TESTIMONY OF FREDERICK D. WOLF, DIRECTOR, ACCOUNTING AND FINANCIAL MANAGEMENT DIVISION, GENERAL ACCOUNTING OFFICE

Mr. WOLF. I am Fred Wolf. I am the Director of the Accounting and Financial Management Division of the General Accounting Office. With me are Mr. Bob Gramling and Gary Bowser, who work for me.

Mr. SHELBY. Your written testimony will be submitted for the record in totality, without objection, and made part thereof. You may proceed to give any oral testimony that you may desire.

Mr. WOLF. Thank you, Mr. Chairman.

Recently a great deal of attention has been directed at the problems of the banking and savings-and-loan industries and actions to resolve them. This morning I would like to discuss one aspect 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 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&L's had negative net worth, and further, 833 S&L's 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&L's 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 2 to 3 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 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. 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 poorquality 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 discernible when industry net worth on a GAAP basis, 3.18 percent, is compared to RAP net worth, 4.19 percent, and tangible net worth, 0.73 percent. This is detailed further in the attachment to our written statement.

Some examples of the differences between RAP and GAAP accounting for thrifts will help to highlight our concern.

Our regulatory accounting practice that impacts the earnings of the S&L industry involves capital losses. Under RAP, but not GAAP, S&L's 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&L's 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. RAP also allows S&L's 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.

RAP also allows the recording of net worth certificates on the books of S&L's 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 under GAAP 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 85-86, September 30, 1985.

Some of these RAP practices, such as income capital certificates-ICC's-have begun to show up in GAAP. Recent reports and constant modifications by FSLIC and requests to the Financial Accounting Standards Board-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 for energy banks. This has been manifest in congressional initiatives to permit "loan loss deferral" and similar actions.

Last month, partly in response to these pressures, the Federal bank regulators announced new, more lenient rules for banks that lend to farmers. The proposals included a relaxation of minimum capital requirements and a change in restructured loan reporting requirements that would recognize fewer losses. Since then, the regulators have also decided to extend this relief to banks heavily engaged in energy loans.

The capital forbearance program announced by the regulators allows the primary capital ratios of agricultural and oil and gas banks to fall to three percent of assets without the normal regulatory action. Certain restrictions do apply and the program requires a plan by bank management to restore capital ratios to at least six

percent no later than January 1993. Bank regulators have also "reemphasized" State of Financial Accounting Standards No. 15SFAS 15-"Accounting by Debtors and Creditors for Troubled Debt Restructuring," issued by the FASB.

In conjunction with this reemphasis is a modification of regulatory reporting requirements for restructured debt. If the borrower is performing in accordance with the new terms, restructured debt would be reported as "Restructured and In Compliance with Modified Terms." In other words, a nonperforming asset can now be "restructured" and reported as a performing asset.

Although we are not taking issue with the policy decisions to restructure loans or accept lower equity levels, we do have a problem with the proposed accounting for restructured loans, from three standpoints: Its underlying theory;

The public perception that it is a gimmick when viewed against a backdrop of other RAP-type regulatory actions. A case in point is the March 12, 1986, Wall Street Journal article which reads, "Federal banking regulators, in a move designed to provide some relief for troubled farm and energy lenders, agreed to allow banks to use a more liberal accounting treatment for renegotiated problem loans."

And thirdly, from the standpoint of the impact on auditors and their reports on the fair presentation of financial statements.

First, I would like to share some of my concerns over SFAS 15 and how it has been used in the past. SFAS 15 is not new, and in fact it has been used frequently by larger institutions, especially in relation to troubled international loans.

For a restructuring involving only a modification of the terms of a debt, SFAS 15 states that a lender should not change the recorded investment in the loan at the time of the restructuring unless the investment exceeds the total future cash receipts specified by the modified terms. Modifications of terms may involve a reduction in the stated interest rate on a loan, an extension of the maturity date or dates, or a forgiveness of principal or accrued interest. Ă forgiveness of principal, or accrued interest, often will not result in the immediate charge-off of this amount since modifications are treated a reductions in future interest income and losses are recognized at the time of restructuring only to the extent that total future cash receipts will be less than the recorded investment in the loan.

For example, a $10,000 loan is repayable in 1 year with interest at 10 percent. If the loan terms are modified so that $2,000 in principal is forgiven and the loan is repayable in 3 years with no change in interest rate, no charge-off would be required under SFAS 15, even though the lender has reduced the principal by 20 percent, since under the modified terms, the total future cash receipts on the loan total $10,400: $2,400 in interest, $800 annually for 3 years, plus $8,000 in principal.

The loan balance of $10,000 on the bank's books would not be changed and the bank would accrue interest at 1.333 percent annually, earning $400 in interest income over the 3-year life of the restructured loan.

A restructuring, therefore, can result in a financial institution being substantially worse off under the new loan arrangement

than under the original loan agreement; but not being required to record a loss for accounting purposes. Also, through this process nonperforming loans now take on the appearance of being good loans.

Although some restructurings may be successful in allowing a debtor to work out the conditions that have caused the default, SFAS 15 does not relieve management or the auditors of their responsibility to fairly report the value of assets, including restructured loans-and that means accounting for uncollectible amounts. From an auditors' standpoint, the evaluation of loans includes a collectibility issue which does not seem to be getting equal weight. Let me address that point.

We believe that banks and S&L's have generally been far too slow to recognize the uncollectible portion of their assets. Failures of financial institutions have all too often leaped upon us from nowhere. In retrospect, the failed institutions have been remiss-to be kind-in not establishing a reasonable loss allowance which recognizes the inherent potential losses in their loan portfolios. This is where the role of the Federal regulatory examiners and the independent auditors becomes critical.

Too often, an institution's management, examiners, and auditors act as if a troubled debt restructuring is akin to a religious experience-the lame begin to walk and the blind to see. In reality, however, troubled debtors continue to limp and struggle along. "Restructuring a bad loan does not a good loan make."

We would cite examples of both banks and S&L's which have failed where the loan portfolio has included massive amounts of uncollectible or poor-quality loans against which adequate reserves have not been provided, many of which are known to the committee. Let me just discuss one specific case which is really the final saga of an issue your committee dealt with last year.

In 1985, at the time of the FSLIC takeover of Beverly Hills Savings and Loan Association we were looking at the 1983 and 1984 audits by various independent public accounting firms. At that time, discussions about possible losses centered around amounts up to $40 million and later, in your hearings, up to as much as $150 million. Coopers & Lybrand recently issued its report on its examination of Beverly Hills's 1984 financial statements for the year ended December 31, 1984, reflecting losses of about $415 million, three times the amount earlier expected.

While Beverly Hills may be an extreme example, it represents one of the "new breed" of S&L's which are located predominantly in California and Texas, where, because of changes in regulations at the State level over the last several years, they have embarked on extremely aggressive real estate investment and lending practices. Unfortunately, as in the case of Beverly Hills, it takes some period of time before these losses become apparent, and it requires more intensive audit procedures to uncover these problems.

In regard to the issue of proper valuation of uncollectible loans, our own experience in our audits of FSLIC, FDIC, and the ExportImport Bank-Eximbank-are instructive.

In Eximbank's case, since 1983, we have reported that its financial statements present a misleading picture of its true financial condition. In our opinion, Eximbank's statements do not reflect the