of the depository institutions' problems, and to comment on the related issues which concern us:

--Should federal regulators be allowed to prescribe accounting and reporting rules to artificially inflate the reported financial picture of depository institutions?

Relaxing the accounting and public reporting rules of depository institutions results in a misleading picture of the true financial condition of the institutions, which is

especially disturbing considering the problems that the industry is facing today. There is a need for clear and accurate reporting to enable the Congress and the regulators, as well as investors and the general public, to make the best decisions in response to the magnitude of the problems which the financial institutions face: For example,

--As of June 1985, under generally accepted accounting principles (GAAP), 461 S&Ls had negative net worth, and Further, 833 S&Ls had net worth of from zero to 3 percent of assets.

--These institutions had assets of $433 billion, or 43 percent of the industry's total assets.

--By the middle of 1985, there were about 1,300
out of 3,180 federally-insured S&Ls whose financial
condition must be considered weak when measured by
conventional standards of financial strength.

--Agricultural bank failures, as a percent of total commercial bank failures, have grown from 20 percent in 1982 to over 50 percent in 1985.

--About 28 percent of all commercial banks have

25 percent or more of their loan portfolios in farm
loans.

--The Federal Deposit Insurance Corporation (FDIC) believes that farm bank problems and failures (62 in 1985) will continue at a high level for at least another year.

--Banks which are big energy lenders, especially in the southwest, are being squeezed by the drop in oil prices and by the premiums they must now pay to attract large deposits.

--The Farm Credit System reported a third quarter 1985
loss of $522.5 million, and projected that it may have to
absorb $3 billion or more of loan charge-offs through
1987.

--In addition, the Farm Credit System may have to cope
with as much as $10 billion of "nonearning assets"--bad
loans and land acquired through foreclosures on which the
system may earn little, or nothing--over the next two to
three years.

It is against this backdrop that we need to view the regulators' actions and the role of accounting and public reporting for these institutions. Let us first look at the role of financial reporting, regulatory accounting, and auditing. THE ROLE OF ACCOUNTING AND AUDITING

The United States has a vigorous system of both public and private security and financial markets, which is one of the pillars of our economic structure and second to none in the world. These markets are based, to a very large degree, on the concept that full and fair disclosure provides the primary basis for investor protection.

Full and fair disclosure has three major components:

--a set of generally accepted accounting and disclosure
principles which, if properly applied, should result in a
full and fair view of an organization's financial
position and the results of its operations,

--a responsibility by management to prepare financial statements that provide for full and fair disclosure, and

--annual independent audits which ensure that the financial statements and disclosures by management do, in fact, provide a full and fair picture of the organization.

A comprehensive set of accounting and disclosure standards is necessary to ensure that entities follow uniform principles and rules in preparing financial reports and disclosures.

Standards need to be consistently applied so that similar transactions or events will be reported the same way over time and among similar organizations. To that end, the accounting

profession has distilled its common body of knowledge into

GAAP. These principles embody the consensus of the accounting profession, at a particular time, with regard to the appropriate recording of certain financial transactions and their external reporting as financial information.

USE OF REGULATORY ACCOUNTING PRINCIPLES

Regulatory accounting principles (RAP) evolved as

extensions or modifications of GAAP to meet the specialized accounting and reporting needs of regulatory agencies, such as the Federal Savings and Loan Insurance Corporation (FSLIC) and FDIC.

What is of concern to us is the practice of modifying generally accepted accounting rules to improve, on paper, the financial condition of regulated institutions. This is typically done to allow troubled institutions time to work out problem loans and other poor quality assets. While we do not take issue with the need for institutions to work out acceptable recovery programs with creditors, we believe that accounting and public financial reporting should remain neutral and not become part of the mechanism intended to deal with troubled institutions or their problem debt. Once the line of sound accounting principles and full and fair disclosure is crossed,

it becomes easier to further relax the rules. As recently as the first half of 1981, RAP, GAAP, and even tangible net worth (GAAP net worth less goodwill and intangible assets) were about equal, indicating that the disparity in accounting treatment had not set in. By mid-year of 1985, however, the disparity was plainly discernable when industry net worth on a GAAP basis (3.18 percent) is compared to RAP net worth (4.19 percent) and tangible net worth (.73 percent). See attachment. Some examples of the differences between RAF and GAAP accounting for thrifts will help to highlight our concern. Deferred losses

One regulatory accounting practice that impacts the earnings of the S&L industry involves capital losses. Under RAP (but not GAAP), S&Ls may postpone recognition of losses on asset sales by amortizing them over the time that would have remained to maturity for the assets sold. This rule enables the S&Ls to avoid charging such losses against current period net earnings. Such treatment of capital losses may substantially improve the appearance of an S&L's financial condition, especially since losses are not matched against the funds received from the sale. In contrast, and on a more conservative basis, GAAP requires that losses from sales of such assets be recognized at the time when the transactions occur.

Appraised equity capital

RAP also allows S&Ls to record, on a one-time only basis, the appreciation of an institution's own real estate holdings as an asset, thus increasing an institution's net worth. While the

intent of this practice is to paint the best possible

picture of the industry's health, it is somewhat inconsistent with the conservative accounting requirement to reflect gains only when they are realized. GAAP does not allow the recording of unrealized increases in real estate values, or the

corresponding increases in net worth.

Net worth certificates

RAP also allows the recording of net worth certificates on the books of S&Ls and mutual savings banks, and the recognition of the increased net worth that results. This is not

permissible under GAAP because the certificates issued by the institutions are exchanged for the promissory notes of the federal regulators in the same amount and interest rate, resulting in a swap transaction, which is a nonreportable event under GAAP--this type of swap does not create equity.

These and other RAP practices by FSLIC have created an enormous difference between equity computed under RAP and equity computed under GAAP. Additional examples of RAP/GAAP are included in the report we issued to your committee last year (GAO/AFMD 85-56, September 30, 1985).

Some of these RAP practices, such as income capital certificates (ICCs) have begun to show up in GAAP. Recent reports and constant modifications by FSLIC and requests to the Financial Accounting Standards Boards (FASB) to get them blessed are an indication of the movement in this direction.

More recently, we have seen pressure for banks to also move in this general direction--initially for farm banks but now also