Who Rules Accounting?
Congress muscles in on FASB -- again.
Craig Schneider, CFO Magazine
August 04, 2003
Dennis Beresford is having flashbacks these days, and they are anything but pleasant.
Congress is once again trying to derail the Financial Accounting Standards Board's efforts to
require companies to expense stock options. And for the former FASB chairman, the
lawmakers' moves are a painful reminder of what happened during his tenure at the board's
helm nearly a decade ago. "It's déjà vu all over again," says Beresford, now a professor of
accounting at the University of Georgia.
Under intense pressure from Capitol Hill, FASB under Beresford backed off of a similar
proposal in 1994, compromising not only the board's position on expensing but its very
independence as a standard setter. It took years for the board to buck congressional pressure
again, this time on new, far-reaching rules on derivatives and business combinations. Of
course, FASB's submission to Congress did nothing to prevent lawmakers from scolding the
board for the cautious pace of its deliberations on accounting issues related to the Enron
scandal.
No one in Washington, D.C., claims to desire an end to the independent setting of accounting
rules, at least in public. The legislators insist they are merely trying to aid the struggling
economy by encouraging greater use of entrepreneurial incentives.
But will keeping stock options off the income statement have the desired effect? Many
observers contend that while FASB's 1994 decision not to require options expensing may have
inspired entrepreneurs, it also certainly motivated executives to pump up their companies'
stock prices by whatever means necessary. In fact, the widespread use of nonexpensed stock
options is generally thought to have led not to economic strength, but to inflated stock-market
valuations, excessive executive compensation, accounting frauds, bankruptcies, and the loss
of approximately $5 trillion.
Some managers may welcome congressional efforts to reinflate the stock- market bubble, but
forcing FASB to back down on options could instead undermine whatever confidence in the
financial markets investors have since regained. "The capital markets need high-quality,
unbiased information to make allocation and pricing decisions," says FASB board member G.
Michael Crooch. "Managing accounting data for some hoped-for economic result is too risky
and dangerous."
A Simple Bill
The current fight is still in its early stages. Until recently, in fact, the latest debate over
expensing was limited to arcane issues involving valuation methodology. But now Congress
has reentered the picture, and its legislative steps would render the outcome of the debate
about valuation methods all but moot.
At first glance, the bill introduced in March by Rep. David Dreier (R-Calif.) and co-sponsored
by Rep. Anna G. Eshoo (D-Calif.) — H.R. 1372, or the Broad-based Stock Option Plan
Transparency Act of 2003 — sounds innocuous enough, calling as it does for enhanced
disclosure of stock-option plans.
But the bill, which has attracted considerable bipartisan support, including that of half the
Democratic presidential hopefuls, first demands a three-year study by the Securities and
Exchange Commission to assess the potential impact of broad-based stock-option plans on the
economy.
Meanwhile, the legislation would impose a moratorium on new FASB rules related to stock
options, so if the board went ahead and mandated expensing anyway, the SEC would be
barred from recognizing the rule as part of generally accepted accounting principles (GAAP).
So much for independently set accounting standards.
Back to the Future
In the face of similar pressure nine years ago, FASB's retreat enabled it to live to fight another
day. But board members and others involved in that decision now regret the move. Former
SEC chairman Arthur Levitt admits that urging FASB to back off was "the biggest mistake I
made" during his eight-year tenure.
The International Accounting Standards Board (IASB), FASB's international counterpart, is
clearly concerned about the impact the bill could have on accounting standards in general. "If
the U.S. Congress or political authorities in other countries seek to override the decisions of
the competent professional standard setters...accounting standards will inevitably lose
consistency, coherence, and credibility," warned Paul A. Volcker, former Federal Reserve
Board chairman and current chairman of the foundation that oversees the IASB, in written
testimony.
But Eshoo and Dreier represent districts in California where incentive stock options are still
sacrosanct. And to be sure, high-tech companies, many in their early stages and strapped for
cash, rely on stock options as incentives for employees as well as for executives. According to
these lawmakers, expensing would hobble the ability of such start-ups to attract talent and, in
turn, stifle innovation in the U.S. economy. "This is a public-policy issue," said Dreier in his
testimony at the hearing in June. "This is not an accounting issue."
Yet it's hard to see how accounting is not public policy when the public relies on financial
statements prepared under U.S. GAAP to determine whether companies deserve its capital. In
FASB's view, options should be included in the income statement like other forms of
compensation expense, because that would give shareholders a more honest picture of a
company's finances than burying the impact of options in the footnotes. Investors applaud the
stance. "If the result of having [option-based pay] expensed means you do away with the
plans," says Peter Clapman, senior vice president and chief counsel of corporate governance at
TIAA-CREF, "it means that it was never a particularly good form of compensation in the first
place, because it shouldn't depend on accounting treatment."
The IASB, for its part, agrees with FASB. And there's nearly universal agreement that the
capital markets would benefit from a single global standard for financial reporting on this item
as well as others.
Of course, it's not surprising that FASB's congressional opponents claim their legislation does
nothing to compromise FASB, which was established in 1973 as a replacement for the
American Institute of Certified Public Accountants's Accounting Principles Board.
With a board of seven paid, full-time members intended to keep standard setting a function of
the private sector, FASB's structure is supposed to ensure its independence from private
interests that might interfere with its primary objective of creating neutral accounting rules.
And while the Securities Exchange Act of 1934 gives the SEC the authority to set standards,
the commission delegates that authority to FASB.
Lest Congress forget these facts, current FASB chairman Robert H. Herz reminded members
during a recent House subcommittee hearing on H.R. 1372. "The moratorium," he proclaimed,
would likely establish a "potentially dangerous precedent" and "signal that Congress is willing
to intervene in the independent, objective, and open accounting standard-setting process
based on factors other than the pursuit of sound and fair financial reporting." Herz also noted
that such interference would be "inconsistent with the language and intent" of the SarbanesOxley Act of 2002, which includes added measures to ensure FASB's independence. He warned
Congress that unlike his predecessors, he's "not gun-shy" about promulgating that view.
But Herz's warnings fell on deaf ears. Eshoo agrees that Congress "should not get into writing
accounting standards" and that "FASB should be able to retain its independence." How exactly
can that circle be legislatively squared? "If we are prevented from issuing what we consider to
be a better and high-quality standard," notes FASB's Crooch, "that's not very far from setting
a standard."
Damned Economy
Dreier and Eshoo, however, adamantly defend their efforts. "I'm not doing anything that's
counter to my constitutional obligations," Dreier insists. Eshoo says much the same thing. "I
wish there were a meeting of the minds [with FASB]," she says, "but if there isn't, then I
believe that it is absolutely appropriate. It is not interference, it is Congress exercising its
responsibility relative to our nation's economy." She adds: "FASB has not been willing to
examine anything except expensing, and economic issues be damned. I think we can do
better than this."
Dreier jests that he could — but wouldn't — flip FASB's claim by saying "that they're
tampering with our ability to create policies that encourage economic growth."
But there's reason to believe that Dreier and Eshoo are mistaken about the need to restrain
the board to help the economy. Consider Netflix, an online DVD rental service that went public
in May 2002 and announced this past June that it would expense options. Expensing, says CFO
Barry McCarthy, provides the company with "consistency in financial reporting." And he
doesn't expect the decision to have a negative impact on his ability to raise new capital. "In
my experience," he says, "investors increasingly distinguish between accrued expenses and
real cash expenses."
What's more, McCarthy suggests lawmakers are being disingenuous about the intended
beneficxiaries of the legislation. "Whenever you have large public companies that think their
ox is going to be gored by a change in accounting principles," he says, "there's going to be a
battle about the outcome."
Battle-hardened FASB members aren't taken aback by what's happening. "Standard setting is
not a popularity contest and shouldn't be a popularity contest," notes Jim Leisenring, who was
vice chairman of FASB during the earlier debate over expensing, and one of the two members
who did not succumb to congressional pressure in the final vote. Leisenring, now a member of
the IASB, says, "I believe FASB made a mistake in backing down, but they did so in the
context of having no support from anyone."
A Delaying Tactic
How will the new battle turn out? Because of the dangers posed by the proposal in Congress,
some observers predict it won't get very far. "I don't believe in the face of continuing
revelations of accounting misdeeds that Congress is likely to destroy the standard-setting
process," says Levitt. "It's just a delaying tactic."
Levitt isn't alone in dismissing the threat. TIAA-CREF's Clapman believes some lawmakers who
may have been comfortable 10 years ago openly favoring the high-tech-industry position on
options are reluctant to do so today. "A congressman or -woman who looks at this knows that
their position is being scrutinized in ways that were not the case back in 1993," he says.
What's more, big accounting firms like Ernst & Young and shareholder lobbyists like the
Council of Institutional Investors have reversed their opposition to expensing, while nearly 300
public companies, including Microsoft, have adopted it during the past 18 months in
anticipation of a change in the rules. While Microsoft recently abandoned new options grants in
favor of restricted stock, the technology bellwether has also decided to expense options
already granted.
The SEC has historically supported FASB's decisions, and chairman William H. Donaldson is on
record as favoring the board's efforts to expense options. FASB "has put itself on the line and
said there's an expense attached to stock options," Donaldson told the Economic Club of New
York in May. "I am waiting restlessly for this to happen." But will Donaldson stick to that
position under pressure from Congress or the White House?
With enough political support for the bill, Eshoo predicts that the head of the SEC would find it
difficult not to go along. "Certainly, chairman Levitt did," she observes. Levitt himself thinks
Donaldson will stick to his guns. "We have an SEC chairman that is solidly behind the
expensing proposal," he says.
To be sure, Donaldson also said publicly that he plans to visit with executives in California who
oppose expensing options. "I am willing to listen," he said in May. But he told them not to get
their hopes up. "As far as I'm concerned," he warned, "we have crossed the Rubicon."
Perhaps. Congressional support for the bill is by no means overwhelming at this point. But
Beresford fears that Sarbanes-Oxley has inadvertently made FASB more vulnerable to political
pressure. Previously, about a third of FASB's annual budget came from voluntary contributions
from public accounting firms, the AICPA, and some 1,000 individual corporations.
Under Sarbanes-Oxley, those voluntary contributions are replaced by mandatory fees from all
publicly owned corporations based on their individual market capital-ization. But the fees are
to be collected by the newly formed Public Company Accounting Oversight Board. And the SEC
oversees the PCAOB.
While Beresford believes the new setup gives FASB more independence from the business
community, he says, "it's not clear that it has more independence from the political process.
In fact, it may have less [independence] from Congress and other people in Washington."
Under the new arrangement, it's a pretty simple matter for the SEC to pressure FASB. "The
SEC could give them a hard time with their budget," notes Beresford, "and just not get around
to collecting the money they made."
In other words, how FASB votes on options expensing may depend on how William Donaldson
handles the board's paychecks.
D.C. Versus the Board
Stock options haven't been the only source of friction between the Financial Accounting
Standards Board and its federal overseers. To be sure, the Securities and Exchange
Commission has only officially overridden FASB once since the board's inception in 1973. That
decision came a few years later, as FASB was writing rules for oil and gas exploration and
development costs.
Congress, for its part, has taken an interest in several other FASB projects over the years,
including accounting for derivatives and the business combinations and goodwill project. The
latter issue, which ultimately eliminated pooling of interests accounting, spawned legislation
and arguments that are strikingly similar to those stemming from today's options-expensing
debate.
During hearings on the proposed elimination of pooling, for instance, Cisco Systems Inc. CFO
Dennis Powell, then corporate controller, warned during a Senate hearing that the proposal
"will certainly stifle technology development, impede capital formation, and slow job creation
in this country." He further argued that a switch to the purchase model would lead companies
with a higher percentage of acquired intangible assets "to report an arbitrary, artificial netincome number that is irrelevant and misleading."
Of course, that view assumes that investors' perceptions are more important to economic
growth than business fundamentals, and the bursting of the Internet bubble has thrown cold
water on such thinking, at least for the time being. But that hasn't prevented industry
lobbyists from rehearsing the argument in the latest battle with FASB.
Yet Barry McCarthy, CFO of online DVD rental service Netflix, thinks such concerns are vastly
overblown. "Our investors focus on EBITDA and free cash flow just as much as on net income
and net loss in deciding what the enterprise is worth," he says. "The conventional wisdom on
Wall Street has been that investors look right through the stock-option charges for tech
companies."
According to Silicon Valley, however, they won't if the charges are no longer buried in the
footnotes. The question is, is that a good thing or a bad thing? —C.S.
© CFO Publishing Corporation 2003. All rights reserved.