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S. HRG. 108–862

THE FINANCIAL ACCOUNTING STANDARDS BOARD

AND SMALL BUSINESS GROWTH

HEARING

BEFORE THE

SUBCOMMITTEE ON SECURITIES AND INVESTMENT

OF THE

COMMITTEE ON

BANKING, HOUSING, AND URBAN AFFAIRS

UNITED STATES SENATE

ONE HUNDRED EIGHTH CONGRESS

FIRST SESSION

ON

THE IMPORTANCE OF SMALL BUSINESS INPUT INTO THE DRAFTING OF

ACCOUNTING STANDARDS AND INTERPRETATIONS

NOVEMBER 12, 2003

Printed for the use of the Committee on Banking, Housing, and Urban Affairs

(

Available at: http://www.access.gpo.gov/senate/senate05sh.html

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

RICHARD C. SHELBY, Alabama, Chairman

ROBERT F. BENNETT, Utah

WAYNE ALLARD, Colorado

MICHAEL B. ENZI, Wyoming

CHUCK HAGEL, Nebraska

RICK SANTORUM, Pennsylvania

JIM BUNNING, Kentucky

MIKE CRAPO, Idaho

JOHN E. SUNUNU, New Hampshire

ELIZABETH DOLE, North Carolina

LINCOLN D. CHAFEE, Rhode Island

PAUL S. SARBANES, Maryland

CHRISTOPHER J. DODD, Connecticut

TIM JOHNSON, South Dakota

JACK REED, Rhode Island

CHARLES E. SCHUMER, New York

EVAN BAYH, Indiana

ZELL MILLER, Georgia

THOMAS R. CARPER, Delaware

DEBBIE STABENOW, Michigan

JON S. CORZINE, New Jersey

KATHLEEN L. CASEY, Staff Director and Counsel

STEVEN B. HARRIS, Democratic Staff Director and Chief Counsel

STEPHEN R. KROLL, Democratic Special Counsel

DEAN V. SHAHINIAN, Democratic Counsel

JOSEPH R. KOLINSKI, Chief Clerk and Computer Systems Administrator

GEORGE E. WHITTLE, Editor

SUBCOMMITTEE ON SECURITIES AND INVESTMENT

MICHAEL B. ENZI, Wyoming, Chairman

CHRISTOPHER J. DODD, Connecticut, Ranking Member

MIKE CRAPO, Idaho

JOHN E. SUNUNU, New Hampshire

CHUCK HAGEL, Nebraska

JIM BUNNING, Kentucky

ROBERT F. BENNETT, Utah

WAYNE ALLARD, Colorado

RICK SANTORUM, Pennsylvania

TIM JOHNSON, South Dakota

JACK REED, Rhode Island

CHARLES E. SCHUMER, New York

EVAN BAYH, Indiana

DEBBIE STABENOW, Michigan

JON S. CORZINE, New Jersey

GREG DEAN, Staff Director

ALEXANDER M. STERNHELL, Democratic Staff Director

(II)

CONTENTS

WEDNESDAY, NOVEMBER 12, 2003

Page

Opening statement of Senator Enzi ....................................................................... 1

Opening statements, comments, or prepared statements of:

Senator Ensign ................................................................................................. 1

Senator Allard ................................................................................................... 19

Senator Bunning ............................................................................................... 37

WITNESSES

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

Prepared statement .......................................................................................... 38

Response to written questions of Chairman Enzi .......................................... 86

Peter A. Salg, President, QSC Restaurants, Fort Collins, Colorado on Behalf

of the International Franchise Association ........................................................ 17

Prepared statement .......................................................................................... 62

James K. Glassman, Resident Fellow, American Enterprise Institute ............... 19

Prepared statement .......................................................................................... 64

Richard Forrestel, Jr., Treasurer, Cold Spring Construction Company, Akron,

New York on Behalf of the Associated General Contractors of America ......... 22

Prepared statement .......................................................................................... 70

Walter K. Moore, Vice President, Government Affairs, Genentech, Inc. ............ 23

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

Jeannine Kenney, Vice President, Public Affairs and Member Services, National Cooperative Business Association ............................................................ 25

Prepared statement .......................................................................................... 76

Mark Heesen, President, National Venture Capital Association ........................ 28

Prepared statement .......................................................................................... 81

ADDITIONAL MATERIAL SUPPLIED FOR THE RECORD

Statement of David A. Raymond, President, American Council of Engineering

Companies ............................................................................................................ 94

News Release from the Biotechnology Industry Organization ............................ 96

(III)

(1)

THE FINANCIAL ACCOUNTING STANDARDS

BOARD AND SMALL BUSINESS GROWTH

WEDNESDAY, NOVEMBER 12, 2003

U.S. SENATE, SUBCOMMITTEE ON SECURITIES AND INVESTMENT, COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS, Washington, DC.

The Subcommittee met at 2:03 p.m., in room SD–538, Dirksen

Senate Office Building, Senator Michael B. Enzi (Chairman of the

Subcommittee) presiding.

OPENING STATEMENT OF SENATOR MICHAEL B. ENZI

Senator ENZI. Since the hour of 2:00 o’clock has arrived, and

since we are going to have two votes probably beginning at 2:45,

we will have some interruptions today and we will have to work

around that. When Senator Ensign arrives, we will have him give

his statement. He and I were just in some meetings where there

were some very important discussions going on, and I appreciate

him arriving timely.

Senator Ensign, of course, is the Chair of the High Technology

Task Force, and as such he has had a lot of insight into the effect

on small entities. We will now welcome you and look forward to

hearing your testimony.

STATEMENT OF JOHN ENSIGN

A U.S. SENATOR FROM THE STATE OF NEVADA

Senator ENSIGN. Thank you, Mr. Chairman, and thank you for

this opportunity to testify.

Mr. Chairman, as Chairman of the High Tech Task Force for Republicans in the Senate, I get a lot of opportunities to go out and

visit businesses and listen to them and find out how did they—

some of these are big companies—how did they become big, how

did they start up? Others of them are just starting up, and as a

profession I am a veterinarian and started two different animal

hospitals, so I have a lot of small business experience. There are

unique things that happen to small businesses that they cannot afford that big businesses can afford. There is everything from regulation and complying with certain laws, and there are a lot of

unique things. There is also a lot of lack of experience in small

business people. They are learning as they go along.

Most small business people are entrepreneurs, and it is that entrepreneurial spirit that I want to talk about this morning. That

is the thing that has made America so great and has driven that

economic engine that has driven us to the top of the world.

2

Being an entrepreneur means you take risks. Small businesses,

especially in the high-tech industry that want to go out there and

compete—remember Big Blue, IBM, and way before Microsoft, you

could never compete with IBM. It is the small companies like

Microsoft at that time that saw an opportunity with the development of technology to get into a marketplace where there were

needs that were not being met. One of the tools that they used was

the idea of stock options. They could not afford to pay their employees what the big companies, like Big Blue could pay their employees. So they decided to attract people to their company who wanted

to take risks with them. So not only the person with the idea to

start the company, but also attracting highly talented people to

come to them and share in those risks.

The idea of risk taking is so critical to innovation, and because

small business is truly the engine that is driving our economy, we

want to encourage more and more of those risk takers to associate

with small businesses, not just big business.

Mr. Chairman, you and I have worked on this issue quite a bit,

on the issue of stock options and expensing and what FASB is

doing, I believe that they are completely misguided in what they

are doing. We have been working with industry types to try to

make it much more reasonable. I appreciate the legislation that

you have proposed as a compromise piece of legislation, and I think

that we can develop some momentum with that and try to do the

right thing so that entrepreneurial spirit in business can be maintained so the start-up company that cannot afford the big salaries

can attract the highly talented people that they need to be able to

compete now with today’s Microsofts, with today’s Sun Microsystems, with today’s Oracles, with today’s whatever big business

is today that did not start out as a big business.

Really, the summary of my testimony is that people who care

about small business need to care about this issue. We need to continue to raise it up because as the Chinese are now talking about

going to stock options because they have recognized how well it has

worked in America, and now in America we are thinking about basically doing it in such a way that we cannot offer stock options.

It would be a critical mistake for this country to do that.

Mr. Chairman, I appreciate working with you on this issue and

your leadership, and for you calling the hearing to focus on items,

especially with your background as an accountant, items that can

so severely affect small business in this country. We have to continue to allow the incentives there for small business to flourish.

One last comment. If people say they care about minorities and

women having opportunities, 80 percent of those opportunities

come in small business. If we want America to be that opportunity

society, we need to make sure that there are not regulatory entities

out there that destroy that entrepreneurial spirit in America.

I appreciate your time and your indulgence, Mr. Chairman.

Senator ENZI. Thank you, Senator. I appreciate your comments,

and I appreciate all of the work that you have done, not just in the

high-tech task force area, but as one small businessman to another,

all that you have done in the area of small business.

Senator ENSIGN. Thank you, Mr. Chairman.

3

Senator ENZI. The Subcommittee at today’s hearing will explore

the important role of small business in our Nation’s economy and

the important role played by the Financial Accounting Standards

Board in establishing accounting standards.

The purpose of this hearing or any other hearing is actually to

build a record on the issue, and full statements made by any of the

parties will be a part of the record. We will ask all of you to summarize your comments so that we will have an opportunity to ask

some questions to clarify what you had in your testimony. As I

mentioned, we will be interrupted by votes today. That is fairly

normal. As a result, there will be some necessity to submit questions in writing, and so I will ask you to help in getting answers

to those.

Our country’s small business and entrepreneurial spirit have become woven into the fabric of our Nation. Countries all over the

world should emulate and replicate our high technology centers.

Recent press articles cite efforts by a city in China to replicate the

operations of Silicon Valley, as Senator Ensign pointed out.

Figures cited by the Small Business Administration demonstrate

the importance of small business to our Nation’s economy. I have

some charts here that show that nearly 23 million strong, small

businesses represent more than 99.7 percent of all employers in the

United States. They employ half of all of the private sector employees. They generate 60 percent of the net new jobs annually. They

create more than 50 percent of nonfarm private gross domestic

product, and they produce 13 to 14 times more patents per employee than large patenting firms.

The Financial Accounting Standards Board also is very important to the health of our Nation’s economy. This private sector,

independent board is responsible for establishing and interpreting

the accounting standards for our Nation’s companies. I have been

an ardent supporter of FASB and its independence. The importance

of FASB was seen last year with the passage of the Sarbanes-Oxley

Act. The accounting scandals of Enron, WorldCom, and others

highlighted to us that an independent accounting body is essential

to maintain the high standards and integrity of our Nation’s public

markets. With this high level of responsibility, it is vital that FASB

retain an objective and open process so that accounting standards

can be thoroughly discussed with all sectors of our economy. Sarbanes-Oxley worried about a ‘‘cascading effect’’ to small business.

We concentrated a lot on that, and want to continue to concentrate

on that. It was, and is, a justified concern, and it needs to be recognized by all boards and commissions.

Generally it is very difficult for a small business to participate

in the Federal rulemaking process. Small businesses do not have

the time or the resources, as compared to their large-business

counterparts, to sift through the thousands of pages of Federal regulations, to analyze and comment on the effects on these

small entities.

I remember my first year in office, holding a hearing for small

business under the auspices of the Small Business Committee in

Casper, Wyoming, and had about 100 businesses show up, very

pleased. Afterwards the media said to me, ‘‘Aren’t you a little disappointed in the number of businesses that showed up?’’ I said,

4

* Held in Committee files.

‘‘No, this is small business. If they had an extra person that could

attend an all-day hearing, they would fire him.’’

[Laughter.]

There just is not that kind of flexibility in small business. In

1980, Congress recognized this fact and passed the Regulatory

Flexibility Act, Reg Flex. The Reg Flex Act requires Federal agencies to conduct an economic analysis on virtually all Federal rulemaking proposals to determine if there is a disproportionate burden on small entities. Congress also established a ‘‘small business

watchdog,’’ the Office of Advocacy, within the Small Business Administration, to monitor Federal agencies’ compliance with the Act.

In addition, Congress amended the Act in 1996 to allow small entities to sue in court, to have the implementation of an agency’s rule

set aside until an adequate small business economic analysis had

been conducted.

Since the rise of accounting scandals, FASB has become more active in updating and establishing accounting standards. The Board,

in its attempt to quell the accounting problems of companies in the

Fortune 500 may have overlooked or have not paid enough attention to how the draft statements and interpretations may affect

small entities. In addition, FASB may not have sought enough

input from small firms.

I have another chart here.* For example, FASB relies upon the

Financial Accounting Standard Advisory Council—I think that is

called FASAC—for guidance and advice on draft accounting statements and interpretations. However, out of the 33 members of

FASAC, there are only five small entities and three of those are financial entities. They are marked with stars there. That may not

represent the operations of a typical small business.

In addition, FASB played a critical role in the early and mid1990’s on the Securities and Exchange Commission’s GovernmentBusiness Forum on Small Business Capital Formation. FASB was

represented on the Executive Committee and actively participated

in the annual forum. Unfortunately, during the past 2 years FASB

has withdrawn from the Executive Committee and did not participate in the forums. I understand that at this year’s forum, held in

September, the participants discussed the potential effects of FAS

123 and FAS 150 in detail, but FASB had already withdrawn.

Today, our second panel will highlight three separate accounting

issues that if fully implemented would have substantial effects on

small entities. The first issues concern FIN 46. In January 2003,

FASB released FIN 46 and interpretation of the Financial Accounting Statement 46, requiring the consolidation of variable interest

entities. Does that not sound exciting?

[Laughter.]

Two of our witnesses will discuss that the interpretation would

have a serious effect on venture capitalists investing in small entities, as well as franchisees’ ability to negotiate franchise agreements with franchisers.

The second issue concerns a soon-to-be-released proposal by

FASB on Financial Accounting Statement 123 concerning the expensing of stock options. Two of our witnesses will discuss the detVerDate 11-MAY-2000 17:44 Oct 17, 2005 Jkt 000000 PO 00000 Frm 00008 Fmt 6633 Sfmt 6633 23827.TXT SBANK4 PsN: SBANK4
5

rimental effects if this proposal is not fully vetted, as it would place

a tremendous strain for entrepreneurs trying to gain access to the

equity markets. In addition, the adoption of this proposal may

place U.S. small businesses at a competitive disadvantage with

overseas companies, as Senator Ensign pointed out, that will not

be bound by the standards.

With respect to this initiative I have had serious concerns about

whether FASB has sufficient inclusion of small business entities in

the drafting process. This is an extremely complex initiative. Even

FASB recognized how complex and intricate a project this was

when it established an ad hoc committee, the Option Valuation

Group, to come up with a standard valuation model for stock option

expensing. It is my understanding the group met for the final time

in early October. However, the group was unable to achieve consensus on a valuation model. In addition, the FASB has stated that

it will ‘‘road test the valuation model.’’ I am very interested in how

this will operate and how many small businesses will be involved

in the road testing.

Finally, we have two witnesses who will discuss Financial Accounting Statement 150. Earlier this year, FASB issued a proposal

that would require closely held companies to count its mandatory

redeemable shares as liabilities. If implemented, it would have had

a devastating effect on thousands of closely held businesses across

the country.

With respect to FAS 150, the comment period ended on October

30. In lightning-fast speed, FASB reviewed the small business comments and immediately issued a statement that the implementation of this initiative was put on hold indefinitely. I applaud FASB

for the quick action in this process and the result. In addition, I

applaud the work of Mr. Forrestel. I believe that it was his hard

work and dogged perseverance that made FASB see the potential

effects of the proposal on small entities, and he will be testifying

later today. However, the question that should be asked is whether

the problems with the proposal could have been foreseen earlier.

In light of this, I am proposing that FASB immediately establish

a Small Firm Advisory Committee to work with FASB and FASAC

to address small business concerns early in the process. Currently,

the National Association of Security Dealers effectively use its

Small Firm Advisory Board to review all of the National Association of Securities Dealers’ rulemaking prior to the rulemaking

being issued for comment by NASD and by the SEC. I strongly believe that such a small business committee is essential for FASB.

With respect to FASB, there is no Regulatory Flexibility Act for

small businesses. There is no small business watchdog, and there

is no recourse when an accounting standard has been adopted.

Once FASB adopts an accounting standard it is final until the

FASB board members change their mind. Unlike the Regulatory

Flexibility Act, small entities cannot seek a higher authority for appeal if the small entities believe an accounting standard was adopted with insufficient small business information.

This Small Firm Advisory Committee should review all pending

and future FASB draft proposals and interpretations to ensure

there are no unintended consequences on small business.

6

* Held in Committee files.

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

advance for their testimony. I do greatly appreciate, Chairman

Herz, you for changing your schedule to be with us today. I guess

I will give him a chance to get to the table before I have him testify. If you would move up there, I would appreciate it.

We welcome Robert Herz, who is the Chairman of the Financial

Accounting Standards Board. FASB is a private sector independent

body recognized by the SEC as the entity responsible for establishing accounting standards. As the sole accountant in the Senate

I fought very hard for the independence of FASB during the debates on Sarbanes-Oxley, and I look forward to your testimony on

this extremely important topic of small business and the accounting standards.

STATEMENT OF ROBERT H. HERZ

CHAIRMAN, FINANCIAL ACCOUNTING STANDARDS BOARD

Mr. HERZ. Thank you, Chairman Enzi.

I am very pleased to appear before you today on behalf of the

FASB, and I want to personally thank you, Mr. Chairman, for inviting me to testify on this very important topic, because the active

participation of users, auditors, and preparers of small businesses

in our process is absolutely essential to the development of highquality financial accounting and reporting standards.

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

Senator ENZI. We appreciate all 100 or so pages.

[Laughter.]

They will be.

Mr. HERZ. It is a principles-based document.

[Laughter.]

Mr. HERZ. Our independence from enterprises, auditors, and

other constituents is fundamental to achieving our mission to establish and improve general purpose standards of financial accounting and reporting for both public and private enterprises.

Those standards are essential to the growth and stability of the

U.S. economy because investors, creditors, and other users of financial reports rely heavily on credible, transparent, comparable, and

unbiased financial information to make rational resource allocation

decisions.

The FASB’s independence, which through your leadership and

hard work, Mr. Chairman, was recently reaffirmed and enhanced,

as you noted, through the Sarbanes-Oxley Act. That independence,

as you also noted, is fundamental to our mission because our work

is technical in nature, designed to provide preparers the guidance

necessary to report their economic activities. That guidance creates

the yardstick to measure and report on the underlying economic

transactions of business enterprises. Like investors and creditors,

I think Congress and other policymakers also need an independent

FASB to maintain the integrity of a properly designed yardstick in

order to obtain the financial information necessary to appropriately

assess and implement public policy. While bending the yardstick to

7

favor a particular outcome or type of transaction or industry may

seem attractive to some in the short-run, in the long-run an inaccurate yardstick, that is, a biased accounting standard, is, I believe,

harmful to investors, creditors, and the U.S. economy in general.

The FASB’s open and thorough due process is also fundamental

to our mission. Because the actions of the FASB affect so many organizations, its decisionmaking process must be fair, and as far as

possible, objective. The FASB solicits and carefully considers the

views of all interested parties—users, auditors, and preparers of financial information. Our rules of procedure require an extensive

due process. It involves public meetings, public hearings or

roundtables, field visits or field tests, liaison meetings and other

meetings with interested parties, and exposure of our proposals to

external scrutiny and public comment.

As part of our due process, the FASB, and our Emerging Issues

Task Force, regularly provide additional guidance to assist preparers in implementing the requirements of new and existing

standards. For example, as described in more detail in the full text

of my testimony, we have recently issued implementation guidance

and a proposed modification pertaining to our Interpretation No.

46, or as you said, the exciting topic of Consolidation of Variable

Interest Entities. That includes additional guidance addressing the

application of certain provisions of the interpretation to franchises

and other industries.

We have also recently issued implementation guidance for our

Statement No. 150 on Accounting for Certain Financial Instruments with Characteristics of Liabilities and Equity. That guidance

includes an indefinite deferral of the effective date of certain provisions of that statement relating to the accounting for certain

mandatorily redeemable instruments. That particular deferral is

applicable to all nonpublic enterprises, including cooperatives.

More generally, with respect to the FASB and small businesses,

which is the subject of this important hearing, I would like to make

four brief points. Each of these points is discussed in more detail

in the full text of my testimony.

First, small businesses are difficult to define. From our perspective different constituents have very different notions of what is a

small business. To the extent that a small business is a registrant,

under the Federal securities laws the enterprise is required by the

SEC to prepare financial reports in accordance with generally accepted accounting principles, which include the FASB standards.

For most other small businesses the use of GAAP is primarily a

private choice. For many small businesses, their current and potential lenders, suppliers, and other contracting parties may influence

or control that choice. To the extent, however, that one of those

parties requires that financial reports of a small business comply

with GAAP, that party has also made a private choice. That choice

presumably reflects that party’s opinion that GAAP results in better, more complete, and more transparent information than the use

of other existing comprehensive bases of accounting, such as tax

basis, cash basis, or regulatory reporting. And we are very pleased

that they do make the choice for GAAP.

Second, it has been our experience that the views of representatives of small businesses about financial accounting and reporting

8

are not monolithic. Historically, the users, auditors, and preparers

of small business financial reports have provided the FASB with

distinct and sometimes conflicting input on FASB proposals and

other activities. As I indicated earlier, our mission and due process

procedures require that we carefully consider all views and make

an independent, objective judgment on what will provide the most

decision-useful information, subject always to the constraints of the

costs and benefits of implementing changes to GAAP.

Third, the Board has long recognized that the cost of complying

with financial accounting and reporting standards fall disproportionately on smaller businesses. In recognition of that fact, the

FASB carefully considers requests received from small businesses

to defer effective dates and provide for differential disclosures to alleviate the costs of implementing changes to GAAP. The Board has

also explored on many occasions requests by representatives of

small businesses to provide for differential recognition and measurement provisions in GAAP for small business. After public deliberations, the Board has generally rejected those requests. Why?

Many of our constituents, particularly the users of financial reports, have expressed concerns that a big GAAP/little GAAP system could undermine the comparability and credibility of financial

reports. They also say that such a two-tiered system would add

costs to the users, auditors, and preparers of those reports that

would likely more than offset any perceived benefits achieved by a

differential reporting system.

Finally, the Board actively solicits the views of users, auditors,

and preparers of the financial reports of small businesses in several

ways, including through seeking their participation in our Emerging Issues Task Force, as you mentioned, our Financial Accounting

Standards Advisory Council, the recently established User Advisory

Council, and also on other less formal project task forces and working groups. By scheduling regular public liaison meetings and less

formal private meetings with representatives of small businesses.

Two examples include our public liaison meetings and regular contacts with the Technical Issues Committee of the AICPA Private

Companies Practice Section, and with the Accounting Practices

Committee of the Risk Management Association. And finally,

through participating in many conferences and other speaking opportunities sponsored by or attended by representatives of small

businesses around the country.

We are very aware of the significant focus over the past year on

the financial accounting and reporting of public enterprises, in part

because of the many activities relating to Sarbanes-Oxley, and also

because of the increased attention on the movement toward international convergence of accounting standards. We, however, remain

very committed to serving all of our constituents including private

companies and small businesses, and not-for-profit entities.

Accordingly, Mr. Chairman, we very much appreciate the opportunity that this hearing presents to publicly encourage representatives of private companies, small businesses, and not-for-profits to

more actively participate in our activities, and I very much like

your idea of the advisory committee as well. Greater participation

by those constituents will be very welcome. They will help ensure

that consistent with the FASB’s mission and rules of procedures,

9

the various perspectives of those constituents are effectively communicated to the Board and that they receive the careful consideration that they deserve.

Thank you again, Mr. Chairman, and if you do not break for a

vote, I will take any questions.

Senator ENZI. I hope even when we break for a vote that you will

stay for a few minutes, because I suspect that my colleagues who

said they would be here are waiting until they vote because they

just finished lunch. We started this little early, anticipating there

would be afternoon votes, but not quite that early in the afternoon.

I do applaud your quick response to the indefinite implementation of the FAS 150 issue. I know that prior to the announcement

many of the small businesses thought that FASB was not taking

their concerns seriously. I do understand that the issue is not completely settled and that FASB needs to continue working with the

small business owners and representatives on the issue as it is

being studied further.

But in the process of reviewing comment letters, it appears that

FASB quickly recognized the problems that small businesses would

face with FAS 150. Why was the problem not found earlier though?

Mr. HERZ. I asked that myself, did a little bit of a postmortem,

and I did that just for my own personal edification. I arrived at the

Board in July 2002. The original exposure draft had gone out in

late 2000, and a lot of the deliberations had been done, but I participated in many deliberations after that.

I think the particular issues, from what I can tell going back and

talking to people and looking at letters, and field visits that had

been done then, I think the issues related to the effect on loan covenants, bonding arrangements, all of those were identified or actually discussed fairly comprehensively with, for example, lenders,

who actually preferred the proposal and said they could easily adjust to it.

This is only in my own mind, and as you know as a policymaker,

you balance a lot of things. What swayed me from all of those letters—and then I came actually down here to Washington to meet

with a group of contractors, and other groups went up to meet with

us in Norwalk—was the biggest issue that I do not think had been

identified, and I am not sure exactly why, was the ability to bid

on contracts, that written into many State and local municipality

requirements, to actually bid, are kind of hard-wired requirements

relating to GAAP numbers. I, for one, when I heard that, got convinced that even a 2-year deferral, which is what we had been proposing, would not be enough, that we needed to step back and

think about the issue more.

Senator ENZI. We do appreciate that, and depending upon what

answers come out of that, I will shift gears a little bit on all of my

questions. In the Federal regulatory process, small entities are able

to petition a court to have a Federal agency’s implementation of a

final rule delayed until a correct economic analysis, and its effect

on the small entities, is conducted. Since FASB is a private sector

entity and not the Federal Government, a private right of action

is not available to small entities. What is the recourse for small entities if they believe an accounting standard or interpretation

10

adopted by FASB was based on information that was faulty

or incorrect?

Mr. HERZ. I think it is demonstrated by that episode. I think not

only are our doors open, our letter boxes, our e-mail, our faxes, our

everything, and I think our minds are open too. We get many,

many letters every day through the transom and e-mails, and I

think when you have gotten about three or four of them on the

same topic you do start believing that there is an issue. So, I think

that is part of it.

I also think that we do meet regularly, as I said, with a number

of different groups, and on those groups, there are representatives

of small business. They are usually industry-type groups. A lot of

these issues tend to be industry by industry as well as being overall small business issues. But as I said, I really do like your suggestion of the advisory council.

When I first came to the FASB, one of the complaints was that

users of financial information, investors, creditors, and bond rating

agencies, did not have enough of an active voice, and so I formed

a user advisory council, and I think the same model, if we can get

the right people that can get engaged, would be a great thing.

Senator ENZI. I am pleased to hear you say that if four or five

letters come in, and that over the transom thing rings particularly

strong in Wyoming, but that it makes a difference to you, and I

really appreciate that and hope that small business heard that as

well. I know that the FASB staff has looked at alternative ways

that small business can listen to FASB and the advisory committee

meetings. Can you share with me some of those alternative ways?

I think that currently small business has to either travel to Norwalk, Connecticut or pay 75 cents a minute to listen in. Do you

have any other alternatives?

Mr. HERZ. Yes, that is correct. That is something that the foundation, the trustees, the commercial arrangements are kind of in

their hands, but I will tell you, my own view is that this is a public

service, and I would think it should be free. I know we are also exploring doing webcasts as well.

Senator ENZI. Good. I would encourage you to think of as many

different ways as you can. For small business, 75 cents a minute

on the phone sounds like a pornographic call.

[Laughter.]

Mr. HERZ. Not as exciting.

[Laughter.]

Senator ENZI. I had to notice in your testimony, and I read not

only your summary but also all of the other pages that you submitted, that in your opening statement you did not mention your

initiative on stock option expensing. Is that because you believe

that it is simply not a small business issue? Small business representatives have told me that you and other FASB Board Members dismiss their concerns outright with respect to the issue. Does

that mean that three or four letters have not come through?

Mr. HERZ. No. We have had more than three or four letters and

many, many meetings. Would you like me to update you where we

are in that project?

Senator ENZI. Yes, that would be great.

11

Mr. HERZ. As you know, we put that on our agenda last March,

and as I noted in the roundtable that you organized in May on that

topic, we had a plan and we were going to systematically, thoroughly go through all the issues with a view toward issuing a proposal by the end of this year. We have stuck to that plan. We have

been going through many, many issues, not only on stock options,

but also other equity-based awards. Over the summer, as you mentioned, we focused on valuation issues. I would say that the Option

Valuation Group, all but one person, did agree on recommendations. So, I think there was a consensus as it applied, I will say,

to large public businesses. The issue there is that it requires more

data. Private companies, which obviously include small businesses,

I think our valuation group thought that in many cases you could

get a valuation. I think some of us are more skeptical as to whether you can in all cases get a robust valuation. Certainly it might

be difficult, for example, determining the volatility for a very young

company.

What we have tentatively—and this is very tentatively—decided,

and it ain’t over till it is over, is that companies that do not feel

confident in their ability to get a grant date fair value would be

able to, as a policy matter, adopt an alternative method which

would basically measure the intrinsic value of options granted

through exercise or expiration so that the total expense that they

would accumulate in the income statement through the exercise

date would be the same as the tax deduction that they take. That

is tentative.

As you said, we are not meeting our original goal of getting an

exposure draft out by the year end. One of the reasons is that we

are going to do a number of field visits to large public companies,

smaller public companies, and some private companies. We are trying to enlist private companies at the moment through accountants

and anybody else that would like to do it. We have had some volunteers on that, but we are going out there to meet with them, go

through how would they do this, could they gather the data, how

do they overall feel about the proposal?

Right now our expectation would be that we would issue a proposal for public comment probably in February. It would be out for

public comment for a lengthy period, and we would probably have

some public roundtables, so there is still plenty of time for input.

Senator ENZI. I appreciate that, and you mentioned that this option value group did reach consensus except for one person?

Mr. HERZ. That is what I remember, yes. He was a supporter of

minimum value, that individual.

Senator ENZI. Pardon?

Mr. HERZ. He was a minimum value supporter, what is called

minimum value method.

Senator ENZI. Okay. But the valuation model potentially talked

about by this group for the upcoming stock expensing proposal, currently it is my understanding that the option traders use physicists

to calculate the pricing model for stock options, and most of the

people that voluntarily started expensing stock options early on

have gotten to me, saying that they had a lot of difficulty with

Black-Scholes, so I am glad you are discounting the value of that,

12

and I do not know whether you are considering several pricing

models or just this one pricing model that requires physicists.

Mr. HERZ. No. We are going to set out a framework, an objective,

and explain how one would accomplish that objective. We would

talk about the different models that would be available, but we

would not mandate a particular model, and that is because it may

be that for particular option grants, and given the number and materiality for a particular company, Black-Scholes may get you a result that is close enough. For use for a company that had more

awards of lengthier periods, it probably would not be good enough.

Senator ENZI. But you will wind up with one formula or

a multiple?

Mr. HERZ. No. We will describe objectives and how to get there.

Senator ENZI. You mentioned that you will be field testing the

valuation models with business entities and accounting firms. Is a

field test the same as a road test?

Mr. HERZ. It is a field visit.

Senator ENZI. Field visit.

Mr. HERZ. Visit, which means we go there, we have a detailed

checklist, we send them information in advance, and then we hold

meetings. We ask them to see how they would do it, whether they

can do it, how they would do it, what data would be needed, as well

as just general overall feelings about it.

Senator ENZI. I assume from some of your criteria that you

would be talking about what the cost and the benefit is as well?

Mr. HERZ. Yes. That is a key aspect of those visits.

Senator ENZI. You will be including small businesses in those

road tests?

Mr. HERZ. In fact, the more volunteers we can get, the better. We

just do not show up on people’s doorsteps.

Senator ENZI. I am hoping you will be prepared to help them

with the calculations.

In your testimony you stated that FASB’s open and thorough due

process is also a fundamental to the mission. ‘‘Because the actions

of FASB affect so many organizations, its decisionmaking process

must be fair and as objective.’’ That is a quote from you. It is my

understanding that FASB has not issued FAS 123 for public comment, and will not do so until the spring of 2004. However, I did

receive an unsolicited letter last week from the American Business

Conference, stating that having met multiple times with the members of FASB on this issue, we recognize that the Board, as one of

the members candidly told us last month, is set in concrete on the

matter of expensing. If the matter is set in stone by FASB members, then where is this due process for small business, who have

not even seen the proposal, let alone be able to comment on it yet?

Mr. HERZ. Well, I cannot comment on a secondhand comment.

Senator ENZI. I would hope that does not turn out to be a setin-concrete situation for the Board. And I would hope that the

Board members would not make those kind of comments, particularly to small businessmen who take all of that very seriously.

Mr. HERZ. Perhaps somebody made that, but I often get reports

back from meetings I was at of what supposedly occurred, and I

must have been at a different meeting.

13

Senator ENZI. I want to congratulate you on the number of

speaking things that I did. I think that you probably do more

speaking events than most of the Senators do.

Mr. HERZ. It seems to be a hot topic, and if you get the right

group, an audience, I think it is important to do that, and also to

hang around and talk with people.

Senator ENZI. Also in the paperwork that you submitted to me—

I will find it here in a second. I apologize, I thought I had it. In

your attachment on facts about FASB, 2003 and 2004, you mentioned the precepts in the conduct of your activities. I really appreciate those. I started with the fourth one and worked back in order

of importance to me, but that was to bring needed changes in ways

that minimize disruption to the continuity of the reporting practice,

to promulgate standards only when the expected benefits exceed

the perceived costs, to weigh carefully the views of its constituents,

and to be objective in its decisionmaking, and of course, to review

the effects of past decisions was the last one. I think that is an excellent statement of precepts. I am curious as to what point FASB

reviews this compared to a FAS that they are putting out.

Mr. HERZ. I think the basic mission statement has stayed intact

for a number of years, and it is something that is also discussed

with our trustees of the Financial Accounting Foundation. I can tell

you though that our detailed operating procedures to implement

these, we regularly review them in kind of a continuous improvement mode. I know it is hard to believe, but we are not perfect, and

you learn a lot.

Senator ENZI. We all do. I guess the reason that I listed that

fourth one as the first one is under the explanation, the last sentence said, ‘‘The Board considers it desirable that change be evolutionary to the extent that it can be accommodated by the need for

relevance, reliability, comparability, and consistency.’’

Mr. HERZ. I think that is right, and there are counter-tensions

right now, as you know, as you expressed, in the wake of at least

in the public company arena, given some of the revelations and the

need to at least there to move fairly expeditiously to deal with

some of the problems that were revealed.

Senator ENZI. Definitely, as part of the team that worked on Sarbanes-Oxley, we knew that something needed to be done and did

provide some revolutionary, rather than evolutionary, legislation.

The implementation of it will be very important because how revolutionary each of the steps of the implementation are will ensure

the economy moving forward, but hopefully we will remember the

engine of the small businesses that are 50 percent of the GDP and

all of the jobs and things that we have up there.

Can you share any economic impact studies you have done on

FAS 150, FIN 46, and FAS 123, or any of the other statements?

Is there an economic impact statement that is done, referring back

again to those four principles?

Mr. HERZ. We do an analysis of costs and benefits, and the benefits are in terms of better information, and sitting down with users

and understanding how they would use it in their decisionmaking,

and hopefully they are promoting better decisionmaking and resource allocation through the change in the information.

14

The costs we look at are the costs, the one-time cost to implement by preparers and auditors, the cost of retraining and ongoing

systems changes and the like. I think it is well known, we do not

have an office of economic analysis, per se, and the philosophy is

that if you get better information into the system in a cost-effective

way, that better information will enable better decisions and better

resource allocation.

Senator ENZI. I do thank you for rearranging your time and

being here, and the vote has started now, but I will not expect you

to stay after, although I would hope that you would stay and hear

the testimony from the next panel, and short of you being able to

stay, would hope that some of your staff would stay and do it.

Mr. HERZ. Absolutely.

Senator ENZI. They have some excellent observations, which of

course you can get through the testimony as well, but you will not

be here for the questions, and I am told that four people will be

joining me for the questions. They were hoping to be able to do that

with you, but I will not hold you up for that.

When we sent out the notice for this hearing last Wednesday

night, we did not have any idea how much attention it would receive. Since that time our phones have not stopped ringing, and it

has been from small businesses and their representatives from

across the country that have contacted the office to see if they

could come and testify. Now, clearly, we could have had two or

more additional panels. It should be noted that the small businesses did not want to come and talk about just these three accounting issues, FIN 46, FAS 123, and FAS 150, but other issues

as well. So, obviously, there appears to be a lot of concern and interest on the part of small business.

Mr. HERZ. Can I make a comment on that?

Senator ENZI. Sure.

Mr. HERZ. And in my introductory remarks I talked about there

is this big GAAP/little GAAP issue that every so often comes up,

and it has been surveyed fairly regularly, and the surveys usually

come back and say, well, the people who demand the financial

statements want to keep it the way it is, maybe different disclosures, but if an asset is an asset or if you have a derivative transaction I want it accounted for the same way as a big company. If

you got a special purpose entity, I want it accounted for the same

way.

I think that is generally right, although you can probably tell

from my New Jersey accent, I actually spent a number of years in

my career in the UK. Over there they have developed a differential

set of standards. Most of it is the same, but there are some shortcuts in some areas, and at least in their market it seems to work

fairly well.

The real point I am making is that the issue is about satisfying

the needs of the market, and that to me is where it is at. If the

market were to want a credible, slightly different product, I think

it will be somebody’s responsibility to try and fill that need.

Senator ENZI. On the differential with the small businesses, they

are just hoping of course that the cascading effect does not happen,

and that is why we put some statements in Sarbanes-Oxley to indicate to States that they did not have to adopt Federal principles

15

to do it, and perhaps some wording in there that makes it clear

that small businesses may not have the same capability to generate

the information. As I mentioned, some small businesses think it

takes a physicist to come up with valuations on stock options, and

they do not have those.

Mr. HERZ. That is why we propose as an alternative a much simpler calculation. They may not like it because it potentially creates

volatility.

Senator ENZI. Anything you can do to prevent that cascading effect from happening in instances where it is not necessary, where

they are not affecting the outside individual investors who may not

have the knowledge to interpret some things, but are rather working with professionals like their bankers, who do have the capability. They know the person. They know the business. In most

cases with these small businesses, the audit and an exact inventory

can be done particularly easily because they do not have anything.

Mr. HERZ. Yes. I have audited a lot of small businesses.

Senator ENZI. So, the requirements cannot be the same for them,

one of the important things is for it to be clear that way, but I am

also hoping that small businesses do not have to wage an 11th

hour campaign in order to have FASB listen to their concerns.

Mr. HERZ. I would rather that not happen either.

Senator ENZI. I am very encouraged by your comments about the

small business advisory committee or council or whatever, and I do

applaud you on your recent decisions on FIN 46 and FAS 150

issues. I know there is still a lot of work to be done in that, and

in addition these issues should be addressed much earlier in the

process.

In your statement you readily acknowledge that you have a longstanding position recognizing that the cost of complying with financial accounting and reporting standards do fall disproportionately

on small business.

With respect to the advisory committees that FASB has established, the FASAC, the Emerging Issues Task Force, and the Users

Advisory Council, very good. However, small business representation is a very small proportion of the overall membership, and

reading through the minutes of certain meetings, the concerns

raised by small business sympathizers are given less weight as a

result of having less weight on the committee, and in some instances are dismissed.

You have also submitted the list of speeches, which I already

commented on, but I notice that you spend five times as much

speaking as you do appearing to listen, and the listening is the

part that comes through to me from the small business.

As FASB is an independent body there is an even higher standard for FASB to remain open and objective about the standard-setting process. In addition, the due process rights for small entities

must be clearly delineated. I do have extreme concerns about that

statement about ‘‘set in concrete’’ that I mentioned.

Again, I thank you for appearing here today.

Mr. HERZ. Thank you.

Senator ENZI. It has been most helpful, and we will be submitting some questions, and those who were not able to be here will

be doing that, and I look forward to your answers on that.

16

Mr. HERZ. Thank you very much.

Senator ENZI. Thank you.

Senator ENZI. At this point, since we are past the halfway point

on the vote, I will have a short recess while I go and vote, and

there will be a second vote which should follow shortly after that,

and then we will come back and reopen it with the second panel.

[Recess at 2:59 p.m.]

Senator ENZI. While I was over voting on the two measures, Senator Allard was here, left for the second one. He will be back. When

he is back, we will allow him an opportunity to make some comments as well. And then, of course, following the panel we will

have questions and an opportunity for comments again.

I appreciate everyone’s patience during the vote. Two 15-minute

votes around here can take an hour. But it is so that we make sure

that everybody gets their opportunity to cast their vote and—so I

was able to vote at the beginning of the next one and come back.

Today’s second panel is a cross-section of the small business community with small business owners, financial experts, and a former

small business that can describe what it is like to grow from small

to large while trying to comply with the accounting standards.

In this second panel we have a very distinguished panel of witnesses. We have Peter Salg of Fort Collins, Colorado, who is the

owner/president of a company that has five Wendy’s restaurants.

He is here representing tens of thousands of small franchisers and

franchisees for the International Franchise Association, and has

had some very personal effects on what has happened with FASB.

James Glassman, a Resident Fellow with the American Enterprise Institute and a syndicated columnist with The Washington

Post. He has been closely following and writing about small business financing issues for quite some time.

We have Jeannine Kenney, who is with the National Cooperative

Business Associations, here representing tens of thousands of small

co-ops across the country.

Richard Forrestel is the CFO of a smaller-sized construction company in Akron, New York. I firmly believe that without his dogged

perseverance on FAS 150 issue, FASB would not have arrived at

its decision today to delay the implementation of FAS 150.

And finally, Walter Moore, who will be filling in for Lou Levine,

as Mr. Levine is home with the flu. I remind everybody to get their

flu shots. He will discuss how an entrepreneurial business started

by two gentlemen grew into a multibillion-dollar corporation and

how they managed to deal with the accounting standards while

growing from a small business to a large business.

I thank all of the members of the panel for being here and for

their comments.

Oh, yes, there is one more there than I introduced. I also thank

Mark Heesen, the President of the National Venture Capital Association, for being here. And he deals with a lot of the start-ups of

the small businesses that we have been talking about. I put him

in as the clean-up batter there.

And I appreciate the testimony that all of you provided. I learned

a lot from the testimony, and do know that we picked a significant

panel here of solutions for FASB.

So with that, Mr. Salg, you may proceed.

17

STATEMENT OF PETER A. SALG

PRESIDENT, QSC RESTAURANTS, FORT COLLINS, COLORADO

ON BEHALF OF

THE INTERNATIONAL FRANCHISE ASSOCIATION

Mr. SALG. Thank you, Chairman Enzi, and thanks for the opportunity to testify at this important hearing.

I have worked in franchising since 1968, doing everything from

running a restaurant to running a franchisor with 450 units. My

company, QSC Restaurants, Inc., owns five Wendy’s restaurants in

Colorado. I will be testifying today on behalf of the International

Franchise Association, which represents franchisees, franchisors,

and others in the franchise community. I will be focusing my comments on the impact of FIN 46 as a small franchisee. But I also

want to make sure that you know that the great majority of

franchisors are small businesses, too.

The typical franchisor has less than 200 units and revenues of

less than $5 million. If FIN 46 goes into effect as written, here is

what it would mean to franchisees like me. We would have to have

audited financial statements. This is not required currently, and

would be very expensive. It is not required because it does not

make sense, for two reasons. One, Wendy’s has no contingent liability from my business; and two, I am not a public company.

We might be required to use the same outside auditor as our

franchisor. This is not an explicit requirement of FIN 46, but if my

franchisor’s auditors say they will only be comfortable if my statements are prepared by their people, we are left with little choice.

This requirement will hit single-unit franchisees the hardest. It is

needless to say not every mom-and-pop business can afford

PricewaterhouseCoopers.

We would also be required to adhere to the franchisor’s internal

accounting standards. Franchisees like me have made enormous investments in the way we have chosen to set up our financial statements. Wendy’s P&L does not look like my P&L, and we both have

good business reasons why they should not.

We would have to develop a system to provide internal control

reports to franchisors and adhere to internal-control dictates of the

franchisor’s auditor. I can understand why the franchisor would

want this, since the CEO and CFO are on the hook for criminal

penalties in Sarbanes-Oxley. But why on earth should a privately

held small operator have to institute an extensive internal control

system? This unintended consequence of FIN 46 is, in my opinion,

pure overkill.

Now let us look at the impact on small franchisors. If you have

a successful small business and you are thinking of ways to expand

it, franchising is a great method for a lot of people. But FIN 46

makes franchising much less appealing. First of all, it just got a

lot more expensive to be a franchisee. As I described earlier, you

have to have audited statements done by an expensive firm and acceptable internal control systems, et cetera. Second, your freedom

to operate your franchise just got more limited. I have chosen to

operate my restaurants the Wendy’s way. The menu, the appearance of the store, the quality of the food—things like this must be

standardized across the system so that you, the customer, know

18

what you are going to get when you walk into any Wendy’s in the

country.

But on the other hand, I am an independent businessman. I decide how to set up my business. I decide whether it is a partnership

or an S corp. And I decide who my lawyer and accountant are. I

decide on what capital expenditures I make, and I decide on product pricing. Furthermore, I decide who to hire and fire, what salaries and benefits to offer, and what pension plan to set up. I make

decisions every day that directly affect my bottom line.

So in deciding whether franchising is the way to go, some prospective franchisees will find the level of intrusion called for in FIN

46 more than they can live with. This is, in my opinion, a very serious threat to franchising. If FIN 46 had been in effect when I made

my decision to become a franchisee, I am not sure I would have

made the leap.

There is another problem with FIN 46. When and if I want to

sell my business one day, there will be fewer prospective buyers,

and that will lower the value of my business.

I know the mission of the FASB is to improve financial reporting

so that the public is protected. The entire franchise community

supports that vital goal. But I cannot understand how FASB could

come to the conclusion that hobbling franchising is an acceptable

price to pay for preventing another Enron.

To make matters worse, I do not think FIN 46 accomplishes

FASB’s goal to improve financial reporting when it comes to franchising. If FIN 46 results in a franchisor consolidating the financial

results of its franchisees, it may confuse investors who are not familiar with franchising. A franchisor’s financial results just are not

one and the same with its franchisees’ results.

In other words, FIN 46 is going to make me and a lot of other

people in the franchising world jump through a lot of hoops and

pay a lot of money, with zero public benefit.

In conclusion, it is clear that FASB has not sufficiently understood the implication of their proposal. They apparently have not

been listening to real business people like me. Frankly, I am surprised that FASB would consider doing something like this. FASB

needs to better understand that the rules they set are not just academic exercises. These rules have real-life consequences, and FASB

needs to understand what those consequences are and take them

into account before they act.

In the case of FIN 46, FASB needs to listen carefully to the concerns of the franchising community before its implementation.

Given what Chairman Herz said earlier, it appears FASB is moving in that direction. I like the idea of an advisory council, especially in light of the fact that I did not see franchisees on that big

chart you had up here.

I would be happy to answer any questions that you might have.

Senator ENZI. Thank you. At this point, as I mentioned before,

I will call on the Senator from Colorado for any opening comments

that he might have.

19

COMMENTS OF SENATOR WAYNE ALLARD

Senator ALLARD. I would just like to take a moment to welcome

and thank Mr. Salg for coming here and testifying before the committee. You know, when you are running your own business it is

not easy to get away. And to come all the way to Washington from

Fort Collins, Colorado, is not an easy task.

Mr. SALG. And on my wife’s birthday.

Senator ALLARD. On your wife’s birthday?

Mr. SALG. Yes, I have to go home and fix that tonight.

Senator ALLARD. Hey, I had better send her a birthday card.

Mr. SALG. I think that would be a good idea.

Senator ALLARD. Okay. Drop by the office here. We will take care

of that. Do you want to sign it, too?

[Laughter.]

You know, Mr. Salg epitomizes entrepreneurship. He is a hardworking individual, puts in extra hours, and has an extensive

record of involvement in the restaurant franchise business. Anybody that has been in the business of grocery stores and food,

whether it is a restaurant or whatever, you put in long, hard

hours, and you have rules and regulations you must adhere to. And

one of the reasons I ran for the Senate is because as a small businessman, I was impacted by all these rules and regulations and

high taxes, and it felt like I wanted to have some impact and certainly be a voice for small business. Mr. Salg being here, I think,

is refreshing to hear what he has to say as a small businessman.

As he mentioned, he is testifying on behalf of the International

Franchise Association, as an example of a successful franchisee and

a business person, and it is a pleasure to have you hear before us.

Thank you for your comments and your testimony before this Committee. They will become a part of the record and will have serious

consideration by the Committee.

Thank you, Mr. Chairman.

Senator ENZI. Thank you, Senator.

Mr. Glassman.

STATEMENT OF JAMES K. GLASSMAN

RESIDENT FELLOW, AMERICAN ENTERPRISE INSTITUTE

Mr. GLASSMAN. Thank you, Mr. Chairman, Mr. Allard.

Mr. Chairman, you are to be congratulated for calling a hearing

on this urgent subject. And it is an honor for me to be here on this

panel with real-life practitioners rather than Washington policy

wonks like me.

The determination of the Financial Accounting Standards Board

to require mandatory expensing of stock options by U.S. firms, FAS

123, threatens small businesses and imperils the fragile economic

recovery. The FASB states that its sole mission is,

to establish and improve standards of financial accounting and reporting for the

guidance and education of the public, including issuers, auditors, and users of financial information.

In my view, the proposed expensing of options does not achieve

this aim. But even if it did, you as policymakers, you Senators,

have a more comprehensive mission than the FASB. Your concerns

include improving the economy and increasing job opportunities in

small businesses and elsewhere. The FASB’s proposed action does

20

the opposite. Small business is the engine that drives the U.S.

economy. Small businesses create 60 to 80 percent of net new jobs

annually. And small businesses, moreover, grow into large businesses. For example, Microsoft started in Bill Gates’s garage with

two employees as a partnership in 1975. It now has 47,000 employees and $282 billion in stock market value.

Surveys show that three of the key ingredients in the success of

small businesses are attracting a talented and motivated work

force, limiting compensation outlays, and conserving cash during

the early years of growth. I do not have to tell anyone on this panel

about that. Lately, small businesses as well as large have increasingly turned to employee stock options to satisfy these needs and

achieve success. And unfortunately, the FASB is moving quickly to

change an accounting rule in order to require mandatory expensing

of stock options on corporate income statements.

Such a change would cause a significant reduction in the

issuance of stock options, especially to employees below the top five

corporate officers. For example, America’s best known venture capitalist, John Dorr, said in testimony that he thought, ‘‘broad-base

employee stock ownership will disappear if expensing is mandated.’’ And a review of the economic literature by Brian Hall and

Kevin Murphy concluded that, ‘‘parties on both sides of the debate

agree that such a change, expensing stock options, would result in

granting fewer options, especially to rank-and-file workers.’’

Without the incentive tool of stock options, many of America’s

most innovative firms, small businesses and large, in technology

and nontechnology, will suffer declining productivity with dangerous consequences for national competitiveness, growth, and employment. And one result is that talented workers in the United

States will seek options elsewhere, mainly from our competitors in

Asia. In an article in Barron’s last summer, George Chamillard, the

CEO of Teradyne, wrote that ‘‘while options are under attack in the

United States, elsewhere the stock option as a recruiting tool is on

the rise.’’ Options are drawing scientists from the United States to

Asia, to Taiwan in particular. As a result, he says, the United

States is losing engineers educated at MIT, Stanford, and Caltech.

Asian Nations understand the attraction of options, and they do

not have the same taste for the fetish of expensing options as

American regulators. In fact, the latest 5-year plan of the People’s

Republic of China specifically states that options should be used to

motivate managers.

The FASB, however, has made it clear that it will shortly require

U.S. companies to adopt fair-value accounting under FAS 123. The

problem of valuing the options, however, remains. The FASB acknowledged that its proposed standard on stock options ‘‘should not

prescribe a particular option pricing model.’’ And what is the model

that would be applied? Well, either a Black-Scholes or a binomial

model, it appears, and both of them seriously lack reliability and

accuracy. And my complete testimony gives examples of the lack of

reliability and accuracy, and critical quotes from very distinguished

people.

In other words, the same deterrent that prevented the FASB’s

predecessor from requiring the expenses of options in 1972 still exists today. No one can place an accurate value on them. But 30

21

years of economic history have confirmed that options help improve

the operations of small and large businesses and improve the economy. And for that reason, President Bush supported the current accounting treatment of options in an interview a year and a half

ago. And in addition, leading Democratic presidential candidates—

Representative Richard Gephardt, Howard Dean, Senator Joseph

Lieberman—also oppose expensing of options.

The FASB is trying to find a single number, but one that can be

derived by different means, to describe a highly complex situation.

Such a perversion reminds us of the purpose of accounting conventions in the first place, which is to convey information about the

health and prospects of a company for investors and potential investors. But some information cannot be reduced to a single number, nor should it be. The expensing proposal, nonetheless, as The

Wall Street Journal said, ‘‘serves to satisfy an unquenchable fetish

to see a contingent liability converted, however clumsily and

unconvincingly, into a dollar amount that can be charged against

earnings without caring in the slightest whether it is helpful or

meaningful to do so.’’

And in this case, it is not helpful or meaningful to reduce all that

information about options to a single number. It is confusing, misleading, and utterly unnecessary. In fact, for typical companies, the

information that is provided on stock options today far exceeds information that is provided for far more important aspects of businesses, including intellectual property assets, cash compensation

expenses, leases, and investments.

Finally, the case for stock options is built on a faulty premise,

that investors do not understand, from the current data with which

they are presented, the true status of the firm. In their article, Hall

and Murphy write, ‘‘Several studies have shown that the cost of

options are indeed reflected in stock prices.’’ I noted earlier that

Mr. Herz listed as a benefit of expensing options ‘‘better resource

allocation,’’ as though the managers did not understand themselves

the importance of stock options in their own businesses. Managers

understand, investors understand.

And if investors have the proper information currently, then

why, at this critical time in the economic cycle, should we tamper

with a system that provides incentives and conserves capital?

There is no reason at all. The number one rule in public policy

should be that of the Hippocratic Oath in medicine: First do no

harm. Discourage stock options and you discourage a management

tool that works for vast numbers of the best American companies,

including the small businesses that have made the U.S. economy

the envy of the world.

Thank you.

Senator ENZI. Thank you very much.

Mr. Forrestel.

22

STATEMENT OF RICHARD FORRESTEL, JR., TREASURER,

COLD SPRING CONSTRUCTION COMPANY AKRON, NEW YORK

ON BEHALF OF

THE ASSOCIATED GENERAL CONTRACTORS OF AMERICA

Mr. FORRESTEL. Good afternoon, Chairman Enzi, Mr. Allard. I

am Richard Forrestel, Jr., a CPA and Treasurer of Cold Spring

Construction Company based in Akron, New York. I am testifying

on behalf of the Associate General Contractors of America, AGC, a

national trade association and the voice of the construction industry. While AGC’s membership is diverse, the majority of AGC firms

are closely held businesses just like ours.

I would like to thank Chairman Enzi and the other Members of

this distinguished Committee for the opportunity to discuss both a

potentially devastating impact of FAS 150 on family-owned businesses as well as the general process of communication between

American small businesses and FASB. Cold Spring Construction

Company was founded by my grandpa in 1911. We are a closely

held family-owned construction firm that specializes in highway

and bridge construction.

The risk of FAS 150 to privately held firms like ours and the majority of AGC members cannot be overstated. As written, FAS 150

would have dramatically affected all privately held companies with

mandatory redemption clauses in their buy-sell agreements. The

result will be to take our companies’ more than $10 million in net

worth and make it zero through the imposition of this standard. I

will briefly touch upon the ramifications of such an accounting

bombshell.

Cold Spring builds only public works projects, and all require

surety bonds. First, wiping out our equity would make us unable

to obtain bonds. Second, we would be in violation of loan covenants.

Third, many States, like Pennsylvania, have prequalification requirements in order to bid on public works projects. FAS 150 would

have rendered us unqualified to bid on many projects in Pennsylvania. Finally—and this is strictly a psychological reason—this

change would have dramatically altered the way our balance sheet

looked. Dad first worked for Cold Spring the summer after the Japanese bombed Pearl Harbor. No way, not on my watch, will he be

told that the company that he has worked to build for more than

six decades, the equity just went to zero. No chance.

FAS 150 first came to my attention at an AGC Tax and Fiscal

Affairs Committee meeting in June of this year. AGC wrote a letter

to FASB with our concerns and requested a private meeting in

Norwalk, Connecticut. This was set for October 30. After much

thoughtful preparation, two ABC representatives and I met for 3

hours with two board members and five staff members of FASB.

These people are, in my opinion, the best and the brightest people

in the country in the accounting profession. The seven FASB representatives asked direct and penetrating questions. Honestly, it

made the CPA exam seem awfully easy in comparison. They gave

us a chance to tell our stories and listened well. They did not promise an outcome, but did thank us for our input.

My mindset walking out of the meeting was completely unexpected. Rather than a brick wall, I found an intelligent, thoughtful

23

group interested in hearing about my nonpublic company and how

FASB standards affected me and my industry. I believed FASB

heard us. Last week, FASB issued a change and indefinitely suspended a portion of the standard. In summary, there is no change

to my financial statement.

But the other shoe has yet to drop, because it is FASB’s apparent

intention to address this issue again in the future. The uncertainty

of not knowing what will happen, if anything, will undoubtedly

continue to cause heartburn for lots of people currently contemplating buy-sell agreements.

While the process ultimately worked, it is unfortunate that the

standard caused such turmoil. Large public companies are accustomed to lobbying for or against changes with FASB. We small

companies are not. We often get caught up in changes that probably should be intended for public companies. I think this is exactly

the case with FAS 150.

One possible solution is to consider a semiannual or annual

meeting with FASB staff and representatives of small business.

FASB would benefit from having small business representatives

provide their point of view and at the same time share drafts of

upcoming new standards.

I know that AGC is moving forward with FASB on a new working relationship. The AGC Tax and Fiscal Affairs Committee will

meet in January, and we are inviting a representative from FASB

to join us. We are going to work proactively and ensure we are

staying abreast of the new standards, and will continue to work

with FASB until 150 is finalized.

In conclusion, I would like to thank you for the chance to testify

today and your willingness to listen and, potentially, address our

concerns. As a fellow CPA, I agree with what I believe is Chairman

Enzi’s viewpoint. Congress should not be legislating accounting

standards. I appreciate and agree with the many reasons FASB is

an independent organization; nevertheless, this Committee’s oversight is critical to ensuring all standards-setting agencies are responsive to both large and small entities.

Thank you, and I will gladly answer any questions you might

have.

Senator ENZI. Thank you very much.

Mr. Moore.

STATEMENT OF WALTER K. MOORE

VICE PRESIDENT, GOVERNMENT AFFAIRS, GENENTECH, INC.

Mr. MOORE. Mr. Chairman, Senator Allard, I am Walter Moore,

Vice President of Government Affairs at Genentech.

Today, Genentech has a market cap of over $40 billion. Why the

heck, you might ask, is a company the size of Genentech even interested in the topic of FASB and small business growth? It is because Genentech is the classic American small business story.

The biotech industry was born 25 years ago when a UCSF biochemist and a young venture capitalist each agreed to contribute

$500 to start Genentech. They fought convention. Researchers

could publish their studies. Employees could dress as they liked.

And all employees were given stock options. Among the young sciVerDate 11-MAY-2000 17:44 Oct 17, 2005 Jkt 000000 PO 00000 Frm 00027 Fmt 6633 Sfmt 6633 23827.TXT SBANK4 PsN: SBANK4
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entists who came to Genentech in 1980 was Art Levinson, our current Chairman and CEO.

A primary factor that allowed Genentech to move from a startup

biotech to where it is today was our ability to use broad-base employee stock options. Options make employees think and act like

owners, not just employees who do their job, collect a paycheck,

and go home. Genentech issued stock options to all employees

when it was founded and still does so today.

Genentech actively competes for talent with at least 60 other

biotechs in our ZIP Code. Our ability to remain competitive is directly related to our ability to offer options to all our employees.

However, this is being directly threatened by FASB.

FASB’s proposed stock option rules will impact all companies

that use broad-base stock options without providing investors better financial information. Although we fundamentally disagree that

employee options represent a corporate-level expense, we do believe

that credible, transparent, and comparable financial information is

essential. We also believe that all companies, not just small businesses, face the same valuation issues. Existing valuation models

were designed to value freely tradable options, not employee stock

options with all of their restrictions. If expensing is required based

on these models, the integrity and comparability of financial reporting will be compromised.

A better approach is to require more disclosure. As you can see

from our 10–K, which is Appendix 1 of my testimony, the dilutive

effect that an investor could have from our stock options is readily

apparent at any price point. Because we cannot accurately value

options, expensing will create investor confusion and make income

statements less reliable.

There are many areas of concern about valuation, but I will focus

on only one in my talk today—volatility. Volatility at Genentech

ranged, from 2000 to 2003, from 43 to 75 percent. Appendix 2 is

our stock price over the last 3 years. Curiously, it ranges year-byyear 43 to 75, but I have drawn a line through right here—the 3-

year average is zero.

What is concerning about that is the fact that we do not know

what period to use for volatility. Do we use month, quarter, or

year? Three years? Who knows? In our case, a 20 percent change

in volatility prediction results in a 100 percent change in the option

expense itself.

This should be of concern to you and to the SEC because it is

very easy for us to make a knowledgeable estimate and to have it

be way off. You will not be able to discern the difference between

a knowledgeable estimate and manipulation. And that should be of

concern to everybody involved in public companies.

If FASB really believes stock options are an expense, they have

an obligation to get valuation right. FASB used to believe BlackScholes could accurately predict option expense. They recently

changed course and considered even prohibiting Black-Scholes, the

method virtually every company has used in their footnotes since

1994. Because all current option pricing models suffer from the

same flaws as Black-Scholes, all current models will reach the

same ultimate wrong number.

25

Some believe that expensing any number, however wrong, is better than expensing nothing. We disagree. Under existing accounting rules both here and abroad, an expense is to be recognized only

if it can be reliably measured. Unlike cash compensation or any

other expense that results in an outflow of cash, employee stock options cannot be reliably measured. Mandatory expensing of broadbase stock options flies in the face of the most fundamental accounting rules. FASB must address the significant shortcomings of

stock option pricing models and develop new models before mandating the expensing of all options.

Genentech has met with FASB to communicate the problems

with existing valuation models, and our detailed presentation, we

fear, has fallen on deaf ears. One prudent way to proceed is to

road-test models through footnote disclosure and study how they

actually work, rather than mandating the wholesale changes. Indeed, Genentech would welcome that and would volunteer to work

with the FASB to road-test these.

Thank you.

Senator ENZI. Thank you very much.

Ms. Kenney.

STATEMENT OF JEANNINE KENNEY

VICE PRESIDENT, PUBLIC AFFAIRS AND MEMBER SERVICES

NATIONAL COOPERATIVE BUSINESS ASSOCIATION

Ms. KENNEY. Thank you, Mr. Chairman. I am Jeannine Kenney,

Vice President of Public Affairs with the National Cooperative

Business Association. On behalf of my members and the thousands

of other co-ops that we represent through our national association

members, we appreciate this opportunity to testify specifically on

the impact of FAS 150 on cooperatives.

NCBA is the only National organization representing all types of

cooperatives across all sectors, and it is a very diverse group. Our

members include farmer-owned agricultural marketing and supply

cooperatives, small parent-owned child care cooperatives, consumer-owned electricity, food, health care, housing, and telecommunications cooperatives, consumer-owned credit unions, and

small business purchasing and shared services cooperatives, among

others.

Purchasing cooperatives should be of particular interest to this

Subcommittee because they help small businesses band together to

procure inputs and services that make thousands of independent

businesses more successful.

There are more than 40,000 co-ops in the United States, and

they serve 120 million members. That is more than half of all

adults. To put the size of the co-op sector into perspective, we outnumber publicly traded investor-owned firms by more than 2 to 1.

The vast majority of co-ops are themselves small local businesses

or are purchasing cooperatives that represent thousands of small

local independents. They provide jobs, wealth, and opportunity for

millions of Americans.

Of the many financial challenges confronting co-ops in recent

years, few have generated the level of concern and uncertainty as

FAS 150 has regarding co-op balance sheets. In its last comment

period, FASB received more than 70 comments from cooperatives

26

out of the one-hundred-and-some comments on the extension of the

implementation period for FAS 150. That is 70 percent of comments from co-ops.

By issuing comments and conducting personal meetings with

FASB staff, co-ops and their representatives have participated in

the lengthy consideration and comment processes leading up to

FAS 150. However, until last Friday, it seemed as though these

comments had fallen on deaf ears.

Cooperatives were initially told that to address their concerns regarding FAS 150’s impact, they merely needed to educate their

lenders about their equity structure. Over time, we have received

the clear impression that FASB does not consider cooperatives to

represent a significant business constituency.

It is absolutely critical that co-ops have the opportunity to participate in and be regarded as true stakeholders in FASB’s standards development processes, including having representatives serve

on the Advisory Council.

Mr. Chairman, NCBA supports your notion of a Small Business

Advisory Committee for FASB and would hope that co-ops would

be included on that committee. Even the establishment of a Small

Business Advisory Committee, however, should not preclude the

presence of co-ops and credit unions on the primary Advisory Council. I would note that there is a credit union representative on

FASAC, and it is noted as a small business representative. It actually happens to be one of the larger credit unions in the country,

with more than $1 billion in assets.

Notwithstanding these concerns, we are grateful to FASB for its

recent decision to indefinitely defer the most concerning provisions

of FAS 150 relating to mandatorily redeemable financial instruments. To understand why this is such a concern for co-ops requires a basic understanding of the co-op structure.

Co-ops are owned and governed by their members. Those are the

people or the businesses that buy the goods and services of the coop—also known as the patrons. Members make an equity investment in a cooperative when they join. It is risk capital. In the case

of bankruptcy, it may never be returned to members. Debt holders

are paid first; equity holders last, if at all.

Co-ops return profits to their members in the form of end-of-year

dividends based on the amount of business that member did with

the co-op. They receive these either in the form of cash or as equity

held by the co-op and allocated to individual members known as allocated patronage capital, or in both forms. A member’s equity rises

or falls with the profitability of the business.

Because co-ops typically do not issue public debt, allocated patronage capital is how they accumulate equity. It typically represents most and, in many cases, all of a co-op’s equity.

Co-ops redeem patronage capital in a variety of ways. Some may

never redeem it, others repurchase the shares of members upon

their withdrawal from the co-op, upon death, or upon reaching retirement or other age. Other co-ops revolve equity over a period of

time when specific equity levels are reached and the financial condition of the co-op allows. Some purchasing cooperatives for small

businesses have agreements with their members to redeem shares

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upon their withdrawal of the business, raising concerns similar to

those raised by Mr. Forrestel.

Redemption decisions are generally based in board policy or practice and are occasionally stipulated in the bylaws. But, generally,

redemption decisions are at the board’s discretion. They have no

such discretion for repayment of debt.

FAS 150 requires the classification of mandatorily redeemable financial instruments as liabilities. On its face, cooperatives did not

think FAS 150 applied to them. However, of principal concern to

us is that the standard appears to include, under some circumstances, patronage capital in FASB’s definition of mandatorily

redeemable instruments.

Such instruments are defined as those for which the issuer had

an obligation to redeem. Because of the vagueness of FAS 150 regarding what is considered an obligation, past cooperative discretionary practices to redeem shares could be construed as a constructive obligation in the future, requiring reclassification of the

entirety of the co-op’s capital as a liability. This uncertainty has resulted in different interpretations of FAS 150 by co-op accountants

in identical fact situations.

Equally concerning is the lack of recognition that, in a cooperative, patronage capital as its primary asset is never redeemed all

at once, except in the case of sale or dissolution of the business. It

is completely implausible that all of a co-op’s members would die,

withdraw, or retire in a single year. It is equally nonsensical, then,

to represent that possibility on the balance sheet.

FAS 150, in the absence of the indefinite deferral, and by requiring reclassification of equity as debt, would have created the appearance of insolvency for financially thriving businesses and badly

misstated the financial health of thousands of small businesses

across America. This would have put cooperatives in technical default of their loan agreements. It would also have made it more difficult for them to access new debt financing which, for cooperatives,

is already a challenge because few conventional lenders truly understand the co-op structure. Co-ops would have just one more

thing to explain to lenders.

Moreover—and this a particularly a concern for purchasing cooperatives for small business—having zero equity on your balance

sheet would have damaged your credit worthiness in the eyes of

suppliers, which is critical for purchasing cooperatives seeking to

leverage the best deal from suppliers for their members. And, ultimately, this would have harmed the millions of Americans who are

members of cooperatives.

Throughout this process, FASB either did not understand the coop structure and the implications of FAS 150 on cooperatives or

they chose to disregard them. We understand that the cooperative

structure is unique, but FASB has an obligation to understand it.

In any case, NCBA looks forward to working with FASB as stakeholders to ensure that what would have been a disastrous outcome

for cooperatives will not occur as the board reevaluates the implementation and other issues associated with FAS 150.

Thank you.

Senator ENZI. Thank you.

28

Mr. Heesen, again, I apologize. I had meant in the opening to

mention my regret that we are not in hearings to do slide shows.

I really appreciate the slides that you gave us, which make a nice

clear statement, and I will make sure that everybody takes a look

at that as well.

Mr. Heesen.

STATEMENT OF MARK HEESEN

PRESIDENT, NATIONAL VENTURE CAPITAL ASSOCIATION

Mr. HEESEN. Very good. Thank you.

Cisco, Intel, Genentech, Home Depot, Outback Steakhouse, eBay,

Dell, today, household names; once, all small venture-backed companies, and hopefully there will be a lot more coming down the

pike. In fact, in the United States today, 11 percent of annual U.S.

GDP comes from small venture-backed companies, and we employ

12 million people. This is why NVCA has a vital interest in this

hearing.

While we recognize the pressure that has been placed on FASB

to issue standards more quickly, we have a grave concern that this

rush to regulate has needlessly burdened young companies in several ways.

My first example involves FIN 46, which has frankly created

havoc within the entrepreneurial and private equity communities.

This highly complex interpretation sought to define what types of

entities must be consolidated into a company’s financial statements. This interpretation was extremely complicated, covered new

ground, lacked adequate guidance, and allowed for no transition

time.

To remain GAAP-compliant, private equity firms, and companies

in which they invested, would be forced to consolidate the assets,

liabilities, and operating results of certain, but not all, investments,

thereby significantly altering their financial statements.

Given the frequency of transactions occurring in the start-up and

private equity sectors, the resulting hodgepodge of consolidated information would have so convoluted those entities’ financials that

they would have had to maintain two sets of books—one to meet

FASB’s requirements and one to meet the investors’ requirements.

This result is counterintuitive to FASB’s stated goal of producing

relevant, reliable, and comparable financial statements for all investors.

Over the last several months, CFO’s of private equity firms and

start-ups have spent hours and hours attempting to decipher FIN

46 and how it would apply to them with virtually no guidance from

the FASB. FASB’s aggressive time line exacerbated the situation

with rapid implementation, no new comment period, no new exposure draft, and no attempt to solicit input. We all reacted to this

interpretation only to have FASB recently decide that private equity funds should not implement FIN 46, at least for the time

being.

While we are relieved by this reversal of opinion, we believe that

a process that solicited input up front would have averted this

mess. And your suggestion, Senator, of a FASB Small Business

Committee may have accomplished that. At this point, FASB is

still determining to whom and how FIN 46 should apply, leaving

29

small business investors and the private equity firms in a state of

uncertainty and confusion.

The second example is FASB’s quest to mandate the expense of

employee stock options. NVCA has consistently asserted that the

forced expensing of these options will create a financial albatross

for U.S. start-up companies, leaving them no choice but to negatively alter their critical option programs.

The FASB agreed that these companies are fundamentally different when it passed its current rule, FAS 123, in which specific

provisions are promulgated for private companies. Yet, today,

FASB has inexplicably decided to change the rule and subject private companies to the same rules as public companies. Since the

early 1990’s, we have implored the FASB to identify an acceptable

option valuation standard for all companies. Otherwise, the option

expense number will be meaningless to investors and too costly for

young companies to derive.

Their response has been to fall back on two old models already

discussed—Black-Scholes and binomial methods. Both of them, the

Black-Scholes being tentatively rejected by the FASB themselves

and the binomial methods being extremely complex and even more

subjective than Black-Scholes.

Further, while FASB has acknowledge that it is impossible to

measure the volatility of a company whose stock does not trade, its

recent reversal will now require that volatility be determined by

private companies. We, frankly, cannot comprehend FASB’s sudden

reversal on this issue, as there has been no material change in option pricing theory since 1994, and determining the volatility of a

company whose stock does not trade has not become any easier.

We made these exact points before the FASB board in August.

A copy of that FASB presentation is part of the record. FASB listened and quickly did exactly the opposite of what we were saying.

Both FIN 46 and stock option expensing will not only render a

small company’s financials meaningless, but will also require small

companies who do not have large accounting staffs to hire costly

outside experts.

Further, implementing ill-conceived regulation imposes a financial reporting credibility cost that heavily impacts small companies.

Public company analysts have said that they will look through

numbers impacted by stock option expensing to a company’s underlying financials. Yet over 50 percent of Nasdaq companies and virtually all private companies do not have analyst coverage. Who is

going to look through their numbers?

Today, we urge Congress to engage in the discourse so that we

might avoid serious consequences. Specifically, we believe that

Congress has a role in reviewing FASB’s due process system, how

FASB determines which businesses will be impacted by its rules,

how FASB field tests their proposals, and what the economic and

practical impact of FASB pronouncements are on small businesses

and the emerging business community as well.

Thank you very much for this opportunity to speak to you.

Senator ENZI. Thank you, and thank all of you for your excellent

testimony and for summarizing your remarks. As I mentioned before, the full text will be in the record. And I have dog-eared all

of the testimony and taken some quotes that I will be using freVerDate 11-MAY-2000 17:44 Oct 17, 2005 Jkt 000000 PO 00000 Frm 00033 Fmt 6633 Sfmt 6633 23827.TXT SBANK4 PsN: SBANK4
30

quently to make the case among my colleagues and on the floor,

and they are well-worded and very helpful. I learned a lot from it.

I still have a few questions, though.

Mr. Forrestel, Mr. Salg, and Ms. Kenney, how did you first find

out about FASB’s initiatives that were going to affect the businesses you work with? How far down the road was FASB on these

efforts, and did FASB make any attempt to reach out to your business or association prior to publishing the proposal for comment?

Mr. Salg, you may proceed.

Mr. SALG. Mr. Chairman, I found out about FASB 46 about 10

days ago at the Wendy’s convention in Las Vegas from Mary Shell,

who is in Government Relations, and 2 days later got an e-mail

from IFA, sent to all members. But certainly I had heard nothing

about it prior to that. Now, you might consult with Wendy’s, the

franchise, to see when they first heard about it, but it certainly was

not on my radar screen. I was certainly horrified to hear about it.

Senator ENZI. Thank you.

Mr. FORRESTEL. As a CPA, I had heard a bit about FAS 150, but

we really focused on it at our AGC tax and fiscal meeting in June,

and it was at that point that we started the process of communicating with FASB, and we found them very responsive once we

specifically asked for a private meeting with them.

Senator ENZI. Thank you.

Ms. Kenney.

Ms. KENNEY. In the case of cooperatives, there is a technical

group within our sector, the National Society of Accountants for

Cooperatives, who had been following this from the beginning and

has been commenting. As it became clear that FAS 150 was moving

forward despite co-op input, other groups within the cooperative

sector got involved. Notably, the National Rural Electric Cooperative Association was actively involved in this, and they are one of

our members. Additionally, NCBA became involved when it became

clear that FASB was going to move forward with the rule.

Senator ENZI. Thank you.

Mr. Forrestel, your dad, who is a businessman like mine, was

probably very proud when you became an accountant.

Mr. FORRESTEL. Probably not. He wanted me to be an engineer.

[Laughter.]

Senator ENZI. There are some interesting parts to being in a

business that your dad has some knowledge of. I know that from

experience.

Mr. Glassman, how do you feel about FASB being required to

take into consideration the economic effects of accounting standards on small business?

Mr. GLASSMAN. That is a good question. My position is I think

that Congress should take those issues into effect. I am not sure

whether FASB is competent to take economic issues into effect, but

clearly there is an economic impact to what it does—not everything

it does, but absolutely in FAS 123, and I think it is incumbent on

the Senate and the House to exert its will here and should not be

shy about it. I know there is all of this talk about the independence

of FASB. I really think it is your responsibility because you have

a much broader purview to say this is going to have an economic

effect and do what you can.

31

Senator ENZI. As I mentioned before, I was pleased that in their

precepts they listed that economic effect as one of the precepts that

they are supposed to take a look at. As accountants, we are concerned about their independence, but it has occurred to me that

independence is a lot like freedom. It has to be earned, and that

is one of the reasons we are looking at this issue, to see how earned

the independence is, but I appreciate your answer.

Ms. Kenney, how difficult is it for the small cooperative businesses to participate in the FASB drafting process for the accounting standards? Should FASB be required to do outreach to the

small businesses prior to the draft proposal or interpretation that

is put out for public comment? What is your feeling about the process for involving the cooperatives?

Ms. KENNEY. I think it is really critical that, in particular, cooperatives, but of course all small businesses, be a community that

FASB actively reaches out to. As small businesses, in most cases,

even the trade associations representing them do not have the resources at their disposal that a Fortune 500 company might have,

say, to retain accountants who track everything that FASB does.

So, I would like to see FASB reach out actively and include cooperatives, credit unions, and other small businesses in their process for both identifying emerging issues and addressing them.

Senator ENZI. Did you feel that their statement here today about

having a Small Business Advisory Committee might solve some of

these problems?

Ms. KENNEY. Yes. I think that would be an excellent idea, and

I look forward to working with them to include co-ops in it.

Senator ENZI. Thank you.

Mr. Moore, I do appreciate your being with us today and for filling in for Mr. Levine. Please give him our regards and hopes that

he recovers from the flu very soon. I am sure that he is more concerned about that even than we are.

The question is, if FASB stock option expensing proposal were in

place today, what effect would it have on Genentech and others like

that? Would they have gotten off the ground?

Mr. MOORE. It would have a profound effect at Genentech, since

we obviously give broad-based stock options. I am more concerned

about the 60 small biotechs that surround Genentech who have

been recruiting Genentech employees and other scientists from

Stanford, UCSF, and the other local universities.

As Mr. Glassman said, they do not have much money, and one

of the success traits is to hoard their money and give a piece of

their company.

While Genentech will survive whatever happens on FAS 123, I

do worry about companies like Tularik, Theravance, names that

you have never heard of that are in South San Francisco near us,

small businesses that without stock options are not going to be able

to recruit either Genentech employees, with the kind of expertise

that they need, or academics from our surrounding community.

Senator ENZI. Thank you.

With that lead-in, Mr. Heesen, what effect do you think the stock

option expensing is having on initial public offering market right

now? What effect particularly is it having on small businesses who

are considering using options?

32

Mr. HEESEN. Right now, because you are still able to expense, I

do not think that has been a direct impact on companies presently

because you can either expense or you can elect to simply disclose,

and so venture-backed companies are disclosing. They are not like

Coca-Cola who have decided to go out and expense.

Having said that, the real concern we have is that if companies

are forced to expense, it is going to take a much longer time for

those companies to be able to be attractive in the public market,

which will mean that venture capitalists will have to spend a lot

more time with those companies, which means that they will have

less time to put money and talent into new companies so that there

will be fewer new venture-backed companies being created in the

long-term, and those companies that are on the cusp of going public

will not be able to do so because their financials will suddenly look

very different than they were looking 2 days before.

Senator ENZI. Thank you.

Mr. Glassman and Mr. Heesen, can you give me a little bit of a

feel for what the ramifications for U.S. small businesses will be

when they are bound by more stringent accounting standards than

businesses located overseas, what kind of a comparative—that is

supposed to be under the precepts looked at as well, but what

would be the effect as you see it?

Mr. GLASSMAN. Well, I think it should have a serious effect, and

we are already beginning to see it. As I said in my testimony, and

as I said further in my written testimony, there is a difference in

the way that many Asian countries treat stock options, and there

is not the political pressure against stock options that there is in

this country. And as a result, there is at least anecdotal evidence

that many American-trained scientists are going to countries in

Asia because they are being recruited by companies that are offering them very lucrative stock options, which makes sense.

That is how Silicon Valley recruited engineers from Route 128 in

Boston. It took them a long time in Boston to catch on to what was

going on, and now the same thing is happening in Asia. So it would

certainly get a lot worse if we began to expense stock options with

the result that fewer companies in this country would issue stock

options. That seems to be what almost everyone agrees with. And

with other countries still offering them, you are going to get the

best, the brightest, and the most motivated. These are the people

who are attracted by stock options.

Senator ENZI. Mr. Heesen.

Mr. HEESEN. I think that FASB talks a lot about international

harmonization and that we should have the same accounting

standards as, and normally it is European accounting bodies, be it

England or France. They do not talk about China and India. China

and India are not going to suddenly say we are going to change our

accounting for stock options if they see a powerful incentive to get

Americans to start moving to China and India. There is no question in my mind about that.

Entrepreneurs are not jumping to go to France and England,

frankly, but they will go to India and China to get those options

and make a new life, and they are doing it actually right now.

Senator ENZI. Thank you. My time has expired.

Senator Allard.

33

Senator ALLARD. Thank you, Mr. Chairman.

Ms. Kenney, there are a number of accounting alternatives I

think available to co-ops, perhaps more than just the average small

business that might be out here. If, for some reason or another, you

find options something that you cannot offer, what other incentives

might you use in co-ops to attract good employees?

Ms. KENNEY. That is a very good question. Because co-ops are

not publicly traded companies, they do not issue stock options, and

frankly that is one of the characteristics I think that has helped

keep co-ops relatively free of the Enron-related scandals. There are

a couple of types of incentives stock options can produce.

I believe that for retention of co-op employees, obviously competitive salary compensation is critical. Co-ops also offer tremendous

benefits, both in terms of health and retirement benefits. But retaining and recruiting employees to the cooperative sector is not a

simple issue, and I think it is certainly one that the cooperative

sector is working to address because we do not have some of the

financial wherewithal that other companies might have to attract

certain candidates.

However, employees of cooperatives I think are attracted to the

community-based nature, the community commitment that co-ops

embrace as part of the principles under which they do business.

Senator ALLARD. Now, in a co-op, everybody owns an interest in

the business.

Ms. KENNEY. Correct.

Senator ALLARD. The way you use, for lack of a better word—call

them options or that type of instrument—is that available to everybody, in a way, or is it just offered to your better employees—how

is that handled?

Ms. KENNEY. Some co-ops are jointly owned by their members,

that is, the people who use the goods or services of the co-op, and

by their employees. That is relatively rare. Most co-ops are not able

to issue options to their employees because there is no stock in the

company that is publicly traded or valued in that way.

So the only beneficiaries of a co-op’s value are the equity holders,

which are the members of the cooperative themselves. And in the

case of your State, certainly that includes many electric co-ops

serving rural consumers.

Senator ALLARD. Mr. Salg, you have several restaurants that are

incorporated, and then my understanding is that then that corporation is a member of a larger franchise; is that the way that works?

Mr. SALG. That is correct.

Senator ALLARD. In your restaurants, do you try and establish a

value for each one of those restaurants and then bring that value

into the corporation or the five Wendy restaurants that you have,

do you consider them as one entity when you are doing your accounting?

Mr. SALG. When we do our accounting, we consolidate into one

entity.

Senator ALLARD. Into one entity.

Mr. SALG. Yes.

Senator ALLARD. Do you and other members of the franchise, you

have options that are available to just the officers in your corporaVerDate 11-MAY-2000 17:44 Oct 17, 2005 Jkt 000000 PO 00000 Frm 00037 Fmt 6633 Sfmt 6633 23827.TXT SBANK4 PsN: SBANK4
34

tion or are they available to the managers of the restaurants and

the employees, also?

Mr. SALG. Well, since we are not a publicly traded corporation,

the way we handle that aspect of our business is to have a profitsharing plan for all of our employees, regardless of the level, into

which we put 10 percent of our pretax budget and anything that

we are over budget.

So stock options really are not going to affect my business, but

I can tell you that Wendy’s International, who also operate 1,200

restaurants of their own, have a program called We Share, where

every employee, whether he is flipping burgers or carrying out the

trash or the manager has a shot at getting options in Wendy’s

stock. And I am only guessing, because I am not an accountant,

that this ruling could have a—those are the people, my guess is,

that would get dropped out of the program first.

Senator ALLARD. I see.

Mr. SALG. It wouldn’t the senior VP’s.

Senator ALLARD. Now, the corporation that you have itself does

not own options.

Mr. SALG. No.

Senator ALLARD. But each individual employee—so it is not an

accounting problem, as far as your corporation is concerned.

Mr. SALG. If you are speaking of Wendy’s International, I think

it could be a problem.

Senator ALLARD. No, I am talking about your——

Mr. SALG. QSC Restaurants, Inc.?

Senator ALLARD. Yes.

Mr. SALG. No, it is not a problem.

Senator ALLARD. It is all individual.

Mr. SALG. Yes.

Senator ALLARD. So as far as the corporation being part of this

whole franchise, you are comfortable with the type of disclosure

and public information, and I assume that all of the franchisees

understand the impact of options? I am also assuming they own

stock, and if somebody exercises an option, it comes out of the profits on the stockholders’ side, and I am sure they understand all of

that, and your franchisees understand that aspect of it?

Mr. SALG. I think that they do. I happen to own some Wendy’s

stock, and my accountant tells me I have enough invested in

Wendy’s, but——

Senator ALLARD. Diversify.

[Laughter.]

Mr. SALG. But of course I know them, personally, and I trust

them. I think they are good people. But I think somebody has to

watch, and these guys know a lot more about stock options than

I do because that is not the way I make my living.

What you have heard here from a lot of these people that concerns me, as a guy from out in the sticks, is why don’t they talk

to people like us before they draft this stuff? I mean, if somebody

had—not me, somebody like me—come in and said, what kind of

problem would you have consolidating your financial statement

under FAS 46, consolidating your statement with Wendy’s International, they would have gotten an earful real quick.

35

I mean, number one, from a timing standpoint, heck, my partner’s wife and I do the accounting. It takes us 10–15 days to get

a statement out at the end of the period, but now you want us to

send it down to an auditor. I mean, how fast can that get done by

over 500 individual Wendy’s franchisees across the country, and get

into Columbus, Ohio, and get put into some kind of a meaningful

order in any kind of a timely fashion? Forget the fact that my franchise agreement with Wendy’s International, which I have had for

20 years, does not require me to send my financial information,

other than some verification of my sales, to Wendy’s.

Believe it or not, there are going to be some guys out there who

say, ‘‘Stick it in your ear,’’ when they are asked for their financial

information. You cannot require me to send it to you.

So, I mean, why didn’t somebody talk to people prior to this happening and find out what the practical applications of this are?

Just speaking as a guy from outside, you know, out in the ‘‘toolies.’’

Senator ALLARD. Thank you for your comments.

Mr. Moore, in the growth of your company, do you think that

there would have been other options available than other than

going with your options, I mean, other solutions? Let me put the

question this way. Are there other solutions that you could have

used to attract employees, other than just options that you think

could have been as effectively?

Mr. MOORE. Certainly, there are other options to giving employees stock options. The question is, as a start-up biotech, what kind

of people can we afford on a straight-pay basis? We certainly could

not afford the kind of science we got out of the scientists we hired.

The innovation that Genentech came up with, and continues to

come up, I would submit is the basis of top scientific minds that,

quite frankly, we could have never afforded 25 years ago, barely afforded 10 years ago, and are just beginning to afford today.

So what you have is a lot less innovation out of our firm, and

multiply that 60 times by the small companies that surround us,

and that is a lot of noninnovation in life sciences that I think we

are all counting on in terms of serious unmet medical need today.

And I do not see another way to generate it because there is not

enough money except with options moving out.

Senator ENZI. Thank you.

I see my time has expired, Mr. Chairman.

Senator ENZI. Thank you.

I want to thank all of our witnesses for appearing before us

today. You did an outstanding job. There does appear to be some

significant communications and process problems in FASB reaching

out to and the consideration of small business concerns in the establishment of accounting standards.

I applaud FASB’s commitment today to establish a Small Firm

Advisory Committee to work with FASB and FASAC on small business concerns. I think that will take care of quite a few of the problems at least early enough that small business can be a bigger

voice in making sure that what works for big business also works

for small business.

Small businesses should not have to initiate eleventh-hour campaigns to get their concerns heard.

36

I mentioned earlier that I received many calls from associations

who had businesses who wanted to testify at this hearing. It is

probably just as important to mention that every single one of

those that called that wanted to be here all had the same approach

that this panel did. There was not anyone from the other side, if

there is another side.

I think that is very significant, that all of them were concerns

very similar to what you have given today. It is only my regret that

we were not able to get the details from everyone because, in each

of the presentations, there were some parts that will be very significant that hopefully FASB will listen to and that all of us will

be able to use.

I thank you very much for your time. The hearing record will be

open for 10 days in order to accommodate Members’ statements

and also the opportunity to give you some additional questions in

writing, which I hope you will respond to. While you are doing

that, if you have any other thoughts that we should have, if you

would submit those as well, I would appreciate it.

Today, America’s community bankers, engineering, contracting,

financial executives all submitted testimony as well, and I appreciate and will try to attribute the quotes from each of you as I use

them over the next few days, weeks, and months.

Thank you all very much. The hearing is adjourned.

[Whereupon, at 4:41 p.m., the hearing was adjourned.]

[Prepared statements, response to written questions, and additional material supplied for the record follow:]

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PREPARED STATEMENT OF SENATOR JIM BUNNING

Mr. Chairman, I would like to thank you for holding this hearing today. I would

like to thank all of our witnesses for testifying.

I have been very concerned with the reports that I am hearing regarding the Financial Accounting Standards Board or FASB. We have many small businesses here

today that will tell us that FASB does not listen to them or take their opinion into

account. We also have many large corporations telling us the same thing.

This is very disturbing to me. If FASB is not going to follow their own procedures

that call for public input and make a decision before the comment period has even

begun, why have a comment period? Why even invite input from the industries and

businesses affected if FASB’s decision is a foregone conclusion? It is a waste of time

for everyone involved if FASB is simply going to go through the motions on a comment period.

I certainly respect the independence of FASB. I want them to continue to be independent. I think it is a very bad idea if Congress gets involved in telling private

boards what to do. I think it is an even worse idea to have Congress legislating accounting standards. But FASB is proposing things that may harm our economy. If

Members of Congress think FASB is going to harm our economy, they will be forced

to act. This a bad idea, and it sets a terrible precedent, but many may feel they

will have to for the good of our Nation’s economy. I am pleading with FASB, do NOT

force Congress to act. Listen to the people affected, do not just go through the motions, and make arbitrary decisions. We do not want to get involved. And believe

me, you do not want us to be involved, so do not force us to get involved.

A few years ago, there was a large controversy about the pooling accounting method and whether or not it should be done away with. This Committee held a roundtable with FASB and those affected. Both sides realized there was some common

ground. They got together and worked out a solution that everyone could live with.

I would respectfully suggest that FASB could solve a lot of the controversies they

face right now by following the pooling example. Please sit down with an open mind

with those who are affected by your rules and see if you can come up with a solution

that both FASB and the industry can live with.

I am very happy that FASB has always taken its job of being the police for accounting standards seriously and I am glad they have renewed that commitment

after Sarbanes-Oxley. But any cop on the beat will tell you, you are a much more

effective policeman if you can work things out amongst disputing parties. The most

effective cops do not feel the need to arrest everyone.

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PREPARED STATEMENT OF PETER A. SALG

PRESIDENT, QSC RESTAURANTS, FORT COLLINS, COLORADO

ON BEHALF OF THE INTERNATIONAL FRANCHISE ASSOCIATION

NOVEMBER 12, 2003

Chairman Enzi, Senator Dodd, Senator Allard, other Members of the Subcommittee, thank you for opportunity to testify before you on the impact the Financial Accounting Standards Board (FASB) has on small business growth.

As you know, my name is Pete Salg. I have worked in franchising since 1968,

doing everything from running a restaurant, to running a franchisor with 450 units.

Today, I am a small franchisee. My company, QSC Restaurants, Inc. owns five

Wendy’s restaurants in Colorado.

I will be testifying today on behalf of the International Franchise Association

(IFA), which represents franchisees, franchisors, and others in the franchise community. In the 44-year history of the organization, there has been a clear and constant

effort to promote entrepreneurship for all sectors of American society.

I will be focusing my comments on the impact of FASB FIN 46 on the small

franchisee, but I also want to make sure you know that the great majority of

franchisors are small businesses too. The typical franchisor has less than 200 units

and revenues of less than $5 million. I will mention some of the hardships they face

as a result of FIN 46 as well.

If FIN 46 goes into effect as written, here is what it could mean to franchisees

like me:

• We would have to have audited financial statements. This is not required currently and would be very expensive. It is not required currently because it does

not make sense to require it for two reasons: one, Wendy’s has no contingent liability, and two, mine is not a public company!

• We might be required to use the same outside auditor as their franchisor. This

is not an explicit requirement of FIN 46, but if my franchisor’s auditors say they

will only be comfortable if my statements are prepared by their own people,

Wendy’s is left with little choice and neither am I. This requirement will hit the

single-unit franchisees the hardest. Needless to say, not every mom and pop small

business can afford PriceWaterhouseCoopers or KPMG.

• We would also be required to adhere to the franchisor’s internal accounting standards. Franchisees like me have made enormous investments—enormous at least

in relation to my business—in the way they have decided how best to create their

financials. Wendy’s P&L Statement does not look like my P&L. We both have

good business reasons why they look the way they do and there is no reason they

should look the same.

• We would have to develop a system to provide internal control reports to

franchisors and adhere to internal control dictates of the franchisor’s auditor. I

can understand why the franchisor would want this since the CEO and CFO are

on the hook for criminal penalties provided for in Sarbanes-Oxley, but why on

earth should a small operator have to institute an extensive internal control system? An individual Subway sandwich shop that probably grosses under $400,000

is not the same as IBM and should not be treated as such. This unintended consequence of FIN 46 is pure overkill.

Now let us look at the impact on small franchisors.

Typically, franchisors generate all of their revenue from royalties paid by the

franchisee and that royalty is usually around 5 percent of sales. When you read

about a franchise company you often see reports in the media about their systemwide sales figures. For example, if a franchisor with 100 percent franchises has system-wide sales of $100 million dollars, that sounds impressive. But what it means

is that the franchisor probably has an annual income of around $5 million—5 percent of $100 million. Of the 1,500 franchisors in the United States, probably half

have annual incomes of $5 million or less. So it is important to remember that not

just franchisee—but also most franchisors—are very small businesses.

This hearing is about the impact on small business growth and it is hard to think

of something more stifling to growth than FIN 46.

If you have a successful small business and you are thinking of ways to expand,

franchising is a great method for a lot of people. You share your brand and operating plan with others willing to invest their money to start a franchise and you

both can profit while your brand takes off.

FIN 46 makes franchising much less appealing. First of all, it just got a lot more

expensive to be a franchisee. As I described earlier, you have to have audited statements done by an expensive firm, acceptable internal controls systems, etc. etc.

63

Second, your freedom to operate your franchise just got more limited. I have chosen to operate my restaurants the Wendy’s way—the menu, the appearance of the

store, the quality of the food—things like this must be standardized across the system so that you the customer knows what you are going to get when you walk into

any Wendy’s in the country. This consistency is critical to my success.

On the other hand, I am an independent businessman. I decide how to set up my

business. I decide whether it is a company, a partnership, or an S Corp, and I decide

who my lawyer and accountant are. I decide on what capital expenditures I make

and I decide on product pricing. Furthermore, I decide who to hire and fire, what

salaries and benefits to offer, and what pension plan to set up. I make decisions that

directly affect the bottom line. There are reasons that some franchises within a system fail and others succeed and the biggest one is the abilities of the franchisee.

So, in deciding whether franchising is the way to go, some prospective franchisees

will find the level of intrusion called for in FIN 46 more than they can live with.

This is a very serious threat to franchising. I was an employee of a franchisor for

decades, but I chose to become a franchisee because of the freedom to be an independent businessman and to build my family’s future security through owning my

own business. My restaurants do better than other restaurants because they are

mine. My success is the direct result of my ability to run my operation as I see fit.

If FIN 46 had been in effect when I made my decision to become a franchisee, I

do not think I would have made the leap. That is another problem with FIN 46.

When and if I want to sell my business one day, there will be fewer prospective buyers and that will lower the value of my business.

Looking at another example, suppose you are a publicly traded company with

hundreds of units. First of all, you have the flip side of all the problems facing

franchisees I mentioned earlier. For example, you have to convince hundreds of

independent business people to hire expensive firms to audit your financials and develop internal controls, and you have to convince them to give you a lot of financial

information they have not had to. You also have the Sarbanes-Oxley problem I mentioned earlier. You may want to sell out just to avoid the headaches.

I know that the mission of FASB is to improve financial reporting so that the public is protected and I know that FIN 46 is supposed to prevent shady Enron-style

arrangements. The entire franchise community supports this vital goal.

But I can not understand how FASB could come to the conclusion that the only

way to prevent another Enron is to hobble a way of doing business so important

to our economy and job creation. To make matters worse, I do not think FIN 46

even accomplishes FASB’s goal of improved financial reporting when it comes to

franchising. If FIN 46 results in a franchisor consolidating the financial results of

its franchisees, FIN 46 may reduce financial statement transparency and clarity, as

well as confuse investors who are not familiar with how franchisors and franchisees

work together and how real it is that a franchisor’s financial results are not one

and the same with its franchisee’s results.

For example, for the income statement, this means no longer including franchise

royalty revenue, but instead essentially grossing-up the franchisor’s income statement for the franchisee’s results of operations and then eliminating their combined

impact on the franchisor’s income statement through an adjustment to ‘‘minority interest.’’

For the balance sheet, this means consolidating a franchisee’s assets and liabilities, including, as an example, the franchisees’ debt, even though the franchisor has

no legal obligations associated with the debt. Amounts owed to the franchisor would

be eliminated in consolidation.

Additional disclosure would be needed to explain the consolidated financial results—disclosure necessary not only to provide better information, but also necessary to provide clarity to allow financial statement users to understand the consolidated financial statements presented and distinguish between the economic benefits and risks inuring to the franchisor and those not.

Due to the different business models of franchisors and franchisees, the transparency of the franchisor’s financial position and results of operations often can be

dramatically altered. Consider the example of a 100 percent franchised system that

collects a 5 percent royalty from franchisees. If the franchisees were to be consolidated, the franchisor would report a twenty-fold increase in sales (net of eliminated

royalty income) materially distorting the franchisor’s revenues, gross margin and expenses. Further, note that while the franchisor would gross up the income statement revenue and expenses by a factor of twenty, the franchisee net income would

be entirely eliminated as minority interest such that the franchisor’s net income

would be the same before and after consolidation. A reader of the financial statements might ask whether this results in greater clarity and understanding of the

operations of the franchisor.

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1Small Business Administration, ‘‘Small Business by the Numbers,’’ online publication updated May 2003: http://www.sba.gov/advo/stats/sbfaq.pdf. 2 Ibid.

In fact, there has been a longstanding concern expressed by the Securities and

Exchange Commission (SEC) staff, about the use of ‘‘system wide sales’’ information

(for example, combining franchisee sales with franchisor company sales) in ‘‘selected

financial data’’ and ‘‘management’s discussion and analysis’’ as being potentially

misleading.

In other words, FIN 46 is going to make me and a lot of other people in the franchising world jump through a lot of hoops and pay a lot of money with zero benefit

to the public.

Clearly, FASB has not sufficiently understood the implication of their proposal.

They apparently have not been listening to small business concerns, or to big business concerns for that matter.

I was surprised to see FASB acknowledge in the October 31 exposure draft that,

‘‘[t]he Board’s assessment of the benefits and costs of clarifying and modifying Interpretation 46 was based on discussions with preparers and auditors of financial

statements and on consideration of the needs of users for more consistent application of that Interpretation.’’

It does not seem that real business people like me were consulted on the costs

as well.

In conclusion, thank you for holding this hearing. This experience has been a real

eye opener for me. I am certain there are not very many small franchisees like me

that would ever have thought that FASB could do something like this that could

have such a devastating impact on our businesses. I consider myself to be a pretty

sophisticated franchisee, but I do not think I would have heard of FIN 46 in time

had it not been for the International Franchise Association.

FASB needs to better understand that the rules they set are not just academic

exercises. Those rules have real life consequences and FASB needs to understand

what those consequences are and take them into account before they act.

IFA and its 30,000 members stand steadfast in their opposition to the current

iteration of FIN 46 and urge the Subcommittee to take appropriate action.

I would be happy to answer any questions you have.

Thank You.

—————

PREPARED STATEMENT OF JAMES K. GLASSMAN

RESIDENT FELLOW, AMERICAN ENTERPRISE INSTITUTE

NOVEMBER 12, 2003

Introduction

The determination of the Financial Accounting Standards Board to require mandatory expensing of stock options by U.S. firms threatens to harm small businesses

and imperils the fragile economic recovery. The FASB’s self-stated mission is to improve accounting standards. I do not believe that its proposed expensing of options

achieves this aim, but, even if it did, you as policymakers have a more comprehensive mission than the FASB. Your concerns include improving the economy and increasing job opportunities.

In the testimony that follows, I review the importance of small business, the key

role played by stock options, and the potential damage that the expensing of options

will do to businesses, jobs, and the economy. One inevitable result will be to send

U.S. jobs offshore. I urge you to rein the FASB in by acting immediately to delay

implementation of new standards on options.

Accounting rules may seem arcane and boring, but they are far too important to

be left in their entirety to an unelected board in Norwalk, Connecticut.

Small Business and Stock Options

Small business is the engine that drives the U.S. economy. Businesses with fewer

than 500 employees represent 99.7 percent of all American firms, employ more than

half of private-sector employees, create more than half of private gross domestic

product and, perhaps most important at a time of economy recovery, create 60 percent to 80 percent of net new jobs annually.1 According to the most recent data, in

1999–2000, ‘‘small businesses created three-quarters of U.S. net new jobs (2.5 million of the 3.4 million total).’’ 2

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3 Value Line Investment Survey, Aug. 29, 2003, p. 2207; Yahoo Finance; Microsoft Corp. annual report, 2003, Form 10–K, p. 17. 4 A survey by the National Federation of Independent Business asked respondents to list problems in order of importance. Ranking third (after health insurance and Federal taxes) was ‘‘locating qualified employees.’’ Ranking seventh, out of more than 70 listed problems, was ‘‘workers’ compensation costs.’’ Ninth was ‘‘cashflow.’’ See http://www.nfib.com/cgi-bin/NFIB.dll/

Public/SiteNavigation/home.jsp. 5 Brian J. Hall and Kevin J. Murphy, ‘‘The Trouble With Stock Options,’’ Journal of Economic

Perspectives, vol. 17, no. 3, Summer 2003, p. 49. 6For a good overview of the subject, see Josph Blasi, Douglas Kruse and Aaron Bernstein,

In the Company of Owners (Basic Books, 2003). 7 Hall and Murphy, op. cit., pp. 51-52.

8 Value Line Investment Survey, Oct. 17, 2003, p. 1151; www.staples.com. 9 Committee on Banking, Housing, and Urban Affairs, U.S. Senate, May 8, 2003; transcript

at p. 55. Mr. Doerr has been a partner in the firm of Kleiner, Perkins, Caulfield & Byers since

1980. The firm has sponsored investments in such companies as Compaq, Cypress, Intuit,

Macromedia, Lotus, Netscape, Sun Microsystems, and Symantec, which have led to the creation

of over 30,000 jobs. 10Mellon, ‘‘SFAS 123: Responding to Mandatory Option Expensing,’’ September 2003 survey,

p. 9. 11 Hall and Murphy. op. cit., p. 68.

Small businesses, moreover, grow to large businesses. For example, Microsoft,

started in Bill Gates’ garage, began with two employees as a partnership in 1975

and now has 47,000 employees, 118,000 shareholders, and $282 billion in stock market value.3

Three of the key ingredients in the success of small businesses are attracting a

talented and motivated workforce, limiting compensation outlays, and conserving

cash during their early years of growth.4 Over the past 10 to 15 years, small businesses, as well as large, have turned to employee stock options as a reasonable

means to achieve success:

Stock option plans give executives a greater incentive to act in the interests of

shareholders by providing a direct link between realized compensation and company

stock price performance. In addition, offering employee stock options in lieu of cash

compensation allows companies to attract highly motivated and entrepreneurial employees and also lets companies obtain employment services without (directly) expending cash. Options are typically structured so that only employees who remain

with the firm can benefit from them, thus also providing retention incentives.5

It is evident that the use of options is critical to smaller, early-stage businesses

and that the use of options has broadened and deepened.6 For example, top managers and employees below the top five executive officers in 2002 received more than

90 percent of the total value of options granted—up from less than 85 percent in

the mid-1990’s. Both ‘‘Old Economy’’ and ‘‘New Economy’’ firms issue options. For

Old Economy firms, the average grant-date value of options per employee (below the

top five executives) went from $522 in 2001 to $2,856; for financial firms, from

$1,007 to $5,562; for New Economy firms, from $1,684 to $18,882. (All of these figures are adjusted for inflation, using 2002 constant dollars). 7

High-tech companies are not alone in relying on stock options to motivate their

workforces. One of the great options success stories, for instance, comes from Staples, Inc., the office supply chain, which was launched in 1986 with a single store

in Brighton, Mass., and now has 1,500 stores worldwide and employs 58,000.8

Expensing Options Would Reduce Issuance of Options

to Lower-Level Workers

Unfortunately, the FASB is moving quickly to change an accounting rule in order

to require mandatory expensing of stock options on corporate income statements

issued under generally accepted accounting principles (GAAP).

Such a change, it is widely agreed, would cause a significant reduction in the

issuance of stock options, especially to employees below the top five corporate officers. For example, America’s best-known venture capitalist, John Doerr, said in testimony he that thought ‘‘broad-based employee stock ownership . . . will disappear

if expensing is mandated.’’ 9 A study by consultants at Mellon’s Human Resources

& Investor Solutions also found that companies intend to cut back significantly on

options programs for employees below the top executive level if expensing is enacted.10 A review of the economic literature by Brian J. Hall and Kevin J. Murphy

concluded that ‘‘parties on both sides of the debate agree that such a change [expensing stock options] would result in granting fewer options, especially to rankand-file workers.’’ 11 Dozens of chief executive officers have publicly stated that their

firms will reduce or eliminate options if expensing is enacted. Typical is the CEO

of Advanced Fiber Communications, which stated in a letter to the FASB: ‘‘The exVerDate 11-MAY-2000 17:44 Oct 17, 2005 Jkt 000000 PO 00000 Frm 00069 Fmt 6633 Sfmt 6621 23827.TXT SBANK4 PsN: SBANK4
66

12FASB Comment Letter No. 185. See also many others (Staples, Altera, Genentech, etc.), including, poignantly, FASB Comment Letter No. 29 from Vermont Teddy Bear Company: ‘‘If options are expensed, I can tell you that a small company like the Vermont Teddy Bear Company

will no longer grant them.’’ 13 ‘‘Go West Again? Lured by Stock Options, Techland’s Best and Brightest Moved to California; Next Stop, Asia?’’ Barron’s, July 21, 2003. 14 Ibid. 15Five-Year Plan of the People’s Republic of China. (2001–2005) 16 Agence France Presse, Sept. 24, 2003. http://asia.news.yahoo.com/030924/5/

singapore49820.html 17 ‘‘A false cure for the ills of stock options,’’ by William Baumol and Burton Malkiel, Financial

Times (London), April 3, 2003.

pensing of stock options would likely require AFC to discontinue its broad-based

stock option plan that helps us to retain and motivate our employees.’’ 12

It is reasonable to predict that, without the incentive tool of stock options, many

of America’s most innovative firms—small businesses and large, in technology and

nontechnology industries—will suffer declining productivity, with dangerous consequences for national competitiveness, growth, and employment.

Talented Workers Will Move from United States to Asia

Already, the consequences are becoming apparent. In an article in Barron’s last

summer, George Chamillard, the CEO of Teradyne, a Boston-based maker of automatic test equipment for the electronics industries, wrote that one major factor in

the ‘‘flight of the semiconductor industry from Route 128 [in Massachusetts] to Silicon Valley’’ was ‘‘stock options.’’ Bay Area start-ups ‘‘were romancing East Coast

talent with the opportunity to strike it rich through options . . . Stock options were

a low-cost way to draw talent away from mature companies and into start-ups. In

return for assuming higher risk, the options-givers offered the recruit the chance for

high rewards through equity ownership and a piece of the action. Best of all, the

cost did not hit the P&L—an important point, since there usually were little or no

profits in the early years of a start-up . . . Other industries learned the lesson well,

using options to drive new companies and inject excitement into older ones.’’ 13

Now, writes Chamillard, the next cycle of ‘‘Go West, Young Man’’ has begun.

‘‘While options are under attack in the United States, elsewhere the stock option

as a recruiting tool is on the rise.’’ Options are drawing scientists from the United

States to Asia—Taiwan in particular. As a result, says Chamillard, the United

States is losing ‘‘engineers educated at MIT and Stanford and CalTech.’’ 14 Asian nations understand the attraction of options, and they do not have the same taste for

the fetish of expensing options as American regulators. In its 2001–2005 5-year

plan, China officially encourages the use of stock options to motivate managers.15

A recent study by the consulting firm Towers Perrin found that, with the exception

of Singapore, ‘‘stock options still remain companies’ most popular long-term incentive for their executives.’’ 16 So, where did the fetish for expensing options—which,

at a critical time, imperils U.S. small businesses and the economy as whole—come

from?

Background

An option is literally a choice. The owner of a fixed stock option has the choice

of purchasing shares at a fixed time in the future at a price that was fixed at the

date it was granted. Often, that price is the market price at the date of the option

grant. Therefore, if, by the time of the exercise date, the stock rises above the price

at which it was granted, the owner of the option will exercise the option, purchase

the stock, then either sell the stock at a profit or hold it for a longer period. It is

easy to see how such options help align the interests of managers with those of

shareholders, whose main concern is that the value of their stock increase.

Encouraging management to adopt a shareholder-orientation became a major concern in the 1970’s when managers, who typically owned little stock, were criticized

for using corporate assets for their own benefit and paying scant attention to the

interests of institutions and individuals who were the actual owners of their companies. Options helped change that situation, and they played a key role in the economic revival in the United States that began in the early 1980’s and has lasted,

on an unprecedented scale, for two decades. ‘‘Options,’’ as two distinguished economists recently wrote, ‘‘are needed to ensure compatibility of the interests of stockholders and management, whose divergence has recently been so dramatically demonstrated.’’ 17

The controversy over the accounting treatment for stock options goes back more

than 30 years. In 1972, the Accounting Principles Board issued Opinion No. 25,

which stated clearly that no compensation expense need be recognized for fixed

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18Dechow, P., Hutton, A., and Sloan, R., ‘‘Economic Consequences of Accounting for StockBased Compensation,’’ Journal of Accounting Research, 1996, 1:2, p.2–3. 19 Ibid, p. 3. 20Financial Accounting Standards Board User Advisory Council Meeting, Attachment 2,

Memorandum on ‘‘Equity Based Compensation,’’ FASB User Advisory Council, Oct. 7, 2003, p.1. 21Many statements attest to this fact. See, for example, criticism of Black-Scholes (‘‘it is crazy

to use Black-Scholes’’) by Warren Buffett, the Chairman of Berkshire Hathaway, Inc., in Andrew

Hill, ‘‘Buffett and Munger—In Their Own Words,’’ Financial Times, May 2003. Also, the investment firm Warburg Pincus advised the FASB, ‘‘We feel very strongly that these models [BlackScholes and binomial] do not recognize the fact that employee options are nontransferable [and]

are not liquid’’ (FASB Comment Letter No. 194). 22 ‘‘Bush Supports Businesses in Debate Over Changing Options Accounting,’’ by Michael

Schroeder, Wall Street Journal, April 10, 2002. 23 ‘‘Gephardt Backs Foes of Options Expensing,’’ by Laura Kurtzman, San Jose Mercury News,

June 18, 2003. 24 ‘‘Dean Castigates Bush During Visit to San Jose,’’ by Dana Hull, San Jose Mercury News,

Sept. 8, 2003.

stock options granted to employees ‘‘because of the concern that stock options could

not be reliably valued at the exercise date.’’ 18 As the use of such options increased,

the FASB in 1984 began to reconsider the earlier ruling by its predecessor.19

As a result, companies today have two choices. They can adopt the ‘‘fair-value’’

method of treating options and record them as an expense against earnings in the

year in the which the grant is made, or they can use the ‘‘intrinsic-value’’ method,

which discloses the impact on net income in footnotes but not as a charge against

reported earnings; if shares are issued to accommodate the exercise of options, then

a dilution will occur on that date. Most public companies use the second method.

The FASB, however, has made it clear that it will shortly require U.S. companies

to adopt ‘‘fair-value’’ accounting under FAS 123. The problem of valuing the options,

however, remains. The FASB acknowledged that its proposed standard on stock options ‘‘should not prescribe a particular option-pricing model. Rather the objective

would be to use the option-pricing model that produces the best estimate of fair

value given all the facts and circumstances.’’ 20 And what is that model? Either a

Black-Scholes or a binomial model, it appears—both of which seriously lack reliability and accuracy.21 In other words, the same deterrent that prevented the

FASB’s predecessor from requiring the expensing of options in 1972 still exists

today: No one can place an accurate value on them.

But there is another reason that the past 30 years of economic history have confirmed: Options help improve the operations of small and large businesses and improve the economy. For that reason, President Bush supported the current accounting treatment of options in an interview a year and a half ago, saying that ‘‘they

should be dilutive in [a company’s] earnings per share calculations’’ 22—the situation

that currently prevails. In addition, leading Democratic presidential candidates also

oppose expensing of options. Rep. Richard Gephardt (D-Mo.), for example, supported

the current accounting treatment, saying in June that ‘‘stock options are a very important way to get employees to think like owners.’’ 23 Howard Dean said he would

‘‘not favor expensing stock options if at least 65 percent of the options were distributed widely throughout a company’’ 24—a description of the majority of businesses

today.

Why, then, has intense pressure developed to expense options?

There is little doubt that the campaign for expensing originated in the wake of

the corporate scandals involving such firms as Enron and WorldCom—although in

no case did options play a role in the fraud and deception at the root of the scandals.

There is, as well, an earnest desire by policymakers to provide investors with accurate information about the companies in which they invest. But it is my belief that

expensing options will confuse such investors, not enlighten them.

Expensing of Options Will Confuse and Mislead Investors

Stocks options issued by companies to their employees cannot be accurately valued at the time they are issued. They do not comprise a cash cost, and they have

no market price since they cannot be sold. The Black-Scholes method of valuation,

the ‘‘gold standard’’ for determining the value today of options subject for future contingencies, applies to options that are tradable—not to options whose ownership is

restricted to specific individuals. Consider just one contingency: Many employees

will quit before they options can be exercised and lose all their rights to the value

of the options. That cannot happen with conventional options purchased in open

markets.

‘‘Mark Rubenstein, a finance professor at the University of California at Berkeley,

found that some models used to value options require as many as 16 separate variables.’’ Adjusting only a few of those variables, he found, could produce ‘‘huge difVerDate 11-MAY-2000 17:44 Oct 17, 2005 Jkt 000000 PO 00000 Frm 00071 Fmt 6633 Sfmt 6621 23827.TXT SBANK4 PsN: SBANK4
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25 ‘‘The Imperfect Science of Valuing Options,’’ by Howard Gleckman, Business Week, Oct. 28,

2002. 26 ‘‘Much Ado About Stock Options: The Epilogue,’’ editorial, Wall Street Journal, April 23,

2003. 27Gilead Sciences, Inc., Form 10–K, submitted to the Securities and Exchange Commission,

March 11, 2003.

ferences in costs.’’ For example, in one test, Rubenstein discovered that the value

an option for a theoretical $100 stock could range from under $20 to over $300.25

How valuable is such information to investors? Not very. Can such information be

easily manipulated by firms to meet earnings targets? Of course.

Think about how an employee stock option works. If a company issues an option

today, when the price of its stock is $50 per share, allowing an employee to buy

stock at the same $50 in 5 years time, how can the firm accurately value the option

today if it does not know the price 5 years from today? It cannot, so it has to guess

the value using those multiple variables, including interest rates, volatility, earnings, likelihood of job retention, and on and on.

For that guess to have any usefulness to investors, it needs to be updated frequently. Imagine that the firm originally estimates its stock price at $120 5 years

from now and that, after 1 year, the stock drops to $15. Is it reasonable to believe

that in 4 years, the price will rise to $120? Probably not. So the company should

then reduce its estimate for the value of the options issued the previous year. Such

a reduction would create increased earnings! So as the firm’s stock price drops, its

earnings increase.

Such a perversion reminds us of the purpose of accounting conventions in the first

place—to convey information about the health and prospects of a company for investors and potential investors. But some information cannot be reduced to a single

number. Nor should it be. The expensing proposal, nevertheless, ‘‘serves to satisfy

an unquenchable fetish to see a contingent liability converted, however clumsily and

unconvincingly, into a dollar amount that can be charged against earnings—without

(and here’s the fetish element) caring in the slightest whether it is helpful or meaningful to do so.’’ 26

In this case, it is not helpful or meaningful to reduce all the information about

options to one number. It is confusing and misleading—and utterly unnecessary.

The current regime gives firms a choice: Expense options at the time they are

granted or provide information about the options in the footnotes and record a dilution when the options are exercised. The information provided today by companies

is highly detailed. Consider, for example, the Form 10–K of Gilead Sciences, Inc.,

a biopharmaceutical company based in Foster City, California. The footnote on stock

options extends for four pages. It shows the number of options outstanding, forfeited, exercised, and outstanding for the preceding 3 years, the weighted average

exercise price of those options and the weighted average fair value of options granted. It then breaks down, by four price categories, the number of options and their

average price and contractual life. And it presents a table that shows what net income would be if the company had chosen the alternative method, ‘‘fair value’’ accounting, under FAS 123. There is more information as well.27

In fact, for typical companies, the information provided on stock options far exceeds information provided for far more important aspects of the business, including

intellectual-property assets, cash compensation expenses, leases, and investments.

Under the current regime, investors who require information on stock options can

get it—and get it in spades. They can use it—not as a single number—but as a mass

of detail more important than a single number—to make their decisions. Perhaps

there could be even more transparency. Perhaps the disclosures could be made in

a more uniform way. H.R. 1372 addresses such improvements.

Since 1993, I have written a regular financial column for The Washington Post,

which is syndicated into many other newspapers, including the International Herald

Tribune and the New York Daily News. I have written about investing for many

other publications as well, including The Wall Street Journal, Los Angeles Times,

The New Republic, The Weekly Standard, Forbes, and Worth magazine. I have devoted much of my professional life to educating small investors, so I have a keen

interest in ensuring that investors get all the information they need to make good

decisions.

Do current accounting rules give them such information? Absolutely. Will expensing help them make better choices? Not at all. Will it confuse them and actually

increase the fog surrounding investment decisions? That is highly likely.

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28On the home page of the FASB website: www.fasb.org. 29 ‘‘Now for Plan B: Expensing Share Options,’’ The Economist, March 15, 2003. 30Typical is Charles Munger, Vice Chairman of Berkshire Hathaway, Inc., who has said, ‘‘In

90 percent of the cases, the handing out of options is excessive.’’ Quoted in ‘‘Options Vigilantes,’’

by Robert Lenzner, Forbes, Dec. 23, 2002, p. 67. In addition, the U.S. Secretary of the Treasury,

John Snow, derided stock options in an Oct. 15, 2003, speech as a ‘‘freebie,’’ claiming that, ‘‘in

many cases [options] shortened the time horizon of management and accentuated the ‘shortterm-it-is’ that addicted the markets in the 1990’s.’’ There is, no surprisingly, no economic evidence for this view. In fact, the problem in the 1990’s was that investors took too long a view,

not too short. They thought that companies that were losing money would make money somewhere in the future—lots of money—and bid up stock prices accordingly. Since stock-option use

Continued

Investors Understand the Cost of Options

The case for expensing stock options is built on a faulty premise: That investors

do not understand, from the current data with which they are presented, the true

status of the firm. In their article, Hall and Murphy write, ‘‘Several studies have

shown that the costs of options are indeed reflected in stock prices.’’

That leads to two further questions:

First, if investors already can figure out the cost of options without an accounting

change, then why make the change to expensing and jeopardize small businesses

and the economy as a whole? And

Second, if options are already reflected in stock prices, then why should small

businesses fear the change to expensing? If the costs are known already, then stock

prices should not change.

Let me take the second question first and let Hall and Murphy answer it: ‘‘The

fact that financial markets see through the ‘veil of accounting’ does not imply that

accounting considerations are irrelevant since accounting rules affect—and sometimes distort—managerial decisions.’’ In other words, whatever economists think,

managers fear that a change in the rules will indeed hurt their companies in the

stock market and raise their costs of capital. Such managers—and we have heard

from dozens of them—will cut back their options programs, with an adverse effect

on the economy. My guess, as well, is that stock prices will fall in the short-term

and the cost of capital will rise. Stock prices may rebound, but the damage will be

done. Why, at this critical time in the economic cycle, should we tamper with a system that provides incentives and conserves capital?

Which brings me back to the first question: Why make a change if the change

threatens to harm the economy and produce no benefit? There is no reason at all.

The number one rule in public policy should be that of the Hippocratic Oath in medicine: First, do no harm.

So why is the FASB, an unelected group of accounting mavens, bent on making

such a dangerous change?

The FASB’s Mission

The answer lies in FASB’s sole mission, which it states this way:

‘‘. . . to establish and improve standards of financial accounting and reporting for

the guidance and education of the public, including issuers, auditors, and users of

financial information.’’ 28

But Federal policymakers have a far broader mission.

For example, they are responsible for encouraging—or at least not discouraging—

economic growth, for preserving and increasing jobs, innovation, and U.S. competitiveness. Even if the FASB expensing proposal were cogent from an accounting

viewpoint (and it is not), it would be the duty of Congress and the executive branch

to consider its economic impact. I do not have to remind you. That is your job. You

cannot abdicate it. You cannot farm it out to a group of accountants, however wellmeaning.

Some issues, quite literally, are beyond the FASB.

As a result of expensing options, many firms—among them some of America’s

most successful and innovative—will be forced to take massive charges against

earnings. ‘‘Accounting for [options’] cost by the usual method (the Black-Scholes options-pricing model) would cut tech firms’ reported profits by 70 percent, on some

estimates.’’ 29 Although they will not alter the firms’ cashflow or actual business

prospects from what they are today without mandatory expensing of options, the reduced reported earnings are almost certain to lead, at least in the short-term, to

lower stock prices and a higher cost of capital for the firms. Companies, in addition,

will be discouraged from issuing options in the future. The effect will be to reduce

economic growth, U.S. competitiveness, and job creation.

While some critics have made wild claims about the uselessness of stock options,30

the truth is that firms issue options because they work. They represent an efficient

70

started to accelerate, the United States has enjoyed a period of enormous prosperity, with only

two brief and shallow recessions. 31 Bryan, S., op. cit.

method, especially for companies that have limited cash and depend on innovation

to prosper, to spur employees at all levels to work harder and accomplish more—

and thus to increase the value of the corporation and ultimately its stock price.

Conclusion

Are other incentives, such as cash or perks or the awarding of restricted stock,

better incentives than options? Perhaps for some companies, and nearly all firms

diversify their incentives beyond cash. But academic research shows that ‘‘incentiveintensive’’ firms favor the use of stock options.31 No one knows more about incentives at an individual company than the shareholders, the board, and the top managers of that firm. When they choose stock options, it is hubristic and foolish for

outsiders to second-guess them. Discourage stock options and you discourage a management tool that works for vast numbers of the best American companies—including the small businesses that have made the U.S. economy the envy of the world.

Thank you.

—————

PREPARED STATEMENT OF RICHARD FORRESTEL, JR.

TREASURER, COLD SPRING CONSTRUCTION COMPANY, AKRON, NEW YORK

ON BEHALF OF THE ASSOCIATED GENERAL CONTRACTORS OF AMERICA

NOVEMBER 12, 2003

The Associated General Contractors of America (AGC) is the largest and oldest

national construction trade association in the United States. AGC represents more

than 35,000 firms, including 7,500 of America’s leading general contractors, and

over 12,000 specialty-contracting firms. Over 14,000 service providers and suppliers

are associated with AGC through a nationwide network of chapters. These contractors are engaged in the construction of the Nation’s commercial buildings, shopping

centers, factories, warehouses, highways, bridges, tunnels, airports, waterworks facilities, waste treatment facilities, dams, water conservation projects, defense facilities, multifamily housing projects, and site preparation/utilities installation for

housing development.

I am Richard Forrestel, Jr., a CPA and Treasurer of Cold Spring Construction

Company, based in Akron, NY. I am testifying on behalf of the Associated General

Contractors of America (AGC), a national trade association representing more than

33,000 firms, including 7,200 of America’s leading general contractors, and 12,000

specialty-contracting firms. AGC is the voice of the construction industry.

While AGC’s membership is diverse, the majority of AGC firms are closely-held

businesses like ours. AGC member firms are 94 percent closely held, 81 percent are

owned by fewer than four people.

I serve as the Chair of AGC’s Tax and Fiscal Affairs Committee. It is this subgroup of small business CFO’s and construction accounting professionals who have

spent the last few months trying to understand why the Financial Accounting

Standards Board (FASB) would inflict Financial Accounting Standard 150 (FAS 150)

on the industry. This FASB standard has hit our industry and my committee like

an earthquake. Its has the potential to undermine the fiscal stature of tens of thousands of construction companies, like mine.

I would like to thank Chairman Enzi and the other Members of this distinguished

Committee for the opportunity to discuss both the potentially devastating impact of

FAS 150 on family-owned businesses as well as the general process of communication between American small businesses and FASB.

Cold Spring Construction Company was founded by my grandpa in 1911. We are

a closely held, family-owned construction firm that specializes in highway and

bridge construction. Our projects range in size from $1 million to $40 million. Dad

and his brother, Uncle Tom, both entered the business after serving our country in

WWII and worked together until Uncle Tom died in 1977. As Dad, our Chairman,

approaches his 79th birthday, he still remains very active in the business. In addition, my brothers, Steve, President and CEO, and Andrew, Vice President, are actively involved in managing our business today. We have eight siblings who have

chosen other career paths; however, each worked for the company every summer to

pay for college, as did 12 of my first cousins.

71

1 Buy-sell agreements are an agreement between shareholders, and possibly the corporation,

for the transition of ownership. 2 Surety bonds are guarantees that the contract will be completed and that workers, suppliers,

and subcontractors will be paid. Virtually all public contracts require surety bonds. 3 Loan covenants often require a target net worth. 4 Prequalification: In order to bid on public projects, contractors are required to submit information to the agency. The agency evaluates the contractor’s financial ability to complete the contract.

You get the picture, we, like thousands of other businesses in this industry, are

privately held and intend to remain so. It was with this backdrop that we faced the

potential onslaught of FAS 150. Through our involvement with AGC, I was able to

visit FASB in Norwalk, CT, along with two other representatives of AGC on October

30, 2003.

The risks of FAS 150 to privately held firms like ours, and the majority of AGC

members, cannot be overstated. As written, FAS 150 would have dramatically affected all privately held companies with mandatory redemption clauses in their buysell agreements. That is, if your ‘‘buy-sell’’1 agreement is written so that the company must buy your stock back at some point in the future (for example at death

or retirement), then the contingent future liability must be booked or accounted for

today. For my family’s company, this is all our shares. The result will be to take

our company’s more than $10 million net worth and make it zero through the imposition of this standard.

I will briefly touch upon the ramifications of such an accounting bombshell. Cold

Spring builds only public works projects, all of which require surety bonds.2 First,

wiping out our equity would make us unable to obtain bonds. Second, we would be

in violation of loan covenants.3 Third, many States like Pennsylvania have

prequalification requirements 4 in order to bid on public works projects. FAS 150

would have rendered us unqualified to bid on most projects in Pennsylvania, because the State requires the contractor to show net worth in order to bid. Finally—

and this is strictly a psychological reason—this change would have dramatically altered the way our balance sheet looked. Dad first worked for Cold Spring the summer after the Japanese attacked Pearl Harbor. He has worked his tail off for more

than six decades. No way, not on my watch, will he be told that the company just

lost all it is net worth, even if it is only on paper.

FAS 150 first came to my attention at an AGC Tax and Fiscal Affairs committee

meeting in June of this year. During our two-day meeting, we discussed the implications of the standard—which at that point was effective in December 2003—and decided our best course of action was to put together a task force to contact FASB

with our concerns. At the end of August, AGC sent our four-page letter. This letter

was timed to arrive at FASB the day before their board meeting addressing FAS

150. Because of our letter, and the letters of other associations of nonpublic companies, FASB delayed extension of FAS 150 for an additional year.

While we appreciated the delay, FAS 150 still needed to be permanently amended

for nonpublic companies. During the AGC Midyear Convention in Washington DC

in September, contractors began to educate Members of Congress about this issue.

The Tax and Fiscal Affairs Committee met at the same time, and decided to request

a personal meeting with FASB in Norwalk. FASB responded and began the process

of putting a meeting together. Schedules being what they are, the meeting was set

for October 30, 2003.

Walking into this meeting, I was unwilling to accept any other outcome other

than a complete change by FASB regarding 150. There is absolutely no way I would

have followed through with this standard—and I told FASB this. I was frustrated

that this standard was in place, which seemed like such an obvious mistake to me,

and I believed this was my best, and possibly only, chance to make myself heard.

I could not let this standard be enacted. At the same time, as a contingency effort,

AGC continued educating Congress about the devastating impact of this standard.

After much thoughtful preparation, on October 30, two AGC representatives and

I met for three hours with two Board members and five staff members of FASB.

These people are, in my opinion, the best and the brightest people in the country

in the accounting profession. I found them engaging and concerned with the way

FAS 150 would affect my company, Cold Spring, and the rest of the industry. The

seven FASB representatives asked direct and penetrating questions—honestly, it

made the CPA exam seem easy in comparison. They gave us a chance to tell our

stories and listened well. They did not promise an outcome but did thank us for our

input. We could have asked for nothing more. My mindset walking out of that meeting was completely unexpected to me. Rather than a brick wall, I found an intelVerDate 11-MAY-2000 17:44 Oct 17, 2005 Jkt 000000 PO 00000 Frm 00075 Fmt 6633 Sfmt 6621 23827.TXT SBANK4 PsN: SBANK4
72

ligent, thoughtful room interested in hearing about my nonpublic company and how

FASB standards affected me and my industry.

I believe FASB heard us. Last week, FASB issued a change and indefinitely suspended the portion of the standard that would have forced companies like ours, who

have mandatory redemption clauses with an uncertain date and value of redemption, to book it. In summary, there is no change to my financial statement. But, the

other shoe has yet to drop because it is FASB’s apparent intention to address this

issue again in the future. The uncertainty of not knowing what will happen, if anything, will undoubtedly continue to cause heartburn for lots of people currently contemplating buy-sell agreements.

I intend to remain available to FASB if I can be of further assistance. Having

been through this process now, I know I will find the doors of FASB wide open to

the concerns of my company and to small businesses in general as they move forward. It appears to me that FASB board members and staff are incredibly interested in how their standard will affect all the users of the financial statement, and

willing to hear from everyone.

So, FASB’s process worked, but it is unfortunate that it came down to the eleventh hour. The small business community is certainly partly to blame for our late

involvement in this issue. However, I believe that this experience can be instructive

for others. A better, more public, mechanism could be put in place to ensure useful

communication between FASB and the American small business community at

large.

Large, public companies are accustomed to lobbying for or against changes with

FASB. We small companies are not. We often get caught up in changes that probably should be, at least in my opinion, intended for public companies. I think this

is exactly the case with FAS 150. Great idea for the public companies, disastrous

for us. Our small construction company perspective is necessary to ensure they have

evaluated all of the potential wrinkles in their standard.

One possible effort to consider is a biannual or annual meeting with FASB staff

and representatives of small businesses. Just as the IRS, the Small Business Administration, and other entities have meetings just with small businesses, this

would be an opportunity for all sides to meet and talk. FASB would benefit from

having small business representatives provide their point of view, and at the same

time, share drafts of upcoming new standards. In this way, both small business and

FASB are ‘‘on the hook’’ and working together.

I know that AGC is moving forward with FASB on a new working relationship.

The AGC Tax and Fiscal Affairs committee will meet in January, and we are inviting a representative from FASB to join us. We are going to work proactively and

ensure we are staying abreast of new draft standards. We also will continue to provide information on FAS 150 until this standard is finalized. Our intention is to

keep the lines of communication open and make sure our voice is heard.

In conclusion, I would like to thank you for the chance to testify today, and your

willingness to listen to and potentially address our concerns. As a fellow CPA, I

agree with what I believe is Chairman Enzi’s viewpoint—Congress should not be

legislating accounting standards. I appreciate and agree with the many reasons

FASB is an independent organization. Nevertheless, this Committee’s oversight is

critical to ensuring all standard-setting agencies are responsive to the industry.

I would also like to thank the members of the FASB and their staff. Having now

had the opportunity to work with them directly, I have found them to be smart,

dedicated, and responsive. I would also like to suggest that a better communication

mechanism between the FASB and American small business would benefit the entire economy and its 285 million participants. Thank you and I will gladly answer

any questions you might have.

—————

PREPARED STATEMENT OF WALTER K. MOORE

VICE PRESIDENT, GOVERNMENT AFFAIRS, GENENTECH, INC.

NOVEMBER 12, 2003

Good afternoon. I am Walter Moore, Vice President for Government Affairs with

Genentech. Unfortunately, Lou Lavigne, Genentech’s Chief Financial Officer, is unable to be here today and sends his regrets. As you are probably aware, Genentech

is the founder of the biotechnology industry and is still among the world’s leading

biotech companies, with 12 protein-based products on the market for serious lifethreatening medical conditions and 20 drug candidates in the pipeline. Our strength

is in all areas of the drug development process—from research and development to

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manufacturing and commercialization. Genentech continues to transform the possibilities of biotechnology into improved outcomes for patients. Today, Genentech has a market capitalization of over $40 billion. Why, you might

ask, is a company the size of Genentech testifying today or even interested in the

topic of FASB and Small Business Growth? Because Genentech has a classic small

business story to tell.

Genentech was founded over 25 years ago by a UCSF Biochemist and young venture capitalist. The biotechnology industry was born when they agreed to each contribute $500 to start the company. They fought convention in their business practices. Researchers could publish their findings of their studies, casual dress for all

employees, and all employees were given stock options when the company went public in 1980. Among the young scientists who came to Genentech in 1980 to enjoy

this atmosphere was Art Levinson, our current Chairman and CEO. Genentech

issued stock options to all employees when it was founded, and still does today.

One of the primary factors that allowed Genentech to move from a small start

up biotech company to where it is today was its ability to use broad-based employee

stock options. Employee stock options make employees think and act like owners,

not just employees who do their job, collect a pay check, and go home. Genentech

actively competes for talent with at least 60 other biotechnology companies located

within our zip code, let alone throughout California and the rest of the country. Our

ability to remain competitive is directly related to our ability to offer and provide

robust and broad-based options to our employees at all levels. This has clearly

helped Genentech build and maintain a dynamic team of people that discover, develop, and market life-saving therapies to patients all over the world. However, the

ability for new Genentechs or other success stories to be created is being directly

threatened by the Financial Accounting Standards Board (FASB).

FASB’s proposed new rules on how to account for employee stock options will

greatly impact all companies that use broad-based employee stock options—without

providing investors with consistent, comparable, and reliable financial information.

In the current accounting standard for employee stock options, FAS 123, companies

are allowed, but not required, to expense employee stock options. Private companies

that choose to expense their stock options are allowed to do so under rules that are

different than those applicable to all other companies. The reason for the different

treatment is that it simply is too difficult to value stock options for a company

whose stock either does not trade, or trades infrequently. FASB, without any justification, has decided that this distinction should be eliminated.

We disagree and also believe that all companies, and not just small businesses

and private companies, face the same valuation problems. In fact, we at Genentech

fundamentally disagree with those who believe that employee stock options represent a corporate level expense. That said, we do believe that credible, transparent,

consistent, comparable, and unbiased financial information is essential.

As I mentioned earlier, there are 60 biotech companies in South San Francisco.

The vast majority of these companies are small businesses and their recruitment

strategy is to provide broad-based options to employees to compete with Genentech

and other mature biotechs in our area. Expensing stock options will be a burden

on companies of Genentech’s size, but it will be a much heavier impediment to recruitment of scientists by these small businesses. These small businesses operate in

a global marketplace. One of small neighbors has recently begun construction of a

manufacturing facility in Korea. If the FASB mandates stock option expensing in

the United States and the EU mandates it Europe, some companies will relocate

to countries without mandated stock options expensing.

My testimony today will focus on mandated stock options expensing while highlighting myriad problems with existing valuation methods. Existing models fail to

adequately incorporate factors unique to employee stock options and, if used to establish a corporate expense, will compromise the integrity and comparability of financial reporting. Proponents of mandatory stock option expensing have held that

expensing options will provide investors a more clear understanding of the financial

state of the company. I believe, however, that the current footnote disclosure method

provides more clarity. As you can see from Genentech’s 10–K disclosure, an investor

with a target price can determine the exact dilution in the stock price he or she

can expect. Conversely, expensing options will take the focus away from the real

cost of options, dilution. Instead, companies will report a seemingly ‘‘precise’’ number in the income statement, which, in fact, is totally subjective, unreliable, and cannot account for scientific and technological breakthroughs or failures.

From Genentech’s perspective, the major areas of concern on valuation relate to

FASB’s view that any option pricing model used to compute a corporate expense

must take into account volatility, expected holding periods, and the risk free rate

of return. Moreover, all of the existing models assume that the options being valued

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are freely transferable and, to date, FASB has not allowed companies to factor in

this difference between employee stock options and the options that the models were

designed to value. In addition, FASB has not allowed companies to factor in other

significant restrictions that impact employee stock options, such as black out periods. Trading black out periods can also have a significant impact on the ‘‘value’’ of

an employee stock option. Blackouts, time periods when options cannot be exercised,

are frequently the equivalent of 5 months or more in any given year. For some employees, blackout periods can extend for up to 8 months in any given year. To date,

FASB has not permitted this significant restriction to be taken into account in determining the supposed ‘‘fair value’’ of employee stock options.

One might think that the risk free rate of return should be consistent across companies and industries. This, however, is not the case. Even in our own industry segment, the risk free rates used in the footnote disclosures of Genentech and three

of our chief competitors ranged from 3.9 percent to 5.5 percent in 2001.

When you move on to the issue of volatility, the differences are even greater. At

any point in time the volatility of companies even within the same industry can be

radically different. For example, in our industry in 2001, four companies used volatility assumptions in their 2001 footnote disclosures that ranged from 44 percent to

63 percent. What is the correct volatility to use? Who knows? Biotech is a stunningly risky business: Clinical trials of promising therapies fail more often than

they succeed.

To make matters worse, FASB’s rules require that companies predict their future

volatility. Even if one were to use past volatility as a predictor of future volatility,

which is a dubious proposition to begin with, you can derive significantly different

answers depending upon the number of data points you use. For example, you will

get entirely different answers if you use an average of the prior 3 years’ stock volatility as compared to an average of the quarterly, monthly, or daily volatility over

the same period. At Genentech, our stock experienced a curious volatility over the

last 3 years. Our volatility for calculating stock option disclosure was 75 percent in

2000, 63 percent in 2001 and 43 percent for 2002. We estimate expected stock volatility for 2003 to be 45 percent. However, our actual volatility over 3 years is near

zero. For growth companies, estimating future stock volatility is highly subjective

and the impact of inaccuracies can be material both to reported earnings and potentially to the stock price. If an expected volatility of 60 percent turns out to be 40

percent in practice, estimated options expense is skewed by almost 100 percent, or

$119 million versus $62 million.

No specific number is right or wrong. Virtually any number is a possible answer,

and each can be supported, but you will get a different stock option value depending

on which you use. These differences can be significant, and it will be impossible to

discern the difference between a knowledgeable projection that is wrong and one

that is manipulative.

For small companies whose stock either does not trade at all or trades infrequently it is virtually impossible to compute ‘‘volatility.’’ Yet, that is precisely what

FASB is proposing. How can it be that something that is no more than a mere guess

can result in more meaningful, comparable, and consistent financial statements?

FASB’s desire to finish its stock option project quickly should not overtake the

need to determine whether, and if so how, employee stock options can be accurately

valued. When FASB promulgated FAS 123, it was believed that the Black-Scholes

method could be used to determine an accurate value for employee stock options.

Time showed that FASB’s determination was wrong. Indeed, FASB recently considered prohibiting the use of this method because they determined that it simply does

not work. Instead, FASB is now advocating that companies be allowed to use whatever method they want, with at least some preference for the use of what is known

as a binomial model.

Binomial models require the use of ‘‘binomial trees.’’ These are analogous to a series of decision trees that are used to predict possible future events. As a result,

binomial models permit the modeling of behavior over time, thereby allowing the

inputs used in the model to change during the life of the option. Black-Scholes, on

the other hand, uses a specific and constant number throughout the life of the options. For example, under Black-Scholes, once an assumption is made about volatility, that assumed number remains constant over the term of the option. Under

a binomial model, multiple assumptions could be made about volatility, so that the

volatility estimate could change over the term of the option. Unfortunately, the volatility estimate, whether it changes or not, is still a guess. A binomial model, while

more complicated than Black-Scholes, still suffers from the same problems.

Moreover, a binomial model can produce any answer you want, depending on how

many binomial trees, or iterations, are performed. The following is a chart that

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* Held in Committee files.

shows just how different the answers will be depending on how many binomial

iterations are performed.*

According to binomial theory, the more decision trees that are used, the more precise the answer. The problem is that the more trees that are used, the closer the

binomial estimate becomes to the Black-Scholes estimate. As a result, although the

answer derived from a binomial model at any given point in time will likely differ

from the answer derived under Black-Scholes, it will not be a ‘‘better’’ number, it

will just be different. And if you follow binomial theory and use a significant number of binomial trees, you are back to the Black-Scholes number that FASB has already determined is inaccurate in virtually every circumstance.

Another model being considered as acceptable by FASB is known as ‘‘Crystal

Ball.’’ This model, like a binomial model, is more ‘‘flexible’’ than Black-Scholes.

There are no set parameters. This means that one can use an unlimited number

of variables, and that one can set each variable to a constant number or model the

variable using what is called ‘‘Monte Carlo’’ simulation. As is the case with binomial

methods, the more ‘‘sophisticated’’ the analysis—that is, the more variables and inputs used—the more the ‘‘Crystal Ball’’ number will converge to the Black-Scholes

number.

In the end, all of the option pricing models that exist today were designed to value

something else—freely tradable options—that are fundamentally different than employee stock options. Black-Scholes, binomial models, and Crystal Ball are identical

in one key respect—they all require companies to predict the future, including future stock price and volatility. The only difference is that binomial models and Crystal Ball use more inputs to try to predict the future. One does not need to be a

mathematician to know, however, that whether one is using 5 variables or 500 variables, the future remains impossible to predict accurately. Thus, if one agrees that

continued use of Black-Scholes is not warranted, so, too, should one conclude that

the use of binomial models or Crystal Ball is not warranted—they both lead inexorably to the wrong answer.

As I said in the beginning, this is a problem for companies, large and small. The

problems for small companies are even worse because they frequently do not have

staff qualified to run the models and make determinations as to what assumptions

to use. This all translates to added cost. Any added cost uses precious resources

needed my small companies to grow and add jobs.

I recognize that there are many who believe that expensing some number in the

financial statements is better than expensing nothing. I, however, disagree. Under

existing accounting rules, both here and abroad, an expense is to be recognized only

if it can be reliably measured.

It is beyond doubt that current stock option pricing models cannot accurately

value employee stock options in the hands of an employee let alone estimate a cost

of those options to the company. Mandatory recognition of an expense that cannot

be reliably measured flies in the face of the most fundamental accounting rules.

Some have also argued that there are lots of estimates in financial statements

and that employee stock options are no different. This is false. Some estimates that

are included in the financial statements, like deprecation, only present timing

issues. A company knows how much it spent to buy, for example, a machine. But

under the accounting rules, it is not allowed to expense the entire amount paid in

the year of acquisition. Instead, the company must estimate the useful life of the

machine and expense a prorata portion each year. While the company has to estimate the useful life, it still knows exactly how much it paid so, over time, the correct amount will ultimately be expensed. With stock options, the company not only

has no reliable way to measure the anticipated ‘‘cost’’ of the options, but it also has

no idea when, or even if, a single option will ever be exercised. Yet, under a mandatory expensing scheme, it would be required to determine the expense up front and

recognize an expense. Even if you believe that options should be expensed, how can

it be that an option that is never exercised can result in any expense?

For other types of estimates, like pension costs, companies are required to estimate their total out-of-pocket costs and expense these anticipated costs over time.

To the extent the company’s estimates prove incorrect, however, the company is allowed to ‘‘true-up’’ its expenses to equal what it actually ended up paying. Again,

stock options are different. First and foremost, there never is any out-of-pocket cost

for stock options. Further, while, like pension costs, a company must estimate its

costs up front, unlike with pension costs, the company is never allowed to true up

those costs.

There are other areas where estimates are so imprecise that no expense is recognized as in the contingent liability area. For example, assume a company is in litiVerDate 11-MAY-2000 17:44 Oct 17, 2005 Jkt 000000 PO 00000 Frm 00079 Fmt 6633 Sfmt 6621 23827.TXT SBANK4 PsN: SBANK4
76

gation. Unless a loss is probable, it is not permitted to recognize an expense. However, even if the company knows it will end up paying something to either settle

the case or as part of a judgment, unless the company can reliably estimate what

that amount will be, which is virtually never the case, the company cannot recognize an expense until that expense actually materializes. It must, however, report

the contingency in its financial statement footnotes. Stock options should not be

treated differently. In the end, mandatory expensing of employee stock options is

bad accounting and is in direct conflict with fundamental accounting principles.

In conclusion, Genentech strongly urges that neither FASB nor the Congress rush

to judgment on this complicated yet important issue. Rather, we must attempt to

address the significant shortcomings of existing option pricing models or develop

new models before mandating their inclusion on the face of financial statements.

One prudent way of moving forward would be to ‘‘road test’’ models through footnote

disclosure to discern whether they actually work, rather than mandating wholescale change and risking what we believe would be severe consequences for small

businesses and their employees.

We look forward to working with this Committee and with FASB on this issue.

Thank you for the opportunity to testify.

—————

STATEMENT OF JEANNINE KENNEY

VICE PRESIDENT, PUBLIC AFFAIRS AND MEMBER SERVICES

NATIONAL COOPERATIVE BUSINESS ASSOCIATION

NOVEMBER 12, 2003

Senator Enzi and Members of this subcommittee, on behalf of the National Cooperative Business Association and the thousands of U.S. cooperative businesses that

we represent, thank you for the opportunity to testify on the need for clarity on,

and resolution of, issues raised by Financial Accounting Standard No. 150.

Introduction

The National Cooperative Business Association is the only national organization

representing cooperatives across all sectors of our economy including agriculture,

childcare, electricity, finance, food retailing and distribution, healthcare, housing, insurance, purchasing and shared services, telecommunications and many others. Our

mission is to develop, advance and protect cooperative enterprise.

Of the many financial challenges confronting cooperatives in recent years, few

have generated as much concern and uncertainty as FAS 150. How and whether

these concerns are resolved will have enormous impact on the balance sheets of cooperatives, and equally important, on the individual members those cooperatives

serve, many of whom are small business people themselves—farmers and ranchers,

and the independent owners of local hardware stores, pharmacies, hotels, restaurants, office supply stores, newspapers, and the many other independents served

by purchasing cooperatives.

For this reason, NCBA and its members are extremely grateful to FASB for its

decision last Friday to indefinitely defer FAS 150 for mandatorily redeemable instruments, other than those that are redeemable on fixed dates. We hope to work

with FASB as it reconsiders and evaluates the implementation issues associated

with FAS 150. Our comments below reiterate and build upon the comments submitted to FASB in past comment periods for FAS 150.

Co-op Basics: 40,000 Strong With 120 Million Members

To understand why FAS 150 has been so troubling to co-ops first requires an introduction to co-op structure.

The more than 40,000 co-ops in this country are, by definition, businesses that

are owned and democratically controlled by their members—the people who buy the

goods or services provided by the cooperative, rather than by outside investors.

About 120 million Americans are members of a cooperative—or more than half of

all adults. To put the importance of the cooperative sector into perspective, note that

cooperatives outnumber investor-owned firms by more than two-to-one.

Though many cooperatives are large and well-known businesses—some are included in the Fortune 500—the vast majority of cooperatives are small, communitybased businesses such as food cooperatives, electric cooperatives, agricultural marketing and supply co-ops, worker-owned cooperatives, and purchasing and shared

services cooperatives that serve tens of thousands of independently owned businesses across America’s towns and cities. These cooperatives and their members

generate millions in economic activity, creating jobs, wealth, and opportunity.

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Cooperatives Fall Into Four Categories:

• Producer-owned cooperatives—These are cooperatives owned by farmers or craftsmen who form a co-op to jointly market, process or produce a like-product. There

are 1,600 farmer- or rancher-owned marketing or processing cooperatives in the

United States, most of which are local co-ops. The growth of new generation cooperatives-small co-ops that specialize in value-added agricultural processing has

been spurred by programs and incentives, such as USDA’s Value-added Producer

Grants program, that have originated in the U.S. Senate. Renewable fuels cooperatives—those that process ethanol, biodiesel, and wind power—are a growing

segment of this category. • Consumer-owned cooperatives—Representing the largest category of co-ops, these

cooperatives are owned by the consumers who buy the goods or services of the

business. They are largely small and local in nature and include food co-ops, credit unions, rural electric and telecommunications cooperatives, housing co-ops, parent-owned childcare co-ops, and consumer-owned HMO’s. • Worker-owned cooperatives—These are cooperatives that are owned and controlled by their employees. They are similar to companies with Employee Stock

Ownership Plans (or ESOP’s) in that the workers own the company. However, in

a worker cooperative, the employees benefit from the profitability of the company

earlier than ESOP employees. Members of worker-owned co-ops receive annual

taxable dividends on the company’s earnings, rather than waiting for retirement

to cash in their stock. • Purchasing and shared services—These are cooperatives that are owned by individuals or small businesses that band together to jointly buy goods or services as

a group, thereby lowering their input costs. Unlike buying clubs, the members of

purchasing cooperatives actually own the company, ensuring that it is acting only

in their best interests in procuring inputs and services. This is a growing segment

of the co-op sector, as more and more small businesses see purchasing co-ops as

the key to their survival. We estimate that, nationwide, more than 50,000 independent businesses are members of purchasing co-ops. The Nation’s 1,600 local

farm supply and service co-ops fall into this category, since they are effectively

purchasing co-ops for farmers and ranchers.

Co-op Patronage Equity

Because co-ops are member-owned businesses, their equity is provided by their

members. Generally speaking, co-ops do not issue public debt, though there are a

few exceptions to this rule. Co-op equity, in most cases, consists largely of, or in

many cases, solely of member equity.

A co-op member will make an equity investment, usually in nominal amounts, in

a cooperative upon becoming a member. This investment represents a member’s

ownership interest in the cooperative. This equity stake grows or declines depending

on the co-op’s profitability.

It is important to understand that, unlike investors, co-op members join a cooperative in order to benefit from the goods and services it offers, not to make a substantial return on their initial investment. That is, consumers join food co-ops or credit

unions in order to shop at a particular grocery store and enjoy discounted prices to

members or better rates and lower fees. Farmers join an agricultural marketing coop to benefit from the improved leverage that cooperative has in negotiating prices

for their crop or the premium enjoyed through the co-op’s branding of products.

Small businesses join a purchasing co-op to reduce their costs of doing business, and

workers join a worker-owned co-op to better enjoy the profitability of that company

through annual dividends.

All co-ops operate as not-for-profit businesses in that they return any profits they

earn to their members in the form of end-of-year dividends based on the amount

of business a member did with the co-op—these are referred to as patronage dividends. Members receive dividends either in the form of cash, or as equity held by

the co-op and allocated to individual members-often known as allocated patronage

capital or capital credits or both. Cooperative patronage capital therefore is the accumulation of capital from revenues in excess of expenses over time.

Allocated patronage capital is how a cooperative, and often the only way, builds

up equity in the company. It is recognized by members as risk capital. In the unfortunate incidence of a bankruptcy, co-ops may never return equity to members. Debt

holders are paid first. Patronage capital is an asset that can be called in by lenders.

Holders of equity are paid last, if at all.

By FASB’s own definition, allocated patronage equity is true equity. FASB Statement of Financial Accounting Concepts Statement No. 6, defines equity as the

ownership interest in the business. In a co-op, the equity shares of members—the

owners—is their ownership interest. Further, Concepts Statement No. 6 states,

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‘‘equity distributions to owners are at the discretion and volition of the owners or

their representatives after satisfying restrictions imposed by law, regulation, or

agreements with other entities.’’

In the case of cooperatives, the representatives of the owners are the members

of the co-op board of directors. Co-op boards of directors, which are elected by members, retain the ultimate discretion as to how or whether to return allocated equity

to members. Co-ops have a variety of arrangements regarding redemption of members’ shares.

Some co-ops repurchase the shares of members upon their withdrawal from the

co-op, upon death, or upon reaching retirement or a certain age. Other cooperatives

have a policy of revolving equity of the cooperative over a period of time once specific equity levels are achieved and the financial condition of the co-op allows.

Redemption decisions may be based in board policy, practice, or in the co-op’s bylaws. However, most co-ops have no provisions in their bylaws, but have a past

practice of repurchasing members’ shares upon withdrawal, death, retirement, or on

some revolving basis. And some co-ops may never redeem member equity. Co-op

boards make such discretionary redemption decisions based on the financial and

other needs of the cooperative. Boards have no such discretion with respect to repayment of true debt obligations.

It is important to note that cooperative boards are elected by the members and

change over time. There can be no assumption, then, that the practices and policies

of past boards will be adopted by future boards.

Finally, in instances when the discretion of a co-op board to redeem equity has

been challenged, courts have consistently affirmed that the board of a cooperative

has discretion with respect to redemptions.

Therefore, regardless of redemption policies, co-op patronage capital retains all

the characteristics, as defined by FASB, of equity.

FAS 150

FAS 150, in the form approved by FASB in May, raises serious and unanswered

questions for cooperatives that affect their financial solvency, their ability to meet

loan agreements and ultimately, the ability of the co-op board of directors to exercise its authority over redemption of equity.

Again, we are grateful to FASB for its decision to indefinitely defer FAS 150’s provisions regarding mandatorily redeemable shares of nonpublic entities—the provision of greatest concern to co-ops—pending further board action. This will provide

time for cooperatives to work with FASB on unresolved issues raised by any new

accounting standard.

Cooperatives and their membership organizations have been following FASB’s

work that culminated in FAS 150 for several years and have actively participated

in the comment periods throughout FASB’s process. The recent comment period on

FAS FSP 105–c, the staff position regarding delay of the effective date, drew more

than 70 comments from cooperatives, or roughly 70 percent of all comments FASB

received on this staff position.

However, we are troubled that the concerns and substantive arguments of cooperatives, expressed through the series of FASB comment periods and personal

meetings, were not heard until the eleventh hour. These concerns are similar to

those raised by other professions that actively participated in this process, architectural, engineering and construction-related firms.

Key Issues Regarding Mandatorily Redeemable Financial Instruments

At the heart of co-op concern regarding FAS 150 is how the accounting profession

will interpret the new rule with respect to cooperative patronage capital and whether it will be considered a ‘‘mandatorily redeemable financial instrument’’ under the

varying conditions for redemption. Fundamentally, we believe that co-op patronage

capital should be classified as equity, rather than as liabilities, until such time as

it will be redeemed.

FAS 150 stipulates that mandatorily redeemable financial instruments shall be

classified as liabilities unless redemption is required to occur only upon the liquidation or termination of the reporting entity. FASB defines ‘‘mandatorily redeemable’’

to include instruments that embody ‘‘an unconditional obligation requiring the

issuer to redeem the instrument by transferring its assets at a specified or determinable date, or upon an event certain to occur.’’ [Emphasis added.]

FASB defines ‘‘obligation’’ as a ‘‘conditional or unconditional duty or responsibility

to transfer assets or to issue equity shares.’’ Meanwhile, in the Statement of Financial Accounting Concepts No. 6, FASB notes that an obligation is broader than a

‘‘legal’’ obligation. Concepts No. 6 states that FASB uses ‘‘obligation’’ with ‘‘its usual

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general meaning to refer to duties imposed legally or socially; to that which one is

bound to do by contract, promise, moral responsibility, and so forth.’’

This very broad definition of ‘‘obligation’’ has raised significant questions about

what an ‘‘unconditional obligation’’ within the context of FAS 150 will actually mean

in practice and how it will be interpreted by the accounting profession.

Cooperatives and their accountants have questioned whether the absence of an

unconditional legal obligation with respect to co-op equity redemptions is sufficient

to exclude co-op patronage capital from reclassification as ‘‘mandatorily redeemable

instruments.’’ Though most co-op boards retain discretion on equity redemptions as

noted above, past discretionary practices to redeem such equity under different situations could constitute a constructive duty or obligation, even though there is no

legal obligation to redeem.

Unofficial conversations between cooperative representatives and FASB staff

made clear that this could indeed be an outcome of FAS 150. A history of certain

discretionary redemption practices could therefore require reclassification of all

member equity as liabilities even if there is no obligation to continue those practices

in the future.

Without such clarification, co-ops with a practice of redeeming capital to heirs of

deceased members, to retiring members, or of revolving capital run the risk of having all of their equity reclassified as debt even though only a fraction or no capital

may be redeemed in a given year. Co-op equity is never redeemed all at once, except

upon the sale or dissolution of the cooperative. This would be a nonsensical outcome.

In addition, cooperatives are concerned that FASB has failed to recognize the similarities between co-op patronage capital redemption and similar instruments issued

by for-profit companies that are not considered by FASB to be mandatorily redeemable.

For example, allocated patronage capital in a cooperative is analogous to retained

earnings in a for-profit firm. Just as for-profit companies may distribute retained

earning to owners by paying dividends, cooperatives may return patronage capital

to owners by retiring patronage capital. In both instances, the payments are made

at the discretion of the board of directors. The decision to return capital to owners

in a co-op is made using the same decision process as that used by for-profit companies regarding dividend payouts for preferred or nonredeemable common stock—by

managing the entities’ capital structure and cashflow and examining income tax

ramifications.

FAS 150 clearly states that for companies issuing nonredeemable common or preferred stock, ‘‘Declaration of dividends is at the discretion of the issuer, as is a decision to reacquire shares.’’ It therefore concludes, ‘‘Nonredeemable outstanding

shares of both common and preferred stock lack an essential characteristic of a liability.’’ This is also clearly the case with co-op patronage capital—in most cases,

the co-op has no obligation to redeem member shares. But FAS 150 provides no clarification on this matter for cooperatives.

We are concerned by what will be, without further clarification, disparate treatment of cooperatives relative to for-profit companies exercising similar discretion. If

a for-profit company with continuing dividend payouts is not considered by FAS 150

to have mandatorily redeemable retained earnings, it follows that a cooperative that

has regular redemptions of patronage capital must not be considered to have

mandatorily redeemable patronage capital.

For this reason, cooperatives are seeking greater clarification by FASB that just

as companies issuing nonredeemable common stock have no obligation to pay dividends or reacquire shares despite a past practice of doing so, cooperatives likewise

have no obligation to redeem member shares, although they may have in the past.

In some cooperatives, the agreement between a member and the co-op does include redemption upon termination of membership. However, since it is unclear

when or if such termination will occur, equity associated with such agreements

should not be considered mandatorily redeemable. It is important to underscore,

here, that regardless of such agreements, a member may never receive equity redemption, depending on the financial state of the business—this is because such equity represents a true ownership interest.

Moreover, we seek clarification that patronage capital shall not be classified as

debt until such time as a co-op makes a decision to redeem it and then only that

portion of capital would be classified as a liability. Any other outcome seriously mistakes the nature of the relationship between a cooperative and its owners.

Events Certain to Occur

Also unclear in FAS 150 is what constitutes an ‘‘event certain to occur.’’ While

death falls into this category, it is unclear what other events might be captured.

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For example, some cooperatives, such as purchasing cooperatives for small businesses, may have an obligation to redeem a member’s equity when that member

leaves the co-op. However, in cases where the member is a small business corporation—as is the case for many small business purchasing cooperatives—there can be

no certainty that the membership of that corporation in the purchasing cooperative

will ever be terminated. In many cases, membership is maintained by the successor

owners of the small business. Such obligations to redeem equity should not be reclassified as mandatorily redeemable since the event triggering the redemption is

not certain to occur.

Moreover, FASB should reevaluate whether it is appropriate to reclassify equity

as debt even for some events that are certain to occur, such as the death of a member. In this example, it is preposterous that all member-owners of a cooperative

would die in a given year, bringing into question why the equity of all members

should be reclassified as debt, even if there were a mandatory obligation to redeem.

In summary, NCBA and its cooperative members seek greater clarification from

FASB on the following:

• Co-op patronage capital represents a true ownership interest of the members of

a cooperative and is properly classified as equity.

• Co-op patronage capital shall not be considered a mandatorily redeemable financial instrument until a decision is made or action taken to redeem a portion of

that capital, and that only that portion scheduled for redemption is properly classified as a liability.

• For the purposes of FAS 150, unconditional obligations shall include only legal obligations rather than those perceived as ‘‘constructive obligations,’’ a ‘‘socially imposed duty’’ or ‘‘moral responsibility.’’ Uncertainty in this area could be disastrous

for many small businesses around the country.

• That ‘‘events certain to occur’’ be narrowly defined so as not to include events that

may or may not occur depending on the nature, type and structure of a business.

Potential Impact of FAS 150 on Cooperatives

The uncertainties associated with the application of FAS 150 to cooperative patronage capital generated significant concern among cooperatives because for many

of them, patronage capital makes up the entirety of the business’s equity. The new

standard, if implemented as originally proposed and without further clarification,

could have required many cooperatives to reclassify all of their equity as debt, creating the appearance of insolvency. It is hard to overstate the negative consequences

of that outcome.

Other Impacts Include:

• Debt Financing—The impact of a dramatic increase in liabilities on co-op balance

sheets would put many cooperatives in technical default of their loan agreements

that require certain levels of equity. Moreover, a balance sheet that reflected zero

equity would make it difficult for co-ops to secure new debt financing agreements.

• Relationships with Suppliers—Vendors and suppliers to cooperatives also frequently rely on the business’s balance sheet to assess credit worthiness. An increase in a co-op’s liabilities could adversely affect its relationships with its suppliers.

• Impact on Members—If FAS 150 would have required co-ops to discontinue discretionary redemptions, co-op members and their heirs would be adversely affected by the standard. For purchasing cooperatives, FAS 150 could jeopardize the

financial solvency of the co-op, adversely impacting its ability to serve its small

business owners. And to the extent the reclassification would jeopardize the financial solvency of the business, all member-owners of a cooperative would be

harmed.

• Reduced board discretion on equity redemptions—If FAS 150 had required reclassification of all member equity, it would have effectively converted what had been

discretionary redemptions into mandatory redemptions. That is, the standard

could have reduced the discretion of the board in managing the overall financial

health of the cooperative by eliminating its ability to determine when and whether equity would be redeemed. This outcome would imperil many cooperatives.

FAS 150 Does Not Improve Transparency of Financial Statements

Though one intent of FAS 150’s provision on mandatorily redeemable shares was

to improve the transparency and accuracy of financial statements, for cooperatives

it would have had the opposite effect. It would have seriously misstated the financial health of financially sound and thriving businesses.

FAS 150 addressed this situation by allowing a business with only mandatorily

redeemable shares to include them under liabilities listed separately as ‘‘shares subVerDate 11-MAY-2000 17:44 Oct 17, 2005 Jkt 000000 PO 00000 Frm 00084 Fmt 6633 Sfmt 6621 23827.TXT SBANK4 PsN: SBANK4
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ject to mandatory redemption,’’ in order to distinguish them from other liabilities.

But this allowance tacitly suggests that, in fact, there is something about these instruments that is different from standard liabilities that should not give lenders

pause. What is different, of course, is that for cooperatives, the instrument is truly

equity.

FASB staff also suggested that the issues raised by cooperatives could be addressed by educating lenders and suppliers regarding the nature of co-op patronage

capital. However, changes to accounting standards that require more, not less, explanation cannot represent an improvement in transparency.

Conclusion

NCBA hopes to work with FASB over the coming months to clarify that co-op patronage capital remains properly classified as equity. Moreover, discretionary redemptions in the past should not result in constructive obligation for redemptions

in the future.

The satisfactory resolution of these accounting standard questions is critical to the

continued health and growth of community-based cooperatives across the United

States, and their ability to serve their members, including the many small businesses that belong to cooperatives.

Mr. Chairman, we thank you for opportunity to testify on this important issue.

—————

PREPARED STATEMENT OF MARK HEESEN

PRESIDENT, NATIONAL VENTURE CAPITAL ASSOCIATION

NOVEMBER 12, 2003

Introduction

Good afternoon. I am Mark Heesen, President of the National Venture Capital Association (NVCA). My comments today reflect the views of the NVCA and its members. Our mission includes stimulating the flow of equity capital to emerging growth

companies by representing the public policy interests of the entrepreneurial community. The NVCA represents more than 460 venture capital and private equity firms,

both large and small, throughout the United States. As you know, private equity

is the investment of equity money to support the creation and development of new

businesses. Venture capital and private equity backed companies are very important

to the United States in a classic economic sense and probably even more important

in terms of creating and developing those businesses that are on the leading edge

technologically. Many people argue that this entrepreneurial segment of the economy is the real growth engine for the United States in terms of employment, global

competitiveness, and innovation.

A few years ago DRI/Wharton Econometrics undertook a detailed study of the role

of venture capital in the U.S. economy. They reported that over the 30 year period

that there has been a formal venture capital industry, more than 16,000 companies

received $154 billion in equity financing from private capital sources.

While most of these companies did not turn into big successes, and in fact, most

start-ups fail, those that worked had become a huge portion of the U.S. economy

contributing 11 percent of annual GDP worth over $1 trillion and employing over

12 million people. We have looked at these numbers since the economic downturn

and they appear to remain valid.

The NVCA has a vital interest in the subject of this hearing because the future

viability of our country’s young start-up companies has, in the last year, been compromised by the hasty actions taken by the Financial Accounting Standards Board

(FASB). While we recognize the tremendous pressure placed on the FASB to issue

rules and standards more quickly, we have a grave concern that this rush to regulate has come at the expense of our country’s small businesses who are often the

unintended victims of rules targeted at large corporations.

We recognize fully that Members of Congress are understandably reluctant to become the arbiters of accounting standards. However, the examples I will discuss in

my testimony present a compelling need for checks and balances in our system. Recent FASB decisions have been steeped in flawed processes that provide little opportunity for input from the small business sector. Further, it appears the FASB is

making more of its decisions in a vacuum, broadly applying accounting theories

without any intention of testing whether such theories have practical problems before implementation. Unfortunately, FASB’s rulings must be adhered to by real-life

companies—often by the ones least able to bear a diversion of resources from their

fundamental business purpose to piloting the latest FASB proposal.

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Today, I will talk about two examples where FASB’s actions have had or could

have significant detrimental effects on small business. If left unquestioned to continue on this path, I submit that FASB’s decisions will ultimately affect the growth

of our economy by needlessly raising the cost of capital for young start up companies—the fulcrum of our economic system. This is a dire prognosis and I hope my

testimony will convince you of the seriousness with which we view this situation.

FASB’S Issuance of Financial Interpretation Number 46 Lacked Adequate

Industry Input, Guidance and Transition Time, Creating Significant

Chaos in the Private Equity and Entrepreneurial Communities

The first instance involves the FASB’s January 2003 issuance of Interpretation

No. 46 (FIN 46), Consolidation of Variable Interest Entities (VIE’s). FIN 46 was intended to provide new guidance on what constitutes a VIE and when a VIE is required to be consolidated with another enterprise. FIN 46 was issued as a rapid fire

response to Enron’s flagrant abuse of special purpose entities (SPE’s) and was intended to prevent further manipulation by large corporations. However, the broad

sweep of the rule would have also required many private equity funds to consolidate

the assets, liabilities, and financial results of selected portfolio companies. ‘‘VIE’’ is

a new accounting term for the majority of entities we used to call special purpose

entity, or ‘‘SPE.’’ While VIE’s are often entities created for a single purpose like

securitizations, leasing, or R&D, FIN 46 considers neither an entity’s purpose, nor

its activities. Indeed, ‘‘VIEs’’ are defined only as entities subject to consolidation

under FIN 46. In order to know if a portfolio company is a VIE, a fund would have

had to evaluate each investment based on: (1) ‘‘the nature and amount of the equity

investment in the entity;’’ and (2) ‘‘the rights and obligations of the equity investors.’’ These tests are complex and each must be passed to avoid VIE status.

The capital structures of many private equity funds’ portfolio companies have

characteristics that make it difficult to clear these hurdles. Therefore, FIN 46 would

have certainly required private equity funds to consolidate the assets, liabilities, and

results of operations of selected portfolio companies. This consolidation requirement

would severely impact the private equity fund, its portfolio companies, and its limited partner investors. Although we do not believe that this was the intended result

of FIN 46, it would have been the practical consequence.

Under FIN 46, private equity funds that were required to consolidate their portfolio companies would have found that their GAAP-compliant financial statements

resembled, a conglomerate of some of the companies in which it has invested. While

the requirement to consolidate may not have applied to every portfolio company,

only a few consolidations would render the financial reports of the fund nearly

meaningless for limited partner investors such as universities, endowments, and

public pension funds. Furthermore, a portfolio company’s variable operating results

would obscure changes in the investment value of the total fund, impairing comparability of a fund’s performance over time.

By their nature, private equity portfolios undergo significant changes in their

composition as additional investments are made, companies go public or are acquired. As a result, from quarter to quarter, portfolio companies would go from

being consolidated to being divested, or vice versa, again and again. This variability

impairs comparability of results and diminishes the overall relevance of the reports.

FIN 46 also would impact our small and emerging growth portfolios companies

themselves. For example, if a portfolio company were to enter into a joint venture,

purchase a minority interest in another enterprise, recapitalize, or engage in any

kind of off-balance sheet activity such as synthetic leases, securitizations, or factoring, FIN 46 would force the addition or removal of assets and/or liabilities from

the company’s financial statements. This, in turn, could significantly change the

company’s financial picture and could impact loan covenants and other matters.

When this is coupled with the fact that many of these very different portfolio companies may also have been consolidated with the financial statements of the private

equity fund, the resulting hodgepodge of information would have met none of

FASB’s stated goals of producing relevant, reliable, and comparable financial statements. Private equity financial reports, which limited partners rely upon to make

allocation decisions, would be so convoluted that firms would be forced to derive and

maintain two sets of books—one to meet the FASB requirement and one that investors could comprehend.

Given the potential impact on the VC firms, their portfolio companies, and their

investors, our industry spent an incredible amount of time trying to decipher FIN

46 and how it would apply to current and past transactions. Virtually no guidance

was provided by the FASB despite numerous appeals for assistance from various

constituents. FASB’s deadlines further exacerbated the situation. Issued in January

2003, FIN 46 was to be effective immediately for all VIE’s created after January

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31, 2003 and would have also applied to VIE’s created before February 1. Although

FASB had created a completely new terminology with broad ranging implications

in its shift from SPE’s to VIE’s, there was no new comment period; no new exposure

draft and no attempt to solicit input.

FIN 46 effectively created an emergency call to action to which we all responded.

Thousands of hours were spent on this issue by CFO’s of small start-ups and private

equity firms, attempting to understand its application to our industry and to understand how it would affect each of us. While we are somewhat relieved that FASB

has recently suggested that private equity funds should not implement FIN 46, we

believe that a process that solicited input from the beginning could have averted

this crisis. And the destiny of others still hangs in the balance. Even now, FASB

determined that a limited deferral of the rule was necessary for all businesses. At

this date, FASB is still mulling over these rules, determining to whom and how they

should apply, leaving the small business, investors, and private equity community

hostage to uncertainty and confusion.

FASB’S Quest to Mandate the Expensing of Stock Options has Bulldozed

Ahead Despite Major Flaws in Their Approach at the Expense of Small

Businesses

NVCA has a long history of working with FASB on the issue of stock options and

our opposition to mandatory expensing is well known. We assert that the mandatory

expensing of employee stock options will transform a critical incentive utilized by

the majority of U.S. start-up companies into a financial albatross that will harm

small organizations to such an extent that they will have no choice but to negatively

alter their option programs. The FASB accepted this conclusion in 1995 when it

issued the current rule, FAS 123 in which specific provisions were promulgated for

private companies. Yet, today FASB has inexplicably decided to change the rules to

subject private companies to the same rules as public companies despite overwhelming consensus that such a move is fatally problematic.

Stock options are a critical factor in fueling entrepreneurial innovation and economic growth, and they embody a principle that employees should have a financial

stake in, and financial responsibility for, the companies they help to build. Almost

without exception, young, start up companies use options to compete for talent when

cash is scarce. Stock options allow these organizations to attract the best and the

brightest human capital to bring new ideas to life. The enfranchisement effect has

fostered the entrepreneurial spirit at all levels of organization and has given U.S.

-based companies a competitive advantage over their foreign counterparts. The mandatory expensing of these options carries with it a host of dilemmas with the most

widely-spread concern today being the issue of valuation.

No viable method of valuing employee options exists today. Once thshould be the

definitive answer, the Black Scholes option pricing model has now been virtually rejected by FASB and other experts as an appropriate method for valuing employee

stock options, particularly for private companies. Other models, such as binomial

methods, suffer from the same fatal flaws as Black Scholes and are even more complex. During the last year, we have implored the FASB to address the issue of valuation for employee stock options because without a common, accurate standard, an

expense number will be meaningless to investors and too costly for young companies

to derive.

While public companies face a challenge of valuing these options, private and

newly public companies are confronted with even greater problems. In August of

this year, NVCA sat before the FASB and presented the facts that show that a valuation standard cannot exist for private companies because it is impossible to measure the volatility of a company whose stock does not trade. Volatility is a mandatory

input to the models currently supported by the FASB. From a formulaic perspective,

if one uses the ‘‘wrong’’ volatility there will be a meaningful distortion of the value

of the stock option. FASB is familiar with this issue. In promulgating the current

stock options rules contained in Statement No. 123, FASB determined that measuring volatility for private companies was too difficult. The FASB stated:

‘‘An emerging entity whose stock is not yet publicly traded may offer stock options

to its employees. In concept, those options also should be measured at fair value at

the grant date. However, the Board recognizes that estimating expected volatility

for the stock of a newly formed entity that is rarely traded, even privately, is not

feasible. The Board therefore decided to permit a nonpublic entity to omit expected

volatility in determining a value for its options. The result is that a nonpublic entity

may use the minimum value method . . .’’ Basis for conclusions ¶174. (The minimum

value method allows the volatility input to be set at zero.)

While there have been no material changes in the theory of option pricing since

1994, and estimating the volatility of a stock that does not trade has not become

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any more feasible, the FASB has chosen to reverse their previous conclusion and

move forward with a mandate that requires private companies to derive a volatility

number.

In this regard, we have raised another series of questions: How often do we calculate the value of stock options? Public companies work on a quarterly basis. Private companies do not. They focus on results month-to-month. Should small companies hire experts to come in each month to derive the value of newly granted stock

options are each month? Who will do this work? What will they charge? Can the

Big 4 firms do this work? Who has the liability if there is a mistake? And exactly

how does one compute the volatility of a company whose stock does not trade? FASB

has provided no answers and is unlikely to do so. As I sit before you today, FASB

has failed in its attempts to address the critical issue of valuation, but is nevertheless moving forward in its quest, at the expense of privately held and small businesses.

FASB’S Decisions are Increasing Monetary Costs and Lowering Financial

Reporting Credibility for Small Business

While debating the substance of FASB’s decisions on entity consolidation and

stock option expensing may seem esoteric, the results of those decisions are not.

They translate into significant monetary and credibility costs related to financial reporting that are disproportionately borne by small business.

Aside from the obvious issues of the financials becoming inaccurate and unstable,

a more practical concern is the monetary and human cost that will be required for

young companies to undertake the consolidation and valuation processes. These organizations cannot afford the outside expertise required to work through complex

models. They can no more afford to spend the time to do this themselves. But

FASB’s mandate will nonetheless force them to spend time and money on these accounting issues, raising expenses and lowering the bottom line.

At a time when the overall costs for regulatory compliance continue to escalate

for small business, FASB continues to place additional burdens on small companies,

effectively lengthening the reliance on private equity to sustain a company until it

can reach the profit levels necessary for an IPO or acquisition. This reliance on the

most expensive form of risk capital will subsequently raise the overall cost of capital

throughout the entire system.

Congress has frequently stepped in and compelled Government regulators to perform a cost-benefit analysis prior to the imposition of new regulatory burdens. FASB

too has readily acknowledged the need for this analysis but, apparently, has decided

to ignore the approach they took in Statement No. 123 and in Statement No. 126,

where they stated:

‘‘The Board strives to determine that a proposed standard will fill a significant need and that the costs imposed to meet that standard, as compared

with other alternatives, are justified in relation to the overall benefits from

improvements in financial reporting. . . The Board has long acknowledged

that the cost of any accounting requirement falls disproportionately on

small entities because of their limited accounting resources and need to rely

on outside professionals.’’ FAS 126, Exemption from Certain Required Disclosures about Financial Instruments for Certain Nonpublic Entities, basis

for conclusions ¶¶ 9, 10.

Implementing ill-conceived regulations also imposes a credibility cost that heavily

impacts small companies. For example, if stock option expensing becomes mandatory, many analysts have said that they will ‘‘look through’’ those numbers to a company’s’ underlying financials. But who will protect the smaller companies who do

not have analysts to make this interpretation? Over 50 percent of the Nasdaq companies do not have analyst coverage. With only 50 percent of the small public companies receiving analyst coverage, what is the implication for private companies? It

will be up to the banks, customers, and creditors—who have little access to detailed

financial statements—to try to determine the underlying financial health of emerging growth companies.

When we met with the FASB Board in August, one participant argued that the

public needed to realize that GAAP financials are only accurate +/¥50 percent.

With that view, it is perhaps understandable that FASB feels any number is better

than no number when it comes to valuing stock options. Unfortunately, we believe

that path will have the result of making GAAP financials increasingly irrelevant.

For large public companies, analysts will look through the GAAP numbers to pro

forma statements. At the end of the day, it will be the small start-up segment that

is left holding the bag and bearing the burden of this unnecessary complexity.

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To summarize, should the FASB move forward with its current consolidation and

stock options proposals, private and young public companies will have inaccurate financial statements, prepared at a crippling cost. The entrepreneurial energy that

now accounts for over 10 percent of the U.S. economy will be drained at a time

when the competitiveness and the robustness of the U.S. economy is severely challenged. The FASB remains silent on these challenges and is unequivocally pushing

forward.

Rapidly restoring investor confidence in the public markets has been a priority

for many of us during the last 2 years. Reform continues to be required and we are

all in favor of improving transparency and enhancing financial reporting. However,

the FASB has fallen short in its efforts to enact meaningful changes quickly and

has done so at the expense of small business. Ironically, large corporations, who are

the targets of these reforms, are insulated from this ‘‘ready, shoot, aim’’ approach.

Small start-up companies are not and feel the brunt FASB’s lack of comprehensiveness and concern. We urge Congress to engage in this discourse so that we might

avoid these serious consequences.

Thank you for the opportunity to express NVCA’s views on these vital issues.

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1The FASB recently revised its internal procedures to provide that field visits be undertaken

prior to the issuance of a proposal for public comment for projects that are expected to introduce

significant change or cost to users, auditors, and preparers of financial reports.

RESPONSE TO WRITTEN QUESTIONS OF SENATOR ENZI

FROM ROBERT H. HERZ

Q.1. In your written testimony you referred both to ‘‘field visits’’

and ‘‘field testing’’ that FASB occasionally conducts. Please elaborate on the difference between the two. Please list all companies

currently involved in the testing process and denote which are

small businesses. Please list all small companies that will be included in any future testing.

A.1. A ‘‘field visit’’ generally involves Financial Accounting Standards Board (FASB or Board) members or staff meeting with representatives of individual enterprises or firms that volunteer to engage in an in-depth discussion of a proposed approach or a proposed standard. In contrast, a ‘‘field test’’ generally involves the

volunteer representatives engaging in the actual application of a

proposed accounting approach or standard to certain past or current transactions.

Field visits or field tests are not required by the FASB’s Rules

of Procedure. They are supplemental to the Board’s open, extensive, and public due process procedures. The Board, on occasion,

has chosen to conduct field visits or field tests when, in the judgment of the Board, those procedures might provide the Board with

new information that may assist in obtaining a better understanding of the types of incremental costs and benefits that various

parties may incur or realize in gathering, processing, understanding, and using the information that results from a proposed

approach or standard.1

Field visit participants may request that their participation and

the information they provide to the FASB receive confidential

treatment. Consistent with the FASB’s Rules of Procedure, those

requests are routinely granted.

Below is the current list of enterprises that have, to-date, volunteered to participate in the field visits in connection with the

project to improve the accounting for equity-based compensation.

As noted, some participants have requested confidential treatment.

Your question does not include a definition of ‘‘small businesses.’’

As I indicated in my testimony, it has been our experience that

users, auditors, and preparers of financial reports have very different notions of what constitutes a small business. The list, therefore, denotes three objective categories of field visit participants: (1)

public enterprises (those companies that are registrants under the

Federal securities laws); (2) nonpublic enterprises (those enterprises that are not registrants under the Federal securities laws);

and (3) compensation consulting firms (those firms having both

public and nonpublic enterprises as clients).

Public Enterprises

Aetrium Incorporated

Baxter International Inc.

CVS Corporation

EMC Corporation

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2Grant Thornton LLP (GT) is a national accounting, auditing, and business advisor whose clients are largely nonpublic enterprises. GT has agreed to assist the FASB in conducting the field

visits for some nonpublic enterprises. GT is currently in the process of identifying three to five

nonpublic enterprises to volunteer to participate in the field visits. 3 All of the Board’s major tentative decisions in connection with the project to improve the

accounting for Equity-Based Compensation, and other FASB projects, are publicly available on

the FASB’s website at www.fasb.org.

J.P. Morgan Chase & Co.

Siebel Systems, Inc.

6 additional enterprises requesting confidential treatment

Nonpublic Enterprises

Cargill, Incorporated

Google, Inc.

3 to 5 additional enterprises to be identified by Grant Thornton

LLP 2

Compensation Consultants

Aon Consulting

Mercer Inc.

Mellon Consulting

Q.2. Will the field visits and/or road testing include testing of the

valuation models to be set forth in the upcoming draft proposal for

FAS 123? Will the testing look at the degree of sophistication that

is necessary by small companies to implement a valuation model

to be set forth in the upcoming draft?

A.2. As indicated above, the FASB’s ongoing field visits in connection with the project on improving the accounting for equity-based

compensation are designed to provide additional supplemental

input to the Board. That input is intended to further assist the

Board in assessing and understanding the nature of the costs that

some enterprises would incur as a result of applying the major tentative decisions made by the Board at public meetings since March

2003.3

More specifically, the Board’s field visits are designed to solicit

a broad range of information from participants about the Board’s

tentative decisions. That information is expected to include input

on costs that participants would expect to occur in training or educating personnel or employees about the requirements to estimate

the fair value of equity-based compensation as described in the

Board’s tentative decisions. Participants will be encouraged to comment on all aspects of the changes to reporting that are contemplated in those decisions.

As indicated in my testimony, the Board’s tentative decisions

would not require that a nonpublic enterprise, including a small

business, use an option-pricing model to determine the fair value

of equity-based compensation. The Board has tentatively decided

that nonpublic enterprises would be permitted to account for equity-based compensation using the intrinsic value method through

exercise date. That method, defined as the difference between the

exercise price of the award and the underlying stock price, is relatively simple, is well understood, and will result in a total expense

for financial reporting purposes equal to the amount of expense

that the enterprise would currently report for income tax purposes.

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4The FASB’s website includes the minutes from the Board’s July 8, 2003, public meeting with

the Option Valuation Group.

Q.3. What does the FASB intend to pursue in connection with its

equity based compensation project?

A.3. The Board plans to continue its public deliberations on the

project to improve the accounting for equity-based compensation.

Those public meetings will include deliberations about the results

of the field visits and other miscellaneous issues that have not yet

been deliberated at public meetings. Announcements of those public meetings, the minutes of previous meetings, a detailed summary

of the Board’s tentative decisions to-date, and other materials relating to the project are publicly available on the FASB’s website.

The Board currently plans to be in a position to issue a proposed

standard for public comment in the first quarter of 2004. The

Board, at public meetings, will carefully consider all input received

in response to any proposal before any final decisions are made.

The Board’s current plan is to be in a position to complete its public redeliberations of the proposal and issue a final standard in the

second half of 2004.

Q.4. Will the Option Value Group’s final recommendation be made

publicly available?

A.4. The FASB established the Option Valuation Group (OVG) to

provide the Board with an additional source of input on how best

to develop a standard to measure the fair value of equity-based

compensation. The OVG is composed of individuals who are leading

experts on issues relating to equity pricing.4

Like other FASB task forces and advisory groups, the OVG is

purely advisory. Thus, the OVG has not, and will not, be requested

by the Board to develop a proposal or form a collective view or recommendation on any specific issue. Rather, individual members of

the OVG are solicited by the Board and FASB staff on an ongoing

basis to obtain their individual views, comments, and recommendations on specific issues that are within their areas of expertise and

relevant to the Board’s deliberations.

As was indicated above, those individual views, comments, and

recommendations are only one source of input to the Board in considering how best to measure the fair value of equity-based compensation. All decisions of the Board, including all measurement

decisions, are deliberated at public meetings after carefully considering the views, comments, and recommendations of all interested

parties, including users, auditors, and preparers of the financial reports of public and nonpublic enterprises.

Q.5. In your testimony, you refer to the precepts that FASB adheres to when establishing an accounting standard. One of those

precepts is a ‘‘cost-benefit’’ analysis that FASB conducts on each

proposal. Please elaborate on the ‘‘cost-benefit’’ you intend to conduct in connection with your equity-based compensation project,

and please indicate whether or not such a ‘‘cost-benefit’’ analysis

includes an economic impact study assessing the consequences of a

mandatory expensing standard.

Please elaborate on findings of the cost-benefit analysis that was

done on the proposal for FAS 150. Was a cost-benefit analysis done

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5Statement of Financial Accounting Concepts No. 2, Qualitative Characteristics of Accounting

Information, May 1980, paragraph 137.

for FIN 46. If so, please elaborate on how the analysis was done

and the findings of the analysis.

A.5. As indicated in my testimony, assessing the benefits and costs

of a new or different method of accounting is integral to the Board’s

decision-making process. Every issue in an FASB project has its

own mix of incremental improvement and incremental cost for the

Board to consider.

The principal benefit of any new accounting standard is to provide information that is useful in making business and economic

decisions. Secondary benefits include:

• Maintaining and increasing the credibility of financial statements, which is critical to investor confidence.

• Lowering the cost of capital.

• Increasing the utility that users gain from the new accounting

information, including the ability to select better among various

investment options.

• Increasing the knowledge that a preparer gains about the financial position and results of the enterprise.

The Board’s assessment of a standard’s benefit to preparers,

auditors, creditors, investors, and other users is unavoidably subjective. In making that assessment, the Board also considers the

costs of not issuing a standard (for example, shareholder losses associated with nontransparent accounting), which is inherent in the

benefits indicated above.

As with the benefits associated with a new standard, a standard’s incremental costs are borne by preparers of financial reports

as well as by auditors and users of those reports. The types of costs

associated with a new accounting standard are varied; some are

one-time costs, while others are ongoing costs. The FASB’ s conceptual framework identifies a number of costs that are relevant for

the Board to consider as part of its assessment. Those costs include:

• Costs to the preparer of analyzing, developing, collecting, and

processing the information,

• Costs to the preparer and the auditor of understanding the new

requirements, and

• Costs to the users of analyzing and interpreting the new information.5

Those costs do not include potential ‘‘economic impact’’ costs. As

indicated in my testimony, the mission of the FASB is to develop

and improve financial accounting and reporting standards that result in transparent, credible, and unbiased financial information.

Our mission is premised on the long and widely held belief that unbiased and objective financial information enhances economic and

policy decisions, comparisons between enterprises, capital allocation, investor trust and confidence in financial reporting and the

capital markets, and the growth and stability of the U.S. economy.

Slanting an accounting standard to favor a particular transaction,

industry, or special interest group, because of some potential ‘‘economic impact,’’ thwarts the attainment of those objectives.

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6Testimony of Paul A. Volcker before the U.S. House of Representatives, Committee on Financial Services, June 3, 2003, page 2. 7 ‘‘Rebuilding Investor Confidence, Protecting U.S. Capital Markets—The Sarbanes-Oxley Act:

The First Year,’’ House Committee on Financial Services, pages 3 and 4; Olaf de Senerpont

Dornis, ‘‘Consolidating Options,’’ Daily Deal, June 2, 2003; ‘‘Accounting Rulemakers Tighten

Rules on Liabilities,’’ Reuters News, May 15, 2003; ‘‘In Quick Compromise, FASB Issues Tighter

Rules on SPE’s,’’ Accounting Today, March 2003; ‘‘New Rule to Curb Accounting Abuse,’’ The

Seattle Times, January 17, 2003; Jackie Spinner, ‘‘FASB Tightens Rules on Special Purpose Entities,’’ Washingtonpost.com, January 17, 2003; Deepa Babington, ‘‘Tougher Rules on Enron-Type

Deals Approved,’’ Reuters, January 15, 2003.

There will always be many different business, economic, and social objectives that many may agree are worthy of encouraging,

promoting, or otherwise subsidizing in some manner. Most users,

auditors, and preparers of financial reports, however, agree that

permitting or creating distortions through accounting standards

and the resulting financial information is not the way to achieve

those objectives.

The purpose of financial accounting and reporting is to facilitate

and promote sound, fair, and credible information to enable informed economic decisions. Diverging from that purpose to fulfill

some other objective severely impairs the benefits and utility of accounting standards, weakening the fabric of the capital market system.6

In addition to undertaking the field visits, described above, the

Board’s assessment of the costs and benefits resulting from the

project to improve the accounting for equity-based compensation

will include the following additional procedures:

• Continuous dialogue with users, auditors, and preparers of financial reports throughout the deliberations and redeliberations

about the types of benefits they expect to realize and the costs

they expect to incur as a result of any new requirements,

• An explicit request in any proposal for public comment for input

on how the Board could further reduce the related costs without

reducing the benefits of the proposed requirements, and • Discussions at public Board meetings about the results of the

steps the Board has taken or will take to further consider and

balance the costs and benefits of applying any new requirements

and the relative costs and benefits associated with alternative

approaches that were considered and rejected.

The Board will not issue a final standard in connection with the

project on equity-based compensation unless it can conclude, after

deliberations at public meetings, that the issuance of any new requirements is a sufficient improvement to financial reporting to

justify the perceived costs.

With respect to Statement of Financial Accounting Standards No.

150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity (Statement 150), and FASB Interpretation No. 46, Consolidation of Variable Interest Entities

(FIN 46), both standards address certain financial accounting and

reporting issues that were brought into the spotlight following the

Enron Corp. bankruptcy.7 Those issues include the accounting for

certain debt obligations that were classified as equity and the accounting for certain off-balance-sheet entities, respectively. Many

preparers, auditors, and users of financial reports, including the

U.S. Securities and Exchange Commission and many Members of

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8Statement 150, May 2003, paragraphs 29 and 30; FIN 46, January 2003, paragraphs 27–

29.9Statement 150, paragraphs B82–B84.

Congress, requested that the FASB promptly address those issues.

The Board worked as expeditiously as practicable to establish improved requirements in those areas while at the same time fully

complying with our open, extensive, and public due process procedures.

In connection with both Statement 150 and FIN 46 the Board

concluded, in large part because of the broad and heightened level

of concern about certain of the issues addressed in those standards,

that issuance of the new requirements resulted in a sufficient improvement to financial reporting to justify the perceived costs. The

Board, however, provided for special transition provisions, and special deferred effective dates for nonpublic entities in both standards

to minimize the costs of the new requirements.8 Statement 150 included the following summary description of the Board’s assessment of the costs and benefits of that standard:

The mission of the FASB is to establish and improve standards of financial accounting and reporting for the guidance and education of the public, including preparers, auditors, and users of financial information. In fulfilling that mission, the

Board endeavors to determine that a proposed standard will fill a significant need

and that the costs imposed to meet that standard, as compared with other alternatives, are justified in relation to the overall benefits of the resulting information.

Although the costs to implement a new standard may not be borne evenly, investors

and creditors—both present and potential—and other users of financial information

benefit from improvements in financial reporting, thereby facilitating the functioning of markets for capital and credit and the efficient allocation of resources in

the economy.

The Board determined that the requirements in this Statement would result in

improved financial reporting. In this Statement, certain obligations that require a

transfer of assets and that meet the definition of liabilities in Concepts Statement

6 will be reported as liabilities rather than as equity or between the liability and

equity sections of the statement of financial position. Also, certain obligations that

can be settled by issuance of an entity’s equity shares but lack other characteristics

of equity will be reported as liabilities, rather than as equity as previously required

under Issue 00–19. Those changes result in financial statements that are more

representationally faithful and present a more complete depiction of an entity’s liabilities that will assist users in assessing the future cash flows and equity share

issuances of an entity.

The Board believes that the incremental costs of implementing this Statement

have been minimized principally by (a) requiring cumulative-effect transition instead of restatement of financial statements and (b) providing a delayed effective

date for mandatorily redeemable financial instruments of nonpublic companies. Although the one-time costs for changes needed to apply the accounting requirements

of this Statement may be significant, the benefits from more representationally

faithful information will outweigh those one-time implementation costs and will be

ongoing.9

As indicated in my testimony, since the issuance of Statement

150 and FIN 46, the FASB has received input from many users,

auditors, and preparers of financial reports, including representatives of small businesses, about implementation issues relating to

the application of certain provisions of those standards. In response

to that input, the FASB has issued over a dozen FASB Staff PosiVerDate 11-MAY-2000 17:44 Oct 17, 2005 Jkt 000000 PO 00000 Frm 00095 Fmt 6633 Sfmt 6601 23827.TXT SBANK4 PsN: SBANK4
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10FASB Staff Position No. 150–1, ‘‘Issuer’s Accounting for Freestanding Financial Instruments Composed of More Than One Option or Forward Contract Embodying Obligations under

FASB Statement No. 150, Accounting for Certain Financial Instruments with Characteristics of

both Liabilities and Equity,’’ October 16, 2003; FASB Staff Position No. 150–2, ‘‘Accounting for

Mandatorily Redeemable Shares Requiring Redemption by Payment of an Amount that Differs

from the Book Value of Those Shares, under FASB Statement No. 150, Accounting for Certain

Financial Instruments with Characteristics of both Liabilities and Equity,’’ October 16, 2003;

FASB Staff Position No. 150–3, ‘‘Effective Date, Disclosures, and Transition for Mandatorily Redeemable Financial Instruments of Certain Nonpublic Entities and Certain Mandatorily Redeemable Noncontrolling Interests under FASB Statement No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity,’’ November 7, 2003;

FASB Staff Position No. 150–4, ‘‘Issuers’ Accounting for Employee Stock Ownership Plans under

FASB Statement No. 150, Accounting for Certain Financial Instruments with Characteristics of

both Liabilities and Equity,’’ November 7, 2003; FASB Staff Position No. 46–1, ‘‘Applicability

of FASB Interpretation No. 46, Consolidation of Variable Interest Entities, to Entities Subject

to the AICPA Audit and Accounting Guide, Health Care Organizations,’’ July 24, 2003; FASB

Staff Position No. 46–2, ‘‘Reporting Variable Interests in Specified Assets of Variable Interest

Entities as Separate Variable Interest Entities under Paragraph 13 of FASB Interpretation No.

46, Consolidation of Variable Interest Entities,’’ July 24, 2003; FASB Staff Position No. 46–3,

‘‘Application of Paragraph 5 of FASB Interpretation No. 46, Consolidation of Variable Interest

Entities, When Variable Interests in Specified Assets of a Variable Interest Entity Are Not Considered Interests in the Entity under Paragraph 12 ofInterpretation 46,’’ July 24, 2003; FASB

Staff Position No. 46–4, ‘‘Transition Requirements for Initial Application of FASB Interpretation

No. 46, Consolidation of Variable Interest Entities,’’ July 24, 2003; FASB Staff Position No. 46–

5, ‘‘Calculation of Expected Losses under FASB Interpretation No. 46, Consolidation of Variable

Interest Entities,’’ July 24, 2003; FASB Staff Position No. 46–6, ‘‘Effective Date of FASB Interpretation No. 46, Consolidation of Variable Interest Entities,’’ October 9, 2003; FASB Staff Position No. 46–7, ‘‘Exclusion of Certain Decision Maker Fees from Paragraph 8(c) of FASB Interpretation No. 46, Consolidation of Variable Interest Entities,’’ November 26, 2003; Proposed FASB

Staff Position No. 46–d, ‘‘Treatment of Fees Paid to Decision Makers and Guarantors as Described in Paragraph 8 in Determining Expected Losses and Expected Residual Returns of a

Variable Interest Entity under FASB Interpretation No. 46, Consolidation of Variable Interest

Entities;’’ Proposed FASB Staff Position No. 46–f, ‘‘Evaluating Whether as a Group the Holders

of the Equity Investment at Risk Lack the Direct or Indirect Ability to Make Decisions about

an Entity’s Activities through Voting Rights or Similar Rights under FASB Interpretation No.

46, Consolidation of Variable Interest Entities.’’ 11FASB Proposed Interpretation, Consolidation of Variable Interest Entities, October 31, 2003.

tions,10 and a proposed modification to FIN 46,11 to address certain

of the technical and implementation issues that have been raised.

The FASB continues to monitor the application of Statement 150

and FIN 46. The FASB will consider the issuance of additional

guidance, if necessary, to assist users, auditors, and preparers, including representatives of small businesses, in implementing the

provisions of those standards in a cost-effective manner.

Q.6. With respect to FAS 150, you stated that while this accounting standard has been postponed indefinitely with respect to closely

held companies there is still more to be accomplished. How will the

FASB reach out to small entities to ensure that they are part of

the discussion process for the remaining elements?

A.6. As indicated in my testimony, the Board has begun embarking

on Phase 2 of its project to improve the accounting for Financial

Instruments: Liabilities and Equity. The objectives of Phase 2 include:

• To improve the accounting and reporting by issuers for financial

instruments that contain characteristics of equity, liabilities, or

assets, and

• To amend and improve on the definitions of liability, equity, and,

perhaps, assets in the FASB’s conceptual framework, such that

decisions made in Statement 150 and in Phase 2 are consistent

with those definitions.

Phase 2 also will include a reconsideration of implementation

issues, and, perhaps, classification or measurement guidance, for

mandatorily redeemable instruments of nonpublic enterprises. As

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part of that consideration the Board plans to again actively solicit

the views of users, auditors, and preparers of the financial reports

of nonpublic enterprises, including representatives of small businesses, in several ways, including:

• Seeking participation by representatives of small businesses on

an FASB small business advisory committee,

• Seeking participation by representatives of small businesses on

an FASB Financial Instruments: Liabilities and Equity resource

group,

• Scheduling regular public liaison meetings and less-formal meetings with representatives of small businesses, and

• Participating in conferences and other speaking engagements

sponsored by or attended by representatives of small businesses,

which provide opportunities for having a dialogue with a broad

range of users, auditors, and preparers of the financial reports of

small businesses.

The Board presently expects to issue a proposal for public comment in connection with Phase 2 of the project on Financial Instruments: Liabilities and Equity in the second half of 2004.

As indicated in my testimony, the Board is aware of the significant focus over the past year on the financial accounting and reporting of public enterprises, in part, because of the many activities

relating to the Sarbanes-Oxley Act of 2002. We, however, remain

committed to serving the needs of all users, auditors, and preparers

of financial reports, including those representing small businesses.

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STATEMENT OF DAVID A. RAYMOND

PRESIDENT, AMERICAN COUNCIL OF ENGINEERING COMPANIES

NOVEMBER 12, 2003

Mr. Chainnan, on behalf of the American Council of Engineering Companies

(ACEC), I am pleased to submit this testimony today before the Subcommittee on

Securities and Investment hearing on the Financial Accounting Standards Board

and Small Business Growth.

ACEC is the business association of America’s engineering industry, representing

6,000 independent engineering companies throughout the United States engaged in

the development of America’s transportation, environmental, industrial, and other

infrastructure. ACEC member firms represent the broad spectrum of the engineering industry, from very large firms to small, family-owned businesses. More than

60 percent of ACEC’s membership, about 4,000 firms, are small businesses with

fewer than 30 employees each. Overall, our members employ approximately 500,000

people throughout the 50 States. Founded in 1910 and headquartered in Washington, DC, ACEC is a national federation of 51 State and regional organizations.

ACEC is very appreciative of your leadership, Mr. Chairman, and that of the

Ranking Member, Senator Dodd, in focusing the Subcommittee’s attention on the Financial Accounting Standards Board (FASB) and the impact of FASB’s actions on

our members, particularly smaller engineering firms. The Statement of Financial

Accounting Standards 150 (FAS 150), which was originally released last May, has

generated considerable concern in the engineering industry. While it appears that

FASB has made modifications to the statement in response to industry comments,

we remain concerned over what the future may hold should FASB decide to proceed

with implementation.

ACEC remains strongly opposed to FAS 150 as it was originally released. If implemented, FAS 150 will artificially and unfairly eliminate the net worth of many

nonpublic engineering firms throughout the country. The statement will distort the

true economic value of these firms and present a false picture to the readers of their

financial statements, leading to errors, misunderstandings, and possibly the wrong

conclusions.

As you know, Mr. Chairman, FAS 150 requires non-public companies to classify

as liabilities any financial instrument issued in the form of equity that is

‘‘mandatorily redeemable.’’ A financial instrument is ‘‘mandatorily redeemable’’ if it

requires the company or entity to buy back the assets of a shareholder at a specific

date or time, such as the death of the shareholder, retirement, or termination.

Since many firms have such arrangements in place where shares are automatically repurchased when a shareholder retires, resigns, or dies, the new standard is

expected to affect most non-public engineering firms. Repurchasing arrangements

are typically put in place in order to keep ownership within a family or small group

of key management employees. Stock ownership in small companies is needed to

fuel the entrepreneurial spirit; where an individual’s efforts will reap future rewards based on such efforts. The obligation today is on the individual to perform;

the firm’s obligation to redeem the shares sometime in the future is affected by

events that may or may not happen. More importantly, the value of this obligation

varies based on a variety of internal and external factors, such as profitability (or

lack thereof), industry or market conditions, and even gross national product (as it

may relate to the availability of funding for Federal and State projects.). All of these

factors, I am sure you will agree, are largely volatile, yet FASB apparently believes

a specific and accurate valuation can be assigned. Worse still, any change in the

valuation is to be reflected in the income statement of the entity.

Firms must follow FASB’s standards to comply with generally accepted accounting principles and receive an unqualified audit opinion from their certified public

accountant (CPA). Unfortunately, by classifying as debt equities held by company

shareholders, the affect of the new standard would significantly reduce, or even

eliminate, the net worth of non-public engineering firms. The revisions to financial

statements as required by FAS 150 will not reflect an engineering firm’s real financial condition, yet they will have dire consequences on its ability to obtain new clients, loans, bonding and insurance.

For example, under the requirements of FAS 150, an engineering firm seeking

prequalification with a State department of transportation will present the agency

with a financial statement characterized by an artificially high debt load that could

effectively shut them out from competing for the design work on a road or bridge

project.

The accounting required by FAS 150 recognizes only the eventual re-purchase obligation. It does not recognize the increase in assets that will result from the ‘‘reVerDate 11-MAY-2000 17:44 Oct 17, 2005 Jkt 000000 PO 00000 Frm 00098 Fmt 6621 Sfmt 6621 23827.TXT SBANK4 PsN: SBANK4
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cycling’’ of such re-purchased shares for sale to other owners. When such re-cycling

is recognized, there is no need for FAS 150.

Mr. Chairman, ACEC strongly recommends that FASB take steps to ensure that

the new standard does not apply to non-public, non-SEC registered firms. We believe very strongly that more time and study is needed to carefully and completely

assess the impact this standard will have on privately held engineering firms and

others in the business community. We applaud FASB’s efforts to bring more truth

into financial reporting and believe that disclosure is important, but requiring the

recording of redeemable stock as a liability when no date for redemption is known

and where the valuation is questionable is wrong.

Today’s hearing is a necessary and important first step in the education process.

Once again, Mr. Chairman, on behalf of ACEC and the Nation’s engineering industry, we thank you and Senator Dodd for your leadership on this important issue.

We look forward to working with you in coming months. Thank you.

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