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FASB PROPOSALS ON STOCK OPTION EXPENSING

HEARING

BEFORE THE

SUBCOMMITTEE ON

COMMERCE, TRADE, AND CONSUMER PROTECTION

OF THE

COMMITTEE ON ENERGY AND

COMMERCE

HOUSE OF REPRESENTATIVES

ONE HUNDRED EIGHTH CONGRESS

SECOND SESSION

JULY 8, 2004

Serial No. 108–99

Printed for the use of the Committee on Energy and Commerce

(

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

COMMITTEE ON ENERGY AND COMMERCE

JOE BARTON, Texas, Chairman

W.J. ‘‘BILLY’’ TAUZIN, Louisiana

RALPH M. HALL, Texas

MICHAEL BILIRAKIS, Florida

FRED UPTON, Michigan

CLIFF STEARNS, Florida

PAUL E. GILLMOR, Ohio

JAMES C. GREENWOOD, Pennsylvania

CHRISTOPHER COX, California

NATHAN DEAL, Georgia

RICHARD BURR, North Carolina

ED WHITFIELD, Kentucky

CHARLIE NORWOOD, Georgia

BARBARA CUBIN, Wyoming

JOHN SHIMKUS, Illinois

HEATHER WILSON, New Mexico

JOHN B. SHADEGG, Arizona

CHARLES W. ‘‘CHIP’’ PICKERING,

Mississippi, Vice Chairman

VITO FOSSELLA, New York

STEVE BUYER, Indiana

GEORGE RADANOVICH, California

CHARLES F. BASS, New Hampshire

JOSEPH R. PITTS, Pennsylvania

MARY BONO, California

GREG WALDEN, Oregon

LEE TERRY, Nebraska

MIKE FERGUSON, New Jersey

MIKE ROGERS, Michigan

DARRELL E. ISSA, California

C.L. ‘‘BUTCH’’ OTTER, Idaho

JOHN SULLIVAN, Oklahoma

JOHN D. DINGELL, Michigan

Ranking Member

HENRY A. WAXMAN, California

EDWARD J. MARKEY, Massachusetts

RICK BOUCHER, Virginia

EDOLPHUS TOWNS, New York

FRANK PALLONE, Jr., New Jersey

SHERROD BROWN, Ohio

BART GORDON, Tennessee

PETER DEUTSCH, Florida

BOBBY L. RUSH, Illinois

ANNA G. ESHOO, California

BART STUPAK, Michigan

ELIOT L. ENGEL, New York

ALBERT R. WYNN, Maryland

GENE GREEN, Texas

KAREN MCCARTHY, Missouri

TED STRICKLAND, Ohio

DIANA DEGETTE, Colorado

LOIS CAPPS, California

MICHAEL F. DOYLE, Pennsylvania

CHRISTOPHER JOHN, Louisiana

TOM ALLEN, Maine

JIM DAVIS, Florida

JANICE D. SCHAKOWSKY, Illinois

HILDA L. SOLIS, California

CHARLES A. GONZALEZ, Texas

BUD ALBRIGHT, Staff Director

JAMES D. BARNETTE, General Counsel

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

SUBCOMMITTEE ON COMMERCE, TRADE, AND CONSUMER PROTECTION

CLIFF STEARNS, Florida, Chairman

FRED UPTON, Michigan

ED WHITFIELD, Kentucky

BARBARA CUBIN, Wyoming

JOHN SHIMKUS, Illinois

JOHN B. SHADEGG, Arizona

Vice Chairman

GEORGE RADANOVICH, California

CHARLES F. BASS, New Hampshire

JOSEPH R. PITTS, Pennsylvania

MARY BONO, California

LEE TERRY, Nebraska

MIKE FERGUSON, New Jersey

DARRELL E. ISSA, California

C.L. ‘‘BUTCH’’ OTTER, Idaho

JOHN SULLIVAN, Oklahoma

JOE BARTON, Texas,

(Ex Officio)

JANICE D. SCHAKOWSKY, Illinois

Ranking Member

CHARLES A. GONZALEZ, Texas

EDOLPHUS TOWNS, New York

SHERROD BROWN, Ohio

PETER DEUTSCH, Florida

BOBBY L. RUSH, Illinois

BART STUPAK, Michigan

GENE GREEN, Texas

KAREN MCCARTHY, Missouri

TED STRICKLAND, Ohio

DIANA DEGETTE, Colorado

JIM DAVIS, Florida

JOHN D. DINGELL, Michigan,

(Ex Officio)

(II)

C O N T E N T S

Page

Testimony of:

Herz, Robert H., Chairman, Financial Accounting Standards Board .......... 37

Mayer, Steven C., Senior Vice President and Chief Financial Officer,

Human Genome Sciences ............................................................................. 60

Walker, Hon. David M., Comptroller General, U.S. General Accounting

Office .............................................................................................................. 33

White, Rick, President and CEO, Technet, Chairman, International Employee Stock Options Coalition .................................................................... 48

Material submitted for the record:

Barton, Hon. Joe, letter dated August 9, 2004, to William H. Donaldson,

Chairman, Securities and Exchange Commission, enclosing followup

questions for the record, and responses to same ........................................ 144

Dingell, Hon. John D., letter dated August 4, 2004, to Robert H. Herz,

Chairman, Financial Accounting Standards Board, enclosing followup

questions for the record, and responses to same ........................................ 138

Feldbaum, Carl B., President, Biotechnology Industry Organization, letter

dated June 29, 2004, enclosing comments for the record .......................... 130

Herz, Robert H., Chairman, Financial Accounting Standards Board, response for the record to questions of Hon. Jim Davis ................................ 134

Mayer, Steven C., Executive Vice President and Chief Financial Officer,

Human Genome Sciences, Inc., letter dated June 29, 2004, enclosing

comments for the record ............................................................................... 120

Trumka, Richard L., Secretary-Treasurer, AFL-CIO, prepared statement

of ..................................................................................................................... 116

(III)

(1)

FASB PROPOSALS ON STOCK OPTION

EXPENSING

THURSDAY, JULY 8, 2004

HOUSE OF REPRESENTATIVES,

COMMITTEE ON ENERGY AND COMMERCE,

SUBCOMMITTEE ON COMMERCE, TRADE,

AND CONSUMER PROTECTION,

Washington, DC.

The subcommittee met, pursuant to notice, at 1:35 p.m., in room

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

presiding.

Members present: Representatives Stearns, Shimkus, Shadegg,

Bass, Terry, Ferguson, Issa, Barton (ex officio), Schakowsky,

Towns, Brown, Stupak, Green, Strickland, Davis, and Dingell (ex

officio).

Staff present: David Cavicke, majority counsel; Chris Leahy, majority counsel and policy coordinator; Brian McCullough, professional staff, Will Carty, legislative clerk; and Consuela Washington,

minority counsel.

Mr. STEARNS. Good afternoon. Today the subcommittee will convene and will consider what all of us believe are important questions concerning accounting treatment of stock options.

This hearing continues the bipartisan work we have done in this

subcommittee to improve accounting standards. This work has included examination of restatements at Enron, Andersen, and

Freddie Mac. It has also involved extensive oversight on modernization of FASB and the process by which FASB makes its

rules.

I am pleased that FASB has acted on a number of our recommendations, including closing loopholes on special purpose entities and speeding up the process of decisionmaking.

I want to also thank Ranking Member Jan Schakowsky, for her

spirit of bipartisanship that has helped this subcommittee. I also

would like to thank Chairman Barton for his leadership and for facilitating this hearing, and Ranking Member John Dingell for his

long leadership and vision on accounting issues.

My colleagues, currently FASB provides that companies may either expense options provided to employees or disclose the expenses

in footnotes. Now, companies that disclose the expense in footnotes

do not reflect the expense in their reported earnings. About 575

companies, mostly since the excesses of the 1990’s, have decided

voluntarily to expense options. Now, these companies include General Motors, Ford, Citigroup, Coca-Cola and Microsoft. The rest of

2

public companies that have options choose not to reflect their expense as reported earnings.

FASB is considering a rule change that would require companies

to expense stock options, thereby informing investors of the effect

of the options grants on earnings. This proposal would make GAAP

consistent with international accounting standards which in January will require the expensing of options. This proposal by FASB

is controversial, we grant that, and members have legitimate views

on both sides of this issue.

The rule would cause stock options to be treated like other types

of compensation paid to employees, including cash and stock, which

expense is reflected in companies’ quarterly earnings. FASB’s proposal would also make GAAP consistent with the tax treatment of

options. Currently, companies don’t have to report the expense of

options to their shareholders but can deduct the cost of the same

options on their taxes. I understand that Alan Greenspan, Paul

Volcker, SEC Chairman Bill Donaldson, Treasury Secretary John

Snow, and of course Warren Buffett support FASB’s position.

Many of our leading technology companies who are represented

here today oppose FASB’s position. They argue that options are difficult to value and often expire worthless. As such, the options

should not count as an expense.

We learned from Baruch Lev in a previous hearing that all numbers in accounting, be they accounting, account receivables, pension

expense, or depreciation and amortization, are literally just estimates.

There are rigorous means available for establishing the values of

options. These means are used to tell senior executives the expected value of their pay package. Companies also seem to have an

easier time determining the value of options when they deduct

them on their corporate taxes.

My good colleague, Congressman Richard Baker, has introduced

legislation, H.R. 3574, which would direct the SEC to prevent

FASB from requiring the expensing of options. The Financial Services Committee has approved this legislation, although the bill has

not yet—the committee has not yet filed the report. I expect our

witnesses will discuss this bill today. I hope they will.

There are two points that I would like to highlight for members

of this subcommittee on this legislation. I am concerned that the

legislation may effectively forbid the more than 575 companies that

are voluntarily expensing options from doing so in the future. I

want each of our witnesses to explain to us if this reading of this

legislation is correct by me: If companies that are voluntarily expensing options can no longer do so upon inaction of this legislation, some of those 575 companies, wouldn’t they be in violation of

GAAP? This violation could lead to a significant number of restatements of earnings for those companies.

Regardless of your position, my colleagues, on the merits of this

legislation, forced restatements are not a desirable outcome. During questions, I will ask each witness to address the question of

how the legislation affects those companies that are voluntarily expensing their options.

And second, my colleagues, the legislation provides that options

granted to the top five executives in a company should be exVerDate 11-MAY-2000 13:12 Sep 30, 2004 Jkt 000000 PO 00000 Frm 00006 Fmt 6633 Sfmt 6633 95450.TXT HCOM1 PsN: HCOM1
3

pensed. However, the legislation requires by statute that the volatility of these options be assumed to be zero. The central insight—

the central insight of Fisher Black and Myron Scholes for which

they won the Nobel Prize was that the value of options is determined predominantly by their volatility. If volatility is required by

statute to be zero, then the value of the options will likely be zero

as well. Stock prices go up, they go down. That is volatility. I would

like the witnesses to address the question of why assumed volatility of zero for options should be mandated by statute by this

Congress.

If this legislation moves to the floor, I would encourage Members

on both sides of this issue to support amendments that I believe

would cure those two defects.

On the proposal by FASB, I recognize that expensing options involves estimating their value. Sometimes those estimates will be

incorrect. Accounting statements are supposed to provide investors

with the best current view of the assets and liabilities of a company

at a particular time. Opponents of FASB are wanting to keep treating options as though they are worthless in all situations. If they

are worthless, people wouldn’t want them. So I prefer that we have

financial statements that be approximately correct rather than

completely wrong.

So I look forward to the testimony. With that, the distinguished

colleague, Ms. Schakowsky.

Ms. SCHAKOWSKY. Thank you, Chairman Stearns, and I, too, appreciate your bipartisan approach to this committee’s work and for

holding today’s hearing on one of the most important issues under

our subcommittee’s jurisdiction, accounting standards.

Ranking Member Dingell, your presence here signifies how important accounting standards are to corporate responsibility, investors, and pension holders, and our country’s economic well-being,

especially since you took time out on your birthday to be here. So

I want to wish you a very, very happy birthday.

I also would like to welcome Congressman Rick White. I thank

you for joining us to discuss FASB and the proposed rules that

would require companies to expense all stock options issued to

their employees.

We know from the corporate scandals of the past few years that

accurate and transparent accounting is vital to corporate accountability and shareholder confidence. Yet, the accounting treatment

of stock options allows corporations to continue to distort their true

financial standing. Stock options make up 80 percent of compensation packages for corporate managers. In 2003, CEO pay at 350

major U.S. public companies averaged $8 million, with stock options typically providing the largest compensation component. Despite those facts, stock options are the only form of compensation

that may be completely absent from corporate financial statements.

The unique and unwarranted accounting treatment afforded

stock option has fueled abuses linked to excessive executive pay, inflated company earnings, dishonest accounting, and corporate misconduct. Nobel Prize winner Joseph Stiglitz believes that the absence of stock option expensing requirements has, quote, played an

important part in the spread of other financial chicanery, end

quote, where corporate energy and creativity was, quote, directed

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less and less into new products and services and more and more

into new ways of maximizing executives’ gains at unwary investors’

expense. Unquote.

A September 2002 report by a blue ribbon panel of the Conference Board found that the current accounting treatment of stock

options helped foster a vicious cycle of increasing short-term pressures to manipulate earnings, to bolster stock price, so that those

receiving options could cash in, take the money, and run.

FASB’s proposed rule would remove these perverse incentives,

and help bring transparency to corporate financial statements. Investors and pension plan managers want the kind of accurate financial information that FASB’s rule would provide. It would help

them make informed investment decisions about retirement security.

Since 2002, at least 576 corporations have decided that expensing options is a sound accounting practice that attracts investors

and have voluntarily begun expensing the options that they grant

all their employees. Yet, some of our colleagues are trying to prevent FASB’s proposed rule with H.R. 3574, the so-called Stock Option Accounting Reform Act. If this bill is enacted, it would not only

stop FASB’s rule but would in fact stop those nearly 600 corporations from voluntarily providing an accurate accounting of their expenses.

While it claims to be a compromise and would require the expensing of options given to the top executive along with the four

highest paid officers, it does so in a way that Warren Buffett describes as, quote, mathematical lunacy, unquote. In fact, H.R. 3574

is written so that the options would have no value and would be

reported as a no cost expense. This is not a compromise but a giveaway to corporations at the expense of investors.

In the wake of Enron, Tyco, WorldCom, and other corporate

scandals, this is the wrong message to be sending to all those workers and investors who lost their life savings and retirement security, and it is the wrong policy to pursue if we want to boost consumer confidence and improve our economy.

Far too often Congress has weighed in at the behest of powerful

special interests to back reforms like the expensing of stock options. It is my hope that we have learned from the past and will

let FASB do its job.

I look forward to hearing the testimony of our witnesses, and I

thank you, Mr. Chairman.

Mr. STEARNS. I thank the gentlelady.

The full chairman of the Energy and Commerce Committee, Mr.

Barton.

Chairman BARTON. Thank you, Mr. Chairman. I, too, want to extend my best wishes to John Dingell on his birthday today. We had

a little birthday party for him upstairs with the staff, and we appreciate him being in good cheer today and being here.

I also want to welcome Rick, who used to be a member of this

committee, and encourage Sherrod Brown and Bart Stupak to eat

lots of ice cream and cake so they won’t be in good shape for tonight’s congressional baseball game which we are going to have out

at the field at 7 o’clock.

5

Thank you, Mr. Chairman, for holding this hearing. It is a proper

and appropriate exercise of the Energy and Commerce Committee’s

jurisdiction. It is obvious that the Financial Accounting Standards

Board proposed rules for stock option expensing is an issue that is

clearly within the jurisdiction of the Energy and Commerce Committee and within the meaning of the memorandum of understanding that was reached between this committee and the Financial Services Committee in January 2001. That MOU was a document that was negotiated by the Speaker’s office, former Chairman

Tauzin, and Chairman Oxley to define the jurisdiction over the setting of accounting standards by the Financial Accounting Standards Board. And I quote: This hearing follows 31⁄2 years of subsequent work in this area, including the historic hearings that this

committee held on the collapse of Enron, the problems at

WorldCom, and the general corporate scandals that we have had

in the last 3 or 4 years. Those hearings were led by Chairman Tauzin and led on the minority side by Congressman Dingell. The Energy and Commerce Committee is a committee that will get to the

bottom of things, and we will exercise our jurisdiction in an area

that we clearly have jurisdiction.

Having said that, I think I need to comment on the record on

some issues that are probably on a lot of people’s minds. The Financial Services Committee ordered H.R. 3574, the Stock Option

Accounting Reform Act, out of their committee several weeks ago.

I did not oppose that. I didn’t oppose obviously Mr. Baker, Congressman Baker, and Congressman Oxley and others reporting that

bill. I did ask the Energy and Commerce majority staff to ensure

that our committee’s jurisdiction be protected. Quite frankly, that

is what committee chairmen are supposed to do, and that is certainly something that Chairman Dingell did when he was chairman of this full committee.

When the House leadership announced last week that H.R. 3574

would be on the floor this week, you know, I made a decision that

we would cooperate—and I want to underline cooperate—with that

bill going to the floor. I felt and continue to feel that the Energy

and Commerce Committee should be entitled to a referral of the

bill, and instructed our general counsel to go to the Parliamentarian and ask that it be referred. We also at the staff level

touched base with the Rules Committee. The Parliamentarian did

issue a ruling that had the Financial Services Committee reported

their bill, had they actually filed their report, the Parliamentarian

indicated that it would be referred to our committee.

But I did tell the leadership that if we did get a referral, we

would hold a hearing today, a legislative hearing today on the bill

and would report the bill today so that it would be on the floor tomorrow. At no time did I indicate to the Speaker’s office, the majority leader’s office, the Rules Committee that this committee would

in any way obstruct H.R. 3574 from being reported to the floor for

an up or down vote by the House of Representatives. It was not my

decision to not file the report by the Financial Services Committee.

That is a decision that was made by that committee.

So having said that, what we are doing today, since there is no

bill, there is no committee report that has been filed by the Financial Services, today’s hearing is not a legislative hearing, it is simVerDate 11-MAY-2000 13:12 Sep 30, 2004 Jkt 000000 PO 00000 Frm 00009 Fmt 6633 Sfmt 6633 95450.TXT HCOM1 PsN: HCOM1
6

ply an information hearing, and I am very pleased that FASB and

various private sector individuals are here so that we can have this

hearing and get additional information on the record.

There are substantial policy issues involved. Those issues need

to be aired. The witnesses before us have a wealth of expertise and

are very knowledgeable on the matters that are important in how

we set these standards, if we set standards, on how stock options

are to be expensed. We have asked the witnesses to share their

views because they plainly have something to say, and I believe

they deserve to be heard by this committee.

The decision has been made on the bill that was reported out of

Financial Services, 3574, to not file the report and not report it to

the floor tomorrow. That is not the fault of this committee or of my

responsibilities as chairman of the Energy and Commerce Committee. I respect that decision if that is the decision that has been

made, but in some ways I regret it because I too am concerned

about the pending FASB proposal, and I want the head of FASB

to understand that.

I personally think that it is very difficult to value a stock option

at the time it is granted. No one can predict with any degree of certainty where the future is going to take the valuation of these companies. Sometimes the stock price will go up and the option will become extremely valuable. Other times, certainly in the last 3 or 4

years, stock prices stagnate or decline precipitously and the options

are worthless. I don’t think that we should mandate at the Federal

level the expensing of options that turn out to be worthless. You

know, I think you would set a value on something that can actually

be put in the bank. If you give me a cash bonus of $1,000, it is

worth $1,000. You know, there are ways to determine real value,

but some sort of a guess about where the stock price might be at

a date certain in the future is almost by definition going to be proven wrong.

Financial analysts analyze companies for a living. They are very

aware of the stock option grants that various companies give, the

impact that they have or might have on earnings, and presumably

these analysts have already discounted into the price of that company’s stock whatever the dilution value is, if any, of those options.

The question becomes that requiring mandatory expensing, will

that in itself change the valuation of a company? If it does not affect the valuation of the company, what is gained?

What is certain is that a change to the accounting standards that

would require expensing would transform corporate governance

and would change methods of compensation and possibly impact

our international economic competitiveness. That is a very, very serious issue that needs to be seriously addressed. I hope that we can

address some of those issues at the hearing today. I hope we can

resolve these issues.

If in fact it is a decision that needs to be made that we need to

report a Federal initiative, a Federal bill on these issues, to the extent this committee has jurisdiction we will work to report a responsible bipartisan bill.

I thank Chairman Stearns for holding the hearing. I look forward

to listening to the witnesses, and I thank their attendance at today’s hearing. With that, I yield back the balance of my time.

7

Mr. STEARNS. And I thank the chairman for his leadership.

The gentleman from Michigan whose birthday is today that we

all wish him the best wishes, Mr. Dingell.

Mr. DINGELL. Mr. Chairman, I thank you, and I commend you

for holding this very important hearing.

I want to say a word about my friend, Mr. Barton, the chairman

of the full committee. First, thanks for his good wishes on my

birthday. A day on the green side of the sun is quite an event in

my life. I want to thank him for his kind comments.

I also want to commend him for the courageous and energetic

way in which he has dealt with this committee’s jurisdiction and

the right of this committee to address matters within the longstanding jurisdiction of this committee over accounting, accounting

standards, and the Financial Accounting Standards Board, FASB.

I want to point out that I know that this is not always an easy

task, and I want him to know that I am appreciative, as other

members of this committee, of the rare and courageous way in

which he has addressed this matter, and I want him to know of my

appreciation. I thank you.

I also want to address the exposure draft of FASB and the Baker

bill. These two items, considered along with or against each other,

are very significant issues that deserve the attention of this committee and the public. This committee has been interested in the

question of bad and dishonest accounting going back into the 1970’s

when we first addressed the question of dishonest accounting in

connection with the Penn Central bankruptcy. In that instance, the

committee found that there was out and out lying in the accounting, that the insiders inside the corporation got out of the stock,

left it to the investors, walked away with hundreds of millions of

dollars, and left the taxpayers with a bill for restructuring railroads in the northeast United States that cost the taxpayers over

$7 billion.

It is interesting to note that neither the ICC nor the Internal

Revenue nor the shareholders nor the SEC nor the then ICC had

the vaguest idea of what was happening, because the accountants

had lied, and we were called upon to pony up huge sums of money

on behalf of the taxpayers to address this problem.

Since that time, you can look at the records of corporate failures,

and you will find consistently that those records of corporate failures are almost invariably bottomed on or have as a major participating element dishonest, incompetent, and improper accounting.

Tyco, AOL, WorldCom, Sunbeam, and of course Enron are splendid

examples of how this can be done.

Interestingly enough, the Europeans are beginning to move toward more responsible kinds of accounting in that they seek in

their handling of these matters to see to it that the accountant tells

everybody truthfully what the state of the corporation is so that investors know, so that the corporate officers know, and so that the

public knows the state of affairs in that corporation.

It is to be observed here that the Congress seeks to take from

FASB the authority to address the problem of responsible accounting standards.

I don’t know exactly what is going to be the result of this by the

FASB, and I am willing to wait. I would note that the investigative

8

hearings chaired by our colleague Mr. Greenwood as to the causes

and effects of Enron, WorldCom, HealthSouth, and other accounting debacles, and the hearings chaired by you, Mr. Chairman

Stearns, into the failings of U.S. accounting standards are so that

faulty behavior in accounting has facilitated these debacles, and we

are finding that there have been, amongst other things else, stock

option abuses revealed, accounting standards riddled with loopholes, audit failures, massive failures of corporate governance,

amongst other things.

We have directed FASB to fix the problems within its purview,

such as special purpose entities, stock option accounting, and establishing a framework for measuring financial and nonfinancial

assets and unfair value. It is, after all, what accounting is about.

And if you look at the accounting of other countries, you will find

that other countries have seen their economies go south because

the accounting in those countries is so bad. And, indeed, it is so

bad that not only do the investors, the government not know the

state of affairs of the accounting or the state of affairs of those corporations, but the owners and the operators and the high corporate

officers of those corporations have handled those matters so poorly

and they have been so diligent in lying to themselves and everybody else that nobody has the vaguest idea what in the name of

common sense the situation might be.

So fixing a situation of this sort so that finally the corporations

are able to restructure themselves and come to a sound accounting

and to a sound business state is almost impossible.

We are here today because FASB issued an exposure draft requesting public comment on a proposal to require that companies

account for stock options as an expense using the fair value method. More than 575 American companies have announced their intention to or have begun to voluntary expense their options at fair

value. These corporations can do it. Why is it that others cannot?

I would note that the comment period for FASB’s proposal expired at the end of June. FASB is now in a months long stage of

reviewing all comment letters, including public hearings, and redeliberating and revising the proposed standard. This is a fair and

an open process, one with which I agree and with which I think

no one may take criticism. I cannot say today whether I support

or disagree with the FASB standard since it is still in a state of

flux. I do agree with the general principle, and I observe that it is

required under international accounting standards by foreign competitors of the United States.

As for the Baker bill, all I can say is: ‘‘What were they thinking?’’

I thought this country had seen enough phony accounting, and yet

here we have before us a piece of legislation which sanctifies and

indeed which endorses phony, false accounting. It also prohibits

honest accounting by corporations that feel that this is in their best

interest and in the interests of the shareholders. This is a clear

case study in why Congress should not be in the business of writing accounting standards. It decrees that the company shall count

options as an expense for the five highest corporate executives but

not for anybody else. A most curious decision. The bill prohibits

voluntary expensing of options by the 575 companies that are currently and voluntarily expensing their options. It mandates that

9

when a company is calculating the expense of options for the top

five executives, it shall assume that the price volatility is zero.

Has anybody looked at the different indexes in the securities

markets? They will tell you clearly that volatility is never zero in

the stock market. And they are saying then that it never moves up

and it never moves down. If there ever was an Alice in Wonderland, make believe world, we are seeing it here.

There are other gems of wisdom before us. I ask unanimous consent to insert in the record FASB’s letter analyzing the bill in response to questions that I have posed.

Mr. STEARNS. By unanimous consent, so ordered.

[The information referred to follows:]

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Mr. DINGELL. I thank you. I also ask unanimous consent that a

fine op-ed article by Warren Buffett and a statement by FACTS,

the Financial Accounting Coalition for Truthful Statements, which

is a coalition of over 30 pension funds, consumer/investor groups,

and labor unions who oppose this bill and support FASB’s proposal,

also be inserted into the record.

Mr. STEARNS. By unanimous consent, so ordered.

[The information referred to follows:]

[Tuesday, July 6, 2004—The Washington Post]

FUZZY MATH AND STOCK OPTIONS

By Warren Buffet

Until now the record for mathematical lunacy by a legislative body has been held

by the Indiana House of Representatives, which in 1897 decreed by a vote of 67 to

0 that pi—the ratio of the circumference of a circle to its diameter—would no longer

be 3.14159 but instead be 3.2. Indiana schoolchildren momentarily rejoiced over this

simplification of their lives. But the Indiana Senate, composed of cooler heads, referred the bill to the Committee for Temperance, and it eventually died.

What brings this episode to mind is that the U.S. House of Representatives is

about to consider a bill that, if passed, could cause the mathematical lunacy record

to move east from Indiana. First, the bill decrees that a coveted form of corporate

pay—stock options—be counted as an expense when these go to the chief executive

and the other four highest-paid officers in a company, but be disregarded as an expense when they are issued to other employees in the company. Second, the bill says

that when a company is calculating the expense of the options issued to the mighty

five, it shall assume that stock prices never fluctuate.

Give the bill’s proponents an A for imagination—and for courting contributors—

and a flat-out F for logic.

All seven members of the Financial Accounting Standards Board, all four of the

big accounting firms and legions of investment professionals say the two proposals

are nonsense. Nevertheless, many House members wish to ignore these informed

voices and make Congress the Supreme Accounting Authority. Indeed, the House

bill directs the Securities and Exchange Commission to ‘‘not recognize as ‘generally

accepted’ any accounting principle established by a standard setting body’’ that disagrees with the House about the treatment of options.

The House’s anointment of itself as the ultimate scorekeeper for investors, it

should be noted, comes from an institution that in its own affairs favors Enronesque

accounting. Witness the fanciful ‘‘sunset’’ provisions that are used to meet legislative

‘‘scoring’’ requirements. Or regard the unified budget protocol, which applies a portion of annual Social Security receipts to reducing the stated budget deficit while

ignoring the concomitant annual costs for benefit accruals.

I have no objection to the granting of options. Companies should use whatever

form of compensation best motivates employees—whether this be cash bonuses,

trips to Hawaii, restricted stock grants or stock options. But aside from options,

every other item of value given to employees is recorded as an expense. Can you

imagine the derision that would be directed at a bill mandating that only five bonuses out of all those given to employees be expensed? Yet that is a true analogy

to what the option bill is proposing.

Equally nonsensical is a section in the bill requiring companies to assume, when

they are valuing the options granted to the mighty five, that their stocks have zero

volatility. I’ve been investing for 62 years and have yet to meet a stock that doesn’t

fluctuate. The only reason for making such an Alice-in-Wonderland assumption is

to significantly understate the value of the few options that the House wants counted. This undervaluation, in turn, enables chief executives to lie about what they are

truly being paid and to overstate the earnings of the companies they run.

Some people contend that options cannot be precisely valued. So what? Estimates

pervade accounting. Who knows with precision what the useful life of software, a

corporate jet or a machine tool will be? Pension costs, moreover, are even fuzzier,

because they require estimates of future mortality rates, pay increases and investment earnings. These guesses are almost invariably wrong, often substantially so.

But the inherent uncertainties involved do not excuse companies from making their

best estimate of these, or any other, expenses. Legislators should remember that it

is better to be approximately right than precisely wrong.

If the House should ignore this logic and legislate that what is an expense for

five is not an expense for thousands, there is reason to believe that the Senate—

24

like the Indiana Senate 107 years ago—will prevent this folly from becoming law.

Sen. Richard Shelby (R-Ala.), chairman of the Senate Banking Committee, has firmly declared that accounting rules should be set by accountants, not by legislators.

Even so, House members who wish to escape the scorn of historians should render

the Senate’s task moot by killing the bill themselves. Or if they are absolutely determined to meddle with reality, they could attack the obesity problem by declaring

that henceforth it will take 24 ounces to make a pound. If even that friendly standard seems unbearable to their constituents, they can exempt all but the fattest five

in each congressional district from any measurement of weight.

In the late 1990s, too many managers found it easier to increase ‘‘profits’’ by accounting maneuvers than by operational excellence. But just as the schoolchildren

of Indiana learned to work with honest math, so can option-issuing chief executives

learn to live with honest accounting. It’s high time they step up to that job.

The writer is chief executive officer of Berkshire Hathaway Inc., a diversified

holding company, and a director of The Washington Post Co., which has an investment in Berkshire Hathaway.

Copyright 2004 The Washington Post

25

26

27

Mr. DINGELL. Mr. Chairman, in closing, I look forward to hearing

the testimony of FASB, of GAO, and our high tech witnesses this

afternoon. I am not opposed to trying to find a fair and reasonable

way to address the tech industry’s concerns with the FASB proposal. I ask only that at least at this time we consider that we do

not fully understand what the virtues and vices of this are, nor

have we heard from everybody who wishes to be heard, nor has a

fair and open process been permitted to come to a proper conclusion.

It is clear to me that the Baker bill is not the answer. It is equally clear to me that it is irresponsible and improper meddling in a

process which is too important to be tinkered around with by an

uninformed and ignorant Congress that doesn’t understand highly

technical questions of this kind.

I thank you and yield back the balance of my time.

Mr. STEARNS. And I thank the gentleman.

Mr. Ferguson? Okay. Mr. Stupak?

Mr. STUPAK. Mr. Chairman, thank you. I would also like to commend Chairman Barton for his strong defense of the committee’s

jurisdiction over the issue before us today. The Energy and Commerce Committee has a long jurisdictional history over accounting

standards and the Financial Accounting Standards Board. It is

highly appropriate that we are holding this hearing, and I commend the chairman’s leadership and the subcommittee chair for

holding this hearing.

Today’s hearing will clarify the need for the expensing of stock

options, the need to keep FASB free from political and business interference, and the very real problems with H.R. 3574, the bill recently voted out of the Financial Services Committee, that would

block the FASB proposal.

H.R. 3574 is evidence of exactly why Congress should leave accounting standards to the experts. Politicians are not accountants.

Politicians should leave the rules of balancing the books to the experts. We can’t balance our own books. Under this Congress, the

United States has a debt of at least $7.1 trillion, and we will run

a deficit of at least $521 billion.

For over 30 years we have trusted FASB to set accounting and

reporting standards for private and public companies. Congress

interfered once in that independence in 1993 when it pressured

FASB to not implement a stock option expensing plan then. Had

we not made that mistake, perhaps some of the excesses of the late

1990’s could have been avoided.

Frankly, I think a few companies are trying to generate controversy by making red herring arguments about the FASB proposal. But a consensus among financial experts, accounting experts

and consumer advocates is that the FASB proposal is needed. Federal Reserve Chairman Alan Greenspan, Treasury Secretary John

Snow, SEC Chairman William Donaldson, Warren Buffett, and the

big four accounting firms all support expensing of stock options.

Over 500 companies already expense stock options voluntarily. And

the International Standards Accounting Board, whose standards affect 90 countries, will require the expensing of stock options in

2005. Canada already requires it. Stock option expensing is not

controversial. It is long overdue.

28

Finally, I would like to conclude by saying that H.R. 3574 is a

deeply flawed bill. First, it applies expensing of stock options only

to the CEO and the four other highest paid executives in the company, and the bill sets up a method of valuing those executives’ options that doesn’t make sense. When calculating the value of those

options, the company is to assume that the volatility of the underlying stock is zero. Stock prices move. In fact, the greater the volatility, the greater the value of the stock option. Warren Buffett

gave these two measures a flat out F for logic.

Another huge problem with the bill is that it would prohibit the

voluntary expensing of options by over 575 companies that are currently voluntarily exercising their options including Wal-Mart,

Ford, General Motors, Microsoft, Coca-Cola, and other innovative

younger companies like Netflix. Startup companies that are expensing stock options voluntarily are often seen as more attractive

investments precisely because they expense stock options. The crux

of this matter is transparency. Investors have the right to receive

accurate information about a company’s financial health. We know

too well what happens when companies cook their books. And this

committee knows too well the sham accounting gimmicks used to

inflate earnings and boost stock prices. Soaring stock prices allowed Enron’s CEO Ken Lay to take home $123 million from exercising his stock options the year Enron went bankrupt. $123 million. Yesterday, Ken Lay was indicted on criminal charges. His indictment should serve as a reminder to Congress why this reform

is needed. We should let FASB do their job.

With that, Mr. Chairman, I yield back the balance of my time.

Mr. STEARNS. I thank the gentleman.

Mr. Bass.

Mr. BASS. Thank you, Mr. Chairman, and as the Chair well

knows, I welcome this hearing. I welcome this hearing in the new

light, shall we say, of being able to consider before it reaches the

floor an important issue, not having the jurisdiction of this committee completely obfuscated by another committee.

We have, as the Chair well knows, taken the time here to have

significant hearings on this issue over the last couple of years, and

the content is extremely important.

I don’t want to have any of my comments be interpreted as either

supporting or opposing the issue of expensing of options, because

there are very good arguments on both sides, both for expensing

and against expensing options, and the purpose of this hearing is

to dive into those reasons or issues. And we have very good witnesses here, not the least of which is one of my classmates and

former member of this committee, Rick White, from Washington.

However, as some other members of this committee have said in

their opening statements, we passed a couple of years ago as a result of scandals plaguing our economy, corporate world, the Sarbanes-Oxley bill, and it contained phrases such as ‘‘independent

judgment’’ and ‘‘free from bias’’ when establishing the manner in

which the FASB should set standards, and to have credibility

given, independent credibility given to these regulatory agencies.

Now, I have heard from many of my constituents regarding the

concerns with the FASB proposal that would require expensing,

and I question whether the proposed legislation which might have

29

been on the floor tomorrow had it not been for the leadership of

our full committee chairman and the subcommittee chairman,

whether this is exactly the way we should be going about it.

So I look forward to hearing the testimony of our witnesses here

today, and I thank you, Mr. Chairman, not only for holding this

hearing which you planned to hold quite a few weeks ago, but really working hard to make it relevant.

Mr. STEARNS. I thank my colleague.

Mr. Davis.

Mr. DAVIS. I will waive, Mr. Chairman.

Mr. STEARNS. Okay. The gentleman waives. He will have 3 extra

minutes on his questioning.

Mr. Shadegg.

Mr. SHADEGG. I thank you, Mr. Chairman, and I have a full

statement which I will put in the record.

I simply want to start by commending you for holding this hearing. I think it is very important that we look at this issue. I am

a cosponsor of H.R. 3574, and I believe that there are legitimate

concerns to be looked at here, and I think it is important that this

committee examine those issues.

I personally am not fond of compelling the expensing of all stock

options. I am deeply concerned that that will hurt some industries,

particularly some in my own district that are technology, high-tech

startups and companies that have used stock expensing to

incentivize and to encourage very, very talented employees to take

a risk on their companies, and have done so successfully. And I

think just by dent of philosophy, I believe that everything we can

do within our economic system to give employees a stake in the

profitability of a company or in its success is a step in the right

direction. And so I think it is important that we look at anything

that would put that structure at risk. And I think stock options are

a part of the structure that give employees a stake in the company.

I am concerned about the FASB proposal for a number of reasons. I am particularly concerned that there is no agreed upon

method of valuation which everyone says is in fact accurate. I understand that there is consensus that there are some proposals

that are more accurate than others and some sense that this might

be an improvement, but I think we should, if anything, in this area

go slow. And I think the Baker bill, the H.R. 3574 is a reasonable

compromise in going slow in this area.

I would suggest that it is focused at the top management of the

company, because those are the individuals who can in fact manipulate. And if the concern is, as one of my colleagues said on the

other side, abuse of the corporation or of its financial structure

through stock options, those are the individuals that would be involved in that.

I do want to make two additional points. There has always been

some concern expressed that setting the volatility at zero as the

Baker legislation does means we are setting the value of the option

at zero, and that is clearly wrong. There are five other factors that

go into the valuation of the stock. What setting at zero does is it

creates a level playing field. It is both simple, understandable, and

it produces consistent results which can be easily verified, accordVerDate 11-MAY-2000 13:12 Sep 30, 2004 Jkt 000000 PO 00000 Frm 00033 Fmt 6633 Sfmt 6602 95450.TXT HCOM1 PsN: HCOM1
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ing to Frederick Cook, a FASB appointed member of the Option

Valuation Group.

I think the second issue I want to address is the concern that

some have that the Baker bill would prohibit companies from voluntarily expensing. As has been noted, many companies are currently doing that. I know that from my work on this legislation in

the Financial Services Committee on which I also serve, that it was

certainly not the intent of the authors of the bill to prohibit any

company that chooses to voluntarily expense its stock from doing

so, and that it is at least the belief of Mr. Baker and the authors

of the bill that it in fact does not prohibit any company from choosing to voluntarily expense all of the stock options with which they

issue.

I would conclude by simply saying that in a paper entitled Expensing Options Solves Nothing, a report by Harvard business professor of Business Administration, he argued that, if anything, expensing may lead to a more distorted picture of a company’s economic condition and cash-flow than current financial statements

provide. I think we ought to be guided by those words. I think the

Baker compromise is a reasonable compromise. I certainly believe

we ought to examine these issues. And I commend you, Mr. Chairman, for doing so. But, in the interest of my constituents who are

high-tech companies who believe this is a critical part of the incentives they use to make their companies viable and to compete with

longstanding companies, I think it would be very—we would be ill

served to not look at these issues thoughtfully, and, I hope, require

expensing only where it in fact will aid the marketplace and aid

investors, and not where it will harm the viability of the American

economy and particularly high-techs and startups.

With that, Mr. Chairman, I yield back.

Mr. STEARNS. I thank the gentleman.

The gentleman from Ohio. Mr. Brown.

Mr. BROWN. I thank the chairman. I also wish to send birthday

wishes with Mr. Dingell, who shares a birthday with my mother.

And Mr. Dingell, I would add, since my mother is not here to hear

it, is much younger than my mother.

But the issue of if our publicly traded companies account for

stock options has important implications for the integrity of corporate governance and the soundness of American financial markets, that is why as we consider whether to interfere with efforts

to reform stock option accounting Congress should in fact heed the

physician’s maxim: First do not harm.

In 1995, as we remember, Congress overrode President Clinton’s

veto of legislation limiting shareholder securities lawsuits. The bill

was authored by the then chairman of this committee and cosponsored by its current chairman as well as the current chairman of

the Financial Services Committee. The bill was a not particularly

partisan one; in fact, the veto override passed overwhelmingly. But,

frankly, we got that one wrong, after Enron collapsed in 2001, leaving corporate watchdogs pointing to the 1995 laws, one contributor

to a fast and loose corporate culture that spawned the Enron debacle and a string of other corporate scandals.

Today, with another reform bill before us, Congress may be preparing to repeat that mistake. H.R. 3574 derails FASB’s common

31

sense standards, as Mr. Stupak said, for the clear, open and uniform expensing of stock options. Those standards are supported by

fed Chairman Greenspan, SEC Chairman Donaldson, institutional

investors like the Ohio Public Employees Retirement System,

which incidentally lost $114 million to the Enron scandal.

H.R. 3574 offers the illusion, as we do so often here, of corporate

accountability, because though it requires expensing of options to

top corporate officers, it also effectively requires that the company

place no value on those options. That bill actually undermines existing reforms by prohibiting companies, again as Mr. Stupak said,

that have already begun to expense their options from continuing

that practice. GM and GE, Ford, and UPS and Wal-Mart and Amazon.com and more than 500 other companies believe they can compete effectively with full disclosure, and shareholders for leading

tech firms like HP, Intel, Apple, and IBM believe their interests

are better served by expensing. But this bill makes that illegal.

Here is what President Clinton had to say in his veto message

of the 1995 securities law: Our markets are as strong and effective

as they are because they operate and are seen to operate with integrity. I believe this bill would erode this crucial basis of our market strength. Unquote.

That is just as true today as it was just about a decade ago. I

look forward to the testimony of our witnesses, Mr. Chairman. I

hope we can approach this important issue today and as the legislation advances with the renewed commitment to do no harm.

I yield back my time.

Mr. STEARNS. I thank the gentleman.

Mr. Green.

Mr. GREEN. Thank you, Mr. Chairman.

I would like to commend our Chairman Barton for the defense

of our committee’s jurisdiction on this legislation in particular, and

I would also like to thank you and our ranking member for holding

this important hearing.

It is interesting as we hold this hearing, Ken Lay, former CEO

of Enron, is in a courtroom in Houston facing charges for behavior

this bill seeks to prevent. Under this bill, Ken Lay’s stock options

would have been fully reported. And I support entrepreneurial spirit of American companies; however, we have seen in recent years

there is need to supply shareholders better information on the

value of their share holdings. This bill is a step forward in achieving that goal.

The legislation provides protections from deceptive reporting of

stock values and affords businesses the ability to use such options

to entice the best and the brightest. Such incentives are critical to

the development of technology and related industries where human

capital is the driving force of the industry. Under this legislation,

companies must report stock options going to the top five executives. It is the behavior of top heavy profits that has gotten many

large corporations in trouble, and I believe this is a strong start in

safeguarding the value of stock other shareholders possess.

And, Mr. Chairman, hopefully this is our first hearing and we

are moving in the right direction with this legislation, and I yield

back my time.

[Additional statements submitted for the record follow:]

32

PREPARED STATEMENT OF HON. BARBARA CUBIN, A REPRESENTATIVE IN CONGRESS

FROM THE STATE OF WYOMING

Thank you, Mr. Chairman.

I look forward to our hearing today on an important matter of competitiveness.

The concept of using stock options as an incentive for employee performance helped

contribute to substantial growth in the tech sector and brought many small businesses from infancy to mega-employer status. Having employees who have a stake

in the health of the company is not only a good incentive for the employer to offer,

but also a great wealth-building opportunity for wage-earners.

Now, after some high-profile bankruptcies, stock options are looked upon in a

largely negative manner, and the Financial Accounting Standards Board’s proposal

for them to be expensed will effectively kill the goose that laid the golden egg. In

anticipation of the pending accounting rule update, many companies are changing

how they incentivize performance and how they report the awarding of options, I

think this is an unfortunate trend.

I think we need to preserve the ability of small employers to recruit employees

using incentives like stock options. It’s difficult for small and start up companies

to compete with large companies on salary alone. Stock options offer a potential for

wealth building and an incentive for company growth.

I am also concerned with the assumption that we can predict the cost of stock

option such that they can be included on a company’s balance sheet. If someone

could really determine what the future value of a stock is, wouldn’t we all buy low

and sell high?

There is another aspect to these changes that no one seems to speak about, and

that is the assumption that the stock will always increase. How fair is it for a company to expense these options, then show a poor annual report as a result, then

watch the stock decline to where it is worth less than the price it was granted? Certainly nobody will be exercising their options then.

I look forward to hearing from our distinguished panel on these matters today and

want to continue our dialog as we tackle legislation addressing this matter. I yield

back the balance of my time.

PREPARED STATEMENT OF HON. DIANA DEGETTE, A REPRESENTATIVE IN CONGRESS

FROM THE STATE OF COLORADO

Thank you Mr. Chairman. I am pleased that the members of the Commerce,

Trade and Consumer Protection Subcommittee have a chance to weigh in on this

very important corporate governance issue, especially given this Committee’s jurisdiction over the Federal Accounting Standards Board (FASB).

In July 2002, following the revelations of alleged fraud at Enron, WorldCom and

Global Crossing, the Coca-Cola Company, in an unprecedented move, began to voluntarily report the stock options it granted to its employees as an expense on its

income statement. According to Coca-Cola’s Chief Financial Officer, Gary Fayard,

the expensing of stock options, instead of simply disclosing them in the footnotes,

was the appropriate choice as doing so ‘‘more clearly reflected economic reality’’ and

ensured ‘‘that the confidence of our shareowners was maintained.’’

Since July 2002, more than 500 other U.S. reporting companies, such as Exxon

Mobil, General Motors, BankOne, Microsoft, Amazon.Com and Netflix, have joined

Coca-Cola and started treating the stock options they give to their employees the

same way they do any other form of compensation: as an expense on their income

statements. Despite fears, the expensing of stock options has not led to the sky falling, stock prices plummeting or an employee exodus to China or India at any of

these companies.

Recognizing that hundreds of public companies are already doing so, FASB recently released a draft rule that would require all companies to expense stock options on their income statement. The FASB rule does not prohibit companies from

granting options, but only requires that they are properly accounted for.

Yet, instead of supporting FASB’s efforts in crafting this long overdue rule that

would be instrumental in enhancing the integrity of companies’ financial statements, restoring investor confidence and strengthening corporate governance in our

country, Congress, in an unprecedented move, is threatening to usurp FASB’s authority and block the Security and Exchange Commission’s (SEC) adoption of the

FASB rule.

Such a measure would prove to be a significant step backward from Sarbanes

Oxley and would call into question the commitment this body made to strengthening

corporate governance only two years ago. The bill sponsored by Representative

Baker would not only fail to increase financial transparency or further honest acVerDate 11-MAY-2000 13:12 Sep 30, 2004 Jkt 000000 PO 00000 Frm 00036 Fmt 6633 Sfmt 6621 95450.TXT HCOM1 PsN: HCOM1
33

counting, but would politicize the accounting standards-setting process and would

compromise the independence of FASB.

Simply stated, Congress should not legislate accounting standards nor should it

interfere with the accounting standards-setting process. Not only would doing so

dramatically undermine the independence of FASB, it would set a dangerous precedent. If Congress blocked the FASB rule requiring the expensing of stock options

because it might adversely affect technology companies, what would stop this body

from requiring FASB to change other existing rules, such as its rule on expensing

depreciation that decreases the bottom line for manufacturers? While unlikely, Representative Baker’s bill would open the door to such actions and potentially set us

on a path down a slippery slope.

It is also important to keep in mind that the very companies who are lobbying

Congress against expensing stock options for accounting purposes are expensing

stock options for tax purposes. Currently, a company is able to dole out options with

no impact to its bookkeeping bottom line—the one Wall Street is interested in, while

simultaneously expensing options and reducing its bottom line—its tax liability—for

tax purposes. Such a discrepancy not only leads to an overstatement of earnings for

companies, but also a penalty to those companies who do not use options to compensate their employees. The FASB rule would rightfully correct this double standard.

Many of the companies and some Members who are against the FASB rule claim

that there is no perfect way to value options and for that reason, options should not

be expensed. But as Warren Buffet recently stated in a recent Washington Post editorial on the issue, ‘‘estimates pervade accounting.’’ In fact, accountants use estimates for lots of things, including items already expensed on the income statement,

such as depreciation or amortization. In fact, many accounting experts have said

that the method to value stock options is much more accurate than the method to

value the useful life of a manufacturing plant or a corporate jet for depreciation purposes. As Warren Buffet has admonished, ‘‘legislators should remember that it is

better to be approximately right than precisely wrong.’’

Therefore, I commend FASB in its continued efforts to increase financial transparency and strengthen corporate governance in America. Moreover, Congress

should not interfere with the accounting standard process at FASB nor should it

limit the SEC’s ability to recognize FASB’s authority. Doing so would seriously compromise the independence of FASB, politicize the accounting standard setting-process and even more importantly, undermine Congress’ efforts toward improving corporate governance in our country.

Mr. STEARNS. I thank my colleagues. We are ready for the first

panel. We have the honorable David Walker, Comptroller General

of the U.S. General Accounting Office. We have Mr. Robert Herz,

Chairman of the Financial Accounting Standards Board. And we

have our former colleague, Mr. Rick White, President and CEO of

Technet, Chairman, International Employee Stock Options Coalition. And we have Mr. Steven Mayer, Senior Vice President and

Chief Financial Officer of Human Genome Sciences.

From our colleagues, we have two individuals that are sort of pro

stock options and we have two individuals who are not for stock

options. So I think we have got a balanced hearing. And we welcome your opening statements, and we would like you, if possible,

to keep them under 5 minutes, and thank you.

We will start with you, Mr. Walker. Thank you.

STATEMENT OF HON. DAVID M. WALKER, COMPTROLLER

GENERAL, U.S. GENERAL ACCOUNTING OFFICE

Mr. WALKER. Thank you, Mr. Chairman, Members of the subcommittee. It is a pleasure to be before you here today. In addition

to being the Comptroller General of the United States and head of,

effective yesterday, the Government Accountability Office, still the

GAO, I have been a CPA for over 30 years. So I have had to deal

with these issues both in the public sector and the private sector,

34

the not-for-profit sector, for many years. I felt it was important

that you understand my background on this issue.

I appreciate the opportunity to share GAO’s perspective on the

process of establishing accounting standards for private sector entities, in general, and the FASB’s proposed accounting for stock options, in particular. As has been noted by a number of members,

we fully recognize that the stock options accounting issue is a complex and controversial issue on which reasonable people can and do

disagree.

On June 28, 2004, I sent a letter to the FASB as well as to the

Chair and ranking member of the Senate Committee on Banking,

Housing, and Urban Affairs. My testimony is based primarily on

these two letters.

Thank you, Mr. Chairman, for putting my entire statement in

the record, and I will summarize the highlights.

We support the concepts behind FASB’s current proposed statement requiring that companies use the fair market value method,

which essentially results in companies recording stock options and

other share based compensation arrangements as an expense. In

our view, stock options and other forms of share-based payments

have economic value and represent a form of compensation expense. If they are not compensation, I don’t know what else they

are. Therefore, we believe that the economic substance of such

transactions should be reflected as a compensation expense and in

the calculation of a company’s net income in order to accurately

portray its financial results.

The current standard, which permits companies to choose between the intrinsic and fair market value methods, in effect allows

companies to select their own net income. It also creates a barrier

to comparable financial information, both domestically and internationally, because the choice of methods will result in differences

in reported amounts across companies due to the different methods

of accounting. We believe that a requirement to expense stock options and other share-based payments will provide additional

transparency, clarity, and comparability in financial reporting.

I would also note, as certain other members of the subcommittee

have stated, it would also serve to increase consistency between accounting and tax treatment for share based payments.

We also support the four principal reasons that the FASB has

cited for issuing the new proposed standard. Notwithstanding ours

and others’ views on the merits of various accounting methods for

stock options, we believe that the principle of independence, both

in fact and appearance, with regard to standard setting is absolutely crucial. It is essential to the credibility of and confidence in

the authoritative standard setting process. FASB, in carrying out

its standard setting activities, has an established process in place

to obtain and consider feedback from its constituent groups, including financial statement preparers, auditors, institutional investors,

lenders, creditors, professional analysts, and various other parties.

This process is especially important given the complexity and controversial nature of some accounting standards, including the one

being considered today, accounting for stock options and other

share-based payments.

35

1 U.S.General Accounting Office, Independent Standard-Setting Process for Establishing Accounting Standards for Private-Sector Entities, GAO-04-480R (Washington, D.C.: June 28, 2004).

This letter contained as an enclosure our comment letter to FASB. 2The proposed standard would permit nonpublic companies to measure compensation costs

based on the intrinsic method of accounting at each reporting date until options are exercised

or otherwise settled.

We believe it is critical that the FASB complete its analysis of

comments received on its exposure document on share-based payments and finalize its proposed statement in accordance with the

established independent standard setting process. In our opinion,

the FASB’s independent standard setting process, subject to SEC

oversight, which the Congress properly enacted, should be allowed

to proceed in its consideration of accounting for stock options.

Mr. Chairman, that concludes my statement. I would be happy

to answer any questions after my fellow panel members have a

chance to speak. Thank you.

[The prepared statement of Hon. David M. Walker follows:]

PREPARED STATEMENT OF HON. DAVID M. WALKER, COMPTROLLER GENERAL, U.S.

GENERAL ACCOUNTING OFFICE

Dear Mr. Chairman and Members of the Subcommittee: I appreciate the opportunity to discuss with the subcommittee GAO’s perspective on the process for establishing accounting standards for private-sector entities and then, more specifically,

the current proposals for accounting for stock options. We recognize that accounting

for stock options is a complex and controversial issue on which reasonable people

can and do disagree. As a result, in light of the Financial Accounting Standards

Board’s (FASB) current proposed standard for accounting for stock options and other

share-based compensation, there has been a renewed interest for the Congress to

possibly legislate accounting rules for stock options. On June 28, 2004, we sent a

letter to FASB commenting on its proposed standard and a letter discussing the accounting standard-setting process to the Senate Committee on Banking, Housing,

and Urban Affairs.1

FASB is a non-governmental organization empowered to establish financial accounting and reporting standards for private-sector entities. Although this function

legally resides with the Securities and Exchange Commission (SEC) for public companies as part of its mandate to administer and enforce the provisions of the federal

securities laws, the SEC has traditionally relied on FASB since 1973 to fulfill this

function. The U.S. capital markets depend on a system of continuously improving

financial information about the underlying economic activities of companies. This information is fostered and framed by independently established financial accounting

and reporting standards, collectively referred to as generally accepted accounting

principles (GAAP).

On March 31, 2004, FASB issued an exposure document on a proposed Statement,

Share-Based Payment, an Amendment of FASB Statements No. 123 and 95, which

addresses the accounting for compensation to employees in the form of stock options

and other forms of equity. The FASB’s proposed Statement would generally eliminate the ability for public companies to account for share-based services using the

intrinsic method (which generally results in no expense being recognized) and would

require instead the use of a fair-value-based method, which would generally result

in companies treating stock options granted to employees as an expense based on

their fair value when granted.2 It is important to note that in 1995, when issuing

the current standard that is in place, FASB clearly stated that the fair market value

is the preferable method. The current standard also includes guidance to that effect

and requires that if the fair market value method is not used, then disclosure must

be made of pro forma net income and earnings per share presented as if the fair

market value method had been used.

We support the concepts behind FASB’s current proposed Statement requiring

companies to use the fair market value method, which essentially results in companies recording stock options and other share-based arrangements as an expense. In

our view, stock options and other forms of share-based payment have economic

value and represent a form of compensation expense. Therefore, we believe that the

economic substance of such transactions should be reflected as compensation expense in the calculation of a company’s net income to accurately portray its financial

results. The current standard, which permits companies to choose between the inVerDate 11-MAY-2000 13:12 Sep 30, 2004 Jkt 000000 PO 00000 Frm 00039 Fmt 6633 Sfmt 6621 95450.TXT HCOM1 PsN: HCOM1
36

trinsic and fair value methods, allows companies to select the impact on net income.

It also creates a barrier to comparable financial information, both domestically and

internationally, because the choice of methods used will result in differences in reported amounts across companies due to the different methods of accounting. We

believe that a requirement to expense stock options and other share-based payment

will provide additional transparency, clarity, and comparability in financial reporting.

We also support the four principal reasons FASB cited for issuing the new proposal: (1) addressing concerns of users and others that the use of the intrinsic value

method results in financial statements that do not faithfully represent economic

transactions and can distort the financial condition and operations of the issuer; (2)

improving the comparability of reported financial information through the elimination of alternative accounting methods; (3) simplifying U.S. generally accepted accounting principles by requiring the use of a single method of accounting for sharebased payment; and (4) enabling international convergence and greater international comparability in the accounting for share-based payment.

Notwithstanding our and others’ views on the merits of various accounting methods for stock options, we believe that the principle of independence, both in fact and

in appearance, is essential to the credibility of and confidence in any authoritative

standard-setting processes. With respect to the role of FASB in this and other areas,

we support its efforts, as the SEC’s designated independent non-governmental

standard-setting body, to identify issues for consideration, prepare exposure documents, conduct outreach efforts and solicit comments on exposure documents, and

consider the resulting comments in finalizing and issuing new accounting standards.

FASB, in carrying out its standard-setting activities, has an established process in

place to obtain and consider feedback from its constituent groups, including financial statement preparers, auditors, and users such as individual investors, institutional investors, lenders, creditors, professional analysts, and various other parties.

These processes were established in order to balance the competing interests and

demands of the various groups while providing standards that promote transparent,

credible, and comparable financial information. This time-tested and proven deliberative process has served to strengthen financial reporting and ensure general acceptance of the nation’s accounting standards. This process is especially important

given the complexity and controversial nature of some accounting standards, including the accounting for stock options and other share-based payments.

We believe it is critical that FASB complete its analysis of comments received on

its exposure document on share-based payment and finalize its proposed Statement

in accordance with its established independent standard-setting process. In enacting

the Sarbanes-Oxley Act of 2002, the Congress recognized the importance of having

an independent standard-setting process that facilitates accurate and effective financial reporting and protects investors. As a safeguard, the Act specified criteria

for the SEC to use for determining whether a private-sector accounting standard

setter’s principles will be considered as generally accepted. The SEC determined

that FASB met the statutory criteria established in the Sarbanes-Oxley Act of 2002.

In our opinion, the FASB’s independent standard-setting process, subject to SEC

oversight, should be allowed to proceed in its consideration of accounting for stock

options.

I would like to add that GAO is involved in setting government auditing standards and accounting standards for federal agencies. We have also implemented deliberative processes to obtain and consider the perspectives of affected parties on exposure drafts of proposed standards. Standard setting is, by its nature, an iterative

process and the standard setter needs a high degree of independence to make decisions on what represents the best standard in the public interest.

Mr. Chairman, this concludes my statement. I would be pleased to answer any

questions you or other members of the subcommittee may have at this time.

For further information regarding this testimony, please contact Jeanette M.

Franzel, Director, Financial Management and Assurance, at 202-512-9471 or

franzelj@gao.gov. Michael C. Hrapsky also made key contributions to this testimony.

Mr. STEARNS. Mr. Herz.

STATEMENT OF ROBERT H. HERZ, CHAIRMAN, FINANCIAL

ACCOUNTING STANDARDS BOARD

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

Schakowsky, and members of the subcommittee. I am very pleased

to appear here today. I think this is a very important and timely

37

hearing. I have brief prepared remarks and a full text of testimony,

which I would request be entered into the record.

Mr. STEARNS. By unanimous consent, so ordered.

Mr. HERZ. As you well know, our ability to conduct our work in

a systematic, thorough, and unbiased manner is fundamental to

achieving our mission. The standards we produce are essential to

the growth and stability of the U.S. economy, because creditors, investors, and other consumers of financial information rely heavily

on credible, transparent, comparable, and unbiased financial reports. Financial accounting reporting is meant to tell it like it is,

not to distort or to skew information to favor particular industries,

particular types of transactions, or particular political, social, or

economic goals, other than the goal of sound and honest reporting.

We understand that our proposal on share based payments or equity based compensation is controversial, the subject is controversial, but we felt it very important to address the accounting in this

important area for a number of reasons.

First, there was a high level of public concern expressed by investors, creditors, financial analysts, and many other parties about

the need to improve the accounting in this area.

Second, the complexity and noncomparability in this lack of

transparency created by the alternative accounting treatments

presently available for stock based compensation.

And finally, the opportunity to achieve convergence to a common

high quality international accounting standard in this important

area.

Our proposal is the result of an extensive public due process, a

process that began in November 2002 before the project was added

to our agenda. That process included the issuance of a preliminary

document for public comment, the review of hundreds of comment

letters, review of relevant research studies, consultation with our

formal advisory councils, and with many, many, many other parties, including users, auditors, and preparers of financial reports of

small businesses, an active board deliberation at 38 public meetings.

The proposal reflects the view that all forms of equity based compensation should be properly accounted for as such, and that the

existing exception for so-called fixed plan employee stock options

results in reporting that not only ignores the economic substance

of those transactions, but also distorts reported earnings and other

key financial metrics.

As the Congressional Budget Office stated in their recent report

to Congress, if firms do not recognize as an expense the fair value

of employee stock options measured when the options are granted,

the firms’ net income will be overstated. Thus, under current accounting standards, the greater the use of fixed plan employee

stock options, the greater the distortion of the reported results.

In the public arena, as mentioned, our proposal would bring

about greater comparability between the over 575 companies that

have voluntarily opted to account for stock options and the many

others that have not yet done so. It would also be responsive to the

growing number of companies, including many major technology

companies, whose shareholders by a majority vote have approved

nonbinding proxy resolutions mandating expensing of all employee

38

stock options. The proposal also would result in substantial convergence in the accounting for equity based compensation between

U.S. standards and the international accounting standards that

will be followed by companies in over 90 countries around the

world.

As noted, our neighbor to the north, Canada, who usually follows

our lead in modifying their accounting standards, felt that it could

not wait in this area and decided to mandate expensing of employee stock options beginning in January 2004. I understand that

implementation of Canada’s new standard, which has been adopted

by over 1,500 small businesses and over 500 technology companies,

has to date gone very smoothly.

Now, since the issuance of our proposal for public comment, we

have continued to actively solicit input and response to the proposal. In May, the Board discussed the proposal with representatives of small businesses at the public meeting of our Small Business Advisory Committee. Mr. Mayer is a member of that. Discussions focused largely on the special provisions that were in our proposal that were intended to alleviate the cost and complexity of implementing the standard for small businesses. We are very sensitive to the needs and concerns of startups and small businesses,

and recognize that special provisions might be appropriate.

In June, we held four public roundtable meetings, two in Palo

Alto, California, and two at our offices in Norwalk to discuss the

proposal. Over 70 individuals from a broad range of companies, investors, small businesses, valuation experts, auditors, and so on,

attended the meeting and gave their views. To date, the Board has

also received thousands of comment letters in response to the proposal.

Beginning later this month, we will start redeliberating at public

meetings the issues and comments we have gotten on the proposals. Those redeliberations will be systematic, thorough and objective and will include careful consideration of the input already

received and input that we will continue to solicit throughout the

process. Only after carefully evaluating at the public meetings the

input received and reaching decisions on the issues raised will we

consider whether to issue a final standard.

Our current plans are to complete our redeliberations and be in

a position to issue a final standard in the fourth quarter of this

year. So it was with great concern that I learned that the House

of Representatives may soon vote on H.R. 3574, proposed legislation that if enacted would cut short, preempt and override our current efforts to improve the accounting for equity-based compensation.

We strongly oppose H.R. 3574, as we believe do most investors,

analysts, accountants and many companies. That opposition is

based on many conceptual and technical reasons, including, first,

the proposed legislation is seriously flawed. By mandating the expensing of only those stock options held by the top five executives

and stipulating an unorthodox method for valuing and accounting

for those options, the proposed legislation violates fundamental

concepts of economics and accounting and would legislate significant distortions in companies’ reported earnings, profitability and

other key financial metrics.

39

1 H.R. 3574, 108th Congress, 1st Session (November 21, 2004).

Second, the proposed legislation, although titled the Stock Option

Accounting Reform Act, contains provisions that have exactly the

opposite effect by largely preserving, protecting and perpetuating

the nonexpensing of stock options that has resulted in an unlevel

playing field favoring certain companies that are the greatest user

of fixed plan employee stock options over other companies that

have chosen to compensate their employees in different ways.

Third, the proposed legislation, as mentioned, would be in direct

conflict with the expressed needs and demands of many investors

and shareholders and would appear to prohibit the voluntary expensing of all employee stock options that has been adopted by over

575 U.S. companies.

Fourth, the proposed legislation would strike a real blow to the

FASB’s efforts to achieve timely convergence of high quality international accounting standards and is therefore directly inconsistent

with the language and intent of both the Sarbanes-Oxley Act and

the related SEC policy statement reaffirming the FASB as the Nation’s accounting standard setter.

Fifth, the proposed legislation would raise a host of other practical and implementation issues for companies, auditors, regulators

and the entire financial reporting system.

Finally, and very importantly, the proposed legislation would in

our view establish a very dangerous precedent in that it would

send a clear and unmistakable signal that Congress is willing to

directly intervene in the independent, objective and open accounting standard setting process based on factors other than the pursuit of sound and honest financial reporting.

For those many reasons, we believe that H.R. 3574 if enacted

would result in a major step backwards in the recent efforts by

Congress, the SEC, the FASB and many other parties to restore

public confidence and trust in the integrity of financial reporting.

As Federal Reserve Chairman Greenspan recently noted, the potential enactment of H.R. 3574 would be a bad mistake for the Congress. We wholeheartedly agree.

Speaking not just for the FASB but for the millions of U.S. investors and others that rely on the integrity of financial reporting and

the capital market system, I respectfully urge all of you to oppose

this legislation so that we may continue our work on developing a

high quality standard that will improve financial reporting in this

important area.

Thank you, Chairman Stearns. I too would be happy to respond

to questions.

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

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

STANDARDS BOARD

Chairman Stearns, Ranking Member Schakowsky, and Members of the Subcommittee: I am Robert Herz, chairman of the Financial Accounting Standards

Board (‘‘FASB’’ or ‘‘Board’’). I am pleased to appear before you today on behalf of

the FASB. I want to thank you for the opportunity to publicly express our concerns,

and the concerns of investors, analysts, accountants, and many companies about

H.R. 3574,1 which, if enacted, will cut short and override the FASB’s current efforts

to improve the financial accounting and reporting for equity-based compensation.

40

2See Attachment 1 for information about the Financial Accounting Standards Board.

3See Attachment 2 for excerpts from recent materials about the importance of the FASB’s

independence and concerns about proposed legislation. 4Sarbanes-Oxley Act of 2002, Public Law Number 107-204, Sections 108-109.

5 ‘‘Policy Statement: Reaffirming the Status of the FASB as a Designated Private-Sector

Standard Setter,’’ Exchange Act Release Nos. 33-8221; 34-47743; IC-26028; FR-70 (April 28,

2003). 6Sarbanes-Oxley Act of 2002, Sections 108-109; the legislative history of the Sarbanes-Oxley

Act of 2002 (‘‘Act’’) is clear that the provisions of the Act relating to the FASB were intended

to ‘‘strengthen the independence of the FASB...from . . . companies whose financial statements

must conform to FASB’s rules.’’ Senate Report 107-205, 107th Congress, 2d Session (July 3,

2002), page 13. 7Policy Statement, page 5 of 8.

8See Attachment 1 for information about the Financial Accounting Foundation.

My testimony includes a brief overview of (1) the FASB, including the importance

of the Board’s independence and the ability to conduct its work in a systematic,

thorough, and objective manner, (2) the process the FASB follows in developing accounting standards, (3) the basis for the Board’s unanimous decision to issue a proposal to improve the accounting for equity-based compensation, (4) the input received in response to the proposal, (5) the current status of, and the FASB’s plans

relating to, the proposal, and (6) some observations about H.R. 3574.

THE FASB

The FASB is an independent private-sector organization.2 We are not part of the

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

government is fundamental to achieving our mission—to establish and improve

standards of financial accounting and reporting for both public and private enterprises, including small businesses.3 Those standards are essential to the efficient

functioning and operation of the capital markets and the United States (‘‘US’’) economy because investors, creditors, and other consumers of financial reports rely heavily on sound, honest, and unbiased financial information to make rational resource

allocation decisions.

The FASB’s independence, the importance of which was recently reaffirmed by the

Sarbanes-Oxley Act of 2002 (‘‘Act’’),4 is fundamental to our mission because our

work is technical in nature, designed to provide preparers with the guidance necessary to report information about their economic activities. Our standards are the

basis to measure and report on the underlying economic transactions of business enterprises. Like investors and creditors, Congress and other policy makers need an

independent FASB to maintain the integrity of the standards in order to obtain the

financial information necessary to properly assess and implement the public policies

they favor.

Financial accounting and reporting is meant to tell it like it is, not to allow distortions or skew information to favor particular industries, particular types of transactions, or particular political, social, or economic goals other than sound, and honest reporting. While bending the standards to favor a particular outcome may seem

attractive to some in the short run, in the long run a biased accounting standard

is harmful to investors, creditors, the capital markets, and the US economy.

The FASB’s authority with respect to public enterprises comes from the US Securities and Exchange Commission (‘‘SEC’’). The SEC has the statutory authority to

establish financial accounting and reporting standards for publicly held enterprises.

For 30 years, the SEC has looked to the FASB for leadership in establishing and

improving those standards. The SEC recently issued a Policy Statement reaffirming

this longstanding relationship.5

The Policy Statement, consistent with the language and intent of the Act, also reemphasizes the importance of the FASB’s independence described earlier.6 It states:

By virtue of today’s Commission determination, the FASB will continue its

role as the preeminent accounting standard setter in the private sector. In performing this role, the FASB must use independent judgment in setting standards and should not be constrained in its exploration and discussion of issues.

This is necessary to ensure that the standards developed are free from bias and

have the maximum credibility in the business and investing communities.7

The SEC, together with the private-sector Financial Accounting Foundation

(‘‘FAF’’),8 maintains active oversight of the FASB’s activities.

WHAT PROCESS DOES THE FASB FOLLOW IN DEVELOPING ACCOUNTING STANDARDS?

Because the actions of the FASB affect so many organizations, its decision-making

process must be open, thorough, and as objective as possible. The FASB carefully

41

9See Attachment 1 for information about the FASB’s due process.

10The Securities and Exchange Commission (‘‘SEC’’) also recently reviewed the FASB’s due

process and concluded that ‘‘the FASB has the capacity... and is capable of improving both the

accuracy and effectiveness of financial reporting . . .’’ Policy Statement, page 5 of 8.

considers the views of all interested parties, including users, auditors, and preparers

of financial reports of both public and private enterprises, including small businesses.

Our Rules of Procedure require an extensive and thorough public due process.9

That process involves public meetings, public roundtables, field visits, liaison meetings with interested parties, and exposure of our proposed standards to external

scrutiny and public comment. The FASB members and staff also regularly meet informally with a wide range of interested parties to obtain their input and to better

our understanding of their views. The Board makes final decisions only after carefully considering and analyzing the input of all interested parties.

While our process is similar to the Administrative Procedure Act process used for

federal agency rule making, it provides for far more public deliberations of the relevant issues and far greater opportunities for interaction with the Board by all interested parties. It also is focused on making technical, rather than policy or legal,

judgments. The FASB’s Mission Statement and Rules of Procedure require that in

making those judgments the Board must balance the often conflicting perspectives

of various interested parties and make independent, objective decisions guided by

the fundamental concepts and key qualitative characteristics of financial reporting

set forth in our conceptual framework.

The FASB and the FAF, in consultation with interested parties, periodically review the FASB’s due process procedures to ensure that the process is working efficiently and effectively for users, auditors, and preparers of financial reports.10 Over

the past two years, the FASB and the FAF have undertaken a significant number

of actions to improve the Board’s due process procedures. Some of those actions were

intended to increase the quality and breadth of input to our process, including increasing the input from users, auditors, and preparers of small businesses. Those

particular actions include the following:

• Establishing a Small Business Advisory Committee (‘‘SBAC’’) in order to increase

involvement by the small business community in developing accounting standards. The SBAC, whose members represent diverse perspectives and experiences, comprises lenders, investors and analysts, preparers of financial statements from a broad range of businesses, including controllers and chief financial officers, and auditors from the small business community.

• Establishing a User Advisory Council (‘‘UAC’’) in order to obtain more active user

involvement in our process. The UAC comprises representatives of individual

and institutional investors, investment and commercial banks, rating agencies,

and other groups that represent investors and key users. Several of the members of the UAC are primarily users of financial reports of small businesses.

• Making our public Board meeting announcements available to interested parties

more broadly through an email subscription service.

• Making our public Board meetings available to interested parties for monitoring

via web cast on our website free of charge and via the telephone at a reduced

cost.

• Making all of our proposals for public comment, all of the comments received, and

the full text of all our standards publicly available on our website.

FASB’S CURRENT PROJECT TO IMPROVE THE ACCOUNTING FOR EQUITY-BASED

COMPENSATION

In March 2003, at a public meeting, the Board decided to add a project to its

agenda to address issues relating to equity-based compensation. That decision was

based largely on three reasons.

The first reason was the high level of public concern expressed by creditors, individual and institutional investors, pension funds, mutual funds, financial analysts,

and other users of financial statements about the need to improve the financial accounting and reporting for equity-based compensation. The concern was not just

about perceived abuses of executive compensation, but the broader issue of the appropriate financial accounting and reporting for equity-based compensation, in particular the need to eliminate the exception from expense recognition that presently

exists only for fixed plan employee stock options. Those users of financial statements that have been urging the FASB to eliminate the exception for fixed plan employee stock options include:

42

11 A 2001 survey conducted by the Association for Investment Management and Research

found that more than 80 percent of financial analysts and portfolio managers responding to the

survey believed that stock options granted to employees are compensation and should be recognized as an expense in the income statements of the enterprises that grant them. AIMR, ‘‘Analysts, Portfolio Managers Want Employee Stock Options Expensed on Income Statements, Global

AIMR Survey Shows’’ (November 19, 2001). 12Ten-Point Plan to Improve Corporate Responsibility sand Protect America’s Shareholders

(March 7, 2002). 13 Id. 14See Attachment 3 for a list of 576 companies that have voluntarily adopted option expensing

under the fair value method.

• The Council of Institutional Investors (an association of more than 130 corporate,

public, and union pension funds with more than $3 trillion in pension assets) • Institutional Shareholder Services (serving more than 950 institutional investors

and corporate clients worldwide) • The Office of the State Comptroller of New York (an investor, shareholder, and

sole trustee of the nation’s second largest pension fund at approximately $100

billion in assets) • Moody’s Investor Services • The Central Pension Fund of the International Union of Operating Engineers and

Participating Employers (on behalf of more than 150,000 participants of the

CPF) • The Teachers Insurance and Annuity Association College Retirement Equities

Fund (a financial services company with approximately $262 billion in assets

under management, serving nearly 3 million education and research employees

at 15,000 institutions) • The Investment Company Institute (a national association including 8,938 mutual

funds, 535 closed-end investment companies, and 6 sponsors of unit investment

trusts; its mutual fund members have assets of about $6.539 trillion, accounting

for approximately 95 percent of total industry assets, and 90.2 million individual shareholders) • The Association for Investment Management and Research (now known as the

CFA Institute, a nonprofit professional organization of 61,600 financial analysts, portfolio managers, and other investment professionals).11

• The American Federation of Labor and Congress of Industrial Organizations (representing 13 million of America’s workers in 65 member unions) • The Conference Board Commission on Public Trust and Private Enterprise (cochaired by Peter G. Peterson, chairman of the Blackstone Group, former Secretary of Commerce and chairman of the Federal Reserve Bank of New York,

and John W. Snow, (former) chairman, CSX Corporation and former chairman,

Business Roundtable).

In 2002, President Bush announced a ten-point plan to improve corporate responsibility.12 That plan including the following statement: ‘‘The authors of accounting

standards must be responsive to the needs of investors.’’ 13 There is no other issue

on the Board’s agenda on which investors have been clearer about the need for an

improvement in the existing accounting standards.

The second reason the Board decided to add a project to its agenda to address

issues relating to equity-based compensation was because of the complexity and

noncomparability and, thus, potential lack of transparency created by the alternative accounting treatments presently available for reporting equity-based compensation. That lack of transparency has been magnified by the recent trend of enterprises adopting the voluntary fair value provisions of FASB Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation (October 1995).14 The trend has increased the divergence between the financial reports

of enterprises that do not make wide use of employee stock options as compensation

and the financial reports of those that do, and between those enterprises that voluntarily expense employee stock options and those that do not.

As indicated above, fixed plan employee stock options are the only form of employee stock options that is not required to be reported as an expense in the income

statements of the enterprises that grant them. All other forms of employee compensation, including cash salaries, bonuses, fringe benefits, restricted stock, stock

warrants, performance-based stock options, indexed-based stock options, employee

stock ownership plans, are (and have long been) required to be reported as an expense. Moreover, when equity-based grants of any form are issued to nonemployees

for goods or services, they also are (and have long been) required to be reported as

an expense.

The exception for fixed plan employee stock options is clearly an anomaly in today’s financial accounting and reporting. That anomaly results in an absolute and

43

15 Hearing of the Joint Economic Committee, US Congress, on ‘‘Economic Outlook’’ (April 21,

2004). 16 Hearing before the Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises of the Committee on Financial Services, Testimony of Paul A. Volcker (June

3, 2002), pages 3 and 4. 17 Hearing on H.R. 3574: Stock Option Accounting Reform Act, Before the Subcommittee on

Capital Markets, Insurance and Government Sponsored Enterprises of the Committee on Financial Services, Summary of Testimony of Robert C. Merton (March 3, 2004), page 2 of 3. 18 Joseph E. Stiglitz, ‘‘The Roaring Nineties’’ (October 2003), pages 115-139. 19Statement of Financial Economist Roundtable on the Controversy over Executive Compensation (November 24, 2003). 20 Joint Economic Committee, Republican Senate Staff, Economic Policy Research, ‘‘Understanding the Stock Option Debate,’’ Report 107-04 (July 9, 2002), page 18. 21The Conference Board, ‘‘The Commission on Public Trust and Private Enterprise, Findings

and Recommendations, Part 1: Executive Compensation’’ (September 17, 2002), page 6. 22The Congressional Budget Office, ‘‘Accounting for Employee Stock Options,’’ Section 3 (April

2003), pages 4 and 5. 23 News from Carl Levin, US Senator, Michigan, ‘‘Stock Option Roundtable Dismissed as OneSided’’ (May 8, 2003), page 2; Reed Hastings, ‘‘Expense It!’’ The Wall Street Journal (April 5,

2004). 24 IASB Proposed IFRS, Share-Based Payment (November 2002). 25FASB, Rules of Procedure (December 1, 2002, as amended), page 2. 26 Act, Section 108(a)(2). 27Policy Statement, page 4 of 8.

relative distortion of profitability and other key financial metrics. The greater the

use of those instruments, the greater the distortion. As indicated above, the distortion creates an unleveled playing field that inappropriately favors those enterprises

that are the greatest users of fixed plan employee stock options over other enterprises that either have chosen to compensate their employees in different ways (including different forms of equity-based compensation) or use fixed plan employee

stock options but have voluntarily elected to expense them.

The distortion misleads investors, particularly, but not limited to, less sophisticated investors. The overall effect is a diversion of investment and capital resources

away from their most efficient employment. As Federal Reserve System Chairman

Alan Greenspan stated, ‘‘[if] you don’t expense stock options, then you’re getting a

distorted view as to what the profitability of a particular operation is, and you will

get a distortion in the allocation of capital.’’ 15 Many other economic experts that

have reviewed this issue agree, including former Federal Reserve Chairman (and

current chairman of the Trustees of the International Accounting Standards Committee Foundation) Paul A. Volcker,16 Nobel Prize winning economists Robert C.

Merton,17 and Joseph E. Stiglitz,18 the Financial Economist Roundtable,19 the Republican Staff of the Joint Economic Committee of the US Congress,20 the Conference Board Commission on Public Trust and Private Enterprise,21 and the Congressional Budget Office.22

Many enterprises, including some in the high technology industry, that have voluntarily expensed their employee stock options have requested that the Board mandate the expensing of all employee stock options. It is also interesting to note some

of those enterprises, including Wal-Mart Stores, Inc., Netflix Inc., and Home Depot,

Inc., have historically offered broad-based stock option plans to many nonexecutive

employees and have indicated that adopting fair value expensing for all employee

stock options will not result in a curtailment of those programs.23

The third reason the Board decided to add a project to its agenda to address

issues relating to equity-based compensation was the opportunity to achieve convergence to a common, high-quality international accounting standard in this area. The

International Accounting Standards Board (‘‘IASB’’) issued a proposal in November

2002 that would require that all stock options be expensed at their fair value at

grant date.24 To maximize the opportunity for international convergence, the FASB

concluded that it needed to consider the US accounting requirements for equitybased compensation concurrently with IASB’s consideration of its proposal.

The FASB has long been committed to actively working with the IASB and other

national accounting standard setters to promote international convergence of accounting standards concurrent with improving the quality of financial reporting.25

Both the Act,26 and the Policy Statement,27 indicate the support of the US Congress

and the SEC, respectively, for the FASB’s convergence efforts.

Since March 2003, the Board has held 38 public meetings to discuss the project.

Preparations for those meetings included thousands of hours of research on issues

relating to the project, including the review of the results of many research studies

on the topic.

44

28The Board established the Option Valuation Group to provide information and advice on

how to improve the guidance in Statement 123 on measuring the fair value of stock options.

Proposed Statement of Financial Accounting Standards, Share-Based Payment (March 31, 2004),

paragraph C37. 29 Id.

In addition, the Board and staff have participated in public and private discussions about the project with hundreds of individuals, including members of the Financial Accounting Standards Advisory Council, the UAC, the Option Valuation

Group,28 and other groups and organizations representing preparers, auditors, and

users of financial reports. The Board also has conducted field visits with a variety

of enterprises of various sizes, including small businesses, covering a range of industries to discuss issues relating to the project.

In February 2004, at a public meeting, the Board unanimously agreed to the

issuance of a proposal for public comment. That proposal was issued on March 31,

2004, for a 90-day comment period.29

The proposal contains a detailed Notice for Recipients encouraging comments on

over 20 specific issues. Attachment 4 includes the Notice for Recipients and a Summary of the key provisions of the proposal.

WHAT HAS BEEN THE INPUT RECEIVED IN RESPONSE TO THE PROPOSAL?

Following the issuance of the proposal for public comment the Board has been actively meeting with and soliciting input from valuation experts, and users, auditors,

and preparers of financial reports on issues raised by the proposal. For example, on

May 11, 2004, at a public meeting the Board discussed the proposal with over twenty representatives of small and medium-sized businesses at the inaugural meeting

of the SBAC.

In addition, the Board held public roundtables on June 24, 2004, in Palo Alto,

California, and June 29, 2004, in Norwalk, Connecticut. Over seventy individuals

from a broad range of enterprises, including representatives from the high-technology industry, small businesses, valuation experts, compensation consultants, software developers, auditors, financial analysts, institutional investors, professional

and trade associations, and academics participated at the four half-day public meetings.

To date the Board has received thousands of comment letters in response to the

proposal. Consistent with the FASB’s Rules of Procedures Board members are required to read all of the comment letters received.

The vast majority of the comment letters received in response to the proposal are

form-like letters. Some of those letters are from employees of several high-technology industry companies. While heartfelt in their urging the Board not to do anything that might result in their employers’ reducing the amount of employee stock

option grants, they generally do not address the financial accounting and reporting

issues raised by the proposal. Thousands of other form letters were received from

union employees and investors expressing unqualified support for the proposal.

Excluding the form-like letters, we have many other letters from a broad range

of enterprises, accounting firms, valuation experts, compensation consultants, trade

and professional associations, and academics. Those letters provide detailed input

on one or more of the many financial accounting and reporting issues raised by the

proposal.

WHAT IS THE CURRENT STATUS OF, AND THE FASB’S PLANS RELATING TO, THE

PROPOSAL?

Later this month, the Board plans to begin its public redeliberations of the proposal. The redeliberations, consistent with the FASB’s Rules of Procedure, will address the key conceptual, measurement, disclosure, and cost-benefit issues raised by

the proposal. Those issues will include (1) what is the relevant measurement attribute and relevant measurement date for equity-based compensation; (2) what is

the appropriate basis for attribution of compensation cost; (3) what disclosures

should be required; (4) what is the appropriate transition and effective date for the

new requirements; and (5) what modifications, if any, to the new requirements

should be made for small businesses. For each of these issues the public redeliberations will include careful consideration of the comment letters and other input received from all parties.

The redeliberations also will benefit from the FASB staff and Board’s ongoing discussion of the key issues with interested parties from a broad range of perspectives,

including representatives of small businesses and valuation and compensation experts that the FASB will continue to consult with throughout the entire process. As

45

30Letter from Edward Nusbaum, CEO, Grant Thornton LLP, to the Honorable Richard H.

Baker, US House of Representatives (March 17, 2004), page 4; Hearing on H.R. 3574: Stock Option Accounting Reform Act, Before the Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises of the Committee on Financial Services, Summary of Testimony

of Robert C. Merton; see Attachments 2 and 5 for additional comments from experts on H.R.

3574. 31Of note, after appearing to mandate the substance and timing of the accounting for the expensing of certain stock options in Section 2, and constraining the substance and timing of any

existing or future accounting for expensing stock options in Section 3, Section 5 inexplicably

states that ‘‘[n]othing in this Act shall be construed to limit the authority over the setting of

accounting principles by any accounting standard setting body . . .’’ 32 International Financial Reporting Standard 2, Share-Based Payment (February 2004). 33Stock-Based Compensation and Other Stock-Based Payments, Section 3870 (September

2003).

with virtually all FASB projects, the redeliberations will likely result in a number

of changes to improve the proposal.

Only after carefully evaluating all of the key issues and carefully considering the

input received in response to the proposal will the Board consider whether to issue

a final standard. No final standard may be issued without approval by a majority

vote of the Board.

The Board’s current plans are to issue a final standard in the fourth quarter of

this year. The Board, however, has no fixed deadline for issuing a final standard

and will continue its public redeliberations as long as is necessary to develop a highquality and cost-effective accounting standard that will best serve the needs of investors, creditors, and other consumers of financial reports. As with all of the

FASB’s activities, the SEC staff will closely monitor and oversee the Board’s due

process on this important project.

SOME OBSERVATIONS ABOUT H.R. 3574

As many experts have indicated, the provisions of H.R. 3574 are seriously flawed,

violate fundamental concepts of financial accounting and reporting, and, if enacted,

would be harmful to the overall capital market system.30 The Board strongly opposes such an effort to block improvements to the financial accounting and reporting

for equity-based compensation. That opposition is based on many conceptual and

technical reasons, including the following.

First, H.R. 3574 would override the Board’s independent, objective, open, and ongoing due process to make unbiased decisions on the substance and timing of improvements to the accounting for equity-based compensation.31 As indicated above,

such intervention would be in direct conflict with the expressed needs and demands

of many investors and other users of financial reports. Such intervention also would

appear to be inconsistent with the language and intent of the Act and the related

Policy Statement, both of which were intended to enhance the independence of the

FASB.

Second, H.R. 3574 would have an adverse impact on the FASB’s efforts to achieve

timely convergence of high-quality international accounting standards in this important area. As indicated above, such Congressional intervention would appear to be

inconsistent with the language and intent of the Act and the related Policy Statement, both of which indicate support for the FASB’s convergence efforts.

Enterprises in 90 countries around the world will begin to report all equity-based

compensation as an expense, in a manner generally consistent with the proposal,

beginning on January 1, 2005.32 Those enterprises will join enterprises in Canada,

which were required to begin expensing all equity-based compensation, consistent

with the proposal, beginning in January of this year.33 Of note, over 350 Canadian

enterprises, and hundreds of other foreign enterprises that comply with international accounting standards, are SEC registrants and are required to file their financial reports in the US.

Addressing the impact of H.R. 3574 on the independence of the FASB and the

convergence of accounting standards, The Honorable Paul A. Volcker, Chairman of

the Trustees of the International Accounting Standards Committee Foundation,

stated in recent testimony before Congress:

I suggest that, before acting, Senators and Congressmen ask themselves two

simple questions:

‘‘Do I really want to substitute my judgment on an important but highly technical accounting principle for the collective judgment of a body carefully constructed to assure professional integrity, relevant experience, and independence

from parochial and political pressures?’’

46

34 Hearing on Oversight Hearing on Expensing Stock Options: Supporting and Strengthening

the Independence of the Financial Accounting Standards Board, Before the Subcommittee on Financial Management, the Budget, and International Security of the Committee on Governmental Affairs, United States Senate, Testimony of The Honorable Paul A. Volcker (April 20,

2004), page 2 of 2. 35 H.R. 3574, Section 1. 36 H.R. 3574, Section 2(m)(1)-(2). 37 H.R. 3574, Section 2(m)(3)(A)-(B). 38 Hearing on H.R. 3574: Stock Option Accounting Reform Act, Before the Subcommittee on

Capital Markets, Insurance and Government Sponsored Enterprises of the Committee on Financial Services, Summary of Testimony of Robert C. Merton (March 3, 2004), page 2 of 2. 39 ‘‘High-Tech Holdup,’’ The Washington Post (June 10, 2004), page A18. 40 H.R. 3574, Section 2(m)(4)(A). 41 H.R. 3574, Section 2(m)(4)(B). 42 In commenting on Sections 2(m)(4)(A) and (B), Associated Press, Business Writer, Bruce

Meyerson stated: ‘‘Bizarrely, though the purpose of these two exemptions is to ensure a continued source of cheap fuel for smaller businesses to grow, the bill would also grant a free threeyear pass to Google, an established Internet juggernaut which plans to sell billions worth of

stock in an initial public offering,’’ Bruce Meyerson, ‘‘Congress threatening to derail stock options reform—again,’’ San Jose Mercury News (June 8, 2004), page 2 of 2.

‘‘Have I taken into account the adverse impact of overruling FASB on the

carefully constructed effort to meet the need, in a world of globalized finance,

for a common set of international accounting standards?’’ 34

Third, although titled the ‘‘Stock Option Accounting Reform Act,’’ 35 the provisions

of H.R. 3574 have exactly the opposite effect by essentially preserving, protecting,

and perpetuating the existing accounting for stock options that have resulted in an

unlevel playing field favoring certain enterprises that are the greatest users of fixed

plan employee stock options over other enterprises that have either chosen to compensate their employees in different ways.

For example, the provisions of H.R. 3574 would appear to require that only stock

options granted after December 31, 2004, to the chief executive officer and the four

other most highly compensated employees of certain SEC registrants be reported as

compensation expense in those enterprises’ income statements.36 Thus, if an SEC

registrant grants stock options to employees other than the top five executives, that

compensation cost would not be reported in the enterprises’ earnings.

Moreover, the provisions of H.R. 3574 would appear to require that for purposes

of determining the ‘‘fair value’’ of the stock options granted to the top five executives

the ‘‘assumed volatility of the underlying stock shall be zero.’’ 37 It is universally accepted that a large part of a stock option’s fair value is the result of volatility of

the underlying stock price.38 Thus, the amount of compensation cost for the top five

executives reported in the enterprises earnings would be substantially less than its

fair value.

A recent Washington Post editorial commented on the ‘‘top five executives’’ provisions of H.R. 3574, stating:

The second problem with the bill is its illogical content. In the past, opponents of expensing options have claimed that the value of options is unknowable. But the House bill abandons that claim by requiring that companies include in their profit-and-loss statements the value of options for their top five

executives. Having conceded that, however, the bill goes on to say that the cost

of options granted to employees outside the top circle should be left out, implying that they cost nothing. But they do not cost nothing. In high-tech companies, which grant options generously to middle-ranking employees, the top five

executives get only a small fraction of the total—less than 5 percent in the case

of Intel Corp. or Cisco Systems Inc.

Moreover, the House bill stipulates that companies should use an unorthodox

method for valuing options that minimizes their worth. If the bill became law,

the options granted by Intel last year would force it to deduct a modest $3.5

million from its reported profit—compared with the hefty $991 million it would

have to deduct under the proposed FASB reform. Cisco, for its part, could report

$1.1 billion more in profit if the House bill passed. Small wonder that Intel and

Cisco have led the lobbying charge in favor of the legislation.39

The provisions of H.R. 3574 also would appear to exempt certain SEC registrants

that are ‘‘small business issuers’’ from having to report any compensation expense

for stock options granted.40 Similarly, the provisions would also appear to exempt

certain SEC registrants from having to report any compensation expense for stock

options granted to employees for three years after an ‘‘initial public offering.’’ 41 In

both cases, to the extent that a qualifying SEC registrant grants stock options to

its employees, the amount of compensation cost would be understated in those enterprises’’ reported earnings.42

47

43 H.R. 3574, Section 3(a). 44Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation (October 1995), paragraph 11. 45 Id.; see Attachment 3 for list of 576 companies that have voluntarily adopted option expensing under the fair value method. 46 H.R. 3574, Section 4. 47Statement of Financial Accounting Standards No. 148, Accounting for Stock-Based Compensation—Transition and Disclosure (December 2002), paragraphs 2(e) and 3. 48FASB Exposure Draft, Proposed Statement of Financial Accounting Standards, Share-Based

Payment (March 31, 2004), paragraphs C144-C156. 49Letter from Patricia Doran Walters, PhD, CFA, Senior Vice President, Professional Standards & Advocacy, CFA Institute, to the Honorable Richard H. Baker and the Honorable Paul

E. Kanjorski, United States House of Representatives (May 10, 2004), page 3 of 4. 50 Hearing of the Joint Economic Committee, United States Congress, on ‘‘Economic Outlook’’

(April 21, 2004).

The provisions of H.R. 3574 also would raise a host of practical and implementation issues that would likely be very disruptive to enterprises, auditors, and the entire financial reporting system. As one example, the provisions would appear to prohibit the SEC from recognizing any accounting standard relating to the expensing

of stock options unless and until two conditions are met: (1) an economic impact

study by the Secretary of Commerce and the Secretary of Labor has been completed,

and (2) the standard prescribes exercise or other settlement date measurement for

the options granted.43

Existing accounting standards prescribe as the preferable method of accounting

for employee stock options a grant date fair value measurement approach.44 The

more than 575 enterprises that have begun voluntarily expensing all employee stock

options are required to follow the preferable method.45 That method, however, does

not encompass an exercise or other settlement date measurement approach as would

appear to be required by the provisions of H.R. 3574. Thus, the existing voluntary

expensing of all employee stock options by more than 575 enterprises would no

longer be permitted.

In addition, H.R. 3574 has a section entitled ‘‘Improved employee stock option

transparency and reporting disclosures.’’ 46 The disclosures required under those provisions, however, are not ‘‘more detailed’’ or as comprehensive as those disclosures

required under existing generally accepted accounting principles.47

Moreover, the H.R. 3574 disclosures fail to include the proposed improvements to

disclosures contained in the proposal responsive to the requests of many users of

financial reports, including new and improved disclosures about the related income

statement and cash flow effects of equity-based payment arrangements.48

Finally, and perhaps most importantly, H.R. 3574 would establish a dangerous

precedent in that it would send a clear and unmistakable signal that Congress is

willing to directly intervene in the independent, objective, and open accounting

standard-setting process based on factors other than the pursuit of sound and fair

financial reporting. That signal would likely prompt others to seek political intervention in future technical activities of the FASB. In recently commenting on this

issue, the CFA Institute, whose members include more than 70,000 investment professionals and educators, stated:

Politicizing the process can only work to destabilize it and will ultimately be

detrimental to those investors who have the least ability to gather political influence.49

For all of the above reasons, H.R. 3574 would result in a giant step backwards

in the recent and ongoing efforts by Congress, the SEC, the FASB, and many other

parties to restore public confidence and trust in the integrity of financial reporting.

As Federal Reserve Chairman Alan Greenspan recently indicated, the enactment of

this proposed legislation ‘‘would be a bad mistake for the Congress.’’ 50 I wholeheartedly agree. Speaking not just for the FASB, but for the millions of US investors, creditors, and other consumers of financial reports that rely on credible, transparent, and unbiased financial information, I respectfully urge you to oppose H.R.

3574.

CONCLUSION

In conclusion, let me assure you that you, and the users, auditors, and preparers

of financial reports, including small business financial reports, can have confidence

that the Board will carefully consider the input received in response to our proposal.

That input will be carefully considered in an open, thorough, and objective manner.

Our ultimate goal is to develop, with oversight by the SEC staff, an accounting

standard that will faithfully report the underlying economic effects of equity-based

compensation transactions and, thus, significantly improve the transparency and inVerDate 11-MAY-2000 13:12 Sep 30, 2004 Jkt 000000 PO 00000 Frm 00051 Fmt 6633 Sfmt 6621 95450.TXT HCOM1 PsN: HCOM1
48

tegrity of financial reporting in the US. As indicated above, the enactment of H.R.

3574 would undoubtedly have the exact opposite effect.

Thank you again, Chairman Stearns. We would welcome the opportunity to respond to any questions.

Mr. STEARNS. Thank you.

Mr. White, welcome.

STATEMENT OF RICK WHITE, PRESIDENT AND CEO, TECHNET,

CHAIRMAN, INTERNATIONAL EMPLOYEE STOCK OPTIONS

COALITION

Mr. WHITE. Thanks very much, Mr. Chairman, Ms. Ranking

Member, and the other members of the committee. It is great to be

back in the best subcommittee of the best committee in Congress.

I see a lot of my old colleagues who have moved up several rows

since I was here last time. It is really great to be here and great

to have this seat before you today.

I am currently the CEO of TechNet, a group of technology executives; we are kind of a trade organization for the technology community. I am also Chairman of the International Employee Stock

Options Coalition, which is a group of companies and associations

representing literally thousands of companies, both technology companies and other companies that are concerned with the stock options issue.

I guess it is fair to say we frankly don’t care what this committee

or FASB or any other committee does with executive stock options.

What we are concerned about, what we do care very deeply about

is preserving the ability, the reasonable ability, to grant such options to rank-and-file workers as many companies have done successfully over the past few years.

We do support H.R. 3574. I know that is not directly the subject

of this hearing. I want to address just a couple of points. I have

submitted some testimony for the record. I appreciate the chairman’s willingness to include that.

One issue that has come up and several members have mentioned it, and also I think Chairman Herz mentioned it several

times in his testimony, is whether it is appropriate for the Congress even to be involved in this effort. I want to make sure that

people understand how important it is that Congress should be involved. There are some things that we let experts decide in our society, but there are some things we don’t let them decide. There are

some good reasons for that. We let engineers decide how to get a

spaceship to the Moon, we let lawyers decide how a contract should

be written, but we don’t let them decide whether we go to the

Moon, we don’t let them decide whether a contract should be

formed. Those are decisions that we reserve to others.

The reason is that experts are great in their specific area of expertise but sometimes that high expertise may prevent them from

focusing on the bigger picture. I would submit that is really the

problem we have here. That is the situation I think Mr. Herz finds

himself in, one that is totally understandable given his position. If

you listen to Mr. Herz’ testimony and follow this issue, he will tell

you basically two things. No. 1, accounting should be set by the

FASB because they are the experts on accounting and Congress

should stay out of that effort. I think he has said that today. That

49

is certainly understandable from his perspective. But he will also

tell you that accountants make up FASB, they understand accounting issues but they really don’t understand or don’t focus on anything having to do with the U.S. economy, and FASB will not consider, and I can give you 20 places where he has made this comment, will not consider the impact on the U.S. economy of whatever

accounting standard it decides to implement. That is not in their

expertise. He is absolutely correct. So they won’t consider that.

But you put those two comments together and I think it reveals

a flaw at least in the way that Chairman Herz looks at our system.

He basically means we can set any accounting standard we want

but there is nobody in the chain of command who has the opportunity to decide whether there is going to be a negative effect on

the economy. I would submit to you that that is not a principle that

this committee can live with. Congress has delegated to the SEC

the right to establish accounting standards but not as a goal in

itself. The point of accounting standards are to accomplish things

that this committee thinks is important, not just to further accounting theory. I would submit to you that if the FASB came up

with an accounting theory that made sense to accounting professors but had a really negative impact on the economy, that is something this committee would want to look at. You wouldn’t want to

let them do something that was esoteric and arcane and may make

sense for accounting reasons but had a big impact on economy.

That is something you would not want to happen.

By the same token, if Mr. Herz’ committee came up with a standard for some reason that made a lot of sense to accounting professors but really was so complicated that it could only be understood

by experts in accounting, I think we have all seen examples where

experts sometimes tend in that direction, but if it couldn’t be understood by the individual investor, the average investor, I suggest

that this committee would be concerned about that. We want a system in our country where not just experts but individual investors,

the common individual investor, can understand what accounting

statements are all about. I think the committee would be within its

rights to get involved in a case where that happened, and I would

submit to you that we are in a case right here where both those

things have happened and where it is very important for you to get

involved.

Let me spend just a minute on each one, then I will stop so you

can ask questions. From an economics perspective, let me make

sure you understand the basics of our objection. If there are two

companies out there, one of them owned by the chairman and one

of them owned by the ranking member, that had the exact same

financial performance but let’s say the chairman kind of did the

wrong thing and only allowed the top executive to have stock options and the ranking member decided to do the right thing, which

most of us here I think would agree with, and let every employee

share in the ownership of the company, even though those companies had the same financial performance, even though they had the

same amount of money in the bank, even though there was no difference in the actual assets or debits owned by the corporation, the

company owned by the ranking member would look worse every

month, every earnings report would always look worse than the

50

company owned by the chairman, who actually did the wrong

thing. So if we adopted the approach that FASB is suggesting to

us we are basically penalizing companies every quarter for doing

what we would like them to do, which is to let their employees

have a piece of ownership of the company. It is a public policy incentive that is 180 degrees from what it should be. I think that is

one of the things we are concerned about.

From an investors’ standpoint I think you should understand

that while there definitely is some difference of opinion on whether

we should expense things in the first place, and I think Mr. Mayer

may talk a little bit about some of those accounting issues, there

really isn’t any disagreement that any valuation we come up with

for these stock options is going to be a very complicated formula

and won’t really correspond to reality. It may make sense from an

abstract theoretical perspective, I think FASB would tell you that

in this situation any number is better than zero, but I can tell you

that if you take a number that goes through a formula, it is very

complicated, some people think it is better than zero, and you deduct it from a company’s earnings, the company still has the same

amount of money in the bank, still is doing the same thing, but its

earnings look a lot different than they would in another accounting

situation. While Mr. Herz may well understand that and maybe

the experts on Wall Street understand that and maybe the institutional investors have people who can re-engineer this formula and

back this number out so they can see what the real economic performance is, the average investor on the street won’t have that

ability.

So I would say that the two biggest criticisms that we have are

the very negative economic impact and the difficulty for the average investor to be able to have transparency in what is going on.

We are going to end up with financial statements that distort what

most people would consider the real economic performance of the

company. That might make sense if there were a clear accounting

consensus and there was a clear way to do it and everybody

thought it had to be done. That is not the case. We are in a situation where there is a lot of controversy, and so it doesn’t really

make sense to go down this path.

I will reserve the rest of my remarks for questions, but thank

you so much, Mr. Chairman.

[The prepared statement of Rick White follows:]

July 8, 2004

The Honorable CLIFF STEARNS

Chairman

Commerce, Trade, and Consumer Protection Subcommittee of the

Committee on Energy and Commerce

2125 Russell House Office Building

Washington, DC 20510

DEAR MR. CHAIRMAN: Thank you for the opportunity to submit testimony on the

vitally important issue of accounting for employee stock options and to voice

TechNet’s strong support for H.R. 3574, the Stock Option Accounting Reform Act

of 2003.

The Technology Network, or TechNet, is a national network representing 200 of

the nation’s leading companies in the fields of information technology, biotechnology,

venture capital, investment banking and law. We are proud of the role that our industries have played in the growth of the U.S. economy, due in large part to the

use of broad-based stock option plans to attract and retain talented employees.

51

For many technical and public policy reasons, TechNet strongly supports H.R.

3574. By protecting broad-based stock option plans while requiring expensing of options granted to senior corporate officers, H.R. 3574 represents a compromise that

protects American workers while addressing concerns about senior executive compensation.

Most important, the legislation will preserve broad-based employee ownership,

embodied in the 14 million American workers or 13 percent of the private sector

workforce who hold employee stock options. 94 percent of these stock option holders

consider themselves to be middle class, lower class or working class.

The Financial Accounting Standards Board (FASB) has proposed mandatory expensing of employee stock options using valuation methods that will significantly

distort financial statements in a way that threatens this trend toward broad-based

employee ownership. Mandatory expensing using the Black-Scholes or binomial

valuation models, as proposed by the FASB, will result in gross overvaluation of employee stock options. The resulting inaccuracies will have a tremendous negative impact on the financial statements of companies that grant options broadly. If the

FASB proposal is enacted, these companies will have little choice but to severely

curtail or eliminate stock options to rank-and-file employees.

The Stock Option Accounting Reform Act protects rank-and-file American employees and preserves the broad-based employee ownership that has been the hallmark

of the technology industries and many other innovative companies.

H.R. 3574 also preserves our nation’s international economic competitiveness. At

a time when Congress is focused on domestic job creation, mandated expensing

threatens U.S. innovation and economic growth. All while many of our foreign competitors are accelerating efforts to offer stock options without mandated expensing.

TechNet believes it is critical that Congress support this legislation and not stand

by while the FASB creates regulations that could have significant negative economic

ramifications. The FASB is engaged, perhaps inadvertently, in changing a longstanding accounting policy that has enabled employee ownership, innovation and

entrepreneurship to thrive in American businesses. The FASB’s accounting regulations will have a significant negative impact on economic policy in this country.

Under the guise of an accounting standard, the FASB is taking action that will

bring the U.S. economic model closer to that of Europe—an environment that discourages employee ownership and fails to spur innovation and entrepreneurship.

The American ownership culture is one of our greatest competitive advantages as

a nation.

The Stock Option Accounting Reform Act does not dictate accounting standards.

The legislation preserves the American culture and tradition of broad-based employee ownership, innovation, hard work and new ideas. It simply returns to Congress the prerogative to set economic policy.

TechNet also believes strongly that mandatory expensing of all employee stock options, as proposed by the FASB, is bad accounting. We have met with the FASB

to express our strong concerns with their proposal on a technical level, although

with no impact.

We believe there is a strong technical record that demonstrates that employee

stock options do not represent a corporate expense. There is also a strong technical

record asserting that use of the Black-Scholes or binomial models, as proposed by

the FASB, will result in inaccurate, unreliable and inconsistent measurement of the

fair value of employee stock options.

Existing option pricing models were created to value market-traded options, which

have very different characteristics than employee options. The unique features of

employee stock options are not accounted for under the Black-Scholes or binomial

models. As a result, the FASB’s proposal will require a wide range of subjective

judgments and estimates, resulting in widely divergent results depending on the

subjective assumptions a company makes. Even Dr. Mark Rubinstein, Ph.D. of Finance at U.C. Berkeley’s Haas School of Business, and a creator of the binomial

model, raised these concerns about his own model when he testified before the

FASB.

I have attached for the record several documents which describe in detail the

technical problems inherent in mandatory expensing under the FASB’s proposal.

In summary, we strongly urge Members of the Committee to support the Stock

Option Accounting Reform Act, H.R. 3574. This legislation supports broad-based employee ownership, hard work and innovation. H.R. 3574 is a critical economic policy

approach and we urge the Congress to support it.

Sincerely,

RICK WHITE

President and CEO of TechNet

52

June 29, 2004

Ms. SUZANNE BIELSTEIN

Director of Major Projects

Financial Accounting Standards Board

401 Merritt 7

P.O. Box 5116

Norwalk, Connecticut 06856-5116

Re: Proposed SFAS—File Reference No. 1102-100

DEAR MS. BIELSTEIN: On behalf of the members of The Technology Network

(‘‘TechNet’’), thank you for the opportunity to submit comments in response to the

Proposed Statement of Financial Accounting Standards, Share-Based Payment, an

Amendment of FASB Statements No. 123 and 95. We appreciate the opportunity to

offer our views on this important matter.

TechNet is a national network of 200 chief executive officers and senior partners

of the nation’s leading companies in the fields of information technology, biotechnology, venture capital, investment banking and law. We are proud of the role

that our industries have played in the growth of the U.S. economy, due in large part

to the use of broad-based stock option and other equity-based incentive plans to attract and retain talented employees. Many TechNet members maintain broad-based

employee stock option programs. By giving employees at all levels a chance to share

in their company’s financial success through equity ownership, broad-based stock

option plans boost productivity and are essential to America’s competitiveness and

economic growth.

For reasons discussed in this letter, TechNet has serious concerns with the

Board’s proposal to require mandatory expensing of employee stock options. We believe that the Board’s proposal would result in financial statements that substantially overstate the value of employee stock options, providing less clarity and comparability to investors. Because of this substantial overvaluation, the proposal would

make it prohibitive to offer broad-based stock option plans, encouraging companies

to concentrate share ownership in the hands of senior executives.

The following addresses specific issues on which the Board seeks comment.

I. RECOGNITION OF COMPENSATION COST

Employee stock options do not constitute an expense.

We fundamentally disagree with the Board’s premise that employee stock options

constitute a corporate expense. The issuance of stock options does not result in a

corporate level cost that impacts net income.

Employee stock options do not represent payment for goods or services received.

Rather, employee stock options represent an opportunity for employees to share

ownership in the enterprise for the purpose of increasing shareholder value. They

are an employee-retention device, granted with a prospective view of future employment. A promise to issue employee stock options in return for a promise to provide

services in the future in no way meets the definition of a liability. The issuance of

an employee stock option results in:

• No outflow or consumption of corporate assets;

• No decline in the value of corporate assets;

• No creation of a liability representing actual or expected cash outflows;

Employee stock options have a contingent or hypothetical value to the employee

who receives them. However, this value is not realizable at the time of grant and

employee stock options cannot be converted into cash by either the employee or the

corporation. In fact, in many cases, this potential value is never realized. Further,

in any event, employee stock options will never result in the expenditure of cash

by the company but, in fact, have the potential to provide cash flow to the company.

Just as revenues or gains are not recognized until they are realized or realizable,

the grant of an employee stock option that has no realizable cost should not be considered an expense to the corporation.

We further believe that requiring a fictional income statement impact for a transaction that takes place wholly within the balance sheet is insupportable. Unlike a

fixed asset, the cost of which is an expense that is recognized over its useful life,

employee stock options do not generate an expense that should be recognized either

immediately or over time in the income statement. In fact, employee stock options

cannot be converted into cash and to the extent employee stock options are ultimately exercised, corporate assets are increased by the amount of cash that the employee must pay to exercise the option.

Expensing stock options will also result in balance sheet entries that give a grossly distorted view of a company’s capital structure. When employee stock options are

53

expensed, the value of those options increases a company’s paid-in capital in the equity section of the balance sheet by a phantom number. The company’s capital structure appears altered although no money has changed hands and no stock has actually been issued, or may ever be issued. Further, because the increased expense has

impacted the company’s net income and therefore its retained earnings, the balance

sheet is further distorted. The equity section of a balance sheet should represent

real dollars invested in the equity of the company. Expensing will not only corrupt

income statements, it will serve to distort already complex balance sheets, to the

detriment of investors.

Recent studies of employee stock options and compensation at a comprehensive

sampling of companies provides further evidence that stock options are not compensation in that they are generally not viewed by the employee or employer as

compensation for labor performed and are not granted in lieu of salary compensation. In their book, In the Company of Owners: The Truth About Stock Options And

Why Every Employee Should Have Them, Rutgers University Professors Joseph

Blasi and Douglas Kruse found that, in the companies examined, average employees

who held options were paid competitive wages and benefits irrespective of any options held. Options instead represent ‘‘capital income’’ that workers receive for sharing the risk of ownership in the corporation.

Some have argued that a corporation incurs an opportunity cost in issuing employee stock options, but generally accepted accounting principles have not required

the recognition of opportunity costs. Reliable calculation of the opportunity cost associated with the issuance of stock options would clearly be impossible. And, indeed,

to do so would lead to confusing results.

If employee stock options are considered an expense on the basis of opportunity

costs, then companies should be able to account for the economic benefits that result

from employee ownership. Amending GAAP to incorporate such costs or benefits

into the financial statement would clearly lead to distortions, inaccuracies and investor confusion.

Any cost that may exist with respect to shares or options issued to employees results from the potential dilution of each investor’s share of company ownership,

which may increase when options are granted. This cost is already reflected in the

income statement in the earnings per share (EPS) calculation. Reducing net income

when employee stock options are granted will result in an inaccurate ‘‘double

charge’’ in the financial statements.

Because the potential ‘‘cost’’ of issuing employee stock options is borne by existing

shareholders in the form of potential dilution, we believe that the most appropriate

way to reflect the so-called ‘‘cost’’ of employee stock options is through consistent

and extensive disclosures of data regarding shareholder dilution.

The Board has suggested that financial statements include a range of subjective

estimates and that the estimated valuation of employee stock options is no different.

We firmly disagree with this view. The subjective nature of the inputs into the

Board’s proposed option valuation formulas, the unpredictable nature of factors related to employee stock options and the resulting challenges in arriving at an accurate valuation are unique to employee stock options.

Admittedly, there are uncertainties involved in measurement of other items included in financial statements including depreciation, pension and other retirement

benefits and even stock options granted to third parties as compensation for prior

work performed. All of these examples, however, involve costs that can be valued

and assigned a definite out-of-pocket expense; or are subject to later truing up. Depreciation estimates, for example, merely represent timing issues; the cost of equipment purchased is a readily determined number. Work performed by third parties

can also be assigned a market value. In the case of pension costs, companies are

required to estimate total cost, but these estimates are trued up to reflect actual

costs.

In contrast, there is no reliable way to estimate the value of employee stock options and the Board’s proposal does not provide an opportunity to correct results to

the extent they prove wrong.

The longstanding approach embodied in FASB Statement No. 123 is an appropriate method of accounting for stock options.

We believe that the approach embodied in Statement 123 is an appropriate method of accounting for stock options. Statement 123 recognizes that there is not consensus on whether employee stock options constitute an expense. For all investors,

Statement 123 provides relevant information and supports the public policy goal of

fostering broad-based stock option plans.

Investors and accounting experts have expressed considerable doubt about the accuracy of existing valuation methods include those proposed by the Board. ManVerDate 11-MAY-2000 13:12 Sep 30, 2004 Jkt 000000 PO 00000 Frm 00057 Fmt 6633 Sfmt 6621 95450.TXT HCOM1 PsN: HCOM1
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dating that a distorted charge be incorporated into financial statements will result

in significantly less clarity, consistency and reliability in financial statements. The

established approach required by Statement 123 enables investors who consider the

‘‘compensation cost’’ a meaningful number to easily discern a hypothetical compensation charge and its impact on the financial statement.

Those who consider the ‘‘compensation cost’’ meaningless may ignore that cost.

II. MEASUREMENT ATTRIBUTE AND MEASUREMENT DATE

The grant date of the option is the appropriate date for public companies

to measure the compensation cost of employee stock options

Current stock option accounting rules require that if employee stock options are

expensed, they must be expensed at the date they are granted to the employee. Notwithstanding our position that employee stock options do not represent an expense,

grant date is the correct valuation date because it is when the employer and the

employee agree to the terms of the stock option award.

Exercise date accounting permits reliance on an actual value, rather than estimates. However, it would produce substantial swings in net income based on volatility of the underlying stock. In addition, it would have the perverse result of creating a higher expense when the stock performs well. If employee stock options were

expensed at exercise, the better a company is at increasing shareholder value, the

worse its reported earnings would be.

The Board previously considered and rejected expensing employee stock options

at the date they are exercised. FASB also rejected the view that if employee stock

options were expensed at exercise, the ‘‘cost’’ of the option would be the difference

between the market price of the stock and the amount paid by the employee on the

date the option is exercised. More recently, the International Accounting Standards

Board concluded that employee stock options that are expensed, must be expensed

on the grant date.

We believe that this issue has been thoroughly examined and that the Financial

Accounting Standards Board and International Accounting Standards Board

reached the appropriate conclusion in determining that employee stock options

should be valued at grant date. Nevertheless, as discussed below, we believe the

Board’s current proposal is unworkable on any basis including a grant-date basis.

III. FAIR VALUE MEASUREMENT

Use of the Black-Scholes, lattice or binomial option pricing models will not

result in accurate, reliable or consistent measurement of the fair value

of employee stock options.

We concur with the Board’s view that the fair value measurement should be based

on observable market prices of identical or similar instruments in active markets.

We do not believe, however, that estimates of fair value arrived at using existing

option pricing models will be accurate and reliable. We also do not believe the Board

has provided sufficient guidance to ‘‘ensure that the fair value measurement objective is applied with reasonable consistency.’’

Current option pricing models, including the Black-Scholes model and the lattice

or binomial models, do not ‘‘reflect[ ] any and all substantive characteristics’’ of an

employee stock option. Each of these models was created to value market-traded options. Specifically, these models do not factor in the lack of transferability of employee stock options, as discussed below in the response to the Board’s proposal relative to expected life. As a result, both option pricing models result in substantial

over-inflation of the value of employee stock options. The result is a material distortion of financial statements and a negative impact on the quality of financial reporting.

The Black-Scholes model, in particular, has been widely discredited as a reliable

method of valuing employee stock options. The Black-Scholes model was designed

to value short-term, freely tradable stock options, which have very different characteristics than employee options. Many of the unique features of employee stock options are not accounted for by the Black-Scholes model. As a result, companies that

utilize this model must factor a wide range of subjective judgments and assumptions

into a complex valuation formula. Predictions of a range of variables, including interest rates, stock volatility, and employee exercise behavior will determine the outcome of these calculations, resulting in widely divergent results depending on the

subjective assumptions a company makes. The results will be unreliable and will

defy comparability.

We commend the Board’s apparent recognition that the Black-Scholes model has

limitations when valuing employee stock options, reflected in the Board’s preference

for binomial models. However, binomial models do not address the shortcomings of

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the Black-Scholes method. While the Black-Scholes method is designed to value

traded options and has known limitations with respect to valuation of employee

stock options, other existing valuation models have similar deficiencies. The BlackScholes and binomial models essentially rely on the same variables: stock price, exercise price, time to exercise, risk-free rate of return and expected volatility of the

underlying stock. As with the Black-Scholes model, volatility is the key input and

is difficult to predict.

In addition, these existing option valuation models were designed to value freely

transferable options, yet there are significant restrictions on the transferability of

employee stock options. Employee stock options cannot be bought, sold or pledged.

The Black-Scholes and binomial models do not incorporate a lack of marketability

discount to address such restrictions.

Further, the Black-Scholes and binomial models were designed for options that

are exercisable only upon expiration. Employee stock options, in contrast, typically

have long vesting requirements of up to 10 years and are then exercisable for a period of time, but are worthless if the employee terminates employment prior to vesting. The Board’s proposed option pricing models do not accurately account for these

factors.

The Board’s proposal also does not take into account restrictions that exist during

the vesting period, on the basis that only instruments that vest are ultimately expensed. Again, however, a failure to discount for vesting restrictions overstates the

potential value of an employee stock option.

Any potential value of employee stock options is also significantly reduced—and

made difficult to estimate—by the imposition of blackout periods or trading restrictions on employees. Many companies prevent trading of employee stock options

based on events such as product breakthroughs or major announcements. These

blackout periods vary by individual company and by individual employee, restricting

options exercise and trading opportunities for significant periods of the year. As a

result, the potential value of employee stock options is reduced and made substantially more difficult to estimate.

In short, although the binomial models may have theoretical advantages over the

Black-Scholes method, in practice, they suffer from similar shortcomings. Binomial

models contain a complex series of subjective inputs, and values calculated are

greatly influenced by the many assumptions and choices made. Investors and other

users of financial statements will have no way to understand the complex process

of arriving at employee stock option valuations, nor will they be able to interpret

or compare the resulting financial statements.

Volatility estimates have a material negative impact on financial statements that do not accurately reflect a company’s actual financial performance.

The Board seeks comment on whether a specific method for estimating volatility

should be used and if so, what method should be used and why. We believe that

current option pricing models, including those proposed by the Board, favor companies in non-volatile industries and penalize companies in highly volatile industries.

In addition, these models do not produce reliable and comparable results in large

part because they require assumptions of expected volatility.

The Black-Scholes and binomial valuation models create a disadvantage for companies in volatile industries. Assuming stock price and other terms are the same,

if the stock price is declining in the volatile market and staying constant in the nonvolatile market, the option value will be significantly higher for the company in the

volatile market, under the Black-Scholes formula.

In addition to creating a disadvantage for companies in volatile industries, the

Board’s proposal requires estimates of long-term volatility, inherently unreliable figures. The volatility of the underlying stock expected over the life of the option, up

to ten years, is perhaps the most significant prediction that must be incorporated

into option pricing models. Volatility estimates have the potential to result in substantial swings in stock option valuation yet corporate estimates of future stock volatility truly represent efforts to predict the future.

Rather than rely on historical volatility, the Exposure Draft requires companies

in most instances to consider the extent to which ‘‘future experience is reasonably

expected to differ from historical experience.’’ Companies are further required to estimate future volatility over the life of the option, up to 10 years in the future.

Wide shifts in volatility are a unique feature of technology and high-growth companies, in contrast to many other sectors of the economy with more predictable performance characteristics. The high technology and biotechnology industries are subject to significant swings in volatility due to patterns of scientific breakthrough and

innovation that uniquely characterize these industries. Furthermore, these technoVerDate 11-MAY-2000 13:12 Sep 30, 2004 Jkt 000000 PO 00000 Frm 00059 Fmt 6633 Sfmt 6621 95450.TXT HCOM1 PsN: HCOM1
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logical and scientific breakthroughs or setbacks by a company—or by its competitors—are impossible to predict.

These unpredictable events also have an unpredictable impact on volatility. Experience illustrates that positive events, including strong test results, regulatory approvals and technology breakthroughs, can but do not always increase volatility. In

addition, macroeconomic variables and general market conditions also positively or

negatively impact volatility. Finally, the start and end dates or time period used to

calculate volatility as well as the number of data points used can significantly impact the resulting volatility estimate. In short, events and their impact on volatility

are not possible to predict and positive or negative events can instantly make obsolete any valuation assumptions made at grant date.

Incorrectly estimating the impact of volatility can cause option valuation and expenses to fluctuate significantly. For example, using the Black-Scholes formula and

making reasonable assumptions about stock price, option life, risk free rate of return and number of option grants per year, an estimated volatility of 60 percent

yields an estimated options expense number that is almost 100 percent greater than

the expense number that results from a 40 percent estimated volatility. Changes in

volatility estimates have a dramatic, material change in employee stock options expense, reported earnings and potentially to stock price.

Without a consistent or standardized method of estimating expected volatilities,

similar companies can generate significantly different expense results. Estimates or

predictions of volatility based on events a decade in the future and any valuation

based thereon will clearly be unreliable, except in the case of companies that grant

stock options sparingly (any expense number would be immaterial for companies

with limited option programs). We urge the Board not to adopt a proposal that will

create an unequal playing field by penalizing industries that experience high stock

volatility.

Employee exercise behavior is another significant factor that cannot be accurately estimated.

The Board’s proposal permits use of expected option term rather than maximum

term as a means of addressing the absence of a market for employee stock options.

The Board’s proposal, however, would require companies to forecast employee exercise behavior. Many variables impact employee decisions to exercise stock options,

including vesting horizon, option term, magnitude of in-the-money position, and the

portfolio of options that the employee can exercise in the near and long-terms. In

addition, employee exercise behavior differs based on job classification levels, gender

and age, restrictions on trading due to blackout periods and closed trading windows,

and a range of other factors. Personal decision-making based on individual expectations and needs is virtually impossible to predict, yet the Board’s proposal would

require such estimates.

The unique attributes of employee stock options are not taken into account

by the Board’s proposal resulting in overstatement of the value of employee stock option grants.

The Board’s proposed valuation models do not provide a sufficient discount for the

unique features of employee stock options. Shortening the life of an option by adjusting the contractual terms for expected early exercise and post-vesting employment behavior does not adequately account for the non-transferability attribute and

other unique features of employee stock options, resulting in overstatement of the

value of employee stock options.

Adjusting the ‘‘life’’ of the option from the contractual life may account in part

for the fact that employee stock options vest. However, this adjustment does not address the other restrictions that exist including the fact that an option cannot be

transferred, hedged, pledged, or sold. As a result, many options expire unexercised

because an employee left a company before the options had vested or because the

option price was above the price of the stock when the options became exercisable.

In short, the option pricing models proposed by the Board do not address these features of employee stock options and thus will result in significant over-inflation of

the value of employee stock options.

As a result of these shortcomings, current option pricing models, including those

proposed by the Board, allow a corporation to come up with huge differences in the

expense number depending on the inputs that are used. By failing to account for

the restrictions and other characteristics of employee stock options, current option

pricing models produce unreliable and misleading results that overstate the value

of employee stock option grants, particularly with respect to companies in volatile

industries.

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1 ‘‘Valuing Employee Stock Options: A Comparison of Alternative Models,’’ Analysis Group/Economics for Financial Executives Research Foundation.

A recent study confirmed that the Black-Scholes model systematically overstates

the value of employee stock option grants.1 In a detailed study of the leading valuation models applied to an actual set of employee stock option grants covering 403

million options granted by nine major U.S. companies, the Black-Scholes model consistently overstated the value of the option grants. The authors of the study cited

the failure of the Black-Scholes model to consider the unique features of employee

stock options.

The Board’s proposal does not provide sufficient flexibility to permit the

use of new option pricing models when and if developed.

The Exposure Draft indicates that the Board seeks to adopt a flexible standard

that will permit the use of new option pricing models when, and if, developed. We

are concerned, however, that the Board’s proposed standard appears to preclude the

use of any model that is not based on the Black-Scholes model or a lattice model.

Not only must any model used rely on the Black-Scholes inputs, but the Board’s proposal refers only to lattice and closed and models such as Black Scholes and there

is no clear guidance on the use of alternative models once developed. We are concerned that, as a practical matter, new models could not be used unless they were

derivations of Black-Scholes or binomial models.

We have significant concerns about the Board’s proposal to require options

that vest on a graded schedule to be valued and accounted for separately.

In essence, the Board’s proposal would require that where options vest on a ‘‘graded schedule,’’ that each set of options constitutes a separate award that must be valued separately and accounted for separately. Additional issuances to, for example,

new employees, also would presumably have to be accounted for separately to the

extent they were issued other than on a company-wide grant date. The result would

be multiple valuations for the same option grant and unnecessary complexity resulting in major implementation costs and challenges.

In addition, this approach will result in inappropriate front-loading of the option

expense. Under the Board’s proposal, the expense of new option grants is based on

‘‘graded vesting’’ which accelerates the expense in the early years. Thus, there is

likely to be a greater financial statement impact, or front-loading of the expense,

in the first few years as each year will carry a ratable piece of the historical grants

and an accelerated portion of the new grants. This would be extremely difficult to

administer and impact comparability of financial statements.

The Board’s proposed transition rules would result in unreliable and incomparable financial statements.

We are concerned that the Board’s proposal will result in a significant lack of

comparability due to the inconsistent treatment of new option grants versus prior

option grants. The Board’s proposal would require unvested options to be expensed

based on the Black-Scholes value that was contained in prior footnote disclosures.

Newly issued options, in contrast, would be valued based on the new standard. As

a result, during the transition period, outstanding options would be valued in radically different ways.

In addition, estimates of the value of grants made in prior years using the BlackScholes method will, under this proposal, impact financial statements going forward

despite recognition that these ‘‘values’’ are overstated. The result will be highly confusing for investors, particularly in the case of companies that offer broad-based

plans.

We believe that the Board’s proposal will have a significant, negative impact on emerging growth companies and other non-public entities.

We are particularly concerned about the impact of the Board’s proposal on nonpublic companies given the importance of employee stock options to the success of

emerging growth companies and the reliance of such companies on stock options to

attract, retain and incentivize employees. Further, we believe that the subjectivity

and unpredictability of the estimates required by the Board’s proposal is exacerbated in the case of non-public companies.

All of the arguments outlined above apply to non-public companies. In fact, such

companies will face heightened challenges in estimating the volatility of the stock

that underlies the employee stock option and for which there is no market. There

is no reliable data to measure volatility for most non-public companies. Estimates

based on market volatility will not be reliable because company volatility is often

58

not comparable to industry volatility. In addition, venture-backed companies often

establish new industries with unpredictable volatilities.

The Board’s proposal states that, where it is impossible to estimate the fair value

of employee stock options, companies be required to use an ‘‘intrinsic value’’ method

where the value is adjusted each reporting period. Non-public entities may also elect

this method. We have concerns regarding the Board’s proposed use of an ‘‘intrinsic

value’’ method in which the value of employee stock options is adjusted each reporting period.

This approach will, in effect, bring the stock price directly into the income statement. The expense associated with employee stock options will increase or decrease

each quarter depending on changes in the price of the underlying stock. Under this

approach, it is conceivable that the expense might even be negative in some cases.

In previous examinations of the expensing issue, the Board determined that measuring volatility would be too difficult, resulting in the current use of the minimum

value method for non-public companies. We believe that estimating future volatility

for new, non-public entities remains a significant challenge and we urge the Board

not to require this approach.

A one-year extension of the effective date is not sufficient to address these concerns. The substantial compliance costs that would be imposed on non-public companies would far outweigh any possibly perceived benefits resulting from a mandatory

expensing standard.

The Board should conduct extensive field-testing of proposed option pricing models prior to adoption of any final standard.

There are fundamental differences of opinion within the accounting community on

the threshold issue of whether employee stock options constitute an expense. There

is widespread agreement among accounting experts and in the business community,

however, that current valuation models will not product accurate, reliable and consistent results. As a result, we strongly urge the Board to require field-testing of

any proposed option pricing models prior to the adoption of any final standard.

Field-testing should be comprehensive and enable the financial officers and management of companies to make and test real-life assumptions to determine whether

these models can produce reliable and comparable results. Further, we believe that

the results arrived at through field-testing should be used to develop footnote disclosures until it can be determined that they provide accurate and reliable results. If,

based on sufficient field-testing data, it is determined that the Board’s proposed

models provide credible, transparent, consistent, comparable and unbiased information, and that the footnote disclosure has not addressed investor needs, then the

valuation of stock options on the face of the financial statements should be considered. There is ample precedent for field-testing in cases such as this, in which a

long-standing method of accounting is replaced with a newer, untested approach.

The Exposure Draft and resulting standard will not increase clarity or

comparability for companies or investors.

We support the Board’s stated goal of issuing ‘‘financial accounting standards that

can be read and understood by those possessing a reasonable level of accounting

knowledge, a reasonable understanding of the business and economic activities covered by the accounting standard, and a willingness to study the standard with reasonable diligence.’’ We feel strongly, however, that the proposed Statement will not

achieve this objective.

On the contrary, as detailed in this letter, we believe that the Board’s proposal

would establish a standard that significantly reduces the reliability, comparability

and clarity of financial statements for companies and investors. We believe that the

proposed standard would impose significant burdens on companies, particularly

smaller companies, related to compliance and auditing. Further, we believe the

standard is so complex and subjective as to produce financial statements that cannot readily be understood or compared across industries or over time by the average

investor.

The Board’s proposal will have a negative impact on the ability of companies to offer Employee Stock Purchase Plans.

The Board has taken the position that any Employee Stock Purchase Plan (ESPP)

is compensatory, and an expense must be recognized, unless all holders of the same

class of stock are entitled to purchase shares of stock on no less favorable terms

than the employee. The proposal thus requires companies to treat as an expense the

discount given to employees when they purchase shares under these plans.

Employee stock purchase plans are an important benefit to American workers.

More than 15 million workers at 4,000 public companies across the United States

participate in ESPPs. We are concerned that the likely result of the Board’s proVerDate 11-MAY-2000 13:12 Sep 30, 2004 Jkt 000000 PO 00000 Frm 00062 Fmt 6633 Sfmt 6621 95450.TXT HCOM1 PsN: HCOM1
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2The Journal of Accounting and Economics, April 2002. 3 How Do Employees Value Stock Options, Watson Wyatt Worldwide, March 2004.

4 ‘‘Survey: Firms Say Expensing Would Hurt Rank-and-File,—San Jose Mercury News, describing a June 2002 study of 117 companies by iQuantic Buck. 5 Joseph Blasi, Douglas Kruse and Aaron Bernstein, In the Company of Owners: The Truth

About Stock Options (and why every employee should have them), 2003.

posal will be the reduction or elimination of one of the primary savings vehicles for

millions of average American employees.

IV. ECONOMIC POLICY IMPLICATIONS OF THE BOARD’S PROPOSAL

Mandatory expensing will threaten the trend toward broad-based employee

ownership

Increasingly, employee stock options are being offered by companies in a range

of industries and the clear national trend has been toward increased employee ownership particularly among non-managers. Data from the National Center for Employee Ownership and other sources over the last few years shows that the number

of companies that offer options to all employees continues to grow. Currently, over

14 million American workers or 13 percent of the entire private sector workforce

hold stock options, according to a recent national study by Professors Joseph Blasi

and Douglas Kruse of Rutgers University’s School of Management and Labor Relations and Professor Richard Freeman of Harvard University’s Department of Economics. 94 percent of these employees consider themselves part of the middle class,

working class or lower class, while only 15 percent identify themselves managers.

Mandatory expensing will threaten this important trend.

In the high technology and biotechnology industries that TechNet represents,

stock options and broad-based employee ownership have been an engine of growth,

helping to build some of the nation’s most innovative companies. TechNet member

companies—including many of today’s technology leaders as well as start-ups—have

grown due in large part to the ability to use employee stock options to attract and

retain skilled employees at all levels of the corporation.

A mandatory expensing standard is likely to result in the elimination of broadbased employee stock option plans. Professors Brian Hall of Harvard Business

School and Kevin Murphy of the Marshall School of Business, University of Southern California, have conducted research showing that the perceived value of stock

options to executives at time of grant is typically one-half to two-thirds of the value

under the Black-Scholes method, and may be as little as one-third.2 A more recent

study of over 640 employees at 300 publicly-traded companies suggests that employees place a 30 to 50 percent discount on the value of stock option grants they receive, relative to the Black-Scholes value of the options.3 If forced to absorb a cost

50 to 200 percent greater than their perceived value, companies will face a major

obstacle to offering options.

For companies that broadly issue employee stock options, the inaccuracies that result through application of existing option pricing models are more likely to have

a material negative impact on financial statements, while companies that issue only

a small number of options—usually to senior officers—will not be as significantly

affected. Under a mandatory expensing standard, companies will be forced to restrict stock option grants rather than adding a significant expense, in accounting

terms, to the financial statement. The result will be a decline in broad-based stock

option plans.

In fact, recent studies and press reports confirm that companies will restrict option grants if a mandatory expensing standard is adopted. A 2002 survey of 117

U.S. companies showed that most of the companies surveyed would restrict option

grants to rank-and-file employees if employee stock options were required to be expensed.4 In fact, the study suggested that four of every five companies would grant

fewer employee stock options. A number of corporations have already announced

plans to reduce option grants to non-executive employees in reaction to the Board’s

proposal.

The importance of broad-based stock options and their impact on economic growth

is undisputed. Studies confirm that broad-based plans have a significant impact on

productivity, innovation and economic activity. Companies that offer stock options

to most or all employees have experienced significant increases in productivity.

Most recently, Professors Blasi and Kruse provide empirical evidence that companies with broad-based employee stock option plans receive a one-time, but permanent, boost to productivity of approximately 4 percent, compared to what their productivity would have been without employee ownership. Total shareholder returns

increase by an average of approximately 2 percent.5 Anecdotal evidence by employVerDate 11-MAY-2000 13:12 Sep 30, 2004 Jkt 000000 PO 00000 Frm 00063 Fmt 6633 Sfmt 6621 95450.TXT HCOM1 PsN: HCOM1
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ees and managers in a range of industries confirm the power of stock options to motivate employees through equity ownership.

V. CONCLUSION

TechNet strongly believes that the flexible approach set forth in Statement

No.123 provides appropriate information to investors. We have serious concerns that

an expensing standard utilizing existing valuation methods as proposed by the

Board will result in inaccurate and inconsistent financial reporting.

Existing valuation models are not adequate for valuing employee stock options.

We believe that the Black-Scholes and binomial models proposed by the Board fail

to adequately incorporate factors unique to employee stock options. The need to

make multiple subjective determinations of the variables used in the Black-Scholes

or binomial stock option valuation models will threaten the comparability and consistency of financial reporting across companies and across industries.

Thank you for the opportunity to comment on this important matter. Please contact me at (650) 213-1160 for any further discussion of our comments.

Sincerely,

RICK WHITE

President and CEO

Mr. STEARNS. I thank my colleague.

Mr. Mayer.

STATEMENT OF STEVEN C. MAYER, SENIOR VICE PRESIDENT

AND CHIEF FINANCIAL OFFICER, HUMAN GENOME SCIENCES

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

Schakowsky, and members of the subcommittee. Thank you for the

opportunity to appear before you today at this important hearing.

I have submitted my letter to the FASB, my comment letter and

that of BIO, that I ask be included in the record.

Mr. STEARNS. My unanimous consent, so ordered.

[The material appears at the end of the hearing.]

Mr. MAYER. My name is Steven Mayer, Executive Vice President

and Chief Financial Officer of Human Genome Sciences. I am a

member of the Small Business Advisory Committee to the FASB,

as Mr. Herz mentioned, and I did participate in the first meeting

of that committee on May 11 of this year. I have been a participant

in the biotechnology industry for more than 20 years and have

served as Chief Financial Officer of a number of biotechnology companies, both private startups and public companies, for 19 years.

I am pleased to appear today on behalf of BIO, the Biotechnology

Industry Organization, which represents more than 1,000 biotechnology companies and related organizations. Most of these companies are engaged in the search for therapies to prevent, treat and

cure diseases, including cancer, cardiovascular disease, autoimmune disease, infectious diseases such as HIV/AIDS, and many

other serious conditions.

At Human Genome Sciences we were a pioneer in the discovery

of human genes and the application of those discoveries to human

therapeutics. We are currently testing in human clinical studies

breakthrough treatments for cancer, lupus, rheumatoid arthritis,

hepatitis C infection, and even the potential bioterror threat, anthrax. In addition, we are in preclinical development of treatments

for HIV infection and diabetes.

In all of my experience in the biotechnology industry, in every

company with which I have been associated and in virtually every

company with which I am familiar, stock options have played a key

role in the recruitment, retention and reward of the scientists, phyVerDate 11-MAY-2000 13:12 Sep 30, 2004 Jkt 000000 PO 00000 Frm 00064 Fmt 6633 Sfmt 6602 95450.TXT HCOM1 PsN: HCOM1
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sicians, professionals and staff. In fact, all of these companies use

broad-based plans that generally extend to most if not each and

every employee in the company. All of our employees at Human

Genome Sciences are eligible for our stock option program.

So I have a pretty good understanding of how stock options have

been used in our industry over a long period of time and an appreciation of the fact that stock options have been a key ingredient in

making the U.S. biotechnology industry the world leader by a very

wide margin. I am concerned that putting this structure at risk

could jeopardize the important research going on in the biotech industry. That is why I am here today to speak on behalf of BIO in

support of the legislation that you are considering, H.R. 3574, and

to explain why I believe there are fundamental and fatal flaws in

the exposure draft prepared by the FASB that would require mandatory expensing of stock options.

First, I believe mandatory expensing is bad policy that will diminish the entrepreneurial spirit of our industry, reduce the availability of capital and decrease the alignment of interests among

employees, management, and stockholders. Such a change will in

all likelihood have a detrimental impact on a broad range of rank

and file employees who today have an opportunity to accumulate

wealth through participation in the value that they help create.

Second, and most important, I believe expensing is bad accounting that will cause financial statements to become less reliable, less

transparent, less comparable, more volatile, less understandable

and less useful.

Some points. Employee stock options do not represent an expense

as defined in the FASB’s own conceptual framework, CON 6. I

would encourage all the members, or perhaps their staffs, to read

the conceptual framework. It is an excellent document. I commend

the FASB on it. But the FASB definition of expenses in that conceptual framework states that ‘‘expenses represent actual or expected cash outflows that have occurred or will eventuate as a result of the entity’s ongoing major operations.’’ The grant, exercise

or sale of shares from a stock option never under any circumstances result in a cash outflow. In fact, they may result in a

cash inflow.

Another point. Expensing stock options I believe will actually distort earnings per share by double counting the impact of the option, first as an expense and then a second time as dilution. The

true economic impact of issuing stock options is already fully captured in the dilution of earnings per share. It is actually the stockholders who give up a share of their interest in the company in exchange for value created, not the company that incurs an expense.

Transparency. We hear it a lot. We talk about it a lot. Transparency means that one can understand where the numbers come

from and how they were derived. Few people I know understand

the Black-Scholes model, including many of those who use it. No

one I know understands the lattice model nor do they understand

how they will come up with the many estimates required to implement it. This single number is only a theoretical estimate of a cost

that is never actually incurred, that never results in a cash outflow

and that may in our industry, in the biotech industry, overwhelm

every other category of expense in the income statement.

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This is not transparency. What we have today with extensive

footnote disclosure already required by the Securities and Exchange Commission is much more transparent. The information is

readily available to any investor or creditor who wishes to use it.

Increasing the complexity of financial statements in this way will

only make the information less accessible to the average investor,

the small creditor, the independent analyst. The large institutions

will have the legions of analysts needed to untangle and interpret

these complex statements resulting in a less level playing field

than we have today.

My third point is that the cost of implementation and the difficulties of auditing the many estimates that would be required to

implement the expensing of stock options have been severely underestimated and will far exceed, in my view, any benefit that

could possibly be derived from taking the extensive information already available in the footnotes to financial statements and embedding it in the income statement as a single theoretical estimate.

The implementation of this new standard will be a crushing burden

to many companies in our industry.

My grave concern is that the forces that are defining this new

accounting approach are driven by a desire to reshape executive

compensation and not by the goal of improving financial reporting.

Is accounting policy the right way to address the executive compensation issue? In this setting, I am hopeful that Congress will

act to preserve reporting standards that result in clear, reliable,

comparable and informative financial statements.

Thank you again for this opportunity. I will be happy to answer

any questions.

Mr. STEARNS. Thank you, Mr. Mayer. Let me ask you something,

Mr. Mayer. From your testimony, you are saying that you would

agree to expense stock options for all employees if we used the lattice model?

Mr. MAYER. No. I am saying that I think using the lattice model

would be an incredible burden on companies because people don’t

understand it.

Mr. STEARNS. Black-Scholes, you don’t think that——

Mr. MAYER. Black-Scholes is a simpler model that people currently use for doing their footnote——

Mr. STEARNS. But your position is you do not think any stock options should be expensed, is that correct?

Mr. MAYER. That is correct.

Mr. STEARNS. Mr. White, is that your position, that no stock options should be expensed?

Mr. WHITE. As a theoretical matter we don’t think it makes

sense to do it. As a matter of policy it may make sense to make

a distinction for the top five since they do have the ability to manipulate the price of a stock.

Mr. STEARNS. So we are clear that your position is pretty

straightforward that no stock option should be expensed. On the

other side, Mr. Walker and Mr. Herz believe they should be. When

you look at other people who have experience in this matter, I mention Alan Greenspan, Paul Volcker, SEC Chairman Bill Donaldson,

Treasury Secretary John Snow and Warren Buffett, all think they

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should be expensed. Both of you individuals do not agree with

them. Canada is starting to expense them and so is Europe.

So at this point we also have all seven members of the Financial

Accounting Standards Board, we have the four top accounting

firms and legions of investment professionals that say they should

be expensed. Not only that but Warren Buffett, who has had 62

years of investing, is one of the most wealthy men in the country,

has pointed out in his recent editorial that he believes stock options should be expensed. The question is, in his editorial he was

concerned about, and as has been pointed out by one of the members of the panel, is that the idea of zero volatility means there is

no expense.

So I guess the question is, and this is for you, Mr. Herz, H.R.

3574 requires that the assumed volatility for options granted to the

five highest paid executives in a corporation be zero. Mr. Buffett

says that is impossible. In his 62 years he has never seen a stock

that doesn’t fluctuate. He calls it an Alice in Wonderland assumption to state that it would be zero.

So let me ask you a question. Can you expense a stock if its volatility is considered to be zero?

Mr. HERZ. You would get what is called the minimum value approach, which is just accounting for the discounting of the strike

price, but you can actually then engineer the strike price to get a

zero expense and just keep the value the same by multiplying the

number of the grant of the options. The answer is that it defies all

rational, proven finance logic that underlies the whole financial——

Mr. STEARNS. Let’s be fair. In that bill they also have other criteria besides the zero volatility. So comment about those. Do they

make it more credible?

Mr. HERZ. The bill has what is called a true-up at the end for

the spread between the grant price and the value of the stock at

that end, whether it is higher or lower. That is what is called exercise data counting. That is not an accounting that is supported by

many accountants. It is an accounting that the CBO looked into.

Mr. STEARNS. Does FASB support the other options that are in

the bill as a criteria?

Mr. HERZ. No.

Mr. STEARNS. Mr. Walker, the other criteria that is in this bill

besides the zero volatility, do you find those credible to use for expensing options?

Mr. WALKER. I think they are issues that are reasonable to consider but the fact of the matter is I think it is unrealistic to not

consider volatility. To a certain extent, Mr. Chairman, what I am

hearing is an advocacy for social accounting.

Mr. STEARNS. What is social accounting? Define that.

Mr. WALKER. There is a big debate that happens from time to

time saying that you ought to invest or not invest in certain types

of things because of social or societal interests. What I am hearing

from the two panel members who oppose the FASB’s proposed action is that accounting shouldn’t be based on economics, it

shouldn’t be based upon consistency and transparency and substance over form, it should be based upon what kind of social implications it might have.

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I might add, as an anology, I used to be Assistant Secretary of

Labor for Pensions and Employee Benefit Programs, so I am very

familiar with ESOPs, employee stock ownership plans, profit-sharing plans. The Tax Code has all kinds of incentives in it for broadbased, employee-based share arrangements. It also has a number

of additional flexibilities with regard to Federal laws in order to try

to encourage those types of arrangements, but that is different

than how you ought to account for those types of arrangements.

Mr. STEARNS. Let me just conclude. Mr. White and Mr. Mayer,

you have testified that stock options should not be counted as expense because, in your words, ‘‘they represent an opportunity for

employees to share in ownership.’’ But, Mr. Mayer, don’t we expense the direct grant of stocks? Aren’t they expensed when I give

you stocks personally?

Mr. MAYER. Yes. From an accounting treatment——

Mr. STEARNS. If it is true that we force you to expense the stocks

when we give them to you, why wouldn’t it be possible to expense

the option for the stock?

Mr. MAYER. Stocks have certain value. If I give you a share of

stock, it is liquid, you can take it——

Mr. STEARNS. And we are saying options do not have that?

Mr. MAYER. Do not have certain value. In fact that is exactly the

point.

Mr. STEARNS. Doesn’t the corporation go out and have to commit

those at a certain price before they give it to the——

Mr. MAYER. Absolutely not. No. Typically—it depends on the

company but typically the company will reserve shares.

Mr. STEARNS. That is what I mean. When they reserve those

shares, isn’t that a commitment by the company typically and at

that point somebody owns those shares and is protecting that price

value before it goes up or down?

Mr. MAYER. No, absolutely not. The shares that are reserved are

set aside at the behest of the stockholders, the owners of the company, not by management, and under today’s rules all stock option

plans must be——

Mr. STEARNS. But who is going to buy those stocks when it is exercised?

Mr. MAYER. The public market would.

Mr. STEARNS. And who is going to guarantee that price—if you

are going to buy it at 32 and it is 200, who is going to guarantee

that 32?

Mr. MAYER. Well, the 32 is a contractual commitment by the

company.

Mr. STEARNS. Isn’t a contractual commitment an expense if it involves options of stocks?

Mr. MAYER. No, it is not an expense. In fact an expense as defined by FASB is a cash outflow. There isn’t a cash outflow.

Mr. STEARNS. Let me just conclude with Mr. Herz. I am a little

over my time. Yes, Mr. Herz.

Mr. HERZ. Options clearly do have value and any options are

given for other purposes, to acquire goods and services, they are

used in M&A transactions, stock purchase warrants are used as

part of financing packages. In all those cases, it has been long established accounting that you value them and you account for that

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properly. It is just this one form of employee stock option that has

this kind of narrow aperture in the existing accounting literature

that has been used to not account for them.

Mr. STEARNS. My time has expired.

Mr. MAYER. If I could just correct what I think is a misconception on the volatility issue. Zero volatility does not mean zero value

by definition under Black-Scholes. I am less familiar with the lattice model, but you plug in zero volatility into a Black-Scholes

model, you will not get zero value. You will get a lower value than

if you plug in a higher volatility. In fact volatility is the most sensitive parameter and is exactly why I am so concerned about this

because nobody here can predict what the stock market volatility

will be over some 7 or 10 years.

Mr. STEARNS. My time has expired. The gentlelady.

Ms. SCHAKOWSKY. Thank you, Mr. Chairman. Mr. White, I have

to tell you that I was shocked and offended by what I view as the

very—you don’t have to put your mike on because I am going to

ask Mr. Herz to respond—patronizing tone of your testimony in

saying that we had to consider these larger economic questions. I

want to tell you something. That is why we are here right now, the

effect on the economy. If you doubt that, talk to some of these employees of Enron or other victims of corporate misconduct. The reason that we are so concerned about setting some neutral industry

standards and accounting standards and looking at what FASB is

trying to create here is because we have economic victims of this

corporate irresponsibility and misconduct and, in the case perhaps

of Ken Lay, of criminal activity. So we are looking at larger questions here.

I don’t want to say too much because I saw Mr. Herz taking

some notes while you were talking. I want to give him some time

to respond to your patronizing testimony. But you were concerned,

Mr. White, about my company not doing as well because I had to

report those expenses. I just wanted to read to you, in March 2004,

a leading compensation firm, Towers Perrin, issued a study examining 335 companies that switched to stock option expensing and

found that stock performance was the same on average as the rest

of the S&P 500 and Mid Cap 400 indices. Stock option expensing

did not affect company stock prices. The same dire prediction had

been made and shown to be unfounded when FASB first required

companies to begin accounting for their obligations to employees relating to retiree health care benefits.

So I would say, don’t be concerned about my company. Were I

to expense those stock options, it appears that I would be doing

just fine as these nearly 600 other companies seem to be doing, as

Canada, as 90 other countries. And the idea of harmonizing what

we do with the rest of the world, it seems worth commenting on

as well.

I would like, Mr. Herz, to give you the opportunity to respond to

some of the comments that Mr. White made regarding the inapplicability.

Let me just say one other thing. It seems to me that what you

were suggesting, Mr. White, was politicizing the question of these

accounting standards and it seems to me that your suggestion,

rather than helping, undermines investor confidence in accounting

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practices, allows companies to misrepresent their true financial positions, does not allow for honest and transparent accounting, and

prevents investors and pension funds from making informed decisions. It seems to me that is what I heard Mr. Walker saying, too,

I think, is if we want to establish confidence, then doing exactly

what FASB, or perhaps we need more discussion about the exact

nature of it, but the idea of what FASB was suggesting is the direction we ought to go.

Mr. Herz.

Mr. WHITE. You are not going to let me respond, is that correct?

Ms. SCHAKOWSKY. You took more than your time as it was and

I would like now Mr. Herz to use my remaining time. If there are

others who want to give you time, that would be fine.

Mr. HERZ. Thank you. Because I was going to say that I was

kind of grateful to Rick for characterizing my own statements,

which I think he mischaracterized some of them. On the issue of

not considering the impact on the U.S. economy, our mission is exactly about—as you say, it is about the efficient allocation of capital

in the economy. We think that is a huge public policy goal.

Different groups come to us, different industry groups come to us

always and say, my public policy mission is the highest in the economy. We had a group from the steel industry come and quite rationally say steel needs to be made more competitive, the costs are

too high, we want you to exempt us from showing pension costs.

I asked, do you still have those costs? Yeah, but we want you to

put it in the footnotes, make you look more competitive. When we

were doing the thing on special purpose entities, we had a number

of people who were purveyors of different structures saying, well,

my special purpose entity is good, it allows companies by keeping

it off the balance sheet to borrow more and they can hire more people and they can invest in things. We can’t make those kind of decisions nor should we have to.

For us, as I said, it is about trying to get the right accounting,

the issue of investors and backing the thing out. The fact is that

investors, shareholders, institutional investors have all kind of

voted either in resolutions or in all sorts of surveys and they all

back our proposal strongly and the idea of expensing.

He said there is no clear accounting consensus. Yeah, there is

some debate on some of the technical issues, but on the basic issue

of expensing, as mentioned, all the accounting firms I know, not

just the big four, the next two large ones, in the international

arena, the International Accounting Standards Board approved

their standards by 14 to nothing. On that board are people from

nine different countries from all parts of the world. So I think there

is a fair amount of consensus on this issue.

Ms. SCHAKOWSKY. Thank you. Mr. Chairman, I seek unanimous

consent to put into the record a letter that myself and Mr. Dingell

and 22 Members of the House and Senate sent to FASB and also

the list of the 576 companies that have voluntarily adopted option

expensing, a report from Bear Stearns.

Mr. STEARNS. By unanimous consent, so ordered.

[The information referred to follows:]

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Mr. STEARNS. Mr. Shadegg.

Mr. SHADEGG. Thank you very much, Mr. Chairman. I apologize,

I have very little time. I would like to ask you to keep your answers brief if you possibly could. Mr. Walker, in the other committee that considered this legislation, a witness from CBO came

and testified. They were supportive of the FASB rule. I asked him

a question kind of following along Mr. White’s question, which was

in your study did you study the economic impact on the economy;

that is, the impact on the economy of this rule? Actually I asked

him what factors did he look at and what did it show. He responded that in point of fact in its study CBO had not looked at

the impact on the economy, they had simply looked at how the

process could be done.

To my knowledge, GAO has not done a study of the impact on

the economy of enacting the FASB rule, has it?

Mr. WALKER. No, we haven’t. It is my understanding CBO did

look at the impact on competitiveness, though, and said it would

not have an adverse impact on the competitiveness of U.S. companies.

Mr. SHADEGG. That is not what he said. I asked him what factors

they looked at and he said they had not.

Mr. WALKER. They are different issues. You are correct, he did

not look at the other.

Mr. SHADEGG. Mr. Herz, would you agree with me that this is

a gray issue; that is to say, that it is not clear and black and white

and it is not an issue where every logical viewer of the issue would

say yes, we should move to expensing stock options?

Mr. HERZ. I think any knowledgeable person in economics and

accounting would agree.

Mr. SHADEGG. I am troubled by that.

Mr. HERZ. I think you can debate which method. That is a debate, a vigorous debate we have had at the Board.

Mr. SHADEGG. I think you are interested in where I am going so

let me go there. You have pointed out that all the major accounting

firms are now on the side of expensing and you have said you are

on the side of expensing but just a few brief years ago in December

1993, your name appeared on a letter by Coopers & Lybrand saying that using stock option pricing models would result in unreliable information and would have an adverse impact on the comparability and usefulness of financial statements.

Your name appeared on that letter. I presume you supported

that position then. So I guess all of the consensus that you say everybody now, anybody knowledgeable now, would say absolutely

should expense. So that letter was not only wrong 7 or 10 years

ago, it was dramatically wrong?

Mr. HERZ. That is not a letter. It is a thing called a data line

to the practice. All it did was explain people’s views.

Mr. SHADEGG. They seemed to be pretty strong views. They say

point blank using option pricing models results in unreliable information and would have an adverse impact on the comparability

and usefulness of financial statements. Those are pretty strong

words.

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Mr. HERZ. As I said, that thing expressed people’s views, reported people’s views, my personal views. I can say that since that

time I have studied this issue for many, many, many years.

Mr. SHADEGG. And changed your opinion?

Mr. HERZ. I don’t think I had that opinion at that time.

Mr. SHADEGG. Your name and phone number appeared on the

letter.

Mr. HERZ. It says for more information on this subject, please

contact one of the following three people.

Mr. SHADEGG. You put your name and phone number on a letter

that says for more information when you disagreed with the letter?

Mr. HERZ. The letter was a report on views. It was not people’s

views.

Mr. SHADEGG. Mr. White, let me ask you, the chairman read a

pretty lengthy list of people who have said that they think we

should move to expensing. I note that all of those people that he

recited represent large, well-established companies. None of them,

I believe, have made their fortune in startups and quite frankly I

noticed a stark absence of anybody in the high tech field or the

biotech field. I guess I would like to give you an opportunity to tell

me the perspective of startups and the perspective of biotechs and

high techs on this issue and the concern of those companies.

Mr. WHITE. I appreciate that. Actually what I would like to do

is just read a list of other people who actually don’t think that expensing is appropriate. There is a long list, but a couple you might

consider are Commissioner Paul Atkins from the SEC. He disagrees with that. Glen Hubbard, formerly at the White House.

Larry Lindsey, formerly at the White House, also doesn’t agree

that expensing is appropriate. Some of you may remember the

Honorable Tom Campbell, who was a great Member of this institution, now the Dean of the Business School at Berkeley, he doesn’t

agree with the comments that have been expressed.

As I think Congressman Shadegg pointed out, there are professors at Harvard, Princeton, Rutgers, Berkeley, Stanford and many,

many other schools across the country who disagree with that. I

think there has been an effort to suggest that this is a closed issue

by people who really understand it, and I think that is absolutely

false. There is a real, legitimate, principled debate in accounting as

to whether this should be booked as an expense at all.

Mr. SHADEGG. My time is going to run out, Mr. Mayer, but let

me ask you in conclusion, one of the things that troubles me with

the concept of expensing is that there is in fact not agreement on

a correct method of expensing, so much so that FASB itself doesn’t

propose to dictate a method for expensing. I guess I would like you

to explore that as a concern, and there has been reference on the

other side to the idea that this proposal, expensing stock options,

would have precluded the Enron scandals and other recent scandals. My memory tells me those were not the abuses. As a matter

of fact, with regard to some of those I think they were special entities where those companies spun off all of their losses, not showing

those losses on their books, which would not in any way have been

improved or given a better picture or been avoided if we had had

this rule.

I appreciate your comments.

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Mr. MAYER. Certainly the method of estimate is one of the great

concerns that all of us have in the implementation of this plan. The

Black-Scholes method is one that people do understand, although

we also understand the drawbacks of it. The lattice model is a

model that no one understands. One thing that has not been addressed is how these will be audited. The lattice model would require us to make quarterly estimates of employee behavior going

forward 7 to 10 years, of stock market volatility going forward 10

years, and other factors that would all get rolled into this model.

By rough calculation for our company, we would have to make several tens if not hundreds of thousands of calculations each quarter,

and how those will be audited I don’t think anyone has yet addressed.

As far as the question of the recent corporate scandals, I am not

a real student of those. However, it is my understanding that stock

option accounting has not played a role in any of those.

I have to take issue with a couple of people who have said that

this current method prevents investors from making informed decisions. The current SEC disclosure is very clear and very fully informs in footnotes of financial statements all of the information

that someone could want and in fact even the CBO report that has

been referenced says that this information is already available to

investors in the notes to firm’s financial reports. So the information

is there. This has nothing to do with cash-flows. It is merely a different type of accounting treatment from the one that has been in

place for I think some 25 years.

Mr. SHADEGG. Thank you very much. My time has expired. I

thank the Chair for indulging me.

Mr. STEARNS. I recognize Ranking Member Dingell.

Mr. DINGELL. Mr. Chairman, I find myself very interested in the

thesis that this legislation would require that no longer would corporations that have chosen the method of using fair valuation of

options be able to use those.

Can you explain, Mr. White, or perhaps, Mr. Mayer, why we

should ban General Motors or any of the other U.S. corporations

who have decided they want to use this mechanism from using it?

Mr. WHITE. We shouldn’t. I agree. As I understand the bill, it

doesn’t do that.

Mr. DINGELL. It does do that. Mr. Mayer?

Mr. MAYER. I agree we should not, and it is also my understanding that the bill does not do that.

Mr. DINGELL. I find myself very interested, also, in the fact that

the bill says that there would be no—that it would be presumed

there would be no volatility in the stock. That is a curious thing.

Doesn’t that fly in the face of all of our experiences with the indexes? Most recently, for example, the Dow has gone from something like 8,000 to 10,000 and it moves somewhere around 100 or

so points a day. That seems to be at variance with fact, does it not,

gentlemen?

Mr. WHITE. It flows out of the great complexity of this and the

inaccuracy of trying to estimate the value of these things on the

date of grant. It is a little like predicting the value of your stock

into the future, which is a very difficult thing to do. The problem

is with volatility a very small change in your assumptions about

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volatility drives a huge change in the valuation, and so it makes

it very subject to manipulation. It is the biggest area of inaccuracy

in the whole process.

Mr. DINGELL. But to assume that there is no volatility affords

people to do some rather innovative accounting, doesn’t it? And it

would enable us to see people who had this particular responsibility to in fact manipulate the stocks because they could assume

there is no volatility. For example, when the bottom fell out of AOL

or when the bottom fell out of Tyco, they could assume there is no

shift in the value of the stock.

Mr. MAYER. Actually I think quite the opposite. By having zero

volatility you stabilize the basis on which these calculations are

done. That eliminates a huge variable and in fact the most sensitive variable to the calculation. If you allow people or require people to guesstimate or estimate volatility going forward, that estimate is going to be always changing and that is where games will

be played.

Mr. DINGELL. So we have then an assumption that there will be

no volatility in stock. That is a bad assumption, is it not?

Mr. MAYER. I think it is a——

Mr. DINGELL. It may be inconvenient that there is this volatility

but it is still there, isn’t it?

Mr. WHITE. It just points out the futility of this whole exercise.

You can’t get this number right, and so the effort to make it zero

is to stabilize it so it is not quite as wrong as it otherwise would

be. That is really the problem.

Mr. DINGELL. Thank you.

Mr. Herz and Mr. Walker, would I be fair in assuming that all

accounting was absolute and was done on absolute numbers? Or do

we find that there are a lot of estimates that occur in the accounting process?

Mr. WALKER. There are a lot of estimates that occur in the accounting process. Let me give you another one that was controversial. Health care costs, inflation. There was a huge controversy

over accounting for post-employment health benefits because of the

difficulty in trying to project what the estimated total cost of health

care would be, but in the end FASB came up with a clear, consistent and transparent accounting treatment despite that fact.

Mr. DINGELL. I note here that the prohibition on using the fair

value of stock options would affect large numbers of U.S. corporations. This question is to Mr. Herz and Mr. Walker. It would affect

foreign corporations listing on the U.S. market functioning under

international accounting standards, would it not?

Mr. HERZ. Yes. I am not a lawyer but the way I read the——

Mr. DINGELL. It would also affect U.S. subsidiaries of foreign corporations and foreign subsidiaries of U.S. corporations, would it

not?

Mr. HERZ. It would affect anybody who doesn’t use the method

prescribed by the bill.

Mr. DINGELL. So it would ban large numbers of U.S. corporations

and foreign companies from being properly listed on the securities

exchange, would it not?

Mr. HERZ. It would make them undo what they believe is the

better accounting.

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Mr. DINGELL. If you can’t get your reports approved by the SEC,

you can’t list, and all of a sudden you have got real problems under

our securities laws.

I have been looking here at this business of only the top five.

This question is to Mr. White and Mr. Mayer. Why would we limit

it to only the top five?

Mr. WHITE. I think there are two reasons. One of them is more

of a policy-oriented reason. That is what a lot of people are really

concerned about, making sure that executive compensation doesn’t

get out of the control. I think the reason that is more related to

this exercise is that those people are the ones who have the possibility of manipulating the stock price so that it artificially would

go up.

Mr. DINGELL. Let’s take your assumption. Let’s just talk about

Enron, which is always a nice subject of discussion. The top Enron

executives. All of the above were indicted, Ken Lay, Jeff Skilling,

Andrew Fastow, Richard Causey. These are the chairman, chief executive officer, chief financial officer and chief accounting officer.

The only one not indicted was Mr. Jeff McMahon, who was the

treasurer. I suspect in part because he cut a deal with the U.S. Attorney.

As we go on down we find Lea Fastow was also indicted, Michael

Kopper, who was in the treasurer’s office and Ben Glisan. There

were a goodly number of others. You would get the top five but you

wouldn’t get the others, so you wouldn’t know who was stealing

there and who was manipulating the value of stock options or how

this impacted upon the value of the shares of stock of the ordinary

citizen.

Mr. WHITE. And we wouldn’t know under this deal either.

Mr. DINGELL. Are you advocating that we should take that

course of action?

Mr. WHITE. No. In fact, the real problem here, and I will let Mr.

Mayer respond also, but Enron is an example of where they, as far

as people can tell, complied with a lot of accounting standards and

still defrauded people. No matter what we do in terms of accounting, if people are going to lie and break the laws, the rules are not

going to change that.

Mr. DINGELL. And your prohibition would make it easier?

Mr. WHITE. I don’t think so.

Mr. MAYER. I disagree. The value of stock options was not an

issue of all the many issues in the Enron situation.

Mr. DINGELL. Stock options were a major inducement because

what was done was to keep up the value of stock to keep the value

of the stock options up.

Mr. MAYER. And that stock option position was fully disclosed for

Enron like all companies who are SEC reporting companies.

Mr. DINGELL. This would require that only the top five be disclosed. I have mentioned you will find five of those who are wouldbe felons here.

Mr. MAYER. This is talking about expensing the top five, not disclosing. Currently all options are disclosed in the statements, in the

notes to the financial statements. Every single option is currently

disclosed——

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Mr. DINGELL. You would say then that the options either should

not be disclosed or that the value of the options should not be disclosed? Which?

Mr. MAYER. No, I think they should absolutely be disclosed and

should be fully disclosed, but not expensed on the income statement.

Mr. DINGELL. Mr. Herz, you and Mr. Walker may be able to help

us out of this thicket.

Mr. HERZ. My recollection as I watched a lot of these hearings

on TV was that Mr. Skilling actually testified that he used stock

options as a way to inflate earnings. In fact, he basically accused

you in Congress for allowing that to go on, having overridden the

FASB, so to speak, the last time around.

Mr. DINGELL. How then would this five-person exemption or this

five-person requirement impact on the way honest reporting was

done?

Mr. HERZ. Honest reporting looks at the same transaction,

whether it be given to the top person or the 800th person. This is

like saying that only the top five salaries ought to be expensed, the

top five pensions, let’s just show the five top pieces of debt to the

company. There is no consistency or coherence to the financial

statements once you go down that path.

Mr. DINGELL. I would just note here that Mr. Skilling admitted

the benefits of this substitution in effect during his congressional

testimony. He said as follows: ‘‘You issue stock options to reduce

compensation expense and therefore increase your profitability.’’

What is the amount of some of the corporate salaries in some of

these people that would be exempted? It would run to millions or

even hundreds of millions of dollars a year, would it not?

Mr. STEARNS. The time of the gentleman has expired, but I certainly will allow——

Mr. DINGELL. Just that one question, Mr. Chairman. I thank you

for the very great courtesy you have given me.

Mr. HERZ. The amount for individual CEOs can be very large,

but I think from our point of view the issue is that not expensing

it for the rest of the people leaves out a big element of compensation and of cost from the financial statements. In the case of certain major high tech companies, that can run into billions of dollars.

Mr. DINGELL. Mr. Chairman, I thank you for your great courtesy.

Mr. STEARNS. Thank you. The full chairman, Mr. Barton.

Chairman BARTON. Thank you, Chairman Stearns. I want to

again thank this panel for being here. I want to focus on stock options and FASB a little bit, but since Mr. Dingell brought up the

issue of Enron, I think I need to say a few things about that.

This is the committee that did the investigation, that found the

facts that led to all the indictments of Enron, the Energy and Commerce Committee Oversight and Investigations staff. Chairman

Tauzin worked very hard to expose that. I totally supported it. But

my recollection of Enron was that they decided, the corporate leadership, that they had a new corporate model that was not asset

based, that they decided they could run a corporation based on trying to capitalize transactional expertise in their trading and, to the

extent they had asset problems, they spun them off into these speVerDate 11-MAY-2000 13:12 Sep 30, 2004 Jkt 000000 PO 00000 Frm 00110 Fmt 6633 Sfmt 6602 95450.TXT HCOM1 PsN: HCOM1
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cial entities and tried to convince the capital markets that they had

a new way of making money without having any assets to back it

up. Their problems had nothing to do with stock option accounting

or whether it was disclosed or expensed. It had everything to do

with running a corporation with no assets.

I have simplified it, but is that generally what happened? They

tried harder and harder to hide the fact they had no assets and it

finally caught up with them?

Mr. WALKER. Mr. Chairman, it was primarily dealing with special purpose entities, and that was their problem. At the same

point in time I think it is legitimate to ask what is the proper accounting for stock options.

If I might quickly add, one of the things that I heard Mr. Mayer

and Mr. White say was their concern about whether this would

have an adverse economic impact. I would raise as a related question, namely, since you have to disclose in your financial statements what the impact would be on a fair market valuation basis,

anyway, a sophisticated investor would see that. Since it is a

noncash item, I don’t understand why having consistent accounting

treatment is going to have an adverse impact, because the fact of

the matter is a sophisticated investor would consider that anyway.

Mr. WHITE. But we want accounting for unsophisticated investors, too. At least that would be our argument.

Chairman BARTON. That is true. I agree with that. Let me ask

some questions about stock options.

There is nothing in the law or in SEC regulation that prevents

a company from expensing stock options right now, isn’t that true?

If I am the CEO or the board of directors and I want stock options

expensed, generally accepted accounting principles don’t prevent

that. It can be done. We don’t have to have a Federal law to expense stock options. We can make it mandatory, but you can do it

voluntarily if your corporate board wants you to. Isn’t that correct?

Mr. MAYER. Absolutely, under FAS 123, and the 575 companies

that have done that are typically the companies that either don’t

have a lot of options or for whom the impact is not particularly

large.

Chairman BARTON. Again correct me if I am wrong, but under

current law there is nothing that says companies have to grant

stock options but those that do, if they make the decision, they

have to disclose in their annual reports the number of options that

are granted above a certain percent, they have to disclose who they

are granted to and they have to disclose the strike price at which

they can be exercised, isn’t that correct?

Mr. MAYER. That is correct, and the estimate of fair value of

those options.

Chairman BARTON. So if I am a financial analyst and can read,

I can read that and if I am the unsophisticated investor that Mr.

White is referring to, I may not understand it but I can read it and

I can call a financial analyst that for a nominal fee can explain it

to me. Isn’t that correct?

Mr. MAYER. That is correct. And it will be much harder to go the

other way.

Chairman BARTON. What is the worst documented example of a

stock option scandal that has defrauded unsophisticated investors

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in that company? Are there examples of companies that somehow

cooked the books on these stock options and the senior management exercised their options and ran off to Cancun and left these

poor unsophisticated investors with nothing?

Mr. MAYER. I am not aware of any.

Chairman BARTON. Is anybody aware of a real world example of

a stock options scandal?

Mr. WALKER. We haven’t researched that. Let me just say, if people think that an unsophisticated investor is going to understand

the footnotes of a financial statement, that is totally unrealistic.

Chairman BARTON. I am just trying to find out. We have a major

bill. We have had a real debate in the last several years about expensing stock options. Chairman Greenspan of the Federal Reserve

has said we ought to expense stock options and I think Warren

Buffett has said we ought to expense stock options. So the prevailing winds which used to be way back when, when I was in the

private sector, they didn’t need to be expensed. Now the political

wisdom is they need to be expensed. But if we are going to legislate, I want to know, are there real world examples where the

stock options not being expensed has led to real abuse and real investors being defrauded. I am not aware of one. That is why I am

asking the question.

Mr. WALKER. I am not aware of one. I would be happy to take

a look at it, if we were asked to do so. I would say, however, we

have to decide whether or not we want to be a leader or a laggard

with regard to accounting and reporting. We are lagging the world

in this area.

Chairman BARTON. So the rest of the world, these paragons of

economic activity in Western Europe are expensing and they certainly have been leaders, and the Chinese who didn’t even have

stock markets until 10 years ago, maybe they are expensing them,

including everything that the Communist politburo in Peking gets

under the table that we never hear about, so now we have got to

decide to expense.

Mr. WHITE. Mr. Chairman, that is a really good point. Actually

the Chinese are not expensing. They have learned from us. In the

5-year plan of the Communist Party of China, they encourage the

use of stock options to give workers more access and more ability

to own the success of the company.

I would also say I think there is a little misunderstanding about

what has actually happened in Europe. It is true that the International Accounting Standards Board has finalized their standard,

but there is a lot of uncertainty as to whether the political process

over there is going to allow that standard to become effective. It

has been approved by the Commission but it has not been approved

by the governing body of the EU, which has to approve it before

it can take effect.

Chairman BARTON. I am going to come back to Mr. Herz because

he is the long suffering Chairman of the Financial Accounting

Standards Board, which is kind of a thankless job, and if there is

a reason to expense stock options, I would stipulate that that reason is to give confidence to investors that everything that can be

done is going to be done to try to have accountability at the senior

management level of these corporations, that there may not be a

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financial reason to do it but there may be an openness, transparent, confidence reason to do it. If you are going to go down that

trail, I think Mr. Dingell’s question about why stop at the top five

has got relevance.

If we expense stock options, I think FASB’s rules were you are

going to expense them for everybody and Mr. Baker’s bill was just

the top five. You know, is there some magic demarcation line if you

believe expensing is the way to go that we ought to do it, or do you

really feel very strongly if you are going to expense it they should

all be expensed?

Mr. HERZ. Well, if you believe something is expensed, then the

financial statements are wrong and incomplete without all those

expenses being portrayed in it. I mean, you are again saying, you

know, why don’t we just figure out how many of the pensions, we

go down to that level. I think that would be a very slippery slope

for us to go down. Financial statements are supposed to be a faithful representation of the transactions and events as they affect the

company.

Chairman BARTON. So you think for total transparency and accountability, if you are going to have expensing it should be for everybody.

Mr. HERZ. I believe so.

Chairman BARTON. Mr. White, do you think that there can be an

in between.

Mr. WHITE. Well, there actually can be an in-between, and I

think the place where you would draw the line would be right

about where it is, where you are preventing people who might have

the ability to manipulate the price of the stock to feather their own

nest and to make their options worth more. You are preventing

that level of person from doing it. But, you know, for goodness

sake, let us not prevent ourselves from giving these stock options

to the administrative assistants and the engineers assistants and

the people all the way down the line who have been so successful

in creating innovation in these companies. That is really what we

are trying to accomplish.

Chairman BARTON. My time has expired, and I have got one

more question I want to ask, and Mr. Herz wants to add, I think,

something to what Mr. White just said.

Mr. HERZ. First of all, we are not against stock options or saying

that companies shouldn’t grant stock options or that stock options

are better or worse than restricted stock or performance grants or

cash bonuses or having day care centers for the employees or training or whatever. We are just saying let us do the right accounting.

Chairman BARTON. Now, this is my final question, and it is an

‘‘unsophisticated investor-type’’ question. If I get a stock option,

and let us make this as simple as possible. I get a stock option for

one share of stock at a strike price of $100 2 years from the date

the option is granted, and I can take that stock option or I can get

a cash bonus payable next month for $100. So I can have $100 cash

that I get next month or I can have a stock option worth $100 at

the strike price payable in 2 years. If we decide to expense stock

options, do I create, if we expense them, a tax liability on $100 that

is payable this calendar year, or do I get to defer that until it actually materializes?

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Mr. HERZ. My understanding is that the prevalent tax treatment

for what are called nonqualified stock options, which is the major

stock options that are issued by companies, the tax treatment is

that the recipient will have taxable income upon exercise of that

option.

Chairman BARTON. So I don’t have to pay—even if we expense

it, I don’t create a tax liability in the current year that I have to

pay. I don’t have to pay the taxes until I realize something, that

there is actually a financial asset that I can pay part of.

Mr. HERZ. Again to you.

Mr. MAYER. Under current tax law, the tax liability is not related

to the incurrence of expense by the corporation. They are completely separate.

Chairman BARTON. So if we expense stock options, there is not

a cash-flow negative to the stock option holder; there is a contingent fund requirement of the granting corporation to set up a reserve fund for that option. Is that correct?

Mr. MAYER. That is not a reserve fund, but the taxation of the

individual is completely separate from the taxation of the corporation, unless Congress or the IRS chooses to change the regulations.

But under current regulations what the corporation does does not

affect the individual.

Mr. STEARNS. The gentleman’s time has expired.

Mr. Davis is recognized for 8 minutes.

Mr. DAVIS. Thank you, Mr. Chairman.

I would like to ask Mr. Herz and then Mr. Walker if—and I don’t

know how to talk like an accountant, so I will try. In ascertaining

whether an expense or another accounting item should be included

in generally accepted accounting principles, is there such a thing

as an expense or item that is so sufficiently—that is so difficult to

quantify that it should not be made a part of generally accepted accounting principles? And, if so, can you offer an example?

Mr. HERZ. There are very few examples. But in every project we

look at that issue, of whether there is in our view a sufficient reliability, and that is a judgment that we have to make based upon

a lot of input, data, visits to companies, looking in the case of this

kind of thing of valuation, to valuation experts, testing out a lot of

things experienced in other places than that. And then we match

that up against other items. This item, well, we are still getting

more data, but certainly it has already been in the audited footnotes for 8 years. It is based upon accepted models.

The inputs do involve some judgments, as Mr. Mayer said. But

in fact that realm of judgment is probably less than in many other

areas of accounting that involve considerable judgments, and in

fact that is recognized by most users of financial statements. There

is a required disclosure by the SEC of what is called critical accounting estimates, which a company has to lay out the areas that

involve most estimation and subjectivity. Those areas can be eight,

nine, 10 in a particular company. Some of them can—my belief and

from valuation experts, are more difficult to do than this item.

Mr. DAVIS. So there is such a thing as an item that is not sufficiently reliable, and therefore not something that you would try to

assign a value to?

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Mr. HERZ. There are some things like that, but they are very few

in number and diminishing. I am getting use of one here that in

contract accounting, construction contracts for example, one uses

the—you don’t use the percentage of completion method for a long

contract, you use a completed contract method. If you think the estimates are not sufficiently reliable, you go to an alternative measure. But you don’t assume zero either.

Mr. DAVIS. That is an interesting example you pick, because I actually—well, I have sued someone for fraud for trying to state as

a fact what is not a fact, which I guess gets me to another question—I will let Mr. Walker respond to this—which is, I think you

are acknowledging that there are genuine issues as to the reliability of this value but you think the reliability meets the sufficiency threshold. But are we going to create a level of uncertainty

in terms of how a corporation prepares its financials and uses people to prepare financials, such that we are going to have a lot of

liability?

Mr. WALKER. I don’t think that we are going to create a significant degree of uncertainty. The fact of the matter is there are two

issues. One issue is whether or not you should account for these

in a consistent manner based upon a fair market value basis. And

then, second, how you do it.

With regard to the first, I believe the answer to that question is,

yes, you should have consistency in order to improve integrity and

public confidence and avoid adverse selection.

With regard to how do you do it, reasonable people can differ.

Namely, Black-Scholes versus the proposed method. I think that is

a legitimate discussion and debate, if you will. But I do think this

is one that there are generally accepted methods out there; e.g.,

Black-Scholes, that have been used for a number of years and have

already been reported and, therefore, there is a basis to accomplish

the objective.

Mr. DAVIS. Are you or—Mr. Herz.

Mr. HERZ. I should add, first, we are continuing to do some work

on that. Some of the large high-tech companies have said they have

done some work, and we are going to be meeting with them and

we would like to look at what they have done. But also the SEC

staff has said that, you know, to the extent if there are genuine

fears here and there is some legitimacy of those after we go

through all that, they are prepared kind of below our principles to

perhaps put in some safe harbors for companies on some of these

assumptions. But that all has to still—we are not finished, so we

are going to look at all those things.

Mr. DAVIS. Have you done studies that give you the benefit of

hindsight to go back and use either of these methodologies to judge

what would have caused one of these types of companies to quantify as an expense for an option versus what the actual experience

was in terms of volatility and choice as to exercise? And what did

that tell you about the sufficiency of the reliability of your methodology?

Mr. HERZ. Well, that is a good question and it gets to kind of a

fundamental point, that when you value something you value it at

that point in time, and that is a valuation for an option that takes

into account thousands if not millions of potential scenarios. That

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is the way it works. It is not trying to pinpoint at one particular

scenario. Just like the stock price at one point in time is a valuation at that point in time, it is not going to predict what the stock

price is going to be 2 years from now, 3 years from now, 4 years

from now. So it is the valuation at that point in time, it is not a

prediction.

Mr. DAVIS. Okay. Do you or Mr. Walker—you haven’t really answered my question. Have you even attempted to go back and do

that type of study in hindsight? And would it be useful to do so?

I understand your point as well.

Mr. WALKER. We haven’t at GAO. I have got to believe that there

are studies that have been done along those lines in the private

sector.

Mr. DAVIS. If you all don’t know, that is troubling.

Mr. HERZ. Well, there have been studies that show the actual

outcome. Just like I said, it is like you enter a lottery and you pay

$4 for a lottery ticket, and you may win the lottery or you may not

win the lottery. The ticket was still worth $4. Now, some people

are going to win the lottery and others are not. But those are what

these models do, is they, based on all the outcomes, come up with

a value at the date you are doing——

Mr. DAVIS. Well, but when I buy a lottery ticket it tells me what

the prize might be. It doesn’t tell me what my chances are of winning necessarily.

Mr. HERZ. It certainly does.

Mr. DAVIS. Well, people don’t—I don’t know that people really

rely upon that.

Mr. HERZ. The chances of winning this lottery are much higher

on average than an average lottery.

Mr. DAVIS. How—to the chairman’s question, what is the level of

urgency here? If you come to the conclusion that the type of studying I describe is a useful exercise, do you think that you have the

luxury of spending more time doing this or do you feel compelled

to come to a result very shortly?

Mr. HERZ. We have to balance everything. What we want to do

is get to a good answer, a quality standard, and we are going to

consider all the input we have got and continue the input to get

to a good standard. I will tell you, though, that investors, analysts

believe that this should have been done a long time ago and they

are anxious. And serving the capital markets, we have to also consider that issue, also the issues of, you know, the implementation,

time lines. All those are the kind of issues we work on when we

decide what kind of timeframe we ought to do.

Mr. DAVIS. Mr. Chairman, if I could ask one more quick question

of Mr. White and Mr. Mayer.

The bill, as I read it, contemplates the possibility that some form

of methodology that is sufficiently reliable might be developed, But

I think what I have heard you all testify to today is you don’t believe that is going to occur, and perhaps a more credible description

of the bill is to basically—that it basically stands for the position

that this is, we are trying to know the unknowable here.

Mr. HERZ. I think that is true, and I think that actually, you

know——

113

Mr. DAVIS. And I am not saying that I agree with that. I just

want to understand your position.

Mr. WHITE. The reason it is unknowable is—and I think Chairman Herz has defined it very well. What they are shooting for is

the abstract idea of what these things are worth on the grant date.

They don’t really care about what turns out to be the case in the

future. And if you look at an example like Cisco, if you run those

numbers, you get some absolutely dramatic results. $3 billion.

Mr. DAVIS. Thank you.

Mr. STEARNS. The gentleman’s time has expired.

We have three members left and we have six votes. So I would

just ask the members, or a suggestion, if anyone wants to submit

their questions rather than coming back, we could go for possibly

another 10 minutes. We could probably get 5 minutes on each on

a side and then we could adjourn, so you folks wouldn’t have to

come back after six votes, which, Rick, as you know, this could be

a long time.

So at this point Mr. Bass would be the next. And Mr. Bass, my

suggestion is——

Mr. BASS. Mr. Chairman, I will tell you what I will do. I am

going to take 3 minutes instead of 5, and then I am going to yield

2 minutes to whoever is after me. All right?

My position on this bill has not been predetermined before this

hearing, and I am not an accountant either. But I have run a small

business before, and I learned through the school of hard knocks

that there is only one fact in accounting, and that is cash. And

even accounts receivable, inventory, value of fixed assets, backlog,

anything, those are all opinions.

However, I think cash, bonuses, the cost of day care, and other

things that Mr. Herz brought forth really are a fact because they

are cash expenses.

I believe that it is perfectly legitimate for Mr. White to present

a different opinion or a different perspective on the issue of accounting than the two gentlemen from the General Accounting Office and the FASB. It is a legitimate part of this debate. And I appreciate your testimony, Mr. White. I don’t find it patronizing at

all. I also don’t understand why Enron is the subject of every single

debate that we have had this week. And I agree with my friend,

Mr. Barton, from Texas that the issues with Enron were quite—

the issue of expensing of options is really superfluous to this debate.

My question for—a quick question is, a concern that I have that

was evidenced to me by Mr. Greenspan when we had a meeting

sometime ago, that the accounting standards or the accounting

practices of businesses is becoming increasingly divergent from

what they submit to the Internal Revenue Service for tax purposes.

Do you have any comments on that and how this issue addresses

that?

That is my only question, and we will cut it off in a minute.

Mr. WALKER. Well, it is interesting to note that corporations do

get deductions on their income tax return with regard to the value

of stock options even in circumstances where they don’t have to

record an expense in their financial statements. And it could be

significant——

114

Mr. MAYER. Well, that is a bit of an overstatement. Not all stock

options result in a tax deduction. In fact, only a limited variety of

stock options do, and then only when there is a concomitant tax liability or obligation on the part of the individual who has the stock

option. So there is a perfectly matched situation there, and the notion that corporations are getting a big tax deduction without reporting the expense is completely off the mark, in my view.

I would add, if I may, quickly, that I deal with investors and analysts every day and I have for 20 years as a CFO of a publicly

held corporation. Not one, not one single one has ever said to me,

you know, you can expense under FAS 123. Why don’t you do that?

We would like it if you would do that. Not a single one has ever

asked me to do that. I dispute the fact that this is a human cry

from that community.

Mr. BASS. I yield to the gentleman from California.

Mr. ISSA. Thank you, and I will be very, very brief. I guess my

first reaction was hearing that there were 14 accounting firms, including the ones that did WorldCom and Enron. I, like my colleague, can’t understand why we are going to base it on accounting

firms as the basis for it. Plus, to be honest, Mr. Chairman, if I were

an accounting firm, I would not say anything adverse to the Chairman of FASB.

Mr. HERZ. They do all the time.

Mr. ISSA. But I will say, and I, like my colleague, have not made

a decision on the underlying bill, including some of the possible

amendments. But I was concerned, Mr. Herz, when you said that

you were concerned about disadvantaging some companies, as

though your job was to level the playing field between companies.

And you can respond in writing because I don’t want to take more

time than this 2 minutes.

Mr. STEARNS. The time of Mr. Bass has expired. So if you will

answer the question, and then we will ask Mr. Stupak.

Mr. ISSA. I will take it in writing because I know we are in a

hurry. Thank you.

Mr. STEARNS. Thank you.

Mr. Stupak.

Mr. STUPAK. Thank you, Mr. Chairman.

You know, I sat through the Enron hearings. And this double

stock options was a problem. And let me explain the way it was,

because I think it really summarizes where we have been.

The last 5 years before declaring bankruptcy, from 1996 to 2000,

Enron told its stockholders and the whole world that it was rolling

in cash, claiming a 5-year U.S. profit of $1.8 billion. During those

same years Enron deducted $1.7 billion from stock option compensation from its tax returns as a business expense, cutting its

taxes by $600 million and eliminating its tax liability entirely for

4 out of 5 years. In other words, the stock option double standard

allowed Enron to dole out this form of compensation to its executives, including $123 million to Mr. Lay, claim a huge tax deduction, and escape paying U.S. taxes while not showing any stock option expense on its inflated financial statements.

So this is exactly why this legislation can hurt us, and Enron

had a lot to do with it and those of us who sat through it understand it.

115

So how come—and this is this discussion today. How come you

can estimate the value of a stock option for tax purposes but you

can’t do so for accounting purposes? Mr. Walker or Mr. Herz, if you

want to hit that.

Mr. HERZ. Well, for tax purposes it is computed at a different

point in time than we are proposing for accounting purposes. We

are proposing a grant date measure, which we think is the right

economic measure. The Tax Code says look at the spread between

the exercise price and the strike price at the time it is exercised.

Mr. STUPAK. So really you have a double standard here, once you

are using and then you deduct it. And then how do you justify the

double standard then?

Mr. WALKER. Well, the accounting treatment is generally recorded as of the date of grant and it is based on an estimate. Tax

treatment is generally based on actual experience at the time the

grant is exercised. As a result, you can have a situation where you

don’t ever record a financial statement expense and yet you may

still get a substantial tax deduction.

Mr. STUPAK. So this has got to be zero, or you don’t know how

to do it because it is too complex. They already do it, because even

Enron in these financial statements that many people looked at but

didn’t pick up because it was in a footnote, they had to put a value

on the options in the footnotes. So when you say it is a zero or it

is too complex, you can’t figure out, that just doesn’t hold water.

Mr. HERZ. Unless companies calculate it or communicate it to the

executives and to the employees at the time they do it.

Mr. STUPAK. Sure.

Mr. MAYER. If I may, I have to disagree with that. I think it is dead wrong. The calculation for tax purposes is a subtraction. $10

minus $6 leaves $4 profit.

Mr. STUPAK. But even if there is a subtraction, there is still a

value.

Mr. MAYER. Correct, And that is a very doable calculation that

you can do. The calculation we are talking about here in the lattice

model is a theoretical calculation of a number that never occurs,

that can never be measured or audited.

Mr. STUPAK. Let me go to Mr. White, because he argued that

there is no accurate way to estimate the value of stock options, as

you said in your testimony. But the Chicago Board of Options Exchange facilitates over 8.8 million option trades each day. Do you

believe that professional traders engaging in millions of trades involving millions of dollars each day do so without knowing the

value of the options or buying or selling?

Mr. WHITE. No, but those are totally different. They are tradable

options. These stock options aren’t tradable. You can’t transfer

them. It is illegal to transfer them to anybody, and they have no

value at the time they are granted. So it is a totally different situation.

Mr. STEARNS. We have about 41⁄2 minutes left to get to the floor.

Mr. STUPAK. I have got some more questions. I will put them in

writing.

Mr. STEARNS. Let me just conclude the hearing. And I thank the

colleagues. We will leave the record open for 5 days to allow additional questions. And also, just to notify my colleagues, Chairman

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Barton and Mr. Dingell and myself and Ms. Schakowsky are going

to write to the Securities Exchange Commission in reference to Mr.

Barton’s question, which I think is very relevant: Have stock options caused any abuses because of misinformation for investors? I

think that is welcomed to know.

And I want to thank the witnesses for their patience and for a

lively hearing. The subcommittee is adjourned.

[Whereupon, at 3:57 p.m., the subcommittee was adjourned.]

[Additional material submitted for the record follows:]

PREPARED STATEMENT OF RICHARD L. TRUMKA, SECRETARY-TREASURER, AMERICAN

FEDERATION OF LABOR AND CONGRESS OF INDUSTRIAL ORGANIZATIONS

‘‘There are cases where you can use equity to impact your income statement. And the most—the most egregious, or the one that’s used by every

corporation in the world is executive stock options. And as a matter of fact,

I think FASB tried to change that, and you introduced legislation in 1994

to keep that exemption. And essentially what you do is you issue stock options to reduce compensation expense and therefore increase your profitability.’’

Former Enron President And CEO Jeffrey Skilling before the

Senate Commerce, Science And Transportation Committee on February 26, 2002

On behalf of the American Federation of Labor and Congress of Industrial Organizations (AFL-CIO) and our affiliated unions’ 13 millions members, I appreciate the

opportunity to comment on the proposal by the Financial Accounting Standards

Board (FASB) to require the mandatory expensing of stock options and on H.R.

3574, the Stock Option Accounting Reform Act.

Stock option expensing will have an unambiguously positive impact on the economic security of America’s working families. Our interest in stock option expensing

stems from the fact that our members are also investors. Union members participate in benefit plans with over $5 trillion in assets. Pension plans sponsored by

unions affiliated with the AFL-CIO hold almost $400 billion in assets, and union

members also participate in the capital markets as individual investors.

The AFL-CIO strongly supports FASB in its recent decision to close the accounting loophole that has that has allowed corporations to understate the true cost of

executive compensation. FASB’s proposal is part of a global trend towards greater

accounting transparency. Starting in 2005, the International Accounting Standards

Board has ruled that 7,000 companies in 90 countries must start expensing stock

options.

We oppose calls to postpone implementation of mandatory expensing until 2006

because any delay will only give companies time and an incentive to award megagrants to CEO’s while they can still do so without recording them as an expense.

Companies that are truly unable to implement expensing beginning in 2005 should

have the option of delaying implementation of the rule for one or two quarters and

then retroactively applying the new standard.

The FASB proposal provides a reliable cost estimate that takes into account the

unique characteristics of employee stock options. It also provides broad flexibility for

small businesses that are not publicly traded. Further, the FASB proposal should

have zero compliance costs for publicly traded companies, as the current accounting

rules already require corporations to provide investors with an estimate of their

stock option expense in the footnotes of company earnings statements.

This is not the first time FASB has attempted to require appropriate expensing

of stock options. In the mid-1990’s, just as stock options were becoming a popular

form of executive compensation, FASB attempted to require option expensing, but

was pressured by Congress into abandoning its position. We believe that this

thwarting of FASB’s role as an independent body was a key initiator of the chain

of events that led to the corporate scandals of the last several years.

This time, we hope that Congress will respect FASB’s independence and not interfere with its decision. Unfortunately, though, we are seeing yet again an assault on

FASB’s independence. Some of those opponents of mandatory expensing are falsely

attempting to portray FASB’s efforts as an attack on workers. They have suggested

that expensing stock options will benefit trial lawyers, encourage offshoring, and stifle innovation.

We should say at the outset that the AFL-CIO does not oppose broad-based stock

options programs. We are always in favor of better wages and benefits for workers—

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1Mark Rubinstein, ‘‘On the Accounting Valuation of Employee Stock Options,’’ Journal of Derivatives, Fall 1995. 2Fiscal year 2003 data from company proxy statements.

3Stock Plan Dilution 2004: Overhang from Stock Plans at S&P Super 1,500 Companies, Investor Responsibility Research Center.

be they in the form of stock options, pensions or health insurance. We view stock

options as one appropriate form of medium-term compensation for employees, but

as an inappropriate substitute for the basic wages and benefits needed to support

a family.

What we oppose is giving one particular form of compensation—in this case, stock

options—preferential accounting treatment over other more important employee

benefits such as wages, pensions or health care. If the corporate opponents of stock

option expensing truly want to help America’s working families, they should instead

focus their efforts on encouraging the expansion of retirement plans and health care

coverage.

Executive Compensation and Stock Option Expensing

Not expensing stock options has widened the pay gap between CEOs and workers.

Executives disproportionately benefit from stock options and this cost has been kept

off the books. Moreover, not expensing stock options has artificially boosted profit

reports, thereby generating further increases in CEO pay. Unfortunately, the voice

of America’s working families and their retirement savings is diffused in comparison

to the concentrated interest of highly paid Silicon Valley executives who are opposing stock option expensing.

In our view, stock options have only widened the pay gap between executives and

ordinary workers. In 1980, prior to the widespread use of stock options in executive

compensation, CEO pay stood at approximately 42 times the average worker. Two

decades later, CEO pay reached 531 times the average worker’s pay. The majority

of this increase was due to stock options, which have become the biggest component

of today’s CEO pay packages.

In a last ditch effort to de-link the issue of stock option expensing from the politically explosive issue of executive pay, the opponents of stock option expensing have

backed H.R. 3574, the Stock Option Accounting Reform Act. This bill purports to

require the expensing of stock options for the top five most highly paid executives.

However, this so-called compromise bill is a sham. In addition to creating an accounting fiction that some stock options are a cost while others are not, this bill will

dramatically understate the true cost of CEO stock options.

Moreover, H.R. 3574 would prohibit companies who already expense all of their

stock option grants from continuing to do so. By limiting expensing to the top five

executives’ options grants, this bill will force companies that already expense all of

their employees’ options to report less accurate earnings. According to Bear, Stearns

& Co., 576 companies have announced their intention to voluntarily expense stock

options, including companies representing over 40 percent of the market capitalization of the S&P 500 Index. H.R. 3574 will not just override FASB, but it will override the stock markets that increasingly demand expensing as a matter of financial

transparency.

The bill would require companies using an option pricing model like Black-Scholes

to assume that the underlying stock price has zero volatility. This would be accounting fraud by act of Congress. This ‘‘minimum value’’ approach—as its name implies—results in unrealistically low cost estimates. Moreover, the minimum value

approach can easily be manipulated to drive the reported value to zero or near

zero.1 This is done by raising the exercise price and multiplying the number of options in order to maintain the real value of the grant while lowering its reported

‘‘minimum value.’’

The bill would allow CEOs to continue to receive stock option mega-grants without having to report the real cost to shareholders. It is no secret why Silicon Valley

executives are leading the fight against option expensing. According to SEC filings,

the CEOs of the ten public companies who are the corporate members of the socalled International Employee Stock Options Coalition hold on paper a combined

$916 million in unexercised stock options.2 Not one dollar of these CEO’s stock options has ever been expensed in these companies’ earnings statements.

Not expensing stock options has cost shareholders real money by encouraging

their overuse for executive compensation. According to the Investor Responsibility

Research Center, companies in the Information Technology sector have an average

potential dilution from stock options of 25.7 percent, as compared to 17 percent for

the S&P 1500.3 This measure of stock option overhang is one way that shareholders

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4 Bureau of Labor Statistics, ‘‘Pilot Survey on the Incidence of Stock Options in Private Industry in 1999,’’ press release October 11, 2000. 5 ‘‘AEA Study Finds 84% of High-Tech Workers Receive Stock Options,’’ AEA press release,

August 14, 2002. (This survey almost certainly suffers from selection bias, as AEA members

with broad-based plans had more incentive to respond.) 6 2002 Gallup Poll of Media Use and Consumer Behavior for the San Francisco market, cited

in Mark Schwanhausser and Jeanne Cardenas, ‘‘Stock Options Slow After Dot-Com Bust,’’ San

Jose Mercury News, December 13, 2002. 7Statement of Robert H. Herz, Chairman, Financial Accounting Standards Board, for the

Roundtable on ‘‘Preserving Partnership Capitalism Through Stock Options for America’s Workforce,’’ United States Senate, May 8, 2003. 8 ‘‘Accounting for Employee Stock Options,’’ Congressional Budget Office, April 2004.

gauge the potential dilution to their holdings from the equity being transferred to

executives and other employees.

Who Gets Stock Options?

In contrast to CEOs, relatively few ordinary workers receive stock options. At the

height of the stock market boom in 1999, only 1.7 percent of private sector employees received stock options, according to the Bureau of Labor Statistics (BLS). Stock

options are much more prevalent among the ranks of managers and skilled professionals; the BLS found that only 0.7 percent of private sector workers earning less

than $35,000 received stock options, compared to 12.9 percent of workers earning

$75,000 and above.4

Compared with large corporations, few small businesses grant any of their employees stock options. BLS data shows that only 2.1 percent of companies with 100

employees or less granted stock options, compared to 10.1 percent of companies with

over 100 employees. We believe this data shows that stock option expensing will

have little, if any, impact on America’s small business.

Those who wish to portray stock options as a broad-based benefit typically focus

on technology companies where stock options are sometimes granted to a cross-section of employees. For example, the American Electronics Association claims that

publicly-traded technology companies grant stock options to 84 percent of their employees.5 Even in Silicon Valley, however, households with stock options are in the

upper tax brackets, with a median income of $122,000.6 According to SEC filings,

the CEOs of the ten public companies who are the corporate members of the socalled International Employee Stock Option Coalition (the ‘‘IESOC’’) hold on paper

a combined $916 million in unexercised stock options. The authors of the book In

the Company of Owners estimate that ‘‘roughly 30 percent of all options are in the

hands of top five executives’’ and ‘‘most of the remaining 70 percent is spread very

narrowly among other executives and managers.’’

For the reasons discussed above, these statistics are unlikely to change. Stock options are ill-suited either as a way to make ends meet from day-to-day or as a substitute for a traditional defined benefit plan or a properly diversified defined contribution plan. As a result they have been and are likely to continue to be supplemental medium-term compensation for high-income employees.

Investor Concern

We agree with FASB Chairman Robert Herz, who last year testified before the

Senate that ‘‘financial reporting standards that bias or distort financial information

to favor a particular transaction, industry, or special interest group undermine the

credibility and value of that information and the proper functioning of the capital

markets by impairing investors’ capital allocation decisions.’’ 7

We believe we speak for most investors on this issue. In a report released earlier

this year, the Congressional Budget Office concluded that ‘‘recognizing the fair value

of employees stock options is unlikely to have a significant effect on the economy

(because the information has already been disclosed); however, it could make fair

value information more transparent to less-sophisticated investors.’’ 8

Since 2003, a majority of shareholders at 44 companies have voted in favor of resolutions to require stock option expensing. These include high-profile technology

companies such as Intel, Apple Computer, Adobe Systems, IBM, and Texas Instruments, despite strong opposition to expensing by these companies’ boards of directors. Other high-tech companies such as Microsoft, Amazon, and Netflix have joined

the nearly 600 companies that voluntarily expense stock options.

There is also near unanimity in favor of mandatory expensing among institutional

investors and governance advocates, including the ‘‘Big Four’’ accounting firms, the

Conference Board Commission on Public Trust and Private Enterprise, the Council

of Institutional Investors, Institutional Shareholder Services, and the Teachers Insurance and Annuity Association—College Retirement Equities Fund.

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9Deborah Soloman, ‘‘SEC Probes Options Grants Made As Company News Boosts Stock,’’ Wall

Street Journal, March 30, 2004.

Individuals such as Berkshire Hathaway CEO Warren Buffett, Securities and Exchange Commission Chairman William Donaldson, Public Company Accounting

Oversight Board Chairman William McDonough, General Accounting Office Comptroller General David Walker, Federal Reserve Chairman Alan Greenspan, former

Federal Reserve Chairman Paul Volcker, and Nobel Prize-winning economists Robert Merton and Joseph Stiglitz are all in favor of mandatory expensing.

Valuation Issues

Opponents of mandatory expensing have exaggerated valuation issues related to

stock options. They claim, for example, that options cannot be accurately valued,

that options vary in value after they are granted, and that options turn up in earnings per share calculations.

The fair value of stock options can be estimated using the Black-Scholes-Merton

formula or a binomial lattice model that incorporates employees’ expected behavior.

Though these values are estimates, so are the values used for numerous other line

items on corporate financial statements, including depreciation, amortization, and

inventory-related adjustments. Options do vary in value after they are granted—but

so do a variety of payments and agreements made by companies including payments

made in foreign currencies or long-term commodity contracts. No one would suggest

that these should be left off the companies’ financial statements.

Opponents of expensing contend that options are double counted if they are

charged to earnings, because the cost of options is already reflected in dilution. This

argument ignores the opportunity cost of granting stock options to employees. Moreover, other forms of equity compensation that are expensed also result in dilution.

For example, the estimated value of restricted stock grants to employees is deducted

as a compensation cost, affecting both the EPS numerator and the denominator. To

ignore the cost of stock options in the numerator is to assume that revenue-increasing labor services provided in exchange for stock options are provided free of charge.

As for the claim that pricing methods overstate the value of employee stock options because employees may exercise options early and may forfeit options if they

leave the company, FASB has already addressed this issue. FASB would allow companies to modify cost estimates to reflect patterns of forfeiture and early exercise,

and adjust these estimates, if necessary, based on subsequent information.

Perverse Incentives

Because stock options have received preferential accounting treatment, companies

have been reluctant to innovate when it comes to executive compensation. Many

companies, for example, have told us that they are reluctant to use performancebased stock options that are indexed to their competitors because indexed stock options must be expensed under the current accounting rules. That’s bad news for

Americans’ retirement savings, which depend on companies having responsible CEO

pay.

Unlike actual share ownership, stock option grants to CEOs create perverse incentives that are not in the best interests of long-term shareholders:

• stock options can encourage executives to take excessive risk-taking by promising

all the benefit of share price increases with none of the risk of share price declines,

• stock options can reward short-term decision-making because many executive

stock options can be exercised just one year after the grant date;

• executives can profit from share price volatility (a measure of shareholder risk)

by timing when they exercise their stock options;

• because option holders are not entitled to dividends, dividend yields have fallen

to historic lows, and many companies have instead used this cash for stock

buybacks to prevent dilution from executives’ stock option exercises; and

• stock options can create a strong incentive to manipulate company stock prices

through creative and even fraudulent accounting.

The Securities and Exchange Commission has been examining whether some companies—particularly in the high tech sector—have inappropriately timed their stock

option grants to executives.9 By granting stock options just prior to releasing market-moving information that boosts the stock price, companies can simultaneously

put extra money into the pockets of executives and understate the estimated costs

of these option grants in their SEC filings. Given all these drawbacks, we believe

an over-reliance on stock options for executive compensation has contributed to

many of the corporate scandals we have witnessed in recent years.

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Conclusion

The goal of accounting is to facilitate accurate comparisons between companies—

a goal not being met under the current system, when some companies expense options and others do not. If stock options are not expensed, a company that pays its

employees in stock options has lower compensation costs and therefore artificially

higher earnings. As former Enron CEO Jeffrey Skilling explained in his Congressional testimony, ‘‘you issue stock options to reduce compensation expense and,

therefore, increase your profitability.’’

Companies that do not expense stock options are hiding their true cost from investors, creditors, and other consumers of financial reports. FASB’s decision to require

stock option expensing in 2005 will strengthen investor confidence in financial statements. The efficient allocation of capital to the most economically valuable business

activities depends on consistent accounting rules. For this reason, we believe all

businesses should expense stock options, so that stock options do not artificially

boost any company’s profit reports. Congress should let FASB do its job.

We appreciate the opportunity to present our views on this important matter.

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