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CORPORATE ACCOUNTING PRACTICES:
IS THERE A CREDIBILITY GAAP?
TUESDAY, MAY 14, 2002
U.S. House of Representatives,
Subcommittee on Capital Markets, Insurance,
and Government Sponsored Enterprises,
Committee on Financial Services,
Washington, DC.
The subcommittee met, pursuant to notice, at 2:05 p.m., in room 2128, Rayburn House Office Building, Hon. Richard H. Baker, [chairman of the subcommittee], presiding.
Present: Chairman Baker; Representatives Kanjorski, Gillmore, Castle, Royce, Lucas, Weldon, Hart, Sherman, and Lucas.
Chairman BAKER. I would like to call this hearing of the Capital Markets Subcommittee to order. This hearing today represents another step in the subcommittee's continuing effort to properly assess the reporting of corporate financial condition to the market.
It appears, in the aftermath of Enron, Global Crossing, and others, there is a need for the subcommittee and the Congress to carefully review all of the elements that bring about market discipline and to ensure that shareholders and investors are getting concise and accurate reports on the companies in which they are invested, or in which they are considering making such investment.
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Over the past few months, there have been many troubling revelations, and I wish to make it clear that I think our system by and large works very well, and that it is, in the aggregate, a system that is conducted by professional people trying to do a professional task. And it is unfortunate that the inappropriate conduct of so few has brought about such broad-based market dislocation. Nonetheless, it is our responsibility, I believe, to fairly assess where there may be inadequacies, and for the subcommittee to act appropriately based on the best counsel that we can receive.
I am pleased today to have the participants that we do have for our hearing. I think all of them will be very helpful in helping the subcommittee arrive at appropriate considerations and recommendations for future committee action.
At this time, I would recognize Mr. Kanjorski for any opening statement he might make.
Mr. KANJORSKI. Thank you. Mr. Chairman, I ask that my full remarks be made a part of the record.
Chairman BAKER. Without objection.
Mr. KANJORSKI. Mr. Chairman, I want to congratulate you, first, for having this hearing. I then want to address some of the things that have happened over the last 6 months, and their relationship to some of the groups involved in today's hearing.
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Certainly, Enron's collapse and at least some of the other recent earnings restatements that have occurred in corporate America over the last year, and which will continue for a short period in the future, are disturbing. More disappointing, from the standpoint of the world's wealthiest, freest economy, is that excess sometimes drives good, reasonable people to unacceptable extremes.
Even though I am a lawyer and I have gotten used to the legal profession being kicked around in my life, I have to say that I have great sympathy for the accounting profession. In a broad sweep, they seem to be being painted with the primary responsibility for Enron's collapse and these other weaknesses in our system. They have been burdened with our unwillingness as a society and as an economy to decide whether we are going to use principle-based or rule-based accounting systems. The excesses in our capitalistic system that have occurred over the last 8 or 10 years could have driven the weakest among us to steer away from our values or basic principles.
In terms of the accounting profession, they do not need a defender, but I will try to defend them a little bit. I hope that we as a committee, a Congress, and American people do not castigate the profession unduly, or fail to recognize the importance of the profession and their incredible contribution to the free economy of the United States over the years. It is only through their very professional activity that the economy of the United States has gotten to the point it is now, which is the greatest economy in the world.
There seems to be a problem with some management in corporations. There seems to be a problem of corporate governance in some corporations. There seems to be a problem with some accountants that work for some corporations. And as a lawyer, I have to say, there seems to be an awful lot of questions as to whether the legal profession has risen to the occasion.
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But I do distinguish in our society the difference between people that are in business to do things, and people in the professions to maintain standards. I hope that we do not discourage the future students of this country from entering the honorable profession of accounting because of what has occurred. The behavior of a few represents a very, very small portion of the accounting profession. Those accountants that I have had the pleasure of knowing over my lifetime and doing business with, I can say have acted with incredible ethics and proper conduct within the system. I want to make that point as a matter of record.
We have also had in this situation a merging of the question of what is a professional and what is a businessman. As I was coming back to the hearing today, I was thinking—not to further alienate another group—about investment bankers. I sort of thought: Maybe we could say that investment bankers are businessmen, and businessmen are to a large degree salesmen; these investment bankers are salesmen in Brooks Brothers suits.
But, there is a difference between them and a lawyer and an accountant. The latter are professionals. They really deal with such substance, and have had such high credibility, that even raising a question about them injures them and injures our society.
I think this hearing today can be very productive, and I think we should look into what new rules have to be put in place and what can be done to tighten the accounting system. The new economy is so significantly changed. We have moved from accounting for the production of screwdrivers, which was rather easy, to trying to figure out the value of derivatives, which is not easy. But we should not just find a target defendant, if you will, and castigate them because of some of the failures of this system. Instead, we should concentrate on the positive. What can we do for better governance? What can we do to make sure that management is more responsive to the marketplace and to the shareholders? What can we do to the professionals that step out of line? We should also ask whether or not the free market system or the profession can respond appropriately, or whether there is need for new rules and regulations?
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But, by no means should we run down this path with tremendous speed. I think the fear I have now is more that we can injure the system and have unintended consequences come out of our acts, than if we act deliberatively. We must study what has happened, and try and only be as responsive as absolutely necessary.
So I look forward to the very competent list of witnesses we have today to give us the proper map to follow on that course.
Thank you, Mr. Chairman.
[The prepared statement of Hon. Paul E. Kanjorski can be found on page 148 in the appendix.]
Chairman BAKER. Thank you, Mr. Kanjorski.
Mr. Lucas, or Ms. Hart, either one have an opening statement?
[No response.]
Chairman BAKER. Mr. Sherman.
Mr. SHERMAN. Thank you, Mr. Chairman. I regret, I think my statement will have a slightly different tone than that of my more senior, more learned, and more knowledgeable colleagues.
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I don't think that we can say all is going well, and we just had a problem with one company due to the moral failings of a few individuals, and now that those individuals are no longer making important national economic decisions, everything is fine. And I realize that is not what my colleagues have said, but to the extent anybody would exaggerate their comments to reach that conclusion, I would respond that instead, the markets don't think that way.
The market value of what is being traded on Wall Street has not just dropped by a few tens of billions of dollars representing the overstatement of the value of the stock of Enron, but rather our markets are selling for perhaps a trillion dollars less than they would be if, in virtually every company, but especially those that deal with derivatives or those that deal with energy—but across the board, people did not factor in as bigger than any terrorism risk, as big as perhaps a recession risk, an accounting risk.
In our first set of these hearings, we discovered—at least a USC accounting professor told us, and I am not blinded by my UCLA loyalties to the wisdom of that professor—that if only the Enron folks had dotted their i's and crossed their t's, perhaps any one of several different accounting firms would have blessed, correctly—or at least arguably correctly—what they did. If only they had put up a few additional millions of dollars to make sure that their special-purpose entities reached that glorious 3 percent independence level, then they would have been allowed to use those special-purpose entities for covering the billions of dollars of losses through the appearance of being insured against those losses by derivatives, and without the accounting system taking into account the fact that they had, in effect, insured the creditors of their insurer, and, in fact, had no insurance against the losses which they chose not to state; and this whole house of cards came tumbling down not because it was a phony house of cards that the accounting profession would never allow to stand, but just because it didn't meet those independence standards that could have been met for a few million dollars of additional capital.
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We have had a rules-based system and a principles-based system. The principles are always there. They don't need to change, but they are never enough. They weren't enough for Enron, they weren't enough for the accounting scandals of ten or 20 or 30 years ago. You, in addition, need rules, and the rules do have to change, because there are two accounting systems that we have in this country, and we can compare them. We have a tax accounting system and a financial accounting system.
The tax accounting system, we know we have to plug new loopholes every couple of years, because the tax lawyers come up with new loopholes every couple of years. And if we still had the 1939 code, we wouldn't be collecting any taxes at all, at least from more sophisticated taxpayers.
And we need to also plug loopholes in the accounting principles promulgated by the FASB. And I would hope that you are moving—and we have talked about this privately—very quickly—not precipitously, but very quickly—toward special rules dealing with derivatives, dealing with a company's own stock, and dealing with, especially derivatives on and dealing with the company's own stock.
I think the SEC and FASB have failed us to some extent up until now in allowing smart people to logically talk to other smart people in one of the most respected accounting firms in this country, and convince each other that they were in compliance with the rules. If only a few million dollars had been there, as they thought it had been—if only these SPEs had really been independent—when, in fact, the rules should have prohibited them from getting anywhere close to where they were.
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I would add that we also, perhaps, need to look at—and I brought this up in legislation, but I know that was just the first piece of legislation—the fact that the AICPA, in its governance of the ethics of accounting firms, allowed a situation where David Duncan was the final decisionmaker as to whether Arthur Andersen would sign an opinion, when, in fact, it ought to be the Quality Review or Technical Review department of any accounting firm that makes that decision.
So I do think we have some changes to make—SEC, FASB, AICPA—and that not only was there an Enron problem, but the market perceives a great risk, and I think correctly, that perhaps to a less than Enron extent we have problems with other companies being traded on the exchanges.
Thank you.
Chairman BAKER. Thank you, Mr. Sherman.
Mr. SHERMAN. Mr. Chairman, if I could also honor Mr. Jenkins in his last month of service with the FASB. It is my understanding that after many years of outstanding service, that he will be leaving.
Chairman BAKER. Absolutely. If there are no further opening statements, I would like to recognize our panelists.
We have with us today Mr. Robert K. Herdman, who is the Chief Accountant for the Securities and Exchange Commission, and appears before this subcommittee for the first time. Welcome, Mr. Herdman—second time? Welcome here. Glad to have you, sir. Your full testimony will be made a part of the record, but feel free to proceed as you choose.
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STATEMENT OF ROBERT K. HERDMAN, CHIEF ACCOUNTANT, SECURITIES AND EXCHANGE COMMISSION
Mr. HERDMAN. Thank you, Mr. Chairman. Chairman Baker, Ranking Member Kanjorski, and Members of the subcommittee, I am pleased to appear before you on behalf of the Securities and Exchange Commission to testify concerning the roles of the SEC and the Financial Accounting Standards Board in establishing generally accepted accounting principles, and questions that have arisen with respect to the relevancy of generally accepted accounting principles in today's business environment.
I know that all of the Members of this subcommittee have worked diligently over the past few months, and I would like to commend the leadership shown by you, Mr. Chairman and Ranking Member Kanjorski, as well as Chairman Oxley and Ranking Member LaFalce of the full committee, in exploring these important issues and working to maintain investor confidence. I would also like to add that the SEC has appreciated the opportunity to work with you and your staffs, and we look forward to continuing that cooperation.
Recent events and press articles have raised questions about the transparency of the accounting and disclosure practices of some companies. While our financial reporting system in the U.S. continues to be the best in the world, certain aspects of the system can and should be improved. In particular, the Commission believes that the process for setting financial accounting standards must be enhanced so that changes to accounting standards can be implemented more quickly, be more responsive to market changes, and provide more transparent information to investors.
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The SEC has a unique position in the financial reporting process. The Commission not only has authority under the securities laws of the United States to set accounting standards to be followed by public companies, but also the power to enforce those standards. Practically since its inception, the Commission has looked to the private sector for leadership in establishing and improving the accounting methods used to prepare financial statements. The body currently performing that function is the FASB.
With this context in mind, I would like to share with the subcommittee the SEC's insights into the standards-setting process, and the reforms needed to continue to support our capital markets. The SEC is on the front line of financial reporting by virtue of its day-to-day activities, and often is among the first to identify emerging issues and areas of accounting that need attention. On issues already identified, such as revenue recognition and accounting for business combinations, the staff refers them to the FASB for guidance. As the FASB conducts its deliberations, the SEC staff monitors the project to ensure that any final standard improves financial reporting for investors.
The SEC staff should not dictate final standards, but rather we should allow the private sector standard-setting process to work under our oversight. Once a project is completed, the SEC staff should evaluate the final product taken as a whole, and only if the product taken as a whole is not in the best interest of investors would action on our part be necessary.
As companies adopt new standards, the SEC staff also monitors implementation, addresses additional questions, and refers unique issues to the FASB's interpretive body, the Emerging Issues Task Force. Through this cycle, many EITF issues that have been addressed were done so at the request of the SEC because of implementation problems it observed in practice.
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In light of the SEC's unique role, it is critical that the SEC work closely with the FASB. However, no matter how good accounting standards are, there always will be instances where some answers will not be clear and additional guidance will be needed. In these instances, we have encouraged companies and their auditors to discuss the issue with the staff on a so-called pre-clearance basis. The cooperative efforts between the public and private sectors has given the United States the best financial reporting system in the world, and the Commission is working to make it even better.
In this day and age, one cannot talk about standard-setting in the United States without discussing international convergence. While convergence can have a variety of different meanings, it is generally assumed that ultimately all standard-setters should agree on a single high-quality accounting answer. To this end, the SEC has encouraged both the IASB and the FASB to re-examine their agendas in order to speed up their short-term convergence efforts.
I would also like to address another critical and related part of the financial reporting process, which is the oversight of the accounting profession. Auditing provides credibility to financial statements and comfort to investors. Accordingly, the Commission is actively exploring ways to strengthen the system of overseeing the work of the accountants that perform audits of public companies. In my written testimony, I have outlined the model we are pursuing, which is similar to the CARTA bill passed by the House last month.
In summary, even though our system is the best at present, there is room for improvement. Recent events have been a catalyst for reform, and the work related to implementing needed reforms. While it is imperative that the criticism of the accounting standards-setting process be addressed, we should not abandon the system that has allowed us to achieve what we have to date. Instead, we must take the opportunity to make fundamental improvements to standard-setting and oversight.
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Thank you for your interest and having scheduled this hearing today, and inviting me to participate. I am pleased to answer any questions that the subcommittee Members may have.
[The prepared statement of Robert K. Herdman can be found on page 152 in the appendix.]
Chairman BAKER. Thank you, Mr. Herdman.
Our next witness is Mr. Edmund L. Jenkins, Chairman of the Financial Accounting Standards Board, and certainly no stranger to the subcommittee.
We have worked with you over the years, Mr. Jenkins, on a number of topics, and I know that retirement plans are in the offing. My best to you in whatever the future may bring, and we certainly have regard for your years of work and contribution. Please proceed as you choose.
STATEMENT OF EDMUND L. JENKINS, CHAIRMAN, FINANCIAL ACCOUNTING STANDARDS BOARD
Mr. JENKINS. Thank you very much. Chairman Baker, Ranking Member Kanjorski, and Members of this subcommittee, I am pleased to appear before you today on behalf of the Financial Accounting Standards Board. I have brief prepared remarks, and I appreciate your entering my full testimony into the record.
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The FASB is an independent private-sector organization. We are not part of the Federal Government, and we receive no Federal funding. Our independence from the Federal Government, reporting enterprises, and auditors, is fundamental to achieving our mission to set accounting and reporting standards to protect the consumers of financial information, most notably investors and creditors. Those consumers rely heavily on credible, transparent, and comparable financial reports for effective participation in our capital markets.
The FASB has no power to enforce its standards. Responsibility for ensuring that financial reports comply with accounting standards rests with the officers and directors of the reporting enterprise, with the auditors of the financial statements, and for public companies, ultimately the SEC.
The FASB also has no authority with respect to auditing, including auditor independence and scope of services. Rather, our responsibility relates solely to establishing financial accounting and reporting standards.
The title of this hearing, ''Corporate Accounting Practices: Is There a Credibility GAAP?''—with two A's—might be read to imply that generally accepted accounting principles, or GAAP, are the main contributor to what many perceive to be the growing lack of credibility of corporate financial reports.
I strongly disagree. U.S. GAAP, when properly applied, still produces the most transparent financial reports in the world, financial reports that are an essential element of an efficient capital market.
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Should U.S. GAAP be improved? Without question. And as part of the Board's ongoing process, the FASB is actively working with our constituents, including the SEC, as Mr. Herdman mentioned, to continue to make necessary improvements to GAAP. In addition, the FASB—and our financial accounting foundation, which has oversight over us—is reviewing and modifying our due process procedures and taking other steps to improve the efficiency and effectiveness of the standards-setting process. Those actions are described in detail in the full text of my testimony.
In my opinion, the most efficient and effective accounting standards-setter imaginable, and the highest quality accounting standards conceivable, could not have prevented the Enron bankruptcy; could not have prevented the many corporate restatements of recent years; and could not alone improve the credibility of financial reports.
Remember that restatements, including the Enron restatements, are done to bring financial statements into compliance with existing accounting standards. By working together, standards-setters, reporting enterprises, auditors, and regulators share the responsibility for a credible and transparent financial reporting system. Each party must carry out its responsibilities in the public interest.
Reporting entities seeking to access the capital markets for financing are responsible for preparing the financial reports and presenting those reports to investors. Those enterprises must apply GAAP in a way that is faithful to the intent of the standards. Unfortunately, the far too common practice of seeking loopholes to find ways around the intent of the standards obfuscates reporting and does not result in a transparent and true reflection of the economics of the underlying transactions. That practice must end.
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Auditors examine the financial reports of enterprises to determine that GAAP has been fairly applied. Auditors also must assure that the stated intent of the standards are followed, and not accept facile arguments that the reporting is acceptable because the standard does not explicitly say that the reporting is unacceptable.
Auditors have a primary responsibility to the public, since consumers do not have the same access to the underlying facts about an enterprise's operations and transactions. Auditors must end the practice of accepting ''Show me where it says I can't do this'' accounting.
Finally, regulators, principally the SEC, are responsible for protecting the investor. Through their oversight and enforcement activities, regulators assure that enterprises report their financial statements based on GAAP, and that auditors are independent and examine financial statements using accepted auditing standards. The SEC must have the resources that it needs to fulfill that important role.
Thank you, Mr. Chairman. I very much appreciate this opportunity and your courtesy, and I would be pleased to respond to any questions.
[The prepared statement of Edmund L. Jenkins can be found on page 164 in the appendix.]
Chairman BAKER. Thank you very much.
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I would like to start with the announcement made today by Standard and Poor's to go to a ''core value'' reporting assessment methodology where, for example, one-time non-recurring revenues are not booked as operating profits in a quarterly statement—from a sale of an asset, for example. Have you had a chance yet, Mr. Jenkins, to be familiar with those, or do you have some opinion about what they are doing?
Mr. JENKINS. I have only seen the reports in the media about this, and I just, prior to this hearing, did receive the news release from Standard and Poor's, which I have quickly read. But I am generally familiar with what Standard and Poor's is trying to do. They announced a couple of months ago that they were going to look into this area.
And I believe that they are doing what analysts truly should do—analyze the financial statements. I believe it is the role of financial reports and financial statements to provide the information that is necessary for analysts to do their job. And that includes providing good information that they can use to make adjustments.
The core earnings approach is one that is an important approach, because it is designed to provide the information that is most likely to be replicable in the future—and, after all, it is future operations that form the basis for investment decisions. But it is all based, as Standard and Poor's acknowledges, on the underlying information in financial statements, reported earnings.
I wouldn't want to, without further study, get into the individual adjustments that they are making. But I believe that this approach is entirely appropriate. It is very consistent with the AICPA's Special Committee's report on improving financial reporting, that recommended that we try to do a better job of displaying information that is recurring from that that is non-recurring.
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So I think this is—as long as it is based on information that comes from audited financial reports, and the items and the amounts that are used to come up with the core earnings are clearly displayed, so that investors can make their own determinations on whether those adjustments are the ones they would make, I would support this effort.
Chairman BAKER. Well, I only have concern with regard to the possible creation of another set of accounting standards with which businesses have to comply and still have to meet the generally accepted standard, which, of course, FASB generates.
What was of interest to me is that from their statement of a couple of months ago, that they were able to move so quickly to the presentation of these standards in such a short fuse, realizing the potential consequences of this announcement for capital formation generally. Which gets to the question that is obvious and evident of concern: why does it take so long to go from an Emerging Issues list to a final statement that changes, ultimately, market compliance with a new standard?
Almost any subject—we can even go back to the SPEs themselves—from the initial authorization to the statement issued last—well, this April—relative to the committee's work. What is it that can be done to expedite a more prompt reaction to evidently market difficulty?
Mr. JENKINS. Well, one very significant and important difference, particularly for this subcommittee, I believe, between Standard and Poor's and the FASB is that they have no responsibility to carry out any open public due process with respect to what they are doing. And I, for one, believe that our open due process—an opportunity to listen and hear from all of our constituents before we make decisions—is central to the credibility of the FASB. And I believe that Congress, as well, wants to be assured that constituents have adequate opportunity to weigh in on our decisions. So that is at the core of the difference between, I think, between Standard and Poor's and the FASB's activities.
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We also undertake really fundamental changes. Standard and Poor's approach—and this isn't to denigrate it in any way—is going to take information that comes from our accounting standards to come up with the amounts that they are going to use for these adjustments. But without the standards that we have, they wouldn't have reliable, consistent information, perhaps, about unrealized gains or losses from hedging activities, for example. So those complex issues do take time to research and study.
Still, there is no question that we need to move more rapidly in establishing standards. And we have undertaken some efforts, even before Enron, to do that. Most recently, as you perhaps know, the voting majority required for issuing a standard has been changed from a supermajority to a simple majority. That, at the margin, will help speed things up.
We are changing our internal process. We intend to go more toward a principle-based approach to standards, as Congressman Sherman mentioned. We have principles in our standards. It is trying to answer every conceivable standard that, as a part of setting standards, that gets into overly detailed rules. We do this for the benefit of our constituents, but it takes time and it increases the complexity. So we are going to try to cut down on the number of detailed questions that we answer as a part of our approach. Internally, we have undertaken new internal plans with respect to how we approach projects.
We accept the criticism that we need to move more quickly. But it is also essential that we end up with high quality standards, and that they have been subjected to open due process.
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Chairman BAKER. Thank you. We will, I am certain, come back for an additional round of questions, given the number of Members here. But I do want to give other Members a chance to proceed.
Mr. Sherman.
Mr. SHERMAN. Yes, Mr. Chairman. I am a little less sanguine than the other Members of this subcommittee. We are told over and over again that the U.S. accounting system is the best and the most transparent in the world. I would add that Nero fiddle as Rome burned, and as he was fiddling he would have been justified in singing along with the fiddled that Rome, even after the fire, was the most powerful city in the world. We do need to do more than just say we are better than other systems, such as the Russian business system.
There is a huge credibility gap. And even Nero, I think, ordered that the fire be extinguished before due process was fully carried out. We do have a fire going on here.
Now, Mr. Jenkins points out that the SEC is responsible for enforcing FASB standards with regard to publicly traded companies. Mr. Herdman, I am told that during all of 1999 and 2000—roughly 730 days—that not a single hour of SEC professional time was spent with regard to looking at or enforcing the FASB standards on the Enron financial statements, even though those statements included absolutely incomprehensible footnotes. Can you tell me that that information is wrong?
Mr. HERDMAN. No, I believe that is correct, Congressman.
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Mr. SHERMAN. So Mr. Jenkins tells us that the SEC is supposed to enforce, and in this case—even on my quiet, residential street, a policeman comes by, you know, more than once every 2 years.
I think that we have also left out one element of the enforcement, and it is, in fact, the primary element of enforcement, and that is the trial lawyer system, the civil bar. In fact, if any company's stock drops according to a variety of formulas, you can count on a lawsuit.
And what worries me, Mr. Jenkins, is if we go to a system that says, we are not really relying on specific rules, we are relying on principles like ''do the right thing.'' First, if we could really rely on such principles, we wouldn't need auditors at all. Shouldn't businesspeople just do the right thing? Why do we have to audit them to make sure they do the right thing?
But putting that aside, if we rely just on relatively simple principles, could you ever get summary judgment against a plaintiff who sued, noting that stock had declined significantly and that other people applying those same relatively vague principles would have provided a much less rosy picture of the company the investor invested in?
Mr. JENKINS. Well, I am not an attorney, so I am not going to opine on whether you could get summary judgment on anything.
But I think it is a matter of finding the right balance. I agree with you that it is not enough to say look to our rather complete conceptual framework, for example, on which we start when we develop a standard, because it doesn't address the specific issue that is under consideration. We need to develop the principles that come from that conceptual framework that are relevant to the particular issue at hand.
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Then I think it is not enough, either, to quite stop there. We need to make sure that there is sufficient guidance as to how to implement those principles to a reasonable extent to assure that people will generally apply those principles in a consistent way.
Mr. SHERMAN. If I can cut you off, what if we went with a simple income tax law? Just a dozen pages, basically, and then at the end we just say, ''Pay your fair share''? Do you think Federal revenues would go up or down?
Mr. JENKINS. I don't have an opinion on that, either.
Mr. SHERMAN. Let's face it. They would go down precipitously, and this country would not be a superpower anymore.
Mr. JENKINS. Well, I think there is, though, in fairness, the purpose of the Internal Revenue code and the purpose of financial reporting, I think, are significantly different.
Mr. SHERMAN. They are somewhat different and somewhat the same. You go to an accounting firm; you pay that accounting firm. They complete your income tax statement, and you will be most happy with their services if they report the lowest possible earnings to the Federal Government. You go to an accounting firm; you pay that accounting firm. And you will be most happy with their services if they report the highest possible earnings to your shareholders.
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Now, the only difference—and it is a difference none of us delight in—is that the second kind of accounting activity can result in a civil lawsuit against the accountant. There are some other differences as well. But to say that the pressure on the financial accountant is less than on the tax accountant; to say that we accept as a society that the tax accountant will do everything legal to report the lowest possible earnings to the Federal Government, but that the financial accountant will somehow be immune from the same principle, from the same fact that they are being paid by the client, I think, asks us to substitute wishful thinking for an examination of the economic structure.
Tax accountants are professionals, too. Yet, if we were to discover that tax accountants tried to come up with the lowest possible reported earnings, we wouldn't have hearings here. We wouldn't be surprised. We would have hearings if a tax accountant wasn't doing that.
And I don't think that we can rely on general principles, enforced not at all by the SEC—at least with regard to Enron during 1999 and 2000—and enforced chiefly by a civil bar. But I shudder to think what the civil bar will do if the standards are made, are replaced with principles.
But I get your point; you are trying to do both. And I think I have run out of time.
Chairman BAKER. And if I can, just for the record, if the IRS is listening, my tax accountant always makes me pay the higher amount.
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[Laughter.]
Mr. SHERMAN. He will be losing all of his clients, except one.
Chairman BAKER. Yes, but I won't be audited.
I think for the moment I will start with another round while we are waiting for other Members to return. I want to get back to this timeliness question, and how we can construct a system which gives opportunity for public comment, but draws a more narrowly defined constraint around that activity.
For example, if a problem would come up through the Emerging Issues Committee, as of that date when it is on that agenda—sort of a starting gun—that within a year, if there hasn't been some resolution or final statement issued—there may be work documents, there may be some other background that has been assigned to get us close to a position, but yet not yet there, as in the case of SPEs—shouldn't there be some other mechanism—perhaps throw it over the fence at the SEC shop and have them, with some time obligation come up with the resolution? In other words, a predetermined series of steps that lead us to a judgment?
It is like a court proceeding. Sometimes you don't get all the stuff timely filed; sometimes it is not admissible—whatever the case may be. But ultimately, you have to deal with a certain set of facts and reach the best judgment you can within the constraints in which you operate. But I think in this instance, our constraints are so difficult we can't get there. And I think the cost of that is worse than not having ample input from all parties concerned.
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Would you like to respond, Mr. Jenkins, to that approach or concept?
Mr. JENKINS. Well, I think it is fair to say that we ought to set appropriate goals in terms of timeliness for each individual subject that we take up. But I don't think that those goals would be the same in each case; it would depend on the complexity of the issue.
But I think it is fair to set some goals and to stick with them. That means, particularly, I think—and this is something else that we are working on—is making sure that the scope of the issue is narrow enough, that we get the inadmissible stuff out at the front end, so that we have a good shot at reaching a conclusion on what we do undertake to address in a relatively short period of time.
Chairman BAKER. Let me jump in on that goal description that we are talking about. What troubles me is rules that are not intended—that are perhaps manipulated by smart individuals for a specific unintended consequence—which create the difficulty. But if we go at it with the view that ultimately an accounting activity is—two things in mind: one is to give a fair snapshot of true financial condition at the time of its preparation, which is always understood; but two, it is an activity which will enhance the ability of the corporation to succeed, in a very broad statement. In other words, if we do it this way, we are likely to be successful.
What troubles me about—let's take indefeasible rights of use. And looking at a particular statement—I don't remember the corporation at the time. But they were booking revenue in a current quarter from the prospective sale of a telecommunications service for which the network did not yet exist.
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Now, I don't know how that could possibly be held up to be a measure that adds value to the system. And from my limited understanding of how these things should work, that ought to be a prohibited activity. Perhaps you can book one-time sales, or one-time events, or aberrant activity in revenue, but it certainly ought to be noted, so that if you are in the business of making shoes, and you happen to have a rich uncle who passes away and you get a $500,000 life insurance benefit and you put that in the business, you have got to show that that is $500,000 of Old Uncle Joe, and not sales of shoes.
We are not there. I think my problem with the current system is when you look at a statement, you can't determine, from the current reporting requirements, what their underlying business activity is generating.
Mr. Herdman, you want to jump in on any of this?
Mr. HERDMAN. Thank you, Mr. Chairman. I think, on the example you just cited, on the indefeasible rights of usage, that there needs to be some real care taken here between what was being done in the financial statements prepared under generally accepted accounting principles and filed with the SEC, as opposed to what was being disclosed in earnings press releases using alternative measurement sources commonly referred to as pro forma earnings, and certainly the kind of thing that Standard and Poor's action today is intended to prevent.
And while we have some investigations in process with respect to some of the companies that engaged in the Indefeasible rights of use-types of transactions—and I can't get into specifics—I do think that it is very important to—and I hope you get some comfort from the fact that the Commission has put out some advice, some cautions to companies with respect to their earnings press releases, that the minute they depart from generally accepted accounting principles in those press releases, they run the risk of violating the Anti-Fraud provisions of the securities laws.
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And we also have pointed out to them that when they do present these alternative measurements, that the only way that they in effect have what you might call a safe harbor from violations of the securities laws is to present a clear, specific, itemized reconciliation between the results under generally accepted accounting principles and under this alternative measurement that they have forwarded to the public through their press releases.
Chairman BAKER. Well, I will press it just a little bit further. Let's assume for the moment that it is clear, at least from the outside looking in, that the corporate structure was intended to obfuscate debt, or to create revenue. When you ask the individuals involved in the creation of these accounting methodologies, ''What was the business purpose for doing this?'' there ought to be a rational explanation as to the public benefit or shareholder benefit that accrued from that activity.
Where that is absent, and it appears to be obfuscating true financial condition, some sort of liability ought to attach to that effort. And that, I think that is my frustration, is it appears that people are saying, well, this complies with GAAP. Well, if that is complying with GAAP, we need to make it clear that GAAP provides for honest disclosure of true financial condition.
Is there a question about that? I mean, when somebody says it is GAAP-compliant, does that obviate you from any criminal liability?
Mr. JENKINS. Well, I think that the whole goal of presenting financial statements is to provide transparency of information, which is another way of saying what you have just said, I believe. And we need to do that. That has to be our goal. That is why financial statements and financial standards need to be continually improved.
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Chairman BAKER. Well, it is a fine point. But for me, it is important anyway—if you are GAAP-compliant——
Mr. JENKINS. Yes.
Chairman BAKER. But, the consequences of being GAAP-compliant in some circumstances lead to a hiding of true financial condition, that still should be a violation of something. Is it?
Mr. JENKINS. Well, I think that gets to the issue of how the GAAP information is displayed in the financial statements. And that gets to your question of putting the proceeds from a life insurance policy in revenues; I don't think that that is in compliance with GAAP. I don't think that that should be done. I am not aware that it is done.
And there are some fundamental rules of what goes into revenues and what is other kinds of income. But we need to have disclosures when we have these unusual or one-time revenues.
Chairman BAKER. Yes, sir?
Mr. HERDMAN. And there are a couple of cases that are very much on point. In the late 1960s, one of the Federal courts handed down a decision in a case called U.S. vs. Simon, in which the decision was that just because financial statements comply with all of the measurement requirements of generally accepted accounting principles is not an absolute defense if the result is misleading, and the disclosures about it are misleading.
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And the SEC has, I think, a very instructive enforcement case from the mid-1990s against Caterpillar Corporation, in which the company had a huge increase in sales in one of its foreign divisions as a result of basically putting a big sale on toward the end of the year. And it was accounted for, it was all accounted for correctly. These were valid sales, there was nothing wrong with them. But their management discussion and analysis, which is intended to be an adjunct to the financial statements and through which management is supposed to explain through its eyes to the investors what is happening with the company, what has happened, and what has happened in the past that may not be repeated in the future—and in that particular case, there was no mention of the fact that the huge increase in sales in the fourth quarter—and I believe it was a Brazilian subsidiary—was entirely due to a very unusual event that didn't have a chance of being replicated in the next year.
And so there are indeed strictures against providing a misleading picture, even if the underlying financial statements are presented in accordance with GAAP.
Chairman BAKER. I will follow that up with a more detailed written inquiry. But it is a point around which I think there is some considerable difficulty.
Mr. ROYCE. Mr. Chairman.
Chairman BAKER. Mr. Royce.
Mr. ROYCE. Thank you, Mr. Chairman. I had an opening statement that I would just like to introduce for the record, if that would be all right.
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Chairman BAKER. Without objection.
Mr. ROYCE. And then I would like to go to Mr. Jenkins, as Chairman of the Financial Accounting Standards Board, and ask him a question about a 1994 report which he directed. He wrote about special-purpose entities in that report, ''Users are concerned that current rules may permit companies to exclude from their balance sheets rights and obligations that make companies appear to be less risky''—less risky—''than they are''—of course, that is exactly what Enron did. Yet FASB did not issue a definitive statement on these special-purpose entities, other than two short letters, one in 1990 and one in 1991. And the 3 percent rule in those letters was what Enron, in fact, abused.
And so my question would be, couldn't FASB have possibly reduced the risk of the abuse by acting decisively at that time? I mean, the problem had been identified, but there wasn't decisive action taken. And that is my initial question.
Mr. JENKINS. Well, as you know—and this isn't an answer to your question directly, but I will get to that—we are working to provide guidance specifically on accounting for SPEs, and now on an expedited basis. I know that that sounds a little bit like closing the barn doors after the horse is gone, and I accept that criticism.
We at the FASB have been working over the years to try to come to some acceptable decisions with respect to accounting for special-purpose entities. But it is not sufficient to simply say that every special-purpose entity should be consolidated, because special-purpose entities have a variety of purposes, and it is only where the special-purpose entity does not have sufficient independent purpose, and/or is not capitalized sufficiently by an independent third party, that consolidation should really take place. And the devil is, we found, in the details of defining those particular circumstances.
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We at the FASB have tried twice since 1994 to issue guidance on consolidations. And in each case, the concerns raised about our proposal, and how those proposals were overreaching, from both the business community and the accounting profession, caused the board to conclude that it could not go forward and develop a standard that would be generally accepted.
Mr. ROYCE. Which of the major accounting firms opposed that?
Mr. JENKINS. All of them.
Mr. ROYCE. Every one of them?
Mr. JENKINS. The 3 percent rule was designed to address a particularly unique circumstance involving a single type of a transaction. And through practice, it was probably appropriate for that particular transaction—it got extended in practice to apply to some other transactions. Of course, the essence of the Enron situation as I understand it is not the 3 percent rule per se—in some cases, apparently, they didn't have 3 percent; in other cases they didn't follow the 3 percent rule because the 3 percent had to be maintained throughout the life of this entity, and it went down, and they didn't replenish it, so to speak. So they apparently didn't follow the rules.
It also had to be independent, and there couldn't have been any other guarantees or support, nor could the 3 percent have come through the back door as being provided by Enron or one of the affiliates, apparently, in some of the transactions that part of the requirement wasn't followed as well.
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So that is why I said in my opening remarks that the standards, even if they are minimal, and perhaps need to be improved, if the standards aren't followed for whatever reason, the best standards in the world aren't going to solve these issues.
Mr. ROYCE. No. But I think they did cite this rule as their argument.
Mr. JENKINS. Yes.
Mr. ROYCE. I mean, they attempted, at least, to attach their line of reasoning to this rule.
Mr. JENKINS. I believe that is correct.
Mr. ROYCE. I was going to ask Mr. Herdman if he thought that FASB could have taken better measures to reduce the risk of abuse of special-purpose entities. I know this is in hindsight, but what does the Securities and Exchange Commission think now about that?
Mr. HERDMAN. Congressman, I think this is an example of what Mr. Jenkins was alluding to earlier when he talked about the size of projects and the scope of projects that FASB undertakes. The particular subject matter where this was being considered was the Board's project on consolidations.
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The proposals that Mr. Jenkins referred to were not focused solely, or even principally, on special-purpose entities. They were focused on the question of consolidation of subsidiaries more broadly, and proposed sweeping changes to that particular practice, which many accountants felt had not been controversial.
And so, when something like that occurs, it occurs to us now, that that is the time when it is important for the Board to re-examine the scope of its product. In other words, if they have a project, they come out with a proposal that would attempt to deal with four or five things. And if there are one or two that there is general agreement should be done and it is important to get them done, but the other two or three have failed yet to capture the imagination of the audience, we think that it would be better for the Board to go on and fix the one or two things that everyone is in agreement need to be fixed, and work harder on the others or reconsider whether they need to be done.
And so that is, I hope, a lesson for all of us for the future in terms of how this agenda can be better managed to make sure that the pressing issues do get dealt with promptly.
Mr. ROYCE. Are you familiar with Arthur Andersen or Enron marketing their unique interpretations of how to utilize special-purpose entities in order to boost earnings per share, and basically going into the market and saying let us work with you, with other companies, to show you how we can do this? Are you familiar with a history of Andersen doing that?
Mr. HERDMAN. Congressman, we are still investigating Arthur Andersen and Enron, and I can't comment on that.
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Mr. ROYCE. Can't comment on that? OK. Thank you again. Thank you, Mr. Chairman.
Chairman BAKER. Mr. Sherman.
Mr. SHERMAN. Yes. I would hope that the FASB would be closing this barn door, because I think you have got tens or hundreds of billions of dollars' worth of horses that still haven't escaped the corral.
I do think there is a legitimate purpose for special-purpose entities—for example, in my hometown it is not unusual to legitimately shift the risk that a particular movie or group of movies is going to be successful or fail to a group of investors. While the studio does the work of creating the movie, other people can take the risk and place their bets as to whether the latest film will be successful.
The Chairman puts forward an interesting idea, and that is that there be a business purpose doctrine, and those transactions that have no business purpose not be recognized. That is an interesting part of tax accounting. Is that part of financial accounting as well?
Mr. JENKINS. Well, I think we try to understand the business purpose of transactions and, as I say, develop standards that do the best job they can of displaying that purpose.
Mr. SHERMAN. If there is a transaction that has no purpose other than causing the recognition of income or deferring the recognition of loss, does that transaction give an effect in preparing financial statements?
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Mr. JENKINS. Well——
Mr. SHERMAN. Is there a clear yes or no? Or is that one of those hazy things?
Mr. JENKINS. I think it is pretty hazy, but——
Mr. HERDMAN. Well, Congressman, just like under the tax law there is a concept that if the only motivation for a transaction is to reduce taxes, then as I understand it, it is not lawful.
Mr. SHERMAN. Yes. I am familiar with it in tax law. I am asking whether there is a similar principle——
Mr. HERDMAN. However, certainly when we look at transactions with companies, if it is clear that the only reason they entered into a transaction was to achieve a particular financial statement result that would not have been attained had they not entered into the transaction, then we would generally disagree with their proposed accounting.
However, I will caution you, just as in the tax area, that it is very difficult to find a transaction that can be characterized as solely being done to achieve a particular——
Mr. SHERMAN. It is always possible to find a tail, even if that tail isn't big enough to wag the dog.
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Mr. HERDMAN. There are always other motivations, absolutely. So that is not a very good principle.
Mr. SHERMAN. It is not a bad principle. It is helpful.
Mr. HERDMAN. It is not a very effective one, though, perhaps.
Mr. SHERMAN. Speaking of effective enforcement, and the whole idea of enforcing general principles—not numerical principles, where we can say, oh, here is this exact rule, but rather, the general principle that, for example, the prose in the financial statement and in the report to shareholders be accurate—you pointed out the Caterpillar example. But it is my understanding that in Caterpillar, with its failure to tell shareholders about the Brazilian situation, that not a single day of jail time was done by a single executive, accountant, or auditor. Can you tell us how large a fine—or let me know if I am wrong on the jail time. But also, can you tell us how large a fine was imposed on Caterpillar?
Mr. HERDMAN. I don't recall, Congressman.
Mr. SHERMAN. Could it have been that no fine or a fine of just $50,000 or $100,000 was imposed?
Mr. HERDMAN. Since I can't recall, it could be.
Mr. SHERMAN. So even the preeminent example of enforcing vague principles, we are not, we don't have a specific level of punishment? I would hope you would furnish that for the record, but it is my understanding of SEC general practice that they might have gotten, you know, a really tough letter in their file. And given what is at stake in these transactions, perhaps the only enforcement we really have, much to our own chagrin and not to our joy, is the trial bar.
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I would like to posit—we have talked about special-purpose entities, which is part of the Enron problem. And I have asked the FASB on more than one occasion to expedite a review also of another part, and that is, even if you are transacting with a fully legitimate entity, the transaction in derivatives may be misstated.
I would like to conjure up the idea of a Genron Corporation that wants to state the largest possible earnings per share. It has two portfolios of investment securities. One is in the restaurant industry, where they have gained $1 billion and they have recently sold at a $1 billion profit. And, of, that is a $1 billion profit. They have another portfolio that they haven't liquidated their position in of high-tech companies, which on a mark-to-market basis has declined by $2 billion.
But they don't want to recognize a $2 billion loss, because they have a derivative issued by the Kiticorp—not to be confused with Citicorp—but a large, completely independent, very financially sound corporation. And this derivative says that if you lose any money, up to $2 billion, on your high-tech portfolio, we will give you the money. So you haven't lost anything; it is like your factory burned down, but you have perfect fire insurance.
But then there is a provision that says, to the extent that Kiticorp has got to give money under this debenture, Genron Corporation must give shares with a value of, in this case, $2 billion to Kiticorp's parent corporation, so that in effect, they owe something—they have insured their insurer.
Is it clear under FASB pronouncements that under these circumstances the $2 billion loss must be recognized, because although it is in effect insured by a completely independent, highly creditworthy company, the provisions of that derivative or insurance policy, if you will, require Genron to issue stock to Kiticorp or its parent?
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Mr. HERDMAN. We are investigating that company, Congressman.
Mr. SHERMAN. Well, I am asking what—this is not something you are investigating. This is Genron Corporation; I just made it up.
Mr. HERDMAN. But the facts are——
Mr. SHERMAN. Do we know what accounting principles call for? Or is the accounting result of this transaction unknowable at this time?
Mr. HERDMAN. It would depend, I believe, on the terms of the equity derivative, and whether it could be settled net or would require the outlay of cash or the distribution of shares.
Mr. SHERMAN. In this situation, Genron Corporation is to receive $2 billion in cash to make it whole from its $2 billion of investment losses in high-tech stock. And Genron Corporation is to issue $2 billion worth of Genron shares for no additional compensation to the parent company of Kiticorp, of the company that is giving it the cash. Under those circumstances, must the $2 billion be recognized as a loss?
I mean, it is either ''yes,'' ''no,'' or ''we don't know.''
Mr. HERDMAN. I would have to consult further with—there are some very complicated requirements that need to be looked at with respect to equity——
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Mr. SHERMAN. In fairness, this is a question I have asked behind closed doors two or three different times. I am not completely sandbagging you, although I guess you didn't know I would be asking it quite this way at this time. I wonder if Mr. Jenkins can give us an answer; what does the FASB have to say about this transaction?
Mr. JENKINS. Well, I think, first of all, I would say that there needs to be disclosure of these arrangements in the financial statements. And we are issuing shortly some clarifying guidance of existing literature to make it clearer than it should have been in the past, apparently, that disclosures with respect to guarantees, even if they are remote or not likely to be called, need to be disclosed.
Mr. SHERMAN. Well, this one is clear. I mean, they owe the $2 billion worth of stock. They have a right to receive the $2 billion in cash. Both of these are triggered the moment they sell their high-tech portfolio at market. This isn't a remote contingency like ''what if our factory does burn down?'' The factory has burned down. You have a right to cash from your insurance company, and under my example, you have an obligation to give that insurance company $2 billion worth of your stock.
Mr. JENKINS. I didn't understand your example to say that the loss had incurred, and under the insurance policy the money was now due.
Mr. SHERMAN. Well, it would be due upon the liquidation at market of a portfolio of publicly traded corporate stock that is usually mark-to-market. So if you are going to mark-to-market under ordinary circumstances, the sale transaction of the stock is thought to be irrelevant.
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Mr. JENKINS. Well, again, you understand——
Mr. SHERMAN. OK. Well, let's put it like this: it is not a remote contingency that you would choose to sell a stock on which you have lost $2 billion, losses that have already—would have been recognized on a mark-to-market basis.
Mr. HERDMAN. I would start with the presumption that the loss needs to be recognized. But I would need to consult further very complicated accounting rules that pertain to the issuance of so-called equity derivatives.
Mr. SHERMAN. OK. I would hope that—it is my understanding—I mean, I didn't make this one up completely. I mean, this is the loophole that Enron thought they found. They think it works. They think they didn't dot their i's and cross their t's. There are a lot of other companies out there who are capable of dotting i's and crossing t's. And I would like to know whether this loophole exists. And that is why I would ask each of our two witnesses to furnish for record an answer to this excessively complex question.
And so I will ask you to do that in the future.
Chairman BAKER. Thank you, Mr. Sherman.
Mr. Royce, did you want another round?
[No response.]
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Chairman BAKER. Mr. Herdman, before we conclude the panel, do you have a position on behalf of the SEC relative to where we might go with regard to shortening time consideration for development of financial accounting standards? Have you arrived at any recommendations yet?
Mr. HERDMAN. We have. We have spoken with the FASB about this issue at some length, and we believe that—of course, it is a mixture of things. It is scope definition. We believe that the move toward a more principles-based approach, and not needing to attempt to answer every question that comes along the way, should enable the Board to move faster on its projects.
It is very time-consuming to try to come up with the definitive answer for every question that comes up. And they should really need only to answer enough to make sure that the principle that they have in mind is operable in the real world. And I think that that is something that can be done.
We believe that the recent decision by the FASB trustees to change the voting requirement from 5 to 2 to 4 to 3, if implemented aggressively, should enable the Board to move more quickly because, to the extent that there are minority views, at some point in time it will be possible for the Board, presumably through its Chairman, to say, we have heard enough and now we need to proceed and get this thing done. So we think that is positive.
We also think that it is positive that the board of trustees has asked the question about whether the size of the Board should be reduced from seven members to five. It has concluded at this point to leave the size of the Board at seven members, but it has charged Mr. Jenkins's successor, Mr. Herz, with the task of conducting his own study over the next few months as to what he believes needs to be done to increase the timeliness and efficiency of the Board, and report back to the trustees with a view toward they would implement whatever changes he recommends, that they believe are reasonable.
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So I think that it is a combination of factors, Mr. Chairman. And I think that the Board and its oversight foundation show all signs that they are working to improve in this regard. And over the next 6 months or thereabouts, hopefully they will be able to demonstrate the improvement in terms of the projects that they are working on.
Chairman BAKER. Well, just, again, without having the competency to make the judgment, I make it anyway. It seems that a principles-based value reporting system, some of which we will hear about in the next panel, offers a great deal of appeal. I don't know, frankly, other than marketing purposes and to show that you are running faster than you were a year ago, that historical 90-day-old data, at best, really tells you about what the company is doing tomorrow—especially in light of the apparent use of accounting methodologies which do not result in an accurate financial picture being portrayed even of the historic data.
Now, I don't ascribe that to the fault of FASB, because in good intent, with arduous and lengthy study, the rules have been developed for what we believe to be the best public policy. And they have been misused. It would seem, at the end of the day, if we are building value and we want to encourage corporate CEOs to invest for the long term and not worry about the next quarterly earnings report, that there are some simple principles we could outline, and that if you were consistent with those principles—until we catch you otherwise—that the core reporting that maybe Standard & Poor has talked about is a good place to start, and move from there.
But the current system, I think, given the speed with which technology enables businesses to develop new product and new business structure—we are trying to regulate traffic on the interstate while we are still hooking our horses up to the wagon. And they are running by us. And I think we have to be more nimble in our ability to respond to identifiable problems in a short period of time.
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No response needed, but if you would like, please.
Mr. HERDMAN. That is the danger of the cookbook-style of standards, that while it appears to close off all possible avenues of different interpretation, the people who are out there creating transactions are always going to be way ahead of those who are writing the rules, the detailed, loophole-closing rules intended to try and close off their initiatives.
And so accounting principles that are more principles-based will be simpler. And a principle is not to say ''pay your fair share'' or ''do the right thing.'' The principle has to be expressed in the context of the particular area that is being addressed. For example, the Board's recent standards on business combinations, I think, are a real positive step in the right direction, in that they really did approach this whole area in a very principled basis, and there are implementation details that need to be applied by individual companies.
But the principles are clear, the objectives are clear. And while there will be some differing interpretations on some of the implementation details, I believe that the resulting reporting will be comparable, and the product will be useful to investors.
Chairman BAKER. I think it is certainly worthy of pursuit. I thank you. Mr. Castle, I know you have just arrived, but did you have a question for this panel?
Mr. CASTLE. I do, Mr. Chairman, if I may take a moment.
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Chairman BAKER. Certainly.
Mr. CASTLE. I am sort of starting from scratch, and I guess my question is of Mr. Jenkins.
But I am interested in—and I guess concerned; but in all candor, I don't really know enough about it to express my concern, articulate it as well as I should—with the stock options situation and the accounting side of it. And I am worried about it from an executive compensation point of view, but I am not too sure we can legislate in that area, so I won't ask you questions about that.
But it is my understanding that FASB had some sort of an expense option on this—I am not sure I understood exactly how that was going to work—and I think backed off at some point, maybe under congressional pressure or whatever the reasons may be. But I am interested as to the status of that now. I realize that as the value of companies was growing, it was a valuable tool. And I am not even suggesting options are not a valuable tool, and I am not even saying they should not be part of executive compensation.
But I am just amazed in my reading about it that there is not an accounting entry at some point or another. It obviously has to dilute capital. I mean, it just automatically has to at such time as it is exercised. And at such time as it is granted, it essentially is giving a right which could dilute capital, which greatly impacts stockholders and can impact the entire valuation of a company. In fact, there have been studies showing that some profits would be losses if this was properly accounted for.
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And if you could just give me the rationale of FASB now—or is it changing again, and you are about to look at it again and have some sort of firm accounting practices with respect to stock options?
Mr. JENKINS. Let me first describe where we are today.
Mr. CASTLE. Thank you.
Mr. JENKINS. Our standards require that the use of stock or stock options for almost every transaction would result in an expense charge. So if you issue, if you give stock to an employee—not a stock option—you expense it. If you give stock to pay your attorney or to buy a truck, you recognize it either as an expense or an asset.
We have one exception, and that exception is the employees—certain types of employee stock options that you have referred to. Not even all employee stock options. That is an exception.
Our standard says that even those—it is preferable that those options be expensed at their value determined at the date they are granted. Our standard—it is preferable, but it is not required. And the reason that it is preferable but not required is, as you also suggested, the Board received intense criticism and pressure from Congress in 1994, leading to a sense of the Senate resolution requiring us to stop work on stock options, and proposed legislation that in effect would have put the FASB out of business.
Mr. CASTLE. Well, let's look at it in the year 2000. And I thought it was actually later in 1994 that all that pressure occurred.
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Mr. JENKINS. No.
Mr. CASTLE. But let's look at it in 2002, maybe with the advantage of hindsight. I mean, I would hope that Congress wouldn't feel quite the same way it felt in 1994—perhaps none of us individually do; perhaps FASB does not, I don't know. My sense is that a lot of wise heads around Washington and economists around this country are certainly thinking the other way now.
And to me, it just seems absolutely apparent. I mean, I don't know how the heck you can have an entry, a numerical impact on a corporation of such magnitude, and not somehow or another do something with it at this point. Is there a change going on? Is FASB looking at it differently? Can we put all this pressure from before behind us so we can go forward with doing something?
And I want to do the right thing. I am not trying to——
Mr. JENKINS. Yes.
Mr. CASTLE. And I realize it is extraordinarily difficult to determine the actual value at the time of issuance. But to me, it just seems completely wrong to ignore it.
Mr. JENKINS. That is one of the principal arguments that is used against recognizing the expense. We do require disclosure of the amount. We require that in diluted earnings per share, that the impact of these options be reflected so the dilutive effect is shown. There is work going on internationally in the International Accounting Standards Board. Their goal and their objective is to expense all share-based payments. The circumstance outside of the United States is significantly different than it is here in the U.S., in that virtually no share payments or share-based payments, even the ones I described that are getting expensed here, are expensed outside the United States. So they have a longer way to go than we do.
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My belief is that if the international board is successful in meeting their objective, that consistent with our pledge at the FASB to work toward convergence of standards around the world, that the Board at that time—I won't be here, or be at the Board, but at that time I believe it would be incumbent upon the Board to consider then whether or not it would undertake a project in this area.
Chairman BAKER. If I could also add, too, Mr. Castle, the Standard and Poor's announcement today on the core valuation does require the expensing of the stock options as an element of their reform. It is probably the most controversial part of their package. But that was announced earlier today, Mr. Castle.
Mr. CASTLE. As something Standard and Poor's is going to require?
Chairman BAKER. Right, in their valuation on the companies on which they report.
Mr. CASTLE. On their ratings?
Chairman BAKER. They have a new core value assessment they are going through, which basically gets rid of any non-related revenues, requiring disclosure of certain types of debt structures, and part of that is requiring the expensing of options for employees. And that is the basis on which the S&P will now rate the productivity of companies. And it was just announced this morning.
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Mr. CASTLE. Well, Mr. Chairman, my time is up, and I will yield back. But I would just like to close by saying—and I appreciate your answers on this, Mr. Jenkins. I realize the political circumstance, although I thought it was later. But my own judgment is that out of all this Enron mess and Andersen mess, what we really need are clear rules and laws with respect to this.
And if there is anything that is ambiguous to me, it is stock options. If I look at a report, a quarterly report, and I see that a million stock options were issued—and again, to the executive compensation, particularly when it is issued by a company which has lost money the year before, so they rewrite it, but it is with a lower ceiling or whatever the effect is where it would take hold, so that the corporate executive can take advantage of it. To me, that is a corporate compensation, executive compensation issue of huge magnitude we need to consider.
But having said that, I just think there is also an accounting entry, automatically, that needs to be looked at. I think it is really unfair, frankly, to the companies as well as the stockholders, and even to some of the executives who would take advantage of it. I think a good executive would tell you do it in such a way that it measures our worth in terms of what we are doing, and show it in some way or another. And I just feel that something should be worked out on this.
So I hope that FASB, working with the international folks, and Standard and Poor's, anyone else who is discussing this, will come up with some common standard so all of us, as just average poor investors out there, can figure out what is happening.
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I yield back, Mr. Chairman.
Chairman BAKER. Thank you, Mr. Castle.
Mr. Weldon, do you have a question?
Dr. WELDON. Yes, thank you, Mr. Chairman, I just have a couple of quick questions. Sorry I missed your testimony, gentlemen.
But for Mr. Herdman, I had a question about FASB's sources of funding. As I understand it, their sources of funding are publication sales and contributions from accounting firms and companies. As I understand it, there has been some recent debate about securing a constant funding source for FASB. Can you give me the SEC's view on this issue, or do you have a view?
Mr. HERDMAN. Well, there are a couple of things that have been happening historically. The first is that the FASB has been engaged in deficit spending for the last 4 or 5 years, I believe. Its funds today come from a combination of—I think it is very clear from Mr. Jenkins's testimony—two-thirds of their revenues come from the sale of their publications, their standards and what have you. The other one-third comes from contributions from the business community and from the accounting profession.
And we think that it would be beneficial if FASB could get a broader source of more assured funding in the future so that there no longer are questions about whether the fact that their support comes from those who must abide by their rules creates the impression that somehow that impacts the quality of their rules. And also, just because it is a tough world out there, and if the way that you are getting your support is to go around and solicit contributions, when times get tough that is often one of the first things to go.
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So we believe that as we consider what needs to be done with respect to oversight of the auditing profession and the ways to achieve funding for that, that there are some very promising ideas with respect to how the FASB might be included in that type of funding—broad-based, private sector funding that would be an assured source of funds for the Board and for any organization, assuming that there isn't a legislated organization that would have a different source of funding. But as we think of alternatives and what we must do from a regulatory standpoint, if there was not a legislated organization to oversee the auditors, we have to create funding ideas there. We think that the same ideas ought to be applicable to FASB's support.
Dr. WELDON. Thank you very much. I just had a quick follow-up question. Maybe it is not a quick question. Mr. Jenkins was referring to international accounting standards, and I understand that you in your testimony provided some mention of the convergence of international accounting standards with U.S. standards. We were talking a few minutes ago about expensing share-based payments.
Did you want to elaborate on that a little bit more? I have got a few minutes left here. Did you want to say anything more?
Mr. HERDMAN. I would be glad to.
Dr. WELDON. Where is that heading?
Mr. HERDMAN. The SEC's mission is really twofold. The first is to protect investors. The second is to make sure that American markets stay competitive with the rest of the world. And for a number of years the SEC has had rules on its books with respect to foreign companies that want to list their shares on U.S. exchanges or otherwise register them with the Commission. And those rules pertaining to filing requirements—taking into account, from the time that they were written, that there are many countries out there and a great diversity of quality of accounting standards—have required from the outset, and continue to require today, that those so-called foreign private issuers either prepare their financial statements for U.S. filing purposes using U.S. GAAP, or reconcile from their home country GAAP to what the results would be under U.S. GAAP. And that is done for net income typically as the principal reconciling item.
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There has been a lot of staff work done by the SEC over the years looking at the quality of so-called international accounting standards written by the International Accounting Standards Committee initially. And now for the last year-and-a-half that has been reformed, restructured into the International Accounting Standards Board. A couple of years ago, the European Union decided that all 7,000 listed companies domiciled in EU member countries, starting in the year 2005, would have to use international accounting standards as opposed to French or German or Spanish standards in their annual reports that get filed with the various exchanges in Europe.
A combination of the two things, the restructuring of the IASB and the step taken by the European Union, really makes the IASB a major player in the development of accounting standards around the world. They have a lot of work to do to go back and improve the quality of some of their older standards. They are very much engaged in that right now. We have encouraged both the IASB and the FASB to take a single-minded approach to trying to achieve convergence with one another—approximate convergence—by the year 2005. We recognize that there are going to be huge efforts underway by the IASB and by European companies to convert to these international accounting standards, and we think—I personally think that the time is right for the Commission to consider whether the confluence of those events and the continued improvement in the international standards is such that they should be permitted for U.S. filing purposes by these foreign private issuers.
Chairman BAKER. Thank you, Dr. Weldon. Mr. Sherman, you had a wrap-up?
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Mr. SHERMAN. Yes. I think we have loophole-ridden financial accounting standards; that we are painfully slow in plugging those loopholes; that we have a system for financial accounting standards publication which, if we applied it to tax accounting, would cause this country no longer to be a superpower in the world because it wouldn't have the revenue. And the argument against all this is, well, principles—no matter—will be enough. We don't make anybody do anything, but ask them to—just give them some vague guidance.
And one illustration of whether this works or not is in the area of putting a charge to earnings when you issue a stock option. The FASB has indicated that it is preferable to have such a charge to earnings. But that is a principle; the rule is you don't have to do it.
Can either of the witnesses identify any of the Big Four-and-a-half accounting firms that has as its uniform policy that a charge to earnings must be made by its clients, when material, when they provide an employee stock option? Can you name any of the firms?
Mr. HERDMAN. Congressman Sherman.
Mr. SHERMAN. A simple question. Can you name a firm?
Mr. HERDMAN. But the accounting firms don't make those decisions for clients. When the rule is as explicit as it is here, companies have a choice, and——
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Mr. SHERMAN. OK, companies have a choice. And if they don't—can you name a single company that follows the preferred standard, or a single auditor who has failed, who has issued an adverse or qualified opinion because the company has failed to follow the best principle as stated by the FASB?
Mr. HERDMAN. Two companies that follow the preferred approach out of the Fortune 500. Boeing is one of them, and for the life of me, I can't recall who the second one is.
Mr. SHERMAN. So that would be one half—no, that would be less than a half of a percent.
Let me shift over to something else, and that is I know the wringer that a small company goes through to go public with their initial public offering, IPO. And sometimes they are trying to raise $10 million, $20 million in assets. How many accountants reporting to you, Mr. Herdman, work on these initial public offerings, as compared to the number of accountants that you have deployed to read and ensure at least the completeness, if not the accuracy, of statements filed by the thousand biggest companies in the country?
Mr. HERDMAN. None of those accountants actually report to me. They are all in our Division of Corporation Finance.
Mr. SHERMAN. OK. How many at the SEC?
Mr. HERDMAN. I believe the number of accountants in the Division of Corporation Finance is approximately 100 people.
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Mr. SHERMAN. One hundred people. So you have 100 accountants that can look at both the new small companies and the big established companies. Now, of those 100, how are they divided between those two tasks?
Mr. HERDMAN. It depends on the volume of IPO transactions. In the current environment, virtually everyone is looking at filings of established public companies. A couple of years ago, when there were a lot of IPOs, then those have to take precedence.
Mr. SHERMAN. Those take precedence?
Mr. HERDMAN. Because they are new to the system. And so it depends on the relative volume of what is going on at a particular point in time.
Mr. SHERMAN. So if a company is trying to go public and raise $20 million, they are guaranteed to have a careful SEC review of their filing, and a comment letter that requires that they provide supplemental and corrective information necessary to make everything clear and up to spec. Is that a——
Mr. HERDMAN. For a company undergoing an IPO, they are guaranteed they would have a review. They are not guaranteed they would have a comment letter, but they can be pretty assured they will get one.
Mr. SHERMAN. OK, so they will get a comment letter. So you are trying to raise $20 million, you are pretty sure you are going to get a comment letter, guaranteed review. And yet if you are Enron, a company that was accused of fraud by the entire California Democratic delegation back a couple of years ago—so not a company with necessarily the highest business standards, or at least not in the opinion of the Democrats from California—you could go a couple of years without a review at all?
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So you could be one of the ten largest companies in America, no review; trying to raise $20 million, guaranteed review? Maybe that is one of the reasons we have got a problem.
Mr. Chairman, I yield back.
Chairman BAKER. Thank you, Mr. Sherman. That is, I think, why some Members have a bill in to make sure that some of those big corporations file appropriately with the SEC. I think they are called GSEs, something like that. That is another whole subject matter.
Mr. SHERMAN. I think that would not include Enron, would it?
Chairman BAKER. No. I was making a very small joke about the volatility of the reporting issue.
Mr. SHERMAN. I would agree with you. It is a small joke.
Chairman BAKER. I want to thank the Members of the panel for their courteous use of time today and their participation. Your insights have been helpful to the subcommittee. We know we have a long road ahead of us and a lot of work to do in this area, and we look forward to working with both FASB and the SEC in the future in resolution of these important matters. Thank you very much for your participation.
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Mr. HERDMAN. Thank you.
Mr. JENKINS. Thank you.
Chairman BAKER. At this time, I would like to call the members of our second panel to the witness table at their convenience.
I would like to welcome each of you here this afternoon. We thank you for your time and willingness to participate.
Our first witness to be heard from is the Co-Director of the AEI-Brookings Joint Center for Regulatory Studies, Dr. Robert Litan. Welcome, Dr. Litan.
STATEMENT OF ROBERT E. LITAN, CO-DIRECTOR, AEI-BROOKINGS JOINT CENTER FOR REGULATORY STUDIES
Mr. LITAN. Thank you very much, Mr. Chairman, for inviting me here today to summarize some of the key conclusions of a book called The GAAP Gap, a book that I recently wrote with Peter Wallison at American Enterprise Institute about the future of corporate disclosure in the internet age. In brief, I think we will agree with a number of panelists today—and I am guessing here—that corporate reporting needs to be updated to fit with modern business realities.
One of the purposes of disclosure rules is to help investors make informed judgments about the future, because equity prices, after all, embody the collective judgment of investors about the future prospects of companies. Current GAAP-based financial statements, even if they are clean as a whistle, only go so far toward meeting this objective, for four reasons.
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Number one, recent financial reports inherently are backward-looking, especially so because, for the most part, assets and liabilities are recorded at historical cost, not current market values.
Number two, much of the value the market assigns to many companies cannot even be found on their balance sheet or income statements. That is because this value is intangible and cannot be easily bought and sold on the marketplace independent of the value of the firm.
Number three, non-financial information relevant to price in the future that may never directly show up in any financial report, such as the gain or loss of new customers, insider stock sales or purchases, is constantly being generated—and in any event, much more frequently than quarterly. To its credit, the SEC has recently proposed that more such information should be disclosed in such 8-K filings by companies, and more rapidly than ever before.
And finally, the development of new computer-based technologies may soon make it possible for investors, on their own or through independent advisors, to manipulate company-specific information so that they don't have to rely on GAAP-based financial statements that companies now produce. Specifically, I refer here to a new computer language, Extensible Business Reporting Language, that allows firms to place what are called ''tags,'' or identifiers, on all kinds of financial and non-financial information. Investors and analysts can then easily manipulate and compare these data, which is not possible with financial reports that are now available on the internet in the language HTML.
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These four conclusions have several policy implications.
Number one, while it is tempting to solve the intangibles problem by having firms place values on those assets, this is not generally appropriate, in my view, because it puts auditors in an impossible situation, especially in the wake of Enron. There are few if any organized markets for intangibles, so auditors have no objective benchmarks for verifying those values. The better approach, and one which addresses the need for more forward-looking information, is for firms to disclose more non-financial information that may give rise to intangible value, such as employee turnover, product return rates, measures of innovation and so forth. The SEC can and should accelerate the disclosure of such information by convening working groups of experts from different industries to identify which of these measures are most helpful and to publicize the results, so that investors, analysts, and other professionals can begin demanding to see such data.
Second, the SEC should encourage more frequent internet-based reporting, not only of non-financial information, but even financial data. Companies already balance their books and compile information internally much more frequently than quarterly. If investors had access to real-time data, it is conceivable—not certain, but conceivable—they would place less emphasis on the quarterly earnings figures with which markets and firms are now obsessed. In turn, this could reduce incentives for firms to manage their quarterly earnings to hit expected targets.
Third, the SEC should encourage the use of XBRL, and thus give powerful tools to investors, by perhaps requiring Electronic Data Gathering Analysis and Retrieval System submissions to be in XBRL by a fixed date.
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And finally, the movement toward a new reporting model will not, in my view, eliminate investor demand for having financial reports comply with a certain standard, whether it be U.S. GAAP or the international accounting standards that you just discussed. In my written testimony, I argue that it is highly unlikely in this country that we will ever replace GAAP with IAS. Instead, I try to make the case for allowing all firms—not just foreign firms, but all firms listing their shares on U.S. exchanges—to choose between GAAP or IAS without necessarily having to do reconciliation, as is now required for foreign companies, as was just explained.
Competition between standard-setters would encourage both standard-setters to respond to market developments more rapidly, and thus solve a problem that you, Mr. Sherman, identified, which is the slowness of FASB. It may also—that is, competition also may reduce some of the political influence that has affected FASB rule-making in the past, since firms choosing what is perceived by investors to be the weaker standard would be punished by the markets for doing so.
Thank you, Mr. Chairman, and I look forward to answering your questions.
[The prepared statement of Robert E. Litan can be found on page 248 in the appendix.]
Chairman BAKER. Thank you very much, Dr. Litan.
Our next witness is Mrs. Ellen Masterson, Partner-in-Charge of Global—lost my glasses, wait a minute—in charge of Global Audit Methodology and ValueReporting, PricewaterhouseCoopers. And for the record, I have read ValueReporting about a half-dozen times trying to absorb it all, and I think it is an excellent piece of work. And the conclusions reached, I think, are excellent in the publication.
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Ms. MASTERSON. Great. Thank you, Mr. Chairman.
Chairman BAKER. You will need to hit that little button.
Ms. MASTERSON. Oh. Thank you.
STATEMENT OF ELLEN H. MASTERSON, PARTNER-IN-CHARGE OF GLOBAL AUDIT METHODOLOGY AND VALUEREPORTING, PRICEWATERHOUSECOOPERS, LLP
Ms. MASTERSON. Thank you for those kind words, and thank you for the invitation to speak with you today.
When we wrote The ValueReporting Revolution at PwC in the fall of 2000, the topic of transparency was not as in vogue as it is today. Our book captures the results of our research into the effectiveness of corporate reporting in meeting the needs of investors around the world. Based on surveys of thousands of investors, analysts, and managers, there were several consistent messages that came out.
One, at the time surveyed, more than a third of the companies believed they were undervalued in the marketplace. Second, few investors regard corporate reports as very useful. Third, the market is excessively focused on short-term earnings; we can all agree on that. And finally, it was clear that companies could benefit significantly by improved transparency, including higher share prices where warranted.
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From our research, which is ongoing today, we have defined certain communication gaps that drive the difference between the way management values their business and the market value today. The most significant of those communication gaps are three that I would like to discuss with you. One we call the information gap: investors need information they don't get. Second, there is a reporting gap: management agrees information is important and that they are not reporting it. And thirdly, the quality gap, where management simply doesn't have all the important performance information they need.
This quality gap often underlies the reporting gap. Management doesn't have all the information; they don't report it because they don't have it. And that gap is by far the most troublesome.
We group the kinds of information that investors want into four categories, fairly simple: market information, company strategy, and the key information used to manage the company; finally, the value platform, measures of the real drivers such as innovation and brands, people and customers, as Dr. Litan just mentioned.
Many of the elements underlying the four categories will differ by industry sector, but the four categories hold true for all companies. Investors and analysts and managers all agree this is the information that is important and that they need.
So if all agree, why doesn't management communicate more? There are likely many answers, some of which we have heard—it is not required, it is competitive, it is not reliable, we don't want to go first, there are no standards. And the more we disclose, the more legal liability we have.
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And yet we haven't met a CEO or CFO who doesn't basically agree that eventually the market will approach a new model for communication similar to our ValueReporting framework. Many companies are leading the way on a voluntary basis.
In the spirit of transparency, we have no conclusive evidence that better disclosure will actually lead to accurate share prices. But our survey respondents did indicate the benefits of greater transparency to companies would be increased management credibility, more long-term investors, improved access to capital, and more accurate share prices.
There are benefits to investors as well. Simply put, value reporting would give investors the information they need to make better investment decisions.
ValueReporting requires dramatic changes in management and board attitudes toward corporate reporting. In recent hearings, I understand, the subcommittee has looked at the role of the board and the audit committee in corporate governance. Boards of Directors need the information embodied in ValueReporting to properly evaluate management, and they have a responsibility to make sure that investors get such information as well.
We encourage the creation of new venues for reporting, beyond the boundaries of traditional financial statements, to give investors more information about the real sources of value in the business. Thus, we don't propose to make traditional financial reporting less relevant, or to replace it, or to put lots of intangibles on the balance sheet.
Thinking in terms of the balance sheet probably misses the point. Companies should give the market reliable and relevant information, and the market will figure out what to do with it.
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I appreciate the opportunity to be with you today, and look forward to answering questions.
[The prepared statement of Ellen H. Masterson can be found on page 259 in the appendix.]
Chairman BAKER. Thank you very much.
Our next witness is Professor of Accounting, The Wharton School, University of Pennsylvania, Dr. Robert Verrecchia.
Welcome, Doctor.
STATEMENT OF ROBERT E. VERRECCHIA, PUTZEL PROFESSOR OF ACCOUNTING, THE WHARTON SCHOOL, UNIVERSITY OF PENNSYLVANIA
Mr. VERRECCHIA. Thank you for inviting me.
In the brief time that I have to testify, I would like to offer the perspective of someone who wears the proverbial ''two hats.'' That is, first I would like to offer the perspective of someone whose instruction material touches on many of the issues that are central to the debate about the process that promulgates accounting standards and firms' adherence to those standards. Later, I would like to offer the perspective of the researcher who has attempted to document the economic benefits of increased disclosure and greater transparency.
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With regard to pedagogy, it is at least a partial indictment of the financial reporting process that one of the most popular elective classes in the Wharton MBA program is an accounting class whose chief purpose is to discuss how firms gerrymander their financial statements to conform to the letter of various U.S. generally accepted accounting principles, U.S. GAAP, but not necessarily the spirit. Further, one of the most popular executive education programs sponsored by Wharton is one in which the financial reporting peccadilloes of firms are brought out into the open and put forth for ridicule.
Many of the instructors at Wharton are sensitive to the concern that in regaling students with tales of financial reporting chicanery, we may also be promoting this behavior on the part of our graduates. In our conceit, we rationalize our way around this dilemma by arguing that in any accounting Armageddon, it is important for our students to be better-armed than the students from our peer institutions.
In short, viewed from the rarified air of academe, the accounting standard process appears structured in such a fashion as to produce the occasional accounting debacle. Industry and financial groups, and their auditors, sponsor a private sector agency, the Financial Accounting Standards Board, to offer accounting pronouncements and guidance from which the very same corporations and their auditors will either benefit or suffer. In other words, it is a process that, at best, seems fraught with moral hazard problems, and, at worst, results in accounting opinions that appear to pander to the worst aspects of corporate America.
These problems are only exacerbated when auditors who lobby the rule-making process in behalf of their corporate clients are then asked to implement these rules. In an environment like this, should we have expected anything less than the occasional Enron/Andersen misadventure?
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Part of the problem with the rule-making process is the failure to be guided by two broad principles. One, wherever practical, all publicly traded companies should be required to adhere to a regime of full and fair disclosure. And two, whenever effective control is exercised over an entity, financial results of that entity should be fully consolidated into the controlling firm.
Unfortunately, all too often in the rule-making process, corporations, through their lobbyists, appear to employ a variety of self-serving arguments to circumvent these principles. This problem is further exacerbated by the fact that the rule-making process itself seems more absorbed in the detailed minutiae of accounting transactions than in the economic substance of those transactions.
Opponents of the recognition of substance employ these arcane debates to frustrate rule-making at all levels. No better example of this exists than the treatment of employee stock options.
But from a research perspective, the real tragedy of recent financial reporting deficiencies is the failure of all representatives in this debate to recognize the clear and obvious economic benefits of increased disclosure and greater transparency—lower costs of capital for firms, increased liquidity for firm equities, greater participation in the capital generation process by the public, and so forth. Recently, contemporary accounting research has attempted to document these benefits. While somewhat nascent, this research nonetheless is consistent with prevailing notions that increased disclosure is beneficial to the capital generation process.
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Commitments to increase disclosure on the part of firms do indeed result in lower costs of capital, increased liquidity, and so forth. The research results are clear and compelling, and buttress traditional claims that greater transparency enhances access to capital markets.
But if contemporary research can document the benefits of increased disclosure, why do publicly listed corporations not embrace it to the fullest extent? One rationale for less than full disclosure is that disclosure may require disseminating information about a firm's proprietary business model, proprietary management expertise, proprietary technology, and so forth. This, in turn, may work against the interests of a firm that reports publicly, and to the benefit of firms that compete against it.
To the extent to which these competitors are based outside the U.S. or report under accounting standards other than U.S. GAAP, this provides powerful political leverage for less disclosure. But in a sense, a call for greater disclosure is no different from a variety of welfare arguments. While full disclosure and full consolidation may lead to both winners and losers in capital markets, indisputable increased disclosure serves the greater good.
In short, the thought with which I would like to leave the subcommittee is that the rule-making process be governed by an ideal of full and fair disclosure and full consolidation. Perhaps stated differently, arguments in favor of anything less than full and fair disclosure and full consolidation should require a high burden of proof. While full and fair disclosure and full consolidation will not eliminate failures that result from fraud, flawed business models, and/or unexpected industry and economic downturns, they will work to ensure that failures are not the results of a reporting system that gives firms and their managers unwarranted discretion to obfuscate an entity's overall financial condition.
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Thank you very much, and I will await any questions.
[The prepared statement of Robert E. Verrecchia can be found on page 285 in the appendix.]
Chairman BAKER. Thank you very much, Doctor.
Our final witness on this panel is Mr. Steven Wallman, CEO of FOLIOfn, and a former SEC Commissioner from 1994 to 1997. Welcome, sir.
STATEMENT OF STEVEN M.H. WALLMAN, CEO, FOLIOFN, INC., AND COMMISSIONER, SECURITIES AND EXCHANGE COMMISSION, 1994-1997
Mr. WALLMAN. Thank you, Mr. Chairman. And today I am representing only myself.
Our capital markets are clearly the means pursuant to which capital flows from those who have it to those who need it. I don't think there is any proposition that can be gainsaid other than that our capital markets do, in fact, work better than anybody else's. They work better now than they have in the past. But the recent events of the last year have also shown how much more we need to do in order to make them work even better.
Capital markets rely on public disclosure to work efficiently. Financial statements, along with other mandated and voluntary disclosures, are, if you will, the bedrock of that system. And they are what allow investors to make efficient resource allocations.
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Generally accepted accounting principles are the language of financial statements. More than half-a-dozen years ago, it was apparent that GAAP was starting to fail in one of its most essential purposes, which was to be able to provide useful, timely, and relevant disclosures to investors. About 6 years ago, we commenced a study at the SEC looking into these issues. At that time, the whole proposition that there might be something failing with regard to GAAP was viewed as somewhat heretical. I think today, in hindsight, it is not quite as heretical.
Let me explain five ways, sort of the normal who, what, where, when, and how, where GAAP is currently having some difficulties in fulfilling its purposes.
First, in connection with sort of what is measured, accounting principles are geared to measure bricks and mortar—basically a tangibles-dominated world from the past. Increasingly today, the drivers of wealth production are intangibles. They are generally created internally, not acquired, but GAAP generally measures them only when acquired, not generally when they are created internally. So we have a sort of what is measured inconsistency.
Who is measured has been brought to light in connection with what we are seeing now with special-purpose entities and other arrangements, where the boundaries of a firm are increasingly difficult to discern. It used to be you could tell where a firm began and where it ended, and what business it was in. But derivatives today, SPEs, off-balance-sheet activities, partnership arrangements, and other kinds of things have blurred that boundary quite considerably.
A third area obviously is timeliness of measurement. Things move more quickly now than they have in the past. Financial statements clearly are generally backward-looking, even though there is forward-looking disclosure embedded in financial statements—reserves, for example, are clearly forward-looking. Yet the concept of a forward-looking financial statement is one that is hard for some to discern.
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Access to information is another. GAAP is its own language at this point. Those who wish to understand what is truly going on in a financial statement have to spend some significant amount of time investigating it. And in fact, there are people who spend their careers taking the aggregated information in financial statements and then disaggregating it in order to understand what is really happening.
Moreover, the language of GAAP is now sufficiently esoteric and specialized in many cases that it has even its own dialects with regard to specific industries and different instruments and circumstances within those industries. And even though financial statements increasingly, I think, fairly put, are beyond the comprehension of the lay person, and even many professional investors, we continue to require their distribution to all, maintaining the to-some-degree fiction that they should be useful to all. At base, I think we in a sense almost mislead people when we suggest that financial statements should be distributed widely because they are widely understandable. They clearly, at this point, are not.
Finally, how things are measured; accounting requirements clearly, in my view, have become very rules-oriented. You heard earlier somebody talk about them as sort of a by-the-book type of check-the-box type of accounting, and I think that that is a problem. We need to have more goals-oriented, more principle-oriented approaches. We will not be able to close loopholes, but one of the most effective, one of the most overwhelmingly effective standards in the securities laws for the last three-quarters of a century has been one very simple concept, the notion of 10(b)(5). And that is in essence a very broad-based principle with regard to disclosure, and it has been, if you will, one of the most effective means for ensuring appropriate disclosure ever created.
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The current scandals clearly indicate, I think, how outdated GAAP can be when people stretch it to the extreme. Let me talk about a couple things that might be useful to try to address some of these concerns.
One is, FASB and the SEC have already taken important steps to address some of the intangibles deficiencies. And they are doing more, and I think that is worthwhile, in terms of general principles there. In addition, Chairman Pitt and the SEC have already asked for further disclosure with regard to the principal accounting judgments that are currently being made by accountants and issuers. I think that is a very important thing to get out into the public disclosure.
In addition, there are other incremental steps that I think are worthwhile to take. One is the idea of re-educating the profession that the overall principle of financial statement reporting is that they have to present a true financial picture of the company, and not basically what is in accordance only with respect to generally accepted accounting principles, but whether or not the overall presentation is in accordance with generally accepted accounting principles and a fair presentation.
And finally, there are some other suggestions that one could explore, such as requiring a second firm to provide a review of the more important principles and judgments being made by an auditing firm, at least in connection with the largest corporations, so that there is a means for some double-check with regard to the very broad-based and important decisions that are being made in connection with major firm audits.
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Thank you.
[The prepared statement of Steven M.H. Wallman can be found on page 289 in the appendix.]
Chairman BAKER. Thank you, Mr. Wallman. You were discussing a point which I had raised with the earlier panel, with regard to the obligation to present an accounting methodology that reflects true value, and that where the utilization of an accounting mechanism is not for the purpose of building value or enhancing shareholder perspective, that that be questioned or noted in some special way. Is it your view that that is not the underlying principle of compliance with GAAP today, that we are so technically focused on the construction of the rule that bright people spend a lot of time trying to figure out how to comply with the rule and become, therefore, GAAP-compliant, but by so doing obfuscate the true financial condition of the company?
Mr. WALLMAN. I think there are two points in what you are bringing up. One is the question of whether there are transactions engaged in that have no true business purpose, but which are being done in order to take advantage of a rule. And the second is whether or not, even when that is not being done, are the rules such that the presentation to investors that is generated by the operation of those rules is such that it does not fairly present the overall financial picture of the company?
With regard to the latter, I think the answer is clearly yes. I think people who read financial statements today, unless they are well-endowed with an interest in financial reporting and accounting, must have difficulty understanding the true nuances of what it is that is being described. The descriptions are no longer in plain English. The words that are being used, whether it is net income or something else, clearly have at this point a whole language behind them that is far beyond what the assumption is when you look at the word, from an English standpoint.
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With regard to the first, whether or not there are those who attempt purposefully to obfuscate, it is a large world. I am sure the answer is that there are those who do, and there are, I am sure, those who get away with it as well. There are those who, I think, could be caught, if you will, by having a simple principle that says if the accountants cannot be convinced that there is a business purpose for something, regardless of what the accounting is, there should be disclosure of the fact that it appears that there is no business purpose for the transaction. That obviously would stop those transactions from going forward. And I am not sure there is anything negative with regard to that conclusion.
Chairman BAKER. Thank you.
Did anybody want to jump in on the topic, with regard to—and I know your general views about what the current deficiencies are of the rules. But I am getting at the consequence of the current rules. Even when you comply, you may not be presenting a clear picture of financial condition. Certainly with regard to forward-looking statements or identifiable business risk or new market development, or whatever might be the thing of value down the road that you are not disclosing, but I am even worried about the accuracy of the historical statement that is GAAP-compliant, in light of the technicalities in which the rules are constructed. They are very difficult for anyone to understand, and more FASB tries to define it, the more complicated the system becomes that they are trying to fix.
I don't know how we get out of this. I don't think we can go from a historical-looking current system to a forward-looking internet-based system overnight. But certainly there has to be some force in the market to bring about these changes—and I don't know that the Congress is the appropriate forum for that to occur. But what are your recommendations about how we get where we need to be? What is the first next step?
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Dr. Litan.
Mr. LITAN. Well, I think there are several steps. On the forward-looking information question, which relates to all these non-financial indicators that several of us talked about, as well as to moving to the internet, the prime mover, in my opinion, has to be the SEC. It shouldn't do it by mandate; it should do it by encouragement, arm-twisting, if you will, education. But it has to be the agency out in front helping to create a demand among investors—working through the media, because once people know that this information is out there, or capable of being produced, then sophisticated investors, namely institutional investors, I think, will begin to demand it. And you will see a virtuous cycle. But somebody has got to start the cycle, and it has got to be the SEC.
Now, the second point concerns the existing GAAP-based system, not the forward-looking information. Now you get into this debate which has no clear resolution, where you have GAAP, which has highly detailed rules versus international accounting standards, which are basically principles-based, and much more general in nature. But, as Congressman Sherman pointed out, the international rules may allow too much discretion. So you're damned if you do and damned if you don't.
There are problems with each approach, which is why I end up recommending competition. Rather than give a monopoly to one rule-setter in one geographic area, I would like at least to see some marketplace competition. Firms choose among the standards, and then what the media will do and the analysts will do is they will write about which standard, on the whole, better serves investor interests. And you will get investor demand, I think, for the better standard. And let them go at each other, head to head.
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But I think in the absence of competition, you are going to be beating a dead horse.
Chairman BAKER. Ms. Masterson, or Dr. Verrecchia? Can you comment on the subject?
Ms. MASTERSON. Yes, I would. I think there is a lot—as you said, this is not a one-step process. In fact, it is probably a longer process than any of us wants to think about.
But certainly one of the outcomes of the system we have today is this, I think several of us mentioned the obsession with earnings, with current short-term earnings. And the earnings game is very real. We see that; we got a lot of information about it in our research.
And the fact is that those short-term earnings pressures don't really turn into that long-term investor value in many cases. And so where we get the rules that are so focused on short-term wins and companies feeling that it has got to be this quarter over last quarter, and immediate results, and not an ability to really talk with investors about what they are doing to build long-term value—I think that is where, whether it is rules or principles, we just get caught in that same old cycle.
So getting more information about the long term—I agree that the SEC is a main player here. I think industry-driven initiatives have got to come into play, and the FASB has actually sponsored some of the industry-based coalitions. We do have early adopters in the marketplace today, and hopefully there will be some pressure to follow them.
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But giving investors more information about the long term can hopefully balance out that obsession with short-term earnings, which I think is at the heart of the manipulation, whether there are rules or principles.
Chairman BAKER. Right, thank you.
Mr. Castle, did you have a question?
Mr. CASTLE. Thank you, Mr. Chairman. I want to sort of start where I stopped before. And I am delighted that you gave me the information about Standard and Poor's beginning to bring stock options into their corporate reporting. Maybe they heard I was going to ask questions about this today or something like that.
I would like to really, I think, ask all of you this question. And you all were in the room when I asked questions about it before. But I am a little hung up on this subject, admittedly. I know it is a smaller part of the transparency issues, and I agree with the Chairman, I think accounting methodology which reflects true value is what we are all after. I think we all would basically agree on that. And I agree with the short-term earnings pressures that Dr. Litan and Ms. Masterson have both talked about. If there is some way to spread it out so we didn't always look for it, I think it would be helpful indeed.
But stock options in particular do trouble me. I have seen all kinds of opinions on it. I have seen expensing options when granted, expensing options when they are actually executed, or just leaving it alone and doing it in the footnote. I see here from an article in Business Week, which I clipped out, the boards make matters worse by so lavishing options on executives they now account for a staggering 15 percent of all shares outstanding—whether it is true or not, if it was even remotely close to true, that is an astounding number, a percentage of the capital of any corporation which exists out there.
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And I don't know what the right answer is. And as I said at the beginning—and I am not getting into this—I just think executive compensation has perhaps gotten out of hand in this country. And that is something that I think the corporations are going to have to look at in terms of their own management. And their directors—although the directors benefit from all this as well—and everybody else.
But from an accounting point of view, it seems to me that all of us who are interested in this have a responsibility. And I can't imagine you haven't thought about this issue in some way or another, even though some of you didn't speak to it directly here today. And I would be interested in your views on it. What are your views on what we should do on the accounting entries on stock options?
And you can do whatever you want. You can duck and say, ''I haven't thought about it.'' You can say we should expense it when they are granted, or expense it later, and the methodology by which that would be done. And you will probably have about a minute apiece, when it is all said and done. But I would just be interested—you are four diverse people, even though you have commonality in terms of the area you look at. And I would just be interested in your views on this. Apparently, everybody seems to have different views—the President and Mr. Greenspan differ, others differ. And I am just interested in what the wealth of good, valuable opinion on this subject is.
So maybe we could just go across the table and start with Dr. Litan and go from there.
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Mr. LITAN. I will side with Chairman Greenspan. He said that the one thing we know is that the right answer is not zero. The stock options are valuable; we know that, and they are valuable at the time of granting.
Now, the people who oppose assigning a value say the so-called Black-Scholes method of valuing options is not perfect because the options have all kinds of restrictions; a lot of times the stock isn't well-traded, so you don't have the data to do the precise Black-Scholes valuation. My answer to that, and I think Chairman Greenspan said the same thing, is you do an estimate off that, and even if it is arbitrary, it is better than nothing.
We do it all the time. We have depreciation schedules which are arbitrary. We have loss estimation for bad loans, which is not a science. It is more an art than a science, but we don't just simply pretend the loan is good when it isn't and put a 100 percent value on it. I think an estimate here is better than zero. And so yes, I think there is a right answer. It may not be the perfect answer, but we know that the current system is not the right answer.
Mr. CASTLE. Thank you. Ms. Masterson?
Ms. MASTERSON. I think I am going to take Steve's line and say I am going to speak for myself and not my firm on this one, if I may.
Mr. CASTLE. I actually was only asking you, not for your firm's opinion.
Ms. MASTERSON. Because I am not here to make a statement on behalf of PricewaterhouseCoopers about the accounting for stock options. So I am going to take a little bit different tack, if you don't mind.
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But I think you have hit the point on the head, and that is executive comp in general. One of the things that all investors really want more information about is the quality of management. And management, by and large, is what they are investing in. And whether it is in the income statement, on the balance sheet, in the notes, the information needs to be there about management, the quality of management, the compensation of management, the value that the board has placed on management and where the incentives are leading management behavior.
So I think that fulsome disclosure—with all due respect, if I can dodge the placement of that, I would appreciate it.
Mr. CASTLE. Thank you. And Dr. Verrecchia, I will throw a kicker in on yours, because I think you said in your testimony, and I think I saw it in your writing, that you actually think this has enhanced value to the corporation, if stock options are correctly reported. Maybe I am mis-stating that. I would be interested in that as well as the other question.
Mr. VERRECCHIA. Well, I think any disclosure enhances. But I think that specifically with regard to this, this strikes me as so straightforward and obvious that I think it speaks very much to the controversy about rule-making in general. Obviously they should be an expense. It is probably much easier to measure, through Black-Scholes or otherwise, the value of that expense, than it is a whole bunch of other things that are synthetically amortized.
So in a way, what has happened is people have used this measurement issue to, if you will, put forth an agenda that nothing be recognized at all in the form of an expense, without recognizing that something like that option, like in very sophisticated communities, can be valued with a high degree of accuracy. And so I think most of the arguments are totally disingenuous, that suggest somehow it should not be recognized as an expense because of measurement issues. And if we can't see through this issue, then there is no hope for rule-making in general.
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Chairman BAKER. Thank you.
Mr. Wallman.
Mr. WALLMAN. The measurement issue, I think, is a red herring. And I don't think the argument has really been on that since it was first raised in the mid-1990s. I think everybody understands that issue, both sides.
The question is how best to present the information, and what is—in some cases, the perception of broader-based impacts. And you have had the argument for quite a number of years that expensing it would be something that could deter the use of stock options. As a society, is that something we want or not? Should accounting be neutral or not? These are a number of interesting and important policy decisions that transcend the mechanical questions of whether or not you can come up with a value. The answer is, of course you can. The question is really how best to then use that information.
Some have suggested that there be additional disclosure of the actual calculated expense, and that can be a disclosure. Others have suggested a separate line-item in the financial statements that would break this out, because you get one of the other confusing aspects, as you mentioned yourself earlier, that operating profits, for example, in some companies could be wiped out by showing expenses which are not cash expenses and which could be, therefore, quite misleading to investors looking at the financial statements, wondering how it is that this company can keep making a lot of money in the traditional sense of making a lot of money, but keep reporting losses because the stock price keeps going up.
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And you do get very strange anomalies where the more the stock price goes up, the more there could be an expense; the more the stock price goes down, the less of an expense. Yet management or the employees haven't changed. So you get some very interesting circumstances as to how best to describe, disclose, and present this information.
So I don't think the focus ought to be on the measurement issues. Clearly, that is inapposite, and I think everybody understands that. The real issue or debate has been for the last decade how best to present this information, both to investors so they understand what it is, to managers so it can be used, and also how do these factors implicate themselves in more broad-based societal issues that people have been arguing about for a long time.
I think we should remember this whole debate started in part when managers and others used to get a lot of cash. And there was an awful lot of movement on the corporate governance side to start paying managers not in cash, but in stock and stock options, in order to better align their interests with the corporation. And the view was that we needed to have some way of trying to convince companies and managers to take equity-based compensation so their interests would be aligned with shareholders, as opposed to simply taking cash from the company.
Mr. CASTLE. Are you willing to opine how you would do it, if you were doing the accounting?
Mr. WALLMAN. Actually, I am happy to, because I was on the record as proposing an answer that was in between. And I would be happy to pursue that in detail if you would like. But in essence, it was a hybrid that came up with the equivalent of a charge in terms of coming up with the amount, the measurement amount, but showing it on a separate item, so that it was fully disclosed and people could understand what it was, as opposed to mixing it into an overall cash, otherwise understood compensation expense.
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Mr. CASTLE. Thank you. I appreciate all of your answers, which I think were clear and helpful, and I yield back, Mr. Chairman.
Chairman BAKER. Mr. Castle, on that subject, the Chairman wrote on October of last year to FASB relative to the expensing of stock options. And in the response that FASB gave to the Chairman, they arrived at a disclosure regime, not requiring expensing. But they got to this point in a rather convoluted way, because their preference was to expense, but because of the divisiveness of the subject matter, I quote, ''the Board chose a disclosure-based solution for stock-based employee compensation to bring closure to the divisive debate on the issue, not because it believes that solution is the best way to improve reporting.''
So our non-political board happened to make a political judgment, I guess, which gets me to the next difficult question that none of you have spoken to yet. Can we get where we need to go with FASB as the accounting regulator, centered on a rule-based system? Aren't we looking at a very—this issue itself presents evidence of the difficulty. With regard to derivatives treatment, there was a 10-year debate. With regard to SPEs, there was a 10-year debate and then a statement issued saying we have decided not to take a position.
In the world in which we live, it may not be the fairest, but we need decisive response to inappropriate market conduct, so that investors at any time and moment are getting access to clear-cut, helpful, usable information. We are trying to put a horse and an automobile together here, and I think that we maybe better advised to go get us another mechanic. What is your view about the viability of reform versus a whole new approach?
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Yes, sir?
Mr. LITAN. Well, I think, as I said in my written testimony, a second-best solution to the slowness problem is to have the SEC threaten to step in and set a rule with some kind of deadline. I want to be clear, I don't think that is a perfect solution, but it is better than where we are now.
Now, the problem inherently, both as to slowness and to political influence, is that ultimately FASB can, at any moment, be influenced by the Congress. And it will be as long as FASB reports to the SEC. It is inherently a political creature. I think the only way to reduce political influence is to have competition in standards, as I said before.
Now, you could imagine replacing FASB with IAS, international standards. But that would just move the politics to some other place, it would move it to London. And then it would dilute American interests, obviously. We would have to compete with overseas interests. But I am not sure that would be a necessarily better answer. London may be even slower than Greenwich, Connecticut.
And, by the way, I am not sure IAS would be a stable solution. I think we would end up, over time, having national accounting bodies potentially interpret IAS to apply to specific countries. And so we could end up right back where we are now, with different flavors of different accounting standards.
Chairman BAKER. From your perspective, is FASB asset-limited? If they have been operating in a deficit posture for the past 4 years, they obviously can't be adding on any large numbers of staff. Is it advisable to consider a federally based support system for FASB to break the tie between the industry and the FASB regulatory body, and to give them pay parity in order to do the work they need to do? Is that an element of the delay, or is that a factor at all?
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Mr. LITAN. Well, I will give my opinion, and then I don't want to monopolize attention. I think that a more stable funding source could help reduce the perception that FASB is in anybody's pocket. But it doesn't solve the political problem that I put my finger on, because you can still get political interests working through the Congress who don't like stock option expensing, and they can still stop FASB in its tracks.
So I don't think the funding thing, while it may be meritorious, is a perfect magic bullet. I think the only chance you have got is competition, and let the market pressure both FASB and IAS to come up with more rapid standards, and also to do so in a way that is in the investor's interest.
Chairman BAKER. Any differing opinions?
Mr. WALLMAN. Yes. I mean, I think competition is an interesting idea, and people have suggested it a number of different places. It is not a panacea, though, and it will not, in my opinion, I think, do much other than create two fora where politics can be brought to bear in various respects. And I don't think you are guaranteed a better result out of either of them just because you now have competition between them.
I think we also end up with the potential issue for there to be misunderstandings. It obviously becomes somewhat more confusing for investors who now have two different sets of standards. It is already confusing for investors in trying to figure out what GAAP is meaning; forget trying to figure out what two different kinds of GAAP mean. I mean, there are a number of different issues.
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On the other hand, I think the convergence that has been talked about is also happening, and I think on most issues you end up with people who are intelligent concluding reasonably the same thing with regard to how to try to do something. The problem is that the world is very complex, and the problem is that when you continue to try to come up with specific rules that cover things, it becomes increasingly like the tax code.
And like the tax code, we don't have people out there who decide that they can intrinsically and inherently understand it just by sort of looking at a bunch of books. There are tax lawyers who are paid to do nothing but try to figure it out, and we have courts that are specialized in trying to understand it.
We are in a position here where we are looking for something that is useful for the marketplace as a whole and for investors generally speaking. And in order to provide something to them that is useful, it needs over time to be something that has more and better disclosures with respect to it. And to some degree, we create, I think, a problem by trying to roll things up to specific numbers.
I think Standard and Poor's is a great example of an entity that has attempted at this point—in part because there were concerns about whether or not the numbers it is using are useful for what it is trying to do—to now itself try and analyze it better, and to come up with its own view of core numbers, separate from what FASB and what the SEC and others think are the generally accepted accounting numbers that ought to be suggested to the public, and different from what it is that we will have the public see in audited financial statements. S&P will basically use its own.
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That is an interesting opportunity, if you will, for competition. We already have competition there, if you will, and we will see whether or not people prefer to see what S&P produces versus what it is that somebody else produces.
I think it was said earlier in the previous panel, too, that you can end up in a position where as long as you have got full information out there, and the line items are clear and the disclosure is obvious, you can end up with others—whether they are analysts, whether they are entities like S&P or others—creating, if you will, their own view of what financial statements are like.
So I think that we, in essence, end up with sort of the competition, if you will, for ideas and thoughts through that means, without trying to come up with multiple places to have influence peddled with regard to politics and financials.
Chairman BAKER. Do I take from that, then, you do not believe that a regulatory restructuring makes any sense? That it is pressure to get the current structure to move in the disclosure regime that you see as appropriate?
Mr. WALLMAN. I think that whenever there is a failing, there is a question of whether or not there needs to be a change in the overall structure. And I think it is a worthwhile question to ask. Personally, I think that to some degree the failing has been in the approach. It has been too much of an attempt at, if you will, closing barn doors after horses have escaped, trying to come up with the next rule to take care of the last problem. And what we need is a more forward-looking approach, if you will, to regulation.
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I think that the people are in a position to be able to exercise that, and to do it appropriately, if one can step back and take a more general approach to rule-making. And I think the SEC has begun to do that, and has done it in various instances. And I think the FASB, with its new business combinations approach, has done that as well. So I think you are starting to see that, and I think people have recognized that that is a necessary element to appropriate rule-making going forward. That, I think, is the restructuring.
There is a separate set of issues, which is whether or not there is a sufficient level of resources both at the Commission and at FASB, whether or not the funding really ought to be something where the private sector has to step up to fund this, which necessarily entails the question of where is influence coming from with regard to that.
But I think stock options is a worthwhile point in case: the pressure there came not from the private sector suggesting they were going to withdraw funds from the FASB if it went forward with the project; the pressure there came from Congress suggesting that FASB was doing something inappropriate if it were to expense stock options.
Chairman BAKER. Thank you.
Mr. Castle, did you have any further questions?
[No response.]
Chairman BAKER. I don't know if anybody wants to make any further comment on the Standard and Poor's approach that was issued today, if you have any degree of familiarity with it. But if, after review, you find it of interest, or if there is comment worthy to send to the Committee, we would be appreciative for analysis and comment as we move forward.
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This is a very meager beginning to a very long process, but I want to express my appreciation to each of you for your time in being here today. Your insights have been very helpful to us, and I am certain we will be working together over the coming months toward the goals we all have in mind.
Thank you very much. Our hearing is adjourned.
[Whereupon, at 4:30 p.m., the hearing was adjourned.]