[House Hearing, 108 Congress]
[From the U.S. Government Publishing Office]



 
                        THE ACCOUNTING TREATMENT


                       OF EMPLOYEE STOCK OPTIONS

=======================================================================

                                HEARING

                               BEFORE THE

                            SUBCOMMITTEE ON
                     CAPITAL MARKETS, INSURANCE AND
                   GOVERNMENT SPONSORED ENTEREPRISES

                                 OF THE

                    COMMITTEE ON FINANCIAL SERVICES

                     U.S. HOUSE OF REPRESENTATIVES

                      ONE HUNDRED EIGHTH CONGRESS

                             FIRST SESSION

                               __________

                             JUNE 03, 2003

                               __________

       Printed for the use of the Committee on Financial Services



                           Serial No. 108-32





                       U.S. GOVERNMENT PRINTING OFFICE
90-627                       WASHINGTON : 2003
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                 HOUSE COMMITTEE ON FINANCIAL SERVICES

                    MICHAEL G. OXLEY, Ohio, Chairman

JAMES A. LEACH, Iowa                 BARNEY FRANK, Massachusetts
DOUG BEREUTER, Nebraska              PAUL E. KANJORSKI, Pennsylvania
RICHARD H. BAKER, Louisiana          MAXINE WATERS, California
SPENCER BACHUS, Alabama              CAROLYN B. MALONEY, New York
MICHAEL N. CASTLE, Delaware          LUIS V. GUTIERREZ, Illinois
PETER T. KING, New York              NYDIA M. VELAZQUEZ, New York
EDWARD R. ROYCE, California          MELVIN L. WATT, North Carolina
FRANK D. LUCAS, Oklahoma             GARY L. ACKERMAN, New York
ROBERT W. NEY, Ohio                  DARLENE HOOLEY, Oregon
SUE W. KELLY, New York, Vice Chair   JULIA CARSON, Indiana
RON PAUL, Texas                      BRAD SHERMAN, California
PAUL E. GILLMOR, Ohio                GREGORY W. MEEKS, New York
JIM RYUN, Kansas                     BARBARA LEE, California
STEVEN C. LaTOURETTE, Ohio           JAY INSLEE, Washington
DONALD A. MANZULLO, Illinois         DENNIS MOORE, Kansas
WALTER B. JONES, Jr., North          CHARLES A. GONZALEZ, Texas
    Carolina                         MICHAEL E. CAPUANO, Massachusetts
DOUG OSE, California                 HAROLD E. FORD, Jr., Tennessee
JUDY BIGGERT, Illinois               RUBEN HINOJOSA, Texas
MARK GREEN, Wisconsin                KEN LUCAS, Kentucky
PATRICK J. TOOMEY, Pennsylvania      JOSEPH CROWLEY, New York
CHRISTOPHER SHAYS, Connecticut       WM. LACY CLAY, Missouri
JOHN B. SHADEGG, Arizona             STEVE ISRAEL, New York
VITO FOSSELLA, New York              MIKE ROSS, Arkansas
GARY G. MILLER, California           CAROLYN McCARTHY, New York
MELISSA A. HART, Pennsylvania        JOE BACA, California
SHELLEY MOORE CAPITO, West Virginia  JIM MATHESON, Utah
PATRICK J. TIBERI, Ohio              STEPHEN F. LYNCH, Massachusetts
MARK R. KENNEDY, Minnesota           ARTUR DAVIS, Alabama
TOM FEENEY, Florida                  RAHM EMANUEL, Illinois
JEB HENSARLING, Texas                BRAD MILLER, North Carolina
SCOTT GARRETT, New Jersey            DAVID SCOTT, Georgia
TIM MURPHY, Pennsylvania              
GINNY BROWN-WAITE, Florida           BERNARD SANDERS, Vermont
J. GRESHAM BARRETT, South Carolina
KATHERINE HARRIS, Florida
RICK RENZI, Arizona

                 Robert U. Foster, III, Staff Director

  Subcommittee on Capital Markets, Insurance and Government Sponsored 
                              Enterprises

                 RICHARD H. BAKER, Louisiana, Chairman

DOUG OSE, California, Vice Chairman  PAUL E. KANJORSKI, Pennsylvania
CHRISTOPHER SHAYS, Connecticut       GARY L. ACKERMAN, New York
PAUL E. GILLMOR, Ohio                DARLENE HOOLEY, Oregon
SPENCER BACHUS, Alabama              BRAD SHERMAN, California
MICHAEL N. CASTLE, Delaware          GREGORY W. MEEKS, New York
PETER T. KING, New York              JAY INSLEE, Washington
FRANK D. LUCAS, Oklahoma             DENNIS MOORE, Kansas
EDWARD R. ROYCE, California          CHARLES A. GONZALEZ, Texas
DONALD A. MANZULLO, Illinois         MICHAEL E. CAPUANO, Massachusetts
SUE W. KELLY, New York               HAROLD E. FORD, Jr., Tennessee
ROBERT W. NEY, Ohio                  RUBEN HINOJOSA, Texas
JOHN B. SHADEGG, Arizona             KEN LUCAS, Kentucky
JIM RYUN, Kansas                     JOSEPH CROWLEY, New York
VITO FOSSELLA, New York,             STEVE ISRAEL, New York
JUDY BIGGERT, Illinois               MIKE ROSS, Arkansas
MARK GREEN, Wisconsin                WM. LACY CLAY, Missouri
GARY G. MILLER, California           CAROLYN McCARTHY, New York
PATRICK J. TOOMEY, Pennsylvania      JOE BACA, California
SHELLEY MOORE CAPITO, West Virginia  JIM MATHESON, Utah
MELISSA A. HART, Pennsylvania        STEPHEN F. LYNCH, Massachusetts
MARK R. KENNEDY, Minnesota           BRAD MILLER, North Carolina
PATRICK J. TIBERI, Ohio              RAHM EMANUEL, Illinois
GINNY BROWN-WAITE, Florida           DAVID SCOTT, Georgia
KATHERINE HARRIS, Florida
RICK RENZI, Arizona





                            C O N T E N T S

                              ----------                              
                                                                   Page
Hearing held on:
    June 03, 2003................................................     1
Appendix:
    June 03, 2003................................................    73

                               WITNESSES
                         Tuesday, June 03, 2003

Dreier, Hon. David, Member, U.S. House of Representatives........     2
Eshoo, Hon. Anna G., Member, U.S. House of Representatives.......     4
Barrett, Craig R., Chief Executive Officer, Intel Corporation....    48
Glassman, James K., Resident Fellow, American Enterprise 
  Institute......................................................    53
Herz, Robert H., Chairman, Financial Accounting Standards Board..    21
Hills, Hon. Roderick M., Partner, Hills & Stern..................    51
Nightingale, Deborah, Project Manager, Sun Microsystems..........     7
Volcker, Hon. Paul A., Chairman, International Accounting 
  Standards Committee Foundation Trustees........................    45

                                APPENDIX

Prepared statements:
    Oxley, Hon. Michael G........................................    74
    Dreier, Hon. David...........................................    75
    Eshoo, Hon. Anna G...........................................    78
    Gillmore, Hon. Paul E........................................    81
    Kanjorski, Hon. Paul E.......................................    82
    Royce, Hon. Edward R.........................................    84
    Stark, Hon. Pete.............................................    86
    Barrett, Craig R.............................................    88
    Glassman, James K............................................   102
    Herz, Robert H...............................................   113
    Hills, Hon. Roderick M.......................................   158
    Nightingale, Deborah.........................................   166
    Volcker, Hon. Paul A.........................................   169

              Additional Material Submitted for the Record

Eshoo, Hon. Anna G.:
    Employee Stock Options: The untold story.....................   173
Stark, Hon. Pete:
    Copy of H.R. 626.............................................   190
    Financial Accounting Standards Board letter, February 3, 2003   193
Hills, Hon. Roderick M.:
    ``True and fair is not hard and fast,'' article, The 
      Economist, April 24, 2003..................................   199


                        THE ACCOUNTING TREATMENT



                       OF EMPLOYEE STOCK OPTIONS

                              ----------                              


                         Tuesday, June 3, 2003

             U.S. House of Representatives,
         Subcommittee on Capital Markets, Insurance
              and Government Sponsored Enterprises,
                           Committee on Financial Services,
                                                   Washington, D.C.
    The subcommittee met, pursuant to call, at 10:05 a.m., in 
Room 2128, Rayburn House Office Building, Hon. Richard H. Baker 
[Chairman of the subcommittee] presiding.
    Present: Representatives Baker, Ose, Shays, Gillmor, Oxley 
(ex officio), Castle, Lucas of Oklahoma, Manzullo, Ney, Kennedy 
of Minnesota, Brown-Waite, Renzi, Royce, Kelly, Shadegg, Green, 
Miller of California, Toomey, Capito, Hart, Tiberi, Harris, 
Kanjorski, Hooley, Sherman, Meeks, Inslee, Gonzalez, Hinojosa, 
Crowley, McCarthy, Matheson, Miller of North Carolina, Emanuel 
and Scott.
    Chairman Baker. Welcome all those who are in attendance 
today.
    Because of the nature of the panels we have this morning, 
there being three in number and the distinguished participants 
in each of those panels, I am going to suggest--I have 
discussed with Mr. Kanjorski and his side minimizing opening 
statements to myself and Mr. Kanjorski, and we will enter into 
the record all of the members' statements for that purpose, 
simply to expedite our hearing and move forward to important 
testimony which we will receive.
    Today, the Subcommittee on Capital Markets turns its 
attention to expensing employee stock options and, more 
specifically, H.R. 1372, the Broad-Based Stock Option Plan 
Transparency Act introduced by Representatives Dreier and 
Eshoo. This hearing is especially timely as we are moving 
towards issues of proposed standards on the mandatory expensing 
options later this year.
    Stock options for executives, managers and employees have 
served as an important tool for cash-strapped companies in 
their efforts to attract and retain skilled management and 
employees. However, there are clearly two schools of thought on 
the methodology for proper accounting treatment.
    Proponents of expensing include the big four accounting 
firms, institutional investors, as well as the current Chairman 
Greenspan and former Chairman Volcker. Their views and options 
are a form of compensation just like salary and bonuses. As 
compensation is an expense and as expenses eventually impact 
earnings, options should therefore be recorded and subtracted 
from income.
    Opponents justifiably argue expensing has a different view. 
They believe that mandatory expensing would discourage the use 
of options and adversely have an affect on innovation, economic 
growth, job opportunity and national competitiveness. 
Furthermore, options for expenses to company valuation is a 
most difficult issue. For example, use of different option 
pricing models and different assumptions can lead to 
significantly different economic consequences.
    H.R. 1372 would seek to have SEC issue regulatory 
requirements which would enhance disclosure of employee stock 
options while prohibiting the SEC to recognize new accounting 
standards related to stock options until a report is submitted 
to Congress and to this committee on the cost-effectiveness of 
such regulation. This report would follow a period of 3 years 
of study.
    This is a very controversial but very important issue, and 
I look forward to hearing from each of our distinguished 
panelists this morning.
    I will turn to Mr. Kanjorski for an opening statement.
    Mr. Kanjorski. Thank you, Mr. Chairman.
    Mr. Chairman, I, too, am interested in the stock option 
issue. We should look at its effect on corporate returns and 
disclosures.
    I think we should move forward with our panel, however. In 
the nature of saving time and efficiency, I move that my 
opening remarks be entered into the record.
    Chairman Baker. Without objection. Thank you, Mr. 
Kanjorski.
    [The prepared statement of Hon. Paul E. Kanjorski can be 
found on page 82 in the appendix.]
    Chairman Baker. If there be no further statements at this 
time, I would like to move forward quickly to our distinguished 
panel and recognize the Chairman of the Rules Committee, the 
distinguished David Dreier.

    STATEMENT OF THE HON. DAVID DREIER, A REPRESENTATIVE IN 
             CONGRESS FROM THE STATE OF CALIFORNIA

    Mr. Dreier. Thank you thank you very much, sir. This is the 
first time I have been in this room; and this room has changed 
a lot since I have been in here, Mr. Chairman.
    Let me say I appreciate the fact that you and Mr. Kanjorski 
and the members of this subcommittee have agreed to hold what I 
think is a very important hearing, and I believe that what we 
have really done here is recognize that there is a problem. We 
all know that the problem of corporate corruption came to the 
forefront, and your full committee addressed that issue with 
passage of the Sarbanes-Oxley legislation. I know that there 
are many people out there who are still focused on a number of 
the concerns, and I believe that Ms. Eshoo and I are focused on 
those and really have tried to step up to the plate and 
responsibly address this issue with the legislation that we 
have introduced.
    Now, some have alleged that our legislation is an 
interference in the accounting standards setting process. The 
fact is, Mr. Chairman, we can't divorce--as Members of Congress 
we can't divorce ourselves from our responsibility for dealing 
with accounting standards, but we also have to look at the very 
real impact that those standards will have on economic growth, 
investors in this country, shareholders and the economy as 
well.
    Unlike the FASB board members, we are elected officials. 
And I am not an accountant, I am not an expert on this, Mr. 
Chairman, but I will tell you that I know that we have an 
obligation to the American worker and to the American investor 
to do everything that we can to preserve an environment that 
allows entrepreneurs to play a role in growing our economy.
    Now, there is a disagreement between those who take a 
static view of the economy and see stock options as something 
that could theoretically impact shareholders today and those 
who understand the dynamics of an evolving, technology-based 
economy that views stock options as an important tool for 
increasing all share value in the future.
    Now, if you try to cement the cost of those stock options 
and their grants up front, you will undermine the engine that 
will grow the company pie, because mandatory expensing--and I 
have no problem with voluntary expensing, but mandatory 
expensing will eliminate the use of broad-based employee stock 
option plans.
    I am not concerned about executive compensation. We know 
there has been some abuse there, and obviously that needs to be 
addressed. What I am concerned about is the potential to 
jeopardize the stock option plans for employees. I mean, this 
is a public policy issue, Mr. Chairman. It is not an accounting 
issue.
    Expensing--mandatory expensing will do little to curb the 
number of stock options granted to top executives, but it will 
directly harm, as I said, the ability of rank and file 
employees who enjoy corporate ownership.
    Deborah Nightingale from Sun is going to be testifying in 
just a moment, and she is going to talk about--I read her 
testimony last night. She is going to talk about the 
innovation, creativity and the role that she plays as a partner 
in her company.
    Mandatory stock option expensing not only threatens the 
high-growth sectors of our economy but will actually result in 
an investor receiving inaccurate information about a company's 
use of employee stock options.
    Now, our bill will mandate--Mr. Chairman, our bill will 
mandate the uniform and standardized disclosure of employee 
stock options without resulting in the elimination of broad-
based stock options.
    Now you don't have to be an accountant to recognize that 
stock options are not actually an expense. If you look at the 
definition of an expense, that is anything that results in an 
outflow of a company's assets or an increase in the company's 
liabilities. Employee stock options meet neither test.
    I mean, let's propose, for instance, that on the first of 
January of this year company A had hired a computer programmer 
at a salary of $50,000 a year plus 100 stock option grants that 
can be exercised at a price of $10 no earlier than 5 years from 
the date of hire. Only the cash salary and nothing for the 
options. There is no cash outflow for the options and no 
liability created at any time, not when they are granted, 
vested or exercised. Indeed, when the stock options are 
exercised, the company actually receives money, and obviously 
the only thing that ultimately happens is the potential 
dilution of that stock. So all shareholders need to do is be 
informed of exactly what that option package consists of, and 
that is what our legislation is designed to do.
    Now, Mr. Chairman, the fact is employee stock options never 
actually impose an expense or cost on companies. Since that is 
the case, why is there this endless debate with FASB and others 
in the accounting community over expensing stock options or 
explaining exactly what the cost to companies is?
    Well, that brings me to, actually, a visual aid that I have 
here, Mr. Chairman; and I would just like to share this with 
you.
    This is a map of the universe from 2,000 years ago; and 
basically Claudius Ptolemy, as we all know, came up with this 
amazing theory that the earth was the center of the universe, 
and for 1,500 years--that is 15 centuries, Mr. Chairman--that 
view continued on and on and on by great minds who basically 
supported the Ptolemaic theory and Copernicus, Galileo, Brahe, 
the whole gang of these people ended up supporting it. The 
Mathematical Compilation, a 13-volume treatise, was put 
together, and guess what? We found, when all of a sudden Johann 
Kepler came forward, that while 15 centuries of stating that 
the earth was the center of the universe was out there, they 
were wrong.
    It is true that you can take all kinds of facts and justify 
almost anything, but it doesn't necessarily make it right. That 
is why I don't believe that options are an expense, and I hope 
very much that we will be able to expeditiously move forward 
with this legislation to address the understandable concerns 
that FASB and all the rest of us raise.
    Thank you very much, Mr. Chairman.
    Chairman Baker. Thank you, Chairman Dreier. We have members 
requesting copies of that chart for further----
    Mr. Dreier. And I will tell you that likely you might 
conclude that this is a meeting of Sherwood Boehlert's Science 
Committee.
    Chairman Baker. It could be helpful to a lot of us I think. 
Thank you.
    [The prepared statement of Hon. David Dreier can be found 
on page 75 in the appendix.]
    Chairman Baker. Our next witness this morning is the 
Honorable Anna Eshoo, distinguished Member, and glad to have 
you here as a cosponsor of this important legislation.

   STATEMENT OF THE HON. ANNA G. ESHOO, A REPRESENTATIVE IN 
             CONGRESS FROM THE STATE OF CALIFORNIA

    Ms. Eshoo. Good morning, Mr. Chairman. Thank you for having 
me here today to testify on the issue of expensing of stock 
options to the distinguished ranking member Mr. Kanjorski and 
to the Chairman of the full committee Mr. Oxley, who has worked 
with us to have this hearing. We very, very much appreciate it.
    I want to divide my comments up into what the expensing of 
stock options will not do and then the plus side of what stock 
options represent to the rank and file employees in so many 
companies in our companies today.
    I think, first of all, that the term stock options is 
something that people instantly think of when the term is 
stated that it has--it is a term that has become sullied; and 
that, of course, is the result of the misuse and the abuse of 
stock options that produced the scandals and the excessive 
executive compensation. I believe really that these events have 
led to a renewed call, because this is a call that took place 
many years ago in my first term when I came to the Congress in 
1993, and I think that these events have led to the call for 
expensing, leading many to believe that this is the ultimate 
prescription for what might ail us.
    Congress, as you know, and this committee of course knows, 
responded by the Sarbanes-Oxley bill that passed in the last 
Congress.
    So what will the expensing of stock options not accomplish? 
What will it not do?
    First of all, in my view, the expensing of stock options 
will not rein in any excessive executive compensation in 
corporate America. If in fact stock options are not available, 
anyone that is at the top of a company, a corporation, that 
board of directors is going to find some way to compensate 
people that are at the top. There may be some things that we 
haven't heard of, but certainly top executives in this country 
will be compensated, compensated well, and it is their board of 
directors and their respective committees that will take care 
of that.
    I think it is relatively easy for companies like GE and 
Coca-Cola to expense stock options. Keep in mind that they 
provide stock options to only a few, a very small number of 
their rank and file, and provide those stock options on a 
smaller basis to their executives.
    Companies in my district and many other companies across 
the country today--in my district, it is mostly biotechnology 
and high-technology sectors. They use stock options very 
differently than the companies that became the poster children 
for corporate fraud.
    If in fact the expensing of stock options had been on the 
books, the debacle at Enron would have still taken place. So it 
should not be thought of as the prescriptive that some have 
described.
    Rather than handing out options only to senior executives, 
new economy companies offer them broadly, and when I say 
broadly, it is very broad. They turned their entire employee 
base into corporate partners who have a stake in the future 
success of their company.
    Recent research indicates that at the top 800 technology 
companies in our country, 80 percent of the stock options are 
granted to the rank and file employees, not senior executives, 
and in the last decade over 10 million employees have received 
stock options.
    So who loses if stock options are required to be expensed? 
Not senior executives who will be compensated, as I said, in 
one way or another. But it is the rank and file employees. They 
are the ones that would lose out on this benefit. Why? Because, 
faced with the prospect of taking a huge charge against their 
bottom line in accounting statements, most companies would 
simply drop the broad-based option plans and eliminate this 
benefit to all but senior executives.
    Broad-based--I think it is very important for the committee 
members to take this out of the hearing, that broad-based stock 
option plans have turned employees into corporate partners by 
tying the interest of the employee together with the company 
and its shareholders.
    Small entrepreneurial companies start up with very little 
capital, and so they have used stock options as the magnet to 
attract and to retain bright and talented employees that are 
critical to that company's success. And seated to my left is 
one of those employees, Debbie Nightingale of Sun Microsystems. 
She obviously is going to testify and speak to you in her 
personal story, but what you should also know is that she 
serves part time as a lieutenant colonel in the Army Reserves.
    I just returned from Iraq with Chairman Hunter, and were it 
not for the role that our Reserves are playing, we would have 
had a much, much tougher time in the engagement there.
    I also have brought, Mr. Chairman, a very thick compilation 
of statements from employees that I ask be placed in the record 
as well.
    Chairman Baker. Without objection.
    Ms. Eshoo. Thank you.
    [The following information can be found on page 173 in the 
appendix.]
    Ms. Eshoo. These employees have used their options to 
purchase their first homes, to send their kids to college, to 
finance their retirements, to donate and sometimes begin 
foundations and charities; and they have contributed to our 
economy every step of the way.
    Now, the FASB has indicated it will only focus on 
accounting standards and not economic standards when it rules 
whether to require stock option expensing. I agree that 
accounting standards are best left to FASB, but promoting job 
growth and economic viability is a responsibility of the 
Congress. It is something that we all have the responsibility 
for. So while FASB says it won't look at the economic impact 
its decision will have, again, we have the responsibility to 
examine these factors and ensure that our national policies 
foster economic growth.
    Investors and shareholders access to information on how 
companies use stock options can and should be bolstered without 
throwing the baby out with the bath water, as expensing really 
would do.
    The legislation that Chairman Dreier and I have introduced 
we believe strikes an appropriate balance by requiring 
companies who offer stock options to disclose additional 
information to every shareholder and potential investor. Our 
bill, H.R. 1372, requires and includes plain English 
descriptions of share value dilution. That is something that 
investors and potential investors should be able to see and 
understand.
    The bill expands and builds a more prominent disclosure of 
stock option-related information, and it includes a summary of 
stock options granted to the five most highly compensated 
officers in a company or corporation.
    The bill also directs the SEC to monitor the effectiveness 
for investors of the enhanced disclosure requirements and 
report its findings back to this committee, and during that 
time frame the SEC would be prohibited from recognizing as a 
generally accepted accounting principal any new accounting 
standard on stock options.
    What our legislation does not set is accounting standards. 
Some have criticized this provision as a mandate on FASB, and 
nothing in our bill requires Congress to get into the standard-
setting business. Congress can and should do many things. I 
don't think it should do that. We have problems keeping up with 
our own books, much less do otherwise.
    The legislation directs the SEC to exert its appropriate 
role in maintaining the integrity of our markets and to ensure 
that our economic policies foster growth. Forcing companies to 
expense stock options at some arbitrary value as the FASB 
decision is likely to require I think would be both misleading 
to investors and to shareholders alike. Our legislation 
provides greater transparency about the use of stock options 
without unfairly penalizing the innovative employees that are 
really building America's economic future.
    So I thank you, Mr. Chairman, to the ranking member, and to 
the Chairman of the full committee for inviting us here today 
to speak to a story of success in our country and that we can 
move on in terms of transparency and other reforms without 
damaging what has become one of the most important recruiting 
and maintenance tools for small companies and others in our 
country. Thank you very, very much.
    Chairman Baker. Thank you, Ms. Eshoo.
    [The prepared statement of Hon. Anna G. Eshoo can be found 
on page 78 in the appendix.]
    Chairman Baker. Which leads us to our final participant in 
this panel, a Project Manager for Sun Microsystems, Ms. Deborah 
Nightingale. Welcome, Ma'am.

    STATEMENT OF DEBORAH NIGHTINGALE, PROJECT MANAGER, SUN 
                          MICROSYSTEMS

    Ms. Nightingale. Thank you, Mr. Chairman.
    Thank you, Mr. Chairman and committee members, for the 
opportunity to speak to you today about the importance of 
broad-based stock options to rank and file employees 
nationwide. I would also like to thank Representatives Dreier 
and Eshoo for their leadership on this important issue.
    I am here today speaking as one individual, but I know that 
I represent the view of thousands of my colleagues at Sun 
Microsystems and hundreds of thousands of employees nationwide.
    Today, I have a dual career, working full time for Sun 
Microsystems, and I serve part time as a lieutenant colonel in 
the Army Reserves. I started my career on active duty, and 
after 5 years I did make the decision to pursue some civilian 
opportunities. However, I have always remained in the Reserves, 
because I enjoy the military.
    Within several weeks after 9/11, I was mobilized for over 6 
months to help lead the airport security mission at San 
Francisco and other northern California airports. In the 15 
years since I have left active duty, I have worked for four 
companies, both high-tech and non-high-tech.
    Having worked in both high-tech and non-high-tech, one big 
differentiator, in my opinion, is employees in high-tech do 
tend to be more innovative and entrepreneurial. Granted, high-
tech often pays more, but the question is, once you have a 
well-paid, secure employee, how do you keep him or her 
motivated to keep innovating and taking risks? One simple and 
very effective answer--solution is stock options.
    I think and work differently as a result of stock options. 
I have always been a dedicated employee, but due to stock 
options I am incented to do much more than simply work hard and 
please the boss. I am motivated to drive results for Sun 
Microsystems so that I can participate in some sizable profit 
sharing, not just a better-than-average pay raise.
    Working in operations, I am constantly looking for 
innovative ways to cut costs so that Sun Microsystems can 
continue to invest in their R&D. I have a strong sense of 
ownership and a real stake in Sun. Simply put, Sun does well, I 
do well.
    As a member of the Armed Forces, I know that the 
technologies developed by U.S. high-tech are key elements of 
our military strength and our national security. A unit under 
my command as a battalion commander deployed to Iraq about 4 
weeks ago. As a result of a recent fire fight in Iraq, one 
soldier has been evacuated to Spain and will be coming back to 
the U.S. for major surgery before he will be returning home. 
These soldiers are in harm's way every day. I will never forget 
what one senior officer said to me: We need to do whatever we 
can to make sure it is a very unfair fight in our favor.
    I worry every day about those soldiers over there, but I do 
feel just a little bit better knowing that we have given them 
the best technology and equipment in the world. We need to 
ensure that U.S. high-tech companies maintain their competitive 
edge. I definitely worry about the possibility that other 
foreign competitors could begin using broad-based stock options 
just when the U.S. is taking measures to curtail the 
feasibility for our U.S. companies.
    In summary, broad-based stock options are really good for 
both companies and employees. Stock options are a key reason 
that I came to work for a high-tech company and a key reason 
that I stay at Sun. Broad-based stock options create employee 
commitment and loyalty. They attract and encourage innovators 
and entrepreneurs. They give U.S. companies a competitive 
advantage, and stock options really do matter to rank and file 
employees like myself.
    In summary, H.R. 1372 makes a lot of sense to me. It 
increases disclosure requirements right now without 
discouraging any broad-based stock options. It also provides 
for more time to study the issue and look for win-win 
solutions. This issue is an important issue to me and my fellow 
employees. We do not want to see broad-based stock options 
eliminated.
    Thank you very much.
    Chairman Baker. Thank you very much, Ms. Nightingale.
    [The prepared statement of Deborah Nightingale can be found 
on page 166 in the appendix.]
    Chairman Baker. Ms. Eshoo, you raised a point in your 
comments with regard to FASB's focus on accounting principles 
as opposed to economic policy. Is it your judgment that the 
current availability and reporting methodology for options 
enhances capital formation, business creation? It is a tool of 
principal value to the smaller not necessarily technology based 
but innovative companies that are out there that otherwise 
might have difficulty in attracting capital that a larger brick 
and mortar institution with a track record might not have.
    Ms. Eshoo. There isn't any question in my mind that it has 
served as a very, very effective tool. I am looking across both 
sides of the committee, and I think most of the members have 
come to--at one time or another travelled to my Congressional 
district, and so--and because members wanted to learn how these 
small companies, these incubators were--you know, what the 
ingredients were that was spawning the companies, the ideas, 
but also the tools that help attract employees and to hold 
them.
    Now, I think it is really a great American story. Now, why 
we would want to take an accounting standard to rejigger this 
and destroy it is still a real question to me. There is not--
there isn't any question in my mind that this has served very, 
very well. I mean, Debbie's story is one of--an eloquent story 
of tens of thousands. So I think that we really shouldn't be 
throwing the baby out with the bath water.
    Are there more reforms that can take place? Absolutely. But 
this accounting standard that wipes out what the rank and file 
are going to get, keeping in mind that executives will always 
be recompensed in some way I think is wrong-headed. But has it 
attracted employees? Absolutely, and it is a retention tool as 
well. And keep in mind, again, that small companies don't start 
up with a great deal of capital. This is one of the magnets 
that has drawn some of the best and the brightest to the 
companies that then go on and build, and the average person has 
really won under this--you know, what has taken place. I don't 
have any question in my mind, and I think that members that 
have travelled to my district and the region that I am from 
have seen this firsthand.
    Chairman Baker. Chairman Dreier, do you see it as a start-
up issue, or do you see it in a broader perspective with regard 
to expensing of options?
    Mr. Dreier. Well, I mean, it is a broad issue. But I will 
tell you that if you take, Mr. Chairman--look, up until 
recently, 45 percent of the gross domestic product growth in 
this country has emanated from the tech sector of our economy. 
We are hurting--and I represent the Los Angeles area. I am not 
from the Silicon Valley, but we know that this has been 
broadening all across the country.
    This morning I was listening to National Public Radio, and 
they were talking about a program that is going on today on the 
technology sector right here in the District of Columbia. We 
know we have the corridor going out to Dulles Airport. It has 
grown all over. There are start-up companies that need to have 
an incentive to continue to pursue their work, and we all 
recognize that there has been a problem of corporate abuse. I 
mean, there is no secret about that whatsoever.
    That is why I believe empowering shareholders and investors 
with more information as to what the policy is rather than 
putting into place a policy which frankly not FASB--I don't 
believe FASB--but there are some forces out there, Mr. 
Chairman, that have as a goal the complete elimination of stock 
options, and to me that would do more to undermine the 
entrepreneurial spirit for existing companies as well as those 
start-ups than almost anything else.
    Chairman Baker. I thank the gentleman.
    I think much of the comment is based on the presumption 
that when an option is granted the only way that thing is going 
to go is up. There hasn't been a lot of discussion about the 
consequences of when things go in reverse, and I think that is 
an area where we need to do a lot of examination.
    Mr. Dreier. We have certainly seen that.
    Chairman Baker. I have no further questions but just want 
to thank both of you for your testimony and participating in 
this hearing this morning.
    Mr. Kanjorski.
    Mr. Kanjorski. Thank you, Mr. Chairman.
    An interesting history lesson Mr. Dreier gave us, 1,500 
years of perhaps incorrect analysis of where we were. I wonder 
if that applies to the----
    Mr. Dreier. I wouldn't say perhaps. I don't think that--we 
still think that the earth is the center of the universe.
    Mr. Kanjorski. I know there are some members of this 
committee, Mr. Dreier, that may be flat-earthers that don't 
overargue that point.
    Mr. Dreier. They didn't believe there was a flat earth, 
actually, about--that is another misnomer, if you want to 
continue the history lesson.
    Mr. Kanjorski. But it just raises the question that there 
is a large, compelling thought that tax cuts will stimulate the 
economy by a large element. So that theory may also be tested 
sometime in the future.
    Mr. Dreier. Well, it worked under President Kennedy and it 
worked under President Reagan and it worked under President 
Harding and I think that it will work under President Bush.
    Mr. Kanjorski. Well, if we assume that that is what--the 
compelling reasons for the successes of those economies, but we 
will argue that another day.
    There has to be a middle ground here. Certainly I don't 
think we should take it upon ourselves to make a judgment as to 
what the proper tools to stimulate the economy, encourage 
entrepreneurial activity is, but, on the other hand, we have 
seen that in some instances stock options have led to abuses 
which have caused problems which have put investors at risk, 
just as off-shore deals in Enron caused a great deal of 
problem.
    I just looked at a paraphrase that I was going to ask two 
congressional witnesses, particularly Mr. Barrett of Intel, who 
will be on the next panel. He suggests certain conditions under 
which we could establish a rhyme or reason how you look upon--
if you have had an opportunity to know what his position is and 
how you look upon his thoughts of--maybe I should relate it to 
all employee stock option plans should be approved by 
shareholders. No more than 5 percent of the options should go 
to the top executives, while permitting substantial majorities 
of employees to participate. Companies should provide more 
frequent and understandable disclosures. Options should vest 
over longer periods, like 4 years, and compensation committees 
should be comprised of outside directors. Finally, he argues 
that expensing options under the Black-Scholes technique is 
inherently inaccurate.
    Do you have any thoughts on his proposals?
    Mr. Dreier. Well, I don't know that he is proposing 
actually mandating all of those provisions. I believe that the 
policies that a company moves ahead with are policies which 
clearly should be disclosed to shareholders. That is the goal 
that Ms. Eshoo and I have with our legislation here.
    I know that there are--and I am not going to speak for any 
of the other witnesses who are going to be coming forward, but 
I know that there are some of the panelists who are proponents 
of expensing who actually believe that Black-Scholes should not 
be the guide here, just as Mr. Barrett points out in his 
statement. But I think that, again, empowering investors, 
shareholders with as much information as possible as to what 
that company's policies are, if they choose to expense, they 
clearly should be able to do that. We just want with our 
legislation to have as much information made available as 
possible so that they understand the impact that it will have 
on the value of their investment.
    Ms. Eshoo. To the distinguished ranking member, I think 
that Mr. Dreier has covered that well. I would just put out on 
the table a couple of other thoughts, and that is that, again, 
the term stock options having become sullied, and I think that 
the way perhaps you look at this legislation should be that we 
are establishing a firewall so that the broad-based is not 
wiped out.
    When you think of the companies--and we--there was a lot of 
debate and reference to the companies that were involved in the 
scandals. You didn't read or hear about those that did broad-
based stock options as being part of that mess, most frankly; 
and I don't think you can point to an employee stock option 
anywhere in the country that has been abused or is the source 
of some kind of scandal. So it is something that I think 
Republicans and Democrats alike should be looking to protect. 
This is for extraordinary, ordinary people. We are not talking 
about the top. We are talking about what goes across a company, 
whether it is small, medium or large. So I think the 
appreciation of what they are should be what is kept in the 
forefront and what it does for our overall economy.
    This one-size-fits-all accounting standard that is being 
proposed by FASB is what is going to wipe it out. We are saying 
don't let that take place, and I think the ideas that--and I 
think it is important that the scandal that ripped through this 
country that lessened the confidence of the American people to 
invest, that those that head up companies and corporations 
certainly should be coming forward with ideas about how to 
create greater transparency and such, and we have some of those 
things built into the bill.
    Mr. Kanjorski. Thank you, Mr. Chairman.
    Chairman Baker. Chairman Oxley.
    Mr. Oxley. Thank you, Mr. Chairman.
    Let me first welcome our witnesses, particularly our good 
friend, the Chairman of the Rules Committee, the distinguished 
Chairman of the Rules Committee.
    Mr. Dreier. Nice to be on this side of the table.
    Mr. Oxley. Yes.
    And to my former colleague from the committee across the 
hall, we are glad to have you with us as well; and we are glad 
to have an opportunity to provide a forum for this most 
interesting issue. It has been my experience that after passage 
of Sarbanes-Oxley that the perception out there, right or 
wrong, is that somehow by expensing stock options you have got 
a silver bullet that would somehow end all of the problems that 
we have had in corporate America, and obviously you have been 
around long enough to know that it is not that easy, and it is 
a far more complicated than that.
    Let me ask both of our congressional witnesses to respond. 
Greg Barrett, the Intel Chief Executive Officer, is going to be 
on our third panel; and reviewing his statement, he says that 
mandatory expensing of stock options means that stock options 
ultimately will only be offered to the most senior managers, if 
at all.
    From your perspective, is it good public policy to go in 
that direction? And what does that say about rank and file 
workers and the potential for growth in the economy and 
particularly attracting those kinds of workers?
    Mr. Dreier. Well, thank you very much for that question, 
Mr. Chairman.
    I think that we have tried to make it very clear here. I am 
not going to worry about the compensation of executives. I 
mean, these men and women are very smart, shrewd, capable 
people. They are going to figure out how to get compensated.
    But if we move towards expensing, which jeopardizes the 
potential for growth in so many of these companies, my fear is 
that what will happen is that the Deborah Nightingales of the 
world will be the ones who will not have the incentive that is 
necessary to continue with this creativity.
    Remember, Mr. Chairman, I mean, our quality of life and the 
number of jobs that have been created have been tremendous. Our 
quality of life has been improved because of technological 
advances that we have seen.
    Deborah was just talking about the very important national 
security, the armed services aspect of this in dealing with the 
war in Iraq. We know that so many of the things that we enjoy 
have come from this, and the idea of squelching this creativity 
among rank and file employees I think would have a devastating 
impact on both job creation and our quality of life.
    Ms. Eshoo. Mr. Chairman, first, let me thank you again for 
your leadership and your working with us to create this forum 
and examine this issue, which is really so important to the 
economic life of our country, healthy economic life of our 
country.
    I think that any suggestions that corporate leaders have, 
both Mr. Barrett--that the committee should pay close attention 
to it. I mean, this is all about ideas on how to create better 
transparency and to continually rebuild the confidence that the 
American people have ultimately in our markets and the system 
that we have. I mean, that is the coin of the realm. That is 
why we have the broadest, deepest markets in the world. If 
there is anything that we have worried about is what the 
scandals did to affect the average investor, and we know that 
we have many average investors in our country today.
    So on what any of the ideas are, certainly pay close 
attention to them for more transparency and increasing the 
confidence of potential investors and the investors that are 
there, but also I think that, again, we can't--I think at a 
time--I have almost 10 percent unemployment in my congressional 
district today, close to 10 percent unemployment, and this is 
the place more than any other place in the country that fuels 
our national economy. Why would we choose to take something 
that has been an overwhelming success with employees, broad-
based stock options, and cast it aside today, I really don't 
know.
    I think the Congress can accomplish two things: higher 
transparency, better transparency and the protection of these 
broad-based stock options. I think we can do both. I think we 
can accomplish both.
    Mr. Oxley. Thank you.
    Mr. Chairman, let me commend you for putting together an 
all-star group of witnesses today, and we look forward to the 
testimony of the other panels as well. But we appreciate our 
colleagues, particularly Ms. Nightingale, to have you with us 
today, and I yield back.
    Chairman Baker. Thank you, Mr. Chairman. We appreciate the 
courtesy of your attendance as well.
    We will go regular order. I just have--note that we have a 
number of members who have expressed an interest in questions, 
and we do have a couple of more panels of prominence this 
morning. So I will go down the order by time of arrival and 
certainly want to be recognized, but the courtesy of brevity 
will be most appreciated and noted.
    Mr. Gonzalez.
    Mr. Gonzalez. The simple question is, who will determine 
the method--or the manner of methodology? Is it going to be 
FASB? Is it going to be the SEC? Is it the new accounting 
board? Because the final analysis, whether we wait 3 years or 
not, if we disagree with the findings or the determination of 
FASB, what are the options?
    Mr. Dreier. Well, let me just say that our goal with the 
legislation is very clearly just to have each company provide 
whatever structure they have in place for their handling of 
options, have that information become--be made available to the 
investors who are out there, to the shareholders. That is our 
goal with this legislation. That is why it is called the Broad-
Based Transparency Act.
    Ms. Eshoo. Well, what the bill calls for is for the SEC to 
examine how the higher transparency that is called for in the 
bill actually works, and that is very important. I think for 
those of you that may not be absorbing the message that 
Chairman Dreier and Debbie and myself are here to talk about 
today, I think it is very important that the SEC examine this. 
We really should have a definitive statement based on a good, 
solid period of time to understand what this means to our 
economy and also what the greater transparency would bring 
about, and the bill provides for that.
    Mr. Gonzalez. And at the end of 3 years if FASB remains in 
their position today?
    Ms. Eshoo. Pardon me?
    Mr. Gonzalez. What happens is they come out with the same 
methodology whether you wait 1 year, 2 years or 3 years. Are we 
going to have someone trumping basically FASB?
    Ms. Eshoo. Well, I think that it is very important to build 
into this something that FASB does not do, and they have stated 
that, and it is fair enough for them to state that they do not 
include economic considerations in their considerations for 
accounting standards. They stop at accounting standards. They 
do not take into consideration economic impacts. That is where 
we come in, and that is why we have built what we have built 
into in the bill.
    Mr. Dreier. Obviously, Mr. Gonzalez, this is something that 
will continue to be addressed as we go down the road. We just 
believe that right now it is important for us, recognizing, 
having put into place the Oxley-Sarbanes legislation, we need 
to ensure that we don't throw the baby out with the bath water. 
We want to do everything that we can to make sure that the 
Deborah Nightingales of the world still have opportunity. That 
is our goal.
    Mr. Gonzalez. Thank you very much.
    Chairman Baker. Thank you, Mr. Gonzalez.
    Mr. Shays.
    Mr. Shays. Mr. Chairman, in the sake of moving forward, I 
happen to agree with my colleagues and understand where they 
are coming from. I thank you for being here, thank you and 
would defer questions.
    Chairman Baker. Thank you for your insight, Mr. Shays.
    Ms. McCarthy.
    Mrs. McCarthy. I thank my colleagues. Again, my question 
was actually already answered the second time around, so I will 
pass on to the next speaker.
    Chairman Baker. Thank you very much.
    Mr. Green.
    Mr. Green. Thank you, Mr. Chairman.
    Mr. Chairman, I am interested in hearing from the next 
panel, so in the interest of time I will pass as well.
    Chairman Baker. Thank you, sir.
    Mr. Emanuel.
    Mr. Emanuel. This is a question for both Members. Have you 
found any difference between a start-up company and its use of 
options to recruit talent versus an established company that is 
already a NASDAQ-listed company and its use of options where 
they permeate throughout the company from top management down 
and how--because I have heard in your presentation, obviously, 
the importance of options in the sense of recruiting talent, 
but where does that exist for a company in the early studies 
today versus a start-up, versus an established company listed 
on NASDAQ, et cetera?
    Mr. Dreier. Well, it is a very good question, Mr. Emanuel; 
and I will tell you that I believe that both are equally 
important. Obviously, when we think about the technology sector 
of our economy, we think about the amazing success stories, 
created from absolutely nothing over a relatively short period 
of time, ultimately being job creators and then, as I was 
saying to Mr. Oxley, improving our quality of life, our 
standard of living. So the real attention is focused on those 
new start-ups, but this is obviously something that you are 
going to be hearing from Mr. Barrett in his testimony about the 
impact that mandatory expensing could have on a large company 
which is out there, still very creative, but obviously it would 
have a greater impact on a larger number of people, a 
detrimental impact on a larger number of people than the 
potential that exists with the start-up companies.
    Ms. Eshoo. I agree with Chairman Dreier. I think it is 
important--and you already know this--that just as your 
children are small and they grow, these small companies have 
grown in relatively short periods of time.
    Mr. Emanuel. You are not suggesting I give options to my 
kids.
    Ms. Eshoo. Well, you have a real investment in them. That 
is for sure.
    I would suggest to members that they get a copy of this 
book, In the Company of Owners, and it says why every employee 
should have them. I think it is the most definitive look at 
stock options. It is by Joseph Blasi, Douglas Kruse and Aaron 
Bernstein; and if any of you have questions on where to get it 
or wherever, I can tell you about it.
    Mr. Dreier. You can get it online, is where you can get it.
    Ms. Eshoo. Well, it may have been sent to Members as well. 
If it is sitting in your office, take it home, because this 
will be highly instructive to you and goes to the heart of many 
of the questions that have been asked, both in terms of small 
companies, large, how they would be affected. They all have 
employees, and I think that the story over the last decade of 
what broad-based stock options have done, both in the offering 
of them and the growth of companies, is pretty clear.
    I think that Debbie wanted to add something to this.
    Ms. Nightingale. Thank you very much.
    I just want to add that, living and working in Silicon 
Valley, I definitely have seen and had a perspective of friends 
and peers of mine that have taken that big leap and gone off to 
work for a small company that has offered them a bunch of stock 
options. They leave a larger-paying job to go to a smaller-
paying job to go off and be entrepreneurs and take that chance.
    In addition, though, I would say, as an employee of Sun 
Microsystems, Sun at one point not too long ago was one of 
those little start-ups. It is now a very big company. But 
working within a big company, I think the stock options 
absolutely have a role as well. Because big high-tech companies 
that don't keep innovating go out of business. The history 
books show lots of examples.
    So while I might have a little bit more security working 
for Sun Microsystems, if myself and my peers and everybody else 
does not keep innovating and keep taking chances then Sun is in 
trouble. And it is really because of those stock options, as I 
mentioned in my testimony that we go the extra mile. You know, 
I could just sit by, easily doing my job, keeping the boss 
happy, not really taking that risk, but instead myself and my 
peers absolutely will go the extra mile, work those 60, 70, 80-
hour weeks that we are not being paid for because we stand to 
benefit a lot if these stock options become of great value.
    Thank you.
    Chairman Baker. Thank you, Mr. Emanuel.
    Mr. Ose.
    Mr. Ose. Thank you, Mr. Chairman.
    I want to welcome our witnesses here. I am ordinarily on 
the other side of this discussion from the Chairman, so it is 
good to see you. Ms. Eshoo, nice to see you. Ms. Nightingale, 
Lieutenant Colonel, welcome.
    I think at the heart of this legislative proposal is the 
issue of mandating a certain treatment for these stock options, 
and at the heart of that question is how do you go about 
valuing them. One of the things that I struggle with, which I 
would appreciate your input on, is whatever system you use for 
valuating these stock options, whether they be narrowly or 
broadly distributed, there are assumptions underlying the 
valuations. Is it your concern that the assumptions, say, under 
a Black-Scholes method or some iteration of that, is it your 
concern that the assumptions will be as inaccurate, perhaps, as 
the current levels of disclosure might be?
    Mr. Dreier. Absolutely. I mean, that is--I think that it is 
virtually impossible to make a determination as to exactly what 
that value is; and, as I say, the only impact that really is 
going to come here upon exercise of those options is ultimately 
diluting the value of that stock. That is why our goal here is 
to focus on the shareholders, the investors to provide them 
with as much information as possible.
    Ms. Eshoo. I think it is important to note that in the 
Sarbanes-Oxley legislation that executives are now required in 
a very clear and--a clear and strict manner to report under 
penalty of law what--you know, their statement of financial 
health of the company, and they are held responsible for that.
    Now, if in fact you add to this the mandatory expensing of 
options and you cannot predict what the value of those options 
are going to be, what does that do to Sarbanes-Oxley? What does 
it do to people that have to report as that law requires? So it 
points to the weakness I think of the FASB proposal in that it 
is next to impossible to state what the value that--the value 
of those options are going to be, and I think it is an 
intrinsic weakness of what the proposal presents. In real life, 
I don't know how these executives are going to be able to, as I 
said, stay true to and remain whole and legal, so to speak, 
under Sarbanes-Oxley in the obligations that they have as a 
result of that law.
    Mr. Ose. If I might recast Ms. Eshoo's remarks, I think 
this exactly pinpoints the problem here. We are potentially 
criminalizing by mandate assumptions having to do with future 
interest rates, future discount rates, future earnings, future 
inflation, future changes to market conditions and the like 
that no one from Mr. Greenspan to Mr. Buffett to Mr. Baker or 
Mr. Ose can accurately predict, and this is a horrendously 
questionable approach, notwithstanding our desire to disclose 
to the investing public what it is they need to understand in 
these financial statements. I just want to be clear. We are 
potentially criminalizing mistakes on assumptions made in 
valuing these options that no one can predict with certainty 
out into the future.
    Thank you, Mr. Chairman.
    Mr. Dreier. Thank you, Mr. Ose, for being a cosponsor of 
our legislation.
    Chairman Baker. Thank you, Mr. Ose. I don't know about Mr. 
Greenspan or Mr. Buffett, but you certainly were right with 
regard to forecasting my abilities.
    Mr. Scott.
    Mr. Scott. Thank you very much, Mr. Chairman.
    I would just like to ask a question of my distinguished 
colleagues, Ms. Eshoo and Congressman Dreier. On the stock 
options, do you believe that stock options provide appropriate 
incentives to executive employees, number one? And, secondly, 
do you believe that stock options should be spread out among 
employees other than executives or that executives should have 
only a certain percentage of their compensation in stock 
options?
    Mr. Dreier. Well, those are good questions, Mr. Scott. 
Thank you for them.
    I will say that, as Mr. Kanjorski pointed out in outlining 
Mr. Barrett's testimony that you will be hearing in a few 
minutes, he talks about a level of compensation that executives 
should receive as far as options are concerned; and, as I have 
said, I am not concerned about the compensation that executives 
get. I mean, they are going to figure out how to be 
compensated. My concern is that this proposal could jeopardize 
the opportunity for the Deborah Nightingales of the world, the 
rank and file employees who are coming up with these 
innovative, creative proposals to succeed, and that is really 
what I think we are getting at here.
    So the answer to your question, sir, yes, I want to make 
sure that we have these options made available to those who are 
working on the front line in these companies. I think that is a 
very, very important thing, and that is part of the incentive, 
as Deborah just said. People who are actually in reasonably 
high-paying jobs, they will take a lower level of compensation 
to go to a start-up company with options being made available 
so that they can be part of that engine for growth.
    Mr. Scott. Thank you.
    Ms. Eshoo. I think, to my colleague and friend, that it is 
important to note that in H.R. 1372 that we call for a summary 
of stock options granted to the five most highly compensated 
officers. I think that that is very important not only for 
investors and potential investors but for everyone in a 
company, in an organization to know who has what and how much 
of it. I don't think that information was readily available in 
many of the companies that brought about and participated in 
the ruination, really, of many people's lives in the country 
and the companies that they worked for. So I think that is a 
very important consideration.
    There may very well be coming from this committee and from 
outside the Congress some even better ideas for transparency, 
and I think that we should--I know that Mr. Dreier and I are 
open to that, and also the members of the committee as well, 
because this is all about a delicate balance. And I have 
respect for FASB. I don't think that they are in the business 
of writing accounting standards, and I respect that, and I have 
in the past with legislation where I didn't direct them to do 
anything, but I thought it was the responsibility of the 
Congress on economic issues to step in.
    So, yes, this is important and should be protected for rank 
and file for the broad-based organizations, those that are a 
part of it, but I also think that--and we know what we have 
built into the bill, and that is why I restated.
    I think that--I hope we have, you know, answered your 
questions. They are very good ones, and we have to keep being 
sensitive to that. It is not just because we are in the 
aftermath of these scandals. I think what the scandals have 
taught us is that we better very well take care of the 
investing public. Otherwise, no matter what is on the stock 
market, they are not going to want to go near it.
    Ms. Eshoo. These options and what they represent to people 
are a very important part of that mix.
    Mr. Scott. Thank you both very much.
    Chairman Baker. Thank you, Mr. Scott.
    Mr. Royce.
    Mr. Royce. Thank you.
    Chairman Dreier, I think your point is the question of 
whether we are really making financial statements more precise, 
if they are really going to be more accurate if we are forced 
to adjust the actual earnings by inputting noncash charges 
derived through a flawed model in there, into the income 
statement. And I guess your position is that because the 
supporters of this Black-Scholes model say at best it is kind 
of right, it is in the ballpark--and detractors, of course, say 
it is way off the mark--that instead you want publication of 
shared dilution in financial statements in plain English and 
that that is going to objectively reflect how stock options are 
going to impact shareholdings, is that your position?
    Mr. Dreier. Exactly. You got it exactly right.
    Mr. Royce. The thing I have a harder time understanding is, 
when you mandate charts and graphs on the part of the SEC in 
order to show the dilution effects, would you have any mock-up 
or would you have an example of what you have in mind with 
respect to how you are going to convey that?
    Mr. Dreier. I don't know what it would consist of. I can't 
tell you what it would consist of.
    Mr. Royce. The SEC is going to basically make that 
interpretation.
    Mr. Dreier. Clearly will do that.
    Mr. Royce. Well, thank you, Mr. Chairman.
    Chairman Baker. Thank you, Mr. Royce.
    Mr. Meeks.
    Mr. Meeks. Thank you, Mr. Chairman.
    I want to thank my colleagues. This is one of those 
occasions when you come to a hearing where you are completely 
undecided. I am completely undecided, and the information that 
you have provided is very valuable to me to come to a 
determination because I think it is absolutely important for 
the American public that we bring back some integrity into our 
system.
    My question just went along the same lines of 
Representative Scott. You know, I understand the transparency 
issue, and I think that it is important. I understand that we 
don't need to throw the baby out with the bath water. The whole 
thing with executive pay as to maybe limiting it to something, 
I want to hear the rest of the testimony. Because it seems to 
me that those top executives, particularly the CEO, the CFO, 
would be the ones that would have the ability as well as the 
motivation, even though you may have transparency issues there, 
to try to manipulate the value of those stock options to their 
benefit because they have it; and that becomes the key, is to 
being sure that someone does not manipulate the value of it so 
that you have it falling through the bandwagon.
    The question I have is, basically, within the bill, is 
there any way, any disincentive in the bill to prevent the top 
executives from--you know, other than maybe eliminating them 
having the possibility of having stock options so they won't 
manipulate the value of it to their benefit?
    Mr. Dreier. Well, I mean, I will just say to you that I 
believe that everyone who is involved in a company should have 
the opportunity to benefit. Again, I argue that the threat of 
mandatory expensing will not hurt in any way the plans for 
compensation for those executives, Mr. Meeks. The people who 
will be hurt by expensing and those who are moving down the 
road and some who, as I said earlier, support the actual 
elimination of stock options, it will be the rank and file 
employees will be hurt.
    The reason I say it is that the executives of these 
companies will continue to find other ways to be compensated. 
And I don't think that we should stand in the way of their 
being compensated. I mean, I am not one who is a proponent of 
dictating exactly what the salary level should be for 
executives. I think that should be determined by the boards of 
directors and the shareholders. But I think that empowering 
people with as much information is as far as I happen to 
believe we should go.
    I want to thank you for being a cosponsor of our 
legislation, too.
    Ms. Eshoo. To my colleague, Mr. Meeks, you asked I think in 
many ways the $64,000 question. I think it is important to keep 
in mind that stock options in and of themselves did not cause 
the scandal. It was, as you pointed out or touched on, the 
manipulation of the statement of earnings and all that 
followed, which really goes to the heart of what Sarbanes-Oxley 
was all about. That is what that legislation sought to correct. 
There is now appropriate and enormous burdens, as it were, 
which need to be borne legitimately by those at the top of a 
company where they sign off in terms of the accounting and 
everything that goes with it and file those statements with the 
SEC. That is an enormous change and I think is a very important 
and healthy one to take.
    But this accounting standard as expressed by FASB I think, 
and I don't know want to keep repeating it, is so detrimental 
to what stock options, the broad based for the employees, would 
do; and that is what we are seeking to protect.
    I am just as outraged as you and all the members of the 
committee, the Congress and our constituents over the abuses. 
There is no way to defend the indefensible, and that is what 
that legislation directed itself toward. We want to build on 
some of the things that we think can and should be accomplished 
for more transparency. But I think it is a very clear case of 
what we really should protect and not cast overboard.
    Mr. Meeks. Yield back.
    Chairman Baker. Mr. Gary Miller.
    Mr. Miller of California. Thank you for being here. I am a 
cosponsor of the bill, so I do support it 100 percent.
    I agree with you. Executives are going to be taken care of. 
It is the rank and file that generally get left behind, if 
anybody.
    It is a great bill. I support it. I am looking forward to 
the next panel.
    Mr. Dreier. Thank you for your support, Mr. Miller.
    Chairman Baker. Mr. Crowley.
    Mr. Crowley. I thank you, Mr. Chairman. I will be very 
brief as well.
    I want to thank my colleagues for testifying today, Ms. 
Nightingale for her testimony. Most impressed, especially you, 
Ms. Eshoo, in terms of impact on your district, what this means 
in terms of job loss, a district that is experiencing a great 
deal of job loss in this current crisis.
    I had the opportunity of being in India last year talking 
about the need for the Indians to be more transparent, to 
encourage more investment by the United States investor and at 
the same time having to defend our own system here because of 
Enron, a company that had considerable trouble gaining a 
contract, putting a contract to rest in India. There is still a 
great deal of bad taste in the mouths of many Indians, 
especially the government. So I do think it was interesting to 
be talking today about the need for transparency.
    I agree 100 percent that the more the investor knows about 
what the stock options are, especially of the top executives, 
but also the employees themselves of the company, the more they 
know about that as well, I think the broader and more light of 
day that is shown on this issue can have a major impact as to 
the actions of those who would try to manipulate the value of 
those stocks to defraud the company, to defraud the people who 
work there but, more importantly, to defraud the American 
investor, the mom and pop who are now engaged in the stock 
market like never before.
    So I appreciate all of your testimony today, especially 
you, Chairman Dreier. I want to make sure I made the point that 
the Chairman--appreciate having you in front of us as well.
    Mr. Dreier. You sound like a co-sponsor of our legislation.
    Mr. Crowley. Well, not as of yet. But the option is always 
open, so we will talk about it.
    Chairman Baker. Mrs. Kelly.
    Mrs. Kelly. Mr. Chairman, I have no questions for my 
colleagues. I appreciate their testimony today.
    Chairman Baker. Thank you very much.
    Ms. Hooley.
    Ms. Hooley. Hopefully, a quick question to my colleagues. 
Thank you for being here today, talking about this issue. I 
think it is an important issue for many of the companies.
    The question is, if we are going to provide transparency 
information--and I absolutely believe we need to do that--are 
we going to treat companies differently if only the executives 
get stock options as opposed to a company with broad-based 
stock options?
    Mr. Dreier. Well, I just say that that is information that 
would be made available to the shareholders; and, quite 
frankly, it is my view that I would rather be invested in a 
company that provides options to the Deborah Nightingales of 
the world who are going to come up with the creative proposals 
that will ensure the success of that company than I would 
simply to the executives of the company.
    Ms. Eshoo. It is a good question. The legislation doesn't 
change what you describe. In fact, I think today we probably 
have more companies in the country that do not offer broad-
based stock options, but it is growing, and that is why we want 
to protect it. It is an important tool. But it doesn't--the 
legislation doesn't differentiate between the two.
    Ms. Hooley. Thank you. I yield back.
    Chairman Baker. Thank you, Ms. Hooley.
    Mr. Inslee.
    Mr. Inslee. Thank you.
    I want to thank the sponsors for their work. Because we sat 
through scores of hearings in this room following the Enron 
collapse and the like. I can't think of a case where this 
really would have solved the problem that caused those 
collapses, and I think it is important not to let our 
justifiable concern about those defaults lead us to something 
that may not get where we want to go.
    I want to thank you, particularly, Ms. Eshoo, your comment 
about there are better ways to go about this, particularly 
looking at shareholder approval, which is important to these 
issues. I hope we go in that direction. Thank you.
    Chairman Baker. Mr. Kanjorski.
    Mr. Kanjorski. I request a statement be made for the record 
by Congressman Pete Stark. It is included together with his 
statement, an analysis and letters and a bill.
    Chairman Baker. Without objection. Thank you, Mr. 
Kanjorski.
    [The prepared statement of Hon. Pete Stark can be found on 
page 86 in the appendix.]
    Chairman Baker. There being no further questions of this 
panel, I want to express my appreciation to you for your time 
committed to this hearing. It has been very valuable to the 
committee.
    Mr. Dreier. Thanks again for holding this hearing. I know 
you will get some very interesting input from the next two 
panels, and we look forward to the conclusion that you will 
draw on that.
    Chairman Baker. Look forward working with you.
    Ms. Eshoo. Thank you very much to your legislative 
hospitality, to the ranking member and to all the members that 
came to this hearing today, I think speaks highly of the 
committee that there would have been the kind of participation 
that we saw here today. Thank you very much.
    Chairman Baker. We have a total of 47 members on the 
subcommittee. We had in excess of 30 here today, which speaks 
to, I think, the importance of the issue. Thank you for your 
courtesy.
    Ms. Eshoo. Thank you.
    Chairman Baker. At this time, I would ask our next witness 
to come forward, Mr. Rob Herz. It is my pleasure to welcome as 
our next panelist Mr. Robert Herz, Chairman of the Financial 
Accounting Standards Board. Welcome, sir.

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

    Mr. Herz. Thank you Chairman Baker, Ranking Member 
Kanjorski, and members of the subcommittee.
    As you said, I am Robert Herz, Chairman of the Financial 
Accounting Standards Board. I am very pleased to appear before 
you today on behalf of the FASB.
    I have some brief prepared remarks. I would respectfully 
request that those remarks and the full next of my testimony 
and all supporting materials be entered into the public record.
    Chairman Baker. Without objection.
    Mr. Herz. The FASB is an independent private-sector 
organization subject to oversight by the U.S. Securities and 
Exchange Commission. Our independence from enterprises, 
auditors, and other constituents is fundamental to achieving 
our mission--to establish and improve standards of financial 
accounting and reporting for both public and private 
enterprises. Those standards are essential to the efficient 
functioning of the capital markets and the U.S. economy because 
investors and other users of financial reports rely heavily on 
credible, transparent, comparable and unbiased information to 
make rational resource allocation decisions.
    Our work is designed to provide investors and the capital 
markets with the most useful yardstick to measure and report on 
the underlying economic transactions of business enterprises. 
Like investors, Congress and other policymakers also need an 
independent and objective FASB to maintain the integrity of a 
properly designed yardstick in order to obtain the financial 
information you need to properly assess and implement public 
policies. While bending the yardstick to favor a particular 
outcome may seem attractive to some in the short run, in the 
long run a crooked yardstick in the form of a biased accounting 
standard is harmful to investors, to capital markets, and the 
U.S. economy.
    In March of this year, at a public meeting, our Board 
unanimously decided to add a project to its agenda to address 
issues relating to improving the financial accounting and 
reporting for stock-based compensation. That decision was based 
largely on three factors:
    First, the high level of concern expressed by individual 
and institutional investors, pension funds, mutual funds, 
creditors, financial analysts and other users of financial 
statements, as well as America's trade unions, consumer groups, 
the conference board's Commission on Public Trust and Private 
Enterprise, and the major accounting firms about the need to 
improve the reporting for stock-based compensation, in 
particular the need to eliminate the narrow but often used 
exception for so-called fixed plan employee stock options, 
which are the only form of stock-based compensation that is not 
currently reported as an expense in the financial statements.
    Secondly, the growing noncomparability and, thus, potential 
lack of transparency created by the alternative accounting 
treatments presently available for reporting stock-based 
compensation which has been magnified by the recent trend of 
hundreds of major U.S. companies--sometimes as a result of 
shareholder resolutions and votes--to adopt the voluntary 
expense recognition provisions of our 1995 standard.
    And, third, the opportunity to achieve convergence to a 
common, high-quality global accounting standard for stock-based 
compensation. There is no subject on our current agenda on 
which we have received so many strong and heartfelt calls for 
action. They go beyond the abuses of executive pay to just 
plain wrong accounting.
    In April, the Board began its initial public deliberations 
to consider improvements to the recognition, measurement and 
disclosure of stock-based compensation. To date, we have held 
four public meetings and have reached certain tentative 
conclusions.
    In the coming weeks and months, at public meetings, the 
Board will continue its deliberations of the many issues 
relating to this project, including the measurement issues and 
special issues related to private companies, to start-ups, to 
venture-backed companies. The Board's public deliberations of 
the issues will be systematic, thorough and objective. The 
deliberations will benefit from a review and analysis of the 
vast amount of research and other literature in this area. The 
deliberations will also benefit from the ongoing input of our 
constituents, including the advice of leading valuation and 
compensation experts that we will consult with throughout the 
entire process.
    We currently plan to be in a position to issue a proposal--
we have not issued anything yet--for public comment in the 
fourth quarter of this year. Any proposal would have to be 
approved by an affirmative vote of the majority of the Board. 
The proposal would be exposed for an ample public comment 
period so that all interested constituents will have the 
opportunity to provide detailed responses. The Board will also 
consider whether to hold public roundtables or public hearings 
to solicit additional input on the proposal.
    Prior to making any final decision on any changes to the 
accounting for stock-based compensation, the FASB would 
consider at public meetings all of the input received in 
response to the proposal. The Board would not issue any final 
standard until it has carefully considered at public meetings 
the views of all constituents. Like any proposal, any final 
standard would have to be approved by an affirmative vote of 
the majority of the Board.
    We have reviewed H.R. 1372. We note that, if enacted, it 
would impose a more than 3-year moratorium on any FASB 
improvements to the financial accounting and reporting for 
stock-based compensation. We strongly oppose H.R. 1372 for a 
number of reasons.
    First, the moratorium would unduly intervene in the Board's 
independent, objective and open process to make unbiased 
decisions on the substance and timing of improvements to the 
accounting for stock-based compensation. Such intervention 
would be in direct conflict with the express needs and demands 
of many investors and other users of financial reports. Such 
intervention would also appear to be inconsistent with the 
language and intent of the Sarbanes-Oxley Act and the related 
and recently issued SEC policy statement reaffirming the FASB 
as the Nation's accounting standard setter.
    Second, the moratorium would have an adverse impact on the 
FASB's efforts to achieve timely convergence of high-quality 
global accounting standards on stock-based compensation. The 
FASB is actively working with the International Accounting 
Standards Board and other national standard setters in an 
effort to achieve convergence in this important area and in 
many other important areas. The moratorium would likely hamper 
those efforts and again appears inconsistent with the language 
and intent of the Act and the related SEC policy statement, 
both of which explicitly encourage international convergence.
    Finally, and perhaps most importantly, the moratorium would 
establish a potentially dangerous precedent in that it would 
sent a clear and unmistakable signal that Congress is willing 
to intervene in accounting standards based on factors other 
than the pursuit of appropriate accounting. That signal would 
likely prompt others to seek political intervention into future 
accounting standard activities.
    We have all witnessed the devastating effects and loss of 
investor confidence in financial reporting that have resulted 
from companies intentionally violating or manipulating 
accounting requirements. What impact then on the system and on 
investors' trust in financial reports might there be if it were 
perceived that accounting standard setting was being 
deliberately biased toward the pursuit of particular objectives 
other than those relating to appropriate financial reporting or 
that the FASB was being blocked from pursuing timely 
improvements in financial reporting?
    For all these reasons, again, we strongly oppose H.R. 1372 
and any other legislation that would seek to undermine and 
impair the Board's independent, objective and open standard 
setting process.
    Again, thank you, Mr. Chairman. I would be happy to respond 
to any questions.
    Chairman Baker. Thank you, Mr. Herz. I appreciate you being 
here this morning.
    [The prepared statement of Robert H. Herz can be found on 
page 113 in the appendix.]
    Chairman Baker. I have a series of questions that go really 
to a broader issue. The question of valuation of stock options 
is a very fine point on a big platform of issues. It would be 
my view that if you go back over the past 24 months and look at 
the volatility of the NASDAQ and require an individual to value 
the options granted to employees and then look at the value of 
those options 89 days later, it would be a very difficult 
calculation to know which way the wind was blowing.
    On the other hand, the underlying argument for additional 
transparency and the ability of the prospective shareholder to 
understand the current valuation of a corporation is something 
no one could possibly object to. It would seem the current 
retrospective rules-based system that is based on the reporting 
paper data on a 90-day trail gives a false impression of 
understanding corporate performance. Have you or has the agency 
explored extensible business reporting language as a platform 
on which to have a real-time market performance analysis where 
an empowered shareholder could at the close of business on a 
daily basis not only look at options but look at the loss of a 
particular customer, look at the loss of a supplier, the award 
of a big contract?
    If we are trying to eliminate volatility, you have to do 
what large corporations do in this country on a daily basis: At 
the close of business, look at your risk, look at your assets 
and determine where you are. Arguing over whether we price 
options on a 90-day platform, given underlying market 
volatility, interest rate exposure, credit risk, if we adopted 
everything FASB proposes right now I wouldn't feel a bit better 
than I do this morning.
    Can you respond?
    Mr. Herz. Yeah. Thank you. Very excellent set of questions. 
I think you had two main questions in there, one about the 
valuation of stock options, although that kind of led to 
another broader question.
    You know, the issue of the valuation first, we are going to 
have a hard look at it. We are consulting with lots of experts. 
Our predecessors 10 years ago concluded that it could be 
appropriately valued, reliably valued----
    Chairman Baker. Let me jump back in on that point on 
valuation. Whether we use binomials or Black-Scholes, if you 
had an extensible business recording platform, you could sit at 
your own PC Apple mainframe and say, the value today at the 
close of business Black-Scholes, value today binomial A, B, C. 
Then you could get all the variables because there isn't a 
single way to arrive at value, and the number of variables 
outside the formula assessment also vary. So you could plug in 
different valuables on different analyses and come up with a 
recommendation.
    Now, the typical investor may not want to do that, but this 
is where you get back to turning to my local accountant and 
say, figure this out for me, as long as he has got the tools to 
do it. Shouldn't we be moving more in that direction?
    Mr. Herz. Well, let me continue. Thank you.
    You know I am a big supporter of XBRL and expansion of 
business reporting. You know I was a co-author of a book called 
The Value Reporting Revolution: Moving Beyond the Earnings 
Game.
    Chairman Baker. I have read it many times.
    Mr. Herz. That is something that I think not only we but I 
think the whole private sector with I think some regulatory 
stimulus from the SEC needs to pursue. I agree with your point 
there.
    The other point is--and that would provide additional 
information. But there is a basic accounting system which keeps 
a base score on earnings, cash flows, other things. And all 
transactions, whether they be cash, whether salary, profit 
sharing, and all stock compensation transactions other than a 
narrow form of stock options are accounted for at fair value in 
the financial statements. They are scored that way in 
determining earnings.
    And the issue of, you know, can you calculate the value of 
this particular instrument at a point in time--and those 
calculations take into account current data. They don't project 
future data. Take into account the current prices of stock, 
current interest rates and the like, and they calculate values. 
That is what underlies trillions of dollars of options trading 
markets. People trade in options, and there is a value at a 
point in time.
    I agree that you can get--like you say, you know, you can 
plug it in, and you could get values every day and deliver them 
over XBRL, and that would be very informative. But that doesn't 
mean that the basic accounting information itself at the date 
of grant, the value of the date of grant consistent with all 
other stock-based compensation gets scored then.
    Chairman Baker. But that is like taking a photograph of 
your child while you are overseas and snail mailing it. By the 
time it gets to you, that is what your child used to look like. 
But that is not what he looks like today. He has got a buzz cut 
and a ring in his ear. I mean, things have changed.
    That is my point. In dealing with reporting in business 
accounting we are still using a system built in many years ago. 
We are in the slide-rule era and people are using PCs at home.
    Arguing this specific point, although understandably 
important in the overall assessment of business performance, I 
understand, but it goes to the broader issue of FASB's policy 
mission of advising the policymakers on our end, does the 
current system provide a responsive measure of corporate 
performance, given the decade we have just endured? I don't 
think anyone can say it does, particularly when we are trying 
to move to an international accord where there are considerable 
differences between a rules- and principles-based system.
    Mr. Herz. Well, I agree with you. But I think financial 
reports are an integral part, a very vital part, because they 
are the ultimate score, the ultimate feedback. All the other 
information, including the kind of information that I advocated 
in the value reporting revolution, is both supplementary and 
very complementary. You get a better picture through all of 
that.
    Chairman Baker. My time has expired.
    I find it very difficult to focus solely on this issue, 
make a judgment that this is going to satisfy the information 
that is really needed in order to make an informed judgment 
when the presumption for this modification is that people can't 
make an informed judgment using--without modifying the current 
rule. Although it is not the obligation of FASB to be concerned 
about economic models, many of us in the Congress are very 
concerned about economic models and how we can encourage 
business growth. This goes right at the heart of that.
    Mr. Kanjorski.
    Mr. Kanjorski. Thank you, Mr. Chairman.
    Mr. Herz, I want to reiterate for the record you are an 
independent nonprofit organization. Is that correct?
    Mr. Herz. Yeah. We are independent, and under Sarbanes-
Oxley we hope we have been made more independent through the 
mandated funding mechanism that now applies to both us and the 
public company accounting oversight board.
    Mr. Kanjorski. You are charged with establishing a single 
rule to apply for accounting purposes to public corporations. 
Is that it?
    Mr. Herz. Public corporations, private companies and not-
for-profit entities.
    Mr. Kanjorski. It seems that our prior panel felt that this 
was above an accounting rule problem but goes to the essence of 
whether or not the economy survives and grows. Do you feel your 
organization is able to establish a rule for accounting 
purposes that will cause greater transparency for the investing 
public and not interfere with or in some way compromise the 
growth of the economy of start-up and high-tech companies?
    Mr. Herz. Yes.
    A couple of points there. First, you know, we believe 
clearly that better accounting information adds to better 
decisions in the marketplace, better credibility in the 
marketplace; and that has its own huge economic benefits when 
you translate it over the whole overall economy.
    Second, and, again, we are not looking per se at the macro 
issues, but I can't help but have noticed that the issue of 
stock options is, this particular instrument, according to the 
U.S. Bureau of Labor Statistics in the year 2000, which was 
apparently a banner year for the issuance of stock options by 
companies, was only granted to 1.7 percent of the total U.S. 
nonexecutive work force.
    Thirdly, as I said, in terms of the private companies, 
start-ups, we are going to look at that separately, apart from 
the large public companies.
    Mr. Kanjorski. So that it is possible to take into 
consideration start-up companies and particular specialized 
high-tech companies, that they could get a different rule that 
applies to them as opposed to across the board?
    Mr. Herz. I can't speak for my fellow board members, but I 
think the distinction would be with companies that have an 
actively traded stock versus those that don't.
    Mr. Kanjorski. I am sort of amazed here today that after 
all these years it seems to me such a contested issue and the 
desire now to impose legislation to affect that. What is your 
general opinion as to what kind of a precedent this would set, 
that if the Congress adopts a particular piece of legislation 
to somewhat change the independence of FASB in establishing 
accounting rules?
    Mr. Herz. Well, I think--as I said in my opening remarks, I 
think it would be a dangerous precedent, because we are 
constantly faced with groups that want to basically--they have 
gotten comfortable with the existing rules and how they can 
then use those in their business transactions. Any time we want 
to move things forward by proposing change to get better 
accounting, closer to economic concepts, you know, we are often 
opposed by the people who would rather keep the status quo; and 
they will always argue economic consequences. I think the 
history of that would show that those usual dire predictions of 
major negative economic consequence were not borne out once the 
better standard was put in place.
    Mr. Kanjorski. Do you feel that we also have to take into 
consideration the international accounting standards that we 
are in competition with now in terms of the global economy and 
that, in effect, the rule that you are trying to put together 
and propose would take us closer to international accounting 
standards?
    Mr. Herz. Yeah. This issue, you know, was not only looked 
at by the FASB over the last 20 years, the last time 10 years 
ago, but it has been looked at by the International Accounting 
Standards Board and by accounting standard setters in many, 
many other counties; and everybody comes to a very similar 
conclusion about the accounting aspects of this. As I said, the 
IASB is ahead of us. They are intending to propose--issue their 
final standard later this year, probably around the time we 
just issue a proposal. The international accounting standards 
will apply starting 2005 for all of Europe. They are going to 
apply for Australia, New Zealand, Russia. They already apply 
for many other parts of the world that for years used 
international accounting standards. So to a certain extent we 
would be the odd man out.
    Mr. Kanjorski. Thank you, Mr. Chairman.
    Mr. Ose. Mr. Shays.
    Mr. Shays. Thank you very much, Mr. Chairman.
    For the sake of honesty, I have to disclose that FASB is in 
my district. There are many things about FASB that I love and 
cherish. There is only one that I don't. That is it sometimes 
takes you all too long to act.
    I am in a quandary because I believe we need to have better 
formation of capital, but I also believe that we need to have 
disclosure. I believe that that people need to know the facts. 
But what I am wrestling with is that this is an issue of 
valuation. In other words, by disclosing the stock option are 
we--you are only making money--you only take advantage of the 
option if the stock goes up.
    I would also say to you I had a number of parents call me 
because their children had been given these glorious stock 
options which they never took advantage of but had to pay a 
significant tax on when the companies went out of business, 
which was a tragedy for these young kids who thought somehow 
they had a great future.
    My question to you is, why are we acting now and why didn't 
we act 5 years ago?
    Mr. Herz. I think we are--first of all, let me--three 
issues, valuation issue, the issue of the stock price going 
down, and the option being worthless or deep out of the money, 
and then why are we acting now.
    On the first issue, again, we are going to look at that 
very carefully. Again, the models--and we have got lots of 
suggestions as to how to improve the valuation. Things come 
into our door every day. You know, again, the models that 
support the public option trading markets, whether it be equity 
options, interest rate currency options, commodity options and 
lots of other options, those models all support this trillion--
trillions of dollars of trading in markets. The question is 
then can you apply those models to employee stock options 
because they have certain other features, including the 
forfeitures prior to vesting, nontransferability and other 
kinds of adjustments?
    The issue is really what is the cost to the company. 
Because we are preparing the financial statements for the 
company. The accounting standards deal with the company's 
financial report.
    Mr. Shays. You say what is the cost of the company or the 
value of the company?
    Mr. Herz. It is viewed to be, from the company's 
perspective, what is the value of the instrument that it 
grants. And that is the real issue. What is the commitment and 
hence the value of that instrument that is granted by the 
company unilaterally at that date, and how do you value that 
most reliably?
    The third issue of why are we taking action now, because we 
have gotten hundreds of letters, e-mails, input from people, 
recommendations of many, many groups who have studied this to 
say that action needs to be taken. I think it has been prompted 
in the wake of the--not only the scandals but the market 
meltdown of people believing that the financial information was 
incorrect.
    Mr. Shays. Is it also an issue of political pressure and is 
it also a question of, frankly, not knowing what to do?
    Mr. Herz. Is it an issue of political pressure in what 
regard?
    Mr. Shays. Well, did FASB feel that for the last so many 
years that had they acted there would have been a fire storm 
that would have been difficult to contend with.
    Mr. Herz. Of course, I only joined July 1st. So I can only 
relate what people have told me. But certainly, after the 
experience of 10 years ago, I think FASB was a little gun shy 
and virtually, other than academics and some people who 
understood options, no one supported the FASB at that point. 
Now there are many, many parties who are not only supporting 
this change but have demanded it.
    Mr. Shays. The bottom line is that there was some--well, 
part of it was being a little gun shy, as you say, and from 
your standpoint that no longer exists.
    Mr. Herz. I am not gun shy. I am careful, and I study 
things, but I am not gun shy, and I don't think my colleagues 
are.
    Mr. Shays. So that issue is resolved.
    The second issue is a reluctance because--maybe not knowing 
what is the right thing to do. A lot of letters saying you need 
to act. Are you totally comfortable that your actions will be 
the right thing?
    Mr. Herz. Well, I have a lot of confidence in our process. 
As I said, we are early on. We haven't even gotten to a 
proposal yet, which is kind of what I always find amusing.
    Mr. Shays. So your argument here is let us go through the 
process and let Congress evaluate what we have done.
    Mr. Herz. Exactly. We have a very rigorous, thorough and I 
believe objective process. We get input from everybody. We send 
out a proposal. We get wide comment.
    Mr. Shays. How long is it going to take for that process to 
end?
    Mr. Herz. Our goal right now is to get a proposal out by 
year end. That would be out probably, my guess, for a 90-day 
comment period. We would probably hold some public roundtables. 
We then analyze what all the input is.
    Mr. Shays. Thank you for your good work and the good work 
of your organization.
    Thank you, Mr. Chairman.
    Mr. Ose. [Presiding.] Mr. Gonzalez.
    Mr. Gonzalez. Thank you, Mr. Chairman.
    Thank you, Mr. Herz.
    I guess I need to frame the question a certain way. I love 
process. I love systems. I like predictability. I like to look 
at other certain boards or whatever that we look to for their 
expertise that set certain standards, that it is my 
understanding. At the present time, people are questioning 
whether--how relevant your standards are going to be, that they 
don't really reflect the real world. I tend to lean in that 
direction. I guess I am like Galileo, who really didn't believe 
that the Earth was the center of the universe until the 
Catholic church had a talk with him. So while I await some 
religious experience, I am leaning over there.
    You heard Congressman Dreier, especially Congressman 
Dreier, who basically made that analogy with what you are doing 
today. Do you share any of their fears, though? Is that what 
you are going to do, that you have some sort of accounting 
certainty in that pure world of accountants, which is wonderful 
in many ways, but what is the advantage, what is the benefit? 
Everything that we feared and that happened and we are trying 
to avoid, again the Enrons and the WorldComs, what you are 
going to do, according to a lot of people, and again I tend to 
agree with them, wouldn't have avoided any of those disasters 
or catastrophes. So what I am saying is, is there a real-world 
application with what you are about to do? And do you disagree 
with Congressman Dreier's opinion that this could be something 
that could be disastrous for many companies?
    Mr. Herz. Well, first of all, I also enjoyed Congressman 
Dreier's map of the world. I thought the conclusion was going 
to be that California was the center of the universe. But----
    Mr. Ose. The Chairman would instruct the witness that that 
is accurate.
    Mr. Gonzalez. Only if Texas supplies you guys with enough 
energy.
    Mr. Herz. I am in trouble because I am from New Jersey.
    Mr. Ose. You send it. We are still not going to pay for it.
    Mr. Herz. Nobody from New Jersey here, huh?
    The issue on pure certainty, and we are never purely 
certain, but I think our process comes up with the right 
accounting. And I think accounting is very important. There is 
a whole discipline to it, and there is a whole way we measure 
incomes, show balance sheets, show cash flows and the like.
    I read those articles--or editorials yesterday in the Wall 
Street Journal, as you may have; and I know the two gentlemen 
quite well, Bennett Stewart and Peter Wallison because I have 
worked with them. Some of what they say I agree with, and some 
of it I don't agree with. In fact, the parts that I and others 
agree with at the Board, we have been moving aggressively to 
try and build more economic concepts into the accounting, more 
reflection of cash flows and the like.
    You know, there is--just wanted to--because I was struck by 
those works, and I particularly--I met with Bennett Stewart 
when he was developing his work last fall on Accounting is 
Broken--Here is How to Fix It--a Radical Manifesto. He suggests 
a number of adjustments to accounting, and one of the ones he 
suggests are stock option grants are an expense.
    He says many corporate managers have found it difficult to 
understand that the cost of handing out options is an expense 
because they have collapsed two steps into one. An employee 
option grant is substantively the same as compensating the 
employee with cash, which is an obvious operating expense, and 
then compelling the employee to turn around and use the cash to 
purchase an option from the company for its fair market value. 
The true option expense is given by the option's fair market 
value of the date of grant. Once the option is outstanding, the 
employee becomes like any other equity holder and the gains and 
losses from exercising the option or letting it expire should 
not be recognized as a corporate expense or income item.
    He goes on to expound as to why, you know, based on 
economics that is just the right answer. He has other 
adjustments. For example, he strongly argued about special 
purchase entities that they ought to be consolidated. Well, we 
took care of that earlier this year. He argues that there ought 
to be better delineation between operating items in the income 
statement and financing. We totally agree. We are working 
towards that with the International Accounting Standards Board. 
So we are working on those kinds of things in order to improve 
the utility of the information.
    As to the disastrous impacts, no, I don't believe there 
will be. I believe that certain companies have gotten used to 
using a particular form of stock option.
    Let me be very clear on this: There are many forms of 
equity-based compensation. There are restricted stock grants. 
There are employee stock option plans, ESOPs. There are various 
forms of stock options, stock options that are tied to 
corporate performance or unit performance. There are stock 
options that are tied to an interest rate, that are tied to 
your performance relative to a competitor's performance. And 
all of those get expensed. There is just this one form which 
has been an accounting anomaly for 30 years now.
    Mr. Gonzalez. Thank you very much.
    Mr. Ose. Mr. Herz, I just I believe you have set a new 
record here with your submitted testimony.
    Mr. Herz. We like to be complete.
    Mr. Ose. I do want to compliment you on the thoroughness of 
your presentation.
    In the attachments, attachment number 7, there is a 
submittal from the conference board I believe, and one of the 
footnotes--the Conference Board, Commission on Public Trust and 
Private Enterprise. One of the footnotes on page 5 indicated 
that a Merrill Lynch study shows that expensing stock options 
would result in a decline of approximately 70 percent in 
earnings per share in the high-tech industry compared with 
declines of 12 percent in telecom industry, 9 percent in the 
consumer materials industries, from 2 to 7 percent in other 
industries, and 10 percent in the overall S&P 500.
    Now there may be some accountants within our membership 
here in the House of Representatives, but I can tell you that 
every one of us would hear about declines in valuation of 
401(k)s and IRAs and individual portfolios. If expensing stock 
options were to cause a decline in the value of people's 
portfolios, why would any Member of Congress vote for it?
    Mr. Herz. Well, it is because I would hope that you would 
believe in the importance and value of the right information. 
The right information then leads to certain things happening, 
people understanding what the performance really is.
    Mr. Ose. You are suggesting Sarbanes-Oxley does not 
accomplish the transparency that you are seeking.
    Mr. Herz. Well, I think on this issue, clearly this issue 
has been left unresolved. It was left to us to decide whether 
or not to try and address it, and based upon all the input we 
decided unanimously that it was something that needed to be 
addressed.
    Mr. Ose. I do want to highlight one point. Within the 
financial statements of America's corporate industry, those 
that are publicly traded, are the impacts of dilution reflected 
in the statements themselves for granting of options?
    Mr. Herz. That is an excellent question. Earnings per share 
is a calculation. It is a metric. It is not part of an 
accounting system. All it says is that if you--everybody who 
basically, you know, could be a shareholder based on a 
calculation you then divide that into the current earnings 
number. So it is not captured--economic dilution is not 
captured in the accounting numbers.
    It is the same issue as, for example, you know, if you pay 
a lawyer with stock or stock options, it is absolutely clear 
that you would show that legal expense as an expense and you 
would reduce earnings. You would also show it in the numerator 
to the earnings per share calculation in addition to the 
denominator. The only instrument which escapes that treatment 
are these so-called fixed plan stock options. They get in the 
earnings per share calculation once the option is in the money, 
but they don't get an economic charge in the income statement.
    Mr. Ose. Within the statements themselves, perhaps in the 
footnotes, are not the effects of dilution reflected?
    Mr. Herz. There is a pro forma disclosure that came about 
as a result of the FASB's action in 1995. Most of the 
commentators that we have had for a variety of reasons that, 
you know, users of financial statements have said that is not 
adequate. It needs to be factored into the accounting numbers 
themselves.
    One of the reasons is that they cite--I guess there are a 
couple of reasons--is they use not just earnings per share 
numbers, but they also calculate all sorts of other numbers 
based on the accounting numbers, things like return on equity, 
return on assets; and unless you put it into the accounting 
numbers, it makes their life quite difficult. Further, they 
pick up numbers from databases, and unless you put it into the 
accounting numbers those things are not picked up.
    Mr. Ose. But the information is in the statements.
    Mr. Herz. The information is in a footnote. By the way, it 
is in an audited footnote. It has been there for----
    Mr. Ose. Sort of like this.
    Mr. Herz. Which, by the way, is covered by the Sarbanes-
Oxley certification--has been. And it is there. But it is not--
it is a pro forma number. It is kind of like saying on special 
purpose entities, why don't you just put the information 
relating to a special purpose entity in the footnotes and don't 
make them show the debt or the assets on their balance sheet.
    Mr. Ose. We will come back to the special purpose entities, 
because that is not related to this issue at all. But my time 
has expired.
    I would like to recognize Mr. Emanuel.
    Mr. Emanuel. Thank you, Mr. Chairman. I will follow up with 
a question I asked earlier.
    We have got this either/or choice and a failed attempt to 
try to find if there is a middle ground here. Has anybody 
looked at or have you looked at the difference of how you 
would--whether you would expense stock options on a private--
not private but a public company, recruiting--they are used 
differently for a big public company versus an early stage 
company.
    I have this kind of aversion to Congress getting into the 
accounting business. I have an aversion of FASB getting into 
the--no. But how do you get towards maybe finding at a certain 
point whether it is a market capital company, you--maybe it is 
a stupid question.
    Mr. Herz. No, I think it is an excellent question. It is an 
excellent question. It is a question we intend to look at. 
Because certainly, if nothing else, the valuation issues when 
you don't have publicly traded stock become of another realm on 
valuing an option. Companies that have publicly traded stock 
they may themselves have traded options. So when you have a 
private company, a start-up, even if it is pre-IPO I think that 
is a real issue.
    Plus you take a start-up, and you get six guys together in 
a garage, and you say we are going to divide, you know, divide 
it into six pieces, that to me is a formation issue, a founders 
issue, rather than a compensation arrangement. So we are going 
to look very carefully at those issues and where that dividing 
line might lie.
    Mr. Emanuel. Because I think this--you know, companies use 
options to attract talent early on, which is so important to 
the creation of that company and its ability to go public, that 
options may be used later on in later stage companies that one 
could argue it is--I think the panel before you, one of the 
members--one of our colleagues said it is like other forms of 
compensation package. Well, health care, retirement benefits 
therefore do get expensed at that level. Why options would be 
treated differently is something else.
    On the other hand, I am sensitive to the fact that it has 
become so ingrained in the culture, in the economy and the 
everyday running of a business that you don't want to--you know 
this is going to have a negative effect. A decision that you 
guys made to expense options will have a negative impact. And 
maybe short-term companies and CEOs and management will adjust, 
but to disregard it at----
    Mr. Herz. Remember, across the whole capital market, as I 
said, according to the statistics only a small portion of 
nonexecutive workers receive stock options; and of course we 
have gotten fairly strong support from the trade unions that 
represent America's workers on the need to change the 
accounting. So, you know, I agree with your thinking, the 
thinking about different companies, different uses.
    Mr. Emanuel. Most importantly, different points in their 
maturity. That actually, rather than this being linear, options 
change over time as the company has developed into a different 
place, where it started and where in its midlife, so to say, 
and that therefore the options become something different over 
time, et cetera. I don't know, as you look at that, you think 
about it as you guys analyze this.
    Mr. Herz. Thank you.
    Mr. Emanuel. Thank you, Mr. Chairman.
    Chairman Baker. [Presiding.] Mr. Toomey.
    Mr. Toomey. Thank you, Mr. Chairman; and thank you, Mr. 
Herz.
    I may be getting in a little over my head here because I am 
not an accountant, but I do understand something about the 
economic of options. I used to trade options professionally.
    One of my concerns here, and I appreciate this is a tricky 
dilemma that we face here, but I guess my concern is whether or 
not the proposal that seems to be coming from the FASB here is 
going to best reflect the economic reality of these 
transactions. And specifically my concern is that if you go 
down the road of expensing, which I am not advocating, but as 
you seem to be heading down that road, it occurs to me that you 
may be doing it in a way that by design almost necessarily 
misrepresents the economics of the transaction. Because you 
recognize an expense at one point in time sort of, you then 
spread it over the life of the option, but you never do 
anything to reflect the change in value.
    As you know, if a company were to short a call option on 
another company, which is what this is, we are taking a short 
position and a call option on one's company, you would have 
that as a liability which would you then mark to market. You 
would capture that value on day one, but you would then 
recapture the change in value if it diminished in value or you 
would show greater expense if it became a greater liability. 
But that provides a convergence to economic reality.
    And I understand that what you are doing instead seems to 
be more consistent with the way other forms of equity are 
treated, but it seems to end up misrepresenting the economic 
reality. And now I am further concerned--and one of the reasons 
I am not comfortable with expensing is if you go down this 
other road of showing it as a liability and marking it to 
market, you create this bizarre anomaly of showing earnings or 
losses that are a function solely of fluctuations of the stock 
price and have nothing to do with the operating forms of the 
company, which one suspects this is not necessarily very useful 
to investors, which is why I sort of end up thinking that 
really the best reflection of the economic reality here is to 
show the impact of the dilution in the event that the options 
are in fact issued.
    So could you comment on this? It seems to me--and I don't 
mean to be harshly critical here, but it seems to be almost a 
half measure in terms of capturing expense, because it never 
captures the change that would better reflect economic reality.
    Mr. Herz. Yeah. I don't know if I can do justice to this 
discussion in this hearing or make my points succinctly enough, 
because this is an issue that we and accountants and economists 
have debated for a long, long time, the issue of when to 
measure. We call it the measurement date issue. Do you measure 
it solely at grant date? Do you measure it from grant date 
through to the vesting date when the person has performed the 
services, or do you measure it right to the exercise date, kind 
of like the way the tax method does it? And there can be 
arguments for all three, but I think the argument--the last 
argument that you argued about--maybe it was the next to the 
last one about the idea of marking it to market right through 
exercise date, there are some proponents that would say not 
only employee stock options but all call options issued by a 
company ought to be accounted for that way, including a call 
option that is embedded in convertible debt or warrants that a 
company issues for financing or to obtain goods and services. 
That is an issue we are looking at also internationally in 
terms of the distinction between liability and equity. Where is 
that line?
    Accounting traditionally has drawn the line at things that 
are equity, a stock option is an equity, just like a share of 
stock. And when you use that to acquire goods and services, 
that becomes the measure of that transaction.
    Now, I would posit that that is the accurate measure of 
that transaction at that point.
    Mr. Toomey. Is or is not?
    Mr. Herz. Is. The question then is, is something else going 
on after that, which is more of a financing item, and I think 
you would have to look at it not only for just employee stock 
options but all call options that a company may issue related 
to its stock. We are going to look at that, but I think the 
measure of the compensation or if you use options to buy goods, 
that is what they are recorded at at that date. That is a 
pretty clear issue in accounting right now.
    Mr. Toomey. It just seems worrisome to me that we would go 
down a road that says we will knowingly and intentionally 
refuse to recognize that an expense that we put on an income 
statement on day one and that we subsequently learn is never 
going to occur in any economic reality but we are never going 
to do anything about correcting that, and that is where you end 
up if you don't do the--again, I am not advocating that we use 
that model, but that is--given that inherent set of difficult 
choices, it seems the dilution model is rather appealing.
    Mr. Herz. Yeah. I understand the accounting conclusion is 
different. The conclusion of many economists, including 
Chairman Greenspan, including three Nobel prize winners, is not 
that. But it is a good debate to have.
    Mr. Toomey. Thank you.
    Chairman Baker. Thank you, Mr. Toomey.
    Mr. Gonzalez.
    Mr. Crowley.
    Mr. Crowley. Thank you, Mr. Chairman. Thank you, Mr. Herz, 
for being here today and for your comments. I think that many 
of us could look back in the 1990s and see both the positive 
and the negative effects of the market and what took place 
during then, especially in the high-tech industry, but I think 
we can all agree that for overall what took place during the 
1990s was highly beneficial towards the economy of our country, 
and especially the growth of the high-tech industry and the 
impact that that had. Many would argue because of the ability 
to not have to necessarily expense these items that that 
actually encouraged growth in development within high-tech, and 
it has been touched upon by a number of my colleagues.
    What I would be interested in knowing is do you think, one, 
that it is appropriate for Congress to be inquiring into this 
issue? Because I think it goes beyond just technical accounting 
standards. It goes towards the larger macro economic policy 
issues, job creation, job loss potential because of these new 
standards that you are suggesting. Are you factoring in the 
macroeffect that this would have on our economy? And can you 
tell us--I mean, I know who is supporting the standards change. 
Can you tell us about what comments you received in opposition 
to it? And just lastly, in terms of your time line, I believe 
you expect to have these standards in place by the spring, 
April of 2004. Do you think that that is realistic given I 
think all of our experience with government how slow we are to 
move, whether or not you as quasi will do it any faster than we 
in government can?
    Mr. Herz. Thank you. On the macroeffects again, you know, 
we study the economic effects of the transactions, and our 
clear belief is and our mandate is that we then come up with an 
accounting that we think under our concepts, under looking at 
characteristics like relevance or reliability or what is the 
better accounting, and we test that out with users, financial 
information to see how they use it, how they make decisions, 
things like that. And then we weigh that against the costs, the 
costs of the company to provide that information and the like. 
You know, our clear mandate is to produce accounting 
information that is more useful for people who need to have 
independent neutral information to make decisions.
    On the opposition, we got opposition from a number of 
companies, particularly in the high-tech industry, you know, 
who wrote us a lot, a lot of letters. There was opposition 
earlier from other people in industry, but I think most of 
industry has now said let's focus on the measurement issues, 
you know, can it be done reliably, how, you know, what is the 
best way to measure it.
    The April 2004, we would like to stick to that, but we are 
going to do this thoroughly and objectively and systematically 
and consult with lots and lots of people and get lots and lots 
of input. You know, I am committed to try and move the FASB 
more quickly than it has in the past, and I think we have 
demonstrated that on some of the things we have done over the 
last year, but I don't want to sacrifice the appropriate due 
process to make sure that we are getting to the appropriate 
result.
    Mr. Crowley. I would just in closing say that it has been 
suggested to me that FASB in this case is acting more like 
Congress and this committee acting more like FASB in terms of 
our approach, possibly in terms of looking at this and 
examining it before we throw the baby out with the bath water. 
But I appreciate the gentleman, his testimony and his time this 
afternoon.
    Chairman Baker. Thank you, Mr. Crowley. Mr. Tiberi.
    Mr. Tiberi. Thank you, Mr. Chairman. Following up a bit on 
Mr. Toomey's questioning with respect to the cost issue of 
expensing stock options, do you believe there is a cost to the 
companies?
    Mr. Herz. Oh, absolutely.
    Mr. Tiberi. Explain how.
    Mr. Herz. It is the economic cost of issuing that option at 
that date. I don't know if you were here when I read the piece 
by----
    Mr. Tiberi. I wasn't. I apologize.
    Mr. Herz. By Bennett Stewart, but basically to paraphrase 
it, there are lots of different ways of looking at it. I mean, 
you are issuing an economic instrument that you could have 
issued a similar instrument to the market, got the cash and 
paid the employee in cash. Another way that economists look at 
it is that you are basically forcing the employee to buy the 
instrument. So I think most economists say that, yes, there is 
a cost at that date to the company. It is an opportunity type 
cost, but it is relevant in terms of comparing the company's 
actions versus other actions.
    Mr. Tiberi. And you believe that there is a cost to the 
shareholder as well then?
    Mr. Herz. Well, any cost that is a cost to the company is a 
cost to the shareholder.
    Mr. Tiberi. And not just a cost to the shareholder as 
opposed to the company?
    Mr. Herz. Again, let me explain that there is an accounting 
system that measures revenues, costs to the company. There is 
also a metric called earnings per share. That is a metric. It 
is just a calculation. It is a calculation that says instead of 
looking at the existing number of outstanding shares let's take 
this period's earnings and pretend that there were more shares 
outstanding based upon things like options, and it spreads 
that--then says instead of, you know, there being a dollar 
earnings based upon the outstanding issues shared, you factor 
in the options, maybe it is 80 cents and the like. But that is 
outside of the accounting system.
    Mr. Tiberi. Were you here for Ms. Nightingale's testimony?
    Mr. Herz. Yes.
    Mr. Tiberi. Referring to her testimony, she talked about 
this issue of options being a benefit to her as an employee, a 
benefit to her as an employee, a tool that her company can use 
to attract not only employees but also potentially capital. 
What is your response to that?
    Mr. Herz. Well, first of all, we don't set the laws, and we 
are not telling anybody that they can't issue options. And, 
again, this form of option is one of many forms of options, and 
the other forms of options already get expensed. It is one of 
many forms of equity-based compensation, some of which are very 
broad-based that get expensed and the like. So I don't know 
whether her particular employer might decide to consider that 
form, another form or the like. I would think they might 
consider continuing it. I don't know. One of the great things 
about stock options is they have very favorable tax treatment. 
You get a tax deduction for the full-spreaded at exercise, and 
many, many companies have gotten lots and lots of tax benefits 
in a form of reduced tax payments from this device.
    Mr. Tiberi. Would you agree that there are many, many 
people who have been the beneficiary of stock options, who have 
done quite well and otherwise wouldn't have if there were the 
ability to have stock options given them?
    Mr. Herz. Well, again, across the economy the best 
statistic I have available is that only 1.7 percent of the 
nonexecutive workforce has received any options. So I am sure 
there are many people that have benefited from other forms of 
equity compensation. I am sure there are many people that have 
benefited from profit sharing plans that a company has or stock 
appreciation rights or lots of other ways that companies can 
innovatively compensate people.
    Mr. Tiberi. Do you think--where did this information come 
from, the 1----
    Mr. Herz. The U.S. Bureau of Labor Statistics, their figure 
for year 2000.
    Mr. Tiberi. And you believe that your proposal at FASB 
won't prohibit this from----
    Mr. Herz. No.
    Mr. Tiberi. Explain why.
    Mr. Herz. We can't prohibit any transaction. We just say if 
you do something, here is how to account for it.
    Mr. Tiberi. Obviously there are some who believe that your 
role is--some up here believe that your role is--you are 
overstepping your role in what you are doing.
    Mr. Herz. We set accounting standards for transactions and 
economic events that occur to business enterprises. So if you 
choose to issue stock options or if you choose to issue other 
forms of compensation, all we would say is here is how to 
account for them.
    Mr. Tiberi. You don't believe that your role will stop 
that?
    Mr. Herz. No.
    Mr. Tiberi. Thank you, Mr. Chairman.
    Chairman Baker. Thank you, Mr. Tiberi.
    Mr. Inslee.
    Mr. Inslee.  Thank you. I have yet to win a Nobel prize in 
economics, so I approach this issue with some humility. But 
there are a couple of things that I want to--that I have sort 
of concluded and I want to ask you a question. If you reach my 
conclusions, what do we do then?
    First, I sat through a score of hearings about all the 
Enron-related debacles, and I was struck during those hearings 
of repeated rapacious behavior by these what I believe to be 
criminals. It didn't involve this issue. I mean, we went 
through months of testimony, and I just can't remember seeing 
that the lack of expensing was really the critical thing that 
occurred to these corporations. That is just an observation 
that I had throughout these hearings.
    Secondly, this concerns me a little bit, because I 
understand the desire for a number, but it bothers me to say 
that a bad number is better than no number at all, and I think 
that is where we are headed a little bit because of the 
difficulty of assessing this vehicle. And to me the real issue 
really is dilution, diminution of value to the shareholders, 
and if you reach that conclusion that that is really what we 
ought to be aiming here for is a fair assessment of the 
potential dilution of stockholder value when an option is 
issued, if you sort of reach that conclusion as I have, what 
advice would you give us on how to form a vehicle to really 
give investors that type of information?
    Mr. Herz. Okay. Thank you. Let me make sure I got your 
questions--your points. On the rapacious behavior, we are not 
trying to cure that. We are just trying to provide an 
accounting standard that deals with an anomaly, a 30-year 
anomaly that most people recognize is an anomaly among forms of 
stock-based compensation and how to account for it.
    The issue on the bad number, again, we are going to look at 
that. We have been told by a lot of experts that you can get a 
pretty reliable number that is more reliable than a lot of 
other things in the financial statements. That doesn't mean 
that those numbers are bad either. There is a required 
disclosure now that the SEC has. It is called critical 
accounting policies and estimates, and you will find that 
companies disclose those in 10 or 12 areas. And what they are, 
they are a fulsome disclosure of the way the company went about 
making estimates in the area of inherent uncertainty. Most of 
those deal with other types of things. They deal with things 
like impairment of long-lived assets. They deal with reserves 
like loan loss reserves and the like. They deal with things 
like that, and I think you will find that, you know, we are 
going to look at this. And we have been told by other people 
who have looked at it that the relative precision on these 
kinds of things is much higher than on those kinds of numbers 
that have been for years and years in the financial statements.
    Again, on the dilution, you know, we will agree to disagree 
that dilution is not the only effect here, is not the complete 
effect. There is an economic cost. It is an economic cost that 
is associated with all other equity transactions, and by the 
way, these instruments are used not only to compensate 
employees. They are used to acquire goods and services from 
outsiders. They are used in M&A transactions. They are used to 
make investments and the like, and all of those get accounted 
for at the value of the option at that date.
    Mr. Inslee. Let me--just one closing comment. I think one 
of the things you said that is important in the context of how 
the public perceives this, that this really is not a response 
to the Enron wave. It is coincidental in time, and I think that 
is an important point, because I think the public has sort of 
washed those two together. And I appreciate your comment that 
these are separate issues.
    Mr. Herz. I think that is an excellent point, because I 
sometimes give it in speeches. I say, you know, on the one hand 
we have people saying that if you do this accounting you are 
going to destroy America. On the other hand, if you do--people 
saying if you don't do this accounting, we are not going to 
rein in all this corporate abuse and all that. And I say, gee, 
we are just trying to prescribe what we think is the right 
accounting.
    Mr. Inslee.  Thank you.
    Chairman Baker. Thank you, Mr. Inslee.
    Ms. Hart.
    Ms. Hart. Mr. Chairman, I am going to pass to Mr. Shadegg. 
I think he has a question.
    Chairman Baker. Mr. Shadegg.
    Mr. Shadegg. Thank you. Mr. Herz, let me first of all start 
with a disclaimer. This is not my field, not my topic. I also 
apologize for being here late. I have been bouncing back and 
forth between two hearings.
    Let me start with a first question. Sophisticated investors 
from current disclosures are aware of the existence of stock 
options; and to the extent that they dilute the stock that is 
out there, they are cognizant of that, are they not?
    Mr. Herz. I guess there is some mixed evidence on that. 
Before you got here I explained that the fact that it is in the 
footnotes most people don't think is enough.
    Mr. Shadegg. But it is not footnotes.
    Mr. Herz. Yes.
    Mr. Shadegg. You propose to go all the way to the solution 
of expensing stock options. Pardon me, but have you already 
proposed a different method for valuing those stock options 
than the--I guess it is Black-Scholes value estimate that is 
currently being used?
    Mr. Herz. No. We haven't proposed anything yet. We are at 
the beginning of a process to assess all these issues.
    Mr. Shadegg. If you were to require that stock options be 
currently valued, would you use that method, or would you come 
forward with another method?
    Mr. Herz. We have received numerous suggestions from all 
sorts of academics, people who are experts in valuation 
compensation, experts on ways to--that they believe would 
provide better valuations. Our staff is at the beginning of 
looking at all of those kinds of suggestions.
    Mr. Shadegg. I think Congress is confronted with an issue 
here, and they are trying to resolve it and do what they think 
ought to be done. I read a portion of your testimony, and it 
pretty much says you don't think the legislation that has been 
proposed by those that were on the prior panel is a good idea, 
and I have read your specifics on that. And quite frankly, most 
of your specifics legitimately go to protecting FASB's turf and 
say this is FASB's job. The Congress shouldn't intervene. It 
could have an adverse impact on FASB's efforts and it could set 
a dangerous precedent. Those are words you used. Well, I 
understand that, I understand the role of your agency. Do me a 
favor then. Respond for me to those who are going to appear on 
the panel after you to the criticism that says, number one, 
there is no way to accurately value these stocks now, that the 
Black-Scholes process does not provide an accurate valuation 
because these are not traded options, and second, address the 
issue that those people also raise about how do you set forth a 
value for a stock option that will never be used?
    I spent the week last week with a good friend. He had some 
options issued by the company he used to work for. He was let 
go from that company, and he could never exercise the option. 
It is not a value. And address the concern of those who say 
anything you do will be inaccurate and therefore requiring CEOs 
to certify to what is inaccurate puts them in an untenable 
position.
    Mr. Herz. Yeah. Okay. The issue of valuation--and, again, I 
will go over it. You weren't here. Again, we are looking at all 
of that. You know, the question is can it be valued with 
sufficient reliability. We are going to look at that hard. 
People who have looked at that before us, our predecessors at 
the FASB 10 years ago, the International Accounting Standards 
Board, many experts in the field all say that it can be done.
    Chairman Greenspan a few weeks ago in response to a 
specific question on this said that is just flat wrong. I was 
on the International Accounting Standards Board at the time 
they started looking at this issue. Unfortunately or 
fortunately, I left for the FASB before they got to this 
particular issue of measurement reliability. So I am looking 
forward to getting into that and making my own hard judgments 
on whether or not these can be sufficiently reliably valued at 
the date of grant or any other date after that.
    The issue of the certification, the SEC tells me that the 
companies that already are certified with the figures in their 
footnotes have implicitly already said that, because the 
information certified already includes all the information in 
the footnotes of which this is in the footnote.
    The second thing I would tell you is that 280 companies or 
so, major U.S. corporations, have voluntarily switched to the 
expensing method. Well, these are among America's biggest, most 
respected companies with highly respected CEOs and the like, 
and they must believe they can do it.
    Mr. Shadegg. I guess I could respond by simply saying if 
current disclosure is inadequate, some argue, you say it is in 
the footnotes and they are already certifying it, but the new 
method is also admittedly inaccurate, maybe we are best to 
leave those companies to decide which of the two voluntarily 
most accurately tells the public about the condition of their 
stock?
    Mr. Herz. Yeah. The argument that--well, first of all, we 
believe that excluding it from the financial statements makes 
the financial statements wrong. You know, obviously if we 
conclude that this is a valid expense, then it ought to be in 
the income statement just like any other expense.
    Mr. Shadegg. So you have already concluded the footnote is 
inadequate?
    Mr. Herz. Well, we have generally concluded historically 
that footnote disclosure is very useful, but it is not a 
complete substitute. And I went through this before on this 
particular issue. People have said to us that, for example, the 
reason it is not enough is that people pick up information, 
analysts and the like, from databases. And unless it is in the 
accounting information, they don't pick it up.
    Mr. Shadegg. I appreciate it. My time is expired. I 
appreciate your input.
    Chairman Baker. Thank you, Mr. Shadegg.
    Ms. Hart, did you have a question at this time?
    Ms. Hart. I will just be brief, Mr. Chairman. Thank you. 
You had just mentioned in your answer to Mr. Shadegg that, oh, 
these corporations have made the decision to expense their 
stock options, and, gee, would they do that if they couldn't 
figure out a value, and I think my answer to that question, 
having been on this committee through the entire storm of the 
last session, would be they thought they had to and they will 
figure out a way to value them. I don't know that there is 
anything that is clear about where they can go with that. And I 
am interested in actually seeing your process through to the 
end.
    Can you give us just a little window about how you would 
actually go about valuing an option in light of the fact that 
it isn't necessarily worth anything until it is exercised?
    Mr. Herz. Well, again, an option is worth something, maybe 
not to the employee, but there is a cost to the company. 
Options, I mean, there are trillions of dollars of traded 
options in the market. There are options embedded in 
convertible debt and you get a lower interest cost, and there 
are calculations that very precisely do all those things. So I 
understand from an employee's point of view that is the case, 
but our accounting standards deal with the accounting by a 
company and what are its costs, what are its revenues.
    Ms. Hart. I follow that, but taking that one step further, 
it is the value to a company which they could actually sell out 
of market. I understand that, but as far as the date--when you 
talk about the date of the valuation, are you looking toward 
that date that is actually given to the employee?
    Mr. Herz. Yeah. Date of grant to the employee.
    Ms. Hart. So that is the actual date that you would use?
    Mr. Herz. When the company officially commits itself.
    Ms. Hart. So that is your actual date. And from there you 
are going to go ahead more based on what that option could be 
worth on an open market?
    Mr. Herz. Well, what you would do is you would value an 
option through whatever technique we would come to, and we are 
going to look at this hard, as I say, at the date that the 
company commits to the employee to grant the certain number of 
options. And then you establish a value. If the terms of the 
options say that--to the employee you can't exercise this for, 
say, 3 years, a vesting period, the way it is looked at is that 
that is the service period over which the company benefits from 
that cost. So you spread that cost over the 3 years that the 
employee gets it. If the employee never gets it because he 
leaves the company, we would reverse everything because a deal 
was not consummated.
    Ms. Hart. So things can get pretty complicated. Have you 
been conferring at all with these companies that have decided 
to use the expensing method within the last year or so?
    Mr. Herz. We have talked to a lot of them, and, again, 
calculations that they think they will be doing are under the 
same calculations that they have been doing for 7 years that 
are in the footnotes.
    Ms. Hart. Okay. Thank you. I have no further questions. 
Thank you, Mr. Chairman.
    Chairman Baker. Thank you, Ms. Hart.
    Mr. Sherman.
    Mr. Sherman. I have arrived just at the right time. First, 
I don't think you can defend the present system that you have 
got or the present rule on stock options. I remember while I 
was studying accounting I learned two things. First, 
comparability, the ability to compare two like companies and 
tell which one is producing more net income or has a higher 
book value, is one of the essential elements of any good series 
of accounting principles.
    The second thing I learned while I was studying accounting 
is that you could turn on the TV and see the taste test, Pepsi 
versus Coke. There was a big commercial back then. And the 
people being tested were often blindfolded. Well, today you are 
blindfolded if you are trying to compare earnings per share of 
Pepsi and Coke, because of course they use different systems 
for comparing the cost of compensating their executives.
    But as I understand it, what you are saying is the 
professionals dealing with securities can by looking at the 
footnotes turn Pepsi into Coke by making some calculations and 
determining what Pepsi's earnings per share would be if they 
used the same method. Is that true?
    Mr. Herz. They can from the footnote data--first of all, 
let me go back. Thank you for that comment on comparability, 
because that is an absolutely essential ingredient to good 
accounting information and to the information that is used in 
the marketplace and investment decisions and capital 
allocation.
    They can make those adjustments, but one of the issues 
apparently is that they can't make them everywhere, because the 
databases that they use don't pick up--if it is not in the 
accounting information, the accounting--you know, they pick up 
the straight information from the income statement, not from 
footnotes.
    Mr. Sherman. Well, you are saying that those who don't 
bother to read the footnotes cannot compare Pepsi and Coke, but 
if you are getting your advice from a team of professionals in 
a few hours, they can do the calculations to put Pepsi's 
earnings per share calculated exactly what it would be if they 
used----
    Mr. Herz. They can do the bottom line but they can't do 
other things like gross margin and other aspects that they 
might want to calculate, because it is not broken out that way.
    Mr. Sherman. Well, once you have determined what the 
expense item would have been on Pepsi's financial statements, 
can't you then calculate everything else? What is missing?
    Mr. Herz. Well, for example, let's say people not only in 
production but in sales and marketing and other parts of the 
enterprise----
    Mr. Sherman. So a portion of the compensation cost should 
not be charged to this year's expenses, but instead could be 
part of inventory----
    Mr. Herz. Inventory or other things below the gross margin 
and the like and things that are needed in financial--proper 
financial analysis.
    Mr. Sherman. So without much controversy, you believed at 
least require beefier footnotes so as to provide in effect a 
complete restatement of what those financials would look like--
--
    Mr. Herz. Yeah.
    Mr. Sherman. ----if the expensing method was used?
    Mr. Herz. We could. I mean, I think the concern is that you 
do it on one item, then we are going to have pro forma 
disclosures on everything. Why have financial statements?
    Mr. Sherman. Well, the problem you have here is this is the 
only item I am aware of where the FASB has announced there is a 
right way to do it, but we don't have the fortitude, I think is 
the term, to tell everybody to do it that way.
    Mr. Herz. Oh, we have the fortitude.
    Mr. Sherman. Well, you haven't--I mean, your current 
release on this is the right way, and 98 percent of the 
companies are doing it a different way.
    Mr. Herz. Right.
    Mr. Sherman. I don't know of any other issue that is this 
hot. I don't know of any other issue where you can't just say, 
this is the right way. Do it this way. So at a very minimum, if 
you can't impose that same standard on this issue, which is too 
high, you could provide the same pro formas. Then the world out 
there could decide which of the two numbers to use. The 
analysts could all decide that they like the pro forma number 
better, or they could like the main number better, but----
    Mr. Herz. They could. I mean, we--there was a survey of--
that the AIMR did a couple of years ago of their membership. 
The AIMR is the Association for Investment Management Research, 
and they surveyed thousands of people. They got about 2,000 
responses from financial analysts and portfolio managers, and 
one of the questions they asked was is footnote disclosure 
enough, and the answer was no.
    Mr. Sherman. It is obviously a lot easier for them if you 
are able to come up with one number and they don't have to read 
the footnote. What you are basically saying in the survey is 
they don't want to read the footnotes and they certainly don't 
want to do the additional work of----
    Mr. Herz. That may be so or there may be others----
    Mr. Sherman. Trust me. No one wants to read those 
footnotes. Thank you, Mr. Chairman.
    Chairman Baker. Thank you, Mr. Sherman.
    Mr. Ney, did you have a question?
    Mr. Ney. Thank you. Thank you, Mr. Chairman. Welcome. Some 
people have argued that requiring expensing of the stock 
options will undermine clarity of the financial statements and 
provide greater opportunity really for fraud, because the 
valuation methodology would not be exact, and I just wonder 
what your view on that would be.
    Mr. Herz. Well, our view is that--again, once we have gone 
through our whole process and we have concluded that not only 
conceptually it is an expense but it can be measured with 
reliability, that that is the right thing to do, to put that 
number in. To leave it out is to make the financial statements 
distortive.
    You can provide lots of other information in the footnotes, 
continue to do that, provide lots of other information. We are 
looking at that as well, because there are other aspects 
related to these. For example, the ongoing mark to market might 
be instructive right through their exercise date, lots of other 
things that could be useful and informative, as well as trying 
to make the financial statements correct.
    Mr. Ney. On a note about the component stock options which 
people have pretty well agreed they are difficult to value, and 
one of the people testifying--I think it was Mr. Craig 
Barrett--he will be on the third panel--points out that the 
CEOs are now required to certify the accuracy of their 
company's financial results and that the problems inherent in 
valuing stock options will make that extremely difficult.
    So my question again is the first part I said. How can we 
require the CEOs to do that when everybody has kind of agreed 
that that is a difficult thing to do?
    Mr. Herz. As I said earlier, having talked with the SEC, 
their belief is that under section 302, the CEO has already 
been certifying the information that is in the footnotes on 
this.
    Mr. Ney. Thank you.
    Chairman Baker. Thank you, Mr. Ney.
    Mr. Herz, we appreciate your courtesy in being with us for 
such a length of time. This of course is an important issue, 
but the broader question of financial reporting generally is of 
interest to me, and we look forward to working with you over 
the months to come. Thank you, sir.
    If I may invite our third panel, participants to come 
forward.
    I want to welcome each of our panelists here this morning 
and for your patience. This has been a much lengthier hearing 
than some would have expected, and I know of time constraints 
on our first witnesses. I certainly want to express 
appreciation for your participation but understand the 
necessity for your departure after the conclusion of your 
remarks.
    Our first to be heard this morning is the Honorable Paul 
Volcker, former Chair of the Federal Reserve, and in his 
capacity as Chairman of the International Accounting Standards 
Committee Foundation Trustees. Welcome, sir.

STATEMENT OF THE HON. PAUL A. VOLCKER, CHAIRMAN, INTERNATIONAL 
       ACCOUNTING STANDARDS COMMITTEE FOUNDATION TRUSTEES

    Mr. Volcker. Thank you, Mr. Chairman. I appreciate your 
courtesy in letting me go first, and I will steal out with an 
appointment with some of your colleagues, and I will come back 
if I can dispose of that and you are still talking. But let me 
just be quick with a couple of points.
    I am, as you indicated, the Chairman of the Trustees of the 
International Accounting Standards Foundation. We appoint the 
Board that makes the decisions. I am not the one who makes the 
decisions. I am not to interfere with those technical 
decisions.
    Having said all that, let me make a few comments. I think 
the basic issue you are all grappling with here is what should 
the role of the determining boards with, whether you are 
talking about FASB nationally. You haven't got any jurisdiction 
over the international, but we are aiming for consistency 
internationally, and those boards, both the domestic and the 
international, have been set up to provide insulation from 
extraneous influences. They are set up as professional boards 
to make professional judgments of integrity, and that decision 
making is to be protected by a rather elaborate arrangement, 
including my board of trustees, including the trustees of the 
domestic FASB.
    We have people who are not accountants on the Board. Some 
of them are drawn from business. Some of them are accountants. 
Some of them are drawn from analysts. They have large and 
elaborate advisory procedures. So these decisions are not 
reached in a vacuum, but in the end they are reached on the 
basis of professional judgments directed to assure what the 
best accounting judgment is and hopefully, from my viewpoint, 
to achieve international consistency over time.
    Now, I recognize it is amply apparent here that how you 
value stock options is exceedingly controversial. I might say 
to those that argue that it is not an expense, we better stop 
the practice of permitting the expense on tax returns. I don't 
think we can argue that they are a tax deduction and not an 
expense. That is why they are a tax deduction. And we are a 
little inconsistent the way they are accounting for now. I 
don't think we can argue that they have no cost. It is very 
difficult to know what that cost is, certainly on the grant 
date.
    There is one date where we know the cost, and that is when 
they are exercised. You can look it up in the Wall Street 
Journal. There is no doubt about it. That is the date that is 
used as an expense for tax purposes.
    I want to emphasize, when you consider what viewpoint you 
might want to take in the area, that while stock options are 
controversial, they are not the most controversial issue, in my 
judgment, that the standard setters are going to face. There 
are a number of extremely basic and controversial issues that 
will arise in accounting over the next months and years, and I 
think some of those will have a more profound effect on the 
financial world than will any decision that is made on whether 
there is to be expressing of options.
    There is a rather furious debate going on in Europe right 
now about the application of a proposed ruling by the 
International Board which will become law in Europe unless the 
European Commission says no, unless the European Commission 
vetoes it, about the handling of financial instruments. This is 
a ruling which has already been in effect in the United States 
under GAAP for some years. The International Board said they 
think they made an improvement, that it should be applied 
internationally. There is very great opposition in Europe. 
There are very strong political pressures being brought on the 
European Commission.
    Now, all my point in making this is if Congress wants to 
intervene in this particular decision, is a great precedent for 
everybody intervening in every decision that they don't like. 
The professional standard-making boards have been set up 
deliberately to provide a degree of insulation away from the 
professional judgment.
    So I want you to understand what you do here is not limited 
to the particular question of stock options. I think it would 
be obviously from my point of view a bad precedent for a 
political body to begin overriding the professional judgments 
of the independent standard makers, whether they are 
international or domestic. It will certainly lead to a lot of 
inconsistency internationally and all of that would be damaging 
I think to the basic international framework--the financial 
framework.
    Now, I happen to think, in looking at stock options as a 
matter of substance, that they are deeply flawed, and I know of 
no other word for it, as an incentive for business management. 
I think it is clear after experience, and they are largely a 
phenomenon of the last 15 years or so, that in the middle of a 
bull market there are enormous rewards that really weren't 
intended. They rise to grotesque--and I use that word 
advisedly--rewards for some business managers because you were 
in the midst of a bull market. People who performed well got 
richly rewarded. People that performed mediocrelly when the 
stock market was going up so fast got rewarded. People that 
performed relatively poorly or the stock performed relatively 
poorly got richly rewarded because of the popularity of stock 
options.
    Not only that, that there are clearly, I think it has been 
demonstrated, temptations for abuse in terms of incentives, 
that the incentive is given to the manager to attempt to affect 
the price of the stock, sometimes in ways that are inconsistent 
with the long-term health of the company. And I think we 
unfortunately have seen examples of that.
    Now, I understand that for start-up companies or venture 
capital companies, you have some discussion of that, you are 
under somewhat a basically different situation, where you have 
the owners of the companies, the founders of the company making 
a decision basically about how they want to distribute some 
stock, and they are not at that stage publicly owned companies 
at all. When I say I think they are basically flawed as a 
compensation instrument, I am talking typically about the big 
public companies that are tempted to abuse stock options. They 
may not abuse it. You have got one company here that feels very 
strongly about the use of stock options. They distribute them 
very widely, and don't concentrate them so heavily on a limited 
group of people. But unfortunately that is not uniform practice 
by a long shot. We have seen these egregious examples where 
people have gotten very large payoffs for stock options the 
very year that company goes bankrupt or has a decline in stock 
price of very large amounts. And when you get in a bear market, 
nobody gets rewarded, good, bad or indifferent economic 
performance.
    So I would say there are better ways of motivating people, 
better ways of aligning incentives than the use of--I will use 
the words carefully--a fixed price stock option by large 
publicly owned companies without concentrated ownership, where 
the ownership itself is basically not making the decision but 
the managers that are affected are making the decision.
    I think that is a certain background for this whole 
discussion when we talk about the overall impact of stock 
options. I am not arguing they should be outlawed. I am just 
arguing that as a matter of corporate practice that a company 
that wants to use them should do a certain amount of explaining 
as to why in their particular circumstances and the manner in 
which they use their stock options is justified. I think in the 
end of the day, the pricing of the stock option one way or 
another will encourage more conservative behavior and more 
prudent behavior with respect to fixed price stock options.
    The point was made earlier ironically when you have a 
performance-based stock option, it is already expensed and it 
is an interesting phenomenon. Not many companies use it. So you 
have to ask why not. The temptation is because they are not 
expensed to abuse them in some cases. You can't avoid the 
uncertainty I think of expensing them, which is very real, 
because one thing you know is zero expense is not true. I think 
the overwhelming professional economic opinion says if there 
isn't expense to stock options and there wasn't expense, we 
shouldn't be deducting it for tax purposes.
    [The prepared statement of Hon. Paul A. Volcker can be 
found on page 169 in the appendix.]
    Chairman Baker. Thank you, Chairman Volcker. We appreciate 
your participation today. We are here. We welcome you back if 
it works out for your schedule.
    Our next witness would be introduced by Congressman 
Shadegg. Congressman.
    Mr. Shadegg. Thank you, Chairman Baker. It is my privilege 
to introduce today Dr. Craig Barrett, the CEO of Intel. Dr. 
Barrett is a constituent of mine from Arizona and one of the 
distinguished witnesses we have today. As you know, Intel is 
one of the largest, if not the largest supplier of 
microprocessors and has played a significant role in shaping 
computer and information technologies.
    Since joining Intel in 1974, Dr. Barrett helped perfect the 
process for manufacturing Intel's powerful microprocessors. He 
became CEO of Intel in 1998. Prior to that he had an impressive 
record of academic achievement at Stanford University, where he 
served on their faculty.
    He also has a demonstrated commitment to public service. He 
has been a passionate advocate of higher education and of 
placing higher education within the reach of a wider range of 
students. He has testified before Congress about strengthening 
math, science and technology education requirements and has 
advised the President on education issues. He has also been an 
outspoken advocate for higher standards in education.
    It is a privilege to have Dr. Barrett with us today.

 STATEMENT OF CRAIG R. BARRETT, CHIEF EXECUTIVE OFFICER, INTEL 
                          CORPORATION

    Mr. Barrett. Thank you, Mr. Shadegg. Mr. Chairman, it is a 
pleasure to be here. Sometimes after listening to some of the 
prior testimony, I wish I was here talking about education and 
math and science. It is perhaps a simpler problem to solve.
    What I would like to do is perhaps represent the high-tech 
community at this table this morning. I have submitted some 
prepared remarks. I will try to summarize those briefly. I want 
to talk primarily about three subjects. One is the importance 
of stock options to America's economic health going forward, 
why expensing stock options is not a solution to corporate 
corruption, a topic that has been discussed some today, and why 
expensing of stock options will confuse corporate financial 
statements and confuse investors. We have heard statements to 
the contrary this morning, and I would like to give you my 
perspective on that.
    I also want to compliment Representatives Dreier and Eshoo 
for putting H.R. 1372 in play. I enjoyed their comments this 
morning. I am going to look forward to working with them on 
this bill going forward.
    If you look at the United States economy today and 
increasingly going forward, it is a knowledge-based economy. 
You can determine that either by looking at the number of 
knowledgeable workers in the United States over time. You can 
look at that, at the assets of companies as they move. If you 
look at the nonfinancial assets of the company, they 
increasingly move from property and equipment and raw material 
to in fact intangibles such as patents, copyrights and 
knowledge based on their workers.
    Those two trends are absolutely going forward. It is in 
fact the only way the United States supports the standard of 
living it has today. It has to add more value to its goods and 
services than other countries or our standard of living goes 
down and our employees can't afford to get paid.
    If you look at the company that I am proud to represent, 
Intel Corporation, it was founded in 1968 by Bob Noyce and 
Gordon Moore. They founded that company out of Fairchild. At 
Fairchild they learned the important lesson that employees as 
partial owners of companies can contribute more to that 
company, will contribute more to that company, will do more to 
make that company successful. When Intel started, approximately 
30 percent of its employees were given stock options. Today 
essentially all of our 80,000 employees receive stock options.
    Speaking at this table as a CEO today with experience in 
running a major corporation, with 30 years of experience in the 
industrial field, I can testify that stock options are a great 
incentive to employees to be owners of companies, to work 
harder for companies and to make those companies successful. In 
my opinion, this is why we give stock options. The owners of 
the company recognize that. The owners are the shareholders. 
They agree to a dilution of their holdings in the company on 
the basis that the employees will work harder and make the pie 
bigger.
    Intel is not alone in this area. If you look at Intel, 
which I think is a company of substantial success over the last 
35 years, Microsoft, Dell, Cisco, you can go right down the 
list, all of these companies were founded in the same fashion, 
founded off of knowledge-based workers, and this incentive 
ownership in the company has been a prime motivating factor for 
those employees to work hard.
    We could look at it slightly differently. Those are all 
large companies that I mentioned. If you look at small 
companies, start-up companies and start-up companies do create 
the basic fuel to create jobs and wealth in the United States, 
stock options are an excellent tool for start-up companies. 
Those companies cannot afford to pay often the salaries that 
major companies can, and therefore they must compete with the 
stock options to attract knowledgeable workers into their base.
    I think if you were to expense stock options as some of our 
previous speakers have mentioned--subjected to and in fact had 
the harsh reality of the profit and loss statement, the profit 
to earnings ratio, the stock price associated with that 
expensing, you would see a dramatic move away from granting 
stock options in the United States. You would have to do that. 
This would be at the same time when we are competing 
increasingly not with Europe, which Mr. Volcker mentioned IASB 
represents primarily, but we are increasingly competing with 
Asia, and the Asians have no intentions of expensing stock 
options. That is where the competition is in the future.
    One of the other areas that was mentioned this morning was 
this book, which I would suggest that everyone read. 
Representative Eshoo mentioned this. If you are interested in 
the data in terms of return on investment productivity, return 
on capital growth for companies with a wide holding of stock by 
their employees, that is, companies with broad-based stock 
options, I think this book is the bible on that topic. 
Occasionally it is useful to interject data when discussing 
this topic. This book is full of data.
    There has been a lot of talk about one of the reasons for 
expensing options is to curb corporate corruption. I totally 
disagree with this topic. The companies such as Enron, WorldCom 
and others that have crashed and burned did not crash and burn 
because they were not expensing stock options or because they 
had broad-based option programs. They crashed and burned 
because the executives in those companies broke the law. They 
deserve to be punished. They deserve to be prosecuted for what 
they did. They betrayed the public trust.
    I think what this discussion is all about, though, is the 
impact that broad-based options can have on companies and their 
success. I would like to make just a few simple suggestions 
which would help introduce the topic of broad-based option 
programs and the impact they can have on companies and the 
value they add. And it is really a five-step program.
    First is that option programs should be approved by 
shareholders. The shareholders are the owners of the company. 
They are the ones that are agreeing to the dilution of their 
proportion of the company. Broad-based option plans should be 
exactly that, broad-based option programs, and you ought to 
limit the amount of options that go to the top executives at 
companies. At Intel our compensation committee is taking the 
move to limit it to 5 percent or less of the options go to the 
proxy five.
    A key element of the Dreier-Eshoo bill is that companies 
should provide investors with sufficient information, whether 
it is a footnote or not, and by golly, if you read any of our 
financial statements today, they are filled with footnotes on 
all sorts of topics and any seasoned investor who doesn't 
bother to read the footnotes is certainly not a seasoned 
investor.
    But the footnotes should be written in plain English. 
Options ought to vest over an extended period of time, 4 years 
or so, and compensation committees who are the committees that 
dispense options to the executives and companies should be made 
up entirely of outside directors. That is the job of the 
compensation committee. That is the job of the directors. They 
can't shirk that.
    If you do those five things, I think you will do more to 
solve any potential abuse of option programs, and you will 
create jobs. You will create growth. You will create economic 
strength and innovation and entrepreneurship in the United 
States.
    I do want to end my comments with just a brief vignette 
about the accuracy of Black-Scholes, which has had some 
discussion this morning, the accuracy and transparency of 
financial statements and what you would project to the casual 
investor if you followed something like the Black-Scholes 
technique, which I believe to be inherently inaccurate in 
valuing options.
    I wrote an op ed piece for the Wall Street Journal a few 
weeks ago. I pointed out in the last few years Intel would have 
expensed via Black-Sholes over $3 billion worth of expense for 
options which are currently underwater. That is, their strike 
price is less than the current market price. That $3 billion, 
had it been on our expense, would have decreased earnings. 
Those options may never be exercised. Stock price may rebound, 
they may be exercisable, but unlikely. That $3 billion of 
expense would never come back to Intel had it been charged. So 
it is a one-way street if you expense on the date of grant.
    I can't imagine how any investor would have the situation 
clarified by having over $3 billion of expense on RP&L which 
may never occur. It may be obvious from my comments that I 
disagree with Mr. Herz. I disagree with the direction that FASB 
is going. I don't think there is an expense in the form he 
suggests to the company.
    There is an expense to the shareholders. That expense is 
dilution. They approved that dilution when they approved the 
shareholder plan.
    So I think the shortcomings in the expensing methodology 
are profound, but I think perhaps more important would be the 
shortcomings to economic development and economic well-being in 
the United States if you were to do away with broad-based stock 
option programs, which is what I entirely believe expensing 
would do.
    Thank you.
    Chairman Baker. Thank you, Mr. Barrett. We appreciate your 
time here today.
    [The prepared statement of Craig R. Barrett can be found on 
page 88 in the appendix.]
    Chairman Baker. Our next witness is the Honorable Roderick 
M. Hills, Partner, Hills & Stern. Welcome, sir.

STATEMENT OF THE HON. RODERICK M. HILLS, PARTNER, HILLS & STERN

    Mr. Hills. Thank you, Mr. Chairman. I ask that my remarks 
that I sent in to you be accepted.
    Chairman Baker. Without objection, as will all witnesses' 
testimony.
    Mr. Hills. I see that an article from The Economist April 
24th that was to be with my remarks is not here. If I may 
submit that later.
    Chairman Baker. Absolutely.
    Mr. Hills. I appreciate the opportunity to offer my views 
as to H.R. 1372, legislation which I think is fair to say is a 
reaction to the problems--I would say the crisis that faces the 
accounting profession.
    The problems which I list in some detail in my prepared 
remarks are, among other things, causing a fundamental change 
in accounting to the increasing use of market values, rather 
than historic costs, engaging profits and losses, and in the 
use of general principles, rather than a myriad of rules to 
evaluate financial statements.
    Whether options should be accounted for or not I suggest is 
part of this process of change. It seems to me there are lots 
of reasons why options should be accounted for. They are a 
material factor in how companies compensate employees. They can 
significantly affect stock prices. And I am sad to say they 
have, because they are not accounted for, distorted the 
compensation policies of some companies.
    Why then is there a problem? Well, it is, of course, the 
opinion of many CEOs who believe with justification that their 
strong prices may be severely hurt by costing. They believe 
that analysts and investors will punish their stock prices if 
management, using information that is largely in their 
financial papers, public papers today, applies a Black-Sholes 
type formula and uses the resulting number to reduce reported 
earnings per share.
    You might ask why in the world would analysts have any 
different view of the value of the company because the 
management does the math that he or she could do as an analyst. 
The fact is and the problem is that over the years the 
accounting profession and the analyst community have not been 
making the kinds of judgments about earnings and the kind of 
judgments about the assets of corporations that would long ago 
have given us an understanding of what the true cost--because 
it is a cost--of stock options. It would give us a better 
understanding of many other things about our assets and the 
costs of running a corporation.
    Yet I don't see how you cannot sympathize with CEOs who do 
not wish to shoot themselves, if you will, who argue that a 
Black-Sholes number will not be a precise gauge of cost. So we 
ask why our FASB and the ISAB persist and, in short, why isn't 
H.R. 1372 a perfect answer?
    It is attractive in one way. It puts the fight off again. 
It has been a long fight. It is not going to go away. It is an 
understandable approach. But I suggest to you that the studies 
contemplated are simply another way to delay something that is 
inexorable.
    It is only going to be when accountants, companies and 
analysts begin to wrestle with the various approaches to 
valuation in the context of a profit and loss valuation that we 
are going to get the discipline we need to make the world 
understand option costs as well as so many other things. The 
fight against pricing of options is the lack of precision, the 
fear that it will cause so much uncertainty that it becomes a 
worthless process and somehow will destroy the use of stock 
options.
    I have served on boards over 34 years, 18 different boards. 
My own view is that this, too, will pass. We will find a way to 
value stock options; and stock options used intelligently by 
companies, as they have been by Intel, will continue to be 
used; and analysts will figure out that the value of the 
company has not been affected.
    The real point of my remarks is to say that the costing of 
options is not the most serious accounting problem facing 
corporate America today. This Economist article which I have 
asked to be submitted identifies so many other areas that have 
even more pressing reasons for reform, and the article warns 
again of the confusion that may arise or will arise again and 
again as reform continues in these other areas as well as when 
the profession moves to the use of general principles in 
evaluating companies' presumptions rather than specific rules, 
and as we move to market values rather than fixing costs on 
historical basis.
    Profits, says the article, may come to be stated as a range 
of figures, each of them arrived at by using different 
accounting assumptions. This, continues The Economist, may 
sound worryingly uncertain, but it may be better than trying to 
rely on a brittle illusion of accounting exactitude, which is 
liable to collapse during times of economic strain.
    I suggest to you that the changes of accounting that are 
coming is because of a growing realization that we have for too 
long relied upon this brittle illusion of accounting 
exactitude. I suggest to you that the accounting difficulties 
of the past few years are in some significant part caused 
because of our reliance upon precision in accounting.
    I believe Congress should suffer the transformation to 
continue. The role of self-regulation is intact. It has a far 
stronger oversight with a new public company, accounting 
oversight board, with a newly staffed SEC that has far more 
resources to do its job. I suggest to you an effort now by 
Congress to stop this fledgling effort will be a serious 
interference with the development of the accounting profession 
that we so badly need.
    I have no love at all for the Black-Sholes formula. I 
sincerely hope that it is not adopted as a requirement for a 
corporate America.
    More important, I very much hope that FASB and the SEC will 
allow flexibility in the costing of options, let different 
companies use different formulas. The fact that there will be 
no precise formula or no precise number should be a vivid 
illustration of the fact that much of the information in the 
profit and loss statements today, much of that information is 
equally imprecise.
    If I may close by saying that Robert Frost--and this is as 
early as 1905, when he wrote a poem called The Hardship of 
Accounting: Never ask of money spent where the spender thinks 
it went, for no one was ever meant to remember or invent what 
he did with every cent. What Robert Frost knew almost a hundred 
years ago is beginning to be understood by us. I fear that H.R. 
1372 will impede the development of that understanding.
    Thank you very much.
    Chairman Baker. Thank you, sir. We appreciate your 
contribution this morning.
    [The prepared statement of Roderick M. Hills can be found 
on page 158 in the appendix.]
    Chairman Baker. Our last witness is Mr. James K. Glassman, 
Resident Fellow, American Enterprise Institute. Welcome back, 
sir.

   STATEMENT OF JAMES K. GLASSMAN, RESIDENT FELLOW, AMERICAN 
                      ENTERPRISE INSTITUTE

    Mr. Glassman. Thank you, Mr. Chairman.
    Mr. Chairman, Mr. Kanjorski, members of the subcommittee, I 
am concerned that the FASB is rushing to a decision that is not 
in the public interest and that it is ignoring serious critics 
of expensing stock options, among them not only successful 
business leaders such as Mr. Barrett but respected economists 
and a large number of financial and accounting professionals.
    By the way, despite Mr. Herz' earlier response to a 
question, at last count opposition to expensing is running 
three to one ahead of approval in comment letters.
    I strongly favor the approach in H.R. 1372. In my view, 
requiring the expensing of stock options would be a serious and 
disastrous mistake for three reasons:
    One, by severely discouraging the use of a powerful 
incentive for employees at all levels, all levels, mandatory 
expensing is likely to have a dangerously adverse impact on 
innovation, economic growth, and national competitiveness. 
Options work. They align the interests of managers and 
shareholders, and they provide a powerful incentive to 
innovation and hard work.
    Two, mandatory expensing is likely to confuse and mislead 
rather than further enlighten investors. You heard quite simply 
there is no way to value stock options accurately at the time 
they are granted.
    Three, as a long-term strategy, mandatory expensing leads 
accounting policy in precisely the wrong direction. The 
expensing of stock options has become a prime example of an 
accounting fetish, a kind of obsession to reduce contingent 
liabilities and other forms of information about a company to a 
single number that can be included in earnings statements under 
GAAP, Generally Accepted Accounting Principles. GAAP earning 
statements in truth comprise only one view of a company's 
health and prospects, as my friend Mr. Hills just stated, and 
often a distorted one. Investors need many views, and they are 
poorly served when policymakers elevate GAAP to a kind of holy 
status.
    These three points are discussed at great length in my 
testimony. But in my remaining time let me just address a 
couple of issues that relate directly to the role of Congress.
    The FASB has a single mission which it states this way. 
This is a quote: ``To establish and improve standards of 
financial accounting and reporting for the guidance and 
education of the public, including issuers, auditors and users 
of financial information.''
    Federal policymakers have a far broader mission. For 
example, they are responsible for encouraging economic growth, 
for preserving and increasing jobs, innovation and U.S. 
competitiveness. Even if the FASB is not--even if the FASB 
expensing proposal were cogent from an accounting viewpoint, 
and it is not, it would be the duty of Congress and the 
executive branch to consider its economic impact. I do not have 
to remind you. That is your job. You can't abdicate it, you 
can't farm it out to a group of accountants, however well-
meaning.
    In fact, Mr. Herz said earlier, he said that the moratorium 
``unduly intervenes.'' That is a quote. I disagree. I assume 
that you disagree, too.
    Second, do not be intimidated by all this technical talk 
about accounting. Understand that accounting is not a science. 
It is not biology or astronomy. Accounting attempts to render 
in words and number the history and current status of 
businesses. The best way to do that is a matter of opinion. 
There is no single right way to do things. And often accounting 
rules allow choices and flexibility. And that is a good thing.
    The current rule allows companies either to expense options 
at the time grants are made or to explain their possible 
effects in footnotes and then dilute earnings.
    I discussed in my testimony a typical firm, Gilead 
Sciences, a biotech company. I just pulled the 10-K off a pile 
that I have in my office whose footnote extends to four pages. 
Now, understand that footnotes, if you never read a 10-K, and I 
am sure every member up there has, footnotes are printed in the 
same type as everything else in a statement. They are 
tremendously important. No serious investor would ever ignore 
footnotes. These footnotes show far more information, quite 
frankly, about options than they do about other more important 
aspects of the business such as intellectual property assets or 
cash compensation and leases.
    The current regime is perfectly valid. The accounting 
profession and top academics are not united in their support of 
the change that the FASB proposes. As a result of expensing 
options, many firms, among them America's most successful and 
innovative, will be forced to take massive charges against 
earnings. These charges are likely to lead to lower stock 
prices and higher cost of capital for the firms. Companies, in 
addition, will be discouraged from issuing options in the 
future; and firms will be less likely to list on the public 
markets. The likely effect will be to reduce economic growth, 
U.S. competitiveness and job creation.
    It is the responsibility, in short, and in conclusion, of 
elected public officials to weigh the economic costs and to 
act. I do not question the sincere desire of the FASB and its 
supporters to restore investor confidence through a mandatory 
expensing. But I have written a column for several large 
newspapers about investing for many years. I think I know small 
investors. It is my judgment that investor confidence will 
probably be affected negatively, if at all, and the economy 
will be placed at risk. This subcommittee under those 
circumstances cannot sit idly by and watch new accounting rules 
imperil what is today a tender and tentative recovery.
    Thank you.
    Chairman Baker. Thank you, Mr. Glassman.
    [The prepared statement of James K. Glassman can be found 
on page 102 in the appendix.]
    Chairman Baker. I will start out by talking about the 
current environment we find ourselves in, especially in light 
of distinguished Chairman Volcker's comments advising the 
committee to be careful in moving forward on any of these 
subject matters.
    I can go back in financial services in this decade with 
regard to proposals relative to the treatment of derivatives, 
the adequacy of loan loss reserves. There have been any number 
of occasions when there have been public expressions concerning 
the manner in which disclosure should be made. I suspect that 
will continue. In fact, the FASB approach today is not to act 
precipitously but to engage potentially in public roundtables 
or public hearings to further assess the feelings of those in 
the enterprise in the stake-holding business as to their view 
of the proposed rule modification.
    To that end, I think it is also important to confirm what 
you characterize, Mr. Hills, as the brittle illusion of 
exactitude, that in fact in this effort we should move quickly 
beyond the issue of the expensing of options and look at the 
adequacy of the current reporting methodology in the broad 
sense in light of the significant changes in the way our 
economy performs today versus two decades ago, much less the 
last 50 years.
    In an earlier exchange, I was asking the FASB 
representative concerning the appropriateness of XBRL and 
having a much more rapid reporting of material fact that is 
principles based instead of rules based. Just in editorial 
comment, our system is defective; and the fact that we find, as 
a policy perspective, deficiencies, for example, Sarbanes-
Oxley, requires us to act.
    I guess what I am suggesting is that we don't really have 
to run very fast to stay ahead of the historic pace of FASB in 
promulgating regulations. This ought to be a complementary 
approach where we can have a public discussion, allow 
professionals to reach their conclusions but, at the same time, 
evaluate whether those conclusions fit in the context of our 
current economic condition.
    I am worried unless we get to real-time material fact 
disclosures that everything else is throwing very small life 
jackets overboard to people in very deep seas when they really 
need a whole new vessel. I don't know how we get there, but I 
suggest that, rather than this being an inappropriate 
exploratory activity, it is highly appropriate to fully 
understand how this expensing of options and the reform 
associated with it fits into the broader picture of reform of 
our whole financial reporting system.
    I don't really have a question, but I just sense that we 
are also all so focused on the expensing aspect the bigger 
picture is passing us by and that is far more important because 
of the inevitable changes that are likely to come.
    Mr. Hills, would you want to respond, given your concerns?
    Mr. Hills. I appreciate that.
    I also want to pay a compliment to my friend, Mr. Glassman, 
who has made a wonderful argument for eliminating the profit 
and loss statement. But, unfortunately, we have one; and it is 
going to change.
    This Economist article which I recommend strongly says we 
may be looking at ranges of values. We will not have an 
earnings per share that we can look at with precision. We may 
look at a place where different companies will make different 
assumptions as to what they did--the assumptions they used in 
coming to the concludes they came. It will be ambiguous. It 
will be of concern. But I think it is better the people 
understand the ambiguity rather than think it is not ambiguous.
    As I said before, there is no reason why an analyst today, 
a good one, can't look at the information in the financial 
papers and figure out in some fashion what he thinks the cost 
is of a company. Because, believe me, some companies abuse 
options enormously.
    Chairman Baker. Let me jump in. At this point, as opposed 
to taking the current methodology of a snapshot of a current 
corporation of a date certain with given facts that are in 
effect on that specific date, we really ought to have a motion 
picture analysis where you can take in variables of your 
choosing that you plug into a system that then quantifies your 
predictions about corporate performance in light of the 
conditions as you view them, interest rate risk, credit rate 
risk, customer satisfaction surveys. There is a whole array of 
things that tell you where the company is going as opposed to 
where it has been. That is the problem, is that the current 
system looks back and gives you an old snapshot. It doesn't 
tell where the corporate leadership is taking the company over 
the next few months.
    Mr. Hills. I think that is right, but you need a freeze 
frame once a year.
    Chairman Baker. But the issue is, on what do you base the 
freeze frame? Is it mark to market in current time? I think we 
have the technology today to get us to a mark to market on a 
daily basis.
    Mr. Hills. We are moving, as I said before, like it or not, 
inexorably toward market values rather than historic costs and 
trying to understand the values of corporations; and that is 
going to be a rocky road to get from one place to another.
    Mr. Kanjorski. Thank you, Mr. Chairman.
    Mr. Chairman, I find myself in a peculiar situation here on 
this side of the aisle. We are supposed to be the pragmatists 
and the liberals, and I find myself arguing for Edmund Burke's 
theory that you don't change it if it is not broken and you 
maintain something until it gives value.
    Here we have a long-term attempt to take professionals, 
create FASB, empower them to establish these rules and 
principles. We now have a process we are going to a global 
market looking for standardization and transparency so that 
securities can be traded world wide and we can have a view. And 
yet we are sitting here as the Congress second guessing and 
much inferior to the experts I may say at FASB or in the 
corporate world. We are imposing on a single basis whether or 
not we are going to expense one part of stock options or not 
expense it and worried a little bit about the impacts.
    Mr. Barrett, I have a great deal of respect for you and 
your company, but do you really believe that that $3 billion 
that doesn't show up, that the analyst and the people that are 
making that evaluation, if we change this rule and you had to 
expense that $3 billion in stock options that would appear on 
your sheet, suddenly wouldn't be explainable and understandable 
and that it would just have a tremendous effect at driving your 
stock value down on the market?
    The reason I pose that question to you, if that is the 
case, then Mr. Glassman and others that have testified aren't 
correct that people are paying any attention to the profit and 
loss statements. You already show that information in one 
place. Now it is going to move to another place in the profit 
and loss to be reflected, and yet you seem not to have very 
much faith in the analytical community or the investor 
community if that is going to so impact on your individual 
stock.
    Mr. Barrett. As the CEO of a company, I can't say I have no 
faith in the investor community. The analyst community is a 
different topic.
    Mr. Kanjorski. Touche.
    Mr. Barrett. My comment was merely that Mr. Sarbanes was 
here earlier. I do get to certify my results every quarter, 
transparent to the investor community, et cetera, et cetera. I 
would suggest that $3 billion is big enough to be noticeable in 
a certification process. It is big enough to be noticeable by 
an investor. It is big enough to swing the tide. If that is an 
error, then everything I do for Sarbanes-Oxley is trivial. I 
worry about $1 million and $10 million issues on the financial 
statement.
    Mr. Kanjorski. Mr. Barrett, I understand that. But I think 
Mr. Hills' point is that we are getting so raptured in 
absoluteness in accounting when, in fact, it is just another 
way of getting a snapshot. The problem I am worried about is 
now corporate America that has been using these stock options 
are coming for a release or a protection to the Congress of the 
United States, and we are going to start establishing this 
precedent that every element of our corporate structures that 
get impacted in some negative way by accounting rules proposed 
by FASB in the future, they don't have to worry about that. 
They just turn it into a political issue. Come on up here to 
the Congress, probably no greater informed than the average 
investor in America.
    And I don't have a great deal of respect for that standard 
of--in spite of your feeling, Jim, that they are so well 
informed, do you really want us up here to turn this into 
periodic political issues as to what we do with expensing? It 
isn't very sexy. It isn't very attractive. And you are going to 
be dealing with people making these decisions on an ad hoc 
basis that could be very dangerous for corporate America, for 
the accounting profession and what it represents to get any 
insight on reliability. You know, we are just going to be where 
the numbers are, where the administration feels we should come 
down.
    In this instance, so many of the respected people in our 
society seem to come out on the favor of doing the expensing. I 
mean, Paul Volcker is certainly equal in stature to Mr. 
Greenspan; and they are both in favor of expensing. And I think 
they make an adequate point. If corporate America can take a 
tax deduction based on the expense, why in the world can't it 
show it on its balance sheet? If I had my way, the statement 
would have to be identical to the tax statement so that we have 
reality there instead of these special provisions.
    Mr. Barrett. But you know that the tax laws are 
substantively different from the accounting laws across the 
board.
    Mr. Kanjorski. But why, Mr. Barrett? Because every time we 
have a tax bill on the Hill corporate America fills these halls 
with lobbyists who get their special provisions and their 
special ways. Now there is no rhyme or reason between what is 
good tax policy and what is reality in what should be taxed 
because everybody and their mother's uncle have a special 
provision up there.
    Mr. Barrett. Thirty years ago, Congress decided that it 
would be a tax-neutral event to tax stock options; and, 
therefore, they gave companies that depreciate a deduction 
associated with that.
    If I could give you one thought, though, with regard to 
your earlier comments.
    Chairman Baker. Let me interject, if I might, with a little 
bad news. Not to cut Mr. Kanjorski off, we are down to 5 
minutes on three votes. There are members who have expressed 
significant interest in coming back after the break for the 
votes. I don't know that each of you--of your schedules, but 
Mr. Volcker possibly could come back. If you are available, we 
would like to recess at this moment and return, and that way we 
can give adequate time for members to follow up on their 
questions. Is that appropriate?
    Mr. Kanjorski. Very high-priced talent here, but if they 
will remain.
    Chairman Baker. We leave it at their scheduled 
availability. We certainly understand if you cannot. But we 
will be gone about 20 minutes.
    We stand in recess.
    [recess.]
    Chairman Baker. If I may, I will call our subcommittee 
meeting back to order.
    To continue, Mr. Kanjorski was into his questioning; and we 
will put 2 minutes on the clock to pick up where you left off, 
if you would like to pick up.
    Mr. Kanjorski. I know it was a great question. I just can't 
remember it. It was the issue on--Mr. Volcker pointed out if 
the corporation can take the tax deduction, obviously that 
requires a calculation of what the value is. Why can't we just 
disclose it on the form? Why shouldn't we have parity in those 
two things? I will throw it out to the committee as a whole.
    Mr. Barrett. Well, are we trying to align accounting 
principles with Tax Code? I mean, it is my understanding that 
30 years ago when Congress decided that options were taxable 
income they assigned some value to them, they did a tax-neutral 
assessment and allowed the corporations to take a deduction.
    Mr. Kanjorski. Right. The point I guess I want to make is, 
if you asked, in my opinion, 100 common people walking the 
street, most people would assume that, whatever your report is, 
a profit as a corporation is also taxed as a profit. They don't 
understand the double or triple accounting of tax difference.
    I have to tell you something. We went over to vote--I am 
not going to name the Members, but several Members were 
relatively shocked when they found out--you mean they are not 
paying taxes on these options? Or they are not--or they have 
given a tax deduction on these options when in fact they are 
not reported on the sheet?
    So don't overestimate the knowledge of the Congress or the 
American people. Most of us would like to think simplistically 
of how things are going, and every day we spend here in 
Congress we get more confused.
    Mr. Barrett. I get more confused every day I read the Tax 
Code.
    Mr. Kanjorski. Do you have any suggestion on Mr. Volcker's 
idea that if we are going to use it for tax deduction it should 
be able to be reported?
    Mr. Hills. Well, I have to say, in fairness, the Tax Code 
is a different bargain than the accounting rules. So I don't 
think you can insist upon consistency since there is a 
hobgoblin of inconsistency. So it is a good argument, but I 
would rather rely upon the fact that we do have GAAP with all 
of its weakness.
    We do have a profit and loss statement, whether we should 
or should not. We do have a requirement of an audited 
statement. People can argue about all of those things, but we 
do have them, and so we should make them as good as we can make 
them. I say soldier on.
    I must say I think this hearing and the airing of this 
subject is terribly important, and I do think that Congress 
should not be unaware of it. I can imagine that there are times 
when Congress needs to step in. I think it is premature now. I 
don't think the hearing is premature. But it is going to be 
another year, perhaps, or more before it moves.
    We will know a lot more about this subject when FASB sends 
out its pronouncements, and I think we will all be comforted by 
the period that this is happening. I truly believe that Intel 
will be able to have the same option program it had today, even 
if FASB finds a way to require that options be valued in some 
fashion for purposes of earnings per share.
    Mr. Glassman. Mr. Kanjorski, I associate myself with Mr. 
Hills' remarks. Not the last one about the option program. I 
think Mr. Barrett is the best expert on that.
    But can I comment on something you said earlier about 
Edmond Burke and not kind of changing things just to change 
them? If we accept your argument, which is that there is enough 
information out now or that the information today if it is 
sufficient is not going to change the value of the company if 
expenses--if options are mandatorily expensed, that seems to me 
just as good an argument for keeping the current regime. So I 
think Edmond Burke would probably say, well, we have had it for 
30 years. Why not continue it? Why make the change if the 
information is currently on the table?
    Mr. Kanjorski. I guess the argument to that is, then why 
have FASB and why have an attempt to go to international 
accounting? And then basically what--I just think, Mr. 
Glassman, what you are doing is you are telling the Congress 
that we are the final arbiters of all these individual rules 
and regulations on how we do things. And we like to think that 
of ourselves, but then you are talking about the whim and fancy 
of Congress as it changes every 2 years. I am not sure we are 
going to get the standardization. I am not sure we are going to 
get to some certainty, not numbers certainty but at least form 
and process certainty.
    Mr. Glassman. One last comment. I absolutely respect that 
position, Mr. Kanjorski, but I think that this is clearly an 
issue that for good reason has disturbed a very important 
sector of the U.S. economy. I mean, I think we need--I have I 
think--just as you respect the idea that you don't intervene in 
every last little accounting issue, I also respect the fact 
that the engine behind this economy over the last 10 or 20 
years really has been high technology; and high technology 
firms are very strongly opposed to this. And I think that 
they--among others. And I think we need to--you need to examine 
it for that reason. And you are examining it today, and I 
congratulate you.
    Chairman Baker. Mr. Ose.
    Mr. Ose. Thank you, Mr. Chairman.
    I am amused by the thought when Chairman Volcker was here--
when Chairman Greenspan comes, the traders all hinge on 
everyone's remarks. I am amused by some poor trader in the 
options pit trying to follow this discussion today, pro or con, 
and what their reaction is.
    One of the reasons I am a capitalist is that I enjoy 
immensely the dynamic nature of the economy. I think the issue 
that I would like to explore is, when we talk about American 
standards of corporate transparency relative to reporting this 
or that on the financial statements of American corporations, 
relative to perhaps the standards in the International 
Accounting Standards Board which, correct me if I am wrong, is 
largely focused more towards the European-type of corporation, 
we end up missing where most of the growth seems to be 
occurring now in the world economy and that is around the 
Pacific Rim.
    One of the tools that our corporate leaders use to attract 
talent, obviously, is compensation in one form or another. I 
would be curious particularly of Mr. Barrett's input as to, as 
America's leading-edge corporate entities compete for talent in 
the world economy, what is the value or use of options? And if 
we depreciate that value by whim or fancy of Congress what the 
impact of that will be.
    Mr. Barrett. I think you can get the right vector, the 
right direction if you look at just what has happened in the 
last 10 years.
    First, if you look at Taiwan, with the growth of the high-
tech community in Taiwan which basically grew at the expense of 
U.S. firms because it was basically hiring U.S. workers back to 
Taiwan with options and start-up companies, you then just 
follow that point in time to what has happened in mainland 
China, what is happening in India. Mainland China, it is more 
in the manufacturing side; and in India it is more in the 
software side.
    If you look at both of those countries or all three of 
those geographic areas building up, you look at the fact that 
the U.S. educational institution is still the best in the world 
at creating highly educated technical personnel. Roughly half 
of the Ph.D.s that graduate in the physical sciences in the 
U.S. are foreign nationals. They are increasingly going home. 
They are not staying here. And if you put U.S. corporations at 
a structural disadvantage I think you will just accelerate 
that.
    That is where the action is in the future. The action is 
not in western Europe. The action is in Asia. You take Intel as 
the proxy. Asia Pacific, excluding Japan, is our biggest 
marketplace today, bigger than western Europe, bigger than the 
United States and growing much faster than either.
    Mr. Ose. Are you suggesting that, to use Mr. Kanjorski's 
phrase, the whim and fancy of Congress may lead to unintended 
consequences of exporting of these high-tech jobs to an even 
greater degree than perhaps might be occurring today?
    Mr. Barrett. I think that is the potential danger, yes.
    Mr. Ose. Thank you, Mr. Chairman.
    Chairman Baker. Mr. Sherman.
    Mr. Sherman. I have so many comments I would be asking 
folks to respond in writing to some of the questions that I 
raise here.
    The first point some of you have talked about, principles 
based rather than rules based accounting, please don't do it. 
Don't move in that direction. Investors need solid information 
they can rely upon.
    Imagine if we had rules for determining, okay, how much 
will an appropriations bill cost. We could possibly agree on 
something that narrow. But if instead we wanted to apply the 
big principle of is it a fiscally responsible appropriations 
bill, I suggest you and I might disagree.
    Imagine if the Chair of the Appropriations Committee could 
hire me to opine on the fiscal responsibility of his 
appropriations bill. I do think, though, that you could ask for 
three or four different pro formas, each prepared with strict 
standards.
    Keep in mind that these auditors are selected by and paid 
by the company, just as we wouldn't have the Chair of the 
Appropriations Subcommittee selecting who is going to opine on 
the fiscal responsibility of his or her bill.
    Chairman Volcker raises an interesting issue, and that is 
that the present system wildly distorts our executive 
compensation system.
    Imagine if you had a cash-strapped company that was trying 
to provide incentives for its workers and managers. That 
company might set aside a million shares to be given as bonus 
shares. Top management might get the shares not based on 
whether the stock price goes up but whether it goes up compared 
to an index of companies in the same industry.
    Because good management doesn't just ride the wave, good 
management outperforms the wave. You might give the division 
head bonus shares based upon the success of his or her 
division. You might give employee shares based on that 
employee's department. But if you did any of those things you 
would be using shares to compensate employees in a logical way. 
You get penalized by GAAP because, as I understand it, correct 
me if I am wrong, all of those methods would be expensed 
because you are giving shares to employees based on something 
other than the plain vanilla stock option plan.
    Another company in the staple industry decides, oh, we are 
just going to have stock options for everybody. So some 
division head realizes that the success of his or her division 
slightly influences the company, provides some incentive.
    Now I don't know which of these two systems is the better 
way to compensate executives or employees, but you do know that 
companies should decide that, without GAAP telling them, that 
they are going to be tremendously penalized if they choose 
anything other than stock options.
    On the other hand, the Black-Sholes formula charging income 
when the options are granted seems pretty distortive. If you 
bring in an executive and say, Jack, you are doing a good job, 
here is a 3-year contract, and we are going to give you a 
raise, the cost of that compensation is charged over the 3 
future years in which that executive works. But if you call him 
in and say, you are doing a great job, here's a 3-year 
contract, we are not going to give you a raise, we are going to 
give you options, then under Black-Sholes you charge income the 
year you give the person the raise rather than the 3 years that 
that person is going to work presumably for the company's 
benefit. Do I have that right?
    Mr. Volcker. I should not pose as an expert in this area, 
but my understanding is that what the international body 
suggested in their exposure draft--they haven't decided yet--is 
that you would amortize.
    Mr. Sherman. That you amortize it over a length of time.
    Mr. Volcker. Right.
    Mr. Sherman. I have been told something else. But clearly 
if you have a stock option designed to provide an incentive 
over the period of time when the employee holds that option, 
that the cost is amortized over the period of time and that 
would eliminate that concern.
    I agree with several panelists that nothing we do on this 
stock option would have solved the Enron or the corruption 
thing. Managers are always going to have it in their interest 
to overreport earnings, and the corrupt ones will do that 
unless the auditors prevent them from doing it. The idea if 
they didn't have stock options they wouldn't want to overreport 
earnings--there are so many reasons to want to overreport 
earnings.
    I will ask, starting with Chairman Volcker, if you have any 
comments to the----
    Mr. Volcker. I don't fully agree with you on your last 
point. I fully agree that there are the lot of reasons that go 
into corruption or fraud or pressing the envelope too far, but 
I am afraid that we do see some evidence that the nature of 
fixed price stock options creates a temptation that adds to 
other incentives they might have.
    Let me quote, if I may----
    Mr. Sherman. If we didn't pay our managers so much, then 
maybe they wouldn't have as much incentive. But can you think 
of any way of rewarding managers for success of a company that 
wouldn't cause them to seek to distort any measure of the 
success of the company?
    Mr. Volcker. You, I think, have a problem. I think some 
methods are more vulnerable than other methods. There is 
tremendous leverage in a stock option.
    So let me just read, if I may, a comment which I found 
interesting. It was by a dean of a business school who formerly 
was a strong advocate of stock options. He said, ``mea culpa. 
You know, it was a simple idea. We compensate managers with 
company stock or options so they will do the best for the 
shareholders. It doesn't always work that way. Motivating 
managers with company stock can damage on a grand scale, 
encouraging them to pursue strategies to fatten their wallets 
at the shareholders' expense. Consider the trajectories of 
Enron and its ilk as well as a host of dot coms, companies 
devastated by managers motivated by powerful stock-based 
incentives.''
    Mr. Sherman. I understand you can find people wailing and 
bemoaning stock options and doing it in good prose. But is 
there any way to provide large incentive payments to managers 
based on a measure of their performance that would not be 
subject to--would not provide an incentive to managers?
    Chairman Baker. That will be the gentleman's last question.
    Mr. Volcker. Are there any that are perfectly----
    Mr. Sherman. Or even less likely than stock options.
    Mr. Volcker. Restricted stock which you have to hold for 
some time, taking the ups and down of the stock and hold it for 
a considerable period of time beyond the vesting period. That 
has a quite different incentive. Even stock options, if you 
were required to hold them for, let's say, your whole period of 
employment, would reduce the incentive you have to do short-
range manipulation.
    So it is the matter of degree. It is not----
    Chairman Baker. The gentleman's time has expired.
    Mr. Chairman.
    Mr. Oxley. Thank you, Mr. Chairman; and let me welcome this 
outstanding, all-star panel. I made a special effort to get 
back because I did want to, first of all, welcome you and, many 
of you, welcome back. We have some veterans here who have 
testified before this committee more than once. But we are 
delighted to have all of you here and to have your knowledge 
and participation.
    Mr. Volcker, fixed-price options are an exceedingly popular 
way of providing compensation. Why haven't more companies used 
performance-based options in that respect?
    Mr. Volcker. Well, I think one reason--I will give you two 
reasons. One reason is that the performance based options, I 
think it is an anomaly, are expensed. So if you are worried 
about how your immediate impact is going to be on the earnings 
statement, you are biased towards fixed-price options.
    I once was the director of a company that had performance-
based options, and I think it was an appropriate way to do it, 
but it does get into a lot of arguments about exactly how you 
measure performance. Do you do better than your competitor's 
stock price? Do you set some hurdle rate for return on capital?
    Mr. Volcker. Do you have a price-earnings ratio?
    There are a lot of different measures you can take, but I 
know we spent a lot of time arguing about it. So it is more 
complicated, but it makes I think, by and large, on the face of 
it more sense than a fixed-price option, which demonstrably has 
capricious results, because it is so affected by the total 
change in the stock market rather than the performance of an 
individual company.
    You know, American managers suddenly didn't become geniuses 
in the 1990s compared to where they were in the 1980s. At 
least, they weren't six times more genius, but that is when the 
stock market went up. Then it goes down by 50 percent. I don't 
think they are all stupid. So you get very capricious results. 
It has got quite a lot of resemblance to giving a lottery 
ticket, because so much of the result is not dependent upon the 
performance of the particular company.
    Mr. Oxley. Mr. Barrett, do you have a comment on that?
    Mr. Barrett. I think I would echo some of Mr. Volcker's 
comments. It is complicated to decide exactly what metrics you 
would choose, and you get capricious results on either side. 
The market can go up or down without you, and should you be 
benefited by that or disciplined by that is always the 
question.
    We have adopted a fixed-price option. It is relatively 
simple and straightforward. If the shareholders benefit, then 
they only benefit when the price goes up. Then presumably you 
are doing a good job for your shareholders, not perfect but 
very simple and straightforward.
    Mr. Oxley. Mr. Hills.
    Mr. Hills. Devising a compensation policy for any company 
is a marvelous task. Cash, stock options, deferred 
compensation, retirement benefits, health plan, it is a 
complicated transaction. A lot of it should be based upon 
performance.
    Personally, in the various boards on which I have sat, we 
have always had performance-based stock and some performance-
based options. We found performance-based stock is probably a 
little easier to work with, is less volatile, but, as Chairman 
Volcker said, the decision to use these things is controlled by 
GAAP policy more than it is by common sense.
    Mr. Oxley. Interesting.
    Mr. Glassman.
    Mr. Glassman. The use of stock options, it seems to me, is 
the purest way to align the interests of management with those 
of shareholders. The price of a stock is the best manifestation 
of a company's value. It is better than any kind of 
performance-based measure because millions of people are voting 
on what the value is every day. It is not perfect. Absolutely. 
But it really is the best.
    So if you want to align the interest of managers and 
shareholders, which is what companies want to do and should 
want to do and which was not done, by the way, to a great 
extent in the 1970s--we got into trouble for that--the best way 
to do it is through stock options. And frankly, obviously, 
there are some risks to be run there, the temptation to 
manipulate in some way the stock, but I don't think there is 
any way to avoid that unless you bar managers from owning stock 
period, and that wouldn't be a very good idea.
    Mr. Hills. Let me comment, Jim.
    The best way to align the shareholders' interest of 
management is with stock, not stock options. You find 
yourself--I found myself more than once in a situation where 
you have to make a decision on a board or on a company, and if 
that decision means you have nothing, which is what happens if 
the stock goes along a certain point, that affects your 
decision, as distinguished from the stock goes down a buck. If 
the stock goes down a buck, you may have lost 50 bucks. If the 
stock goes down a buck, you may have lost all your options. So 
I would say to you that the best way to align stockholders and 
managers is with stock.
    Mr. Oxley. What about that, Mr. Glassman?
    Mr. Glassman. I think stock is a good way to align the 
interests of stockholders and managers. There is a very 
interesting paper on the differences between the two which I 
cite in my testimony and I am happy to introduce as an exhibit.
    I do think, however, that options in some ways because of 
their leverage, because the increases are so dramatic, that 
makes it a much more important incentive for managers. I think 
options are a very good way to do it, frankly, rather than 
awarding stock.
    Mr. Oxley. Mr. Volcker.
    Mr. Volcker. It is--just an obvious problem with a fixed-
price stock option is you gain when the leverage goes in your 
direction; you don't lose when it goes in the other direction. 
That is a silly kind of incentive, frankly, for any manager. 
You can get a fixed-price stock option, and compare to the 
performance of the stock of a company that did no better than 
the interest on a government bond in the 1990s, you make a lot 
of money. Now, is that a great incentive? I mean, you took no 
risk of loss, and you made a lot of money when the shareholder 
would have been better off buying a government bond.
    Mr. Glassman. I would say, Mr. Volcker, that if your 
compensation as a CEO is 50 percent or 30 percent or some large 
number tied up in stock options, that if those options become 
worthless that is a big hit to you.
    Mr. Barrett. Could I offer one comment?
    Mr. Oxley. Yes, Mr. Barrett.
    Mr. Barrett. I read an interesting summary by the proponent 
of expensing stock options who alluded that there would be 
immense innovation in the field of executive compensation 
associated with this whole movement. I was dismayed by that for 
the following reason. The way companies are successful is we 
have innovation in products and services and we compete in the 
world's marketplace. If all we get out of this is a discussion 
on innovation and compensation strategy, I think we will have 
collectively lost.
    Mr. Oxley. Mr. Chairman, my time is expired. Let me once 
again thank our distinguished panel. This has been a most 
interesting day--I think the Chair will agree--and one of our 
better hearings that we have had because of the quality of 
witnesses that we have had. I yield back.
    Chairman Baker. Absolutely. Thank you, Mr. Chairman.
    Mr. Shadegg.
    Mr. Shadegg. Thank you, Mr. Chairman.
    Let me start out with what I think are some points of 
agreement, and if I am incorrect, please let me know. Let me 
start out with a premise that I think all of you are agreed 
that stock options are not the cause--were not the cause of the 
Enron WorldCom scandals with which we were faced a year ago and 
that this committee dealt with. We all agree that they are not 
the cause?
    Mr. Volcker. Sorry. I don't agree with that. I think they 
were probably a contributing factor.
    Mr. Shadegg. Okay.
    Mr. Hills. I would say that it is a contributing factor. 
Certainly not the dominant factor. In many of the scandals it 
was a contributing factor.
    Mr. Shadegg. Let me try one that I think you will agree 
with. I believe we all agreed, particularly, Mr. Volcker, you 
and Mr. Hills agreed that there were bigger problems facing us 
in terms of corporate accounting than in terms of the stock 
option issue. Is that correct?
    Mr. Barrett. Yes. I think all three of us--or four of us 
might agree on that topic.
    Mr. Shadegg. Yeah. I think we all agreed on that, but 
particularly the other two.
    I think there was agreement that valuing is difficult and 
imprecise, and I think both Mr. Volcker and Mr. Hills would 
agree with that, even though Mr. Barrett and Mr. Glassman are 
stronger critics of the ability to value stock. Is that right?
    I think we also have agreed that broad-based stock 
options--and here it is particularly Mr. Barrett and Mr. 
Glassman have said broad-based stock options are a good vehicle 
to give employees ownership in a corporation, to give them a 
sense of ownership, to tie them to the company, but I think 
there is all agreement across the board that broad-based stock 
options have a value in incenting employees and making them a 
part of the company.
    Mr. Volcker. I agree with that, but I don't know if they 
can do it more effectively than giving them stock or a 
performance option.
    Mr. Hills. I must also say it is company specific. It is 
quite true of a wide range of companies that broad based is 
terrific, but there are a whole lot of questions that it 
doesn't make any sense at all.
    Mr. Shadegg. Mr. Glassman made the point and Mr. Barrett 
that they are very important in incentivizing particularly in 
the high-tech field but generally across the board, and I 
didn't find a disagreement with that amongst the other two 
witnesses.
    I think there also is agreement across the board that 
narrow stock options limited just to top management can in fact 
distort corporate conduct and hurt the overall interest of the 
corporation. Are we pretty much agreed on that?
    Go ahead, Mr. Barrett.
    Mr. Barrett. We continue to get into this corrupt actions 
by senior executives. It is not clear to me always that stock 
drives that one way or the other. There are certain rules of 
conduct we all ought to be obeying if we are CEOs. If we obey 
those rules of conduct, we don't trade on insider information, 
we don't do things untoward to the P/L, then I don't see an 
issue. But if people want to be criminals, they will be 
criminals.
    Mr. Shadegg. I agree with that.
    The point I thought there was agreement on is that a narrow 
stock option could in fact distort the conduct of some 
corporate executives even when it is not illegal, causing them 
to highlight temporary profits for their personal gain. I guess 
I will concede to you that that leads me to the conclusion that 
expensing looks like a solution in search of a problem.
    I guess I want to ask you, Mr. Hills, if we are agreed that 
any particular valuation method will in fact be somewhat 
accurate, a point more strongly held by two of your panelists 
than by you. Why isn't it better off to simply rely on the 
current disclosure mechanism and allow competing mechanisms for 
valuating those stock options in the marketplace rather than 
prescribing a single one which will have whatever inherent 
defects that particular method for valuating them is?
    Mr. Hills. I would say two things. First, it is not that it 
is inaccurate. It is that it has a lack of--it has an area of 
imprecision, no greater, as Mr. Herz said, than other things in 
the P/L statement. There are imprecisions in many parts of the 
profit and loss statement. Imprecision in cost recognition, for 
example, dwarfs any imprecision you get in the cost of a stock 
option.
    Mr. Shadegg. So aren't we just shifting the imprecision 
created by the current footnote structure where you gather a 
certain amount of information and all of the observers of the 
market can look at that footnote information and make their 
valuation of what those options do to the corporation's actual 
profit and loss position versus a prescribed method where we 
say, okay, this is the way you will valuate these stock 
options. And now we have prescribed one error. All we have done 
is shift the imprecision, I would argue, from one place to the 
other. But the unsophisticated now believe, well, this is the 
right answer because government, FASB in this case, mandated 
it.
    Mr. Hills. This is a good argument for not having an 
earnings per share conclusion. But if you have an earnings per 
share conclusion, there are things that ought to be in it. Cost 
recognition ought to be in it. Cost earnings options should be 
in it. There may be, as I indicated from The Economist article, 
a range of assumptions that may be chosen differently by one 
company from the other, so there will be flexibility left 
hopefully in doing it, but imprecision has never been a reason 
for not putting something in earnings per share.
    Mr. Shadegg. I guess the second question I have is, doesn't 
your argument against precision accounting, which I thought was 
a fascinating argument, auger against expensing stock options 
and having the FASB prescribe the method in which they will be 
valued?
    Chairman Baker. If I may, let that be your last question so 
I can get in one more gentleman in before Mr. Volcker has to 
leave. And to whom was that addressed?
    Mr. Shadegg. Mr. Hills.
    Mr. Hills. My answer is that, first of all, I am not 
against precision. I just can't find it.
    Mr. Shadegg. But if we can't find it now, are we going to 
find it any better with FASB prescribing expensing and how?
    Mr. Hills. There is a degree of inexactitude in accounting 
and the trick here----
    Mr. Shadegg. I thought you made that point compellingly.
    Mr. Hills. And the trick here is to do as good a job as you 
can for only one measure of the value of the company. One of 
the problems here is our analysts aren't trained enough to look 
at other values. Earnings per share ought not to be the 
controlling factor it is in valuing stocks.
    Chairman Baker. Thank you, Mr. Shadegg.
    I am understanding you to say that we have that snapshot 
once a year, but it may be kind of fuzzy when we look at it?
    Mr. Hills. Yes. You need glasses.
    Chairman Baker. Thank you.
    Mr. Shays.
    Mr. Shays. Thank you.
    I am sorry you gentlemen had to wait so long and then we 
had to have the break. I have been here 16 years, but I feel 
like you all know more on this issue in your pinky than I know 
on my entire body, but maybe that is why we have witnesses. But 
I can react to what you are saying, and some of it to me is 
just on the face of it somewhat hard for me to come to grips 
with.
    I mean, Mr. Glassman, when you talked about FASB rushing 
into a decision, I think they act slower than a turtle. You 
know, I don't feel there is a rush to a decision. I feel like 
this has been an issue that we have been debating for years, 
and they are finally doing what they should have done a while 
ago. So I am just reacting to that and would love to hear your 
comment of why it is a rush.
    I feel--and I am looking for reaction. I am asking myself, 
is the question we don't want investors to know the truth or is 
it we want them to know the truth, we just don't know what the 
truth is? But somehow we know how to tell people when we 
expense it it has value, and somehow we think--and I am 
reacting again to you, Mr. Glassman--that we say, you know, 
investors are smart. They read the fine print.
    Well, a lot of investors don't read the fine print. They 
don't read anything. They just invest. And maybe that is their 
problem, but it seems to me that if investors are smart enough 
to read the fine print, they are smart enough to recognize that 
the company may not have the same value on the marketplace for 
some dumb reason, because all of a sudden they have to expense 
it. And it would seem to me they would say, well, part of the 
reason why they are valued this way is they had to expense it. 
But to me it is--I mean, disclose that.
    But to me as an investor, I would say, hey, this is 
undervalued stock. Now, maybe I am just all screwed up here, 
but I would like comments.
    I would also like comments on the other issue. It used to 
be we took the lead and the ISAB followed. It seems to me 
because we have not seized the initiative the ISAB may be 
taking the initiative. If they then decide that this has to be 
an expensed item and we don't, what challenges are involved 
with that?
    So I mentioned Mr. Glassman's name more than once. Why 
don't you start?
    Mr. Glassman. Thank you, Mr. Shays.
    The reason I use the word ``rush'' is certainly FASB has 
taken a long time to get to this issue, but I think under new 
management it seems to be moving very, very quickly and I think 
too quickly, but that is a matter of judgment. Mr. Herz said 
that there are people--why is it moving quickly? Because people 
are not--groups are not only supporting but demanding some kind 
of action.
    On this fine print--and I think that is a very important 
question. First of all, it is not fine print. The print is as 
big as it is for the P/L statement. So it is not fine, but it 
actually provides fine information, important information. 
About half of Americans own shares through mutual funds and 
other institutions, and I would hope and I know that the 
managers of those institutions in fact do read the footnotes. 
And if they don't, they shouldn't be in their jobs, and they 
certainly do. So that information is there.
    The point I was trying to make in my testimony--and it is 
not, as Rod Hills said, that I don't believe in P/L statements. 
It is just that----
    Mr. Shays. It was a funny comment, and you didn't laugh.
    Mr. Glassman. You are right. I didn't laugh, because I 
think----
    Mr. Shays. That was the high point of the whole damn 
hearing, frankly.
    Mr. Glassman. Well, now I am going to provide you with 
another high point. It is not that I don't believe in P/L 
statements. I think they are very, very important, but I think 
they are only one way of valuing a company.
    Let me quote the sainted Warren Buffett, not on public 
policy but on something that he really knows a lot about, which 
is investing. He says, how do you value a company? You just 
want to estimate a company's cash flows--notice he says cash 
flows. He doesn't say earnings or P/L statement--cash flows 
over time, discount them back and buy for less than that.
    Mr. Shays. See, I think he told you that so you would make 
bad investments and he could keep making good ones.
    Mr. Glassman. That is true, but I own his stock. So the 
point is cash flow is tremendously important.
    I think we are headed for a revolution, and the Chairman 
recognizes it. He mentioned XBRL. Things are changing in 
accounting, and I think we are fighting the last war in talking 
about expensing. It is like this is a Crimean War, okay. What 
is happening more and more--and I wish FASB and the Congress 
and the SEC would start promoting this kind of thinking. We 
need more--there is tons of information out there that is okay. 
They use it every day. I think investors should have more 
access to it, and I actually believe that the current regime 
with the footnotes and all that stuff actually promotes that 
kind of thinking much more than trying to shoehorn a single 
number into a GAAP statement which doesn't tell you all that 
much about a company.
    Mr. Barrett. I think you have got a good representation of 
this just this last quarter. One of the 280 companies who have 
said or actually do expense options, Amazon.com, reported their 
quarterly earns. They did it precisely with a GAAP P/L and a 
pro forma P/L. Nobody paid attention to the GAAP P/L. They only 
paid attention to the pro forma P/L. What you are going to see 
is precisely that replicated across the board, and frankly I 
thought what we were trying to do was harmonize all this stuff 
so we would get away from pro forma P/L's.
    But in this instance, which I think is representative of 
what is going to happen, people went back--you can shake your 
head, Paul, but this is what they did. They went back and 
looked precisely at the cash flow of that company. They didn't 
look at some arbitrary expense.
    Mr. Shays. Home Depot and Wal-Mart now have spent----
    Mr. Volcker. I am not shaking my head about what they do. I 
think you will find----
    Mr. Shays. Well, let me just make this point before you 
start. Home Depot and Wal-Mart now expense, and has that proved 
to be a negative for them?
    Mr. Barrett. I think if you look at most of the companies 
that expense options, it is a de minimus impact on their P/L. 
They only give options to the top executives of the company. 
They don't have broad-based option programs. If Intel----
    Mr. Shays. Yeah. It is broad based.
    Let me just have Paul just respond if I could. You were 
going to say something, Paul, and I----
    Mr. Volcker. I was going to say, on this pro forma thing, 
this has become a big problem, because companies do present pro 
forma earnings the way they like to present them, which means 
there is no consistency. I would be very disappointed if the 
accounting standards setters do not in the next few years 
promote a standard for a standard pro forma statement that they 
will make a judgment about what should be on the pro forma and 
what should not be on the pro forma, what should be on an 
operating earnings statement to get some consistency. Because 
if you just leave it in a jungle, so to speak, you do get below 
the lines the stuff they don't want to report, and the stuff 
above the lines is good stuff.
    Mr. Hills. Mr. Chairman, would you excuse me? I promised to 
give a lesson to 12 Russians on corporate governance at 
American University, and I really----
    Chairman Baker. I think this effort has been more 
challenging than your task. Let me express appreciation.
    Mr. Sherman wanted to make a brief statement. Please leave 
at your leisure.
    Mr. Sherman. Thank you, Mr. Chairman.
    I want to agree with Mr. Volcker that we need standardized 
rules for the pro forma statements. If they are going to serve 
chocolate, vanilla and strawberry, there ought to be a fixed 
recipe for each one of those three ice creams.
    I think the arguments against expensing options may go too 
far. You have said that we have to compete with Asia for 
capital and for talent, and anything that impairs that effort 
puts us at a disadvantage. I want to point out that maybe 
compensation for managers is a good thing, and we want to 
encourage it. And we want to make companies that compensate 
their managers look good compared to Asian investments, but if 
we are going to do that, wouldn't we do the same thing for 
employee education programs? Wouldn't we do the same thing for 
research and development programs?
    If you buy that argument, then maybe it is critical that we 
as a Congress instruct FASB to say that employee education and 
research programs and maybe all management compensation of all 
types ought not be charged against income, since we want to 
encourage those things or some of them and we want to make our 
companies that do them look good compared to their Asian 
competitors.
    There is this argument that option holders and stockholders 
have identical interests. I think those interests are wildly 
different when it comes to risk. If I am a stockholder and I 
see one policy gives me a chance at the stock going up 10 
percent or maybe it will go down 10 percent, that might be a 
good plan. But if I am an option holder, I would much prefer a 
company that has a chance to either double in value or go 
bankrupt, because whether it goes down 10 percent or goes down 
a hundred percent, I am in the same position.
    Executives, however, are both salary earners, where they 
are going to want a low-risk approach so they keep getting 
their salary, and they are option holders, where they are going 
to want a high-risk approach. When an executive becomes 
primarily not a salary earner but an option holder, you have a 
strong incentive for a high-risk approach.
    Chairman Baker. Can the gentleman wind up? I have got 
somebody else that wants to make a statement before we leave.
    Mr. Sherman. And that concludes my remarks.
    Chairman Baker. I thank the gentleman for wrapping up.
    Mr. Ose.
    Mr. Ose. Thank you, Mr. Chairman.
    I want to express my appreciation to one of our witnesses 
here. When I was a much younger man, I came out of college, 
went in the real estate business, and shortly thereafter was 
confronted with an inflationary environment that was, to say 
the least, challenging. Mr. Volcker played a central role in 
bringing that bear under control. If no one else ever says 
thank you, I intend to today. Thank you for doing that.
    Chairman Baker. If there are no further comments, I just 
want to express my appreciation to you for your time and your 
willingness to stay with us today. It has really been most 
informative. We look forward to FASB's conclusion of their work 
product, but I think this marks a beginning of our long-term 
review of the appropriateness of current accounting regimes and 
not to get into the professional aspects but to the goals of 
our accounting methodology, to assist in all shareholders and 
those who have interest in a transparent, free flow of 
information that benefits the growth of our economy. Thank you 
for your participation.
    Our meeting is adjourned.
    [Whereupon, at 2:37 p.m., the subcommittee was adjourned.]




                            A P P E N D I X



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