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CORPORATE ACCOUNTING PRACTICES:

IS THERE A CREDIBILITY GAAP?

HEARINGS

BEFORE THE

SUBCOMMITTEE ON

CAPITAL MARKETS, INSURANCE, AND

GOVERNMENT SPONSORED ENTERPRISES

OF THE

COMMITTEE ON

FINANCIAL SERVICES

U.S. HOUSE OF REPRESENTATIVES

ONE HUNDRED SEVENTH CONGRESS

SECOND SESSION

MAY 1, 14, 2002

Printed for the use of the Committee on Financial Services

Serial No. 107–67

(

(II)

HOUSE COMMITTEE ON FINANCIAL SERVICES

MICHAEL G. OXLEY, Ohio, Chairman

JAMES A. LEACH, Iowa

MARGE ROUKEMA, New Jersey, Vice Chair

DOUG BEREUTER, Nebraska

RICHARD H. BAKER, Louisiana

SPENCER BACHUS, Alabama

MICHAEL N. CASTLE, Delaware

PETER T. KING, New York

EDWARD R. ROYCE, California

FRANK D. LUCAS, Oklahoma

ROBERT W. NEY, Ohio

BOB BARR, Georgia

SUE W. KELLY, New York

RON PAUL, Texas

PAUL E. GILLMOR, Ohio

CHRISTOPHER COX, California

DAVE WELDON, Florida

JIM RYUN, Kansas

BOB RILEY, Alabama

STEVEN C. LATOURETTE, Ohio

DONALD A. MANZULLO, Illinois

WALTER B. JONES, North Carolina

DOUG OSE, California

JUDY BIGGERT, Illinois

MARK GREEN, Wisconsin

PATRICK J. TOOMEY, Pennsylvania

CHRISTOPHER SHAYS, Connecticut

JOHN B. SHADEGG, Arizona

VITO FOSELLA, New York

GARY G. MILLER, California

ERIC CANTOR, Virginia

FELIX J. GRUCCI, JR., New York

MELISSA A. HART, Pennsylvania

SHELLEY MOORE CAPITO, West Virginia

MIKE FERGUSON, New Jersey

MIKE ROGERS, Michigan

PATRICK J. TIBERI, Ohio

JOHN J. LAFALCE, New York

BARNEY FRANK, Massachusetts

PAUL E. KANJORSKI, Pennsylvania

MAXINE WATERS, California

CAROLYN B. MALONEY, New York

LUIS V. GUTIERREZ, Illinois

NYDIA M. VELA ́ ZQUEZ, New York

MELVIN L. WATT, North Carolina

GARY L. ACKERMAN, New York

KEN BENTSEN, Texas

JAMES H. MALONEY, Connecticut

DARLENE HOOLEY, Oregon

JULIA CARSON, Indiana

BRAD SHERMAN, California

MAX SANDLIN, Texas

GREGORY W. MEEKS, New York

BARBARA LEE, California

FRANK MASCARA, Pennsylvania

JAY INSLEE, Washington

JANICE D. SCHAKOWSKY, Illinois

DENNIS MOORE, Kansas

CHARLES A. GONZALEZ, Texas

STEPHANIE TUBBS JONES, Ohio

MICHAEL E. CAPUANO, Massachusetts

HAROLD E. FORD, JR., Tennessee

RUBE ́ N HINOJOSA, Texas

KEN LUCAS, Kentucky

RONNIE SHOWS, Mississippi

JOSEPH CROWLEY, New York

WILLIAM LACY CLAY, Missiouri

STEVE ISRAEL, New York

MIKE ROSS, Arizona

BERNARD SANDERS, Vermont

Terry Haines, Chief Counsel and Staff Director

(III)

SUBCOMMITTEE ON CAPITAL MARKETS, INSURANCE, AND

GOVERNMENT SPONSORED ENTERPRISES

RICHARD H. BAKER, Louisiana, Chairman

ROBERT W. NEY, Ohio, Vice Chairman

CHRISTOPHER SHAYS, Connecticut

CHRISTOPHER COX, California

PAUL E. GILLMOR, Ohio

RON PAUL, Texas

SPENCER BACHUS, Alabama

MICHAEL N. CASTLE, Delaware

EDWARD R. ROYCE, California

FRANK D. LUCAS, Oklahoma

BOB BARR, Georgia

WALTER B. JONES, North Carolina

STEVEN C. LATOURETTE, Ohio

JOHN B. SHADEGG, Arizona

DAVE WELDON, Florida

JIM RYUN, Kansas

BOB RILEY, Alabama

VITO FOSSELLA, New York

JUDY BIGGERT, Illinois

GARY G. MILLER, California

DOUG OSE, California

PATRICK J. TOOMEY, Pennsylvania

MIKE FERGUSON, New Jersey

MELISSA A. HART, Pennsylvania

MIKE ROGERS, Michigan

PAUL E. KANJORSKI, Pennsylvania

GARY L. ACKERMAN, New York

NYDIA M. VELA ́ ZQUEZ, New York

KEN BENTSEN, Texas

MAX SANDLIN, Texas

JAMES H. MALONEY, Connecticut

DARLENE HOOLEY, Oregon

FRANK MASCARA, Pennsylvania

STEPHANIE TUBBS JONES, Ohio

MICHAEL E. CAPUANO, Massachusetts

BRAD SHERMAN, California

GREGORY W. MEEKS, New York

JAY INSLEE, Washington

DENNIS MOORE, Kansas

CHARLES A. GONZALEZ, Texas

HAROLD E. FORD, JR., Tennessee

RUBE ́ N HINOJOSA, Texas

KEN LUCAS, Kentucky

RONNIE SHOWS, Mississippi

JOSEPH CROWLEY, New York

STEVE ISRAEL, New York

MIKE ROSS, Arizona

(V)

C O N T E N T S

Page

Hearings held on:

May 1, 2002 ....................................................................................................... 1

May 14, 2002 ..................................................................................................... 47

Appendixes:

May 1, 2002 ....................................................................................................... 91

May 14, 2002 ..................................................................................................... 145

WITNESSES

MAY 1, 2002

Boehm, Kenneth F., Chairman, National Legal and Policy Center .................... 16

Hill, Charles L., CFA, Director of Research, Thomson Financial/First Call ...... 13

Holder, William W., Ernst & Young, LLP Professor of Accounting, Director,

SEC and Financial Reporting Institutes, University of Southern California . 9

Montgomery, Hon. Betty D., Attorney General, State of Ohio ............................ 7

APPENDIX

Prepared statements:

Oxley, Hon. Michael G. .................................................................................... 92

Gillmor, Hon. Paul E. ....................................................................................... 94

Kanjorski, Hon. Paul E. ................................................................................... 96

Jones, Hon. Stephanie T. ................................................................................. 98

Boehm, Kenneth F. (with attachment) ........................................................... 123

Hill, Charles L. ................................................................................................. 119

Holder, William W. ........................................................................................... 109

Montgomery, Hon. Betty D. ............................................................................. 100

WITNESSES

MAY 14, 2002

Herdman, Robert K., Chief Accountant, U.S. Securities and Exchange Commission .................................................................................................................. 51

Jenkins, Edmund L., Chairman, Financial Accounting Standards Board .......... 53

Litan, Robert D., Co-director, AEI-Brookings Joint Center for Regulatory

Studies .................................................................................................................. 74

Masterson, Ellen, Partner, PricewaterhouseCoopers, Partner-in-Charge of

Global Audit Methodology and Global Leader, ValueReporting ...................... 76

Verrecchia, Robert E., Putzel Profesor of Accounting, The Wharton School,

University of Pennsylvania ................................................................................. 77

Wallman, Steven M.H., Chairman, Founder and CEO, Foliofn, Inc., Commissioner, Securities and Exchange Commission ................................................... 79

APPENDIX

Prepared statements:

Oxley, Hon. Michael G. .................................................................................... 146

Kanjorski, Hon. Paul E. ................................................................................... 148

Jones, Hon. Stephanie T. ................................................................................. 150

Herdman, Robert K. ......................................................................................... 152

Jenkins, Edmund L. (with attachments) ........................................................ 164

Litan, Robert D. ................................................................................................ 248

Masterson, Ellen ............................................................................................... 259

Page

VI

Prepared statements—Continued

Verrecchia, Robert E. ....................................................................................... 285

Wallman, Steven M.H. ..................................................................................... 289

ADDITIONAL MATERIAL SUBMITTED FOR THE RECORD

Herdman, Robert K.:

Written response to a question from Hon. Brad Sherman ............................ 293

(1)

CORPORATE ACCOUNTING PRACTICES:

IS THERE A CREDIBILITY GAAP?

WEDNESDAY, MAY 1, 2002

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

GOVERNMENT SPONSORED ENTERPRISES, COMMITTEE ON FINANCIAL SERVICES, Washington, DC.

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

2128, Rayburn House Office Building, Hon. Richard H. Baker,

[chairman of the subcommittee], presiding.

Present: Chairman Baker; Representatives Gillmor, Castle,

Oxley, Lucas of Oklahoma, Miller, Kanjorski, Bentsen, Sandlin,

Hooley, S. Jones of Ohio, Sherman, Moore, Maloney of CT, Meeks,

Inslee, and Lucas of Kentucky.

Chairman BAKER. I would like to call this hearing of the Capital

Markets Subcommittee to order. The hearing today is called for the

purpose of examination of the adequacy of our current financial reporting system in light of the speed with which market transactions occur.

Although much attention has been given to the failure and use

of sophisticated accounting instruments, there, quite frankly, is a

much larger question, I think, that the subcommittee will turn its

attention to; that is, the adequacy of the current regulatory system

to appropriately and timely assess the accuracy of financial reporting statements.

There is, it appears at least, extraordinary pressure on management to meet quarterly earnings expectations, and if by utilizing

available methodologies they can meet or exceed street expectations for quarterly reports, that, in fact, enhances shareholder

value. Unfortunately, when those expectations are not met, the perverse result of these accounting mechanisms is to leverage the

amount of loss for shareholders as a result of management’s use of

these instruments.

It does not follow, however, that the utilization of those instruments is inherently in itself a bad thing. There are those who have

used similar instruments for legitimate business purposes and, in

fact, have profited from their use, resulting in enhanced corporate

value for shareholders.

Going back just for a short period of time, immediately after the

Orange County bankruptcy proceeding, there was much skepticism

in the market concerning inappropriate use of derivatives, causing

many in the Congress to express support for an outright ban of

their use. I think further discussion by those appropriately utiVerDate 11-MAY-2000 10:21 Sep 09, 2002 Jkt 000000 PO 00000 Frm 00007 Fmt 6633 Sfmt 6633 C:\DOCS\79559.TXT HBANK1 PsN: HBANK1
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lizing those risk-hedging devices found there to be value added,

and a responsible use benefited all parties concerned. That is why

I believe that the use of special purpose entities and indefeasible

rights of use or whatever else may be devised in the near term in

themselves do not lead one to conclude there is inappropriate conduct, but without appropriate explanation by those responsible

market participants, it makes the subcommittee’s work very difficult.

Unfortunately, there were many asked who were unable to appear today that perhaps could have shed more light on the appropriate utilization of those instruments for the subcommittee’s analysis. And I would hope that in future hearings we have the opportunity to better understand market function in relation to these sophisticated accounting tools.

However, the Financial Accounting Standards Board, which is

the primary location for initial approval of the utilization of these

instruments, unfortunately has been unable to act very swiftly or

act at all in light of the apparent identifiable instances in which

these instruments have not been appropriately utilized.

The elimination of fuzzy accounting is our principal goal. We

should have an ability for a shareholder, a consumer, to pick up a

piece of paper and get an accurate understanding of the true financial condition prior to making an investment. We start there, and

it should go all of the way up from the pension manager to the institutional investor. All should be treated similarly. Ultimately the

performance of a sound capital markets economy must be based on

the free flow of information to all parties concerned in the same

timeframe, without prejudice or manipulation.

Today, I hope to hear from those who have chosen to participate

in our hearing today, for which I am grateful, how the Congress

may appropriately respond or work with others to instill confidence

in the marketplace, enable consumers to make informed investment decisions, and assist in the free flow of capital that ultimately

creates jobs and opportunity in this country. The current question,

the current skepticism serves no one well, and we must figure out

the best and most appropriate manner in which to respond to the

problems we face.

Mr. Kanjorski.

Mr. KANJORSKI. Mr. Chairman, we meet today to learn more

about the problems in corporate accounting practices. Although this

matter has attracted considerable media attention in recent

months, I have held serious reservations about the reliability of

certain corporate accounting practices for some time. These problems could also have potentially serious and negative consequences

on our country’s flourishing capital markets. After all, if investors

cannot trust the reliability of the numbers produced by corporate

accountants in audited statements, then they might as well spend

their hard-earned money on lottery tickets.

Because of my concerns, Mr. Chairman, I wrote to you last June,

well before the collapse of Enron, about the techniques used by

some corporations in order to meet their quarterly earnings estimates. In that letter I urged you to convene hearings on the many

accounting irregularities that contribute to the problem of earnings

management. Included among those practices are the accounting

3

treatment of derivatives, swaps, special purpose entities, goodwill

and stock options.

In my view, we should have convened this hearing before considering the Corporate and Auditing Accountability, Responsibility,

and Transparency Act on the floor of the House last week.

Such a hearing would have helped us to develop a more comprehensive piece of legislation. Nevertheless, Mr. Chairman, I am

pleased that you have called this hearing today. I believe that we

must continue our efforts to guarantee that we maintain the vibrancy of our country’s capital markets in the long term. Our work

today will begin that process.

Our capital markets are the most successful in the world for one

simple reason: investor confidence. The transparency fostered by

the application of the United States Generally Accepted Accounting

Principles, or GAAP, has played an important role in this achievement. Unfortunately, the failure to implement GAAP consistently

has now led to an almost daily discovery of accounting irregularities at American corporations. This evolving situation has also

sparked a crisis of confidence that continues to ripple through our

capital markets.

We have, however, known about these problems for some time.

For example, research published in 2001 by Financial Executives

International identified some startling facts. The study found 464

cases of earnings restatements in corporate America over a 3-year

period, more than the previous 7 years combined. It also determined that 156 earnings restatements in 2000 wiped out more

than $31 billion in market capitalization. I suspect that when we

tabulate these figures for 2001, these two already sizable statistics

will grow considerably.

In recent months the Securities and Exchange Commission has

also broadened the scope of its inquiry beyond the accounting

issues raised by the collapse of Enron to include a laundry list of

other potential accounting abuses at some of the country’s largest

companies. In fact, during the first quarter of 2002, the Commission opened 64 new financial reporting investigations, an increase

of more than 100 percent over the cases begun during the same

timeframe in 2001.

What factors contributed to this troubling state of affairs? In recent decades the rules governing corporate accounting have become

increasingly complex. Since the early 1990s, for example, the Financial Accounting Standards Board has developed several fairvalue measurement, recognition and disclosure standards. These

standards often permit multiple interpretations. Accounting has

also evolved from determining the cost of producing and the revenue from selling a good like a screwdriver to ascertaining the cost

and revenue from selling an intangible service like a 25-year energy derivative. These and other developments have helped to

make corporate financial statements increasingly impenetrable and

confusing.

From my perspective, an effective accounting system must ensure the comparability of financial data from one company to another. Comparability in the data used by investors will allow them

to evaluate apples against apples, and oranges against oranges. ImVerDate 11-MAY-2000 10:21 Sep 09, 2002 Jkt 000000 PO 00000 Frm 00009 Fmt 6633 Sfmt 6633 C:\DOCS\79559.TXT HBANK1 PsN: HBANK1
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provements in accounting transparency will also facilitate the efficient flow of capital.

Since we assumed jurisdiction over securities issues last year, investor protection and financial literacy have become top priorities

for my work on this panel. Investors deserve to have timely financial reports that they can read and understand instead of annually

receiving a Byzantine, incomprehensible document dotted with

countless footnotes.

The collapse of the internet bubble and the downfall of Enron

have only heightened the skepticism of American investors about

accounting practices generally. After our hearings today, we need

to work to change those attitudes by ensuring that our public companies return to the basics of accounting and avoid financial gimmicks and gymnastics in their future filings.

In closing, Mr. Chairman, I believe our committee should comprehensively explore the issues related to corporate accounting

practices. This hearing should also help us to alert investors about

some of the key accounting issues that could affect their portfolios,

and assure them that they are being examined by the Congress.

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

page 96 in the appendix.]

Chairman BAKER. Thank you.

Chairman Oxley.

Mr. OXLEY. Thank you, Mr. Chairman. And I want to commend

you for this hearing.

As we all know, last week the House overwhelmingly passed

H.R. 3763, The Corporate and Auditing Responsibility, Transparency, and Accountability Act of 2002, or CARTA. Chief among

the provisions passed by a strong bipartisan vote were mandates

for increased financial disclosures by publicly traded companies.

We also set forth a new regime for tough oversight of the accounting profession by the creation of a new board under the SEC, which

is the only legally recognized authority over this important function

of our economy. We look forward to the Senate’s swift and bipartisan passage of CARTA.

However, our responsibilities for protecting American households, public pension funds and private investment accounts cannot

end with CARTA. We must continue to review the generally accepted accounting principles and discretionary accounting practices

that American companies use every day to report on their operations.

During the initial phase of our CARTA hearings, and by the way,

we had 7 hearings with 33 witnesses, the Committee publicly discussed the complex principles involved in accounting for financing

tools, such as special purpose entities. We disclosed that those principles had not been clearly stated by the FASB and the SEC, and

that Enron clearly and continually abused these principles.

We also discussed the principles involved in accounting for sales

and swaps of fiber-optic cable capacity among telecom companies

such as Global Crossing, QWEST and WorldCom. After a change

in the principles in 1999, companies increasingly turned to

unaudited pro forma statements to better explain the cash flow in

their business. There is no guidance on the consistent preparation

of those statements, however, which leaves investors and even seaVerDate 11-MAY-2000 10:21 Sep 09, 2002 Jkt 000000 PO 00000 Frm 00010 Fmt 6633 Sfmt 6633 C:\DOCS\79559.TXT HBANK1 PsN: HBANK1
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soned professionals unsure of a company’s or industry’s results or

direction.

Clearly there are plenty of other events that we should have also

reviewed. Accounting principles and corporate practices for reporting revenue from the sale of a business, changes to accounts receivable, company loans to corporate insiders, special accounting mechanisms designed to minimize taxes, and pension fund transactions

have all been raised in the financial press and have been the subject of SEC reviews.

There have been too many restatements of financial statements,

too many SEC investigations, and too many pension plan losses for

us not to dig further into this area.

Our witnesses today will give us their perspectives on the problems in accounting principles and practices and the impacts on different sectors of American life.

I am especially pleased that Betty Montgomery, the distinguished Attorney General of Ohio, has taken the time from her extremely busy schedule to come to Washington today in order to discuss how she is trying to recover losses suffered by public employees. Attorney General Montgomery, who, by the way, is the first

woman Attorney General in the State of Ohio, is now serving her

second term. She and other expert witnesses will, I am sure, advise

us of ways by which we can help investors and employees by encouraging more information and updated financial information by

publicly traded companies. As I said at our Global Crossing hearing

on March 21, it is only by reviewing those practices that we can

help investors to base their decisions upon a company’s real financial condition.

Mr. Chairman, I am going to be having to leave for the floor relatively soon for the Export-Import Bank debate, but we appreciate

your hard work in this area and look forward to a continued dialogue with you. And I yield back.

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

page 92 in the appendix.]

Chairman BAKER. Thank you, Mr. Chairman. Of course, I am appreciative of your participation here today. I know of the legislative

schedule on the floor today, and more importantly your keen interest in having the committee take appropriate action with regard to

all of those matters. We are always appreciative of your willingness

to be such a leader in these issues.

Mr. Bentsen.

Mr. BENTSEN. Thank you, Mr. Chairman. And thank you for calling this hearing. I think that it is appropriate that the committee

continue its hearings on these issues even after the passage of the

CARTA bill, which, as I said at the time during the debate, was

a good first step. But we may find there are other things that we

have to do, so I am eager to hear from our panel.

I might also add in a speech that Fed Chairman Alan Greenspan

gave recently, which caused a lot of focus for other reasons, he commented that our economy is changed to where we value companies

not so much because of physical assets, but because of conceptual

assets. And I think because of that it has changed a lot of the

ground rules of accounting to things that we don’t know in the

Congress, where a lot of judgment calls are having to be made in

6

the profession. And so as such, I think it is appropriate that both

the Congress as well as the industry itself and the ancillary industries, the research analysts and others, continue to review exactly

how you are able to provide a proper assessment of value to investors, to analysts and others.

And so I appreciate the fact that you called this hearing. I hope

that it is one of many more that we will have.

Chairman BAKER. Thank you, Mr. Bentsen.

Mrs. Jones.

Mrs. JONES. Thank you, Mr. Chairman, Chairman Oxley, other

Members of the subcommittee. I am pleased to have an opportunity

to give a brief opening statement. I would ask that my written

opening statement be made part of the record, Mr. Chairman.

Chairman BAKER. Without objection.

Mrs. JONES. First of all, I would like to welcome Ohio attorney

general Betty Montgomery to Washington as well. We were prosecutors together in our prior lives, and so I am glad to see you. And

also I am a PERS retiree, so I am also interested in you holding

onto my dollars. That is personal.

But it is very important that we continue those hearings. I was

one of those Members who voted against the legislation we passed

last week, and the reason I voted against the legislation was because we refused to hold the CEOs accountable for the representations of the financial viability of their companies. I think in order

for us to get by the situations that we find ourselves in in these

current times, we should hold them individually accountable for

their representations of financial viability.

As we go through this process this morning, I will be interested

in hearing from each one of the witnesses who will be testifying.

I thank you very much for taking time out of your schedule for

coming this morning. And I yield the balance of my time.

[The prepared statement of Hon. Stephanie Jones can be found

on page 98 in the appendix.]

Chairman BAKER. Thank you.

Mr. Gillmor, did you have an opening statement?

Mr. GILLMOR. Thank you, Mr. Chairman. Very briefly. I am sorry

that I was delayed. I have another Subcommittee on Oversight and

Investigations going on.

I just wanted to welcome Betty Montgomery, our attorney general. When I was elected to Congress and left the State senate,

Betty took my place as a State senator. She didn’t stay there long.

She became the attorney general. She has been doing a great job.

A lot of people would like to see her stay in that position, but we

have term limits in Ohio, so she is going to be our auditor next

year.

I just want to welcome you to Washington, Betty.

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

on page 94 in the appendix.]

Chairman BAKER. Thank you very much, Mr. Gillmor.

Chairman BAKER. Mr. Lucas. No.

Mr. Miller.

Mr. MILLER. Thank you, Chairman Baker. I really appreciate you

holding this hearing today on accounting practices. I would like to

7

thank you for your leadership on H.R. 3763. It was commendable.

And I just look forward to the testimony today. Thank you.

Chairman BAKER. You could have taken a bit longer. You were

on a roll there.

Is there any further opening statement? If not, I wish to comment on most Members’ observations that we have a continuing obligation. The passage of CARTA is a significant first step, but we

recognize as a committee that market conditions are continually

changing, and our responsibility can no longer be a one-press-conference obligation. It has got to be an ongoing oversight and attempt to understand what is happening in the marketplace.

To that end we very much appreciate each of you participating

here today and giving us your perspectives. As is the custom, your

written statements will be made part of the official record. To the

extent possible, if you can constrain your remarks to the 5-minute

opening period, it helps us in having a better interchange with

Members in the follow-up question period.

I would first like to welcome, as others have, the Honorable

Betty Montgomery, Attorney General for the State of Ohio. We are

indeed pleased that you would give up of your time to be here

today. Welcome.

STATEMENT OF HON. BETTY D. MONTGOMERY, ATTORNEY

GENERAL, STATE OF OHIO

Ms. MONTGOMERY. Thank you, Mr. Chairman.

I want to thank you so much for allowing me to testify today and

inviting me to be here today, as well as thank Congressman Kanjorski and all of the other Members.

As you have noted, Mr. Chairman, this committee has a number

of Ohio legislators, so I forgive you for being provincial with each

other, but you have a great committee.

I was interested particularly in coming to talk to you today because of the enormous impact Enron and Global Crossing, just

those two cases alone, have had on our pension systems in Ohio.

And I have to applaud the House for passing Congressman Oxley’s

legislation in reining in the fraudulent accounting practices which

have cost billions of dollars to investors, millions of dollar to Ohio

pensioners.

My goal today is twofold: to help you draw further public scrutiny on the practices and concerns that have brought us here today,

as well as to help you continue the congressional pressure that you

are discussing here today also. The more public scrutiny that we

place on the scenarios that led to the debacles such as Enron and

Global Crossing, the less likely other companies will be to issue

blatantly false and misleading financial statements.

The impact of Ohio in the ‘‘for what it is worth’’ department,

which we think is very important, is significant. Two of Ohio’s public employee pension funds have lost millions of dollars as they

were investors in both Enron and Global Crossing. We lost more

than $116 million in Global Crossing. We have lost an additional

$114 million in the Enron debacle.

The reason for—we are, at this point, engaged in seeking to be

lead counsel on the Global Crossing litigation as a class action lawsuit, because at this point even—we are unfortunately the largVerDate 11-MAY-2000 10:21 Sep 09, 2002 Jkt 000000 PO 00000 Frm 00013 Fmt 6633 Sfmt 6633 C:\DOCS\79559.TXT HBANK1 PsN: HBANK1
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est—I think we have lost the most among those who have any

losses in the Global Crossing battle here.

Ohio’s pension funds, I want to remind everyone, however, are

strong. We are some of the largest pension funds in the world, and

so this tends to be—although it is an enormous number, still I

think it is certainly, I believe, only less than 1 percent of the value

of those funds.

But nevertheless, one of the things as we sat down with our pension funds and pressed to forward litigation on this is that it was

so critical for us as public entities and certainly critical because of

the fraudulent practices involved that we stand up and draw focus

and spotlight on the problem. It is incumbent upon us as public

servants, just as your obligations are, to work diligently to ensure

that these kind of fraudulent disasters don’t happen again.

Since before Global Crossing went public, Arthur Andersen was

its accounting firm, and Andersen not only provided auditing for

Global, but provided consulting work for them, as you know. For

the year 2000, the most telling statistic that we have is that Global

allegedly paid Andersen $2.26 million for auditing, yet paid a staggering $12 million for consulting. Herein lies the beginning of the

problem.

Andersen lead auditor for Global Crossing was Joseph Perrone.

Perrone co-wrote a memo outlining the aggressing plan for Global’s

executives. He talked about aggressive accounting treatments

called swap agreements—I know you have alluded to this, and you

heard the testimony already—allowing Global to circumvent certain rules regarding swaps. A swap is an exchange of network capacity between telecommunication companies, as you know.

Perrone’s idea: Use swaps to enable Global to record huge gains on

exchanges of capacity, and the exchange of capacity on the books,

even though the swaps had no cash value. Yet it allowed plumping

up of the financial statement to make it look a much wealthier

company than it was.

Global adopted Perrone’s proposal and, frankly, adopted him,

handsomely rewarding him with a position as executive vice president of finance. We know, we believe, we will show in the litigation, that Global entered into swaps that had no legitimate business purpose except to enhance the financial statements, and that

is a very troubling problem that you need to address.

Roy Olofson, the formal Global executive vice president for finance and the whistleblower, said Global routinely entered into

swaps, exchanged network capacity for identical or unnecessary

routes, without exchanging any cash. The sole purpose was to generate paper revenue, increase cash flow, show higher earnings.

We have begun as part of the litigation interviewing employees

of Global Crossing. Part of the ongoing investigation confirmed that

Global entered into the swaps with the knowledge that the transactions and the improper revenue accounting go to the highest levels of Global Crossing. Specific examples are included in my submitted testimony which you have before you.

There are obscure and misleading disclosures, and in no way did

the financial statements disclose the real truth about the swaps.

Frankly, Global Crossing lied to the expense of pensioners, invesVerDate 11-MAY-2000 10:21 Sep 09, 2002 Jkt 000000 PO 00000 Frm 00014 Fmt 6633 Sfmt 6633 C:\DOCS\79559.TXT HBANK1 PsN: HBANK1
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tors and individual John Qs that you and I represent on a daily

basis.

The whistleblower we are lucky to have, Roy Olofson, was

Global’s former executive vice president of finance. He sent letters

and memos to ethics officers, requested an investigation of the accounting methods. He wanted to review the priority of the swaps.

And yet nothing happened with Global Crossing.

Finally, the house of cards began to fall. Cash revenue statement for the third quarter of 2000 was $400 million less than analysts

had predicted. And in January of 2002, Global filed their voluntary

bankruptcy. So within 2 months we have, between Enron and Global Crossing, two of the largest bankruptcies this country has ever

seen, both involving allegations regarding the accounting and the

false accounting, inappropriate counseling.

You know, when Global first entered the publicly traded market, they were worth $64 per share. Now it is down to literally nothing,

and that is based on fraud, deceit, untruthful accounting and the

like. I conclude by saying to you, we believe it is clear that Global

used false accounting methods to undertake schemes to circumvent

existing rules and to essentially defraud investors.

We thank you for the ability to speak to you today. Unfortunately, Enron was not an isolated incident. Investors, both public

and private, deserve accurate, honest information so they can make

sound investment decisions. Even expert investors, such as those

working for public pensions funds, cannot make good choices when

the financial information provided is less than truthful. If the market can’t trust financial information validated by supposedly independent corporate auditing firms, our free market system of trade

is in great danger.

Thank you so much, Mr. Chairman, for allowing me to speak

today.

[The prepared statement of Hon. Betty D. Montgomery can be

found on page 100 in the appendix.]

Chairman BAKER. Thank you very much, Attorney General. We

appreciate your presence today.

Our next witness is Professor William Holder, Professor of Accounting, University of Southern California. Welcome, Professor.

STATEMENT OF WILLIAM W. HOLDER, ERNST & YOUNG LLP

PROFESSOR OF ACCOUNTING; DIRECTOR, SEC AND FINANCIAL REPORTING INSTITUTE, UNIVERSITY OF SOUTHERN

CALIFORNIA

Mr. HOLDER. Thank you, sir. Thank you, Chairman Baker. I am

pleased to appear before you today to testify about corporate accounting practices that are of significance to our capital markets.

The topic is of obvious great importance, and your attention to it

is essential.

As the subcommittee has requested, my testimony will be based

on publicly available information and will address two matters:

One, the use of questionable accounting practices and the degree

of management discretion that is involved in reporting results of

operations that have led to financial statement restatements; and

second, the circumstances surrounding reports of accounting problems at the following companies: Xerox, Adelphia, Dynegy, AOL

10

and WorldCom, and whether these problems at these companies

are further reflected in other publicly traded companies.

Our system of financial reporting which supports the functioning

of our capital markets has developed over a relatively long period

of time, and like other complex systems, financial reporting has

been developed with certain expectations, capabilities, limitations

and conditions in mind.

That system has served us exceptionally well for many years, but

like many such systems, what has been historically exceptional

may require substantial improvement to continue to fulfill its responsibilities. The financial reporting problems of several companies that you have identified provide examples of many of the

changes and the related challenges for the financial reporting system.

With respect to AOL Time Warner, I understand that this com- pany wrote down assets approximating $54 billion in recent days.

This loss generally resulted from acquisitions of companies that did

not prove to be as successful as was anticipated. The need to write

down these assets was generally brought about through a new accounting standard, or relatively new accounting standards, recently

published by the Financial Accounting Standards Board. I also understand the company has acknowledged that a special purpose entity with which it is related has approximately $2 billion of debt

not reflected on its own balance sheet. These circumstances illustrate the effect that new accounting standards can have on financial statements, the subjective nature of many accounting determinations, and how the manner in which a company’s management

decides to structure and operate a company can affect the financial

reporting of its transactions and business activities.

With respect to Dynegy, I understand the company entered info

certain derivative contracts that were accounted for in accordance

with FASB Statement 133. That standard requires such contracts

to be valued at their fair values for financial reporting purposes.

As has been pointed out earlier in the session, estimating the value

of such contracts frequently involves the use of relatively sophisticated modeling techniques and the use of a number of specific, but

necessarily subjective assumptions. Because of the inherent uncertainties involved in developing these assumptions, estimates of the

fair value of such instruments requires complex and subjective

judgments, and the resulting amounts may vary substantially.

Increasing estimated fair values of contracts boosted the company’s income; however, they did not directly nor simultaneously

contribute to the company’s operating cash flows. According to published accounts, the company developed a device referred to as

Project Alpha, involving a borrowing plan which provided income

tax benefits, but that also allowed the company to report additional

cash flows from operating activities. This circumstance illustrates

both inherent uncertainties involved in financial reporting, again,

as well as, again, management’s ability to design transactions and

programs that may accomplish other management objectives, but

that also accomplish financial reporting goals as well.

With respect to WorldCom, I understand that certain accounting

and financial reporting practices of WorldCom have been characterized as aggressive. Specific aspects of these practices have been

11

characterized as pushing the envelope by capitalizing certain costs

of assets that may have been more appropriately reported as expenses.

The SEC, according to published accounts as recently as this

morning’s Wall Street Journal, is involved in investigating revenue

recognition issues at WorldCom with respect to customers who had

already dropped services or otherwise couldn’t—the company would

be unable to collect the amounts. I also understand that there are

disputed sales commissions issues resulting in the possible overbooking of sales.

Practices of such as those characterized in the press are illustrative of the inherent subjectivity of many accounting decisions

and the related necessary professional judgments. They also indicate that the accounting model, because of those subjective aspects,

is subject to potential abuse. These same articles also indicated the

belief that WorldCom is expected to write down goodwill in much

the same manner as I described for AOL Time Warner.

Adelphia Communications. I understand that an important issue

for this company is the appropriate treatment of certain borrowings

by its owners. According to press reports, the Rigas family interest

in Adelphia is reported to approximate a 23 percent economic

stake, majority voting control, five board seats on the nine-member

board, and five top executive positions. I understand that the loans

to the Rigas are guaranteed by Adelphia. A portion of the proceeds

of that debt was used to acquire Adelphia stock, again according

to press reports.

An important financial reporting question relates to whether the

debt of the owners, which is guaranteed by Adelphia, should be reported as the debt of the company. This circumstance also illustrates some of the judgments that are necessary about such fundamental issues as whether and to what extent a company may have

incurred a liability that should be reported on its balance sheets.

Finally, with respect to Xerox Corporation, I understand that the

financial reporting problems here involved accounting for agreements that called for Xerox to lease equipment and to provide related goods and services to their customers. I understand that inappropriate allocations of the overall contractual consideration for

these various goods and services were made to the equipment lease

portions of these contracts. In such a fashion, gross profit on the

lease portion was inappropriately recognized at the beginning of

the lease agreements.

Professional standards provide much valuable guidance on lease

accounting, and they have been in existence since—well, for over

25 years, but, again, the need for professional judgment remains.

I further understand that Xerox changed certain aspects of its

employee benefit programs and systematically and improperly recognized the effects of that change over a number of periods, rather

than recognizing the effects immediately in earnings.

These examples you have asked me to address, and that I have

described very briefly, illustrate that financial reporting requires

many subjective judgments and seasoned judgments. Those that

are generally unfamiliar with the detailed aspects of preparing financial statements are sometimes surprised at the inherent ambiguity and subjectivity of that process. Although financial stateVerDate 11-MAY-2000 10:21 Sep 09, 2002 Jkt 000000 PO 00000 Frm 00017 Fmt 6633 Sfmt 6633 C:\DOCS\79559.TXT HBANK1 PsN: HBANK1
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ments contain and convey the appearance of great precision, many

significant amounts contained therein are inherently imprecise.

The inherent subjectivity provides opportunities for management to

bias and for bias to intrude on the financial reporting process.

Accounting estimates, management’s ability to structure transactions to achieve financial reporting objectives, increasingly complex business transactions and events, and accounting judgments

that must sometimes be made in the absence of professional standards which often naturally lag behind the development of business

transactions and events that they are designed to address each are

important aspects of financial reporting and complicate the accountant’s work.

Differing but good-faith interpretations of existing accounting

standards can and do result from this process. If management perceives accounting numbers to be important, than it is reasonable

to expect them to exercise the inherent discretion provided by financial reporting to manage those numbers.

Management discretion can be abused, and financial reports can

be misstated. As pressure increases on management to achieve

earnings and other financial goals, the motivation to bias information presented in financial statements increases. Many of the elements of our financial reporting system that are currently in place

are designed, in my view, to limit such discretion. Financial reporting standards, the auditing function, the regulatory function, and

the system of corporate governance that we put in place should

each contribute to attaining this goal. Those aspects of financial reporting do not lend themselves, in my view, to easy solution.

It is not sufficient, in my view, to adopt some simplistic approach, such as an unbending obedience to conservatism, and

charge all expenditures about which there is any doubt of realization to expense immediately. Systemic conservatism itself introduces bias into the securities market, and generally unbiased information is considered to be of greater value.

Financial statements are the responsibility of the company. The

auditor also has substantial responsibilities for those statements,

and those responsibilities today, in my view, require that the auditor consider the substance of the transaction in evaluating whether

financial statements may be materially misstated. The inherent

subjectivity of many decisions, however, precludes a singular interpretation of the substance of many transactions. The auditor cannot insist, on pain of a qualified or adverse opinion, that the client

use accounting principles that the auditor considers preferable

today as long as those used by the client are generally acceptable

in the circumstances and appropriately meet other criteria. This

has led on occasion to the alleged use of least common denominator

accounting principles. The importance of and need for objectivity by

all of those that are involved in the financial reporting process, I

think, are self-evident as a result of this discussion.

In terms of accounting standards setting and regulation, both the

FASB and the SEC have worked diligently and for the most part

successfully to address significant financial reporting issues. The

Financial Accounting Foundation, the organization that oversees

the FASB, has recently taken a number of actions to change the

structure and process of standard setting. Additional steps may be

13

necessary. My written submission contains some suggested approaches to address those aspects of financial reporting.

Those who are responsible for interpreting and applying financial

reporting and accounting standards must be objective and independent in their work, as I have said, but they also must not perceive themselves as the adversary of those charged with setting the

standards and enforcing those standards.

Finally, the accounting profession, in my view, should be structured so that it continues to be an attractive career opportunity for

individuals with great intellectual capacity, lofty ambition, and

high ethical standards. To do less relegates this essential profession to diminished capacity, to the detriment of us all.

Thank you for your attention. I will be pleased to answer any

questions that you may have.

[The prepared statement of Prof. William W. Holder can be found

on page 109 in the appendix.]

Chairman BAKER. Thank you.

Our next witness, Mr. Charles Hill, is not a newcomer, Director

of Research, Thomson Financial/First Call. Welcome, Mr. Hill.

STATEMENT OF CHARLES L. HILL, CFA, DIRECTOR OF

RESEARCH, THOMSON FINANCIAL/FIRST CALL

Mr. HILL. Good morning, Chairman Baker, Ranking Member

Kanjorski, and Members of the House Subcommittee on Capital

Markets, Insurance and Government-Sponsored Enterprises.

Thank you for again giving me the opportunity to testify in front

of this subcommittee. I am particularly glad to do so because I believe this subcommittee on both sides of the aisle and its staff have

taken the time to do their homework and understand the problems.

This subcommittee’s early involvement got the ball rolling, thereby either stimulating others to get involved or in some cases forcing their hand to get involved. I also believe this subcommittee is

truly trying to reach a solution that is for the good of all concerned.

Therefore, I am glad to try to help in any way that I can.

The outcome is important not only to restoring investor confidence in the system, but it is important to maintaining the general public’s confidence in the capitalist system. My goal today is

to examine why the system got to the sorry state and what needs

to be done to right the ship.

But why were the abuses greater this time? Three reasons stand

out: One, huge management compensation incentives; two, bigger

and longer bubble during the last economic expansion; three, increasing dependence of analyst compensation on investment banking.

First and foremost in our judgment is that management compensation at public companies has become increasingly dependent

on the relatively short-term performance of the company’s earnings

and/or stock performance. The potential compensation if certain

milestones were met, and often the compensation realized, skyrocketed in the late 1990s to previously unheard of heights. There

was so much at stake that the incentive to push the envelope on

accounting or on the adjusted earnings cited in the earnings release was huge. Apparently some managers succumbed to temptation.

14

In general, the abuses can be divided into those generated by cyclical factors and those generated by secular factors. Even without

the increased monetary incentives for management, the business

cycle would have fostered a number of abuses similar to what happened in previous cycles, but in the 1990s the level of abuses was

exaggerated by both the increased incentives for management and

by the fact that the bubble created during the last cycle was bigger

and longer than in earlier cycles. Therefore, it should come as no

surprise that the abuses in accounting and in earnings releases

were far more egregious than in the just-ended cycles. That the

poster child this time is a company as big as Enron and one who

committed so many serious abuses should be no surprise.

The cyclical problems are the excesses that creep into the system

at the frothy part of the business cycle when investors tend to be

careless and overlook the warning signs that companies are pushing the envelope on accounting rules and earnings releases. The excesses become even more excessive when the economy begins to

slow. Companies push even harder in order to keep up the appearances of continuing good earnings growth.

The inevitable market correction tends to correct most of the

abuses of this type. The investor backlash causes companies to

modify their behavior for the good, and investor confidence returns

until the next market correction reminds investors that they again

let their vigilance slip and that company managements had again

misbehaved. The corrective behavior process starts all over again.

It is kind of like when you go to the carnival, and they have this

game there where they have the gophers that keep popping up.

Well, when we have a market correction, you get the stick, and you

try to beat down as many of these gophers as you can, but you

know that in the next cycle they are going to be popping up again.

But we are going to keep working on it in each cycle.

Sometimes some tightening up of the accounting rules or other

regulations is necessary in each cycle to close some of the loopholes

that emerged in the last cycle as a clever way to inflate earnings.

Several obvious, but in some cases not obvious until after the bubble broke, loopholes that became newly fashionable in the last cycle

include special purpose entities to hide debt off the balance sheet,

a more liberal use of stock options to reduce employee compensation on the income statement, indefeasible rights of use swaps to

inflate revenues, and heavy use of derivatives that resulted in reduced transparency.

Among the old favorites that blossomed again in the last cycle

were the changing of pension funds to inflate or to smooth earnings, and stretching the accounting rules on revenue recognition to

inflate current revenues by including those that would not be unequivocally consummated until a later period.

Another abuse created by the increased management compensation incentives was one that was more of a secular issue and not

just an extension of prior cyclical abuses. That abuse is the pressure that is put on brokerage analysts to help inflate the perceived

earning.

Analysts routinely adjust a company’s GAAP earnings, the earnings required to be reported by the SEC using Generally Accepted

Accounting Principles as enumerated by the Financial Accounting

15

Standards Board, to exclude these items, the analysts consider nonrecurring or non-operating. Companies often would provide earnings in their quarterly releases that were adjusted to a basis of the

company’s choosing.

There was a cyclical nature to this problem in that the company

pushed the envelope on what they considered non-operating or nonrecurring and, therefore, excludable from GAAP earnings.

For example, costs for layoffs and plant shutdowns triggered by

a slow economy became a restructuring charge. The new twist in

the 1990s was that the companies pressured analysts to go along

with the company basis for adjusting earnings, even when the exclusions ran counter to common practice.

Some companies also pressured analysts to maintain favorable

recommendations on the company’s stock. Aiding management in

achieving this was a—was that an increasing part—in many cases,

the majority part of analysts’ compensation was coming from the

investment banking side of the analysts’ firm. Therefore, in addition to the threat of cutting off analyst communication with a company, companies could use the lure of investment banking business

to have additional pressure put on the analyst by the investment

banking arm of the analyst firm.

Even more damning than what happened in the late 1990s is

that the companies still did not seem to get it. Investors had hoped

that the actions of Enron and other abusers of the system would

have led companies to bend over backward to do the right thing in

accounting for their earnings and in presenting them to the public.

Yet some companies continue to abuse the system.

Companies are still providing the so-called ‘‘pro forma’’ or ‘‘adjusted earnings’’ that continue to be on highly questionable footing.

Even some companies that announced in January that they would

no longer be reporting pro forma earnings welshed on their promise

and continued to report them in their first quarter releases.

The new accounting change, FASB 142, that eliminates the amortization of goodwill requires that companies include pro forma results for any prior period cited in their 10(q) and 10(k) filings that

restate the prior period earnings as if FASB 142 had been implemented before the start of those periods. Yet no pro forma first

quarter 2001 results were included in the first quarter 2002 earnings releases in many companies, and some said, when called, that

they would not provide them until the 10(q) was filed.

One company that had provided a pro forma result for first quarter 2001 for the accounting change when they reported last year,

even though FASB 142 had not yet even been issued, chose not to

report a first quarter pro forma number this year when they reported first quarter results. Doing so in the first quarter 2001 release made first quarter 2001 earnings growth look better, but

doing so in the first quarter 2002 release would have made first

quarter 2002 earnings growth look worse—therefore, no surprise in

why they conveniently forgot this year.

Another company that omitted the pro forma first quarter 2001

number showed an earnings increase by doing so. But if the first

quarter 2002 results had been compared to the pro forma first

quarter 2001 earnings, the earnings were down by 1 cent, yet the

16

company and the analysts reports only discussed earnings as being

up.

The net result of this abuse is that it is misleading investors by

inflating the apparent first quarter 2002 earnings growth for many

companies. Unless this practice is changed, it likely will be repeated in the next three quarterly reporting periods.

Despite some companies last year raising the assumed returns

on their pension fund investments in the year when the market

was down, we are not aware of any reducing their assumptions so

far for this year. In the face of growing opposition to the current

accounting rules on stock options, companies continue to announce

repricing of options. Because the cyclical abuses were greater this

time, because the analyst conflict is a new one and because some

companies still do not get it, it follows that the remedies for this

cycle may have to be more severe and more far reaching than those

in prior cycles. We have got to knock a few more gophers down.

[The prepared statement of Charles L. Hill can be found on page

119 in the appendix.]

Chairman BAKER. Thank you, Mr. Hill.

Our next witness is Mr. Ken Boehm, Chairman of the National

Legal and Policy Center.

Welcome, Mr. Boehm.

STATEMENT OF KENNETH F. BOEHM, CHAIRMAN, NATIONAL

LEGAL AND POLICY CENTER, FALLS CHURCH, VA

Mr. BOEHM. Thank you, Mr. Chairman, and I want to thank

Members of the subcommittee for this opportunity to testify.

The Global Crossing bankruptcy, the fourth largest in U.S. history, has cost investors billions. It has cost 9,000 people their jobs.

It has raised serious questions about accounting practices, corporate governance and conflicts of interest in the financial services

industry.

Following some recent articles in both Business Week and the

Wall Street Journal and this morning’s New York Times, a whole

new controversy linked to Global Crossing has arisen. The controversy involves Ullico, formerly the Union Labor Life Insurance

Company, a privately-held company owned by unions and their

pension funds.

Ullico was an early major investor in Global Crossing, and its directors, who were mostly union leaders and former union leaders,

used the telecom’s volatile stock price history to enrich themselves,

apparently, at the expense of the union members and those retirees

whose pension funds own Ullico.

Gary Winnick, the Global Crossing CEO, appreciated Ullico’s

early investment, and he appreciated it so much he cut Ullico’s directors in on purchases of Global Crossing stock at IPO prices. According to labor officials quoted in the Business Week account, this

sweetheart deal enabled Ullico’s directors to make millions of dollars personally. It also raised serious questions as to whether the

stock deal was an improper inducement to Ullico investors to invest

pension funds, which are supposed to be invested conservatively, in

a series of dubious investments with Winnick and his Pacific Capital Group.

17

Many of those companies later had problems like—for example,

you remember Value America, which subsequently went bankrupt.

The major focus in the series of insider stock deals, though, was

what allowed Ullico directors to buy and sell Ullico stock in such

a way as to virtually guarantee that they personally made profits

and avoided losses. The profits, they got; the losses went to Ullico,

and Ullico is owned by the pension funds.

In 1998, departing from a longstanding conservative practice of giving Ullico stock a fixed value of just $25 a share, Ullico began

changing its share price annually according to the value determined by an accounting review. Insiders, meaning the directors,

knew in advance of the price change whether the stock would go

up or down, and with Global Crossing being such a large percentage of the portfolio, it wasn’t hard to follow. It was the equivalent

of investing in the stock market when you knew for sure which

way a given stock would go. It adds a whole a new meaning to

‘‘market timing.’’ .

To further fix the rules, Ullico directors were allowed to profit at

the expense of Ullico itself because the repurchase of stock from

shareholders was set up in such a way as those who held smaller

shares—the directors—could get in on some of those repurchases,

while those holding the larger number of shares, which would be

the pension funds, the retirees and union members, could not participate to the same degree as the directors.

Here is what Business Week labor reporter Aaron Bernstein describes as how this profiting worked:

‘‘In the fall of 1999, Ullico was losing money on its operations, but earned $127 million from selling Global stock. The directors

and the insiders knew that the gains would lift the annual evaluation of Ullico shares from $54 to almost triple that amount, $146,

when the books closed on December 31, so in December of 1999,

Ullico offered each director a chance to buy 4,000 shares at the

1998 evaluation of $54, a can’t-miss proposition. The union pension

funds, that own almost all of Ullico, were not given the same offer

or even told about it.

‘‘In December of 2000 and January 2001, Ullico bought back

205,000 of its 7.9 million shares at $146. The stockholders with

fewer than 10,000 shares are allowed to sell all their holdings, so

officers and directors can take full advantage; again, the pension

funds can’t. Insiders know the decline of Global Crossing stock puts

the true value closer to $75.’’

So it is nice when you can sell shares at $146 knowing they are

only really worth 75.

‘‘In December of 2001, they bought back an additional 200,000

shares, allowing officers and directors who hadn’t sold before to

cash out at 75; again, insiders know that the further collapse of

Global has again cut Ullico’s true value, this time to $44. This was

a zero-sum gain. The directors won; the pension funds lost.’’

Just blocks from this hearing room, a Federal grand jury is hearing evidence about the Ullico case. At the same time, the Department of Labor is investigating, as well. The board of directors were

finding more and more who have personally profited. One of the directors, Arthur Coia, former head of the Laborers Union, was recently banned for life from all union positions after pleading guilty

18

to fraud involving failure to pay taxes on a million dollar Ferrari.

A good question might be why a convicted felon is overseeing pension fund investments.

Others have been implicated as well. Marty Maddaloni, plumber’s union, cashed out at a six-figure amount in terms of profit. He

is under investigation by the Department of Labor for abuses related to his union’s pension fund, which he also heads.

The union official most on the spot is Morton Bahr, a long-time

head of the Communications Workers of America; he is a Ullico Director since 1996. Many of the workers who lost their life savings

because of the Global Crossing bankruptcy were members of his

own union. The emerging record shows he was intimately involved

in the Ullico-Global Crossing deal from the beginning. He pushed

the Global Crossing deal even though the company was not unionized at the time; and he used his authority as a CWA boss to weigh

in for Global Crossing in other business deals.

The favoritism was not a one-way street. The Wall Street Journal

recently reported that Bahr had personally profited to the tune of

$27,000 in his Ullico stock deals, and a spokesman for Mr. Bahr

assured the reporter that Bahr was, quote: ‘‘Concerned about the

propriety of the stock trading by the Ullico board.’’

These are conflicts of interest on their face. Union leaders, not

to belabor the point, have a fiduciary duty to serve the best interest

of their union members and certainly the retirees who depend on

the pensions. The big picture here is that this case is important because it involves the heads of some of the largest unions in the

country improperly, if not illegally, enriching themselves at the expense of union members.

It is also important because it illustrates a growing trend in

union corruption. The Department of Labor IG recently pointed out

he has 357 labor racketeering investigations. Of those, 39 percent

involve organized crime and 44 percent involve pensions and welfare funds. He says that the plan assets that are under risk in

these investigations are more than $1 billion.

What can be done? I think the first step is to acknowledge we

have got a major problem. There are trillions of dollars in pension

funds, hundreds of millions and billions actually in some of these

that are at risk. The public, especially union members, have a right

to know what their directors have done with their money.

There are laws that have major loopholes, and one of them recently pointed out by the Inspector General of the Department of

Labor is that independent accountants are not required to report

ERISA violations to the Department of Labor. That is a loophole

that should be closed.

Union members are entitled to know, or should be entitled to

know, the sources of income of their top officials. Top union officials

should disclose their outside income most probably on the financial

disclosure forms they file annually with the Department of Labor.

If protecting the integrity of billions of dollars in pension funds,

relied upon by millions of honest, hard-working Americans, is not

an issue worth addressing, what is? Thank you.

[The prepared statement of Kenneth F. Boehm can be found on

page 123 in the appendix.]

Chairman BAKER. Thank you, Mr. Boehm.

19

I must say each of you presents a disturbing reason for a critical

analysis of our current system. As a defender of the free market,

I really believe that market discipline reacting to facts is the most

severe and appropriate quick remedy to abusive practices. However, it is obvious that in some instances—not in all—that the pressure on management to meet earnings expectations and to preserve

shareholder value results in authorized accounting methods being

used for purposes for which they were not intended. And when the

losses occur, the resulting leverage brought about by the accounting misstatement causes the losses to be far more severe than had

you simply addressed the fact that you have a small economic

downturn in business performance, and instead of making 2 cents,

you are going to make 1.

It is a result of management’s intention to preserve corporate

growth and to strengthen expectations that 16 or 18 percent rates

of return are somehow normal. Given that and the fact that the

system missed it, it isn’t just the analyst, it isn’t just the accountants; it goes all the way to the financial press. I mean, you can go

back now and get articles written weeks before, months before the

Enron debacle, where they were held out to the world as the new

business paradigm for the next century. Nobody knew what was

about to occur.

The big question here is—without casting blame on any particular participant, is our current system really adequate in light

of the business speed with which we act? How is it possible that

a statement which is based on data at least 3 months old by the

time of its publication, which is a backward-looking analysis, a retrospective view of where the company was, is in any way appropriate to make a forward-looking judgment about where the corporation may be headed?

Since we have relatively few here, I am hopeful we can have

more questions to follow up. But, anybody, jump in here.

Mr. Hill, you are the one who, I believe, said we may be needing

to hit a few more gophers a little more rapidly with this particular

set of circumstances than ever before. I have concerns about

FASB’s slow pace, their academic perspective and their disconnect

from accounting reality to accounting philosophy.

Should we be looking at a much bigger solution here than what

we have talked about in the past?

Mr. HILL. That is a tough one. In the interest of full disclosure,

I should say that I am on one of the FASB task forces on financial

reporting.

I think that FASB understands that some things have to change,

that they have to speed up the process. That is easier said than

done. It probably means more resources for FASB. There is still—

even though FASB members are paid and they have a staff, there

is a lot of work done by committees, like the one I am on, that volunteer. And we have plenty of other duties in addition to trying to

help out with FASB. So, I mean, that is one of the things I think

that slows the process down.

But on the other hand, it is good to get the input from people

who are active in the industry and understand the day-to-day nature of the problems.

20

Chairman BAKER. And just in perspective, FASB could be a research agency to the SEC, to advise and research questions.

For example, they approved the utilization of SPEs. I don’t envision anyone there at the time anticipated how the SPEs would

eventually be utilized in the market, and that is the distinction between a policy and implementation. And the SEC ought to be on

deck looking at those things with the capacity to respond.

And I have been informed that the Attorney General has to leave

here momentarily to catch a plane. Before you depart, from your

perspective, what additional advice would you give to the subcommittee in light of the structural concerns I have? Do you think

we need to be looking at a broader structural remedy, or do you

believe that merely additional disclosure standards and transparency is sufficient to arm you with the tools you need?

Ms. MONTGOMERY. Mr. Chairman and Members of the subcommittee, I hate to echo what you have already said, but what

you have done already is a great first step. The transparency is

really critical.

I would defer to some of these folks here who are more engaged

in security and investment issues than I. But for an Attorney General, we need to have very clear rules with regard to self-dealing—

they are already existing, but walls between accounting, doing accounting and auditing versus making some consultation, and what

happens when there are accountants that do that; and certainly the

self-dealing that happens on board with the directors.

Chairman BAKER. And after my slight interruption, Mr. Kanjorski had a short question.

Mr. KANJORSKI. Madam Attorney General, it is not on this issue

today, but in prior testimony the Attorney General of the State of

Washington mentioned that their pension funds lost $100 million

as a result of Enron’s collapse. But the lawsuits that she is bringing will only be able to afford the recovery about half of that

amount because of the statute of limitation being 3 years, and most

of these fraudulent occurrences went beyond the 3-year period, although they were disclosed just recently.

I notice that Ohio’s pension funds lost $270 million because of

Enron and Global Crossing. Are you running into the same problem? Does a 3-year statute of limitations inhibit your ability to get

back a good portion of these losses?

Ms. MONTGOMERY. At this point, Mr. Kanjorski, it doesn’t apply

to us, although I will say to you in the earlier—obviously, we were

a part of the Washington coalition on the Enron matter. And the

statute of limitations generally is a concern to attorneys general

because we always have various individual State statute limitations which can affect us.

In this instance, it doesn’t affect us.

Mr. KANJORSKI. We discussed that issue in this committee before

it went to the floor last week to expand the statute of limitations

from 3 years to 5 years, and it is to run from the period of discovery.

Do you have an opinion as to whether or not that expansion

would be worthwhile?

Ms. MONTGOMERY. Mr. Chairman and Mr. Kanjorski, as an Attorney General, I will say to you when you give us a longer amount

21

of time to recover, generally we are going to tell you we like that,

particularly when the time doesn’t run until after discovery, or

when it should have been discovered or when it was discovered. So

obviously that is a tool that is very helpful to us.

Chairman BAKER. Thank you very much, Attorney General. I understand the constraints of your schedule.

Ms. MONTGOMERY. I apologize.

Chairman BAKER. Mr. Bentsen.

Mr. BENTSEN. Thank you, Mr. Chairman, and I thank our panel.

I have to say I am reminded of when I went to Wall Street and

was going through my training program, and the head of the program said, if anything goes wrong with the transaction, the first

thing you do is sue everybody and then figure out afterwards what

you are going to do.

I think the testimony of Mr. Holder and Mr. Hill are pretty interesting. And, Mr. Hill, I think in your opening part, you hit the nail

right on the head, particularly in two out of three, and maybe three

out of three, that a lot of what we have going on in this market

we have seen before.

But I think you are right about the short-run aspect of management compensation which—that is just how it is, but it is one that

has been short-sighted from an economic perspective and, apparently, short-sighted from a market perspective. And I think the

level of exuberance, where we went through, where you ended up

having to chase money—I think it was in 1987 when the UAL

buyout deal was going to happen, and the pro forma said they expected the airline industry to have positive growth for the next 7

years; and somebody finally looked at that and said, that is probably realistic. And that fell apart, and the junk market fell apart

for other reasons.

But the question is—and, Mr. Holder, in your testimony you lay

out the issues of subjective accounting and why it has to be subjective. And I appreciate your insight on that and where there can be

abuse.

I guess the question comes down to, other than some very strict

standards on the market—similar to what the Congress did with

respect to banks and thrifts at the end of the last bubble, where

the Congress had arguably a clear line of intent because of the payment system and the Federal backstop to the banking system,

whereas here we are talking about the capital markets where we

do want to have sufficient protection for investors against fraud

and fraudulent activity and ensure there is confidence in the market—but how far can we go? How paternalistic should we be in setting guidelines for management, setting guidelines for auditors?

And to what extent do we impose, you know, the old standard of

caveat emptor?

And the other question I would ask, and particularly to Mr. Hill,

because you at the end say we need some tough remedies, and I

would be interested in knowing what those are.

With respect to research analysts, do you think—I am not proposing this, but I am curious because we keep talking about this

issue—do you think that the time has come that research analysts

on the sell side should be a disclosure item for purposes of the 1933

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act in the same way that an offering document is? Either one on

those points?

Mr. HOLDER. Well, with respect to the earlier question you asked

and sort of directed to me, I don’t think there is a silver bullet to

fix these problems. I think there are a great preponderance of accountants in the country who go to work and do their job in an appropriate fashion; but the weakest link fails when pressures increase, and we have seen a number of those. And in my own view,

I think some fixes are necessary.

I think the FASB can become more nimble on some aspects of

the due process procedure which they go on writing standards

probably becomes as much a vice as a virtue. The learning curve

in terms of information coming to their attention flattens out and

yet there is still due process in which to go.

But if there is a silver bullet or something that comes close to

it, in my own view, I think it lies in strengthening the system of

corporate governance, particularly in boards of directors and, even

more specifically, with audit committees. In my written submission,

I suggested that audit committee Members may, for example—it

may be reasonable to require them to maintain independence from

the company and not be compensated through options or stock of

the company in fulfilling their roles as audit committee members.

I think the whole relationship between an audit committee and

the external auditors can be strengthened and made more muscular, so the audit committee has the sole responsibility and authority to retain and to discharge auditors.

I believe there are a number of promising avenues in the area

of corporate governance that may bear fruit. Again, as you may

have detected from my comments, because of the inherent features

of financial reporting, no matter what you do in standard setting,

no matter what you do in regulation, to get better accounting and

financial reporting answers, the people applying those standards

and rules have to be objective and have to be independent, and if

they are not, bias will intrude. So it is in the area of corporate governance for a variety of reasons that I believe the greatest benefit

may lie at this point.

Certainly there are other things that affect all aspects—the auditing standards that exist, the culture of the auditing profession,

and the culture of the financial reporting profession deserve attention as well.

Mr. BENTSEN. Mr. Hill.

Mr. HILL. Let me first say in the comments before, about the nature of accounting being subjective, that is certainly true, and I

don’t think we can do a whole lot about it. We can try to tighten

it up as much as we can, but there will always be judgment involved.

And a system like that only works if the conflicts are removed;

and by the ‘‘conflicts,’’ I mean the financial incentives. It is the old

story, follow the money. I have said that before here.

But specifically in relation to your question, I think some sort of

separation of the analysts from investment banking is probably desirable. I am not sure what the ultimate answer is. We do need,

certainly, to rebuild the Chinese Wall if we are going to continue

to have research be part of an investment banking firm. But to

23

solve that problem—I mean to be able to rebuild the Chinese

Wall—we have to have compensation no longer coming from the investment banking side of the house to the analysts. There was a

day when it was that way.

But, you know, the underlying problem—I mean, it is really only

a symptom that the analysts are increasingly being paid by the investment banking side of the house. The underlying problem is

that the research departments can’t get paid for the research anymore with negotiated rates. Why, they have been driven down to

the point where there aren’t enough commission dollars to go

around anymore for research.

Now, what is the answer to that? I don’t know. We can’t put the

fixed-rate genie back in the bottle. Do we go to some sort of hard

dollar arrangement? Maybe that is what we have to find somewhat,

to incentivize or regulate; I don’t know.

But, you know, the culture of the institutional investment houses

has been to try to soft hour everything, even though it is a diminishing soft hour pie. I mean, if they could soft hour the janitorial

service, they would.

So I don’t know what the ultimate answer is, but that is the

problem. I mean, until we solve the issue of being able to get paid

for research—I mean, you can’t. The Attorney General of New

York’s idea of separating research off, spinning it off as a separate

thing, I mean, how are they going to get paid?

Mr. BENTSEN. I agree with what you are saying.

Would you agree with the idea, with saying that idea of a research document is treated under the law the same way as an offering document is?

Mr. HILL. Well, I think that would have a chilling effect on research. I think we have to hold the analysts more accountable, but

I don’t think going that far would be a good idea. I mean, it is really an opinion; it is like an opinion you get from a consultant.

I mean, there is no right answer. I mean, if an analyst could be

right all the time, they no longer would be an analyst after a short

time.

Chairman BAKER. In my continuing effort to be extraordinarily

fair, I yielded time to Mr. Kanjorski to ask a question of the Attorney General before her departure. I then stepped over Mr. Kanjorski’s time and went to Mr. Bentsen. So to kind of get us back

on track, I am going to take about a minute to follow up on my

questions and then recognize you for your full 5.

First, on the question of analyst disclosure, I think the rules that

are now soon to be implemented, out for public comment only in

the last 45 days, will go a very long way down that road in making

public the intended effort to simply disclose where you have the

conflict, where you can’t at least trade against your own public recommendations. You can’t have family and friends trading off an upgrade-downgrade price target change; you must make disclosures if

you are paid by investment banking.

I think it is a good first step, and we ought to let that be operative before we go too much further in that arena. I still think the

focus has to be on value added to the corporation. If, in fact, it is

a subjective valuation, somehow that has got to be noted, and then

you can agree or disagree with the subjective determination. But

24

that has got to be different than one and one equals two; that can’t

be subjective.

So if we have hard dollar value, and we can present that information and, in a B part, have values and subjective opinion so you

can make your appropriate judgment, that, to me, seems to be the

goal.

Can you comment with regard to that approach?

Mr. HILL. It is an interesting thought. I hadn’t really thought it

out. It is the first time I heard a suggestion like that.

Chairman BAKER. Well, what we do now is take the subjective

data and put subjective footnotes; and so you scroll through the

facts, and then you get influenced by what is not disclosed as being

subjective. So somehow, just identifying, as we have tried to do

with the analysts, where you have a conflict—the conflict may be

fine and you may be managing it well within the firm, but you

have to let people know that is what you are doing; you can’t keep

that from public light.

I think that is what they tried to do to Members of Congress. We

have to disclose who gives us money, what they do, all sorts of limits and that is hopefully enough to ensure that Members act appropriately in light of the fact that they still get financial contributions from various interests. That is the whole basis on which our

ethics code is structured, and it seems to be appropriate for others.

Mr. Kanjorski.

Mr. KANJORSKI. Thank you, Mr. Chairman.

Mr. Hill, you suggested that fixing accounting problems is somewhat like beating down the gophers. I wanted to make this suggestion to you because we both love cartoon characters from our past:

How about the slaughter of the Schmoos? Every time you hit them,

they divide. And it seems, with this catastrophe, every time we see

something, it multiplies.

The reason I opposed the legislation last week on the floor is, I

do not think we have seen a real analysis of what really happened

at Enron, Global Crossing, and other accounting disasters. As a

matter of fact, I suspect there is almost a conspiracy of silence as

to whom some of the culpable parties are by their absence of being

examined and asked to testify here. And I do not want to necessarily name whom I suspect played a large part in these parties’

involvement.

But, I also think you struck at something: Follow the money. We

have not nearly seen where the big money was made in these

transactions that were set up. This was not some lowly accountant

sitting around a corporation, or even their accounting firm, that sat

down at a low, tertiary level coming up with these gimmicks. This

was real, extraordinary brain power that came out of the sharpest

minds in the accounting field and the investment field in the

United States of America.

And to a large extent, I do not think the accounting firms reaped

all these benefits of extraordinary amounts. I think there are other

parties out there that reaped incredible sums and created this activity. And I am disappointed that the Congress has not gotten to

these parties yet. We have not asked any of these people to testify.

I mean, who wrote these documents? Who came up with these

ideas? Where are the notes? What did they anticipate? Why did

25

they not see conflicts of interest, violations of the law, lack of

standards, criminality?

Quite frankly, I have talked to some of the people that have participated in the writing of these things, and there is a great deal

more for this Congress to learn, which we have not yet learned.

And yet, we are out there trying to thrash around making a decision. I am disturbed because I am wondering whether or not this

is something more than just the excess at the end of a bubble. It

may be an infectious disease of greed and inability to contain oneself in their lust for using the system and abusing the system to

earn money.

There was a column by Mr. Samuelson in the paper this morning

that really strikes home. It goes to financial literacy. I am still confused in my mind about his conclusions. Forgetting the average investor, who gets snookered all the time, let us take a look at the

sophisticated pension fund investors, the real corporate investors,

the people that are paid and supposedly have all the genius to

come up with the right answers. Why are they buying stocks 100

times over earnings?

When Samuelson analyzed the market today, he said—I think—

one of the price-to-earnings figures, on average, was 45-to-1. I don’t

know. Maybe I slipped off the cabbage truck or something, but I

do not ever recall companies profits alone going to inflate the stock.

To a large extent it used to be that stocks’ prices were calculated

on what was their payment, what was their dividend, what was

their revenue. These institutions seem to have lived on that ‘‘profit’’

mentality.

It does not surprise me that this mentality has filtered down into

the union pension funds and everything. Those guys are peripheral

actors. We are talking about a guy making $27,000 on stocks. That

is a joke. There are people that made billions upon billions of dollars on these transactions, and they took it out of the pension

funds. And we were conspirators in that, the Congress.

I just remember a few years ago in this Congress when we

passed legislation in the height of the interest bubble to allow the

corporate pension funds to calculate the value of the pension funds

based on the capital market value of their stock and investments,

and if it was in excess of a certain amount, they could start withdrawing funds. And I have not seen any writers talking about how

many crippled pension funds there are out there that in 1999 and

2000 had huge amounts of these funds drawn out by companies,

and utilized for company purposes. And now, with the market having fallen, I wonder what those funds are worth out of those pension funds.

I just reviewed one report the other day. In 1999, the pension

fund was, I believe, in the vicinity of about $100 million. Today, it

is worth less than $30 million on a market cap basis and it cannot

really cover its long-term obligations. And there is nobody responsible under the law to step up and fill that void, so ultimately it

is going to go to the Government under our pension guarantee program, and the taxpayers are going to pick up the shortfall.

But where are the people writing about these things, analyzing

these effects? When $54 billion disappears, it is a paper loss. But

there are many sets of papers that will get reflected in that loss.

26

And I am worried about the financial literacy of our geniuses on

Wall Street and around the country. Maybe we have to go back and

reeducate these people or restructure how they get paid. We are always talking about how the analysts get paid.

I just want to bring up another point. In Pennsylvania we used

to have a process where the most junior judiciary—the justice of

the peace—was paid on a per case. If he found the defendant

guilty, the defendant had to pay him a fee for the justice’s time.

It was amazing how any charge led to a conviction. If you went to

a justice of the peace in Pennsylvania at that time, you were about

99 percent certain that you were going to be found guilty.

Chairman BAKER. Maybe that is how we ought to prosecute these

guys.

Mr. KANJORSKI. Talking about how people get paid, in tort law,

the judges sitting in the common pleas level of court systems were

paid a percentage of the recovery in a tort case. I can just imagine

how much evidence would go to the jury and how much material

would go to allow a higher verdict for a higher payment.

These are solvable things.

I guess my question is at what point should Government step in?

Have we stepped in enough? Have we stepped in not enough? What

we have already done—last week in the House—I think, is superficial. I do not think it solves the problem. I do not know where

the measure is as to how far we have to go, but I hope we have

hearings to determine that.

I think professionally you have your hand in it. I do not care

what we do on subjective rules. If we have avarice, greed, and malcontents in the professions and in the leadership roles of these corporations, they are going to find a way to accomplish their fraud.

We can pass all the statutes we want, they are just going to find

another way to commit fraud. My experience with good lawyering

is that you get what you pay for. Someone will find a way around

the barrier we construct, and generally, good lawyers do that all

the time.

I am wondering whether we need some basic public discussion in

this country as to the nature of this problem. Does this situation

reflect something of far greater concern to our society, a far greater

threat to our society than just the loss of some stock value, or just

the loss of some money or just, sometimes, limited abuses. I think

it may acutally indicate that we have much more serious systemic

failures in the overall system that are merely being reflected by

what has happened in the last several years in our corporate governance.

Chairman BAKER. If anybody wants to respond, Mr. Hill.

Mr. HILL. I agree with most everything that you said.

And as far as the cultural aspect of it, I think it is this instant

gratification that pervades our culture these days; and as a result,

why everything has become so short-term oriented. I mean, you ask

why a pension fund manager was paying 100 times earnings. Well,

I will tell you why. Because the pension fund managers, the outside ones, are measured every quarter. They have maybe five different institutions managing their pension fund. Every quarter

they kick one out and add a new one.

27

Everywhere you turn, the pressure is on short-term performance.

I mean, the mutual funds, individuals don’t have any patience.

This one is down this quarter, they sell that one and try another

one.

Why did the managers then buy this stuff? Because to keep up

with the guy that was buying the junk and having better performance, he said, well, I have to, too. I know a lot of portfolio managers who were buying stocks that they knew were questionable,

but they felt they had to play the momentum game.

So you are right. We have to find some way to get away from

this short-term orientation and get rid of these incentives that encourage it, like company management compensation, which is so

short-term oriented.

I mean, I think the regulations that come out of Congress should

be of a more positive nature. How can we incentivize managers, analysts, and so forth, to do the right thing rather than saying, well,

you can’t do this because as soon as you say you can’t do this, as

you pointed out, there are going to be some smart guys to figure

out how to get around it. So we have to change the incentives.

Chairman BAKER. Mrs. Jones is next.

Mrs. JONES. Thank God for that rule.

Couple of questions. I am going to stick with you, Mr. Hill. Are

you aware that last week, the SEC issued a new rule—number

8K—with regard to disclosure of certain management transactions?

Mr. HILL. I am aware of it, but that is not one that I have looked

at really.

Mrs. JONES. The purpose was to—in Enron and Global Crossing,

the testimony was that everybody—all the CEOs and the directors

were able to have a way of relieving themselves of their assets

while the value was very high, while the rest of the employees

were stuck with what they had when they finally got to their dollars; and they were at nothing.

Is this one of the things that might assist us in getting where

you are suggesting that we might go?

Mr. HILL. That is certainly a positive step, but it is a drop in the

bucket.

Mrs. JONES. I believe this rule change actually came as a result

of some conversations that we had with Chairman Harvey Pitt,

Chairman of the SEC Harvey Pitt that we had at an earlier hearing. Because there was in place a rule that would allow directors

and managers to have a plan in place to dispose of their assets,

and then they could be shielded from quote/unquote, ‘‘any insider

trading.’’

Let me ask you another question in that line, and I will get to

the other witnesses. With regard to your whole conversation about

compensation, I was just stunned, based on the arrogance of the

Enron and Global Crossing CEOs that came in before this hearing

in response to our questions about what their compensation was

and what their—and unwillingness on their part to even, A, tell us

what the compensation was publicly; and B, to say in response to

some of my questions, ‘‘I didn’t set the salary,’’ and, ‘‘You don’t

know how busy I am as a CEO,’’ and so forth.

I have come to the conclusion, based on the short time I have

been in the Congress, in going through this process, that we realVerDate 11-MAY-2000 10:21 Sep 09, 2002 Jkt 000000 PO 00000 Frm 00033 Fmt 6633 Sfmt 6633 C:\DOCS\79559.TXT HBANK1 PsN: HBANK1
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ly—no matter how much legislation we pass, no matter how many

rules we put in place, to—like they just started doing in law

schools about 15 years ago, requiring that ethics be a part of the

curriculum for lawyers—that each year they would be required to

do an ethical—I think every 2 years in the State of Ohio lawyers

are required to get 2 or 3 or 4 hours of ethics training.

But also just to put out in the world that, hey, that right is right,

and you can’t misuse people, it seems to me is one of the things

we need to look at.

I am going on for a little while, but I am going to ask you a question at this point. I guess all of my colleagues and I do that.

Anyway, though, what do you think, where do we need to go first

in trying to resolve this situation that we find ourselves in in terms

of accounting principles? Where do we strike first?

Mr. HILL. I think you strike for the low-hanging fruit first.

Mrs. JONES. And the low-hanging fruit is?

Mr. HILL. Well, I think the NASD and NYSE proposals that were

are alluded to earlier, that will presumably be OKed pretty much

in their original form a week from today by the SEC, and will presumably go into effect pretty quickly.

There is a max of 90 days, a 60-day and a 30-day, but I think

they will go for the short end of both of those. That is a tremendous

step. If you look at that and divide it into three parts—one is the

conflict issue that I talked about, the compensation issue.

They only did a few perfunctory things there, and I am glad, because if they had tried to solve the problem which—as I mentioned,

the underlying problem really is getting paid for research, but

things would have been so bogged down that we wouldn’t have gotten to the other good things that were in there.

So I am glad that in round one they didn’t try to solve that problem.

Mrs. JONES. On that point, let me ask you this: Do you believe

that CEOs and directors ought to stand behind the representations

that they make about the financial condition of their companies?

Mr. HILL. I agree with some of the proposals that Chairman Pitt

has put forth in that line. I think there should be more responsibility and penalties for CEOs if they are pushing the envelope, and

obviously, if they are cooking the books. But fraud provisions take

care of that.

Mrs. JONES. Mr. Chairman, could I ask unanimous consent for

him to finish the answer to that last question?

Chairman BAKER. We have been very liberal with the use of time

today, so please proceed.

Mr. HILL. The other two parts of the NASD and NYSE proposals

were the disclosure and the recommendations.

Now I think probably some of the discussions in this committee

last year set the stage for what came out of that—I think they really hit a home run in what they have done in terms of the recommendation issues.

I mean, there were two things that—Congressman Kanjorski is

gone, but we joked about that you needed a decoder, a two-level decoder, to figure out what was going on with the recommendations.

One was to put everybody on a common standard, you know, buy

at one firm that was at the top category on a 5-tier basis, and secVerDate 11-MAY-2000 10:21 Sep 09, 2002 Jkt 000000 PO 00000 Frm 00034 Fmt 6633 Sfmt 6633 C:\DOCS\79559.TXT HBANK1 PsN: HBANK1
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ond tier at another and third tier at another. So you had all these

different terminologies and scales.

The other problem was that there was this extreme optimistic

bias in the recommendations, over 100 to 1 in terms of buys and

strong buys, to sells and strong sells in the most commonly used

terminology. But the NASD proposals, I think, really go a long way

to solving that.

As far as the first problem, you can still have your proprietary

recommendation scale, but it becomes supplementary because you

are going to have—at the end of the day, in that report, have to

say it is a buy, a hold, or a sell. So there will be a common scale

and everybody’s recommendations can be compared against each

other.

The second thing is on the optimistic distribution. Every report

is going to have to show the firm’s number of recommendations in

each of those three categories and what percent of those are investment banking clients. In addition, the analyst has to put in a price

chart of the stock with his or her recommendations superimposed

on it.

Chairman BAKER. If I may jump in on that point, given Mr. Kanjorski’s reference to the cartoon, this is the coloring book chart, so

any consumer, a Member of Congress I think can understand this.

You have the price target and the line goes down away from the

estimate. I think that is a very persuasive tool that anybody can

use to get an understanding of what the analyst is doing in relation

to the real performance, and it is historical over a 12-month period.

Mr. HILL. And I think it will force the analysts to say what they

mean and mean what they say.

I mean, if the reports are going to come out for the year or whatever, and every analyst’s report coming out of that firm is going to

be showing that 80 percent of their recommendations are buys and

all their investment banking clients are in the buy category, pretty

soon they are going to have a reputation as a shill. And we have

seen Morgan Stanley come out with a change in their recommendation system that was obviously in anticipation of what they saw

coming; and their distribution initially—I don’t know what it is

today, but initially 22 percent were sells. That is a reasonable distribution. The highest we had seen for any broker prior to that was

8 percent. And there were damn few, you know, that were more

than 1 or 2. Sorry, I shouldn’t have said that.

Chairman BAKER. Mr. Sandlin.

Mr. SANDLIN. Thank you, Mr. Chairman, for calling this hearing.

And we thank the panel for appearing today.

Professor Holder, I wanted to ask just a brief few questions to

understand what you are saying about the intangibles and goodwill. I noticed in your written testimony, you indicated that AOLTime Warner wrote down intangibles and according to the information we have here, is about $54 billion in intangible assets. Is that

correct?

Mr. HOLDER. That is my understanding, yes.

Mr. SANDLIN. That AOL-Time Warner merger was in January,

2000, would that be correct?

Mr. HOLDER. I have that general understanding, yes.

30

Mr. SANDLIN. And from what I understand in your testimony, the

goodwill write-off merely reflects the decrease in value of the stocks

since that merger in January of 2000; would that be correct?

Mr. HOLDER. It is a little more complex than that, I think. But

basically, yes, the standard requires a fair value test for potential

impairments of goodwill.

Mr. SANDLIN. So the drop in the value of the stock directly affects the value of the goodwill?

Mr. HOLDER. It certainly can and, in that case, did in a profound

way.

Mr. SANDLIN. With the changes in the stock market since that

time and particularly in the high tech area and the internet area

and things like that, I think you would logically expect a fairly significant write-off, wouldn’t you?

Mr. HOLDER. I am sorry, sir. In general, you mean?

Mr. SANDLIN. Yes, sir.

Mr. HOLDER. Well, a stock value is diminished and there is goodwill that is on the books of companies from acquisitions of other

companies. While not axiomatic, that would certainly be the relationship you would expect.

Mr. SANDLIN. And there have been particular problems in the

area of high tech stocks. And I guess that is what I was saying.

Mr. HOLDER. Yes, sir.

Mr. SANDLIN. Obviously, this is a very huge merger, and so while

54 billion is clearly a very large amount of money, it is not unusual

in a transaction of this size, would you say? Does that seem to be

proportionate to you?

Mr. HOLDER. $54 billion write-downs, in my experience at least,

would not be unusual in the accounting term of our sense, but it

is a very large loss.

Mr. SANDLIN. It is large, but these are huge corporations.

Mr. HOLDER. Indeed, they are, and the dollars that are involved

in those mergers lead to those kinds of valuations of assets acquired certainly.

Mr. SANDLIN. Correct me if I am wrong. Previously companies

amortized a portion of their goodwill each year; is that the way it

worked?

Mr. HOLDER. Yes, sir, with the exception of some pre–1970 goodwill that wasn’t subjected to that standard, that is generally the

case.

Mr. SANDLIN. And you refer in your testimony about FAS 142,

and my understanding is that intangibles acquired after June 30

have to be annually reviewed with a charge against the earnings

if the market value of the assets drop, or if there is an impairment,

as defined by FAS 142; is that correct?

Mr. HOLDER. Very generally, I think that is a fair statement, yes,

sir.

Mr. SANDLIN. I am not an accountant. I am just a country lawyer.

Mr. HOLDER. I will accept your characterization. I am a simple

teacher.

Mr. SANDLIN. So in my reading of your testimony, you analyze

this transaction and talked about this write-down of intangibles,

31

but you are not indicating under the rules, under FAS 142 or any

other rules, that that write-down was handled improperly, are you?

Mr. HOLDER. No, sir. The description that I tried to write in

here, based upon publicly available information, would lead me to

believe at least that this is unremarkable, at least in a couple of

senses. A business decision got made leading to the acquisition of

a company with certain consideration involved. That decision was

predicated upon expected outcomes, how successful the combined

entities would be.

When that business decision, through hindsight, didn’t come to

pass in the way that was anticipated, then the accounting implication of that is the—and I will say routine application of that accounting standard to value goodwill in light of a possible impairment.

So in that sense, I think the accounting model—and this is a

rather new standard, but the accounting model in that sense works

and achieved what it was designed to do.

Mr. SANDLIN. Right, and I think that is my point. The rules seem

to work and flow naturally from the transaction that happened,

correct?

Mr. HOLDER. That certainly is my understanding at this point,

based upon the publicly available information, sure.

Mr. SANDLIN. Thank you for coming today. I appreciate your testimony.

Chairman BAKER. Thank you, Mr. Sandlin.

Just to follow on Mr. Sandlin’s line of questioning, one point of clarification, the 10K restatement on the $54 billion write-down occurred and was made public December 31 of 2001. Since that point

until now, there has been an additional $10 decline in stock value.

Based on your comment earlier about the not-necessary-but-likely correlation between stock price and deterioration of goodwill, one

might not be surprised to see an additional restatement in some future months, given the current stock deterioration. Would that not

be expected?

Mr. HOLDER. To the extent further impairment occurs, according

to the accounting standard, one would expect to see those losses

being reported as of the time the deterioration takes place, yes, sir.

Mr. HILL. Could I just jump in on that for a second?

Chairman BAKER. Sure.

Mr. HILL. Here is an example, though, of the subjective nature

of accounting. Typically, in the kind of transactions we are talking

about, it is saying that you paid too much for this because it deteriorated in value and didn’t perform as you expected.

But you also can have a situation where a company acquired

somebody with stock and now is subject to this—or in the past,

even when we had pooling, didn’t qualify for a pooling—but you

took our overvalued stock, and you knew it was overvalued, and

you went out and acquired somebody else’s stock that may be overvalued and incurred some goodwill in doing it.

Was that a bad decision? No. You used your funny money to take

advantage of it at that time. But it shows up here eventually as

a write-down of goodwill or impairment. But that is why—you

know, it is not just the numbers, you have to look at what is behind them.

32

Mr. HOLDER. Could I just add one bit of perspective?

Chairman BAKER. Let me just recognize Ms. Hooley.

Ms. HOOLEY. I would like to hear the rest of his answer, and

then I will go on.

Mr. HOLDER. Well, all I was going to say is the accounting standard on how valuations and how acquisitions get recorded is really

pretty clear that what one looks to is the fair value of shares in

the market. So whatever that market value is generally would be

the number that an accountant would use to record the acquisition.

And while you might personally believe that that number is greater

than the actual value, you are still basically obliged to use that

number because it represents the most objective evidence of value

that is attainable. That is all I wanted to say.

Ms. HOOLEY. Thank you, Mr. Chairman. Thank you for testifying.

One of the things that I think has been fascinating and interesting with the debacle of Enron, you have now seen several other

things happen across the United States, whether that is with analysts and who is paying them and that whole situation.

There is another thing that is happening which is—for some of

us finding out about it is relatively new, and this is the corporateowned life insurance that they take out on employees. And we have

a situation where Enron took out corporate-owned insurance, life

insurance, on PGE employees who—this is an Oregon company,

about 2,000 men and women. These are people who virtually lost

all of their retirement savings when Enron imploded. In the case

of Portland General Electric, more than $78 million in such benefits have been set aside for long-term compensation for managers

and directors and supplemental retirement and bonuses for its top

executives. And I understand that life insurance has a legitimate

role in our economy.

And FASB rule 106 requires any publicly traded company that

has an unfunded liability such as retiree health care plans to account for it in the annual financial statement, and life insurance

is often used as the source of that funding.

And the IRS can find out about the COLIs policies directly from

the companies, but there aren’t tight requirements, and this makes

it hard for others to determine just how much money is squirreled

away in the insurance permitting employers to use COLIs to pay

for lavish retirement benefits for executives, such as the situation

at PG&E and Enron. This is because current disclosure rules don’t

require them to distinguish between the executive life insurance

and rank-and-file life insurance.

First of all, do you think these disclosure rules should be amended to require companies to distinguish between the two types of insurance?

Mr. Holder.

Mr. HOLDER. As far as financial reporting goes, the financial

statements generally have been viewed, historically at least, as providing an overview of the enterprise and its past ability to generate

earnings and cash flows from various sources and its general financial structure at a particular point in time. So to require that kind

of a distinction would certainly deviate, I think, at least from the

33

historic general purpose of financial reporting in accordance with

Generally Accepted Accounting Principles.

I certainly recognize that the information you describe would

have relevance to a good number of people. Rather than require

that kind of information as a function of accounting principles, I

probably would advocate that it be provided through other communication mechanisms required by the Securities and Exchange

Commission.

I think that vehicle of additional information outside of the financial statements is well understood, and you see a lot of information of that type contained in official filings, 10-Ks and certainly

other documents filed. To the extent that information was considered to be sufficiently useful, that is where I would recommend it

be provided.

I am shooting from the hip here. I would like to think a little bit

more about it, but I don’t have that opportunity. That is my immediate reaction.

Ms. HOOLEY. Well, when companies report all of their life insurance in an aggregate, accounting rules require that they report the

increases in the aggregate cash value of those life insurance policies, and only if the increases are material. But material is not defined. So do you think we need to define materiality?

Mr. HOLDER. I think the SEC has done a pretty good job in Staff

Accounting Bulletin 99, I think, if I recall correctly, in tightening

what materiality means and reminding the accounting profession

generally that there are qualitative aspects as well as quantitative

aspects to materiality. The FASB has declined to do that beyond

providing very general guidance.

I believe the staff accounting bulletin has had a substantial affect on the way materiality is viewed. It is rather recent. But I

would be content at least myself, to see, you know, the effect that

it has had before I would propose at least additional information.

I believe that was the extent of your question. There may have

been something on the cash value side of it.

Ms. HOOLEY. No. I think you have answered the question. I have

just one other quick question, and this goes back to private companies and what Mr. Boehm was talking about in terms of some of

the pension funds. Certainly we have had some problems in my

State again with this issue.

Private companies generally aren’t required to make public filings with the Securities and Exchange Commission. Why do we

treat them differently? Should they make filings with the SEC?

Would that be helpful, not helpful?

Mr. HOLDER. Private companies or employee benefit plans?

Ms. HOOLEY. Well, employee benefit plans, pension funds, should

those be reported to the SEC? Just sort of what are your thoughts

on that?

Mr. HOLDER. Well, certainly there have been some problems in

that area, as you know. Most employee benefit plans have reporting obligations to the Department of Labor and to the IRS generally if they are subject to ERISA, the Employee Retirement Income Security Act.

Anyway, those two agencies, I believe, are charged with oversight

of financial reporting by pensions and have specified rules over the

34

years. At this point I wouldn’t be inclined to recommend transferring that responsibility to the SEC.

Certainly financial reporting by employee benefit plans can be

improved, and certainly there are incentives for bias and for selfdealing that exist anywhere economic resources are probably aggregated. So many of the things we have said about business enterprises and the issues that need addressing there would certainly

apply to employee benefit plans generally, I think.

Ms. HOOLEY. Mr. Chairman, can I ask one more question?

If there was one thing and only one thing that you would do to

change the law or change reporting or change what we do so that—

you know, I don’t know that you can ever stop what happened with

Enron, but what is the one thing that you would have the most—

you think would be the most significant change we could make?

Mr. HOLDER. I would empower audit committees. I would act to

make them independent of the companies that they serve. I would

make their relationship with the external auditor far more muscular and robust. I would also make that same relationship more

muscular and robust with the chief accounting officer, the chief financial officer of the company.

Ms. HOOLEY. Thank you very much.

Chairman BAKER. Thank you, Ms. Hooley.

Gentlemen, you have done such a good job. The bad news is the

committee is going to do a second round. We have more questions,

so I am going to start off.

First, for the record, I want the subcommittee to know that subcommittee efforts were made to secure comment on these subjects

from AOL Time Warner, from Xerox, from Dynegy, from

CALPERS, and from various pension union management representatives. All, at least for purposes of today’s hearing, declined to appear, and I think that unfortunate because not every action taken

was necessarily taken for untoward purposes. It may have been legitimate business management decisions that simply turned out, in

retrospective analysis, not to be good judgment.

But I think it important that we do get before the subcommittee

at some appropriate time representatives of market participants to

explain how special purpose entities, IRUs, goodwill, all of those

various accounting methodologies are utilized for valid business

purposes that do, in fact, result in shareholder value being enhanced.

Yesterday, I understand that the SEC has released for public

comment a new standard of disclosure requirement, specifically in

the management discussion and analysis section of annual reports

that relates to critical accounting policies. In summary, as I understand it from reading it this morning, it requires in that section

management to describe the assumptions used to arrive at values.

For example, if we are back in our widget manufacturing mode, we

are assuming widget market price will be $10, and that the pricing

for construction and delivery of the widget will be 5. All of those

things are based on certain assumptions: That the cost of raw materials won’t be adversely impacted, that market price will actually

be sustained at $10. And there must be some discussion in a simplistic way of how management came to represent the net value

after expenses of $5 per widget.

35

Are any of you in a position to be able to comment as to the adequacy of this new disclosure standard and your view of its appropriateness?

Professor Holder.

Mr. HOLDER. I just received the document that you referred to

myself last evening and got a chance to read it. I think as far as

accounting standard setting goes, I tried to be inclusive of—there

are lots of ways to improve the system, and standards is one of

those. In recent years you have seen the FASB, as they have produced standards, rather routinely requiring, when accounting estimates are required, that companies disclose the estimate of the requirement for making the estimate, the methods used to make that

estimate, and the significant assumptions that were adopted in the

application of that method.

A couple of years ago, I and a colleague of mine published an article calling for the generalization of that kind of disclosure. And

as I read the—because right now the disclosures are inconsistent

between different estimates, and, you know, it has been done on a

rather ad hoc basis.

This seems to be consonate with the belief that I have had for

some time that where you have ambiguous accounting numbers,

subjective accounting numbers, that one pathway to transparency

is revealing the methods used to make the estimates and the significant assumptions that were adopted in applying those methods.

So I would wholeheartedly support this type of an initiative. As

I understand it, most of this would go at MD&A, in management’s

discussion and analysis. And, as I testified earlier, I think this stuff

might well—I know the SEC doesn’t like to set accounting standards because it is FASB’s province, and there are features like

that. But I think this kind of information, I would advocate it becoming an integral part of the financial statements.

Chairman BAKER. Mr. Hill.

Mr. HILL. I would agree with all of that. I think though, that—

I mean, the SEC can kind of get the word out of how they are going

to interpret some of those things, and I would hope that that interpretation would include that in this kind of discussion, which is

really, I think, taking the footnotes stuff and putting it into layman’s language here, but I think it should include things like, you

know, what percent of our earnings this quarter came from the

pension fund. And, you know, but—and also this—this pro forma

aspect. I think that companies have the right to say this—this is

the way that we think our earnings should be valued, but I think

somewhere they should have to spell out what each of these items

are and defend why they think it should be counter to what common practice is.

So, I don’t know. We will have to wait and see what the SEC interpretation is and how they enforce it, but I think it certainly is

a good step forward and hopefully goes as far as what I am suggesting.

Chairman BAKER. Mr. Boehm.

Mr. BOEHM. My background is as a prosecutor and ethics lawyer,

not an accountant. I will pass.

Chairman BAKER. Thank you.

Mr. Bentsen, another round?

36

Mr. BENTSEN. Thank you, Mr. Chairman.

Although the prosecutors and ethnics lawyers are getting a lot of

work right now.

Mr. Holder, I want to go back to—and Mr. Hill actually—back

to the Enron case, because we looked at that more closely than others, and with respect to both the use of SPEs, which in and of

themselves I don’t think are particularly evil instruments, but obviously can be overused and misused. In the case of Enron—also I

wanted to talk about management compensation.

There has been a lot of discussion about the issue—about whether or not and how options should be disclosed, whether they should

be treated as an expense, whether or not shareholders should have

the right to approve options for management officers and directors.

In addition, in the case of Enron, we saw, I believe, if I recall correctly, that in a number of financing vehicles, SPEs and I guess

some others, Enron put a pledge behind or guarantee behind it,

which they guaranteed that they would—they pledged stock that

would be—to be issued later, which would have the effect obviously

of diluting the stock that had already been issued.

Are those disclosable events, or is it a subjective call on the part

of the company or the accountants as to whether or not that dilution of the stock or potential dilution of the stock would be

disclosable?

Do you think that it is a good idea that Congress should require

public companies to expense options once they are issued? And do

you think that we should beef up the disclosure particularly—and

also have shareholders approve options extended to officers and directors?

Mr. HOLDER. With respect to the options, I have—in fact, I

signed a letter addressed to Congress along with several hundred

or a couple hundred other professors advocating that the fair value

method of accounting for stock-based compensation, particularly

options, be the only method allowed under Generally Accepted Accounting Principles, and that the intrinsic value method of Opinion

25 be discontinued.

So I do believe that that is the appropriate accounting solution

here, because options generally do have a cost. They are a mechanism to a company. And it dilutes the value of shares. And in addition to that, we have empirically demonstrated metrics, options

pricing models, that, in my view, at least sufficiently value them

with sufficient precision and reliability to warrant their recognition

in financial statements.

As it relates to the Enron commitments, we do have an accounting standard that requires that guarantees of the indebtedness of

others be disclosed, even if the possibility of a loss resulting from

that is remote. I have struggled to understand why there was—and

I have not found it—but why there was no disclosure of those guarantees, why there was no disclosure of those commitments. Using

my own reasoning, I can start to develop pathways for why it may

have been believed that the disclosure standard I just referred to

didn’t apply in that circumstance, but it gets rather speculative.

And so I just—I haven’t seen enough facts in the public record for

me to dispositively say, here is why they did what they did or

didn’t do what they did.

37

Mr. BENTSEN. I would just add, in our hearings, the Chairman

may recall, when we had the dean of the University of Texas law

school testify on his report that a number of these options to issue

that were written as a form of a guarantee were also not approved

by the board. It would seem to me again that you are extending

a lot of credit on behalf of the company and thus on behalf of the

shareholders with one or two people apparently making that decision. Is that something where you would see a board function come

into play?

Mr. HOLDER. I don’t understand what you just said. All I said

was, based on what I have seen in the public record, I can’t explain

from a financial reporting standards perspective why a disclosure

wasn’t made. As it relates to the authority to issue or to engage

in such contracts and so on, that is a feature of corporate governance, and I mean—if a company has policies that require a board

approve a particular type of transaction, then that is how that company should operate, I would think. I mean, I am probably

missing——

Mr. BENTSEN. Well, I guess the question is if you are providing

a guarantee using the ability to issue stock in the future to fund

that guarantee, is that a function—if the shareholders aren’t approving the option, should at least the board of directors be approving that option since it is very likely that this action will dilute the

value of the stock that has already been issued? And do the board

of directors have a responsibility to the shareholders to give that

approval?

Mr. HOLDER. In all honesty I am, like I said, I am an accounting

person. You are speaking now of corporate governance and where

the authority to issue stock should be vested. You know, my sphere

of competence, I have an idea, and I have thoughts, but, I mean,

I don’t have particular expertise there that would inform a judgment that might result in legislation. I am happy to give you my

view, but I just feel uncomfortable venturing onto that turf as to

how corporations should operate, what rules should I evolve on

them for issuing the stock.

Mr. BENTSEN. Mr. Hill, if I could you get your comments on the

question of disclosure, shareholder approval of the issuance of options. You raised management compensation as an important issue

and cause. Do you think we need to crack down on the use of options in this respect?

Mr. HILL. Well, I do think there needs to be more control over

them, and I think that shareholder approval of officer and management options is probably a good thing. It has kind of been open

season. But, you know, even if you had that, the problem is if it

is essentially an inside board, why is it going to matter?

But I think it would be a good step, and hopefully the shareholders themselves would step up and actually take a look at the

proxy and vote accordingly. But you know, on the option expense

issue, I kind of—I guess I am going in dangerous ground here to

take a different position than the professor, because I am just like

the Congressman from Texas, a poor country boy here. I know

more about milking than I do about accounting.

But I think we need to think something—on the earnings statement here, we are getting too complex and getting too many whatVerDate 11-MAY-2000 10:21 Sep 09, 2002 Jkt 000000 PO 00000 Frm 00043 Fmt 6633 Sfmt 6633 C:\DOCS\79559.TXT HBANK1 PsN: HBANK1
38

if things in there, whether it is the market ruling—I forget the

FASB number, but if you can help me out there.

Mr. HOLDER. On derivatives? 133.

Mr. HILL. Thank you.

But, I mean, this is distorting earnings. It is going to render

them meaningless. People can’t make estimates. What is going to

come on the future on these things? Is it really representative of

what the company is earning? No. Does the issue need to be

raised? Yes.

But I think—again, I am thinking off of the top of my head here,

but maybe we need to do something where you take some of these

things out of the income statement and you have sort of a risk category where you have the what-ifs. And maybe that is the answer

to it.

But I think, you know, when we—on the option issue, if we are

going to expense them, I think it ought to be when they are exercised, because that is when the lost opportunity cost is for the company, whatever the difference is in the stock price and the exercise

price. Essentially if they had sold that to an outsider, they would

have had full price, but with the option holder, they are foregoing

some of that. So I think even though it is kind of not when the option was granted, obviously, but that is when the company really

incurred the cost and lost the opportunity to have gotten full value

for that share.

Mr. BENTSEN. Thank you, Mr. Chairman.

Chairman BACHUS. Mrs. Jones.

Mrs. JONES. Thank you, Mr. Chairman.

Mr. Holder, I am going to ask you questions this time around

since I asked Mr. Hill before.

And, Mr. Boehm, don’t think we aren’t happy that you are here.

With regard to Time Warner, Mr. Holder, Professor Holder, excuse me, the write-down of Time Warner as you speak to in your

statement is that they are complying with this FASB 142 or FAS

142.

Mr. HOLDER. Yes.

Mrs. JONES. So that was appropriate conduct for them to—understanding the rule—to then do the write-down. Is that a fair statement?

Mr. HOLDER. Based on the public information that I am aware

of, yes, that the accounting was called for in that circumstance.

Mrs. JONES. They stepped forward and did what they were supposed to do?

Could you tell me, do you believe this standard should change at

all or that it should be modified any more than it has been?

Mr. HOLDER. It is a very new standard. Certainly it is having an

effect, as we can see. The issue of how to account for goodwill has

been around for a long time and has been controversial in the——

Mrs. JONES. What did they use to do 20 years ago, if you have

been around that long?

Mr. HOLDER. Unfortunately, I have. Sadly, I have.

When the predecessor standard, APB Opinion 17, was written,

somewhere around 1970, the treatment of goodwill was, subsequent

to its recognition in a purchased business combination, simply one

39

of amortization, and the standard then said over a period not to exceed 40 years.

My own sense is, and my understanding of some experience from

long ago, were that the accounting for goodwill subsequent to its

acquisition at that time was a systematic and rational amortization

of that total amount over some future period, and many companies

were using 40 years. As time passed, that period shortened, and

challenges were raised about things that were becoming goodwill.

People were attempting to take what perhaps earlier would have

been recognized as goodwill and recognized it as other types of intangible assets.

Certainly I am not a tax expert in any sense, but the tax law

intruded here because some things would be amortizable and deductible, but not goodwill during periods of time.

But there really was an impairment test for goodwill until rather

recently. There certainly was not one contained in Opinion 17. And

so this standard is sort of a fresh way to look at accounting for

goodwill subsequent to it—and other intangibles for that matter—

subsequent to its acquisition. And it is an impairment-based, not

an amortization or a spreading of cost-based accounting standard.

You can build a case for either, depending upon what your view

of a measure of earnings ought to be, but I believe the new standard is certainly much more aligned with the conceptual framework

of financial reporting that has been developed also over the last 20

years.

Mrs. JONES. It is fair to say that it is a lot easier for you as a

professor, and Mr. Hill as an experienced accountant, and Mr.

Boehm coming from lawyer ethics, for us to sit in and, for lack of

a better term, pontificate about all of those issues. It is a lot easier

for us to do that than individuals coming from particular companies to come to this subcommittee and in 5 minutes tell their whole

company history and to be able to make some sense of it.

It is a lot easier for us to do that than for an AOL or a Dynasty

or Dynegy or whatever it is—excuse me, anybody here from

Dynegy, I don’t know the name correctly—than for us, in this circumstance—I find myself as a former trial lawyer, 5 minutes to ask

questions, I am just getting rolling before the time is up. So the

forum of congressional hearings, it is a difficult format to present

a situation. Would you agree on that?

Mr. HOLDER. I myself had difficulty trying to confine my remarks

to that period of time. I would suspect that others would be.

Mrs. JONES. Thank you.

Let me, Mr. Boehm, give you the last few minutes of my time

just to speak on anything you would care to speak on, just so we

didn’t bring you here and you don’t feel that you were part of this.

Mr. BOEHM. No. I appreciate that. And I am sorry the Congresswoman from Oregon isn’t here. She alluded earlier to a situation

in her State involving pension funds. What had happened there in

Oregon is that $100 million in pension funds belonging to union

members was lost through racketeers, and that is money that is

lost. And I viewed this case that is developing on Ullico, as there

is a duty that is owed to the retirees, to the people whose money

has been put at risk.

40

And in my exhibits, I have 25 recent cases, these are all cases

in the last year or two. Some of the numbers are staggering. When

the FBI swooped down on the Lucchese family in the year 2000 on

the scheme they had, they were on the verge of transferring $300

million from union pension funds into a management company controlled by the Lucchese crime family. I think it is fair to say that

this particular entity did not have the best interests of the union

workers, the retirees, at stake.

I appreciate the opportunity to answer a question, too. I have a

problem with the 5 minutes and so forth, but I realize the constraints of time, but if I had one thing to leave folks with here, it

would be this: That you have 7 trillion in pension funds in the

United States. You have literally billions of dollars in what they

call those Taft-Hartley funds that are union pension funds. There

are some of the same issues that affect Enron and affect Global

Crossing, which are transparency, accountability, and that the

stakeholders, whether it is a shareholder or a retired union member, ought to have more quality information, accurate information,

as to how their assets—they own the pension fund just as the

shareholders own the corporation—how they are being protected or

not protected.

So you had asked earlier what is one thing that could be done.

The one thing would be laws and policies that have a stronger emphasis on disclosure, because the time-honored saying is sunshine

is the best disinfectant. That is how we prevent these things.

Mrs. JONES. Thank you.

Chairman BAKER. In today’s hearing I will say that no one has

been constrained to 5 minutes.

Mr. HILL. I just was going to add something to your first question about AOL Time Warner. What we are seeing this year is sort

of a one-time event. I mean, there will be impairment of goodwill

as we go forward in future years, but because of the implementation of this new impairment test, why a lot of—I mean, yeah, there

was probably some impairment last year, but we are going back

and applying it to all of those other periods. So you are going to

see some big hits at a lot of companies, whether they are old-line

companies or whether they are new-line companies, this year.

Mrs. JONES. So it is magnified.

Mr. HILL. It is magnified this year. But it will subside in future

years.

The other thing in relation to the history is if you go back 10 or

20 years, most of the goodwill was created by a company paying

cash to buy another company, paying a modest premium over the

value of that company. So a fairly reasonable amount of goodwill

was created and amortized over 40 years.

But what has happened with the information age is that we had

these companies that—as I mentioned before, that go out and make

acquisitions with their highly valued stock, so a huge amount of

goodwill is created. And on top of it, given the nature of these companies, they say you have to amortize it over 3, 4, 5 years. So that

changed the whole situation with goodwill here in recent years and

was one of the reasons why—of moving to—the current system

where we do away with the amortization of goodwill, but have

tougher impairment tests.

41

Chairman BAKER. Mr. Sherman.

Mr. SHERMAN. I have quite a few questions.

I see that we have a professor here from USC. As one of the few

CPAs to come out of UCLA long ago, I may have dreamed of this

situation.

Mr. HOLDER. That bodes ill for me.

Mr. SHERMAN. No, I think we will get along fine. Let’s first take

a look at Enron. Let’s assume that those who were putting this

whole thing together hadn’t been so sloppy or so cheap or so unable

to get Barclay’s Bank to loan them $15 million when they needed

to borrow $15 million. Let’s assume that every one of the special

purpose entities met the 3 percent capital test, so that those who

wanted to prop up this $100 billion house of cards actually had the

few additional million dollars in that that they should have.

Under those circumstances, could Arthur Andersen have legitimately stated that, or even arguably stated, that the Enron financial statements were within the range of materiality, within the

range of possible interpretations of GAAP? Could they have given

them a clean opinion?

Mr. HOLDER. Let me try to answer the question this way. If the

SPEs had complied with all of the requirements that would avoid

their consolidation, then I think not consolidating them would have

complied with Generally Accepted Accounting Principles as a general matter.

My view is reinforced by the belief that professionals need clear

and unequivocal standards to the extent they are possible. And as

I have said earlier, there is great subjectivity in this area that

standards can’t remove. But to the extent that clear, unequivocal

standards could be produced, they should be, and if one complies

with those, then one should be comfortable their conduct is——

Mr. SHERMAN. I couldn’t agree with you more on the need for

clear standards. There are those who have come before this subcommittee or my colleagues who have said, if we could just get together and sing Kumbaya, if we could just tell people in the business world, do the right thing, then they all would. The fact is that

businesses are run by the people who have the best records, and

they get there by being aggressive. And then companies competing

for capital on the stock market, the edge goes to the most aggressive company run by the most aggressive people that run the most

aggressive company.

And to think that long term, because short term everybody remembers Enron, everybody is quaking in their boots, that will last

another 6 months, maybe a year, and then if we don’t—the idea

that those who are singing Kumbaya as they drive to work are

going to be running the most aggressive companies with the highest stock performances kind of ignores our culture.

But I want to get back to the need. Let’s go back to Enron, because what I have said in this room before is that it appears that

this is a company that got a ticket for going 101 miles an hour in

a school zone, but the posted limit was 90. That is to say, if they

had just gotten—put in that extra money to reach that 3 percent,

as you said, Enron, I don’t know if they would be selling for, you

know, 80 bucks a share, because their stock had started to go down

for a number of other reasons, but they would be a happy company

42

selling for 20, 25 bucks a share. Someone would be buying their

shares today, and that person would be making a mistake.

My concern is go back to the—if we don’t consolidate the SPEs—

the SPEs, as I understand it, borrowed money from the investment

bankers, and so it looked like the investment bankers were taking

the risks. And if you don’t consolidate the SPEs and you issue

those financial statements, aha, the risk has been borne by those

who lent money to the SPEs.

What concerns me is that the SPEs, as I understand it, had received assurances from Enron—not the SPEs, but the lenders to

the SPEs had received assurances from Enron that if those loans

ever went in the tank, Enron would issue them a line of Enron

stock. It is as if I go to my accountant and say, my factory burned

down, but don’t worry about it, I have an insurance policy. And he

says, well, yeah, but didn’t you insure your insurer? Well, that

doesn’t count because I am only going to give stock to my insurer.

Under the most liberal reasonable interpretation of today’s Generally Accepted Accounting Principles, and assuming the SPEs are

independent, not only do we not consolidate the SPEs, but do they

achieve the result that the derivatives provided by those SPEs are

recognized and the assurances given by Enron to the creditors of

the SPEs are not reflected in the financial statements?

Mr. HOLDER. Your general question is, is that appropriate?

Mr. SHERMAN. Yes. Within the most reasonable definition of

GAAP.

Mr. HOLDER. It is a very difficult question. The temptation is obviously here to say, obviously not, that there should be greater disclosure and so on.

If I may for just a moment, I think it is probably axiomatic that

the evolution of business transactions and events will exceed even

the most nimble of standard-setters. And so in order to—there are

a whole host of other reasons that I believe as I do, but that is certainly one of them.

Are there deficient standards, standards that may have been acceptable in yesteryear that today aren’t, because transactions are

being written to which those standards apply, that didn’t even envision the——

Mr. SHERMAN. The people looking for loopholes in either Generally Accepted Accounting Principles or in the Internal Revenue

Code will always find them. If you go to sleep for 50 years, you will

collect no revenue, and every company will be reporting higher

earnings every year, because you can’t go to sleep and let the loophole finders get a 50-year head start.

Mr. HOLDER. As unfortunate as it is, that is an abiding feature

of the way financial reporting, the way a lot of things, the rulemakers write rules. Those subject to them craft transactions, sometimes to try to avoid those rules, and I can’t think of a way to stop

that.

But in addition to better standards——

Mr. SHERMAN. Professor, with all due respect, I can; that is, be

as nimble as you possibly can be, and as quick as you possibly can

be. This Congress has passed quite a number of loophole plugs to

the Internal Revenue Code. And now and then there is a loophole

that some who disagree with a tax prevent us from plugging. Like

43

there are those who are opposed to a corporate income tax, so there

is a gaping loophole in the corporate income tax. They say, don’t

plug it.

But while there is disagreement in this House as to whether we

should have a corporate income tax, nobody disagrees that we

should have accurate financial statements given to shareholders,

and the way you get there is you plug the loopholes and also have

a general overarching standard that financial statements should

accurately reflect the situation.

What I am asking here is, is there a loophole that the FASB did

not plug that a reasonable, though somewhat liberal, accountant

could allow a company to exploit that allows the reliance on a derivative issued by a genuinely independent SPE whose creditors

have received assurance from the Enron company that if those

creditors lose money on the loans, they will get Enron stock? Is the

speed limit here 90 miles an hour?

Mr. HOLDER. Hindsight would suggest that is certainly the case,

sir.

Mr. SHERMAN. I mean, my image of the accountants at Arthur

Andersen is not that they were idiots, delusional, or viewed themselves as intentionally committing a crime. They thought the company had found a loophole that worked, and they only gave the

company a ticket leading to that company and their own demise

when they realized they were doing not 90, but 101 miles an hour.

And I have been pressing the FASB not only to deal with the SPE

issue, not only to deal with the mileage above 90, but to deal with

the derivative issue, to deal with the issue of what if you go to a

genuinely independent company and they insure you, but you insure them. What if your factory burns down and you have fire insurance, but, oh, wait a minute, you owe a whole lot of stock to the

fire insurance company?

Mr. HOLDER. Sure.

Mr. SHERMAN. Can you identify other areas where the FASB has

allowed a loophole of this magnitude to exist?

That will have to be my last question. Perhaps other members

of the panel would be allowed to comment on it, but the Chairman

has been incredibly generous with time.

Mr. HOLDER. Adopting your view of loopholes and so on, over the

years a great many accounting standards that have been produced

have been produced in response—at least in the eyes of some as a

response to an accounting abuse. You can go almost as far as back

as accounting standards have been crafted and see that thread of

logic. I think of leases, I think of accounting for leases. I think of

accounting for pensions.

It was earlier a Congresswoman alluded to the other

postemployment benefits standard, 106, that was produced. In

many cases there are unanswered questions that require a standard to be produced. FAS 133 on accounting for derivatives is one

of those. Certainly the future will reveal instances where accounting standards need to be created, and if we had the ability to foresee that need, certainly they should be crafted and produced today.

Accounting standards can be written better. There is no question

about that. There are a whole lot of structural issues, some of

which I relate in my written testimony, on how to improve the

44

standard-setting function. And certainly we should try to anticipate

unfolding transactions, and certainly we should be nimble in responding to those that arise, and we can get better at it, I think,

as a profession, and should, and should be provided the tools to do

that.

But I continue to say, I don’t think that is a complete answer,

because no matter how nimble you are, you can’t be that nimble.

And the people implementing and applying, even if you have got

the best standards, have to apply professional judgment in areas

of great subjectivity, unless you just wring out of the standards almost every aspect of relevance.

Chairman BAKER. Thank you, Professor Holder.

Let me maybe add on just one comment to that of Mr. Sherman’s

relative to FASB. Let’s make a grand assumption, Mr. Sherman,

that you and I are both qualified CPAs in business together. We

are monitoring this SPE transaction over at Enron. We consult. We

can’t get to the right determination as to what we should do, so we

flip over to our FASB home page and turn to the technical inquiry

service where we find a helpful suggestion that the FASB will—in

response to an inquiry we might make, the FASB will not issue a

written response to any technical inquiry; that the staff recommendations are only those; that the only font of authority on all

of this would be an official position by the Board; that we can only

respond to inquiries that relate to an applicable FASB pronouncement.

But listen to what they cannot pontificate on. I shall read. The

FASB staff cannot answer questions in the following areas: Auditor

independence; audit procedures or related auditor reports; compilation and review procedures of related accountants reports; SEC filing requirements; Federal, State or local income tax issues; legal

or contractural issues; structuring of transactions; materiality; detailed, fact-specific questions. And here is the one which I found of

particular interest, which I think is the only appropriate exclusion

from response: research for school assignments.

Now, if that is what our regulator of accounting practices can do

for a CPA in distress in this marketplace, gentlemen, we are in serious difficulty. And I just only learned of that helpful page just a

few moments ago.

We have to have a clear, concise, nimble response someplace

where an inquiry can be made where you know when you get the

answer, you can rely on it. This basically says, we can give you advice, but it doesn’t matter, because if the Board decides otherwise,

you are still in trouble. I think the IRS technical helpline is a pillar

of exemplary service compared to this.

We have a real problem. And let me add that next week we will

have another hearing on this matter at which time we will hear

from the Chief Auditor of the SEC and other interested parties.

This is not the end of our process, this is merely a step in the right

direction.

Did you wish to make further comment, Professor?

Mr. HOLDER. Only if you have an interest. I would react to what

you said.

Chairman BAKER. Certainly. Yes, sir.

45

Mr. HOLDER. In my written testimony I said additional steps can

be taken about the standards-setting and regulatory function. As

the current time many of the things you mentioned are not part

of FASB’s charter. They have no authority to speak on auditing

issues. They are confined just to financial reporting. That may not

be the right way for it to be. And certainly we need to be responsible and responsive to inquires from practitioners. SEC filings, I

mean generally you would ask the SEC about those.

So I clearly understand why you would see many of the limitations of what the FASB——

Chairman BAKER. But on the areas of questionable advice, it

ought to be understood, let’s help you comply with the SEC filings

if we can, but this clearly is outside of our bailiwick. On areas

which should be our responsibilities, you ought to be able to get a

definitive response within a few days on which you base a professional judgment and not be held liable. Why would any CPA step

out and advise a client with the presumption that at a later time

they would be found guilty of non-professional performance?

Mr. HOLDER. Mr. Baker, I think that absolutely makes a lot of

sense. In order to do that, the resources available to FASB to provide responses to the kinds of inquiries they would then expect to

get would be extraordinary relative to what they have today.

They also will have to change some of the Financial Accounting

Foundation’s due process requirements, because once you begin to

provide those kinds of authoritative answers, you would run afoul

of the current due process through which the FASB is supposed to

go before they establish authoritative standards. And so additional

steps need to be taken.

Chairman BAKER. We don’t have a place where the buck stops.

Everybody points at everyone else, and it is not my fault. Accountability is the only answer to this. If you know you are the one at

the end of the game who is going to be held accountable, you have

a tendency to be a lot more critical in your casual assessment.

Mr. SHERMAN. Mr. Chairman, if I could comment on this.

Chairman BAKER. It would be unusual if we had any panel that

even got remotely close to 10 minutes.

Mr. SHERMAN. I want to thank my many colleagues who aren’t

here, thereby giving us more time to talk.

Chairman BAKER. We have, by the way, dissolved our partnership example for the moment.

Mr. SHERMAN. I was looking forward to it.

Chairman BAKER. Well, if there is profitability there.

Mr. SHERMAN. As long as I was the first-named partner.

I would point out that when it comes to independence issues and

especially audit issues, that the AICPA is supposed to fill the function that the FASB fills for Generally Accepted Accounting Principles. Whether that is the right way to do it, whether they do a

good job I will put aside. Likewise the SEC answers some of those

SEC questions. But the most interesting part of your litany, when

the FASB says, we don’t want to deal with fact-based issues, hello.

Chairman BAKER. If it can’t be fact-based, I am going to make

up something here and see if you can answer this one.

As I say, I think that we have a real policy discussion ahead of

us on all of these matters. I do very much appreciate each of your

46

long-standing participation in the hearing. It has been productive

for the subcommittee’s understanding, and the written record will

remain open for an additional 5 days for Members to forward any

written questions they may have or further materials provided by

you.

We appreciate your courtesy, and our hearing stands adjourned.

Thank you.

[Whereupon, at 12:50 p.m., the hearing was adjourned.]

47

CORPORATE ACCOUNTING PRACTICES:

IS THERE A CREDIBILITY GAAP?

TUESDAY, MAY 14, 2002

U.S. HOUSE OF REPRESENTATIVES,

SUBCOMMITTEE ON CAPITAL MARKETS, INSURANCE,

AND GOVERNMENT SPONSORED ENTERPRISES,

COMMITTEE ON FINANCIAL SERVICES,

Washington, DC.

The subcommittee met, pursuant to notice, at 2:05 p.m., in room

2128, Rayburn House Office Building, Hon. Richard H. Baker,

[chairman of the subcommittee], presiding.

Present: Chairman Baker; Representatives Kanjorski, Gillmore,

Castle, Royce, Lucas, Weldon, Hart, Sherman, and Lucas.

Chairman BAKER. I would like to call this hearing of the Capital

Markets Subcommittee to order. This hearing today represents another step in the subcommittee’s continuing effort to properly assess the reporting of corporate financial condition to the market.

It appears, in the aftermath of Enron, Global Crossing, and others, there is a need for the subcommittee and the Congress to carefully review all of the elements that bring about market discipline

and to ensure that shareholders and investors are getting concise

and accurate reports on the companies in which they are invested,

or in which they are considering making such investment.

Over the past few months, there have been many troubling revelations, and I wish to make it clear that I think our system by

and large works very well, and that it is, in the aggregate, a system that is conducted by professional people trying to do a professional task. And it is unfortunate that the inappropriate conduct of

so few has brought about such broad-based market dislocation.

Nonetheless, it is our responsibility, I believe, to fairly assess

where there may be inadequacies, and for the subcommittee to act

appropriately based on the best counsel that we can receive.

I am pleased today to have the participants that we do have for

our hearing. I think all of them will be very helpful in helping the

subcommittee arrive at appropriate considerations and recommendations for future committee action.

At this time, I would recognize Mr. Kanjorski for any opening

statement he might make.

Mr. KANJORSKI. Thank you. Mr. Chairman, I ask that my full remarks be made a part of the record.

Chairman BAKER. Without objection.

Mr. KANJORSKI. Mr. Chairman, I want to congratulate you, first,

for having this hearing. I then want to address some of the things

that have happened over the last 6 months, and their relationship

to some of the groups involved in today’s hearing.

Certainly, Enron’s collapse and at least some of the other recent

earnings restatements that have occurred in corporate America

over the last year, and which will continue for a short period in the

future, are disturbing. More disappointing, from the standpoint of

48

the world’s wealthiest, freest economy, is that excess sometimes

drives good, reasonable people to unacceptable extremes.

Even though I am a lawyer and I have gotten used to the legal

profession being kicked around in my life, I have to say that I have

great sympathy for the accounting profession. In a broad sweep,

they seem to be being painted with the primary responsibility for

Enron’s collapse and these other weaknesses in our system. They

have been burdened with our unwillingness as a society and as an

economy to decide whether we are going to use principle-based or

rule-based accounting systems. The excesses in our capitalistic system that have occurred over the last 8 or 10 years could have driven the weakest among us to steer away from our values or basic

principles.

In terms of the accounting profession, they do not need a defender, but I will try to defend them a little bit. I hope that we as

a committee, a Congress, and American people do not castigate the

profession unduly, or fail to recognize the importance of the profession and their incredible contribution to the free economy of the

United States over the years. It is only through their very professional activity that the economy of the United States has gotten to

the point it is now, which is the greatest economy in the world.

There seems to be a problem with some management in corporations. There seems to be a problem of corporate governance in some

corporations. There seems to be a problem with some accountants

that work for some corporations. And as a lawyer, I have to say,

there seems to be an awful lot of questions as to whether the legal

profession has risen to the occasion.

But I do distinguish in our society the difference between people

that are in business to do things, and people in the professions to

maintain standards. I hope that we do not discourage the future

students of this country from entering the honorable profession of

accounting because of what has occurred. The behavior of a few

represents a very, very small portion of the accounting profession.

Those accountants that I have had the pleasure of knowing over

my lifetime and doing business with, I can say have acted with incredible ethics and proper conduct within the system. I want to

make that point as a matter of record.

We have also had in this situation a merging of the question of

what is a professional and what is a businessman. As I was coming

back to the hearing today, I was thinking—not to further alienate

another group—about investment bankers. I sort of thought: Maybe

we could say that investment bankers are businessmen, and businessmen are to a large degree salesmen; these investment bankers

are salesmen in Brooks Brothers suits.

But, there is a difference between them and a lawyer and an accountant. The latter are professionals. They really deal with such

substance, and have had such high credibility, that even raising a

question about them injures them and injures our society.

I think this hearing today can be very productive, and I think we

should look into what new rules have to be put in place and what

can be done to tighten the accounting system. The new economy is

so significantly changed. We have moved from accounting for the

production of screwdrivers, which was rather easy, to trying to figure out the value of derivatives, which is not easy. But we should

49

not just find a target defendant, if you will, and castigate them because of some of the failures of this system. Instead, we should concentrate on the positive. What can we do for better governance?

What can we do to make sure that management is more responsive

to the marketplace and to the shareholders? What can we do to the

professionals that step out of line? We should also ask whether or

not the free market system or the profession can respond appropriately, or whether there is need for new rules and regulations?

But, by no means should we run down this path with tremendous speed. I think the fear I have now is more that we can injure

the system and have unintended consequences come out of our

acts, than if we act deliberatively. We must study what has happened, and try and only be as responsive as absolutely necessary.

So I look forward to the very competent list of witnesses we have

today to give us the proper map to follow on that course.

Thank you, Mr. Chairman.

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

on page 148 in the appendix.]

Chairman BAKER. Thank you, Mr. Kanjorski.

Mr. Lucas, or Ms. Hart, either one have an opening statement?

[No response.]

Chairman BAKER. Mr. Sherman.

Mr. SHERMAN. Thank you, Mr. Chairman. I regret, I think my

statement will have a slightly different tone than that of my more

senior, more learned, and more knowledgeable colleagues.

I don’t think that we can say all is going well, and we just had

a problem with one company due to the moral failings of a few individuals, and now that those individuals are no longer making important national economic decisions, everything is fine. And I realize that is not what my colleagues have said, but to the extent anybody would exaggerate their comments to reach that conclusion, I

would respond that instead, the markets don’t think that way.

The market value of what is being traded on Wall Street has not

just dropped by a few tens of billions of dollars representing the

overstatement of the value of the stock of Enron, but rather our

markets are selling for perhaps a trillion dollars less than they

would be if, in virtually every company, but especially those that

deal with derivatives or those that deal with energy—but across

the board, people did not factor in as bigger than any terrorism

risk, as big as perhaps a recession risk, an accounting risk.

In our first set of these hearings, we discovered—at least a USC

accounting professor told us, and I am not blinded by my UCLA

loyalties to the wisdom of that professor—that if only the Enron

folks had dotted their i’s and crossed their t’s, perhaps any one of

several different accounting firms would have blessed, correctly—

or at least arguably correctly—what they did. If only they had put

up a few additional millions of dollars to make sure that their special-purpose entities reached that glorious 3 percent independence

level, then they would have been allowed to use those special-purpose entities for covering the billions of dollars of losses through

the appearance of being insured against those losses by derivatives,

and without the accounting system taking into account the fact

that they had, in effect, insured the creditors of their insurer, and,

in fact, had no insurance against the losses which they chose not

50

to state; and this whole house of cards came tumbling down not because it was a phony house of cards that the accounting profession

would never allow to stand, but just because it didn’t meet those

independence standards that could have been met for a few million

dollars of additional capital.

We have had a rules-based system and a principles-based system. The principles are always there. They don’t need to change,

but they are never enough. They weren’t enough for Enron, they

weren’t enough for the accounting scandals of ten or 20 or 30 years

ago. You, in addition, need rules, and the rules do have to change,

because there are two accounting systems that we have in this

country, and we can compare them. We have a tax accounting system and a financial accounting system.

The tax accounting system, we know we have to plug new loopholes every couple of years, because the tax lawyers come up with

new loopholes every couple of years. And if we still had the 1939

code, we wouldn’t be collecting any taxes at all, at least from more

sophisticated taxpayers.

And we need to also plug loopholes in the accounting principles

promulgated by the FASB. And I would hope that you are moving—and we have talked about this privately—very quickly—not

precipitously, but very quickly—toward special rules dealing with

derivatives, dealing with a company’s own stock, and dealing with,

especially derivatives on and dealing with the company’s own stock.

I think the SEC and FASB have failed us to some extent up until

now in allowing smart people to logically talk to other smart people

in one of the most respected accounting firms in this country, and

convince each other that they were in compliance with the rules.

If only a few million dollars had been there, as they thought it had

been—if only these SPEs had really been independent—when, in

fact, the rules should have prohibited them from getting anywhere

close to where they were.

I would add that we also, perhaps, need to look at—and I

brought this up in legislation, but I know that was just the first

piece of legislation—the fact that the AICPA, in its governance of

the ethics of accounting firms, allowed a situation where David

Duncan was the final decisionmaker as to whether Arthur Andersen would sign an opinion, when, in fact, it ought to be the Quality

Review or Technical Review department of any accounting firm

that makes that decision.

So I do think we have some changes to make—SEC, FASB,

AICPA—and that not only was there an Enron problem, but the

market perceives a great risk, and I think correctly, that perhaps

to a less than Enron extent we have problems with other companies being traded on the exchanges.

Thank you.

Chairman BAKER. Thank you, Mr. Sherman.

Mr. SHERMAN. Mr. Chairman, if I could also honor Mr. Jenkins

in his last month of service with the FASB. It is my understanding

that after many years of outstanding service, that he will be leaving.

Chairman BAKER. Absolutely. If there are no further opening

statements, I would like to recognize our panelists.

51

We have with us today Mr. Robert K. Herdman, who is the Chief

Accountant for the Securities and Exchange Commission, and appears before this subcommittee for the first time. Welcome, Mr.

Herdman—second time? Welcome here. Glad to have you, sir. Your

full testimony will be made a part of the record, but feel free to

proceed as you choose.

STATEMENT OF ROBERT K. HERDMAN, CHIEF ACCOUNTANT,

SECURITIES AND EXCHANGE COMMISSION

Mr. HERDMAN. Thank you, Mr. Chairman. Chairman Baker,

Ranking Member Kanjorski, and Members of the subcommittee, I

am pleased to appear before you on behalf of the Securities and Exchange Commission to testify concerning the roles of the SEC and

the Financial Accounting Standards Board in establishing generally accepted accounting principles, and questions that have arisen with respect to the relevancy of generally accepted accounting

principles in today’s business environment.

I know that all of the Members of this subcommittee have

worked diligently over the past few months, and I would like to

commend the leadership shown by you, Mr. Chairman and Ranking

Member Kanjorski, as well as Chairman Oxley and Ranking Member LaFalce of the full committee, in exploring these important

issues and working to maintain investor confidence. I would also

like to add that the SEC has appreciated the opportunity to work

with you and your staffs, and we look forward to continuing that

cooperation.

Recent events and press articles have raised questions about the

transparency of the accounting and disclosure practices of some

companies. While our financial reporting system in the U.S. continues to be the best in the world, certain aspects of the system can

and should be improved. In particular, the Commission believes

that the process for setting financial accounting standards must be

enhanced so that changes to accounting standards can be implemented more quickly, be more responsive to market changes, and

provide more transparent information to investors.

The SEC has a unique position in the financial reporting process.

The Commission not only has authority under the securities laws

of the United States to set accounting standards to be followed by

public companies, but also the power to enforce those standards.

Practically since its inception, the Commission has looked to the

private sector for leadership in establishing and improving the accounting methods used to prepare financial statements. The body

currently performing that function is the FASB.

With this context in mind, I would like to share with the subcommittee the SEC’s insights into the standards-setting process,

and the reforms needed to continue to support our capital markets.

The SEC is on the front line of financial reporting by virtue of its

day-to-day activities, and often is among the first to identify emerging issues and areas of accounting that need attention. On issues

already identified, such as revenue recognition and accounting for

business combinations, the staff refers them to the FASB for guidance. As the FASB conducts its deliberations, the SEC staff monitors the project to ensure that any final standard improves financial reporting for investors.

52

The SEC staff should not dictate final standards, but rather we

should allow the private sector standard-setting process to work

under our oversight. Once a project is completed, the SEC staff

should evaluate the final product taken as a whole, and only if the

product taken as a whole is not in the best interest of investors

would action on our part be necessary.

As companies adopt new standards, the SEC staff also monitors

implementation, addresses additional questions, and refers unique

issues to the FASB’s interpretive body, the Emerging Issues Task

Force. Through this cycle, many EITF issues that have been addressed were done so at the request of the SEC because of implementation problems it observed in practice.

In light of the SEC’s unique role, it is critical that the SEC work

closely with the FASB. However, no matter how good accounting

standards are, there always will be instances where some answers

will not be clear and additional guidance will be needed. In these

instances, we have encouraged companies and their auditors to discuss the issue with the staff on a so-called pre-clearance basis. The

cooperative efforts between the public and private sectors has given

the United States the best financial reporting system in the world,

and the Commission is working to make it even better.

In this day and age, one cannot talk about standard-setting in

the United States without discussing international convergence.

While convergence can have a variety of different meanings, it is

generally assumed that ultimately all standard-setters should

agree on a single high-quality accounting answer. To this end, the

SEC has encouraged both the IASB and the FASB to re-examine

their agendas in order to speed up their short-term convergence efforts.

I would also like to address another critical and related part of

the financial reporting process, which is the oversight of the accounting profession. Auditing provides credibility to financial statements and comfort to investors. Accordingly, the Commission is actively exploring ways to strengthen the system of overseeing the

work of the accountants that perform audits of public companies.

In my written testimony, I have outlined the model we are pursuing, which is similar to the CARTA bill passed by the House last

month.

In summary, even though our system is the best at present,

there is room for improvement. Recent events have been a catalyst

for reform, and the work related to implementing needed reforms.

While it is imperative that the criticism of the accounting standards-setting process be addressed, we should not abandon the system that has allowed us to achieve what we have to date. Instead,

we must take the opportunity to make fundamental improvements

to standard-setting and oversight.

Thank you for your interest and having scheduled this hearing

today, and inviting me to participate. I am pleased to answer any

questions that the subcommittee Members may have.

[The prepared statement of Robert K. Herdman can be found on

page 152 in the appendix.]

Chairman BAKER. Thank you, Mr. Herdman.

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Our next witness is Mr. Edmund L. Jenkins, Chairman of the Financial Accounting Standards Board, and certainly no stranger to

the subcommittee.

We have worked with you over the years, Mr. Jenkins, on a number of topics, and I know that retirement plans are in the offing.

My best to you in whatever the future may bring, and we certainly

have regard for your years of work and contribution. Please proceed as you choose.

STATEMENT OF EDMUND L. JENKINS, CHAIRMAN, FINANCIAL

ACCOUNTING STANDARDS BOARD

Mr. JENKINS. Thank you very much. Chairman Baker, Ranking

Member Kanjorski, and Members of this subcommittee, I am

pleased to appear before you today on behalf of the Financial Accounting Standards Board. I have brief prepared remarks, and I

appreciate your entering my full testimony into the record.

The FASB is an independent private-sector organization. We are

not part of the Federal Government, and we receive no Federal

funding. Our independence from the Federal Government, reporting enterprises, and auditors, is fundamental to achieving our mission to set accounting and reporting standards to protect the consumers of financial information, most notably investors and creditors. Those consumers rely heavily on credible, transparent, and

comparable financial reports for effective participation in our capital markets.

The FASB has no power to enforce its standards. Responsibility

for ensuring that financial reports comply with accounting standards rests with the officers and directors of the reporting enterprise, with the auditors of the financial statements, and for public

companies, ultimately the SEC.

The FASB also has no authority with respect to auditing, including auditor independence and scope of services. Rather, our responsibility relates solely to establishing financial accounting and reporting standards.

The title of this hearing, ‘‘Corporate Accounting Practices: Is

There a Credibility GAAP?’’—with two A’s—might be read to imply

that generally accepted accounting principles, or GAAP, are the

main contributor to what many perceive to be the growing lack of

credibility of corporate financial reports.

I strongly disagree. U.S. GAAP, when properly applied, still produces the most transparent financial reports in the world, financial

reports that are an essential element of an efficient capital market.

Should U.S. GAAP be improved? Without question. And as part

of the Board’s ongoing process, the FASB is actively working with

our constituents, including the SEC, as Mr. Herdman mentioned,

to continue to make necessary improvements to GAAP. In addition,

the FASB—and our financial accounting foundation, which has

oversight over us—is reviewing and modifying our due process procedures and taking other steps to improve the efficiency and effectiveness of the standards-setting process. Those actions are described in detail in the full text of my testimony.

In my opinion, the most efficient and effective accounting standards-setter imaginable, and the highest quality accounting standards conceivable, could not have prevented the Enron bankruptcy;

54

could not have prevented the many corporate restatements of recent years; and could not alone improve the credibility of financial

reports.

Remember that restatements, including the Enron restatements,

are done to bring financial statements into compliance with existing accounting standards. By working together, standards-setters,

reporting enterprises, auditors, and regulators share the responsibility for a credible and transparent financial reporting system.

Each party must carry out its responsibilities in the public interest.

Reporting entities seeking to access the capital markets for financing are responsible for preparing the financial reports and presenting those reports to investors. Those enterprises must apply

GAAP in a way that is faithful to the intent of the standards. Unfortunately, the far too common practice of seeking loopholes to

find ways around the intent of the standards obfuscates reporting

and does not result in a transparent and true reflection of the economics of the underlying transactions. That practice must end.

Auditors examine the financial reports of enterprises to determine that GAAP has been fairly applied. Auditors also must assure

that the stated intent of the standards are followed, and not accept

facile arguments that the reporting is acceptable because the

standard does not explicitly say that the reporting is unacceptable.

Auditors have a primary responsibility to the public, since consumers do not have the same access to the underlying facts about

an enterprise’s operations and transactions. Auditors must end the

practice of accepting ‘‘Show me where it says I can’t do this’’ accounting.

Finally, regulators, principally the SEC, are responsible for protecting the investor. Through their oversight and enforcement activities, regulators assure that enterprises report their financial

statements based on GAAP, and that auditors are independent and

examine financial statements using accepted auditing standards.

The SEC must have the resources that it needs to fulfill that important role.

Thank you, Mr. Chairman. I very much appreciate this opportunity and your courtesy, and I would be pleased to respond to any

questions.

[The prepared statement of Edmund L. Jenkins can be found on

page 164 in the appendix.]

Chairman BAKER. Thank you very much.

I would like to start with the announcement made today by

Standard and Poor’s to go to a ‘‘core value’’ reporting assessment

methodology where, for example, one-time non-recurring revenues

are not booked as operating profits in a quarterly statement—from

a sale of an asset, for example. Have you had a chance yet, Mr.

Jenkins, to be familiar with those, or do you have some opinion

about what they are doing?

Mr. JENKINS. I have only seen the reports in the media about

this, and I just, prior to this hearing, did receive the news release

from Standard and Poor’s, which I have quickly read. But I am

generally familiar with what Standard and Poor’s is trying to do.

They announced a couple of months ago that they were going to

look into this area.

55

And I believe that they are doing what analysts truly should

do—analyze the financial statements. I believe it is the role of financial reports and financial statements to provide the information

that is necessary for analysts to do their job. And that includes providing good information that they can use to make adjustments.

The core earnings approach is one that is an important approach,

because it is designed to provide the information that is most likely

to be replicable in the future—and, after all, it is future operations

that form the basis for investment decisions. But it is all based, as

Standard and Poor’s acknowledges, on the underlying information

in financial statements, reported earnings.

I wouldn’t want to, without further study, get into the individual

adjustments that they are making. But I believe that this approach

is entirely appropriate. It is very consistent with the AICPA’s Special Committee’s report on improving financial reporting, that recommended that we try to do a better job of displaying information

that is recurring from that that is non-recurring.

So I think this is—as long as it is based on information that

comes from audited financial reports, and the items and the

amounts that are used to come up with the core earnings are clearly displayed, so that investors can make their own determinations

on whether those adjustments are the ones they would make, I

would support this effort.

Chairman BAKER. Well, I only have concern with regard to the

possible creation of another set of accounting standards with which

businesses have to comply and still have to meet the generally accepted standard, which, of course, FASB generates.

What was of interest to me is that from their statement of a couple of months ago, that they were able to move so quickly to the

presentation of these standards in such a short fuse, realizing the

potential consequences of this announcement for capital formation

generally. Which gets to the question that is obvious and evident

of concern: why does it take so long to go from an Emerging Issues

list to a final statement that changes, ultimately, market compliance with a new standard?

Almost any subject—we can even go back to the SPEs themselves—from the initial authorization to the statement issued

last—well, this April—relative to the committee’s work. What is it

that can be done to expedite a more prompt reaction to evidently

market difficulty?

Mr. JENKINS. Well, one very significant and important difference,

particularly for this subcommittee, I believe, between Standard and

Poor’s and the FASB is that they have no responsibility to carry

out any open public due process with respect to what they are

doing. And I, for one, believe that our open due process—an opportunity to listen and hear from all of our constituents before we

make decisions—is central to the credibility of the FASB. And I believe that Congress, as well, wants to be assured that constituents

have adequate opportunity to weigh in on our decisions. So that is

at the core of the difference between, I think, between Standard

and Poor’s and the FASB’s activities.

We also undertake really fundamental changes. Standard and

Poor’s approach—and this isn’t to denigrate it in any way—is going

to take information that comes from our accounting standards to

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come up with the amounts that they are going to use for these adjustments. But without the standards that we have, they wouldn’t

have reliable, consistent information, perhaps, about unrealized

gains or losses from hedging activities, for example. So those complex issues do take time to research and study.

Still, there is no question that we need to move more rapidly in

establishing standards. And we have undertaken some efforts, even

before Enron, to do that. Most recently, as you perhaps know, the

voting majority required for issuing a standard has been changed

from a supermajority to a simple majority. That, at the margin,

will help speed things up.

We are changing our internal process. We intend to go more toward a principle-based approach to standards, as Congressman

Sherman mentioned. We have principles in our standards. It is trying to answer every conceivable standard that, as a part of setting

standards, that gets into overly detailed rules. We do this for the

benefit of our constituents, but it takes time and it increases the

complexity. So we are going to try to cut down on the number of

detailed questions that we answer as a part of our approach. Internally, we have undertaken new internal plans with respect to how

we approach projects.

We accept the criticism that we need to move more quickly. But

it is also essential that we end up with high quality standards, and

that they have been subjected to open due process.

Chairman BAKER. Thank you. We will, I am certain, come back

for an additional round of questions, given the number of Members

here. But I do want to give other Members a chance to proceed.

Mr. Sherman.

Mr. SHERMAN. Yes, Mr. Chairman. I am a little less sanguine

than the other Members of this subcommittee. We are told over

and over again that the U.S. accounting system is the best and the

most transparent in the world. I would add that Nero fiddle as

Rome burned, and as he was fiddling he would have been justified

in singing along with the fiddled that Rome, even after the fire,

was the most powerful city in the world. We do need to do more

than just say we are better than other systems, such as the Russian business system.

There is a huge credibility gap. And even Nero, I think, ordered

that the fire be extinguished before due process was fully carried

out. We do have a fire going on here.

Now, Mr. Jenkins points out that the SEC is responsible for enforcing FASB standards with regard to publicly traded companies.

Mr. Herdman, I am told that during all of 1999 and 2000—roughly

730 days—that not a single hour of SEC professional time was

spent with regard to looking at or enforcing the FASB standards

on the Enron financial statements, even though those statements

included absolutely incomprehensible footnotes. Can you tell me

that that information is wrong?

Mr. HERDMAN. No, I believe that is correct, Congressman.

Mr. SHERMAN. So Mr. Jenkins tells us that the SEC is supposed

to enforce, and in this case—even on my quiet, residential street,

a policeman comes by, you know, more than once every 2 years.

I think that we have also left out one element of the enforcement, and it is, in fact, the primary element of enforcement, and

57

that is the trial lawyer system, the civil bar. In fact, if any company’s stock drops according to a variety of formulas, you can count

on a lawsuit.

And what worries me, Mr. Jenkins, is if we go to a system that

says, we are not really relying on specific rules, we are relying on

principles like ‘‘do the right thing.’’ First, if we could really rely on

such principles, we wouldn’t need auditors at all. Shouldn’t

businesspeople just do the right thing? Why do we have to audit

them to make sure they do the right thing?

But putting that aside, if we rely just on relatively simple principles, could you ever get summary judgment against a plaintiff

who sued, noting that stock had declined significantly and that

other people applying those same relatively vague principles would

have provided a much less rosy picture of the company the investor

invested in?

Mr. JENKINS. Well, I am not an attorney, so I am not going to

opine on whether you could get summary judgment on anything.

But I think it is a matter of finding the right balance. I agree

with you that it is not enough to say look to our rather complete

conceptual framework, for example, on which we start when we develop a standard, because it doesn’t address the specific issue that

is under consideration. We need to develop the principles that come

from that conceptual framework that are relevant to the particular

issue at hand.

Then I think it is not enough, either, to quite stop there. We

need to make sure that there is sufficient guidance as to how to

implement those principles to a reasonable extent to assure that

people will generally apply those principles in a consistent way.

Mr. SHERMAN. If I can cut you off, what if we went with a simple

income tax law? Just a dozen pages, basically, and then at the end

we just say, ‘‘Pay your fair share’’? Do you think Federal revenues

would go up or down?

Mr. JENKINS. I don’t have an opinion on that, either.

Mr. SHERMAN. Let’s face it. They would go down precipitously,

and this country would not be a superpower anymore.

Mr. JENKINS. Well, I think there is, though, in fairness, the purpose of the Internal Revenue code and the purpose of financial reporting, I think, are significantly different.

Mr. SHERMAN. They are somewhat different and somewhat the

same. You go to an accounting firm; you pay that accounting firm.

They complete your income tax statement, and you will be most

happy with their services if they report the lowest possible earnings to the Federal Government. You go to an accounting firm; you

pay that accounting firm. And you will be most happy with their

services if they report the highest possible earnings to your shareholders.

Now, the only difference—and it is a difference none of us delight

in—is that the second kind of accounting activity can result in a

civil lawsuit against the accountant. There are some other differences as well. But to say that the pressure on the financial accountant is less than on the tax accountant; to say that we accept

as a society that the tax accountant will do everything legal to report the lowest possible earnings to the Federal Government, but

that the financial accountant will somehow be immune from the

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same principle, from the same fact that they are being paid by the

client, I think, asks us to substitute wishful thinking for an examination of the economic structure.

Tax accountants are professionals, too. Yet, if we were to discover

that tax accountants tried to come up with the lowest possible reported earnings, we wouldn’t have hearings here. We wouldn’t be

surprised. We would have hearings if a tax accountant wasn’t doing

that.

And I don’t think that we can rely on general principles, enforced

not at all by the SEC—at least with regard to Enron during 1999

and 2000—and enforced chiefly by a civil bar. But I shudder to

think what the civil bar will do if the standards are made, are replaced with principles.

But I get your point; you are trying to do both. And I think I

have run out of time.

Chairman BAKER. And if I can, just for the record, if the IRS is

listening, my tax accountant always makes me pay the higher

amount.

[Laughter.]

Mr. SHERMAN. He will be losing all of his clients, except one.

Chairman BAKER. Yes, but I won’t be audited.

I think for the moment I will start with another round while we

are waiting for other Members to return. I want to get back to this

timeliness question, and how we can construct a system which

gives opportunity for public comment, but draws a more narrowly

defined constraint around that activity.

For example, if a problem would come up through the Emerging

Issues Committee, as of that date when it is on that agenda—sort

of a starting gun—that within a year, if there hasn’t been some

resolution or final statement issued—there may be work documents, there may be some other background that has been assigned to get us close to a position, but yet not yet there, as in the

case of SPEs—shouldn’t there be some other mechanism—perhaps

throw it over the fence at the SEC shop and have them, with some

time obligation come up with the resolution? In other words, a predetermined series of steps that lead us to a judgment?

It is like a court proceeding. Sometimes you don’t get all the stuff

timely filed; sometimes it is not admissible—whatever the case

may be. But ultimately, you have to deal with a certain set of facts

and reach the best judgment you can within the constraints in

which you operate. But I think in this instance, our constraints are

so difficult we can’t get there. And I think the cost of that is worse

than not having ample input from all parties concerned.

Would you like to respond, Mr. Jenkins, to that approach or concept?

Mr. JENKINS. Well, I think it is fair to say that we ought to set

appropriate goals in terms of timeliness for each individual subject

that we take up. But I don’t think that those goals would be the

same in each case; it would depend on the complexity of the issue.

But I think it is fair to set some goals and to stick with them.

That means, particularly, I think—and this is something else that

we are working on—is making sure that the scope of the issue is

narrow enough, that we get the inadmissible stuff out at the front

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end, so that we have a good shot at reaching a conclusion on what

we do undertake to address in a relatively short period of time.

Chairman BAKER. Let me jump in on that goal description that

we are talking about. What troubles me is rules that are not intended—that are perhaps manipulated by smart individuals for a

specific unintended consequence—which create the difficulty. But if

we go at it with the view that ultimately an accounting activity

is—two things in mind: one is to give a fair snapshot of true financial condition at the time of its preparation, which is always understood; but two, it is an activity which will enhance the ability of

the corporation to succeed, in a very broad statement. In other

words, if we do it this way, we are likely to be successful.

What troubles me about—let’s take indefeasible rights of use.

And looking at a particular statement—I don’t remember the corporation at the time. But they were booking revenue in a current

quarter from the prospective sale of a telecommunications service

for which the network did not yet exist.

Now, I don’t know how that could possibly be held up to be a

measure that adds value to the system. And from my limited understanding of how these things should work, that ought to be a

prohibited activity. Perhaps you can book one-time sales, or onetime events, or aberrant activity in revenue, but it certainly ought

to be noted, so that if you are in the business of making shoes, and

you happen to have a rich uncle who passes away and you get a

$500,000 life insurance benefit and you put that in the business,

you have got to show that that is $500,000 of Old Uncle Joe, and

not sales of shoes.

We are not there. I think my problem with the current system

is when you look at a statement, you can’t determine, from the current reporting requirements, what their underlying business activity is generating.

Mr. Herdman, you want to jump in on any of this?

Mr. HERDMAN. Thank you, Mr. Chairman. I think, on the example you just cited, on the indefeasible rights of usage, that there

needs to be some real care taken here between what was being

done in the financial statements prepared under generally accepted

accounting principles and filed with the SEC, as opposed to what

was being disclosed in earnings press releases using alternative

measurement sources commonly referred to as pro forma earnings,

and certainly the kind of thing that Standard and Poor’s action

today is intended to prevent.

And while we have some investigations in process with respect

to some of the companies that engaged in the Indefeasible rights

of use-types of transactions—and I can’t get into specifics—I do

think that it is very important to—and I hope you get some comfort

from the fact that the Commission has put out some advice, some

cautions to companies with respect to their earnings press releases,

that the minute they depart from generally accepted accounting

principles in those press releases, they run the risk of violating the

Anti-Fraud provisions of the securities laws.

And we also have pointed out to them that when they do present

these alternative measurements, that the only way that they in effect have what you might call a safe harbor from violations of the

securities laws is to present a clear, specific, itemized reconciliation

60

between the results under generally accepted accounting principles

and under this alternative measurement that they have forwarded

to the public through their press releases.

Chairman BAKER. Well, I will press it just a little bit further.

Let’s assume for the moment that it is clear, at least from the outside looking in, that the corporate structure was intended to obfuscate debt, or to create revenue. When you ask the individuals involved in the creation of these accounting methodologies, ‘‘What

was the business purpose for doing this?’’ there ought to be a rational explanation as to the public benefit or shareholder benefit

that accrued from that activity.

Where that is absent, and it appears to be obfuscating true financial condition, some sort of liability ought to attach to that effort. And that, I think that is my frustration, is it appears that people are saying, well, this complies with GAAP. Well, if that is complying with GAAP, we need to make it clear that GAAP provides

for honest disclosure of true financial condition.

Is there a question about that? I mean, when somebody says it

is GAAP-compliant, does that obviate you from any criminal liability?

Mr. JENKINS. Well, I think that the whole goal of presenting financial statements is to provide transparency of information, which

is another way of saying what you have just said, I believe. And

we need to do that. That has to be our goal. That is why financial

statements and financial standards need to be continually improved.

Chairman BAKER. Well, it is a fine point. But for me, it is important anyway—if you are GAAP-compliant——

Mr. JENKINS. Yes.

Chairman BAKER. But, the consequences of being GAAP-compliant in some circumstances lead to a hiding of true financial condition, that still should be a violation of something. Is it?

Mr. JENKINS. Well, I think that gets to the issue of how the

GAAP information is displayed in the financial statements. And

that gets to your question of putting the proceeds from a life insurance policy in revenues; I don’t think that that is in compliance

with GAAP. I don’t think that that should be done. I am not aware

that it is done.

And there are some fundamental rules of what goes into revenues and what is other kinds of income. But we need to have disclosures when we have these unusual or one-time revenues.

Chairman BAKER. Yes, sir?

Mr. HERDMAN. And there are a couple of cases that are very

much on point. In the late 1960s, one of the Federal courts handed

down a decision in a case called U.S. vs. Simon, in which the decision was that just because financial statements comply with all of

the measurement requirements of generally accepted accounting

principles is not an absolute defense if the result is misleading, and

the disclosures about it are misleading.

And the SEC has, I think, a very instructive enforcement case

from the mid-1990s against Caterpillar Corporation, in which the

company had a huge increase in sales in one of its foreign divisions

as a result of basically putting a big sale on toward the end of the

year. And it was accounted for, it was all accounted for correctly.

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These were valid sales, there was nothing wrong with them. But

their management discussion and analysis, which is intended to be

an adjunct to the financial statements and through which management is supposed to explain through its eyes to the investors what

is happening with the company, what has happened, and what has

happened in the past that may not be repeated in the future—and

in that particular case, there was no mention of the fact that the

huge increase in sales in the fourth quarter—and I believe it was

a Brazilian subsidiary—was entirely due to a very unusual event

that didn’t have a chance of being replicated in the next year.

And so there are indeed strictures against providing a misleading

picture, even if the underlying financial statements are presented

in accordance with GAAP.

Chairman BAKER. I will follow that up with a more detailed written inquiry. But it is a point around which I think there is some

considerable difficulty.

Mr. ROYCE. Mr. Chairman.

Chairman BAKER. Mr. Royce.

Mr. ROYCE. Thank you, Mr. Chairman. I had an opening statement that I would just like to introduce for the record, if that

would be all right.

Chairman BAKER. Without objection.

Mr. ROYCE. And then I would like to go to Mr. Jenkins, as Chairman of the Financial Accounting Standards Board, and ask him a

question about a 1994 report which he directed. He wrote about

special-purpose entities in that report, ‘‘Users are concerned that

current rules may permit companies to exclude from their balance

sheets rights and obligations that make companies appear to be

less risky’’—less risky—‘‘than they are’’—of course, that is exactly

what Enron did. Yet FASB did not issue a definitive statement on

these special-purpose entities, other than two short letters, one in

1990 and one in 1991. And the 3 percent rule in those letters was

what Enron, in fact, abused.

And so my question would be, couldn’t FASB have possibly reduced the risk of the abuse by acting decisively at that time? I

mean, the problem had been identified, but there wasn’t decisive

action taken. And that is my initial question.

Mr. JENKINS. Well, as you know—and this isn’t an answer to

your question directly, but I will get to that—we are working to

provide guidance specifically on accounting for SPEs, and now on

an expedited basis. I know that that sounds a little bit like closing

the barn doors after the horse is gone, and I accept that criticism.

We at the FASB have been working over the years to try to come

to some acceptable decisions with respect to accounting for specialpurpose entities. But it is not sufficient to simply say that every

special-purpose entity should be consolidated, because special-purpose entities have a variety of purposes, and it is only where the

special-purpose entity does not have sufficient independent purpose, and/or is not capitalized sufficiently by an independent third

party, that consolidation should really take place. And the devil is,

we found, in the details of defining those particular circumstances.

We at the FASB have tried twice since 1994 to issue guidance

on consolidations. And in each case, the concerns raised about our

proposal, and how those proposals were overreaching, from both

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the business community and the accounting profession, caused the

board to conclude that it could not go forward and develop a standard that would be generally accepted.

Mr. ROYCE. Which of the major accounting firms opposed that?

Mr. JENKINS. All of them.

Mr. ROYCE. Every one of them?

Mr. JENKINS. The 3 percent rule was designed to address a particularly unique circumstance involving a single type of a transaction. And through practice, it was probably appropriate for that

particular transaction—it got extended in practice to apply to some

other transactions. Of course, the essence of the Enron situation as

I understand it is not the 3 percent rule per se—in some cases, apparently, they didn’t have 3 percent; in other cases they didn’t follow the 3 percent rule because the 3 percent had to be maintained

throughout the life of this entity, and it went down, and they didn’t

replenish it, so to speak. So they apparently didn’t follow the rules.

It also had to be independent, and there couldn’t have been any

other guarantees or support, nor could the 3 percent have come

through the back door as being provided by Enron or one of the affiliates, apparently, in some of the transactions that part of the requirement wasn’t followed as well.

So that is why I said in my opening remarks that the standards,

even if they are minimal, and perhaps need to be improved, if the

standards aren’t followed for whatever reason, the best standards

in the world aren’t going to solve these issues.

Mr. ROYCE. No. But I think they did cite this rule as their argument.

Mr. JENKINS. Yes.

Mr. ROYCE. I mean, they attempted, at least, to attach their line

of reasoning to this rule.

Mr. JENKINS. I believe that is correct.

Mr. ROYCE. I was going to ask Mr. Herdman if he thought that

FASB could have taken better measures to reduce the risk of abuse

of special-purpose entities. I know this is in hindsight, but what

does the Securities and Exchange Commission think now about

that?

Mr. HERDMAN. Congressman, I think this is an example of what

Mr. Jenkins was alluding to earlier when he talked about the size

of projects and the scope of projects that FASB undertakes. The

particular subject matter where this was being considered was the

Board’s project on consolidations.

The proposals that Mr. Jenkins referred to were not focused solely, or even principally, on special-purpose entities. They were focused on the question of consolidation of subsidiaries more broadly,

and proposed sweeping changes to that particular practice, which

many accountants felt had not been controversial.

And so, when something like that occurs, it occurs to us now,

that that is the time when it is important for the Board to re-examine the scope of its product. In other words, if they have a project,

they come out with a proposal that would attempt to deal with four

or five things. And if there are one or two that there is general

agreement should be done and it is important to get them done,

but the other two or three have failed yet to capture the imagination of the audience, we think that it would be better for the Board

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to go on and fix the one or two things that everyone is in agreement need to be fixed, and work harder on the others or reconsider

whether they need to be done.

And so that is, I hope, a lesson for all of us for the future in

terms of how this agenda can be better managed to make sure that

the pressing issues do get dealt with promptly.

Mr. ROYCE. Are you familiar with Arthur Andersen or Enron

marketing their unique interpretations of how to utilize specialpurpose entities in order to boost earnings per share, and basically

going into the market and saying let us work with you, with other

companies, to show you how we can do this? Are you familiar with

a history of Andersen doing that?

Mr. HERDMAN. Congressman, we are still investigating Arthur

Andersen and Enron, and I can’t comment on that.

Mr. ROYCE. Can’t comment on that? OK. Thank you again.

Thank you, Mr. Chairman.

Chairman BAKER. Mr. Sherman.

Mr. SHERMAN. Yes. I would hope that the FASB would be closing

this barn door, because I think you have got tens or hundreds of

billions of dollars’ worth of horses that still haven’t escaped the corral.

I do think there is a legitimate purpose for special-purpose entities—for example, in my hometown it is not unusual to legitimately

shift the risk that a particular movie or group of movies is going

to be successful or fail to a group of investors. While the studio

does the work of creating the movie, other people can take the risk

and place their bets as to whether the latest film will be successful.

The Chairman puts forward an interesting idea, and that is that

there be a business purpose doctrine, and those transactions that

have no business purpose not be recognized. That is an interesting

part of tax accounting. Is that part of financial accounting as well?

Mr. JENKINS. Well, I think we try to understand the business

purpose of transactions and, as I say, develop standards that do the

best job they can of displaying that purpose.

Mr. SHERMAN. If there is a transaction that has no purpose other

than causing the recognition of income or deferring the recognition

of loss, does that transaction give an effect in preparing financial

statements?

Mr. JENKINS. Well——

Mr. SHERMAN. Is there a clear yes or no? Or is that one of those

hazy things?

Mr. JENKINS. I think it is pretty hazy, but——

Mr. HERDMAN. Well, Congressman, just like under the tax law

there is a concept that if the only motivation for a transaction is

to reduce taxes, then as I understand it, it is not lawful.

Mr. SHERMAN. Yes. I am familiar with it in tax law. I am asking

whether there is a similar principle——

Mr. HERDMAN. However, certainly when we look at transactions

with companies, if it is clear that the only reason they entered into

a transaction was to achieve a particular financial statement result

that would not have been attained had they not entered into the

transaction, then we would generally disagree with their proposed

accounting.

64

However, I will caution you, just as in the tax area, that it is

very difficult to find a transaction that can be characterized as

solely being done to achieve a particular——

Mr. SHERMAN. It is always possible to find a tail, even if that tail

isn’t big enough to wag the dog.

Mr. HERDMAN. There are always other motivations, absolutely.

So that is not a very good principle.

Mr. SHERMAN. It is not a bad principle. It is helpful.

Mr. HERDMAN. It is not a very effective one, though, perhaps.

Mr. SHERMAN. Speaking of effective enforcement, and the whole

idea of enforcing general principles—not numerical principles,

where we can say, oh, here is this exact rule, but rather, the general principle that, for example, the prose in the financial statement and in the report to shareholders be accurate—you pointed

out the Caterpillar example. But it is my understanding that in

Caterpillar, with its failure to tell shareholders about the Brazilian

situation, that not a single day of jail time was done by a single

executive, accountant, or auditor. Can you tell us how large a

fine—or let me know if I am wrong on the jail time. But also, can

you tell us how large a fine was imposed on Caterpillar?

Mr. HERDMAN. I don’t recall, Congressman.

Mr. SHERMAN. Could it have been that no fine or a fine of just $50,000 or $100,000 was imposed?

Mr. HERDMAN. Since I can’t recall, it could be.

Mr. SHERMAN. So even the preeminent example of enforcing

vague principles, we are not, we don’t have a specific level of punishment? I would hope you would furnish that for the record, but

it is my understanding of SEC general practice that they might

have gotten, you know, a really tough letter in their file. And given

what is at stake in these transactions, perhaps the only enforcement we really have, much to our own chagrin and not to our joy,

is the trial bar.

I would like to posit—we have talked about special-purpose entities, which is part of the Enron problem. And I have asked the

FASB on more than one occasion to expedite a review also of another part, and that is, even if you are transacting with a fully legitimate entity, the transaction in derivatives may be misstated.

I would like to conjure up the idea of a Genron Corporation that

wants to state the largest possible earnings per share. It has two

portfolios of investment securities. One is in the restaurant industry, where they have gained $1 billion and they have recently sold

at a $1 billion profit. And, of, that is a $1 billion profit. They have

another portfolio that they haven’t liquidated their position in of

high-tech companies, which on a mark-to-market basis has declined

by $2 billion.

But they don’t want to recognize a $2 billion loss, because they

have a derivative issued by the Kiticorp—not to be confused with

Citicorp—but a large, completely independent, very financially

sound corporation. And this derivative says that if you lose any

money, up to $2 billion, on your high-tech portfolio, we will give

you the money. So you haven’t lost anything; it is like your factory

burned down, but you have perfect fire insurance.

But then there is a provision that says, to the extent that

Kiticorp has got to give money under this debenture, Genron CorVerDate 11-MAY-2000 10:21 Sep 09, 2002 Jkt 000000 PO 00000 Frm 00070 Fmt 6633 Sfmt 6633 C:\DOCS\79559.TXT HBANK1 PsN: HBANK1
65

poration must give shares with a value of, in this case, $2 billion

to Kiticorp’s parent corporation, so that in effect, they owe something—they have insured their insurer.

Is it clear under FASB pronouncements that under these cir- cumstances the $2 billion loss must be recognized, because although it is in effect insured by a completely independent, highly

creditworthy company, the provisions of that derivative or insurance policy, if you will, require Genron to issue stock to Kiticorp

or its parent?

Mr. HERDMAN. We are investigating that company, Congressman.

Mr. SHERMAN. Well, I am asking what—this is not something

you are investigating. This is Genron Corporation; I just made it

up.

Mr. HERDMAN. But the facts are——

Mr. SHERMAN. Do we know what accounting principles call for?

Or is the accounting result of this transaction unknowable at this

time?

Mr. HERDMAN. It would depend, I believe, on the terms of the equity derivative, and whether it could be settled net or would require the outlay of cash or the distribution of shares.

Mr. SHERMAN. In this situation, Genron Corporation is to receive $2 billion in cash to make it whole from its $2 billion of investment

losses in high-tech stock. And Genron Corporation is to issue $2

billion worth of Genron shares for no additional compensation to

the parent company of Kiticorp, of the company that is giving it the

cash. Under those circumstances, must the $2 billion be recognized

as a loss?

I mean, it is either ‘‘yes,’’ ‘‘no,’’ or ‘‘we don’t know.’’

Mr. HERDMAN. I would have to consult further with—there are

some very complicated requirements that need to be looked at with

respect to equity——

Mr. SHERMAN. In fairness, this is a question I have asked behind

closed doors two or three different times. I am not completely sandbagging you, although I guess you didn’t know I would be asking

it quite this way at this time. I wonder if Mr. Jenkins can give us

an answer; what does the FASB have to say about this transaction?

Mr. JENKINS. Well, I think, first of all, I would say that there

needs to be disclosure of these arrangements in the financial statements. And we are issuing shortly some clarifying guidance of existing literature to make it clearer than it should have been in the

past, apparently, that disclosures with respect to guarantees, even

if they are remote or not likely to be called, need to be disclosed.

Mr. SHERMAN. Well, this one is clear. I mean, they owe the $2

billion worth of stock. They have a right to receive the $2 billion

in cash. Both of these are triggered the moment they sell their

high-tech portfolio at market. This isn’t a remote contingency like

‘‘what if our factory does burn down?’’ The factory has burned

down. You have a right to cash from your insurance company, and

under my example, you have an obligation to give that insurance

company $2 billion worth of your stock.

Mr. JENKINS. I didn’t understand your example to say that the

loss had incurred, and under the insurance policy the money was

now due.

66

Mr. SHERMAN. Well, it would be due upon the liquidation at market of a portfolio of publicly traded corporate stock that is usually

mark-to-market. So if you are going to mark-to-market under ordinary circumstances, the sale transaction of the stock is thought to

be irrelevant.

Mr. JENKINS. Well, again, you understand——

Mr. SHERMAN. OK. Well, let’s put it like this: it is not a remote

contingency that you would choose to sell a stock on which you

have lost $2 billion, losses that have already—would have been recognized on a mark-to-market basis.

Mr. HERDMAN. I would start with the presumption that the loss

needs to be recognized. But I would need to consult further very

complicated accounting rules that pertain to the issuance of socalled equity derivatives.

Mr. SHERMAN. OK. I would hope that—it is my understanding—

I mean, I didn’t make this one up completely. I mean, this is the

loophole that Enron thought they found. They think it works. They

think they didn’t dot their i’s and cross their t’s. There are a lot

of other companies out there who are capable of dotting i’s and

crossing t’s. And I would like to know whether this loophole exists.

And that is why I would ask each of our two witnesses to furnish

for record an answer to this excessively complex question.

And so I will ask you to do that in the future.

Chairman BAKER. Thank you, Mr. Sherman.

Mr. Royce, did you want another round?

[No response.]

Chairman BAKER. Mr. Herdman, before we conclude the panel,

do you have a position on behalf of the SEC relative to where we

might go with regard to shortening time consideration for development of financial accounting standards? Have you arrived at any

recommendations yet?

Mr. HERDMAN. We have. We have spoken with the FASB about

this issue at some length, and we believe that—of course, it is a

mixture of things. It is scope definition. We believe that the move

toward a more principles-based approach, and not needing to attempt to answer every question that comes along the way, should

enable the Board to move faster on its projects.

It is very time-consuming to try to come up with the definitive

answer for every question that comes up. And they should really

need only to answer enough to make sure that the principle that

they have in mind is operable in the real world. And I think that

that is something that can be done.

We believe that the recent decision by the FASB trustees to

change the voting requirement from 5 to 2 to 4 to 3, if implemented

aggressively, should enable the Board to move more quickly because, to the extent that there are minority views, at some point

in time it will be possible for the Board, presumably through its

Chairman, to say, we have heard enough and now we need to proceed and get this thing done. So we think that is positive.

We also think that it is positive that the board of trustees has

asked the question about whether the size of the Board should be

reduced from seven members to five. It has concluded at this point

to leave the size of the Board at seven members, but it has charged

Mr. Jenkins’s successor, Mr. Herz, with the task of conducting his

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own study over the next few months as to what he believes needs

to be done to increase the timeliness and efficiency of the Board,

and report back to the trustees with a view toward they would implement whatever changes he recommends, that they believe are

reasonable.

So I think that it is a combination of factors, Mr. Chairman. And

I think that the Board and its oversight foundation show all signs

that they are working to improve in this regard. And over the next

6 months or thereabouts, hopefully they will be able to demonstrate

the improvement in terms of the projects that they are working on.

Chairman BAKER. Well, just, again, without having the competency to make the judgment, I make it anyway. It seems that a

principles-based value reporting system, some of which we will

hear about in the next panel, offers a great deal of appeal. I don’t

know, frankly, other than marketing purposes and to show that

you are running faster than you were a year ago, that historical

90-day-old data, at best, really tells you about what the company

is doing tomorrow—especially in light of the apparent use of accounting methodologies which do not result in an accurate financial

picture being portrayed even of the historic data.

Now, I don’t ascribe that to the fault of FASB, because in good

intent, with arduous and lengthy study, the rules have been developed for what we believe to be the best public policy. And they

have been misused. It would seem, at the end of the day, if we are

building value and we want to encourage corporate CEOs to invest

for the long term and not worry about the next quarterly earnings

report, that there are some simple principles we could outline, and

that if you were consistent with those principles—until we catch

you otherwise—that the core reporting that maybe Standard &

Poor has talked about is a good place to start, and move from

there.

But the current system, I think, given the speed with which technology enables businesses to develop new product and new business structure—we are trying to regulate traffic on the interstate

while we are still hooking our horses up to the wagon. And they

are running by us. And I think we have to be more nimble in our

ability to respond to identifiable problems in a short period of time.

No response needed, but if you would like, please.

Mr. HERDMAN. That is the danger of the cookbook-style of standards, that while it appears to close off all possible avenues of different interpretation, the people who are out there creating transactions are always going to be way ahead of those who are writing

the rules, the detailed, loophole-closing rules intended to try and

close off their initiatives.

And so accounting principles that are more principles-based will

be simpler. And a principle is not to say ‘‘pay your fair share’’ or

‘‘do the right thing.’’ The principle has to be expressed in the context of the particular area that is being addressed. For example,

the Board’s recent standards on business combinations, I think, are

a real positive step in the right direction, in that they really did

approach this whole area in a very principled basis, and there are

implementation details that need to be applied by individual companies.

68

But the principles are clear, the objectives are clear. And while

there will be some differing interpretations on some of the implementation details, I believe that the resulting reporting will be

comparable, and the product will be useful to investors.

Chairman BAKER. I think it is certainly worthy of pursuit. I

thank you. Mr. Castle, I know you have just arrived, but did you

have a question for this panel?

Mr. CASTLE. I do, Mr. Chairman, if I may take a moment.

Chairman BAKER. Certainly.

Mr. CASTLE. I am sort of starting from scratch, and I guess my

question is of Mr. Jenkins.

But I am interested in—and I guess concerned; but in all candor,

I don’t really know enough about it to express my concern, articulate it as well as I should—with the stock options situation and the

accounting side of it. And I am worried about it from an executive

compensation point of view, but I am not too sure we can legislate

in that area, so I won’t ask you questions about that.

But it is my understanding that FASB had some sort of an expense option on this—I am not sure I understood exactly how that

was going to work—and I think backed off at some point, maybe

under congressional pressure or whatever the reasons may be. But

I am interested as to the status of that now. I realize that as the

value of companies was growing, it was a valuable tool. And I am

not even suggesting options are not a valuable tool, and I am not

even saying they should not be part of executive compensation.

But I am just amazed in my reading about it that there is not

an accounting entry at some point or another. It obviously has to

dilute capital. I mean, it just automatically has to at such time as

it is exercised. And at such time as it is granted, it essentially is

giving a right which could dilute capital, which greatly impacts

stockholders and can impact the entire valuation of a company. In

fact, there have been studies showing that some profits would be

losses if this was properly accounted for.

And if you could just give me the rationale of FASB now—or is

it changing again, and you are about to look at it again and have

some sort of firm accounting practices with respect to stock options?

Mr. JENKINS. Let me first describe where we are today.

Mr. CASTLE. Thank you.

Mr. JENKINS. Our standards require that the use of stock or

stock options for almost every transaction would result in an expense charge. So if you issue, if you give stock to an employee—

not a stock option—you expense it. If you give stock to pay your

attorney or to buy a truck, you recognize it either as an expense

or an asset.

We have one exception, and that exception is the employees—certain types of employee stock options that you have referred to. Not

even all employee stock options. That is an exception.

Our standard says that even those—it is preferable that those

options be expensed at their value determined at the date they are

granted. Our standard—it is preferable, but it is not required. And

the reason that it is preferable but not required is, as you also suggested, the Board received intense criticism and pressure from Congress in 1994, leading to a sense of the Senate resolution requiring

69

us to stop work on stock options, and proposed legislation that in

effect would have put the FASB out of business.

Mr. CASTLE. Well, let’s look at it in the year 2000. And I thought

it was actually later in 1994 that all that pressure occurred.

Mr. JENKINS. No.

Mr. CASTLE. But let’s look at it in 2002, maybe with the advantage of hindsight. I mean, I would hope that Congress wouldn’t feel

quite the same way it felt in 1994—perhaps none of us individually

do; perhaps FASB does not, I don’t know. My sense is that a lot

of wise heads around Washington and economists around this

country are certainly thinking the other way now.

And to me, it just seems absolutely apparent. I mean, I don’t

know how the heck you can have an entry, a numerical impact on

a corporation of such magnitude, and not somehow or another do

something with it at this point. Is there a change going on? Is

FASB looking at it differently? Can we put all this pressure from

before behind us so we can go forward with doing something?

And I want to do the right thing. I am not trying to——

Mr. JENKINS. Yes.

Mr. CASTLE. And I realize it is extraordinarily difficult to determine the actual value at the time of issuance. But to me, it just

seems completely wrong to ignore it.

Mr. JENKINS. That is one of the principal arguments that is used

against recognizing the expense. We do require disclosure of the

amount. We require that in diluted earnings per share, that the

impact of these options be reflected so the dilutive effect is shown.

There is work going on internationally in the International Accounting Standards Board. Their goal and their objective is to expense all share-based payments. The circumstance outside of the

United States is significantly different than it is here in the U.S.,

in that virtually no share payments or share-based payments, even

the ones I described that are getting expensed here, are expensed

outside the United States. So they have a longer way to go than

we do.

My belief is that if the international board is successful in meeting their objective, that consistent with our pledge at the FASB to

work toward convergence of standards around the world, that the

Board at that time—I won’t be here, or be at the Board, but at that

time I believe it would be incumbent upon the Board to consider

then whether or not it would undertake a project in this area.

Chairman BAKER. If I could also add, too, Mr. Castle, the Standard and Poor’s announcement today on the core valuation does require the expensing of the stock options as an element of their reform. It is probably the most controversial part of their package.

But that was announced earlier today, Mr. Castle.

Mr. CASTLE. As something Standard and Poor’s is going to require?

Chairman BAKER. Right, in their valuation on the companies on

which they report.

Mr. CASTLE. On their ratings?

Chairman BAKER. They have a new core value assessment they

are going through, which basically gets rid of any non-related revenues, requiring disclosure of certain types of debt structures, and

part of that is requiring the expensing of options for employees.

70

And that is the basis on which the S&P will now rate the productivity of companies. And it was just announced this morning.

Mr. CASTLE. Well, Mr. Chairman, my time is up, and I will yield

back. But I would just like to close by saying—and I appreciate

your answers on this, Mr. Jenkins. I realize the political circumstance, although I thought it was later. But my own judgment

is that out of all this Enron mess and Andersen mess, what we

really need are clear rules and laws with respect to this.

And if there is anything that is ambiguous to me, it is stock options. If I look at a report, a quarterly report, and I see that a million stock options were issued—and again, to the executive compensation, particularly when it is issued by a company which has

lost money the year before, so they rewrite it, but it is with a lower

ceiling or whatever the effect is where it would take hold, so that

the corporate executive can take advantage of it. To me, that is a

corporate compensation, executive compensation issue of huge magnitude we need to consider.

But having said that, I just think there is also an accounting

entry, automatically, that needs to be looked at. I think it is really

unfair, frankly, to the companies as well as the stockholders, and

even to some of the executives who would take advantage of it. I

think a good executive would tell you do it in such a way that it

measures our worth in terms of what we are doing, and show it in

some way or another. And I just feel that something should be

worked out on this.

So I hope that FASB, working with the international folks, and

Standard and Poor’s, anyone else who is discussing this, will come

up with some common standard so all of us, as just average poor

investors out there, can figure out what is happening.

I yield back, Mr. Chairman.

Chairman BAKER. Thank you, Mr. Castle.

Mr. Weldon, do you have a question?

Dr. WELDON. Yes, thank you, Mr. Chairman, I just have a couple

of quick questions. Sorry I missed your testimony, gentlemen.

But for Mr. Herdman, I had a question about FASB’s sources of

funding. As I understand it, their sources of funding are publication sales and contributions from accounting firms and companies.

As I understand it, there has been some recent debate about securing a constant funding source for FASB. Can you give me the

SEC’s view on this issue, or do you have a view?

Mr. HERDMAN. Well, there are a couple of things that have been

happening historically. The first is that the FASB has been engaged in deficit spending for the last 4 or 5 years, I believe. Its

funds today come from a combination of—I think it is very clear

from Mr. Jenkins’s testimony—two-thirds of their revenues come

from the sale of their publications, their standards and what have

you. The other one-third comes from contributions from the business community and from the accounting profession.

And we think that it would be beneficial if FASB could get a

broader source of more assured funding in the future so that there

no longer are questions about whether the fact that their support

comes from those who must abide by their rules creates the impression that somehow that impacts the quality of their rules. And also,

just because it is a tough world out there, and if the way that you

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are getting your support is to go around and solicit contributions,

when times get tough that is often one of the first things to go.

So we believe that as we consider what needs to be done with

respect to oversight of the auditing profession and the ways to

achieve funding for that, that there are some very promising ideas

with respect to how the FASB might be included in that type of

funding—broad-based, private sector funding that would be an assured source of funds for the Board and for any organization, assuming that there isn’t a legislated organization that would have

a different source of funding. But as we think of alternatives and

what we must do from a regulatory standpoint, if there was not a

legislated organization to oversee the auditors, we have to create

funding ideas there. We think that the same ideas ought to be applicable to FASB’s support.

Dr. WELDON. Thank you very much. I just had a quick follow-up

question. Maybe it is not a quick question. Mr. Jenkins was referring to international accounting standards, and I understand that

you in your testimony provided some mention of the convergence

of international accounting standards with U.S. standards. We

were talking a few minutes ago about expensing share-based payments.

Did you want to elaborate on that a little bit more? I have got

a few minutes left here. Did you want to say anything more?

Mr. HERDMAN. I would be glad to.

Dr. WELDON. Where is that heading?

Mr. HERDMAN. The SEC’s mission is really twofold. The first is

to protect investors. The second is to make sure that American

markets stay competitive with the rest of the world. And for a

number of years the SEC has had rules on its books with respect

to foreign companies that want to list their shares on U.S. exchanges or otherwise register them with the Commission. And

those rules pertaining to filing requirements—taking into account,

from the time that they were written, that there are many countries out there and a great diversity of quality of accounting standards—have required from the outset, and continue to require today,

that those so-called foreign private issuers either prepare their financial statements for U.S. filing purposes using U.S. GAAP, or

reconcile from their home country GAAP to what the results would

be under U.S. GAAP. And that is done for net income typically as

the principal reconciling item.

There has been a lot of staff work done by the SEC over the

years looking at the quality of so-called international accounting

standards written by the International Accounting Standards Committee initially. And now for the last year-and-a-half that has been

reformed, restructured into the International Accounting Standards

Board. A couple of years ago, the European Union decided that all

7,000 listed companies domiciled in EU member countries, starting

in the year 2005, would have to use international accounting standards as opposed to French or German or Spanish standards in their

annual reports that get filed with the various exchanges in Europe.

A combination of the two things, the restructuring of the IASB

and the step taken by the European Union, really makes the IASB

a major player in the development of accounting standards around

the world. They have a lot of work to do to go back and improve

72

the quality of some of their older standards. They are very much

engaged in that right now. We have encouraged both the IASB and

the FASB to take a single-minded approach to trying to achieve

convergence with one another—approximate convergence—by the

year 2005. We recognize that there are going to be huge efforts underway by the IASB and by European companies to convert to

these international accounting standards, and we think—I personally think that the time is right for the Commission to consider

whether the confluence of those events and the continued improvement in the international standards is such that they should be

permitted for U.S. filing purposes by these foreign private issuers.

Chairman BAKER. Thank you, Dr. Weldon. Mr. Sherman, you

had a wrap-up?

Mr. SHERMAN. Yes. I think we have loophole-ridden financial accounting standards; that we are painfully slow in plugging those

loopholes; that we have a system for financial accounting standards

publication which, if we applied it to tax accounting, would cause

this country no longer to be a superpower in the world because it

wouldn’t have the revenue. And the argument against all this is,

well, principles—no matter—will be enough. We don’t make anybody do anything, but ask them to—just give them some vague

guidance.

And one illustration of whether this works or not is in the area

of putting a charge to earnings when you issue a stock option. The

FASB has indicated that it is preferable to have such a charge to

earnings. But that is a principle; the rule is you don’t have to do

it.

Can either of the witnesses identify any of the Big Four-and-ahalf accounting firms that has as its uniform policy that a charge

to earnings must be made by its clients, when material, when they

provide an employee stock option? Can you name any of the firms?

Mr. HERDMAN. Congressman Sherman.

Mr. SHERMAN. A simple question. Can you name a firm?

Mr. HERDMAN. But the accounting firms don’t make those decisions for clients. When the rule is as explicit as it is here, companies have a choice, and——

Mr. SHERMAN. OK, companies have a choice. And if they don’t—

can you name a single company that follows the preferred standard, or a single auditor who has failed, who has issued an adverse

or qualified opinion because the company has failed to follow the

best principle as stated by the FASB?

Mr. HERDMAN. Two companies that follow the preferred approach

out of the Fortune 500. Boeing is one of them, and for the life of

me, I can’t recall who the second one is.

Mr. SHERMAN. So that would be one half—no, that would be less

than a half of a percent.

Let me shift over to something else, and that is I know the

wringer that a small company goes through to go public with their

initial public offering, IPO. And sometimes they are trying to raise

$10 million, $20 million in assets. How many accountants reporting

to you, Mr. Herdman, work on these initial public offerings, as

compared to the number of accountants that you have deployed to

read and ensure at least the completeness, if not the accuracy, of

statements filed by the thousand biggest companies in the country?

73

Mr. HERDMAN. None of those accountants actually report to me.

They are all in our Division of Corporation Finance.

Mr. SHERMAN. OK. How many at the SEC?

Mr. HERDMAN. I believe the number of accountants in the Division of Corporation Finance is approximately 100 people.

Mr. SHERMAN. One hundred people. So you have 100 accountants

that can look at both the new small companies and the big established companies. Now, of those 100, how are they divided between

those two tasks?

Mr. HERDMAN. It depends on the volume of IPO transactions. In

the current environment, virtually everyone is looking at filings of

established public companies. A couple of years ago, when there

were a lot of IPOs, then those have to take precedence.

Mr. SHERMAN. Those take precedence?

Mr. HERDMAN. Because they are new to the system. And so it depends on the relative volume of what is going on at a particular

point in time.

Mr. SHERMAN. So if a company is trying to go public and raise $20 million, they are guaranteed to have a careful SEC review of

their filing, and a comment letter that requires that they provide

supplemental and corrective information necessary to make everything clear and up to spec. Is that a——

Mr. HERDMAN. For a company undergoing an IPO, they are guaranteed they would have a review. They are not guaranteed they

would have a comment letter, but they can be pretty assured they

will get one.

Mr. SHERMAN. OK, so they will get a comment letter. So you are trying to raise $20 million, you are pretty sure you are going to get

a comment letter, guaranteed review. And yet if you are Enron, a

company that was accused of fraud by the entire California Democratic delegation back a couple of years ago—so not a company

with necessarily the highest business standards, or at least not in

the opinion of the Democrats from California—you could go a couple of years without a review at all?

So you could be one of the ten largest companies in America, no

review; trying to raise $20 million, guaranteed review? Maybe that

is one of the reasons we have got a problem.

Mr. Chairman, I yield back.

Chairman BAKER. Thank you, Mr. Sherman. That is, I think,

why some Members have a bill in to make sure that some of those

big corporations file appropriately with the SEC. I think they are

called GSEs, something like that. That is another whole subject

matter.

Mr. SHERMAN. I think that would not include Enron, would it?

Chairman BAKER. No. I was making a very small joke about the

volatility of the reporting issue.

Mr. SHERMAN. I would agree with you. It is a small joke.

Chairman BAKER. I want to thank the Members of the panel for

their courteous use of time today and their participation. Your insights have been helpful to the subcommittee. We know we have

a long road ahead of us and a lot of work to do in this area, and

we look forward to working with both FASB and the SEC in the

future in resolution of these important matters. Thank you very

much for your participation.

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Mr. HERDMAN. Thank you.

Mr. JENKINS. Thank you.

Chairman BAKER. At this time, I would like to call the members

of our second panel to the witness table at their convenience.

I would like to welcome each of you here this afternoon. We

thank you for your time and willingness to participate.

Our first witness to be heard from is the Co-Director of the AEIBrookings Joint Center for Regulatory Studies, Dr. Robert Litan.

Welcome, Dr. Litan.

STATEMENT OF ROBERT E. LITAN, CO-DIRECTOR, AEIBROOKINGS JOINT CENTER FOR REGULATORY STUDIES

Mr. LITAN. Thank you very much, Mr. Chairman, for inviting me

here today to summarize some of the key conclusions of a book

called The GAAP Gap, a book that I recently wrote with Peter

Wallison at American Enterprise Institute about the future of corporate disclosure in the internet age. In brief, I think we will agree

with a number of panelists today—and I am guessing here—that

corporate reporting needs to be updated to fit with modern business realities.

One of the purposes of disclosure rules is to help investors make

informed judgments about the future, because equity prices, after

all, embody the collective judgment of investors about the future

prospects of companies. Current GAAP-based financial statements,

even if they are clean as a whistle, only go so far toward meeting

this objective, for four reasons.

Number one, recent financial reports inherently are backwardlooking, especially so because, for the most part, assets and liabilities are recorded at historical cost, not current market values.

Number two, much of the value the market assigns to many companies cannot even be found on their balance sheet or income statements. That is because this value is intangible and cannot be easily

bought and sold on the marketplace independent of the value of the

firm.

Number three, non-financial information relevant to price in the

future that may never directly show up in any financial report,

such as the gain or loss of new customers, insider stock sales or

purchases, is constantly being generated—and in any event, much

more frequently than quarterly. To its credit, the SEC has recently

proposed that more such information should be disclosed in such 8-

K filings by companies, and more rapidly than ever before.

And finally, the development of new computer-based technologies

may soon make it possible for investors, on their own or through

independent advisors, to manipulate company-specific information

so that they don’t have to rely on GAAP-based financial statements

that companies now produce. Specifically, I refer here to a new

computer language, Extensible Business Reporting Language, that

allows firms to place what are called ‘‘tags,’’ or identifiers, on all

kinds of financial and non-financial information. Investors and analysts can then easily manipulate and compare these data, which is

not possible with financial reports that are now available on the

internet in the language HTML.

These four conclusions have several policy implications.

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Number one, while it is tempting to solve the intangibles problem by having firms place values on those assets, this is not generally appropriate, in my view, because it puts auditors in an impossible situation, especially in the wake of Enron. There are few

if any organized markets for intangibles, so auditors have no objective benchmarks for verifying those values. The better approach,

and one which addresses the need for more forward-looking information, is for firms to disclose more non-financial information that

may give rise to intangible value, such as employee turnover, product return rates, measures of innovation and so forth. The SEC can

and should accelerate the disclosure of such information by convening working groups of experts from different industries to identify which of these measures are most helpful and to publicize the

results, so that investors, analysts, and other professionals can

begin demanding to see such data.

Second, the SEC should encourage more frequent internet-based

reporting, not only of non-financial information, but even financial

data. Companies already balance their books and compile information internally much more frequently than quarterly. If investors

had access to real-time data, it is conceivable—not certain, but conceivable—they would place less emphasis on the quarterly earnings

figures with which markets and firms are now obsessed. In turn,

this could reduce incentives for firms to manage their quarterly

earnings to hit expected targets.

Third, the SEC should encourage the use of XBRL, and thus give

powerful tools to investors, by perhaps requiring Electronic Data

Gathering Analysis and Retrieval System submissions to be in

XBRL by a fixed date.

And finally, the movement toward a new reporting model will

not, in my view, eliminate investor demand for having financial reports comply with a certain standard, whether it be U.S. GAAP or

the international accounting standards that you just discussed. In

my written testimony, I argue that it is highly unlikely in this

country that we will ever replace GAAP with IAS. Instead, I try to

make the case for allowing all firms—not just foreign firms, but all

firms listing their shares on U.S. exchanges—to choose between

GAAP or IAS without necessarily having to do reconciliation, as is

now required for foreign companies, as was just explained.

Competition between standard-setters would encourage both

standard-setters to respond to market developments more rapidly,

and thus solve a problem that you, Mr. Sherman, identified, which

is the slowness of FASB. It may also—that is, competition also may

reduce some of the political influence that has affected FASB rulemaking in the past, since firms choosing what is perceived by investors to be the weaker standard would be punished by the markets for doing so.

Thank you, Mr. Chairman, and I look forward to answering your

questions.

[The prepared statement of Robert E. Litan can be found on page

248 in the appendix.]

Chairman BAKER. Thank you very much, Dr. Litan.

Our next witness is Mrs. Ellen Masterson, Partner-in-Charge of

Global—lost my glasses, wait a minute—in charge of Global Audit

Methodology and ValueReporting, PricewaterhouseCoopers. And for

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the record, I have read ValueReporting about a half-dozen times

trying to absorb it all, and I think it is an excellent piece of work.

And the conclusions reached, I think, are excellent in the publication.

Ms. MASTERSON. Great. Thank you, Mr. Chairman.

Chairman BAKER. You will need to hit that little button.

Ms. MASTERSON. Oh. Thank you.

STATEMENT OF ELLEN H. MASTERSON, PARTNER-IN-CHARGE

OF GLOBAL AUDIT METHODOLOGY AND VALUEREPORTING,

PRICEWATERHOUSECOOPERS, LLP

Ms. MASTERSON. Thank you for those kind words, and thank you

for the invitation to speak with you today.

When we wrote The ValueReporting Revolution at PwC in the

fall of 2000, the topic of transparency was not as in vogue as it is

today. Our book captures the results of our research into the effectiveness of corporate reporting in meeting the needs of investors

around the world. Based on surveys of thousands of investors, analysts, and managers, there were several consistent messages that

came out.

One, at the time surveyed, more than a third of the companies

believed they were undervalued in the marketplace. Second, few investors regard corporate reports as very useful. Third, the market

is excessively focused on short-term earnings; we can all agree on

that. And finally, it was clear that companies could benefit significantly by improved transparency, including higher share prices

where warranted.

From our research, which is ongoing today, we have defined certain communication gaps that drive the difference between the way

management values their business and the market value today.

The most significant of those communication gaps are three that I

would like to discuss with you. One we call the information gap:

investors need information they don’t get. Second, there is a reporting gap: management agrees information is important and that

they are not reporting it. And thirdly, the quality gap, where management simply doesn’t have all the important performance information they need.

This quality gap often underlies the reporting gap. Management

doesn’t have all the information; they don’t report it because they

don’t have it. And that gap is by far the most troublesome.

We group the kinds of information that investors want into four

categories, fairly simple: market information, company strategy,

and the key information used to manage the company; finally, the

value platform, measures of the real drivers such as innovation and

brands, people and customers, as Dr. Litan just mentioned.

Many of the elements underlying the four categories will differ

by industry sector, but the four categories hold true for all companies. Investors and analysts and managers all agree this is the information that is important and that they need.

So if all agree, why doesn’t management communicate more?

There are likely many answers, some of which we have heard—it

is not required, it is competitive, it is not reliable, we don’t want

to go first, there are no standards. And the more we disclose, the

more legal liability we have.

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And yet we haven’t met a CEO or CFO who doesn’t basically

agree that eventually the market will approach a new model for

communication similar to our ValueReporting framework. Many

companies are leading the way on a voluntary basis.

In the spirit of transparency, we have no conclusive evidence

that better disclosure will actually lead to accurate share prices.

But our survey respondents did indicate the benefits of greater

transparency to companies would be increased management credibility, more long-term investors, improved access to capital, and

more accurate share prices.

There are benefits to investors as well. Simply put, value reporting would give investors the information they need to make better

investment decisions.

ValueReporting requires dramatic changes in management and

board attitudes toward corporate reporting. In recent hearings, I

understand, the subcommittee has looked at the role of the board

and the audit committee in corporate governance. Boards of Directors need the information embodied in ValueReporting to properly

evaluate management, and they have a responsibility to make sure

that investors get such information as well.

We encourage the creation of new venues for reporting, beyond

the boundaries of traditional financial statements, to give investors

more information about the real sources of value in the business.

Thus, we don’t propose to make traditional financial reporting less

relevant, or to replace it, or to put lots of intangibles on the balance

sheet.

Thinking in terms of the balance sheet probably misses the point.

Companies should give the market reliable and relevant information, and the market will figure out what to do with it.

I appreciate the opportunity to be with you today, and look forward to answering questions.

[The prepared statement of Ellen H. Masterson can be found on

page 259 in the appendix.]

Chairman BAKER. Thank you very much.

Our next witness is Professor of Accounting, The Wharton

School, University of Pennsylvania, Dr. Robert Verrecchia.

Welcome, Doctor.

STATEMENT OF ROBERT E. VERRECCHIA, PUTZEL PROFESSOR OF ACCOUNTING, THE WHARTON SCHOOL, UNIVERSITY OF PENNSYLVANIA

Mr. VERRECCHIA. Thank you for inviting me.

In the brief time that I have to testify, I would like to offer the

perspective of someone who wears the proverbial ‘‘two hats.’’ That

is, first I would like to offer the perspective of someone whose instruction material touches on many of the issues that are central

to the debate about the process that promulgates accounting standards and firms’ adherence to those standards. Later, I would like

to offer the perspective of the researcher who has attempted to document the economic benefits of increased disclosure and greater

transparency.

With regard to pedagogy, it is at least a partial indictment of the

financial reporting process that one of the most popular elective

classes in the Wharton MBA program is an accounting class whose

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chief purpose is to discuss how firms gerrymander their financial

statements to conform to the letter of various U.S. generally accepted accounting principles, U.S. GAAP, but not necessarily the spirit.

Further, one of the most popular executive education programs

sponsored by Wharton is one in which the financial reporting peccadilloes of firms are brought out into the open and put forth for

ridicule.

Many of the instructors at Wharton are sensitive to the concern

that in regaling students with tales of financial reporting chicanery, we may also be promoting this behavior on the part of our

graduates. In our conceit, we rationalize our way around this dilemma by arguing that in any accounting Armageddon, it is important for our students to be better-armed than the students from

our peer institutions.

In short, viewed from the rarified air of academe, the accounting

standard process appears structured in such a fashion as to

produce the occasional accounting debacle. Industry and financial

groups, and their auditors, sponsor a private sector agency, the Financial Accounting Standards Board, to offer accounting pronouncements and guidance from which the very same corporations

and their auditors will either benefit or suffer. In other words, it

is a process that, at best, seems fraught with moral hazard problems, and, at worst, results in accounting opinions that appear to

pander to the worst aspects of corporate America.

These problems are only exacerbated when auditors who lobby

the rule-making process in behalf of their corporate clients are then

asked to implement these rules. In an environment like this,

should we have expected anything less than the occasional Enron/

Andersen misadventure?

Part of the problem with the rule-making process is the failure

to be guided by two broad principles. One, wherever practical, all

publicly traded companies should be required to adhere to a regime

of full and fair disclosure. And two, whenever effective control is

exercised over an entity, financial results of that entity should be

fully consolidated into the controlling firm.

Unfortunately, all too often in the rule-making process, corporations, through their lobbyists, appear to employ a variety of selfserving arguments to circumvent these principles. This problem is

further exacerbated by the fact that the rule-making process itself

seems more absorbed in the detailed minutiae of accounting transactions than in the economic substance of those transactions.

Opponents of the recognition of substance employ these arcane

debates to frustrate rule-making at all levels. No better example of

this exists than the treatment of employee stock options.

But from a research perspective, the real tragedy of recent financial reporting deficiencies is the failure of all representatives in

this debate to recognize the clear and obvious economic benefits of

increased disclosure and greater transparency—lower costs of capital for firms, increased liquidity for firm equities, greater participation in the capital generation process by the public, and so forth.

Recently, contemporary accounting research has attempted to document these benefits. While somewhat nascent, this research nonetheless is consistent with prevailing notions that increased disclosure is beneficial to the capital generation process.

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Commitments to increase disclosure on the part of firms do indeed result in lower costs of capital, increased liquidity, and so

forth. The research results are clear and compelling, and buttress

traditional claims that greater transparency enhances access to

capital markets.

But if contemporary research can document the benefits of increased disclosure, why do publicly listed corporations not embrace

it to the fullest extent? One rationale for less than full disclosure

is that disclosure may require disseminating information about a

firm’s proprietary business model, proprietary management expertise, proprietary technology, and so forth. This, in turn, may work

against the interests of a firm that reports publicly, and to the benefit of firms that compete against it.

To the extent to which these competitors are based outside the

U.S. or report under accounting standards other than U.S. GAAP,

this provides powerful political leverage for less disclosure. But in

a sense, a call for greater disclosure is no different from a variety

of welfare arguments. While full disclosure and full consolidation

may lead to both winners and losers in capital markets, indisputable increased disclosure serves the greater good.

In short, the thought with which I would like to leave the subcommittee is that the rule-making process be governed by an ideal

of full and fair disclosure and full consolidation. Perhaps stated differently, arguments in favor of anything less than full and fair disclosure and full consolidation should require a high burden of

proof. While full and fair disclosure and full consolidation will not

eliminate failures that result from fraud, flawed business models,

and/or unexpected industry and economic downturns, they will

work to ensure that failures are not the results of a reporting system that gives firms and their managers unwarranted discretion to

obfuscate an entity’s overall financial condition.

Thank you very much, and I will await any questions.

[The prepared statement of Robert E. Verrecchia can be found on

page 285 in the appendix.]

Chairman BAKER. Thank you very much, Doctor.

Our final witness on this panel is Mr. Steven Wallman, CEO of

FOLIOfn, and a former SEC Commissioner from 1994 to 1997.

Welcome, sir.

STATEMENT OF STEVEN M.H. WALLMAN, CEO, FOLIOFN, INC.,

AND COMMISSIONER, SECURITIES AND EXCHANGE COMMISSION, 1994-1997

Mr. WALLMAN. Thank you, Mr. Chairman. And today I am representing only myself.

Our capital markets are clearly the means pursuant to which

capital flows from those who have it to those who need it. I don’t

think there is any proposition that can be gainsaid other than that

our capital markets do, in fact, work better than anybody else’s.

They work better now than they have in the past. But the recent

events of the last year have also shown how much more we need

to do in order to make them work even better.

Capital markets rely on public disclosure to work efficiently. Financial statements, along with other mandated and voluntary disVerDate 11-MAY-2000 10:21 Sep 09, 2002 Jkt 000000 PO 00000 Frm 00085 Fmt 6633 Sfmt 6633 C:\DOCS\79559.TXT HBANK1 PsN: HBANK1
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closures, are, if you will, the bedrock of that system. And they are

what allow investors to make efficient resource allocations.

Generally accepted accounting principles are the language of financial statements. More than half-a-dozen years ago, it was apparent that GAAP was starting to fail in one of its most essential

purposes, which was to be able to provide useful, timely, and relevant disclosures to investors. About 6 years ago, we commenced

a study at the SEC looking into these issues. At that time, the

whole proposition that there might be something failing with regard to GAAP was viewed as somewhat heretical. I think today, in

hindsight, it is not quite as heretical.

Let me explain five ways, sort of the normal who, what, where,

when, and how, where GAAP is currently having some difficulties

in fulfilling its purposes.

First, in connection with sort of what is measured, accounting

principles are geared to measure bricks and mortar—basically a

tangibles-dominated world from the past. Increasingly today, the

drivers of wealth production are intangibles. They are generally

created internally, not acquired, but GAAP generally measures

them only when acquired, not generally when they are created internally. So we have a sort of what is measured inconsistency.

Who is measured has been brought to light in connection with

what we are seeing now with special-purpose entities and other arrangements, where the boundaries of a firm are increasingly difficult to discern. It used to be you could tell where a firm began

and where it ended, and what business it was in. But derivatives

today, SPEs, off-balance-sheet activities, partnership arrangements, and other kinds of things have blurred that boundary quite

considerably.

A third area obviously is timeliness of measurement. Things

move more quickly now than they have in the past. Financial statements clearly are generally backward-looking, even though there is

forward-looking disclosure embedded in financial statements—reserves, for example, are clearly forward-looking. Yet the concept of

a forward-looking financial statement is one that is hard for some

to discern.

Access to information is another. GAAP is its own language at

this point. Those who wish to understand what is truly going on

in a financial statement have to spend some significant amount of

time investigating it. And in fact, there are people who spend their

careers taking the aggregated information in financial statements

and then disaggregating it in order to understand what is really

happening.

Moreover, the language of GAAP is now sufficiently esoteric and

specialized in many cases that it has even its own dialects with regard to specific industries and different instruments and circumstances within those industries. And even though financial

statements increasingly, I think, fairly put, are beyond the comprehension of the lay person, and even many professional investors,

we continue to require their distribution to all, maintaining the tosome-degree fiction that they should be useful to all. At base, I

think we in a sense almost mislead people when we suggest that

financial statements should be distributed widely because they are

widely understandable. They clearly, at this point, are not.

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Finally, how things are measured; accounting requirements

clearly, in my view, have become very rules-oriented. You heard

earlier somebody talk about them as sort of a by-the-book type of

check-the-box type of accounting, and I think that that is a problem. We need to have more goals-oriented, more principle-oriented

approaches. We will not be able to close loopholes, but one of the

most effective, one of the most overwhelmingly effective standards

in the securities laws for the last three-quarters of a century has

been one very simple concept, the notion of 10(b)(5). And that is in

essence a very broad-based principle with regard to disclosure, and

it has been, if you will, one of the most effective means for ensuring

appropriate disclosure ever created.

The current scandals clearly indicate, I think, how outdated

GAAP can be when people stretch it to the extreme. Let me talk

about a couple things that might be useful to try to address some

of these concerns.

One is, FASB and the SEC have already taken important steps

to address some of the intangibles deficiencies. And they are doing

more, and I think that is worthwhile, in terms of general principles

there. In addition, Chairman Pitt and the SEC have already asked

for further disclosure with regard to the principal accounting judgments that are currently being made by accountants and issuers.

I think that is a very important thing to get out into the public disclosure.

In addition, there are other incremental steps that I think are

worthwhile to take. One is the idea of re-educating the profession

that the overall principle of financial statement reporting is that

they have to present a true financial picture of the company, and

not basically what is in accordance only with respect to generally

accepted accounting principles, but whether or not the overall presentation is in accordance with generally accepted accounting principles and a fair presentation.

And finally, there are some other suggestions that one could explore, such as requiring a second firm to provide a review of the

more important principles and judgments being made by an auditing firm, at least in connection with the largest corporations, so

that there is a means for some double-check with regard to the

very broad-based and important decisions that are being made in

connection with major firm audits.

Thank you.

[The prepared statement of Steven M.H. Wallman can be found

on page 289 in the appendix.]

Chairman BAKER. Thank you, Mr. Wallman. You were discussing

a point which I had raised with the earlier panel, with regard to

the obligation to present an accounting methodology that reflects

true value, and that where the utilization of an accounting mechanism is not for the purpose of building value or enhancing shareholder perspective, that that be questioned or noted in some special

way. Is it your view that that is not the underlying principle of

compliance with GAAP today, that we are so technically focused on

the construction of the rule that bright people spend a lot of time

trying to figure out how to comply with the rule and become, therefore, GAAP-compliant, but by so doing obfuscate the true financial

condition of the company?

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Mr. WALLMAN. I think there are two points in what you are

bringing up. One is the question of whether there are transactions

engaged in that have no true business purpose, but which are

being done in order to take advantage of a rule. And the second is

whether or not, even when that is not being done, are the rules

such that the presentation to investors that is generated by the operation of those rules is such that it does not fairly present the

overall financial picture of the company?

With regard to the latter, I think the answer is clearly yes. I

think people who read financial statements today, unless they are

well-endowed with an interest in financial reporting and accounting, must have difficulty understanding the true nuances of what

it is that is being described. The descriptions are no longer in plain

English. The words that are being used, whether it is net income

or something else, clearly have at this point a whole language behind them that is far beyond what the assumption is when you

look at the word, from an English standpoint.

With regard to the first, whether or not there are those who attempt purposefully to obfuscate, it is a large world. I am sure the

answer is that there are those who do, and there are, I am sure,

those who get away with it as well. There are those who, I think,

could be caught, if you will, by having a simple principle that says

if the accountants cannot be convinced that there is a business purpose for something, regardless of what the accounting is, there

should be disclosure of the fact that it appears that there is no

business purpose for the transaction. That obviously would stop

those transactions from going forward. And I am not sure there is

anything negative with regard to that conclusion.

Chairman BAKER. Thank you.

Did anybody want to jump in on the topic, with regard to—and

I know your general views about what the current deficiencies are

of the rules. But I am getting at the consequence of the current

rules. Even when you comply, you may not be presenting a clear

picture of financial condition. Certainly with regard to forwardlooking statements or identifiable business risk or new market development, or whatever might be the thing of value down the road

that you are not disclosing, but I am even worried about the accuracy of the historical statement that is GAAP-compliant, in light of

the technicalities in which the rules are constructed. They are very

difficult for anyone to understand, and more FASB tries to define

it, the more complicated the system becomes that they are trying

to fix.

I don’t know how we get out of this. I don’t think we can go from

a historical-looking current system to a forward-looking internetbased system overnight. But certainly there has to be some force

in the market to bring about these changes—and I don’t know that

the Congress is the appropriate forum for that to occur. But what

are your recommendations about how we get where we need to be?

What is the first next step?

Dr. Litan.

Mr. LITAN. Well, I think there are several steps. On the forwardlooking information question, which relates to all these non-financial indicators that several of us talked about, as well as to moving

to the internet, the prime mover, in my opinion, has to be the SEC.

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It shouldn’t do it by mandate; it should do it by encouragement,

arm-twisting, if you will, education. But it has to be the agency out

in front helping to create a demand among investors—working

through the media, because once people know that this information

is out there, or capable of being produced, then sophisticated investors, namely institutional investors, I think, will begin to demand

it. And you will see a virtuous cycle. But somebody has got to start

the cycle, and it has got to be the SEC.

Now, the second point concerns the existing GAAP-based system,

not the forward-looking information. Now you get into this debate

which has no clear resolution, where you have GAAP, which has

highly detailed rules versus international accounting standards,

which are basically principles-based, and much more general in nature. But, as Congressman Sherman pointed out, the international

rules may allow too much discretion. So you’re damned if you do

and damned if you don’t.

There are problems with each approach, which is why I end up

recommending competition. Rather than give a monopoly to one

rule-setter in one geographic area, I would like at least to see some

marketplace competition. Firms choose among the standards, and

then what the media will do and the analysts will do is they will

write about which standard, on the whole, better serves investor

interests. And you will get investor demand, I think, for the better

standard. And let them go at each other, head to head.

But I think in the absence of competition, you are going to be

beating a dead horse.

Chairman BAKER. Ms. Masterson, or Dr. Verrecchia? Can you

comment on the subject?

Ms. MASTERSON. Yes, I would. I think there is a lot—as you said,

this is not a one-step process. In fact, it is probably a longer process than any of us wants to think about.

But certainly one of the outcomes of the system we have today

is this, I think several of us mentioned the obsession with earnings,

with current short-term earnings. And the earnings game is very

real. We see that; we got a lot of information about it in our research.

And the fact is that those short-term earnings pressures don’t

really turn into that long-term investor value in many cases. And

so where we get the rules that are so focused on short-term wins

and companies feeling that it has got to be this quarter over last

quarter, and immediate results, and not an ability to really talk

with investors about what they are doing to build long-term

value—I think that is where, whether it is rules or principles, we

just get caught in that same old cycle.

So getting more information about the long term—I agree that

the SEC is a main player here. I think industry-driven initiatives

have got to come into play, and the FASB has actually sponsored

some of the industry-based coalitions. We do have early adopters

in the marketplace today, and hopefully there will be some pressure to follow them.

But giving investors more information about the long term can

hopefully balance out that obsession with short-term earnings,

which I think is at the heart of the manipulation, whether there

are rules or principles.

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Chairman BAKER. Right, thank you.

Mr. Castle, did you have a question?

Mr. CASTLE. Thank you, Mr. Chairman. I want to sort of start

where I stopped before. And I am delighted that you gave me the

information about Standard and Poor’s beginning to bring stock options into their corporate reporting. Maybe they heard I was going

to ask questions about this today or something like that.

I would like to really, I think, ask all of you this question. And

you all were in the room when I asked questions about it before.

But I am a little hung up on this subject, admittedly. I know it is

a smaller part of the transparency issues, and I agree with the

Chairman, I think accounting methodology which reflects true

value is what we are all after. I think we all would basically agree

on that. And I agree with the short-term earnings pressures that

Dr. Litan and Ms. Masterson have both talked about. If there is

some way to spread it out so we didn’t always look for it, I think

it would be helpful indeed.

But stock options in particular do trouble me. I have seen all

kinds of opinions on it. I have seen expensing options when granted, expensing options when they are actually executed, or just leaving it alone and doing it in the footnote. I see here from an article

in Business Week, which I clipped out, the boards make matters

worse by so lavishing options on executives they now account for

a staggering 15 percent of all shares outstanding—whether it is

true or not, if it was even remotely close to true, that is an astounding number, a percentage of the capital of any corporation

which exists out there.

And I don’t know what the right answer is. And as I said at the

beginning—and I am not getting into this—I just think executive

compensation has perhaps gotten out of hand in this country. And

that is something that I think the corporations are going to have

to look at in terms of their own management. And their directors—

although the directors benefit from all this as well—and everybody

else.

But from an accounting point of view, it seems to me that all of

us who are interested in this have a responsibility. And I can’t

imagine you haven’t thought about this issue in some way or another, even though some of you didn’t speak to it directly here

today. And I would be interested in your views on it. What are your

views on what we should do on the accounting entries on stock options?

And you can do whatever you want. You can duck and say, ‘‘I

haven’t thought about it.’’ You can say we should expense it when

they are granted, or expense it later, and the methodology by

which that would be done. And you will probably have about a

minute apiece, when it is all said and done. But I would just be

interested—you are four diverse people, even though you have commonality in terms of the area you look at. And I would just be interested in your views on this. Apparently, everybody seems to

have different views—the President and Mr. Greenspan differ, others differ. And I am just interested in what the wealth of good, valuable opinion on this subject is.

So maybe we could just go across the table and start with Dr.

Litan and go from there.

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Mr. LITAN. I will side with Chairman Greenspan. He said that

the one thing we know is that the right answer is not zero. The

stock options are valuable; we know that, and they are valuable at

the time of granting.

Now, the people who oppose assigning a value say the so-called

Black-Scholes method of valuing options is not perfect because the

options have all kinds of restrictions; a lot of times the stock isn’t

well-traded, so you don’t have the data to do the precise BlackScholes valuation. My answer to that, and I think Chairman

Greenspan said the same thing, is you do an estimate off that, and

even if it is arbitrary, it is better than nothing.

We do it all the time. We have depreciation schedules which are

arbitrary. We have loss estimation for bad loans, which is not a

science. It is more an art than a science, but we don’t just simply

pretend the loan is good when it isn’t and put a 100 percent value

on it. I think an estimate here is better than zero. And so yes, I

think there is a right answer. It may not be the perfect answer, but

we know that the current system is not the right answer.

Mr. CASTLE. Thank you. Ms. Masterson?

Ms. MASTERSON. I think I am going to take Steve’s line and say

I am going to speak for myself and not my firm on this one, if I

may.

Mr. CASTLE. I actually was only asking you, not for your firm’s

opinion.

Ms. MASTERSON. Because I am not here to make a statement on

behalf of PricewaterhouseCoopers about the accounting for stock

options. So I am going to take a little bit different tack, if you don’t

mind.

But I think you have hit the point on the head, and that is executive comp in general. One of the things that all investors really

want more information about is the quality of management. And

management, by and large, is what they are investing in. And

whether it is in the income statement, on the balance sheet, in the

notes, the information needs to be there about management, the

quality of management, the compensation of management, the

value that the board has placed on management and where the incentives are leading management behavior.

So I think that fulsome disclosure—with all due respect, if I can

dodge the placement of that, I would appreciate it.

Mr. CASTLE. Thank you. And Dr. Verrecchia, I will throw a kicker in on yours, because I think you said in your testimony, and I

think I saw it in your writing, that you actually think this has enhanced value to the corporation, if stock options are correctly reported. Maybe I am mis-stating that. I would be interested in that

as well as the other question.

Mr. VERRECCHIA. Well, I think any disclosure enhances. But I

think that specifically with regard to this, this strikes me as so

straightforward and obvious that I think it speaks very much to

the controversy about rule-making in general. Obviously they

should be an expense. It is probably much easier to measure,

through Black-Scholes or otherwise, the value of that expense, than

it is a whole bunch of other things that are synthetically amortized.

So in a way, what has happened is people have used this measurement issue to, if you will, put forth an agenda that nothing be

86

recognized at all in the form of an expense, without recognizing

that something like that option, like in very sophisticated communities, can be valued with a high degree of accuracy. And so I think

most of the arguments are totally disingenuous, that suggest somehow it should not be recognized as an expense because of measurement issues. And if we can’t see through this issue, then there is

no hope for rule-making in general.

Chairman BAKER. Thank you.

Mr. Wallman.

Mr. WALLMAN. The measurement issue, I think, is a red herring.

And I don’t think the argument has really been on that since it was

first raised in the mid-1990s. I think everybody understands that

issue, both sides.

The question is how best to present the information, and what

is—in some cases, the perception of broader-based impacts. And

you have had the argument for quite a number of years that expensing it would be something that could deter the use of stock options. As a society, is that something we want or not? Should accounting be neutral or not? These are a number of interesting and

important policy decisions that transcend the mechanical questions

of whether or not you can come up with a value. The answer is,

of course you can. The question is really how best to then use that

information.

Some have suggested that there be additional disclosure of the

actual calculated expense, and that can be a disclosure. Others

have suggested a separate line-item in the financial statements

that would break this out, because you get one of the other confusing aspects, as you mentioned yourself earlier, that operating

profits, for example, in some companies could be wiped out by

showing expenses which are not cash expenses and which could be,

therefore, quite misleading to investors looking at the financial

statements, wondering how it is that this company can keep making a lot of money in the traditional sense of making a lot of

money, but keep reporting losses because the stock price keeps

going up.

And you do get very strange anomalies where the more the stock

price goes up, the more there could be an expense; the more the

stock price goes down, the less of an expense. Yet management or

the employees haven’t changed. So you get some very interesting

circumstances as to how best to describe, disclose, and present this

information.

So I don’t think the focus ought to be on the measurement issues.

Clearly, that is inapposite, and I think everybody understands that.

The real issue or debate has been for the last decade how best to

present this information, both to investors so they understand what

it is, to managers so it can be used, and also how do these factors

implicate themselves in more broad-based societal issues that people have been arguing about for a long time.

I think we should remember this whole debate started in part

when managers and others used to get a lot of cash. And there was

an awful lot of movement on the corporate governance side to start

paying managers not in cash, but in stock and stock options, in

order to better align their interests with the corporation. And the

view was that we needed to have some way of trying to convince

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companies and managers to take equity-based compensation so

their interests would be aligned with shareholders, as opposed to

simply taking cash from the company.

Mr. CASTLE. Are you willing to opine how you would do it, if you

were doing the accounting?

Mr. WALLMAN. Actually, I am happy to, because I was on the

record as proposing an answer that was in between. And I would

be happy to pursue that in detail if you would like. But in essence,

it was a hybrid that came up with the equivalent of a charge in

terms of coming up with the amount, the measurement amount,

but showing it on a separate item, so that it was fully disclosed and

people could understand what it was, as opposed to mixing it into

an overall cash, otherwise understood compensation expense.

Mr. CASTLE. Thank you. I appreciate all of your answers, which

I think were clear and helpful, and I yield back, Mr. Chairman.

Chairman BAKER. Mr. Castle, on that subject, the Chairman

wrote on October of last year to FASB relative to the expensing of

stock options. And in the response that FASB gave to the Chairman, they arrived at a disclosure regime, not requiring expensing.

But they got to this point in a rather convoluted way, because their

preference was to expense, but because of the divisiveness of the

subject matter, I quote, ‘‘the Board chose a disclosure-based solution for stock-based employee compensation to bring closure to the

divisive debate on the issue, not because it believes that solution

is the best way to improve reporting.’’

So our non-political board happened to make a political judgment, I guess, which gets me to the next difficult question that

none of you have spoken to yet. Can we get where we need to go

with FASB as the accounting regulator, centered on a rule-based

system? Aren’t we looking at a very—this issue itself presents evidence of the difficulty. With regard to derivatives treatment, there

was a 10-year debate. With regard to SPEs, there was a 10-year

debate and then a statement issued saying we have decided not to

take a position.

In the world in which we live, it may not be the fairest, but we

need decisive response to inappropriate market conduct, so that investors at any time and moment are getting access to clear-cut,

helpful, usable information. We are trying to put a horse and an

automobile together here, and I think that we maybe better advised to go get us another mechanic. What is your view about the

viability of reform versus a whole new approach?

Yes, sir?

Mr. LITAN. Well, I think, as I said in my written testimony, a

second-best solution to the slowness problem is to have the SEC

threaten to step in and set a rule with some kind of deadline. I

want to be clear, I don’t think that is a perfect solution, but it is

better than where we are now.

Now, the problem inherently, both as to slowness and to political

influence, is that ultimately FASB can, at any moment, be influenced by the Congress. And it will be as long as FASB reports to

the SEC. It is inherently a political creature. I think the only way

to reduce political influence is to have competition in standards, as

I said before.

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Now, you could imagine replacing FASB with IAS, international

standards. But that would just move the politics to some other

place, it would move it to London. And then it would dilute American interests, obviously. We would have to compete with overseas

interests. But I am not sure that would be a necessarily better answer. London may be even slower than Greenwich, Connecticut.

And, by the way, I am not sure IAS would be a stable solution.

I think we would end up, over time, having national accounting

bodies potentially interpret IAS to apply to specific countries. And

so we could end up right back where we are now, with different flavors of different accounting standards.

Chairman BAKER. From your perspective, is FASB asset-limited?

If they have been operating in a deficit posture for the past 4 years,

they obviously can’t be adding on any large numbers of staff. Is it

advisable to consider a federally based support system for FASB to

break the tie between the industry and the FASB regulatory body,

and to give them pay parity in order to do the work they need to

do? Is that an element of the delay, or is that a factor at all?

Mr. LITAN. Well, I will give my opinion, and then I don’t want

to monopolize attention. I think that a more stable funding source

could help reduce the perception that FASB is in anybody’s pocket.

But it doesn’t solve the political problem that I put my finger on,

because you can still get political interests working through the

Congress who don’t like stock option expensing, and they can still

stop FASB in its tracks.

So I don’t think the funding thing, while it may be meritorious,

is a perfect magic bullet. I think the only chance you have got is

competition, and let the market pressure both FASB and IAS to

come up with more rapid standards, and also to do so in a way that

is in the investor’s interest.

Chairman BAKER. Any differing opinions?

Mr. WALLMAN. Yes. I mean, I think competition is an interesting

idea, and people have suggested it a number of different places. It

is not a panacea, though, and it will not, in my opinion, I think,

do much other than create two fora where politics can be brought

to bear in various respects. And I don’t think you are guaranteed

a better result out of either of them just because you now have

competition between them.

I think we also end up with the potential issue for there to be

misunderstandings. It obviously becomes somewhat more confusing

for investors who now have two different sets of standards. It is already confusing for investors in trying to figure out what GAAP is

meaning; forget trying to figure out what two different kinds of

GAAP mean. I mean, there are a number of different issues.

On the other hand, I think the convergence that has been talked

about is also happening, and I think on most issues you end up

with people who are intelligent concluding reasonably the same

thing with regard to how to try to do something. The problem is

that the world is very complex, and the problem is that when you

continue to try to come up with specific rules that cover things, it

becomes increasingly like the tax code.

And like the tax code, we don’t have people out there who decide

that they can intrinsically and inherently understand it just by sort

of looking at a bunch of books. There are tax lawyers who are paid

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to do nothing but try to figure it out, and we have courts that are

specialized in trying to understand it.

We are in a position here where we are looking for something

that is useful for the marketplace as a whole and for investors generally speaking. And in order to provide something to them that is

useful, it needs over time to be something that has more and better

disclosures with respect to it. And to some degree, we create, I

think, a problem by trying to roll things up to specific numbers.

I think Standard and Poor’s is a great example of an entity that

has attempted at this point—in part because there were concerns

about whether or not the numbers it is using are useful for what

it is trying to do—to now itself try and analyze it better, and to

come up with its own view of core numbers, separate from what

FASB and what the SEC and others think are the generally accepted accounting numbers that ought to be suggested to the public,

and different from what it is that we will have the public see in

audited financial statements. S&P will basically use its own.

That is an interesting opportunity, if you will, for competition.

We already have competition there, if you will, and we will see

whether or not people prefer to see what S&P produces versus

what it is that somebody else produces.

I think it was said earlier in the previous panel, too, that you can

end up in a position where as long as you have got full information

out there, and the line items are clear and the disclosure is obvious, you can end up with others—whether they are analysts,

whether they are entities like S&P or others—creating, if you will,

their own view of what financial statements are like.

So I think that we, in essence, end up with sort of the competition, if you will, for ideas and thoughts through that means, without trying to come up with multiple places to have influence peddled with regard to politics and financials.

Chairman BAKER. Do I take from that, then, you do not believe

that a regulatory restructuring makes any sense? That it is pressure to get the current structure to move in the disclosure regime

that you see as appropriate?

Mr. WALLMAN. I think that whenever there is a failing, there is

a question of whether or not there needs to be a change in the

overall structure. And I think it is a worthwhile question to ask.

Personally, I think that to some degree the failing has been in the

approach. It has been too much of an attempt at, if you will, closing

barn doors after horses have escaped, trying to come up with the

next rule to take care of the last problem. And what we need is a

more forward-looking approach, if you will, to regulation.

I think that the people are in a position to be able to exercise

that, and to do it appropriately, if one can step back and take a

more general approach to rule-making. And I think the SEC has

begun to do that, and has done it in various instances. And I think

the FASB, with its new business combinations approach, has done

that as well. So I think you are starting to see that, and I think

people have recognized that that is a necessary element to appropriate rule-making going forward. That, I think, is the restructuring.

There is a separate set of issues, which is whether or not there

is a sufficient level of resources both at the Commission and at

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FASB, whether or not the funding really ought to be something

where the private sector has to step up to fund this, which necessarily entails the question of where is influence coming from with

regard to that.

But I think stock options is a worthwhile point in case: the pressure there came not from the private sector suggesting they were

going to withdraw funds from the FASB if it went forward with the

project; the pressure there came from Congress suggesting that

FASB was doing something inappropriate if it were to expense

stock options.

Chairman BAKER. Thank you.

Mr. Castle, did you have any further questions?

[No response.]

Chairman BAKER. I don’t know if anybody wants to make any

further comment on the Standard and Poor’s approach that was

issued today, if you have any degree of familiarity with it. But if,

after review, you find it of interest, or if there is comment worthy

to send to the Committee, we would be appreciative for analysis

and comment as we move forward.

This is a very meager beginning to a very long process, but I

want to express my appreciation to each of you for your time in

being here today. Your insights have been very helpful to us, and

I am certain we will be working together over the coming months

toward the goals we all have in mind.

Thank you very much. Our hearing is adjourned.

[Whereupon, at 4:30 p.m., the hearing was adjourned.]

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