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THE FASB STOCK OPTIONS PROPOSAL: ITS

EFFECT ON THE U.S. ECONOMY AND JOBS

HEARINGS

BEFORE THE

SUBCOMMITTEE ON 

CAPITAL MARKETS, INSURANCE AND 

GOVERNMENT SPONSORED ENTEREPRISES

OF THE

COMMITTEE ON FINANCIAL SERVICES

U.S. HOUSE OF REPRESENTATIVES

ONE HUNDRED EIGHTH CONGRESS

SECOND SESSION

APRIL 21, MAY 4, 2004

Printed for the use of the Committee on Financial Services

Serial No. 108–80

(

(II)

HOUSE COMMITTEE ON FINANCIAL SERVICES 

MICHAEL G. OXLEY, Ohio, Chairman

JAMES A. LEACH, Iowa 

DOUG BEREUTER, Nebraska 

RICHARD H. BAKER, Louisiana 

SPENCER BACHUS, Alabama 

MICHAEL N. CASTLE, Delaware 

PETER T. KING, New York 

EDWARD R. ROYCE, California 

FRANK D. LUCAS, Oklahoma 

ROBERT W. NEY, Ohio 

SUE W. KELLY, New York, Vice Chair 

RON PAUL, Texas 

PAUL E. GILLMOR, Ohio 

JIM RYUN, Kansas 

STEVEN C. LATOURETTE, Ohio 

DONALD A. MANZULLO, Illinois 

WALTER B. JONES, JR., North Carolina 

DOUG OSE, California 

JUDY BIGGERT, Illinois 

MARK GREEN, Wisconsin 

PATRICK J. TOOMEY, Pennsylvania 

CHRISTOPHER SHAYS, Connecticut 

JOHN B. SHADEGG, Arizona 

VITO FOSSELLA, New York 

GARY G. MILLER, California 

MELISSA A. HART, Pennsylvania 

SHELLEY MOORE CAPITO, West Virginia 

PATRICK J. TIBERI, Ohio 

MARK R. KENNEDY, Minnesota 

TOM FEENEY, Florida 

JEB HENSARLING, Texas 

SCOTT GARRETT, New Jersey 

TIM MURPHY, Pennsylvania 

GINNY BROWN-WAITE, Florida 

J. GRESHAM BARRETT, South Carolina 

KATHERINE HARRIS, Florida 

RICK RENZI, Arizona 

BARNEY FRANK, Massachusetts 

PAUL E. KANJORSKI, Pennsylvania 

MAXINE WATERS, California 

CAROLYN B. MALONEY, New York 

LUIS V. GUTIERREZ, Illinois 

NYDIA M. VELA ́ ZQUEZ, New York 

MELVIN L. WATT, North Carolina 

GARY L. ACKERMAN, New York 

DARLENE HOOLEY, Oregon 

JULIA CARSON, Indiana 

BRAD SHERMAN, California 

GREGORY W. MEEKS, New York 

BARBARA LEE, California 

JAY INSLEE, Washington 

DENNIS MOORE, Kansas 

MICHAEL E. CAPUANO, Massachusetts 

HAROLD E. FORD, JR., Tennessee 

RUBE ́ N HINOJOSA, Texas 

KEN LUCAS, Kentucky 

JOSEPH CROWLEY, New York 

WM. LACY CLAY, Missouri 

STEVE ISRAEL, New York 

MIKE ROSS, Arkansas 

CAROLYN MCCARTHY, New York 

JOE BACA, California 

JIM MATHESON, Utah 

STEPHEN F. LYNCH, Massachusetts 

BRAD MILLER, North Carolina 

RAHM EMANUEL, Illinois 

DAVID SCOTT, Georgia 

ARTUR DAVIS, Alabama 

CHRIS BELL, Texas 

BERNARD SANDERS, Vermont

Robert U. Foster, III, Staff Director 

(III)

SUBCOMMITTEE ON CAPITAL MARKETS, INSURANCE AND GOVERNMENT SPONSORED

ENTERPRISES

RICHARD H. BAKER, Louisiana, Chairman

DOUG OSE, California, Vice Chairman 

CHRISTOPHER SHAYS, Connecticut 

PAUL E. GILLMOR, Ohio 

SPENCER BACHUS, Alabama 

MICHAEL N. CASTLE, Delaware 

PETER T. KING, New York 

FRANK D. LUCAS, Oklahoma 

EDWARD R. ROYCE, California 

DONALD A. MANZULLO, Illinois 

SUE W. KELLY, New York 

ROBERT W. NEY, Ohio 

JOHN B. SHADEGG, Arizona 

JIM RYUN, Kansas 

VITO FOSSELLA, New York, 

JUDY BIGGERT, Illinois 

MARK GREEN, Wisconsin 

GARY G. MILLER, California 

PATRICK J. TOOMEY, Pennsylvania 

SHELLEY MOORE CAPITO, West Virginia 

MELISSA A. HART, Pennsylvania 

MARK R. KENNEDY, Minnesota 

PATRICK J. TIBERI, Ohio 

GINNY BROWN-WAITE, Florida 

KATHERINE HARRIS, Florida 

RICK RENZI, Arizona 

PAUL E. KANJORSKI, Pennsylvania 

GARY L. ACKERMAN, New York 

DARLENE HOOLEY, Oregon 

BRAD SHERMAN, California 

GREGORY W. MEEKS, New York 

JAY INSLEE, Washington 

DENNIS MOORE, Kansas 

MICHAEL E. CAPUANO, Massachusetts 

HAROLD E. FORD, JR., Tennessee 

RUBE ́ N HINOJOSA, Texas 

KEN LUCAS, Kentucky 

JOSEPH CROWLEY, New York 

STEVE ISRAEL, New York 

MIKE ROSS, Arkansas 

WM. LACY CLAY, Missouri 

CAROLYN MCCARTHY, New York 

JOE BACA, California 

JIM MATHESON, Utah 

STEPHEN F. LYNCH, Massachusetts 

BRAD MILLER, North Carolina 

RAHM EMANUEL, Illinois 

DAVID SCOTT, Georgia 

NYDIA M. VELA ́ ZQUEZ, New York 

(V)

C O N T E N T S 

Page 

Hearings held on: 

April 21, 2004 ................................................................................................... 1

May 4, 2004 ....................................................................................................... 51

Appendixes: 

April 21, 2004 ................................................................................................... 73

May 4, 2004 ....................................................................................................... 163

WITNESSES 

WEDNESDAY, APRIL 21, 2004

Grady, Robert E., Managing Director, Carlyle Venture Partners ....................... 24

Hassett, Kevin A., Director of Economic Policy Studies, American Enterprise 

Institute ................................................................................................................ 21

Holtz-Eakin, Douglas, Director, Congressional Budget Office ............................. 20

Kruse, Douglas, Professor, School of Management and Labor Relations, Rutgers University ..................................................................................................... 18

Scalise, George M., President, Semiconductor Industry Association .................. 28

Smith, Phillips W., Chairman of the Board, TASER International, Inc. ............ 23

Thomas, Jeff, Field Applications Engineer, Altera Corporation .......................... 16

APPENDIX 

Prepared statements: 

Oxley, Hon. Michael G. .................................................................................... 74

Gillmor, Hon. Paul E. ....................................................................................... 77

Hinojosa, Hon. Rube ́n ....................................................................................... 81

Kanjorski, Hon. Paul E. ................................................................................... 82

Grady, Robert E. ............................................................................................... 84

Hassett, Kevin A. .............................................................................................. 90

Holtz-Eakin, Douglas ....................................................................................... 107

Kruse, Douglas .................................................................................................. 125

Scalise, George M. ............................................................................................ 148

Smith, Phil ........................................................................................................ 152

Thomas, Jeff ...................................................................................................... 157

ADDITIONAL MATERIAL SUBMITTED FOR THE RECORD

Baker, Hon. Richard H.: 

FASB Chairman calls for Investors to Speak up on Options, ‘‘The Wall 

Street Journal’’ April 19, 2004 ..................................................................... 159

Royce, Hon. Edward R.: 

Treausurer’s Office, State of California, prepared statement ....................... 161

WITNESSES 

TUESDAY, MAY 4, 2004

Batavick, George, Small Business Advisory Committee, Financial Accounting 

Standards Board .................................................................................................. 60

Herz, Robert, Chairman, Financial Accounting Standards Board ...................... 57

APPENDIX 

Prepared statements: 

Royce, Hon. Edward R. .................................................................................... 164

Page

VI

Prepared statements—Continued

Gillmor, Hon. Paul E. ....................................................................................... 166

Batavick, George ............................................................................................... 168

Herz, Robert ...................................................................................................... 168

ADDITIONAL MATERIAL SUBMITTED FOR THE RECORD

Sherman, Hon. Brad: 

U.S. Securities and Exchange Commission, letter to Hon. Paul Kanjorski, 

May 3, 2004 ................................................................................................... 210

Herz, Robert: 

Written response to questions from Hon. Brad Sherman ............................. 212

(1)

THE FASB STOCK OPTIONS PROPOSAL: ITS 

EFFECT ON THE U.S. ECONOMY AND JOBS 

Wednesday, April 21, 2004

U.S. HOUSE OF REPRESENTATIVES, SUBCOMMITTEE ON CAPITAL MARKETS, INSURANCE, AND GOVERNMENT SPONSORED ENTERPRISES

COMMITTEE ON FINANCIAL SERVICES, Washington, D.C. 

The subcommittee met, pursuant to call, at 10:05 a.m., in Room 

2128, Rayburn House Office Building, Hon. Richard Baker [chairman of the subcommittee] presiding. 

Present: Representatives Baker, Ose, Gillmor, Lucas of Oklahoma, Royce, Manzullo, Oxley (ex officio), Kelly, Ney, Shadegg, 

Biggert, Capito, Hart, Kennedy, Tiberi, Kanjorski, Hooley, Sherman, Inslee, Moore, Capuano, Frank (ex officio), Hinojosa, Lucas of 

Kentucky, Crowley, Clay, McCarthy, Matheson, Lynch, Miller of 

North Carolina, Emanuel, Scott and Velazquez. 

Chairman BAKER. [Presiding.] I would like to call this meeting 

of the Capital Markets Subcommittee to order. 

This morning we are convened for the purpose of reviewing the 

pending Financial Accounting Standards Board stock option expensing proposal and the potential effect its adoption may have on 

job creation and our economic recovery, which I believe to be fully 

engaged. I have given some thought to my opening statement this 

morning and the past few days, but I had the occasion to read 

press reports of yesterday that changed my intentions to open the 

hearing. 

The congressional process is a very open and public process. No 

one ever has accused the Congress of moving too fast, to my knowledge, on anything. It is a process subject to hearings and review 

which we will benefit this morning from our panel of witnesses in 

getting additional comment, and then subject to our ability, a 

markup subsequent to recorded vote, publicly recorded, then a full 

committee review, then if leadership so chooses for consideration, 

then of course a bicameral process and subject to the presidential 

veto. Although many criticize the political process, it is the one 

forum in which every person’s perspective can be vented, can be 

put on the public record, and elected officials held accountable for 

the decisions they make. 

In the matter before the committee today, it is the presumption 

that the Financial Accounting Standards Board is an entity which 

will conduct and review appropriate financial standards absent 

such political necessities, and that professionals for the public good 

shall make determinations in the best interests of our economic 

2

stability. Given that history of the Financial Accounting Standards 

Board, I am the first to acknowledge that I have on prior occasions 

disputed the decisions of the Standards Board on various other 

matters of accountancy practice. I felt, as a public official, the right 

to express those opinions and to disagree on occasion where I 

thought it in the public interest to do so. 

However, it has always been past practice of the Board to refrain 

from engaging in the seamier side of the public policy business and 

was surprised to learn that FASB now has engaged its own lobbying firm. But what really got me more engaged in this matter 

were the comments of the Chairman of the Board, and again let 

me quickly add, if this press report is true, I have also been on that 

side of the coin where my representations have not always been accurately reflected, and quick to respond that should this press account be accurate, from the Wall Street Journal, it raises concerns 

which I think appropriate to bring to the committee’s attention. 

When Chairman Herz yesterday criticized a well-organized lobbying effort within the Congress, but then went on to say, ‘‘One 

thing I cannot control is Congress.’’ I would say, that is a good 

thing. No one person should control the Congress, nor enterprise. 

It acknowledged in the comment that the proposed rule is now 

open to public comment until the end of June. Apparently, members of Congress are the only group that can have no comment on 

the matter until the close of the consideration at the end of June, 

but calling on all in the investor class and those within the business community to make your views known to people in Washington; a call for investors, again, to make your views known. 

We cannot have it both ways. If you expect the Congress to have 

a hands-off approach and allow a regulatory entity to act without 

comment from anyone, I question the need for a public comment 

period because in the midst of the public comment period, this 

hearing has been called for the sole purpose of having those make 

comment on the effect of this proposed rule on the broader economy. To engage the resources of a lobbyist and for the chairman 

of the board to then make a political request of constituencies to 

affect and influence the Congress has now opened the door. If you 

want to have a public discussion where all interested parties express their opinion, there is no more open venue, no more free of 

influence, no more publicly recorded venue than the United States 

Congress. 

Now, I do not always agree with the outcomes of the congressional process, but I have great regard for the process and respect 

the wisdom of 435 members of the House and 100 members of the 

Senate in coming to what is the best-balanced conclusion for the 

public interest. I make no apologies today about having introduced 

a bill and brought this matter to public discussion. I happen to personally believe it is the right thing to do. I will acknowledge there 

are other people with different opinions and I may be wrong, but 

today we have had a group historically known for its nonpolitical 

determinations open the door to political judgments. I hope we can 

do it going forward in a professional manner and all have respect 

for each other at the conclusion of the process, that professionals 

with differing opinions can come to some resolution that ultimately 

is in the best interest of the public. 

3

I apologize to the committee for going on at length, but I felt the 

necessity to express those views. 

Mr. Kanjorski? 

Mr. KANJORSKI. Mr. Chairman, I am not aware of the press comments, but it strikes me that it poses the question of whether you 

will respect me in the morning. 

Chairman BAKER. No. 

[Laughter.] 

Mr. KANJORSKI. Actually, Mr. Chairman, I think this is an important issue, and we meet for the third time in the 108th Congress to study the accounting treatment of stock options. I have a 

prepared statement that I will submit for the record. I guess the 

interests are that this is a recognized problem, one for the accounting industry and the need for certainty in how things are done. 

I am not an accountant by profession, but I also feel that it perhaps is a dangerous ground for us to tread on that the Congress 

will interpose its position on a board that is dedicated and structured to make these determinations. That is not to say that that 

board’s determinations come with the weight of the Constitution or 

perhaps the actions of God to Moses on the mount. 

It is, however, a struggle that could be off-course in terms of I 

think there are two major issues here. One is whether or not this 

Congress supports the fact that we have a structured entity in the 

private sector to make final determinations of accounting rules. I 

think that is vitally important for our system domestically and 

internationally. Two, my interest in this is that I truly believe that 

accounting is for the purposes of transparency of investors and people, that they have a right and a want to know what is the structure and the commitment of the organizations they potentially 

want to invest in. 

I have had the occasion over the last several weeks to visit with 

people that are on both sides of this issue. I have listened to them 

as hard as I can. I remember having a discussion with the president and CEO of one of the major California new-tech companies 

just 2 weeks ago. He struck me with the importance of this for his 

industry. I have great sympathy that in that particular industry, 

this could create a problem, the rule as it is structured. But as we 

discussed it together, he tended to agree with me with the need for 

transparency; that we cannot have every company doing with their 

stock options as they will and anticipate that analysts will discern 

every one of the 27,000 public companies in the United States. 

That is not going to happen, and particularly with the loss of respect for the analysts over the last several years. They probably 

will not be performing that function sufficiently to give transparency. 

So I do not understand why we get to the point of one way and 

not another. I think potentially, and it is too bad we do not have 

both the SEC and FASB here today, but I understand most of those 

groups are on travel internationally and are not available for us 

today. So in that regard, before we conclude and go to markup on 

this subject, I think it is only right that we bring representation 

of FASB and SEC before the committee so that they can spell out 

their arguments, because quite frankly I have a question that I 

4

would like to pose to them that I think is very fundamental and 

important. 

Are there other ways, in accordance with accounting principles, 

that we can get to transparency without necessarily going the full 

gamut of a single rule applying across the board that could disadvantage some of our major technology companies? I do not know 

what the answer to that is, but being rather Burkean in my philosophy that unless you show me the benefits of change, I am more 

apt to hold with tradition. My natural proclivities lead me to support the institutions, whether they are courts of law or organizations such as FASB, that they have the ultimate insight and interest and intention of doing the right thing and propounding the 

proper rules, always subject to review. 

But before we get to the final decision and whether or not the 

Congress should take up singular activity of reviewing, sometimes 

under pressure, the implementation of a rule across the board, I 

think it could be fundamentally destructive to our system if we encourage people to believe that FASB is okay to some extent, but 

where there are interest groups that can rise above that and put 

significant pressure on the Congress of the United States to interpose their will and its will on an organization like FASB, that 

could be very destructive to the entire process of the system. 

Those that favor that position today on a particular accounting 

rule may find out that when they become less significant or less 

important or less apt to be able to affect the actions of Congress, 

they can have suppressive activity brought on them by other special interest groups or pressure groups within our system. That 

tends to go to the destruction of the system as we have it. 

With that in mind, Mr. Chairman, I do ask that we have an additional hearing before we go to markup on this situation, having 

in FASB and the SEC. I look forward to today’s hearing. I think 

the weight of the witnesses, as I discern them, are significantly disadvantaged one side of this proposition right now, although I look 

forward to the testimony particularly given by some of our industrial leaders that are here today to give us an insight on how the 

impact will be in the capital markets and on these particular corporations that exist, and that had some advantage by using stock 

options as a methodology of not tapping into their capital assets 

when they were at the beginning stage or formative stage of their 

endeavors. 

With that in mind, I offer my full statement in the record, Mr. 

Chairman, and look forward to it. I guess I will read The Wall 

Street Journal the day before such hearings so that I am fully 

equipped to respond to the Chairman’s views. 

[The prepared statement of Hon. Paul E. Kanjorski can be found 

on page 82 in the appendix.] 

Chairman BAKER. I thank the gentleman for his statement. It 

certainly will be made part of the record, as will all members’s 

opening statements. 

Mr. Ose, did you have an opening comment? 

Mr. OSE. Thank you, Mr. Chairman. 

I am appreciative of the fact that you are having another of these 

hearings. I remain somewhat bemused by our ongoing debate here. 

We have yet to define a system whereby we can accurately value 

5

these options, whether it be Black-Scholes or binomial equation or 

something of that sort. And yet we are hurtling down a path, at 

least from a regulatory standpoint, to impose a requirement of a 

blanket nature on America’s corporations without defining yet exactly how we are going to value it. 

I would submit to the body that the various opinions that are 

being put forth by people who have moved to expense options on 

their financial statements, as opposed to those who have yet not 

made that move, largely track the enterprise models that they 

speak from. For instance, let us take Mr. Buffett. Mr. Buffett has 

argued in favor of expensing options, but I think if you look at Mr. 

Buffett’s investments, you will find very few of them in the technology business, where options are used for significant compensation to employees. 

I would submit to the body that the difference of opinion in corporate America as to how to treat options, whether to expense 

them or make them transparent within the notes to financial statements, reflects the needs of different enterprises to either compensate their employees or reduce their tax liability. Those who are 

advocating for leaving options in the current situation whereby 

they are disclosed within the notes, are using options as a compensation tool, by and large. Those who are advocating for the expensing of options look at the net impact on their tax liability by 

expensing those options. The net income for that enterprise would 

be less. 

It is perfectly logical, but we still come back to this same point, 

and that is however you value these options, whether you are a 

strong advocate for leaving it the way it is or a strong advocate for 

changing the system, however you value these options your valuations are based on assumptions. If it is the assumptions that are 

driving FASB’s concern, that is if the assumptions may or may not 

be valid, we ought to talk about that, rather than whether or not 

to put them into the financial statements. 

I thank the Chairman for having this hearing. I am still waiting 

for somebody to definitively quantify for me how you value these 

options. Thank you, Mr. Chairman. 

Chairman BAKER. I thank the gentleman for his interest in the 

subject and his statement. 

Ranking Member Frank? 

Mr. FRANK. Thank you, Mr. Chairman. I appreciate the attention 

you are giving to this. 

This is a very difficult issue for me. Intellectually, it is one of the 

harder ones that we deal with. When I was in law school, accounting overlapped with my duties as a state legislator. I was absent 

a lot of times that day when we came up with the issue. I am continually impressed both with the complexity of accounting issues 

and even more difficult for us with their fluidity. 

We have an issue here, though, where I am conflicted. I have 

been convinced by people, particularly in the high technology industry, that this change could do them some damage. I will get in 

a minute to what I think of that, but facts have to be taken into 

account. On the other hand, setting a very strong precedent of this 

Congress setting rules on a specific and technical accounting issue 

is difficult. So we often in this body use procedural arguments to 

6

reinforce our substantive preferences. The tough time comes when 

you have both a genuine procedural preference, as the Ranking 

Member talked about, and a substantive view which will not be 

well served by following that procedural preference. If it is up to 

me, I would not be demanding that these be expensed, but I do not 

want to go into a situation where we become the appellate Financial Accounting Standards Board. 

I must say, while I accept what the high technology people tell 

me, they are a lot of very smart, very decent people who have done 

a lot of good for this economy, and they are overwhelming in their 

view. I must say that what they tell me is somewhat distressing 

because I have to say in substantive terms, this issue to me is 

frankly like some other issues where the reality seems to me to 

have been swamped by perceptions that have taken over. That is, 

whether or not the accounting is changed, whether options are expensed or not, does not change the reality. 

Currently, I am told, they are available in the footnotes. I am not 

a regular reader of the footnotes of financial company statements. 

If we changed the rule, they will not be in footnotes; they will be 

treated differently. The reality will not change. So what we are 

being told, and this is a disturbing fact for me, is that the investment community of America will react very differently to an identical reality depending on how it is presented in financial statements. That is disappointing to me. 

Perhaps one of my illusions was that these cold-headed, hardhearted financial people would be less influenced by whether it was 

in the footnote or not in the footnote. But being told that without 

a change in the reality, the method of presentation of the reality 

will have an enormous impact, but both sides seem to agree that 

it would have this impact, whether or not there is a nominal profit 

or not. I am hoping that people in the high tech industry if this 

does go through will turn out to have underestimated the financial 

community, and that they will be able to tell the difference between reality and perception, but I understand this is troubling. 

I have an alternative that I am going to be introducing later. I 

will be filing the bill later in the week. As I have looked at this, 

I find it hard to see what damage has been done by the current 

accounting treatment of options. I have not had anybody write to 

me and say I was terribly misled because they did not expense the 

options and I invested in them, and look what happened to me. But 

there have been problems with options. 

It seems to me, from what I have learned in my role here on this 

committee, is that the problem with the stock options in our economy is the perverse incentive they have given in some cases to the 

top decision makers in some corporations to spike the stock price 

and then cash in and walk away. There have been large corporate 

entities that have done things that made no sense from the standpoint of the corporation over time, but did make sense because 

there were some corporate executives who benefited short-term. 

I am going to file legislation that would direct the SEC to promulgate rules that will deal with a situation in which the top decision makers in corporations cash in stock options and there is subsequently a drop in the value, because I think that is the public 

policy issue. I am not at this point ready to tell FASB what to do 

7

or what not to do on a subject which is such a difficult one intellectually. But I would hope that the existence of this option, the ability of the regulators to deal with the abuse of the perverse incentives given by stock options to chief executives, would be a relevant 

factor in the field, because we do have a genuine comment period. 

I think it is possible for some of us to say to the FASB that we 

are skeptical of the rectitude of their action, without being committed to overturning them congressionally because I am in that 

bind. 

So I am going to be filing this legislation later that would direct 

the SEC to deal with what seems to me the serious problem here, 

which is the perverse incentive that the current stock option rules 

give to a handful of irresponsible and unethical chief executives 

and their top aides, and hope that that might be a factor in the 

debate. 

Thank you, Mr. Chairman. 

Chairman BAKER. I thank the gentleman for his statement. 

Chairman Oxley? 

Mr. OXLEY. Thank you, Mr. Chairman. 

Let me congratulate my friend from Massachusetts, the Ranking 

Member, for his thoughtful statement. I think his statement does 

point out some of the difficulties that we as policymakers have in 

dealing with this complicated issue. 

This is the third time in this Congress that we will discuss stock 

option accounting. The number of hearings this subcommittee has 

held demonstrates how important this issue is. I applaud Chairman Baker for his good work on this subject. In light of the Financial Accounting Standards Board’s recent proposal, it is particularly 

important now. 

The question of whether stock options should be expensed has 

been debated for many years. Some, like the former Chief Accountant of the Securities and Exchange Commission, Walter Schuetze 

and numerous experts in accounting, believe that the FASB’s position that the issuance of employee stock options creates an expense 

is simply improper accounting. Mr. Schuetze observes that the 

issuance of a stock option to an employee does not change the market capitalization of the corporation, as measured by the market 

value of the outstanding shares and the value of the outstanding 

option. Thus, there is no expense. If there had been a true expense, 

which he defines as the ‘‘using up’’ of an owned asset or the decline 

in the value of an owned asset, then the market value of the outstanding shares and option should have declined, but that is not 

the case. It also makes me particularly glad that I did not take accounting in college. 

Others, like FASB, as evidenced by its recently released proposal, 

take the contrary view, arguing that employee stock options do constitute a corporate expense. FASB’s position is that all employee 

stock options have value, which employees purchase with the services they provide. Because they have value, FASB asserts, when 

stock options are given to employees they give rise to compensation 

costs that are properly included in measuring an enterprise’s net 

income. 

Some point out that the grant of an employee stock option is an 

opportunity cost to the issuer. They argue that if a company were 

8

to grant stock, rather than options, to employees, the company’s 

cost for this transaction would be the cash it otherwise would have 

received if it had sold the shares at the current market price to investors. But this situation is not analogous to that of the issuance 

of employee stock options. Not only are employee stock options 

issued exclusively to employees of the issuer, but each employee 

stock option is written for a specific individual. Thus, there is, by 

definition, no market into which these options can be sold. 

Another significant problem is the accurate valuation of stock options, and we have been through this many times. While there is 

a diversity of opinion on the merits of requiring the expensing of 

employee stock options, there is uniform agreement on at least one 

aspect of this debate. It is extremely difficult to value these options. This gives rise to concerns that strike at the heart of financial statements. What use are they if not for purposes of comparing 

one company’s statement against another’s? 

The FASB itself recognizes that there is no options-pricing model 

that gives an accurate assessment of the value of options across all 

enterprises. The Black-Scholes model has been shown to have significant deficiencies for purposes of valuing employee stock options. 

The Binomial method has similar problems. FASB’s solution is to 

provide no guidance as to what method a company must use to calculate value. 

The lack of a uniform, reliable valuation method creates problems of comparability among companies, accuracy of the financial 

statements themselves, and, as one of our witnesses today suggests, even opens up the possibility of manipulation of earnings by 

management. These are concerns that merit further consideration. 

But as Craig Barrett, the CEO of Intel, has observed, whether or 

not stock options should be expensed is not just an accounting 

issue. It is also an economic issue. And that is the focus of today’s 

hearing. 

Preserving the independence of the Financial Accounting Standards Board is a consideration. That is an issue of process and jurisdiction and certainly the members of this panel have a great respect for FASB’s expertise. However, some issues go beyond that of 

accounting and enter the mainstream of economic policy. If it is 

true that the adoption of FASB’s employee stock option expensing 

rule would cause significant and serious damage to job creation, 

then it becomes an economic policy issue and one that Congress 

should certainly review. 

Dozens of chief executives have publicly stated that their firms 

will reduce or eliminate options if the FASB proposal is enacted in 

order to avoid the negative impact that expensing will have on 

earnings per share, and in turn, the company’s share price. If this 

is the case, then shareholders and our economy as a whole will sacrifice some measure of economic growth. 

The venture capital community has been quite outspoken on this 

issue. One of our witnesses today discusses the great extent to 

which venture-backed companies rely on stock options to attract 

and retain talent. He also points out that in over 70 percent of venture-backed companies, stock options were awarded to all employees, not just top executives. These companies are a significant component of our economy. He cites statistics illustrating that ventureVerDate 0ct 09 2002 10:59 Oct 05, 2004 Jkt 000000 PO 00000 Frm 00014 Fmt 6633 Sfmt 6633 G:\DOCS\95438.TXT FIN1 PsN: MICAH
9

backed companies directly or indirectly accounted for 27 million 

jobs in 2000 and had sales constituting about 11 percent of our 

GDP. These are compelling figures. If the FASB proposal will undermine job creation and economic growth, then it calls for closer 

scrutiny by the Congress. 

The Congressional Budget Office study concluded that expensing 

employee stock options will not have a significant effect on the 

economy. The study argues that the information has already been 

disclosed in footnoted financial statements and thus is reflected in 

the stock price. We will examine today whether this analysis is correct. 

While there are many informed experts on both sides of this 

issue, there are some aspects of this debate on which there is 

agreement. First, expensing employee stock options is not a silver 

bullet for achieving better corporate governance. Second, the importance of transparent, accurate financial statements cannot be overstated. 

Mr. Chairman, I look forward to hearing from our esteemed 

panel of experts today as we consider once again the far-reaching 

implications of the FASB proposal. 

I yield back. 

[The prepared statement of Hon. Michael G. Oxley can be found 

on page 74 in the appendix.] 

Chairman BAKER. I thank the Chairman for his statement and 

for his attendance here today. 

Ms. Velazquez? 

Ms. VELAZQUEZ. Thank you, Mr. Chairman. 

First, I want to thank Chairman Baker and Ranking Member 

Kanjorski for holding this important hearing. Stock options have 

contributed significantly to the economic growth of the U.S. economy, allowing smaller firms to grow and expand in a time when 

the labor markets may have chosen otherwise. During periods of 

strong economic growth and low unemployment, such as the late 

1990s, the demand for specialized labor outstripped supply. As a 

result, wages and benefits were bid up to levels unseen in previous 

periods. 

During such previous periods, companies that were rich were 

often able to attract and retain employees, effectively beating out 

smaller firms that lacked the cash flow of the larger competitors. 

During the 1990s, however, stock options leveled the playing field 

and permitted startups to compete with Fortune 500 companies for 

talented employees. Instead of economic oligopoly, new firms 

sprouted up across the country, providing the critical mass for new 

industries and markets. 

The accounting treatment of stock options is a complex issue. If 

it were not, this issue would not be before us today. First and foremost, I am concerned about any regulatory change that will threaten entrepreneurial activity. I believe that the churning of ideas is 

necessary for the U.S. economy to move forward and create the jobs 

that we so desperately need. Such creative destructionism can provide the U.S. with a model for long-term economic stability. 

FASB has proposed a rule that will alter the accounting treatment of stock options. While the proposed rule does not prohibit 

firms from issuing stock options, it will require firms to expense 

10

these options in their financial statements, a distinct departure 

from FASB’s current approach. I do have serious concerns with this 

proposed rule as it appears that it will disproportionately impact 

smaller companies relying on stock options to finance their early 

development and growth. 

While it is not clear to me that the proposed rule will result in 

more accurate or comparable financial information for public companies, it is apparent that the rule will impose substantial compliance costs on startups. In addition, I am suspicious of any proposal 

that restricts smaller firms’s access to the equity markets. By impeding smaller firms’s ability to be competitive, as I believe this 

proposed rule does, our national economy and more importantly 

our local communities will be less likely to realize the benefits that 

innovation and risk-taking bring: new jobs, an expanded tax base, 

and opportunity for future generations. 

Mr. Chairman, I too echo Mr. Kanjorski’s request for an additional hearing with the FASB Chairman and the appropriate SEC 

officials before we move to mark up the legislation. With this in 

mind, I thank you for your leadership on this issue and I look forward to hearing the testimony of the witnesses on this complex 

issue. 

Thank you, Mr. .Chairman. 

Chairman BAKER. I thank the gentlelady for her statement. 

Mr. Royce? 

Mr. ROYCE. Thank you, Mr. Chairman. Once again, I want to 

thank you for the hearing, and I want to thank you for introducing 

H.R. 3574, the Stock Option Accounting Reform Act. 

Also, on behalf of my colleague from California, Representative 

Eshoo, and Representative Eshoo is your lead co-sponsor of H.R. 

3574, I would like to submit for the record a letter from our California Treasurer, Philip Angelides in which he endorses this bill. 

[The following information can be found on page 161 in the appendix.] 

Let me say, Mr. Chairman, that I am extremely troubled by 

FASB’s proposal which would require firms to expense employee 

stock options. Expensing options will have very negative consequences. In fact, just the threat of expensing has already 

changed the behavior in many firms. Mandatory expensing of employee options will effectively end the practice of granting employee 

stock options as we know it. 

Stock options enable firms, often new economy-oriented firms, to 

attract talent that otherwise would go to companies able to pay 

higher salaries through cash compensation arrangements. Newer 

growth companies tend not to have large stable cash flows. However, through stock options, they can compete by offering employees an up-side in the event that the firm succeeds. 

Incentive is perhaps the most important driver of economic 

growth. People advocating expensing are taking incentive for success away from the very companies that could be producing the 

next generation’s goods and services. No economic model can dispute this argument. 

California rests on the banks of the Pacific Rim. All of our country’s new economy firms, but particularly those in California face 

greater and greater competition from businesses in Central and 

11

East Asia. I ask my colleagues to reflect on the fact that companies 

in China are striving to take away our global edge in technology. 

China graduates now 195,000 engineers and computer programmers annually. Many have made the point that the Chinese government has embraced stock options in its 5-year plan. Here is my 

point. I am worried that while communist China is learning capitalism, we are forgetting it. 

Again, Mr. Chairman, thank you for the leadership on this issue. 

I look forward to the testimony of our distinguished witnesses. I 

yield back. 

Chairman BAKER. I thank the gentleman. 

Mr. Crowley? 

Mr. CROWLEY. Thank you, Mr. Chairman. Thank you for holding 

this hearing today. I want to thank the ranking member as well, 

Mr. Kanjorski, for his input and his presence here today, as well 

as the Chairman and the Ranking Member of the full committee 

for their interest in this issue. 

I want to begin by expressing my gratitude for FASB and the 

role that it plays in our economy, that of ensuring independence 

and credibility of our nation’s accounting systems. At the same 

time, I also have to state that I disagree with FASB’s recently proposed rule change, the mandatory expensing of all stock options as 

I believe this rule does not deal solely with accounting principles, 

but rather also deals with economic policy as well. 

While accounting standards should be left to FASB, economic 

policy should and must remain with Congress and the executive 

branch. I believe this differentiation between accounting policy and 

economic policy must be made when discussing this proposed rule 

change. This proposed regulation will not address concerns about 

excessive executive compensation or reliability of a company’s financial statements. Rather, I believe this rule will adversely affect 

employees who receive stock options, especially employees whose 

companies provide broad-based stock option plans, thereby hurting 

wealth creation and weakening or eliminating the basic economic 

instrument that created the economic boom of the 1990s and is still 

used frequently today by venture capital startups. 

Besides delving into economic policy, which is not I believe the 

role of FASB, I have additional concerns about this rule, such as 

that this expensing mandate will provide less, not more, integrity 

in accounting. Supporters of this rule will argue that it makes accounting more honest. I have to differ. In fact, this rule will allow 

two different methods for companies to expense their options, either binomial or Black-Scholes, both of which are not considered 

accurate evaluation models. In essence, this rule will allow companies to pick and choose their accounting methods, providing more 

confusion, I believe, and more dishonesty in financial statements. 

This rule will allow corporate accountants to decide which expensing system works best for their company’s goals. 

Whereas today, to keep accounting honest, those same firms with 

stock options must, under FASB’s guidelines, disclose the value of 

their options in the company’s financial footnotes, as mentioned 

earlier, or charge it directly against income, leaving no economic 

surprise for any investor. 

12

Additionally, supporters of this rule will argue that there is nothing in this rule that prevents the issuance of stock options and that 

the CBO report states that expensing of options will not have any 

adverse consequences. They go on to argue that some companies 

such as Coca-Cola expense their options now and have not seen a 

drastic adverse affect in their stock price. But when referencing 

Coke as an example or using the CBO report to justify this expensing mandate, supporters of expensing do not take into account the 

issue of broad-based stock option plans that benefit all company 

employees, not the regular stock option plan that benefits the few 

at the top of the corporate pyramid. Companies like Coke provide 

and expense their options, but they are not broad-based plans. 

They are options for top corporate executives. 

The mandatory expensing of stock options would effectively destroy broad-based stock option plans which enhance financial opportunities for workers at all levels, stimulate economic growth, 

and help create the new economy of the 1990s, a new economy, as 

I mentioned before, that we are still feeling the effects of today. In 

fact, it is these broad-based plans that have spread wealth 

throughout all sectors and to all employees of our new economy, 

from CEO to secretary. Ninety-eight of the nation’s top 100 largest 

high-tech firms that focus on the Internet provide options to most 

or all of their employees, and most of these options go to the rankand-file workers, helping stimulate wealth creation for employees 

while allowing employers to attract the best talent. 

Contrary to popular belief, these people receiving broad-based 

stock options are not all located in Boston and San Francisco. Statistics show that 41 percent of those receiving broad-based stock 

options live in the South and 24 percent live in the Midwest. Unfortunately, we already are starting to see, as was mentioned before, the negative effects of this FASB rule. It has not even been 

finalized as of yet. Some companies are already beginning to scale 

back their broad-based option plans in anticipation of the FASB 

rule, and I believe this hurts employees and not the executives. 

I am supportive of an independent FASB for the purpose of making accounting rules, but again this rule is not about accounting. 

It is about economic policy, and I believe that belongs with Congress and the executive. 

I yield back the balance of my time. 

Chairman BAKER. I thank the gentleman for his statement. 

I have no further members on our side seeking recognition for an 

opening statement, so the next person to go to is Mr. Scott. 

Mr. SCOTT. Thank you very much, Mr. Chairman. Certainly, this 

is an extraordinarily important and yet complex issue. 

I think that as we move forward on this, and I have enjoyed 

working with the Chairman on this issue, but it is clear that the 

legislative process is really working here and raising some questions and putting some issues on the table that certainly need to 

be dealt with as we move forward. 

My understanding of H.R. 3574 is that it does indeed immediately dispense with the stock options requirement for the top five 

executives in a corporation. It provides for a study before moving 

forward, and certainly exempts small businesses from the first 

three years. The question is, though, is that enough. 

13

I think there are three issues here that we certainly have to exhaust before we move forward. First of all, what impact does this 

have by immediately stopping the stock options for the top five executives in a corporation, for the rank-and-file members who for 

years have benefited from stock options. I think we have to move 

gingerly to make sure that is continued. 

The other issue, of course, is small startup businesses. Is the exemption enough for the first 3 years, especially our technology companies. It is very important that we respond to that concern. The 

third area of concern for me, of course, is to hear from the SEC, 

to hear from FASB, to make sure as we move forward we are doing 

the right thing in dealing with the abuses and to stop that and regain the confidence of the American people in our most treasured 

possessions, and that is in our corporations that are the bulwark 

of our economic system, without doing tremendous damage otherwise. 

So Mr. Chairman, I really look forward to this, going forward, 

and I hope that we can address those three concerns as we move 

forward as we deal with this very complex issue. 

Thank you. 

Chairman BAKER. I thank the gentleman. 

Mr. Sherman? 

Mr. SHERMAN. Thank you, Mr. Chairman. As the only member 

who will begin his statement by saying I am glad the FASB is looking at this issue, I do have a lot to say. 

Let me begin by looking at this whole idea of broad-based options. I have drafted the option plans. I have consulted with the 

companies on their option process. Yes, there are a few companies 

that have broad-based plans, but in general you are talking about 

80 percent of this benefit going to the top 8 percent of the employees across the board in this economy. When we look at the bill that 

is being proposed to deal with this, it supposedly is there just to 

protect broad-based. 

Look at two important details in the bill. First, even when options are granted to the top five people in the company, you have 

to assume zero volatility. So it is not just a bill to protect broad 

options. It is a bill to massively undervalue options given to the top 

five executives. Second, if you are number six at GM, you are probably doing pretty good. We should instead, if we want to focus on 

broad-based options, look at options which when valued at time of 

grant are less valuable than $100,000 per employee per year. That 

would allow us to make sure that we are giving a special benefit 

only to those options that are not being used for the purpose that 

options have been used for, and that is to make our corporate executives the richest corporate executives in the world by far. 

Now, we should be matching expenses and revenue. That is basic 

accounting. So we are told that somehow a stock option is not really an expense. It is not anything of value. Well, if it was not anything of value that was being given up, why does everybody want 

it? More importantly, what is an option? It is a piece of the future 

growth of the company, transferred from the current shareholders 

to the option grantees, the executives. That is very much a transfer 

of something of value. 

14

That is why if the company were to grant options which could 

be very similar in their form to employee stock options, would it 

grant those to private investors? That would be a recognized transaction. The proof of what I am saying is this. Let’s say we really 

cared not about whether the executives got compensated, but there 

was health care for the bottom half of the employees, particularly 

in big companies that may not even use stock options now. 

We told corporate America, you can grant stock options to insurance companies if those insurance companies are giving health care 

to the bottom half of your employees. That is an expense. It has 

always been an expense. That is why companies do not use that 

as a device to pay their insurance companies. Instead, they have 

to pay them in cash, and increasingly they decide not to pay the 

cost of today’s health care. 

If the transfer of an option to acquire something use for the company, like the work of the employees, is not an expense, why just 

employee stock options? Why can’t you buy your building for stock 

options and not list that as a cost? Why can’t you pay your telephone bill with stock options and not list that as a cost? The reason 

is because stock options is another way of paying an expense. 

Now, if we do things right and expense stock options, then we 

will I think show the world that perhaps unlike China, unlike some 

others, we have the best, clearest, most transparent, fairest, most 

logical accounting system being imposed, even when powerful interests disagree. The effect will be to reduce executive compensation 

in this country. The effect will also be, and it will not be a major 

effect, but it will be an effect. There will be a slight reduction in 

the amount of capital flowing to those companies that use stock options and that capital will instead flow to some older companies 

that tend not to use stock options. Is it better that a stock that 

somebody invest in Intel than invest in Proctor and Gamble? Gee, 

I do not know, but picking winners and losers has never been a 

proper role for this Congress. 

So I would like to argue that FASB is doing its job and we should 

leave them alone. There is one problem. FASB is not doing its job, 

two huge problems up there in Connecticut. First, this exposure 

draft just kind of leaves drifting do you use binomial? Do you use 

Black-Scholes? When do you use one? When do you use the other? 

Any guidance? Or do you just hire the accounting firm, there are 

not many left, but do you just hire the accounting firm that will 

give you the lowest stock option value? If they are going to do their 

job, they ought to do it. 

But there is a much greater problem with FASB and it is a related issue. We cannot talk about stock options without talking 

about research expense, because the biggest argument against 

what FASB is doing is that it will hurt high tech. Well, let’s talk 

about something that really hurts high tech, not just something 

that may disadvantage a few executives in high tech, but rather 

that disadvantages high tech in general. FASB will admit it is completely wrong as a matter of accounting theory, but they have left 

it in place for over 30 years, and that is the expensing of all research. The effect is for us as an economy to under-invest in research, for stockholders to under-invest in companies that do research. 

15

Why is this related? Because if we are going to hit tech with bad 

accounting for research, should we also hit them with good accounting for stock options? Is it fair to take a sector of our economy 

and require them to expense stock options, which is good accounting, while at the same time requiring them to expense the nearly 

$2 billion they do every year of research, which is bad accounting. 

So when this bill comes up, I will propose an amendment that 

it remains in effect only so long as FASB fails to allow for the capitalization of successful research and development expenditures. 

When FASB solves that problem, it will have a far greater affect 

on encouraging investment in high tech than anyone ever argued 

that this stock option thing has a negative affect. If I am able to 

get that amendment passed, and I realize it will be a matter of 

first impression to most of my colleagues, I will support the bill, 

in which case, and I think right now I am the only one speaking 

against it. 

So we need to have a fair accounting system for tech companies, 

one that recognizes that when you give a stock option, you have 

given something, but when you have done research and it is successful research, you have bought an asset. 

I yield back and I thank the Chairman for his indulgence. 

Chairman BAKER. I thank the gentleman. 

Mr. Lucas? 

Mr. LUCAS. I am ready to hear from the witnesses. 

Chairman BAKER. Thank you, Mr. Lucas. 

Mr. Miller? 

Mr. MILLER OF NORTH CAROLINA. I agree with Mr. Lucas. 

Chairman BAKER. And Mr. Hinojosa? 

Mr. HINOJOSA. Thank you, Mr. Chairman. 

Chairman Baker and Ranking Member Kanjorski, I want to 

thank you for holding this very important and timely meeting. 

Chairman Baker, I want to note first and foremost that I am a cosponsor of your legislation, H.R. 3574, the Stock Option Accounting 

Reform Act. I remain an ardent supporter of this legislation despite 

FASB’s March 31 proposed rulemaking that would require companies to report as an expense the value of stock options they give 

to executives and rank-and-file employees. 

In fact, FASB’s recent proposed rulemaking demonstrates how 

important it is that Congress pass your legislation, particularly section three of your bill. Section three would prohibit the SEC from 

recognizing as generally accepted any accounting principle established by a standard-setting body relating to the expensing of stock 

options pending the completion of an economic impact study by the 

Secretary of Commerce and the Secretary of Labor. 

What everyone here needs to recognize is that stock options are 

an important tool to attract talent to new ventures, and that mandatory expensing of stock options will stifle their issuance, reduce 

company profits, and deter innovation and economic growth. 

FASB’s proposed rulemaking likely would result in the disappearance of stock options. The disappearance of stock options will inhibit a company’s ability to attract and retain skilled employees. 

If the FASB rule takes effect, many of the companies will stop 

issuing options to their rank-and-file employees. There is no reliVerDate 0ct 09 2002 10:59 Oct 05, 2004 Jkt 000000 PO 00000 Frm 00021 Fmt 6633 Sfmt 6633 G:\DOCS\95438.TXT FIN1 PsN: MICAH
16

able nor accurate formula to properly value them, contrary to what 

FASB contends. 

In closing, I want to include in my comments concerns that I see 

in global competition with large importing nations like China. Mr. 

Chairman, the Chinese government has incorporated stock options 

into its 5-year economic plan to boost its technology industry. As 

a member of the House Manufacturing Caucus, I know all too well 

that many of America’s manufacturing jobs have already been 

outsourced to China, thus negatively impacting our U.S. economy. 

FASB’s proposed rulemaking poses a similar risk in that venture 

capital companies and high-tech companies might relocate to China 

or other stock option-friendly nations if registered companies are 

required to expense their stock options in the United States. 

Mr. Chairman, I want to work with you and other co-sponsors of 

your legislation to at least delay the implementation of FASB’s proposed rulemaking, either by passing your legislation as a standalone measure, or working together to incorporate it into other legislation to ensure its passage. Hopefully, we will succeed in this endeavor. 

I yield back the balance of my time. 

[The prepared statement of Hon. Rube ́n Hinojosa can be found 

on page 81 in the appendix.] 

Chairman BAKER. I thank the gentleman. 

If there are no other members desiring to make an opening statement, I want to welcome our witnesses to our hearing. I hope you 

have enjoyed it today. We would like to remind each of you that 

despite the length of members’s comments, we do request that each 

of you try to limit your remarks to 5 minutes. Your formal statement will be made part of our hearing record. I welcome each of 

you. We look forward to your comments. 

I would turn first to Mr. Jeff Thomas, field applications engineer, 

Altera Corporation. Welcome. 

STATEMENT OF JEFF THOMAS, FIELD APPLICATIONS 

ENGINEER, ALTERA CORPORATION 

Mr. THOMAS. Chairman Baker, members of the subcommittee, I 

want to thank you for hearing my testimony today. 

My name is Jeff Thomas. I am a field applications engineer for 

the Altera Corporation in San Jose, California. Altera Corporation 

manufactures and sells programmable logic devices, which are 

semiconductor chips used in a broad range of applications. In my 

role as an FAE, it is my responsibility to provide on-site technical 

support to one of our largest customers, which is a major telecommunications company. 

In my daily work, I train engineers on how to use our chips. I 

present our new technology to our customers and I ensure that 

their systems are successful. I am here today because I volunteered 

to participate in this hearing because stock options have played a 

large role in my decision to pursue a career in the high-tech field. 

I wanted to communicate to you the impact that they have on employees as well as companies that offer broad-based stock option 

plans. 

I graduated from Carnegie Mellon University in 2000 with a 

bachelor’s degree in electrical and computer engineering. I had job 

17

offers from a broad range of companies at the time of my graduation. During my time at CMU, I had a couple of summer internships at Fortune 500 companies, and both companies offered me a 

job upon graduation. However neither offered a broad-based stock 

option plan. 

I also interviewed with a number of high-tech firms, and every 

job offer that I got from a high-stock firm did include stock options. 

So I decided that I wanted to work where I had a stake in the success of the company. I decided I liked the idea of being able to profit not only from my salary, but also from the growth of the company. 

In retrospect, I can definitely say I have seen a difference in both 

the behavior and performance of employees in high-tech firms that 

have a vested stake in their company, compared to the people that 

I worked with at companies where they did not have that ownership stake. 

My first day at Altera, I was granted stock options that would 

vest over the next four years. So after one year if I stayed with the 

company, 25 percent of those options would vest. If the stock price 

had gone up, I could buy and sell those options and realize a profit. 

I could not transfer those options or sell them on an open market 

of any kind. I could only use them for my own personal gain. 

Also each year at my annual review, I was granted a new batch 

of stock options based on my performance that would follow a similar vesting schedule. This ensures that I was constantly motivated 

to stay with the company and continue to work for its long-term 

growth . 

Stock options are a great incentive for employees. People work 

hard not only to advance their personal companies, but to grow the 

company as a whole. They allow all employees to grow into the success of the company. As the sales and profits of a company increase, the employees benefit through the appreciation of the stock 

price. This fosters an environment where employees will go out of 

their way and beyond their job descriptions to grow the company 

as a whole. 

Stock options are also a strong motivation to stay with a company. Because of their vesting schedule, employees are incentivized 

to stay with a good company. Since I believe in Altera’s long-term 

vision, I want to stay with the company and continue to build my 

ownership share in that company through the stock option program. Because everybody at Altera has a stake in the company, we 

are all committed to making the company successful in the long 

term. 

This behavior is not unique to Altera. I see this type of dedication and work ethic at companies all around Silicon Valley. All my 

friends, whether they work at big telecom companies or small 

startups, share the same desire to see their company become successful because they share a stake in that company. Engineers in 

the valley often work long hours and weekends to make sure their 

company succeeds because each person has a personal stake in the 

enterprise beyond just their salary. 

Already in my career I can say I have seen the effect of broadbase stock option plans in action. I have been able to compare the 

atmosphere at a high-tech company in Silicon Valley to some of the 

18

Fortune 500 companies I worked at as a summer intern. I can definitely say that people in Silicon Valley work harder, longer and 

care more about the long-term performance of the company than 

employees that are just there to get a paycheck. 

Throughout my career, I want to continue to work at companies 

like Altera that offer stock options to a broad base of employees so 

that I can continue to work towards the shared goal of increasing 

the company’s value. I believe this promotes an extremely valuable 

working environment. 

I also believe that anything that would make it more difficult for 

a company to grant stock options would hurt the company’s performance overall. The success of Silicon Valley is based on the work 

ethic and dedication of its employees. This work ethic is a direct 

result of the fact that employees know that they will share in the 

success of their company. If anything happens that would not allow 

the companies to offer their employees a share in that success, I 

believe the overall performance of that company would be hurt. 

I sincerely hope you will consider these positive impacts of stock 

options on both employees and their companies while you are determining the fate of this bill. 

Thank you again, Mr. Chairman and members of the subcommittee. I am happy to answer any questions you have at this 

time. 

[The prepared statement of Jeff Thomas can be found on page 

157 in the appendix.] 

Chairman BAKER. Thank you very much, sir. 

I follow a script, Mr. Kruse, and I should have recognized you 

first, but your name did not appear first on my list. So I recognize 

you at this time, Mr. Douglas Kruse, professor, School of Management and Labor Relations, Rutgers University. Welcome, sir. 

STATEMENT OF DOUGLAS KRUSE, PROFESSOR, SCHOOL OF 

MANAGEMENT AND LABOR RELATIONS, RUTGERS UNIVERSITY 

Mr. KRUSE. Thank you. I am pleased to be here. 

I am a professor at the Rutgers University School of Management and Labor Relations. I am also Research Associate at the National Bureau of Economic Research in Cambridge, Massachusetts. 

At the NBER, I am working with Professor Richard Freeman of 

Harvard University and my Rutgers colleague Joseph Blasi. We are 

co-directing a project looking at shared capitalist programs in U.S. 

companies. 

I am also co-author of a book that came out last year, In the 

Company of Owners, that looks at broad-based stock options in 

U.S. companies, co-authored with Joseph Blasi and Aaron Bernstein. I regret that I did not bring a copy of the book to wave 

around. As Doug was pointing out, my publisher will never forgive 

me for forgetting that today. 

As part of the NBER project, we added some questions to the 

2002 General Social Survey, a representative survey of working 

Americans. I want to summarize a few results from that and some 

other evidence for you very quickly. What we found was that 13 

percent of private sector employees say they hold stock options. 

That translates into 14 million stock option holders. We also found 

19

that 23 million workers say they own company stock, 15 million of 

them through employee stock purchase plans. 

Contrary to popular impression, most stock option holders are 

not rich executives. In fact, a very striking finding, the one that I 

would really point to, is in appendix one of my testimony. It turns 

out that 79 percent of stock option holders earn less than $75,000 

a year, and well more than half earn less than $50,000 a year. We 

provide a variety of breakdowns in appendix two showing that the 

majority of the stock option holders are non-managers. More than 

90 percent say that they are in the middle-or working-class, and 

they are spread across regions and across the social and political 

spectrum. We do the same thing in appendix three for holders of 

company stock, and find very similar results. They are very representative. 

I have strong reservations about expensing, since many companies say that they are going to first cut broad-base stock options 

if expensing takes place. There were four studies last year in 2003 

that analyzed hundreds of corporations. They found that one-half 

to one-third were already making large cuts in stock option plans. 

One-half to two-thirds planned cuts in employee stock purchase 

plans. 

One might say, well, maybe the companies are just crying wolf. 

In the last few days, Joseph Blasi and I looked at the first 10 companies to file SEC proxies for 2003 out of the largest 20 companies, 

the Fortune 20 companies. Of these 10, six had already announced 

that they will expense stock options. Five of those six have already 

increased the share of stock options going to the top five executives 

from 2002 to 2003, and all six of them increased the share going 

to the CEO. If this trend continues, we think it will be deeply troubling. It could be bad not just for regular employees who will be 

cut out of stock options, but it could be bad for company value as 

well. 

We did a recent study on executive compensation over the past 

11 years in the 2,000 largest companies. We found that increases 

in executive compensation, including different measures of stock 

options, do not predict future shareholder returns. In contrast, we 

surveyed over 20 years of evidence on broad-based employee ownership, profit sharing and stock options in chapter seven of our book, 

that I should be waving around now. The evidence clearly shows 

that broad-based plans are linked to higher productivity and shareholder return on average; not in every company, of course, but on 

average. 

It would be a shame if expensing discourages companies from 

using and extending these plans that can improve performance. 

Public policy should be encouraging policies that improve performance. 

So our conclusion is if there is expensing, it makes sense to 

somehow preserve broad-based plans. One good approach could be 

to expense just for the top five executives, as the current bill proposes. If expensing does go through for all employees, another possibility is to create a tax credit that would offset the option expense 

only for companies with truly broad-based plans. This could be an 

alternative to the existing deduction when options are exercised, so 

20

it could end up actually being revenue-neutral, a tax credit that 

would end up being revenue-neutral. 

Finally just as a last note, I call attention to another House bill 

that would create a presidential commission on employee ownership. Given the importance of all these issues, given the debate 

around this, we think a presidential commission on employee ownership could be a good way to explore those issues. 

Thank you very much. 

[The prepared statement of Douglas Kruse can be found on page 

125 in the appendix.] 

Chairman BAKER. We thank you very much. You may wave the 

book at any time you choose. Thank you. 

[Laughter.] 

We welcome next Mr. Douglas Holtz-Eakin, Director of the Congressional Budget Office. Welcome, sir. 

STATEMENT OF DOUGLAS HOLTZ-EAKIN, DIRECTOR, 

CONGRESSIONAL BUDGET OFFICE 

Mr. HOLTZ-EAKIN. Mr. Chairman, Congressman Kanjorski, members of the committee, the CBO recently delivered to Congress a 

study entitled Accounting for Employee Stock Options, which details the fact that employee stock options are an economic cost to 

firms. They represent an exchange of value in return for labor services, and displaying that value—measured by the fair value or cash 

equivalent of the option and recognized over a period that the labor 

services are used, the vesting period—leads to a more accurate portrayal of net income in economic terms. 

Correspondingly, the failure to display this on financial statements leads to an overstatement of economic net income. Valuing 

employee stock options is a difficult task and is complicated by features such as vesting periods, forfeiture provisions and non-transferability of these options. However, advances in financial analysis 

permit reasonable valuation of such options, as they do comparable 

instruments such as warrants which are currently held in many 

entities portfolios. And such valuations are similar in their accuracy to those of such complicated issues involving uncertainty as 

retiree health benefits, the impairment of goodwill, or the cost of 

environmental cleanup, which may occur in the future. 

These are all currently displayed in the firm’s financial statements. One would anticipate that the increased use of these techniques under the prospect of the proposed FASB standard might 

lead to further advances in the ability to value these options more 

accurately. Recognizing the expense of employee stock options 

would not alter the economic fundamentals of any business. It 

would not alter the markets in which they compete for customers, 

their international or domestic competitors, or the prices that they 

charge. 

It would not have any impact on the labor markets in which they 

hire their workers or the need for compensation and appropriate 

incentives for those workers. It would not alter the technologies 

that they currently deploy nor the incentives to acquire and deploy 

new technologies. And fundamentally, it would not alter the cash 

flows used to conduct their operations. 

21

Any potential economic impact of expensing employee stock options will come through changes in investors’s evaluations of these 

firms. For savvy investors and for most firms, no new information 

will be provided by moving the disclosure from the current notes 

onto the face of the statement. Expensing would simply make it 

easier and more broadly possible to do the same valuations that 

are available today. 

It is the case that some valuations may decline. If so, those firms 

and their workers would suffer the costs and experience disruption 

from the reduced availability of equity capital to those firms in the 

near term. However some may also rise, and on balance one would 

expect that there would be no great overall impact on the U.S. 

economy and that any targeted impacts on particular firms would 

be outweighed by the improved allocation of capital on the economy, resulting in increased employee productivity, and improved 

economic performance. 

One cannot know for sure the overall economic impact in advance of the adoption of the FASB standard. However, the experience as displayed thus far for those firms which have voluntarily 

undertaken expensing or from the experience from countries such 

as Canada which has not only proposed, but implemented an expensing standard, or the area of the European Union which has announced a standard, but not yet implemented it, all suggest that 

there would be no broad-based economic impact. 

Mr. Chairman, we thank you for the chance to discuss our report 

today and look forward to your questions. 

[The prepared statement of Douglas Holtz-Eakin can be found on 

page 107 in the appendix.] 

Chairman BAKER. I thank you very much for your participation 

in our hearing today and your statement. 

Next, I wish to welcome Mr. Kevin Hassett. Please proceed at 

your leisure. 

STATEMENT OF KEVIN HASSETT, DIRECTOR OF ECONOMIC 

POLICY STUDIES, AMERICAN ENTERPRISE INSTITUTE 

Mr. HASSETT. Thank you very much, Mr. Chairman. 

I agree with Mr. Oxley and Mr. Ose, Mr. Chairman, that the best 

reading of the literature is that right now the literature is not exactly sure how to value these options. The literature is not sure 

how to value these options because of issues mentioned by Mr. 

Holtz-Eakin, but also because the options have a much longer life 

than the type of options that are marketed these days. To my 

mind, having been immersed in the technical details since my dissertation, I think that is the most relevant issue here. 

Indeed, Warren Buffett himself said in the Financial Times that 

the minute you get into longer-term options, it is crazy to use 

Black-Scholes. The fact is that is true. In fact, this issue has even 

made it into the leading text books, as is mentioned in my testimony, and developed in more detail in a recent paper prepared by 

Glenn Hubbard and Charles Calomiris for the American Enterprise 

Institute. 

So I think this explains why it is that FASB has been going so 

slowly on this issue, given their clear designs on expensing. The 

fact is, as you get close to expensing and think about how to do it, 

22

contrary to Mr. Holtz-Eakin’s statement, you find that it is not the 

case that there is an accepted way to do it, which is why FASB has 

refused to specify, it appears to me in reading their documents, 

precisely how firms are supposed to do it. 

So in my testimony, what I do is really go after the question that 

Mr. Frank raised in his opening statement. How is it that you 

could actually change the world if the market is efficient, if it is 

looking at the details on options already, then if you move an expense calculation maybe that is incorrect up to the top line, what 

effect does that really have on anything? Just like if we subtracted 

10 from earnings, then what a rational investor would do is they 

would just add 10 back in. So if we do something wrong, the rational market ought to see through it. 

What I found after studying this issue with my colleague Peter 

Wallison at the American Enterprise Institute, who as you know is 

a very distinguished attorney who has worked for President 

Reagan and has had other positions in town, is that it is very likely 

that if we do not tell firms how to expense options and know that 

we are basically giving them a problem to solve that has not been 

solved by the literature, then we are going to open up a real legal 

mess that will potentially tie firms up in class action lawsuits for 

years and cause you to have to consider new legislation. 

In my testimony, I provide a simple example of the state that I 

think we might end up in if FASB has its way. That is, suppose 

that for example a publisher that finishes a book in 2003 and plans 

to send it to the book stores in 2004, is required to forecast the 

sales in 2004 for that book by FASB and include that in their 2003 

statement. And FASB does not tell them how to forecast it. They 

just say, you have to say, since you paid for the expenses of the 

book in 2003 what the sales are going to be in 2004. 

Well, the firm would presumably try its best to develop a model 

to forecast sales, but of course on average there would be a whole 

lot of firms that would make errors. As soon as they make those 

errors, the earnings will be misstated, and that will open the firm 

up to class action lawsuits. It is my belief and Mr. Wallison’s belief, 

and we have spelled this out in great detail in a paper that is just 

coming out in Regulation magazine, that the real reason why the 

expensing of options is going to cause firms to not use them as 

much as they do now, and to shy away from them, is because if 

you do not specify a model, then everybody is going to get the expense wrong. Probably about half the firms at least are going to 

have over-stated their earnings because their model led them to do 

that. With that over-statement, they are going to find themselves 

enmeshed in really difficult lawsuits. 

So I think it would be a big mistake for FASB to require the expensing of options without expressly stating how to do it. If they 

expressly state how to do it, then the firm will at least have the 

defense that we are just following FASB’s directions and that defense might well be a reasonable one and a successful one. Absent 

that, I think that FASB is creating a real mess for our corporations 

and one that will lead them to shy away from the use of options. 

Thank you. 

[The prepared statement of Kevin A. Hassett can be found on 

page 90 in the appendix.] 

23

Chairman BAKER. Thank you very much. I appreciate your participation. 

Our next witness is Mr. Phil Smith, chairman of the board, Taser 

International. Welcome, sir. 

STATEMENT OF PHIL SMITH, CHAIRMAN OF THE BOARD, 

TASER INTERNATIONAL, INC. 

Mr. SMITH. Thank you, Mr. Chairman and subcommittee members. It is a pleasure to be here. Let me give you a quick background and then launch into what I have to say. 

I have an undergraduate degree from West Point, MBA and I 

have a PhD in business and a specialty in finance, so I clearly understand all the theoretical arguments. I have been a corporate officer in three Fortune 500 companies and I have done five hightech startups. I spent the last 35 years in this business, so I have 

lived it from almost the inception. 

I guess I am one of the few guys here who can talk from practical 

reality and not some theory. I really get a kick out of most of the 

people testifying yesterday in the Senate and have never seen an 

option, used an option, have ever benefited from an option or ever 

used them to try and attract employees to a company. That is what 

is most disappointing to me. The people that are really involved 

have had very little voice in what is going on. I hope that this committee takes this to heart. 

I can give you one example, of these five startups. I did one in 

the Silicon Valley in 1983 that we sold in 1985 very successfully. 

The employees out of that company started 12 new companies. 

They took the money they earned from the options and literally 

like a thing exploding with seeds, 12 new companies started in the 

Silicon Valley in 1985 from the people from that company. 

I can go through example after example. I do not have the time. 

Options are used not only for employees. As I pointed out in my 

testimony, when we went public 3 years ago at my current company, Taser International, we were in need of some interesting 

board members to comply with the corporate governance that 

Chairman Oxley has been kind enough to levy on all corporations 

in America. When you go out and talk to significant board members and people with a strong background, there is a real risk in 

coming on a public company’s board today. The trial lawyers love 

to have them. People are very concerned about joining public 

boards, especially young public companies. One of the ways we got 

the people we did, the caliber we got, was the ability to use options. 

Now, it turned out they have been very successful. They all have 

made quite a bit of money as a result of that. But at the time they 

took those options, they accepted the risk. You take this option 

away from us and force to expense and I do not know how we are 

going to attract these board members. We could not have afforded 

to pay them the money it would have taken to get them on our 

board and provide the governance that the Congress is looking for. 

The second thing is, it is a double whammy for small companies. 

A current thing, our stock is extremely volatile. It fell 32 percent 

yesterday, which happens to be just one data point. The stock is 

up 6000 percent over the last 12 months. We have what is called 

a very high volatility. We get penalized because, one, we are a 

24

small company and secondly, we are highly volatile. You take the 

measurement of our company. We will get two penalties, not just 

one. One, we are small; second, we are highly volatile. 

Those will really impact the bottom line of our company, and obviously a lot of our investors are retail investors. I agree, the sophisticated investor can read the footnotes in our balance sheet. 

They are cops. They are police officers around the country that own 

100 or 200 shares. They do not understand the sophistication of 

footnotes, and they are not going to understand when all of a sudden the earnings drop on the company compared to other companies in the industry. 

Third, I would like to talk about the issue of tax. Our corporation 

has not paid tax for the last couple of years because of employee 

options. When they exercise their option and make the profit, they 

pay a personal tax. The corporation gets the benefit. We have been 

able to retain that tax and use it to grow, and we have grown our 

employee base to 199 employees from 70 a year ago by using that 

cash flow. It would normally have been paid as corporate income 

tax. Nobody has talked about the tax issue here, about the corporations that are allowed to retain that tax, the cash on their balance 

sheets and use it to grow. 

Let me give you one last thing. We have stopped issuing options. 

We have given all our employees their final options this year. They 

vest by the end of the year, merely because of this legislation. We 

do listen to what goes on in Washington. We do watch what is 

going on and we are not about to penalize our shareholders and 

ourselves by issuing a bunch of options that we have to expense in 

future years. We have told our employees there will be no more options if this passes, and the only people that are going to get it are 

the top five. 

My last comment, as Mr. Sherman mentioned, he tried to contain executive compensation with the $1 million salary cap, and we all 

see how effective that was. They just reported the highest executive 

compensation in the country this past year, I think it was in USA 

Today. So it had very little effect on the top five. Your proposal will 

address the top five and let the average employee have a chance 

to benefit in the success of their company. At Taser, we have 20 

millionaires, from secretaries to production employees, right up the 

line. They are the ones who are going to lose out. Those are the 

ones who will not get the options. It will still go to the top five. 

I certainly hope you are successful, Mr. Chairman. 

Thank you. 

[The prepared statement of Phil Smith can be found on page 152 

in the appendix.] 

Chairman BAKER. Thank you very much for your contribution 

here. 

Our next witness is Mr. Robert Grady, managing partner, 

Carlyle Venture Partners. Welcome. 

STATEMENT OF ROBERT E. GRADY, MANAGING PARTNER, 

CARLYLE VENTURE PARTNERS 

Mr. GRADY. Thank you, Mr. Chairman and members of the subcommittee. I appreciate the opportunity to present this morning, 

not only on behalf of the Carlyle Group, which is one of the world’s 

25

largest private equity firms, but also I serve as a member of the 

board of directors of the National Venture Capital Association. By 

coincidence, I also have taught for the last decade on the faculty 

of the Stanford Business School, which we will come back to in a 

minute. 

The FASB has asked for comment on this exposure draft, and 

our comment is simple. The proposal is inappropriate. It is incorrect as a matter of financial and accounting theory. I think it is 

poorly thought-out and it is very definitely unworkable. 

Before I comment directly on the exposure draft, let me just offer 

a little context that makes clear the typical use of stock options 

today in the economy. 

The two venture capital funds that I spend every day managing, 

which were started in 1997 and 2002 respectively, have investments in about 38 different companies, all started from the ground 

up. Those 38 companies employ over 4,000 people. In the five private companies on whose boards I sit, Blackboard here in Washington, DC; Panasas in Fremont, California; USBX in Los Angeles; 

Secure Elements out in the Virginia suburbs; and Ingenio, also in 

California; incentive stock options are granted to every single employee, from the receptionist to the CEO. That is typical in the venture capital world. In fact, according to a recent survey by the 

NVCA, over 70 percent of venture-backed companies award stock 

options to every single employee. You heard Professor Kruse state 

that half of all option holders in the country earn less than $50,000 

a year. 

The standard type of grant in a venture-backed company is a 

grant that is vested to encourage an employee to stay at the company. A typical structure, in fact the most commonly used in venture-backed companies, calls for the grant to vest over 4 years, just 

like the grants that Mr. Thomas received when he joined his company, with so-called ‘‘cliff vesting’’ on the first anniversary of employment of one-quarter of the options and then monthly vesting of 

the remaining three-quarters each month over the next 3 years. 

That is an important point to understand about how options 

work, because under the FASB’s exposure draft, with its provisions 

for graded vesting, the normal grant of stock options, the one that 

virtually every venture-backed company in America uses, will have 

to be valued 37 different times per grant. Somehow, the FASB believes this will make financial statements more understandable. 

Let me turn to the FASB’s exposure draft and how its policies 

will work or not work if implemented. First, I do feel compelled to 

start with a fundamental conceptual point, and that is that options 

are units of ownership. They are shares. They are not expenses. 

They are not claims of cash against the company’s resources. They 

are not the use of a company asset. Basically, they should be treated and disclosed, in my view, in the denominator, if you will, of the 

earnings-per-share calculation. If you account for them in both the 

numerator and the denominator, you are double-counting them. 

So if in fact FASB were proposing in this exposure draft that 

when companies report earnings per share, they had to disclose in 

every case the fully-diluted share count, that is, including all options outstanding in the denominator, I think that would be a fair 

and very workable proposal. I think this point is essential, because 

26

at its heart, what this debate is all about is that many Americans, 

and in fact people all over the world, are willing to trade off cash 

compensation for units of ownership. They are willing to earn less 

cash today and thereby create less in terms of ongoing expenses by 

the company, so that over the long term the company will be worth 

more. In other words, they are thinking like owners. It is good for 

other shareholders who might choose to join them along the way 

that they are thinking like owners, because their interests are 

aligned as mutual owners of the securities of the company. 

Ironically, the proponents of expensing say that requiring it will 

not have the dire effect that many predict, that some of us predict, 

because they say investors will just in effect ignore it. Investors 

will basically strip out the effect of expensing and look straight to 

cash EPS. So in other words, they will ignore GAAP. The reason 

they will do it is precisely because it will not be representative of 

the company’s true expenses. That is exactly what I believe Representative Frank was saying, if reality does not change. So the 

irony of the FASB proposal, in other words, is that it is likely to 

undermine confidence in and the use of GAAP accounting, which 

one presumes to be the exact opposite of the objective of the proposal. 

In the gymnastics that FASB has had to go through to get over 

this fundamental point, in trying to define units of ownership as 

expenses instead of shares, they have created a number of problems that I would just like to touch on and enumerate briefly. 

The first obstacle, of course, is trying to define the appropriate 

measurement date at which to value an option. There are two different possibilities. The FASB has suggested that the grant date is 

appropriate. The problem with this, of course, is that the value of 

the option at grant date is highly uncertain. It may never vest. The 

employee might leave. It may never be exercised because the stock 

may never be ‘‘in the money’’ during the appropriate time frame. 

An alternative is to move the measurement date to the exercise 

date, and that would even be worse because it would simply penalize the most successful companies, those with the brightest prospects, for the mere fact that their stock has appreciated. You have 

heard the example of Taser. Their profits would be wiped out by 

the mere fact that their stock had appreciated, regardless of the 

performance of the company. 

A second problem which the committee has discussed today is 

how to value what an option would be worth. FASB suggests using 

observable arms-length transactions, but of course for private company options they have never traded, so the value of the option has 

to be modeled somehow. There is a choice of modeling and methodologies to use, and whatever choice you make leads to a radically 

different assessment of value. 

That, of course, leads to the third problem, which is that any of 

the models that one could choose, including Black-Scholes, named 

for the late Fisher Black and my former colleague at the Stanford 

Business School, Myron Scholes, and a binomial model for that 

matter, rely on one key variable and that is the estimate of the volatility of the underlying stock. Of course, since private company 

shares have not traded, any estimate of volatility is basically a 

guess. Actually, FASB makes it worse because they say we are not 

27

to look at historical volatility; you are to estimate future volatility. 

So any estimate of volatility will be subject to both potential manipulation and inaccuracy. 

That, of course, leads to a fourth problem, which is to try to get 

around this problem of estimating in advance the volatility, FASB 

has given private companies in the proposal the option to use intrinsic value as a way of valuing options. Under this methodology, 

the value of the option is adjusted for every reporting period, every 

quarter, or in some cases of private companies, every month, and 

is changed to reflect an estimate of value or stock price if it is a 

public company. That is basically a form of variable accounting 

which brings stock price directly into the income statement of the 

company, and of course introduces the potential for wild swings 

from quarter to quarter of the value of any given option, so it will 

be massively confusing for investors. 

The fifth problem is that FASB ignored that most private company employee options are highly restricted. That is, they are not 

only subject to vesting, but they cannot be transferred; they cannot 

be hedged; they cannot be pledged; they cannot be sold. So it is 

very hard to value these restrictions. Interestingly, FASB argues 

that no restrictions that exist during the vesting period should 

even be considered in valuing the options. Clearly, an option that 

is subject to restrictions is worth less than an option that is subject 

to no restrictions, yet FASB would have them be recorded at exactly the same price. So much for the concept of fair value. 

Finally, in seeking to identify the proper time period over which 

to attribute the expense that the exposure draft would require, the 

FASB creates a whole new set of problems. For example, the exposure draft suggests that companies should try to model or predict 

the groups of their employees for purposes of predicting their exercise behavior. That is because the proposal calls for them to adjust 

the contractual term for expected early exercise or post-vesting behavior. Obviously, that would be a completely speculative exercise 

that would be almost preposterous in its unreliability. 

All of these obstacles, by introducing theory, uncertainty and 

subjectivity in place of the actual experience, which is what financial statements are supposed to reflect, will make the income statements of companies less reliable, not more reliable. 

In the end, Mr. Chairman, I think what is clear from FASB’s 

proposal is, as you suggested in your opening statement, that it is 

responsive not to the volume of comments it has received from the 

venture capital community or companies that use options, but rather to the political process. I do believe this is fundamentally a political proposal and, as you said, Mr. Herz is quoted as inviting people to contact their representatives. I do believe it is in response 

to something that has nothing to do with employee options, which 

is the reported abuses at places like Tyco, WorldCom, Adelphia, et 

cetera, where people stole company resources, allegedly, or reported 

incorrectly the financial performance of the company. 

In this regard, the National Venture Capital Association does 

support the legislation you have proposed. We believe it is responsible. We believe it is appropriate to exempt private companies 

where it is impossible to value the options from the expensing requirement. Having taken 175 or so companies public in my career, 

28

I believe it is appropriate to exempt companies during their first 

three years of being a public company so that you can get some 

trading experience and understand how to assess the volatility of 

the stock. With that, we do hope that the Congress will act on your 

proposal. 

Thank you, Mr. Chairman. 

[The prepared statement of Robert E. Grady can be found on 

page 84 in the appendix.] 

Chairman BAKER. Thank you very much. 

Our final participant this morning is Mr. George Scalise, president of the Semiconductor Industry Association. Welcome. 

STATEMENT OF GEORGE M. SCALISE, PRESIDENT, 

SEMICONDUCTOR INDUSTRY ASSOCIATION 

Mr. SCALISE. Thank you, Mr. Chairman and members of the committee. I am George Scalise. It turns out I have been in the semiconductor industry for about 45 years, so I have seen it from the 

very earliest days and I have seen what stock options have done 

to help build this industry from a startup to what is now a $200 

billion a year industry. I also have been the beneficiary of that 

process of stock options. 

First of all, the SIA strongly supports H.R. 3574 and we commend the leadership of the Chairman as well as the 30 members 

of the committee that are co-sponsors of the legislation. Going back 

to the industry for just a moment, the U.S. semiconductor industry, 

the U.S.-based companies, are the most competitive in the world 

today and have been since the onset of this industry. We currently 

have about 50 percent of that $200 billion a year market. It turns 

out that only 20 percent of that market is here in the U.S. However, about 70 percent of our manufacturing is located here in the 

U.S. The average employee earns about $97,000 and we have about 

255,000 employees here. 

So this program that we are talking about is very vital to this 

industry and has been since the onset. Semiconductors, as you 

probably know, are the building blocks for the whole information 

technology market, which is now a $1 trillion export market for the 

U.S. So whether you are talking about equipment or software, it 

does not really matter; whether it is games or automobiles, they all 

embody semiconductors. 

The other thing that is important about this is that semiconductors and the IT industry now represent about 8 percent of the economy, but it turns out they are more than 30 percent of the growth; 

they reduce inflation by about 1 percent a year; they increase productivity by about 1 percent a year. As a consequence, they make 

a major contribution to the overall economy. 

Keep in mind, our prices go down every year by at least 30 percent. Every year the prices go down by at least 30 percent. So if 

you bought a bit of memory in 1995 for $1, you would be paying 

about 2 cents for that today. In a few more years, you will be paying 1/100th of a cent or less than that as we go along. So this kind 

of contribution is something that we need to find ways to encourage 

and support and make continue to happen going forward. 

Going on to the competition, as I said, this is a worldwide market. It is also worldwide competition. As someone said earlier, our 

29

competitors overseas have now seen the wisdom of using stock options as a method of dealing with their employees, compensating 

their employees. In a recent forum that we had at Stanford University, about a month ago, we had representatives from Taiwan, 

China, Korea and the U.S. talking about the industry and what 

was going on, and what the competition was all about. One of the 

folks from Taiwan pointed out that they do not really have a cost 

associated with stock options because there is no tax benefit, therefore they can grant these very lavishly, if you will, and the employee gets a great benefit from it. 

As a consequence, they have now attracted about 5,000 of some 

of the very best engineers we have in this industry, to go to Taiwan 

to be a part of the industry there today. Now, granted, a number 

of our employees are foreign-born. They come to our universities, 

are trained, and they come to work with us here. But up until very 

recently, they have been employees that stayed with us. We are 

now beginning to see that migration reversing and going the other 

direction. In large part, it is because of the kind of compensation 

and the kind of tax structure that is associated with stock options. 

Let me just turn for a moment to the accounting side of this, because I know that is one of the important arguments that is being 

put out here. I think that our greatest concern, I think you have 

seen editorials on the part of some of our CEOs in the industry, 

who are making it very clear that if there is going to be a change, 

the investing public is going to have to see something that is very 

transparent, that is very accurate, and is very comparable from 

company to company. I think the evidence that we have heard 

about here today, and I do not want to go into it again because I 

think you have heard it, is that that is not possible with the proposal that is in front of us today. 

Therefore, I think the legislation that is being proposed to take 

a hard look at this and make sure we understand just what the 

consequences are, is very, very critical, so that we do not make that 

mistake of adopting something that is not going to be transparent, 

that is not going to be accurate, and will not be comparable from 

company to company. That would create more confusion, and in 

particular it will disadvantage the small investor versus the professional investor by a wide margin. That is the last thing that we 

should have happen. 

The other point that I would like to make is on the stock purchase plan, which is a very important part of all of our companies. 

Again, the companies that have stock purchase plans is for 100 

percent of the employees, just like our stock options are for anywhere from 80 to 95 percent of our employees; in some cases 100 

percent. That will absolutely destroy the employee stock purchase 

plan if this proposal goes forward. 

Again, I think this is one of the great opportunities for young 

people to get their first real shot at building equity for themselves 

and their families is through these stock purchase plans. They are 

very, very quick to unfold, and again if the company does well, 

these people can do very well and they can begin to buy their 

homes and do the other things that young families do. So I think 

it is very important that we make certain that we maintain the 

30

vigor and the opportunity associated with employee stock purchase 

plans. 

Finally, as far as international convergence is concerned, I do not 

really see why we have to rush to try and come together with IASB 

and whatever their proposal happens to be, because first of all I do 

not think there is a timetable associated with that that is going to 

necessarily come to pass. There is a lot of controversy with the European companies on the IASB proposal, and therefore I think we 

ought to set that aside as having no real validity as far as consideration as we take a look at this FASB proposal that is in front of 

us. 

Thank you. I am ready to answer any questions. 

[The prepared statement of George Scalise can be found on page 

148 in the appendix.] 

Chairman BAKER. Thank you, sir. Before I proceed with questions of my own, I just want to yield time to Mr. Shadegg for purposes of an introduction. Mr. Shadegg? 

Mr. SHADEGG. Thank you, Mr. Chairman. 

I simply want to welcome Mr. Phil Smith of Taser International, 

chairman of the board. I apologize. I was across the hall in a hearing of the Commerce Committee which happens to be dealing with 

some issues that affect Arizona, Luke Air Force Base, the Goldwater Range right now, so I had to be there and could not be here 

during opening statements. 

I welcome Mr. Smith. Taser is located in the metropolitan Phoenix area where my congressional district is. I appreciate his testimony here today. Mr. Chairman, as you know as a member of the 

Congress who is deeply concerned about the FASB proposal and believes the better alternative is in fact the legislation you have introduced, I appreciate Mr. Smith’s comments on that point, and I 

simply wanted to be able to welcome him to the committee as a fellow Arizonan. 

Thank you, Mr. Chairman. I yield back. 

Chairman BAKER. Thank you, Mr. Shadegg. 

Professor Kruse, I am interested based on your study of industry 

practice that is evident in the book. In identifying the problem that 

started the current academic discussion, was there evidence in your 

view of broad-based plans being manipulated adverse to either the 

corporate or public interest? 

Mr. KRUSE. With respect to broad-based plans, no. We came to 

this interest in broad-based plans out of a couple of decades of research we have done on broad-based employee ownership, profit 

sharing, programs that involved employees in company performance. That is where we came at it from. 

When we looked into broad-based plans, doing very extensive research on this, both quantitative and qualitative research, we did 

not find the broad-based plans being manipulated in the way that 

a lot of the executive plans obviously have been. 

Chairman BAKER. Is it not true that with regard to SEC rule 

treatment of the top five proxy requirements for disclosure and disclosure of compensation, that there is now precedent for the top 

five being treated differently today from others within a corporate 

reporting structure? 

Mr. KRUSE. Yes, that is true. 

31

Chairman BAKER. So I can make the legitimate claim that the 

selection of the top five is consistent with other body of law and 

regulation by way of special disclosure for those set of individuals? 

Mr. KRUSE. I believe so. 

Chairman BAKER. Thank you. 

Mr. Grady, you made comment with regard to the difficulty of 

predicting accurately volatility in a startup company. Is it not the 

case that FASB now and has historically allowed privately held 

corporations to set volatility at zero? 

Mr. GRADY. Yes. The current rule allows minimum value to be 

the methodology used in calculating the value of an option, but the 

proposed rule disallows the use of that going forward. It actually 

complicates matters by allowing three different ways for options to 

be valued. It says for the old options, you can use minimum value, 

but going forward you have to switch to using one of the models 

I suggested, one of the lattice or binomial models. 

Chairman BAKER. Let me help make that point. Where you have 

a historic record and could possibly predict volatility, you do not 

have to; and going forward on startups that you can’t, you are 

going to be required to. 

Mr. GRADY. Right. Well, for all options going forward under the 

proposal. Yes. 

Chairman BAKER. Mr. Smith, you discussed the fact that in your 

corporation you have now given notice to employees going forward 

that this year’s grant of options is it. It has also been stated by others on the panel and from other reports that foreign competitors 

now put banners up at job fairs, ‘‘options granted.’’ What is the potential impact from your perspective on future startups on innovation if we, within the United States, preclude granting of options 

without expensing, and our competitive industries in international 

markets are allowed to proceed as they have historically, given the 

allegations of job economic recovery and all the concerns about 

outsourcing. 

Mr. SMITH. In our company today it is not as important as it 

was. We are now a pretty visible company and we have a lot of 

cash. But when we started the company, over the 11 years it took 

to get there, it was extremely important. We were hiring people at 

below-market wages, no question about it. Our average people 

make $40,000 a year, by the way, that have the stock options that 

I referenced in my written statement. So it is not the high-paid 

people. 

We have a lot of people who come into the company and take 

those jobs. Think about it. A person is sitting in a large corporation 

with a 401(k), a pension plan, great health benefits, and you are 

going to give him a chance to come into a less-than-ideal working 

environment, nothing is fancy in a small startup company. It is 

pretty rough-going. You ask him to work 12 or 14 hours a day, and 

they don’t generally have very good health benefits and certainly 

do not have 401(k) or pension plans. What is the incentive for a 

person to do that? And you are going to pay him less money? 

I remember when I left Boston, I was working for 

Computervision. It was a Fortune 500 company at the time. We 

were standing in a 9,000 square-foot house, and my wife says: let 

me understand this; you are taking a cut in pay to 40 percent of 

32

what you are making now; you have options in a company which 

is out of money, it was a venture startup; and I am going to have 

a house that is about as big as the garage on this house. Why am 

I not excited about moving to the Silicon Valley? 

That is the issue. You have to have some compensation for these 

people to take that risk and make those moves. I have done it multiple times in my life. I have been broke more times than I have 

made money by doing that, but that is the whole part of an entrepreneur. Getting these people to take that risk, you have to offer 

them something. 

One thing I would like to point out. I do not know why we are 

in such a rush to be like everybody else. The last thing I want to 

be is like everybody else. Everybody else in the world did not create 

the growth engine and jobs that we did in the Silicon Valley, right 

out to the beltway here with AOL and MCI and many great companies got started. These options were an instrumental part of it. 

I do not know why we are in such a heck of a hurry to go out 

there and dismantle the machine that has worked and served us 

so well in the past, especially now when we need to develop the 

next new thing to put people back to work in this country. I would 

not be tampering with anything in this area for the next couple of 

years until we find what the next new thing is and get these people 

back to work. 

A long-winded answer. 

Chairman BAKER. I thank you for the answer. It is sort of like 

the fire department showing up when the house is on fire and simply burning the rest of the neighborhood. It just does not seem to 

be a responsive solution to the problem at hand. 

Mr. Frank? 

Mr. FRANK. Thank you, Mr. Chairman. 

I would just say to the previous witness that I do not know when 

you sold that house, but given what has been happening to house 

prices in Massachusetts, a 9,000-square-foot house, you would have 

to have some pretty good options to beat what you could have made 

on that if you had held it. 

I want to just expand on what I said before. Let me talk to the 

people who are in the industry, who have told me, and I take this 

with great seriousness, that if the expensing requirement goes 

through they will stop giving options. I guess we ought to be very 

specific why. Obviously, the reality will not have changed. Why will 

you have to stop giving options? Is it the reaction of the investor 

community, the lender community? What will require you to stop 

granting these if the reality has not changed, but the way in which 

you are to account for them does? 

Mr. SMITH. Is that question for me, sir? 

Mr. FRANK. Any of you. 

Mr. SMITH. I will take a shot at it. We stopped it because we do 

not want to impact our operating performance next year for our 

shareholders because of these options being expensed. 

Mr. FRANK. Excuse me. The question is this, it is not the reality. 

So the shareholders, what will cause the share price to drop? Is it 

the reaction of an investor community that says, hey, they moved 

this from the footnote to the bottom line. That is my frustration. 

33

Mr. SMITH. Let me explain it to you. I think you were out of the 

room. A lot of our shareholders are policemen. They are cops. They 

own 100 to 200 shares of our stock. When they look at the income 

statement, they have no idea what footnotes are or anything else. 

All of a sudden they are going to see this dramatic change next 

year. I would say a good 40 percent——

Mr. FRANK. There are two problems with that. I would hope we 

could try to just educate the community. Cops have to be fairly sophisticated about something. The other thing is, unfortunately your 

arguments cuts a little bit both ways because one of the arguments 

people have now is, well, that information about the options is already there. It is in the footnote. When you argue that while it is 

in the footnote, they will not read it, you are unfortunately frankly 

giving support to some who say people do not know it is there. It 

cannot be both. It can’t be available and impervious. 

Mr. SMITH. I am going to make one comment and pass it off to 

some of my colleagues. If it ain’t broke, don’t fix it. 

Mr. FRANK. I am sorry. That is not good enough for me. We are 

here in a deliberative process and I am trying to express the sympathy I feel. But sloganeering like that does not help me. I am not 

a car. Don’t put a bumper sticker on me. I am asking you a question and I want an answer. There is a problem here. It may lead 

us to a broader problem. Your argument appears to be that the investor community on which you have to depend, in particular an 

investor community because of the nature of your product that is 

not the broader one, does not understand this. We need to have 

more than just a bumper sticker. 

Mr. Grady? 

Mr. GRADY. Congressman Frank, I think it does beyond that. 

What clearly will happen if you move it into the income statement, 

it will reduce, of course, the reported profitability of the company, 

even though the operating circumstances of that company will not 

have changed, the cash will not have changed, the cash expenses 

will not have changed. 

Mr. FRANK. No reality will have changed. 

Mr. GRADY. But it will radically reduce——

Mr. FRANK. Okay. Who will be influenced by that? 

Mr. GRADY. I think investors will be influenced by that. 

Mr. FRANK. Okay. 

Mr. GRADY. As we have discussed during the hearing, the method by which people will calculate how much that expense will be 

will be highly variable from company to company. It will make, in 

effect, the reported P/E ratios of all companies, which is how the 

comparing is done, less comparable. 

I will give you a real world example. The way people calculate 

earnings will be just considerably more different from company to 

company because there are all these methodological issues. 

Mr. FRANK. But can’t you say, then, look, this is the way it used 

to be, and this is the reason for that volatility. It is there now, the 

reality is there now. Options are clearly not a nothing. They have 

some impact. 

Mr. GRADY. The reality is there now and most investors, to your 

point, are sophisticated enough to look at the fully diluted share 

price and calculate their EPS. 

34

Mr. FRANK. Are they able to make comparisons? 

Mr. GRADY. The sophisticated investor will strip out the option 

expense and compare cash EPS, which means they will render 

GAAP irrelevant. 

Mr. FRANK. Are you saying a sophisticated investor would disregard the existence of options in deciding whether or not to, you 

say, strip out. Please let me finish the question, Mr. Grady. 

You are telling me that the sophisticated investor would simply 

ignore the existence of the options? I assume that is what ‘‘strip 

out’’ means. 

Mr. GRADY. They would ignore it for purposes of comparing. 

Mr. FRANK. Mr. Grady, please stop, because I think you are obfuscating, unintentionally. 

Mr. GRADY. No, I am not. 

Mr. FRANK. Then I may be, but here is the deal. I am an investor 

and I am trying to make a decision. When I make a decision based 

on, I do not invest in any real companies because we get enough 

people claiming we are guilty of conflict of interest, so fortunately 

I am free of that, but I am an investor and I am looking, you say, 

well, after the FASB thing, it will be hard to make comparisons. 

But how do I make the comparison now? 

Presumably, if I am a sophisticated investor and I am trying to 

decide between one or another company and one has a certain 

amount of options and one does not, and another has options. How 

do I value those now? Or do I not take those into account in deciding when to invest? 

Mr. GRADY. You do take them into account, as I said, in determining the share count for the company in the denominator of the 

earnings-per-share calculation. I believe that people will continue 

to do that. 

Mr. FRANK. But is that easier to do now than it would be later? 

Why? Why is it easier to make those comparisons now than it 

would be if the accounting treatment differed? 

Mr. GRADY. The ability to calculate the number of shares will be 

the same as it is now. What will be different will be the quality 

of the earnings being reported. 

Mr. FRANK. I understand that. But you understand that those 

are just affected by the accounting. The reality has not changed, 

has it? 

Mr. GRADY. The reality is being proposed to be changed, and that 

is that people have to take into——

Mr. FRANK. They do not have to. Investors are free to make his 

or her own decisions. The company is still there and those things 

are still there and the investor can still make the decisions based 

on——

Mr. GRADY. Here is what will change, I believe, in reality. The 

most common means by which investors compare stocks is price/

earnings ratio. You will now have a wildly different set of assumptions that go into the ‘‘E’’ in a PE ratio. 

Mr. FRANK. Okay. My last question is this, because here is what 

we are saying is that frankly the people who are getting more beat 

up here are the investors who do not come out of this looking all 

that smart. 

Mr. GRADY. But I think——

35

Mr. FRANK. Excuse me, Mr. Grady, please stop interrupting. This 

is just not helpful. The point is this, what you are telling me is that 

if FASB’s rule goes through, even though the reality of the company will not have been changed if they continue to give options, 

investors will look only at the P/E and will make bad decisions. 

They will make decisions on inadequate information. Inevitably, 

this has got to be something of a negative judgment on the investor 

community because you are saying if you do this, they will just look 

at the P/E and that will make this enormous difference to them, 

when in fact you were telling me it really should not, given that 

this is a perfectly reasonable thing to continue to do. 

Mr. GRADY. May I make one comment? 

Mr. FRANK. Sure. 

Mr. GRADY. I believe that to avoid the confusion, which we were 

both just speaking about, what will happen is people creating the 

companies, people starting the companies, people running the companies will say, to avoid the confusion I will use more cash to reward employees and less options. 

Mr. FRANK. I understand. But the confusion is on the part of the 

investor who is reading the situation. 

Mr. GRADY. Which means less companies will be started. 

Mr. FRANK. I understand that. The question is why that would 

be the case. It really does come down to apparently a lack of confidence that investors will be able to sort this out. 

Mr. GRADY. Right. I believe this will make reporting more confusing, not less confusing. 

Mr. SMITH. Let me add one thing. Reporting is one thing. Hiring 

employees is another. If you are out there, Mr. Frank, and you are 

trying to hire employees as a young startup company and you are 

competing against well-established big companies that have much 

better benefits, better pay, et cetera, what the heck are you going 

to offer them? 

Mr. FRANK. Excuse me. You totally misunderstand my point. I 

understand that, that options are attractive. What I was trying to 

get at is, what about FASB would lead you to stop issuing options? 

That is the question. So your answer is totally irrelevant to what 

I was asking. 

Mr. GRADY. It is the cost, the cost on the bottom line. 

Mr. FRANK. I have gone over my time and I do not think this is 

going to be enlightening. 

Chairman BAKER. If the gentleman would yield for just a minute, 

I appreciate the gentleman’s sincere effort at this. I just want to 

make one small explanation if it might be helpful. It does change 

economic reality in this case. If there is a granting of an option at 

a fixed price, and going forward the price does not move in the 

money and the option is not exercised, the FASB requirement 

would require you to expense that in the current dollar disclosure, 

so you would have a negative impact on the corporate profit, which 

is not an accurate disclosure of true financial condition. 

However, going forward if the option is exercised at a higher dollar price, I think argument can be made that contributions of those 

individuals who are engaged in the corporate structure as a result 

of the grant of the options, have increased value and therefore the 

dilutive effect on the residual shareholders is minimal, if at all. So 

36

it is not 100 percent accurate, but I think the negative effect of expensing when they are not exercised is far worse than the residual 

effect of expensing at the time of exercise, which is now required. 

Mr. FRANK. I thank the Chairman. That is in the spirit of what 

I was saying. Again, it all comes down, unfortunately, to the way 

it is perceived. Let me just say one further thing, Mr. Chairman. 

I just want to now, in the absence of the Ranking Member of the 

subcommittee who had to leave, I just want to notify you that we 

are going to use our Rule 11 rights to ask for another day of hearings. A letter with the appropriate number of signatures will be delivered to you before the end of this hearing so that we can have 

another hearing. 

Let me just say, this comes from people both for and against the 

bill. This is not a sign that people are against the bill. This is just 

an important subject and we will be asking for it. There is no reason that they should hold up any schedule of any action, so it is 

not to be taken as hostile to the bill. 

Chairman BAKER. The Ranking Member had indicated to me his 

interest in that, and I said I have no such reluctance, but out of 

courtesy to the chairman I have not had a chance to visit with him 

about the schedule. 

Mr. FRANK. That is why we thought we would use Rule 11, because that is an option to the chairman. He is a busy fellow. We 

do not like to bother him. 

[Laughter.] 

Chairman BAKER. We always appreciate your creative assistance 

in the conduct of the committee. 

[Laughter.] 

Mr. FRANK. Mr. Chairman, I cannot take credit for creating Rule 

11. That somewhat pre-dates me. 

Chairman BAKER. I recognize that and am thankful for that. 

Chairman Oxley? 

Mr. OXLEY. Thank you, Mr. Chairman. I certainly would not 

have any objection to another hearing on this matter. It is complicated and difficult, but very, very important in terms of our economic future in this country. 

Mr. Grady, good to see you again. Welcome back to Capitol Hill. 

Mr. GRADY. Thank you, Mr. Chairman. It is good to be here. 

Mr. OXLEY. It is good to know that there is life after work at the 

White House. 

[Laughter.] 

You had emphasized in your testimony the issue of competition, 

particularly as the FASB proposal may very well, as I understand 

your testimony, put us at a disadvantage versus some of the Asian 

tigers, for example, that have learned some things, apparently, 

from our system and are quite aggressive in that area. I wonder 

if you would care to comment specifically on the competitiveness 

issue. Mr. Scalise and others that want to join in, I would be glad 

to hear from you as well. 

Mr. GRADY. I think you can look in both directions, both to the 

east and toward Europe as well. I was struck by something that 

the Director of CBO said regarding CBO’s study and saying that 

they did not see different effects in Europe versus the United 

37

States, where IASB is now of course proposing expensing of stock 

options. 

What is observable is that I believe the United States has outperformed the EU countries quite substantially, and I believe one 

of the principal reasons that has been true is because of the availability of risk capital, which has gone into startups, and because 

of the contribution of startups to U.S. GDP. What you now see is 

Europe has lower levels of venture capital investment, lower economic growth, and considerably higher unemployment. That has 

been the case for some time. 

We did a study at the National Venture Capital Association to 

try to measure the contribution of venture-backed companies, 

mainly startup companies, to the U.S. economy. I refer to it in my 

written testimony, but I think it is important to highlight the results to the members. It showed that venture-backed companies in 

the year 2000 employed directly 12 million Americans and directly 

and indirectly, as Chairman Baker said earlier, 27 million Americans. Some of the other findings were that these companies accounted for $1.1 trillion in sales or 11 percent of U.S. GDP on far 

less than 1 percent of the invested capital in the country for the 

entire 30-year period measured. 

So the job-creating leverage of these startup companies has been 

very high. The principal tool that they have used, as everyone on 

the panel has noted, has been to on the one hand pay people less 

cash, but by allowing them to trade-off units of ownership for cash 

compensation. That has been the model that has worked. People 

have wanted a piece of the rock. I do believe, as a number of witnesses and Mr. Smith have said, Taser is witnessing it and other 

companies are witnessing it on the competitive front, that people 

in both companies in Taiwan and China and elsewhere are advertising their willingness to give ownership to employees as a way of 

inducing them to come to work there. 

Mr. OXLEY. So really one of the concerns, the latest buzz word 

around here, is outsourcing, and we are hearing all about that. In 

fact, this issue certainly cuts into that entire issue, does it not? 

Mr. GRADY. I believe it does, because it will also raise the cost 

of creating the jobs here in the United States, as I was attempting 

to comment to Mr. Frank. I believe what will happen is that at the 

margin, startup companies will be required to raise more cash with 

which to compensate employees, which just means there will be 

less startups funded because there is only in effect so much cash 

to go around. So I think this would be adverse to the job creation 

prospects of the economy going forward. 

Mr. OXLEY. Thank you. 

Mr. Smith, why are so many CEOs opposed to expensing? Is it 

because it would lower the value of the options? From a CEO’s 

standpoint, what is the major issue that you have with the proposal? 

Mr. SMITH. I think Mr. Grady covered it pretty well. It is the 

valuation of the company. People look at price/earnings to justify 

purchasing or not purchasing a stock, the availability of capital in 

the equity markets. One of the things I pointed out before you 

came into the room, and that is we were able to attract some pretty 

significant board members on our company by using options. WithVerDate 0ct 09 2002 10:59 Oct 05, 2004 Jkt 000000 PO 00000 Frm 00043 Fmt 6633 Sfmt 6633 G:\DOCS\95438.TXT FIN1 PsN: MICAH
38

out those, I frankly do not know how we would have gotten those 

people to come on and help us with the corporate governance we 

are now facing. 

That is a real issue for small companies. You do not have a lot 

of cash. You have a lot of risk to offer people that come on the 

board. The trial lawyers love small public companies because their 

stock is pretty volatile and they generally get into a lot of stockholder lawsuits in which directors do not want to be involved. So 

I frankly am at a loss. This is going to be my last startup. I would 

be concerned about how you are going to get the right types of individuals to sit on these boards if you take away some of these incentives. 

We just stopped giving them. We have already told our employees no more options. They all vest by the end of this year. That is 

it. If this legislation passes, the only people that are going to get 

them are going to be the four or five senior people at the top. I do 

not know what we are going to do in the future going forward. 

Mr. OXLEY. That is interesting. It hearkens back to our hearings 

we had on securities litigation reform, which I think really did enhance our knowledge about what was going on out there. One area 

that has not been well discussed, and I am glad you brought it out, 

was the large potential for litigation in these areas, to the point 

where some of these trial lawyers were having computers that essentially spit out complaints based on a loss of value in the market. 

Quite extraordinary, and that ultimately led, as you know, to passage of that legislation, and I think I am right, the only veto President Clinton had overridden, with a strong bipartisan effort on 

both the House and the Senate. 

So I think you have touched upon another interesting issue that 

is certainly important in this debate, that I had not considered 

until recently. I appreciate your testimony. 

I yield back. 

Chairman BAKER. I thank the Chairman. 

Mr. Scott? 

Mr. SCOTT. Thank you very much, Mr. Chairman. 

It is the general feeling on this committee that you support H.R. 

3574, the basically immediate expensing of the top five executives’s 

stock options. Correct? And that the concern is that it goes no further, that there be no expensing of options for rank-and-file employees. In this legislation, it does not exactly, it is my understanding and I am a co-sponsor of it, but what we are saying is 

that no further expensing of these stock options until a couple of 

things take place; that there be an economic cost-benefit analysis 

study of different elements; and that the accountants come up with 

a more accurate way of measuring cost. 

What say you about that? Is that enough to register safety on 

any concerns that we go beyond? I am not sure what I am hearing 

here, and especially from you, Mr. Smith. Did that satisfy you? 

Mr. SMITH. Let me just say one thing. My mother had some ugly 

kids, but no dumb ones. What I have worked out is that we are 

not going to get this thing through. I think expensing any options 

is a bad idea, but I am practical enough to understand to get some 

change, to hold off this gigantic force to get options expensed, we 

are willing to concede to the five top people. 

39

I think we do need a study because I think there are some real 

impacts people have not thought about, not only the lawsuits that 

are going to erupt, the cash that young companies are using from 

these employee options. The way it works is if an employee exercises their option, they pay the government taxes, but the company 

gets a credit for that. It keeps our cash and allows us to hire more 

people. I do not know whether anybody has even looked at that aspect of this thing. 

There is an enormous tax base sitting out there of cash being 

used by young startup companies to fund their operations. If you 

take that availability of cash away and they now have to pay taxes 

to the federal government, you are going to start impacting these 

small companies’s growth. So from those aspects, I would like to 

see nothing expensed, but being a practical person, as I said, my 

mother did not have any dumb kids, we are deciding this is the 

best option we can see to go forward. We think those economic 

studies will prove that out in the future. 

I will yield to my other colleagues. 

Mr. SCOTT. Professor Kruse, what percentage of companies that 

offer stock options offer them to a broad spectrum of their employees? 

Mr. KRUSE. I do not have a ready answer to that off the top of 

my head what percent do. We have found that at least in a related 

survey of companies, we did find that about 3 percent of companies 

gave broad grants to employees, to more than 50 percent of their 

employees in the past year. But the number that may have done 

that in the years prior to that, we do not know. Still, 3 percent of 

companies gave grants in the past year and that is consistent with 

a BLS study as well. 

Mr. SCOTT. And you believe the FASB rule would act as a deterrent to incentives for the rank-and-file employees? 

Mr. KRUSE. Based on what companies are saying, that this is 

going to be something that causes them great concern, that they 

are likely to cut back on the broad-based plans and encourage concentration of executive options. 

Mr. SCOTT. Mr. Scalise, you mentioned that stock options are 

granted to around 90 percent of high-tech employees. What posture 

would we be in with this rule in terms of the semiconductor industry especially, and its ability to compete with foreign companies? 

Mr. SCALISE. I think it would have a major impact on our ability 

to compete. Again, getting back to your prior question, 100 percent 

of our companies grant stock options. As you pointed out, roughly 

95 percent of those go to a broad base of employees outside of the 

executive ranks. 

I recently completed a study for the President’s Council of Advisors on Science and Technology dealing with manufacturing and innovation. This is one of the issues that we dealt with. I think what 

we have to recognize today is that we are truly in a new competitive environment out there, not only in manufacturing, but for people. I just gave you one data point there saying that roughly 5,000 

of our good engineers, these are not just the rookies, these are the 

good well-trained engineers that have been in the business for a 

number of years, have now gone back to Taiwan. A number of them 

are going to China now. 

40

So we are going to be greatly impacted if they can offer the stock 

option with the tax treatment they have, which is no taxable event; 

versus ours which is a highly taxed event as it currently stands. 

Then you have the other part of the problem which is dealing with 

the expensing issue, which makes for the volatility within the company, which the companies have to dampen if they are going to 

avoid some of the litigation that has been talked about here. 

So it is a very complex set of issues that come together here. Suffice it to say that for the two reasons, the expensing and the volatility as associated with that, and the tax treatment we have 

versus the tax treatment of our competitors overseas, these are 

both working against us as far as maintaining our technology leadership going forward. 

Mr. SCOTT. Thank you very much. 

Chairman BAKER. Thank you, Mr. Scott. 

Mr. Royce? 

Mr. ROYCE. Thank you, Mr. Chairman. 

I would like to begin by building on your last point, and maybe 

ask Dr. Smith, if we look at these proposed rules and let’s say we 

take a hypothetical, and we have a company that has to expense 

$100 million of option grants. So the accounting rules would have 

that firm debit expense and credit paid-in capital. So now we look 

forward 1 year, 2 years, 3 years into the future, and let’s say none 

of the options have been exercised because the firm’s stock has declined in value during that time period. 

So now what do we have? I would say we have a balance sheet 

that borders on being fraudulent at this point, and investors would 

be getting a false sense of the company’s true financial picture at 

that moment. At the same time, we have passed Sarbanes-Oxley. 

Under Sarbanes-Oxley, we have dictated that you signed under 

perjury that the financials reflect the true operating income and 

expense and the correct balance sheet position of the company. 

The question that I have, Dr. Smith, is, given our hypothetical, 

because you have now expensed that $100 million in option grants 

several years prior, are you now in violation of Sarbanes-Oxley? 

And more importantly, could some trial lawyers believe you are in 

violation of Sarbanes-Oxley? 

Mr. SMITH. Let me just say one thing. The only employment this 

is going to impact is the trial lawyers are going to make more 

money and hire more trial lawyers. It is hard for me to guess, but 

you can bet they will sue. If you look at most of the cases out there, 

they never go to court. These lawyers are into the idea of settling 

with these companies and insurance companies outside of court. 

So the answer is, anything like this that opens a door, they will 

definitely come in. 

Mr. ROYCE. More slap suits? 

Mr. SMITH. Absolutely. We may have been delivered a lawsuit 

today. Our stock dropped 32 percent yesterday and that generally 

brings them right out of the woodwork. That is the one company 

fear of most of us here, so this is just one more thing we have to 

deal with. 

Mr. ROYCE. I will also ask you, we heard from the CBO director. 

Director Holtz-Eakin argued that expensing will help the economy 

41

because resources will be allocated more efficiently. Do you agree 

with that argument? 

Mr. SMITH. Absolutely not. It is the big companies that benefit 

from this. These are not the people who employ and create the new 

jobs. They employ lots of people, but they are not the growth gazelles that really provide a lot of employment. Those are coming 

from young startup companies like us. The big companies will benefit because they have no volatility in their stock. They give very 

few options out to people. The penalties will go to the people like 

us who are creating the jobs, who are small and have the very volatile stock. So I absolutely take issue with that, and I do not know 

anybody at the CBO that ever started a company or ever gave out 

a stock option or ever received a stock option. 

Mr. ROYCE. I am going to ask Mr. Grady to respond to that question as well. The other suggestion that was made by the CBO director was that the venture capital community will fill the void. I 

would just like to ask Mr. Grady, it seemed earlier that you disagreed with that argument. I would like to hear your reasons. 

Mr. GRADY. I do disagree because what will happen is the venture capital community will have to use more cash to compensate 

employees, which means we will create fewer companies with fewer 

employees, by definition. 

On the first question of the efficient allocation of capital, I believe it will not increase the efficiency because it will create some 

of the anomalies that you have suggested. Your first question was 

not merely hypothetical. For example, Intel Corporation, and 

maybe Mr. Scalise wants to comment on this, I believe reported 

that they would have taken charges if expensing were a requirement, into the several billions of dollars, more than $2.5 billion, for 

options granted in 2001 and 2002 or 2003 that expired without 

being exercised; that were never in the money and that therefore 

basically never existed. Under this proposal, the accounting for 

those options that never existed, those shares that never existed, 

would be identical to the case in which Intel had spent $2.5 billion 

or $3 billion of cash. Clearly, that is not an optimal or even accurate result. 

As I said in my earlier statement, that is the problem with being 

required to value the options on grant date. You could switch it 

and say, gee, we will value them on exercise date or you could use 

this intrinsic value method that I mentioned. That creates its own 

anomalies, because if you use the intrinsic value and say a stock 

comes public at $20 and the stock trades down, but you recorded 

a value the day the company came public at $20 and the options 

had a certain assessed value. 

If the stock went down, you would actually decrease the value of 

those options. So what you would be saying is, because the stock 

went down you are judging that company now to be more profitable. 

Mr. ROYCE. We have an opportunity for a real-world response if 

we could go to Mr. Scalise and just let him respond in terms of the 

actual difficulty we would be putting a firm like Intel into. 

Mr. SCALISE. I think it would be significantly more difficult. Your 

mention of the Sarbanes-Oxley Act is really critical here, because 

these two do come together. When you look at the lack of transVerDate 0ct 09 2002 10:59 Oct 05, 2004 Jkt 000000 PO 00000 Frm 00047 Fmt 6633 Sfmt 6633 G:\DOCS\95438.TXT FIN1 PsN: MICAH
42

parency, the lack of comparability, and then the volatility that results from that, and then the requirement to attest to all of these 

documents when in fact you will create expenses on issues that 

never really occurred in the final analysis, as just pointed out by 

Mr. Grady here, it is very complicated and it is very interrelated. 

It is going to create a lot of hesitation with regard to putting out 

more stock options because they are not going to do it. They are 

not going to want to increase the volatility and increase the risk 

of more and more litigation, because as we all know we have folks 

just sitting out there waiting to drop that next lawsuit. 

Mr. ROYCE. Thank you, Mr. Chairman. 

Chairman BAKER. I thank the gentleman. 

Mr. Sherman? 

Mr. SHERMAN. Yes, as I count, we have six panelists who are in 

favor of the bill. My guess is that that is reflected up here as well. 

We can compete with China to have the loosest accounting standards so our companies can report the highest income, no matter 

how much money they spend on this or that, report a lot of income. 

Or we can compete with Europe to have the tough and reasonable 

accounting standards uninfluenced by what would be viewed at 

least by the public in a highly publicized first-ever intervention to 

provide looser accounting standards to encourage what is viewed as 

executive compensation. I think we need to compete with Europe 

for capital by showing that we have the best accounting standards. 

What flabbergasts me is that this bill, if I hear Mr. Grady and 

others correctly, would have the effect of helping high-tech companies like the ones based in my state compete for capital against 

these lower-tech companies that are most associated with some of 

the other regions of the country. I have folks from other regions of 

the country supporting the bill and trying to help high-tech companies in my state get capital. I thank them. 

Mr. Smith points to this big practical problem. He could not afford to adequately compensate board members. The company could 

not afford to do that without the stock options. You know, now and 

then I hear from one of my constituents that board members are 

not being adequately compensated, or the company cannot afford to 

compensate board members. But I hear more often that the company cannot afford to provide health care. 

So if we want for the first time ever to tell the FASB to do something because we want to encourage companies to do something, 

why don’t we tell them that what you pay for health insurance 

should never be listed as an expense? Or at least provide them 

with an avenue, if you give a 30-year promissory note to the health 

insurance company, you do not have to list it as an expense. Give 

stock options to a health insurance company; provide coverage for 

your employees, you do not have to list it as an expense. 

Why have we decided that the first time Congress will demand 

a departure from regular accounting is to encourage companies to 

do something we think is vital. Stock options, not health care. 

Mr. Hassett points out that it would invite lawsuits if we tell 

companies they have to expense stock options, but we do not tell 

them how. And Mr. Grady echoes this. I could not agree with you 

more. But Mr. Hassett, how is it that we have not had a lot of lawsuits already because we have a requirement that this information 

43

be disclosed in footnotes and we have no real standards to tell companies how to put it in the footnotes. Don’t trial lawyers read footnotes? I know they are real small, but you can blow them up and 

show them to a jury. 

Mr. HASSETT. Here is the state of affairs that concerns us. When 

we put the account for options into earnings, we say, well, it used 

to be we thought we were making $8 this year, but now we are 

going to put in the expense for options and it is $7. And then we 

run for a few years, say, at $7 as earnings every year. And then 

at the end of that period, people vest and realize, and it turns out 

that when we said that our earnings were $7, which will be true 

for probably half the companies, we were incorrect because it was 

a prospective figure. 

Mr. SHERMAN. I understand the incorrectness. 

Mr. HASSETT. The point is that it is in the earnings statement. 

Mr. SHERMAN. So you are saying that you cannot go to a jury and 

say, I am an investor; I thought that their adjusted earnings adjusted for the expense of compensating people with options was 

such and so, as disclosed in their footnote, and it turned out to be 

such and so. I think we have some lazy trial lawyers out there that 

are not taking advantage of the vaguenesses of our current accounting standards. 

Mr. HASSETT. May I respond, Mr. Sherman? 

Mr. SHERMAN. Yes. 

Mr. HASSETT. Thank you. I think that the current state of the 

accounting rule suggests that we are not so sure precisely whether 

it is $5 or $4 or $3 and that we are leaving it in the footnotes. For 

the shrewd investor, it is his or her job to figure out what he thinks 

they are worth when he is deciding whether or not to buy the 

stock. I think that is the appropriate state of affairs. I think when 

we put it in the earnings statement, we are giving people the false 

impression that we know exactly the value. 

Mr. SHERMAN. You are making a policy argument. I was just 

wondering why creative trial lawyers are not making the counterargument. 

Mr. HASSETT. I think because the ambiguity is there. 

Mr. SHERMAN. Let me go on. This bill is being put forward as 

protection for broadly based stock options. You can put a lot of lipstick on a pig. Zero volatility for the options given to the richest 

executives in America, and you put that in a bill and you say you 

are trying to help secretaries? The number six guy at GM; the 

number six guy at Intel are somehow struggling manufacturing 

workers? 

If the bill was well crafted to achieve its alleged purpose, it 

would deserve a lot more support than a bill, a huge portion of the 

benefit of which is going to go to the number six guy at General 

Motors and the number one guy at Intel whose options will be valued at zero volatility. 

We have heard discussions of employee stock ownership plans, 

ESOPs, none of which are affected by the FASB pronouncement 

that we are here to discuss. In fact, those plans are going forward. 

They are big in our economy and they do not get any favored accounting treatment, nor is anybody arguing that they should get a 

favored accounting treatment. 

44

Mr. Kruse tells us that 79 percent of those who hold options 

make under $75,000. Let’s say in your survey there was a company, because I have seen a company like this, 100,000 options 

held by each of the top two guys. Another 100 employees, all with 

incomes under $75,000, each get about 50 or 100 options. If you 

were surveying that company, wouldn’t you conclude that 98 percent of the option holders are people who make under $75,000, if 

that was your whole population of the survey? 

Mr. KRUSE. That is absolutely true. 

Mr. SHERMAN. So what we do know is that there are a lot of 

working-class folks and middle-class folks who have stock options, 

but there may not be a lot of options in the hands of working-class 

folks. 

Mr. SMITH. Let me answer that one because I have a practical 

application. 

Mr. SHERMAN. Your company is great. 

Mr. SMITH. Forty-five percent is going to the top; 55 percent goes 

to the working people below that. 

Mr. SHERMAN. Your company is great, but that does not tell us 

about the economy overall. If you were running all these companies, things might be different. 

Mr. SMITH. GM does not tell us about the economy overall either. 

It is the small companies that are providing the jobs. The guys you 

are going to penalize are the job-creators. That is the reason we are 

here today. 

Mr. SHERMAN. Mr. Smith, I just want to comment. Not every 

small company is giving stock options. Your beauty shop, no stock 

options. Your local dry cleaner, no stock options. Lots of small companies. Your machine shop, very rarely do they give stock options. 

So to take the idea that all the jobs created by small business 

are driven by stock options, they are driven by other things. 

Mr. SMITH. How about a few facts here? The facts are the job gazelles, the small growth companies that are providing the jobs are 

not the hairdressers and not the ones you mentioned. They are 

companies just like us. Those other people that are giving the jobs 

in this economy——

Mr. SHERMAN. Mr. Smith, it is my time. I did not even ask you 

a question. Your gazelle-like feistiness is appreciated. But the fact 

is that is we as a Congress decide to contort the accounting rules 

for the purpose of pulling capital out of the old economy and putting it into the kinds of companies that Mr. Smith thinks should 

get the capital, that is a whole new economic planning role for this 

Congress. I do not know whether it is better to see stock purchased 

in Proctor and Gamble or in Mr. Smith’s company. I know he 

thinks that his company is the best way for our society to allocate 

its capital. 

I yield back. 

Chairman BAKER. Thank you, Mr. Sherman. I let you go on well 

beyond time in recognition of your position on the issue, but for 

members’s purposes, I am going to try to recognize as many as we 

can before adjourning. We have a set of five recorded votes which 

would disrupt the committee process significantly. 

So Mr. Shadegg, if you have a comment? 

45

Mr. SHADEGG. Thank you, Mr. Chairman. Let me begin with one 

question. 

As I understand the FASB proposal, they do not say how to do 

this. They say you simply have to do it. So let me begin, since we 

can obviously make it clear as the questioning has just suggested, 

I will ask each of you quickly, and I would like you each to answer, 

is there a single agreed-upon method by which this ought to be 

done that will make the reporting of all companies parallel or comparable for stock evaluators? Just yes or no. 

Mr. SCALISE. No. 

Mr. GRADY. No, there is not, and especially not for private companies. 

Mr. SMITH. No. 

Mr. HASSETT. No. 

Mr. HOLTZ-EAKIN. No. 

Mr. THOMAS. No. 

Mr. KRUSE. No. 

Mr. SHADEGG. I think that kind of sums up my deep concern. Mr. 

Grady, my friend Mr. Frank on the other side I do not think ever 

let you get across that point. I am going to tell you what I think 

your point was, and then you tell me if I am right. I think your 

point was, look, yes there are footnotes now; yes, people can evaluate this information; yes, sophisticated investors can look at it. But 

if you compel it to be a much more prominent factor in the reporting of the company’s performance and in this calculation of P and 

E, given that nobody has agreed upon the right way to do it, then 

we are going to have inconsistent results and it could lead to much 

greater abuse of investors than what we currently have. Is that the 

essence of your position? 

Mr. GRADY. I would agree exactly with that statement. 

Mr. SHADEGG. I just think this is a huge deal. We just heard a 

comment about how we could create the loosest accounting system 

in the world. I would suggest quite frankly I think FASB is proposing that we make the accounting system looser than it is right 

now. I understand IASB has said we are going to do this in Europe. 

It seems to me, first of all, I am aware that in some countries in 

Europe right now they require stock expensing and in those countries there are essentially no options or option expensing, and essentially there are no options. 

It seems to me perhaps what we ought to do this time, if IASB 

has decided this is a great idea, why don’t we let Europe go first 

and watch them and see if in fact it does not damage them. My 

concern, given a world market, is that if we do it and some others 

do not do it, we could be putting ourselves at a dramatic competitive disadvantage which I would rather not do at this particular 

point in time. 

Mr. Holtz-Eakin, I know that you did the study and the analysis 

that looked at how stock options would affect both stock prices and 

the company’s access to capital. Is that right? 

Mr. HOLTZ-EAKIN. We did a study on the accounting of employee 

stock options. 

Mr. SHADEGG. Right. Here is the question I want to know. How 

did you go about evaluating the question I have raised, which is, 

46

how many companies would continue to offer stock options and to 

what extent does your report give us the answer to that question? 

Mr. HOLTZ-EAKIN. The report actually does not address the individual decision by firms to offer options versus other forms of compensation. 

Mr. SHADEGG. So it does not look at the issue of whether——

Mr. HOLTZ-EAKIN. It looks at the accounting of those two activities. 

Mr. SHADEGG. So it kind of assumes a static situation and says, 

if these companies are offering stock options now, this is how they 

are performing and they are not expensing them. If they continue 

to offer them, here is what would happen under that static kind 

of analysis. It was not looking at the question of whether or not 

they would be disincented from continuing to offer stock options. 

Mr. HOLTZ-EAKIN. I think a fairer way to say it would be that 

it looks at the relative treatment of stock options as employee compensation versus other forms of compensation. It puts them on a 

level playing field and examines the accounting treatment in that 

setting. 

Mr. SHADEGG. Given the great concern expressed by Mr. Smith 

and others that the net effect of this rule is going to be to disincent 

companies from offering stock options, and indeed from my perspective since I like startup companies and I like innovation and 

I like new people coming into the market and I think that is where 

America leads the world, wouldn’t you agree that that is an issue 

we should look at before adopting a change in policy? 

Mr. HOLTZ-EAKIN. I think it has been a bit frustrating to hear 

the way the issue has been characterized today because the key 

issue here is to remember that the income statement is designed 

to display in a fair fashion the net income, the matching of costs 

and the revenues generated by a firm for purposes of financial disclosure. It is clearly the case that stock options could still be a part 

of that employee compensation. 

Mr. SHADEGG. Let me go back to Mr. Frank’s style. You are not 

answering my question. My question was as a policymaker, not can 

they do it differently, my question was shouldn’t we look at the effect of the policy not just on what will it do to stock prices, but 

rather on the incentives it would create to continue or discontinue 

engaging in the process of offering options? 

Mr. HOLTZ-EAKIN. It depends on the question you want answered. If the question is, what will produce broad economic performance in the United States, I do not think that is the central 

question. If the question is, how many stock options will be granted 

in the United States, it is a very central question. 

Mr. SHADEGG. Since I think how many are issued affects our 

economy and at the end of the day everything I look at I have to 

put at least through that filter, it seems to me to be of grave concern. 

Mr. Chairman, I know you want to get to a number of other witnesses. I strongly feel that with the concerns that have been expressed here by all of the witnesses, before we leap off into this 

abyss, we need to look at it more carefully. It is odd to me. It seems 

to me strange that the IRS would put out a regulation that says 

we want every taxpayer to report X, but quite frankly we do not 

47

know how you are going to value X. I have trouble with a policy 

that says we are going to solve this problem; we are going to tell 

you to address this issue, but we are not going to give you a uniform method for calculating it, and we think we are bringing more 

certainty to the market. That is just a grave concern on my part. 

I yield back the remainder of my time. 

Chairman BAKER. Mr. Miller? 

Mr. MILLER OF NORTH CAROLINA. Thank you, Mr. Chairman. 

Mr. Smith, I know that you expressed at the beginning a frustration that no one who seems to be involved in this debate on our 

side knows anything about stock options. I admit that I never have 

had one, but my brother works for a bank. He has described to me 

what he does. At the end of it, I knew he worked for a bank. 

[Laughter.] 

He has some fairly impressive titles, but I also know that banks 

pass out titles instead of compensation. I hope we never have to 

value that. 

[Laughter.] 

I am trying to figure out how this works and whether it really 

is going to provide any kind of useful information to middle-class 

investors. Let me try to get a feeling for how this works. My understanding is a mid-level employee may be given 3,000 options. The 

market price of the company now is $55, and one-third or 1,000 are 

exercisable in a year, say, at $60; the next one-third a year later 

at $65; the next year, the last 1,000 at $70. They expire if not exercised within 5 years of when they vest and they cannot be transferred and they are forfeited if they are not exercised at the time 

the employee leaves the company. Is that generally the way it 

works? Kind of, Mr. Grady? 

Mr. GRADY. That is generally the way it works. The only slight 

correction I might make is that typically the strike price on those 

options would be the $55 at which they were granted. They probably might choose to exercise them if the stock went up to $60 or 

$70 a year later; and if the stock went down to $40, they would 

not exercise. 

Mr. MILLER OF NORTH CAROLINA. But if they have an option at $60, they would rather buy it through the market rather than by 

exercising the option. 

Mr. GRADY. Because it goes below, yes, sir. 

Mr. MILLER OF NORTH CAROLINA. But it has some value, but if 

it is not traded, would you value it by what? If the company has 

analysts and they project a 10 or 15 or 20 percent stock price per 

year in the next 5 years. Do you look at that? If there are no analysts following the company, do you look at what the board of directors or the management forecasts are for growth of earnings? How 

do you value something that can be exercised in the future? 

Is there any understanding at all whether these will be valued 

at the time of exercise or when they vest, when you can exercise 

them, or at the time of their issue in the first place? 

Mr. GRADY. The exposure draft suggests valuing them at the 

time of grant, when they are issued in the first place, when their 

value is frankly highly speculative. 

Mr. MILLER OF NORTH CAROLINA. So even when you are being 

granted something that is only at $70, that you can exercise at $70, 

48

even though the stock is trading at $55, you have to establish some 

value for that and declare it now. 

Mr. GRADY. Yes. You have to estimate what the value would be. 

Mr. MILLER OF NORTH CAROLINA. Okay. If stocks are not exercised in the next year or the year after that, is there any requirement that the company go back and true up the cost because the 

stock went up or down? 

Mr. GRADY. Generally, no. For public companies if they value 

them at the time of grant, that is it. Now, there are different methods. Some have said intrinsic value would be allowed for private 

companies where you would go back and true up each quarter. The 

FASB actually seeks comment on whether instead of using grant 

date as the measurement period, you should use exercise date. 

As I mention in my testimony, while that would get around the 

problem of how hard it is to value the options at grant date, it creates a different problem which is if you require them to be expensed on the exercise date, what you are in effect doing is penalizing the most successful companies and helping those whose stock 

price has languished. 

Mr. MILLER OF NORTH CAROLINA. I think most of the testimony 

today has been about the effect on the economy of encouraging or 

discouraging, or to use the current noun-verb, incentivize or incent 

or disincentivize or disincent. But just looking at this from the 

standpoint of middle-class average investors, is this going to provide them more useful information than a footnote telling them 

how many options are out there and what the terms are under 

which they can be exercised. 

Mr. GRADY. I believe it will provide them with less reliable information, far less reliable information for the investor for all the reasons we said in our testimony. 

Mr. MILLER OF NORTH CAROLINA. Alright. I am probably the last 

one to have anything. Mr. Smith, I want to assure you that I have 

lived my brother’s experience. My brother and his wife and my wife 

and I have a beach cottage together. When the stock of his company is doing well, he wants to go in together and reupholster the 

furniture and buy a DVD for the cottage. When the stock is not 

going well, he wants to sell. 

Mr. SMITH. My comments have related primarily to the people 

testifying, not the people sitting on that side, obviously, the policymakers. I am more frustrated by the fact that like yesterday in the 

Senate, all the people that were testifying basically there were no 

business people. They were people having FASB, prior Federal Reserve chairmen, and all those sorts of folks. Great folks, but never 

in my opinion ever started a company. 

Chairman BAKER. The gentleman’s time has expired. 

I will get Mr. Lynch in, if I can. 

Mr. LYNCH. Thank you, Mr. Chairman. 

I want to thank you, Mr. Chairman, for your good work and the 

panel for helping us out. I apologize for having to rush out here at 

the end. Prior to coming to the Congress, I was actually an iron 

worker for about 20 years, so I am similar to some of the production employees you have been talking about earlier today. I also 

was a former union president of the iron workers. So I spent a considerable amount of time working toward greater corporate responVerDate 0ct 09 2002 10:59 Oct 05, 2004 Jkt 000000 PO 00000 Frm 00054 Fmt 6633 Sfmt 6633 G:\DOCS\95438.TXT FIN1 PsN: MICAH
49

sibility, greater corporate accountability, transparency, and those 

issues. 

That much being said, I have to say that I have some very, very, 

very serious concerns about this FASB exposure draft that is under 

consideration today. I think it is a real mistake. It has been my 

own experience that the granting of stock options has given a lot 

of opportunity for rank-and-file employees to own a piece of the 

rock, as has been said earlier here today. 

It does in fact incentivize the workplace for many of our workers, 

if they know that if they work their tail off that they are going to 

help the company succeed, and then by doing so they themselves 

will be enriched. That is a good thing for America and I think it 

is a good thing for our corporations here. 

Again, Gillette Safety Razor Corporation is in my district. A lot 

of the young fellows and women who went to high school with me, 

went to work. Some husbands and wives in the same corporation 

for Gillette. They have a great stock purchase program at Gillette. 

A lot of the folks that I went to high school with went to work on 

the assembly line and now they are looking pretty closely at retirement. Some of those people when Gillette was at their high end 

were millionaires, based on the amount of stock that they had purchased in their own company. Good hard workers. I do not want 

to see that opportunity denied from rank-and-file workers. I think 

that it would be a mistake to adopt this rule that would basically 

kill that whole process. 

I know especially in the high-tech area, this is an important tool 

in bringing bright young employees into the workplace. I do have 

one question, and then I am going to run out. I know that we have 

talked about H.R. 3574, which would basically expense the options 

granted to the top five employees. In thinking about this problem 

in a different way, would it be better, and this is for the entire 

panel, and you might have to holler your answers as I run down 

the hallway, would it be better to look at some fixed percentage of 

the stock options granted each year and expense those some small 

percentage, so that it is not just the top five? Because the top five 

companies, as Mr. Smith has pointed out, in a small corporation to 

force expensing on that small group may have a detrimental effect 

on the operation of the corporation itself. I just wanted to get that 

out there. I think it is a great suggestion in terms of a compromise, 

but there might be a better compromise out there. 

I want to thank you for coming here. Mr. Chairman, I want to 

thank you for your enormous patience. 

Chairman BAKER. I thank the gentleman. 

Did anyone care to respond? 

Mr. HOLTZ-EAKIN. The key for fair portrayal of net income is the 

value of options granted, not the number of people that you choose 

to expense, or to the extent that you have revealed the value of options granted, you will become closer to net income as measuring 

the economics of the corporation. 

Mr. LYNCH. Right. I understand that. 

Mr. HOLTZ-EAKIN. A fixed fraction of the value reveals the value 

of options granted. That would be tremendous. 

Mr. LYNCH. Okay. Thank you. Thank you, gentlemen. 

50

Chairman BAKER. Let me express my appreciation to each of the 

witnesses. We certainly do appreciate your participation. This obviously is a difficult subject and we are doing our best to achieve the 

best public policy. 

There being no further members to be recognized, I do now adjourn this meeting of the Capital Markets Subcommittee. 

Thank you. 

[Whereupon, at 12:40 p.m., the subcommittee was adjourned.] 

(51)

THE FASB STOCK OPTIONS PROPOSAL: ITS 

EFFECT ON THE U.S. ECONOMY AND JOBS 

Tuesday, May 4, 2004

U.S. HOUSE OF REPRESENTATIVES, 

SUBCOMMITTEE ON CAPITAL MARKETS, INSURANCE

AND GOVERNMENT SPONSORED ENTERPRISES, 

COMMITTEE ON FINANCIAL SERVICES, 

Washington, D.C. 

The subcommittee met, pursuant to call, at 2:05 p.m., in Room 

2128, Rayburn House Office Building, Hon. Edward R. Royce presiding. 

Present: Representatives Shays, Royce, Hart, Sherman, Moore, 

Frank (ex officio) and Hinojosa. 

Mr. ROYCE. [Presiding] I would like to call this meeting of the 

capital market subcommittee to order. 

This afternoon we are going to convene for the purpose of reviewing the pending Financial Accounting Standards Board employee 

stock option expensing proposal, and we are also going to be looking at the potential effects its adoption may have on job creation 

and on the U.S. economy. 

In previous hearings on this subject, I have expressed deep concerns about the potential economic consequences of FASB’s proposal to require the mandatory expensing of employee stock options. 

Like other supporters of Chairman Baker’s legislation, H.R. 

3574, I believe that broad-based stock options have played an important and positive role in our economy. Stock options enable 

emerging companies which often do not have a tremendous amount 

of excess cash or a tremendous cash flow to attract talented employees that would otherwise not work for such innovative firms. 

Some people claim that issuing stock options represents an expense to a firm. However, stock options do not represent a cost to 

an entity. No cash is ever disbursed from the company’s treasury. 

Existing shareholders may see their ownership diminished through 

dilution, but current accounting standards already require potential dilution to be fully disclosed. 

In the not-so-certain case that employee options are actually exercised and the employing company then receives cash, employees 

who accept options are taking a well-known risk. There are no 

guarantees a firm will succeed and its stock price will rise. 

We hear about the successes in business, but we should not forget there are far more failures. Creative destruction leaves a wake 

of failed ideas. 

52

The specific purpose of today’s hearing is to explore the economic 

impact of FASB’s proposal. Economic behavior has already changed 

because of this proposal. Many technology firms have already announced that they will no longer issue employee stock options. As 

a result, many firms have not been able to attract needed employees. Whether an individual is risk-averse or that individual is risktaking, or even risk-loving, he or she is not likely to leave their job 

with a large, mature firm to go to a start-up for a compensation 

package containing less cash and no stock options. 

If one accepts the premise that FASB’s proposal will end broadbased stock option plans as we know them today, then we should 

think about the potential long-term negative consequences for our 

economy. Firms like Intel, Microsoft, Cisco and Yahoo all used 

stock options at their early stages to attract their employees. Other 

nations in Asia are now trying to incubate an environment like the 

one that we had here. 

Would these firms have reached their amazing levels of success 

had stock options not been an available tool for recruitment? Will 

this proposal inhibit the development of the next Intel? Established 

firms will survive and prosper under any new rule issued by FASB, 

but I think some of us are concerned that new firms may not develop as a result, and I believe that it is important for Congress 

to raise these concerns. 

We are very fortunate to have Mr. Herz and Mr. Batavick here 

today to help deal with these issues, and I hope that in your opening remarks you will address such questions as has FASB fieldtested valuation models? Has FASB considered the economic consequences of mandating expensing? Has FASB considered that 

mandatory expensing could give foreign-based firms a competitive 

advantage in attracting employees? Is FASB concerned that its proposal could make financial comparability between firms more difficult? And lastly, is FASB still open to considering other nonbinomial methods or models for this approach? 

I look forward to hearing answers to these and many other questions, and I would like to turn to my California colleague now, Mr. 

Brad Sherman, for any opening statement he might like to make. 

[The prepared statement of Hon. Edward R. Royce can be found 

on page 164 in the appendix.] 

Mr. SHERMAN. I thank my friend and colleague from the Los Angeles area. I want to commend Chairman Baker for having hearings where at least we finally hear from the FASB, since we have 

had so many hearings criticizing their work or their intended work. 

It would have been nice if the Chairman had gone one step further 

and scheduled these hearings at a time when most of our colleagues would be able to attend, and that these hearings could be 

as widely attended as the hearings bashing the FASB were. Of 

course, those were scheduled at a time when there could be votes 

on the floor. These are scheduled many hours before the first vote 

of the week, and it would have been nice, I guess, if the Chairman 

had at least scheduled these hearings at a time that was convenient for him to attend. 

I have signed letters for a long time, as one of the few CPAs in 

Congress, saying let the FASB do its job. My problem is the FASB 

has not been doing its job in two areas, both directly related to 

53

high-tech firms principally, although—stock options go way beyond 

high-tech. 

The first is stock options where for—going back to the APBs, let 

alone the FASB announcements, you have punted on this issue 

with a unique approach where you say, this is the right way, but 

you are free to do it some other way. 

Where are the plaintiff’s lawyers when you need them in that? 

The second area is in research, where you and I have talked, Mr. 

Herz. You know that demanding the write-off of research is very 

harmful to our economy and is wrong accounting and has been, and 

that there isn’t a single accounting theory book I can find published in the last century that would form a basis for the immediate write-off of research; and, yet, what we have here is, in some 

bizarre way, compensating errors. You don’t make high-tech firms 

write off their executive compensation, but you do force them to 

treat every research project as if it is a black hole that produces 

no asset. 

Now you are undoing one part of the problem without the other. 

It may very well be that we should wait to deal with one issue 

until you can deal with the other. Correcting one of two errors 

where there are compensating errors may give you a worse appraisal of how the high-tech sector is doing than leaving the matter 

alone until you can deal with both. 

But let me put some dollar figures to contrast the size of these 

two. Stock options, if expensed last year, total expense would have 

been $47.6 billion. Some roughly $10 billion of that was expensed 

as companies voluntarily decided to expense stock options, but 

roughly $38.6 billion, to calculate it in a variety of different ways, 

would have been expensed had this provision been applicable last 

year. 

In contrast, on the research side—and I think this number is 

way too low, but the number I have been given by the National 

Science Foundation is $176 billion, and I would suggest that the 

private sector is probably doing a lot more research than that. 

So the research is at least triple in importance, perhaps a factor 

of 5, a factor of 10. And so when you go to determine what are the 

net results of our high-tech firms as compared with firms that don’t 

do much research and may not do much in the way of stock options, you have these offsetting errors. The one you are not—the 

one we are not dealing with, the one you haven’t dealt with yet, 

is at least five times as big and would cause more investment in 

companies that do research. 

Now, we are told that stock options aren’t an expense. Let’s 

apply this to every use of stock options other than compensation. 

Well, first we are told stock options are not cash. Well, you could 

issue shares of stock, and that would not be cash either, and I 

won’t bother to ask this as a question, because we all know the answer. 

If you issue a bunch of shares of stock to compensate your employees, you have to list it as an expense even though it cost you 

no cash. The sole effect is to dilute the shares outstanding. You 

have to list it as an expense. You issue stock to your lower-level 

employees, to your upper-level employees, to your board members 

an expense. 

54

If you were to issue shares to the best charity in our country, you 

would have to list it as an expense. If you were to issue shares to 

an insurance company to provide health care for your employees, 

an expense. And if you did options, if you gave options to a charity, 

you gave options to a health insurance company, you gave options 

to a special fund that was rebuilding Iraq, it is on that we have 

decided that the only thing that is so important that we as a Congress should interfere with the FASB and interfere with the basic 

rules of accounting theory is not in the area of charity. We could 

get more charitable contributions if we just decided charity never 

has to be listed as an expense, or if you use stock or you use options to make a charitable contribution. We could have more health 

care for employees if we just tweaked the accounting rules and said 

cash or stock or options used to pay for health care doesn’t have 

to be listed as an expense. But health care for our employees, charity paid for by the corporate sector, these do not attract the attention of Congress. The only area where Congress wants to tweak the 

employees is in executive compensation. 

Now, we are told that it is broad-based. We were told that a lot 

of low-level employees get some options, but almost all the options 

are going to some people who are at the top of corporations, and 

it is that reason that the bill itself is written to define broadly 

based as, well, you are just not one of the top five employees, so 

if you are the number six person in Intel or the number six person 

at Disney, you are a poor, struggling secretary, I don’t think so. 

We are told about competitiveness. Well, we can compete for capital around the world with two approaches. One is the European 

approach, and it has always been the American approach. That is, 

have tough accounting standards, do the best job of enforcing them, 

give investors the most accurate possible picture according to accounting theory. You guys haven’t done a good job on research in 

stock options, but on everything else that has been our proposal. 

That is the European approach. 

The other way to compete is to emulate what I would call the 

Bangladesh model. That is to say, let companies report what they 

want. They will report high earnings, and everybody will want to 

invest. 

I would suggest nobody in this room has chosen to invest in 

whatever stock market can give them the loosiest, goosiest, rosiest 

accounting picture possible, but rather they turn to those stock 

markets which have the toughest standards. 

So I look forward to questioning my friends at the FASB on 

whether their exposure draft really does do the job, and I have got 

some severe problems with it, why they have decided to take an industry that is punished unfairly by your rule on research and punish them fairly by correcting your multiyear problem on stock options, and to proceed with these hearings. But I would say that before we tweak the accounting rules to encourage executive compensation, we ought to tweak the accounting rules to encourage 

health care coverage for rank-and-file employees. 

Now, I do have—I would like unanimous consent to insert in the 

record a letter from the SEC Chairman to the Ranking Member of 

the subcommittee Mr. Kanjorski dated May 3rd in which he states 

that the process established by the FASB to consider the pending 

55

stock option proposal should be allowed to run its course. I wonder 

if there is any objection. 

Mr. ROYCE. Without objection. 

[The following information can be found on page 210 in the appendix.] 

Mr. SHERMAN. I yield back. 

Mr. ROYCE. If they are so ordered. 

If there are no more opening statements, I would like to——

Mr. SHERMAN. There may be some. 

Mr. ROYCE. All right. Let me turn to Mr. Shays and——

Mr. SHAYS. I would be happy to defer to the Ranking Member. 

Mr. ROYCE. We will go to our Ranking Member. 

Mr. FRANK. I want to be brief, because I just want to, first of all, 

make clear the Ranking Member of the subcommittee Mr. Kanjorski had requested this and thought it was very important, but 

a resident of his district was killed in Iraq, and he is understandably at that funeral. So I want to make clear that his absence is 

not anything that was avoidable, and this remains a very important subject to him, and I appreciate the fact that we are going 

ahead with the hearing at his request. 

And secondly, I want to say I am torn, as I have said before. I 

am very reluctant to see us interfere with the FASB, partly because while the previous speaker is an accountant, almost nobody 

else around here is, and we as Members of Congress inevitably 

have to deal with subjects where the subject matter is very difficult 

for lay people. I am loathe to get us into more of these. 

Of all the roles I do not wish to play, it is being the appeals 

board to the FASB. Indeed, I think one sure way to cut down on 

campaign spending would be if Members knew that the consequence of winning a congressional seat and spending all that 

money was that you got to be the superappellate board on the most 

arcane accounting issues, I think that would be a severe disincentive. 

On the other hand, I have listened to some people for whom I 

have an enormous amount of respect in an industry which is very 

important to us, both because of the inherent good it does and because of the contribution it makes to our economy in various forms 

of high technology, and I am struck by the virtual unanimity of 

their concern. And so one of the things that I am going to hope that 

Mr. Herz can address is who is getting hurt by this. 

Obviously there are technical questions to be resolved about 

what is or isn’t the appropriate accounting, but accounting is, after 

all, the—a functional discipline. It is not an abstract one. We use 

accounting so we can better understand reality, and I do have a 

question as to whether or not—and maybe this isn’t within FASB’s 

jurisdiction—but is it the view of the Board and others who are advocates of this change that there are now investors who are being 

misled? Are there people who invest in these companies, and because options are not expensed but are listed elsewhere—obviously, 

I think we all agree, if people were giving the options and weren’t 

telling you, that would be a terrible problem, but that is not what 

is currently allowed. 

So the question is are there people now who are being misled 

into investing, because while the information is being presented, it 

56

is being presented in a form different than you think accounting 

principals require? And that is really, I think, a very important 

question for us, at least within the FASB. 

I continue to believe myself that the damage that I have seen 

done by options has come in the perverse incentive in some case 

options have given the heads of some corporations, in many cases 

not high-tech corporations, who give themselves options, cash them 

in after the stock price has been driven up, and shortly thereafter 

the stock price tumbles, partly because some of the things that 

drove the price up weren’t very good things for the long term. That 

is an abuse. I see it. I think we should try and deal with that and 

ask the SEC to help. 

But that is the central question, because I accept what I hear 

from a large number of people in the high-technology area that this 

will be damaging to them, and I want to know what harm are we 

undoing. 

So the last thing I would say is that it is also the case obviously 

that I guess there are very few—we know the perception and reality intermingle. This appears to be a case where perception is everything, because the reality is not being changed. The reality of 

options being granted won’t change. Apparently a lot of people on 

both sides of this issue think in enormous-amount terms on how 

they are described, and I would hope that we could address the implications of that. Thank you, Mr. Chairman. 

Mr. ROYCE. Thank you. 

Mr. ROYCE. Mr. Shays. 

Mr. SHAYS. Thank you. I just want to disclose the fact that FASB 

is in the 4th Congressional District of Connecticut, so I may be unduly influenced by that; to say that we are grateful FASB is in the 

Fourth Congressional District, we appreciate the good work the 

Board does, even if some of its members are not enlightened 

enough to live in the 4th Congressional District. And I would say 

to you that in my judgment, a tie goes to FASB. 

Mr. ROYCE. Mr. Moore. 

Mr. MOORE. Thank you, Mr. Chairman. I just want to thank the 

Chairman, the Ranking Member for convening this hearing. I want 

to also extend my appreciation to the witnesses for appearing. I 

look forward to your testimony. We will have questions. Thank you 

very much. 

Mr. ROYCE. Any other opening statements from the Members? 

In that case we will go to an introduction of our witnesses. First 

we have Mr. Robert H. Herz. Mr. Herz was appointed Chairman 

of the Financial Accounting Standards Board effective July 1st of 

2002. Previously he was a senior partner with 

PricewaterhouseCoopers. 

Prior to joining the Financial Accounting Standards Board, Mr. 

Herz was PricewaterhouseCoopers’ North American theater leader 

of professional, technical risk and quality, and a member of the 

firm’s global and U.S. Boards. He also served as a part-time member of the International Accounting Standards Board. Mr. Herz is 

both a certified public accountant and a chartered accountant. 

We are also fortunate to have here his colleague Mr. George 

Batavick. Mr. Batavick was appointed to the Financial Accounting 

Standards Board effective August 1st of 2003. Prior to joining 

57

FASB, Mr. Batavick was most recently the former controller of 

Texaco. In this post he had companywide responsibility for strategy 

and policy matters covering all aspects of accounting and financial 

reporting, special studies, internal controls and tactical plan coordination. 

Welcome back, Mr. Herz. You have the floor, and I would ask 

both of our witnesses—you will be recognized for a 5-minute summary of your testimony. Your written statements will be made part 

of the record. Mr. Herz. 

STATEMENT OF ROBERT H. HERZ, CHAIRMAN, FINANCIAL 

ACCOUNTING STANDARDS BOARD 

Mr. HERZ. Thank you, Representative Royce and members of the 

subcommittee. George is with me because he heads up our Small 

Business Advisory Committee, and he will be talking about some 

of that activity. 

We are pleased to appear before you today on behalf of the 

FASB. We are very happy to participate in this hearing, particularly since H.R. 3574 or any similar legislation if enacted would 

preempt and override our ongoing public due process to improve 

the accounting and financial reporting for equity-based compensation. 

We have some brief prepared remarks, and we would respectfully 

request that the full text of our testimony and all the supporting 

materials be entered into the public record. 

Mr. ROYCE. Without objection. 

Mr. HERZ. As you know, our ability to conduct our work in a systematic, thorough and unbiased manner is fundamental to achieving our mission of improving accounting and financial reporting 

standards in this country. Those standards are essential to the 

growth and stability of the U.S. economy because investors, creditors and other consumers of financial reports rely heavily on credible, transparent, comparable, unbiased financial information to 

make their investment and credit decisions. 

Now, because the actions of the FASB affects so many organizations, our decision-making process must be open, thorough and as 

objective as possible, and therefore, our rules of procedure require 

a very extensive and public due process. 

We issue proposals for comment, and then after that, when we 

get the comments, we hold roundtables, we actively redeliberate all 

the key issues. Those redeliberations often do result in significant 

changes and improvements to the proposals. 

The Board makes final decisions only after carefully considering 

and analyzing the input of all interested parties. We do our best 

to try and balance the often conflicting perspectives of various parties and make independent, objective decisions guided by the fundamental concepts and key qualitative characteristics of sound, fair 

and transparent financial reporting. 

In March of 2003, at a public meeting, we decided to add a 

project to our agenda to address issues relating to improving the 

accounting for equity-based compensation. The project was in response to the high level of public concern expressed by many individual and institutional investors, financial analysts, creditors, 

major accounting firms, many study groups and many other parVerDate 0ct 09 2002 10:59 Oct 05, 2004 Jkt 000000 PO 00000 Frm 00063 Fmt 6601 Sfmt 6601 G:\DOCS\95438.TXT FIN1 PsN: MICAH
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ties, including many Members of Congress, about the need to improve the accounting for equity-based compensation. 

Many believe that the existing reporting for equity-based compensation results in significant distortions in the reporting of earnings, operating results and operating cash flows, distortions that 

they believe cannot be remedied solely by improvements in disclosures. So the ultimate goal of our project is to develop a standard 

that results in reporting that more faithfully reflects the underlying economic effects of equity-based compensation and that brings 

about greater comparability of reporting. 

The project also provides an opportunity to achieve greater international convergence of accounting standards, an objective that we 

have been specifically encouraged to pursue by the Sarbanes-Oxley 

Act, by the U.S. SEC and by many other parties. 

On March 31st of this year, we issued by a unanimous vote a 

proposal for public comment to improve the accounting for a wide 

range of equity-based compensation arrangements. That proposal is 

a result of a very extensive public due process. The process included the issuance of a preliminary document for public comment, 

the review of over 300 comment letters and over 130 unsolicited 

letters, review of research and consultation with many, many parties. 

Based on our extensive public due process to date, the Board believes that the proposal would significantly improve the financial 

reporting for equity-based compensation arrangements. By creating 

greater transparency, completeness and a more level playing field 

in the accounting for different forms of equity-based compensation, 

we believe that the proposal would enhance the comparability of reported results between enterprises that choose to compensate their 

employees in different ways. 

The proposal would achieve it through a number of provisions, 

including eliminating the existing exception for so-called fixed-plan 

employee stock options, which, as Representative Sherman indicated, 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 also includes provisions that we believe would improve the transparency of the effects of equity-based compensation 

on reported cash flows and that are aimed at addressing what 

many believe have been significant distortions in the reporting of 

operating cash flows by companies that make significant use of employee stock options. 

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

existing exception for fixed-plan employee stock options results in 

reporting that not only ignores the economic substance of those 

transactions, but also distorts reported earnings, profitability and 

other key financial metrics. 

I would note in contrast that this distortion again, as Representative Sherman indicated, does not occur when the same company 

uses stock options or similar instruments such as warrants for purposes other than compensating employees; for example, in acquiring goods or other services, or in financings or M & A transactions. 

In all those cases the current accounting has long required that the 

59

options or warrants be properly valued and accounted for in the financial statements. 

In the public company arena, the proposal would bring about 

greater comparability between the now over 575 companies that 

have voluntarily opted to account for the cost of employee stock options and the many others that have not done so. 

It would also be responsive to the growing number of companies, 

including a number of major technology companies, whose shareholders by a majority vote have approved nonbinding proxy resolutions mandating expensing of all employee stock options. Managers 

of a number of those companies have indicated that they are awaiting completion of our project in order to respond to the demands 

of their shareholders. 

The proposal would also result in substantial convergence in the 

accounting for equity-based compensation between our standards 

and international standards that are followed in over 90 countries 

around the world. 

I would also note that in Canada, who often follows the lead of 

the U.S. in improving accounting standards, they felt they could 

not wait on this topic and decided to mandate expensing of all employee stock options beginning in January of this year, and I understand that implementation of their new standard is going very 

smoothly. 

Finally, with regard to the potential economic consequence of our 

proposal, many economic experts that have addressed the issue of 

the accounting for employee stock options, including Federal Reserve Chairman Alan Greenspan, former Federal Reserve Chairman Paul Volcker, Nobel Prize-winning economists Robert Merton, 

and Joseph Stiglitz, and groups like the Financial Economist 

Roundtable, the Republican staff of the Joint Economic Committee 

of the Congress, the Conference Board Commission on Public Trust 

and Private Enterprise co-chaired by Pete Peterson and John 

Snow, major investment banks, and the Congressional Budget Office have all indicated support for mandatory expensing of employee stock options. 

Indeed, many of these experts have also indicated that mandatory expensing could have positive economic consequences because 

of the improvements in capital allocation that would result from 

having more credible, comparable and transparent financial information, not to mention helping to continue to shore up public confidence in financial reporting. 

Now, we recognize that one size may not fit all, so I am going 

to hand over to George in a second who will discuss the several 

special provisions contained in our proposal relating to small businesses and start-ups, as well as other matters relating to our continuing work and due process on this topic. 

I would like to assure you that we recognize the importance of 

small business and start-ups to job creation, to entrepreneurship 

and to our Nation’s economy, so we also understand that any 

standards we prescribe that apply to small business must not only 

be conceptually sound, but also must be operational and cost-effective. 

Mr. ROYCE. Mr. Batavick. 

60

STATEMENT OF GEORGE J. BATAVICK, BOARD MEMBER, 

FINANCIAL ACCOUNTING STANDARDS BOARD 

Mr. BATAVICK. Thank you, Mr. Royce, and thank you, Bob, and 

good afternoon 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 and accounting reporting standards. 

First, there is no Federal law requiring nonpublic 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 or State regulators. To the extent that one of these parties requires that the financial reports of small businesses comply with 

our standards, that requirement presumably reflects the 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 public due process procedures that the cost 

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 and preparers of the financial reports of small businesses to provide for 

special provisions to alleviate the costs of implementing our standards. Those requests come from our continuous and ongoing due 

process and deliberations throughout the life of the project. 

If you are following our project on equity-based compensation, 

and you wanted to keep up on what was happening, all interested 

parties, including small businesses, can take advantage of our free 

weekly action alert, which is by e-mail. We discuss current agenda 

items and past Board decisions. Interested parties can also attend 

our Board meetings, call in or listen to our free Webcast of our 

meetings on the day of the meeting, with replays of our meetings 

available 1 week thereafter. 

Our meetings also get extensive news coverage by the top news 

agencies, and our free Web site includes up-to-date summaries of 

all equity-based compensation issues discussed in our tentative decisions. 

We actively seek input from various State CPA societies, and 

membership in turn brief their clients, in many cases small businesses, on the status of this and other Board activities. 

In addition, liaison meetings with various groups having smallbusiness representation and Board member and staff speaking engagements provide additional means of receiving valuable input 

from the small-business community. 

With respect to this proposal on stock-based compensation, it is 

our understanding that although the use of employee stock options 

is present at some small businesses, particularly start-ups and venture capital-backed enterprises that plan to become public enterprises, the vast majority of small businesses, over 95 percent, in 

the U.S. do not grant employee stock options. 

61

As indicated earlier, however, for those small businesses that are 

affected by our proposal, the proposal includes several provisions 

intended to alleviate the cost of implementation. First, the proposal 

includes a special provision that would permit most small businesses, including all that are not public, to measure compensation 

costs using a simpler, less costly intrinsic value method rather 

than the fair value method that would be required for most public 

enterprises. 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 

most small businesses that are nonpublic enterprises with 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 for 1 year until 2006. 

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

recipients that highlights and describes all these special provisions. 

The notice requests that respondents to the proposal indicate 

whether there are other special provisions for small businesses that 

might be appropriate and whether any or all such special provisions should be extended to public enterprises that are small business issuers under the Federal securities laws. 

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

small business at the inaugural public meeting of our Small Business Advisory Committee next week, May 11th. Our request for 

agenda items for this meeting showed interest in this proposal. We 

also plan to hold public roundtable meetings in June with valuation and compensation experts, and users, auditors, preparers of 

financial reports to discuss a broad range of issues about the proposal. 

Following the end of the proposal’s comment period in June, the 

Board plans to redeliberate at public meetings issues raised in response to the proposal. Those redeliberations will include very careful consideration of the ongoing input received from all parties, including ongoing input from the members of the Small Business Advisory Committee. Only after carefully evaluating the input at public meetings will the Board consider whether to issue a final standard. 

The Board’s current plans are to complete its deliberations and 

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

this year. 

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

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

the information we obtain in connection with this hearing will be 

carefully considered. 

In conclusion, let me assure you that you, the users, auditors and 

preparers of financial reports, including small business financial 

reports, can have confidence that the Board will continue to actively reach out and solicit input in response to our proposal. That 

input will be carefully considered in an open, thorough and objective manner. Our ultimate goal is to develop an accounting standVerDate 0ct 09 2002 10:59 Oct 05, 2004 Jkt 000000 PO 00000 Frm 00067 Fmt 6601 Sfmt 6601 G:\DOCS\95438.TXT FIN1 PsN: MICAH
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ard that will faithfully report the underlying economic effects of equity-based compensation transactions and thus significantly improve the transparency and integrity of financial reporting in the 

United States. 

Thank you again, Representative Royce and other subcommittee 

members. Bob and I would welcome the opportunity to respond to 

any questions. 

Mr. ROYCE. I thank you, Mr. Batavick. 

[The prepared statement of Robert Herz and George Batavick 

can be found on pages 172 and 175 in the appendix.] 

Mr. ROYCE. Let me begin by asking a question of Mr. Herz. 

Mr. Herz, in a letter to the Financial Accounting Standards 

Board dated December 29th of 1993, Coopers and Lybrand contended that using option pricing models results in unreliable information and would have an adverse impact on the comparability 

and usefulness of financial statements, and your name and number 

are provided as contact information to discuss this letter. I wanted 

to ask you how you reconcile your position in this letter with your 

position today. We are assuming that the letter would not have 

provided your contact information without your endorsement of the 

arguments that are made there, which are some of the arguments 

that we have heard on the Hill over the last month again replayed 

as we have discussed this issue. 

Mr. HERZ. Well, I don’t remember the particular memorandums. 

I obviously take good faith that that is it. 

Mr. ROYCE. Well, don’t take it on faith. It says, if you have any 

questions regarding our comments, please contact Ronald Murray 

or Bob Herz at this number, or David Lookate. 

Mr. HERZ. Right. I think that, you know, at that time I did believe on the face of it without a lot of investigation, I just had come 

into the national office of Coopers and Lybrand, and from the practice that, you know, those were the views. Those were the views 

that we were hearing from many clients at the time. 

I have now had the benefit of an intensive look at this subject, 

both on the International Accounting Standards Board and also at 

the FASB, I mean, an intensive look at it, and you live and you 

learn. I don’t believe that those arguments, as far as at least the 

valuation, hold water. Will they have an impact on emerging businesses? Well, we have got special provisions in our proposal, A; 

and, B, yeah, there are economic consequences in terms of better 

information that arise from changing accounting standards. 

Mr. ROYCE. Well, let me ask you a question about that intensive 

look, and I may be wrong on this, but to my knowledge, as far as 

the Board is concerned, I don’t think that you field-tested valuation 

models when it comes to trying to determine this new methodology. 

I don’t know that you have taken various valuation models by a 

cross-section of companies so the significant data would be collected 

on the accuracy and reliability of these different valuation models. 

And I was going to ask you, are there any studies that you have 

relied on that show specifically that the binomial method values 

employee stock options accurately? 

Mr. HERZ. Well, we have done a lot of work on the valuation 

area. We have convened a group of expert panel called our Options 

Valuation Group, which are experts in valuation compensation, eqVerDate 0ct 09 2002 10:59 Oct 05, 2004 Jkt 000000 PO 00000 Frm 00068 Fmt 6601 Sfmt 6601 G:\DOCS\95438.TXT FIN1 PsN: MICAH
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uity derivatives, which a stock option is. Our staff and the Board 

met with them a number of times. We did have field visits to a 

number of companies that included a cross-section of companies 

across industries and sizes of companies, both public and private. 

We have reviewed the results of research studies on data that exists. 

Let me step back, though, that——

Mr. ROYCE. Let me explain where I am going with this so that 

you better understand my point. Your spokesman Cheryl Thompson defended the decision not to field-test valuation models by telling the press that the ultimate field test has already taken place. 

She added that public companies have been performing this field 

test for 7 consecutive years, so the test sample is huge. It involves 

thousands of companies. 

I believe I am correct in assuming that Ms. Thompson is referring to the use of Black-Scholes in footnote disclosures over the 

past number of years. I suppose that one could argue that it makes 

sense if the exposure draft required all companies use the BlackScholes model, but what we are now doing is urging companies to 

use something different, which is the binomial method. And so my 

question here is why not conduct field tests on the accuracy of that 

particular model? 

Mr. HERZ. Well, the—first of all, there are now 575 companies 

that are expensing in their income statements. Some of those use 

the binomial model, and we have talked to them. 

Secondly, it is a misnomer to call them completely two different 

models. They are basically related. They are derived from the same 

financial economic theorem. The binomial model is really opening 

up the Black-Scholes model. The Black-Scholes is kind of a hardwire model that you put in one set of assumptions, and you get a 

result. The binomial works off of exactly the same theory, but you 

can peer into the hard-wiring and look at it period by period, and 

you can make adjustments for better data period by period. 

Mr. ROYCE. Well, you make the point that 576 firms, in your 

words, have——

Mr. HERZ. Can I——

Mr. ROYCE.—expense—let—let me just ask you, do any of those 

companies have broad-based stock option programs? Because there 

are thousands and thousands of companies that have not embraced 

this, that do have broad-based stock option programs, and that is 

where we are focused. And I will let you respond to that, and then 

I have one last question before we go to my colleague here. 

Mr. HERZ. Well, there are a number of companies with broadbased plans that have gone to expensing, like Netflix and Home 

Depot and Wal-Mart and the like. 

My other point I was trying to make is that the binomial model 

is regularly used on a daily basis to value equity derivatives and 

other derivatives. It is a model that works. 

Mr. ROYCE. My last question is this, and I realize the Financial 

Accounting Standards Board is pretty far down the path on this 

proposal, but that said, just yesterday I learned of a new proposed 

method of expensing options that works very differently than 

Black-Scholes and works differently than this binomial method and 

that you have articulated, and I was going to ask what your opinVerDate 0ct 09 2002 10:59 Oct 05, 2004 Jkt 000000 PO 00000 Frm 00069 Fmt 6601 Sfmt 6601 G:\DOCS\95438.TXT FIN1 PsN: MICAH
64

ion would be in terms of being open to consider this new proposal 

for expensing at this point in the process. 

Mr. HERZ. Oh, we are open—we get suggestions almost daily, 

so——

Mr. ROYCE. So what would the process and the timetable be——

Mr. HERZ. The process is they should send us something in writing, and then we will have a look at it, and we will meet with 

them. And we have done that with many different parties. And we 

also, when we get something like that, consult with our panel of 

experts also. 

Mr. ROYCE. Thank you, Mr. Herz. 

We will go to Mr. Sherman. 

Mr. SHERMAN. Thank you, Mr. Chairman. 

Mr. Batavick, your testimony provided really useful, personally, 

information. Right after these hearings I am going to go out and 

sell all the stock in the company that makes Ambien. That stock 

is going to crash once everyone becomes aware that replays of 

FASB meetings are available for free. 

It is rather absurd for you to say that small businesses don’t 

have to use FASB pronouncements in preparing their financial 

statements if they choose not to go public. Every bank wants statements prepared under Generally Accepted Accounting Principles, 

and FASB pronouncements cannot be ignored in determining what 

is generally accepted. And, of course, our State corporate laws 

make certain dividends illegal unless certain capital—certain 

amounts of capital are available calculated under GAAP. So you 

understate the importance of your Board if you say that you are 

not legally binding on nonpublic companies in this country. 

Speaking, though, of small businesses, the binomial method, as 

I understand it, could be expensive to use, could involve many 

thousands of dollars of accounting fees. Let’s say you had a small 

company, you used Black-Scholes, and you came out with, say, half 

a million dollars of stock option compensation expense. But that 

half million was material. Is there anything in the exposure draft 

that says in order to help you save on accounting fees, as long as 

your Black-Scholes number is under half a million, you can use binomial; or does the exposure draft say if you are tiny, then whatever amount that is material to you, you have to go spend the 

money on the accounting fees to use the more sophisticated approach? Do you allow a less expensive calculation method for small 

companies? 

Mr. BATAVICK. Right now we are not requiring one method over 

the other. What we are saying is the fact that we have a BlackScholes method, we also have the binomial method, and the statement we make in the proposal is that in certain circumstances that 

may be preferable, but it is also based on if you have the information available to——

Mr. SHERMAN. I would hope that—and I will get to this in a second. I think it is a tragic flaw in your exposure draft that you provide so little guidance as when to use one method or when to use 

the other and——

Mr. HERZ. Could I just interject, if I might? 

Mr. SHERMAN. Yes. 

65

Mr. HERZ. In our proposal if a small business is a private company, they don’t even have to use option pricing models. They can 

elect not to use option pricing models. 

Mr. SHERMAN. Yes, but many of—if they are not someday going 

to be public, nobody may want the stock options anyway. Stock options are generally used for companies that intend to go public. I 

realize there may be some exceptions to that. 

Mr. HERZ. We don’t say if you are going to go public. If you are 

private, you——

Mr. SHERMAN. You don’t have to. I would hope that GAAP would 

mean the same thing, that we would take the—I know you can propose vague standards. That is what you have done the last 30 

years. You said you can expense them or not expense them, your 

choice. Now you are going to say, well, by Black-Scholes, binomial, 

or if you are not public, some other guesstimate. 

I would hope that you would provide real guidance to the profession, that people reading financial statements are not going to have 

to look at the footnotes and try to guess what was done and how 

to make two statements comparable. The whole idea here is you 

should be able to compare Coke and Pepsi, not the taste test, the 

financial test. And for a while there, one was expensing and one 

wasn’t. Now we are going to have one binomial and one BlackScholes and then some small beverage company using a third 

method or no method at all. 

I would hope that if you are in the standards-writing business, 

you would write standards, not guidelines, not guesstimates, especially when those who oppose what you are doing have said this 

could be a fertile area for lawsuits. 

Now, I realize there are other areas of accounting where a judgment is required, but here you are talking about executive compensation, the juiciest thing to bring before a jury. You are inviting 

lawsuits when you take that juicy area and you don’t provide guidance. 

I would hope that guidance would factor in availability of information, would factor in cost of calculation, and would then say, 

okay, apply Black-Scholes. If you meet these standards of materiality, if you meet this dollar figure, then you have got to go use the 

binomial, and here’s how you ought to use it. 

Let’s see. My next question, though, is why don’t you delay this 

whole thing until you get the research thing right, and are you concerned that you are now going to have—eliminate this compensating error, and you are going to adopt an accounting system for 

this country that discriminates against our high-tech sector? 

Mr. HERZ. Let me go back to a few other points you made and 

then go to the R&D point. 

I think if you look at our exposure draft, there is plenty of guidance on valuation. It may not be hard-wired guidance. It is guidance that fulfills what we have been told to do in objectives-oriented standards by the SEC in the report they issued to you last 

summer, to Congress on Sarbanes-Oxley. It is much more detailed, 

for example, than in many other areas of valuation. I——

Mr. SHERMAN. As is executive compensation. Two accounting 

firms should come up with the same answer. If they don’t, there 

66

is going to be lawsuits, and if there is going to be lawsuits, that 

is a strong argument for us to pass this bill. 

Mr. HERZ. If you look at our notice to recipients, there are several questions specifically on that point, how hard-wired, how prescriptive would you like us to get, models, assumptions. Now, we 

have already gotten some responses that say we have already provided too much guidance. So there is a diversity of views. I——

Mr. SHERMAN. Well, of course. The people who don’t want to expense options want as much looseness as possible so they can state 

as low a number as possible. 

Mr. HERZ. But one of those responses is from a major audit firm. 

Okay? So——

Mr. SHERMAN. But they tend to agree with their clients. Surprise. 

Mr. HERZ. I don’t know if their clients feel that way. I mean, the 

point is there is a diversity of view. We have asked the question 

specifically because we recognize that sensitivity. We can hard-wire 

everything if that is what people want. 

Mr. SHERMAN. Or that one accounting firm could compete under 

the slogan, we use the play in the joints to understate your executive—to minimize the statement of your executive compensation. It 

would be a whole new slogan. 

Mr. HERZ. I think one of the benefits of the Sarbanes-Oxley, the 

auditors are doing more robust audits, I believe. The SEC is certainly reviewing a lot more, and this is an area they would intend 

to review. 

On your R&D question—and, you know, you and I have had discussions. I personally agree with you, but thousands don’t. And I 

will tell you there is good news on that front, or potentially good 

news on that front, in that we met with the International Accounting Standards Board, like we do every 6 months, and we, subject 

to our own agenda processes, agreed to look at the area of both 

R&D and more broadly intangibles. 

Mr. SHERMAN. But, Mr. Chairman, shouldn’t you stop all work 

on this stock option thing, which is going to hit high-tech hard—

and they are already screaming—when you are already hitting 

them? And fairly, I might add, but you have been hitting them 

hard and pounding them hard, much harder unfairly. Shouldn’t 

you abstain from correcting this mistake until you can deal with 

that mistake, or do you think you should just pound high-tech 

when they are right on the accounting and when they are wrong 

on the accounting? 

Mr. HERZ. Well, again, the issue of R&D, you and I may agree 

personally. There are many who don’t, so——

Mr. SHERMAN. Is there any accounting theory textbook, that supports the idea of expensing every research expenditure done inhouse no matter how valuable the results are and no matter how 

provable the value of those results are? 

Mr. HERZ. The accounting rationale is that it is not sufficiently 

measurable. 

Mr. SHERMAN. You can’t measure—yes. That is—you know how—

let’s put it like this: There is no accounting theorist I am aware of 

anywhere in this country that would come to the conclusion that 

you should write off all R&D. 

67

Mr. HERZ. I would ask the—in response to your suggestion, 

which, you know, I agree with—as you know, I agree with not only 

capitalizing R&D per se, but I think the whole area of intangibles 

that are big-business value drivers is something that is missing off 

of contemporary balance sheets. 

I will tell you, though, the history of this issue 

being—the last time, I understand, it was raised by the FASB a 

few years ago, the biggest opponents of it were the high-tech firms. 

Mr. ROYCE. Mr. Frank. 

Mr. FRANK. Mr. Herz, in the full text that you gave us, and I appreciate it, on page 27, you address towards the end the objections, 

and you list four of them. The last one is you phrase the objection 

as mandatory expensing of employee stock options will have negative economic consequences. 

To me that is the nub of what we are here for. We are not the 

plutonic board of perfect accounting. We get involved where there 

are negative economic consequences, and I have to tell you, I 

don’t—I think if I were a judge and this was the argument, you 

would lose on summary judgment. I mean, you make a lot of good 

arguments, but there is none. 

You kind of implicitly—and that may not be controlling, but this 

is so you will understand the dilemma. Implicitly, in the beginning 

of the second paragraph of that page, the Board’s operating precepts require it to consider issues in an even-handed manner without attempting to encourage or to discourage specific actions. That 

does not imply that improved financial reporting should have no 

economic consequences, but it seems to me to be a concession 

that—not a concession, a statement that you are going to go ahead 

and do this, and that is the dilemma many of us have, because I 

certainly agree on the accounting—let me ask you, to go back to 

the question I posed, other than aesthetically, who is getting hurt 

now by the current accounting firm options? Who is the victim? 

Mr. HERZ. Well, I think this all kind of relates together.You 

know, our mission is to improve financial reporting——

Mr. FRANK. I understand that, but if that is the answer, okay, 

but is somebody being hurt now by the current situation? 

Mr. HERZ. Well, certainly the people who were surveyed the financial analysts, surveys of investors, tech investors, all say they 

want it in the score because it is not transparent right now. They 

don’t—they pick up numbers from databases. The CBO said that 

it would be more transparent——

Mr. FRANK. Please, I don’t need you to tell me what the CBO 

said. I rarely pay attention to them. And transparency is a means, 

if not the end. And if the answer is it is wrong and it doesn’t make 

a difference if anybody is getting hurt, then okay. But as far as 

transparency, let me say this: The information is there now, isn’t 

it? It is just not—if I were going to invest in a company, which I—

we get enough ethics from—so I don’t address individual companies. But if I was going to invest in an individual company, I or 

somebody I was paying to help me do this would read the footnote. 

So let me put it this way: If I were going to invest in an individual 

company, would I get more information about what is actually happening one way versus the other? 

68

Mr. HERZ. You’re going to get more information the way we are 

proposing it 

Mr. FRANK. What information would I get from you that I don’t 

now get? I would get the fact that the options would be—would I 

not now get the fact that the options were being granted and how 

many there were? Would I not know that? 

Mr. HERZ. You would know that, but you would not know things 

like operating margins, return on equity, all those things that are 

just—by not running it through the financial statements, you are 

not getting the full accounting 

Mr. FRANK. You are saying that I would be—that the investors 

can’t do that themselves. I get everything else and then I get the 

options, and I wouldn’t be able to, myself, figure out or decide for 

myself to what extent the existence of the options added to or detracted from the value of the investment? 

Mr. HERZ. If you were a sophisticated investor and you took the 

footnote, you would be able to get part of that information, not all 

of it 

Mr. FRANK. What wouldn’t I be able to get? 

Mr. HERZ. You wouldn’t be able to get things like gross margin, 

you wouldn’t be able to get operating results, you would have to recompute——

Mr. FRANK. Well, those are things to which there is some element of uncertainty, though; right? 

Mr. HERZ. Well, they are things that if you do the accounting 

properly, they are just there. 

Mr. FRANK. Well, but isn’t there some element of uncertainty 

there? I mean, I was struck when you told Mr. Sherman that the 

obstacle to dealing with research differently is that it is hard to 

measure. Is it a lot easier to measure than the options, or a lot 

harder? 

Mr. HERZ. No, the options are much easier to measure than the 

early stage of research 

Mr. FRANK. And you couldn’t just make available to people what 

the measurements are and let them do it themselves? 

Mr. HERZ. We have been doing that 

Mr. FRANK. Okay, we have been doing that. Who has been hurt? 

Have you gotten any complaints? Is there anyone we know of that? 

Mr. HERZ. Yes. 

Mr. FRANK. No, I know they said we would rather. Did anyone 

say I was misled? 

Mr. HERZ. Yes. 

Mr. FRANK. I invested unwisely? 

Mr. HERZ. Yes, we have lots of letters from individual investors. 

Mr. FRANK. Well, I have read your comments and the samples 

you gave. None of them say that. You gave one set of samples. You 

didn’t give the other. You gave people that said, oh, these greedmongers, they are terrible. You have people saying it would be 

more desirable. But surely you understand the difference between 

a general assertion that it would be desirable and an assertion that 

an individual was hurt. 

Does anybody anywhere—I will make a plea. There are other 

people here from the SEC; would anyone bring forward to me some 

69

individual who was misled because the options were not expensed? 

Do you know of any claims of that sort, Mr. Herz? 

Mr. HERZ. Yes. 

Mr. FRANK. Where are they, Mr. Herz? They are not in your 

statement. Point them to me. Which one did I miss? 

Mr. HERZ. I don’t know, we have got hundreds and thousands. 

Mr. FRANK. Well, you picked some out. None of the ones you 

picked out say that. None of the ones you picked say ‘‘I was misled,’’ and I am reading them. I strongly recommend people like me 

will stay away from the market as long as they are passed out like 

funny money 

Mr. HERZ. Can we follow up with you? 

Mr. FRANK. Yes. Okay. And I am surprised we haven’t heard reports because this is the issue. 

Mr. HERZ. I think an important point is that it is a well-known, 

well-accepted thing in accounting, that disclosure doesn’t cure bad 

accounting. And we get requests all the time for just put it in the 

footnotes. When we were going through the improvements——

Mr. FRANK. Sir, you do realize this is totally irrelevant to my 

question? If you want to give more general statements about why 

you should do this, okay. And that is part of the problem you have 

got. 

I thank the Chairman for the indulgence. Here is the problem 

you have got, and I don’t want—I am not a co-sponsor of the bill. 

I am really torn here. But I have people telling me this is going 

to cause a problem. I mean, I have a technical intellectual argument. Clearly these are not free. I understand that. How you account for them there is a question. 

But a lot of people are saying, look, this is going to cause a problem; and they are going to cause a problem again because of the 

way the market will perceive this. And so as a public policymaker, 

not as an accounting technical specialist, I say, okay, well, if there 

is a potential for the problem here, what are we solving? What are 

we solving? What problem am I solving other than an intellectual 

failure? 

Frankly, if I was going to go around this city and resolve every 

intellectual failure, I would be a wreck. So I am looking for some 

public policy break. And, yes, I would appreciate it, please follow 

up with me, because I think that is why you are here. You are not 

here because people differ with you technically on the accounting. 

As was implied in the question from Mr. Sherman, no one cares 

about that. That is your job, and we are glad you have it and are 

ready to do it. 

The issue here is, is there some real economic harm that could 

come? And that is the area I think in which further help from you 

would help your cause, and so that is it. 

Yes, I yield to my colleague from California. 

Mr. SHERMAN. I would say the one obvious harm is that those 

companies that choose not to use stock options are at a disadvantage in attracting capital as opposed to those who do. 

Mr. FRANK. Okay. But I would say again, because people in the 

market don’t understand this, it all comes down—to some extent I 

have to say I feel a little bit good about this in one sense, having 

been for years told, listen—well, let me say there was a former maVerDate 0ct 09 2002 10:59 Oct 05, 2004 Jkt 000000 PO 00000 Frm 00075 Fmt 6601 Sfmt 6601 G:\DOCS\95438.TXT FIN1 PsN: MICAH
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jority leader of this institution who used to say government is 

dumb and markets are smart. Well, these markets ain’t the smart 

ones. These are the markets that are confused because of the accounting. 

So I am just a little glad to say that. I agree. But that is the 

issue; it is not the investor being misled, it is the competitive disadvantage to the other people. 

I am sorry. Did the other gentleman from California want me to 

yield? 

Mr. ROYCE. No, I was just going to make the point that it is easier just to point out the intellectual failures in this city than in the 

market. 

But we are going to go to Mr. Hinojosa. 

Mr. FRANK. Thank you 

Mr. ROYCE. Mr. Hinojosa, you also had an opening statement you 

wanted to make, and at this point we will give you that opportunity, and then, please, go to your questions. 

Mr. HINOJOSA. I will submit my opening statement in writing. 

Mr. ROYCE. Without objection. 

[The prepared statement of Hon. Rube ́n Hinojosa can be found 

on page 81 in the appendix.] 

Mr. HINOJOSA. I would like to make a statement and ask a question or two. Thank you, Chairman Royce. 

I am very pleased that the subcommittee had the opportunity to 

hear the views of the Financial Accounting Standard Boards, or 

FASB, on its proposal to expand stock options, especially since you 

are the entity that will be directly impacted by the legislation I 

have co-sponsored and supported thus far, H.R. 3574, the Stock 

Option Accounting Reform Act. 

I am aware of the allegations that have been made, that FASB 

has been hiring lobbyists, or, rather, actually having registered lobbyists on staff who have been encouraging Members of Congress to 

support its proposed legislation, thus calling into question the longstanding perception of FASB as an independent agency. Certain individuals have come to my office recently to express concerns about 

particular aspects of H.R. 3574. And after listening to you make 

your statement and the questions that the Chairman and others 

have asked, I will reread through today’s testimony and have my 

staff obtain a copy of it to determine if those concerns were addressed, as well as having them follow up with FASB. 

Mr. Batavick, what is your background? 

Mr. BATAVICK. Most recently, I was the retired comptroller of 

Texaco, Inc. We were acquired by Chevron a few years ago, and because of that I left the combined company. Prior to that I was with 

Getty Oil Company. That was acquired by Texaco. And before that 

I was in public accounting. 

Mr. HINOJOSA. Those are very good companies, very large, and 

I just cannot understand how you can be speaking so much for the 

small businesses unless you ran small businesses before you went 

to Texaco. 

Mr. BATAVICK. Actually, when I was going through school, I 

worked two summers at a public accounting firm that only did the 

accounting for small businesses. I did both accounting as well as 

auditing. Also, when I joined Getty Oil Company, most of our servVerDate 0ct 09 2002 10:59 Oct 05, 2004 Jkt 000000 PO 00000 Frm 00076 Fmt 6601 Sfmt 6601 G:\DOCS\95438.TXT FIN1 PsN: MICAH
71

ice stations are not owned by the company themselves, they are 

owned by small businesses. And I worked very closely with those 

small businesses during my early years. 

Mr. HINOJOSA. Well, Mr. Chairman, and Ranking Member Barney Frank, and Congressman Sherman, again thank you for calling 

this important hearing and I look forward to working with you. 

Mr. ROYCE. Thank you. Mr. Herz, you wanted to respond? 

Mr. HERZ. Yes, I wanted to respond to the question about lobbyists. I want to be very clear on this. We have not asked any firm 

to lobby for us with respect to our proposed standard to improve 

the accounting for equity-based compensation. 

Our Washington, D.C. Representative, Jeff Mahoney, since 1996 

has provided information and responded to questions about the 

FASB and its activities from staff and Members of Congress, Federal Government officials and other interested parties in Washington, D.C. He also works hard to keep interested parties informed. And, yes, we do speak our minds when there is proposed 

legislation that would intrude upon our independence and upon our 

ability to do our work in a thorough, open, and objective way. 

Jeff also arranges for me to meet directly with Members of Congress, Federal Government officials, and other interested parties to 

provide them with timely information on our activities. 

Because our communications sometimes entail lobbying contacts, 

as defined in the Lobbying Disclosure Act, relating to proposed legislation like this one, relating to our mission and activities, Jeff 

and I, and my predecessor since 1998, were registered under the 

Lobbying Disclosure Act on behalf of the Financial Accounting 

Foundation, our parent group. 

Basically, the history of this is that when Chairman Baker introduced a bill in 1998 relating to accounting for derivatives, many 

Members of Congress solicited the views of Mr. Mahoney and our 

then-chairman Ed Jenkins. They consulted with legal counsel who 

advised them to be safe, to register as lobbyists. When I came on 

board they registered me as a lobbyist. That has nothing to do with 

this particular matter in question. 

In fact, I think it is a little bit like the pot calling the kettle 

black. We have all read all the stories, and in a Senate hearing last 

week one of the Senators used the term high-tech lobbyists swarming all over Capitol Hill. We did not start anything here in Congress. It is your purview. We welcome the inquiry and all of that, 

but we try to respond to the questions of Members about the proposed legislation. But that is all. 

Mr. ROYCE. Mr. Herz and Mr. Batavick, we want to thank you 

both for appearing before our panel today. Let me also note that 

some members may have additional questions for both of you which 

they might want to submit in writing. If we can give them 30 days 

to submit those questions, and within those 30 days if you would 

complete your response for the record, we will collect those from 

you. 

Again, we thank you both for making the trip here to testify 

today. This hearing is adjourned. 

[Whereupon, at 3:17 p.m., the subcommittee was adjourned.] 

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May 4, 2004

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