Management Letter: Suggested Improvements in IRS' Accounting Procedures and Internal Controls

Published by the Government Accountability Office on 1999-06-30.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

       United States

-GAO   General Accounting
                     D.C. 20548

       Accounting and Information
       Management Division


       June 30,1999

       The Honorable Charles 0. Rossotti
       Commissioner of Internal Revenue

       Subject:      Management better: Suggested Imnrovements in IRS Accountme Procedures
                     and Internal Controls

       Dear Mr. Rossoti

       In March 1999, we issued our report on the results of our audit of the Internal Revenue
       Service’s (IRS) financial statements and IRS management’s assertions regarding the
       effectiveness of its internal controls for the tical year ended September 30,1998.’ We also
       reported our conclusions on IRS compliance with significant provisions of selected laws and
       regulations and on whether IRS systems substantially comply with requirements of the
       Federal Financial Management Improvement Act of 1996.

       The purpose of this-letter is to report additional matters identified during our tical year 1998
       audit regarding accounting procedures and internal controls that could be improved and to
       advise you of previously reported management lette? issues that continue to exist. These
       matters are not considered material in relation to the financial statements; however, they
       warrant management’s consideration. In our fiscal year 1998 audit, we identified internal
       control matters concerning policies and procedures over (1) processing abatements,
       (2) Federal Managers’Financial Integrity Act (FMFIA) reporting, (3) reconciliation of
       custodial disbursement accounts, and (4) payroll processing and reporting. We also found
       that certain issues reported in our management letter for fiscal year 1997 continue to exist.
       These previously reported issues pertain to policies and procedures over (1) management’s
       discussion and analysis, (2) completeness and integrity of master file data, and
       (3) commingling of receipt and refund transactions in general ledger accounts. We have
       offered suggestions for resolving these problems or mitigating their effect on IRS operations
       at the end of our discussion of each of the internal control matters described iri this letter.

       ln its response to this letter, IRS agreed with several of the issues we discussed and our
       suggestions but disagreed with our observations regarding internal controls over FMFIA
       reporting, key performance indicators, and master file data At the end of our discussion of
       each of the issues in this letter, we have summarized IRS related comments and provided our

       ‘See Financial Audit: IRS Fiscal Year 1998 Wnancial Statements (GAO/AIMD-99-75, March 1,1999).

       %ee Management Letter: IRS’Account~w procedures and Internal Controls (GAO/AIMD9&211R, September 2,1998).

                                                  h&F-~~~               GAO/AND-99-182R IRS Management Letter

evaluation. We have also incorporated IRS comments in the letter where appropriate. The
complete text of IRS response is included in the enclosure to this letter.

Abatements Were Not Processed PromDtlv                         and Accurately
or Reconciled to the General Ledver

The Comptroller General’s Standards for Internal Controls in the Federal Government states
that transactions and other significant events should be promptly recorded if pertinent
information is to maintain its relevance and value to management and requires that
supervisors continually review and approve the assigned work of their staff. Such reviews
should detect and correct errors, misunderstandings, and improper practices. A proper
system of internal controls should also include procedures to periodicaUy reconcile general
ledger account balances to detailed supporting records to ensure that the general ledger
accounts provide complete and reliable financial data. A basic purpose of general ledger
accounts is to summarize similar transactions for management’s internal decision-making and
financial reporting purposes.

We found that IRS’policies and procedures over abatement3 transactions did not ensure that
abatements were processed promptly or that the abatement transactions recorded on IRS
master file records were accurate. As a result of processing delays and erroneous
abatements,4IRS made substantial amounts of avoidable interest payments on abatement
transactions, issued improper refunds, and recorded incorrect tax assessments. We also
found that IRS was unable to reconcile total abatement transactions recorded on its master
files to its general ledger accounts for abatement transactions. Specifically, we found the

     Of the 175 abatement transactions in our sample, IRS unnecessarily paid interest because
     of processing delays on 18 (19 percent) of 94 abatement items where a refund was issued
     that we reviewed. The Internal Revenue Code generally requires IRS to pay interest on
     refunds, including refunds resulting from an abatement, if the taxpayer’s request is not
     processed within 45 days of receipt; however, the time it took IRS to process these 18
     transactions ranged from 3 months to over 4 years. IRS paid over $2 million in interest on
     a tax abatement of $10.4 million in one case that took over 2 years to process. In another
     case, IRS paid interest of $3.2 million on a tax abatement of $6.9 million. Although the
     Internal Revenue Code generaLlyrequires IRS to pay interest when refunds are not
     processed within 45 days of receipt, IRS does not have policies and procedures in place to
      ensure that abatement transactions are processed promptly, or to allow managers to

“IRS may abate (reduce) the amount of a tax assessment and related penalties and interest under certain cixumskmces.
Examples of circumstances where IRS abates a tax liability include (1) excessive tax assessments, (2) penalties and interest due
to an IRS error, (3) admhMr&ve and collection costs not wananling collection of the amount due, (4) unpaid assessments
discharged in bankruptcy, and (5) IRS acceptance of partial payment of an unpaid tax assessment in settlement of the balance
 ‘Erroneous abatements are abatements recorded for incorrect amounts based on supporting documentation.

 Page 2                                                             GAO/ADD-99-182R IRS Management Letter

    identify the extent, impact, and cause of processing delays. As a consequence, IRS had to
    pay interest and taxpayers were denied prompt service.

l   IRS policy specifies that an official review be performed for abatement transactions when
    the abatements are due to an offer-in-compromise, a bankruptcy discharge, or initiated by
    examination and the abatement amount exceeds a certain dollar threshold; however, this
    policy was not always effective in preventing erroneous abatements. We found that 131
    (75 percent) of the 175 total abatement transactions in our sample had no evidence of
    supervisory review, including 18 that that should have been subjected to review based on
    IRS’criteria. Of these 131 abatement transactions, 6 (5 percent) were erroneous. We also
    found that supervisory reviews that were performed were ineffective in reducing errors.
    Of 44 abatement transactions included in our sample that showed evidence of supervisory
    review, 2 (4.5 percent) were erroneous. Of the 8 errors we identified, 3 resulted in
    incorrect refunds and 5 resulted in either overstated or understated tax assessments. The
    effect of the overstatements was that the taxpayers were assessed for taxes that they did
    not owe, while the understatements could result in lost revenue to the government.

l   Through the duration of our audit, IRS was unable to reconcile total abatement
    transactions recorded on its individual and business master files to its general ledger
    accounts for abatements. At June 30,1998, the IRS master files, which provide the
    detailed record of abatement transactions, showed total abatements of $26 billion, which
    was $2.9 billion (10 percent) less than the $28.9 billion recorded on the general ledger
    accounts. According to IRS, $1.5 billion of the $2.9 billion difference was attributable to
    IRS inappropriately recording interest paid on abatement transactions to an abatement
    general ledger account. However, IRS could not provide supporting documentation for
    the interest payments posted to the account, nor could it provide an explanation for the
    remaining $1.4 billion difference. According to Chief Financial Officer staff, IRS began
    recording interest paid on abatement transactions in a separate account during the first
    quarter of fiscal year 1999. Therefore, this problem may not affect the reconciliation
    process in the future. Nonetheless, IRS’inability to reconcile its general ledger and
    detailed subsidiary abatement records increases the risk that errors or irregularities may
    occur and not be promptly detected. According to IRS, it has since successfully
    reconciled abatement transactions for the first two quarters of fiscal year 1999. We wilI
    review these reconciliations during our fiscal year 1999 audit.


To’correct these problems, we suggest that IRS do the following.

1. IRS should implement appropriate policies and procedures to ensure prompt processing
   of abatement transactions. The policies should establish appropriate time frames for
   processing abatements, a methodology for monitoring the timeliness of abatement
   processing, and procedures to identify the causes for delays and formulate corrective
   actions. These procedures should focus on mmimizmg interest paid due to abatement
   processing delays.

Page 3                                             GAO/AIMD-99-182R IRS Management Letter

2. IRS should reassess the criteria used to determine when supervisory reviews are
   performed, given that 75 percent of IRS abatements are made with no supervisory review.
   Factors to consider would include dollar thresholds, risk of inappropriate refunds being
   disbursed, and the experience level of staff making abatement decisions.

3. IRS should ensure that for abatements that require supervisory review, the reviews are
   performed in a manner sufficient to detect and prevent erroneous abatement transactions.
   We further suggest that IRS implement policies and procedures to ensure that the
   supervisory reviews are documented when performed.

4. IRS should revise its policies and procedures to require a periodic, but not less than
   quarterly, redonciliation of detailed abatement records to general ledger accounts.
   Further, IRS should require that documentation be retained to support reconciling items.

IRS Comments and Our Evaluation

ln its response to a draft of this letter, IRS did not specifically address our observations and
suggestions regarding internal controls over abatements.

IRS’ FMFIA Assurance Statement                  Did Not Adeauatelv           Report
All Known Material Weaknesses

FMFIA requires executive agencies, including the Department of the Treasury, to annually
report to the President and the Congress whether their internal accounting controls comply
with the objectives specified in the act. As a major component of Treasury, IRS annually
provides Treasury an FMFIA assurance statement attesting to the conformance of IRS
internal controls with the objectives specified in the act, which forms the basis for a major
segment of Treasury’s required annual FMFIA report. Because of its high degree of visibility
and significance to the Treasury, IRS annual FMFIA assurance statement needs to include all
known material control weaknesses that could materially affect IRS, and therefore
Treasury’s, operations and disclose sufficient information about the reported weaknesses to
clearly describe the problems and specify planned corrective actions.

However, we found that IRS’fiscal year 1998 FMFIA assurance statement to Treasury did not
fully disclose all known material weaknesses existing during fiscal year 1998that could
adversely affect IRS operations. For example, we advised IRS of internal control deficiencies
related to excise tax certifications in February 1998,which were subsequently discussed in a
report issued in November 1998.’However, IRS did not fully disclose the significance of
these issues or planned corrective actions in its FMFIA assurance statement although it
substantially agreed with the facts presented in the report. IRS has informed us that
corrective actions have since been implemented to address these issues. We will review
these issues during our fiscal year 1999 audit to assess their effectiveness.

 ‘See Excise Taxes: Internal Control WeaknessesMfect Accuracv of Distributions to the Trust Funds (GAOMMD-99-17,
 November 9,1998).

 Page 4                                                          GAO/AlM.D-99-182RIRS Management Letter

In addition, we reported several internal control weaknesses during our fiscal year 1998 audit
that we considered to be material under FMF’IA that were not adequately disclosed in IRS’
fiscal year 1998 assurance statement to Treasury. These weaknesses related to IRS

l   documentation for unpaid assessments,
l   support for nonpayroll operating expenses,
l   reconciliation of fund balances with Treasury,
l   controls over taxpayer receipts and taxpayer data,
l   controls over refunds and earned income tax credits (ElTC), and
l   lack of subsidiary ledgers for accounts payable and undelivered orders.

The magnitude of these wealmesses was such that along with material weaknesses in
property management and computer security, they resulted in us concluding that IRS’internal
controls were not effective for fiscal year 1998. The effects of several of these weaknesses
were also so significant as to preclude us from rendering an unqualified opinion on five of
IRS’six principal financial statements for fiscal year 1998. However, IRS’F‘MF’IAassurance
statement did not identify these issues as material weaknesses or provide corrective action
plans but rather reported them as issues we had identified on which IRS would follow up. In
addition, IRS officials indicated that the corrective action plan for the reported material
weakness in financial accounting of revenue addresses the material weakness we reported in
unpaid assessments with respect to the need for a related subsidiary ledger. However, since
this material weakness and related corrective action plan make reference to taxpayer account
data rather than to unpaid assessments, it is unclear if the plan would provide a subsidiw
ledger for unpaid assessments and/or other aspects of tax collection transactions. As a result,
IRS fiscal year 1998 F’MF’IAreport did not provide sufficient information to permit IRS,
Treasury, and other users of the assurance statement to fully understand the nature and
magnitude of the internal control weaknesses and accounting system deficiencies facing IRS
and affecting its operations. Although some of these issues, at least in terms of their
significance, were not identified until January 1999, others were communicated to IRS in time
to develop corrective action plans for the fiscal year 1998 F’MF’IAassurance statement.

IRS officials informed us that with the exception of some aspects of the weaknesses in
controls over tax receipts and taxpayer data, each of these issues was either (1) considered
material and corrective action plans have been developed subsequent to the issuance of IRS
fiscal year 1998 F’MPIA assurance statement or (2) not considered material and was therefore
reported to Treasury through other mechanisms along with related corrective action plans.
The latter category includes the weakness in documentation for unpaid assessments,which
we continue to consider a material weakness. We believe it is important that the material
nature of these wealmesses be timely recognized and appropriately disclosed in IRS annual
assurance statement to Treasury because of its high degree of visibility and the major role it
plays in the Treasury Department’s F’MFU report to the President and the Congress. We will
followup during our fiscal year 1999 audit to review the nature and reporting of corrective
action plans subsequently prepared by IRS.

Page 5                                             GAO/AIMD-99-182RIRS Management Letter


We suggest that IRS review its FMFIA reporting process and ensure that all material control
weaknesses existing during the reporting period are identified and included in IRS annual
FMFIA assurance statement to Treasury in sufficient detail to clearly define the problem and
describe IRS planned corrective actions. In addition, we suggest that IRS officials
responsible for Fh0TA reporting periodically meet with us to keep informed of issues
identified during ongoing audits.

IRS Comments and Our Evaluation

In its response to a draft of this letter, IRS disagreed with our position regarding its FMFIA
reporting. However, IRS acknowledged that it had sufficient documentation on the known
issues for timely inclusion in the fiscal year 1998 FMFIA assurance statement (FMFIA
statement). We believe this supports our conclusion that IRS was in a position to adequately
disclose these issues in its fiscal year 1998FMFIA statement. IRS also expressed the
following specific concerns about our discussion of IRS FMFIA reporting.

l           IRS stated that since the significance of some of these issues was not identified until
            January 1999, IRS did not have the opportunity to address them in its FMFIA assurance
            statement. We disagree. Although IRS fiscal year 1998 FMFIA assurance statement
            purports to disclose all known material weaknesses existing during fiscal year 1998, it
            was not issued until February 1999. Because IRS was aware of all these issues and their
            magnitude prior to the release of its FMFIA statement, all of these issues should have
            been disclosed as material weaknesses.

    l       IRS noted that it had accepted our prior recommendations related to its certification of
            excise taxes and implemented them during fiscal year 1998, thereby eliminating the need
            to cite this issue as a material weakness. However, our work during and subsequent to
            fiscal year 1998continued to identify weaknesses in IRS’excise tax certification process,
            and these weaknesses were communicated to IRS during the course of our audit.

    l       IRS stated that it declared the issue regarding supporting documentation for unpaid
            assessments to be a significant control deficiency, which is not part of the FMFIA
            assurance statement, rather than a material weakness. However, in view of the
            magnitude of IRS reported unpaid assessments($222 billion as of September 30,1998)
            and the fact that we have reported this issue as a material internal control weakness every
            year since our fiscal year 1996 audit, it should be reported as such in IRS FMFIA
            assurance statements until it is corrected.

        l   IRS stated that it declared some of the issues to be material weaknesses in fiscal year
            1999 based on our fiscal year 1998 audit. However, since IRS was aware that these issues
            existed during fiscal year 1998,they should have been disclosed in the fiscal year 1998
            FMFIA assurance statement.

        The complete text of IRS comments on our observations regarding IRS FMFIA assurance
        statement is included in the enclosure.

        Page 6                                            GAO/AIIVLD-99-182RIRS Management Letter

Custodial   Disbursement    Accounts   Had Unreconciled      Differences

Treasury policy and prudent financial management practices require IRS to reconcile its
general ledger custodial fund accounts to Treasury’s records each month Reconciling these
accounts involves identifying differences between IRS and Treasury records, determining the
reasons for the differences, and promptly correcting them. Correcting the differences should
result in adjustments to either Treasury or IRS records, or both.

However, we found that IRS did not resolve all reconciling differences between its custodial
general ledger accounts and Treasury records. IRS’December 1998 reconciliation showed
unreconciled differences between the balances of three custodial general ledger accounts and
Treasury records at September 30,1998. The unreconciled differences between Treasury’s
Undisbursed Appropriation Account Ledger, TFS 6653, and the following IRS custodial
general ledger accounts were approximately

l   $489 million in 0903, HQ Disbursement Principal;
l   $483 million in 0904, HQ Disbursement, Interest; and
l   $670 million in 0906, HQ Disbursement, Earned Income Tax CR.

These differences existed prior to fiscal year 1998 and may be due to either IRS or Treasury
incorrectly recording or omitting disbursements, warrants, and adjustments. The lack of
timely, thorough reconciliation increases the risk that errors or irregularities may occur and
not be promptly detected and impairs IRS’ability to produce reliable interim financial
information as a management tool. IRS officials have stated that current transactions in these
accounts are being routinely reconciled to prevent a recurrence of this condition. We will
follow up during our fiscal year 1999 audit to assess the effectiveness of these reconciliations.


We suggest that IRS amend its policies and procedures to require prompt resolution of
differences identified during its monthly reconciliation between its (1) custodial general
ledger accounts containing the refund, interest, and EITC fund balances and (2) Treasury

IRS Comments and Our Evaluation

In its response to a draft of this letter, IRS did not specifically address our observations and
suggestions regarding internal controls over these custodial disbursement accounts.

Controls    Needed to Ensure Accurate      Pavroll   Processing

The Comptroller General’s Standards for Internal Controls in the Federal Government states
that one objective of internal control systems is to ensure that expenditures applicable to
agency operations are recorded and accounted for properly so that accounts and reliable
financial and statistical reports may be prepared. To achieve this objective, agencies such as
IRS that use a service organization to process payroll transactions should establish internal
control policies and procedures adequate to ensure that the services provided meet the

Page 7                                               GAO/AIMD-99-182R IRS Management Letter

objectives of agency management. Adequate internal controls over input and output data to
prevent or detect material misstatements are particularly critical when it has been
determined that the service organization’s system of internal controls does not provide
reasonable assurance that payroll transactions are processed and reported accurately.

IRS uses the U.S. Department of Agriculture’s (USDA) National Finance Center (NFC) as the
service organization that processes the biweekly payroll for its employees. The USDA Office
of Inspector General’s (OIG) fiscal year 1997 review of internal control structure stated that
because of material wealmesses in controls over payroll processing at NFC, the accuracy and
reliability of data processed by NFC and the resulting reports ultimately depends upon the
user agency and any controls implemented by such agency.6 However, during our fiscal year
 1998 audit, IRS officials informed us that they had not implemented compensating controls to
ensure that NFC accurately processed and reported IRS $5.8 billion in payroll and related
benefits. Through our audit procedures, we were able to determine that payroll reports
generated by NFC were consistent with the information IRS provided to NFC for the
processing of its payroll activity. However, because of the material weaknesses at NFC, IRS
needs, on a continuing basis, sound procedures to ensure the accuracy and reliability of NFC
payroll processing and NFC reports of payroll transactions.


We suggest that IRS review the USDA OIG annual audit report on NFC’s internal control
structure to be informed about risk in the control environment at NFC and implement
enhanced control procedures to compensate for the weaknesses identified in NFC’payroll
systems. Enhanced procedures should include (1) review of a random sample (e.g., 25
employees) of NFC payroll payments for accuracy by comparing data provided to NFC to
information received from NFC on a quarterly basis and (2) analytical review procedures to
determine that IRS overall payroll expense is reasonable. Implementation and execution of
the compensating controls should be documented.

IRS Comments and Our Evaluation

In its response to a draft of this letter, IRS did not specifically address our observations and
suggestions regarding internal controls over payroll processing.

IRS’ Kev Performance Indicators Are Not
Alwavs Accurate and SUDDO~bk!

 Office of Management and Budget (OMB) Bulletin 97-01 requires #at each annual financial
 statement include a brief narrative overview of the reporting entity, also known as the
 management discussion and analysis (MD&A). The MD&A should provide a clear and
 concise description of the reporting entity and its mission, activities, program and financial
 results, and financial condition. To be of maximum benefit to the Congress, the public, and

 %SDA OIG Fiscal Year 1997 National Finance Center Review of Internal ContrOt Structure (114013FM, March, 1998). As of the
 date of this letter, USDA OX’s Cal year 1998 report was not yet available.

 Page 8                                                           GAO/AlMD-99-182R IRS Management Letter

    other users of IRS MD&A, the key performance indicators @PI) it contains should be
    reliable, accurate, and supported by IRS records. KPIs that do not meet these standards do
    not provide IRS management and congressional decisiomnakers the information they need to
    improve government performance consistent with the intent of the Government Performance
    and Results Act of 1993.

    For fiscal year 1998, we found weaknesses in IRS policies and procedures over its MD&A
    process that resulted in KPIs that were sometimes erroneous or not based on appropriate
    information. We found similar weaknesses in our fiscal year 1997 financial audit.’ We found
    the following deficiencies in IRS’MD&A preparation for fiscal year 1998.

    l   The actual program cost amounts used to calculate the “mission effectiveness indicator”
        and “cost to collect $100 of taxes” KPIs did not agree with IRS fiscal year 1998 Statement
        of Net Cost, which in turn is based on IRS general ledger. Instead of using data from its
        general ledger, which were subjected to audit and which appropriately is IRS system for
        tracking costs for financial reporting purposes, IRS used information from its budget
        formulation system to calculate these KPIs. The budget formulation system reflected a
        program cost of $7.429 billion, which is about $320 million less than the program cost of
        $7.749 billion reported on the fiscal year 1998 Statement of Net Cost. As a result, these
        two KPIs were calculated on a basis inconsistent with the program cost reported on IRS’
        financial statements. Although IRS has decided not to report these two KPIs in the future,
        the problems discussed above are indicative of weaknesses in IRS’KPI preparation

    l   Erroneous calculations were not always detected in the IRS review process. For
        example, to make the “total collection percentage” indicator comparable for fiscal years
        1997 and 1998, IRS needed to recalculate the net collected revenue amount and the “total
        collection percentage” indicator. For Bscal year 1997, IRS revised the net collected
        revenue amount, but held the “total collection percentage” constant. As a result, the
        “total collection percentage” performance measure was reported at 87.3 percent, instead
        of 85.9 percent. This error caused the mission effectiveness indicator to be overstated for
        fiscal year 1997.

    We previously reported that IRS did not have documented policies and procedures governing
    the preparation and review of its KPI information. During 1998, IRS drafted policies and
    procedures to address this issue, including requirements that KPIs be subject to supervisory
    review. However, the problems we noted above indicate that these policies and procedures
    were not always effective. These problems reduce the value of the KPIs to IRS management,
    the Congress, the public, and other users of IRS MD&A


    We suggest that IRS ensure that supervisory reviews are sufficiently detailed to assure that
    the KPIs are accurate, reliable, and useful to users. This should include basic review

    ‘See GAO/AlMD9fh211R, September 2,199Fi

    Page 9                                            GAO/AI&ID-99-182R IRS Management Letter

procedures designed to identify and correct the types of problems we have identified, such as
recalculations of the KPIs. We also suggest that IRS ensure that KPI data released to the
Congress, OMB, and the public, are consistent with comparable information in IRS financial
statements, so that these important users are not provided conilicting information.

IRS Comments and Our Evaluation

In its response to a draft of this letter, IRS disagreed with our observations concerning
internal controls over KPIs. IRS stated that the reported deficiencies in its KPIs resulted from
our interpretation of the issues. We disagree. In its MD&A, IRS based its “Budget Cost (in
Dollars) for IRS to Collect $100”on a different total cost figure ($7.429 billion) than IRS
reported in its Statement of Net Cost ($7.749 billion). As a result, IRS used two different
amounts for the costs of its programs for fiscal year 1998in its external reports. Both cannot
be correct. Releasing conflicting information in this manner can generate confusion among
users of this important information and impair the credibility of information communicated
externally by IRS. With respect to the error in the calculation of the “total collection
percentage,”IRS response to this letter did not dispute that this error occurred and was not
identified and corrected. However, IRS indicated that we did not communicate our concern
 about this KPI until after IRS annual report was completed. We disagree. Our concern about
the calculation of this KPI was communicated to IRS in the second week of February 1999,
 well before IRS annual report was first released to the public in May 1999. IRS also states
 that all workpapers supporting KPIs were signed and dated by the IRS preparer, the
 preparer’s supervisor, and the annual report preparer. We agree; however, as evidenced by
 the KPI error discussed in this letter, such reviews have not always been effective in
 identifying and correcting errors before they are published.

The complete text of IRS comments on our observations regarding internal controls over
KE% is included in the enclosure.

Continued Inaccuracies         in Master File Data

Managers need reliable financial data for internal decision making and reporting and to allow
IRS to efficiently and effectively collect unpaid taxes and ensure that IRS provides
satisfactory service to the taxpayers.

 In our management letter for fiscal year 1997: we reported that the data contained in IRS’
 master files were not always accurate. As a result, some tax assessments, and the related
 interest and penalties, were misstated. We found similar inaccuracies in master file records
 during our fiscal year 1998 audit. For example, in one case, documents we reviewed showed
 that the taxpayer owed $88,000 for unpaid payroll taxes. However, IRS master file indicated
 that the taxpayer owed $88,090, overstating the tax liability by $50,000. This error occurred
 because when the taxpayer filed an amended return increasing his or her tax liability, IRS
 erroneously added the taxpayer’s amended total tax assessment to the amount already
 recorded on the master file, rather than recording only the increase in tax liability shown on

 %ee GAO/AIMD-9%211R,September 2,1998.

 Page 10                                             GAO/AIMD-99-182R IRS Management Letter

the amended return. The error was not detected and corrected because IRS officials do not
review adjustments to taxpayers’ accounts in a manner adequate to ensure that adjustments
are correctly recorded.

Errors in master file records can cause both IRS and taxpayers to expend unnecessary time
and expense researching and resolving errors, cause or exacerbate disputes with taxpayers,
result in inefficient operations, and impair IRS’ability to produce reliable balances for its
custodial financial statements.


We reaffirm the suggestion in our management letter for fiscal year 1997that IRS implement,
where cost beneficial, policies and procedures to more closely monitor the recording of
adjustments to the master files to ensure that such adjustments are posted accurately. These
policies and procedures should include requirements that adjustments be reviewed and
approved by an IRS supervisor, or that IRS officials requesting the adjustments subsequently
review the tax accounts to ensure that the adjustments were properly recorded.

IRS’Comments and Our Evaluation

In its response to a draft of this letter, IRS disagreed with our observations concerning
internal controls over master file data. IRS indicated that implementing our suggestion to
more closely monitor adjustments to taxpayer accounts would be costly and would delay
payment of refunds, thereby decreasing taxpayer satisfaction. However, IRS has not provided
us any analysis to measure the impact of additional scrutiny of adjustments on IRS costs or
taxpayer satisfaction. Additionally, the cost and potential for future negative impact of such
additional procedures on taxpayer satisfaction should be weighed against the impact such
errors are having on affected taxpayers. While we recognize that the element of human error
cannot be completely eliminated, we continue to believe that IRS should sufficiently monitor
these adjustments to reduce the frequency and magnitude of such errors to the minimum
level practicable.

The complete text of IRS comments on our observations regarding internal controls over
master file data isincluded in the enclosure.

ReceiDt and Refund Transactions Continue         to Be
Comminded in General Ledger Accounts

A basic purpose of general ledger accounts is to group and summarize similar transactions by
type for financial reporting purposes. Recording similar transactions in the proper accounts
is essential to facilitate preparation of fmancial statements and to minimize the risk of

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 B-28267 1

 We previously reported several instances where IRS recorded different types of transactions
 in the same general ledger accounts9 In our fiscal year 1998 audit, we found that this
 condition continued to exist. Specifically, IRS continued to use (1) revenue and refund
 accounts to record noncash revenue and refund adjustments, (2) refund accounts to record
 revenue transactions, and (3) a refund reversal” account to record revenue transactions, as
 described in the following examples.

 l          General ledger accounts 2110,2120, and 2130 are revenue accounts designated for
            recording monies collected for payment of taxes. However, IRS also recorded noncash
            revenue and refund transactions, such as excise tax credits and disbursement of excess
            Federal Insurance Contributions Act (Social Security tax) taxes, in these accounts.

  l         Accounts 5100 and 2410 were designated to record refund transactions; however, IRS
            used these accounts to record both refund and receipt transactions. IRS recorded Federal
            Agency Tax Payments and Returns (FEDTAX) receipts in account 5100 and then later
            used account 2410 to reverse the FEDTAX transactions recorded in account 5100.

     l       About $4.6 million collected by the Department of Justice as a result of court proceedings
             and transferred to IRS were commingled with refund reversal transactions in IRS general
             ledger suspense account 4970, Unapplied Refund Reversals.

     IRS commingled transactions this way because its general ledger lacks the accounts needed
     to separately record certain transactions. However, using the same general ledger accounts
     to record different and incompatible types of transactions in this fashion distorted balances in
     both revenue and nonrevenue accounts. This also delayed identifying the proper
     classification of previously unclassified transactions and clearing them from the refund
     reversal suspense account.


  In response to our fiscal year 1997 management letter, IRS indicated that it had efforts
, underway to bring IRS general ledger into conformance with U.S. Government Standard
  General Ledger. Until this goal is achieved, we continue to suggest that IRS (1) establish
  separate general ledger accounts for recording revenue and nonrevenue transactions and
  refund and refund reversal transactions, and (2) ensure that these accounts are only used to
  record the type of transactions designated.

         IRS Comments and Our Evaluation

         In its response to a draft of this letter, IRS did not specifically address our observations and
         suggestions concerning commingling transactions in certain general ledger accounts.
         However, IRS noted its ongoing efforts to develop a revenue financial reporting system that

         %ee GAO/AIMI198-21lR, September 2,1998.

         “A refund reversal is a transaction recorded to ehninate Tom a taxpayer’s account a refund previously recorded in error.

         Page 12                                                             GAO/AIMD-99-182R IRS Management Letter

IRS believes will bring its general ledger into conformance with the U.S. Standard General
Ledger. However, in the near term, this initiative will not resolve IRS problems with
commingling transactions in general ledger accounts.

The complete text of IRS comments on our observations regarding internal controls over
these general ledger accounts is included in thb enclosure.

Except for the limitations on the scope of our work on IRS principal financial statements as
described in our audit report,” we conducted our audit in accordance with generally accepted
government auditing standards and OMB Bulletin 9808.

This letter is intended for use by the management of IRS. We are sending copies to Senator
Ted Stevens, Senator Robert C. Byrd, Senator Fred Thompson, Senator Joseph I. Lieberman,
Senator William V. Roth, Senator Daniel P. Moynihan, Representative Bill Archer,
Representative Charles Rangel, Representative C.W. Bill Young, Representative David R.
Obey, Representative Dan Burton, and Representative Henry A Waxman, in their capacities
as Chairmen and Ranking Minority Members of Senate and House Committees. We are also
sending copies to the Honorable Robert E. Rubin, Secretary of the Treasury; the Honorable
Jacob 3. hew, Director, Office of Management and Budget; and other interested parties. This
letter is a matter of public record and its distribution is not limited. Consequently, copies are
available to others on request.

We acknowledge and appreciate the cooperation and assistance provided by IRS officials and
staff during our audit of IRS fiscal year 1998 financial statements. If you have any questions
or need assistance in addressing these matters, please contact me at (202) 5123406 or
Charles R. Fox, Assistant Director, at (202) 512-5261.

Sincerely yours,

 Financial Management Issues


“See GAO/AIMD99-75, March 1,1999.

Page 13                                            GAO/.AIMD-99-182RIRS Management Letter

                         Comments kom         the Internal       Revenue Service

                                              DEPARTMENT         OF THE TREASURY
                                                 INTERNAL    REVENUE       SERVICE
                                                   WASHINGTON,      D.C.   20224

            AND FINANCE

                     Mr. Jeffrey C. Steinhoff
                     Acting Assistant Comptroller General
                     U.S. General Accounting office
                     441 G. Street, N.W.
                     Washington, D.C. 20548

                         Dear Mr. Steinhofh

                     Thank you for the opportunity to respond to your draft letter titled, Management
                     -Suggested        Improvements in IRS’Accounting Procedures and Internal
                     Controls, dated May 24,1999. The Internal Revenue ‘Service (IRS) is r@%%ting
                     that our response be included in the final report.

                     In reviewing the draft letter, we have noted your comments which suggest the
                     potential for improved internal controls and accounting procedures. While the
                     IRS agrees with several of GAO’s observations, we do take exception to the .
                     comments regarding FMFIA, Key Performance Indicators. and Master File Data.
                     The following will provide substance to IRS’ position:


                     Regarding the issues raised by GAO within FMFIA. the IRS believes it has
                     provided sufficient documentation on the issues known about for timely inclusion
                     in the FY 1998 Assurance Statement. The IRS provided this information to GAO
                     and the Treasury Department, including information on sign’ficant control
                     deficiencies, which are not officially a part of the Annual Assurance Statement.
                     As GAO points out, the significance of some of these issues were not identified
                     until January 1999. Therefore, the IRS did not have the opportunity to address
                     these in it’s FY 1998 report On these issues, based on an agreement with GAO,
                     the IRS documented in the FY 1998 Assurance Statement actions the Service
                     would take in FY 1999, assuring full disclosure under FMFIA

                     In each of the issues raised by GAO, IRS:

                     l      Accepted the GAO recommendations and implemented them during FY 1998,
                            thereby eliminating the’need to dedare a material weakness (Rx&e Tax

                     0      Declared a significant control deficiency in FY 1998and provided the
                            corrective action plan to GAO and the Treasury Department. (Supporting
                            Documentation for Unpaid Assessments). We understand GAO believes this
                            is a material weakness and the IRS is reconsidering it;

14                                                      GAO/AlMD-9!+182R IRS Management Letter


                 l   Declared a material weakness in N 1999 based on the FY 1998 Financial
                     Statement Audit. (Support For Non Payroll Operating Expenses,
                     Reconciliation of Fund Balances with Treasury, and Lack of Subsidiary
                     Ledgers for Accounts Payable and Undelivered Orders - to be addressed by
                     IRS Administrative Accounts Material Weakness;and Controls Over Refunds
                     and Earned Income Tax Credits - to be addressed by Filing Fraud in EITC
                     Material Weakness); and

             l       Addressed, or will address GAO recommendations within existing action
                     plans previously provided to GAO and the TreasuryDepartment as part of the
                     FY 7998 Assurance Statement (Control Over Taxpayer Receipts and
                     Taxpayer Data - addressed by Service Center Security, District Office
                     Security, and Gther Facitii - Type Security Material Weaknesses; and
                     Recruitment, Background and Security Investigations Significant Control

            We fully agree with GAO’s suggestion that FMFIA officialsmeet with GAO to
            keep us informed of issues identified during the audit process. This will allow us
            to address issues earlier than we have in the,past.

            Key Performance Indicators (KPl’s)

            The IRS believes that the deficiencies characterized by GAO in the IRS’ MD&A
            preparation are a resutt of their interpretation of the issues. From an IRS
            operational perspective, all KPl’s were calculated in a manner consistent with
            those contained in the IRS StrategicPlan through 2002 (published
            September 30,1997), and were subsequently reappmved by Treasury’s Office of
            Strategic Planning on August 4,1998. As GAO acknowledges, the IRS
            completed the Statement of Net Cost for the first time in FY 1998. Previously, it
            had not been a federal reporting requirement and therefore was not considered
            as a data source for KPI calculations.

            The recalculation of prior year results for comparability to current fiscal year
            when the KPt formula had changed was completed and documented by the IRS,
            where appropriate. Although the IRS had made revisions to its KPl’s based on
            valid and agreed to GAO informal observations, the issues discussed in this area
            were not disclosed until the IRS Annual Report was completed. Enhanced
            IRS/GAO cqmmunkzations should preclude thii from reoccurring.

            As GAO acknowledges, the IRS has prepared policies and procadures that
            govern the preparation and review of KPI results. In all cases, FY 1998 KPI work
            papers were signed and dated (to evidence review and approval) by the
            preparer, the preparer’s supervisor, and the annual report preparer. Only in
            cases where GAO dealt directly with IRS staff and requested supplemental
            material was there variation to this preparationand reviewprocess.

15                                            GAO/AIMD99-182R IRS Management Letter


            Master File Data Inaccuracies

            It is the IRS’ goal to provide the best possible service to taxpayers but the
            recommendation that IRS managers review all adjustments to taxpayer accounts
            is not feasible. Currently, the Service Center performs a quality review of several
            million adjustment inputs to taxpayer accounts to determine their accuracy. The
            cost of reviewing all adjustments and the impact on both the Service and
            taxpayers does not warrant implementing this suggestion. For the IRS, the cost
            would be additional staffing, dramatic increases in Adjustments/Correspondence
            Branches inventory levels (currently at highest levels since 1985). addiional
            interest paid on delayed refunds to taxpayers, and decreases in taxpayer
            satisfaction. tt would take longer to get answers to questions and to receive
            refunds, negatively impacting on taxpayers. In implementing this suggestion, we
            would still not eliminate the human error factor.

            Receipt and Refund Transactions Continue to be Commingled in General
            Ledger Accounts

            Finally, the IRS would like to update GAO on our progress in addressing the
            issue of commingling receipt and refund transactions in the general ledger. The
            IRS has wmpleted business user requirements and is developing a revenue
            financial reporting system (called the Financial Reporting Release). Th&.system
            will enable us to comply with the Federal Financial Management Improvement
            Act of 1996, JFMIP Core Financial System Requirements, and OMB Circular
            Number A-127 titled, Financial Management Systems, by using the U.S.
            Standard General Ledger and providing an audit trail to transactions at the
            detailed level. Currently, Senior Executiies within the IRS are evaluating thii
            system and its w&/benefits     to determine if it is still the most effective
            methodology to support the Service’s efforts related to modernization and
            implementing the Restructuring and Reform Act of 1998.

            We appreciate the input provided by GAO and will continue to work with you to
            consider and address each of your suggestions and take the necessa ry steps to
            implement appropriate improvements.


 16                                          GAO/AIMD-99-182R IRS Management Letter
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