKILL, Missouri 

JON TESTER, Montana 

SUSAN M. COLLINS, Maine 

TED STEVENS, Alaska 

GEORGE V. VOINOVICH, Ohio 

NORM COLEMAN, Minnesota 

TOM COBURN, Oklahoma 

PETE V. DOMENICI, New Mexico 

JOHN W. WARNER, Virginia 

JOHN E.SUNUNU, New Hampshire

MICHAEL L. ALEXANDER, Staff Director 

BRANDON L. MILHORN, Minority Staff Director and Chief Counsel 

TRINA DRIESSNACK TYRER, Chief Clerk 

PERMANENT SUBCOMMITTEE ON INVESTIGATIONS 

CARL LEVIN, Michigan, Chairman 

THOMAS R. CARPER, Delaware 

MARK L. PRYOR, Arkansas 

BARACK OBAMA, Illinois 

CLAIRE McCASKILL, Missouri 

JON TESTER, Montana 

NORM COLEMAN, Minnesota 

TOM COBURN, Oklahoma 

PETE V. DOMENICI, New Mexico 

JOHN W. WARNER, Virginia 

JOHN E. SUNUNU, New Hampshire

ELISE J. BEAN, Staff Director and Chief Counsel 

JOHN C. MCDOUGAL, IRS Detailee 

MARK L. GREENBLATT, Staff Director and Chief Counsel to the Minority 

MARK D. NELSON, Deputy Chief Counsel to the Minority 

GUY FICCO, IRS Detailee 

RUTH PEREZ, IRS Detailee 

MARY D. ROBERTSON, Chief Clerk 

(III)

C O N T E N T S 

Opening statements: Page 

Senator Levin .................................................................................................... 1

Senator Coleman .............................................................................................. 9

WITNESSES 

TUESDAY, JUNE 5, 2007

Stephen F. Bollenbach, Chairman, Board of Directors, KB Home, Los Angeles, 

California .............................................................................................................. 16

John S. Chalsty, Chairman, Executive Compensation and Human Resource 

Committee, Occidental Petroleum Corporation, Los Angeles, California ........ 17

William Y. Tauscher, Member and Former Chairman, Compensation Committee, Safeway, Inc., Pleasanton, California .................................................... 19

Kevin M. Brown, Acting Commissioner, Internal Revenue Service .................... 30

John W. White, Director, Division of Corporation Finance, Securities and 

Exchange Commission ......................................................................................... 31

Lynn E. Turner, Former Securities and Exchange Commission Chief Accountant, Broomfield, Colorado .................................................................................... 39

Mihir A. Desai, Arthur M. Rock Center for Entrepreneurship Associate Professor, Harvard University, Graduate School of Business Administration, 

Boston, Massachusetts ......................................................................................... 42

Jeffrey P. Mahoney, General Counsel, Council of Institutional Investors, 

Washington, DC ................................................................................................... 44

ALPHABETICAL LIST OF WITNESSES

Bollenbach, Stephen F.: 

Testimony .......................................................................................................... 16

Prepared statement .......................................................................................... 55

Brown, Kevin M.: 

Testimony .......................................................................................................... 30

Prepared statement .......................................................................................... 72

Chalsty, John S.: 

Testimony .......................................................................................................... 17

Prepared statement .......................................................................................... 60

Desai, Mihir A.: 

Testimony .......................................................................................................... 42

Prepared statement with attachments ........................................................... 95

Mahoney, Jeffrey P.: 

Testimony .......................................................................................................... 44

Prepared statement with attachments ........................................................... 124

Tauscher, William Y.: 

Testimony .......................................................................................................... 19

Prepared statement .......................................................................................... 63

Turner, Lynn E.: 

Testimony .......................................................................................................... 39

Prepared statement .......................................................................................... 90

White John W.: 

Testimony .......................................................................................................... 31

Prepared statement .......................................................................................... 79

Page

IV

EXHIBITS 

1. Exexutive Stock Option Compensation—Book versus Tax Return Diffential 

For Exercised Stock Options, chart prepared by the Permanent Subcommittee on Investigatons Staff .................................................................... 236

2. Exexutive Stock Option Compensation—Book versus Tax Return Diffential 

For Exercised Stock Options, (detailed version), chart prepared by the 

Permanent Subcommittee on Investigatons Staff .......................................... 237

3. KB Home Exexutive Stock Option Compensation—Book versus Tax Return 

Diffential, chart prepared by the Permanent Subcommittee on 

Investigatons Staff ............................................................................................ 238

4. Occidental Petroleum Exexutive Stock Option Compensation—Book versus 

Tax Return Diffential, chart prepared by the Permanent Subcommittee 

on Investigatons Staff ...................................................................................... 239

5. Cisco Systems Exexutive Stock Option Compensation—Book versus Tax 

Return Diffential, chart prepared by the Permanent Subcommittee on 

Investigatons Staff ............................................................................................ 240

6. UnitedHealth Group Exexutive Stock Option Compensation—Book versus 

Tax Return Diffential, chart prepared by the Permanent Subcommittee 

on Investigatons Staff ...................................................................................... 241

7. Safeway Exexutive Stock Option Compensation—Book versus Tax Return 

Diffential, chart prepared by the Permanent Subcommittee on 

Investigatons Staff ............................................................................................ 242

8. Monster Exexutive Stock Option Compensation—Book versus Tax Return 

Diffential, chart prepared by the Permanent Subcommittee on 

Investigatons Staff ............................................................................................ 243

9. Mercury Interactive Exexutive Stock Option Compensation—Book versus 

Tax Return Diffential, chart prepared by the Permanent Subcommittee 

on Investigatons Staff ...................................................................................... 244

10. Comverse Exexutive Stock Option Compensation—Book versus Tax Return 

Diffential, chart prepared by the Permanent Subcommittee on 

Investigatons Staff ............................................................................................ 245

11. Apple Exexutive Stock Option Compensation—Book versus Tax Return 

Diffential, chart prepared by the Permanent Subcommittee on 

Investigatons Staff ............................................................................................ 246

12. Note To Charts Prepared By the Permanent Subcommittee On Investigations Staff .......................................................................................................... 247

13. Responses to questions for the record submitted to Kevein M. Brown, 

Acting Commissioner, Internal Revenue Service ........................................... 248

14. Responses to questions for the record submitted to Stephen F. Bollenbach, 

Chairman of the Board of Directors, KB Home .............................................. 250

(1)

EXECUTIVE STOCK OPTIONS: SHOULD THE 

INTERNAL REVENUE SERVICE AND 

STOCKHOLDERS BE GIVEN DIFFERENT 

INFORMATION? 

TUESDAY, JUNE 5, 2007

U.S. SENATE,

PERMANENT SUBCOMMITTEE ON INVESTIGATIONS,

OF THE COMMITTEE ON HOMELAND SECURITY

AND GOVERNMENTAL AFFAIRS, 

Washington, DC. 

The Subcommittee met, pursuant to notice, at 9:02 a.m., in room 

SD–342, Dirksen Senate Office Building, Hon. Carl Levin, Chairman of the Subcommittee, presiding. 

Present: Senators Levin and Coleman. 

Staff Present: Elise J. Bean, Staff Director and Chief Counsel; 

Mary D. Robertson, Chief Clerk; John McDougal, Detailee, IRS; 

Guy Ficco, Detailee, IRS; Ross Kirschner, Counsel; Genevieve 

Citrin, Intern; Mark L. Greenblatt, Staff Director and Chief Counsel to the Minority; Mark D. Nelson, Deputy Chief Counsel to the 

Minority; Timothy R. Terry, Counsel to the Minority; Emily T. Germain, Staff Assistant to the Minority; Ruth Perez, Detailee, IRS; 

Kunaal Sharma, Intern; Adam Healey (Senator Tester); and Chris 

Pendergast (Senator Carper). 

OPENING STATEMENT OF SENATOR LEVIN 

Senator LEVIN. Good morning, everybody. The Subcommittee will 

come to order, and what we would like to do is begin with a moment of silence in tribute to our friend and our colleague, Craig 

Thomas of Wyoming, who passed away yesterday after a courageous battle with leukemia. And I would ask everybody to stand for 

a moment in silence. 

[Moment of silence.] 

Senator LEVIN. Thank you. 

The subject of today’s hearing is executive stock options. Stock 

options give employees the right to buy company stock at a set 

price for a specified period of time, typically 10 years. Stock options 

are a key component of executive pay. 

According to Forbes magazine, in 2006, the average pay of the 

chief executive officers (CEOs), of 500 of the largest U.S. companies 

was $15.2 million. Nearly half of that amount—$7.3 million—came 

from exercised stock options. On the high end, one CEO cashed in 

stock options for $290 million, another for $270 million. Forbes also 

2

published a list of 30 CEOs in 2006, who each had at least $100 

million in vested stock options that had yet to be exercised. 

J.P. Morgan once said that CEO pay should not exceed 20 times 

average worker pay. In the United States, in 1990, average CEO 

pay was 100 times average worker pay; in 2004, the figure was 300 

times; today, it is nearly 400 times. Stock option grants to executives are a big part of the modern chasm between executive pay 

and the pay of average workers. 

Stock options have been portrayed as a way to align corporate 

executives’ interests with those of stockholders because they 

produce income for an executive only if the company’s stock price 

rises. But stock options have also been associated with a litany of 

abuses ranging from dishonest accounting to tax dodging—from 

Enron, to the backdating scandal to the Wyly brothers in Texas, 

who, as our hearing showed last summer, tried to dodge U.S. taxes 

by sending $190 million in stock options to offshore shell companies 

that they secretly controlled. 

Today’s hearing is looking at a stock option issue that does not 

involve allegations of wrongdoing. Rather, today’s hearing focuses 

on a set of mismatched accounting and tax rules that are legal. 

These rules require companies to report one set of stock option 

compensation figures to investors and the public on their books, 

and a completely different set of figures to the Internal Revenue 

Service (IRS) on their tax returns. In most cases, the resulting tax 

deduction has far exceeded the expense shown on the company 

books. 

When a company’s compensation committee learns that stock options often produce a low compensation cost on the books while 

generating a whopping tax deduction frequently, it is a pretty 

tempting proposition for them to provide their executives with 

large amounts of stock options. The problem is that the mismatch 

in stock option accounting and tax rules also shortchanges the 

Treasury to the tune of billions of dollars each year while fueling 

the huge gap between executive pay and average worker pay. 

Calculating the cost of stock options may sound straightforward, 

but for years companies and their accountants engaged the Financial Accounting Standards Board (FASB), in an all-out, knock-down 

battle over how companies should record stock option compensation 

expenses on their books. In the end, FASB issued a new accounting 

rule, Financial Accounting Standard (FAS) 123R, which was endorsed by the SEC and became mandatory for all publicly traded 

corporations in June 2005. In essence, that rule requires all companies to record a compensation expense equal to the fair value on 

grant date of stock options provided to employees in exchange for 

their services. 

Opponents of the new accounting rule predicted that it would severely damage U.S. capital markets. They warned that stock option 

expensing would eliminate profits, discourage investment, depress 

stock prices, and stifle innovation. Last year, 2006, was the first 

year in which all U.S. publicly traded companies were required to 

expense stock options. Instead of tumbling, both the New York 

Stock Exchange and NASDAQ turned in strong performances, as 

did initial public offerings by new companies. The dire predictions 

were wrong. 

3

In contrast to the battle raging over stock option accounting, relatively little attention was paid to the taxation of stock options. 

Section 83 of the Tax Code, first enacted in 1969, is the key statutory provision. It essentially provides that when an employee exercises stock options, the employee must report as income the difference between what the employee paid to exercise the options 

and the market price of the stock received. The corporation can 

then take a mirror deduction in the same amount as a compensation expense. 

For example, suppose an executive had options to buy one million shares of company stock at $10 per share. Suppose 5 years later 

the executive exercised the options when the stock was selling at 

$30 per share. The executive’s income would be $20 per share, for 

a total of $20 million. The executive would declare $20 million as 

ordinary income, and in the same year the company would take a 

corresponding tax deduction of $20 million. Although in 1993, Congress enacted a $1 million cap on the compensation that a corporation can deduct from its taxes so taxpayers 

would not be forced to subsidize millions of dollars in executive 

pay, an exception was made for stock options, allowing companies 

to deduct any amount of stock option compensation without limit. 

The stock option accounting and tax rules now in place are at 

odds with each other. Accounting rules require companies to expense stock options on the grant date. Tax rules require companies 

to deduct stock option expenses on the exercise date. Companies 

have to report the grant date expenses to investors on their financial statements and exercise date expenses on their tax returns. 

The financial statements report on all stock options granted during 

the year, while the tax returns report on all stock options exercised 

during the year. In short, company financial statements and tax returns report expenses for different groups of stock options using 

different valuation methods, resulting in divergent stock option expenses for the same year. 

Now, to test just how far these figures diverge, the Subcommittee 

contacted a number of companies to compare the stock option expenses that they reported for accounting and for tax purposes. The 

Subcommittee asked each company to identify stock options that 

had been exercised by one or more of its executives from 2002 to 

2006. The Subcommittee then asked each company to identify the 

compensation expense that they reported on their financial statements versus the compensation expense on their tax return. In addition, we asked the companies’ help in estimating what effect the 

new accounting rule would have had on their book expense if it had 

been in place when their stock options were granted. And we very 

much appreciate the cooperation and the assistance which has been 

provided by the nine companies whose data is being disclosed 

today, particularly including the companies that were asked to testify. We are grateful to all of them for their cooperation and for 

their information, and we are particularly, again, grateful to the 

three companies who are before us today to provide us with that 

information. 

The data showed that under then existing accounting rules, the 

nine companies generally showed stock options as a zero expense 

on their books. The one exception was Occidental Petroleum, which 

4

1See Exhibit 1 which appears in the Appendix on page 236. 

in 2005, began voluntarily expensing its options and recorded an 

expense for a few options. When the Subcommittee asked the companies what their book expense would have been if the new FASB 

rule had been in effect, all nine calculated a book expense that remained dramatically lower than their tax deductions. 

The chart which I am putting now before us, Exhibit 1,1 shows 

the book-tax differences, using the book expense calculated under 

the new FASB rule. It shows that the nine companies alone produced $1 billion more in tax deductions than the expense shown on 

their books, even using the tougher new accounting rule. There tax 

deductions far exceeded their book expenses, not because the companies were doing anything wrong, but because the current stock 

option accounting and tax rules are so out of whack. 

KB Home, for example, is a company that builds residential 

homes. Its stock price has more than quadrupled over the last 10 

years. Over the same period, it repeatedly granted stock options to 

its then-CEO. Company records show that over the past 5 years, 

KB Home gave him 5.5 million stock options, of which he exercised 

more than 3 million. 

With respect to those 3 million stock options, KB Home recorded 

a zero expense on its books. Now, had FASB’s new rule been in effect, KB Home calculated that it would have reported on its books 

a compensation expense of about $11.5 million. KB Home also disclosed that the same 3 million stock options enabled it to claim 

compensation expenses on its tax returns totaling about $143.7 

million. In other words, KB Home claimed a $143 million tax deduction for expenses that on its books under current accounting 

rules, the new accounting rules, would have totaled $11.5 million. 

That is a tax deduction 12 times bigger than the book expense. 

Occidental Petroleum, the next company on the chart, disclosed 

a similar book-tax discrepancy. This company’s stock price has also 

skyrocketed in recent years, dramatically increasing the value of 

the 16 million stock options granted to its CEO since 1993. Of the 

12 million stock options the CEO actually exercised over the past 

5 years, Occidental Petroleum claimed a $353 million tax deduction 

for a book expense that under current accounting rules would have 

totaled just $29 million. That is a book-tax difference of more than 

1,200 percent. 

Similar book-tax discrepancies apply to the other companies that 

we contacted. Cisco Systems’ CEO exercised nearly 19 million stock 

options over the past 5 years and provided the company with a 

$169 million tax deduction for a book expense which under current 

accounting rules would have totaled about $21 million. 

UnitedHealth’s former CEO exercised over 9 million stock options in 5 years, providing the company with a $318 million tax deduction for a book expense which would have totaled about $46 

million. 

Safeway’s CEO exercised over 2 million stock options, providing 

the company with a $39 million tax deduction for a book expense 

which would have totaled about $6.5 million. 

Altogether these nine companies took stock option tax deductions 

totaling $1.2 billion—a figure five times larger than their combined 

5

stock option book expenses of $217 million. The resulting $1 billion 

book-tax difference represents a huge tax deduction windfall for the 

companies simply because they issued lots of stock options to their 

CEOs. Tax rules that produce outsized tax deductions that are 

many times larger than the related stock option book expenses give 

companies an incentive to issue huge stock option grants because 

they know that the stock options can produce a relatively small hit 

to profits and probably a much larger tax deduction that can dramatically lower their taxes. 

To gauge just how big the tax gap is for stock options, the Subcommittee asked the IRS to perform an analysis of its overall data 

on stock option book-tax differences. The new Schedule M–3, which 

went into effect last year for large corporations, asked companies 

to identify differences in how they report corporate income to investors versus what they report to Uncle Sam. The resulting M–3 data 

applies mostly to 2004 tax returns. 

The IRS found that corporations took tax deductions on their tax returns for stock option compensation expenses which were $43 billion greater than the stock option expenses shown on their financial statements for the same year. Those massive tax deductions 

enabled corporations as a whole to legally reduce their taxes by billions of dollars, perhaps by as much as $15 billion. 

When asked to look deeper into who benefited from the stock op- tion deductions, the IRS was able to determine that the entire $43 

billion book-tax difference was attributable to about 3,200 corporations nationwide, of which about 250 companies accounted for 82 

percent of the total difference. In other words, a relatively small 

number of corporations were able to generate a $43 billion tax deduction by handing out substantial stock options to their executives. 

The current differences between stock option accounting and tax 

rules make no sense. They require companies to show one stock option expense on their books and a completely different expense on 

their tax returns. They allow companies to take tax deductions that 

overall are many times larger than the stock option expenses 

shown on their books, which not only shortchanges the Treasury 

but also provides an accounting and tax windfall to companies giving out huge stock options and creates an incentive for companies 

to keep right on giving out those options. 

The book-tax difference is fueling an ever deepening chasm between executive pay and the pay of average workers. The stock option book difference is a historical product of accounting and tax 

policies that have not been coordinated or integrated. Right now 

stock options are the only compensation expense where companies 

are allowed to deduct much more on their tax returns than the expense shown on their books. And I emphasize that is the only compensation expense where that is allowed. 

In 2004, companies used the book-tax difference to claim $43 billion more in stock option deductions than the expenses shown on 

their books. We need to examine whether we can afford this multibillion-dollar loss to the Treasury, not only in light of the deep Federal deficits but also in light of the evidence that this stock option 

book-tax difference is contributing to the gap, the growing gap, between the pay of executives and the pay of average workers. 

6

In past years, I have introduced legislation to require stock option deductions to match the stock option expenses shown on company books. I hope our witnesses today will indicate whether they 

agree that Federal tax policy should be brought into line with accounting policy and provide that corporations deduct on their tax 

returns only the amount of stock option expenses that is shown on 

their books. 

[The prepared statement of Senator Levin follows:]

PREPARED STATEMENT OF SENATOR LEVIN 

The subject of today’s hearing is executive stock options. Stock options give employees the right to buy company stock at a set price for a specified period of time, 

typically 10 years. Stock options are a key contributor to executive pay. 

According to Forbes magazine, in 2006, the average pay of the chief executive officers (CEOs) of 500 of the largest U.S. companies was $15.2 million. Nearly half of 

that amount, 48 percent, came from exercised stock options that produced average 

gains of about $7.3 million. On the high end, one CEO cashed in stock options for 

$290 million, another for $270 million. Forbes also published a list of 30 CEOs in 

2006, who each had at least $100 million in vested stock options that had yet to 

be exercised. J.P. Morgan once said that CEO pay should not exceed 20 times average worker pay. In the United States, in 1990, average CEO pay was 100 times average worker pay; in 2004, the figure was 300 times; today, it is nearly 400 times. 

Stock options have been portrayed as a way to align corporate executives’ interests with those of stockholders, because they produce income for an executive only 

if the company stock price rises. But stock options have also been associated with 

a litany of abuses ranging from dishonest accounting to tax dodging—from Enron, 

to the backdating scandal, to the Wyly brothers in Texas who, as our hearing 

showed last summer, tried to dodge U.S. taxes by sending $190 million in stock options to offshore shell companies they secretly controlled. 

Today’s hearing is looking at a stock option issue that does not involve allegations 

of wrongdoing. Rather, today’s hearing focuses on a set of mismatched accounting 

and tax rules that are legal. These rules require companies to report one set of stock 

option compensation figures to investors and the public on their books, and a completely different set of figures to the Internal Revenue Service (IRS) on their tax 

returns. In most cases, the resulting tax deduction has far exceeded the expense 

shown on the company books. 

When a company’s compensation committee learns that stock options often 

produce a low compensation cost on the books, while generating a whopping tax deduction, it’s a pretty tempting proposition for them to pay their executives with 

stock options instead of cash or stock. The problem is that the mismatch in stock 

option accounting and tax rules also shortchanges the Treasury to the tune of billions of dollars each year, while fueling the growing chasm between executive pay 

and average worker pay. 

Accounting Battle. Calculating the cost of stock options may sound straightforward, but for years, companies and their accountants engaged the Financial Accounting Standards Board in an all-out, knock-down battle over how companies 

should record stock option compensation expenses on their books. 

U.S. publicly traded corporations are required by law to follow Generally Accepted 

Accounting Principles (GAAP), issued by the Financial Accounting Standards Board 

(FASB), which is overseen by the Securities and Exchange Commission (SEC). For 

many years, GAAP allowed U.S. companies to issue stock options to employees and, 

unlike any other type of compensation, report a zero compensation expense on their 

books, so long as, on the grant date, the stock option’s exercise price equaled the 

market price at which the stock could be sold. 

Assigning a zero value to stock options that routinely produced millions of dollars 

in executive pay provoked deep disagreements within the accounting community. In 

1993, FASB proposed assigning a ‘‘fair value’’ to stock options on the date they are 

granted to an employee, using a mathematical valuation tool such as the Black 

Scholes model, and then including a grant date expense on companies’ financial 

statements. Critics responded that it was impossible accurately to estimate the 

value of executive stock options on their grant date. A bruising battle over stock option expensing followed, involving the accounting profession, corporate executives, 

FASB, the SEC, and Congress. 

In the end, FASB issued a new accounting standard, Financial Accounting Standard (FAS) 123R, which was endorsed by the SEC and became mandatory for all pubVerDate 0ct 09 2002 10:41 Sep 24, 2007 Jkt 036611 PO 00000 Frm 00010 Fmt 6633 Sfmt 6621 C:\DOCS\36611.TXT SAFFAIRS PsN: PAT
7

licly traded corporations in June 2005. In essence, FAS 123R requires all companies 

to record a compensation expense equal to the fair value on grant date of stock options provided to employees in exchange for their services. 

The details of this accounting rule are complex, because they reflect an effort to 

accommodate varying viewpoints on the true cost of stock options. Companies are 

allowed to use a variety of mathematical models, for example, to calculate a stock 

option’s fair value. Option grants that vest over time are expensed over the specified 

period so that, for example, a stock option which vests over four years results in 

25% of the cost being expensed each year. If a stock option grant never vests, the 

rule allows any previously booked expense to be recovered. On the other hand, stock 

options that do vest must be fully expensed, even if never exercised, because the 

compensation was actually awarded. These and other provisions of this hard-fought 

accounting rule reflect painstaking judgements on how to show a stock option’s true 

cost. 

Opponents of the new accounting rule predicted that it would severely damage 

U.S. capital markets. They warned that stock option expensing would eliminate 

profits, discourage investment, depress stock prices, and stifle innovation. Last year, 

2006, was the first year in which all U.S. publicly traded companies were required 

to expense stock options. Instead of tumbling, both the New York Stock Exchange 

and Nasdaq turned in strong performances, as did initial public offerings by new 

companies. The dire predictions were wrong. 

Tax Treatment. In contrast to the battle raging over stock option accounting, relatively little attention was paid to the taxation of stock options. Section 83 of the 

tax code, first enacted in 1969, is the key statutory provision. It essentially provides 

that, when an employee exercises stock options, the employee must report as income 

the difference between what the employee paid to exercise the options and the market value of the stock received. The corporation can then take a mirror deduction 

for the same amount of income. 

For example, suppose an executive had options to buy 1 million shares of company stock at $10 per share. Suppose, five years later, the executive exercised the options 

when the stock was selling at $30 per share. The executive’s income would be $20 

per share for a total of $20 million. The executive would declare $20 million as ordinary income, and in the same year, the company would take a corresponding tax 

deduction for $20 million. Although in 1993, Congress enacted a $1 million cap on 

the compensation that a corporation can deduct from its taxes, so taxpayers 

wouldn’t be forced to subsidize millions of dollars in executive pay, an exception was 

made for stock options, allowing companies to deduct any amount of stock option 

compensation, without limit. 

Book-Tax Differences. The stock option accounting and tax rules now in place are 

at odds with each other. Accounting rules require companies to expense stock options on the grant date. Tax rules require companies to deduct stock option expenses 

on the exercise date. Companies have to report grant date expenses to investors on 

their financial statements, and exercise date expenses on their tax returns. The financial statements report on all stock options granted during the year, while the 

tax returns report on all stock options exercised during the year. In short, company 

financial statements and tax returns report expenses for different groups of stock 

options, using dramatically different valuation methods, resulting in widely divergent stock option expenses for the same year. 

Company Data. To test just how far these figures diverge, the Subcommittee contacted a number of companies to compare the stock option expenses they reported 

for accounting and tax purposes. The Subcommittee asked each company to identify 

stock options that had been exercised by one or more of its executives from 2002 

to 2006. The Subcommittee then asked each company to identify the compensation 

expense they reported on their financial statements versus the compensation expense on their tax returns. In addition, we asked the companies’ help in estimating 

what effect the new accounting rule would have had on their book expense if it had 

been in place when their stock options were granted. We very much appreciate the 

cooperation and assistance provided by the nine companies whose data is being disclosed today, including the three companies that were asked to testify. 

The data showed that, under then existing accounting rules, the nine companies 

generally showed stock options as a zero expense on their books. The one exception 

was Occidental Petroleum which, in 2005, began voluntarily expensing its options 

and recorded an expense for a few options. When the Subcommittee asked the companies what their book expense would have been if the new FASB rule had been 

in effect, all nine calculated a book expense that remained dramatically lower than 

their tax deductions. 

This chart, which is Exhibit 1, shows the book-tax differences, using the book expense calculated under the new FASB rule. It shows that the nine companies alone 

8

produced $1 billion more in tax deductions than the expense shown on their books, 

even using the tougher new accounting rule. Their tax deductions far exceeded their 

book expenses, not because the companies were doing anything wrong, but because 

the current stock option accounting and tax rules are so out of whack. 

KB Home, for example, is a company that builds residential homes. Its stock price 

has more than quadrupled over the past 10 years. Over the same time period, it 

repeatedly granted stock options to its then CEO. Company records show that, over 

the past five years, KB Home gave him 5.5 million stock options of which he exercised more than 3 million. 

With respect to those 3 million stock options, KB Home recorded a zero expense 

on its books. Had FAS 123R been in effect, KB Home calculated that it would have 

reported on its books a compensation expense of about $11.5 million. KB Home also 

disclosed that the same 3 million stock options enabled it to claim compensation expenses on its tax returns totaling about $143.7 million. In other words, KB Home 

claimed a $143 million tax deduction for expenses that on its books, under current 

accounting rules, would have totaled $11.5 million. That’s a tax deduction 12 times 

bigger than the book expense. 

Occidental Petroleum, the next company on the chart, disclosed a similar booktax discrepancy. This company’s stock price has also skyrocketed in recent years, 

dramatically increasing the value of the 16 million stock options granted to its CEO 

since 1993. Of the 12 million stock options the CEO actually exercised over the past 

five years, Occidental Petroleum claimed a $353 million tax deduction for a book expense that, under current accounting rules, would have totaled just $29 million. 

That’s a book-tax difference of more than 1200%. 

Similar book-tax discrepancies apply to the other companies we contacted. Cisco 

System’s CEO exercised nearly 19 million stock options over the past five years, and 

provided the company with a $169 million tax deduction for a book expense which, 

under current accounting rules, would have totaled about $21 million. 

UnitedHealth’s former CEO exercised over 9 million stock options in five years, providing the company with a $318 million tax deduction for a book expense which 

would have totaled about $46 million. Safeway’s CEO exercised over 2 million stock 

options, providing the company with a $39 million tax deduction for a book expense 

which would have totaled about $6.5 million. 

Altogether, these nine companies took stock option tax deductions totaling $1.2 

billion, a figure five times larger than their combined stock option book expenses 

of $217 million. The resulting billion-dollar book-tax difference represents a huge 

tax deduction windfall for the companies simply because they issued lots of stock 

options to their CEOs. Tax rules that produce outsized tax deductions that are 

many times larger than the related stock option book expenses give companies an 

incentive to issue huge stock option grants, because they know the stock options will 

produce a relatively small hit to profits and a much larger tax deduction that can 

dramatically lower their taxes. 

To gauge just how big the tax gap is for stock options, the Subcommittee asked 

the IRS to perform an analysis of its overall data on stock option book-tax differences. The new M-3 Schedule, which went into effect last year for large corporations, asked companies to identify differences in how they report corporate income 

to investors versus what they report to Uncle Sam. The resulting M-3 data applies 

mostly to 2004 tax returns. 

The IRS found that stock option compensation expenses were one of the biggest 

factors in the difference between book and tax income reported by U.S. corporations. 

The data shows that, in 2004, stock option compensation expenses produced a booktax gap of about $43 billion, which is about 30% of the entire book-tax difference 

reported for the period. That means, as a whole, corporations took deductions on 

their tax returns for stock option compensation expenses which were $43 billion 

greater than the stock option expenses shown on their financial statements for the 

same year. Those massive tax deductions enabled the corporations, as a whole, to 

legally reduce their taxes by billions of dollars, perhaps by as much as $15 billion. 

When asked to look deeper into who benefitted from the stock option deductions, 

the IRS was able to determine that the entire $43 billion book-tax difference was 

attributable to about 3,200 corporations nationwide, of which about 250 corporations 

accounted for 82% of the total difference. In other words, a relatively small number 

of corporations was able to generate a $43 billion tax deduction by handing out substantial stock options to their executives. 

There are other surprises in the data as well. One set of issues involves 

unexercised stock options which, under the new accounting rule, will produce an expense on the books but no tax deduction. Cisco told the Subcommittee, for example, 

that in addition to the 19 million exercised stock options mentioned a moment ago, 

their CEO holds about 8 million options that, due to a stock price drop, would likely 

9

expire without being exercised. Cisco calculated that, had FAS 123R been in effect, 

the company would have had to show a $139 million book expense for those options, 

but would never be able to claim a tax deduction for them since they would never 

be exercised. Apple pointed out that, in 2003, it allowed its CEO to trade 17.5 million in underwater stock options for 5 million shares of restricted stock. That trade 

meant the stock options would never be exercised and so would never produce a tax 

deduction. In both cases, under FAS 123R, it is possible that stock options would 

produce a reported book expense greater than a company’s tax deduction. While the 

M-3 data suggests that, overall, accounting expenses lag far behind claimed tax deductions, the possible financial impact on an individual company of a large number 

of unexercised stock options is additional evidence that stock option accounting and 

tax rules are out of kilter. 

Another set of issues has to do with how the corporate stock option tax deduction 

depends upon decisions made by individual corporate executives on whether and 

when to exercise their stock options. Normally, a corporation dispenses compensation to its employees and takes a tax deduction in the same year for the expense. 

With respect to stock options, however, corporations may have to wait years to see 

if, when, and how much of a deduction can be taken. UnitedHealth noted, for example, that it gave its former CEO 8 million stock options in 1999, of which, by 2006, 

only about 730,000 had been exercised. It does not know if or when it will get a 

tax deduction for the remaining 7 million options. 

If the rules for stock option tax deductions were changed so that the annual deduction matched the expenses shown on a company’s books in the same year, companies could take the deduction years earlier, without waiting for exercises, and it 

would allow companies to deduct stock options that vest but are never exercised. 

It would treat stock options in the same manner as every other form of corporate 

compensation by allowing a deduction in the same year that the compensation was 

granted. 

Conclusion. The current differences between stock option accounting and tax rules 

make no sense. They require companies to show one stock option expense on their 

books and a completely different expense on their tax returns. They allow companies 

to take tax deductions that, overall, are many times larger than the stock option 

book expenses shown on their books, which not only shortchanges the Treasury, but 

also provides an accounting and tax windfall to companies doling out huge stock options, and creates an incentive for companies to keep right on doling out those options. The book-tax difference is fueling an ever deepening chasm between executive 

pay and the pay of average workers. 

The stock option book-tax difference is a historical product of accounting and tax 

policies that have not been coordinated or integrated. Right now, stock options are 

the only compensation expense where companies are allowed to deduct much more 

on their tax returns than the expense shown on their books. In 2004, companies 

used the book-tax difference to claim $43 billion more in stock option deductions 

than the expenses shown on their books. We need to examine whether we can afford 

this multi-billion dollar loss to the Treasury, not only in light of the deep federal 

deficits, but also in light of evidence that this stock option book-tax difference is contributing to the growing gap between the pay of executives and the pay of average 

workers. 

In past years, I’ve introduced legislation to require stock option tax deductions to 

match the stock option expenses shown on the company books. I hope the witnesses 

today will help us analyze the policy issues, and indicate whether they agree that 

federal tax policy should be brought into line with accounting policy, and provide 

that corporations deduct on their tax returns only the amount of stock option expenses shown on their books.

Senator LEVIN. Senator Coleman. 

OPENING STATEMENT OF SENATOR COLEMAN 

Senator COLEMAN. Thank you. Thank you, Mr. Chairman. I want 

to thank you for initiating this investigation and for the dedicated 

focus and long effort you have given to ensure that investors in 

America’s publicly traded companies have full access to important 

information regarding executive compensation. 

I have a longer statement that I would like entered into the 

record, Mr. Chairman, but let me discuss perhaps three issues in 

my opening. 

10

First, why are we concerned? The Chairman has detailed the explosion of executive pay. In 2006, CEOs earned almost 400 times 

the wage of the typical rank-and-file employee, and while it is said 

that exceptional performance demands exceptional pay, it is troubling when mediocrity is rewarded with a king’s ransom. But why 

are we in government concerned about this? One of the concerns 

is that this excess, including the exorbitant severance packages 

paid to executives ejected from their companies, at times under 

cloud of scandals, robs shareholders of earnings that are rightfully 

theirs and draws on the retirement savings of America’s hardworking families. 

Without a closer link to performance, extraordinary CEO pay 

packages threatens to undermine the average investor’s trust in 

our markets. More than 80 percent of Americans and 90 percent 

of institutional investors, including pension and retirement funds, 

think CEOs of large companies are overpaid. More disturbing, 60 

percent of corporate directors—the very people who determine executive pay—believe CEOs of large companies make more than they 

deserve. Warren Buffett once argued that CEO pay ‘‘remains the 

acid test’’ to judge whether corporate America is serious about reform. If so, the results so far are anything but encouraging. Ultimately, some semblance of reality should be restored to executive 

pay. 

There was a column yesterday in the Minneapolis Star Tribune,

one of my hometown papers, by Charles Denny, a former CEO, and 

he noted that ‘‘our Nation’s great wealth is a product of free market capitalism operating within, and ultimately governed by, the 

political system of democracy.’’ And what Mr. Denny offers—and it 

was a very timely piece—is unique insight in concluding that if the 

current corporate excesses ‘‘continue unchecked, the electorate’s 

support of the political/economic concept of democratic capitalism 

will be severely tested.’’ I share Mr. Denny’s concern, and if the 

business community does not do something soon, companies are 

going to get more pressure from the Federal Government and from 

Congress in particular. 

So how did we get here? Clearly, there are a number of factors 

that have propelled executive salaries into the stratosphere. First, 

it cannot be overlooked that as CEO salaries have grown over the 

past 25 years, so too has the average size of large American companies. Indeed, the companies that will testify today exemplify this 

important point, as they have all produced substantial increases in 

profits over the past 15 years, much to the benefit of their shareholders. Moreover, the competition for high-performing CEOs is 

higher than ever, and the costs associated with recruiting and retaining top managers have bid up the compensation packages for 

all executives. That said, the pink elephant in the room is the stock 

option. When one considers the numbers that Senator Levin mentioned in his opening statement—that in 2004, stock options resulted in a book-tax gap of $43 billion—it becomes clear that the 

impact of stock options on executive compensation cannot be overstated. 

In fact, for the past 15 years, executive pay has been defined by 

the option. In 1992, for example, Standard & Poor’s 500 companies 

issued only $11 billion in stock options. In the year 2000, when opVerDate 0ct 09 2002 10:41 Sep 24, 2007 Jkt 036611 PO 00000 Frm 00014 Fmt 6633 Sfmt 6601 C:\DOCS\36611.TXT SAFFAIRS PsN: PAT
11

tion compensation reached its peak, companies issued options 

worth more than $119 billion. And although somewhat abated, 

companies still issued tens of billions of dollars’ worth of stock options last year. 

To be clear, stock options are valuable and legitimate incentive 

tools, and the increased use of stock-based compensation reflects a 

logical attempt by publicly traded companies to align the self-interests of their executives with the best interests of the shareholders. 

By replacing cash with long-term incentives, stock options are 

meant to make managers think like owners and ensure that executive pay is linked to company performance. And during the early 

1990s, options worked as intended—executive pay increased as 

shareholders profited. 

But in the overvalued market of the late 1990s, it became clear 

that the link between performance and pay had grown tenuous at 

best. As the bull market charged, it seemed that executives got rich 

just by showing up for work, and investors began to deride stock 

options as ‘‘pay for pulse.’’ Worse, executive decisionmaking seemed 

more short term than ever. Earning manipulations in Enron, 

WorldCom, and elsewhere underscored what many investors already feared; stock options provided company managers with perverse incentives to personally profit from artificial, even fraudulent, inflation of share values. 

The intent behind stock-based compensation—to align managers’ 

and shareholders’ interests and to reward and retain high-performing executives—is noble, but anything can be destructive in excess. The meteoric rise in executive pay, especially where 

undeserved, has caused shareholders to complain that companies 

issued far too many stock options on terms that were far too generous. Options often vest too quickly, rarely include true performance hurdles, and upon exercise, shares can frequently be sold 

without restriction. 

Regrettably, Congress must take some blame for this excessive 

and at times unwarranted executive compensation. We changed the 

rules. In 1993, as the Chairman mentioned, Congress attempted to 

rein in executive pay by enacting Section 162(m) of the Tax Code. 

This section limits to $1 million the tax deductions companies can 

take for salaries of their top executives. Congress did not, however, 

extend this cap to stock option pay, and almost immediately companies shifted to this fully deductible and, therefore, cheaper form of 

compensation. As a result, when the stock market booms, as it did 

during the early 1990s and the last few years, total executive compensation skyrockets, often regardless of executive performance. 

To make this point clear, consider that in 1994, 1 year after Section 162(m) was passed, the average CEO was earning $1.7 million 

in total compensation, including about $680,000 from stock option 

exercises. By 2004, CEO compensation had risen by more than 400 

percent, to more than $7 million annually. Notably, more than 

three-quarters of that compensation, or more than $5 million, came 

from stock options. In other words, Congress’ attempt to limit executive salaries had just the opposite effect. As Chairman Cox of the 

SEC, who will testify later this morning, recently told another Senate committee, Section 162(m) ‘‘deserves pride of place in the muVerDate 0ct 09 2002 10:41 Sep 24, 2007 Jkt 036611 PO 00000 Frm 00015 Fmt 6633 Sfmt 6601 C:\DOCS\36611.TXT SAFFAIRS PsN: PAT
12

seum of unintended consequences.’’ For the record, I agree with 

Chairman Cox. 

So where do we go from here? Well, the good news is the climate 

is changing. The Chairman noted that FAS 123R is in place. It has 

provided some long overdue reform. Before it became effective in 

2005, accounting rules—contrary to economic logic—did not require 

companies to report the cost of stock options to investors, but under 

the new rule, companies must now subtract the total value of stock 

option compensation from their financial earnings. This corrects a 

longstanding and poorly conceived policy that required companies 

to hide the true cost of stock option compensation from their investors while reporting that amount to the IRS in order to claim a tax 

deduction. 

This point bears repeating. As Senator Levin noted earlier, most 

companies that report large book-tax gaps for stock options do so 

simply because different tax and accounting rules require them to 

do so. Although it is too early to assess the full impact of FAS 

123R, it is already clear that companies are issuing fewer stock options, requiring longer vesting and holding periods, and hopefully 

setting truer performance benchmarks. So it is hoped that as a result of FAS 123R, the book-tax gap should narrow. 

I am concerned, however, that while the book-tax gap for stock 

options is closing, the information gap for executive pay remains 

much too large. Too often, shareholders are left in the dark regarding how much their top executives really make. And even when 

this information is disclosed, shareholders still have little, usually 

no input into executive compensation. Equally troubling, shareholders often perceive that the so-called independent directors who 

set executive salaries have cozy relationships with the CEO, often 

to the detriment of the investors they are supposed to represent. 

In an environment that allows collegiality to trump independence, 

investor confidence can and will be undermined. 

It is, therefore, imperative that companies take steps to ensure 

that top executives’ pay is fair and deserved. In doing so, I encourage the industry that often reminds us that the market, not the 

government, should set prices to practice what it preaches. This requires that companies open their compensation decisions to shareholder scrutiny. Companies must provide clear, plain-English disclosures of CEO pay to their investors and encourage more contact 

between independent directors and shareholders. Moreover, companies should consider submitting executive pay to shareholder votes, 

or even allowing shareholders to vote on the directors themselves. 

In this way, the interaction between the investors and directors 

will take place before lawsuits and proxy fights and in the form of 

constructive negotiation rather than costly litigation. 

I should add that I am encouraged by the SEC’s new rules that 

require proxy statements to include summary tables and plain-language disclosures of top executives’ pay. But more work remains to 

ensure that investors receive full, easily digestible disclosures of executive compensation. Shareholders cannot be left to believe that 

the executive pay game is rigged against them. Executive pay must 

be determined by those it affects, and where poor performance has 

distorted compensation, companies must act quickly to put things 

13

right. If they do not, I can assure that this will not be the last congressional hearing on executive pay. 

You will note, Mr. Chairman, that my focus here is on shining 

a light on what is going on, giving investors information. I do 

worry, as we move forward, that we avoid unintended consequences, that we avoid the danger of repeating what we did in 

1993 as we moved into this area. Clearly, the gap is real. It is 

there. I would note, however, that on the total reported tax deduction, the companies take. The individual is paying taxes on that 

amount, so the government is getting some compensation there. 

When you look at some of the best-growing companies, if the market were to go down, would the proposed rule changes have the 

same effect? Or, in fact, if we have companies taking deductions up 

front and then the options never vested, would we be giving companies a tax break, a shadow tax break, for which the IRS would 

never get the revenue? 

So as we move forward, let us be clear as to what the consequences are. I do think there is a responsibility that the corporate community has not responded to. And so I thank the Chairman for this hearing, and I look forward to the testimony. 

I have two meetings that I have to attend, Mr. Chairman, but 

I will be coming back. Thank you. 

[The prepared statement of Senator Coleman follows:]

OPENING STATEMENT OF SENATOR COLEMAN 

Thank you for attending today’s hearing. I want to thank this Subcommittee’s 

Chairman, Senator Levin, for initiating this investigation and I want to commend 

him on his many years of dedicated focus on this issue. Today’s hearing continues 

your long effort to ensure that investors in America’s publicly traded companies 

have full access to important information regarding executive compensation. 

For the past 25 years, the pay checks cashed by America’s top executives have 

grown exponentially. During the 1990s in particular, executive pay exploded to unprecedented levels, and by 2002, the average American worker earned in a year 

what the average CEO took home every evening. Last year alone, CEOs at America’s 500 largest companies earned an average of $15.2 million apiece—a staggering 

increase of almost 40 percent from just the year before. 

It seems inconceivable that in 2006 CEOs earned almost 400 times the wage of 

the typical rank-and-file employee. And while it is often said that exceptional performance demands exceptional pay, it is troubling when mediocrity is rewarded with 

a king’s ransom. There are far too many examples of excessive pay for poor performance, of executives and their families receiving millions of dollars in undisclosed 

company perks, and of exorbitant severance packages paid to executives who have 

been ejected from their companies under the cloud of scandal. Such excess robs 

shareholders of earnings that are rightfully theirs and draws on the retirement savings of America’s hard-working families. 

Without a closer link to performance, extraordinary CEO pay packages threaten 

to undermine the average investor’s trust in our markets. More than 80 percent of 

Americans and 90 percent of institutional investors’including pension and retirement funds—think CEOs of large companies are overpaid. More disturbing, 60 percent of corporate directors—the very people who determine executive pay—believe 

CEOs of large companies make more than they deserve. Warren Buffet once argued 

that CEO pay ‘‘remains the acid test’’ to judge whether corporate America is ‘‘serious’’ about reform. If so, the results so far are anything but encouraging. Ultimately, 

some semblance of reality must be restored to executive pay. 

I am concerned by the widening loss of confidence in the business community. 

Charles Denny, who is a former CEO, noted in an article that ran yesterday in one 

of my home town newspapers, the Star Tribune, that ‘‘[o]ur nation’s great wealth 

is the product of free-market capitalism operating within, and ultimately governed 

by, the political system of democracy.’’ As a former CEO, Denny offers unique insight in concluding that if current corporate excesses ‘‘continue unchecked, the electorate’s support of the political/economic concept of democratic capitalism will be seVerDate 0ct 09 2002 10:41 Sep 24, 2007 Jkt 036611 PO 00000 Frm 00017 Fmt 6633 Sfmt 6621 C:\DOCS\36611.TXT SAFFAIRS PsN: PAT
14

verely tested.’’ I share Mr. Denny’s concern, and if the business community doesn’t 

do something soon, companies are going to get more pressure from the Federal Government and from Congress in particular. 

So how did we get here? Obviously, a number of factors have propelled executive 

salaries into the stratosphere. First, it cannot be overlooked that, as CEO salaries 

have grown over the past 25 years, so too has the average size of large American 

companies. Indeed, the companies that will testify today exemplify this important 

point—as they have all produced substantial increases in profits over the past 15 

years, much to the benefit of their shareholders. Moreover, the competition for highperforming CEOs is higher than ever, and the costs associated with recruiting and 

retaining top managers have bid up the compensation packages for all executives. 

That said, the pink elephant in the room is the stock option. When one considers 

the numbers that Senator Levin mentioned in his opening—that in 2004, stock options resulted in a book-tax gap of $43 billion—it becomes clear that the impact of 

stock options on executive compensation cannot be overstated. 

In fact, for much of the last 15 years, executive pay has been defined by the op- tion. In 1992, for example, S&P 500 companies issued only $11 billion in options. 

In 2000, when option compensation reached its peak, companies issued options 

worth more than $119 billion. And although somewhat abated, companies still 

issued tens of billions of dollars worth of stock options last year. 

To be clear, stock options are valuable and legitimate incentive tools. And the increased use of stock-based compensation reflects a logical attempt by publicly traded 

companies to align the self-interests of their executives with the best interests of 

their shareholders. By replacing cash with long-term incentives, stock options are 

meant to make managers think like owners and ensure that executive pay is linked 

to company performance. And, during the early 1990s, options worked as intended—

executive pay increased as shareholders profited. 

But in the overvalued market of the late 1990s, it became clear that the link between performance and pay had grown tenuous at best. As the bull market charged, 

it seemed that executives got rich just by showing up for work, and investors began 

to deride stock options as ‘‘pay for pulse.’’ Worse, executive decision making seemed 

more short-term than ever. Earnings manipulations at Enron, Worldcom, and elsewhere underscored what many investors already feared; stock options provided company managers with perverse incentives to personally profit from artificial, even 

fraudulent, inflation of share values. The intent behind stock-based compensation—

to align managers’ and shareholders’ interests and to reward and retain high performing executives—is noble, but anything can be destructive in excess. The meteoric rise in executive pay, especially where undeserved, has caused shareholders to 

complain that companies issued far too many stock options on terms that were far 

too generous. Options often vest too quickly, rarely include true performance hurdles, and upon exercise, shares can too frequently be sold without restriction. 

Regrettably, Congress must take some of the blame for this excessive, and at 

times unwarranted, executive compensation. In 1993, Congress attempted to rein in 

executive pay by enacting Section 162(m) of the tax code. This section limits to $1 

million the tax deductions companies’ can take for the salaries of their top executives. Congress did not, however, extend this cap to stock option pay, and almost 

immediately companies shifted to this fully deductible, and therefore cheaper, form 

of compensation. As a result, when the stock market booms, as it did during the 

1990s and in the last few years, total executive compensation skyrockets, often regardless of executive performance. 

To make this point more clear: Consider that in 1994, 1 year after Section 162(m) 

was passed, the average CEO earned about $1.7 million in total compensation, including approximately $680,000 from stock option exercises. By 2004, average CEO 

compensation had risen by more than 400 percent, to more than $7 million annually. Notably, nearly three-quarters of that compensation, or more than $5 million, 

came from stock options. In other words, Congress’ attempt to limit executives’ salaries has had just the opposite effect. As Chairman Cox of the SEC, which will testify 

later this morning, recently told another Senate committee, Section 162(m) ‘‘deserves pride of place in the museum of unintended consequences.’’ For the record, 

I agree with Chairman Cox, as long as that museum is the hall of fame. 

So where do we go from here? Well, the good news is that the climate surrounding 

executive pay is already beginning to change. FAS 123R, a recent change to the accounting rules for stock options, has provided long overdue reform. Before FAS 123R 

became effective in 2005, accounting rules—contrary to economic logic—did not require companies to report the costs of stock options to their investors. Under the 

new rule, companies must now subtract the total value of stock option compensation 

from their financial earnings. This corrects a long standing, and poorly conceived, 

policy that required companies to hide the true cost of stock option compensation 

15

from their investors, while reporting that amount to the IRS in order to claim a tax 

deduction. 

This point bears repeating. As Senator Levin stated earlier, most companies that 

report large book-tax gaps for stock options do so simply because different tax and 

accounting rules require them to do so. Although it is still too early to assess the 

full impact of FAS 123R, it is already clear that companies are issuing fewer stock 

options, requiring longer vesting and holding periods, and hopefully setting truer 

performance benchmarks. Moreover, although differences between the tax rules and 

accounting rules governing stock options remain, now that every option issued represents a direct hit to the company’s bottom line, the $43 billion book-tax gap that 

existed in 2004 should narrow significantly. 

I am concerned, however, that while the book-tax gap for stock options is closing, 

the information gap for executive pay remains. Too often, shareholders are left in 

the dark regarding how much their top executives really make. And even when this 

information is disclosed, shareholders still have little, and usually no, input into executive compensation. Equally troubling, shareholders often perceive that the socalled independent directors who set executive salaries have cozy relationships with 

the CEO, often to the detriment of the investors they are supposed to represent. In 

an environment that allows collegiality to trump independence, investor confidence 

is undermined. 

It is therefore imperative that companies take steps to ensure that top executives’ 

pay is fair and deserved. In so doing, I encourage the industry that often reminds 

us that the market, not the government, should set prices, to practice what it 

preaches. This requires that companies open their compensation decisions to shareholder scrutiny. Companies must provide clear, plain-English, disclosures of CEO 

pay to their investors, and encourage more contact between independent directors 

and shareholders. Moreover, companies should consider submitting executive pay to 

shareholder votes, or even allowing shareholders to vote on the directors themselves. 

In this way, the interaction between investors and directors will take place before 

lawsuits and proxy fights, and in the form of constructive negotiation rather than 

costly litigation. I should add that I am encouraged by the SEC’s new rules that 

require proxy statements to include summary tables and plain-language disclosures 

of top executives’ pay. But more work remains to ensure that investors receive full, 

easily-digestible disclosures of executive compensation. Shareholders cannot be left 

to believe that the executive pay game is rigged against them. Executive pay must 

be determined by those it affects, and where poor governance has distorted compensation, companies must act quickly to put things right. If they don’t, I can assure 

that this will not be the last Congressional hearing on executive pay. 

In closing, I would like to thank each of the witnesses that are here today. I look 

forward to your testimony.

Senator LEVIN. Thank you so much, Senator Coleman. 

Let us now welcome our first panel to this morning’s hearing: 

Stephen Bollenbach, Chairman of the Board of Directors for KB 

Home; John Chalsty, Chairman of the Compensation Committee 

for Occidental Petroleum Corporation; and William Tauscher, member and former Chairman of the Compensation Committee for 

Safeway. We welcome you to the Subcommittee, gentlemen. Pursuant to Rule 6, all witnesses who testify before the Subcommittee 

are required to be sworn, and at this time I would ask all of you 

to please stand and raise your right hand. 

Do you swear that the testimony you will give this morning before this Subcommittee will be the truth, the whole truth, and 

nothing but the truth, so help you, God? 

Mr. BOLLENBACH. I do. 

Mr. CHALSTY. I do. 

Mr. TAUSCHER. I do. 

Senator LEVIN. We are using a timing system today, and 1 

minute before the red light comes on, you will see the light change 

from green to yellow, which will give you an opportunity to conclude your remarks, and your written testimony, of course, will be 

printed in the record in its entirety. We would ask that you limit 

your oral testimony to no more than 5 minutes. 

16

1The prepared statement of Mr. Bollenbach appears in the Appendix on page 55. 

Again, we thank each of you and your companies for providing 

us with the information that we have requested. It is very important and useful to us, and, Mr. Bollenbach, we will have you go 

first, followed by Mr. Chalsty and then Mr. Tauscher. 

TESTIMONY OF STEPHEN F. BOLLENBACH,1 CHAIRMAN, 

BOARD OF DIRECTORS, KB HOME, LOS ANGELES, CALIFORNIA 

Mr. BOLLENBACH. Good morning, Chairman Levin. My name is 

Stephen Bollenbach, and I recently joined KB Home as the first 

non-executive chairman of the board. I am currently CEO of Hilton 

Hotels Corporation as well as co-chairman of the board of that company. On behalf of KB Home and its 4,500 employees nationwide 

and its thousands of subcontractors doing business with the company, I would like to thank you for the opportunity to appear here 

today. 

Before I turn to matters raised by the Subcommittee, I would 

like to introduce you briefly to KB Home. This year, we are proud 

to be celebrating 50 years of building quality homes, a story that 

began with two visionaries from Detroit—Eli Broad and Donald 

Kaufman. They established this company to serve the needs of 

entry-level housing with homes that are well designed and affordable. Fifty years later, we have developed over 1.5 million—for 1.5 

million families we have developed homes. They come from all 

walks of life, but with a focus on first-time homeowners, we have 

been able to make the dream of homeownership possible for young 

families, immigrants, minorities, and in the high-cost metropolitan 

areas of America, for teachers, nurses, firemen, policemen, and 

other folks otherwise priced out of the communities in which they 

work. Last year, about 40 percent of the families who came to KB 

Home were buying their first home, and 66 percent were minorities. Continuing our tradition of civic engagement, KB Home is the 

only national home building company to have come to New Orleans 

following Hurricane Katrina. We have made nearly a $20 million 

investment in Louisiana. 

Now let us turn from the business of KB Home and to the business of this meeting. I will speak to two issues: The accounting 

issues and the recent changes at KB Home. 

First the issues related to accounting. I want to stress that KB 

Home has no view on the accounting and tax treatment of stock options. We have taken no position on this issue, and we really do 

not expect to. We will follow whatever rules are in effect, and we 

follow them as they change from time to time. 

With that, I think the Subcommittee should understand that KB 

Home tax-books differential on the chart that we saw a minute ago 

is due to the extraordinary business performance of the company 

and the very large increase in its stock price between 2000 and 

2005. During that time KB Home’s stock price increased 600 percent. Over the same period, the S&P 500 managed to increase only 

.002 of 1 percent. If KB Home’s stock price had merely performed 

as the S&P 500 had performed, our tax-book differential would 

have been negligible. 

17

1The prepared statement of Mr. Chalsty appears in the Appendix on page 60. 

Recent corporate changes at KB Home. KB Home has made a 

number of corporate changes in the past 6 months following a comprehensive independent investigation into its stock option practices. That investigation discovered that in certain instances our 

former CEO and the head of Human Resources picked stock option 

grants using hindsight. As a result of that investigation, both our 

former CEO and the head of Human Resources have left the company. 

KB Home also restated its financial statements to reflect an additional $41 million in compensation expense plus related tax 

charges over 6 years. While $41 million is a lot of money, to put 

that number in perspective KB Home’s net income over the same 

period was nearly $3 billion. Of more importance for the future of 

KB Home, our Board of Directors took strong and swift action to 

reform the company’s compensation and governance practices. The 

board separated the position of CEO from the chairman of the 

board, eventually selecting me as KB Home’s first non-executive 

chairman. Our directors used to be elected for 3-year terms; now 

they are elected for 1-year terms. The employment agreement we 

recently signed with our new CEO embodies the best practices in 

the compensation area. 

The board made other governance changes in the process, more 

than doubling the ISS corporate governance rating. Among companies in our industry, our rating is now in the 97th percentile. KB 

Home, like other home builders, is currently operating in a very 

challenging environment. We have worked diligently to put the 

issues of the last several months behind the company. Its employees and many of its shareholders can look forward to the future, 

and so KB Home can continue helping Americans achieve the 

dream of homeownership. 

So thank you for giving me the opportunity to make this statement on behalf of KB Home, and I will attempt to answer any 

questions you may have. 

Senator LEVIN. Thank you very much, Mr. Bollenbach. Mr. 

Chalsty. 

TESTIMONY OF JOHN S. CHALSTY,1 CHAIRMAN, EXECUTIVE 

COMPENSATION AND HUMAN RESOURCE COMMITTEE, OCCIDENTAL PETROLEUM CORPORATION, LOS ANGELES, CALIFORNIA 

Mr. CHALSTY. My name is John Chalsty. I have spent most of my 

professional career working in investment banking and finance. 

From 1986 to 2000, I served as Chief Executive Officer and then 

Chairman of DLJ. In connection with my service on the Occidental’s board, I currently serve as Chairman of Occidental’s Executive 

Compensation and Human Resources Committee. I would like to 

make two important points. 

First, the Compensation Committee only grants stock options 

pursuant to plans that have been approved by Occidental’s shareholders, and the company fully discloses to its stockholders the 

granting of such stock options as required by law and regulation. 

The granting of stock options to officers and employees is a longVerDate 0ct 09 2002 10:41 Sep 24, 2007 Jkt 036611 PO 00000 Frm 00021 Fmt 6633 Sfmt 6601 C:\DOCS\36611.TXT SAFFAIRS PsN: PAT
18

standing practice well understood by the company’s stockholders, 

who have seen the management transform and refocus the company from 1990 to 2006. During that period, the company has increased core profits from $191 million to more than $4.3 billion, reduced debt by 65 percent from more than $8 billion, and increased 

its stock market value by 650 percent to $41 billion. Occidental’s 

transformation increased the oil and gas sales from 17 percent of 

total sales in 1990 to 72 percent in 2006. The use of stock options, 

which align the interests of management and stockholders, as a 

part of the company’s compensation program is not a surprise to 

the stockholders, the investment community, the regulators, or the 

public. 

Second, throughout this period the company’s treatment of stock 

options for both tax and accounting purposes complied fully with 

all applicable laws, rules, and regulations, and no one has contended otherwise. No stock options were backdated. No restated 

SEC financial statement filings have been required in the last 15 

years. 

Occidental has complied fully with all Federal, State, local, and 

foreign tax laws. The result of this compliance with the law has 

been that over the past 5 years, from 2002 to 2006, Occidental has 

paid more than $4 billion in corporate income taxes in the United 

States. In sum, Occidental is a successful U.S. company that complies fully with the law and pays substantial taxes. 

As the Subcommittee has requested, I would like to provide a 

brief overview of Occidental’s policies and procedures for granting 

stock options. Stock options are granted by the Compensation Committee, which is composed entirely of independent directors. The 

Compensation Committee may, as it deems appropriate, engage 

special legal or other consultants to report directly to the committee. 

All new stock plans and amendments to existing stock plans 

must be reviewed by the Compensation Committee before being 

submitted to Occidental’s Board of Directors for approval. In making its recommendation to the Board of Directors, the Compensation Committee takes into consideration the potential dilutive effect 

of such awards, as well as changes in compensation practices. New 

stock plans must first be approved by stockholders before they can 

be implemented. 

The Compensation Committee grants stock awards at regularly 

scheduled meetings. No stock options granted by Occidental have 

ever been backdated. 

Accordingly, the intrinsic value of the options on the date of the 

grant is zero. The plans do not permit re-pricing of options without 

the approval of stockholders, and Occidental has not re-priced any 

options. The stock options granted by Occidental vest one-third 

each year over a 3-year vesting period, are exercisable for a 10-year 

term, and are subject to forfeiture. In making grants to the executive officers, the Compensation Committee considers personal performance, industry practices, prior award levels, outstanding 

awards, and overall stock ownership in an effort to foster a performance-oriented culture and to align the interests of executive officers with the long-term interests of the company and its stockholders. 

19

1The prepared statement of Mr. Tauscher appears in the Appendix on page 63. 

Occidental complies fully with both the accounting and tax rules 

with respect to stock options. From an accounting perspective, pursuant to FAS 123R, on July 1, 2005, Occidental began recognizing 

fair-value compensation. Compensation is measured using the 

Black-Scholes option. 

With reference to Occidental’s Federal tax returns, in accordance 

with IRS regulations, Occidental has reported deductions in its corporate tax returns for non-qualified stock options in the year they 

were exercised. For non-qualified stock options, the amount of Occidental’s corporate tax deduction is the same as the amount included in taxable income by the exercising executives on their individual Federal income tax returns—that is, the difference between 

the fair market price and the option exercise or strike price. Any 

variations in these two numbers are the result of a difference between the applicable accounting and tax regulations. 

The accounting rules and the tax rules are designed to pursue 

different objectives using different approaches with frequently different results. I cannot say that one is ‘‘right’’ and the other 

‘‘wrong’’. What I can say with certainty is that Occidental has complied, and will comply, with whatever accounting and tax regulations the respective accounting and tax standard setters apply to 

the granting and exercising of stock option awards. Thank you. 

Senator LEVIN. Thank you very much, Mr. Chalsty. Mr. Tauscher. 

TESTIMONY OF WILLIAM Y. TAUSCHER,1 MEMBER AND 

FORMER CHAIRMAN, COMPENSATION COMMITTEE, SAFEWAY, INC., PLEASANTON, CALIFORNIA 

Mr. TAUSCHER. Thank you, Chairman Levin. I am William Y. 

Tauscher, and I am appearing today on behalf of Safeway. I have 

been a member of the Board of Directors of Safeway since 1998 and 

also a member of Safeway’s Executive Compensation Committee 

since 1998. I served as Chair of the Executive Compensation Committee from 1998 until 2006. Besides being a Safeway Director, I 

am the Chairman and Chief Executive Officer of Vertical Communications, a public communications technology company, and I have 

previously been Chairman and Chief Executive Officer of Vanstar, 

a national computer services company, and before that Chairman 

and Chief Executive Officer of FoxMeyer, another public nationwide health care distributor. 

Safeway is one of the largest food and drug retailers in North 

America, operating approximately 1,750 stores in the United States 

and Canada. Our revenues in 2006 were $40 billion, and we have 

about 200,000 employees. We have received a number of national 

recognition awards in environmental sustainability and social responsibility. We received a corporate governance rating of 93.1 

from Institutional Shareholder Services. The company has also 

been instrumental in advancing important public policy discussions. Safeway has recently taken a lead position among American 

businesses to advance health care reform, building a coalition of 

nearly 50 large companies. 

20

Our compensation program has been instrumental to our success. 

Safeway’s Executive Compensation Committee has designed its 

compensation program to attract and retain the best management. 

Our compensation program closely links the compensation of company executives with the company’s financial performance and substantially aligns that compensation with the long-term interests of 

the shareholders. Because of that linkage, our board has been able 

to retain for nearly 15 years one of the best CEOs in corporate 

America. 

Under Steve Burd’s leadership, the company has outperformed 

97 percent of the companies listed in the S&P 500 over the last 

14.5 years he has served. The compound annual growth rate of 

Safeway’s stock price over this time period, at 19.8 percent, has 

been twice that of the S&P 500. Safeway has outperformed many 

outstanding U.S. companies during this period. From 1992 to 2006, 

the company’s market capitalization increased from $1.3 billion to 

$15.2 billion. The Company’s annual earnings per share during 

that period increased from 9 cents to $1.94. These are extraordinary accomplishments considering the maturity of the sector and 

the nature of its competition. This has been accomplished, by the 

way, while helping the communities we serve by donating or raising more than $1.25 billion in cash or goods, or 18 percent of net 

income, to charitable organizations. 

The company’s recent performance has been excellent. In 2006, 

the return on investment in our stock was 47 percent, about 3 

times the 15.8 percent return experienced by the S&P 500. An article in Bloomberg News last month noted that Safeway’s performance since 2004 was better than 75 percent of the companies in the 

S&P 500, and in 2006 was in the 94th percentile. 

We compete with a peer group of companies and numerous other 

companies for executive talent and, therefore, we need to pay, we 

believe, at market levels. The task for the Compensation Committee is to keep an eye on compensation levels at comparable companies and determine how to reward for extraordinary results. At 

Safeway, the Committee intentionally sets executive salary levels 

below market and uses bonuses and stock options to provide compensation slightly above competitive norms when the company performs well. Even given the recent success of the company, Mr. 

Burd’s compensation has been within the lower range of large companies in the United States. In fact, his total compensation ranks 

in the bottom 10 percent of the companies in the S&P 100—we are 

about in the middle of that group from a size standpoint—and his 

equity compensation ranks in the bottom 5 percent of that group. 

Because of the company’s success over the past 10 to 15 years, 

Mr. Burd’s stock options have increased in value, and he has been 

rewarded along with other investors in Safeway’s stock. Unlike 

many other CEOs, Mr. Burd behaved like a long-term stockholder, 

typically holding his options until the end of the option period—historically, 10 to 15 years. By doing so, he has missed out on opportunistic peaks in the share price. This practice has also caused options to produce gains at a single point in time rather than spread 

out over many years, and these gains may not coincide with good 

performing years for the company. For example, Mr. Burd’s 2003 

and 2004 option exercises occurred at relatively low price points for 

21

the company’s stock. This was not an opportune time to exercise, 

but the terms were expiring. When looking at these blocks of exercised options, it is important to consider them as 10-year compensation instruments and not associate them with 1 year’s performance in the year of exercise. 

Much of the criticism leveled at executive compensation these 

days relates to extraordinarily large severance packages that are 

given to CEOs upon their departure. Safeway is proud of the fact 

that none of its executive officers has an employment contract or 

a severance agreement. The CEO and other executive officers serve 

at the will of the board. If our CEO was terminated for any reason, 

we would have no obligation to pay him any severance. 

With respect to the accounting rules, Safeway adopted FAS No. 

123R, the accounting rule governing the expensing of stock options, 

in the first quarter of 2005. With the advice of expert consultants, 

Safeway has used the Black-Scholes methodology for valuing options for expense purposes, by far the most commonly used methodology for this purpose. 

We understand the Subcommittee is examining several issues at 

this hearing, including how a company’s accounting expense for 

stock options, determined using Black-Scholes or other options 

valuation methodologies, compares with the tax deductions a company takes when those options are exercised. We have three quick 

principal observations. 

First, we believe any evaluation of the accounting expense for 

stock options should appropriately focus on all option grants, not 

merely option exercises. A snapshot comparing the accounting expense for exercised stock options to subsequent tax deductions for 

specific option exercises will result in a distorted picture. For example, such a comparison will not account for the expensed amounts 

on options that are never exercised because they expire with the 

exercise price higher than the company’s current stock price. Thus, 

such a snapshot might exaggerate what seems, at first, to be a disparity between the accounting expense and the tax deductions. 

Second, we believe the Subcommittee should assess this issue 

across a broad range of companies. The disparity between accounting expense and tax deductions will be greatest in companies that 

have outperformed their historical performance, like the group 

gathered here. By contrast, the accounting expense may significantly exceed tax deductions in companies that have underperformed their historical performance. A more accurate assessment of 

this issue requires an examination of numerous companies—

outperformers and underperformers. 

Finally, third, the Subcommittee, we believe, should not view the 

exercise of an option in a particular year as compensation simply 

for that year. When an option is exercised, the executive will receive the benefit of the appreciation in the value of the stock since 

the grant of the option. This may represent compensation for the 

executive’s service for many years, possibly a decade or more, especially when the executive exercises the option at the end of the option period. As I have already commented, the extraordinary 

growth in Safeway’s stock value from 1992 through 2006 resulted 

in a very significant value for options granted early in that period. 

22

1The chart referred to appears in the Appendix on page 236. 

This extraordinary increase in value is properly viewed as the result of more than 10 years of effort to improve stockholder value. 

I hope Safeway’s participation today helps illuminate these accounting and tax policy rules for the Subcommittee, and I stand 

ready to answer questions. 

Thank you, Mr. Chairman. 

Senator LEVIN. Thank you, Mr. Tauscher. Let me start with you, 

Mr. Tauscher, and work the other way. Take a look at Chart 1,1

if you would, in your book. According to the data that Safeway provided to the Subcommittee, the total amount deducted by Safeway 

on its tax returns for stock options exercised by the chief executive 

officer between 2002 and 2006 was $39 million. Is that figure accurate? 

Mr. TAUSCHER. Yes, Mr. Chairman, it is. 

Senator LEVIN. And because the options exercised in those years 

were granted before accounting rules required an accounting expense to be taken on your books, the company took no book expense for any of those options at that time. Is that correct? 

Mr. TAUSCHER. Yes, Mr. Chairman, that is correct as well. 

Senator LEVIN. Now, your company also did a computation at the 

Subcommittee’s request—and we appreciate your doing so—of what 

the expense would have been booked for those options if the new 

Financial Accounting Standard had been in effect during those 

years, and the total book charge would have been about $6.5 million. Is that correct? 

Mr. TAUSCHER. That is also correct. 

Senator LEVIN. All right. So in your case, options with a $6.5 million book expense under today’s rules would produce a tax deduction six times that amount. Is that correct? 

Mr. TAUSCHER. That is correct. 

Senator LEVIN. Now, in the Occidental Petroleum case, Mr. 

Chalsty, the options granted to your CEO would have caused a 

book expense under the new rules of about $29 million and ultimately generate total tax deductions for the company on exercise 

of those options of about $353 million. Is that correct? 

Mr. CHALSTY. Yes, sir. 

Senator LEVIN. And the deduction is about then 12 times the 

book expense. Is that correct? 

Mr. CHALSTY. Yes. 

Senator LEVIN. Mr. Bollenbach, KB Home’s CEO exercised stock 

options between 2002 and 2006 that the new accounting rules 

would have required to be expensed on the company books at a 

total of $11.5 million while the tax rules allowed it to deduct almost $144 million or over 12 times the book expense. Is that correct? 

Mr. BOLLENBACH. Yes, sir. 

Senator LEVIN. Let me ask each of you whether or not at the 

time you award options and issue these options you are aware of 

the fact that there is a potentially greater tax deduction available 

to the corporation than the book value of those options. Is that 

something you are aware of, Mr. Bollenbach? 

23

Mr. BOLLENBACH. Yes. We understand the rules both from the 

accounting standpoint and from the tax standpoint, we understand 

that they are different and there will, therefore, be differences. 

Senator LEVIN. And that there is at least a potential—and you 

hope a great potential because you hope the company will be profitable—that the tax deduction that will be available will be significantly greater than the book number that is shown? 

Mr. BOLLENBACH. I think that what the company and the directors think about is that they need to comply—and they have no 

choice. They need to comply with two sets of rules, and that is simply the result of the set of rules. I do not think there is any other 

thoughts around that. 

Senator LEVIN. So you are not aware of the fact when you issue 

options that if the company does well, which is your hope, that you 

will have a significant tax deduction upon the exercise of those options? That is not something you think about, a tax deduction for 

your own company? 

Mr. BOLLENBACH. It is not something that I would think about 

in the context of the stock options, but I agree with you that, given 

what you have said, if the company performs well and its stock 

goes up, then there will be potentially a tax deduction that is larger than the accounting charge that was booked. Yes, I am aware 

of that. 

Senator LEVIN. But you are saying that is not something that 

goes through your mind when you decide to issue large numbers 

of stock——

Mr. BOLLENBACH. It is not in my mind, it is not a tax planning——

Senator LEVIN. Is it, as far as you know, in any of the company 

personnel’s mind? 

Mr. BOLLENBACH. I do not know what is——

Senator LEVIN. You do not know. Mr. Chalsty, is that something 

in your mind? 

Mr. CHALSTY. No, it is not, and I do not know if it is in any others’ minds. I am aware that any reported—any excess of tax deduction of total expense is, of course, offset by the recipient, who pays 

taxes on exactly the same amount. 

Senator LEVIN. So in terms of the company tax bill, you are saying that the award of stock options in large numbers that could potentially and hopefully from a company’s perspective, because it 

wants to be very profitable, result in a large tax deduction but 

without any similar number being taken from the bottom line on 

the books is not something which goes through your mind? 

Mr. CHALSTY. No, it does not. We are a Compensation Committee. 

Senator LEVIN. All right. Mr. Tauscher, is that something which 

goes through your mind? 

Mr. TAUSCHER. I can honestly tell you that in all the time of 

doing this, I have never thought about the tax deduction as some 

kind of corporate benefit for what we are doing. We literally are 

trying to design a program first that we test against market; second, we hope the company outperforms and the option outperforms. 

There is no question, though, that under the current way the rules 

work, if the company outperforms, as these three companies have, 

24

there will be a larger tax deduction than the book accounting that 

is set now under the new FASB rules. That is just a fact. 

Senator LEVIN. Are you aware——

Mr. TAUSCHER. When we sit and plan for that, we are not sitting 

and talking about a great tax deduction. We are talking about motivating a chief executive for a great result. 

Senator LEVIN. I am sure of that. But is there not a secondary 

benefit, a huge benefit, in terms of tax deductions for the company 

if the company performs well? The more profitable a company is, 

the more its stock goes up, the more valuable that stock option is 

when it is cashed in, the greater the tax deduction instead of taxes 

being paid commensurate with greater profitability as to the stock 

option. I know companies pay taxes based on profits, but the exercise of that option reduces the taxes, and the greater the profits, 

the greater the number of options, if they have been issued, the 

greater the deduction. 

Mr. TAUSCHER. All of that is absolutely true, Mr. Chairman. The 

only comment I would add to that is I do not think we look at it 

terribly differently than if there was some kind of incentive bonus 

program that was paid in cash, the company did very well, the employee would get a cash bonus, the cash bonus would be deductible, 

the employee would pay tax on it. So the same thing is happening 

here. 

Now, whether that is causing a certain behavior, I can only tell 

you again it is not contemplated as part of the activity that is going 

on here. 

Senator LEVIN. Have you ever issued bonuses in this amount, 

cash bonuses contingent——

Mr. TAUSCHER. No, I have not. 

Senator LEVIN. Contingent on performance. 

Do you, Mr. Chalsty, if cash bonuses contingent on performance 

have ever been issued in this amount? 

Mr. CHALSTY. No, we have not. 

Senator LEVIN. Mr. Bollenbach. 

Mr. BOLLENBACH. I am not aware of them. 

Senator LEVIN. Thank you. Senator Coleman. 

Senator COLEMAN. Thank you, Mr. Chairman. 

I want to focus, if I can, on transparency, but I want to go back 

to Mr. Tauscher’s comments first. 

In effect, in 1993 when Congress limited compensation to the $1 

million figure, stock options really then became the preferred 

choice of compensation. Would you agree that the growth in stock 

options or the use of stock compensation was a direct result of the 

law in 1993, which basically allowed you to issue options that did 

not show up on the company’s books at that point in time as any 

expense, but at the same time it was a way to provide, obviously, 

compensation for executives and it worked out rather well? Is there 

any question about cause and effect between 1993 accounting 

changes and the growth of stock options? 

Mr. TAUSCHER. Well, Senator Coleman, I do not draw as direct 

a connection, though I will say to you, without question, that when 

the base salary all of a sudden had limits in terms of tax deductibility and the other forms of compensation did not, I am sure that 

it had an effect. I am not sure it was sort of a direct thing where 

25

people said, OK, we have to issue a lot more stock options now because we have a limit on base salary. But it had to have some connection, without question. 

Senator COLEMAN. And in part of your fiduciary responsibility, 

you want to show growth in the company. If there are those things 

that are going to impact perceived growth and you can legally 

avoid that, there is no nefarious purpose here. We simply set in 

place a process that limited executive compensation in one area, 

but did not limit it in the other, and if you want to compensate 

people, I presume you followed the law. Is that right? 

Mr. TAUSCHER. That is right. But I think there is also a factor 

here that stock options tend to make executives look longer term. 

They are more strategic. They align them more, at least in the view 

of our Compensation Committee, with the shareholders as opposed 

to short-term compensation. Of course, base salary has no incentive 

or no performance part to it. So I think there was some of that at 

work as well. 

Senator COLEMAN. And I think we are in agreement here, but I 

will express my concern that we are only looking at high-performing companies here. We also have to look at options that are 

not exercised. Among the proposals that folks have looked at is to 

equalize book value and tax value in year one, so companies would 

get their deductions right up front. But then in the end, if the options are not exercised, if the stock goes down, your company would 

have received a deduction but the IRS would have nothing because 

they are never getting taxes from the executive on option’s if they 

are not exercised. They are not getting any tax revenue from that. 

So that would be a concern, which you mention in your point about 

bringing all the companies in to the equation. Here we have highperforming companies. They have done well. We have this graph. 

And clearly these companies have outperformed and have strong 

performance. If you bring in a low performer, however, one whose 

options are not exercised, then, in fact, IRS, the government, would 

lose in that example. 

So I understand, and I am very concerned about this law of unintended consequences. I really do believe that in 1993 we made a 

mistake. And in the zeal to say we are going to put a lid on executive compensation, it is kind of like squeezing a balloon. You 

squeeze it on one end, and it pops out on the other. 

On the other hand, I am deeply concerned about the public perception of executive pay. You have all these stories of, as I said before, pay for pulse, not pay for performance. So to me the issue becomes one of transparency. Can we get investors more involved in 

these things? Can we do things to heighten the level of public confidence? Because I think there is a consequence if we lose that public confidence. 

Congress is considering a bill that would require publicly traded 

companies to give shareholders an advisory vote on corporate compensation committees. I have read that a number of companies are 

out in front of this proposed legislation and are already considering 

adopting such proposals voluntarily. To all three of you gentlemen, 

have your companies considered doing so? Why or why not? Mr. 

Bollenbach. 

26

Mr. BOLLENBACH. We have looked at that and have not adopted 

that at this point. I think if it becomes a general practice of industry we would adopt such a policy. 

Senator COLEMAN. Any benefits or negatives to it? What is your 

reaction to it? Rather than just following the herd, is there a sense 

that this would be a positive or negative? 

Mr. BOLLENBACH. Well, for me, personally, I think it has both 

the potential to be positive in terms of making more public the 

compensation, and it has the possibility of being negative because 

I am concerned about special interest groups that really do not represent the shareholders, might have a very small holding and be 

vocal at meetings and vote against it. So I think it has both potential for good things and bad things. 

Senator COLEMAN. Mr. Chalsty. 

Mr. CHALSTY. We have not adopted that. We have, however, 

looked at it, and we are also, as Mr. Bollenbach says, holding a 

watching brief, if you will, on what happens. I do not really see 

that too much is to be gained by it, but we will watch and see what 

happens. 

Senator COLEMAN. Mr. Tauscher. 

Mr. TAUSCHER. I think we are pretty much in the same position, 

Senator. We do have a practice, however, that we have initiated in 

the last few years of going out to our largest shareholders and informally talking about aspects of our various compensation programs, and that does help in that you can get specific discussions 

on specific issues rather than sort of a broad reach thing that may 

be difficult to interpret. We have found that to be a good practice. 

Senator COLEMAN. My last comment in this round. My sense is 

that folks are cautious and kind of seeing which way the herd is 

going. I would urge you gentlemen to figure out a way to get ahead 

of the pack, because Congress will herd you in a direction because 

the shareholders, our constituents, are upset. They cannot understand these widening gaps. They cannot understand the pay-forpulse mentality. And I would urge you, rather than kind of see 

which way the wind is blowing, to figure out the direction we can 

move in to provide greater transparency. And I think it would be 

very helpful. Thank you, Mr. Chairman. 

Senator LEVIN. Thank you. I think each of you has said that the 

potential tax savings are not a factor in terms of the number of options that you would grant. Is that correct? I think each of you said 

that is not a factor. 

Mr. CHALSTY. Yes. 

Mr. TAUSCHER. Yes. 

Mr. BOLLENBACH. Yes. 

Senator LEVIN. Would you then have no objection if the tax rules 

were changed so that the tax deduction were the same as the book 

value? 

Mr. BOLLENBACH. Well, for us we do not really have an opinion 

on that, and——

Senator LEVIN. So you would not object if the law were changed? 

Mr. BOLLENBACH. No. We really would simply follow the law. 

Senator LEVIN. But you would not take a position as to whether 

or not the law should be changed? 

27

Mr. BOLLENBACH. No. I just truly think that is what the government does, is it sets these policies, particularly in the area of tax, 

and companies follow the law. 

Senator LEVIN. Well, I know that you will follow it, but you 

would not have any position or objection to our changing the law 

to put in sync the book value and the tax return value? 

Mr. BOLLENBACH. As a company, no. 

Senator LEVIN. Mr. Chalsty. 

Mr. CHALSTY. Chairman, I think we would have no objection either. We would follow the law. But I am curious as to exactly how 

you would do that. Are you saying that the companies would pay 

tax—would have to declare it and would not get the tax advantage 

while the recipient would still pay taxes? 

Senator LEVIN. Sure. 

Mr. CHALSTY. Now, it seems to me there is double counting 

there. 

Senator LEVIN. But in terms of the taxing of the corporation, putting aside tax policy, you would not object from a corporate point 

of view? 

Mr. CHALSTY. I understand the effect on the corporation, but on 

tax as a whole, it seems to me with the individual paying taxes on 

the award that is given and a company not getting a tax write-off, 

it seems to me that in the total package, there is double counting 

of taxes. 

Senator LEVIN. I would disagree with you because the person 

who is selling his stock, buying and selling his stock, is getting that 

money from a different source, not from the company. So I would 

disagree with you on that. But in terms of your company’s position, 

you would not object if the tax law were changed so that your tax 

deduction was the same as you showed on the books? 

Mr. CHALSTY. I can only state again the company would follow 

the laws as written. 

Senator LEVIN. I know, but in terms of lobbying Congress, if we 

were looking at that, would your company take a position for or 

against that change? 

Mr. CHALSTY. Chairman Levin, I cannot speak for the company 

as a whole. 

Senator LEVIN. Fair enough. Mr. Tauscher, do you have any objection if the law were changed to put in sync the value on the 

books with the tax deduction amount? 

Mr. TAUSCHER. I think I would echo something I heard Senator 

Coleman say. I would want to make sure that there had been a 

fairly comprehensive look at the way the numbers really work in 

matching book expense to tax expense. Generally speaking, I think 

matching book and tax expense is a good thing. So I am not personally opposed to it—we would certainly follow whatever rules were 

asked, as the other two gentlemen said. 

But I do think, as I said in some of my comments, it is very important to work with some of the data here because I am not sure 

that when you work with the data comprehensively, look at options 

not expensed, etc., it will turn out in quite the same way that the 

macro numbers that we are talking about here today imply. 

Senator LEVIN. Well, I think that may be—we do not know what 

the macro numbers will turn out to be because we do not have the 

28

finished product yet from the IRS. We got part of it and we are 

very grateful for it, but it surely suggests something very strongly, 

which is that there is not only a gap between the book value for 

stock options that is taken at the time of the grant, but there is 

an overall significant gap—we do not know precisely how much—

between that amount and the amount that is shown on tax returns 

by corporations. And my question is whether or not all of you who 

seem to say, well, this is not a factor in your compensation, which 

is—I take your testimony and there is no basis to disagree with 

you. I am not on a compensation committee. But I would think that 

any corporation would consider the possibility that if it grants a 

whole bunch of stock options and hoping its profits go up, by God, 

we are going to get a huge tax deduction as well. Our executives 

are going to do very well if our stock price goes up—that is the intent—and we get a big tax deduction as a result. Wow. How many 

times does that happen? 

I will take your word for it. It is not a factor that goes in your 

mind, but I think the opposite side of that is what you testified to, 

Mr. Bollenbach. You just would not mind if we changed the law to 

make sure that the tax deduction is no different from the book 

amount. And I think that follows logically, and, Mr. Chalsty, your 

point is perfectly appropriate, that the person receiving all the 

money when he sells his stock pays taxes which are larger than the 

corporation got as a tax deduction. I would disagree with your conclusion, but it is a fair question. And, Mr. Tauscher, your point is 

certainly fair that you have to look at the overall picture, which we 

do not quite have. We do not know, for instance, how many corporations would then get a tax deduction for options which are 

never exercised because the value goes down. We know there are 

some of those, by the way. We do not know the amount. But given 

what has gone on at least recently, we would know and believe 

that it would be a significant amount. There would be a significant 

gap which would remain, perhaps not as big percentage-wise because of the reasons Senator Coleman gave. Some stock value obviously goes down and options are not exercised at the end. But, 

nonetheless, the company got a deduction up front based on BlackScholes or whatever, so that is a legitimate point as well. 

But the key point, which I hope Congress will look into, is this 

gap, and this is a group—we do not know if it is exactly that big 

or this big until the IRS finishes with all of its data. But when it 

does finish with its data, we will have an idea as to whether it is 

that big or this big. But it is there, and it represents both a loss 

to the Treasury, but also it represents a fueling of this gap between 

executive pay and the average worker, which has gone up now to 

an amount that no one believed it could ever reach. 

You have all been very helpful. You have been forthright. We are 

grateful to you. We are grateful to your companies. We are glad 

you are profitable. And we appreciate your testimony and your 

being here today. As I pointed out—and I think everybody appreciates that this is a case where what is being done is legal. We are 

not looking into something which is illegal. And we particularly appreciate people showing up with a risk that it will be misunderstood, that what we are doing here would be misunderstood. We 

hope it will not be misunderstood. We are looking at a current tax 

29

law which has a bizarre feature in it which we think needs. I do 

not want to speak for any other Senator, but which I think needs 

to be changed. 

Senator Coleman, do you want to add anything? 

Senator COLEMAN. Yes, just very briefly. First of all, I want to 

make clear, Mr. Chairman, that I am not sure in the end we will 

be in the exact same place on what we do legislatively, but I think 

this issue has to be looked at. I applaud your putting this hearing 

together. There is a lot of concern out there in my State about this 

issue, and so I think we have got to deal with it. 

Just very quickly, Financial Accounting Standard 123R is just in 

effect. Has that at all changed—are you changing your view of 

using stock options? Can you look into the future a little bit for me 

and talk to me about the use of stock options as compensation pre123R versus post FAS 123R? Mr. Tauscher. 

Mr. TAUSCHER. Well, I can only tell you that we are seeing data 

from various research firms that are being served up as a part of 

our practice with the Compensation Committee that says stock options have fallen now as amount issued by almost 30 percent. So 

given we are following market, that is a guideline that we are trying to do to retain executives. There is no question it has had an 

effect we have not seen yet, and given the timing of these options 

issued being previously granted years ago and the new FAS 123 effect just really starting, I think we are going to have some changes 

in these numbers as we go forward given the data we are seeing 

so far. 

Senator COLEMAN. Mr. Chalsty. 

Mr. CHALSTY. We are having a change in the allocation of stock 

options, but the change is really because of the dilution effect of 

stock options. We looked at it, and we have felt that the stock options are providing significant dilution to the number of shares. So 

they are being changed for performance-related stock, and that has 

the effect of not increasing the dilution, but it also has the effect 

of putting essentially all of the management’s compensation at risk 

for performance, which we think has been very good. 

Senator COLEMAN. Can you give me a sense of the scope of the 

change in terms of use of options? 

Mr. CHALSTY. Well, options have been reduced. In fact, options 

as such have been eliminated. The company awards SARs, stock 

appreciation rights which have essentially the same impact. But 

there are these performance-related awards which are—if the company meets certain criteria going forward, then the management 

will receive these awards. 

Senator COLEMAN. Mr. Bollenbach. 

Mr. BOLLENBACH. You know, I am so new to the company that 

I really cannot answer that for you today, but I would be happy 

to have it investigated and respond to your counsel or to you directly 

Senator COLEMAN. Great. Last, I would just comment again regarding my point about transparency. The SEC has rules about executive pay disclosure. I would urge all you gentlemen and others 

who are listening to look at that disclosure and work to make it 

simpler and make it clearer so your shareholders understand what 

you are paying your executives. I think there is concern about conVerDate 0ct 09 2002 10:41 Sep 24, 2007 Jkt 036611 PO 00000 Frm 00033 Fmt 6633 Sfmt 6601 C:\DOCS\36611.TXT SAFFAIRS PsN: PAT
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1The prepared statement of Mr. Brown appears in the Appendix on page 72. 

fidence, and those things that can be done to make disclosures digestible for the average investor, I think it would be very helpful 

and would be very worthwhile. 

Thank you, Mr. Chairman. 

Senator LEVIN. Thank you, Senator Coleman. And, again, Mr. 

Chalsty, thank you for raising an issue which is an important aspect of the stock option issue, which is the dilution issue, the average stockholder, by the large number of options when they are 

granted, that is an important issue. It is important to stockholders. 

It is important to us. It is not the focus of this Subcommittee, but 

it is something that we should have mentioned. And I am glad that 

you raised it. 

Thank you all and you are excused. 

Let me now welcome our second panel of witnesses this morning: 

Kevin Brown, the Acting Commissioner for the IRS, and John 

White, the Director of the Division of Corporation Finance at the 

Securities and Exchange Commission. 

Pursuant to Rule 6, as I have mentioned, all witnesses who testify before this Subcommittee are required to be sworn, and I 

would then ask both of you to stand and raise your right hand. 

Do you swear that the testimony you will give before this Subcommittee will be the truth, the whole truth, and nothing but the 

truth, so help you, God? 

Mr. BROWN. I do. 

Mr. WHITE. I do. 

Senator LEVIN. Mr. Brown, let us call on you first, then followed 

by Mr. White. Thank you for being here. 

TESTIMONY OF KEVIN M. BROWN,1 ACTING COMMISSIONER, 

INTERNAL REVENUE SERVICE 

Mr. BROWN. Good morning, Chairman Levin and, Ranking Member Coleman. I am pleased to appear before you this morning to 

discuss executive stock options and the book-tax differences between financial statements and tax returns filed by companies. 

Former Commissioner Everson met with this Subcommittee several 

times and enjoyed a positive relationship. I hope that we can continue that relationship, and I truly appreciate the important work 

that this Subcommittee and its staff have performed on behalf of 

tax law enforcement. 

Let me begin with the difference between taxable income and 

book income, the income companies report under Financial Accounting Standards. The goal of tax administration is to measure 

income and deductions in accordance with the provisions that Congress establishes in the Internal Revenue Code. The goal of financial reporting is to provide data that are comparable between companies according to applicable accounting standards. Where tax law 

and accounting standards diverge, companies sometimes attempt to 

show the smallest possible tax profit and the largest possible book 

profit. 

A divergence between tax and book income and deductions is reflected in the so-called book-tax difference for stock options. This 

book-tax difference reflects differences between the tax and acVerDate 0ct 09 2002 10:41 Sep 24, 2007 Jkt 036611 PO 00000 Frm 00034 Fmt 6633 Sfmt 6601 C:\DOCS\36611.TXT SAFFAIRS PsN: PAT
31

1The prepared statement of Mr. White appears in the Appendix on page 79. 

counting regimes. Absent additional evidence, a book-tax difference 

does not itself indicate noncompliance with our tax laws. 

Let me offer a few words about administration of our tax laws 

regarding stock options. 

First, the provisions of the code with respect to stock options, 

with several notable exceptions I will mention shortly, have generally not proven difficult for large corporations to comply with if 

they have the requisite governance and appropriate recordkeeping. 

This is true for both qualified and non-qualified stock option plans. 

Second, the IRS is generally unable to identify most stock option 

issues until a tax return is filed and an examination started. For 

executive stock options granted under non-qualified plans, these 

would be returns for the years in which the stock options were exercised, not granted, generally 1 to 10 years after the date of grant. 

As a result, stock option problems are often identified by others 

first—the media, shareholders, stock analysts, and the Securities 

and Exchange Commission. This was the case most recently with 

backdated stock options. 

Third, the IRS is not responsible for the examination of corporate 

governance with respect to executive stock options. Our role is limited to enforcement of those provisions that address how corporations and executives must treat stock options under the Internal 

Revenue Code, regardless of the motivation for or cause of the noncompliance. Where the Service identifies possible stock option or 

other executive compensation noncompliance, we attempt to deliver 

appropriate and focused examination and compliance responses. 

For example, the IRS is undertaking the review of over 180 companies with confirmed or potential issues with respect to the backdating of stock options. We are well underway with our work in 

this area and will carefully scrutinize the tax returns and other information of companies implicated in this arena. 

Notably, the Service also addressed the tax shelters that involved 

the improper transfer of stock options to family-controlled entities. 

A settlement initiative commenced in 2005 has resulted in the completion of 156 examinations and assessed taxes, penalties, and interest totaling over $211 million. 

The Service appreciates the Subcommittee’s keen interest in the 

subject of executive stock options. I look forward to answering your 

questions about the items I have touched upon as well as any other 

areas of interest to you. Thank you. 

Senator LEVIN. Thank you, Mr. Brown. Mr. White. 

TESTIMONY OF JOHN W. WHITE,1 DIRECTOR, DIVISION OF 

CORPORATION FINANCE, SECURITIES AND EXCHANGE COMMISSION 

Mr. WHITE. Chairman Levin, Senator Coleman, thank you for inviting me to testify before you today on behalf of the Securities and 

Exchange Commission on issues concerning stock option compensation. 

Let me first review the Commission’s role in this regard. The 

Commission is a neutral observer in matters relating to the form 

and amount of executive pay. As a disclosure agency, we focus on 

32

ensuring that a company’s disclosure of its compensation decisions 

and practices is sufficiently transparent so that investors can properly assess the information and reach their own conclusion. It is 

not the role of the Commission to judge what constitutes the right 

level of compensation, correct types of compensation, or to place 

limits on what is paid. 

Sir, as you know—and it has been discussed earlier today—the 

growth of equity-based compensation, particularly in the form of 

employee stock options, has been dramatic. In the use of option 

compensation, as it has increased, we have seen both abuses and 

the need for enhanced disclosure and transparency. And the Commission has been very active in that regard. 

First, our Division of Enforcement is currently investigating 

more than 140 companies concerning possible fraudulent reporting 

of stock option grants and exercises. Including the actions that 

were announced last week, the Commission has charged four companies and 18 individuals (affiliated with nine different companies) 

with improper stock option grant practices. Fortunately, future opportunities for these kinds of abusive practices have been reduced 

considerably as a result of Sarbanes-Oxley, accounting changes, 

and a number of Commission initiatives. I would like to outline 

three of those initiatives. 

The first is in 2002, following the passage of Sarbanes-Oxley, the 

Commission adopted rules requiring that officers and directors publicly report the grants of options 2 business days after the date of 

grant instead of after year-end, making backdating considerably 

more difficult. 

Second, in 2004, of course, the Financial Accounting Standards 

Board issued FAS 123R, requiring, in effect, employee options to be 

expensed commencing in 2006. 

And, third, in 2006, the Commission substantially revised its executive compensation disclosure rules effective for the current 2007 

proxy season, including many new disclosures relating to options. 

For the first time, the dollar amount of compensation attributable 

to options must be disclosed. This is the same amount that is expensed under FAS 123R. This amount must be included as part of 

the employee’s total compensation in the disclosure. Separately, 

and in addition, the full grant date fair value of option awards 

must also be disclosed. 

So those are the principal changes that have been made. I would 

like to take the remainder of my time to briefly describe how FAS 

123R changed option accounting and to contrast that with the tax 

requirements that Commissioner Brown has described. 

Dating back to 1972, under APB Opinion 25, no compensation expense was recorded for the typical employee stock option grant if 

the option was granted ‘‘at the money,’’ which is what most companies did. 

In 1995, FASB changed the rules and issued FAS 123, which permitted companies to elect either to expense options or, if they made 

certain footnote disclosures, to continue to follow APB Option 25 

and record no expense. Most companies elected to make the footnote disclosure and continue to record no expense. That was in 

1995. 

33

In 2004, of course, the FASB issued FAS 123R, which eliminated 

that election that was available under FAS 123 and generally requires the expensing of options. Under this approach, compensation 

expense is based on the option’s fair value at the date of grant and 

is recognized over the vesting period. Fair value is typically measured using an option pricing model such as Black-Scholes. 

In contrast, as Commissioner Brown has described, for tax purposes for non-statutory stock options, when an employee exercises 

an option the company is permitted a deduction equal to the option’s intrinsic value, and the employee recognizes ordinary income 

in the same amount. So that is contrasting the two sets of rules. 

Just one final observation. I know your Subcommittee is looking 

at the new aggregate Schedule M–3 data for 2004, and FAS 123R 

did not become effective for most companies until 2006. So there 

is no surprise if there is a substantial book-tax difference for 2004. 

But starting in 2006, when all companies were required to follow 

FAS 123R, presumably that tax-book difference will be less. But I 

think it is very important to realize that even when FAS 123R is 

fully implemented, there will be significant company-to-company 

differences between the book expense and the tax deduction for a 

variety of factors. You have alluded to a number of them, but I at 

least was able to list down four of them, so let me just list the four 

and then I will be done. 

First, the amount involved is calculated differently, fair value 

versus intrinsic value. 

Second, the timing of the measurement of the amount is different 

(the grant date versus the exercise date). And, thus, if you have unanticipated movements in stock price, either up or down, you will 

have no impact on the book expense but a very significant impact 

on the tax deduction, as was mentioned on the previous panel. 

Third, the period of recognition is different. It is either over the 

vesting period versus at the exercise date. 

And, fourth—and I guess one that often is not mentioned—the 

event-triggering measurement and recognition is under the control 

of a different party. It is a company decision to grant versus an employee decision to exercise, for whatever the employee’s circumstances are. 

So, Mr. Chairman, that completes my opening remarks. I would 

be pleased to take any questions. 

Senator LEVIN. Thank you, Mr. White. 

Mr. Brown, first, let me thank you and thank the IRS for performing the data analysis which we requested on the stock option 

material that is in the new Schedule M–3. Your staff was helpful 

and cooperative. We appreciate that. Would you tell us about the 

Schedule M–3 data on the book-tax difference that you have put together for us? 

Mr. BROWN. Well, roughly 31,000 companies filed Schedule M–

3s; approximately 3,000 of them showed a book-tax difference. The 

net there was about $43 billion, and as you mentioned before, Mr. 

Chairman, a small number of companies contributed to a great 

deal of that. Roughly 250 companies comprised about 82 percent of 

the book-tax difference for stock options. 

34

Senator LEVIN. Now, of the $43 billion which you indicate is the 

difference, the total book-tax difference for Schedule M–3 filers in 

2004 with respect to stock options. Is that correct? 

Mr. BROWN. That is correct, sir. 

Senator LEVIN. All right. Of the 250 companies which you say represented 82 percent of that $43 billion gap, how many of the 

250 companies represented over half? Do you have that offhand? In 

other words, our figures are that the top 100 companies represented 56 percent of the gap. Is that something that your figures 

also show? 

Mr. BROWN. Yes, that is correct. 

Senator LEVIN. All right. And the top 50 companies represented 

42 percent of the gap. Is that what your figures show? 

Mr. BROWN. Yes, sir. 

Senator LEVIN. Were you surprised to see that 250 companies 

were responsible for 82 percent of the total? 

Mr. BROWN. I do not know if ‘‘surprised’’ would be the right word. 

It certainly was a number that piqued my curiosity, and when you 

look at this, part of it is explained by the fact that the data is not 

complete yet, that this requirement is just coming online, as Mr. 

White mentioned. I would actually like to look at future years’ 

numbers before I draw a conclusion. 

Senator LEVIN. Does the $43 billion in a single year represent a 

significant differential? 

Mr. BROWN. It is a lot of money, yes, sir. 

Senator LEVIN. Even at the IRS. 

Mr. BROWN. Even at the IRS. [Laughter.] 

Senator LEVIN. Now, there are differences, obviously, which we 

have been discussing this morning, between the financial accounting and the tax reporting rules. Have your two agencies had any 

discussions either in the context of stock options or on a much 

broader level of the possibility of having consistent reporting of corporate transactions for book and tax? Have you had discussions 

about that issue? 

Mr. BROWN. I did not before yesterday. I believe our staffs have 

had some discussions about this. 

Mr. WHITE. I am not aware of any discussions other than the 

ones we have had preparing for this. 

Senator LEVIN. Do you have any conclusions or opinions on the 

subject, whether there ought to be consistent reporting? We will 

start with you, Mr. Brown. 

Mr. BROWN. I do not have an opinion on that. Obviously, we like 

both the symmetry and the precision in the current system. It is 

relatively straightforward. It is easy to administer. We like that as 

tax administrators. 

Senator LEVIN. Is the amount shown on the books now after 

FASB’s rule precise? 

Mr. BROWN. I am not an expert in Black-Scholes valuation. 

Senator LEVIN. Mr. White, is the amount that is shown on the 

books a precise amount now? In other words, once it is on the 

books, is it a precise amount? 

Mr. WHITE. Once the amount is determined at the date of grant, 

it remains fixed. 

Senator LEVIN. Would you say ‘‘fixed’’ is the same as ‘‘precise’’? 

35

Mr. WHITE. Yes. 

Senator LEVIN. All right. So that once the method is utilized and 

the dollar figure is determined, it is a precise figure and it is on 

the books. Is that correct? 

Mr. WHITE. That is correct. 

Senator LEVIN. And you are interested in precision, aren’t you, 

Mr. Brown? 

Mr. BROWN. Yes, sir. 

Senator LEVIN. Is that a precise figure, then? 

Mr. BROWN. Obviously, our agents would have to educate themselves about Black-Scholes and the other methods for——

Senator LEVIN. No, not how it is reached, but is the figure that 

is on the books a precise figure? 

Mr. BROWN. I will take his word for it that it is precise, yes. 

Mr. WHITE. I might clarify that in some cases companies follow 

the liability method and you could have a variable number. 

Senator LEVIN. Right. I understand. But whichever method is 

used, after the method is utilized, there is a specific figure that is 

put on the company’s books. Is that correct? 

Mr. WHITE. That is correct, sir. 

Senator LEVIN. OK. And that would be precise from your definition of ‘‘precise,’’ Mr. Brown? 

Mr. BROWN. Yes, sir. 

Senator LEVIN. Are stock options the only kind of compensation 

that you are aware of, Mr. Brown, where the corporation gets to 

deduct more than the expense shown on its books? 

Mr. BROWN. Yes. 

Senator LEVIN. In those cases where the price of the stock that 

is sold after the exercise of the option is greater than the price that 

is shown on the books, that is what we are referring to. 

Mr. BROWN. They are the only ones that I am aware of. 

Senator LEVIN. And we do not know whether that represents 60, 

70, 80, or 90 percent. It would depend on the stock market and a 

lot of other things. Is that correct? 

Mr. BROWN. Yes. 

Senator LEVIN. But in your analysis that you have done of that 

1 year, that seemed to represent a significant percentage of the 

gaps. 

Mr. BROWN. Yes. It is the third largest number behind depreciation and reportable transactions. 

Senator LEVIN. All right. Senator Coleman. 

Senator COLEMAN. One of the questions that comes up is the 

valuation models with Black-Scholes or binomial lattice models, 

kind of the two used most often? 

Mr. WHITE. Yes, they are. 

Senator COLEMAN. Is your sense, Mr. White, that they provide an 

accurate—we have looked at, obviously, some of the figures provided by the Chairman, and clearly there is a question whether 

these are accurate means of estimating option values. Have you assessed the accuracy of these SEC-approved valuation models? Are 

there other options that are out there? 

Mr. WHITE. ‘‘SEC approved’’ is probably not exactly the terminology I would use. FAS 123R was a rule that came about through 

the deliberative process that occurs at the FASB, which is an indeVerDate 0ct 09 2002 10:41 Sep 24, 2007 Jkt 036611 PO 00000 Frm 00039 Fmt 6633 Sfmt 6601 C:\DOCS\36611.TXT SAFFAIRS PsN: PAT
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pendent standard setter which is overseen by the SEC. Obviously, 

FASB went about this process over a substantial period of time and 

came to the conclusion that using a model is an acceptable way of 

doing this. Black-Scholes is the model that has emerged as the 

most common one. 

Senator COLEMAN. Companies have flexibility, as I understand it, 

in choosing the model. They do not have to use Black-Scholes. They 

can use something else. Is there some value, some benefit, in requiring all companies to use the same valuation model? Or is there 

some concern that standardization would result in less disclosure? 

Why the flexibility? And is there an issue with standardization? 

Mr. WHITE. Again, the rules were set by FASB here, and given 

in this world where I think we are focused on principles-based accounting, their decision to provide some latitude in terms of the 

method would seem to make sense. 

What FASB said was that the best choice would be a model that 

looked at a market-based instrument that was similar or the same 

as the options. But if that is not available, then you should look 

at a model that met—there were a number of criteria that are listed in the rules that the model needs to meet, and Black-Scholes 

and the lattice model in most circumstances meet those criteria. 

But, I mean, certainly the rule gives you some flexibility to choose 

the method. 

Senator COLEMAN. One of the things that we do not have in front 

of us, because we do not have the data yet, is the impact of this 

gap, tax-book gap, post-FAS 123R. Do we have any sense as to 

whether most publicly traded companies report similar gaps once 

FAS 123R is in effect? Do we have any data as to—and, again, it 

is early, but can you give us a sense, perhaps Mr. Brown, or even 

Mr. White, of where we are going with post-use of FAS 123R? 

Mr. BROWN. We do not have any data to offer, anything more 

than just a guess. 

Senator COLEMAN. As I listened to the data from the Chairman, 

if I am correct, 82 percent of the gap comes from 250 companies. 

I think you indicated that the $43 billion results from a survey of 

3,200 companies, so there are about 3,000 companies that have—

82 percent from 250, so 18 percent results from the rest, the 3,000 

companies. My sense is that the book-tax gap is not as large for 

a large number of companies that issue stock options even before 

FAS 123R. And, again, I am trying to get a sense of where we are 

going to be after FAS 123R. 

Mr. BROWN. I think one of the problems was the rule was not—

it is just coming online, so it is difficult to predict. 

Senator COLEMAN. What do you do with the issue—one of the 

concerns that I—again, look back, and my sense is that the 

changes that we made in 1993, in Section 162(m) which capped 

companies’ deductions for salaries paid to top executives, caused 

companies to switch from cash to stock option compensation. They 

are giving compensation—the value of the company is not diminished in terms of an SEC perspective, though there are these obligations out there. And yet those are real obligations. In the end, 

when they capitalize on those obligations, this huge benefit to the 

individual, and also benefit to the company by way of the deducVerDate 0ct 09 2002 10:41 Sep 24, 2007 Jkt 036611 PO 00000 Frm 00040 Fmt 6633 Sfmt 6601 C:\DOCS\36611.TXT SAFFAIRS PsN: PAT
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tion. So that is the world that the Congress created with Setion 

162(m). 

My concern is as we go—if the solution is one in which we kind 

of cap—equalize tax value and book value early on, for instance, in 

the scenario if the market is not rising and, in effect, we give deductions up front based on what we project equalizing tax and book 

value, and if options are not exercised or if there is a diminution 

of stock price, what happens in terms of monies coming to the IRS? 

Mr. BROWN. Well, you would have the deductions claimed in the 

years during the vesting period, and you would not have income 

recognized by the employee on the back-end if the stock was not 

in the money. 

Senator COLEMAN. So you would have shadow deductions. You 

would have deductions taken with the company, in effect, not giving anything to the—they would get the value of the deduction but, 

in fact, not submitting anything to the IRS. 

Mr. BROWN. You would lose the symmetry there. 

Senator COLEMAN. So how do you account for that? How do you 

find a system that does not have that problem? 

Mr. BROWN. Well, the current system does not have that problem 

because you match exactly the income with the deductions. 

Senator COLEMAN. Again, I keep wanting to get back to disclosure, disclosure, disclosure, disclosure. 

Last question, Mr. White. The SEC has provided new proxy disclosures. How satisfied are you with them? Could we push the envelope on proxy disclosures? 

Mr. WHITE. Well, the new disclosures are just coming in, in the 

month of—in April, May, and June, so in terms of a thorough analysis of them, we are just starting that process, actually in my division. But as a general matter, I think we are optimistic and 

pleased. 

One of the concerns that has been expressed is one that you have 

alluded to several times this morning of how well people have done 

in following plain English and in clarity in writing the new disclosures. I know Chairman Cox has commented on that as well, that 

is probably an area that is going to require a little bit of work, and 

is one of the things we are looking at. 

But I think as a general matter, just as a preliminary look, we 

are pretty happy with what has come in. 

Senator COLEMAN. We look forward to working with you on that 

issue. It is important. We have seen it with our review of credit 

card companies and disclosures to individuals there, and, again, 

concern to the average shareholder. I think they are at a substantial disadvantage today with the lack of easy access to information, 

so hopefully this will be a step in the right direction. 

Thank you, Mr. Chairman. 

Senator LEVIN. Thank you. Mr. Brown, under the current FASB 

system, when options are granted to employees, the companies take 

an expense now. Is that correct? 

Mr. BROWN. That is correct. 

Senator LEVIN. And that is true whether or not the employee 

gets any benefit from it at all. For instance, if the stock becomes 

worthless, the employee would get no benefit whatsoever? 

Mr. BROWN. That is correct. 

38

Senator LEVIN. Do you support the FASB rule? 

Mr. BROWN. It is sort of out of my province. 

Senator LEVIN. Mr. White, do you support the FASB rule? Does 

SEC support the FASB rule? 

Mr. WHITE. The SEC believes that the FASB has gone through 

the appropriate deliberative process to pass the rule, and we have 

reviewed that as they have gone along, and through our oversight 

role of the FASB in this regard, we are satisfied. 

Senator LEVIN. OK. So assuming that it is a satisfactory rule 

now, Mr. Brown, it does result in the company being able currently 

to take an expense. Is that not correct? 

Mr. BROWN. That is correct. 

Senator LEVIN. On its books. 

Mr. BROWN. That is correct. 

Senator LEVIN. Even though there may not be any benefit whatsoever to the taxpayer. 

Mr. BROWN. That is correct. To the employee, the employee 

tax——

Senator LEVIN. Potential tax——

Mr. BROWN. That is right. 

Senator LEVIN. Employee taxpayer. Do you have a problem with 

that? 

Mr. BROWN. My area is making sure that the deductions and the 

income are properly reported, so what happens with regard to the 

books is not an area the IRS focuses on. 

Senator LEVIN. You are going to receive, I believe, the 2005 data 

sometime later this year. Is that correct, Mr. Brown? 

Mr. BROWN. That is correct. 

Senator LEVIN. And then as soon as that information becomes 

available, will you make the same kind of analysis of that data as 

you did for the 2004 data for this Subcommittee? 

Mr. BROWN. Yes, sir. 

Senator LEVIN. And let us know what the results are? 

Mr. BROWN. Yes. 

Senator LEVIN. Then would you at that time also include an estimate of what the revenue effect would have been for 2005 if the 

stock option tax deduction had matched the stock option book expense? Are you going to be able to do that for us? 

Mr. BROWN. Yes, sir. We will give it our best try. 

Senator LEVIN. OK. I know Senator Coleman has a number of 

other things he is trying to cover this morning, so he is covering 

a lot of territory. 

Thank you both very much for your testimony and for your cooperation. 

We will call our third panel. Let us now welcome our final panel 

of witnesses for this morning’s hearing: Lynn Turner, former SEC 

Chief Accountant; Professor Desai, the Arthur Rock Center for Entrepreneurship Associate Professor at Harvard University’s Graduate School of Business Administration; and Jeff Mahoney, who is 

General Counsel of the Council of Institutional Investors. 

We welcome you to this Subcommittee. In the case of Mr. Turner, 

we are going to welcome you back to the Subcommittee. You testified before this Subcommittee in 2002 on the role of financial instiVerDate 0ct 09 2002 10:41 Sep 24, 2007 Jkt 036611 PO 00000 Frm 00042 Fmt 6633 Sfmt 6601 C:\DOCS\36611.TXT SAFFAIRS PsN: PAT
39

1The prepared statement of Mr. Turner appears in the Appendix on page 90. 

tutions in Enron’s collapse, and it is still very much an issue in the 

news and the courts. We appreciated your testimony then. 

Mr. TURNER. Thank you, Senator. 

Senator LEVIN. Under Rule 6, again, all witnesses who testify are 

required to be sworn. We would ask that each of you stand and 

raise your right hand. 

Do you swear that the testimony you will give before this Subcommittee today will be the truth, the whole truth, and nothing but 

the truth, so help you, God? 

Mr. TURNER. I do. 

Mr. DESAI. I do. 

Mr. MAHONEY. I do. 

Senator LEVIN. You were here for the explanation of the timing 

system, I believe, and we will have you, Mr. Turner, go first, followed by Professor Desai, followed by Mr. Mahoney. And, again, we 

appreciate your appearance here today. 

TESTIMONY OF LYNN E. TURNER,1 FORMER SECURITIES AND 

EXCHANGE COMMISSION CHIEF ACCOUNTANT, BROOMFIELD, COLORADO 

Mr. TURNER. Thank you, Chairman Levin, as well as Ranking 

Member Coleman, for inviting me here today. I think this issue of 

stock options is certainly an important issue, so I commend both 

of you for holding this hearing in this Subcommittee. 

My views, I am going to try to summarize in light of the time 

we have here, so I would ask that the written testimony be entered 

into the record. 

Senator LEVIN. It will be made part of the record, as will all the 

testimony. 

Mr. TURNER. My views are also going to be fashioned based on 

the fact that I currently serve as a corporate board member, also 

a member of trustees of a mutual fund who invest in these companies, having served in my prior life as a chief financial officer and 

SEC Chief Accountant as well as managing director of an investment proxy and financial research firm. And certainly, as you have 

mentioned, the issue of executive compensation has been one that 

has attracted a lot of interest in the past, regardless of the perspective from which one observes it. However, in the past decade, many 

of the newspapers on the front pages have heralded the excesses 

in compensation at more than just a few public companies. Certainly these excesses are due in no small part to abuses in the use 

of stock options. Recent decisions of the Delaware courts have highlighted the activities of illegal backdating and spring-loading of options and the lack of transparency surrounding that process, as 

well as the lack of fiduciary fulfillment of their obligations on the 

part of directors. And research has suggested that during the period from 1996 to December 2005, over 13 percent of all stock option grants were done inappropriately and manipulated in some 

fashion or form. 

But backdating has not been the only option. We have seen repricing of stock options become all too common in a situation 

where, in essence, the holders of those options were given a mulVerDate 0ct 09 2002 10:41 Sep 24, 2007 Jkt 036611 PO 00000 Frm 00043 Fmt 6633 Sfmt 6601 C:\DOCS\36611.TXT SAFFAIRS PsN: PAT
40

ligan when the prices went down that obviously the average investor—the 90 million Americans investing in these companies were 

not given the same economic benefit. 

We have seen over 1,000 occasions where public companies have 

accelerated the date on which options were considered vested such 

that employees did not even have to work the entire time they 

were supposed to work for those options. And in some cases, that 

resulted in great intrinsic value going to the people who held those 

options. 

We have heard a lot of discussion this morning about the new 

FASB accounting pronouncement, FAS 123R, and yet no sooner 

was the ink drying on that document than people were trying to 

get around how the calculation was made. And it brought on some 

practices, including manipulation of key assumptions. It appears 

that they are once again managing the numbers that are reported 

to investors as opposed to really trying to manage the business. 

On this point, I would just like to say, Chairman Levin, you deserve tremendous kudos, because when the fight was on about 

whether or not to really show the true economic value of these options and the financial statements, you yourself were a key supporter in improving the transparency for investors in that regard. 

And as an investor, I would just like to thank you and the other 

Members of Congress who helped get us where we needed to be on 

that. 

But I guess my biggest concern, when you look at the abuses and 

you look at things on options, is that there has been now more 

than one—a number of economic studies by academics that indicate 

that there is a direct linkage between the use of stock options and 

heightened fraud in public companies. I do think that options have 

become like an addictive drug for executives because of the tremendous upsides that are there. I am certainly not the only one. 

Former Federal Reserve Chairman Paul Volcker has also raised 

some of the same type of concerns. 

In light of that, I think we ought to really consider what steps 

can be taken to help foster good governance and management and 

lawful behavior and greater transparency. And I think it can. 

As a former business executive and partner in a major international accounting firm, I have seen up front how income tax laws 

and regulations do affect business decisions, sometimes in a negative fashion. It should be no surprise that my experience has shown 

that management often tries to maximize both the amount and 

timing of expense deductions for income tax purposes while minimizing them for purposes of financial reporting to investors. It is 

simply a matter of minimizing net income for tax purposes and 

maximizing net income reported to investors. 

Income tax deductions can have a very significant impact on the 

cash flow of any company, and so it behooves management to maximize them. And, of course, the analysis of any stock option program is going to include the impact of the cost to the company on 

a net basis, after factoring in any benefits from income tax deductions. As such, these tax implications also provide a strong incentive for management to see how close to the line they can get when 

preparing their income tax returns and encourage taking of aggressive income tax positions. This is especially true for public compaVerDate 0ct 09 2002 10:41 Sep 24, 2007 Jkt 036611 PO 00000 Frm 00044 Fmt 6633 Sfmt 6601 C:\DOCS\36611.TXT SAFFAIRS PsN: PAT
41

nies. And as we have seen with recent corporate scandals, some 

seem blinded to when they are getting close to the line as opposed 

to going over it. 

As a result, I would strongly recommend the creation of tax legislation and regulations that would foster a consistent calculation of 

the amount of the deduction for the fair value of options for both 

financial reporting and income tax purposes. I firmly believe there 

is an economic cost to the issuance of options. That cost should not 

vary simply because it is reported to the Internal Revenue Service 

on a Form 1120 as opposed to investors on a Form 10–K. 

Unfortunately, current income tax regulations have created incentives that have led to the abuses noted earlier and should be 

considered for appropriate modifications. In that regard, I echo 

some of the comments of Ranking Member Coleman with respect 

to Section 162(m). 

Legislation that did result in symmetry would create a very positive incentive for companies to stop manipulating and minimizing 

the amount of expense they report to investors. Rather, it would result in a more balanced approach in which both transparency for 

investors and income tax considerations would be balanced. In essence, the desire to report higher earnings to investors by manipulating the amount of stock option expense downward would be appropriately balanced by the desire to maximize income tax deductions, and in doing so maximizing cash flow. 

Legislation giving shareholders an advisory vote on compensation, such as that recently passed in the House, should also be 

adopted. Many foreign countries such as the United Kingdom, the 

Netherlands, and Australia have already adopted such legislation, 

and it is an important part of their regulatory scheme, and I think 

would be important to the competitiveness of our U.S. capital markets. 

Finally, I believe active and appropriate oversight by the SEC of 

reporting of executive compensation is needed as well. Actions 

taken to date indicate that many responsible for the option backdating scandal will either never be known or will avoid accountability for behavior outside the law. We have over 260 companies 

announce that they are investigating for option backdating. Academic research indicates that there are hundreds more that have 

never come out and fully disclosed it. As we heard from the SEC 

earlier this morning, despite several hundred cases, we have only 

had four cases brought against companies to date, and only 18 executives, which is basically a drop in the bucket compared to what 

is happening. That is hardly what I would call an effective law enforcement system. Likewise, the use of models to fair value options 

that are intended simply to minimize and manipulate the value of 

stock options should be more closely examined by the SEC and prohibited. 

That concludes my remarks, and I would be happy to take any 

questions. 

Senator LEVIN. Thank you, Mr. Turner. Professor Desai. 

42

1The prepared statement of Mr. Desai with attachments appears in the Appendix on page 95. 

TESTIMONY OF MIHIR A. DESAI,1 ARTHUR M. ROCK CENTER 

FOR ENTREPRENEURSHIP ASSOCIATE PROFESSOR, HARVARD UNIVERSITY, GRADUATE SCHOOL OF BUSINESS ADMINISTRATION, BOSTON, MASSACHUSETTS 

Mr. DESAI. Chairman Levin and Senator Coleman, it is a pleasure to appear before you today. I am an Associate Professor of Finance at Harvard Business School, where I conduct research on 

corporate finance and public finance and their intersection, specifically about how taxation influences firm behavior. 

Independently, the topics of financial accounting, tax accounting, 

and stock options are extremely confusing. Taken together, they 

can be overwhelming and, frankly, mind-numbing. While my written comments below are much more nuanced, I thought I would 

begin with a thought experiment that I have found helpful for simplifying the relevant issues and then summarize five conclusions 

that are detailed in my written comments. 

Imagine if you were allowed to represent your income to the IRS 

on your 1040 in one way and on your credit application to your 

mortgage lender in another way. In a moment of weakness, you 

might account for your income favorably to your prospective lender 

and not so favorably to the IRS. You might find yourself coming up 

with all kinds of curious rationalizations for why something is an 

expense for the tax authorities but not an expense to the lender. 

You do not have this opportunity and for good reason. Your lender can rely on the 1040 they review when deciding whether you are 

creditworthy because you would not overly inflate your earnings 

given your desire to minimize taxes. Similarly, tax authorities can 

rely on the use of the 1040 for other purposes to limit the degree 

of income understatement given your need for capital. The uniformity with which you are forced to characterize your economic 

situation provides a natural limit on opportunistic behavior. 

While individuals are not faced with this perplexing choice of 

how to characterize their income depending on the audience, corporations find themselves in this curious situation. A dual reporting system is standard in corporate America and, judging from recent analysis, the system can give rise to opportunistic behavior. As 

we have heard today, a significant cost for corporations—the cost 

associated with compensating key employees with stock options—

was until recently treated as an expense for tax purposes but not 

for financial accounting purposes. This can be viewed as the most 

advantageous way to treat an expense—reducing the firm’s tax liability while not detracting at all from its financial bottom line. 

Recent changes in financial accounting have changed this asymmetry so that there is now an expense associated with stock options, but a considerable difference still exists with tax rules. Specifically, the amount and timing of the deduction are distinctive. 

Grant and exercise values, as well as their timing, will differ significantly. Historically, the distinctive treatment of stock options 

has contributed significantly to the overall difference between financial and tax accounting reports, as shown in my work and recent work based on the Schedule M–3 reconciliation. 

43

Does this situation make sense? In order to consider this question, my written statement reviews the nature of the dual reporting 

system in the United States, the debate over changing this system 

to one where conformity would be more common, the international 

experience with increased conformity, evidence on the behavioral 

consequences of stock options, and international variation on the 

tax treatment of stock options. Several conclusions emerge. 

First, as suggested by the example above and further elaborated 

on below, the dual reporting system can enable opportunistic behavior by managers at the expense of both investors and tax authorities. This insight, from an emerging body of work labeled the 

‘‘corporate governance view of taxation,’’ suggests that tax authorities can be meaningful monitors that complement the activities of 

shareholders concerned with opportunistic insiders. Under the current dual reporting system, it is impossible for investors to tell 

what firms pay in taxes. A major part of a cost structure of a firm, 

its tax payments, are completely unavailable to an investor, and 

this clouds what a firm’s true economic performance is. The evolution of the two parallel universes of financial and accounting reporting systems appears to be a historical accident rather than a 

manifestation of two competing views of what profits should be. 

Aligning tax definitions with financial accounting standards can 

have payoffs to investors and tax authorities, can lower compliance 

costs of the corporate tax, and potentially allow for a lower corporate tax rate on a wider base. Concerns over greater alignment 

between tax and financial accounting are important, but many of 

these concerns are overstated, as I discuss below. 

Second, changing financial accounting standards has stimulated 

debate worldwide on the virtues of greater conformity. Many countries, including notably the United Kingdom, have shifted toward 

greater alignment of tax and accounting reports with little apparent disruption. More broadly, tax authorities in many countries in 

the European Union explicitly reference financial accounting treatments in several parts of the tax treatment of corporations. Indeed, 

the European Union is contemplating yet a more aggressive alignment between tax and accounting rules. The relative segregation of 

financial accounting and tax treatment of corporate income appears 

to make the United States somewhat anomalous by international 

standards. By itself, this international experience is informative 

but hardly decisive as the United States may choose quite different 

rules for good reasons. Nonetheless, it is enlightening to see that 

increased conformity can work and need not represent a doomsday 

outcome as some have suggested. 

Third, stock options are a critical part of our economic system 

today. They are extremely valuable tools that have numerous benefits and several costs. Their use is influenced by their accounting 

treatment and by their tax treatment. Research is quite clear on 

this. As such, changing the accounting and tax treatments of stock 

options can be expected to change their use. Existing evidence, 

though scant, is consistent with the recent increased disclosure limiting the use of stock options but also with investors appreciating 

the disclosure and changing their valuations of firms accordingly. 

Fourth, there exists considerable variation internationally on the 

tax treatment of stock options. In particular, some countries, such 

44

1The prepared statement of Mr. Mahoney with attachments appears in the Appendix on page 

124. 

as Canada, do not allow any tax deduction for stock options while 

others take the deduction at the time of grant and others follow the 

United States and provide a deduction at the time of exercise. 

Again, this international experience is informative but hardly conclusive as the United States may choose quite different rules given 

that stock option compensation is much more central to compensation in the United States than elsewhere. Nonetheless, it is enlightening to realize that there are many different ways to solve this 

problem and that the current situation is not a natural solution. 

Fifth, and finally, bringing the tax treatment of stock options 

into alignment with the recent changes to the accounting treatment 

has a number of virtues. First, it would make the tax treatment 

consistent with the accounting profession’s well-reasoned analysis 

of when this deduction is appropriate and what the right amount 

of the deduction is. Second, as with other movements toward greater alignment, reducing the reporting distinction in how managers 

are paid can create greater accountability and reduce distortions to 

the form of managerial compensation. Third, there is limited reason to believe that the purported costs typically attributed to greater alignment between tax and financial accounting would be relevant in this setting. There are a number of nontrivial complications associated with such a change, particularly related to the 

matching principles and issues that came up previously. While 

these complications are nontrivial, they can be overcome readily if 

legal and political will exists. 

In sum, this example of increased alignment between financial 

and tax accounting has much to recommend it and need not be 

viewed as a radical departure from global practice. It will still 

allow for the many benefits of incentive compensation to accrue to 

the U.S. economy without continuing the distortions associated 

with the current anomalous distinction between tax and accounting 

reports. 

Thank you, Mr. Chairman, for the opportunity to share these 

views, and I look forward to answering any questions. 

Senator LEVIN. Thank you, Professor Desai. Mr. Mahoney. 

TESTIMONY OF JEFFREY P. MAHONEY,1 GENERAL COUNSEL, 

COUNCIL OF INSTITUTIONAL INVESTORS, WASHINGTON, DC 

Mr. MAHONEY. Chairman Levin, I am Jeff Mahoney, General 

Counsel of the Council of Institutional Investors. I am pleased to 

appear before you today on behalf of the council. The council is a 

not-for-profit association of more than 135 public, labor, and corporate pension funds with assets exceeding $3 trillion. Council 

members are generally long-term shareowners responsible for safeguarding assets used to fund the pension benefits of millions of 

participants and beneficiaries throughout the United States. Since 

the average council member invests approximately 75 percent of its 

entire pension portfolio in U.S. stocks and bonds, issues relating to 

U.S. corporate governance are of great interest to our members. 

The council has long believed that executive compensation is one 

of the most critical and visible aspects of a company’s governance. 

45

Analyzing and evaluating pay decisions, including decisions involving the granting of executive stock options, is one of the most direct 

ways for shareowners to assess the performance of boards of directors. As a result, approximately one-half of the council’s corporate 

governance ‘‘best practices’’ policies focus on executive compensation issues. In recent months, the council has been active on three 

important corporate governance fronts involving executive stock options. 

First, in March of this year, the council’s general membership approved a revision to the council’s corporate governance policies that 

recommended that companies provide annually for advisory 

shareowner votes on compensation of senior executives. In approving this policy, council members generally agreed that an annual 

advisory vote on executive compensation would benefit investors 

and company governance because it would provide a mechanism for 

shareowners to provide ongoing input to company boards on how 

a company’s general compensation policies for executives, including 

their policies relating to stock options, are applied to individual pay 

packages of those executives. 

Second, the council has publicly raised concerns about the Securities and Exchange Commission’s December 2006 amendments to 

the Commission’s new proxy statement disclosure rules on executive compensation and related-party disclosures. Those amendments, we believe, lessened the usefulness of the information contained in company proxies by changing the requirements for the reporting of the amount of executive stock option and equity-based 

awards that appear in the new summary compensation table in 

those disclosures. As a result of the change, the summary compensation table, as now revised by the amendments, no longer informs investors of the compensation committee’s current actions regarding executive stock options and similar equity-based awards. 

Moreover, the change sometimes results in the reporting of a negative compensation amount which I believe most parties would agree 

is not particularly useful information when assessing the performance of compensation committees. We, however, are pleased that 

the SEC staff has publicly acknowledged our concerns and other investor concerns that have been raised about the initial implementation of the new rules. The SEC staff has indicated that they are 

initiating a review project that will result in a report this fall that 

analyzes the first year compliance with the new rules, and we look 

forward to reviewing and commenting on the report. 

Finally, we have been monitoring the implementation of the 

FASB’s Statement 123R. That standard, which became effective 

last year for most companies, is important to investors because, as 

the Chairman knows, it closes a significant loophole in financial reporting. That loophole had a number of effects, one effect being 

that it encouraged companies to issue an excessive amount of socalled fixed-price stock options to the exclusion of other forms of 

stock options and other forms of compensation that are more closely linked to long-term performance; and, second, the loophole also 

had the effect of permitting companies to understate their compensation costs, thereby distorting their financial reports and as a 

result diverting investment and capital resources away from their 

most efficient employment. 

46

The ongoing stock option backdating scandal provides a reminder 

that the financial accounting and reporting for executive stock options is an area in which there is a high risk of misapplication of 

reporting requirements. The council, therefore, has been advocating 

that audit committees, external auditors, the Public Company Accounting Oversight Board, and the Commission should all actively 

support the high-quality implementation of the new FASB standard on accounting for stock options. In that regard, representatives 

of the council staff and the CFA Institute recently met with staff 

of the SEC’s Office of the Chief Accountant to discuss our concerns 

about the potential use in financial reports of prices that Zions 

Bancorporation has received in its recent offerings of a financial instrument they developed called ‘‘Employee Stock Option Appreciation Rights’’ or ‘‘ESOARS.’’ Zions has proposed that the price for its 

ESOARS qualify as a market-based approach for valuing stock option awards for financial reporting purposes for its own options and 

they plan to market this product, to other public companies as well. 

After consulting with leading valuation and accounting experts 

from around the country, the council staff has concluded that, as 

presently constructed, Zions ESOARS results in a downward biased 

valuation for stock option awards. The lowball valuation would systematically underreport compensation costs, thereby distorting 

company financial reports. The council, therefore, has respectfully 

requested that the Office of the Chief Accountant prohibit Zions 

and all other public companies from using Zions ESOARS for financial reporting purposes unless and until the fundamental failings 

of the product have been remedied. 

We look forward to continuing to work cooperatively with the 

SEC, this Subcommittee, and other interested parties to address 

these and other corporate governance issues relating to executive 

stock options. Our goal is to ensure that the issues are resolved in 

a manner that best serves the needs of investors and the U.S. capital market system. 

Thank you, Mr. Chairman, for inviting me to participate at this 

hearing. I look forward to the opportunity to respond to any questions. 

Senator LEVIN. Thank you, Mr. Mahoney. 

This is an issue which was raised with the first panel, not exactly the focus of the hearing, but I think it is important that we 

get your comments on it. Given the millions of options that are 

being handed out to executives, does that have a negative effect on 

existing shareholders, other shareholders? Mr. Turner, what is the 

effect of the large number of stock options granted particularly to 

executives on the other shareholders? Does it water down their 

stock? 

Mr. TURNER. Certainly, if you look over the years, the use of options has grown, especially since the mid-1980s, and that has resulted in a significant increase in the growth of overhang and dilution and potential dilution to existing shareholders. In fact, if you 

looked at reports that have been put out by rating agencies such 

as Fitch’s, they have noted that it has actually become a significant 

drain on investor assets and that to avoid increasing dilution, 

many companies have had to go out and spend cash on fund share 

buybacks. And as a result, it has certainly had a significant impact, 

47

negative impact on cash. So the significant growth in the use of options has had a very real impact. I think it is why the Conference 

Board in part recommended and others have recommended—and I 

certainly think it is a good recommendation—that companies start 

to look at other vehicles such as restrictive stock, which I know has 

gotten increasing use in recent years. 

Senator LEVIN. Thank you. Professor Desai. 

Mr. DESAI. I think the major consequence for other shareholders 

is not quite so much the dilution issue as the behavioral response 

to the stock options, and by that I mean two things. One is, on the 

positive side, it makes them potentially more performance oriented. 

And on the negative side, it has been shown to, first, increase risk 

taking; second, it has been associated with more aggressive accounting treatments; and, third, it is questionable whether there is 

a way to have CEOs set their own pay in an arm’s-length way. 

So to me, the major consequences to the other shareholders are 

all the behavioral responses that the CEO undertakes, which can 

be potentially good and can in many cases be quite negative, and 

it has been shown to be negative. 

Senator LEVIN. Thank you. Mr. Mahoney. 

Mr. MAHONEY. The council agrees that the potential dilution represented by stock options is a direct cost to shareholders. As I 

pointed out in my testimony, we prefer that compensation be performance based, and prior to FAS 123R, many of the stock options 

granted were not performance based. And that is why we supported the expensing of stock options. 

Senator LEVIN. The IRS has now released the data showing that overall in 2004, about 3,200 corporations claimed $43 billion more 

in stock option expenses on their tax returns than they reported to 

investors on their financial statements. Mr. Turner, does that number surprise you? 

Mr. TURNER. No, not at all, especially given the accounting rules 

at the time. But I think that even when you get good data for 2005 

and subsequent years after the implementation of FAS 123R, I suspect that you are still going to see that the deduction for tax purposes runs ahead of what it is for book purposes. Perhaps the best 

indication of that is if business and tax lobbyists obviously thought 

that they were going to get a bigger deduction for FAS 123R, I suppose they would be at your desk signing up to support you. And 

so far I have not seen anyone standing outside your door looking 

to support you on that, so I think that probably is a pretty good 

indication of which one is going to be the bigger deduction for 

them. 

Senator LEVIN. Professor Desai. 

Mr. DESAI. No, it does not. Those numbers jibe with numbers 

that myself and others produced prior to the Schedule M–3 reconciliation being available, so they do not surprise me. And I 

should mention nor does the concentration of that gaps amongst a 

relatively small set of firms surprise me. That, too, is something 

that has been in the data for a while and is clearly true. 

Just by way of perspective, the reason that is so concentrated is 

because, in fact, market values of firms are highly concentrated. So 

I think those numbers make a lot of sense. 

Senator LEVIN. Thank you. Mr. Mahoney. 

48

Mr. MAHONEY. No, it does not surprise me. It is my understanding that financial reporting and tax reporting historically 

have had very different purposes. Where financial reporting attempts to reflect the underlying economic substance of an activity 

in the periods that that activity occurs, tax reporting has not always had economic substance as an underlying factor. I am not an 

expert on tax accounting, but certainly there are a number of areas 

of tax law where the underlying economic substance of the activity 

is not the basis for the tax treatment. 

Senator LEVIN. Well, as far as we can tell, the only type of compensation where corporations are allowed to deduct from their tax 

as an expense that is larger than the expense on their books is 

stock options. Is that your understanding, too? Do any of you know 

of any other form of compensation where that is true? 

Mr. TURNER. Senator, I heard you ask that question of the IRS 

Commissioner, and I think he confirmed that is true. Certainly, as 

I was thinking about that, I tried to think back to days when I was 

signing these income tax returns, and I think that was certainly 

consistent with what my understanding was. 

Senator LEVIN. Professor Desai, do you know of any other example of this? 

Mr. DESAI. No, I do not. I will say that there is a dizzying array 

of new financial contracts being awarded to management, and it is 

not clear to me that all of those—for all of those things this is true. 

So I do not quite know, but I think the IRS Commissioner——

Senator LEVIN. Do you know any, Mr. Mahoney? 

Mr. MAHONEY. No, I do not. 

Senator LEVIN. For each of you, looking at the new rule, FAS 

123R, would you say that the—first of all, do you support the rule? 

Do you think it is a good rule? Mr. Turner. 

Mr. TURNER. I think getting the expensing of stock options into 

the financial statements and really showing a true picture to investors was long overdue and a good rule. There are pieces of it that 

I would probably change, but overall I think it was a very good 

rule. 

Senator LEVIN. Professor Desai. 

Mr. DESAI. Agreed. 

Senator LEVIN. Mr. Mahoney. 

Mr. MAHONEY. We agree. It is consistent with our policies. 

Senator LEVIN. All right. Now, under the current tax rule that 

we have, you can get a much larger tax deduction than your book 

value shows is the value of the—or the expense for the option that 

you granted. Does it make sense for companies that do very well, 

hand out a lot of stock options, when their stock price goes up, they 

get bigger tax deductions and lower taxes? Is that, from a tax policy, good, that incentive to give tax options, since they do well, if 

the company does well, result in a larger deduction, it means the 

more profitable the company, the larger the tax deduction rather 

than the larger the tax? Is that good tax policy, Mr. Turner? 

Mr. TURNER. Well, I have for a long time been a believer that absent some real driving policy that Congress wants to get into, such 

as creating additional capital investment, which we do on depreciation and asset acquisitions, I have long been a believer that we 

should have symmetry and more economic substance to what goes 

49

into our tax rules. And in that regard, I have always been a supporter of getting more symmetry between the economic substance 

that is reported in financial reports and what goes into our income 

tax returns. I think the income tax returns should show more economic policy than what they are. And so to the degree that they 

differ, I do not think that is good tax policy. Therefore, I think it 

would be good to have symmetry in the executive compensation. I 

would also, quite frankly, have symmetry in other areas, such as 

for uncollectible accounts receivable and for inventories that have 

gone bad and are obsolete. There are differences there that I think 

also fall into the same categories, and I do not see a reason, a real 

good tax policy for having differences there as well. 

So I am a fan of trying to keep it simple, if you will, make it 

more simple. I think most Americans would like to see the Tax 

Code greatly simplified, and I think this would be an opportunity 

to do that in a number of areas. 

Senator LEVIN. OK, but including in terms of today’s hearing, 

having the tax deduction be the same as the amount shown on the 

books? 

Mr. TURNER. Absolutely. 

Senator LEVIN. Professor Desai, do you have any comment? 

Mr. DESAI. Yes, I would agree with what Mr. Turner said. I 

think greater alignment generally is a smart idea, and particularly 

in this context makes sense. I have two points on that. 

First, typically tax policy tries to accelerate a deduction when 

times are bad, so the situation you are describing is unusual. And 

then the second point I would make——

Senator LEVIN. When you say ‘‘unusual,’’ you also mean not desirable, particularly, or——

Mr. DESAI. Hard to rationalize, yes. 

Senator LEVIN. OK. 

Mr. DESAI. And then the second point would just be that in some 

sense it is a simple issue, which is when was this compensation for 

and how much was the compensation. And I have great faith in 

FASB and the ability of experts to come up with a good answer to 

that. And it seems like if we can piggyback off that answer in the 

Tax Code, that would seem to make sense. 

Senator LEVIN. Mr. Mahoney. 

Mr. MAHONEY. The council has not established any policies on 

taxation at all, but as a taxpayer myself and a small investor, I 

agree with my other two panelists that that is not good tax policy. 

Senator LEVIN. Is this feature of stock options, is this particular 

feature that the company does well, that they then get a much bigger tax deduction in their income tax reports than they show on 

their books a driving force in the use of stock options, one, in your 

judgment? And, two, in the gap that exists, which seems to be 

growing, between executive pay and average worker pay, would you 

say that it is a driving force in both? 

Mr. TURNER. I do not know. The way I think I would put it, Senator, is to say there are a number of factors that enter into the consideration of using options and the magnitude of the options that 

you are going to use. Certainly the opportunity for a company to 

go up in value, which any management team strives for, creates a 

real incentive to use options. And now I am speaking as a former 

50

executive and CFO—when you look at option plans along with anything else, you are trying to look at what is a reasonable compensation level for the people, especially vis-a-vis the peers. And I think 

that becomes first and foremost, but certainly the tax implications 

of the ability to use options is one of the factors that one would 

consider. Even at the board level it is considered, because in almost 

every proxy the board discusses and discloses Section 162(m) as 

well. 

And certainly I would have to say the Section 162(m), as Ranking Member Coleman has noted, is a factor here that I think, quite 

frankly, Congress should also take a look at. I would view it as, in 

a way, a package situation. I think your move to get symmetry is 

superb and excellent and should be undertaken. I would undertake 

that with reconsideration of Section 162(m), and at the same time, 

though, I would also want to put in there the shareholder advisory 

vote that has been adopted in the House. I think if you could put 

a package like that together, that would be a marvelous tax package. 

Senator LEVIN. We heard earlier this morning from the first 

panel that they do not look at the tax aspects of the options that 

they recommend or decide upon on compensation boards. Do you 

buy that? 

Mr. TURNER. No, I do not buy that because—and, again, sitting 

on corporate boards, I think most corporate boards do sit down, at 

least in the compensation committee, and have a discussion about 

the implication of Section 162(m). And, in fact, often, where I have 

been the managing director of research and provide voting recommendations on proxies, one issue that often comes up for a vote 

is the issue of does the compensation package meet Section 162(m) 

requirements. 

Senator LEVIN. But does this feature of stock options that it potentially has this huge tax deduction without showing it as an expense to the same extent on the books, is that a feature which 

would be in your mind as a member of the compensation committee? 

Mr. TURNER. It certainly is, and I have chaired three audit committees now, and not only is it on my mind as a matter of stock 

compensation, and certainly much more in my mind since the option backdating scandal. Senator Grassley had a fine hearing here 

in the Finance Committee last September that got into that whole 

issue. And so I would be surprised if people said it does not enter 

into my consideration as the CFO or as a board member. I think 

I would be negligent if I had not considered the overall cost package. So I was somewhat surprised by that. 

Again, that is often discussed and laid out in a proxy, which I 

would hope every corporate board member reads before they get 

filed. So to say ‘‘I did not even think about it,’’ is somewhat surprising. 

Senator LEVIN. Professor Desai. 

Mr. DESAI. I would concur. On your first question, has it been 

an important driver of the growth of options, I think if firms do not 

factor in the tax consequences and boards do not think about that, 

then there is a question of whether they are pursuing their fiduciary responsibility. So I would think they would be, and, in genVerDate 0ct 09 2002 10:41 Sep 24, 2007 Jkt 036611 PO 00000 Frm 00054 Fmt 6633 Sfmt 6601 C:\DOCS\36611.TXT SAFFAIRS PsN: PAT
51

eral, I think people are pursuing their fiduciary responsibility. So 

I think that it does matter. 

And then the second related point is there is evidence that tax 

departments inside corporations are becoming more active participants in financial decisionmaking, and they are becoming viewed 

as places where you can squeeze profits out of. And so it would be 

surprising if tax concerns were just not visible. 

On your second question about whether this relates to the overall 

gap in income inequality, that is a much harder question. The 

available research on that suggests that the gap is surely due in 

part to this kind of pattern but also has many other determinants, 

which I am sure you are well aware of. 

Senator LEVIN. Mr. Mahoney. 

Mr. MAHONEY. I have never sat on a corporate board, but as a 

close observer of financial accounting and reporting for over a decade, certainly tax implications are a very important factor or feature to the structure of many, if not most, corporate transactions. 

Senator LEVIN. If we close this gap and we have the tax return 

reflect the amount shown on the books for the value of the stock 

option when granted, at that point the taxpayer, the stock option 

holder who exercises that option down the road, if that stock goes 

up—which it obviously would need to, or else the option would not 

be exercised—will be paying a larger tax on a larger amount than 

the company got as a tax deduction. That does not trouble me particularly for the reason I gave, but it did trouble one of our witnesses. 

Mr. Turner, if you get symmetry where you have described and 

I have described and you support and I support, does that eliminate asymmetry which is important or relevant as between the tax 

deduction given to the company and the taxable income to the option holder when that option is exercised? 

Mr. TURNER. Again, I thought for a while about the question that 

you asked earlier this morning, and I guess my initial take is, no, 

I am not that troubled by it because, in fact, part of that gain is 

in essence a holding gain from the date that the vesting ended 

until the time period they actually exercise and sell their stock. So 

for that reason, I am not particularly troubled. 

The other thing is that we have done research at Glass, Lewis 

that indicates 80 to 85 percent of these options are cashless exercises anyway, so as you appropriately noted this morning, it is not 

the company that is paying in the cash, if you will. So given the 

magnitude of the cashless exercise in these, which are really nothing more than turning it back into a bonus type cash payment, I 

really do not have a problem that that income is going to be a higher number. And certainly they have the cash in the pocket, if you 

will, if in fact it is higher. 

If, on the other hand, the options are never exercised—and we 

all need to keep in mind that some of these options never are exercised—certainly then in that case the employee will not be getting 

taxable income for that because they would not have ever exercised. 

Senator LEVIN. Professor Desai. 

Mr. DESAI. Sir, I think it is useful to frame this as a transition 

from one kind of symmetry to another kind of symmetry. So the 

52

current symmetry is within the Tax Code for the corporate and the 

individual, and the symmetry you are talking about is at the corporate level between financial and tax. 

As to whether I am bothered by the potential that the individual 

is going to have a larger income than we gave a deduction for, I 

do not think that is terribly problematic. I mean, in some sense, 

one way to think about this is if we believe symmetry—or if we believe the compensation happens at the time of grant, as accounting 

standard setters have suggested, then we are affording some relief 

to the income taxpayer by delaying the taxable event until the time 

of exercise, meaning the natural time, if we really believe the 

matching principle is important, then again at the time of grant 

under this new system. So there is actually some relief being afforded to that taxpayer, and I think in that setting, not just relief 

in terms of time, but also relief in terms of not having phantom income and also relief in the sense of only having a tax obligation in 

the good state in the world. 

So all of that makes me think that these concerns can be mitigated. 

Senator LEVIN. Mr. Mahoney. 

Mr. MAHONEY. I have very little tax expertise, but my view 

would be that I do not think this is a significant problem. I would 

agree with my co-panelists. 

Senator LEVIN. Just a few more questions. Let me ask you, Mr. 

Mahoney, this question. You described in your prepared statement 

some concerns with the new SEC disclosure rules for executive 

compensation, particularly how stock options are valued in the 

summary compensation table. You presented an example of a CEO 

who might be listed as receiving negative compensation. Would you 

just elaborate on that for a moment? 

Mr. MAHONEY. The SEC’s executive compensation disclosure 

rules, as originally adopted back in August, they require that stock 

and option awards be reported in this new summary compensation 

table at their full grant date fair value. That decision in the original final rules was consistent with the council’s recommendations 

and the recommendations of many investors. 

However, the SEC’s December 2006 amendments to the original 

final rules made a change requiring that stock and option awards 

be reported in the summary compensation table in an amount 

equal to the dollar amount recognized in the financial statements 

in accordance with FAS 123R, though there are some exceptions to 

that as well. 

By more directly linking the compensation disclosure in the 

proxy statement to the amount of compensation expense recognized 

under FAS 123R, that creates some circumstances where a named 

executive officer’s reported stock-based compensation in the new 

summary compensation table can be negative. Now, those circumstances may occur, for example, when the change in the market value of an award that is classified as a liability award for FAS 

123R purposes is negative in a period. That would be one example. 

Another example would be where it becomes unlikely that the 

performance condition of a previously recognized performancebased award will no longer be achieved. That circumstance may 

also create a negative amount in the summary compensation table. 

53

We believe that the SEC’s December 2006 amendments are inconsistent with the use of proxy statements by shareholders because proxy statement disclosures are intended to provide investors 

with information to evaluate the annual decisions of the compensation committee. We believe that showing the full grant date fair 

value in the summary compensation table is the better way to report stock and option awards. 

Senator LEVIN. Thank you. Do either of the other witnesses have 

a comment on that? 

Mr. TURNER. At Glass, Lewis we obviously do recommendations 

on over 11,000 companies and their proxy and on this specific issue 

of the magnitude of compensation and the compensation committee, and I would just say that I think Jeff’s understanding is 

very consistent with ours. Our large institutional investors, who 

manage over $10 trillion in value, typically want to assess the compensation committee based upon their decision in a particular year, 

and one of the key factors they use in making that assessment is 

the value of the options granted in that particular year. And, therefore, to get that information, they need the disclosure of the 

amount of the fair value of the options granted in that particular 

year. 

When the SEC made the last-minute midnight change, if you 

will, just before Christmastime, they eliminated that transparency 

for institutional investors, and we heard time and time again from 

those how it made it much more difficult to analyze that table. So 

I would concur with what Mr. Mahoney said. 

Senator LEVIN. Professor, do you have——

Mr. DESAI. Nothing. 

Senator LEVIN. Let me now conclude with just a very brief comment. 

We have received evidence today that companies are legally 

claiming tax deductions for their stock option expenses that are far 

in excess of the expenses actually shown on the books. Nine companies claimed $1 billion more in stock option deductions than they 

would have shown on their books even with the new stricter accounting rule that FASB has adopted for stock options. Altogether 

in 2004, companies claimed $43 billion more in stock option deductions than they showed on their books under that IRS data. 

Right now, stock options are the only form of compensation 

where a company is allowed to deduct more than the expenses 

shown on its books. It is as if the Tax Code allowed a company to 

pay an employee $10,000 for their services and then deduct 

$100,000, 10 times as much. It contradicts common sense. It treats 

stock options differently from all other forms of compensation. It 

costs the Treasury billions of dollars each year. It creates an incentive for companies to give out huge stock option grants, further inflating executive pay compared to average worker pay and diluting 

the stock of other stockholders. 

One solution which I favor is to make stock option tax deductions 

match stock option book expenses. Doing that would bring stock options into alignment with all other types of compensation in the 

Tax Code. It would save billions of dollars by revising an overly 

generous stock option tax deduction to make the deduction match 

actual book expenses. And I believe it would also eliminate a bookVerDate 0ct 09 2002 10:41 Sep 24, 2007 Jkt 036611 PO 00000 Frm 00057 Fmt 6633 Sfmt 6601 C:\DOCS\36611.TXT SAFFAIRS PsN: PAT
54

tax difference that encourages and gives incentives to hand out 

more stock options than companies otherwise would, which drives 

executive pay even higher compared to the pay of average workers. 

And it also is giving incentive for some companies to play games 

with the accounting rules and how they value stock options on 

their books, and that is something which we also ought to try to 

prevent. In 2006, CEO pay averaged over $15 million with half coming 

from exercised stock options. CEO pay is now 400 times average 

worker pay. It is out of whack with average worker pay, and part 

of the reason is that accounting and tax rules for stock options are 

also out of whack. The best way, I believe the only way that I can 

foresee, to fix this problem is to bring stock option accounting and 

tax rules into alignment with each other. I introduced a bill to accomplish that back in 1997. I did it again in 2003. There was not 

a lot of traction at that time for either of those bills, mainly, I 

think, due to the battle which was raging over stock option accounting. Now that that accounting issue is resolved and the number is fixed, once it goes onto the books, as FASB has decreed, 

there is now a clear fixed number that goes on the books. Once one 

of the methods is used, we now, it seems to me, have no justification to have a different number in the books for the value of stock 

options than is taken by companies in their tax returns. 

So we are going to try again. I think that the environment is now 

sufficiently different with the resolution of the accounting rule that 

we may be able to get the traction which was missing in prior 

years. 

I was glad to hear from at least one of our witnesses in the first 

panel that that was OK with them, that companies were totally 

neutral on that subject—at least his company was. I look forward 

to neutrality on the part of all of our corporate community when 

this bill is forwarded. I say that with some irony. I am sure that 

we will not have total neutrality, but, nonetheless, we hope that 

companies and, most importantly, that stockholders and investors 

will see the value in having this symmetry finally between what 

the books show and what the tax returns show as well. 

To our witnesses, you have been very helpful, forthcoming, 

thoughtful, and we appreciate all of your testimony, and we will 

stand adjourned. 

[Whereupon, at 11:37 a.m., the Subcommittee was adjourned.] 

(55)

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