Federal regulators are undermining public confidence in financial institutions by allowing troubled banks and savings and loans to use "artificial accounting" techniques to hide their problems and stay alive, the government's accounting office told Congress yesterday.

Frederick D. Wolf, director of the accounting and financial management division of the General Accounting Office, told a House subcommittee that the GAO did not take issue with the need to give "troubled institutions time to work out acceptable recovery programs with creditors." But, he said, "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."

Relaxing the accounting rules of banks and savings and loan institutions results in a misleading picture of their financial health, Wolf told the House subcommittee on oversight and investigations. He said the situation is particularly troublesome given the growing number of bad farm, oil and real estate loans and the record number of bank and S&L failures.

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

Many of Wolf's concerns were repeated by the two other witnesses at the hearing: Peter O. Stearns, former director of the Federal Savings and Loan Insurance Corp., the federal agency that insures S&L deposits up to $100,000, and William M. Isaac, former chairman of the Federal Deposit Insurance Corp., the federal agency that insures bank deposits for the same amount.

Since 1980, Congress and the Federal Home Loan Bank Board have relaxed the bookkeeping requirements for ailing savings and loans to boost the value of their assets as a way to keep them in compliance with regulatory requirements and thus avoid shutting them down.

The bank board, which regulates the nation's thrift institutions and the FSLIC, has wanted to prolong the life of many ailing institutions, because allowing them to fail all at once would bankrupt the FSLIC. FSLIC's funds are sapped by the payouts it must make to depositors each time a thrift closes.

Regulators and the House and Senate banking committees defend the bookkeeping techniques, but many also have wondered if prolonging the life of troubled thrifts has increased the ultimate cost to FSLIC of closing or selling them.

Last month, the Federal Deposit Insurance Corp., the Office of the Comptroller of the Currency and the Federal Reserve Board -- the three federal agencies that regulate banks -- softened rules for bank funding and bookkeeping in an effort to encourage banks to restructure and get rid of troubled loans.