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S. HRG. 108–612

IMPACT OF STOCK OPTION EXPENSING

ON SMALL BUSINESSES

HEARING

BEFORE THE

COMMITTEE ON SMALL BUSINESS

AND ENTREPRENEURSHIP

UNITED STATES SENATE

ONE HUNDRED EIGHTH CONGRESS

SECOND SESSION

APRIL 28, 2004

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

(

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

(II)

COMMITTEE ON SMALL BUSINESS AND ENTREPRENEURSHIP

ONE HUNDRED EIGHTH CONGRESS

SECOND SESSION

OLYMPIA J. SNOWE, Maine, Chair

CHRISTOPHER S. BOND, Missouri

CONRAD BURNS, Montana

ROBERT F. BENNETT, Utah

MICHAEL ENZI, Wyoming

PETER G. FITZGERALD, Illinois

MIKE CRAPO, Idaho

GEORGE ALLEN, Virginia

JOHN ENSIGN, Nevada

NORMAN COLEMAN, Minnesota

JOHN F. KERRY, Massachusetts

CARL LEVIN, Michigan

TOM HARKIN, Iowa

JOSEPH I. LIEBERMAN, Connecticut

MARY LANDRIEU, Louisiana

JOHN EDWARDS, North Carolina

MARIA CANTWELL, Washington

EVAN BAYH, Indiana

MARK PRYOR, Arkansas

WESTON J. COULAM, Staff Director

PATRICIA R. FORBES, Democratic Staff Director and Chief Counsel

(III)

CONTENTS

OPENING STATEMENTS

Page

Allen, The Honorable George, a United States Senator from Virginia ............... 5

Bayh, The Honorable Evan, a United States Senator from Indiana ................... 7

Ensign, The Honorable John, a United States Senator from Nevada ................. 8

Enzi, The Honorable Michael B., a United States Senator from Wyoming ........ 1

Levin, The Honorable Carl, a United States Senator from Michigan ................. 3

Pryor, The Honorable Mark, a United States Senator from Arkansas ............... 10

TESTIMONY

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

Connecticut ........................................................................................................... 10

Batavick, George J., Board Member, Financial Accounting Standards Board,

Norwalk, Connecticut .......................................................................................... 10

Holtz-Eakin, Douglas, Director, Congressional Budget Office, Washington,

DC .......................................................................................................................... 21

Levin, The Honorable Carl, a United States Senator from Michigan ................. 33

Carron, Keith, Ph.D., Founder and President, CC Technology, Laramie,

Wyoming ............................................................................................................... 51

Diamond, Stephen F., Visiting Assistant Professor of Law, Cornell Law

School, and Assistant Professor of Law, Santa Clara University School

of Law .................................................................................................................... 59

Glover, Jere W., Brand and Frulla, Washington, DC ........................................... 69

Jones, Marc, President and Chief Executive Officer, Visionael Corporation,

Palo Alto, California ............................................................................................ 81

Kavazanjian, John, President and Chief Executive Officer, Ultralife Batteries,

Inc., Newark, New York ...................................................................................... 89

Mendoza, Roberto G., Chairman, Integrated Finance Limited, New York,

New York .............................................................................................................. 96

Schnittker, Christopher P., Senior Vice President and Chief Financial Officer,

Cytogen Corporation, Princeton, New Jersey .................................................... 100

ALPHABETICAL LISTING AND APPENDIX MATERIAL SUBMITTED

Allen, The Honorable George:

Opening statement ........................................................................................... 5

Batavick, George J.

Testimony .......................................................................................................... 10

Prepared statement .......................................................................................... 15

Bayh, The Honorable Evan:

Opening statement ........................................................................................... 7

Carron, Keith:

Testimony .......................................................................................................... 51

Prepared statement .......................................................................................... 53

Diamond, Stephen F.:

Testimony .......................................................................................................... 59

Prepared statement .......................................................................................... 61

Ensign, The Honorable John:

Opening statement ........................................................................................... 8

(IV)

ALPHABETICAL LISTING AND APPENDIX MATERIAL SUBMITTED—[continued]

Page

Enzi, The Honorable Michael B.:

Opening statement ........................................................................................... 1

Post-hearing questions posed to Professor Diamond ..................................... 131

Post-hearing questions posed to Mr. Herz ...................................................... 133

Post-hearing questions posed to Mr. Holtz-Eakin ......................................... 149

Post-hearing questions posed to Mr. Mendoza ............................................... 154

Fitzgerald, The Honorable Peter G.:

Prepared statement .......................................................................................... 120

Excerpts from testimony provided by the Honorable Alan Greenspan,

Chairman, Federal Reserve Board, during the Joint Economic

Committee Hearing on Economics Outlook ................................................ 122

Remarks by Chairman Alan Greenspan at the 2002 Financial Markets

Conference of the Federal Reserve Bank of Atlanta, Sea Island,

Georgia, concerning Stock Options and Related Matters .......................... 123

Glover, Jere W.:

Testimony .......................................................................................................... 69

Prepared statement .......................................................................................... 71

Herz, Robert H.:

Testimony .......................................................................................................... 10

Prepared statement .......................................................................................... 15

Holtz-Eakin, Douglas:

Testimony .......................................................................................................... 21

Prepared statement .......................................................................................... 24

Jones, Marc:

Testimony .......................................................................................................... 81

Prepared statement .......................................................................................... 83

Kavazanjian, John:

Testimony .......................................................................................................... 89

Prepared statement .......................................................................................... 92

Subsequent submission of added comments ................................................... 156

Kerry, The Honorable John:

Prepared statement .......................................................................................... 301

Levin, The Honorable Carl:

Opening statement ........................................................................................... 3

Prepared statement .......................................................................................... 33

Letter of Clarification on tax treatment of incentive stock options (ISOs) .. 129

Mendoza, Roberto G.:

Testimony .......................................................................................................... 96

Prepared statement .......................................................................................... 98

Pryor, The Honorable Mark:

Opening statement ........................................................................................... 10

Schnittker, Christopher P.:

Testimony .......................................................................................................... 100

Prepared statement .......................................................................................... 103

(V)

COMMENTS FOR THE RECORD

Page

Burns, The Honorable Conrad, a United States Senator from Montana:

Prepared statement .......................................................................................... 166

Coalition to Stop Stock Option, The, prepared statement ................................... 170

E*Trade Financial, prepared statement ................................................................ 173

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

Connecticut, prepared statement and attachments .......................................... 177

Kerry, The Honorable John, prepared statement ................................................. 301

Mendoza, Roberto G., Chairman, Integrated Finance Limited, New York,

New York, Proposal by IFL for Expensing Ex-employee Compensatory Stock

Options for Financial Reporting Purposes ......................................................... 303

Smith, Dr. Craig, Chairman, President and CEO, Guilford Pharmaceuticals,

Baltimore, Maryland, prepared statement ......................................................... 325

TechNet New England, prepared statement ......................................................... 329

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IMPACT OF STOCK OPTION EXPENSING

ON SMALL BUSINESSES

WEDNESDAY, APRIL 28, 2004

UNITED STATES SENATE, COMMITTEE ON SMALL BUSINESS AND ENTREPRENEURSHIP, Washington, DC.

The committee met, pursuant to notice, at 10:04 a.m., in room

428A, Russell Senate Office Building, Hon. Michael Enzi presiding.

Present: Senators Enzi, Fitzgerald, Allen, Ensign, Levin, Bayh,

and Pryor.

OPENING STATEMENT OF THE HONORABLE MICHAEL ENZI,

A UNITED STATES SENATOR FROM WYOMING

Senator ENZI. I will go ahead and call this hearing to order. I

want to welcome all of the panelists from our two distinguished

panels and express appreciation for all of you taking the time to

provide us with the information. This is the Small Business Committee, and the approach is on small business. I have to admit that

early on in this process I made the mistake of calling in some people that had experience with what I was talking about, had resources to be able to talk about it, and some of those were big businesses and it confused the message. So I am very pleased that we

are able to do a small business hearing to emphasize some of the

small business aspects and to make sure that there is some kind

of a positive delineation between the requirements that we have for

mature businesses and growing businesses, particularly small businesses. Small businesses do make up a significant part of all business. There are 23 million small businesses, which is 99.7 percent

of all employers. That is one-half of the private sector employers

and 60 percent of the net new jobs, 50 percent of the non-farm private GDP and 13 times more patents per firm than the big patenting firms.

Now, I do want to congratulate FASB for work that they have

done and for their importance to the international economy. I have

been a very strong defender of their independence and am still a

strong defender of their independence. It is extremely important

that they be an independent board.

I am recognizing kind of a failure to communicate, and it is a

failure on my part because I have not been able to get across this

small business aspect, the start-up that has been so important in

the United States and so important that China is now outdoing

new start-ups about 40-to-1 over us. It is because they have a business plan that calls for stock options for small businesses, for startups.

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Again, small business does not have the opportunity that big

business does to represent themselves in a lot of these things. I

mentioned a hearing—my first year, this Small Business Committee allowed me to hold a hearing in Casper, Wyoming, on some

of the difficulties small businesses were having with the Federal

Government. When it was over, one of the news media came up to

me and said, ‘‘You didn’t have a very good turnout today. Only

about 100 businesses showed up.’’ Well, Casper is not all that big

compared to here, and my comment was, ‘‘Any small business that

has the extra resources and people to be able to come and testify

would fire that person because they can’t afford him.’’

I was pleased that Chairman Herz announced in the November

hearing that he was going to have a Small Business Advisory Committee, and I had emphasized it in my opening comments. So, I

was particularly pleased that he had paid attention to that.

Now, I had envisioned it to be like NASD’s Advisory Committee,

and NASD’s Advisory Committee meets 4 times a year and they

kind of pick what things they want to review on behalf of business.

It is my impression that the advisory committee that has been selected at this point for FASB is going to meet twice a year, and

they are only going to talk about the topics that FASB wants them

to address. I hope there can be some more flexibility in there.

I have also been a little disturbed at some of the letters coming

from Members of that Small Business Advisory Committee lobbying on behalf of FASB. I am very worried about the lobbying aspect of this whole thing. Answering questions is extremely important. Educating us is extremely important, but out-and-out lobbying is something that seems kind of out of place in all of this.

I do appreciate the opportunities that I have had to meet with

the Chairman and members of FASB. When I see that there is a

conference call with institutional investors and they are being encouraged by the Chairman to contact Congress—now, institutional

investors are people that, you know, even delve in the realm of

hedge funds. It is not small business, and they are being asked to

tell us that it is all okay.

Now, in some testimony last week, it was mentioned that the

rule is only eight pages long. Well, if you count the appendices, it

is 229 pages, and it is very disturbing to me that there are only

two mentions in that whole thing about small business.

Now, small business has an investment in stock options. There

are 1.4 million businesses. They represent 15.4 million jobs, and

they are concerned about what is happening with their stock options.

Another thing that disturbed me about the rule, without any advance warning, suddenly employee stock purchase plans showed up

in that. Now, when we are talking about small business in Wyoming, that means that the mom-and-pop business trying to sell

their business to their employees, trying to give their employees an

opportunity to take it over so there is continuity in the business,

are now going to pay attention to FASB and have some complicated

rules that they have to follow. I know in last week’s testimony that

there was mention that the FASB standards for small business are

a private choice.

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Well, unless it says so somewhere, unless there is a very definite

statement, every bank, every supplier, anybody that deals with the

business is going to have to make sure that they are following the

standard that FASB put out. Somehow we have to make a distinction on that, and until we make a distinction, there isn’t any business that really has a choice.

So I think we are kind of passing the buck and shirking the responsibility for small business. It is kind of a mad hatter’s game

of hide-and-seek for small business where they try to find things

out.

I know that a lot of the controversy around this hinges around

executive compensation. I know that Congress is very jealous of a

lot of people that make a lot of money. We have shown it in actual

bills that we have passed limiting the cash compensation that executives can make.

It doesn’t matter what we do. There are ways around what we

do. Sometimes as we try to put those things into place, we kind of

foul things up for everybody.

A recent article in The Washington Post found that with or without stock options, executives are going to get their pay. So this proposal wouldn’t do anything to curb executive compensation, but it

will curb the ability of ordinary workers to receive stock options,

and it will curb small business’ ability to hire workers and to create new jobs.

One of the ways that a start-up business gets really good technical people is to offer stock options so that they can grow with the

business. These small businesses don’t have any other way to really provide that incentive for them to come in. They don’t have

enough cash to pay them cash up front, so it will have a drastic

effect on small businesses. This hearing is intended to hear what

small business has to say, and that will be the second panel.

I would like to welcome our witnesses today and thank them in

advance for their testimony. I will mention that I have condensed

my opening comments considerably and hope that people will kind

of stick to a format of about 5 minutes on their statements so that

we will have time for questions. There are a lot of things we need

to go over in this.

On our first panel today, we have two members of FASB: the

Honorable Chairman Robert Herz and George Batavick who is

chairing the Small Business Advisory Committee. In addition, we

have the Honorable Douglas Holtz-Eakin, the Director of the Congressional Budget Office. I appreciate all of you appearing today.

Senator Levin, any opening comments?

OPENING STATEMENT OF THE HONORABLE CARL LEVIN,

A UNITED STATES SENATOR FROM MICHIGAN

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

This is a very important hearing, and we look forward to hearing

from our panelists as to the purpose of the FASB rule, what the

origin of the rule is, and as to whether or not it has a particular

effect on small businesses as distinguished from other companies,

and if so, what that effect is.

We adopted a reform following the Enron disaster called Sarbanes-Oxley, and one of the things we did in Sarbanes-Oxley was

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to give FASB greater independence by giving it a source of revenue

which would be protected. We saw that FASB was put under huge,

huge political and lobbying pressure about 10 years ago when they

decided to require that options be expensed like all other forms of

compensation. FASB had to back off at that time despite their beliefs. It is supposed to be an independent accounting board which

adopts accounting standards free from political pressure, and this

time around it did what it believed was the right thing to do, which

is to treat stock options as compensation like all other forms of

compensation.

Stock options are the only form of compensation which, up until

now, do not need to be expensed. If you give somebody stock, conditional or otherwise, if you give somebody a bonus, conditional or

otherwise, based on performance, that must be expensed at one

point or another. It is compensation. It has got to show up on the

books.

There has been this treatment of stock options which is unlike

any other incentive pay or any other pay or compensation of any

kind, which for reasons we saw very clearly in the early 1990s, are

excluded from the usual rule, which is that compensation is going

to show up on the books. Companies get a tax deduction for compensation. They get a tax deduction when the stock options are exercised. In fact, it is now typical that employees get tax deductions

up front when the stock options are granted. That is even now allowed, and many employees of small businesses take tax deductions immediately.

So in terms of the argument you can’t value stock options, they

are valued all the time. They are valued in footnotes which are

shown, and employees who take tax deductions now, when given

the stock option are allowed in many instances to take tax deductions now. Yet, it doesn’t show up on the company’s books as an

expense.

That double standard fueled the Enron disaster. What happened

in Enron and many other companies is that the executives enriched

themselves by taking huge amounts of stock options, made the

company look a lot better than it was through phony accounting,

made the books look great, showed a big profit for the company,

had the stock value go up, exercised their options, enriched themselves, and left their companies bankrupt.

The question always haunted me: How could they do that? How

can they make the books show a profit and not pay income tax on

that profit? How do they survive as an executive by showing a profit on their books but not having to pay Uncle Sam the income tax

on that profit? The answer was stock options, because those same

stock options which enrich them, in Enron and too many other

companies, at the expense of stockholders and employees, those

same stock options are a tax deduction. So Enron could deduct the

value of those stock options on its income tax, but not show the

value of those stock options as an expense on its books. So it had

these large profits shown, which were phony profits, but did not

have to honestly show the stock option value as an expense on its

books. That was a major part of the Enron disaster for us.

Putting all that aside, we have an independent accounting board

now, which has made a decision that it is going to require that

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stock options be expensed. Our Chairman points out that stock options are an extremely valuable tool. They are. So are bonuses a

valuable tool for performance. So are grants of stock based on performance, but they all have to be expensed.

Our Chairman points out that stock options are being used in

China, and that is great. The issue here isn’t whether or not stock

options are used. The question here is the accounting for stock options. What will the accounting rule be for stock options? That is

the issue, not whether stock options are granted; not anymore than

it is whether or not bonuses are granted for performance or whether or not stock itself is given for performance.

Again, when bonuses and stock are given based on performance,

they are shown as an expense on the books. That is what the accounting rule is. Stock options are the only form of compensation

which is not treated like other forms of compensation, and that is

what FASB is proposing to change.

One final comment on China. I understand—and I would like our

witnesses to comment on this—that in focusing on stock options,

China is also adopting the International Accounting Standard

Board rule, which is going to go into effect next year, which requires that stock options be expensed. If we are correct, in China,

which is going to make greater use of stock options, they are going

to adopt the same accounting principle for those stock options in

China as FASB is proposing here domestically.

Finally, a very small percentage of our small businesses use

stock options, as far as we can tell. I hope our witnesses will comment on that. The best figure that we can get is that about 3 percent of small businesses, according to one study, use stock option

grants. So regardless if or not we have the same accounting rule

or a different accounting rule for stock options relative to small

businesses under the current rule, which does not require expensing, those stock options do not need to be expensed at all, since

only 3 percent of our small businesses apparently use the stock options. Of course, no business, unless it is incorporated, unless it is

public, has to adopt the Generally Accepted Accounting Principles,

(GAAP). So I think—and I would like statistics on this from our

witnesses—the vast majority of small businesses do not follow the

GAAP rules because they are not public companies. I would like to

hear some testimony on that as well.

Thank you very much, Mr. Chairman, for bringing us together.

It is a very important subject, and I look forward, at least as long

as I can stay here, to hearing from our witnesses.

Senator ENZI. Senator Allen.

OPENING STATEMENT OF THE HONORABLE GEORGE ALLEN,

A UNITED STATES SENATOR FROM VIRGINIA

Senator ALLEN. Thank you, Mr. Chairman, for having this hearing, and thank you for your expert leadership on this very important issue, which I think affects our economy, our jobs, and the opportunities particularly for small businesses, start-ups, and those

that may be small businesses and not publicly traded, but ultimately might be.

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I vow to stay here through much of this hearing. We have a battle on the floor possibly on trying to stop taxing of the Internet, so

I may have to leave if we get back to that.

Let me make a few observations here on why I think the way

that you are bringing the Small Business and Entrepreneurship

Committee into focus here on the impact, particularly on smaller

businesses, is so right and so appropriate.

First, let me just give everyone here my view. I think incentives

are a great idea. I think it is a great idea if employees own part

of the company or have the potential of owning more of the company. It has been suggested—and I think it makes a great deal of

sense intuitively—that if an employee cares more about just a paycheck every two weeks and actually cares about the market share

and how a company is growing and they also have that incentive

that those stock options that they might someday get will actually

have some value, I think that is a great motivation. In fact, one

respected technology CEO said, ‘‘Employees with stock options are

like homeowners; whereas, those without stock options are like

renters.’’ He saw a difference in attitude, commitment, and the

level of entrepreneurial spirit. It all makes a great deal of sense.

My concern with what the Financial Accounting Standards Board

is planning to do with this exposure draft—and it seems like they

have preordained that they are going to do it—is the impact all

this is going to have on jobs and the ability of broad-based stock

ownership for broad-based employees, not the top executives of the

company, but the ability for companies that may have 50, that may

have 500 employees, they may have even 5,000 employees. The

point is all the employees from clerical to some of the engineers,

to the scientists, to the innovators, all of that is going to have an

adverse impact on their productivity and those opportunities for

those individuals.

Now, what we have here is an elected Senate, and we are faced

with unelected officials on the Financial Accounting Standards

Board. And the effect of all the benefits of stock options for employees, broad-based employee stock options, will come to an end if this

proposal goes forward. The question, though, and the whole issue

here is how are you going to treat employee stock options as an accounting expense and disregard just certain fundamental issues.

First, employees’ stock options are not freely tradable. They

inure to the benefit of an employee, and they only have any value

of whatever that strike price is eventually achieved 4 or 5 or 6

years down the road. So how do you value something that has no

market? How do you put a price on something if it is not for sale?

The answer is you cannot, and there is no accurate way to value

these options without an open market.

On top of it all, we have a proposal now that really hasn’t been

field-tested very much, this binomial approach as opposed to BlackScholes, which has generally been discredited. So on top of it all,

an untested proposal is going forward on something that really is

not evaluable.

The stock options, of course, take several years, and the other

thing is for small businesses—and even larger businesses—when

they have downturns, say in the technology sector, because they

are using stock options, which may or may not become worth someVerDate 11-MAY-2000 12:50 Oct 14, 2004 Jkt 095840 PO 00000 Frm 00012 Fmt 6601 Sfmt 6601 E:\DOCS\95840.TXT SCANNER PsN: SCANNER
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thing someday, rather than laying off employees, they don’t have

that underlying expense because say their salary component. Their

salary that they pay every month, is not as high because they are

giving more in stock options. So instead of laying people off, their

expenses are less, and that keeps folks motivated, staying with the

company, not jumping to another job, so that when the demand

kicks in, that talent is still there for that company.

I do also find it distressing that on the Pacific Rim and particularly in China, the People’s Republic of China has companies in

that country advertising and promoting themselves that they have

employee stock options. I would hope in the United States of America that we would want to make sure that we are competitive and

that we do not lose talent, we do not lose those jobs, offshoring, so

to speak, because of the better incentive packages that creative

innovators can get from working in a company in the People’s Republic of China. I will also point out Bear Stearns said that if

FASB is determined to fundamentally change—to go with their

flawed assumptions about their proposals as far as expensing stock

options, there will be a 44-percent decline in the Nasdaq 100 companies’ profits that they would have been required to expense, employee stock options, if they had to in 2003. So, granted, the

Nasdaq 100 are not necessarily small businesses; however, they are

businesses—and I do care about businesses, large, small, and medium size, and a lot of small businesses, a lot of those companies

on Nasdaq at one time were small businesses. So I think it is very

important that we address the economic impact of this on jobs, the

competitiveness of the country, and particularly in looking at small

start-up companies that want to retain good people, quality people

in their workforce, as well as attract people to serve on the board

of directors that will also help those companies grow.

I thank you, Mr. Chairman, for your leadership on this very important issue.

Senator ENZI. Thank you.

Senator Bayh.

OPENING STATEMENT OF THE HONORABLE EVAN BAYH,

A UNITED STATES SENATOR FROM INDIANA

Senator BAYH. Thank you, Mr. Chairman. As much as I would

like to think that the audience is gathered here today to hear me

give a speech, I suspect that they are here to listen to our panel,

and I am here to listen and learn. Let me just take 2 minutes to

sort of share my perspective with which I am approaching this

issue.

It seems to me that our job as public policymakers is to attempt

to reconcile a couple of very important and potentially competing

concerns that will be brought up in the course of these deliberations. The first is the importance of the accounting aspect of all of

this, the need for accuracy and transparency in accounting that is

vitally important to the functioning of our capital markets, the confidence and trust that investors, both large and small, can place in

the American system of free market enterprise. That is a very important concern I know we are going to be hearing about today.

Senator Allen alluded to some of the difficulties of achieving accuracy in this context. It seems to me from what I can hear that

8

perfection is likely to escape us, but, nevertheless, we need to do

the best we can in terms of achieving accuracy and transparency.

There is also a set of other issues that some of our colleagues

have touched upon here. I refer to these as the macroeconomic

issues: incenting innovation, which I think is very important in

terms of what the competitiveness of the American economy is

going to be going forward; global competitiveness, vitally important

at this juncture with increased globalization and competition.

It is possible that there is going to be some tension between

these different principles that we seek to embody in our decisionmaking. I was going to say the potential consequences are significant. A couple of decades ago, I believe, the treatment for health

care expenses was changed, moving that from a footnote up into

the balance sheet, and it set off a chain of events, which may be

good, may not be good, depending on your perspective. They were

very significant. Companies began to take health care costs much

more seriously. That led to the rise of managed care organizations,

which has led to, in some respects, a backlash against the provision

of care in that regard, which has then led to the call for the Patient’s Bill of Rights, et cetera, et cetera, et cetera. A change in the

accounting treatment of health care expenses led to really some

profound changes in a seventh of the American economy. That

touches upon the daily lives of almost every American.

So as I said, that may have been good, it may not have been

good, but it was profound. It makes it vitally important that we get

this right and at least make some attempt to anticipate what the

impact of all this is going to be on accuracy and transparency, but

also on the rate of innovation and our ability to compete globally

with those we have to compete with.

Those are sort of some of the principles I am trying to approach

this debate with. I want to thank our panel members and others

for being here today, and I look forward to receiving their wisdom.

Thank you, Mr. Chairman.

Senator ENZI. Thank you.

Senator Ensign.

OPENING STATEMENT OF THE HONORABLE JOHN ENSIGN,

A UNITED STATES SENATOR FROM NEVADA

Senator ENSIGN. Thank you, Mr. Chairman. I think this is a vitally important issue when it comes to the competitiveness of

America in the global economy. What Senator Bayh just talked

about, I think, is exactly right. If we mess this up, there could be

severe consequences, and I hope that our panel is taking that to

heart.

What Senator Levin mentioned was that this isn’t about whether

to use stock options or not. This is just about how to account for

those. The problem with that statement is that the people who are

issuing stock options are telling us that if FASB goes ahead with

what they are planning, broad-based stock option plans will come

to an end.

Now, are the top employees going to get stock grants and are

some companies going to use stock grants? Yes. The top employees

aren’t the people that we are worried about. It is the rank and file

employee out there that will no longer, as Senator Allen talked

9

about, be an owner in the company. Silicon Valley was built on

stock options. A lot of these start-up companies that could not afford to pay the top prices were giving lower wages, and stock options, basically allowing the individual employees themselves to be

an entrepreneur. Part of being an entrepreneur is being a risktaker. As a veterinarian, I started my own animal hospital in Las

Vegas. I was a risk-taker. I was putting my own heart, sweat,

money, everything at risk.

Well, that is what broad-based stock options plans do to the

front-line employee, do to the secretary, do to the engineer, do to

all rank and file workers. They become owners in the company, believers in the company.

When we put in these types of accounting standards that are so

complex, you confuse people. I am not an expert, I am not an accountant like our Chairman is. Listening to the CFOs out there

and to the people that are going to actually have to comply with

this, they are pulling their hair out. They are saying there is no

way that they are going to do this. Company after company after

company is telling us that, and especially now if—in this draft proposal, you give two different options, binomial, Black-Scholes, and

a company is forced to pick one and not the other, you are setting

people up for frivolous lawsuits from trial lawyers.

If we are going to expense—which I disagree with in the first

place—then we should certainly have a valuation method that is

accurate, but also one method that everybody uses so there isn’t a

choice out there because, otherwise, I believe it is going to once

again be just a tremendous windfall to the trial lawyers in America.

What we should be after is accuracy and transparency, and I still

don’t understand—and maybe the panel can address this—why disclosing stock options at the various prices that they were given on

the various financial statements and income statements, why those

wouldn’t be accurate enough for the average investor. I mean, that

is what you are trying to do. You are trying to say, okay, as an investor I see those out there, I can figure out any dilution that represents. But if they are actually being expensed and forcing restatements and effecting the stock price, it just doesn’t seem to

make sense. My father is a chairman and CEO of a public company. It started at $25 a share, went to $42 a share, to $17 a

share, back to $28, down to $7 a share, back to $28 a share, back

to $15 a share, to $42, back to $25, and now it is up to $60.

The volatility of markets makes expensing of stock options so incredibly complex that I frankly think that is going to hurt investors

and our company and the biggest thing I think that is going to hurt

is our competitiveness in the global community. We should be looking at everything we can do to make American business more competitive in the global marketplace. That means reforming regulation and the way we tax our companies and accounting rules. That

is certainly a regulation, and we should not be making American

companies less competitive, especially with the Pacific Rim, which

anyway, is by far the most competitive place for the United States.

So I look forward to hearing from our panel today and certainly

hope that our panel is listening to the people who are on the front

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petitiveness of the United States. You know, they are, we are, and

I hope that we do this right because I am very afraid of what is

going to happen.

Senator ENZI. Thank you.

Senator Pryor.

OPENING STATEMENT OF THE HONORABLE MARK PRYOR,

A UNITED STATES SENATOR FROM ARKANSAS

Senator PRYOR. Mr. Chairman, I am glad you brought this very

important issue before the committee today. I appreciate your leadership on it, and I think any comments I would have would really

just be ground that has already been plowed by these other Senators. So I would like to just hear from the panel now.

Thank you.

Senator ENZI. Thank you.

We will move to the panel then, and the first person to present,

of course, will be the Chairman of the Financial Accounting Standards Board, Chairman of FASB, Robert Herz. He joined

PricewaterhouseCoopers in 1974 after graduating from the University of Manchester in England with a B.A. degree in economics, and

moved on to Coopers and Lybrand. He has been real active in the

AICPA with the security regulations committee and a

transnational auditors committee of the International Federation of

Accountants. An amazing background, and he has a recent book,

‘‘The Value of Reporting Revolution: Moving Beyond the Earnings

Game.’’

Mr. Chairman.

STATEMENT OF ROBERT H. HERZ, CHAIRMAN, FINANCIAL ACCOUNTING STANDARDS BOARD, NORWALK, CONNECTICUT;

AND GEORGE J. BATAVICK, BOARD MEMBER, FINANCIAL ACCOUNTING STANDARDS BOARD, AND CHAIRMAN, FASB

SMALL BUSINESS ADVISORY COMMITTEE, NORWALK, CONNECTICUT

Mr. HERZ. Well, thank you, I guess it is Acting Chair Enzi, and

thank you, Members of the Committee. I am Bob Herz, Chairman

of the FASB. With me, as you said, is George Batavick, one of my

fellow Board members, and he will be chairing our newly established Small Business Advisory Committee. That very good idea

did come from Senator Enzi, and we thank him for that. We are

pleased to appear before you today on behalf of the FASB and

thank you for allowing us to participate in this very important and

timely hearing.

We certainly recognize the importance of small business to job

creation, to entrepreneurship, and to our Nation’s economy. Accordingly, we also recognize the need to carefully evaluate whether our

proposed improvements to financial reporting, not just on this subject but in general, not only are conceptually sound and meet the

needs of the users of those reports, but also whether the proposed

improvements can be implemented by small businesses in a costeffective manner.

We have got some brief prepared remarks, and I would respectfully request that the full text of our testimony and all supporting

materials be entered into the public record.

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Senator ENZI. Without objection, they will be included.

Mr. HERZ. As you know, we are an independent private sector organization. Our ability to conduct our work in a systematic, thorough, and unbiased manner is fundamental to achieving our mission, which is to establish and improve general purpose standards

of financial accounting and reporting for both public and private

enterprises. We believe those standards are essential to the growth

and stability of the U.S. economy because creditors, investors, and

other consumers of financial reports rely quite heavily on credible,

transparent, comparable, and unbiased financial information to

make their economic and investment decisions.

Now, because the actions of the FASB affect so many organizations, our decisionmaking process must be open, it must be thorough, and it must be as objective as humanly possible. Our rules

of procedure require an extensive and public due process. That

process involves public meetings, public hearings or roundtables,

field visits or field tests, liaison meetings with many interested

parties, consultations with our advisory councils, exposure of our

proposed standards to external scrutiny and public comment, and

then after the comment period, public redeliberation by the Board,

which often, I will tell you, does result in significant changes and

improvements to proposals.

Our due process procedures do include participation by users,

auditors, and preparers of the financial reports of small business.

The recent formation of the Small Business Advisory Committee is

intended to further enhance that participation.

We make final decisions only after carefully considering and analyzing input of interested parties. We try our darndest to balance

the often conflicting perspectives of the various parties in order to

make independent, objective decisions guided by the fundamental

concepts and key qualitative characteristics of sound, fair, and

transparent reporting.

On March 31, we issued a proposal for public comment to improve the accounting for equity-based compensation. It is out for a

comment period of 90 days, and we will be holding roundtables and

other meetings. George will talk about that. It is the result of an

extensive public due process that began in November 2002. That

process included the issuance of a preliminary document for public

comment, review of over 300 comment letters received and over 130

further unsolicited letters, consultation with advisory committees,

review of relevant research, meetings with valuation and compensation experts, field visits to companies, public and private discussions with hundreds of individuals, and active deliberation of

the Board at 38 public Board meetings, of which about half of those

meetings small business issues and non-public-company issues,

were discussed.

Based on our work to date, we believe the proposal would significantly improve the financial reporting for equity-based compensation arrangements. We would do that by creating greater transparency and completeness in the reporting and a more level playing field in accounting for different forms of equity-based compensation. We believe the proposal would enhance the comparability of reported results, profitability, and other key financial

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ployees in different ways. The proposal would achieve this by a

number of provisions, but most notably, and I guess most controversially, by the proposed elimination of the existing exception

for so-called fixed-plan employee stock options, which are the only

form of stock option, and which are the only form of equity-based

compensation that is not currently required to be reported as an

expense in the financial statements. The proposal reflects our view

that all forms of equity-based compensation should be properly accounted for and that the existing exception for fixed-plan employee

stock options results in reporting that not only ignores the economic substance of those transactions, but that also distorts reported earnings, profitability, and other key financial performance

metrics.

Thus, under the current rules, the greater the use of these instruments to compensate employees, the greater the distortion of

the reported results. I would note in contrast, this distortion does

not occur when companies use stock options or similar instruments

which can often be quite complex, such as stock purchase warrants

for purposes other than compensating employees, for example, to

acquire goods and services, employ consultants, or in financed

M&A transactions, because in those cases, the current rules do require that the options or the warrants be valued and properly accounted for.

Now, just to digress into the public company arena for just one

second, and then we are going to have George focus on small business, in the public company arena the proposal would also bring

about greater comparability between the nearly 500 companies that

have now voluntarily opted to account for the cost of employee

stock options in their financial statements and the many others

that have elected not to do so.

It would also result in substantial convergence in the accounting

for equity-based compensation between U.S. standards and the

international accounting standards that are followed by companies,

including many small and non-public companies in over 90 countries around the world.

I would like to now hand it over to George who will discuss the

several special provisions contained in the proposal that relate to

small business as well as some other small business matters and,

very importantly, talk about our continuing work and due process

on this important subject.

Mr. BATAVICK. Thank you, Bob, and good morning, everyone. Before I outline the special small business provisions contained in our

proposal to improve the accounting for equity-based compensation,

I would first like to provide some brief background on small businesses and financial accounting and reporting standards.

First, there is no Federal law requiring non-public enterprises to

use FASB standards. Thus, for most small businesses, the use of

our standards is primarily a private choice. For some small businesses, that choice may be influenced by whether they have plans

to become a public enterprise.

For other small businesses, the decision to follow FASB standards may be influenced or controlled by their current or potential

lenders, suppliers, other contracting parties, et cetera. To the extent that one of those parties requires that the financial reports of

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small businesses comply with our standards, that requirement presumably reflects that party’s opinion that our standards result in

better, more transparent information for their respective purposes.

Second, it is also important to note that the FASB has long recognized, as part of our ongoing public due process procedures, that

the costs of complying with our standards can fall disproportionately on small businesses. In recognition of that fact, the Board actively solicits and carefully considers requests from users, auditors,

preparers of financial reports, and considers whether or not there

should be special provisions to alleviate the costs of implementing

our standards.

These requests come from our continuous and ongoing due process and deliberations throughout the life of a project. In this project

on equity-based compensation, if you are following it, all constituents, large and small, could have taken advantage of our free weekly action alert e-mail subscription, which discusses current agenda

items and past Board decisions. They could have attended an open

Board meeting. They could have called in, or they could have listened to our free webcasts of meetings on the day of the meeting

and one week after. Our meetings also get extensive news coverage, and our free website includes an up-to-date summary of all

equity-based compensation issues as well as our tentative decisions. We sought input from various State CPA societies, who in

turn briefed their clients—in many cases small businesses—on the

status of the project. Lastly, liaison meetings with various groups

having small business representation and Board and staff speaking

engagements provided additional means of receiving valuable input

from the small business community.

With respect to this proposal, it is our understanding that although the use of employee stock options is prevalent at some

small businesses, particularly start-ups and venture capital-backed

enterprises that plan to become public enterprises, the vast majority of small businesses, 3 percent or less, in the U.S. do not grant

employee stock options. As indicated earlier, however, for those

small businesses that are impacted by our proposal, the proposal

includes several special provisions intended to alleviate the costs of

implementation.

First, the proposal includes a special provision that would permit

most small businesses, including all that are non-public, to measure compensation cost using a simpler, less costly intrinsic value

method, rather than the fair-value-based method. Under the intrinsic value method, the amount of compensation expense required to

be reported would generally be equivalent to the amount of the income tax deduction for stock options.

Second, the proposal includes a special provision that provides

that most small businesses that are non-public enterprises would

have a simpler, less costly prospective transition to the new requirements. Finally, the proposal includes a special provision that

provides that the effective date of the proposed standard for nonpublic enterprises would be delayed 1 year until 2006.

I would also like to note that the proposal includes a Notice for

Recipients that highlights and describes these special provisions.

The notice requests that respondents to the proposal indicate what

other special provisions for small businesses might be appropriate

14

and whether any or all such provisions should also be extended to

public enterprises that are small business issuers.

The Board currently plans to discuss the proposal’s special provisions and other issues about the proposal with representatives of

small businesses at our inaugural public meeting of our Small

Business Advisory Committee on May 11. Our request for agenda

items, which was made to this committee for this meeting, showed

interest in this proposal. We also plan to hold several public roundtable meetings with valuation and compensation experts, users,

auditors, preparers, et cetera, in June to discuss a broad range of

issues.

Following the end of the comment period in June, the Board

plans to redeliberate, at public meetings, issues raised in response

to the proposal, including all those issues raised by the small business community. Those redeliberations will include careful consideration of these requests, including ongoing input from the Small

Business Advisory Committee.

Only after evaluating the input at public meetings will the Board

consider whether to issue a final standard.

On behalf of myself and Bob, I would again like to express our

appreciation for inviting us to participate in this hearing. All the

information we obtain at this hearing will be carefully considered.

In conclusion, let me assure you—and I know Bob will also assure you—that you and the users, auditors, and preparers of small

business financial reports can have confidence that the Board will

continue to reach out actively and solicit input from representatives of small businesses in response to our proposal. That input

will be carefully considered in an open, thorough, and objective

manner that will best serve the interests of all parties.

Thank you again, and Bob and I would welcome any opportunity

to respond to questions you may have.

[The prepared statement of Mr. Herz and Mr. Batavick follows:]

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Senator ENZI. Thank you.

That was Mr. George Batavick, who is not only on FASB, but he

is the Chairman of the Small Business Advisory Committee. He is

the former Comptroller of Texaco, Inc. He has company-wide responsibility for strategy and policy matters covering all aspects of

accounting and financial reporting, special studies, internal controls, and tactical plan coordination, and he has had a career in

public accounting at Arthur Andersen. Thank you for the testimony.

The next person to testify will be Dr. Douglas Holtz-Eakin, who

is the sixth Director of the Congressional Budget Office. He spent

18 months as a Chief Economist for the President’s Council on Economic Advisers, and he serves as CBO’s representative on the Federal Accounting Standards Advisory Board. He served as editor of

a number of publications—the National Tax Journal, been involved

with the Journal on Human Resources, and a whole list of them,

very impressive list of them. We look forward to your testimony,

Dr. Holtz-Eakin.

STATEMENT OF DOUGLAS HOLTZ-EAKIN, DIRECTOR,

CONGRESSIONAL BUDGET OFFICE, WASHINGTON, DC

Mr. HOLTZ-EAKIN. Mr. Chairman, members of the committee, the

Congressional Budget Office recently delivered to Congress a report

on the accounting for employee stock options, which examined the

issue from an economic perspective, with a particular focus on

measurement issues and on the economic implications of accounting for stock options. I want to highlight three main points of that

report, and then I would be happy to take your questions.

The first point is that granting stock options to employees results

in a cost to the firm that is equivalent to cash and other non-cash

compensation. Using the fair value or cash equivalent of compensatory options at grant and recognizing that value over the period

when the corresponding labor services are provided—the vesting

period—brings accounting closer to the economic reality of total

firm expenses and net income.

That finding is based on three observations:

First, is that stock options are valuable to employees; otherwise,

they would not accept them as a substitute for other compensation.

Second, the value of options can differ among employees and

change over time. However, the reporting entity is the firm. In reporting net income for the firm, costs should be recognized at the

time the labor services are provided; expensing over the vesting period reports that cost for the firm. Any subsequent changes in the

value of the options represent a shift of resources among stakeholders in the firm and not a change in the cost of labor compensation—a point that we explain in more detail in the report.

Finally, stock options can be cost-effective. Beneficial incentive or

productivity effects will be reflected in earnings. A fair display of

the cost-effectiveness will be achieved by showing the cost of labor

services required to produce those earnings. For that reason, any

accounting standard should recognize their value, but not prohibit

the use of stock options.

The second major point is that valuing stock options is more difficult than valuing cash compensation. The difficulty does not apVerDate 11-MAY-2000 12:50 Oct 14, 2004 Jkt 095840 PO 00000 Frm 00027 Fmt 6601 Sfmt 6601 E:\DOCS\95840.TXT SCANNER PsN: SCANNER
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pear to preclude the recognition of their fair value, however, especially when compared with the intricacy of other calculations of

compensation expenses.

It is more difficult than cash or non-cash benefits, such as employee health insurance, largely because the price is not observed

and because it has some special features, such as vesting periods,

forfeiture provisions, and restrictions on transferability. However,

advances in financial analysis now permit reasonable valuation of

a wide variety of such warrants, and indeed they are present in

many investment portfolios, including those of the Federal Government.

To provide some perspective, the valuation of employee stock options can be compared with another form of compensation: retiree

health benefits. To value those, a firm must forecast employees’

tenure, the retirees’ marital status, trends in health and mortality,

changes in medical technology, and the ultimate cost and utilization of medical services. In short, the valuation exercise is forwardlooking and is based on uncertain and volatile prices. Current

methods for employee stock options address an analogous situation,

and robust options-pricing methods are now available to every

MBA. Moreover, as the demand for such valuation increases, we

would anticipate further analytic advances and an increased supply

of people providing this service to firms.

The final point I want to make from our report is on the economic implication of recognizing the expense of employee stock options. This accounting requirement would not change the economic

fundamentals of any business, large or small. Firms’ cash flows

would not be affected. Their customers, product markets, and competition would be unchanged. Small and large businesses would

face the same labor market conditions, and they would have the

same tools available to attract highly productive labor. Their taxes

would be unchanged. In fact, the underlying financial facts would

be precisely the same for all businesses after the accounting

change. Thus, the only channel for any real economic effect would

be changes in investors’ valuation of these businesses.

One would expect that for savvy investors and for most firms, expensing would provide no new information and, therefore, no

change in value. Current standards require firms to calculate and

disclose, in audited notes, the fair value of the options grants and

the effect of recognizing them as an expense, on net income. Expensing would only make this information available more easily

and to a broader audience.

Now, it has been argued that there will be a significant decline

in stock prices as a result of expensing. In advance, no definitive

evidence can be offered for this claim. However, evidence from

other similar events—for example, the early 1990s exposure draft

from the FASB, firms that have voluntarily adopted expensing in

the United States, and firms that have expensed these grants in

Canada or the European Union—argues against any significant

overall effect on stock prices.

A related concern is that stock prices of businesses too small to

be tracked by market analysts may be adversely affected by expensing. Many of the CEOs of such firms believe that expensing

will reduce their stock prices and have announced that they will

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stop granting options. This is a serious issue. The economic importance of these entrepreneurial firms and the informed source of

these reports requires that we consider it carefully.

It may be the case that investors in such small firms may be surprised by the information received from expensing stock options

and that this will cause a decline in stock prices, an increase in the

cost of equity capital, and potentially sizable near-term losses for

managers and employees. If some firms are relatively overvalued,

other firms are relatively undervalued, and those firms will enjoy

a corresponding increase in their stock prices as a result of the accounting change. This would permit near-term expansion of markets and employment by such firms. Those offsetting effects reduce

the possibility of a significant overall effect.

Moreover, these same considerations suggest that improved information will allow capital in the economy as a whole to flow to

its most productive uses. For the economy as a whole, this would

provide a benefit in the form of increased productivity and competitiveness.

Thanks, and I look forward to your questions.

[The prepared statement of Mr. Holtz-Eakin follows:]

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Senator ENZI. I want to thank all three of you for your outstanding testimony and particularly for the more extensive documents that you have provided for us. I was able to go through quite

a few of those, but I need to have some answers to some more general questions to start out with.

I am concerned about the method of gathering information about

the proposed standard. I guess I am a little disappointed that the

concentration is on convincing Congress that what you are doing is

right rather than soliciting comments to find out whether what you

are doing is right. I am just not familiar with this process of a

Board that is supposed to be soliciting—and everything that they

write talks about listening and process and accountability and

thoroughness, and they have had the appearance of being locked

into a primary approach from the very beginning, and everything

that seems to be happening continues to put forward that approach.

For instance, I got a letter from the Big Four accounting firms,

and they said that that was at the solicitation of FASB officials,

asking us not to do any legislation. I have said a number of times

that if the small business aspect—if there is an appearance that it

has been listened to, then legislation may not be necessary. But if

it isn’t listened to, there may be a landslide toward doing it.

It is based around listening, not about legislating, and there is

so much concentration being done on the legislation that I am not

sure that the listening is being done.

Chairman Herz, would you comment on that, as well as your role

as a lobbyist?

Mr. HERZ. Well, I think we listen a lot. We meet with many people. We get lots and lots of input. I went over that. Inevitably, some

people have views, and when you don’t accept their views, they say

you are not listening. Listening does not necessarily mean that you

agree or obey.

We are continuing to listen. We really are. In fact, on the small

business aspect, your suggestions have been outstanding, I think,

on the Small Business Committee. Just from my meetings with

you, I think I have taken on some of your infectious passion for the

subject, and we will continue to do that.

At a hearing actually on the House side back in June, I said that

I don’t think personally one-size-fits-all in that regard. One of my

involvements was being a managing partner of a series of investment funds that invested in a lot of things, including venture capital, direct equity investments in start-ups and the like. I think I

have got a pretty decent feel for that.

Our job is ultimately to find the right accounting, accounting

that is sound, accounting that is also cost-beneficial, that is understandable, and we are going to listen real hard and work it real

hard. You have my commitment to that.

As for the lobbying, I can’t help but thinking that it is kind of

a little bit like the pot calling the kettle black. You know, we all

know from all the press reports—and we didn’t want to politicize

this issue. Long before we even put this on the agenda, the International Stock Option Coalition was formed, was ready—you know,

the press, on Capitol Hill, you called a roundtable yourself right

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table, but hearings were all called. This is about the fifth or sixth

hearing this month on this subject.

I understand. I actually think Senator Bayh’s perspective is kind

of where I would come down. You guys have got—I mean, this is

a public policy issue, and there are competing—there may be competing goods. I hope there aren’t competing goods. I mean, my view

is let’s get the accounting right. If you want to incent innovation

through stock options, triple the tax deduction, do something else,

but let’s get the information set right so that the capital markets

can work.

In regard to lobbying, we have not asked any firm to lobby for

us with respect to our proposed standard to improve the accounting

for equity-based compensation. Since 1996, our Washington, DC

representative, Jeff Mahoney, has provided information and responded to questions about the FASB and our activities from staff

and Members of Congress, Federal Government officials, and other

interested parties here in Washington, DC. He also arranges for me

to meet directly with many of you, with your staff, and other people

in Washington. Our communications sometimes entail lobbying

contacts as defined in the Lobbying Disclosure Act relating to proposed legislation that relates to our activities, both Jeff and I and

my predecessor, Ed Jenkins, were registered under the Lobbying

Disclosure Act on behalf of the Financial Accounting Standards

Board.

Our intent is not to lobby, not to politicize at all, but, we have

seen on the other side since this issue began and more lately with

the well-publicized fly-ins of executives and, as Senator Fitzgerald

said at last week’s hearing—I don’t know what adjective he used—

that the place was swarmed with, crawling with high-tech lobbyists. We would rather have this issue discussed on its merits like

we are doing today rather than through a political context.

Senator ENZI. Well, I appreciate that. I can tell you, I wouldn’t

have been nearly as surprised had I gotten a letter from each of

the Big Four accounting firms instead of a joint one from the Big

Four accounting firms. I didn’t know they got together on that personal of a basis.

But to move on, I am really pleased that you did a Small Business Advisory Committee. I am hoping that you will perhaps make

it a little bit more of a Small Business Advisory Committee. Under

NASD—and I keep using that as an example because I am hearing

a lot of good reports on things that are happening as a result of

it, the chairman is actually from a small firm. The advisory committee meets on a regular basis. The advisory committee selects

what it is going to hear. On your advisory committee, they are

going to have a half a day, I think, to look at this proposal and go

into the details on this intrinsic and fair value and Black-Scholes

and binomial valuation models. I am also wondering if that is nearly adequate. And I am wondering how the comments by the Small

Business Advisory Committee will become a part of the docket then

on what you are actually going to do. I am also a little concerned

about people from that committee already writing letters and saying what is going to happen. If it hasn’t even met, it seems a little

premature for the committee to have any kind of an opinion yet.

Would either of you care to comment on that?

31

Mr. BATAVICK. Yes, Senator, I would. Going back to the meeting

itself, as you know, when we formed this committee, we reached

out to over 20 different organizations for representation—the

American Community Bankers, the National Venture Capital Association, Small Business Administration, etc. We believe we have an

excellent committee. I have spoken with just about everyone that

was nominated for the committee, and I can tell you they are very

enthusiastic on two fronts. They are enthusiastic that they are

going to be providing us with important issues that we can consider, but they are also interested in getting together as a group

so the users and the preparers and the auditors can hash out

issues.

It was raised earlier today: Why do some of these private companies follow our standards? Well, these are the types of issues we

are going to be discussing to make sure that the users understand

what the preparers and the auditors are going through.

We did go out prior to the meeting with a suggestion for agenda

items. We did receive a number of requests, and those requests

were around the area of equity-based compensation, which, as Senator Enzi said, is going to be the largest topic discussed at our

meeting. We also thought it was important to discuss other issues

that they brought up. They brought up our Standard 150 on mandatory redeemables. They brought up issues on business combinations. They brought up issues on various other matters like the accounting environment, and whether we should we have differential

accounting standards.

So based on those agenda requests from the committee, Mr. Senator, we formed the agenda itself. Also, we are not looking to have

just two meetings a year. Unfortunately, that was mis-communicated. What we meant to communicate is that, at a minimum, 2

times a year we will meet. We are going to discuss during this

meeting what type of frequency will make sense. Even if the frequency of the meetings is only 3 or 4 times a year, let’s say, or 5

or whatever, that doesn’t mean that we don’t reach out to this committee whenever we want to. That doesn’t mean that they can’t

pick up the phone and call us and give us their input.

If you look at the agenda on equity-based compensation, what

you will see is that when we talk about the provisions, when I brief

this committee on some of the differential provisions we have for

non-publics, we are going to ask them: Should this be expanded to

other small businesses and how? What do you need to educate

yourself? What help do you need to implement the requirements?

These are all the questions that we are going to be spending a

considerable amount of time on at our inaugural meeting. The people that I spoke with are very energetic, very excited about getting

together. And I believe they feel coming in here that they will be

able to have input and they will be able to make a difference.

Senator ENZI. I appreciate that, and it is very encouraging, and

I will be looking forward to the results on that. I know that my

time has run out, but I have to ask Dr. Holtz-Eakin a question. I

will mention that I would appreciate it if we could put some additional questions to everybody in writing and get some responses.

What we are doing, of course, is building a record so that we know

32

what to do in the future and how things are going based on what

we have heard today.

Dr. Holtz-Eakin, in the CBO study on FASB, was there any independent technical accounting analysis or just the documentation

used from FASB itself? I noticed that there wasn’t any mention of

small business in the CBO study. So was there any input from

small business? Were there any additional studies that were used

besides information from FASB?

Mr. HOLTZ-EAKIN. Well, certainly the CBO study reflects our

reading of the broad accounting and research literature in economics on both the measurement issues and the economic implications.

So it is far from focused on just the materials received from FASB

but, rather, on the entire record of published research.

Senator ENZI. Okay. I will have some additional questions.

Mr. HOLTZ-EAKIN. Certainly.

Senator ENZI. I appreciate it.

Senator Levin.

Senator LEVIN. Thank you, Mr. Chairman.

Mr. Chairman, first of all, I would like my statement to be made

part of the record, including that portion which lists some of the

leaders in the financial and accounting world who have supported

the expensing of stock options.

Senator ENZI. Your full statement will be a part of the record.

[The prepared statement of Senator Levin follows:]

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Senator LEVIN. These supporters include Alan Greenspan, Treasury Secretary Snow, SEC Chairman Donaldson, Public Company

Accounting Oversight Board Chairman McDonough, former SEC

Chairman Levitt, and a lot of investors, including Warren Buffett,

the Council of Institutional Investors, the Investment Company Institute, Financial Services Forum, Consumer Federation of America, National Association of State Treasurers, Institute of Management Accountants, and the Conference Board’s Commission on

Public Trust and Private Enterprise.

None of these folks want to hurt small business. All of these

folks want honest accounting, and that is what this is all about.

Second, I must say I admire the guts and the courage of the

major accounting firms in this country because they have decided

to do what they believe is right, which is to support the FASB approach. I can’t tell you the pressure that was put on those accounting firms to go against FASB. It was huge. We talk about lobbying?

The pressure placed on the accounting firms by their clients to go

against FASB was intense.

I have seen that kind of lobbying, by the way, up close and personal. I testified in front of FASB 10 years ago when it first tried

to adopt this rule, and there was a room full of hundreds of executives all testifying against FASB, putting huge pressure on them,

and they backed down.

They didn’t back down this time, and rather than being critical

of the four accounting firms for coming together and standing together to do what they believe is right, despite huge pressure from

their own clients, I give them great credit for coming together. If

they feel that they have to stand together because they are stronger when they are all taking a similar position, then that is not uncommon around here. We can understand that, and I give them

credit for their courage. I hope we have the courage not to interfere

with the independence of FASB, just the way accounting firms

have the courage now to protect the independence of FASB, because that is what this is about. It is not about whether or not we

are going to promote incentive pay or stock options.

I am all for stock options. I am all for honest accounting. These

are not inconsistent. The question is: How do you account for incentive pay? That is the issue here—not whether you give stock options or bonuses or other forms of incentives, which I think all of

us are for. It is a question of accounting for it, and when the professionals who are in charge of the accounting rules tell us honest

accounting requires that they be accounted for just like other kinds

of incentive pay, I think it would be a mistake for the political leaders of this country to then interfere with that judgment. That is

what we are being asked to do, to overturn the independent judgment of FASB. I hope we resist that pressure just the way the accounting firms have resisted the pressure and just the way FASB

has resisted the intense pressure from mainly executives. Let’s not

kid ourselves, what is involved here for the most part are stock options going to executives, because that is where most of the stock

options go. The vast majority of them go to executives and have

fueled the huge increase in executive pay that we have seen in this

country.

40

In 1990, the pay gap between CEOs and average workers was

100 times. Last year, CEO pay at 350 of the largest public companies was 300 times average worker pay, and stock options were the

largest single factor in that pay gap.

Now, with the time that is left, I just want to ask a few questions

about some of the statements which have been made about the alleged negative impacts of honest accounting. There has been a

study made of companies that have switched to stock option expensing voluntarily, without being required to, and this was a Towers Perrin study. Are any of our panelists familiar with that study?

Are you, Dr. Holtz-Eakin?

Mr. HOLTZ-EAKIN. The staff has looked at it. It was part of the

input into our report.

Senator LEVIN. Does that study show that of the 335 companies

that switched to stock option expensing, their stock performance

was the same, on average, as the rest of the S&P 500?

Mr. HOLTZ-EAKIN. It showed a minimal impact of the move to expensing on stock prices.

Senator LEVIN. All right. Now, Merrill Lynch has taken the following position, against the argument that expensing options will

harm U.S. technology leadership and job creation. Their point is

this: the logic that expensing stock options will harm technology

leadership leads you to the following faulty logic: U.S. technology

leadership and job creation depend on the systematic misrepresentation of financial statements.

‘‘One might as well argue,’’ Merrill Lynch says, ‘‘that money

spent on research and development shouldn’t count as an expense

because it provides employment and helps industries advance.’’

Do you agree with that, Mr. Herz?

Mr. HERZ. Yes, I agree with that, and I would go further. There

are lots of good things that, you know, we just account for properly:

pensions, training, occupational health and safety costs. All those,

I think we would agree, are good things. But we do proper accounting for them.

So it is hard to understand why for this particular item—and I

guess I understand a little bit the emotionalism because it involves

the ownership and motivation of the people through the ownership.

But, you know, the question really from our point of view is: What

is the right accounting? What will make the financials more transparent? What will make the capital markets work better?

Senator LEVIN. On that issue, on the ownership issue—because

I think all of us want to promote ownership. I have been a big supporter of ESOPs, employee stock ownership plans. I think they are

great. I am all for them. It is a different issue from how do you

account for stock options and other incentive pay. I want to just get

into one particular kind of stock options, incentive stock options,

ISOs, that are given to employees that qualify for special treatment

under the Tax Code. I want to see if I understand this correctly.

These incentive stock options which are given are taxable when

they are given.

Is that correct, Mr. Herz?

Mr. HERZ. I am not a tax expert, but there used to be a thing

called an 83(b) election, which effectively says tax on the grant

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date, and that is a decision versus kind of waiting to get the final

result and the appreciation and get taxed at that point.

Senator LEVIN. So we have a situation where a lot of our employees have the option to pay the tax when the option is granted to

them rather than when it is exercised. Is that correct, as far as you

know?

Mr. HERZ. Well, yes. Based upon this conversation, that is my

recollection. But I am not a tax expert.

Senator LEVIN. Okay. Does anyone else on this panel know about

that?

Mr. HOLTZ-EAKIN. No.

Senator LEVIN. All right. Well, then, let me just make this statement, and if it is not true, I will have to ask someone on the second

panel. Unhappily, I can’t be here to hear the answer, but we will

find out for the record.

The National Center for Employee Ownership has reported the

following: in a 2002 survey of 275 high-tech, venture-backed firms

with 20 to 100 employees, over 80 percent of the firms gave their

employees incentive stock options that qualify for special treatment

under the Tax Code. Incentive stock options, or ISOs, allow an employee to pay the tax on the value of their stock options on the

grant date, employees who prefer to pay for them because they

think they have less value now than they will downstream, which

means they have to be valued now. And it happens all the time.

Do you disagree with that?

Senator ENSIGN. Yes.

Senator LEVIN. All right. In other words, if I am misstating that,

fine. What I am saying is that under this provision of the Tax

Code, employees with these incentive stock options have the

right——

Senator ENSIGN. They pay ordinary income when they take the

gain.

Senator LEVIN. They can also value them now. They have an option—no, no. Excuse me. I hope we have a tax expert in the room

here because this is a very important point. We all assume that

employees pay the tax when they exercise the options, and that is

probably the case much of the time. But employees under these incentive stock option plans qualify for special treatment under the

Tax Code where they are allowed to pay a tax when it is granted,

before it is exercised. In order to do that, they have to be valued.

Now, again, if I am right—and I believe I am—this is a very significant point because what it means is that the argument about

valuation, that you can’t value these things, is wrong on many

counts. We value things that are much more difficult to value than

stock options. For instance, grants of stock which will be given to

you if a company reaches a certain profitability level, those grants

of stock are valued now, even though you don’t know if a company

will ever get to that profitability level. They value that now. It is

compensation. There is no exception for that. It must be valued on

this year’s—it must be shown, excuse me, on this year’s books of

the company. So there are very difficult things to value in terms

of compensation which may or may not be achieved downstream.

For instance, if a company reaches a certain point, you promise

a bonus, that must show on the company’s books as compensation.

42

Even though it is conditional upon a company reaching a certain

point, it must show as compensation on a company’s books, unlike

stock options which never have to show on a company’s books as

a compensation.

I want to go back to this one point. I think it is important for

this committee to get the answer to the question I am raising on

the incentive stock options that qualify for special treatment under

the Tax Code where an employee is allowed now to take a tax deduction based on the value now of that stock option, even though

it cannot be exercised now and can only be exercised later.

Mr. Chairman, I think I have probably taken more time than I

should, and I want to thank the Chair and my colleagues for their

leniency on this.

Senator ENZI. Thank you.

Senator Ensign.

Senator ENSIGN. Thank you, Mr. Chairman.

I do want to address some of the things I talked about in my

opening statement. First of all, Senator Enzi’s legislation would exempt the top five executives. We have heard that this is all about

the executives in the company and that would exempt the top five

executives.

In the light of Sarbanes-Oxley, if you are a CFO/CEO and you

have to certify these financial statements, and now with the severe

penalties that Sarbanes-Oxley brings to the fore, if you were one

of those CEOs/CFOs, would you continue broad-based stock option

plans if you had been giving them in the past?

Mr. HERZ. If I think they are good thing, yes, absolutely.

Senator ENSIGN. And you think you could value them accurately

based on——

Mr. HERZ. Oh, yes. They are already in the footnotes, and those

are part of the audited certified financial statements, have been for

8 years. There are 500 companies doing it. Microsoft just took a

charge of $2.5 billion or something.

Senator ENSIGN. Isn’t Microsoft now doing stock grants, though?

Mr. HERZ. Going forward they are going to restricted stock

grants, but they took their charge for the existing options, some

number like that. You know, it takes some work, particularly if you

have got a broad-based plan; just like if you have a pension plan

you have got to do some work. But these things—our experience,

you know, we had a whole panel of valuation experts. We talked

to the companies that are actually putting it in their——

Senator ENSIGN. Would you use binomial or Black-Scholes going

forward?

Mr. HERZ. It depends on the company’s circumstances, and that

is why we—first of all, the myth that there are two different methods is not right. They are based on the same financial economic

theory. The binomial model is just a more flexible version of BlackScholes. Black-Scholes is just like a hard-wired thing. The binomial

is like being able to open it up by periods, but they are based on

the same financial economic theory. The binomial allows you to put

in more inputs, model in blackout periods. So if you have a more

complicated plan that goes out longer, you might want to use the

binomial in order to get a more refined estimate, just like if I am

a company that only has a few fixed assets and figuring out depreVerDate 11-MAY-2000 12:50 Oct 14, 2004 Jkt 095840 PO 00000 Frm 00048 Fmt 6601 Sfmt 6601 E:\DOCS\95840.TXT SCANNER PsN: SCANNER
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ciation, I will probably use some historical kinds of facts versus

doing—if I had a lot of fixed assets and different types, I would

probably do what are called lifing studies.

Senator ENSIGN. Well, why do you think—because the chairman’s bill exempts the top five executives. Why——

Mr. HERZ. No, the other way around. It captures the top five.

Senator ENSIGN. That is what I mean. But what I mean is that

it basically takes away the argument that—the CEOs/CFOs of the

company would be arguing to keep broad-based stock plans because

it benefits them. So we have taken that off the table. Why would

they, in arguing against what you all are doing because they believe that it has been a valuable tool, and the feedback that I am

getting from them is negative, and I don’t know that a lot of you

understand it, or accountants in the public understand it. Why do

they think there are so many problems with it? Why are they concerned about Sarbanes-Oxley? Why have we heard from so many

of them that they will do away with broad-based stock option plans

because of what you are doing? I mean, why are those concerns out

there if they are not real?

Mr. HERZ. Well, let me make a few comments before I try to play

psychologist.

Senator Enzi’s legislation, we believe it is fatally, seriously

flawed conceptually on a number of grounds, and it really would

amount to no expensing, largely. It has a method where there is

zero volatility, it doesn’t capture the actual value of the options,

and it can be manipulated very easily to come to no expense. So,

you know, I don’t think that does any kind of trick, with all deference to my colleague accountant here, the good Senator.

Why they are arguing that, they may believe it. I happen—this

is only my own view, okay? I am not them. I believe that they truly

believe, you know, in their business model. I have seen it because

I have invested in some of those companies, start-ups. Some of

them went public, and they have very much a culture of that and

a true belief that that is the secret formula to success. I think that

they are, therefore, almost foisting one argument after another

after another after another after another.

Our role is to try and get as much information and input as we

can to understand as best we can what the real situation is, and

that is what we try to do.

Senator ENSIGN. Well, Mr. Chairman, like I said, I know my time

has expired, and I just think that the people who are out there who

have created these successful business models ought to be paid attention to more closely than they are today because we are in a

highly competitive global marketplace, and if we take away one of

the tools that has led to this high-tech revolution that we have had

in the United States of America, if we take away one of the most

valuable tools they have to attract great employees, we could do

some great damage to our economy. I know that that is not what

you are after, but that may be, in effect, what you end up doing.

Thank you, Mr. Chairman.

Senator ENZI. Thank you.

Senator Bayh.

Senator BAYH. Thank you, gentlemen, for your time today.

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Let me start off by asking a couple of questions about the differing institutional roles of the organizations you represent and our

responsibility here in the United States Congress. Am I right in

saying, Mr. Herz, I think I wrote down during your opening remarks that you realize that the accounting issues are important to

innovation and competitiveness. That is why you take your time to

try and get it right. My understanding is your charge is, while you

understand those are important, it is not really to take into account macroeconomic issues like innovation and global competitiveness and that sort of thing; is that correct?

Mr. HERZ. Yes. We have a charge that says we must be what we

call neutral. That does not mean we apply Swiss accounting. It

means that in developing what we think is the better accounting,

we look at the economic attributes of the transactions, how they

impact on the company, its earnings, its cash flow, its financial position, earnings per share.

Senator BAYH. My point is you focus strictly on the accounting

and not so much on the—once you are convinced you have got the

accounting right, in your opinion, you do not focus on the ramifications quite so much.

Mr. HERZ. And I think the belief there is that the public good we

are serving is that the better information therefore makes for a

better capital market, you mentioned all of that.

Senator BAYH. Right. Let me follow up on that. It is possible that

these different concerns need not be in competition with one another. As I said in my opening comments, I hope we can reconcile

it because you do not want to sacrifice transparency and accuracy

for the sake of competitiveness and innovation. At the same time,

innovation and competitiveness are important, and to the extent

there is interplay between these two things, we need to figure out

what it is and try and get the balance right so that we do not just

serve the interests of accounting accuracy, and that is very important, but that we serve the overall interests of the society we represent well.

So there are some institutional differences here in terms of the

breadth of issues we look at, and I am interested to know, is there

any analysis been done to see if these things, first of all, can be—

I am going to have you, Mr. Eakin—is that how you pronounce

your last——

Mr. HOLTZ-EAKIN. Holtz-Eakin.

Senator BAYH. I am sorry. You did address this at least in theoretical terms, but have any of you done any analysis on what the

impact the proposed changes would have on innovation, on global

competitiveness, on those sorts of broader concerns?

Mr. HERZ. My esteemed colleague can answer that.

Senator BAYH. I assume the answer would be no and no, and Mr.

Holtz-Eakin, let me get to you.

You did mention some of these concerns. I took from the tenure

of your answer though, that your response was sort of from a theoretical economic perspective as opposed to having actually done an

in-depth survey of some kind.

My additional question to you would be, I wonder if when the

change in the treatment of health costs was done, did people anticipate the sort of profound impact that it was going to have on the

45

health care system, or at least did they try to anticipate what the

consequences were going to be? As I said in my opening statements, those changes may have been good, they may have been

bad, but they were profound, and I would hope that before we undertook that kind of thing somebody would have attempted to think

it through.

Mr. HOLTZ-EAKIN. There are a lot of different dimensions to your

question, and I will address them one at a time. The first is that

there is a lot of research on the importance of institutions, legal,

regulatory and accounting institutions for economic performance.

Senator BAYH. These specific proposed changes.

Mr. HOLTZ-EAKIN. These specific proposed changes, we have

seen——

Senator BAYH. The effect on innovation——

Mr. HOLTZ-EAKIN. Canada propose to——

Senator BAYH. —— [continuing]. And global competitiveness.

Mr. HOLTZ-EAKIN. We have seen Canada propose and implement

this.

Senator BAYH. I am sorry, we have seen?

Mr. HOLTZ-EAKIN. We have seen Canada propose and implement

expensing. We have seen the EU move there, but we have not had

a chance to observe what happens after the fact. But we will have

the chance to observe changes from regimes where you did not expense to where you did.

Senator BAYH. We will have.

Mr. HOLTZ-EAKIN. We do not have——

Senator BAYH. But have we as we are sitting here today?

Mr. HOLTZ-EAKIN. We do not have this exact isolated change, but

we have observed comparable events.

You talk about retiree health benefits, the evidence from that,

again not definitive, is that it did not change dramatically overall

valuations of firms. Investors were broadly aware of the——

Senator BAYH. It had a dramatic effect on——

Mr. HOLTZ-EAKIN. It had implications——

Senator BAYH.——[continuing]. Health care was treated.

Mr. HOLTZ-EAKIN. But the channels were—we can talk about

those channels, but in terms of the impact that we would see from

this expensing proposal, you would expect it to affect valuations of

firms.

Senator BAYH. Again, this gets to my first question, which is the

range of issues that you have to consider may in some respects be

different than the range of issues we have to consider, and while

it may not have led to the change in valuations, it did have broad

societal impacts that at least deserve some discussion and understanding before you embark upon a profound change I would think.

Yes, Mr. Herz?

Mr. HERZ. I will use some loose wording. Let us suppose that we

all agree that a proposed accounting change is absolutely right

from accounting, a strict accounting point of view, that it is the

right information. It provides better information, better capital allocation because people are now better informed and can make better decisions. Are we saying the truth hurts? I am trying to figure

this out because we are visited all day long by people from different

industries who will make cases like that. When we went to bat tryVerDate 11-MAY-2000 12:50 Oct 14, 2004 Jkt 095840 PO 00000 Frm 00051 Fmt 6601 Sfmt 6601 E:\DOCS\95840.TXT SCANNER PsN: SCANNER
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ing to deal with the special purpose entity problems that were

highlighted by Enron, and that turned out to be fairly widespread,

people would come to us and say: Yes, well, I understand it is really the company’s debt, but my special purpose entity is very good.

It allows the company to borrow more, to employ more people, to

do more R&D. That is good for the economy.

We had a person a while back come from—was advocating we do

something related to the steel industry as they were having some

problems, and he said: You know, the problem, the steel industry,

backbone of America, absolutely needed for national defense. And

I do not want to seem cynical here, but it is just that we are on

the front line of listening to these things. He said: The problem is

we are not cost competitive. We need to be more cost competitive.

The big problem there is we have all of these pension costs. You,

Mr. FASB, we want you to put all that in the footnotes, take it out

of the financial statements.

That is not going to make him more cost competitive. It is just

going to hide the information.

Senator BAYH. Of course. My point simply is to you that accuracy

is important. There may be consequences to changing the accounting treatment that I think at least from the broader societal perspective, you may reach a decision it is the right thing to do, let

us go ahead. But to ignore the fact that there may be other consequences, it seems to me, would be a dereliction of our duty.

Mr. HERZ. I absolutely agree with that. I agree with that, and

I thought you couched your opening remarks—you guys have a

tough job every day balancing the——

Senator BAYH. Which leads me to my last set of questions for all

three of you, which is, has there been any analysis done of some

of these other proposals that seek to strike a balance and to reconcile the competing differences, things that would treat large companies and small companies somewhat differently, things that

would restrict the exercise of options on the part of executives so

they could not game the system, so to speak, things that would encourage or treat differently companies that had broad democratic

use of options as opposed to those that were highly concentrated

among use?

There are several other suggestions that have been made about

how you might be able to try and reconcile these two things. Has

there been any attempt to look at those alternatives and to see how

they would kind of stack up versus the ones we have been presented with here?

Mr. HERZ. It seems to me they are not mutually exclusive, doing

the right accounting and doing some of those other things ought to

be potentially complementary. That is why I said that—and again,

I am advocating my public policy. That is my job, to do the right,

get the right accounting. But I believe very strongly in that, and

it seems to me that if you then say, well, I want to counteract, notwithstanding the accounting, I really want to continue to make

sure there are broad-based plans. Let us figure out some other way

through means at your disposal, taxes or whatever. And I understand that bumps up against other competing priorities.

Senator BAYH. It reminds me—and this will be my final comment, Mr. Chairman. It reminds me in some ways some of the curVerDate 11-MAY-2000 12:50 Oct 14, 2004 Jkt 095840 PO 00000 Frm 00052 Fmt 6601 Sfmt 6601 E:\DOCS\95840.TXT SCANNER PsN: SCANNER
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riculum we had in law school where we would focus on efficiency

analysis, what was the most efficient allocation of resources, and

you tried to enact the laws in a way that would promote maximum

efficiency. However, you also had to be aware that there were other

societal concerns in addition to efficiency, and there were times in

a democratic society that perhaps you would choose not to take the

most efficient path, you would try and quantify what the cost was,

but you were trying to achieve other objectives. I do not know

whether it is innovation or competitiveness. That is why I ask.

And, Mr. Chairman, I am concerned. What if any—there may be

none—but what, if any, is the effect on innovation? What is the effect, if any, on global competition? It is only then that you can see,

well, is there a tradeoff here, and if so, how big is it, and what is

the price we are paying for going one direction or the other?

Mr. HERZ. I am with you, but the best I can do is all the highlyesteemed people that have spoken, Mr. Greenspan, former Chairman Volcker, other people whose analysis seems to be that it would

not have those negative effects. I do not know what their basis is

other than the genius in their head.

Senator BAYH. Yes, Mr. Batavick?

Mr. BATAVICK. Yes. The only thing that I would like to add to

what Bob said is that for the most part this information is already

included in footnote disclosures. So when we first adopted our

Statement 123, the analysts and other users of that information

could very well have taken that information into account. I do not

believe there are any studies out there that show that putting the

information in the footnotes caused innovation to be hurt whatsoever. And also, if our proposal does go through and we do require

expensing on the income statement, that information will be readily available, be readily disclosed. We have specific disclosures

around that information so the readers of the financial statements

can tell exactly what the expense is of the stock options.

Although I do not have any empirical data, my gut tells me that

it should not hurt innovation because if it is a good business decision to have a stock option plan, then the accounting for that really

should not impact innovation in the company.

Senator BAYH. Then, Mr. Holtz-Eakin, I will let you finish up because you have been generous with your time, and there are other

hearings going on, unfortunately simultaneously. Your gut tells

you, your intuition tells you, that may all be exactly right, but I

go back to the retirees’ health care cost situation. You know, from

an accounting standpoint, absolutely, and it may have been, in fact,

the absolute right thing to do, but there were some pretty significant consequences, non-accounting consequences that flowed from

that. That had a big impact on society, and I think at least we have

some responsibility to try and anticipate what those impacts are

going to be, and is it, in fact, the right thing to do on balance? That

is really my whole point here today.

Mr. Holtz-Eakin, you get the last word as far as I am concerned.

Mr. HOLTZ-EAKIN. What I hear you saying, Senator, is that there

may be larger policy objectives than simply the good accounting

and that is certainly the case.

The evidence in the economics literature is that efficient well-informed capital markets on average engender innovation and proVerDate 11-MAY-2000 12:50 Oct 14, 2004 Jkt 095840 PO 00000 Frm 00053 Fmt 6601 Sfmt 6601 E:\DOCS\95840.TXT SCANNER PsN: SCANNER
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ductivity growth better than almost any other instrument that the

private market could imagine. It still may be the case that as a policy matter you might wish to, for example, target more societal resources toward the high-tech industry for a policy objective, and if

so, the efficiency question becomes whether an accounting tool focused on employee compensation is the best way to achieve that.

Senator BAYH. I am glad you mentioned that.

Mr. HOLTZ-EAKIN. That is the way to frame the issue.

Senator BAYH. Because Mr. Herz mentioned this in his remarks

too, and this really will be my final word. Do these interests in

some way compete? If so, how significant is it, and if it is in some

way significant, are there different ways to achieve the other societal objectives, innovation, global competitiveness, other than the

accounting treatment? And most importantly for us, Mr. Chairman,

have these questions been answered? It seems to me that is kind

of a big issue hanging over us today.

Thank you.

Senator ENZI. Thank you very much. I do have to comment in regard to one of your comments about the courage of the Big Four

accounting firms. I am told by businesses that the cost of doing this

binomial or the Black-Scholes calculation will run about half-a-million dollars a year. That is not courage. That is compensation.

I appreciate all the comments here. In that previous round, I

concentrated on both applauding you for the small business aspect

that you put in there, and encouraging you to go further, and I am

very encouraged by those comments. But I do have to ask just a

little bit about the stock option expensing itself.

Mr. Herz, I would like your comments on this statement: Key

valuation assumptions are subject to considerable judgment and

significantly affect option values. For example, a 5 percentage point

change in volatility, which you mentioned in regard to my bill,

which can be justified solely by alternative ways of looking at historical volatility, produced on the average a 15 percent change in

option value, a change in expected term from 3 to 5 years, again,

easily justifiable, produce on average nearly a 40 percent increase

in option value. The key assumptions are subject to so much judgment and guesswork that selections among a wide range could be

justified as the best estimates. The end result would adversely affect the comparability of financial statements of companies in the

same industry and at the same stage of development.

Do you have a reaction to that?

Mr. HERZ. Yes. We have met several times and our staff with our

panel of very knowledgeable people. We have also visited companies, and there is some judgment involved and there is some skill

involved in doing this. They posited though that the range would

be a lot tighter than you are stating, and certainly the ranges historically have been tighter than that, and that is because there is

some market discipline in all of this that goes on. There are the

auditors or the SEC looking at things. There are people that, quantitative people, buy side analysts and all that that compare one

company with another, and it imposes some discipline.

This is a real issue and we have posed in our book here, which

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ples for people, not the standard itself. We have posed a lot of questions around the valuation. Some people would like us to basically

get much more prescriptive so that you would almost ensure that

the range is very small. We could prescribe volatilities. We could

prescribe—we could take the term out of it and just see how long

the employee actually stays. All those things are possible.

We are trying to go along the lines of an SEC study that was delivered to Congress last summer on what is called principles-based

accounting, where they strongly advocated that the use of bright

lines and arbitrary uniform assumptions did not get to the best reporting. What got to the best reporting was diligent analysis and

judgment by the companies and by the auditors. I recognize, however, that there are tensions in this current environment. There

are people who—and I understand it—that are concerned with the

second guessing aspect, whether it be the trial bar or enforcement

agencies or whatever, and that is a much broader issue than I

think this particular topic.

All registrants now disclose what are called critical accounting

estimates, and those are inherent areas in accounting that have

significant judgment and impact on the reported financial statements. I can read you the one from—I just happen to have Intel

Critical Accounting Estimates: The methods, estimates and judgments we use in applying our accounting policies have a significant

impact on the results we report in our financial statements. Some

of our accounting policies require us to make difficult and subjective judgments, often as a result of the need to make estimates of

matters that are inherently uncertain. Our most critical accounting

estimates include assessment of recoverability or goodwill, which

impacts write-offs of goodwill, valuation of non-marketable securities, et cetera., valuation of inventory, and they go on and on and

on.

Senator ENZI. And they charge considerably for the work that

they do, and then put in a little protector from the trial lawyers,

right?

Mr. HERZ. No, this is something that the SEC put in, not the

other—it is to inform people that the income statement and the

balance sheet include a lot of estimates. We have a cash flow statement that, for those who say that accounting ought to be much

more cash-based, well, you have a cash flow statement, but there

is a whole package of financials.

Senator ENZI. I want to go ahead with that statement that I was

using because it goes on to say: Beyond the complex accounting

questions involved, the issue of employee stock options also raises

some significant economic considerations. Not only would the approach under consideration be harmful to mature companies, it

would impose the heaviest burden on emerging high-growth companies. There is some more to the statement, but that is enough to

get the flavor for it. That is from a Coopers & Lybrand letter of

February 5th, 1993, and the person to be referred to for questions

is you. I do not want to put you in the category of a reformed Senator, but——

Mr. HERZ. We live and learn.

Senator ENZI. I appreciate the testimony of all three of you, and

I do have quite a few additional questions in more detail. I have

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learned that if I do the really detailed questions here, it puts people to sleep, but it is information that we significantly need, and

particularly from Dr. Holtz-Eakin.

Thank you very much.

We will change now to the second panel, and I want to sincerely

thank the second panel for their patience and consideration, but

mostly for the outstanding testimony that they have that we are

about to put into the record so that it can be shared extensively.

While they are taking their position there, I would like to take

this opportunity to welcome our second panel to the Senate Committee hearing on the impact of stock option expensing on small

business. This is a rather large panel, and we look forward to hearing all of your comments on the important issue.

First I would like to welcome Dr. Keith Carron, the President

and Founder of CC Technology, and the CEO of Delta Nu, both

small business start-ups located in Laramie, Wyoming. I thank you

for coming here to testify, Dr. Carron, and let me personally thank

you for all you have brought to Laramie through your hard work

and enterprise. CC Technology and Delta Nu are great examples

of the positive impact that small businesses can have on our rural

communities.

Our second panelist will be Professor Stephen Diamond, and Professor Diamond is visiting us today from Cornell Law School, where

he teaches international corporate governance issues. He also fills

various advisory and consulting positions for large and small companies, and we thank you for coming today.

Next I would like to welcome Dr. Jere Glover back to the Senate

Committee on Small Business. Mr. Glover has worked on both his

committee and the House Small Business Committee and has testified before Congress many times concerning the matters of small

business, and we appreciate his expertise.

Following Mr. Glover is Marc Jones. He is the President and

CEO of Visionael Corporation, a small business located in Palo

Alto, California. He is here before us as a small business owner,

and an executive involved in every aspect of his company from

strategy implementation to administration.

Then we have—I am going to need some help with this name—

John Kavazanjian, the President and CEO of Ultralife Batteries,

Inc. Ultralife was incorporated in 1991 and has since become a

public company with offices in New York and England.

Then Mr. Robert Mendoza will be testifying. Mr. Mendoza is the

Founder and Chairman of Integrated Finance Limited, a global financial advisory committee. Mr. Mendoza is also a Managing Director of IFL Capital, which is a limited liability company, and the

U.S. broker-dealer affiliate of IFL.

Next we have Mr. Christopher Schnittker, the CFO of Cytogen

Corporation, located in Princeton, New Jersey, and Cytogen is a

publicly traded biopharmaceutical company that develops medicines for cancer, respiratory and other diseases, and as a fellow accountant, I welcome your comments and insight here today.

Dr. Smith was not able to be here so we will submit his testimony for the record.

We will begin then with Dr. Keith Carron of Laramie, Wyoming.

Dr. Carron.

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

OF THE UNIVERSITY OF WYOMING

Dr. CARRON. Thank you, Chairman Enzi and members of the

committee for inviting me here. I am President and Founder of a

technology small business start-up. We are in Laramie, Wyoming,

and I would like to explain the role that stock options play in the

development of our company and to tell you why I believe the proposed FAS 123 would be detrimental to our growth and perhaps

even our survival.

Our company was conceptualized in 1997 by two chemistry professors from the University of Wyoming, and I want to state right

off the bat that we did not follow the traditional rules of finding

large capital to start our company. Instead we wrote Small Business Innovation Research proposals and Small Business Technology Transfer proposals, otherwise known as SBIR and STTR

proposals.

We waited until the proposals were funded, then we incorporated

the company, and being two university professors, somewhat naive

in business, we added a third founder who is an expert in entrepreneurship. Since 1998, our company has acquired over $3.7 million in seed

capital from the SBIR and STTR programs. These grants have led

to two important outcomes, first as intellectual property in the

form of patents which are owned by the university and licensed

back to us for commercialization, and second, we developed a manufacturing division which designs, manufactures, and sells our

products.

The first outcome, I would like to comment, is a direct result of

the Bayh-Dole Act in 1980, which was conceived to capitalize on a

pool of knowledge that exists in academia. The SBIR/STTR programs have provided us with an avenue that takes this knowledge

from the university and to produce it in the marketplace.

The second outcome, our manufacturing division, has already

created jobs and wealth in Laramie. Laramie is a small community,

about 30,000 people. Companies such as ours are rare in Wyoming,

but we are now demonstrating how a technology based enterprise

can play a vital role in bringing new wealth to our community by

creation of high value-added products that are sold worldwide.

Our manufacturing division has grown out of a single engineer

and myself to a business with six full-time employees, and five

part-time employees. These employees have made significant contributions to the growth of the enterprise and will continue to do

so. In Laramie it is very hard to find key employees, so we have

to either retain them when we do find them, or we have to recruit

the experience from elsewhere. Recruitment requires cash. In a

start-up business cash is short. We are usually cash starved, and

as my business adviser reminds me, when you are out of cash, you

are out of business.

So one of the most important components of our cash preservation plan is to replace cash incentives with stock options. The best

method we have found is the IRS-endorsed Incentive Stock Option

Plan, which provides our employees with the opportunity to participate in the wealth creation from their own ongoing contributions.

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For example, we are now trying to recruit a high-salaried employee

from California, and the most compelling component of our offer

has been the stock option plan which will allow him to share in the

wealth that he will help create.

Lowering profits by expensing stock options creates, in my opinion, a circular problem. Under FAS 123, the options will be expensed, resulting in decreased profitability for my company. The

grantee is thus less likely to exercise the option, rendering invalid

the whole original assumption that the option has incurred an expense.

Our small business was funded by seed capital provided by the

United States Government through the SBIR/STTR programs, and

this model, by its very nature, leads to neutral income statements.

These programs are not intended, in themselves, to be a source of

wealth creation. When a company is ready to emerge from the

R&D mode and to commercialize, it must achieve and maintain

profitability to attract working capital. Expensing stock options

works against this goal and adds an intangible imbalance to the income statements.

Why do I say intangible? The majority of small businesses fail.

The expensing of options will only increase this failure rate, and

the irony is that the expense will never be incurred because the options will never be exercised.

Finally, to comment on how widespread the knowledge of FAS

123 is, a week ago I was approached by two bankers from

Wheatland, Wyoming. They wanted to bridge our company with a

Government agency, the Export-Import Bank, to support a working

capital line of credit. The Export-Import Bank is designed to help

small companies export their products and reduce the country’s

trade imbalance. But it is required right up front that their clients

have a positive net worth. I believe that by expensing stock options, we would decrease our likelihood of ever receiving this assistance.

I would also like to note that neither of the bankers from

Wheatland, Wyoming had heard of FAS 123, and I would also like

to note that when we formed our stock option plan through a CPA

firm, we were never told that they would show up as an expense

on our balance sheet.

I would like to end by saying that, I believe because of the recent

abuses highly visible by public companies, the FASB is trying to

create a solution, but it will have unintended consequences of doing

significant harm by slowing the growth or preventing the growth

of private small business start-ups.

Thank you.

[The prepared statement of Dr. Carron follows:]

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Senator ENZI. Thank you very much.

Mr. Diamond.

STATEMENT OF STEPHEN F. DIAMOND, VISITING ASSISTANT

PROFESSOR OF LAW, CORNELL LAW SCHOOL, AND ASSISTANT PROFESSOR OF LAW, SANTA CLARA UNIVERSITY

SCHOOL OF LAW

Mr. DIAMOND. Thank you, Chairman Enzi, for having this important hearing and inviting me to testify.

I will suggest today that, one, the expensing of stock options is

an important step towards restoring accuracy, transparency and

credibility to the American economy, and two, American managers

should reconsider their aggressive use of stock options as a form

of compensation because options create a hidden conflict of interest

between inside option holders and outside shareholders.

While there may be some difficulty for some companies in adjusting to this new regime, that will be temporary and it will be more

than compensated for by an overall lower cost of capital for those

same companies, and for those companies that are now only the

dream of a young inventor putting in long hard hours in a garage

or a university laboratory somewhere.

I am a law professor who specializes in corporate finance and

corporate governance, but my interest in this issue is not just an

abstract academic exercise. After graduating from Yale Law School,

I practiced corporate law in New York and in Silicon Valley for 5

years. While in private practice, I advised dozens of start-ups and

public companies, as well as the investment banks and venture

capital firms that provide them with financing. I continue to serve

as an adviser to start-up companies and was recently elected to a

seat on the board of directors of a small publicly-traded technology

company, where I also serve on the audit committee and chair the

compensation committee.

As an academic it is my job to study and help design institutions

to improve overall economic performance. An important principle

guiding such institutions in this country is our 70-year-old dedication to providing investors with the best information we can about

what is happening to their money. Failing to expense stock options

violates this core principle. It undermines the fragile relationship

between insiders and outsiders in our corporate system, thus raising the cost of capital for new investment projects.

It also creates an often hidden and little understood conflict of

interest between outside shareholders on the one hand and inside

option holders on the other. Granting corporate insiders huge option packages allegedly motivates the insiders to manage the corporation in the long-term interest of public shareholders. But this

argument is based on a mistaken assumption that stock options are

the same as stock. They are not. Options are a different financial

instrument from the stock that an option holder receives in exchange for the exercise of the option. In fact, recipients of options

do not look forward to becoming long-term investors in a company’s

stock alongside their fellow outside investors. No, instead they look

to the day when they can exchange their option for stock and then

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holders in the form of costly debt incurred by the company to pay

for the shares given to the option holders. In the world of stock options, insiders get paid first, and it is the remaining shareholders

who must pay them.

Investors provide the capital to entrepreneurs, who by virtue of

their specialized technical or managerial talent, are tasked with

the control of the day-to-day operations of a business. In return, investors expect those entrepreneurs will not only work hard on their

behalf, but will also be fair and honest in their dealings with them.

This relationship is known in corporate law as the separation of

ownership and control. When the separation between investors and

managers widens, it can cause money to stay on the sidelines.

Today investors are still reluctant to make the very risky and

uncertain investments that need to be made to kick start a recovery of the high tech sector. As one example of investor discontent,

at Texas Instruments, one of our country’s oldest and most successful high technology companies, 57 percent of shareholders voted

earlier this month in favor of a proposal recommending to the

Board of Directors that they expense stock options.

That is why it is so perplexing to me that so many resist such

a basic reform. In fact, Silicon Valley ought to be doing precisely

the opposite of what it is doing. It should be showing as much leadership and innovation on this issue as it does on basic scientific research and development. Is it not just a bit strange in these circumstances that corporate managers want to deny their own investors access to vital financial information such as the impact of

stock option grants on the overall value of the company? That stock

options have value is certainly beyond debate. It is confirmed simply by the fierceness of the opposition to expensing them. One can

only conclude that the defensive posture of some is about protecting

a strategy of shifting wealth from outside investors to insider option holders, when the insiders have a significant advantage in assessing the real value of the company.

This increases investor uncertainty about value, and thus damages the credibility of all potential entrepreneurs who hope to raise

capital for new companies in the future.

Thank you again for the opportunity to share my views with you

today. I ask that my written statement be submitted for the record,

and I look forward to answering your questions.

[The prepared statement of Mr. Diamond follows:]

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Senator ENZI. Thank you very much. Everyone’s full statement

or additional statement, if they want to submit it for the record,

will become a part of the record. We do appreciate your testimony,

so even if you have a couple of additional thoughts that you need

to put in, that is welcome as well.

Mr. Glover.

STATEMENT OF JERE W. GLOVER, BRAND AND FRULLA,

WASHINGTON, DC

Mr. GLOVER. Thank you, Chairman Enzi. I am pleased to be here

to testify about FASB’s proposal to expense stock options.

While I have been and am a CEO of several high-tech companies,

my primary experience in my career has been involved in helping

reduce regulatory burdens on small business and create a fair marketplace and playing field for small businesses. The one thing that

I have learned is that one size does not fit all. That is true in shoes

and it is especially true in standards and Government regulations.

During the last 3 years of my experience as Chief Counsel for

Advocacy at the Small Business Administration, we reduced unnecessary regulatory burdens on small businesses by over $20 billion.

We were consistently faced with agency claims that protecting the

public interest forced the agencies to place specific burdens on

small business, just as FASB is proposing to do now.

These officials routinely said that if their regulations were not finalized exactly as they had proposed, that the environment, worker

safety, investor trust, or whatever, would cease to exist.

Forced to reexamine the problems that their regulations were

causing, agencies found that small businesses were not the cause

of the problem in most cases, and that the regulatory burdens they

were proposing were unnecessary and could be modified. In some

instances small businesses were completely exempted and the public interest was still served.

I oppose any agencies or organizations that are imposing unnecessary and unintended burdens on small business. FASB’s proposal, if finalized as proposed, while well intended, will have a devastating impact on growing small businesses, especially those in

Government contracting and those who need to finance their businesses. The burdens in dollars, lost management time and lost opportunities will adversely affect innovation and job creation in

America.

Let me explain why I believe the expensing proposals will have

an adverse impact that is contrary to the public interest. First,

many companies will simply stop giving employees stock options.

This to me is the worst possible outcome because it would deprive

them of key employees that are necessary to grow and expand their

businesses.

Second, many companies will find that they cannot comply with

the requirements simply because of the cost will be prohibitive.

Third, for those companies who choose to comply, what if they

are Government contractors? Will they be determined, because they

have negative net worths and negative profit statements, to be financially not feasible. Under the FAR Regulations, they are not

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rowing, as the first witness just talked about on this panel, will the

banks understand when they come in with negative financials?

More importantly, will the Government agencies like the ExportImport Bank, or like the Small Business Administration, make an

exception? And what is going to happen when the auditors from the

Federal Reserve, Comptroller of the Treasury and FDIC come into

the bank and say, look at the financials of the companies you are

lending to. I think that that is going to create an additional problem.

Of course, there is the issue of tax consequences on how these

options are being treated. Today there is a good bit of flexibility,

and I certainly use that in my companies and I know many, many

companies do have that flexibility. Will FASB’s new proposal

change their ability to have that flexibility? I suspect so.

FASB could have avoided this problem if they had, one, adequate

representation on the board itself, who fully understood small business and implications. One of the critical problems here is they do

not understand—and accountants, by and large, many of them do

not understand—how tight cash is for starting companies. They do

not have $100,000 or $200,000 or $300,000 to spend on valuation,

and even if they did, it would be taking away from other activities.

If they had done a regulatory flexibility analysis. If they had

even looked at the opportunity to propose separate regulations for

small businesses, they would have proposed different regulations

for small businesses. There is no tiering of their proposed regulations. Of course, they could have easily exempted small businesses.

The Regulatory Flexibility Act, which applies to all Federal and most State agencies, has had a phenomenal impact, $40 billion of

regulatory savings to date. FASB has completely ignored it.

Under the circumstances, I think that you have to look at the situation. The SEC has found it could live with the Regulatory Flexibility and live well with it, and they do a wonderful job. Had they

considered small business at the beginning, I do not think we

would be here, and I do not think they would be under the pressure that they are under now. I think small businesses have historically, these solutions that we have talked about are not new.

Each White House Conference has recommended them. Congress

has recommended them. Most Presidents have required them.

FASB has chose to fit everything into one-size-fits-all, and quite

frankly, that is not proper.

Thank you.

[The prepared statement of Mr. Glover follows:]

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Senator ENZI. Thank you very much.

Mr. Jones.

STATEMENT OF MARC JONES, PRESIDENT AND CHIEF

EXECUTIVE OFFICER, VISIONAEL CORPORATION, PALO

ALTO, CALIFORNIA

Mr. JONES. Thank you, Mr. Chairman. My name is Marc Jones,

and as you mentioned, I am the President and Chief Executive Officer of Visionael Corporation. I appreciate you giving me the opportunity to share my views on the recently released Financial Accounting Standards Board draft calling for the expensing of these

broad-based stock option plans that are so prevalent and in favor

in Silicon Valley, and the impact of this proposal on small businesses like Visionael.

Our small business is a leading provider of network security and

network management solutions designed for the largest and most

complex corporate government and service provider networks. We

have more than 60 large customers worldwide including customers

like Sprint, Verizon, EDS, IBM, the Pentagon and the White House

Communications Agency.

Thus, the importance of the stock option issue in front of the

committee cannot be overemphasized. Broad-based stock option

plans have given me the opportunity to live the American dream.

I have been able to buy a house, send my children to good schools,

and now be the CEO of a small business. Broad-based stock option

plans have also given quite a few Visionael employees the possibility to dream that dream that they themselves can be entrepreneurs, that they can be partners in owning a business and that

they can dream one day of the financial success and the rewards

that are associated with our company’s success.

Now we have a stock option system that works, and it is being

threatened by FASB’s current exposure draft. FASB is proposing to

require all businesses, including small businesses like Visionael, to

use a complex formula to calculate the value of stock options, and

count that inaccurate cost as an expense. The FASB proposal will

curtail or perhaps even eliminate the ability of small business owners to offer our employees stock options.

There are a number of problems with the FASB proposals. Fundamentally, small business owners are opposed to the creation of

inaccurate expenses on our financial statements. Our survival is

predicated on being able to provide our customers, our suppliers

and our financial backers accurate, easy to understand financial

statements. For example, an important component of Visionael’s

capital structure is a line of credit we have with a local bank. They

provide us funds while we wait to collect monies owed to us by our

customers. However, any borrowings under that line of credit must

be repaid if we are unprofitable. Thus, including inaccurate expenses related to our stock option plan into our financial statements could have the impact of us losing an important source of

capital for our business.

In addition, it will be difficult to absorb the additional cost of

complying with the FASB proposed regulations. We will need to

hire outside consultants, some of those accounting firms that you

mentioned earlier, along with additional finance personnel in order

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to comply with the FASB regulations. I currently estimate that

Visionael compliance could easily cost us $100,000 or more annually. This means that we will not be hiring two additional engineers, sales people or perhaps we may not undertake certain marketing programs that we would otherwise invest in. These compliance costs are true hard costs, and we will be using expensive capital to pay for them.

I am going to move off of my prepared remarks for a minute because I listened to the panel previously, and the problem that I am

having with the previous discourse is that I hear lots and lots and

lots about policy this and economic that, and that footnotes here

and all that stuff.

The reality of it is that this is equity. It is a form of equity. Who

has what piece of the pie? And from a financial-statement perspective, 97 or 98 percent of the issue is a balance sheet issue of, if you

look at the company, how is it split up. We currently handle 97 and

98 percent of the issue already on the balance sheet, with full disclosure to anyone—investors and other people interested and other

stakeholders in the country.

We are now talking about 1 or 2 percent of this issue, and we

are potentially creating rules, and regulations and costs on small

businesses that none of the previous panel talked about the small

business. They couched it in terms of Texas Instruments that, and

HP this, and whatever. That is not the point. The point is how are

small businesses supposed to deal with this situation, and what impact will that have on their cultures, their people, their environments, and their opportunities to be successful? So, from

Visionael’s perspective, and I represent—I am one of the ‘‘they,’’

right? Our company is a venture-backed technology company that

is trying to create value for our customers here and around the

world. We do not get it. And the impact of these proposed regulations on our business are very, very ominous, and for us to willynilly look for the truth—the question was about, what is wrong

with the truth? Well, if we could come up with the truth, it might

help. And the question is what is the cost of getting to the truth?

So those kinds of considerations, in my humble opinion, need to be

addressed as part of what we do, the decisions that this committee

is responsible for making.

So I apologize for taking more time, and I thank you, and I

would be happy to answer any questions you might have.

[The prepared statement of Mr. Jones follows:]

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Senator ENZI. Thank you very much.

Mr. Kavazanjian.

STATEMENT OF JOHN KAVAZANJIAN, PRESIDENT AND CHIEF

EXECUTIVE OFFICER, ULTRALIFE BATTERIES, INC.,

NEWARK, NEW YORK

Mr. KAVAZANJIAN. Thank you, Mr. Chairman. Thanks for allowing us to express our opinions. I hope I can be as eloquent as Mr.

Jones.

The issue of expensing of stock options is a very significant one

to us. We make batteries. We are a small company in Upstate New

York, Newark, New York, outside of Rochester. We have been in

business for 14 years. Five years ago, I became the President, and

the company had never been profitable. We are now profitable, over

the last year, and we employ 900 people now, up from about 250

several years ago, and stock options are a very important part of

the way we have been able to attract and retain our professional

talent. Without the engineers, the sales people, the professional

managers in the company, there would be no work for the 75 percent of the people who come in every day to make batteries.

Expensing stock options serves no useful purpose in the basic

reason we do financial reporting. That is what everybody is missing. Implementing the standard will hurt everyone, but the big

companies do not notice it. It will fall heaviest on the small and

growing companies like Ultralife, and I will tell you why.

First, financial reporting has one purpose. It is to provide the

shareholders with the information on the operational performance

of the firm and the data on which to calculate the value of the firm.

There are multiple methods for this, and most of them come down

to a discounted present value of cash flows, but the fact is that expensing stock options has no added value to that function.

It provides cash, when people exercise them. We are missing

that, also. People actually have to buy the stock. And, number two,

it dilutes the stock. Well, we already do a Treasury method dilution

which takes into account that. It hurts us in our EPS when stock

options are exercised. It is accounted for already. Both of these effects are very adequately accounted for.

And, in fact, I was thrilled to hear some of our previous people

say, in the footnotes to the financial statements, all of the data is

there already. So what purpose is the rule aimed at?

Well, it seems it is not aimed at giving investors an easier way

to evaluate a company. In fact, it is going to do the opposite. It is

going to make it tougher. And for small companies like us, who do

not have all of this analyst coverage to go wade through it, I mean.

Certainly, McDonald’s, and Microsoft, and AT&T, no problem. The

analysts will just back it out. What it is aimed at is to curb excessive executive compensation. I cannot think of a less-effective way

to do this than through an accounting change; that really obscures

the real operating effectiveness of a company. Put in restrictions,

put in standards, put in additional shareholder approvals, take

away the tax deductibility, any of that stuff, but do not screw up

the one way we reflect to our shareholders how we are doing and

what we are worth.

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For a small company like us, there is a whole bunch of things

it is going to do:

First, it is going to make it harder to attract talent. I mean, you

hear that from anybody here. We have to compete against stable

companies in our area, like Xerox, Kodak, and Bausch and Lomb,

three large companies that are very stable. People take a risk when

they come to work for us. We have been able to give stock options

to the lowest level of the company. The majority of our grants go

to non-executives. It is a major reason we did not lose people when

we went through tough times in retrenching the company, and it

is a major reason why we retain our talent ever year. The shareholders want this, and they approve of our option plans.

I have done well, because I took a risk in joining the company,

coming from Xerox, on the stock options. I have investors who call

me up and say, ‘‘We are really glad that you are doing well on it

because you earned it.’’

We have been able to grant those stock options down into the

company. We have a big challenge, as I said, of being noticed by

the marketplace. Most investors look right to the bottom line. And,

in fact, we made money in the first and second quarters of last

year for the first time. I think—I have not done the detailed calculation—but when our stock went up, if we redid the calculation,

we probably would have had to take a charge that would have put

us in a loss position in the third quarter. Imagine sitting in a conference call and saying to your investors, we did great this quarter,

but we lost money because you wanted our stock so badly, the price

went up. It is hard to understand. We increased the value of the

firm. We had a positive cash flow. We had good results from operations, but we would have had a loss. It does not make sense.

We need access to capital. I think Mr. Jones was exactly right.

We are going to bump up against loan covenants. It is going the

put a damper on the share price. I do not want to get too technical

on finance, but the corollary to the Modigliani-Miller papers, which

are the seminal paper on valuing a firm, from Merton said that if

you have less information about a company, the share price will be

down because of systematic risk. This is what is going to happen.

It is going to obscure information about the company, and it is also

going to put more overhead in our financial statement. So $100,000

is probably kind of what we are looking at here. We have already

doubled our accounting costs because of Sarbanes-Oxley. I am not

going to begrudge that, because if it helps investor confidence, we

will do what we have to do, but this does not help investor confidence.

And the last thing is it is going to cause is fluctuations. When

interest rates change and basic assumptions change, we are going

to have a duty to redo these models. So the better we do in some

cases, the worse we are going to do—because we are going to take

a charge—and then the worse we do, the better we are going to do

because when they reverse that charge, it will actually increase the

fluctuations, and fluctuations are bad for companies like us because

investors are worried about stability.

So it just seems like this does not make sense to me and to a

lot of people here. We cannot let the accounting community bow to

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quately disclosed, it is already accounted for in our EPS, and it

adds nothing to the ability of investors to judge us as a business.

It is going to hurt our access to capital, it is going to hurt our ability to invest in capital, to reduce our cost of labor so that we can

keep production in the United States, and it is going to hurt jobs.

It is disproportional on small businesses. The big ones, it is not

going to hurt as much, and that is why they do not want to fight

the political battle, and they are just letting it happen.

I will also be happy to answer any questions, and thank you so

much.

[The prepared statement of Mr. Kavazanjian follows:]

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Senator ENZI. Thank you very much.

Mr. Mendoza.

STATEMENT OF ROBERTO G. MENDOZA, CHAIRMAN,

INTEGRATED FINANCE LIMITED, NEW YORK, NEW YORK

Mr. MENDOZA. Mr. Chairman, I would like to thank the committee for giving me the opportunity to testify on this important

matter. I do so with some trepidation, though, as you will understand in a second.

I believe that the FASB’s position is generally correct, and furthermore that the expensing of options will, in fact, prove beneficial

to small businesses and the entrepreneurial spirit. Essentially, I

conclude that the analysis of the expensing issue does not differ

materially for small companies relative to larger ones and that no

constituency benefits from omitting any compensation costs from

the income statement.

The fundamental point, of course, is whether or not options represent an expense; that is to say, a cost which should be deducted

from revenue in the income statement in the same way as all of

the other forms of employee compensation. Since there is general

acceptance that options are a highly valued form of employee compensation, it seems clear that they should be expensed provided

that it is feasible to measure adequately the cost to the issuer of

expensing them and, B, that there is no public policy imperative to

require a different, legislatively-mandated accounting treatment.

Financial markets provide compelling evidence that it is perfectly

practical to value options which are far more complex than employee stock options through the use of models. Each day literally

billions of dollars are traded based on models which depend on the

fundamental insight of the Black-Scholes-Merton formula. While it

is true that models will only provide an estimate of the cost of

granting options, this is not a reason, in my opinion, for not expensing them. The preparation of financial statements requires

judgment and a great deal of reliance on estimates; for example,

amortization and depreciation schedules and the value of intangibles such as R&D expenses, to name but two. Model-based expensing of options provides approximately the right answer. Failure to

expense options provides a precisely wrong answer because, clearly,

the cost cannot be zero.

I do not believe that the argument that expensing options

through the income statement results in double-counting of the expense withstands logical scrutiny. To make the point with an extreme example, let us assume two identical companies, each with

annual income of $100,000, and each with non-employee compensation expenses of $20,000. So, at that level, we have $100,000 of revenue. Both companies have $20,000 of cost. However, one company

pays its employees $10,000 in cash, plus sufficient option grants to

enable it to attract and retain the employees it needs, and the

other pays its employees solely in cash of $40,000. These two companies are otherwise totally identical. The only difference is that

one of them pays its employees wholly in cash, the other one pays

them partly in cash and partly with options. If you fail to expense

the options, the first company will record pre-tax income of

$70,000, while the second one will show pre-tax income of only

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$40,000. Such a result distorts the comparability of financial statements even between two otherwise identical companies.

My final point is that expensing options will actually benefit

small companies and encourage start-ups. The calculation procedure will not impose a material cost on management either in

terms of time or expense, and in a moment, rather than give you

an estimate, I am going to give you some precise numbers. Income

statements which properly reflect the real costs incurred by the

business, specifically including all of the compensation costs, will

make it easier to attract capital because investors will be able to

measure properly the potential returns from the investment.

My conclusion is that it would not serve the public interests for

the Congress to mandate a different accounting treatment, but I

make this point not simply from a theoretical corporate finance

perspective, but also from recent personal experience.

In December 2002, my two partners—Peter Hancock and Bob

Merton—and myself raised a substantial amount of money from

third-party investors to found an international firm, IFL, which

you referred to in your opening, Mr. Chairman. Our goal is to do

an IPO within 5 years. We, too, are living the traditional American

Dream. We have made considerable progress during our first year.

We now have 40 colleagues—we did not start in a garage. We

started in a spare office at a law firm with three people—we now

have 40 colleagues, are licensed as a broker-dealer in the United

States and Japan and are growing rapidly. We told our investors

that we planned to expense compensatory options, whether or not

we were required to do so, before we started the company.

We believe that this commitment to realistic and transparent accounting helped us to raise the capital for a venture which was

both highly risky and highly ambitious.

Thank you.

[The prepared statement of Mr. Mendoza follows:]

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Senator ENZI. Thank you very much.

Mr. Schnittker.

STATEMENT OF CHRISTOPHER P. SCHNITTKER, SENIOR VICE

PRESIDENT AND CHIEF FINANCIAL OFFICER, CYTOGEN

CORPORATION, PRINCETON, NEW JERSEY

Mr. SCHNITTKER. Thank you, Senator Enzi, for the opportunity

to participate in this hearing and to round out this panel. My name

is Chris Schnittker, and I am a Senior Vice President and the

Chief Financial Officer of Cytogen Corporation. I am here today on

behalf of my company and millions of other public and private

small companies that stand to be seriously impacted by the proposed accounting rules set forth by the FASB in their recent exposure draft on share-based payment.

First, allow me to provide a brief description of my company and

how it relates to this hearing. Cytogen Corporation is a small, publicly held biopharmaceutical company located in Princeton, New

Jersey, at the very heart of the East Coast pharmaceutical corridor.

We recently have grown to 65 employees, most of whom are dedicated to selling and marketing our two lead oncology productsQuadramet, a therapeutic radiopharmaceutical to ease the pain of

metastatic cancer, or cancer that has spread to the bone, and

ProstaScint, a monoclonal antibody-based molecular imaging agent

used to image the extent and spread of prostate cancer. We are

also developing Combidex, a novel molecular metastatic lymph

node imaging agent which is currently under review by the FDA.

Further, we support a research and development joint venture to

develop prostate cancer therapies based on our proprietary prostate-specific membrane antigen, or PMSA, marker technology.

Clearly, each product or product candidate addresses the serious

and substantial unmet medical needs of cancer patients and the

physicians who serve them.

Cytogen relies on the dedication and drive of our board of directors, officers and employees to achieve its reach on our currently

marketed products and to progress its other product candidates

through the long and expensive process of drug research and development. To this end, we have chosen a compensation program for

our employees which includes, among other elements, stock option

grants and participation in an employee stock purchase program.

Our stock option program is a broad-based one, granting stock options to every employee of the company, from our CEO, to my department’s staff accountants, to each of the company’s administrative assistants. We believe such a program best aligns the interests

of all employees with that of the company and its outside shareholders—simply stated, improving shareholder value—but also

boosts productivity and allows each and every employee to own a

part of our success. I would suggest it also allows them to feel some

of the pain of an unsuccessful business or a market downturn with

underwater stock options plaguing our industry during the past

few years.

At the company level, stock-based compensation allows us to attract, retain, and motivate highly qualified scientific and management personnel, many of whom are courted by the Fortune 500

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trate the difference between those pharmaceutical companies and

Cytogen, I offer a very brief story.

From the window of my offices in Princeton, which literally sits

in the shadow of a Top Five pharmaceutical company, I often watch

their corporate helicopter deliver people from their New York City

offices for meetings, a trip that probably takes them, at best, 20

minutes. This is the same trip that my CEO and I have done several times a week, by car or by train, which often take upwards of

3 hours each way. I certainly do not begrudge this company its success. In fact, in certain aspects of our business, they are a critical

business partner of ours. But I do hope that someday Cytogen has

access to that level of capital, where private aircraft is a necessity

rather than a distant luxury. As we are both competitors for the

same intellectual capital in the oncology drug development arena,

clearly, much of the deck is stacked against a company like

Cytogen because of its size and resource constraints. The promise

of stock-based compensation among the smaller companies’ employees help to level this playing field.

Further, on our employee compensation model, as the cash outlays for our employee health insurance programs and defined benefit pension plans increase exponentially, we—and most other

smaller start-up companies—look to non-cash compensation to supplement cash compensation so as to retain and motivate our employees. In order to compete with large pharmaceutical companies,

we need to be able to offer meaningful equity compensation in lieu

of the larger cash salaries, bonus programs and other perks offered

by other employers in our industry.

I am afraid that, with the expensing of stock options, small businesses will be denied yet another form of compensation to level the

playing field and its larger counterparts in the industry. We may

investigate the same moves made by other companies towards restricted stock grants and performance-based stock options, but each

carries with them a complexity that can be difficult for small companies to administer and equally difficult for rank-and-file employees to understand and, perhaps more importantly, believe in their

value. Even with those new compensation methods, I hope we will

be able to keep the critical ownership and entrepreneurial spirit

alive across all employees at Cytogen.

One of my responsibilities as the chief financial officer is to budget and plan for our future growth, but also to allocate our scarce

capital resources, both human and financial, in the pursuit of our

corporate goals. The appropriate mix of cash-based versus equitybased compensation for our employees is just one of these decisions. Clearly, the current market has told us that companies who

have not yet set a clear course toward a sustainable and profitable

business model will not survive. This initiative is especially challenging in the biotechnology industry with our 10-year-plus drug

development time lines, disappointments or delays inherent to research and the enormous capital required to progress that research

in a timely way.

Cytogen has made several conscious choices in this regard, and

we believe the market has rewarded us by moving from a market

capitalization of just under $30 million in late 2002, to a current

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market capitalization of $230 million, a greater than 600-percent

improvement in shareholder value.

I would like to sum up my comments with my reflections as to

why, and perhaps other employees like me, choose to work for

small, development-stage businesses. It is not for the stability of a

big company around you with adequate capital to ensure its existence, it is not for the businesses that, to some degree, run themselves due to their market share on vast resources. Among many

other reasons, it is simply the speed of innovation, a responsiveness

to change, the ability to work with leaders and coworkers who embrace entrepreneurial spirit and the chance to change the face of

a dreaded disease like cancer and improve the quality of life for the

patients and their families who are affected by it.

On behalf of Cytogen and other similar small businesses, I sincerely appreciate the opportunity to express our views on this

issue.

[The prepared statement of Mr. Schnittker follows:]

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Senator ENZI. Thank you.

I want to thank all of the panelists for their enthusiastic and

varied testimony. It covered a wide range of information here. I

also want to thank Chairman Herz for staying and listening to the

comments. There was just a tremendous amount there, and I think

it helps to explain a little bit why some of the big mature companies are particularly excited about expensing theirs and why small

companies may not be. I am reminded, when I went to Kyoto for

some of the negotiations on global warming, and when I got there

I found out that the United States was the only country that was

there under the impression that it was an environmental conference. All of the rest of them realized it was an economics conference, and we took some blows as a result of that, and some of

the other countries did very well.

This is perhaps a mature versus growing company issue, but I

do really get excited when I’m around small businessmen, and I

know that it is that excitement that you have and your understanding of what you are doing that is really the secret to the success of your companies. You have taken some risk and been willing

to do that, and I have no doubt that the companies here will succeed.

Mr. Kavazanjian, did I get it?

Mr. KAVAZANJIAN. Yes.

Senator ENZI. All right. Your presentation made me think that

your batteries will do better than that company that has the funny

bunny.

[Laughter.]

Mr. KAVAZANJIAN. We hope so.

Senator ENZI. You really did a great job. All of you are excellent

spokesmen on the issue, and again there is that variety of information, and I want to get into that a little bit.

I will start with Dr. Carron because you have worked with SBIR

and STTR and competitively competed for awards. Will the stock

option hamper the growth and ability of firms to participate in

that, and can you provide any examples of areas that it might have

an affect on the business?

Dr. CARRON. Well, those programs, again by their very nature,

you write a budget, and at the end of the grant period, you had

better have matched your budget. So they lead to balanced income

statements.

If we try to attract employees through the stock option plan, that

will give us a negative balance on our income sheets and, I believe,

lead to the failure of our company just because we will not be able

to grow out of that R&D mode into a mode that actually manufactures and sells products, which I believe is the goal of the SBIR

and STTR programs.

Senator ENZI. Right. When you get one of those grants, it is my

understanding that you are routinely audited. Do you think there

would be any concerns on how the expensing of options is done and

what impact that might have?

Dr. CARRON. Well, you are correct. We do have to undergo an annual audit. I am not sure how the agencies would view a negative

income statement, but I am sure it would be a bad strike on our

company.

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Senator ENZI. Thank you.

Mr. Schnittker, you broke away from a large pharmaceutical

company to pursue a specialized niche in technology, and one of the

things that kind of is in the back of my mind is can all of your employees pronounce the names of the stuff that you have? Is that a

part of the test?

Mr. SCHNITTKER. I think we work very hard to try to make those

names difficult to pronounce.

[Laughter.]

Senator ENZI. I was impressed that you just rattled those off. But

you have pursued a specialized niche in technology, and given that

your firm was able to retain and recruit personnel, and you said

through stock options, how would you propose to recruit and retain

employees if this rule is finalized this way?

Mr. SCHNITTKER. Well, there are other alternatives that are out

there. It is something that we have considered a lot lately. In fact,

just two weeks ago, we took on a very important hire who was an

individual from Amgen. It involved a relocation to the East Coast,

and he will now be our senior vice president of sales and marketing.

One of the considerations that obviously any employee makes

when they decide to come on with a firm is what the package is

worth and what the company offers. For us, we are looking at

things like restricted stock programs, perhaps increased compensation, perhaps increased bonus programs, a variety of other things,

many of which are cash based, which is difficult for us. Capital

comes at a great cost. I heard somebody else on this panel mention

that.

The other option that we are looking into are performance-based

stock options, which have a little bit of a different accounting impact, but are extremely difficult to administer, especially in the

rank-and-file employee range. It is very difficult to create a series

of objectives that are quantifiable and measurable for absolutely all

of your 65 employees.

My CEO is compensated with stock options that are performance

based, and I think that is very important, and it is very clear to

identify for a CEO what his four or five goals are over the next 5,

10 years, but I really question our ability to do that much broader

than senior management.

Senator ENZI. So the other employees there, their performance

measurement is how well the stock does, then.

Mr. SCHNITTKER. How they support the company and its success.

We have a very robust goal-setting program. We have a lot of requirements that go right down into the individual departments:

Clinical Development, Research, Sales and Marketing. So they all

understand what their piece is of the bigger pie, and as long as

they do their piece, the theory is that that will support the company’s success.

Senator ENZI. I have been trying to get the Federal Government

to do a performance and results type of compensation. I have not

had much success.

Thank you.

Professor Diamond, on the last page of your written testimony,

you mentioned getting rid of options altogether. So are you against

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stock options or just because they are accounted for differently at

the present time? I am curious as to that statement.

Mr. DIAMOND. I think that stock options, as I suggested in my

oral statement, create a conflict of interest between the

optionholders and outside investors. And we have to keep in mind

that wherever there is a small business, there are also lots of small

investors, and they deserve a clear and unbiased picture of the financial condition of the company. And I think stock options induce

insiders, and particularly senior managers, to manage the company

in a way that increases risk and volatility and then distorts the

outcome for the company.

So, in the long run, I think that we should move away from stock

options. I favor use of restricted stock or cash-based forms of compensation.

Senator ENZI. So that would be why it was noticeably absent in

your testimony—any discussion about the accounting of the evaluation process, which is one of the concerns of the small business is

how you get to that number.

Mr. DIAMOND. Well, I am not particularly troubled by the resources that will be required to provide accurate valuation. The

market does it already in part, and I think that services will

emerge to provide that for small companies, if it is necessary. I

think we have to be very careful here about blurring the lines. We

are talking about small companies that want to go public. Stock options for small companies that do not want to go public are really

irrelevant. So we are talking about small companies that want to

tap into the public markets. That is where the options have real

value for the employees.

That talented individual did not leave Amgen to join a small, I

am sorry, company that I had not heard of before in Princeton,

New Jersey, right, because he expects to be part of a private company for the rest of his life. He expects it to be a public company

and to sell his shares into the public markets at some great profit

to himself. So we have to be careful that we do not blur the line

between all 22.9 million small firms in this country and maybe the

million or so that really are looking to tap into the public markets.

If you are looking to tap into the public markets, you are tapping

into the large retirement systems of America’s workers, teachers,

toll booth collectors, police officers, nurses, et cetera, whose retirement assets provide the fundamental capital that goes into our

public markets. And those individuals deserve a clearer, better picture, more accurate picture of the financial condition of these companies. It seems appropriate for certain small companies that intend to move in that direction to begin to adopt the FASB approach. A company that does not intend to go public does not have

to because they do not have to use GAAP accounting. So really, the

option for many small companies is just to ignore the FASB.

But if you are going to be talking about tapping into the public

markets, where the real payoff is for these individual employees,

you are living in a different world.

Senator ENZI. I will move to Mr. Mendoza because we are talking

about here, at this point, the ability to easily calculate that. Mr.

Mendoza, you used to be with JP Morgan as an investment banker,

and so you worked with Mr. Merton of the Black-Scholes-Merton

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valuation model. Last year, JP Morgan Chase entered into an

agreement with Microscoft, where JP Morgan Chase would buy the

outstanding stock options of the Microsoft employees, and based on

our calculations, the pricing is well below the valuation that would

occur of Black-Scholes-Merton was actually used.

How would you account for the discrepancy, especially since

Microsoft is one of the most heavily followed stocks by researchers?

If they do not use Black-Scholes-Merton, then why would small

growing companies do it? They made a major shift, and you probably have some insight into that for us.

Mr. MENDOZA. Well, I will try, Mr. Chairman.

First of all, in terms of my own background, I did work for JP

Morgan for 31 years, but left before the merger with Chase Manhattan. So I was not involved in that particular transaction. I do

know something about it and have, together with my partners,

written about it in an op-ed piece.

I think that the fundamental point that I would make is that the

purchaser of those options—in that case, the bank—did use a pricing methodology which was either a naive Black-Scholes model or

some variant, as the chairman of the FASB discussed this morning.

Those valuation models all have a common heritage. They are not

different in the way that has been represented, but I think it was

as simple as the buyer using a valuation model, and the seller not

doing so. The seller got too low a price, and the buyer got the difference. It was pure economics.

Senator ENZI. But heavily discounted.

Mr. MENDOZA. Absolutely. It was heavily discounted because the

buyer did use the model and bought the options at a lower-thanmodel price.

Senator ENZI. You were able to raise $45 million, I think, to start

an international investment banking firm and are planning to do

an IPO?

Mr. MENDOZA. We are hoping to, but it is a few years away.

Senator ENZI. Have you evaluated what the cost of expensing

your stock options will have on the ability to do that IPO?

Mr. MENDOZA. Yes, sir. We think it will facilitate it, as it facilitated the raising of the money because we believe that honest,

transparent, realistic accounting just attracts buyers. As Chairman

Greenspan has recently said, we believe that the market is going

to place an increasing premium on the integrity of financial statements and not counting a very important part of your compensation cost, expensing some of it and not the rest of it, does not, I

think, promote integrity of financial statements.

I did mention in my prepared remarks that I was going to give

you some numbers on the actual costs in terms of time or money

of expensing options. Our small company has just negotiated an

agreement with a new investor who is going to purchase around 10

percent of our stock. He, quite appropriately, asked for audited

statements which we did not have. Our accounting firm is

PricewaterhouseCoopers, and we asked them how long it would

take to provide audited statements from the drafts they had already given us, and it takes about 3 weeks.

The draft came back yesterday, and one of the things that had

not been done was to expense our options. So we called up and

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said, well, we need to expense the options because that is what we

believe is right. They told us that under APB 25, you could use a

zero volatility assumption which, again, would result in no expense. We said, no, we need to expense them, but we do not want

to be silly about this. If it is going to delay the process so we cannot raise our additional funding, we will not do it. We are not required to.

The answer came back that it would not delay the process, it

would not increase the cost of our audit, and we computed the

number, the actual expense number, in under 20 minutes.

Senator ENZI. Thank you.

Mr. Glover, since FASB is not a Federal agency, but a privatesector entity, are there any remedies available to small business if

FASB does get it wrong?

Mr. GLOVER. I do not know of any, sir. I think all Federal agencies and most State agencies have to comply with some version of

the Regulatory Flexibility Act. While this is a quasi-Government or

Government-sanctioned entity, the Regulatory Flexibility Act, the

Administrative Procedures Act, none of the safeguards apply. And

I would think, candidly, that there are no small businesses with

the financial resources to have challenged it under any circumstances.

Senator ENZI. Since FASB is a federally recognized standard-setter, should the FASB 123 proposal be subjected to the Regulatory

Flexibility Act or should FASB be required to live up to the standards set in the act?

Mr. GLOVER. I think the latter part of that question is very clear.

They certainly should be. We have not found any Federal agencies,

despite protestations at the beginning, that could not meet and

comply with the law, and when they did, they found that they got

a better outcome. So I think that they should.

The legal issue of whether the law should be changed, I think

that is going to be dependent upon whether FASB changes its existing pattern of activities and really does take it seriously. I am

dead serious, when somebody does a regulation that one size fits

all, it will not work. Small businesses cannot afford and cannot

handle the kinds of burdens, problems, and they do not have the

facts upon which to make these assumptions. Many of these companies simply do not have the experience.

So I think, if they do not take that into consideration, if they do

not begin considering small business seriously, if they do not have

a very active advisory board and make that happen, I think you

will have to consider making the law, including them and some

other quasi-Federal agencies that have similar situations.

Senator ENZI. FASB is reaching out to small business with their

advisory board. A question that I have for all of you is how would

you suggest getting the word out to the small business community?

Most of them are not going to notice until a FASB directive actually impacts them, but we would like for them to be involved in the

comment period so that they can—and I will start with you, Mr.

Glover.

Mr. GLOVER. Well, I alerted, I am also the Executive Director of

the Small Business Technology Coalition, which is the largest

group of SBIR companies in the country, and I did alert our board

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to that issue. They generally were supportive of my comments

today, in the board action, and have directed that we comment on

this.

So I think we will get the word out to companies. Because I

think the unintended consequences for Government contracting

firms and other firms is they will suddenly find themselves in a situation where they cannot obtain audited financial statements for

no other reason—and I disagree that all of these companies are

going public. They are going to be impacted, and I think we will

try to get the word out to those companies, and hopefully some of

the other small business groups will do the same.

Senator ENZI. Thank you.

Mr. Jones, do you want to comment on that?

Mr. JONES. Just on that particular issue. As I listened to that,

I thought it was kind of interesting because I know, in our company, our heads are pretty down. I had no idea that the Small

Business Advisory Committee had this website and whatever, and

the real question is how would I?

And so the big issues for, I think, our small companies are what

is the composition of the Advisory Committee? Where do the people

come from, and what are their backgrounds that they can help in,

one, understanding the issues, truly understanding, not that they

are not responsible, but that they understand the issues because

they are living it, in terms of the composition of the committee

itself. And then those people have access to lots of other similarly

situated people who can provide the kind of input that I understood

from the testimony today was wanted by the committee, the Advisory Committee.

Senator ENZI. From your testimony, and also Mr. Kavazanjian’s,

you mentioned that you had kind of a broad base, and I am curious

as to what you think the effect will be on your lower-level employees, the non-executives. I appreciated your comments that this becomes an extra step and does not have a lot of value. Now, if you

are going to be doing some additional capital-raising or something

like that, then there could be some additional value to it, but if you

are just trying to operate, as you have been operating, what effect

is it going to have on your lower-level employees?

Mr. JONES. It has a significant impact on our lower-level employees because I think part of what has been missing in the debate

about all of the stock options is that there are all sorts of things

that can happen, but the question is, for lower-level employees,

how much capital do they have with which to actually buy restricted stock or to purchase the actual stock options?

I will not go into it, but I can actually answer the questions that

came up earlier about the tax implications of the grant of a stock

option and what is the difference between a non-qualified and an

incentive stock option and so on and so forth. All of us, we actually

live that stuff each and every day, and suffice to say, without getting into the details, it was totally mischaracterized this morning.

The impact that was characterized and the truth is 180 degrees different.

Anyway, putting that aside, the impact on our employees would

be significant because, for us, it is all around capital, how do we

get capital, and what is the impact of our financial statements on

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capital? So, if we have to spend a disproportionate amount of

money in order to get what FASB believes are accurate financial

statements, that is disproportionate in the context of what impact

it will have on our financial statements, that is sort of backwards

from our perspective.

So, when we look at, in our case, the reality—and I am sure Mr.

Diamond, who has been in Silicon Valley, would attest to this, the

way that we today understand the market value of our companies,

there are two ways:

The first is when you are raising capital. So, in our particular case, we have raised $40 million with kind of—I guess we have

messed-up, if they have got clean financial statements, we have

messed-up financial statements, but somehow we have been able to

raise $40 million with those messed-up financial statements because we have not been expensing stock options. And so the only

time the market determines the value of our business is when you

go out and you raise money, and you have various people who set

the price for the stock as they purchase into your company.

Every other period is done by the board of directors, and the

board of directors are not experts in the financial valuation of a

particular company on a particular day. And if you look at companies which go public, a significant amount of effort, and time and

expense comes in the SEC process, where all of those stock grants

are reviewed, and there is an understanding based on sort of what

has happened so that you can look backwards as to whether the

valuation of those companies were appropriate for stock issuance

purposes, stock option issuance purposes at each of those various

points.

And that is probably the single biggest issue of investment and

time as part of the public offering process. That, by itself, says that

small companies don’t have any of the art and skill that was referred to before around being able to implement these set of proposed regulations, and so we will have no choice, because we do not

have it, our board of directors do not have it, the liability associated will be very, very significant in terms of, because it goes directly to the financial statements, so you have got to go and make

sure you have got experts that are providing you with the information. It is going to be a significant impact on our hard costs in

terms of complying with the proposed regulations.

Mr. KAVAZANJIAN. Can I build on that a little bit?

First, this whole thing, the reason why small business is having

a hard time being heard here is because there is a sense of inevitability about this thing happening. I had a director tell me, who

was a former CEO, he just retired, he said, ‘‘Yes, you are right, but

it is going to happen anyway.’’

And the way the inevitabilities had happened is in the assumption that a stock option is an expense like any other expense. And

to characterize it any other way is dishonest. I have heard a lot of

times from several people today about we have to have honest financial statements, and I am insulted by that. We have very honest financial statements. All of the data is there. Every piece of

data is there

And so we have a little different viewpoint of it as an expense.

Yes, it is an expense in one regard, but it is an equity expense. The

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shareholders have said to the employee, if you will stay here and

be dedicated to this company, we will let you buy the stock as if

you are reaching back to the day that we gave you the option. I

sold equity at $4, I sold equity at $5, I sold it at $13, and my stock

is $22. I did not revalue that equity on my balance sheet.

We will never win that battle. The accountants have decided that

there are beans that are not in a jar that have to be put in a jar

somewhere. It does not help the investment community value the

firm. We will do nothing different. We will try to do nothing different, assuming I keep my job, we will try to do nothing different,

except to educate people, if this happens, about what the real performance of the company is.

And that is where my accounting firm has a heart attack because

I say, gee, what I am going to lead with in my press release is our

profitability, before stock option expensing, was ‘‘X,’’ and they have

a heart attack because it is not GAAP. I am not a financial professional, although I was trained in finance, 2 or 3 years ago the flexibility was taken away from us to present alternative ways of looking at our financial statements that might enhance things because

they are not GAAP—Generally Accepted Accounting Principles.

So we have this one-dimensional model in what is a four-dimensional world: three dimensions plus time. And everybody wants to

sound bite one number. And we give them the sound bite of one

number that does not let them evaluate the firm, that further obscures it, it is going to be a mess. So we are going to try to educate

the community if it does happen. The problem is that the initial

assumption that is an expense, not an equity expense, but a period

expense having to do with performance of the company, it is wrong,

and I am not going to waste my time trying to convince FASB of

that because I do not think they are going to get it. That is where

we are.

Senator ENZI. Thank you.

Mr. Diamond.

Mr. DIAMOND. If I could just reply to some of this. Look, the

problem is Enron had its SPEs, its off-balance sheet vehicles, disclosed in its footnotes, also. It also had its stock option grants disclosed in its footnotes, but no one could figure out the toxic combination of the two, and the danger is that you get boards of directors who think that stock options are far less costly to a company

than they really are, and you create a mono-culture inside the firm

to take risks with other people’s money, as Justice Brandeis called

it, and you drive the company into the ground.

Now, it may be that, historically, we thought that American

managers were too risk averse, and a shift to an equity-based

world in the 1970s and 1980s was important, and that is where the

stock option culture first emerged. But it took hold with toxic effect

in the late 1990s, and we are still feeling the effects of that. We

funded far too many companies, quite frankly, in the late 1990s,

too much money chasing too few good projects, and we ended up

with a huge crash.

The NASDAQ is still only at about 50 percent of its peak in the

spring of 2000. Confidence has not returned to the market. Money

is sitting on the sidelines. I am quite certain that you run an honest business and that you do the best to disclose to your shareVerDate 11-MAY-2000 12:50 Oct 14, 2004 Jkt 095840 PO 00000 Frm 00120 Fmt 6601 Sfmt 6601 E:\DOCS\95840.TXT SCANNER PsN: SCANNER
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holders, but the world gets a little bit more complex than that, and

we are talking about the larger picture here.

If I could make just one comment about the issues that came up

this morning with respect to global competition. I would not look

to China as a model for how to disclose information to investors.

It is a corrupt system. There is no rule of law. There is no transparency. There is no independent Securities and Exchange Commission. There is nothing that looks like the Financial Accounting

Standards Board. There is no genuine private sector. It is an entirely politically controlled regime.

We have to tap into the world capital markets in this country for

a $1.5 billion every day, net, to keep funding our businesses. Foreign investors continue to be willing to put money into this economy for one simple reason, and this is what makes the American

economy more competitive than any other economy in the world.

We protect minority shareholders’ rights. We give them information

under the securities laws, and we give them State corporate law to

govern the way in which companies are managed. If minority

shareholder rights are not protected in this country, people would

not invest here.

Foreigners know they can pour money into the American economy and know that there is some basic protection for investors

while they do so, and that is why this reform is such a crucial signal to the global economy and to the U.S. economy as a whole.

Senator ENZI. I want to tell you that one of the reasons that I

have a lot of faith in this country is because there are a lot of small

businesses, and there are a lot of small businessmen like we have

on this panel here today. It highly encourages me, when we talk

about Enron or WorldCom or Tyco or some of those, we are not

talking about small business, and we are really not talking about

an accounting problem. We are talking about out-and-out fraud. We

are talking about a lack of ethics in this country among certain

people, not all of them. There are a lot of big businesses out there

that are acting ethically. All of the accounting rules in the world

did not keep Enron from doing what they were doing.

There were people—and I recommend a book called, ‘‘My Brother’s Keeper,’’ which is a biography of a guy that teaches at George

Washington University by the name of Emitai Etzioni, who had the

opportunity to teach an ethics class at the Harvard School of Business. He went through, in his opening session, a series of questions

asking about ethical problems. He started out with some that were

grey, and he worked through to some that were absolutely black

and white to everybody I know, and he still had these Harvard

Business School future executives. In fact, at the time that he did

that, they would be the executives that are running these companies right now, saying, ‘‘Well, how does it affect the bottom line?’’

They did not say, ‘‘Is it right?’’ They said, ‘‘How does it affect the

bottom line?’’

The stock options question for small business is not that same

kind of a question. I have got to tell you, when I was working on

that Sarbanes-Oxley, a little over a year-and-a-half ago, companies

were afraid to do restatements, even if restatements raised the

value of their company because, even if it raised the value of their

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company, their stock went in the toilet because people were equating a restatement with fraudulent activity.

For small business, this is going to be—probably for big business,

too, but they have more capability to explain what is going on—

it is going to be a restatement. These companies that already exist

are going to be restating what they have been doing and winding

up with some negative balance sheets. The Small Business Administration may get it and may make some exceptions, but it is going

to require some changes there. Bankers, when the meeting started,

there was standing room only. In the back of the room, there must

have been 10 or 15 bankers. I know they were from Wyoming. I

will get to meet with them later today. I do not think they loan on

negative balance sheets either.

I am also concerned about one line replacing many footnotes.

People I know have been able to look at the footnotes, make some

translation, decide how the company was doing. So I really have

some concerns about what we are doing here, but mostly from the

standpoint of small business because we have small businesses in

this country that are growing, and we need to make sure that we

keep new small businesses.

I held an inventors conference this last summer, and Wyoming

is the least-populated State in the Nation, and because of Senate

ethics, I was not able to advertise for it. I still had 85 people show

up that were right on the verge of having, they have got an invention. They just were not sure what to do with it next, and they

have been concerned about how are they protected. We had people

there that talked about trademarks, and patents, and copyrights,

and prototyping, and venture capital, and marketing, and manufacturing, and shipping, and I am pretty sure I am going to get probably about 75 businesses out of that, some of them with some absolutely great products that I wish could talk about, but they are still

in proprietary stage.

I am hoping that some of those companies will be able to use

stock options to get the talent they need because, while they may

have $100,000, it is going to cost them more than $10,000 for their

employees unless they can use stock options, and they are limited

on cash. We are having trouble attracting venture capital out our

way. So I am trying to watch out for those folks.

I do appreciate everybody’s testimony today. The witnesses were

outstanding on both panels, but there obviously appears to be a significant difference of opinion. Our small business witnesses have a

completely different perspective on FASB’s stock option expensing

proposal than FASB or the non-small business witnesses.

As we heard from our witnesses and the former chief counsel for

advocacy, it is absolutely essential that FASB get it right the first

time. I want you folks to still be in business after the rule goes into

effect. If FASB gets it wrong, some small businesses will not have

any recourse. They will not last long enough for any changes to be

made.

I do look forward to hearing the comments from the Small Business Advisory Committee, and I am very encouraged by the comments today that it will be opened up, perhaps with more meetings

and more opportunities to have some say in what the agenda will

be.

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With respect to due process, I am extremely concerned that

FASB seems to have already made up its mind on the proposals,

and the words do not match up with the actions. If anything, it appears that FASB is orchestrating, through members of its parent

board and through a one-sided outreach effort, the notice and the

comment process. Now, I hope I am proven wrong on that. FASB’s

actions do not live up to the high standards that we expect of federally recognized standard-setters, and I strongly believe that if

FASB were a Federal agency, then its actions would violate the due

provisions of the Administrative Procedures Act. I know there have

been some field tests. I am not aware of any of those being done

on a small business.

I would like to thank Chairman Herz for being here for the entire thing. It is really outstanding when somebody from that level

stays for all of the testimony and the questions. I would like to personally thank Chairman Snowe for allowing me to chair this vital

Small Business and Jobs hearing today.

I thank all of you for your time. The record will remain open for

10 days. We will be submitting some more detailed questions to

you and would really appreciate your responses.

Thank you.

[Whereupon, at 1:10 p.m., the hearing was adjourned.]

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