SEC AND CORPORATE AUDITS

Federal Securities Laws: Problems Regarding Beverly Hills Savings and Loan Association

THURSDAY, NOVEMBER 7, 1985

HOUSE OF REPRESENTATIVES,

COMMITTEE ON ENERGY AND COMMERCE,

SUBCOMMITTEE ON OVERSIGHT AND INVESTIGATION,

Washington, DC.

The subcommittee met, pursuant to notice, at 10:10 a.m., in room 2123, Rayburn House Office Building, Hon. Ron Wyden presiding (Hon. John D. Dingell, chairman).

Mr. WYDEN. The subcommittee will come to order.

Let me read into the record the opening statement of our very distinguished chairman, Mr. Dingell of Michigan, and then I will have a statement of my own.

This is a continuation of the subcommittee's hearings to determine whether Federal regulatory agencies and public accounting firms are meeting their responsibilities under the Federal securities laws. The securities laws require that investors and the public be given accurate and complete information regarding the activities of publicly owned corporations. The regulatory system we depend upon to meet these requirements includes Federal agencies such as the Securities and Exchange Commission and the Federal Home Loan Bank Board, as well as the public accounting firms which are required by law to independently certify the financial information that corporations in this country provide to the public. The subcommittee will examine the accounting rules used by the savings and loan industry to report its financial results to regulators and the public. Some of those rules seem extraordinarily curious to those of us who are not accustomed to the peculiar logic of savings and loan accountants.

For example, last July, the Chairman of the Federal Home Loan Bank Board and his staff tried to explain to me how a debt could be an asset in measuring the regulatory net worth of a savings and loan institution.

The subcommittee will explore how an asset can be created from the amount a savings and loan institution pays in excess of the real value of a company it acquires. In other words, how can a savings and loan institution create an asset from paying too much for something?

The accountants call this excess amount goodwill, but many experts say there is little or no real value in the goodwill assets car(171)

ried on the books of many savings and loan institutions. If that is true, then the savings and loan industry is in even more serious trouble than we have been led to believe. A recent General Accounting Office report on federally insured savings and loan institutions shows that goodwill has grown from less than 1 percent of regulatory net worth at the start of 1981 to more than 63 percent of regulatory net worth at the end of 1984.

If accountants in the savings and loan industry have allowed their clients to place nonexistent assets on their balance sheets, then it is the clear and immediate responsibility of the appropriate Federal agencies to stop this practice and to assure Congress and the public that they receive accurate information regarding the financial health of those institutions.

The real truth regarding the solvency of a major industry entrusted with safeguarding depositors' money cannot be left to the whimsy of certain self-interested corporate managers and their accountants.

The real facts about problems in the savings and loan industry may be unpleasant and hard to accept, but we will not be able to correct those problems by attempting to fool the public with accounting tricks. This subcommittee has a responsibility to assure that accurate and complete financial information on the status of savings and loan institutions is provided to the Congress and the public, as required by the Federal securities laws. The subcommittee intends to meet that responsibility in the most vigorous way. Let the record show that that was the prepared statement of our very distinguished chairman, Mr. Dingell of Michigan who unfortunately cannot be here now and we hope will be here later.

I have a very brief statement of my own and let me just pick up very briefly on the prepared remarks of Chairman Dingell with respect to the savings and loan industry in effect having nonexistent assets on their balance sheets.

It seems to me that what the Home Loan Bank Board is engaged in is a major coverup. In effect, the Home Loan Bank Board is not being straight with the American people and making it clear_how serious this problem is. It seems to me that when the Home Loan Bank Board has figured out a way to make nothing, which is what you have when you talk about the goodwill of a failed financial institution, for the Home Loan Bank Board to make nothing become something of value, that that is engaging in accounting gimickry, perpetuating a myth and the Home Loan Bank Board's own staff has indicated that the failure to start dealing with this problem rather than just pretending it doesn't exist is just going to make it tougher for us to deal with it in the end, and it seems to me that this coverup-and I use the words deliberately because I don't think the Home Loan Bank Board is being straight with the public about how serious this problem is-has got to be changed.

Our leadoff witness, Professor Briloff, refers to this phenomenon that I and Chairman Dingell have mentioned as accounting alchemy or creating assets out of nothing. He and our other distinguished analysts have zeroed in on the issue of goodwill as an asset, particularly for those institutions where the Federal Home Loan Bank Board is engaged in a salvage operation. Taken to its logical extreme, entering goodwill on an institution's books as an

asset can, and apparently is, used to make up the difference between net identifiable assets-real assets-and liabilities. Thus, the books are magically balanced and we send the message across the country that there is solvency or regulatory net worth. In effect, it is perpetuating a bizarre myth and it seems to me that given the precarious position of the FSLIC fund, it is somewhat understandable that the Bank Board would encourage and even facilitate these sorts of questionable bookkeeping practices, but that still doesn't make it in the public interest.

The other question we need to address this morning is what the effect of these practices are going to be in the long run to this country. Already, as we will see in the difficulties Coopers & Lybrands is having in meeting their responsibilities at the new Beverly Hills Savings & Loan, one casualty of this process is the important financial reporting principle of timeliness. What else results from trying to maintain a perception of solvency or regulatory net worth?

Another result, clearly, is to prevent or delay any sort of massive hemorrhaging of the FSLIC fund-and prevent or delay any need to bail out or recapitalize the fund in some other fashion and again the question, it seems to me, is what is gained by maintaining this kind of Alice in Wonderland charade. I think we are making this problem even worse and making our job that much tougher when the eventual day of reckoning is at hand.

At this point, let me recognize our very distinguished colleague from Ohio, Mr. Luken, for any opening statement he may have.

Mr. LUKEN. Mr. Chairman, I think you have rather completely stated what the hearing is about and some of the background that has led to it. I would suggest that from the testimony that we have heard, the phrase "accounting standards" as applied to the practices with reference to savings and loans that we have investigated is an oxymoron. There really aren't any accounting standards that are effective that prevent, for example, an auditing firm which is aware that a savings and loan is heading toward bankruptcy as a result of risky practices and investments, there apparently isn't any way that that accounting firm can be helpful at all according to the testimony that we have had and I think the question, therefore, is doesn't at some point the accounting firm at least have an obligation to inform its client that its operating practices are risky and might be propelling toward insolvency.

I think that is the question that looms as big as any one that we will be concentrating on as the hearing progresses.

Mr. WYDEN. Thank you.

The gentleman from Florida.

Mr. BILIRAKIS. Mr. Chairman, today's hearing presents an opportunity for us to explore what I believe are complex accounting questions regarding the treatment of savings and loan institutions which are taken over by the Government, particularly under novel arrangements such as the management consignment program used for Beverly Hills Savings & Loan and some 16 other institutions under the Board's supervision.

How should goodwill be treated? Goodwill is one of those elements of a business which is both real but difficult to quantify. Establishing an accounting standard or guideline for reporting it in

the kind of cases we are going to discuss today is a complex undertaking. An undertaking that I note is being done by the accounting profession through its emerging issues task force at its meeting scheduled for today.

The questions raised today regarding how the regulatory accounting principles differ from general accounting principles are relevant to our investigation. That the use of one set of principles results in different numbers than the use of another focuses on only half the question. The other, and more important question is "Does RAP have a purpose that is different from GAAP, and does it, in fact, serve its purpose?"

These issues are relevant. The savings and loan industry is undergoing major changes. The November 4 issue of Business Week noted the paradox that while 1985 industry profits will approach a record $5 billion, approximately 20 percent of the 3,200 savings and loans are losing money. Whether the answer is merging of FSLIC and FDIC as the Business Week article suggests, the establishment of a Federal asset disposition association as announced by the Home Loan Bank Board yesterday, or adopting one or more of the multitude of proposals before the Congress is a matter that other congressional committees and the industry are exploring.

The accounting questions addressed here today are a relevant part of that larger issue.

I welcome the witnesses here today. Hopefully they will help to clear up some of that area for us.

Thank you, Mr. Chairman.

Mr. WYDEN. Our first witness will be Dr. Abraham J. Briloff, professor of accountancy, Bernard M. Baruch College of the City University of New York.

Welcome, Mr. Briloff. We appreciate all the assistance and expertise you have given our subcommittee. I think you are aware that it is the practice of our subcommittee to swear all witnesses. Do you have any objection to being sworn, Professor Briloff? Mr. BRILOFF. I do not.

[Witness sworn.]

Mr. WYDEN. Professor Briloff, do you desire counsel today?

TESTIMONY OF ABRAHAM J. BRILOFF, PROFESSOR OF ACCOUNTANCY, BERNARD M. BARUCH COLLEGE, CITY UNIVERSITY OF NEW YORK

Mr. BRILOFF. I do not have counsel in the ordinary sense, Mr. Chairman, in the sense that I don't have legal counsel. However, for the record, I would like to make clear that I feel that I am being counseled as I sit here and reflect on my proposed testimony by three distinguished persons: first, Lewis Carroll, who is asking me to rewrite Alice in Wonderland-

Mr. WYDEN. For the record, we are very interested to hear your statement. It is the practice of the subcommittee to not only entitle you to the right to counsel, but to a copy of the subcommittee rules. Let the record show that there is a copy of the subcommittee rules there beside you to have throughout your appearance today. We will put your full prepared remarks into the record in their entirety, Professor Briloff, and if you could just highlight your

principal concerns, the subcommittee is very anxious to hear from you today.

Mr. BRILOFF. I appreciate that and I have received a copy of the rules in the mail, Mr. Chairman. As I started to say, I believe that I am being counseled by Lewis Carroll suggesting that I rewrite Alice in Wonderland and Through the Looking Glass consistent with generally accepted accounting principles, or GAAP, or whatever you might call it.

I also am being counseled presently by Hans Christian Andersen, who keeps informing me of the morals involved in the Emperor's New Clothes and I am also being counseled by George Orwell who is saying rewrite "1984" 1 year later because as I move along and as I kept writing I couldn't help but feel that I was really indulging in the unreal. Nonetheless, it is this absurd state which is what it is that we are addressing ourselves to this morning.

Now, the remarks were somewhat light but as I flesh out my remarks very briefly, I appreciate that, Mr. Chairman, I believe you will see the reasons why I introduced my commentary in that fashion.

First, one preliminary matter that I believe requires clearing up as a consequence of the July hearings that you alluded to where Chairman Dingell, the distinguished Chairman Dingell, was nonplussed about when liabilities become equity, when liabilities become assets and he asked the question, was I better off way back when I had heavy indebtedness or am I better off now when I am relatively free of indebtedness.

I have been plagued by that particular question in terms of what we have in the real world. We in accounting have the old adage, my credit is good; I owe everybody. If you owe nobody, it means your credit is bad so maybe the chairman's credit is not so good now, therefore he is not as well off as when he was indebted.

When we hear about so-called leveraged buyouts which means. that a corporation's equity is transmuted into debt. Wall Street goes wild over that corporation saying management is doing well by converting equity into debt. As a consequence, it may well be that maybe more debt is better.

Also as I recall a couple of months ago when the Nation's balance sheet tilted from being a creditor nation to being a debtor nation an American statesman indicated during the course of an interview that that indicates that the rest of the world has confidence in us because they are desirous of lending us money.

So it is that if Chairman Dingell was sitting there, Chairman Wyden, I would say I really don't know the answer as to whether you were better off or worse off back then.

So it is that the world is not that straight and not that real, but now I want to turn to the critical business at hand which has been very effectively and persuasively summarized by the statements from the chairman in absentia and the others.

I want to turn first to what I refer to as the Federal Home Loan Bank Board's SOS. They sent a letter to 11 major accounting firms-I was not one of them-asking for their counsel as to what would happen or what does happen when they take over a basket case like Beverly Hills and transfer it to the MCP, the Manage