What Are Regulatory Accounting Principles?

Regulatory accounting principles (RAP) were introduced by the former Federal Home Loan Bank Board (FHLBB) for the savings and loan industry (thrifts) that it oversaw in the 1980s with disastrous results. Regulatory accounting principles were created to assist low net-worth savings and loan associations with meeting capital requirements. The flawed accounting procedures that the FHLBB allowed the thrifts to liberally use were pointed to as one of the underlying causes of the savings and loan industry debacle in the late 1980s.

Understanding Regulatory Accounting Principles (RAP)

The relaxed rules of RAP enabled many otherwise insolvent institutions to artificially increase their reported profits and net worth. Some of the egregious accounting principles that the thrifts were permitted to apply were:

  • Recording a loss from a sale of a mortgage loan as an asset that could be amortized over the remaining life of the mortgage. In the 1980s, thrifts held large portfolios of long-term mortgages carried at cost on their balance sheets. The sharp rise in interest rates during the decade caused drops in the market value of these mortgages substantially below book value, yet RAP allowed losses to be classified as assets. Moreover, the deferral of losses allowed the thrifts to continue leveraging assets at a capital requirement of 3%, and to generate tax shields from the amortization of realized losses.
  • Entire and immediate recognition of income from construction loan fees. Active in the real estate market in the 1980s, thrifts were able to book fees (2.5% of the loan amount) from originating construction loans entirely upfront instead of partial recognition to match the costs incurred in originating the loan and then ratably for the balance of the fee over the life of the loan.
  • Inclusion of "appraised equity capital" for calculation of regulatory net worth. Appraised equity capital, a novel concept, was the amount that certain capital assets such as PP&E had appreciated above their book values. Thrifts were allowed to be selective, only recording these unrealized appreciation gains for capital assets whose market values increased above book values; assets whose market values declined below book values could be ignored.
  • Forty-year goodwill amortization of acquired thrifts. Troubled thrifts that were acquired carried significant amounts of mortgage assets far below book values. By buying another thrift with such assets at a heavy discount (fair market value minus book value), the thrift was able to record income over the estimated life of the assets on an interest-method basis of 10 years. Goodwill amortization, on the other hand, could be spread out over 40 years, which meant that during the 10-year period after acquisition, the acquirer could book profits since annual goodwill amortization expense was much smaller than under a 10-year requirement that existed before the implementation of RAP.

In the aftermath of the savings and loan crisis, Congress eliminated the FHLBB and, along with it, RAP. The Resolution Trust Corporation was set up and the thrifts that survived were forced to start using GAAP rules.