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108th Congress                                            Rept. 108-609
                        HOUSE OF REPRESENTATIVES
 2d Session                                                      Part 1

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



 
                   STOCK OPTION ACCOUNTING REFORM ACT

                                _______
                                

                 July 15, 2004.--Ordered to be printed

                                _______
                                

  Mr. Oxley, from the Committee on Financial Services, submitted the 
                               following

                              R E P O R T

                        [To accompany H.R. 3574]

      [Including cost estimate of the Congressional Budget Office]

  The Committee on Financial Services, to whom was referred the 
bill (H.R. 3574) to require the mandatory expensing of stock 
options granted to executive officers, and for other purposes, 
having considered the same, report favorably thereon with an 
amendment and recommend that the bill as amended do pass.

                                CONTENTS

                                                                   Page
Amendment........................................................     1
Purpose and Summary..............................................     4
Background and Need for Legislation..............................     4
Hearings.........................................................     7
Committee Consideration..........................................     7
Committee Votes..................................................     8
Committee Oversight Findings.....................................    12
Performance Goals and Objectives.................................    12
New Budget Authority, Entitlement Authority, and Tax Expenditures    12
Committee Cost Estimate..........................................    12
Congressional Budget Office Estimate.............................    12
Federal Mandates Statement.......................................    14
Advisory Committee Statement.....................................    14
Constitutional Authority Statement...............................    14
Applicability to Legislative Branch..............................    14
Section-by-Section Analysis of the Legislation...................    14
Changes in Existing Law Made by the Bill, as Reported............    17

                               Amendment

  The amendment is as follows:
  Strike all after the enacting clause and insert the 
following:

SECTION 1. SHORT TITLE.

  This Act may be cited as the ``Stock Option Accounting Reform Act''.

SEC. 2. MANDATORY EXPENSING OF STOCK OPTIONS HELD BY HIGHLY COMPENSATED 
                    OFFICERS.

  Section 13 of the Securities Exchange Act of 1934 (15 U.S.C. 78m) is 
amended by adding at the end the following:
  ``(m) Mandatory Expensing of Stock Options.--
          ``(1) Named executive officer.--As used in this subsection, 
        the term `named executive officer' means--
                  ``(A) all individuals serving as the chief executive 
                officer of an issuer, or acting in a similar capacity, 
                during the most recent fiscal year, regardless of 
                compensation level; and
                  ``(B) the 4 most highly compensated executive 
                officers, other than an individual identified under 
                subparagraph (A), that were serving as executive 
                officers of an issuer at the end of the most recent 
                fiscal year.
          ``(2) In general.--Subject to paragraph (4), every issuer of 
        a security registered pursuant to section 12 shall show as an 
        expense in the annual report of such issuer filed under 
        subsection (a)(2), the fair value of all options to purchase 
        the stock of the issuer granted after December 31, 2004, to a 
        named executive officer of the issuer.
          ``(3) Fair value.--
                  ``(A) In general.--The fair value of an option to 
                purchase the stock of the issuer that is subject to 
                paragraph (2) shall--
                          ``(i) be equal to the value that would be 
                        agreed upon by a willing buyer and seller of 
                        such option, who are not under any compulsion 
                        to buy or sell such option; and
                          ``(ii) take into account all of the 
                        characteristics and restrictions imposed upon 
                        the option.
                  ``(B) Pricing model.--To the extent that an option 
                pricing model, such as the Black-Scholes method or a 
                binomial model, is used to determine the fair value of 
                an option, the assumed volatility of the underlying 
                stock shall be zero.
          ``(4) Exemptions.--
                  ``(A) Small business issuers.--This subsection shall 
                not apply to an issuer, if--
                          ``(i) the issuer has annual revenues of less 
                        than $25,000,000;
                          ``(ii) the issuer is organized under the laws 
                        of the United States, Canada, or Mexico;
                          ``(iii) the issuer is not an investment 
                        company (as such term is defined under section 
                        3 of the Investment Company Act of 1940 (15 
                        U.S.C. 80a-3));
                          ``(iv) the aggregate value of the outstanding 
                        voting and non-voting common equity securities 
                        of the issuer held by non-affiliated parties is 
                        less than $25,000,000; and
                          ``(v) in the case of an issuer that meets the 
                        criteria in clauses (i) through (iv) and is a 
                        majority-owned subsidiary, the parent of the 
                        issuer meets the requirements of this 
                        paragraph.
                  ``(B) Delayed effectiveness.--The requirements of 
                this subsection shall not apply to an issuer before the 
                end of the 3-year period beginning on the date of the 
                completion of the initial public offering of the 
                securities of the issuer, and shall only apply to an 
                option to purchase the stock of an issuer granted after 
                such date.''.

SEC. 3. PROHIBITION ON EXPENSING AND ECONOMIC IMPACT STUDY.

  (a) Prohibition.--Section 19(b) of the Securities Act of 1933 (15 
U.S.C. 77s(b)) is amended by adding at the end the following:
          ``(3) Prohibition on expensing standards.--
                  ``(A) In general.--The Commission shall not recognize 
                as `generally accepted' any accounting principle 
                relating to the expensing of stock options unless--
                          ``(i) it complies with the requirements of 
                        subparagraph (B); and
                          ``(ii) the economic impact study required 
                        under section 3(b) of the Stock Option 
                        Accounting Reform Act has been completed.
                  ``(B) Requirements.--A standard referred to in 
                subparagraph (A) shall require that--
                          ``(i) if an option to purchase the stock of 
                        an issuer that is subject to the requirements 
                        of section 13(m) of the Securities Exchange Act 
                        of 1934 is exercised--
                                  ``(I) any expense that had been 
                                reported under that section 13(m) with 
                                respect to such option shall be 
                                recomputed as of the date of exercise 
                                and shall be equal to the difference 
                                between the price of the underlying 
                                stock and the exercise price; and
                                  ``(II) to the extent the recomputed 
                                amount differs from the amount 
                                previously reported under section 13(m) 
                                with respect to such option, the 
                                difference shall be reported in the 
                                fiscal year in which the option is 
                                exercised as a reduction or increase, 
                                as the case may be, of the total 
                                expense required to be reported under 
                                that section 13(m) during that fiscal 
                                year;
                          ``(ii) if an option to purchase the stock of 
                        an issuer that is subject to the requirements 
                        of section 13(m) of the Securities Exchange Act 
                        of 1934 is forfeited or expires unexercised, 
                        any expense that had been reported under that 
                        section 13(m) with respect to such option shall 
                        be reported in the fiscal year in which the 
                        option expires or is forfeited as a reduction 
                        of the total expense required to be reported 
                        under that section 13(m) during that fiscal 
                        year; and
                          ``(iii) to the extent that any reduction 
                        required under clause (i) or (ii) exceeds total 
                        option expenses for any fiscal year, such 
                        excess shall be reported as income with respect 
                        to options to purchase the stock of the 
                        issuer.''.
  (b) Economic Impact Study.--Not later than 1 year after the date of 
enactment of this Act, the Secretary of Commerce and the Secretary of 
Labor shall conduct and complete a joint study on the economic impact 
of the mandatory expensing of all employee stock options, including the 
impact upon--
          (1) the use of broad-based stock option plans in expanding 
        employee corporate ownership to workers at a wide range of 
        income levels, with particular focus upon non-executive 
        employees;
          (2) the role of such plans in the recruitment and retention 
        of skilled workers;
          (3) the role of such plans in stimulating research and 
        innovation;
          (4) the effect of such plans in stimulating the economic 
        growth of the United States; and
          (5) the role of such plans in strengthening the international 
        competitiveness of businesses organized under the laws of the 
        United States.

SEC. 4. IMPROVED EMPLOYEE STOCK OPTION TRANSPARENCY AND REPORTING 
                    DISCLOSURES.

  (a) Enhanced Disclosures Required.--Not later than 180 days after the 
date of enactment of this Act, the Commission shall, by rule, require 
each issuer filing a periodic report under section 13(a) or 15(d) of 
the Securities Exchange Act of 1934 (15 U.S.C. 78m, 78o(d)) to include 
in such report more detailed information regarding stock option plans, 
stock purchase plans, and other arrangements involving an employee 
acquisition of an equity interest in the company. Such information 
shall include--
          (1) a discussion, written in ``plain English'', in accordance 
        with the Plain English Handbook published by the Office of 
        Investor Education and Assistance of the Commission, of the 
        dilutive effect of stock option plans, including tables or 
        graphic illustrations of such dilutive effects;
          (2) expanded disclosure of the dilutive effect of employee 
        stock options on the issuer's earnings per share;
          (3) prominent placement and increased comparability and 
        uniformity of all stock option related information;
          (4) the number of outstanding stock options;
          (5) the weighted average exercise price of all outstanding 
        stock options; and
          (6) the estimated number of stock options outstanding that 
        will vest in each year.
  (b) Definitions.--As used in this section:
          (1) Commission.--The term ``Commission'' means the Securities 
        and Exchange Commission.
          (2) Issuer.--The term ``issuer'' has the meaning provided in 
        section 2(a)(7) of the Sarbanes-Oxley Act of 2002 (15 U.S.C. 
        7201(a)(7)).
          (3) Equity interest.--The term ``equity interest'' includes 
        common stock, preferred stock, stock appreciation rights, 
        phantom stock, and any other security that replicates the 
        investment characteristics of such securities, and any right or 
        option to acquire any such security.

SEC. 5. PRESERVATION OF AUTHORITY.

  Nothing in this Act shall be construed to limit the authority over 
the setting of accounting principles by any accounting standard setting 
body whose principles are recognized by the Securities and Exchange 
Commission under section 19(b)(1) of the Securities Act of 1933 (15 
U.S.C. 77s(b)(1)).

                          Purpose and Summary

    H.R. 3574, the Stock Option Accounting Reform Act, will 
require the mandatory expensing of stock options granted to 
executive officers. Specifically, the bill will preserve broad-
based employee stock option plans and address the economic 
implications of stock option expensing by prohibiting the 
Securities Exchange Commission (SEC or Commission) from 
recognizing as generally accepted an accounting principle that 
requires the expensing of employee stock options unless an 
economic impact study is completed and a ``truing-up'' 
mechanism is provided. The bill imposes a new requirement that 
public companies report as an expense on their income 
statements stock options issued to the company's chief 
executive officer and the next 4 highest compensated employees. 
Further, the bill mandates that when reporting those stock 
option expenses, companies use a specific accounting formula 
that assumes that stock prices do not fluctuate. H.R. 3574 
exempts small businesses from expensing stock options 
altogether. In addition, newly public companies avoid expensing 
options for top executives in the initial 3 years.

                  Background and Need for Legislation

    In the bull market of the 1990s, employee stock options 
were widely celebrated as a vital instrument in the growth of 
the high-tech sector. Employee stock options give the holder a 
right to buy shares at a fixed price over a fixed period of 
time. If the value of the company's stock rises, an employee 
can exercise the stock option and sell it for a profit. The 
theory behind issuing stock options is that it aligns the 
interests of managers and shareholders and gives employees 
added incentive to help their company succeed. Broad-based 
employee stock options, especially in the technology sector, 
have led to economic growth, created great wealth for a large 
number of employees, and have been a driving force behind the 
success of many new ventures.
    In any discussion of the accounting treatment of stock 
options it is important to note that the SEC has always had the 
ultimate authority to determine accounting standards for public 
companies under the securities laws. Prior to the enactment of 
the Sarbanes-Oxley Act, the SEC used its interpretive authority 
under section 13(b) of the Securities Exchange Act of 1934 to 
``define technical, trade, accounting and other terms * * * 
consistently with the provision and purposes of'' that Act. 
Since 1973, the SEC on its own authority deferred to the 
Financial Accounting Standards Board (FASB) for purposes of 
defining what is ``generally accepted'' for accounting 
purposes. The FASB is an independent, private-sector 
organization with no Federal charter for its activities.
    Enactment of the Sarbanes-Oxley Act in the 107th Congress 
added section 19(b) of the Securities Act of 1933 (1933 Act) 
which specifically authorized the SEC to recognize any 
accounting principles as ``generally accepted'' which were 
established by a standards setting organization meeting the 
description of the FASB. However, the SEC always retained the 
statutory authority to establish its own definition of 
``generally accepted,'' either generally, or with respect to 
particular standards, a principle reiterated twice in the 
Sarbanes-Oxley Act, both in section 3(c) and 108(c).
    FASB's current accounting standard for employee stock 
options recognized by the SEC provides that companies may 
either recognize the value of employee stock options as an 
expense or release relevant and detailed disclosure about those 
options in footnotes to company financial statements. The 
footnotes show how treating options as an expense would affect 
the company's profits.
    On March 31, 2004, FASB proposed a rule that would require 
every company to count the value of all outstanding stock 
options that have not yet vested as an expense over the period 
they vest--a period that typically extends 3 to 5 years. 
Therefore, even if a company chose to stop issuing options 
altogether, it would still have to report expenses from options 
issued in earlier years, as they vest. The proposed rule would 
charge against earnings the estimated value of theoptions when 
they are issued, regardless of their value when they are exercised or 
if they are not exercised at all.
    Broad-based employee stock option plans are a valuable tool 
used to attract talent to new ventures. It is widely believed 
that a rule requiring mandatory expensing of stock options will 
stifle their issuance, reduce company profits, and derail 
economic growth and innovation. Because stock options give 
employees a stake in their company and the potential to share 
in wealth creation, the disappearance of stock options will 
inhibit a company's ability to attract and retain skilled 
employees. If the currently proposed rule takes effect, many 
companies have stated that they will stop issuing options to 
their rank-and-file employees. In fact, this is exactly what 
some European-based companies have done following the issuance 
of the international rule requiring mandatory expensing of 
stock options. For example, after the rule was adopted in 
February, DaimlerChrysler AG and Deutsche Telekom announced 
that they will no longer issue stock options. In the United 
States, in anticipation of a rule requiring mandatory expensing 
of stock options, many companies such as Microsoft have stopped 
issuing stock options.
    The accuracy of treating stock options as an expense is a 
matter of some debate among accounting experts. Moreover, the 
Committee received repeated testimony stating that there is no 
reliable or accurate formula to properly value those stock 
options. Under the proposed FASB rule, public companies would 
be required to estimate the cost of the options they award 
using either the Black-Scholes or binomial valuation models to 
calculate their value.
    The use of either of these models for purposes of valuing 
employee stock options has been widely criticized. Both models 
rely on unpredictable and unreliable assumptions about interest 
rates and stock volatility in computing the values. In fact, 
the differences between the two models are sometimes large 
enough to make comparisons between companies difficult. Senator 
John Ensign, who chairs the Senate Republican High Tech Task 
Force, has said:

          The absence of an established, reliable method for 
        measuring the value of stock options will result in 
        confusion, uncertainty, and conflict. Trial lawyers 
        will get rich as companies are forced to pick from 
        flawed valuation models, and share prices plummet.

    SEC Commissioner Paul Atkins is also concerned about 
mandatory expensing and has said efforts to require options to 
be treated as an expense could fail to give shareholders a 
clearer picture of a company's financial health and could do 
more harm than good. Stock option expensing will result in many 
companies reporting lower profits than they showed before they 
had to show stock options as an expense--even though the 
companies may have experienced virtually no substantive change 
in their operations. For instance, 2003 earnings of companies 
in the S&P; 500 would have been 8 percent lower had companies 
been forced to treat options as an expense. It has been 
estimated that the operating earnings of the 100 largest 
companies traded on the Nasdaq stock market would have been 44 
percent lower in 2003.
    Finally, start-up companies would be severely harmed by 
mandatory expensing because it would make it more difficult for 
these companies to raise capital. H.R. 3574 addresses this 
concern by mandating the completion of the economic impact 
study before the Commission may recognize an accounting 
principle requiring the expensing of employee stock options. 
Some experts have opined that mandatory expensing for stock 
options would eventually push high-tech start-up companies to 
other countries, such as China and India, which do not require 
stock option expensing. This argument is bolstered by the fact 
that the Chinese government has incorporated stock options into 
its 5-year economic plan to boost its technology industry.
    Venture-capital-backed companies have driven the global 
competitiveness of the United States by creating jobs, 
generating revenue, and fostering innovation. United States 
companies originally funded with venture capital now represent 
11 percent of annual GDP and employ over 12 million Americans. 
A study published in 2000 comparing the productivity of public 
companies that offer broad-based stock option plans versus 
those that do not found that average productivity of the former 
grew 6 percent faster.
    Critics of employee stock option plans have argued that 
those plans served as a motivating factor behind recent 
executive corruption scandals at public companies where, they 
argue, financial statements were falsified in order to enrich 
the top executives. H.R. 3574 addresses these concerns by 
requiring that public companies report as an expense on their 
income statement all options granted to the chief executive 
officer and the next 4 highest compensated employees. 
Accordingly, H.R. 3574 would be the first legislative mandate 
to require expensing of any kind for employee stock options. 
The bill exempts small businesses (defined as companies with 
annual revenues and aggregate outstanding stock of less than 
$25 million) from this requirement. It also provides an 
exemption from this requirement for companies for 3 years 
following their initial public offering.
    In addition, H.R. 3574 requires the Commission to issue a 
rule mandating that public companies include more detailed 
information on stock option and stock purchase plans in their 
public periodic reports.This information will include, among 
other things, plain English descriptions of the dilutive effect of 
stock options, the impact of that dilutive effect on earnings per 
share, and the number of outstanding stock options.
    H.R. 3574 prohibits the SEC from recognizing an accounting 
principle requiring that employee stock options be reported as 
an expense until the following conditions are met: (1) an 
economic impact study is completed, and (2) the accounting 
principle contains a ``truing-up'' mechanism.
    With respect to the study, the Departments of Commerce and 
Labor are required to produce a joint study within one year on 
the economic impact of the mandatory expensing of stock 
options, focusing on the use of broad-based plans and their 
role in recruiting new employees, stimulating research and 
innovation, and fostering economic growth and international 
competitiveness. The Committee expects that the Commission will 
review this study and consider its results prior to recognizing 
as ``generally accepted'' any accounting standard relating to 
the expensing of employee stock options, and expects that the 
Commission will not recognize as ``generally accepted'' such an 
accounting principle if the study demonstrates that such 
principle would have a significant negative economic impact,
    With regard to the ``truing-up'' requirement, the bill 
requires, that in order for the Commission to recognize as 
``generally accepted'' an accounting principle relating to the 
expensing of employee stock options, that principle must 
provide that when a stock option is exercised, the option's 
previously reported expense must be recomputed as of the date 
of exercise, and any amount that differs from the amount 
previously reported should appear in the company's financial 
statement for the year in which the option is exercised as a 
reduction or increase, as appropriate, of the total option 
expense reported. In the event that an option is forfeited or 
expires unexercised, H.R. 3574 requires the option to appear as 
a reduction of the total expense reported during the same 
fiscal year. H.R. 3574 includes a savings clause to clarify 
that nothing in the bill limits the authority of an accounting 
standards setting body whose principles are recognized by the 
SEC to set accounting standards.

                                Hearings

    The Subcommittee on Capital Markets, Insurance, and 
Government Sponsored Enterprises held a hearing on H.R. 3574, 
the Stock Option Accounting Reform Act. The following witnesses 
testified: Ms. Karen Kerrigan, Chairman, Small Business 
Survival Committee; Mr. Mark G. Heesen, President, National 
Venture Capital Association; Mr. Reginald Reed, Manager, 
Software Development, Cisco Systems; Professor Robert Merton, 
Harvard Business School; and Mr. Arthur W. Coviello, President 
and Chief Executive Officer, RSA Security.

                        Committee Consideration

    The Subcommittee on Capital Markets, Insurance, and 
Government Sponsored Enterprises met in open session on May 12, 
2004, and approved H.R. 3574 for full Committee consideration, 
as amended, by a voice vote.
    The Committee on Financial Services met in open session on 
June 3 and 15, 2004, and ordered H.R. 3574 favorably reported 
to the House, with an amendment, by a record vote of 45 yeas 
and 13 nays (Record vote no. FC-21).

                            Committee Votes

    Clause 3(b) of rule XIII of the Rules of the House of 
Representatives requires the Committee to list the record votes 
on the motion to report legislation and amendments thereto. A 
motion by Mr. Oxley to favorably report the bill to the House 
with an amendment was agreed to by a record vote of 45 yeas and 
13 nays (Record vote no. FC-21). The names of Members voting 
for and against follow. 


    The following amendments were considered by record votes. 
The names of Members voting for and against follow.

          An amendment to the amendment in the nature of a 
        substitute by Mr. Sherman, No. 1a, eliminating the zero 
        volatility assumption, was NOT AGREED TO by a record 
        vote of 14 yeas and 43 nays (Record vote no. FC-18). 
        
        
    An amendment to the amendment in the nature of a substitute 
by Ms. Maloney, No. 1e, confirming SEC authority, was NOT 
AGREED TO by a record vote of 14 yeas and 45 nays (Record vote 
no. FC-19). 



    An amendment to the amendment in the nature of a substitute 
by Mr. Sherman, No. 1f, applying the FASB standard for options 
exceeding $100,000 per employee, was NOT AGREED TO by a record 
vote of 12 yeas and 47 nays (Record vote no. FC-20). 



    The following amendments were also considered:

          An amendment in the nature of a substitute by Mr. 
        Oxley, No. 1, making various substantive and technical 
        changes to the bill, was agreed to by a voice vote.
          An amendment to the amendment in the nature of a 
        substitute by Mr. Sherman, No. 1b, providing a 1-year 
        deadline for an economic impact study was agreed to by 
        a voice vote.
          An amendment to the amendment in the nature of a 
        substitute by Mr. Baker, No. 1c, regarding preservation 
        of authority, was agreed to by a voice vote.
          An amendment to the amendment in the nature of a 
        substitute by Mr. Sherman, No. 1d, making the 
        provisions of the bill effective until SEC adoption of 
        rule providing for recognition of certain development 
        expenditures as intangible assets, was withdrawn.
          A substitute amendment in the nature of a substitute 
        by Mr. Kanjorski, No. 2, replacing the provisions of 
        the bill with the provisions of the ``Accounting 
        Standards Integrity Act,'' was not agreed to by a voice 
        vote. The request for a recorded vote was withdrawn.

                      Committee Oversight Findings

    Pursuant to clause 3(c)(1) of rule XIII of the Rules of the 
House of Representatives, the Committee held a hearing and made 
findings that are reflected in this report.

                    Performance Goals and Objectives

    Pursuant to clause 3(c)(4) of rule XIII of the Rules of the 
House of Representatives, the Committee establishes the 
following performance related goals and objectives for this 
legislation:
    The Securities and Exchange Commission will (1) enforce the 
provisions of this legislation requiring that every issuer of a 
security registered pursuant to section 12 of the 1934 Act show 
as an expense in its annual report the fair value of all 
options to purchase the stock of the issuer granted after 
December 31, 2004, to a ``named executive officer'' of the 
issuer and (2) not recognize as ``generally accepted'' any 
accounting principle relating to the expensing of stock options 
unless it complies with certain requirements for ``truing-up'' 
the expense attributable to an option and an economic impact 
study must has been completed by the Departments of Commerce 
and Labor.

   New Budget Authority, Entitlement Authority, and Tax Expenditures

    In compliance with clause 3(c)(2) of rule XIII of the Rules 
of the House of Representatives, the Committee finds that this 
legislation would result in no new budget authority, 
entitlement authority, or tax expenditures or revenues.

                        Committee Cost Estimate

    The Committee adopts as its own the cost estimate prepared 
by the Director of the Congressional Budget Office pursuant to 
section 402 of the Congressional Budget Act of 1974.

                  Congressional Budget Office Estimate

    Pursuant to clause 3(c)(3) of rule XIII of the Rules of the 
House of Representatives, the following is the cost estimate 
provided by the Congressional Budget Office pursuant to section 
402 of the Congressional Budget Act of 1974:

                                     U.S. Congress,
                               Congressional Budget Office,
                                     Washington, DC, June 25, 2004.
Hon. Michael G. Oxley,
Chairman, Committee on Financial Services,
House of Representatives, Washington, DC.
    Dear Mr. Chairman: The Congressional Budget Office has 
prepared the enclosed cost estimate for H.R. 3574, the Stock 
Option Accounting Reform Act.
    If you wish further details on this estimate, we will be 
pleased to provide them. The CBO staff contacts are Melissa E. 
Zimmerman (for federal costs), and Paige Piper/Bach (for the 
private-sector impact).
            Sincerely,
                                       Douglas Holtz-Eakin,
                                                          Director.
    Enclosure.

H.R. 3574--Stock Option Accounting Reform Act

    Summary: H.R. 3574 would require publicly traded companies 
to include the value of a certain portion of stock options as 
an expense in the firm's annual financial report. (This 
practice is known as ``expensing stock options.'') The bill's 
requirement would apply to the stock options granted to a 
company's chief executive officer and the four highest-paid 
executive officers. The bill would exclude certain small 
companies from this requirement.
    Under the bill, the Securities and Exchange Commission 
(SEC) would create regulations for expensing stock options, and 
the Departments of Commerce and Labor would study the economic 
impact of implementing expensing of stock options for all of a 
company's employees. CBO estimates that implementing H.R. 3574 
would not have a significant effect on spending subject to 
appropriation and would not affect direct spending or revenues.
    H.R. 3574 contains no intergovernmental mandates as defined 
in the Unfunded Mandates Reform Act (UMRA) and would impose no 
significant costs on state, local or tribal governments.
    H.R. 3574 would impose private-sector mandates as defined 
in UMRA on certain companies. Based on information from 
industry and government sources, CBO expects that the aggregate 
direct costs of complying with those mandates would fall below 
the annual threshold established by UMRA for private-sector 
mandates ($120 million in 2004, adjusted annually for 
inflation).

Impact on the private sector

            Expensing of stock options held by executive officers
    Section 2 would impose a private-sector mandate on certain 
companies that grant some compensation through stock options. 
The provision would require such companies to recognize as an 
expense in their annual report to the SEC the fair value (as 
defined in the bill) of certain options to purchase stock 
granted to the chief executive officer and the four most highly 
compensated executives of the company. To recognize an expense 
means it is included in the calculation of reported net income. 
Current accounting standards require that firms recognize as an 
expense or disclose the fair value of all stock options they 
grant. Consequently, CBO expects that complying with this 
mandate would result in minimal additional cost.
            Additional disclosures in periodic reports
    Section 4 would require the SEC to implement rules that 
would require certain companies to provide more detailed 
information specified in the bill regarding employee stock 
option plans in the periodic reports filed with the SEC. 
According to industry and government sources, most of this 
information is already required by the SEC in the periodic 
reports provided by firms. Therefore, CBO expects that the 
direct cost to comply with this mandate would be minimal.
            Standards for expensing stock options
    Section 3 would prohibit the SEC from recognizing as 
``generally accepted'' any accounting principle relating to the 
expensing of stock options unless it complies with certain 
requirements specified in the bill and an economic impact study 
required in the bill has been completed. If the SEC adopts the 
requirements in the bill for expensing stock options as 
generally accepted accounting principles, those requirements 
would be new private-sector mandates on certain companies that 
grant stock options. Such requirements are similar to current 
rules that companies follow regarding the expensing of stock 
options for income-tax purposes. Consequently, CBO expects that 
complying with such requirements would result in minimal 
additional cost to firms.
    Estimate prepared by: Federal Costs: Melissa Zimmerman; 
Impact on State, Local, and Tribal Governments: Sarah Puro; and 
Impact on the Private Sector: Paige Piper/Bach.
    Estimate approved by: Peter H. Fontaine, Deputy Assistant 
Director for Budget Analysis.

                       Federal Mandates Statement

    The Committee adopts as its own the estimate of Federal 
mandates prepared by the Director of the Congressional Budget 
Office pursuant to section 423 of the Unfunded Mandates Reform 
Act.

                      Advisory Committee Statement

    No advisory committees within the meaning of section 5(b) 
of the Federal Advisory Committee Act were created by this 
legislation.

                   Constitutional Authority Statement

    Pursuant to clause 3(d)(1) of rule XIII of the Rules of the 
House of Representatives, the Committee finds that the 
Constitutional Authority of Congress to enact this legislation 
is provided by Article 1, section 8, clause 1 (relating to the 
general welfare of the United States) and clause 3 (relating to 
the power to regulate interstate commerce).

                  Applicability to Legislative Branch

    The Committee finds that the legislation does not relate to 
the terms and conditions of employment or access to public 
services or accommodations within the meaning of section 
102(b)(3) of the Congressional Accountability Act.

             Section-by-Section Analysis of the Legislation


Section 1. Short title

    This section establishes the short title of the bill, the 
``Stock Option Accounting Reform Act.''

Section 2. Mandatory expensing of stock options held by highly 
        compensated officers

    Section 2 amends section 13 of the Securities Exchange Act 
of 1934 (the 1934 Act) to add a new section 13(m), requiring 
that every issuer of a security registered pursuant to section 
12 of the 1934 Act show as an expense in its annual report the 
fair value of all options to purchase the stock of the issuer 
granted after December 31, 2004, to a ``named executive 
officer'' of the issuer.
    ``Named executive officer'' is defined as all individuals 
serving as the issuer's chief executive officer during the most 
recent fiscal year, regardless of compensation level, and the 4 
most highly compensated executive officers, other than the 
chief executive officer.
    The section defines the ``fair value'' of an option to 
purchase the issuer's stock as the value that would be agreed 
upon by a willing buyer and seller of the option, taking into 
account all of the characteristics and restrictions imposed 
upon the option. In addition, the section provides that, to the 
extent that an option pricing model, such as the Black-Scholes 
method or a binomial model, is used to determine the fair value 
of an option, the assumed volatility of the underlying stock 
will be zero.
    The section includes two exemptions from the expensing 
requirement for small business issuers and new issuers. In 
order to qualify for the small business issuer exemption, the 
issuer must (a) have annual revenues of less than $25,000,000; 
(b) be organized under the laws of the United States, Canada, 
or Mexico; (c) not be an investment company; (d) have 
outstanding voting and non-voting common equity securities held 
by non-affiliated parties amounting to less than $25,000,000; 
and (e) in the case of an issuer that meets the aforementioned 
criteria and is a majority-owned subsidiary, a subsidiary of a 
parent that also meets the aforementioned criteria.
    The exemption for new issuers provides that the expensing 
requirements of this provision do not apply in the first 3 
years after an issuer's initial public offering and only 
applies to options granted after the 3-year grace period.

Section 3. Prohibition on expensing and economic impact study

    Section 3 amends section 19(b) of the 1933 Act by adding a 
new paragraph (3), prohibiting the Securities and Exchange 
Commission from recognizing as ``generally accepted'' any 
accounting principle relating to the expensing of stock options 
unless: (a) it complies with certain requirements for ``truing-
up'' the expense attributable to an option; and (b) an economic 
impact study has been completed.
    To satisfy the ``truing-up'' requirement of this section, a 
standard must meet 3 conditions:
    First, the standard must provide that if an option to 
purchase the issuer's stock is exercised and that option is 
subject to the requirements of new section 13(m) of the 1934 
Act, then (a) any expense that had been reported with respect 
to the option must be recomputed as of the date of exercise and 
will be equal to the difference between the price of the 
underlying stock and the exercise price; and (b) to the extent 
the recomputed amount differs from the amount previously 
reported with respect to that option, the difference must be 
reported in the fiscal year in which the option is exercised as 
a reduction or increase, as the case may be, of the total 
expense reported during that fiscal year.
    Second, the standard must provide that if an option to 
purchase an issuer's stock is forfeited or expires unexercised 
and that option is subject to the requirements of new section 
13(m), then any expense that had been reported with respect to 
that option must be reported in the same fiscal year as a 
reduction of the total expense reported.
    Finally, to the extent that any reduction required under 
the two previous paragraphs exceeds total option expenses for 
any fiscal year, then that excess must be reported as income 
with respect to options to purchase the stock of the issuer.
    To satisfy the economic impact study requirement of the 
section, the Secretary of Commerce and the Secretary of Labor, 
within 1 year of the date of enactment of this legislation, 
must conduct and complete a joint study on the economic impact 
of the mandatory expensing of all employee stock options. The 
section requires that this study specifically address the 
impact of mandatory expensing of employee stock options on (1) 
the use of broad-based stock option plans in expanding employee 
corporate ownership to workers at a wide range of income 
levels, with particular focus upon non-executive employees; (2) 
the role of those plans in the recruitment and retention of 
skilled workers; (3) the role of those plans in stimulating 
research and innovation; (4) the effect of those plans in 
stimulating the economic growth of the United States; and (5) 
the role of those plans in strengthening the international 
competitiveness of businesses organized under the laws of the 
United States.

Section 4. Improved employee stock option transparency and reporting 
        disclosures

    Section 4 requires enhanced disclosure about stock option 
and similar plans. Specifically, it requires that, no later 
than 180 days after the date of enactment of this legislation, 
the Commission must, by rule, require that each issuer filing a 
periodic report under section 13(a) or 15(d) of the 1934 Act 
include in that report more detailed information regarding 
stock option plans, stock purchase plans, and other 
arrangements involving an employee acquisition of an equity 
interest in the company. This information must include six 
components: (1) a ``plain English'' discussion of the dilutive 
effect of stock option plans, including tables or graphic 
illustrations of such dilutive effects; (2) expanded disclosure 
of the dilutive effect of employee stock options on the 
issuer's earnings per share; (3) prominent placement and 
increased comparability and uniformity of all stock option 
related information; (4) the number of outstanding stock 
options; (5) the weighted average exercise prices of all 
outstanding stock options; and (6) the estimated number of 
stock options outstanding that will vest in each year.
    The section also defines the terms ``commission,'' 
``issuer,'' and ``equity interest.''

Section 5. Preservation of authority

    This section clarifies that nothing in this bill limits the 
authority over the setting of accounting principles by an 
accounting standards setting body whose principles are 
recognized by the SEC.

         Changes in Existing Law Made by the Bill, as Reported

  In compliance with clause 3(e) of rule XIII of the Rules of 
the House of Representatives, changes in existing law made by 
the bill, as reported, are shown as follows (new matter is 
printed in italic and existing law in which no change is 
proposed is shown in roman):

           SECTION 13 OF THE SECURITIES EXCHANGE ACT OF 1934


              TITLE I--REGULATION OF SECURITIES EXCHANGES


                     PERIODICAL AND OTHER REPORTS 

  Sec. 13. (a) * * *

           *       *       *       *       *       *       *

  (m) Mandatory Expensing of Stock Options.--
          (1) Named executive officer.--As used in this 
        subsection, the term ``named executive officer'' 
        means--
                  (A) all individuals serving as the chief 
                executive officer of an issuer, or acting in a 
                similar capacity, during the most recent fiscal 
                year, regardless of compensation level; and
                  (B) the 4 most highly compensated executive 
                officers, other than an individual identified 
                under subparagraph (A), that were serving as 
                executive officers of an issuer at the end of 
                the most recent fiscal year.
          (2) In general.--Subject to paragraph (4), every 
        issuer of a security registered pursuant to section 12 
        shall show as an expense in the annual report of such 
        issuer filed under subsection (a)(2), the fair value of 
        all options to purchase the stock of the issuer granted 
        after December 31, 2004, to a named executive officer 
        of the issuer.
          (3) Fair value.--
                  (A) In general.--The fair value of an option 
                to purchase the stock of the issuer that is 
                subject to paragraph (2) shall--
                          (i) be equal to the value that would 
                        be agreed upon by a willing buyer and 
                        seller of such option, who are not 
                        under any compulsion to buy or sell 
                        such option; and
                          (ii) take into account all of the 
                        characteristics and restrictions 
                        imposed upon the option.
                  (B) Pricing model.--To the extent that an 
                option pricing model, such as the Black-Scholes 
                method or a binomial model, is used to 
                determine the fair value of an option, the 
                assumed volatility of the underlying stock 
                shall be zero.
          (4) Exemptions.--
                  (A) Small business issuers.--This subsection 
                shall not apply to an issuer, if--
                          (i) the issuer has annual revenues of 
                        less than $25,000,000;
                          (ii) the issuer is organized under 
                        the laws of the United States, Canada, 
                        or Mexico;
                          (iii) the issuer is not an investment 
                        company (as such term is defined under 
                        section 3 of the Investment Company Act 
                        of 1940 (15 U.S.C. 80a-3));
                          (iv) the aggregate value of the 
                        outstanding voting and non-voting 
                        common equity securities of the issuer 
                        held by non-affiliated parties is less 
                        than $25,000,000; and
                          (v) in the case of an issuer that 
                        meets the criteria in clauses (i) 
                        through (iv) and is a majority-owned 
                        subsidiary, the parent of the issuer 
                        meets the requirements of this 
                        paragraph.
                  (B) Delayed effectiveness.--The requirements 
                of this subsection shall not apply to an issuer 
                before the end of the 3-year period beginning 
                on the date of the completion of the initial 
                public offering of the securities of the 
                issuer, and shall only apply to an option to 
                purchase the stock of an issuer granted after 
                such date.

           *       *       *       *       *       *       *

                              ----------                              


                SECTION 19 OF THE SECURITIES ACT OF 1933

                      SPECIAL POWERS OF COMMISSION

  Sec. 19. (a) * * *
  (b) Recognition of Accounting Standards.--
          (1) * * *

           *       *       *       *       *       *       *

          (3) Prohibition on expensing standards.--
                  (A) In general.--The Commission shall not 
                recognize as ``generally accepted'' any 
                accounting principle relating to the expensing 
                of stock options unless--
                          (i) it complies with the requirements 
                        of subparagraph (B); and
                          (ii) the economic impact study 
                        required under section 3(b) of the 
                        Stock Option Accounting Reform Act has 
                        been completed.
                  (B) Requirements.--A standard referred to in 
                subparagraph (A) shall require that--
                          (i) if an option to purchase the 
                        stock of an issuer that is subject to 
                        the requirements of section 13(m) of 
                        the Securities Exchange Act of 1934 is 
                        exercised--
                                  (I) any expense that had been 
                                reported under that section 
                                13(m) with respect to such 
                                option shall be recomputed as 
                                of the date of exercise and 
                                shall be equal to the 
                                difference between the price of 
                                the underlying stock and the 
                                exercise price; and
                                  (II) to the extent the 
                                recomputed amount differs from 
                                the amount previously reported 
                                under section 13(m) with 
                                respect to such option, the 
                                difference shall be reported in 
                                the fiscal year in which the 
                                option is exercised as a 
                                reduction or increase, as the 
                                case may be, of the total 
                                expense required to be reported 
                                under that section 13(m) during 
                                that fiscal year;
                          (ii) if an option to purchase the 
                        stock of an issuer that is subject to 
                        the requirements of section 13(m) of 
                        the Securities Exchange Act of 1934 is 
                        forfeited or expires unexercised, any 
                        expense that had been reported under 
                        that section 13(m) with respect to such 
                        option shall be reported in the fiscal 
                        year in which the option expires or is 
                        forfeited as a reduction of the total 
                        expense required to be reported under 
                        that section 13(m) during that fiscal 
                        year; and
                          (iii) to the extent that any 
                        reduction required under clause (i) or 
                        (ii) exceeds total option expenses for 
                        any fiscal year, such excess shall be 
                        reported as income with respect to 
                        options to purchase the stock of the 
                        issuer.

           *       *       *       *       *       *       *